Company Focus Guan Chong

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1 Bloomberg: GUAN MK Reuters: GNCH.KL Malaysia Equity Research PP 11272/04/2012(029344) BUY RM2.94 KLCI : 1, (Initiation coverage) Price Target : 12-Month RM 3.60 (22% upside) Potential Catalyst: Rising sales tonnage and better margins Analyst KOK Chiew Sia chiewsia@hwangdbsvickers.com.my Price Relative RM Relative Index (LHS) Relative KLCI INDEX (RHS) Forecasts and Valuation FY Dec (RM m) 2010A 2011F 2012F 2013F Turnover 1,169 1,508 1,912 2,175 EBITDA Pre-tax Profit Net Profit Net Pft (Pre Ex.) EPS (sen) EPS Pre Ex. (sen) EPS Gth Pre Ex (%) Diluted EPS (sen) Net DPS (sen) BV Per Share (sen) PE (X) FD PE Pre Ex. (X) P/Cash Flow (X) EV/EBITDA (X) Net Div Yield (%) P/Book Value (X) Net Debt/Equity (X) ROAE (%) Consensus EPS (sen): N/A N/A N/A Other Broker Recs: B: 0 S: 0 H: 0 ICB Industry : Consumer Goods ICB Sector: Food Producers Principal Business: Manufactures and sells cocoa ingredients Source of all data: Company, DBS Vickers, Bloomberg Apr 2011 Sweet temptation Global manufacturer of cocoa ingredients Capacity boost and secured orders to drive profit Buy; RM3.60 TP pegged to 10x FY12 fully diluted EPS, offering 22% upside potential Cocoa ingredients maker. (GC) manufactures and sells cocoa ingredients: cocoa butter (54% of FY10 revenue), cocoa powder/cake (43%) and cocoa liquor (3%). Exports were 92% of sales last year as it counts global chocolate manufacturers like MARS, Hershey s and Lotte as customers. Sweet spot. From 6k MT p.a. in 1990, GC had raised capacity gradually to 140k MT now to rank among the top 10 cocoa processors in the world. It is set to grow bigger when another 60k MT p.a. at its new plant in Indonesia which has the advantage of buying zero-tariff local beans is fully completed by 2Q12. Earnings visibility driven by secured sales. The Group s current 140k MT running capacity is fully taken up by customer orders, thus keeping it busy until end It normally signs forward contracts with buyers and secures cocoa bean supply simultaneously. Matching selling prices with bean costs via hedging insulates it against fluctuating cocoa prices, thus locking in margins and earnings upfront. We project 2-year net profit to expand at 16.3% CAGR to RM135.3m in FY12F. Initiate coverage with Buy call and RM3.60 TP. Our fair value is pegged to 10x target PE, using fully diluted FY12F EPS. This is a steep discount to DBSV s 15x FY11/12 PE accorded to Singapore-listed Petra Food, its nearest peer. GC is an under-researched counter. We like it because its market cap (RM941m) is poised to expand along with strong profit growth. Potential risks to earnings are a global economic collapse (leading to customers deferring deliveries as demand falls) and disruptions to cocoa bean supply. At A Glance Issued Capital (m shrs) 320 Mkt. Cap (RMm/US$m) 941 / 314 Major Shareholders Resources Sdn 52.0 Misi Galakan Sdn Bhd (%) 8.5 LTAT (%) 5.2 Free Float (%) 30.1 Avg. Daily Vol.( 000) 719 Refer to important disclosures at the end of this report

