Shaken, But Not Stirred; Initiate BUY

• After a forgettable 2017 marked by the impact of regulation and other adverse market factors that affected a number of its divisions, we believe Japfa is on a recovery path and see FY18E-20E profit back up to USD89-116m levels from USD16m in FY17.
• Its integrated industrialised farming model across multiple proteins and geographies in Asia should make it a long-term winner from the secular trend of rising protein consumption in Asia’s growing middle class. Around 70% of our FY18E EBIT forecast is derived from the relatively stable animal feed and dairy segments.
• Japfa currently trades at 9x FY18E P/E while our SOTP based Target Price of SGD0.86 implies 14x FY18E P/E, a 13% discount to peers’ 16x.

Company Profile

Japfa has grown from a single poultry feed mill in Indonesia started in 1975 to a leading pan-Asian agri-food company operating in six countries. A diversification strategy into new geographies and other proteins over the years allowed it to tap new growth opportunities and revenues streams while mitigating single market / protein risk that the company originally faced (for example the proportion of non-Indonesia grew from 18% in FY13 to 26% in FY17).

Today, Japfa is one of the largest industrialised agri-food companies that produce multi animal proteins. Its business is vertically integrated across the value chain: animal feed production, breeding and commercial farming.

Japfa’s primary animal proteins are poultry, swine and dairy. It is the second-largest feed producer in Indonesia and the largest milk producer in China. 

The holding company, listed on the Singapore Exchange, holds a 52% stake in the Indonesia- based PT Japfa Comfeed Indonesia TBK and 100% stake in the dairy, APO (Animal Protein Others) and consumer food segments.

Investment Summary

Japfa is one of Asia’s largest industrialised agri-food companies vertically integrated across the value chain from animal feed production, breeding, commercial farming to consumer food. Its main animal protein products are in poultry, swine and dairy (with a much smaller presence in beef and aquaculture).

It operates in the six countries of Indonesia, China, Vietnam, Myanmar, India and Singapore where the first three account for the lion’s share of revenues. It is one of the leading poultry players in Indonesia and is the most efficient milk producer in China.

Japfa’s operational reporting is by along the four following segments:

• PT Japfa Comfeed Indonesia TBK (PT Japfa TBK; JPFA:Indonesia): Indonesian listed subsidiary with c85-90% of profits from poultry farming and the balance from cattle farming and aquaculture.
• Dairy: Dairy cattle farming for raw milk production in China, Indonesia and branded milk in Indonesia.
• APO: Other animal protein comprising of swine and poultry farming in Vietnam, Myanmar and India.
• Consumer food: Branded, ready-to-eat consumer products in Indonesia and Vietnam.

Supportive secular protein consumption growth tailwinds

Japfa operates in some of the most populous emerging economies in Asia that cumulatively house around three billion people or c40% of the world population. According to Organisation for Economic Co-operation and Development (OECD), levels of meat consumption in these markets, while growing fast, are still far below levels witnessed in developed markets and global averages (for example Indonesia’s annual meat consumption in 2016 was only 11kg/capita vs. the global average of 34kg/capita).

The economies are also growing fast - the International Monetary Fund (IMF) forecasts per capita GDP growth in Japfa’s key markets ex-China at 5.9-8.7% CAGR in 2017-2023E, higher than the global average of 5.1%.

OECD expects meat consumption in these markets to continue to grow at a high 11-13% CAGR in 2016-2016 as overwhelmingly carbohydrate-based diets characteristically witness protein substitution with rising disposable incomes and a growing pool of middle-income families.

FY18E should be a turnaround year

We expect FY18E earnings to revert back to 2015 levels, in the absence of the various ‘one-off’ of FY17, such as:

• The significant USD34m loss for APO was due to a plunge in Vietnam swine prices, which fell below production cost due to China’s import ban that came into effect in 4Q16. The market supply has since adjusted to the new norm as evidenced by recovering pork prices in 1Q18 and we expect the segment to post a USD10m profit this year.
• Indonesian poultry growth is also expected to normalise from an overall weak consumption year in 2017 supported by the recovery in coal and crude oil prices and relative stability in CPO, sectors that that employ a material proportion of low to middle income families. The government directed parent-stock culling in mid-2017 has also helped adjust supply levels. Also, the Government’s minimum wage hike of c8.1% in 2018 for the provinces should provide households some incremental spending power (food accounts for over 50% of Indonesian consumer spending).
• PT Japfa TBK took a one-off charge of USD10m in FY17 for VAT provision adjustments; management indicate this is non-recurring in nature.

