Dairy Farm Stock Analysis 2019

Dairy Farm Stock Analysis

To continue on with our supermarket frenzy, I thought to myself that it wouldn’t be complete to do a stock review on Sheng Siong but left out on its competitor, Dairy Farm. Hence, this article would be focused on Dairy Farm so that we can have a better understanding of the 2 supermarket companies and decide on which is a better buy. If you have not read the previous post on Sheng Siong, here is the link to it. It is highly recommended that you read on it first as most of the content here would be referenced to Sheng Siong. Without further ado, let’s dive right into it.

Business Overview of Dairy Farm

To start off, Dairy Farm is obviously a much bigger company that has a diversified business spanning across 11 countries in Asia. The 5 main business segments of Dairy Farm are Supermarkets, Convenience Stores, Health & Beauty, Home Furnishings and Restaurants. These are all well-known brands that need no introduction as most of us would be familiar with them, except for a few.

There are 9,747 outlets from all its business segments (5,474 for supermarkets and convenience stores) for Dairy Farm but only 55 for Sheng Siong. So we are really talking about 2 different companies that differ widely in terms of their scale and size. Everything seems good so far for Dairy Farm, it is bigger, more diversified, has a stronger brand and they seem to emerge as the obvious winner in comparison to Sheng Siong. But does bigger always mean its better? We will see later on. Before that, let’s have a quick look at their revenue breakdown.

Sales Revenue Breakdown

Sales revenue for Dairy Farm as of 2018 is around US$ 11.7 billion as compared to Sheng Siong which is only around $890 million. Supermarket accounts for the lion’s share of the group’s total revenue followed by Health & Beauty, Convenience Stores and finally IKEA. Take note that their revenue is NOT US$ 21.9 billion as we don’t take in 100% of sales figures from associates and joint-ventures when doing consolidation. This is not consistent with international accounting standards and its not meaningful. But I guess the management just wants to show us the “potential” financial performance if ALL of its associates and joint ventures are included.

According to international financial reporting standards, we only take in the proportionate share of results from associates and joint ventures which is added on as a separate line item in the consolidated profit and loss statement. As seen above, Dairy Farm used US$ 11.7 billion and not US$ 21.9 billion, so don’t be misled by figures shown in the first few pages of their annual report.

Dairy Farm has 3 investment in Joint-ventures & associates. One is Yonghui supermarket (China) which it holds a 20% equity stake in it. The second one is Maxim’s Caterers which it holds a 50% equity stake in and the last one is Robinson Retail Holdings in the Philippines which it holds a 20% equity stake in it. Its investment in associates and joint ventures contributes to a net amount of 132.8 million.

Comparison of Operating Profits (Supermarkets)

Before we begin our analysis, there are some adjustments that need to be made. If we really want to find out who runs a better supermarket business, it would not be exactly fair to compare financial ratios side-by-side against Sheng Siong. This is because Dairy Farm has a whole range of other businesses such as health & beauty, restaurants, home furnishings, all of which have very different characteristics from supermarkets. Therefore, I would first filter out financial figures attributable to Dairy Farm’s supermarket segment before doing a direct comparison with Sheng Siong. This is to ensure that we are comparing apples to apples.

I plotted out Dairy Farm and Sheng Siong supermarket’s operating margins over the past 6 years from 2013 to 2018. Operating profits is used as it accounts for differences in capital structure and financial leverage. Sheng Siong has zero debt but Dairy Farm has 40% debt. It would not be appropriate if we use net profits because Dairy Farm has to deduct interest expenses before reaching the bottom line. Hence, the EBIT margin serves as a better comparison to understand the underlying strength of their financial operations. Let’s have a look…

What do you see? Does it surprise you that Dairy Farm’s supermarket margins are spiralling downhill to almost 0%!? Furthermore, this is just EBIT, meaning that interests and taxes have not been paid yet. If we count in both of these expenses, I doubt equity shareholders would receive much.

This is the reason why I previously mentioned that the weakness of a supermarket business is that they have a very thin margin to work with. Their financial performance is largely dependent on 3 things: Market share, Volume of sales and Efficiency of cost control. If the company fails to control operational costs effectively, you end up seeing these kinds of extremely low margins.

