Company Focus Guan Chong

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1 Bloomberg: GUAN MK Reuters: GNCH.KL Malaysia Equity Research PP 11272/04/2012(029344) 29 Jul 2011 BUY RM2.71 KLCI : 1, Price Target : 12-Month RM 3.60 Reason for Report : Company update and 2Q11 results preview Potential Catalyst: Rising sales tonnage and better margins DBSV vs Consensus: Nil as DBSV is the only broker covering this company 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 Revenue 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 (%) Earnings Rev (%): Consensus EPS (sen): Other Broker Recs: ICB Industry : Consumer Goods ICB Sector: Food Producers Principal Business: Manufactures and sells cocoa ingredients Source of all data: Company, DBS Vickers, Bloomberg Riding on the growth trajectory Solid 2Q11 earnings expected driven by Batam s new capacity On track to meet our FY11F earnings growth of 19% Maintain Buy with RM3.60 TP (+33% upside potential) Batam lift in 2Q11. (GC) s 2Q11 results are expected to get a boost from a full-quarter contribution from its Batam plant, which commenced operations in Mar11. After processing 6.2k MT of cocoa beans in 1Q11, we estimate an output of 14-15k MT from the Batam plant this quarter, bringing the Group s total production to 34-35k MT in 2Q11 (vs 1Q11 s 26k MT). Assuming a lower EBITDA margin of 11% (vs 13.3% in 1Q11 which was lifted by better pricing contracts carried forward from previous years), pretax profit is estimated to come in at around RM38m (+50% y-o-y; +12% q-o-q). After factoring in a higher effective tax rate of 19% (10.8% in 1Q11) as only c.rm9m in export tax incentive allowances are left to be utilized this could translate to a net profit of approximately RM30m (+56% y-o-y; flat q-o-q) in 2Q11, on track to meet our full-year projection of RM119m. Entering the next phase of growth. Our recent visit to the Batam facility which has a more spacious and systematic layout compared with the Pasir Gudang plant reveals that GC s expansion plan is progressing well. It is on track to add another 60k MT in Batam by 2Q12, taking its overall grinding capacity to 200k MT p.a. To move further downstream, a powder facility will be installed by early-2012 for cocoa powder production in Batam and alkalization & deodorisation facilities will also be added in stages to make more value-added products. The completion of the additional capacity expected to be filled by rising secured demand for cocoa ingredients from its customers has prompted us to maintain our FY10-12F earnings CAGR of 16.3%. Maintain Buy. Current PE valuation for this global manufacturer of cocoa ingredients is attractive at 7.9x FY12F FD EPS vs closest listed peer Petra Food s 16.8x (PETRA SP; Hold). The recent share price weakness down 11% from a high of RM3.05 on light volume since May11 amid the broad market slide presents a buying opportunity for investors. Maintain Buy with TP of RM3.60, based on a PE of 10x on FY12F FD EPS. At A Glance Issued Capital (m shrs) 320 Mkt. Cap (RMm/US$m) 867 / 294 Major Shareholders Resources Sdn 52.0 Misi Galakan Sdn Bhd (%) 9.6 LTAT (%) 8.3 Free Float (%) 30.1 Avg. Daily Vol.( 000) 264 Refer to important disclosures at the end of this report

2 Highlights Positive vibes at the official launch of GC s Batam plant. The official opening of GC s new plant in Batam, Indonesia in early July 2011 was well attended by guests comprising mostly its customers, suppliers and distributors (from as far as Europe and the US), as well as the local government officials. Taking the opportunity to mingle around, we get the sense that there is a strong business relationship between GC and its business partners. An additional capacity of 60k MT on the way. The Batam plant with an installed annual capacity of 60k MT is already up and running since Mar11. The next phase of development for the modern