• Dairy Farm International’s FY18 core earnings below on lower food operating profit, higher HQ costs, and lower JV/associates income.
• Final DPS of 14.5 US cts declared.
• Slash FY19-20F earnings by 16% each.
• Maintain HOLD with lower Target Price of US$8.44.

Maintain HOLD, Lower Target Price to US$8.44

• We see slower earnings growth outlook ahead as we believe DAIRY FARM INTERNATIONAL HOLDINGS LTD (SGX:D01) will take time to improve its Southeast Asian food business. In addition, HQ costs for the CEO’s newly assembled management team will also be higher going forward.
• With the food business in Southeast Asia plagued by keen competition and higher operating costs, the team has put in place a multi-year transformation plan to achieve operational efficiencies in pricing, food and service quality, store presentation, customer retention, backend supply chain etc. We believe this will take time to implement.
• For now, we do not see significant upside for Dairy Farm International’s share price until signs of green shoots start appearing for the Southeast Asia food business.

Where We Differ

• We believe Dairy Farm International’s outlook will be relatively muted on higher HQ costs along with more time needed to turnaround its Southeast Asian supermarket/hypermarket business.

Potential Catalyst

• Faster than expected earnings turnaround from food business will depend on sustained earnings recovery from the successful implementation of Dairy Farm International’s new multi-year transformation plan.

Valuation

SOTP valuation methodology.

• Our target price of US$8.44 is derived from sum-of-parts valuation methodology. We value Dairy Farm International’s core business at US$6.80 based on DCF, 20% and 18% stakes in Yonghui and RRHI based on market values at US$1.84 and US$0.35 respectively; and higher net debt at US$0.55 per share.

Key Risks to Our View

• Significant near-term earnings improvement. We believe any share price upside will be driven by sustained earnings recovery potential.
• Upside risk on the stock is faster turnaround of its Southeast Asian food business. We believe that earnings would have to improve significantly to derail our neutral bias on the stock.

What's New - FY18 Results Below; Dragged by Higher HQ Costs, and Lower JV/associates Income

FY18 core profit below:

• Dairy Farm International’s FY18 headline net profit slumped to US$92m (-77% y-o-y) as 2H18 saw net impairments, provisions, one-off costs amounting to US$332m.
• The huge write-off was largely related to restructuring charge for the Food business in Southeast Asia (goodwill and asset impairments for Giant) offset by business and property disposals (including sale of Singapore’s outlet properties for 7-Eleven).
• Core PBT (which excludes business change costs recognised in FY17 for the closure of underperforming stores and stock clearance in the Food Division) declined 6% y-o-y to US$525m, below our expectations.

Health & Beauty, and Home Furnishing lead revenue growth:

• Dairy Farm International’s FY18 revenue grew 4% y-o-y to US$11.7b, led by 16.9% y-o-y improvement from Health & Beauty (US$3b) and 10.5% y-o-y growth in Home & Furnishing sales to US$721m. Health and Beauty sales improved from the strong performance of tourists arrivals from Mainland China to Hong Kong and Macau along with better sales in South East Asia.
• IKEA sales were driven by strong SSSG in Taiwan and Indonesia, and a full year contribution of a new store in Hong Kong that opened in 4Q17.

Food business declines as supermarkets/hypermarkets disappoints:

• Food business declined 0.6% y-o-y, dragged by 2.2% y-o-y decline from the supermarket/hypermarket business (US$5.9b) offset by convenience stores’ 4.2% y-o-y growth (US$2.1b) driven by more stores in China and Hong Kong.
• Supermarkets/hypermarkets were dragged by poor sales in Southeast Asia especially Giant, while Hong Kong sales declined.

Lower operating margins on higher admin expenses:

• Gross margin outperformed at 31% (+0.6ppt) and was above our expectation of 30%. Headline operating margin was 3.7% (- 0.2ppt) on EBIT of US$431m (-3.7% y-o-y).
• Opex was higher than expected as
  1. admin expenses within support office costs (US$103m, +79% y-o-y) increased; and
  2. core food segment was dragged by lower supermarket/hypermarket operating margins (0.6%, -1.7ppt) on weaker margins in Singapore, higher store expenses in Malaysia, higher rents and labour in Hong Kong.