Why did their Supermarket Business Stumbled?

The reason why Dairy Farm’s EBIT margin for its supermarket has fallen so drastically can be attributed to weak sales and failure to control costs effectively. The first sign of weakness came when Dairy Farm decided to shut down its Giant hypermarket chain at VivoCity. It is unable to pay for the increase in rental for lease renewal to Mapletree Commercial Trust. Giant’s footprint in Singapore is shrinking as many other stores such as the one at Bukit Panjang and Whampoa have also begun closing down. Guess which tenant replaced Giant at Bukit Panjang? That’s right. Sheng Siong.

It’s not just in Singapore but this trend has been happening across regionally in other parts of Southeast Asia countries. Leases have lapsed and stores are under-performing. One Giant hypermarket in Vietnam has been divested and a number of stores in Malaysia and Indonesia are shutting down. Competition in Indonesia is intense as the country’s market share is dominated by a sprawling number of mini-marts such as Alframart and Indofood.

As a result, this has led to a goodwill impairment of US$20 million for its Giant business in Singapore and another US$81.5 million goodwill impairment for its Giant business in Malaysia. An asset is impaired when the carrying amount (book value) exceeds the recoverable amount (market value). The management has assessed the recoverable amount based on value-in-use calculations using cash flow projections over the next 5 years. In simpler terms, sales forecasts have weakened significantly.

Management’s Explanation for the Poor Performance

From its 2018 webcast, the CEO and CFO brought up a couple of pointers that explains why their supermarkets’ margins have fallen so drastically.

Firstly, Costs from rental and labour, particularly in Hong Kong, are sky-rocketing and this has led to a compression in their margins.

Secondly, they do not have a centralized procurement system and sourcing decisions for suppliers are made individually. If buying and negotiating are done individually, they can’t take advantage of supplier discounts from bulk buying. This results in the inconsistency of costing and the same product might end up having different margins across different regions.

Thirdly, they fail to consider the supply chain aspects when expanding their store outlets and this has led to increased costs from longer-distance transport deliveries.

Lastly, they underestimated local supermarket competitors as some of them have great products which are selling at cheaper prices. This is the reason why we should never underestimate Sheng Siong. Despite its layout looking run-down, a large number of locals still visit these household supermarkets to source for their grocery supplies routinely.

Declining Sales & Increasing Operating Expenses

As a result of the above factors, sales from supermarkets have declined by US$ 1 million and costs have increased from poor cost management in areas such as procurement and supply chain. These two twin factors put its supermarket business in a perfect storm that caused their EBIT margins to fall so drastically until its almost 0%!

While Dairy Farm seems like they are all over the place, Sheng Siong sees their EBIT margin increasing very consistently. Their competitive advantage lies at efficient cost control and getting supplies at favourable prices. They are very focused as they have a large central warehouse at Mandai, a centralized procurement system and an effective chain of distribution network.

I highlighted that Sheng Siong is efficient in cost control because their operating expenses as a % of revenue are much lower at around 16-17% and they kept them steady at this range for the past 6 years. On the other hand, Dairy Farm’s operating expense as a % of revenue is inching upwards from 24.76% in 2013 to 27.95%. Not only their operating expenses as % of revenue are higher, but they also can’t seem to keep it under control too.

So does bigger always mean its better? The answer is it depends on the quality and competency of management. Scaling up to a certain size is a different ball game altogether. Venturing into different countries require an understanding of consumer preferences as well as local competitors. One model might work in a country but fail miserably in another. A good example is 7-11’s failure in Indonesia and success in China. Aggressive expansion without cost control is very risky and it would not be long before cost runs ahead of sales.

Dairy Farm’s Overall Financial Performance

*Do note that we are just comparing Dairy Farm’s supermarket business in the above analysis and I am not talking about Dairy Farm as a whole. It’s just to compare the operational and financial strength of the supermarket business between Dairy Farm and Sheng Siong. What if we include all of Dairy Farm’s other businesses in our calculations. Let’s take a look at the group’s financial performance as a whole.