2 The Business Model Global cocoa ingredients supplier. (GC) started its cocoa bean processing business in Pasir Gudang, Johor in 1990 with a bean grinding capacity of 6k MT p.a. It was listed on the Main Board of Bursa Malaysia in Apr Over the last 20 years, it has grown into the largest cocoa ingredients manufacturer in Malaysia (80k MT p.a.) with 36% market share of the total cocoa ingredients exports valued at RM3.2b in GC also owns a 49% stake in Carlyle Cocoa based in Delaware, USA which has a 7k MT p.a. cocoa cake pressing facility. Last year, it set foot in Indonesia (where it sources most of its cocoa bean supply from), investing a sum of RM120m to build a new plant in Batam with an annual installed capacity of 60k MT (already operational in 1Q11) and another 60k MT (to be completed by 2Q12). Today, it is ranked among the top 10 largest bean processors in the world with total grinding capacity of 140k MT versus the global industry s total of 3.5m MT. GC s cocoa ingredient products are sold under the Favorich brand. It exports c.95% of its cocoa ingredients to >60 countries via a global distribution network of >70 multinational trading companies/agents and some directly to key customers like MARS, Hershey s and Lotte. In FY10, GC s top five markets were the US (35%), Singapore (12%), Russia (9%), Holland (6%) and Monaco (5%). REVENUE AND COST DRIVERS Fig1: Revenue Breakdown by Product in FY10 Cocoa Powder, RM314m, 27% Cocoa Liquor, RM42m, 4% FY10: RM1,169m Cocoa butter and cocoa powder are the key products. GC s key products are cocoa butter (54% of FY10 turnover) and cocoa cake/ powder (43%), which are ingredients extracted from cocoa beans (Fig 1). Cocoa butter is mainly used for making premium chocolates, while cocoa cake is processed further into cocoa powder, which will then be alkalised into different grades (differentiated by colours) for the manufacturing of lower-grade chocolates and as flavourings for drinks, icing, etc. As a rule-of-thumb, each 1MT of cocoa beans input would yield about 0.8MT of cocoa liquor (in liquid form), which can be further processed into 0.35MT of cocoa butter and 0.45MT of cocoa cake/powder (Fig 2). The remaining 0.2MT is waste, comprising cocoa shells, sands and stones. There is also little obsolescence risk as cocoa beans and cocoa ingredients have a shelf life of 2-5 years. Fig 2: Cocoa Bean Extraction Process Source: Company Capturing profits margins. GC usually captures its profit margins upfront by matching selling prices with bean costs by using hedging instruments. It does this by entering into backto-back forward contracts and bean supply contracts to hedge against price movements and currency risks. From the company s perspective, there is no open position taken in the hedging process, which is entered into solely for the purpose of locking in the prices. Cocoa Cake, RM185m, 16% Cocoa Butter, RM628m, 54% Typically, GC will first negotiate sales contracts for cocoa butter for forward delivery where it agrees to sell the product in the future (normally in 3-12 months) at a selling price to be set prior to delivery (based on a formula of pre-determined butter ratio multiply by an exchange-quoted terminal price of cocoa beans). This way, both GC (seller) and its customer (buyer) will be sharing pricing risks as the transacted butter selling price will vary with the terminal price. Meanwhile, GC will almost immediately secure the quantity of beans required at a negotiated discount/premium to the same terminal price benchmark. From the revenue and costs Page 2

3 angle, this back-to-back arrangement in the physical market represents a natural hedge against volatile cocoa bean prices, hence securing its cocoa butter profit margins. There is also an option for GC to hedge using the futures market (which constitutes c.10-15% of sales, comprising mainly the small orders), especially if there is no matching contract in the physical market at a particular point in time. Next, GC will start negotiations to sell the cocoa cake/powder at spot or forward at a set price. It will then immediately lock in cocoa beans for the equivalent amount of cake/powder sold by fixing beans prices with suppliers in the physical market or entering into a paper hedge in the futures market (in which any gains / losses after closing an initial long position would be used to cover fluctuations in cocoa beans prices), thus assuring its cocoa powder profit margins as well. We illustrate below the accounting treatment of revenue and gross profit in GC s books. Example - Sell 35 MT of cocoa butter 9 months forward - Set cocoa butter price = butter ratio x terminal price - Butter ratio is determined upfront (say at 1.3x) - Buy 100 MT of cocoa beans 6 months forward - Set cocoa bean cost = terminal price less discount - Discount is determined upfront (say at USD200 per MT) - Sell 45 MT of cocoa powder 6 months forward - Cocoa powder selling price is fixed outright (say at USD4,500 per MT) - Purchase the equivalent quantity of beans and lock in cost (say at USD3,000 per MT) by hedging either in the physical or futures market - Terminal price is fixed prior to delivery (say at USD3,500 per MT) - Manufacturing cost = USD200 per MT (assumed) Accounting treatment (upon delivery) for: - Cocoa butter sales = (Tonnage x Yield) x Selling price = (100 x 0.35) x (1.3 x 3,500) = USD159,250 - Cocoa powder sales = (Tonnage x Yield) x Selling price = (100 x 0.45) x (4,500) = USD202,500 - Total revenue = USD159,250 + USD202,500 = USD361,750 - Cocoa bean cost = (Bean quantity) x (Average bean price) = 100 x [(3,300+3,000)/2)] = USD315,000 - Total cost = (Cocoa bean cost) + (Manufacturing cost) = USD315,000 + (200 x 100) = USD335,000 - Gross profit = (Total revenue) (Total cost) = USD361, ,000 = USD26,750 - Gross profit margin = (Gross profit) / (Total revenue) = 26,750 / 361,750 = 7.4% Historical price trends. The selling price of cocoa butter which is a commodity product because of its homogenous characteristics is relatively stable as it is calculated by multiplying the exchange-quoted terminal price of cocoa beans with a butter ratio (which will fluctuate to determine the end selling prices based on market forces). Since 2005, cocoa butter had been sold at US$4,000/MT US$6,000/MT (Fig 3). Fig 3: Butter Price and Butter Ratio Trend US$/MT 7,000 6,000 5,000 4,000 3,000 2,000 1, F 2012F 2013F Cocoa butter Butter Ratio Ratio (x) In contrast, cocoa powder selling prices which are set on a negotiated basis and vary according to grades, alkalised level, and customer specifications tend to lag cocoa butter price trends. Generally, it moves inversely with cocoa butter ratio (Fig 4). - Page 3

