AI #14: Investing in a Malaysian obsession

Watch a Malaysian food-stall holder preparing the national drink of teh tarik and you’ll get quite a show. It’s no good just dumping tea leaves in hot water and pouring a bit of milk on top: as the name teh tarik (“pulled tea”) suggests, the mix needs to be poured from jug to jug, letting it fall as far as you can each time, to get the right foamy, frothy texture.

Watch a Malaysian food-stall holder preparing the national drink of teh tarik and you'll get quite a show. It's no good just dumping tea leaves in hot water and pouring a bit of milk on top: as the name teh tarik ("pulled tea") suggests, the mix needs to be poured from jug to jug, letting it fall as far as you can each time, to get the right foamy, frothy texture.

You can't just use any milk, either. Teh tarik needs condensed milk, which has been processed to make it far sweeter and thicker than it was when it first came out of the cow.

And that leads to a bit of a quirk in the condensed milk market. Normally, condensed milk is cheap, basic nutrition it sells best in places were people are poor and can't afford fresh milk. Once incomes rise, they switch away from it.

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Except in Malaysia, that is. Despite being well past the poverty stage, the country's teh tarik obsession means that it's still one of the world's most enthusiastic consumers of condensed milk.

And that fact is what led me to this week's recommendation which didn't entirely turn out how I expected. As I headed to a meeting in the suburbs of Kuala Lumpur a few weeks ago, I thought I was going to see a cheap, stable business in a sector that's about as defensive as you can imagine. And it is all that but it also has a lot more growth potential than I expected

10 years of impressive growth

Etika International Holdings dates back to 1997, when three Malaysian stockbroking brothers teamed up with three former executives from the dairies division of Singaporean conglomerate Fraser and Neave (F&N) to build a new condensed milk business. F&N was the market heavyweight, alongside tough competition from other firms such as Nestl and local dairy Dutch Lady.

Etika was starting from scratch, with 0% of the market in 1999. A decade later, it's the second largest player after F&N, claiming a market share of 20%. And in the segment of the market where it's focused most selling to food stalls and other trade businesses the company says that its Dairy Champ brand is neck and neck with F&N. It's also built a solid export business, notably to Africa where poor logistics and refrigeration make condensed milk the only milk product that can be easily shipped around (the high sugar levels means it doesn't go off).

Overall, from 2005 (when the firm first listed) to 2010, revenues have grown by 35%/year on average and profits by 44%/year. This was a pretty good start and an impressive accomplishment on the part of the management. But more recently, the company has been expanding beyond condensed milk and Malaysia, as it aims to build a diversified regional food and beverage group and that's where the future growth prospects I mentioned above come in.

Its first deal in 2006 was to buy Pok Brothers, a long-standing Malaysian wholesaler of frozen and premium foods to clients such as supermarkets, restaurants and hotels. This gave Etika new product lines such as meat and bread but more importantly an established distribution network that could take it to new customers. As the chart below shows, revenues and profits grew very strongly in the aftermath of the deal.

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Now it's aiming to repeat the trick through a series of acquisitions that should overlap in expertise, distribution and raw materials. For example, management think there's a great deal of potential in the Indonesian condensed milk market, which Etika estimates to be 1-2 times the size of the Malaysian one but is still highly fragmented. However, getting a foothold there has been tough: distribution is extremely difficult, not helped by the fact that Etika must import all its products.

So last year, it bought a distribution business in Jakarta. This year, it purchased an instant noodle maker with a disused factory that it plans to convert to producing condensed milk. The two businesses by themselves are small, but Etika believes that putting them together and adding its own expertise will let it build a platform for growth in condensed milk in Indonesia.

Simultaneously, it thinks it can turn around the loss-making noodle business by improving how it operates in Indonesia and by supplying it with an export market through its supply chain in Malaysia. Growing the noodle business will also overlap with plans to grow its baked goods business in Malaysia, since the two share the same raw material (flour) and a larger Etika will have greater purchasing power when buying these inputs.

It's also keen on the fast-growing Vietnamese market, where it recently bought a small dairy company. This mostly produces products for the lower end of UHT (long-life) milk market, which are sold in cheap Tetra Fino packaging (basically a plastic bag filled with milk).

Etika believes it can expand the Vietnam business in two directions. First, it can grow its condensed milk sales, which makes sense to me: Vietnamese coffee is a condensed milk-based drink like teh tarik, so Etika would be selling its product into a similar niche to the one it occupies in Malaysia. Secondly, it may try to go upmarket with UHT milk, moving into selling milk in Tetra Pak cartoons, which cater to less price-conscious shoppers and carry better margins.

