Monday, March 06, 2017/ 5:32 PM /ARM Research
In contrast of most consumer names whose bottom-line succumbed to the combined pressure of naira weakness, weak consumer purchasing power and elevated interest rate environment, Flour Mills of Nigeria Plc (FMN) core earnings has improved significantly from prior year’s core operating loss.
The upsurge in core earnings largely stemmed from prices driven gains to revenue, as FMN continually adjusted sales prices to reflect input cost inflation.
This cost-reflective sales prices appears to be paying off as revenue increases more than offset effect of FX losses and elevated finance charges on earnings. Accordingly, FMN posted FQ3 17 EPS of N0.36 vs a loss in FQ3 16.
Going forward, we believe the largely non-discretionary nature of FMN’s products as well as increased consumer switch from more expensive substitute point to sustained revenue growth, which as with 9M 17 should continue to trump cost pressures.
Given the underlying improvement in FMN’s core earnings on one hand and the sizable upside implied in our fair value estimate (FVE) of the company on the other, we recommend a BUY rating on the stock.
Figure 1: Trend in core earnings (N’ billion)
Naira weakness underpins higher finance charges and FX loss
Over FQ3 17, FMN’s operating performance was hurt by a sharp rise in finance cost (+33.8% YoY) which tracked movement in borrowings (+41.4% YoY). In discussions with FMN, management linked the higher gearing to impact of NGN depreciation on funding for imports.
Specifically, FMN raised additional N75 billion short term debt to fund Letters of Credit (LCs) for its raw material imports. Consequently, the jump in borrowings raised the company’s leverage ratio by 41% YoY to an eight-quarter high of 2.4x.
Supporting this claim, we note that the amount of prepayment deposited for LCs surged fivefold YoY over 9M 17 to N49.7 billion.
Figure 2: FMN’s debt mix
Figure 3: Trend in finance cost (N’ billion)
Another pressure point in the result was the presence of a N4 billion FX loss which management attributed to the revaluation of the company’s trade payables and FCY loan of $20 million (4% of total borrowings) for its real estate division.
While FX rate at the interbank market was unchanged during the period, management noted that the closing rate adopted in fair valuing the company’s transactions reflected a combination of spot interbank FX rates as well as CBN and commercial forward FX rates.
Aggressive repricing helps preserve margins
Despite the FX issues, FMN posted strong top-line growth on account of higher prices. Management stated that on average, FMN hiked prices 30-40% YoY across product lines in a bid to pass-on input cost pressures.
Despite the price hikes, FMN reported modest volume growth—single digit across product line.
In our view, the largely non-discretionary nature of FMN’s product portfolio and a predominantly wholesale customer base ensured inelastic demand responses to price hikes.
The key benefit of FMN’s continuous repricing of its products at replacement cost was evident on gross margin which expanded (+170bps YoY to 12.7%) in the review period.
Pertinently, the price hikes neutered higher cost of raw materials, which surged 62.7% YoY, as impact of naira weakness more than offset moderation in commodity prices. The foregoing combined with more muted increases in OPEX helped drive core operating margin higher (+270bps YoY to 5.7%).
Figure 4: Trend in FMN’s Gross and EBIT margins
Overall, despite the costs associated with higher gearing to fund raw material imports, FMN extended its streak of positive core earnings to the third consecutive quarter, with FQ3 17 PAT printing at N932 million vs. N5.0 billion loss recorded in FQ3 16. Over 9M 17, PAT is at N7.4billion vs a normalized post tax loss of N4.7 billion in 9M 162.
Defensive features confer earnings resilience
Looking ahead to the final quarter of FY 17, we see no changes to FMN’s pricing tactic and estimate FQ4 17 turnover at N129.7 billion (+64.4% YoY) – which is 4% lower than management guidance of N135 billion.
In a reverse from prior quarters, global wheat prices have climbed (+6% YTD) reflecting declines in the supply glut. Incorporating the bullish price outlook and persisting NGN pressures on imports inform our forecast COGS-Sales ratio for FQ4 17E at 86.9% (9M 17: -274bps YoY to 86.3%) which translates to a gross profit estimate of N17.0 billion.
Elsewhere, largely static movement on the interbank FX rate at N305/$ and improved dollar supply in February dampens scope for FX losses over FQ4 17, in our view.
However, we raise our finance expense projection to N6.6 billion (+32% YoY) to reflect the recent upsurge in borrowings. Overall, we forecast FQ4 17E earnings to print at N1.6 billion (FQ4 16 loss after tax of N4.6 billion) with FY 17E core EPS at N3.45 vs. -N3.3 in FY163.
Perhaps, reflective of the strength in core earnings, FMN share price has declined at a slower pace (-7% YTD) relative to the broader food producers in our coverage universe (-27% YTD).
That said, on an FY 17E basis, the stock P/E at 5.0x is at a significant discount to Bloomberg Middle East & Africa peers at 17.0x. Last trading price of N17.21 is at a 47% discount to our FVE of N25.32 which translates to a BUY rating.
Figure 4: Trend in FMN’s price to core earnings ratio
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