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Tug Of Fools: Dairy Farm – The Bear Argument

After reading the bull argument, you would see Dairy Farm International Holdings Ltd  (SGX: D01) as a consistent performer. Backed by the defensive nature of its businesses, the company has been able to generate cash flow to reward its shareholders.

However, as with operating any business, there exists business risks. It can arise due to internal as well as external factors. This kind of risk affects a company regardless of its size and business line.

In the case of Dairy Farm, there are three types of business risks that are currently adversely impacting the company’s business.

Firstly, the company is grappling with strategic risk that is present due to its competitive business environment. The second pertains to compliance risks that arose due to policy changes. The third is market risk, more specifically currency risk. Lately, detrimental effects of these risk factors on Dairy Farm’s operations have become more apparent. This prompts investors to rethink if it makes sense to go in at current valuation.

Slowing Revenue Growth

The food segment, which consists of supermarkets, hypermarkets and convenience stores, is the mainstay for Dairy Farm. It accounts for close to 75 percent of total revenue.

Barring FY09 which fell within the Global Financial Crisis period, this segment has seen substantially slower turnover growth for the past few years. For FY13, revenue growth slowed to 3.5 percent compared to 12.5 percent in FY10. This drag continued into 1H14, where growth of a mere 1.5 percent was posted. This dampened sales performance as the company registered a 3.9 percent increase in revenue for the six-month period, the slowest pace since 1H09.

Revenue Growth (Year-On-Year)

diary farm tug of fools graph 3

Source: Company Report

Given that majority of food revenue is derived from more established markets, the falling growth rates could suggest that the company is experiencing declining market share. This is not surprising considering how intensely competitive the fast-moving consumer goods retailing space is. Furthermore, demand is highly responsive to price changes because product differentiation is almost non-existent.

Thinning Margins

Dairy Farm has operations spread across 11 Asian markets. Much as the company has a diversified portfolio, it is exposed to regulatory changes in these markets.

In particular, the company has to cope with policy changes that were implemented in Singapore and Indonesia recently. Restriction on foreign labour hire such as tighter foreign worker quotas and higher foreign worker levies in Singapore and mandatory minimum wage in Indonesia have added another burden to performance.

Operating Margin

diary farm tug of fools graph 4

Source: Company Report

This is on top of increasing costs in terms of rentals. The concern here is that margins might be compressed further. Further deterioration in profitability does not bode well with Dairy Farm’s inherently low-margin business. From FY09 to FY13, operating margin for the supermarkets and hypermarkets segment lost 1.8 percentage points. The five-year average of the profitability measure was 4.9 percent. This paled in comparison to its peer Sheng Siong’s average of 6.9 percent.

Currency Translation

Another worry with a diversified portfolio is the exposure to foreign exchange risks. Weakness in regional currencies will translate to lower profits even though performance in local currencies improves.

Dairy Farm’s Indonesian unit is a case in point. Profits from its Indonesian arm depressed profits due to a weaker rupiah which has depreciated about 25 percent against the US dollar in 2013.

As the US economic growth continues to gain traction along with the end of the stimulus programme and expectation of an interest rate hike in 2015, the US dollar is expected to strengthen. This might eat into profits, translating to lower profitability in US dollar terms.

The Rise Of E-Commerce

While the latest acquisition of a 20 percent stake in hypermarket operator Yonghui Superstores signals Dairy Farm’s commitment to the Chinese market and could bolster future earnings, the Chinese up-and-coming e-commerce space is an obstacle to traditional retailing.

Though still at an infancy stage, the range of products available online has expanded to include food categories. This might drive up the online shopping population further. Based on findings from Kantar Worldpanel, the global market leader in consumer panels, the base of households shopping online for FMCG goods in the country has been increasing exponentially. Total penetration sits at 28 percent. In less than three years, China’s online penetration is expected to surpass 50 percent.

Therefore, unless the company establishes an online shopping platform, what it might be looking at is limited growth opportunities.

SI Research Takeaway

Coupling the e-commerce concern with the combination of slowing revenue growth and thinning margin in its main business segment might not sit well with the company’s current valuation. Using the latest five-year compounded annual growth rate of earnings per share, the price-earnings to growth (PEG) ratio stands at 3 times. This means that Dairy Farm is trading at a rich valuation.

One certainly do not want to overpay for an investment. At this point with the circumstances highlighted, it might be wiser for an investor to monitor before committing when opportunities arise.

You can read The Motley Fool Singapore’s bull argument here.

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