AI #7: Petra shouldn't underperform for long

21st September 2010

Petra shouldn't underperform for long

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Welcome to this week's Asia Investor, which for a couple of reasons hasn't quite worked out the way I planned. First, I've been struggling to shake off an illness, which has cut down my working time. And secondly, my recommendation shortlist has been causing some unexpected problems.

You'll remember that I cancelled my planned recommendation last week because the stock I had lined up had moved above my buy limit. Unfortunately, the same happened to the alternative recommendation I was working on for this week.

I had another alternative in mind and I've almost completed a report on it but in finalising the details, I became concerned about something the management seemed to be glossing over: briefly, they appeared to be downplaying the potential importance of some recent problems in its business and more importantly not treating it as an event that needed to be notified to investors.

For this reason, at the very least I'd want to see how the business responds to this over the next couple of quarters. What's more it also raises potential governance and transparency issues, making me feel that the business should perhaps trade at a lower valuation to reflect this.

I'm not happy to have to delay my next recommendation twice. But I'd never consider recommending a company that I don't think represents good value or where I have unresolved concerns about its business purely to meet a deadline.

I'm working on a new stock that's looking very attractively valued at this stage, and I should have the full report with you next week. But in the meantime, there are a couple of status changes on two of our portfolio holdings. I've also had a couple of questions concerning Petra Foods that may be interesting to some of you, so now seems a good time to go over them.

Hold your 34% paper gain on Hsu Fu Chi

If you hold our Chinese confectionary play Hsu Fu Chi, you'll have noticed that the stock has moved to S$3.11, above my buy limit of S$2.85. That's a paper gain of 34% since we added it to the portfolio at the beginning of June.

I think this is a great company and a very strong long-term investment. It's certainly not time to sell. But as I discussed during its last results update, the question is whether it's time to raise the buy limit to reflect those strong results, or whether the stock may have got ahead of itself.

The difficulty is this. I believe Hsu Fu Chi has benefited from favourable commodity price movements over the last year and has seen its margins expand. It's not immediately clear whether it can defend these wider margins, or whether raw material costs and higher wages will bring them back down again.

Given Hsu Fu Chi's potential market and its strengths, I don't think the stock is too expensive. It currently trades on a trailing p/e of around 21, which seems reasonable. But there is some scope for disappointment and weaker earnings if margins shrink back.

Consequently, I want to see the next quarter's results and see how Hsu Fu Chi is responding to price pressures before I decide whether to increase my valuation. For now, the stock moves to a HOLD.

ICICI is a hold after 28% paper gains

The other big recent mover has been our Indian banking play, ICICI Bank. We're investing in this through the US-listed American Depository Receipts, which are now trading at $48.92, above my buy limit of $44.4. The ADRs have seen a price return of 28% since mid July. Almost all of this has been due to the rise in the underlying shares, rather than changes in the rupee-dollar exchange rate.

You might recall my argument for ICICI. After overreaching itself and incurring some bad loans during the boom, the bank is now getting back into shape and profitability should recover strongly in the next few years. But because earnings for the next year or so were likely to be sluggish compared with peers, the market is taking a short-term view and overlooking the enormous long-term potential of India's leading private-sector bank.

Investors now seem to be reassessing its prospects. The stock has been handily outperforming the Indian market in the last few weeks. But ICICI is now trading on a trailing p/e of 27, which I regard as fairly high for a cyclical such as a bank even one with such good growth prospects. As I said before, ICICI's earnings should pick up solidly in the next couple of years. But I'm not currently confident that they'll rise enough to deliver my minimum 15% target annual rate of return for new investments from this price level.

I'm happy to keep ICICI for the long-term at these levels. However, I think for new investments there are better value financials elsewhere. Investors may well have an opportunity to buy ICICI at a lower valuation in the future. It's certainly not highly valued enough to sell yet, but I'm moving it to a HOLD.

Petra chocolate shouldn't underperform for long

Finally, let's take a look at our cocoa and chocolate investment, Petra Foods. This is actually the worst performing stock in the portfolio so far and one of two that's in the red, down around 9% since I initially recommended it.

There's no obvious reason in terms of company news for its underperformance. The stock had a strong run-up before we bought it, and that momentum may simply have run out of steam for now.

But my suspicion is that the cocoa price may be playing a part. Petra is not a proxy for cocoa. It tries to pay on raw material prices in its consumer division, while its cocoa processing division sells capacity on cost-plus contracts and hedges the cocoa price. I've said that I think that it may be able to get slightly higher margins as bean prices rise, but the direct impact on earnings should be muted.

Nonetheless, the fact that it rose strongly as cocoa soared this summer and is now falling back as cocoa weakens makes me feel that some investors have been buying into the stock on the assumption that it's highly geared to higher prices and have sold out as prices declined.

I'd expect this weakness to be short-lived. Petra's trading on around 19 times my base case for the current year and 13 times my base case for next year. Given its very solid set of second half results, I think my estimates have a good chance of being conservative. So I continue to think Petra is a strong long-term prospect and it remains a BUY up to S$1.6.

Source Bloomberg

Five year performance: 2005 -+30.91% | 2006 +66.67% | 2007 -14.44% | 2008 -75.32% | 2009 +171.05%| 2010 + 26.67%

A closer look at the case for Petra

This a good opportunity to discuss a couple of questions about Petra that I've received from subscribers. Before I begin, let's quickly recap Petra's business.