looking facility is in progress now. Phase 2 will involve the addition of another 60k MT, bringing its total annual grinding capacity to 120k MT in Batam and 200k MT (including the Pasir Gudang plant) in Malaysia. To be completed by 2Q12, total investment cost for its Batam operation is estimated at RM150m, of which about half of it would be spent on Phase 2. This would be funded by a combination of internal funds and bank borrowings. GC plans to expand its production process in Batam (from producing just cocoa cake currently) to cocoa powder by installing a powder facility by early It also intends to add alkalization & deodorisation facilities in stages to produce more value-added cocoa butter and solid products. Tight cocoa bean supply from Indonesia has eased. GC saw its cocoa bean inventory dropping to as low as two weeks at one point in 2Q11 (from 63 days in 1Q11 and 67 days in FY10) due to a shortage of Indonesian cocoa bean supply caused by: (a) a drought season in April; and (b) exporters delaying sales to take advantage of a lower export duty of 10% in May (vs 15% in April). However, the situation has improved to c.45 inventory days currently as the supply of Indonesian beans is back to normal since June, which was also partly helped by the purchase of African beans from Ivory Coast. Buying more beans from Africa. GC will gradually source more African beans going forward given the rising competition for Indonesia cocoa beans supply following increased requirements from GC s Batam plant (totaling 120k MT by 2Q12) and other players like Petra Food (PETRA SP). As a result, GC plans to increase its supply mix of African beans from c.10% to c.30-40% in 2012, mostly for its Pasir Gudang plant (which has a grinding capacity of 80k MT). In terms of pricing, African beans (at c. US$3,390/MT) are currently more affordable than the Indonesian beans (at c. US$3,811/MT) following the: (a) revival of African beans supply after the end of the civil war in Ivory Coast; and (b) imposition of export duty (of 10-15%) on cocoa beans exports by the Indonesian government. However, we understand that the difference of the all-in purchase costs from using African beans could be minimal due to higher transportation cost and longer transportation time. Figure 1: Price of Indonesia beans > Ivory Coast since Apr11 US$/mt Sep-09 Nov-09 Jan-10 Mar-10 Source: Bloomberg, DBSV May-10 Jul-10 Indonesia Sep-10 Nov-10 Ivory Coast Demand for cocoa ingredients is still intact. Demand for cocoa ingredients used mainly for making chocolates and flavorings is intact despite the ongoing debt crisis in the Europe and the US, which made up >50% of GC s sales. Reflecting this, we understand that its existing capacity of 140k MT is already almost fully taken up by secured orders until end-2011, thus providing earnings visibility for the Group. 2Q11 results preview. We expect GC to post a net profit of c. RM30m in 2Q11 (+56% y-o-y; flat q-o-q). The flattish sequential quarterly profit is mainly attributable to a higher effective tax rate (our estimate of 19% in 2Q11 vs 10.5% in 1Q11) as GC utilizes the balance c. RM9m of its export tax incentive allowances (vs RM22m in 1Q11). We estimate 2Q11 pretax profit to be around RM38m (vs 1Q11 s RM33.8m), as EBITDA margin could have come in weaker q-o-q in the absence of better pricing contracts. The Group s 2Q11 performance, nevertheless, is projected to be stronger at the topline (+38% q-o-q) due to a full-quarter contribution from Batam, based on a production output of c.14-15k MT versus 6.2k MT in 1Q11. Jan-11 Mar-11 May-11 Jul-11 Page 2