4 Fig 4: Powder Price Moves Inversely with Butter Ratio US$/MT Ratio (x) 6, , , GC has established business relationships with its regular suppliers, whom it has dealt with for 5-15 years. Its top five cocoa bean suppliers accounted for c.69% of its cocoa bean purchases (Fig 6). It sources 90% of its cocoa beans requirement from Indonesia (cheaper due to lower grades), and the remaining 10% from Africa. On average, it carries 2-3 months of cocoa bean inventory. 3,000 2,000 1, F 2012F 2013F Cocoa powder / cake Butter Ratio Yet, despite the wild swings in cocoa bean prices over the years, GC s profit margins which are usually locked in upfront had been stable in recent years (Fig 5), except in FY08, when it was hit by the global economic crisis Fig. 6: List of current suppliers ADM Cocoa Pte Ltd Olam Internation Ltd Continaf BV Touton SA Noble Cocoa SA ECOM Agroindustrial Corp Ltd ECOM Agroindustrial Asia Pte Ltd Dapsa Holdings Sdn Bhd Lim Lian Hua (Sarawak) Sdn Bhd Source: Company s Prospectus Singapore Singapore Holland France Switzerland Switzerland Singapore Malaysia Malaysia Fig 5: Cocoa Bean Price vs GC s Pretax Margin Trend (%) (US$/MT) , F 2012F 2013F 3,500 3,000 2,500 2,000 1,500 1, Pretax margin Cocoa bean price Cocoa bean is largest cost item. Cost of goods sold (COGS) is 90-93% of revenue, of which about 90% is for raw materials i.e. cocoa beans. The balance is production costs such as electricity and direct labour. It has minimal fixed costs other than staff costs (c.250 work force) and depreciation, which added up to a combined c.2% of revenue in FY10. Page 4

5 Growth Prospects Global demand growing at 2% p.a. Worldwide purchase / import volume of cocoa butter, cake and powder which are used for the manufacturing of chocolate and cocoa-based products has been growing at 2-3% p.a. European countries like Germany, France, Belgium, Holland and UK are the key importers with an estimated combined 50% market share of cocoa butter imports and 30% of cocoa cake/powder imports. USA is also a large importer of cocoa butter and cake/powder, accounting for about 10% and 20% of world purchases, respectively. Emerging markets seeing faster growth potential. Chocolate consumption had been mainly driven by the European and USA markets in the past. But we should see greater opportunities in emerging markets like Asia, where chocolate consumption is relatively lower than in developed countries. Also, the bright economic growth prospects in the region are expected to result in a growing middle and upper income population, which will demand a larger variety of chocolate products and flavours. Tapping on changing consumer preference. Changing market trends and consumer preferences are also fuelling demand for cocoa ingredients. For example, chocolate and confectionery manufacturers are introducing individuallywrapped snack-sized products as well as a larger variety of chocolate products in the form of dark chocolate, white chocolate and sugar-free chocolates. Growing outsourcing trend. GC is poised to benefit from the increasing trend of outsourcing cocoa beans grinding by major chocolate manufacturers (who normally also grind cocoa bean in-house for internal consumption) as they focus more on marketing and brand-building. Dwindling domestic competition. In Malaysia, there are currently 10 sizeable local players (Fig 7). GC is the largest cocoa bean processor with an annual output of 80k MT. The domestic industry capacity is about 300k MT, but we understand many operators are running at low utilisation rates, while some may have exited following the economic crisis in 2008/2009. Globally, the top four cocoa processors are Archer-Daniels- Midland Co (ADM), Barry Callebaut AG, Cargill (with an approximate annual capacity of k MT each) and Petra Food (370k MT). Combined, they made up c.50-60% of global cocoa processing capacity. GC is probably in the bottom half of the top 10. Fig 8 shows the world grinding capacity breakdown by country. Fig 7: Major local cocoa ingredients manufacturers Cocoahouse Sdn Bhd Delfi Cocoa (M) Sdn Bhd JB Cocoa Sdn Bhd KL-Kepong Cocoa Products Sdn Bhd Koko Budi Sdn Bhd Koko Malaysia Sdn Bhd Maestro Swiss Cocoa Sdn Bhd Majulah Koko Tawau Sdn Bhd Malaysia Cocoa Manufacturing Sdn Bhd Source: Company s IPO Prospectus Fig 8: World Grinding Capacity by Country 2009/2010 '000 MT Netherlands 400 Ivory Coast United States Germany High entry barriers. It will be highly challenging for a new player to enter the cocoa ingredients manufacturing industry and profit immediately. On top of a high start-up investment to set up a manufacturing plant (US$1m for every MT of installed capacity), it also requires management experience and technical know-how to run efficiently and generate high production yields. Size matters too, as operation efficiencies depend a lot on economies of scale. Capacity will more than double. GC s main plant in Pasir Gudang, Johor, is already running at full steam (with 80k MT p.a. bean grinding capacity). It is running 24/7 in order to maintain the optimal temperature / heat required for the processing of cocoa beans. To cater to the rising demand for cocoa ingredients, it has expanded to Batam, Indonesia with an installed production capacity of 60k MT (available in 1Q11) and an additional 60k MT (fully ready by 2Q12). Batam was chosen to be its plant location because of its proximity to bean suppliers and for cost savings purpose (given cocoa beans exports from Indonesia will be subject to duty effective from Apr 2010). 300 Malaysia 222 Brazil 170 Ghana 120 Indonesia Page 5