Revenue is increasing consistently but net income doesn’t seem to keep up in pace with revenue. In 2018, it has fallen drastically due to a business restructuring cost of US$ 347 million! This has caused their net profit margin to fall abruptly from around 3-4% on average to 0.78%!

Significant Asset Impairments & Provisions

You might be curious about what is this “business restructuring cost”. US$347 million is a significant amount and it’s definitely worth investigating. After all, it’s the main reason why their net profit margin falls to 0.78%. Here is a breakdown found under its notes.

We have previously touched on goodwill impairment for its Giant business in Malaysia and Singapore which amounts to US$102.1 million. Impairment of tangible assets largely comes from impairment of leasehold properties. What is interesting is their onerous lease provisions. Here is a quote from Dairy Farm’s FY18 annual report.

“Provisions for onerous lease contracts were recorded in respect of under-performing or loss-making locations, where management identified that the expected future cash inflows were lower than the contractual lease obligations. The provisions were calculated based on the terms of rental agreements and the earlier of the remaining lease term or possible exit date.”

A provision is made when the net costs of exiting the leases exceed the economic benefits expected to receive. In lay man terms, it simply means that they are projecting that sales would fall short of rental payments.

Their financial figures are definitely not as rosy as Sheng Siong. The good news is that these impairments and business restructuring costs are mostly non-cash in nature. These are all just write-offs that decreases net asset value in their books, but it does NOT represent cash outflows. The net cash impact is estimated to be less than US$ 50 million.

Nevertheless, when there is a substantial amount of impairment in their assets, it is usually an indication of market weakness and this serves as a clue that sales revenue or earnings growth is slowing down in the near future.

You might argue that “Business restructuring costs” is a one-off expense line item. What if we exclude this and compare its operating income? Does it look any better? Let’s have a look.

Operating Income seems more stabilized. But again, we see a declining trend in their operating income margins. Part of this reason is that their supermarket and hypermarket business take up a huge chunk of the group’s total operating expenses. When their supermarket segment fails to deliver, it generally drags down the entire group’s financial performance.

Despite the increase in sales revenue over the years, both net income and operating income margins have declined and past financial performance point towards the same direction, which is downtrend. These are all warning signs to keep in mind and financial figures don’t lie. Just by looking at the above charts and figures, you can tell that Dairy Farm’s operations, especially their supermarket business, are showing signs of weakness and it is showing up all over their financial statements.

When EBIT starts declining, a whole range of other key financial ratios starts falling as well. I would not go too much into detail about all of them, but I just want to bring out 2 main ratios: ROIC & Interest Coverage Ratio.

Return on Invested Capital (ROIC)

ROIC measures how efficient capital is used to generate returns to the firm. It is calculated by taking EBIT after tax divided by invested capital. Unlike ROE, we are calculating the returns that the company made using both debt and equity. This is to include in the debt portion which is excluded in an ROE metric.

To illustrate, a company that made $30 million net profits with $100 million book value of equity would give a 30% ROE. You might think that’s good. But what if this company has $75 million of debt and EBIT is $35 million? EBIT is simply net profits re-grossed for tax plus interest expenses. ROIC falls to 20% (35 / (100 + 75)). Essentially, ROIC is preferred over ROE because we want to take into account how efficient management used debt to generate returns. To find out more about how ROIC is computed, you can refer to my previous post here.

The proper way to use ROIC is to compare it to WACC or weighted-average cost of capital. ROIC should be above WACC or else it is destroying shareholder’s value. Do note that this section is all assumptions, so take it with a pinch of salt. I used the cost of debt as interest expense over total borrowings and average it out over the past few years. Below are all the figures that are used in the computation.

The latest WACC that I came up with is around 5.05% and ROIC is 10.8%. So management is still generating decent returns for the company. However, their ROIC has declined by 50% from 21.6% in 2013 to 10.8% in 2018. This is due to falling EBIT as mentioned above. Again, if you want to find out more about ROIC and WACC, you can read it up from the previous post.