3 In terms of product breakdown, after showing a balance mix of 48% each in 1Q11, cocoa solids (comprising cocoa cake and powder) could exceed cocoa butter on the back of the increased contribution from Batam (which produces only cocoa cake currently). No change in our earnings forecasts. Our estimated 1H11 net profit of c. RM60.5m (+54% y-o-y) suggests that the Group is on course to meet our full-year earnings of RM119m (+19% y-o-y). Driven by the capacity boost and secured orders, we are maintaining our FY11F-12F earnings projections (which imply a 2-year CAGR of 16.3%). This will be underpinned by rising demand for GC s cocoa ingredients and a growing outsourcing trend from major chocolate manufacturers. Key Risks Insufficient supply of cocoa beans. The supply of cocoa beans could be affected by a few factors such as: (a) political upheavals; (b) adverse weather; (c) lack of government support in the form of subsidy grants and land rights to grow cocoa plantations; and (d) unstable pricing. Global cocoa beans supply is presently estimated at c.3.5m MT p.a. While cocoa beans supply is facing limited growth due to the factors mentioned above, the new capacity additions by cocoa grinders like GC could create greater competition for cocoa beans supply. However, we believe GC is in a position to secure sufficient beans supply given its long standing relationship with major suppliers. USD exposure. GC has c.20% net exposure to foreign currency risk 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. From an accounting perspective, a weaker USD will hit its bottomline when converted back to RM. Based on our sensitivity analysis, a 5% depreciation of the USD from our base case assumptions of an average exchange rate of RM2.91 in FY11 and RM2.78 in FY12 would trim our FY11F- FY12F net profit projections by 4.7% and 5.1%, respectively. On the positive side, when USD drops against RM, GC will benefit from foreign exchange gains in the form of cheaper interest and principal repayments on its USD borrowings (which amounted to US$184.4m as of end-2010, used primarily to purchase cocoa beans). Even though GC normally enters into forward and option currency contracts to manage its overall exchange rate exposure, these hedge positions may or may not be able to fully cover its forex risks due to timing difference of settlements between receipts and payments in the foreign currency. Valuation Two is a company. There will be a new listing of a cocoa beans processing company on the Malaysian stock exchange coming up Johor-based Kan Sam Food Berhad. We understand that Kan Sam Food s founder and Chairman, Tey Kan Tey Hin Ken is the uncle to GC s CEO, Brandon Tey. However, although they share a similar pedigree, there is currently no cross holding between the two companies and they run their business independently. Based on publicly available information, Kan Sam Food made RM48m in net profit on the back of RM504m in revenue in FY10 (with an annual capacity of 50k MT). This is considerably smaller when compared with GC s earnings of RM100m and revenue of RM1.2bn last year. As details of the IPO offer price for Kan Sam Food is not available yet, the valuation benchmark to be set by Kan Sam Food remains to be seen. In any case, we believe GC which ought to trade at a premium given its larger size should also be benchmarked against overseas peers (like Singapore-listed Petra Food) due to its export-driven business model. Maintain Buy on GC. Current PE valuation is undemanding at 7.9x FY12F FD EPS vs Petra Food s 16.8x (PETRA SP, Hold, S$1.74 TP). The share price weakness which has retreated by 11% from a high of RM3.05 in May11 to RM2.71 recently offers investors an opportunity to accumulate the stock. Maintain Buy with a target price of RM3.60 which is pegged to a PE multiple of 10x FY12F FD EPS. We like GC as an emerging global manufacturer of cocoa ingredients with attractive valuations and strong earnings growth potential (2- year CAGR of 16%). Page 3

