This article first appeared in The Edge Financial Daily, on November 17, 2015.

Stability In Consumer F&B

HAVING looked at the instant coffee sector, we now turn to the dairy industry in our last piece of the F&B series. The three leading players in Malaysia’s dairy industry are Nestle Malaysia Bhd ( Valuation: 1.50, Fundamental: 1.35), Fraser & Neave Holdings Bhd, and Dutch Lady Milk Industries Bhd ( Valuation: 1.50, Fundamental: 2.30).

These companies are principally domestic-oriented. In FY2014, Nestle and F&N derived 79% and 61% of total sales from the local market, respectively, while Dutch Lady generated most of its earnings within Malaysia.

Despite moderating private consumption growth, dairy manufacturers are less susceptible to economic cycles, thanks to a strong captive domestic market and relatively inelastic demand. Positively, milk powder prices, which have hit multi-year lows amid the global commodities rout, have helped to boost bottom line and margins — offsetting the negative impact of the weak ringgit.

Indeed, in the latest earnings releases, dairy businesses reported an expansion of margin on the back of modest growth in sales (see table 1). In an extreme case, F&N’s dairies division recently reported a staggering 158.5% jump in operating profit, compared with the modest 8.8% increase in sales.

With low beta and stable dividend income (see table 2), these stocks offer relative stability in an increasingly volatile stock market. All have a good track record of paying dividends on the back of steady operating cash flows. Dutch Lady sports the highest dividend yield at 4.6%.

Compared to REIT, utility, tobacco and other non-cyclical sectors, the local dairy sector provides better long-term earnings growth potential, driven by the country’s economic and population growth as well as shifting consumer preference to more convenient and healthy food.

Moreover, their margins are protected by strong economic moats. There are high barriers to entry such as huge upfront capital outlay, time to build brand trust and market share.

Case in point, although we saw F&B packaging companies Can-One Bhd ( Valuation: 1.80, Fundamental: 1.10) and Johore Tin Bhd ( Valuation: 1.40, Fundamental: 1.00) moving upstream to dairy products manufacturing, they largely operate in lower margin canned milk product segment with most of their products exported to other Asian and African countries.

To put things into perspective, Nestle, F&N and Dutch Lady reported steady growth between FY2005 and FY2014 and recovered swiftly from the 2008 global financial crisis. Notably, in the past 10 years, earnings growth have outpaced revenue growth — boosted by economies of scale, better sales mix, and continuous product innovation.

Of the three leading players, we pick Dutch Lady as our preferred exposure to the still expanding local dairy industry, given its comparatively higher dividend yield and favourable growth prospects.

The company, the smallest amongst the three, grew at a faster clip compared to its bigger peers Nestle and F&N (see table 3). Revenue increased at a CAGR of 9% while net profit expanded by a quicker pace of 17%.