Interest Coverage Ratio

The interest coverage ratio is calculated by taken EBIT divided by interest expense. It is a measure of short-term liquidity and it’s used to determine the ability or strength of the company to pay its debt obligations.

Dairy Farm used to have an interest coverage ratio of 75 times! That’s really insane. But you can see what happened over the years. I would not dwell too much on this as interest coverage ratio is simply a function of EBIT over interest expenses. If EBIT falls, interest coverage would definitely fall unless they pay off their debts to reduce the denominator.

Have we killed the company?

If you are still around, let’s try and explore the potential upsides of Dairy Farm.

Management Restructuring

The first and foremost thing to understand about Dairy Farm is that they are undergoing a restructuring process. The new CEO, Ian McLeod, has taken over Dairy Farm on 18 Sep 2017 in an attempt to save the company. McLeod has 30 over years of retail experience and he is previously the CEO of Southeastern Grocers, the 5th largest supermarket chain in the US. He also took on a managing director role in Coles, one of the largest supermarket brands in Australia, where he oversaw significant market improvement which outperformed the market. He has a strong record of driving profitable growth, but he warns shareholders that there are no “quick fixes” and the entire restructuring process takes 5 years.

Here’s look at the 5-year plan for Dairy Farm.

You can see that the first point right off is building a strong leadership team. There is a 80% change in top leadership positions and they have really done a huge overhaul on the entire management team. The CEO of North Asia & Group convenience, CEO of Southeast Asia, CEO of North Asia Health & Beauty, Chief Digital Officer, Group Human Resource Director, Group Supply Chain Director, Group Property Director are ALL appointed in 2018.

They have raised the bar in capabilities and previous executives are all replaced with new hire talents. These group of new hires are highly qualified and they have a collective experience of around 200 years in the retail and consumer sector! Each of these CEOs and key management executives is reviewing operational inefficiencies from A-Z and this company is basically re-booting its system.

For example, the Chief Supply Chain officer who has 30 years of experience in the FMCG sector is now looking into making supply chains more efficient. It is trying to adopt a more centralized approach in doing things so as to gain tighter control and operational consistency over the individual business segments. There is a lot of strategic reviews going on as the entire management is re-looking at its value proposition of different brands. For example, they have decided to shut down its hypermarket business entirely and move towards new pilot stores. Significant investments in digital technology such as integrating SAP across other businesses are also taking place over a multi-year plan.

Strategic Priorities and Improvement Programmes

They are all doing the right things and focusing their resources in the right direction. But the problem is that it usually takes years for such efforts to materialize into positive returns for shareholders. This is because the restructuring process usually entails huge investment CAPEX costs in the initial phase. For example, they have to buy new software, new systems, do upgrades, invest in new technologies, do trial-runs, pilot tests and the list goes on. There is definitely a learning cost involved and it’s not going to be easy. You can notice that their improvement programmes mostly relate to revitalize the loss-making supermarket business segment.

Decent Growth in Other Business Segments

Supermarket is their only business that is under-performing. If you look at Health & Beauty, Home & Furnishing and Restaurants, they are all making good earnings growth, especially health & beauty. Sales from Health & Beauty increased by 16% and operating income increased by 59%! This is driven by Hong Kong and Macau’s stellar performance from increased local spending and rebound in tourists from China.

IKEA sales went up by 11% but operating profit remains flat. This is because they are investing significantly in expansion. There will be several new stores coming up, 1 in Hong Kong, 2 in Taiwan and another 2 in Indonesia. Initial investment costs usually take a few years before it materializes into earnings in the financial statement. Additionally, they are also converting a giant hypermarket in Indonesia into a smaller format IKEA store in 2019. This is in line with management’s restructuring plan to do away with hypermarket concepts.

Restaurant’s sales increased by 16% and operating profits increased by 13%. Maxim’s caterer has licensing agreements with strong brands such as Starbucks, Shake Shack and Genki Sushi. They recently signed lease terms with the airport authority to operate restaurants and Starbucks in Macau airport commencing this year. Shake Shack also opened up its first store in Shanghai and Genki Sushi opened up its first store in KL.