This should overlap with a new joint venture to bottle UHT milk in Aseptic PET packaging in New Zealand for its own sales and third party brands. The company is also aiming to move into UHT milk in Malaysia to expand its dairy product range there into higher value-added areas.

Etika could easily double in size

As the chart below shows, dairy products are still the core of Etika's business with a smaller contribution from the frozen foods business. I won't go into too much detail about the other two divisions: packaging makes cans for its condensed milk but also sells to a few external customers, while nutrition makes sports and weight loss products from milk powder. Etika bought this business from New Zealand's Fronterra in 2007 and it's small, but solidly profitable, being number one in its market in New Zealand and selling well in Australia too.

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That's not going to change but geography probably will. At present, Malaysia is still the biggest contributor (see chart below); however, this is a fairly mature market. Etika can try to gain more market share and move into new lines, but it will be difficult to transform the size of the business from here.

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But Vietnam and Indonesia have much more potential these are much early stage markets and offer much more opportunity for growth. Etika only needs to win a small share of these to have a major impact on its earnings.

Obviously, there is no guarantee that Etika's expansion plans will pay off. Sometimes, synergies that appear to be there just don't materialise. With management trying to pull together several new acquisitions, there is a risk that they will be stretched too thinly.

In some of these markets, competition could be tough. Indofood dominates the Indonesian noodle sector, for example, while expanding upmarket in UHT milk in Vietnam would mean competing with Vinamilk, often said to be the best-run company in the country.

That said, management has a good track record in starting from scratch and taking on incumbents in Malaysia. And the company does not aim to be the market leader; if it can just take a few percentage points of these large target markets and run them efficiently and profitably, it will make a very big difference.

I think it's entirely possible that Etika could double in size over the next five years or so. And given that it currently trades on a p/e of 8.5 times and offers a dividend yield of 4%, it looks cheap for its potential even taking into account these execution risks.

Institutions are starting to show interest

Why is Etika so cheap? Until recently, it's been struggling to attract much in the way of institutional shareholder interest, probably due to its small size (market cap of S$238m) and fairly unglamorous business. That looked like changing earlier this year, when a private equity fund at Templeton Emerging Markets (headed by high-profile investor Mark Mobius) was in talks to invest through a convertible bond. In the end, Etika and Templeton were unable to agree on terms and the deal fell through but the fact that a major institution was looking is encouraging.

For now, the Tan family remain the controlling influence with a combined shareholding of 50.82%. Two of the ex-F&N executives who co-founded the group also have stakes of over 5%. Members of the Pok family, former owner of Pok Brothers, have a number of individual holdings totalling slightly over 5%.

Among other shareholders of note, PPB Group controlled by Malaysian billionaire Robert Kuok has a holding of just under 5%. I also know the NT Asian Discovery Fund, which is a shareholder in a couple of other Asia Investor portfolio stocks, has a small stake.

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This is a fairly small stock, with a market cap of S$238m, and suffered from very low trading volumes when it first listed in 2004. This has improved more recently and over the last year, it's had an average daily volume of about 280,000. The free float is around 25% according to Bloomberg data, although this may be an overestimate since stocks like this often have a number of small long-term holders who aren't interested in selling.

So like most Asia Investor stocks, this is a small cap with the usual liquidity risks, but you shouldn't have trouble taking any reasonably sized position.

In addition to the usual risks when investing in Asia Investor companies, I'd stress the following for Etika:

First, I must re-emphasise that there is significant execution risk when trying to integrate a number of new acquisitions and expand into new markets. I'm encouraged by the management's track record, but there can be no certainty of success. On the plus side, it has the buffer of a stable, defensive business in its Malaysian dairy, giving it that reassuring combination of a solid core business and growth prospects that I always like to see in a company.

Second, Etika is a heavy user of raw materials such as milk, sugar, flour, palm oil and other commodities, and as such is exposed to price rises in these. These could impact margins, which have fattened in recent years as the company gained scale: gross margin was almost 26% last year, from 14% five years ago.

The company says that it believes that it will be able to pass on raw material price increases to customers, and I think its record of profit growth through the commodity price spike in 2007-2008 suggests good cost control measures. That said, its strategy has been to grow market share though being slightly better value than the market leader. Thus, its pricing power may be ultimately be more limited than that of some of the leading consumer brand producers in our portfolio, and its earnings will be more vulnerable to commodity price volatility.

