QL Resources Bhd
(Feb 11, RM6.90)
Maintain sell with a lower target price (TP) of RM6.58 (previously RM6.63): After our recent meeting with management, we remain cautiously optimistic about QL Resources Bhd’s earnings outlook. While the marine products manufacturing (MPM) segment is expected to support the group’s earnings with: i) remarkable segment’s top-line growth underpinned by capacity ramp-up; and ii) bottomed out margin; the remaining two core business divisions — integrated livestock farming (ILF) and palm oil actitivites (POA) — are expected to be dragged by an increase in the feed meal costs and soft crude palm oil prices. We increase our earnings forecast by 2.9% for financial year 2019 (FY19) but decrease FY20/FY21 earnings by 2.6% and 1.7% respectively. We change our valuation method to discounted cash flow (DCF), deriving a lower TP of RM6.58 a share. Maintain “sell”.

 
During the first half of FY19 (1HFY19), the MPM segment achieved year-on-year (y-o-y) revenue and profit before tax (PBT) growth of 12% and 11% respectively. This could be attributed to the recovery of fish cycle as weather conditions improved and the commissioning of two new surimi-based production units in Hutan Melintang in Perak. Management indicated that the weather conditions of late continued to improve, suggesting that the segment’s margin may bottom out soon with the rise in total fish catch and production. In our forecast, we expect the full-year MPM segment’s PBT margin to steady at 14% (+0.3 points y-o-y).

Going forward, the MPM segment’s capacity expansions include: 1) completion-cum-commissioning of a new pilot frozen surimi-based processing factory in Surabaya, Indonesia (with a capacity of 3,000 tonnes a year); 2) increasing aquaculture production capacity from 1,500 tonnes a year to 5,000 tonnes a year by FY23; and 3) investing in deep-sea fishing fleet to 30 boats (+three units) by FY20. We believe these initiatives could fuel future profit growth and further solidify the group’s position as the largest surimi producer in Asia as well as fishmeal producer in Malaysia. We are forecasting FY19-FY21 revenue growth of 14.5% to 18.1% for the MPM segment.

Recall that the ILF segment recorded a narrower margin of 4.3% in 1HFY19 (against 5.4% and 4.5% in 1HFY17 and 1HFY18). The squeeze in margin was largely attributable to ongoing stiff competition in feed meal’s raw materials trade, that are corn and soybean, and depressed egg prices in Peninsular Malaysia. While we gathered that the competition is declining gradually and the egg prices have been recovering since August 2018, we take a conservative stance and expect margin improvement only to occur by FY20. This is because corn and soybean prices have been trending higher since July 2018 possibly (Figure 1 and 2) due to reduced crop production arising from lower harvested acreage and poor weather conditions. Note that the price of corn, being the core feed meal to poultry, has increased by 3% y-o-y (average price during March-December period) while soybean has decreased 5% y-o-y during the same period.

Nevertheless, we acknowledge QL’s focus to continuously expand its regional poultry operations may provide buffer and growth to the ILF segment in the medium to long term. These expansions include: a) to ramp up production of commercial feedmill in Bekasi, Indonesia to 15,000 tonnes/month; b) plan to build second commercial feedmill in East Java; and c) to double egg production in Vietnam for addressing Vietnam’s rising demand for eggs. Furthermore, we believe that operating conditions could be better in the Indonesian and Vietnamese operations with favourable pricing and cost structure

QL’s POA unit was negatively affected during 1HFY19 mainly due to: i) lower fresh fruit bunch (FFB) production; ii) lower extraction rate owing to excessive rainfall and labour shortage; iii) increasing competition which affected the CPO mill utilisation rate; and iv) a decline in the CPO price. We opine that the weak operating environment may persist into 2HFY19 and FY20, which would result in weak results. Note that the CPO price declined to RM2,150 a tonne as of January 2019 (-11% from March 2018), with an intraday low of RM1,775 in November. We project QL to secure a CPO price at an average of RM2,400 a tonne and its Indonesian FFB production to decline by 10% y-o-y to 114,000 tonnes in FY19, therefore delivering FY19 segment PBT of RM22.1 million (-21% y-o-y). For FY20 and FY21, we are projecting a rather flattish growth with PBT recording RM22.2 million and RM24.2 million respectively. Despite anticipating FFB production in the subsequent years, arising from QL’s increasing mix of prime aged palms in Indonesia, we believe earnings growth could remain bleak given the soft CPO price and competitive landscape.

To date, QL has opened a total of 81 FamilyMart stores, which is on track to achieve its targeted FY19 store count of 90 units. To expand its market reach further, QL would open additional 50 to 100 stores per year over the next couple of years until reaching a total of 300 stores by FY22. The key area focus of store establishments would remain in Klang Valley due to the high population density. Even though the FamilyMart venture has yet to contribute to the group’s earnings due to high start-up costs, we remain sanguine about the long-term prospects of FamilyMart to QL’s growth strategy

We marginally adjust the operating cost structure and revised our FY19-FY21 effective tax rate assumption to 14.8%-20.3% (from 15.5%-18.4% previously). All in, we raise our earnings forecast by 2.9% for FY19 but reduce FY20/FY21 earnings by 2.6% and 1.7% respectively.

We change our valuation method to DCF with a discount rate of 6.7% and terminal growth rate of 3.5%, deriving a lower TP of RM6.58 a share (from RM6.63 a share previously). We believe the discount rate is fair compared with our consumer food and beverage universe while the higher growth rate is ascribed to the group’s business integration strategy. However, we maintain our “sell” recommendation on the stock given the unfavourable risk return trade-off and low dividend returns at about 1%. — TA Securities Bhd, Feb 11