Following our recent meeting with management, we find that earnings outlook for FY18 and FY19 would be driven by stable top-line growth of between 2.0% to 5.0%. However, this may be offset by near term cost pressures from increasing raw material costs, i.e.: flour and carton packaging. Nevertheless, the group would strive to manage cost down by reducing wastages and ensuring optimal production utilisation rate. We reduce our earnings forecasts by 3.0% to 14.2% for FY18 to FY20. Downgrade our call from Buy to Sell with lower target price of RM1.12/share based on DDM valuation.

Resilient Top-line growth

Hup Seng’s FY18 top-line growth is expected to be stable YoY at 4.4%. This would be driven by strong domestic sales growth of estimated 9.8% YoY on the back of i) higher disposable income within the B40 group from generous cash allocations from the government; and ii) reduction in income tax rates by 2.0% for the M40 group tax payers in 2018. However, the strong domestic sales are expected to be partially offset by weaker export revenue, which is expected to reduce by 8.5% YoY on the back Ringgit appreciation against US Dollar in 2018. Note that ringgit appreciation has an adverse impact on the export revenue due to translation loss. We have projected that the average ringgit value to be at MYR4.05/USD for 2018, which is 24-bps stronger than 2017’s average of MYR4.29/USD.

For FY19, top-line growth is expected to be lower at 3.4% YoY to RM323.6mn underpinned by softer growth in domestic sales at 3.4% due to continuous pressure from high costs of living amongst consumers and stronger export sales growth at 3.4% mainly from translation gain. Our projections are premised on stable consumer spending in Malaysia and weaker average ringgit value at MYR4.15/USD in 2019 and 2020.

Increasing Costs Pressures

Profit margins for FY18 is expected to be stable at 14.5% level as increases in transportation costs and staff costs are likely offset by decrease in costs of skimmed-milk powder and chocolate chips on account of stronger Ringgit. Despite the weakness in crude palm oil price, the refined palm oil price to remain steady above RM3,000/tonne in 2018 due to robust demands for the soft commodity.

However, for FY19, we expect profit margin to reduce by 1.4%-pts YoY to 13.1% due to i) the surge in flour price; ii) increase in packaging and transportation costs; and as well as iii) the rise in staff cost. Based on our channel checks, flour price is expected to rise by up to 5.0% in end-2018 and this would dampen profit margin as flour accounts for roughly 25% of production costs. Meanwhile, the packaging cost, which we believe account for 20% of production cost, is also expected to increase due to rising carton prices.

Furthermore, the impending rise in petrol pump price from 2Q19 onwards, following the Budget 2019 announcement that petrol price will return to floating rate scheme, would put further pressure on profit margin. Staff cost is expected to rise in tandem with the rise in minimum wage to RM1,100/month from RM1,000/month in Malaysia. Note that Hup Seng has over 200 workers whereby we believe up to 60% of them are currently earning minimum wage in Malaysia. On a brighter note, the cost pressure would be partially mitigated by lower coarse sugar price of RM2.85/kg (previously RM2.95/kg).

Higher Capacity by FY20

Recently in Sep-2018, Hup Seng announced its plan to purchase an oven for EUR2.5mn (MYR12.1mn) from Italy. This oven is expected to increase the group’s production capacity by 15.0% from 33,000 tonnes/year. The installation is expected to complete in 4QFY19 and the commission of operation would likely begin in 1HFY20. Note that current wastage rate is up to 4.0% and the new oven is expected to reduce wastage rate down to 3.0%. We are positive on this purchase as this is in line with the group’s long-term sustainable growth objective.

Impact

We reduce our earnings forecasts by 3.0%, 14.2% and 5.7% for FY18, FY19 and FY20 respectively on the back of rising cost pressure which is expected to compress profit margin.

Recommendation

We downgrade our call from Buy to Sell with a lower target price of RM1.12/share (previously RM1.25/share) based on DDM valuation approach.

Source: TA Research - 14 Nov 2018