OMAN FLOUR. February 8, organic : RO : RO VARIANCE COMPANY UPDATE. valuable. thereby. improve its reasons: Senior.

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1 INVESTMENT RESEARCH OMAN FLOUR MILLS SAOG (OFMI.MSM) Management aims to drive the company s sales and profitability higher by seeking organic growth in related food segments as growth potential in its existing flour and animal feed businesses is limited RECOMMENDATIONN : HOLD CMP (27 JAN 2011) : RO FAIR VALUE : RO VARIANCE : 6% FINANCIAL INDICATORS CMP (27-Jan-2011) MCAP (RO MN) 97.2 EPS E (RO) BV Q (RO) P/E ( E) 14.0 P/BV (Q ) 2.2 ROAA ( E) 12.0% ROAE ( E) 14.3% ASSETS, Q (RO Mn) 60.4 NETWORTH, Q (RO Mn) 46.4 Source: Company Statements and FINCORP Investment Research COMPANY UPDATE INVESTMENTT OPINION February 8, 2011 ANALYSTS Anil Kumar, CFA Senior VP - Research anilkumar@fincorp.org Tel: (+968) Ext. 340 Gaurav Ramaiya Asst. Vice President - Research gaurav@fincorp.org Tel: (+968) Ext. 320 Oman Flour Mills management is pursuing an aggressive organic growth strategy by venturing into related food products such as bakery and poultry in order to signficantly improve the company s turnover and profitability in the years ahead. The parent company s business model is a cash cow but offers little growth prospects as it doesn t have any pricing power with local flour price being regulated by the government. Strong competition from local and regional flour makers makes it difficult for OFMI to expand its market share signifcantly and animal feed market is also facing saturation. The parent company has formed three subsidiaries and one associate in recent years engaged in production and marketing of table eggs, poultry meat and bakery. Atyab Investments LLC, a 100% owned subsidiary of the parent company, is its most valuable subsidiary which in turn holds fully Atyab Bakery LLC and has a 50% stake in Atyab IFFCO LLC, a 50/50 joint venture with IFFCO of UAE. Atyab Investments will be the main driver for the company s future growth as it is currently building a RO 11 million industrial bakery at Barka and also plans to develop and own one of the largest poultry farms in the Middle East at Ibri in association with a strong regional poultry player, IFFCO. Though these new segments can enable the group with better pricing power and thereby improve its return ratios, execution risks are significant for the following reasons: 1. OFMI s management does not have any prior experience in operating bakery and poultry businesses 2. A high levell of competition in the poultry business with abundant supply of eggs and meat by several domestic, GCC and foreign players. The poultry business

2 is also exposed to risks such as bird flu and is not an easy business to manage. A new player needs to sell either at lower prices than competition or provide a differentiated product such as better quality in order to win market share and payback period can actually be longer than expected. We believe that OFMI stock is transitioning into a growth stock instead of a defensive stock as its management attempts to diversify the group s business model by investing a large sum which can be as high as RO 36 mn over the next few years into industrial bakery and poultry farm. In our view, the decision of the management to diversify into newer but related areas despite significant risks is justified as OFMI suffers from lack of pricing power in its primary flour business. Despite having a much smaller market share, its local competitor Salalah Mills has been more profitable owing to its better price realization in exports to the African Horn nations. We expect the equity discount rate for OFMI stock to increase from its current level of 10.4% taking into account risks the management is taking in order to improve its sustainable ROE beyond 15% from its existing setup. Our fair value for the stock is RO based on an expected EPS of 44 baisas for E and a forward P/E multiple of 13.2x as explained in the valuation section of this report. The government s reinroduction of subsidy on wheat in the last quarter of 2010 should protect its gross margin in the quarters ahead and deliver a stronger bottom line in H (OFMI s FY ends in June) compared to H provided its investment portfolio doesn t hurt. BUSINESS MODEL The parent company of Oman Flour Mills group (OFMI) is the Sultanate s leading flour maker commanding a market share of around 65%. The parent company has been growing organically over the years and currently can produce 800 MT/day of flour. It has plans to set up a new flour mill at Sohar with an initial capacity of 300 MT/day and expandable upto 2000 MT/day to cater to the rising population in Oman besides looking for opportunities in the UAE. In addition, the company also has an animal feed mill with a capacity of 1100 tons/day. The parent company markets its flour products under the brand DAHABI with over 20 varieties of flour and related products. It also produces and markets animal feed products under the BARAKAT brand name. The group includes four subsidiaries which are central to its future growth as shown below: Modern Poultry Farms SAOC (MPF), is an 86% owned subsidiary of OFMI engaged in the production and sale of table eggs and related by products (spent hens and poultry manure). The company currently produces more than 100 million table eggs per year and markets them under the brand name DANA. Bread House LLC, is an 100% owned newly launched subsidiary involved in the marketing and distribution of frozen bakery products and owns bakery cafés. Atyab Investment LLC, is an 100% owned subsidiary, setup as a management company to spearhead the operations and investments of the parent company. Atyab Investment currently holds a 100% interest in FINCORP INVESTMENT RESEARCH Page 2