6 GC also has a 7k MT cake pressing plant in Delaware, USA, under 49%-owned Carlyle Cocoa Co. LLC. This plant principally caters to the end-user market in the US, importing cocoa cakes from GC to be pressed into cocoa powder before delivering to customers. Fig 9: GC's operating plants Location Capability Annual capacity Pasir Gudang, Johor Bean grinding 80,000 Batam, Indonesia^ Bean grinding 60,000 Delaware, USA Cake pressing 7,000 ^ Total grinding capacity of 120k MT by 2Q12 Source: Company Batam plant advantage. Starting April 2010, there is an export duty imposed on cocoa beans exported out of Indonesia. The government imposed this with the aim of diverting more fermented beans (or processed beans) supplies to local grinders, as well as to encourage more cocoa planting. Indonesia produces an estimated 570k MT of cocoa beans annually, the third largest in the world (the top cocoa growing country is Ivory Coast). The export duty ranges from zero to a maximum of 15%. Under the multi-tier structure, cocoa beans exports will be subject to: (a) 5% tax if US cocoa prices average US$2,000-2,750/MT; (b) 10% if prices average US$2,750-3,500/MT; and (c) 15% if prices exceed US$3,500/MT. This means that the Batam plant (90%-owned by GC) is now enjoying cost savings because it can purchase Indonesian cocoa beans at more competitive prices than its overseas peers. In addition, the semi-finished intermediate raw materials which are not subject to export tax can be sold to its Pasir Gudang plant for further processing. Page 6

7 Management & Strategy Management composition. GC is essentially a family business, founded by the Tay family who owns c.60%. The key management personnel - CEO, COO and CFO - have been with the Group for close to 20 years. They each specialise in their respective job scope, with the overall direction and strategy guided by the CEO. Tay Hoe Lian (CEO) and Tay How Tay How Sick (COO) are cousins. The CEO is the driving force behind the Group, having successfully led the Group to become the top player in the local cocoa processing industry, penetrated new markets like Europe, Middle East and South American, and expanded its product range into premium cocoa powder. Key Management Team Manager Current Appointment Previous Experience Y Bhg Dato Dr Mohamad Musa Bin Md Jamil (Year joined 2005, Age 63) Tay Hoe Lian (Year joined 1993, Age 45) Tay How Tay How Sick (Year joined 1989, Age 50) Hia Cheng (Year joined 1991, Age 44) Source: Company Executive Chairman - Responsible for strategic business planning and advises on R&D activities Managing Director & CEO Responsible for overall direction and execution of strategies of the Group Executive Director & COO - Responsible for overall operations of the Group Executive Director & CFO - Responsible for finance & trading departments which involve sourcing cocoa beans and marketing of cocoa ingredients. Director General of MCB. Has about 30 years experience in cocoa beans and products R&D, grading, and international marketing. Held various management positions in Guan Chong since graduation. Has about 18 years experience in the industry. Involved in plant operation, dealing with cocoa processing, production line set-up and machinery modification/ maintenance. Has about 22 years experience in the industry. An auditor with TH Liew & Gan for 5 years and later joined as Accounts Supervisor overseeing administration, financial and foreign currency management. Directors' Remuneration Executive Directors Non-Executive Directors Total RM RM Fees 36,000 78, ,000 Salaries & Allowances 981, ,800 Bonuses 243, ,000 EPF & SOCSO 144, ,635 ESOS - - Benefits-in-kind 109, ,983 1,593,418 Number of Directors Executive Directors Non-Executive Directors Total RM1 to RM50, RM50,001 to RM100, RM100,001 to RM150, RM150,001 to RM200, RM200,001 to RM250, RM250,001 to RM300, RM300,001 to RM350, RM350,001 to RM400, RM400,001 to RM450, RM450,001 to RM500, Source: Company IPO Prospectus Page 7

