• Earnings back to growth track with sustainable high single-digit growth in FY17-18e
• Store rationalization enhanced profitability; Higher margin sales mix and economies of scale to lift margins further
• Associates‘ average earnings growth at 17% p.a. in FY17-18e
• Initiate coverage with Buy rating with a SOTP-derived TP of US$9.89; Attractive valuation after share price retracement

Company Overview

Dairy Farm International Holdings Limited (“Dairy Farm”) is a leading Pan-Asian retailer. The Group, together with its associates and joint ventures, operated over 6,600 outlets across 12 markets, with FY2016 total sales* exceeding US$20bn.

* Total sales include 100% revenue of its associates and joint ventures

Its four divisions include: 1) Food (Supermarkets, Hypermarkets and Convenience Stores); 2) Health and Beauty; 3) Home Furnishings (IKEA businesses); and 4) Restaurants (Maxim’s, a leading Hong Kong restaurant chain).

Dairy Farm is incorporated in Bermuda and has a standard listing on the London Stock Exchange, with secondary listings in Bermuda and Singapore. It is a member of the Jardine Matheson Group.

Investment Thesis

1. Multiple levers to drive up margins: We expect Dairy Farm margins to expand in the next few years. This will arise from better sales mix of higher margin products. The four key product categories will be (i) higher Fresh food; (ii) more Corporate Brand (a.k.a. private label) items; (iii) expanding into the upscale market; and (iv) increase Ready-to-Eat products. These categories still lag competitors.
2. More economies of scale: (i) Establishing distribution centres in key countries to enhance efficiencies via bulk handling; (ii) Implementing Group-wide merchandising system to improve inventory management; and (iii) Streamlining supply chain and increase direct sourcing across countries and companies within its Group. Margin enhancement to materialize in three distribution centres – Singapore (opened in May-16), Philippines (opened in May-17) and Malaysia (target to open in 2H17).
3. Expanding store network to lift sales. 7-Eleven store count in Guangdong is on-track to grow by 10% p.a. to 1,000 by end-FY18. It has the potential to double Hong Kong’s size given the vast population base in Guangdong. Meanwhile, a fourth IKEA store in Hong Kong is scheduled to open in Oct-17 and a site for a second store in Jakarta had been secured.
4. Fast growing associates to boost earnings. Yonghui and Maxim’s are contributing over US$100mn or 20% to the Group’s EBIT. We expect the profit contribution from its associates to grow 24%/8% in FY17/18e.

Key Investment Risks

• Prolonged macro headwinds in Hong Kong, Macau, Indonesia and Malaysia
• Intensifying competition and increasing operating costs could erode margins
• Regulatory risks in operating countries
• Unfavourable exchange rate movements will affect the Group’s US dollar reported results and led to lower underlying earnings for the period
• Cancellation, termination, or unfavourable renegotiation terms and conditions of concessions, franchises and key contracts could have an adverse effect on the business operations

Business Overview

At 30 Jun-17, Dairy Farm and its associates and joint ventures operated over 6,600 outlets across 12 markets, and employed over 180,000 people.

The Group operates under a number of well-known brands across four divisions, namely Food, Health and Beauty, Home Furnishings, and Restaurants.

Figure 5: Regional Footprint and Principal Brands

Investment Thesis

Margin gains and store expansion plan to fuel medium-term growth

Dairy Farm is constantly investing to enhance its competitive position, increase customer convenience and adapt to emerging consumer trends. We think that the Group is poised to ride the macro tailwind in Asia’s developing markets.

1. Margin enhancement on the back of (a) better sales mix of higher margin products, and (b) improving economies of scale

a) Increase Fresh participation and moving into upscale market 

• Food is the Group’s key revenue and earnings generator; but fetches low single-digit operating margins.
• In view of the competitive pressure from not only brick-and-mortar rivals, but also the rising e-commerce players, the Group continuously expands its fresh products offerings and product innovations to drive up profitability.