An underappreciated business model

We believe the market has yet to fully understand and appreciate Japfa’s diversified business model due to a number of factors:

1. The business is quite complex with multiple proteins and countries;
2. The stock is thinly covered by the street;
3. It has a fairly short listing history (since Aug-2014) and hence an insufficient track record to demonstrate to the market the ability to recover from downturns; and
4. The short track record of earnings has also been volatile for various reasons (details below).

While Japfa has a short listing history and track record, its subsidiary, PT Japfa Tbk, which accounts for 70% and 58% of our FY18E revenue and core profit forecast has been listed since the early 1990’s.

Looking at its financial performance for the past 15 years, we observe characteristics that suggest the core underlying business is likely a lot less volatile than what the market perceives due to Japfa’s relatively short listing history:

• PT Japfa Tbk’s revenue/EBITDA/operating profit grew at a 15%/23%/32% CAGR for FY03-FY17. Importantly, in terms of gauging growth consistency, all three metrics posted y-o-y growth for 12 of these years;
• Net profits grew at a lower 14% CAGR over the same period with y-o-y growth delivery for eight of the years. Apart from some small one-off items, the material components responsible for driving profit swings were non-operating and non-cash in nature, such as mark-to-market currency translation gains or losses arising from multi-currency operations and revaluation of biological assets (IFRS13 treatment for agricultural asset valuations in effect from 1 Jan 2013).

We also highlight the animal feed business (for poultry, cattle, swine) that accounts for over 40% of profits is the backbone of its business model insulating its operating profit from market gyrations in protein ASPs. This is evidenced by relatively stable feed margins with quarterly fluctuations that range largely within +/-2% around the c14% average seen since 2010. This is despite significantly higher volatility in feed raw material input prices (corn, soybean meal) and the USD/IDR F/X rates (as some of these inputs are imported) over this period. Management states this is because feed raw materials, principally corn and soybean meal are tradable commodities with long shelf lives, which enables it to price through the cycles as there is no urgency to reduce inventories.

Also animal feed production is a much higher entry barrier business requiring technology and capital, and hence does not face supply competition from the unorganised sector of small scale farmers.

Valuation Holds Upside Headroom

We value Japfa on a sum-of–parts based on ascribed EBITDA multiples for its business segments of:

1. PT Japfa TBK;
2. Dairy; and
3. APO and Consumer.

Our target price after incorporating a 10% holding company discount is SGD0.86 which implies 14x FY18E P/E, a modest 12% discount to the peer average.

Japfa is currently trading at 9x FY18E P/E, a significant discount of 44% to peers in the market and a 25% discount to its 52% owned subsidiary, PT Japfa TBK. 

We believe the market has yet to fully understand and appreciate Japfa’s diversified business model due to a number of factors, such as complexity of the business, thin broker coverage, fairly short listing history and short track record of earnings that we discussed in detail earlier in this report. We believe this valuation gap should narrow with the market concerns over the drag of losses of the previous year in smaller business APO and consumer food reversing and narrowing, respectively.

Overview of our SOTP methodology:

• PT Japfa TBK: Based on 6x FY19E EBITDA. This is pegged to a 33% discount to CP’s consensus FY19E EBITDA, on par with PT Japfa TBK’s 5-year P/E mean discount to CP.
• APO: based on 6x FY19E EBITDA. Similar basis as PT Japfa TBK as the Vietnam swine and other overseas poultry business also operate under the same business model as PT Japfa TBK.
• Dairy: Based on 5x FY19E EBITDA, this is pegged to China Modern Dairy’s FY19E EBITDA. It has the smallest market cap among all the dairy peers, but its milk sales volume in FY17 of 1,149m kg is more than double that of Japfa’s 480m kg.
• Consumer food: We do not ascribe any EBITDA valuation multiple for the consumer business which could hold some potential upside to our valuation. While FY17 had EBITDA losses, the segment has posted small positive EBITDA contributions in prior years FY13-16. We also do expect it to turn back into positive EBITDA in 2018E. The reason we ascribe zero value to the business is the much higher level of uncertainty in the timing of the EBITDA turnaround (as that is dependent on the behaviour of competitors).