8 Segmental Forecasts Demand driven output. On the back of rising demand, GC is set to sell more cocoa ingredients. We expect sales tonnage which fell from 72k MT in FY08 to 60k MT in FY09 before recovering to 79k MT last year after the global economic downturn will climb to 118k MT this year and 150k MT the following year. Cocoa butter and cocoa powder will grow in tandem. As cocoa butter and cocoa cake/powder are co-existing byproducts that are extracted simultaneously from cocoa beans, their contributions will grow hand-in-hand. In terms of sales revenue mix, cocoa butter is projected to account for 45%-47% in FY11 and FY12 (versus FY10 s 54%), while cocoa cake/powder will contribute slightly more at 50%-52% (up from 43% last year) due to better selling prices. The balance will come from the sale of cocoa liquor/cocoa shelf. We have assumed the following average selling prices per MT: (a) cocoa butter USD5,539 and USD5,595 for FY11 and FY12 respectively; and (b) cocoa powder USD4,237 (FY11) and USD4,618 (FY12). Key risks to our forecasts are: (a) Tight bean supply Global cocoa bean supply remains tight at c.3.5m MT. This is because cocoa is a lessfavoured crop compared to palm oil and rubber trees, as it is more vulnerable to diseases and requires more effort to cultivate. Any supply disruption in cocoa beans (as the raw material) will hamper the production process of cocoa grinders like GC. Segmental Analysis (b) Contract defaults This could happen especially during the economic crisis, when customers postpone or cancel existing orders as demand plunges and bean suppliers fail to deliver the raw material due to a sudden shortage. (c) Hedging mismatch To lock in its profit margins upfront, GC will usually match the selling prices of its cocoa ingredients with bean costs by entering into (and actively managing) hedging positions either in the physical or futures market. However, an imperfect hedge could still exist due to the lagged effect (as GC tends to combine smaller sales contracts before locking in equivalent bean costs) and a mismatch of hedging contracts, particularly during economic / financial upheavals. This open exposure could make the earnings stream less predictable. In addition, there is foreign exchange (forex) exposure. GC has c.20% net exposure to foreign currency risks as nearly all receivables (since exports account for c.95% of sales) and payables (mainly for bean purchases, which constitute c.80% of revenue) are denominated in USD. There is also risk from the Group s USD borrowings (US$184.4m as of end-2010), which are used primarily to purchase cocoa beans. To constantly manage its overall exchange rate exposure, GC normally enters into forward and option currency contracts. Similarly, these hedge positions may or may not be able to fully cover its forex risks due to possible timing difference of settlements between receipts and payments in the foreign currency. FY Dec 2005A 2006A 2007A 2008A Revenues (RM m) Cocoa Butter Cocoa Cake/ Powder ,171 Others Total ,169 1,508 1,912 2,175 Key Assumptions FY Dec (RM m) 2005A 2006A 2007A 2008A Cocoa bean price 2,108 1,704 2,135 2,408 2,616 3,090 3,357 3,525 3,701 Production capacity 50,000 60,000 75,000 75,000 75,000 80, , , ,000 Sales tonnage 50,016 51,481 58,963 71,736 59,851 79, , , ,380 Page 8

9 Financials - Quarterly / Interim Performance Little seasonality effect. While consumption of cocoa-based products is typically higher during festive seasons (like Christmas), GC s sales trend has shown little seasonality effect as: (a) cocoa ingredients buyers stagger their purchases; and (b) cocoa ingredients are increasingly used in more industry applications. GC s quarterly revenue ranged from RM270m to RM332m from 1Q10 to 4Q10. They rose by between 53 and 124% yoy, mainly boosted by larger sales volume and higher average selling prices. Meanwhile, net profit per quarter was stable at RM18-20m except for 4Q10, which saw a 543% jump yoy to RM42.9m. This was also lifted by a reversal of tax provision after adjustments to tax incentive for Increased Export Allowance (of RM18.7m). Expect strong 1Q11 performance. GC s first quarter result due in May is expected to be equally robust. This is assuming maximum utilisation rate at its Pasir Gudang plant (80k MT p.a.) and maiden contribution from Batam operation (commissioned in February with initial capacity of 60k MT). Subsequent quarters earnings should be even stronger as GC gradually ramps up production at Batam. Quarterly / Interim Income Statement (RM m) FY Dec 1Q2009 2Q2009 3Q2009 4Q2009 1Q2010 2Q2010 3Q2010 4Q2010 Turnover Cost of Goods Sold Gross Profit Other Oper. (Exp)/Inc (139) (116) (154) (207) (240) (244) (268) (299) Operating Profit Other Non Oper. (Exp)/Inc Associates & JV Inc Net Interest (Exp)/Inc (2) (1) (1) (1) (1) (1) (1) (1) Exceptional Gain/(Loss) Pre-tax Profit Tax 0 (1) (2) (3) (7) (6) (9) 11 Minority Interest Net Profit Net profit bef Except EBITDA Sales Gth (%) N/A (14.6) EBITDA Gth (%) N/A (8.3) Operating Profit Gth (%) N/A (8.3) Net Profit Gth (%) N/A 1, (1.1) (8.4) Gross Margins (%) Operating Margins (%) Net Profit Margins (%) Page 9