Figure 6: The better gross margins will lift Core EBIT margin to 4.5% by end-FY18e

Figure 7: Stronger contribution from its Associates and Joint Ventures will prop up another 20bps p.a. at net margin level in FY17-18e

• Fresh from the farm – Quality Fresh products translate into better margins.

Over the past three years, the Group has integrated Fresh Production Centre and the Dry Distribution Centre in Taiwan (2014); opened three distribution centre hubs in Indonesia (2014); and commenced a new Fresh Food Distribution Centre in Singapore (May-16). These translate to a higher Fresh penetration, which increased by over 20 bps in the FY2013-16. 

Management shared that its Fresh participation rate is still lagging behind NTUC Fairprice and Sheng Siong, despite being the second largest retailer in Singapore. Nonetheless, the new 75k sqft fresh food distribution centre in Singapore should level its playing field with NTUC Fairprice and Sheng Siong, and bode well with its plan to increase fresh participation. Management shared that lead time from farm to shelf in Singapore has shorten by 50%. The additional capacity also enables higher value food production – such as processing of fresh products.

We expect the two additional new fresh distribution centres that will commence operations this year – Philippines (opened in May-17) and Malaysia (target to open in 2H17), to further improve Food margins.

• Taking shopping to a higher level – Capture upscale consumers by including more imported and exclusive brands which demand higher margins.

We also expect the Group to benefit from its plan to increase its ownership in Rustan’s to 100% with the acquisition of the remaining 34% interest from its joint venture partner.

b) Capitalizing on convenience via Ready-to-Eat products and enhanced service offerings in Convenience Stores

Ready-to-Eat (RTE) food offerings continue to gained traction. Sales of RTE products grew over 10% YoY in FY16, double the rate of overall growth in Convenience Store. It has also revamped store format to incorporate a small dining in or seating area.

To draw higher footfall, it has also introduced enhanced service offers, such as establishing pick-up points and e-lockers services to complement the booming e-commerce industry, as well as cash withdrawal services, bill payment facilities, courier services, and prepaid card top-ups services over the counter.

c) Higher penetration of Corporate Brand in both Food and Health& Beauty segments

Corporate Brand (a.k.a. private labels) not only provide customers alternatives, but also enhance business profitability. The Group has over 10,000 SKUs (stock keeping units) under its Corporate Brands across Food and Health and Beauty segments. However, the penetration rate lags at mid-single digit percentage for Dairy Farm, as compared to mainstream retailers’ 25% to 50%.

This also implies that there is more scope for growth and margin expansion. In particular, its Health and Beauty division in New Markets. In 2016, over 900 new products were launched. More than 450 of these Corporate Brand products were introduced into the developing markets of Vietnam, Cambodia, Indonesia and the Philippines, which recording an impressive 117% sales growth in 2016. 

Figure 10: More SKUs and new Corporate brands launched under its grocery segment

d) Strengthening and streamlining supply chain and boosting stock management capability

Establishing advanced infrastructure across the region. These centralized distribution centres could:

• Enhance efficiencies driven by higher bulk handling. The Group could lower cost of goods and shorten the time from field to shelf, thus improving the quality and freshness of its fresh product offerings, and stock availability levels.
• Provide capacity to create higher value food production and bringing wider range of products to its consumers.

Efficient inventory management via technology. Its Group-wide newly implemented SAP merchandising system will reduce handling costs, strengthen key processes in the supply chain and enhance business analytics.

Shortening supply chain via direct sourcing. Leveraging on each other’s operating scale and sharing of know-how, would propel greater synergies and collaboration across the Group as well as with partners.

• Improve local and international sourcing – Diversify its range of product offerings while keeping costs low. E.g. collaboration with 7-Eleven Japan to source exclusive and unique Japanese products for its Singapore and Hong Kong markets.
• Manages common sourcing in general merchandise – Consolidate common range across business units and better coordination of seasonal promotions.