Looking For a Bargain? Here’s Why You Might Want to Consider Dairy Farm International Holdings Ltd

Pan-Asian retailer Dairy Farm International Holdings Ltd  (SGX: D01) has had a horrible time over the past two years. Since its shares closed at an all-time high of US$13.65 on February 2013, there’s been a sustained decline, so much so that its shares are now 36% lower at US$8.72 each.

Over the same timeframe, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which mimics the fundamentals of Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has inched up by 2%.

But, there may be some light at the end of the tunnel: Those tough two years that Dairy Farm has had to suffer through may have helped turn the share into a possible bargain today.

A historically cheap valuation

At first glance, Dairy Farm’s trailing price-to-earnings (PE) ratio of 23 at the moment may seem high. That’s especially so when we consider that 1) the SPDR STI ETF is valued at just 13 times its trailing earnings currently and 2) Dairy Farm’s profit growth has slowed down considerably over the past few years.

Dairy Farm's earnings growth

Source: S&P Capital IQ

But, as you can see in the chart below, the company’s now near the cheapest it’s ever been since the start of 2010 based on its PE ratio as a result of its fall from grace over the past two years.

Dairy Farm historical price-to-earnings ratio since start of 2010

Source: S&P Capital IQ

Having a below-average valuation helps set the stage for a mean reversion to occur with Dairy Farm. A reversion to the mean is a concept which value investors may be familiar with and it’s the simple idea that, as investment manager Dean Williams puts it, “something usually happens to keep both good news and bad news from going on forever.”

In an investing context, a reversion to the mean may be seen in how below-average valuations (where Dairy Farm is now arguably at) come before above-average returns. But, this doesn’t mean that Dairy Farm will necessarily be a bargain. Investor Ric Dillon writes:

“On the behavioural-finance side, one of many inefficiencies comes from people anchoring on the past. People assume something is cheap, say, just because it hasn’t traded at such a low valuation for five or ten years. But that doesn’t matter, what matters is what will be.”

In other words, it’s still important to cast an eye on the future prospects of a company’s business even if it has what seems to be a bargain-basement valuation – Dairy Farm is no exception.

Shopping for growth

Dairy Farm’s in the business of running hypermarkets, supermarkets, convenience stores, pharmacies, home furnishing stores, and food & beverage retail outlets. All told, the company has more than 6,100 stores in 11 countries and territories across Asia (this includes Hong Kong, Singapore, Malaysia, the Philippines, and more).

When it comes to room for growth, Dairy Farm’s not complaining of a lack of space. Here’s my colleague Chin Hui Leong on the topic:

“Singapore and Hong Kong currently houses more than half of the 5,889 [at end-2013] retail outlets for Dairy Farm. At the same time, China alone has at least nine cities which are larger than Hong Kong in terms of population size. In 2013, Dairy Farm had only 972 retail outlets in China, so there is space for the company to grow further in the country.

Furthermore, according to Euromonitor International, China and Indonesia are each expected to generate more than a trillion U.S. dollars in additional sales through convenience stores in 2014. Dairy Farm has a strong convenience store presence in both countries.

Another report from the Economist suggests that rapid urbanisation and a growing middle class is expected to drive sales for the overall retail environment in Asia. The research outfit estimates that Asia will be the home to 1.7 billion middle class citizens by the year 2020.”

A recent US$909 million strategic investment made by Dairy Farm that was completed just this April for a 19.99% stake in China-based grocery retailer Yonghui Superstores may also help the former reignite its earnings growth.

The investment isn’t just a passive one as Dairy Farm commented in its latest 2014 Annual Report that “many opportunities have been identified to collaborate and drive benefits for both companies” following the deal.

Yonghui Superstores has good experience in China’s grocery retail market (having been founded in 1995) and has a solid track record of growth. To the latter point, the Chinese outfit’s revenue has tripled from RMB12.3 billion in 2010 to RMB36.7 billion in 2014; meanwhile, its profit has surged by 180% from RMB305 million to RMB852 million.

These traits increase the possibility that Yonghui Superstores can be a good partner for Dairy Farm in the latter’s planned expansion of its Food business (this business segment consists of Dairy Farm’s supermarket, hypermarket, and convenience store operations) in China.

For some perspective on the opportunities at hand, Dairy Farm’s chief executive Graham Allan had commented in a recent earnings presentation that Dairy Farm’s market share of the $800 billion modern grocery retail market in China is only 1% (this includes Dairy Farm’s Yonghui Superstores investment).

A Fool’s take

With Dairy Farm’s historically-low valuation at the moment and its long runway for growth, it may just be a bargain now. But, there are still significant risks to consider, such as the rise of e-commerce and potential problems in China.

E-commerce has led to the demise and weakening of many once-mighty brick-and-mortar retailers in the West and it’s worth keeping an eye on the steps that Dairy Farm’s management is taking to counter any possible threats from that angle.

The Chinese government has a desire to transform China’s economy into one that counts consumer spending as an important pillar of growth. That alone may provide a strong tailwind for Dairy Farm’s planned expansion into Asia’s largest economy. But, it’s also no secret that China’s economic growth is slowing and any prolonged slump may just throw a wrench in the works and shorten Dairy Farm’s runway for growth in China.

In addition, competition in the super- and hypermarket space in the country is very tough to say the least. Big Western supermarket operators like Carrefour, Tesco, and Walmart have all tried their hand at cracking the Chinese market, only to end up with eggs on their faces. There’s no guarantee whatsoever that Dairy Farm’s Chinese expansion can succeed even if it has roped in a seemingly strong partner in Yonghui Superstores.

All told, investors would have to weigh the risks and rewards in order to come up with an intelligent investing decision when it comes to Dairy Farm.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Dairy Farm International Holdings.