3 Atyab Bakery LLC (an industrial bakery project) and a 50% interest in Atyab IFFCO LLC (a joint venture with UAE based IFFCO in the poultry segment). Sohar Poultry SAOG, is 91% owned by Atyab IFFCO LLC and an indirect associate of.the parent company of Oman Flour Mills group Sale of flour products and animal feed currently account for nearly 90% of the company s total sales. The company also exports its products to other countries, however, export sales have lagged its overall sales growth due to cost inefficiencies in the form of higher freight costs besides threat from growing local flour mills in its import markets. Key strengths of the parent company include: Strong cash generating core businesses The company s core flour and animal feed businesses generates healthy cash flows which allows it to adequately meet its working capital and capex needs. For the most recent FY , the company generated net operating cash flow of RO 9.06 million and currently has cash and bank balances of RO 10.6 million. Low financial leverage The company is effectively debt free helped by its strong cash flow generation. Proximity to the Northern Oman and UAE markets The company s location in Muscat places it a close proximity to markets in the Northern Oman as well as the UAE, compared to Salalah Mills. Looking to leverage this advantage, the company is also planning to setup a new flour mill in Sohar, which can further improve its reach to the UAE market. The Government of Oman owns a 51% stake in Oman Flour Mills. H FINANCIAL PERFORMANCE Oman Flour Mills reported a net profit of RO 3.26 million in H , which is a decline of 37.7% YoY while its sales were nearly flat at RO million. The sharp drop in the company s bottom line can be attributed to a squeeze in its gross margin in Q owing to sharp hike in cost of grain (from supply disruption in global markets due to adverse weather conditions) coupled with a lack of government subsidy and a weak dollar. The Government later reintroduced subsidy on wheat which provided cushion to its margins in Q On a sequential basis, net profit rose 21.4% in Q to RO 1.79 million from RO 1.47 million in Q Q2 sales saw a 6.4% QoQ growth to RO million, while gross margin expanded from 17.5% to 19.9% as the government reintroduced subsidy on flour and allowed a marginal price increase to match higher commodity prices. Investment and other income was also 37.9% higher QoQ at RO 404 k, which can be attributed to fair value gains of its investment portfolio through P&L as the local stock market gained. FINCORP INVESTMENT RESEARCH Page 3

4 Oman Flour Mills Financial Performance H (RO'000) Q Q QoQ % H H YoY % Revenues 11,161 11, % 22,987 23, % Gross Profit 1,953 2, % 6,570 4, % Operating Profit 1,299 1, % 5,231 2, % Investment & Other Income % % Net Profit 1,475 1, % 5,244 3, % MARGINS Gross margin 17.5% 19.9% 28.6% 18.8% Operating margin 11.6% 13.1% 22.8% 12.4% Net margin 13.2% 15.1% 22.8% 14.2% Source: Company Financials Over the past five years, the company s sales have grown at a modest CAGR of 7.2%, reflecting a saturated domestic flour market coupled with its lack of pricing power. Further growth in its sales should come from a planned increase in capacity to meet incremental demand from population growth. Export sales of the company have also lagged as the company s location in Muscat puts it at a disadvantage compared to its competitor, Salalah Mills, in terms of higher freight costs to the African horn nations. These nations are also setting up their own flour mills which can erode the market share of exporters. Competiton from regional producers who sell their brands in Oman is also hurting the market share of OFMI. More importantly from a profitability perspective, the company has no pricing power with regard to flour, as flour price is regulated by the government. This exposes the company to risk from volatile raw material commodity prices such as wheat and corn, which saw a sharp increase in the previous year. However, the company derives benefit from susbsidy on wheat during periods of high prices which helps in reducing its raw material costs. As such, the company s gross margin trend reflects movement in raw material prices as well as the availabilty of subsidy from the government. Net profit margin has historically been more volatile due to the company having a significant exposure to equities measured at fair value through P&L. RO'000 14,000 12,000 10,000 8,000 6,000 4,000 Trend of Total Sales, EBITDA & Net Profit ( E) Sales CAGR: 7.2% 60,000 50,000 40,000 30,000 20,000 2,000 10,000 0 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11(E) 0 Total Sales (RO'000) RHS EBITDA (RO'000) LHS Net profit (RO'000) LHS Note: Company's fiscal year ends June 30 FINCORP INVESTMENT RESEARCH Page 4