You can see that other business segments of Dairy Farm are healthy and both sales as well as earnings are growing.

Stable Cash Flow Position

No surprises here. From a cash perspective, their figures look more stable and decent. Cash in bank seems pretty stable increasing over the years building up a healthy reserve of cushion. Unlike Sheng Siong where you see some years that FCF goes into the red (meaning they used their cash reserves to top up CAPEX investments), Dairy Farm is able to finance CAPEX requirements entirely using cash flow from operations.

Additionally, dividends paid (grey line) are BELOW their free cash flow. The above diagrams tell us that Dairy Farm is operating their business at a very sustainable level. Their dividend yield is rather low at 2.5% though. Unless their supermarket business turnovers faster than expected, I really doubt they can increase their payouts any time soon. Furthermore, their immediate problem is in reviving the supermarket business in SEA. This is not a stable mature company with a consistent increase in earnings, at least not yet. Their margins are currently under serious threats and I don’t think paying dividends would be on their priority list.

Conclusion

In summary, Sheng Siong seems to be the clear winner when it comes to supermarkets. But if we want to compare 2 businesses as a whole, that is another question altogether.

what I like about Dairy Farm is that they have strong brands that are well diversified across Asia. Their strategic objectives are well positioned as they want to grow in China, maintain strength in HK and revitalize SEA.

One clear advantage that Dairy Farm has over Sheng Siong is that they have been represented in China for more than 25 years with 7-11 and 14 years with Mannings. They have a strong partnership with Yonghui (China’s supermarket chain) while Sheng Siong only has 2 years of experience in China.

If we want to talk about potential growth in China, Dairy Farm has the upper-hand advantage. There is a huge upside potential as Guangdong province has 100 million population, 20x larger than Singapore. Dairy Farm’s growth prospect is definitely higher than Sheng Siong, but whether it can effectively sustain that growth remains unanswered.

What I don’t like is that their supermarket business is in a really bad shape. Their supermarket business accounts for the LARGEST portion of the group’s operations and if it continues sliding downhill, the entire group financial performance would get dragged down inevitably.

Fortunately, something is being done and this new team of leadership is trying to revive the business. Supply chain and procurement processes are going to be made more efficient in hopes to reduce costs significantly. They are also reviewing their stock management, product mix and working capital needs to improve gross margins. Competition with local players on the ground will continue to be a challenge for the group but I believe the management team would get their away around this by enhancing its branding and value proposition.

The biggest risk to me is that this leadership team is new, it’s their first time working together and they are pretty much in the initial phase of building relationships. Everything will be revamped from culture to operations and the dynamic of this team still remains unknown. We will never know anyway.

Dairy Farm is going through a restructuring phase right now and internal operational costs are expected to increase even higher in the next quarters. We can never be certain of the competency of these new hires and it can take up to years before their initiatives and improvement programmes start showing up in the financial margins.

The earnings report for the next quarter would largely be dependent on the financial and operational performance of its other business segments. This is because it is impossible for its supermarket business to turn around immediately. Losses from supermarkets would be offset by gains from other areas. Furthermore, operational costs and CAPEX is likely to increase due to the restructuring of their business.

Considering the slowdown in future sales and earnings from its supermarket business, I would probably stay away from the current price of 7.88. The next 5 years would probably be challenging and turbulent. Now is a time to monitor their leadership transformation plan and observe the financial impacts of their initiatives. If prices fall significantly lower, then this is a counter worth looking at as I believe that they are a good business in the long-run.

Ultimately, everything boils down to the competency and quality of the new leadership team led by Ian McLeod. He has done it before for Coles, can he do it again for Dairy Farm?

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8 Comments

    • I have not calculated the intrinsic value price yet. But I would definitely demand a higher margin of safety for the risk taken.

  1. Considering that a significant portion of DF’s revenue is coming from Hong Kong, do you think it will have a significant negative impact on their overall turnaround strategy? You think the current price of 5.72 is a good entry price?

    • Agreed. Definitely. But the problem with commodity business is they compete on costing and profits are largely driven by store expansions which have huge CAPEX outlay.

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