Asia Investor #05: A great way to cash in on Indonesia's addiction to chocolate

A great way to cash in on Indonesia's addiction to chocolate

I've sampled my fair share of strange snacks on my travels around Asia. There was the carton of salted soymilk I drank in Guangdong. And the curry paste filled donut I bought in a Japanese bakery. But the "Silver Queen" (pictured below) is right up there with them.

An unexpected mix of chocolate and cashew nuts, this bar did absolutely nothing for my appetite. I like milk chocolate. And I like cashew nuts. But the combination seemed a good way to ruin both of them.

Still tens of millions of consumers completely disagree with me. Silver Queen is one of the top selling bars in Southeast Asia's biggest and most promising chocolate market Indonesia.

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And just like the soymilk and curry donuts, that mouthful of chocolate-and-cashew brought home a useful lesson for my investment strategy. What sells in one market may be totally different to what people like a few hundred miles away.

Many investors make the mistake of ignoring this fact - thinking about Asia as one block. In reality, there are many more differences between countries than you find in Europe. That's why I am looking to find three-to-five stocks for each of our key themes consumer goods, healthcare, financial services, education and infrastructure - so that we can invest in as many different markets as possible.

So far, we've had a couple of recommendations from China and a couple more in India. There's also some exposure to the financial sector in Singapore and Malaysia. The point is that it's vital that we keep diversify far and wide across Asia.

And that's where this week's stock and the Silver Queen come in. Not only does this Indonesian-focused chocolate maker bring us into a new country. But it is also the dominant player in a market that grew by 27% a year on average between 2000 and 2008.

The company is called Petra Foods. And I think its share price could rise by 39% from here.

The Indonesian success story that is spreading right across Asia

Petra Foods is a Singapore-listed firm working in two different parts of the chocolate industries: cocoa ingredients and branded consumer products. Although both ultimately come down to cocoa beans, they are very different businesses.

The cocoa ingredients division is a processor and supplier of products such as cocoa liquor, cocoa butter and cocoa powder. In short, it takes cocoa beans and turns them into intermediate foodstuffs that food producers then use in their own finished goods.

This is quite a specialised business and one that's growing. While major chocolate manufacturers such as Nestl and Cadbury used to have their own processing divisions, in recent years they have begun outsourcing some of this work to firms like Petra who have been building up capacity in response.

Currently, Petra is number four in the world in cocoa-grinding capacity, behind Archer Daniels Midland and Cargill from the US and Swiss firm Barry Callebaut.

But although the cocoa ingredients arm accounts for around half of profits, it's actually the other half that we're interested in. It's Petra's branded goods division that makes it such an appealing consumer play for the Asia Investor portfolio. This involves selling own-brand such as Silver Queen, Cha Cha, Top and many others directly to consumers.

There are three factors that make the branded goods division such an exciting prospect - a fast growing home market. Some very successful ventures across Asia. And partnerships with some of the worlds biggest confectionary groups. Let's take the home market first.

Petra's core consumer market is Indonesia, where the firm was first set up several decades ago. Petra has a combined market share across its brands of around 50%, way ahead of any competition. But there's still considerable growth potential: the market grew at 27% a year on average in 2000-2008, yet chocolate consumption per capita is still on 0.3 kg per capita per year, compared with around 0.9 kg in Singapore and 1.1 kg in Japan.

Rising incomes, increased marketing and better availability including modern retail chains with air-conditioning and cold storage should help propel sales for some while yet. And while Indonesia doesn't have the profile of China and India in international investors' eyes, a population of 235 million and youthful demographics makes this a very promising long-term consumption story.

Indonesia dominates sales for this division, as the chart below shows. But other regional markets Malaysia, Singapore and the Philippines are growing in importance, at 34% of sales last year from 7% in 2004.

The most interesting of these three is the Philippines, where Petra currently has around a 10% share, concentrating on lower-cost products. Again, this an appealing long-term market with similar current consumption levels to Indonesia and a population of around 94 million.

As well as producing and selling its own brands, Petra also uses the distribution channels its built up to sell products made by other firms, such as Toblerone and Guylian. Building a sales and distribution network in an emerging market is not an easy business, especially across an archipelago with shaky logistics like Indonesia. So it makes sense for outsiders to partner with firms like Petra rather than trying to do it themselves. Last year, the split between own and third party sales was around fifty-fifty.

The consumer business has long been a strong performer, posting good growth year-after-year, even during the global crisis. Gross margins are solid and stable at around 30% and its market position in Indonesia in particular is enviable.

Unfortunately, Petra has been held back a little in recent years by its ingredients business, as the chart below demonstrates.

But those problems won't hold Petra back for long.

Why Petra is poised for a rebound in sales

In fact, the cocoa ingredients issues really come down to one market: Europe. The Asia and Latin America segment continued to grow profits throughout the crisis. Petra currently has four plants in Asia, two in South America and two in Europe. Its newest plant in Hamburg was bought three years ago and has been undergoing an extensive investment and upgrading programme.

