Monday, 14 November 2011

Poultry stocks start to hatch?

KUALA LUMPUR: Poultry companies are not the first thing that typically come to mind when someone is looking for a stock to buy. Long viewed as unexciting and small with volatile earnings, the sector has largely been shunned by investors.

Sentiment was further dented by outbreaks of bird flu. But there are good reasons to change that perception. Many poultry stocks are trading at low single digit multiples and below book value. Add an ongoing industry consolidation, the end of bird flu and rising chicken and egg prices, the bigger companies may end up much more profitable as economies of scale set in. This could well trigger a re-rating of the sector.

Over the past year, poultry-related stocks have proven to be fairly resilient compared to the general market. Many, particularly those mainly involved in egg production, have hatched some good returns despite the weak broader market, as their earnings in recent quarters have shown a marked improvement.

Using as a benchmark the FBM KLCI, which fell by 3.9% to 1,468.75 last Friday from 1,528.01 a year ago, poultry stocks have performed relatively well.

Year-to-date Huat Lai Resources Bhd has gained 45.3%, Farm’s Best Bhd (38.6%), TPC Plus Bhd (18.8%), Teo Seng Capital Bhd (14.1%), CAB Cakaran Corp Bhd (11.1%), Lay Hong Bhd (2.3%), LTKM Bhd (0.5%), QL Resources Bhd (0.3%), while Leong Hup Holdings Bhd has shed 4.2%.

Most poultry counters are trading at a low price-earnings ratio (PER), below book value and have small market capitalisations.

Seven stocks, Teo Seng, Huat Lai, Farm’s Best, CAB Cakaran, Lay Hong, Leong Hup, and LTKM are trading at single digit PER, as low as 3.35 times for Farm’s Best, while seven stocks are trading below their book values. This makes them attractively priced yet fairly defensive stocks in an uncertain market.

“It would not be surprising if they become acquisition targets,” said an industry observer, adding that they have shown good growth over the last few years and there have been increasing mergers and acquisitions in the sector.

Among the names to watch, industry observers say, are Teo Seng, Huat Lai, Lay Hong, LTKM and Farm’s Best, as these stocks are trading at low PER and price-to-book valuations (P/BV).

As economies of scale improve through expansion, M&A or improved efficiency, earnings will expand and their already low PER could decline.

Market observers think Teo Seng deserves a look as the company has an excellent profit track record, unlike many of its peers, having chalked up compound annual growth rate (CAGR) for revenue and net profit of 9.2% and 20.8% since it was listed in 2008. Despite being one of the best performing stocks within the sector, its valuations are still low with a trailing PER of 5.31 and P/BV ratio of 0.93 times.

Another poultry company to note is Huat Lai, the country’s largest egg producer, which also chalked up the largest stock performance gains among its peers. Its stock has returned 45.3% over the past year and is still trading at a low trailing PER of 3.72 and decent P/BV of 1.34 times. Although its net profit in the past five years has been shaky, many say that once its proposed acquisition of TPC goes through, synergies should smoothen things out.

Under the new parentage of QL Resources, the fourth largest egg producer, Lay Hong has a more promising outlook coupled with good earnings growth in the past few years. Although its stock returned a mere 2.3% in the past 52 weeks, its reasonable PER of 5.62 times and P/BV of 0.71 times should still appeal to investors.

Investors seeking a company with recent good growth might want to consider LTKM, the fifth largest egg producer. Its CAGR from 2007 to 2011 came to 15.2% for revenue and 31% for net profit. It was trading at a trailing PER of 5.1 times and had a P/BV of 0.63 times.

Also deserving a mention is Farm’s Best, with its diverse range of poultry-related operations and recent expansion. The stock has returned 38.6% over the year, trades at a trailing PER of only 3.35 and at half book value. It has recently entered into two sales and purchase agreements to acquire two broiler farms, which will increase its broiler production by about 6% and is expected to contribute about RM16 million in annual revenue from 1Q12 onwards.

Positive industry outlook
On a macro perspective, the poultry industry has an encouraging long-term outlook given the strong demand for its products, coupled with increasing prices and Malaysians being one of the biggest consumers of eggs in the world.

The number of table eggs produced in Malaysia has grown 49.69% from 5.72 billion in 2000 to 8.57 billion in 2010, according to data from the Federation of Livestock Farmers’ Associations of Malaysia (FLFAM).