4 Figure 2: Peer valuation Company FYE Price Mkt cap PE Div Yield CAGR Net gearing ROE FY10- (local) (US$ m) FY10A FY11F FY12F FY13F FY11F FY12F 12F (%) (%) Archer-Daniels-Midland Jun , Barry Callebaut AG Aug , Petra Foods Ltd Dec , Dec Average ex GC Source: Bloomberg, DBS Vickers Figure 3: 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 77,833 80,325 82, ,919 2,184 2,234 2,367 Barry Callebaut AG 6,503 6,639 6,654 7, Petra Foods Ltd 1,566 1,851 1,990 1, Source: Bloomberg, DBS Vickers Figure 4: Quarterly results trend FY Dec (m) 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 Sales Malaysia n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a Overseas n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a EBITDA n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a Malaysia n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a Overseas n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 5.9 Others n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 2.0 Interest Income n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0.1 Depreciation n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. (3.6) Other Operating Expenses (139.4) (116.3) (153.5) (207.0) (240.3) (244.5) (268.4) (298.9) (255.0) Operating profit Interest Expense (1.6) (1.4) (1.3) (1.5) (1.5) (1.2) (1.2) (1.2) (1.2) Pretax Profit Tax (0.4) (0.8) (2.0) (2.7) (7.4) (5.7) (9.2) 10.8 (3.7) Minority Interests (0.1) (0.3) (0.2) (0.1) (0.1) (0.1) (0.0) Net Profit Margins (%) Operating profit Pretax profit Net profit Effective tax rate (33.5) 10.8 Source: Company, DBS Vickers Page 4

5 Key Assumptions Cocoa bean price 2, , , , ,701.2 Production capacity 75, , , , ,000.0 Sales tonnage 59, , , , ,380.0 Sensitivity Analysis 2011 Production +/- 1% Net Profit +/- 1.1% Segmental Breakdown Revenues (RM m) Cocoa Butter Cocoa Cake/ Powder ,171 Others Cocoa Cake/Powder sales contribution is expected to exceed Cocoa Butter, as we expect Powder ASP to trend up. Total 643 1,169 1,508 1,912 2,175 Income Statement (RM m) Revenue 643 1,169 1,508 1,912 2,175 Cost of Goods Sold (608) (1,052) (1,343) (1,704) (1,942) Gross Profit Other Opng (Exp)/Inc (9) 0 (7) (12) (16) Operating Profit Other Non Opg (Exp)/Inc Associates & JV Inc Net Interest (Exp)/Inc (6) (5) (5) (6) (4) Exceptional Gain/(Loss) Pre-tax Profit Tax (6) (11) (29) (48) (53) Minority Interest (1) 0 (5) (7) (9) Preference Dividend Net Profit Net Profit before Except EBITDA Growth Revenue Gth (%) (7.4) EBITDA Gth (%) Opg Profit Gth (%) Net Profit Gth (%) Margins & Ratio Gross Margins (%) Opg Profit Margin (%) Net Profit Margin (%) ROAE (%) ROA (%) ROCE (%) Div Payout Ratio (%) Net Interest Cover (x) Source: Company, DBS Vickers Margins Trend 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 2009A 2010A 2011F 2012F 2013F Operating Margin % Net Income Margin % Margins are expected to be resilient, benefiting from higher ASP and economies of scale. Page 5

6 Quarterly / Interim Income Statement (RM m) FY Dec 1Q2010 2Q2010 3Q2010 4Q2010 1Q2011 Revenue Cost of Goods Sold Gross Profit Other Oper. (Exp)/Inc (240) (244) (268) (299) (255) Operating Profit Other Non Opg (Exp)/Inc Associates & JV Inc Net Interest (Exp)/Inc (1) (1) (1) (1) (1) Exceptional Gain/(Loss) Pre-tax Profit Tax (7) (6) (9) 11 (4) Minority Interest Net Profit Net profit bef Except EBITDA Growth Revenue Gth (%) (12.7) EBITDA Gth (%) (8.3) Opg Profit Gth (%) (8.3) Net Profit Gth (%) (1.1) (8.4) (29.9) Margins Opg Profit Margins (%) Net Profit Margins (%) Source: Company, DBS Vickers Margins Trend 14% 12% 10% 8% 6% 4% 2% 0% 1Q2009 2Q2009 3Q2009 4Q2009 1Q2010 2Q2010 3Q2010 4Q2010 Operating Margin % Net Income Margin % 1Q2011 Page 6