Weak Asean sales and rising costs led to sharp drop in Supermarket/Hypermarkets’ operating margins:

• Operating margin for Supermarkets/Hypermarkets was down by 1.7ppts to 0.6% on rising costs in markets such as Singapore, Malaysia, Macau, and Hong Kong., Convenience stores’ operating margin was up 0.6ppt to 4.2% on higher margin from own brand sales.
• Health & Beauty’s operating margin improved to 11% (+2.9ppts) due to better mix of own brand products. However, IKEA’s operating margin dipped to 9.5% (-0.9ppt), affected by currency fluctuation, higher COGS and pre-opening expenses for new stores.

Lower Yonghui contribution:

• Associates/JV profit came in at US$132m (-9% y-o-y), below expectations, dragged by weaker Yonghui’s contribution which saw losses from new retail formats, and an understated 9-month contribution as Yonghui’s Dec end quarter has yet to be announced, and higher cost of new employee incentive scheme.

Higher debt to fund acquisition of 51% stake in Rose Pharmacy:

• Net debt ratio increased from 0.36 to 0.51x as loans increased (to US$1b) to fund the acquisition of the remaining 51% interest in Rose Pharmacy, while cash balances dipped slightly to US$296m affected by this acquisition.

DPS unchanged:

• Final DPS of 14.5 US cts was in line with estimates and the same as last year, bringing total DPS to 21 US cts.

Kitchen Sinking Giant, Long Term Transformation Taking Place

Writing-off part of Giant in South East Asia:

• Net write-offs and impairments of US$332m were largely due to store closures and reduction in goodwill of Giant. While the huge write-off was seen in the P&L, cashflows remain unaffected. Operating cashflow generated remained strong at over US$640m, supporting an unchanged full year DPS of 21 UScts despite the poor headline profit.
• We believe the kitchen sinking exercise will help to rebase and lower headline earnings such that it will be easier to register earnings growth in the coming years.

Long term transformation taking place.

• Dairy Farm International has now completed its strategic review and also put in place a new management team, which will embark on a multi-year transformation plan. The strategic review concluded that Southeast Asia Food was not viable in its current form. This has also led to asset and goodwill impairment at Giant particularly in Malaysia, Indonesia and Singapore. The Southeast Asia food business is facing challenges from rising costs and keen competition.
• There is further room to improve through operational efficiencies through pricing, food and service quality, store presentation, customer retention, backend supply chain etc.

Immediate plan focuses on building a strong base.

• The multi-year transformation plan’s strategic priorities are
  1. Grow in China;
  2. Maintain Strength in Hong Kong;
  3. Revitalise Southeast Asia;
  4. Build Capability; and
  5. Drive Digital Innovation.
• The initial stage focuses on building a strong leadership team, define its store brand customer proposition by sector and country, end-to-end supply chain review, implement plans to leverage scale, improve IT infrastructure & digital capability, align resource to business challenges, and establish cultural values. The plans outlined include phases two and three will take more than 5 years to implement, achieve and realise benefits.

Not expecting quick fixes from the multi-year programme.

• The “multi-year transformation” should give management time to fix the food business in Southeast Asia. However, we believe earnings growth visibility in the immediate term may be clouded by higher staff costs and continued challenges in the Giant operations.

Cut FY19-20F earnings by 16% each:

• We expect higher operating costs and lower operating margins going forward. Dairy Farm International hired a new leadership team including supply chain, HR, a Southeast Asia CEO, a Chief Digital Officer, Property Director and a Chief Customer officer in FY18, to help execute the turnaround. These staff costs will impact HQ costs in FY19- 20F.
• We also see Supermarkets/hypermarkets’ operating margins staying muted as investment is poured into the business for a better supply chain, back end infrastructure and support. As such, we anticipate operating margins to trend lower going forward.
• We believe most of the write-offs have been made and should be significantly lesser ahead if any.

Maintain HOLD, with lower SOTP based Target Price of S$8.44:

• Following the earnings cut, Target Price is reduced to S$8.44 accordingly.
• We see limited upside going forward due to subdued growth as core operating profit was both lower y-o-y, which disappointed. As implementing the transformation programme may take a few years, we will turn positive when signs of green shoots start appearing for the Southeast Asia food business.
• Maintain HOLD.

Source: DBS Research - 04 Mar 2019