We initiate coverage on Dairy Farm with a contrarian BUY rating and a  DCF-derived  TP  of  USD11.20,  representing  a  19%  upside.  We believe  the  growth  of  modern  retailing  is  at  an  inflection  point  in several  ASEAN  markets.  In  China,  the  market  is  still  fragmented, with  opportunities  to  consolidate  market  share.  Dairy  Farm  is  an excellent play on these themes, given its unrivalled scale. 

Asia's  bellwether  retail  stock.  Dairy  Farm  has  a  diversified  portfolio, with mature market cash cows providing stability against emerging Asiangrowth markets such as Indonesia and the Philippines. It has leadership positions  across  most  of  its  businesses.  With  its  scale  and  balance sheet,  we  believe  the  company  can  not  only  withstand  intensifyingcompetition but also emerge stronger from it.  

Recent reorganisation could boost  efficiency. We are positive on therecent  refreshing  of  its  management  team  and  reorganisation.  The company will now be managed firstly by business formats, rather than by geography.  By  leveraging  on  its  scale  across  various  markets,  we believe  that  the  company  may  reap  more  synergies  through  its  supply chains and branding.  

Appetite  for  China  may  have  returned.  Dairy  Farm's  expansion  into China has been relatively  subdued  over the years, likely due to Jardine Matheson Group's  (JM SP, NR)  history as a foreign  "Hong"  (business). In Aug 2014, the company announced its biggest merger and acquisition (M&A)  to date, taking a 20% stake  in Yonghui Superstores (601933 CH, NR) for USD925m. We believe this move may herald further expansionin China, which still remains a relatively fragmented market with  growth opportunities.  

Initiate  coverage with  a  contrarian  BUY  call.  Our  DCF-based  TP  of USD11.20  implies  a  26.5x  FY15F  P/E.  We  expect  a  3-year  net  profit CAGR of 10.6% from FY14-16F.  Although  growth is steady rather than spectacular, the stock deserves a premium for its  size  and  outstandingtrack record.  

Key  risk  is  a  depreciation  of  regional  currencies  against  the  reporting currency USD, although this is mitigated by around 40% of its revenue from Hong Kong.

Asia's bellwether retail stock.  Dairy Farm is one of the largest retailers  in Asia exJapan, and has diversified exposure to  the region through several formats, including supermarkets,  hypermarkets,  convenience  stores,  health  and  beauty  stores,  home furnishing  and  restaurants.  Its  revenue  is  mostly  stable  and  defensive  in  nature, serving the basic needs of the  population. The company has leadership positions in most  of  its  businesses  and  operates  many  well-known  retail  brands  including Wellcome, Mannings, Giant and Cold Storage.

Excellent exposure to emerging Asian  markets.  We like Dairy Farm's diversified portfolio, with  mature markets serving as cash  cows while the company grows into emerging  Asian  markets.  In  particular,  we  see  significant  growth  potential  over  thenext  three years in China, Indonesia and the Philippines  -  markets which will  likely benefit from the structural growth of modern grocery retailing. With deep pockets to invest  both  organically  and  inorganically,  the  company  is  able  to  hold  its  ground against intensifying competition and take a longer-term view.

Recent reorganisation may  improve efficiency.  We are positive on Dairy Farm's refreshing  its  management  team  and  reorganisation.  Instead  of  a  geographicallyorganised  company,  Dairy  Farm  is  now  managed  by  business  formats  (health  and beauty, supermarkets and convenience stores). The aim is to  reap  synergies across its  supply chains and have a more consistent branding across countries. We belie ve Dairy Farm is now more ready to leverage on its considerable scale. 

Outstanding growth track record  may  continue.  Dairy Farm has a track  record of resilient  growth  through the cycles. We  expect  a  sales  CAGR  of  6.5% over  FY14-16F,  driven by  store count expansion  and  incremental increases in sales per outlet. 

Its recurring net profit CAGR of 10.6% over the same period will  likely  be boosted by margin  improvements  and  contribution  from  the  new  20%-owned  China  associate Yonghui Superstores. This record USD925m investment is a signal  that  Dairy Farm's appetite for China may have returned, which could lead to upside growth surprise.Initiate  coverage  with  a  contrarian  BUY  call.  Our  DCF-based  TP  of  USD11.20 implies  a  26.5x  FY15F  P/E.  While  growth  is  likely  to  be  steady  rather  than spectacular,  we  believe  the  company  deserves  a  premium  for  its  size,  defensive business nature and ability to generate cash flow to reward its shareholders. Key risk is a depreciation of regional currencies against  the  reporting currency USD. Around 40% of sales are derived from the  Hong Kong  market, where currency is pegged to the USD.