10 Financials Income Statement Profitable track record. GC has been profitable since 1999, growing at 35.6% CAGR to register a net profit of RM100.0m in FY10. This was boosted chiefly by higher sales tonnage amidst continuous capacity expansion and better operating efficiencies. However, in FY08, net profit fell 52% yoy to RM6.8m despite a 50% increase in revenue to RM694.3m (as sales tonnage rose 21.7%) due to margins squeeze. FY10 net profit jumped 7-fold. GC had a superb year in FY10 when net profit jumped 600% yoy to RM100m from FY09 s RM14.3m with revenue hitting RM1.2b (+81.8% yoy from RM642.6m). This was lifted mainly by demand recovery following the global economic crisis (as sales volume improved 32.4% yoy to 79,243mt in FY10, after a decline of 16.6% yoy to 59,851mt in FY09) and higher average selling prices especially for cocoa powder (+80% yoy to c. US$3,500-4,000/mt). Derivative gains / losses are recurring accounting items. In the profit & loss account for FY10, the Group had disclosed that earnings was lifted by: (a) realised gain on commodity futures contracts of RM12.8m; and (b) realised gain on foreign exchange of RM16.4m. These accounting entries were related to GC s hedging positions that were entered into as part of the normal course of operating activities. Essentially, given an effective hedging strategy, any derivative gains recognised would have offset corresponding losses (which otherwise would have caused it to incur higher cocoa beans price or US$ financing cost) and vice versa. Therefore, last year s net profit jump was not inflated by the lumpy exceptional gains. As of 31 Dec 10, the outstanding contract amounts of derivative financial instruments for: (a) hedging price risk via commodity futures were RM74.3m (for sale contracts) and RM78.4m (for purchase contracts); and (b) hedging currency risk via forward forex contracts and forward currency options stood at RM168.9m (for sale contracts) and RM108.6m (for purchase contracts). For these outstanding derivative financial instruments, its accounting treatment is to mark-to-market the fair values of the contracts using the market rates at the end of each reporting period with any changes in the fair values to be recognised in the profit or loss account. As an example, last year, GC booked in: (a) a net fair value gain on financial derivatives of RM3.6m; and (b) unrealised gain on forex of RM2.8m. Expect net profit to grow 16.3% CAGR in FY We expect GC to sustain its double-digit net profit growth momentum going forward, with a projected CAGR of 16.3% to RM135.3m in FY12. This would be driven mainly by: (a) an increase in sales tonnage of 118k MT (+49% in FY11) and 150k MT (+27% in FY12) as it ramps up the production output from its new Batam plant; and (b) steady gross margins 10.9% each in FY11 and FY12 assuming firm selling prices and stable raw material costs. Based on the existing order book, both its plants in Pasir Gudang and Batam would be running at maximum capacity from now until at least end of the year. Earnings boost from tax incentive. Net profit for FY11F should continue to benefit from tax incentive of Increased Export Allowance given by the Malaysian government, which amounted to c.rm80m (being 70% of its statutory income) as effective tax rate dropped to 10% in FY10. We understand GC still has a balance of c.rm35m to be utilised this year. We have projected an effective tax rate of 19% for FY11F and 25% for FY12-13F. Fig 10: Production Tonnage (Quantity of Beans Processed) MT 200, , , , , ,000 80,000 60,000 40,000 20,000-50,000 51,500 59,000 73,225 67, F 2012F 2013F Pasir Gudang 80,400 Batam Fig 11: EBITDA yield (US$/MT) and gross margin trend (%) (%) (US$/MT) ,000 80, ,500 80, ,000 80, F 2012F 2013F EBITBA y ield (US$/mt) Gross Margin Page 10

11 Sales Trend Operating Cost Trend Profitability Trend RM m 2,000 1,500 1, Total Revenue Revenue Growth (%) (YoY) 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Other Operating Expenses (-) Cost of Goods Sold (-) RM Net Profit (After-extraordinaries) (LHS) Net Profit Growth (%) (YoY) (RHS) 610% 510% 410% 310% 210% 110% 10% FY Dec (RM m) 2005A 2006A 2007A 2008A Turnover ,169 1,508 1,912 2,175 Cost of Goods Sold (379) (347) (430) (649) (608) (1,052) (1,343) (1,704) (1,942) Gross Profit Other Opg (Exp)/Inc (10) (7) (10) (27) (9) 0 (7) (12) (16) Operating Profit Other Non Opg (Exp)/Inc Associates & JV Inc Net Interest (Exp)/Inc (4) (5) (8) (9) (6) (5) (5) (6) (4) Exceptional Gain/(Loss) Pre-tax Profit Tax (3) (3) (3) (2) (6) (11) (29) (48) (53) Minority Interest (1) 0 (5) (7) (9) Preference Dividend Net Profit Net profit before Except EBITDA Sales Gth (%) N/A (8.0) (7.4) EBITDA Gth (%) N/A (18.0) Operating Profit Gth (%) N/A 4.3 (4.0) (24.4) Net Profit Gth (%) N/A 3.1 (19.1) (52.3) Effective Tax Rate (%) Page 11