A potential 200% gain if all goes well

With so many new acquisitions and changes taking place at Etika, it's pretty hard for an outsider to estimate how they're likely to affect earnings until we see at least the first half of FY2011. I think it's entirely possible that the firm could double in size over the next five years or so, but timing is uncertain.

So the table below includes my base case, which I believe is reasonably conservative. For comparison, CIMB, the only broker covering Etika at present, is estimating that earnings ramp up much more quickly, with net income of RM82.6m in FY2011 and RM96m in FY2012.

Note that Etika carried out a 1:1 share bonus issue in October in an effort to improve liquidity by increasing the number of shares, thus my estimated EPS is actually a like-for-like rise of 10% rather than a fall.

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Etika is on a price/earnings ratio of around 8.5 times FY2010 and 7.8 times my FY2011E (at the current SGD/MYR exchange rate). That looks very reasonable given its growth potential, even allowing for its small size and execution risks.

The company declared a final dividend of 1.25 Singapore cents per share at the results announcement in November, following an interim dividend of 1.0 cents. Adjusting for the impact of the bonus issue, that's a total dividend of 1.75 cents, up from the equivalent of 1.4 cents the previous year and a healthy 3.9% yield on the current price. Given the firm's steady record of increasing its dividend, I would expect that to rise next year if all goes well with the expansion strategy.

Turning to the balance sheet, the only point that raises the eyebrows slightly is that net debt to equity is up to 0.8 (from 0.6 last year). Again, this reflects recent expansion: cash paid for acquisitions, investment in new facilities and higher working capital needs, including build-up of inventories. It's a bit higher than I would usually want in a company, especially a small one, but it's justifiable given the expansion strategy and I would expect to see it come down next year, so for now I'm comfortable with it.

There are no signs of financial stress at present. The current ratio (short-term assets to short-term liabilities) of 1.4 as at end September 2010 doesn't raise any concerns about short-term solvency. Cash on hand has been rising steadily over the years, and stood at RM26m, while the firm arranged an RM368m financing facility with three Malaysian banks earlier this year (total bank borrowings at present under this and other facilities stands at RM197m, so it has plenty of headroom).

One common threat with fast-growing firms is that receivables due from customers get out of control ie the business isn't good enough at collecting what it's owned and so runs out of cash even while booking more and more sales. Etika's receivables have ticked up in the last year as the business expands and cashflow was down, so this bears watching to ensure that the cash comes in next year - although I think the management should be too experienced to let this get out of hand.

Overall, this seems to be a good quality business with a very solid, defensive core business and excellent growth prospects in markets like Indonesia and Vietnam. So what would be a fair price for it?

One thing that's important to bear in mind is that for all its strengths, Etika is not a leading consumer brand like some of food and beverage stocks already in the Asia Investor portfolio. It sells mostly business-to-business and doesn't have the same degree of brand loyalty and pricing power that a dominant consumer firm does. As a result, an investor shouldn't pay the same price that they would for Hsu Fu Chi or a Vitasoy, because a business like Etika is unlikely to be able to maintain the same kind of profit growth over the very long run.

However, if it succeeds in growing earnings as well as I expect from the acquisitions, it's likely to attract much more investor interest and trade on a higher valuation. If earnings were to double over five years, as I believe is possible, and the stock rerate to a p/e of around 12.5 to reflect that growth, we could be looking at a potential price gain of around 200%.

Obviously, we're not willing to pay that now. But I think an estimated p/e of around 10 is justifiable, weighing Etika's growth potential against the risks and its small size. Based on my FY2011E, that implies a buy limit of S$0.57.


Buy: Etika International Holdings

Ticker: ETK (Bloomberg), ETIK (Reuters), 5FR (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$238m

Bid/mid/offer prices: S$0.445/S$0.445/S$0.45

Buy limit: S$0.57

52-week low/high: S$0.2-S$0.53

Etika is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

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Just a quick portfolio update before I go. ARA Asset Management has passed my buy limit again in the past week, so my formal recommendation changes to a HOLD.

That's it from me this week and indeed this year. I'll be back with the next issue in early January, when I'll be looking in detail at why I expect the kind of consumer staples business that are the core of Asia Investor to do better than almost any other kind of company over the long run. And as part of that, I'll give you the fuller update from my meeting with Petra Foods that I mentioned in the last issue.

Before I go, I'd like to thank you for subscribing to Asia Investor over the last few months and wish you a prosperous 2011.