5 Margin (%) % % 1 5.0% Trend of profit margin ( E) Jun 07 Jun 08 Jun 09 Jun 10 Jun 11(E) Gross Profit Margin (%) EBITDA Margin (%) Net Profit Margin (%) Note: Company's fiscal year ends June % Trend of ROAE & ROAA ( E) ROAE & ROAA (%) % 1 5.0% Jun 07 Jun 08 Jun 09 Jun 10 Jun 11(E) Note: Company's fiscal year ends June 30 ROAE (%) ROAA (%) Source: Company statements and FINCORP Investment Research PROFITABILITY TREND OF LOCAL FOOD & BEVERAGE COMPANIES We have compared key profitability indicators of local food & beverage companies which includes Oman Flour Mills (OFMI), Salalah Mills (SFMI), A Saffa Foods (SPFI) and the UAE based Agthia group. A Saffa foods has consistently led our universe in terms net profit margin (NPM) during E. Oman Flour Mills enjoyed a higher NPM than its two direct competitors,salalah Mills and Agthia group, but it includes significant investment income and not strictly comparable. Oman Flour Mills move to enter poultry segment appears to be sensible as it can be NPM accretive. 2 Net Profit Margin Comparison 15.0% 1 5.0% (E) OFMI SFMI (group) SFMI (parent) SPFI AGTHIA Note: Fiscal year shown for OFMI ends June 30 FINCORP INVESTMENT RESEARCH Page 5

6 In terms of Return on Invested Capital (ROIC ), Salalah Mills leads our universe by a substantial margin as it enjoys a better realization from exports to Africa. Salalah Mills parent company delivered a strong ROIC of 19.4% in 2010 while consolidated ROIC was even better at 21.4%. OFMI has a higher ROIC than Agthia s but below Salalah Mills. Return on Invested Capital Comparison 25.0% % 1 5.0% (E) OFMI SFMI (group) SFMI (parent) SPFI AGTHIA Note: Fiscal year shown for OFMI ends June 30 SFMI on a consolidated basis leads our universe in terms of ROE which was 29.2% in OFMI s ROE is only slightly above that of Agthia at 14.3%. We expect OFMI to achieve a ROE of around 19% once its new ventures stabilize. 4 Return on Equity Comparison (E) OFMI SFMI (group) SFMI (parent) SPFI AGTHIA Note: Fiscal year shown for OFMI ends June 30 FINCORP INVESTMENT RESEARCH Page 6

7 FUTURE GROWTH RELIES HEAVILY ON THE SUCCESS OF ITS NEW VENTURES Considering limited growth opportunities in its traditional business segments of flour and animal feed products, the company has started to invest in allied food products such as frozen bakery and poultry products to improve its product mix and generate a higher sustainable return on equity. Bread House LLC Frozen bakery products franchisee The company commenced operations of this new business in 2009 to market and distribute frozen bakery products besides launching bakery cafés. Its distribution network has been established and has started supplying to leading hotels and hypermarkets. Management has indicated that the business is showing good potential and it expects its performance to improve post commencement of production from the company s proposed industrial bakery venture by mid Atyab Bakery LLC Industrial bakery The company has commenced construction of an industrial bakery, under the name, Atyab Bakery LLC at an estimated cost of RO 11 million. Orders for equipment have been placed and land has been acquired close to Barka with a view to cater to demand from the local and UAE markets. Management expects to start installation of the equipment by Feb 2011 and commence production from mid Atyab IFFCO Poultry LLC Poultry Farm Conceived as a 50/50 joint venture with UAE based IFFCO group, this venture intends to produce broilers catering to the Oman and UAE markets at an estimated cost of RO 25 million. The company is considering setting up one of the largest poultry farms in the Middle East at Ibri with a production capacity of 15,000 tons of chicken and two million hatching eggs per year. In addition, the company also acquired a 91% stake in Sohar Poultry Farm SAOG with a view to expand its product mix Sohar Flour Mill New flour mill To meet incremental demand for flour from a growing population the company has plans to establish a new flour mill in Sohar with an initial wheat milling capacity of 300 MT/day and expansion capacity to 2,000 MT/day. The operations of the new mill will be in conjunction with the government s plan to setup a strategic food reserve by storing wheat in silos at Port of Sohar. VALUATION Fair 1 year forward P/E multiple OFMI has historically traded in a forward P/E band of 3x to 23x over the past five years. The stock currently trades at a P/E multiple of 14.4x its estimated FY EPS of 44 baizas per share. The recent sell off in OFMI stock suggests that the market is largely focusing on the short term impact of margin pressure and not adequately factoring in the future growth prospects from its new initiatives. Owing to risks involved for any company in new business lines, we would expect the discount rate for OFMI to move higher till it sees stability in those segments. OFMI should be henceforth viewed as a growth stock rather than as a defensive food player profile. The stock s P/E band going forward is likely to be broader as its risk profile and ROE generating ability increase. FINCORP INVESTMENT RESEARCH Page 7