7 Balance Sheet (RM m) Net Fixed Assets Invts in Associates & 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 Asset Breakdown Inventory % Debtors % Net Fixed Assets % Associates'/J Vs 0.0% Bank, Cas and Liqui Assets - 3.2% Non-Cash Wkg. Capital Net Cash/(Debt) (218) (194) (194) (206) (154) Debtors Turn (avg days) Creditors Turn (avg days) Inventory Turn (avg days) Asset Turnover (x) Current Ratio (x) Quick Ratio (x) Net Debt/Equity (X) Net Debt/Equity ex MI (X) Capex to Debt (%) Z-Score (X) NA NA NA NA NA Typically high net gearing due to large working capital needs. We expect this to improve with better operating cash flow. Cash Flow Statement (RM m) Capital Expenditure Pre-Tax Profit Dep. & Amort Tax Paid (4) (6) (11) (29) (48) Assoc. & JV Inc/(loss) Chg in Wkg.Cap. (52) (19) (32) (62) (64) Other Operating CF 6 (2) Net Operating CF (22) Capital Exp.(net) (4) (51) (70) (70) (15) Other Invts.(net) Invts in Assoc. & JV Div from Assoc & JV Other Investing CF 0 2 (35) (23) (10) Net Investing CF (4) (49) (105) (93) (25) Div Paid (7) (19) (18) (36) (41) Chg in Gross Debt 40 (23) (50) Capital Issues Other Financing CF (1) Net Financing CF 32 (42) (8) (26) (91) Currency Adjustments Chg in Cash (2) 2 Opg CFPS (sen) Free CFPS (sen) (8.1) Source: Company, DBS Vickers A 2010A 2011F 2012F 2013F Capital Expenditure (-) High capex is related to construction of Batam plant. Page 7

8 This document is published by Vickers Research Sdn Bhd ( HDBSVR ), a subsidiary of Investment Bank Berhad ( HDBS ) and an associate of DBS Vickers Securities Holdings Pte Ltd ( DBSVH ). The research is based on information obtained from sources believed to be reliable, but we do not make any representation or warranty as to its accuracy, completeness or correctness. Opinions expressed are subject to change without notice. This document is prepared for general circulation. Any recommendation contained in this document does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. This document is for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. HDBSVR accepts no liability whatsoever for any direct or consequential loss arising from any use of this document or further communication given in relation to this document. This document is not to be construed as an offer or a solicitation of an offer to buy or sell any securities. DBS Vickers Securities Holdings Pte Ltd is a wholly-owned subsidiary of DBS Bank Ltd. DBS Bank Ltd along with its affiliates and/or persons associated with any of them may from time to time have interests in the securities mentioned in this document. HDBSVR, HDBS, DBSVH, DBS Bank Ltd, and their associates, their directors, and/or employees may have positions in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking/corporate advisory and other banking services for these companies. HDBSVR, HDBS, DBSVH, DBS Bank Ltd and/or other affiliates of DBS Vickers Securities (USA) Inc ( DBSVUSA ), a U.S.-registered broker-dealer, may beneficially own a total of 1% or more of any class of common equity securities of the subject company mentioned in this document. HDBSVR, HDBS, DBSVH, DBS Bank Ltd and/or other affiliates of DBSVUSA may, within the past 12 months, have received compensation and/or within the next 3 months seek to obtain compensation for investment banking services from the subject company. DBSVUSA does not have its own investment banking or research department, nor has it participated in any investment banking transaction as a manager or co-manager in the past twelve months. Any US persons wishing to obtain further information, including any clarification on disclosures in this disclaimer, or to effect a transaction in any security discussed in this document should contact DBSVUSA exclusively. DBS Vickers Securities (UK) Ltd is an authorised person in the meaning of the Financial Services and Markets Act and is regulated by The Financial Services Authority. Research distributed in the UK is intended only for institutional clients. Wong Ming Tek, Head of Research Published and Printed by Vickers Research Sdn Bhd ( U) Suite 26-03, 26 th Floor Menara Keck Seng, 203, Jalan Bukit Bintang, Kuala Lumpur, Malaysia. Tel.: Fax: general@hwangdbsvickers.com.my Page 8