As you may remember, the company has two divisions. The first is cocoa processing for third parties in Asia, Europe and Latin America. The other is the manufacturing, distribution and sale of its own and third party chocolate brands in Southeast Asia. On the branded goods side, it's the dominant player in Indonesia. Its strong brands and enviable distribution network make it an obvious partner for foreign firms entering the market.

Some readers have said that they like the look of the consumer business, but are not keen on the cocoa processing division, which has higher capital requirements and lower margins. So why does Petra stay in this line of business, and why is the stock attractive in comparison to pure branded goods plays such as Vitasoy and Hsu Fu Chi?

It's a very valid question and one that I have thought about in some depth. I've discussed some aspects of the question in past issues, but let me expand on them in more detail.

Firstly, as I mentioned in the original report, it's certainly Petra's branded goods operation that interests me. And it's true that firms such as Vitasoy and Hsu Fu Chi in the portfolio (and other names such as Tingyi and Want Want that I haven't included on valuation grounds) offer purer exposure to this EM consumer theme than Petra, since they lack a third-party processing division.

On the other hand, I think it's important to be diversified within themes. That means that I don't want all my consumer exposure to be to China. I'm striving to keep the portfolio balanced, as I discussed in the recent quarterly review.

I want Indonesia and SE Asia to feature in the portfolio and these markets are harder to access via stocks listed in Hong Kong, Singapore or the West. Consequently, I regard Petra as an attractive easy way to invest in Indonesia and SE Asia consumption for most investors.

That said, I wouldn't recommend it if I thought that the other side of the business was bad. I'm not going to chase diversification at the expense of quality. I view the processing division is a perfectly decent business with good prospects. It's just not as interesting as the consumer division and not of interest to me by itself.

It makes sense to ask whether Petra would be a better investment if it divested the processing arm and became a pure branded goods firm. It's a very logical question from a business strategy point of view. But in this case, I'm not sure that it would.

In particular, there are quality control issues attached to sourcing ingredients. The prospect of contamination or poor quality materials getting into the supply chain is one of the biggest brand risks for consumer companies. Given the lower quality assurance standards within many Asian markets, it makes sense Petra would want to keep control over its inputs.

To ensure their needs are met, consumer firms in the region often choose to integrate more than those in Europe or the US might. For example, Hsu Fu Chi's expansion plans include investing in a packaging plant to have better control over costs in that part of the supply chain.

Given that Petra has processing expertise in-house, it makes sense to capitalise on that expertise by being an outsourcer for firms like Nestl and Mars. These diversified groups have a much stronger argument for shedding their processing divisions. They operate in hundreds of categories and cocoa processing is much more of a niche to them than it is to a chocolate specialist like Petra.

That said, margins in cocoa processing are always going to be lower than in branded consumer goods. Capital requirements are greater. To see this simplistically, note that the cocoa ingredients division had assets of almost $770m as at end of June, while the branded consumer division had assets of around $205m. Yet both reported roughly the same operating profit. This includes both fixed capital requirements and higher working capital requirements. Inventories, which are mostly cocoa beans for processing, amounted to around $450m.

However, as an investor I don't mind this as long as I'm not overpaying for this side of the business. We can think about Petra as the sum of two parts. Let's assume that Petra's FY2011 earnings are split roughly fifty-fifty between processing and consumer. Then on my FY2011E base case, we are hypothetically paying 10 times next year's estimates for the relatively low-growth ingredients business, and around 16 times next year's estimates for a strong consumer business with much stronger long-term growth prospects. Both parts of this seem fair to me.

What we may need to be concerned about with firms with two different divisions is the different risk profile of each division's earnings. Volatile earnings are an issue with many capital-intensive processing businesses, which are exposed to commodity price movements, output price movements and abrupt changes in demand for your products. This can potentially leave you with an expensive new expanded plant and very weak sales as the economic cycle turns down.

This is very true of businesses like steelmaking, which is why I generally don't like investing in these industries. But cocoa is a little different. As I've mentioned, Petra operates a cost-plus business on committed contracts, while demand for chocolate is relatively though not totally defensive in recessions. So although this is a processing business, there isn't the same degree of earnings risk attached.

Of course, one other concern with processing businesses can be the debt used to fund its capital needs and in particular working capital for inventories, which in Petra's case are obviously very sensitive to cocoa prices and rose in response to higher prices. There is obviously a risk of a capital squeeze during a crisis.

That said, Petra's cocoa bean inventories are a highly liquid asset and purchased for committed contracts hence they are the kind of asset that banks are usually happy to provide trade finance for. And perhaps more tellingly, Petra made it through the global financial crisis, which is probably the biggest stress test we'll see for a long time.

So while the cocoa processing division doesn't have the combination of long-term, low-capex growth prospects combined with defensive demand that make consumer staples business so attractive, it doesn't have the kind of qualities that should give me sleepless nights either.

I certainly wouldn't pay as much for Petra's processing business as for the consumer goods. And I wouldn't be interested in it as a standalone business since it doesn't fit my strategy (other than at a very low price).

But I don't think the presence of the processing business detracts from Petra's merits. Given the strength of the consumer business and the exposure Petra offers to Indonesia and Southeast Asia, I think the stock is a valuable part of the Asia Investor portfolio.

That's all from me this week. Again, my apologies for the delay in bringing you a new recommendation and I'll be back next week with a new report. In the meantime, you can email me on asiainvestor@moneyweek.com if you have any questions.

Regards,

Cris Sholto Heaton

ASIA Investor

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