• At 9.4x CY20F, the market has priced in weaker Vietnam profits after the African Swine Fever (ASF) outbreak in Vietnam since 19 Feb, in our view.
• But narrower net profit growth in its Indonesia poultry business post 3Q19F, and larger-than-expected disruption in Vietnam are potential downside risks. Valuations could retrace to the -0.5 s.d. level (c.8.0x), until headwinds dissipate.
• Downgrade to REDUCE from Add with a lower SOP Target Price of S$0.63.

More Downside in the Longer Term; Downgrade to Reduce

• At current valuations, we believe the market has priced in weaker Vietnam swine profits, mainly attributable to the potential impact of ASF outbreak in Vietnam.
• Japfa’s share price could re-rate till 3Q19F on sustained Indonesia poultry margins ahead of the Lebaran season and the continual day old chick (DOC) supply shortage. However, in the longer term, potentially narrower y-o-y growth for Japfa (SGX:UD2)’s poultry business towards FY20F and larger-than-expected disruption in the Vietnam swine business could be risk factors, in our view. As such, we believe the stock could retrace to 0.5 s.d. below average mean levels.
• We lower our SOP-based Target Price to S$0.63 as we turn cautious on the stock.

African Swine Fever (ASF) Outbreak in Vietnam

• According to the PigProgress website, Vietnam’s first case of African Swine Fever (ASF) was reported on 19 Feb, in 8 households in 3 locations in Hung Yen and Thai Binh provinces, southeast of the capital of Hanoi. On 11 Mar, the PigProgress website announced that the outbreak of African Swine Fever in the north of Vietnam is spreading at a rapid pace, with the number of infected communities rising to 79. It mentioned that in total about 6.7k pigs in 10 provinces have been killed or culled to avoid further contamination, mainly in villages (i.e. no professional farms have been reported thus far).
• To recap, the most recent large outbreak of ASF was in China. It started in early Aug 18 in the Liaoning province in Northeast China. According to Rabobank’s 4Q18 quarterly report, since AFS was first reported, there were over 30 separate cases reported in eight provinces between Aug and Oct 18. It also mentioned that larger farms could be more defensive against the disease, given their heightened biosecurity measures.
• However, in Rabobank’s latest 1Q19 pork quarterly summary, it said that the ASF outbreak in large, modern farms in China has astonished the market, a sign that controlling the disease can be complicated, in our view. The World Organisation for Animal Health recently mentioned that since the first occurrence of ASF in China, 115 outbreaks have been reported in 28 different administrative divisions.
• To contain the disease, the Chinese government has put into effect transport bans on the affected regions since Aug 18. This resulted in price mismatches (live hog prices fell below breakeven levels in the northern and northeastern provinces whilst prices in hog-deficit provinces increased). The shortage of pork has resulted in some changing protein patterns whereby beef and poultry consumption has increased.
• Based on the outbreak in China, we believe that
  1. whilst industrialised farmers (like Japfa) may stand a better chance in Vietnam, there are no guarantees that they will not be affected by the disease as well;
  2. swine prices may increase or at least stay flat as the supply declines and
  3. if there is a shift in consumption to other proteins, demand for Japfa’s swine will also fall, though this could be offset by an increase in poultry demand.
• Japfa guided that none of its swine farms have been impacted to date. In its recent 4Q18 results announcement it mentioned
  1. its cost of production could increase due to the implementation of enhanced biosecurity measures,
  2. sales volume of its swine feed sold to external parties could continue to fall as the swine population in Vietnam is likely to decline with the culling of infected animals (CY18: -8.7% y-o-y as the Vietnam swine industry was impacted by China’s ban on Vietnam swine since end-CY16) and
  3. sales volume of Japfa’s fattening swine (CY18: +3.7% y-o-y) could be impacted in the event that any of its farms are directly affected by ASF.
• It is still early days, but for now we conservatively forecast Japfa’s Vietnam revenue to fall by 4.7% in FY19F, and EBIT to shrink by 47.3% as we assume lower margins of 4.4% (vs. CY18: 8.0%). Vietnam accounted for 68% of revenue and 94% of EBIT for Japfa’s Animal Protein Other segment in CY18F.

Poultry Tailwinds Could Moderate Towards FY20F

• Pt Japfa Tbk’s (Japfa’s Indonesian subsidiary) FY18 EBIT grew 63% y-o-y, driven mainly by higher average selling prices (ASP) for day old chick (DOC) and broiler poultry due to the lack of DOC supply.
• According to our Indonesian analyst, poultry supply and demand should have reached an equilibrium in 2018 (following the massive culling exercises in 2016-17) but the ban on antibiotics in poultry feed in Jan 18 resulted in an increased mortality rate and growth cycle, disrupting supply and leading to all-time high DOC and broiler prices of Rp20k and Rp5.5k, respectively, in FY18.
• Pinsar (an Indonesian poultry organisation) projects the poultry supply shortage to be worse in FY19F, with poultry supply of 3bn chicks vs. FY18’s 3.2bn. While grandparent stock (GPS) imports jumped 9% y-o-y in 2018, these DOC will likely only hatch by 3Q19F. Our Indonesian analyst expects DOC prices to continue to rise in FY19F given the growth cycle of DOC, though broiler prices could remain weak in Feb 19, before eventually inching up in Mar 19.
• The increase in DOC prices in FY19F is a boon and will catalyse Pt Japfa Tbk’s earnings throughout the Lebaran season (May 19) and at least until 3Q19F, in our view. However, supply/demand could stabilise towards CY20F as the DOCs imported in CY18 hit the market, and potentially moderate forward earnings growth. We also note that local Indonesia corn prices rose at end-CY18, which could stifle further growth in feed margins.
• We forecast PT Japfa Tbk’s FY19/20/21F EBIT to decline by 4.6%/2.5%/0.2% on the back of more conservative margins of 10.3%/9.7%/9.5% (vs. CY18: 11.0%).

Forecast Revisions

• Our lower expectations for the Vietnam swine business (-44.6% and -40.7% for FY19-20F EBIT), and the continued moderation in Indonesian poultry margins (expect margins to fall to 10.3% and 9.7% in CY19 and CY20F vs. 11% in CY18) lower our FY19 and FY20F EPS forecasts by 1.4% and 5.9%, respectively.

Valuation and Recommendation

• Japfa’s share price is down 16% from its high of S$0.84 on 21 Feb and 8% since its results announcement on 28 Feb.
• We believe the decline in the share price was due to the reports of AFS outbreak in Vietnam and Japfa’s guidance in its results announcement that its Vietnam swine business could potentially be affected by higher costs and lower swine feed volumes.

Source: CGS-CIMB Research - 13 Mar 2019