But the process of upgrading the new plant in Hamburg seems to have taken longer and cost more than expected. Consequently, Europe has been a steady drag over the last couple of years.

The good news is that this should be over. The upgrade is now complete and the factory is now producing generic cocoa products. More importantly, customers are starting to complete their quality assurance checks on the plant; once these are done, the plant will be able to sell much more high margin customised ingredients that will make the whole investment process worthwhile.

So over the next couple of years we should see a step up in sales and margin in cocoa ingredients as this division gets back on track. Meanwhile, sales in the consumer division continue to run at a very solid pace, up 18% year-on-year in local currency terms in the first quarter.

A solid family business with the right contacts

The roots of Petra Foods go back to the 1950s, when the current chief executive's father began producing Silver Queen chocolate bars in Indonesia. The group was set up in its current form in 1984 and is headquartered in Singapore, where it listed on the stock market in 2004. CEO John Chuang and his family are the controlling shareholders, with a combined stake of just over 50%. Several institutions hold smaller stakes.

The free float is around 25% and the average daily volume over the past 12 months has been a little under 500,000 shares, although this includes a number of large block trades a figure more reflective of typical trading would probably be in the 100,000-200,000 range. While this is not highly liquid, I don't anticipate that Asia Investor readers will have trouble filling any normal-sized orders.

Petra is a family business, with the risks to minority shareholders that having a single controlling shareholder brings. As I've mentioned before, the Asia Investor strategy will often involve investing in family firms, since the corporate sector in the region is still dominated by family or state-controlled groups. So I look for a long business history, a good reputation or reliable investors or board members as indications that outsiders will be treated fairly.

There can never be any guarantees, but with Petra the signs are encouraging as they should be with any stock that makes it into Asia Investor. The family have a long history in the industry and seem highly committed to the business, while the management team includes plenty of experienced staff recruited from elsewhere.

Meanwhile, the board has four independent directors from solid professional backgrounds, most notably Davinder Singh, who is a former member of Singapore's parliament and also acts as the personal lawyer of Lee Kuan Yew, the founding prime minister of Singapore. Unlike many Asian governments, Singapore is largely free of petty corruption, so the presence of senior establishment figures is usually a positive. (Arguably there are elements of institutional corruption in its political system, but that's a different matter.)

There's one small potential conflict of interest involving ongoing transactions with firms owned by the Chuang family that operate in other segments of the chocolate business (mostly industrial chocolate and very low end unbranded chocolate sold by hawker stalls). In general, I dislike any related party transactions since it can be a sign that management or controlling shareholders are taking advantage of minority shareholders, but they're common in Asia and it's sometimes necessary to compromise. In this case, the compromise seems small and the firm appears to be handling matters in an exemplary way.

The deals are not alarming in scope. The amounts involved are small relative to Petra's revenues, at $23m compared to total sales of $1.2bn in 2009. The firms do not compete directly with Petra and the businesses don't look especially attractive on the limited information available, so it doesn't seem that shareholders are being disadvantaged by them not being part of the Petra group.

From a governance point of view, the transactions are clearly and transparently disclosed in the firm's reports. In addition, there is a covenant whereby the independent directors can oblige the Chuang family to sell their interests in these firms either to Petra or to third parties if they conclude that these businesses are competing with Petra.

One might have doubts about whether such covenants would be enforced. But even the presence of them is unusual. Combined with a credible set of independent directors, this suggests that the firm is doing its best to keep everything above board.

A few risks to consider

In addition to the usual Asia Investor risk warnings, I'd emphasise the following:

Like all food producers, Petra is exposed to rising prices in commodities such as cocoa, sugar, milk, paper (for packaging) and so on. The risk is that it may not be able to pass these increases on fully. On the positive side, the firm has shown good ability to use its brand strength to raise selling prices in recent years when needed.

The situation with cocoa for processing is a little different. This is more or less a cost-plus'business, with the primary cost being cocoa beans. Rising cocoa prices increase headline revenue, but the nature of contracts and Petra's hedging policy minimises the impact on profitability.

However, higher prices increase the working capital needed to purchase inventory for processing before the finished products are sold on to customers and the cash for them received. Thus Petra's short-term debt level has risen sharply as a result of the recent rise in bean prices and this bring some balance sheet risks, in the form of potential difficulty raising the necessary finance.

On the positive side, beans are highly liquid assets purchased to meet committed sales contracts the kind of deal that banks are usually keen to lend against. Petra has room to spare within its current financing facilities and is moving to strengthen its balance sheet, as I'll discuss below. Thus the danger of liquidity problems seems low, but this exposure to higher working capital demands is an intrinsic risk of its business model that investors should understand.

Most of Petra's businesses are well established and are only subject to the usual businesses risks reputation, increased competition and so on, which the firm should be well placed to respond to. However, success with the new plant in Hamburg is dependent on it meeting customers' quality standards for premium ingredients.

So far it's received a number of certifications from customers, but more are yet to be completed. There's no reason to expect that this process won't be fully successful, but if it weren't, that would hurt Petra's plans to focus on premium products and would thus reduce profitability at the plant.