Japfa is also trading at a stub value of just 3.1x FY18E P/E, after excluding Japfa’s 52% stake in PT Japfa’s TBK. We believe the rest of the segments are deeply undervalued as dairy and APO are both profitable segments. 

The Key Risks

Most of Japfa’s key investment risks are quite typical for most agri-food businesses, i.e. they pertain to cyclical demand-supply imbalances that affect market ASPs, the price and availability of commodity raw material inputs, market competition factors, and the wild cards of disease, regulatory change (import restrictions, tariffs and duties) and weather related operational disruptions.

The two key company specific risks in our view are

1. Japfa’s high level of gearing that is a result of a period of heavy capex and investments; and
2. the combination of numerous Asian operating currencies, some USD denominated debt and USD reporting that results in an unpredictable F/X rate impact to reported profits from both realised and unrealised translation gains or losses. 

High gearing levels that might require equity raising

Net gearing is forecast to significantly increase from 0.7x in 2017 to 1.1x in 2018E from a combination of debt taken on to finance a minority buy-out in its dairy segment and higher capex. We forecast net cashflow to be negative for 2018E.

Discussions with the company suggest that net gearing of 1.0-1.1x is around the upper threshold of what management is comfortable with and hence we believe some equity capital raising activity is likely over the next couple of years, such as through a placement, rights issue or entry of a strategic investor at the subsidiary level, etc.

Forex related risks and sensitivity

Japfa’s profits would be put at risk from a significant depreciation in the IDR, CNY and the VND against the USD (Indonesia, China and Vietnam are its largest markets), its reporting currency. Japfa’s major revenue streams are denominated in IDR, CNY and the VND, while it has debt and associated interest expense denominated in USD. Prices of some of its raw material commodity inputs are USD linked as well.

Our sensitivity analysis suggests a 10% depreciation of IDR against USD is estimated to reduce Japfa’s earnings by 2%, and vice versa, while a 10% depreciation of CNY against USD will reduce Japfa’s earnings by 5.6%, and vice versa.

Demand supply imbalances for poultry, swine and milk

A sudden drop in market demand or oversupply of Japfa’s proteins and milk would adversely affect their ASP and profitability. For instance, Japfa went through the boom and bust cycle of China’s dairy industry from 2013-2015 (driven by cheap imports flooding the market from Russia banning EU products in retaliation against sanctions) and Vietnam’s swine industry from 2015-2017 (triggered by growth in stock in 2015 followed by China’s pork import ban in late-2016).

Price and availability of corn and other feed raw materials

Raw materials (corn and soybean meal the largest components) make up 85- 90% of cost of goods sold. The prices of these raw materials are determined by the global commodity market and weather conditions.

Although Japfa typically can pass on these costs, a sudden spike could impact profitability as price-through mechanisms usually have a lag. Japfa imports raw materials, such as corn, soybean meal, feed vitamins, animal protein meal and wheat products from the US, South America, China, India, Europe, Australia and Canada.

Competition in the consumer food space

The downstream branded consumer food business in Indonesia has many established players and hence competitive intensity is generally moderate to high across various food categories. The market goes through periods of price competition and high levels of promotional activity when there are new entrants, which is what Japfa’s ambient food business faced in 2017.

Disease outbreak

Outbreak of diseases affecting livestock is a big risk for Japfa. In the past, disease outbreaks, such as the H5N1 and H7N9 strains of avian influenza in Indonesia and China in 2003 and 2013 caused significant drops in demand for poultry. In addition, these viruses could trigger the mass culling of livestock, halt production and increase the possibility of incurring significant impairment losses.

Source: Maybank Kim Eng Research - 21 Jun 2018