12 Financials Balance Sheet Net gearing is normally high. This is because GC s business requires large funding for the purchase of raw materials. In a standard operating cycle, GC s credit term from cocoa beans suppliers is typically shorter than the average time taken to convert the raw materials through the production process into cash. To illustrate the timing gap, last year, GC had to settle its trade payables in about 21 days, but took 67 days to move the inventory and another 32 days to collect its receivables. Consequently, GC carries a large debt in its books. But the bulk is short-term financing facilities at 94% of gross borrowings of RM205.4m as at end-fy10 that are mainly trade loans and bankers acceptances. Sitting on the corresponding side of its balance sheet is RM154.9m in inventories (comprising raw materials, work-in-progress, finished goods etc and is stated at the lower of cost and net realisable value). After taking into account RM11.9m cash balance, its net gearing was 1.1x. This should not be a major concern given its strong debt servicing ability with a high interest coverage ratio of 23.2x (on the back of a low effective interest rate of 2-3%) last year. Going forward, as its profit base grows, GC could use the rising operating cash flow to part finance its working capital requirements (which depends on market price of cocoa beans) and rely less on bank borrowings. This would translate into lower interest costs and net gearing. Breakdown of Assets (2011) Breakdown of Capital (2011) Financial Leverage & Net Debt to Equity Debtors % Inventory % Net Fixed Assets % Bank, Cash and Liquid Assets - 3.2% Common Shareholder s' Equity % LT Debt - 3.4% ST Debt % Net Debt/(Cash) Net Debt to Equity (X) (R.H.S) Financial Leverage (X) (R.H.S) FY Dec (RM m) 2005A 2006A 2007A 2008A Net Fixed Assets Invts in Assocs & JVs Other LT Assets Cash & ST Invts Inventory Debtors Other Current Assets Total Assets ST Debt Other Current Liab LT Debt Other LT Liabilities Shareholder s Equity Minority Interests Total Cap. & Liab Page 12

13 Leverage Analysis (x) Net Interest Cover EBITDA Gross Interest Cover Total Debt to EBITDA Total Debt to Total Assets Total Debt to Capital Net Debt to Equity Net Debt to Equity ex MI Capex to Debt Liquidity Analysis (x) Cash Ratio Current Ratio Quick Ratio Page 13

14 Financials Cash Flow RM120m capex for expansion in FY10-12F. GC has started construction of a new cocoa processing plant in Batam, Indonesia. The facility is estimated to cost c.rm120m, and will raise annual production capacity by 120k MT when fully completed by 2Q12. GC had spent c.rm70m in Phase 1 to add 60k MT p.a. installed capacity in Feb In our financial projections, we assumed total capex of RM130m, of which c.rm50m was recorded in FY10 and the balance RM80m would be booked in FY Cash position climbing up. Capex funding will be primarily from its internally generated cash flows. In addition, GC intends to use the incremental operating cash flows for working capital purposes (to buy cocoa beans) or pare down debt. Consequently, its cash pile will likely remain small in the near future, despite the strong earnings growth momentum. We expect its cash position to rise from RM11.9m at end- FY10 to RM19.2m by end-fy12. This does not take into account the potential conversion of 60m warrants (issued in Feb 2011 and expiring in Feb 2016), which could bring in RM120m cash proceeds upon conversion into GC shares (1-for-1 ratio at an exercise price of RM2.00 each). Cash Flow Trend Free Cash Flow Per Share Free Cash Flow As At Year End (0.09) CF from Op CF from Invt CF from Fin Free Cash Flow Per Share Free Operating Cash Flow Per Share FY Dec (RM m) 2005A 2006A 2007A 2008A Pre-Tax Profit Dep. & Amort Tax Paid (2) (1) (1) (1) (4) (6) (11) (29) (48) Assoc. & JV Inc/(loss) 0 (1) (1) Chg in Wkg.Cap. (23) (23) (17) (49) (52) (19) (32) (62) (64) Other Operating CF 0 (1) (1) 0 6 (2) Net Operating CF 1 (1) 3 (34) (22) Capital Exp.(net) (13) (16) (35) (8) (4) (51) (70) (70) (15) Other Invts.(net) Invts in Assoc. & JV Div from Assoc & JV Other Investing CF 6 (7) (35) (23) (10) Net Investing CF (7) (24) (34) (8) (4) (49) (105) (93) (25) Div Paid (8) (10) (8) (2) (7) (19) (18) (36) (41) Chg in Gross Debt (14) (23) (50) Capital Issues Other Financing CF (2) 0 (1) (1) Net Financing CF (42) (8) (26) (91) Currency Adjustments 9 (3) (2) 2 Chg in Cash Page 14