While the annual growth of 4.12% is modest, it has outpaced the country’s population growth of about 2.02% annually.

As for egg consumption, Malaysia ranks as one of the highest globally with an average consumption per capita of 320 eggs annually, compared with 250 in the US.

The majority of eggs produced are consumed domestically, but there is also growing demand for exports, which accounted for 14% of total production in 2010, according to an article in the November 2011 edition of Poultry International. The bulk of these exports went to Singapore (63.9%), while the remaining markets include Indonesia and Hong Kong.

Despite the billions of eggs produced, producers reportedly enjoy a gross margin of only one sen an egg, on average.

According to the article, the annual ex-farm price per egg was 30 sen in 2010 with production costs running at 29 sen. This puts the value of 2010’s egg production at RM2.57 billion, but with implied gross profit of only RM85 million.

Given the slim margins, poultry players appear, since late last year, to be positioning themselves to achieve higher economies of scale through M&A.

And it is a game where the biggest and most efficient players make the money, and the smaller ones are either loss-making or being weeded out.

Indeed, the slew of recent M&A is creating some excitement in the sector, throwing the spotlight on undervalued companies and triggering consolidation exercises that may well produce stronger, more profitable and potentially exciting players.

It is also noteworthy that egg prices have been on the rise this year, especially over the last month, which should be positive for margins. According to the Federation of Livestock Farmers’ Associations of Malaysia, the price of ex-farm Grade A eggs has risen by 16.7% from 30 sen per egg in early October to 35 sen on Nov 14.

M&A galore
For a sector that’s normally quiet, there has been a relatively large number of M&A over the past year.

It started in August 2010, with QL Resources Bhd buying a 23.29% stake in Lay Hong Bhd for RM48.55 million.

Last month, Huat Lai proposed to acquire a 35.65% stake in TPC for RM8.08 million.

Interestingly, the stakes of Lay Hong and TPC were sold by the same company, London Biscuits Bhd (Lonbisco) -- a confectionery maker.

In between, there was Leong Hup Holdings (an integrated poultry operator) and Emivest Bhd (mainly involved in livestock feed), receiving an offer in November 2010, totalling RM426 million from a major shareholder, Emerging Glory Sdn Bhd, to acquire all their assets and liabilities.

According to a news report last month, Leong Hup has still not decided when it will call an EGM to deliberate on the proposed takeover, but it could likely have it in the last quarter of the year or 1Q12.

Integration: Vertical or horizontal?
Interestingly, when Lonbisco bought into Lay Hong and TPC in Nov 2006 and Feb 2010, its rationale then was to ensure an adequate, regular and continuous supply of eggs at a “controlled price” to meet its ongoing expansion plans. Lonbisco is a manufacturer of cakes and confectionery.

It did not provide a rationale for disposing of its stakes but industry observers believe that the investments did not provide effective synergies.

According to an analyst, unlike Lonbisco, Huat Lai and QL will enjoy cohesive synergies as they are acquiring companies which have similar operations to their own.

He said the companies will achieve synergies from raw material sourcing arrangements, supply chain networks and operational efficiency.

The synergy between Lonbisco and the poultry companies, he explained, may not have been that effective because eggs, although a major ingredient in London Biscuit’s products, did not account substantially for its product costs.

In contrast, the analyst said, KFC Holdings (M) Bhd is an example of a synergy that worked well. He said KFC restaurant’s main product, chicken, accounts for a large part of its product costs and is backed by the company’s fully integrated poultry operations.

KFC’s wholly-owned subsidiary, Ayamas Integrated Poultry Industry Sdn Bhd, is involved in breeder and broiler farms, hatchery, and feedmill. KFC also has wholly-owned subsidiaries that have plants for processing and further processing poultry.

KFC’s integrated poultry operations in 2010 had an inter-segment revenue of RM287.88 million, which accounted for 35% of the segment’s total revenue of RM821.28 million.

The total revenue for KFC’s integrated poultry operations has grown by 16.5% annually from 2006 to 2010.

Given that margins in the egg business are slim, it would therefore make better sense for players to merge and gain economies of scale, rather than food producers acquiring them for vertical integration.

This article appeared in The Edge Financial Daily, November 14, 2011.

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