Key Risks
Escalating operating costs in mature markets. Dairy Farm is mainly a fast-moving consumer  goods  (FMCG)  retailer,  which  relies  on  high  volume  turnover  to  offset inherently low, stable  margins. For example, its  operating and net recurring margins have been  around  5-6% and 4.5-5.3% respectively in the last five years. Escalating operating costs, in the form of rental and human resources, may subject the company to short-term cost pressures, which  could  take some time to pass through. This may hurt profitability, especially in more mature markets where  growth is too moribund to offset higher costs.

Depreciation of regional currencies against USD.  Dairy Farm reports in  the  USDand  is  being  based  in  Hong  Kong,  its  headquarter  costs  are  HKD-denominated (pegged  to  the  USD).  We  estimate  around  40%  of  its  revenue  is  derived  from  the Hong Kong  market, with other major revenue currencies being  SGD,  MYR, IDR and TWD.  A  depreciation  of  these  regional  currencies  will  translate  into  lower  USD profitability.
Price wars in the face of  intensifying  competition.  In the FMCG retailing space, competitors  tend  to  sell  a  similar  range  of  products,  with  limited  room  for  product differentiation.  Instead,  retailers  value-add  through  customer  loyalty  programmes, exclusive house brands retail experience and better store locations. Scale and pricing strategy is also a key component. W hile competition is generally rational, especially in  mature  markets,  price  wars  do  erupt  from  time  to  time,  as  competitors  or  new entrants  seek  to  increase  market  share.  Such  price  wars  could  compress  margins temporarily.

Regulatory  changes.  Dairy  Farm  is  considered  a  foreign  operator  in  most  of  its markets outside Hong Kong, and hence  is subject  to policy risks. In many emerging ASEAN markets such as Indonesia and Vietnam,  government regulations may be a barrier  aimed  at  protecting  domestic  operators  or  traditional  retailers.  A  change  in policy  or  government  stance  may  be  detrimental  to  Dairy  Farm's  operations  and could prevent the company from achieving its optimal efficiency and profit.

Valuation
DCF-based TP of USD11.20.  Dairy Farm's business is defensive in nature, and the company has a diversified portfolio which will likely help it grow over business cycles.Therefore,  we  believe  DCF  is  the  most  appropriate  valuation  methodology  for  this stock. We initiate coverage on Dairy Farm, with our TP of USD11.20, implying a 19% upside from the current share price.

Deserves  a  premium.  Our  TP  implies  a  26.5x  FY15F  P/E  and  18.2x  FY15F EV/EBITDA. We expect Dairy Farm  to show a 3-year net profit CAGR of 10.6% from FY14-16F. Our TP-implied P/E valuation implies about a 10% premium to its regional peers' average of 23.7x FY15F P/E and 14.5x FY14F EV/EBITDA. However,  we  believe  Dairy  Farm  deserves  the  premium  given  its:  i)  substantially 
bigger size, ii) defensive business nature, and iii) diversified portfolio.

Asia's bellwether retail stock.  Dairy Farm is one of the largest retailers  in Asia-ex Japan,  and  has  diversified  exposure  to  the  region  through  several  formats.  The company  is  a  pioneer  of  modern  retailing  in  the  region  and  benefits  from  the structural  shift  away  from  traditional  retailing.  Its  main  businesses  include  grocery food  retailing  (supermarkets,  hypermarkets  and  convenience  stores),  health  andbeauty  (pharmacies),  home  furnishings  and  restaurants  -  through  its  50%-owned associate Maxim's.

Serves  basic  retailing  needs.  We  believe  a  common  theme  among  these businesses is that  its  revenue  is mostly  stable and defensive in nature, serving the basic needs of the Asian population.  Asia  will  likely  remain a key growth market over the next decade and accounts for more than half the world's population in the current year,  according  to  Euromonitor  estimats.  The  company  already  has  exposure  tomainland China, Hong Kong, Macau, Taiwan, Malaysia, Indonesia, Vietnam, Brunei, Singapore, Cambodia, the Philippines and India. Entry into new Asian markets is also possible, in our view.

 

Hong Kong
Mature  market  boosted  by  Chinese  mainland  tourists.  Hong  Kong  is  a  mature retail market, and  is  known as one of the biggest shopping destinations  in the world. Historically, its retail sales/capita (USD8,400 in 2013)  has been  one of the highest  in Asia. This is  boosted by Chinese mainland tourists, which made 17m  trips into Hong Kong in 2013.

More specifically, grocery retail sales showed a 7.1% CAGR over the last five years. Despite being considered a mature market, Euromonitor still expects grocery retailing to achieve  a 3.9%  sales  CAGR over the next five years. Hong Kong  is Dairy Farm's largest geographical market by revenue an d makes up an estimated 40% of group sales in 2013.

Source: OSK-DMG