8 Oman Flour Mills P/E Valuation Bands x FY FY FY FY FY High P/E (1 yr fwd) Low P/E (1 yr fwd) Current P/E (1 yr fwd) Source: FINCORP Investment Research The equity discount rate for the company is currently 10.4% based on its P/E E multiple of 14.4x, an expected dividend payout ratio of 57% ( based on an expected cash dividend of 25 bzs per share and an EPS of 44baizas) and a sustainable ROE of 15% from its existing setup. We expect the equity discount rate to move higher to 12.5% owing to its foray into new business lines but expect its long term ROE potential to improve to 19%. This equates to a fair forward P/E multiple of 13.2x based on the Gordon growth model as shown below: Formula: 1 year forward P/E = payout ratio/(cost of equity sustainable earnings growth rate) Sustainable earnings growth rate = retention ratio x sustainable ROE Current implied cost of equity = 10.4% Sustainable ROE from existing setup = 15% Payout ratio = 57% New cost of equity = 12.5% Sustainable ROE target = 19% Payout ratio = 57% Earnings growth rate = (100% 57%) x 19% = 8.17% Fair forward P/E = 57%/(12.5% 8.17%)= 13.2x Fair value for OFMI stock = 13.2 x RO = RO EV/EBITDA band OFMI s enterprise value ranged between 2.2x and 14.8x its 1 year forward EBITDA over the past five years. The stock currently trades at a forward EV/EBITDA multiple of 11.1x which is at around its average EV/EBITDA multiple in the past two years. FINCORP INVESTMENT RESEARCH Page 8

9 Oman Flour Mills EV/EBITDA Valuation Bands x FY FY FY FY FY High EV/EBITDA (1 yr fwd) CurrentEV/EBITDA (1 yr fwd) Source: FINCORP Investment Research Low EV/EBITDA (1 yr fwd) INVESTMENT RESEARCH CONTACT DETAILS Anil Kumar, CFA (+968) Ext. 340 Gaurav Ramaiya (+968) Ext. 320 Mable Pereira (+968) Ext. 323 Disclaimer The research team of The Financial Corporation, SAOG (hereto referred as FINCORP) has prepared the information, analysis and expressed its opinion on the subject matter of this report. The information contained has been obtained from sources believed to be reliable and in good faith, but which may not be verified independently. While utmost care has been taken in preparing the above report, FINCORP makes no guarantee, representation or warranty, whether express or implied, and accepts no responsibility or liability as to its accuracy or completeness of the data, being provided. All investment information and opinions are subject to change without notice. The investor will indemnify FINCORP and its directors, officers, and employees against any loss or damage or other liabilities (including costs), which they may suffer as a result of reliance on this report. This report is not to be relied upon in substitution for the exercise of independent judgment. Also, not all customers may receive the material at the same time. This document is for private circulation and information purposes only. It does not and should not be construed as an offer to buy or sell securities mentioned herein. FINCORP will not be liable for any direct or indirect losses arising from the use thereof, and the investors are expected to use the information contained herein at their own risk. FINCORP and its affiliates or their officers, directors and employees may own or have positions in any investment mentioned herein or any investment related thereto and from time to time add to or dispose of any such investment. FINCORP and its affiliates may act as market maker or assume an underwriting position in the securities of banking companies discussed herein (or investments related thereto), and may sell them to or buy them from customers on a principal basis and may also perform or seek to perform investment banking or underwriting services for or relating to those banking companies. Authors or contributors of this report could have direct interest in the capital market or in the securities mentioned herein. The investments discussed or recommended in this report may not be suitable for all investors. Investors must make their own investment decisions based on their specific investment objectives and financial position, and using such independent advisors, as they believe necessary. Income from investments may fluctuate. The price or value of the investments, to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. This document is strictly for the use of recipients only. None of the material provided herein may be reproduced, rewritten, rehashed, published, resold or distributed in any manner whatsoever without the prior and explicit written permission of FINCORP. FINCORP INVESTMENT RESEARCH Page 9