Almarai, the Gulf’s largest dairy company, recently announced its plan to issue the second tranche of its riyal denominated sukuk next year, to Saudi private investors. This comes after the first tranche in March that had raised one billion riyals, was 4.7 times oversubscribed. The Islamic bond issuance is part of the company’s plan to finance a SAR16 billion investment programme over the next five years. However, for now, this large capex programme is proving to be a drag on the company’s performance.
Third quarter net profit, announced last month, rose a mere 4.7% to SAR 450 million - falling short of several analysts’ expectations - not just due to high commodity prices but also because expansion costs ate into earnings, Reuters reported. Last December, the Saudi Arabian dairy and food producer acquired Fondomonte SA, an Argentinian firm, to supply feedstock to its dairy and poultry units.
While the company’s fundamentals are strong, there are operational risks related to the poultry business, price increase restrictions by the Saudi government and commodity price volatility.”
Nonetheless, for 2012, the stock is up 20 per cent, and 34 per cent for the past 12 months. Analysts are unsure about outlook for the stock in the next 12 months, however some are optimistic about its long-term prospects because of the company’s expansion plans.
“In the near term, poultry related losses and the commodity price volatility is going to keep a check on the earnings growth prospects of the company,” said Shakeel Sarwar, fund manager and head of asset management at SICO, Bahrain. “But its long term business prospects are still sound, considering the strength of the Almarai brand name, market leadership position and strong management.”
Sarwar pointed out that Almarai’s third quarter profits were 5 per cent higher than last year. This was mainly because of strong increase in sales (up 27 per cent), in part a result of it taking a bigger stake in its joint venture with PepsiCo.
But, “The company is still being affected by the elevated commodity prices in the global market, which have depressed its profit margins,” Sarwar said. “This has been aggravated by the start-up costs related to its poultry operation, which is undergoing a large scale expansion.”
The expansion of the poultry operation and employee costs have come under scrutiny from analysts. “Financing costs that were previously capitalized will be expensed as the poultry expansion is commissioned in the fourth quarter of 2012,” says Riyad Capital in a report last month.
“The recent pressure to limit increases in poultry prices for consumers is a further negative for Almarai in the short-to-medium term,” said NCB Capital, the Saudi Arabian investment bank, in its October report on Almarai’s results. But it added that poultry is the next big catalyst for the company and some patience is required. “With SR4 to 5 billion in capex planned for poultry, it is a key business for Almarai [and it is expected to contribute 16 per cent of sales by 2016. The poultry business is likely to see strong top line growth in 2013, although it will only break-even in 2014,” the October NCB Capital report said.
As the company expands into different businesses, there’s also the wage burden that should be taken into account, says Ahmed Korayem, associate Research analyst at Riyad Capital. “Group headcount increased by 29 per cent year-on-year 26,647 with approximately 24% Saudization ratio. Labor initiatives underway will “either dilute Almarai’s ratio or raise wage pressure significantly. We note that employee costs as a ratio of sales increased to 17 per cent in 2011 and threaten to further erode operating leverage.”
Increasing food prices are expected to put pressure on margins again in second half of 2013, according to NCB Capital. “With key soft commodity prices increasing in the past few months, this is expected to pressure Almarai margins in 2013.”
However, there is a possibility of these figures improving. Riyad Capital commented: “Easing commodity prices provided some margin relief [and] management has identified areas for operational improvements to derive further efficiencies in the coming periods. Lean production and packaging improvement will be areas of focus in 2013.”
But concerns about the company’s capital expenditure programme remain. NCB Capital said that: “Although this will enhance the top-line, depreciation will increase costs, pressurizing margins. We have concerns regarding the extent of the returns possible on this investment.”
Sarwar pointed out that Almarai’s return on equity (RoE) based on past 12 months’ earnings is 19 per cent (adjusted for one-off items), which is “very good”; and its current ratio is 1:1, which looks “healthy.” Debt accounts for 54% of the total capital, which is on the high side, but considering its cash flow generating capability this is not worrisome, he added. Almarai’s debt to EBITDA is 3.8 times. This has been climbing steadily in recent years.
As the company is in the expansion mode, they are keeping the dividend yield at a low level (approximately two per cent), says Sarwar. If an investor is looking for income stock, while Almarai pays regular dividends, there are more attractive shares on the market, which offer higher dividend yields, said Korayem.
Almarai has generated a total return of 23 per cent on an annualized basis during the past 5 years. In comparison, says Sarwar, the S&P Saudi index has fallen by 1% on annualized basis over the same period. Almarai’s beta co-efficient was 0.8, which implies that stock is less volatile compared to the market. “Hence, from risk-reward point of view, Almarai has been a very good investment proposition.”
But, this doesn’t mean the stock will produce similar return going forward,” Sarwar warned. “While the company’s fundamentals are strong, there are operational risks related to the poultry business, price increase restrictions by the Saudi government and commodity price volatility.”
Riyad Capital has a “sell” recommendation on Almarai. The company defines sell as being overvalued. Its October report had a target price of SAR 56. The current price of the stock is around SR68.
NCB Capital has a “neutral” rating on the stock. In its October 9 report, it said: “We remain neutral on Almarai with our target price increasing to SR63.8. Key concerns include pressure on 2013 margins due to higher raw material prices, as well as the returns possible on the high capex. The coming 12 months will continue to be investment rather than returns focused and thus [there will be a] lack of catalysts to provide upside for the stock. We believe the current market price is fair once these risks are factored in.
Audi Saradar Investment Bank has also a “hold” recommendation on the stock. “We believe that the company will be affected by the increase in input cost despite the integration of Fondomonte,” wrote Alaa Ghanem, analyst for Audi Saradar. We retain our target price of SAR 66.71 and our recommendation to Hold.”