15 Financials ROE Drivers Margins drove up ROE. GC saw its ROEs dropped from 29.3% in FY05 to a low of 7% in FY08, before rebounding to 14.4% in FY09. This was due to falling net margins. In FY10, ROE jumped to 69.7% as net margin improved by 6.3 ppt to 8.6%, predominantly driven by larger sales volume and higher average selling prices for cocoa powder. ROAE / ROAA Trend (%) Margin Trend (%) Total Debt & Gross Interest Cover 73.0% 63.0% 53.0% 43.0% 33.0% 23.0% 13.0% 3.0% Ret on Avg Equity (ROAE) % Ret on Avg Assets (ROAA) % 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% EBITDA Margin % EBIT Margin % Net Income Margin % x 43.9x 38.9x 33.9x 28.9x 23.9x 18.9x 13.9x 8.9x 3.9x Total Debt (+) Gross Interest Cover (X) (YoY) FY Dec 2005A 2006A 2007A 2008A Profitability Ratios Sales Growth (%) N/A (8.0) (7.4) Gross Margin (%) Operating Margin (%) Net Profit Margin (%) ROAE (%) ROA (%) ROCE (%) Activity Ratios Debtors Turn (average days) Creditors Turn (average days) Inventory Turn (average days) Total Asset Turnover (x) Fixed Asset Turnover (x) Page 15

16 Valuation Initiate coverage with BUY rating. We initiate coverage on GC with a BUY rating and RM3.60 target price pegged to a 10x FY12 fully diluted EPS of 36.1 sen. The steep discount to DBSV s benchmark valuation of 15x for its closest peer, Singapore-listed Petra Food, is due to GC s smaller market capitalisation, plant capacity, as well as revenue and earnings base (see Fig. 12 for peer comparison table). GC s share price has surged from RM0.42 a year ago to RM2.94 currently. Despite this, the stock is still attractive, trading at undemanding FY12 fully diluted PE of 8.3x versus Petra Food s 14.4x (PETRA SP; Hold). Interestingly, listed plantation-based conglomerate Kuala Lumpur Kepong (KLK) has just announced the disposal of its balance 40% stake in Barry Callebaut Malaysia (BCM) for RM117.7m. BCM a member of Barry Callebaut Group (BCG) is a manufacturer of cocoa liquor, butter and powder with an annual capacity of 70k MT for cocoa products and 10k MT for chocolate compounds in Malaysia. The deal was undertaken pursuant to an agreement that: (a) KLK may exercise a put option to require BCG to acquire the remaining 40% shares in BCM for RM117.7m (inclusive of working capital); and (b) BCG may also exercise a call option to require KLK to sell the remaining 40% shares in BCM based on 9x audited average EBITDA (of the 3 preceding financial years) plus cash minus all interest bearing debts at that point in time. Using the simple EBITDA multiple as a ballpark valuation benchmark, GC s rating of 7.6x FY10 EBITDA appears comparatively cheap at the current share price. Investment merits. On top of its attractive valuations, we like GC because it is a fast-growing global cocoa ingredients manufacturer. Its annual capacity will jump to 200k MT by 2Q12 while earnings will expand at 2-year CAGR of 16.3%. We predict GC s market capitalisation (RM941m currently) will increase going forward, to reflect this exciting growth potential. Incremental returns from dividends. GC may be contemplating a fixed dividend policy to reward shareholders with a visible and sustainable dividend income stream. It paid 7.6 sen net DPS or 18.3% of net profit last year. Assuming 30% dividend payout, our forecast DPS would be 11.1 sen (FY11) and 12.7 sen (FY12), which translate into 3.8% and 4.3% net dividend yields, respectively. Fig12: Peer valuation Company FYE Price Mkt cap PE Div Yield CAGR Net gearing ROE (local) (US$ m) FY10A FY11F FY12F FY13F FY11F FY12F FY10-12F (%) (%) Archer-Daniels-Midland Jun , Barry Callebaut AG Aug , Petra Foods Ltd Dec Dec Average ex GC Source: Bloomberg, DBS Vickers Fig 13: Peer comparison Company Revenue (US$m) Pretax margin (%) Net profit (US$m) FY10A FY11F FY12F FY13F FY10A FY11F FY12F FY13F FY10A FY11F FY12F FY13F Archer-Daniels-Midland 61,682 73,619 76,206 81, ,919 2,172 2,336 2,487 Barry Callebaut AG 5,973 6,215 6,679 7, Petra Foods Ltd 1,566 1,751 1,921 1, Source: Bloomberg, DBS Vickers Page 16

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