Foreign currency risk will be a factor with all Asia Investor recommendations and I don't attempt to forecast currency movements other than a general view that Asian currencies will rise against developed world ones over time. In Petra's case, the firm does business in a range of currencies, including local Asian ones, US dollars and euros, while reporting its results in US dollars and having shares quoted in Singapore dollars.

Clearly in the short term, there is potential for currency fluctuations to have an effect on profits, although over periods of a couple of years or longer, I would expect these to even out. The firm's operates a prudent policy of hedging some currency risks by matching borrowings to liabilities: ie US dollar investment producing US dollar revenues will be funded by US dollar borrowings.

Finally, the firm is in a dispute with the Indonesian tax office over allegations of transfer pricing (where a company transacts between subsidiaries at distorted prices to move profits out of a high tax area into a lower one). This could potentially lead to a back tax bill of $7.6m. Petra is contesting the assessment, arguing that its sales were done in accordance with OECD transfer pricing guidelines. It's impossible to know what the outcome of the case will be.

Why Petra could make you 39% while protecting your portfolio

At first glance, the most off-putting thing about Petra is the balance sheet. Net debt to equity stood at a rather eye-popping 235% as at end March 2010. This headline figure is a little misleading however: as mentioned above, much of it reflects increased short-term debt to fund the higher cost of inventories due to cocoa price rises and the ramp up in operations at the Hamburg plant. Absent another large rise in cocoa prices, this debt should fall quite rapidly as Petra delivers the processed goods to its customers and receives full payment.

Excluding inventory financing, adjusted net debt to equity was at 62% in March, down from 70% in December. Since then, the firm has carried out an S$85.2m (US$63m) share placement to raise further funds for investment and working capital, while also planning to diversify its borrowing sources and extend the maturity of its debt to reduce liquidity risks. Finally, with the Hamburg factory coming on stream, all major business will be profitable and generating cash. So management appear to have a sharp focus on managing financial risks and the trend in the balance sheet should be an improving rather than deteriorating one over the next year or so.

Petra's recent results and my estimates for the next two years are shown in the table below. (There's no revenue estimate because it's largely irrelevant to profitability in the cocoa ingredients business, while also being dependent on volatile cocoa prices and thus not usefully predictable; my estimates for this division are based on volumes and margins.)

For comparison, the average of analysts' estimates from Bloomberg is for around US6.5 in FY2010 and US8.5 in FY2011, putting mine towards the conservative end of the range.

In valuation terms, the stock currently trades on around 20 times my estimates for FY2010 (based on a SGD-USD exchange rate of 1.35). Weighing up the potential of its consumer business versus the lower growth prospects of the cocoa ingredients division beyond the point when profitability has recovered, this looks about the right multiple. Any significant rerating upwards would probably require it to be seen as more of a pure consumer play that's possible in the long run if the consumer division share of earnings continue to expand, but probably not for some years.

So I would keep Petra on a p/e of around 20 and look forward to FY2011 as the point at which the investment in its European plant has begun to pay off. On my estimates, that would indicate a potential price of around S$2/share then, or upside potential of a bit under 40% on the current share price. Discounted back to today at a minimum required rate of return of 15% per year gives a buy limit of S$1.6.

Unlike some Asia Investor recommendations, Petra clearly isn't vastly underpriced. The potential return would still be attractive, but other stocks in the portfolio have higher prospective upside if all goes well.

However, my goal with Asia Investor is not to just to pick stocks with triple-digit potential returns, but to build a portfolio that benefits from Asia's key trends while balancing risk. A stock like Petra is useful for this because it has limited exposure to China or India and gives us access to a major consumer market that is largely independent of both. As such, it fills an important niche and makes a valuable addition to our portfolio.

Recommendation

Buy: Petra Foods

Ticker: PETRA (Bloomberg), PEFO (Reuters), P34 (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$880m

Bid/mid/offer prices: S$1.4/S$1.42/S$1.44

Buy limit: S$1.6

52-week low/high: S$0.72/S$1.44

Yearly change: 2005 +30%; 2006 +67%; 2007 -15%; 2008 -76%; 2009 +197%; 2010 +29% (to update)

For UK readers, Petra is listed on Singapore's main board and so will be eligible for an ISA if your provider allows foreign shares to be held in one.

That's all from me this week. If you have any queries, please drop me a line on asiainvestor@moneyweek. Otherwise, I'll be back in a fortnight with another recommendation at present I'm looking at a few possibilities for our first investment in the healthcare and education sectors. In the meantime, you can access the ASIA Investor archive on the MoneyWeek website by clicking here. The password for the next fortnight is continental.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report: Petra Foods first quarter 2010 presentation, Petra Foods annual reports 2004-2009, Petra Foods listing prospectus, Petra Foods website, regulatory announcements and results from Petra Foods, reports from DBS Vickers, Standard & Poor's, SIAS Research, data from Bloomberg, 2010 World population data sheet

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