Flour Mills of Nigeria: Core Momentum Inspires Fresh Upside


Tuesday, August 29, 2017 / 10:54 AM / ARM Research

The stone the builders rejected…

Prior to the FX-induced equity rally in Nigeria, the food sub-sector bore the brunt of a challenging macro-economic environment as investors priced in effects of constrained consumer income, naira depreciation and high interest rate on the performance of food producers. 

The scale of aversion was however not equal across sector names with the shares of Flour Mills of Nigeria (FMN), Honey Well Flour Mills and Cadbury taking a greater beating. Investors’ aversion to FMN’s stock was underpinned by the negative core earnings1 declared in the two financial years ending March 2016.

Precisely, the combination of higher input cost, sizable FX losses as well as upsurge in finance charges deprived the otherwise low margin business of profitability. The latter drag was consequent on a surge in debt levels which pushed the company’s net gearing ratio  to a then record high of 164% at the end FY 15 (Bloomberg EMEA average: 56%) despite receiving N18.2 billion in cash from sale of UNICEM.

…has become the pillar stone
However, FMN’s operating performance turned the corner in the financial year ending March 2017 with the company posting its highest operating profit3 on record (+156% YoY to N42.9 billion) while profit from core operations (PAT less profit from sale of associate) printed at a six year high of N8.8 billion (FY 16: N9.3 billion loss).  

The improved performance largely stemmed from its robust turnover4, which printed at a historical high of N524.5 billion (+53.1% YoY) following price hikes (YoY: Flour: +40%, Noodles: +31%, Spaghetti: +29%) in the food segment (81% of overall revenue) and pick-up in volumes5.  

Supporting the robust top-line was an 81% YoY cutback in other loss to N1.5 billion largely reflecting absence of a N4 billion impairment charge6 recorded in the preceding year and, to a lesser extent, an 11% YoY contraction in FX losses to N5.7 billion7. 

However, FX pressures still lingered. Particularly, given the company’s high dependence on imports (FY 17 import-COGS ratio: 88%), sustained naira weakness underpinned an upsurge in the company’s raw materials cost (+53.1% YoY) which in turn drove COGS (+50.1% YoY) higher.  

The effect of naira depreciation also bloated the company’s working capital needs, as it inflated both inventories (twofold higher YoY to N117.3 billion) and prepayments (fivefold higher YoY to N71.5 billion). Consequently, FMN raised its shortterm borrowings (+63% YoY to N191 billion) which, together with a higher interest rate environment, drove finance charges to a record high of N32.5 billion (76% of EBIT).  

Management attributed the upsurge in prepayment to the severe illiquidity at the interbank FX market, which resulted in a nearly three-fold YoY jump in the company’s deposit for imports (letters of credit) to N26.4 billion over the period.  

The tight dollar supply also compelled the company to queue at CBN’s forward market (of five months tenor), with the knock-on effect underpinning a N31 billion deposit for FX relating to forward and futures contracts (vs. nil in FY 2016). 

Overall, despite lingering currency woes and elevated interest rate environment, the turnaround in FMN’s performance stemmed from significant improvement in the company’s core operations.  

Earnings Surge As FX Pressures Subside
In more recent releases, some of these FX pressures however dissipated following CBN’s liberalization of the FX market which helped underpin strong naira gains at the noninterbank FX windows. Particularly, over FQ1 18, FMN reported FX-induced other income of N3.2 billion on revaluation of outstanding FX liability at cheaper FX rate even as inventories (-6% QoQ to N109.7 billion) and prepayments (-48% QoQ to N36.6 billion) declined.  

FMN’s management attributed contraction in the latter to improved liquidity in the currency market and reduction in the tenor of CBN’s forward contract to 2 months (five months previously) which enabled the company to meet its outstanding letter of credit obligation (N26.2 billion) and lower its deposit for FX relating to forward and futures contracts (-58% QoQ to N13.0 billion) respectively.

Against this backdrop, FMN cutback its borrowings (-21.4% QoQ to N190 billion) which in turn applied downward pressure on interest charges (-39.8%QoQ to N8.9 billion). Thus, aided by a double-digit revenue growth (+25% YoY to N148.9 billion, QoQ: +10.7%) which was sustained for the sixth consecutive quarter in FQ1 18, FMN reported its highest core earnings in 21 quarters (N4.5 billion) in the period.

Largely reflecting expected improvements in the company’s performance and an overall investor excitement trailing the introduction of the IEW window in April, the company’s share price has outperformed the broader food index (FMN: +62% YTD; Food Index:

+47% YTD; NSEASI: +36% YTD).  

However, since the release of its FQ1 18 result on the 1st of August 2017, the company’s share price has been largely flat—a development we attribute to investors’ concern about the sustainability of the company’s debt contraction.  

For us, we believe this concern is slightly exaggerated with our view reflecting an expectation for a largely unchanged debt level. 

Naira gains and cutback in debt underpin bullish outlook
In projecting our outlook for the company over the rest of the financial year, we begin by estimating the company’s debt levels. On long term debt, management’s guidance of limited capital outlay over the near term underpins our view for sustained stability of the company’s largely concessionary borrowings from the CBN.  

However, on short term borrowings, we project a modest rise (+7%) from current levels to N169 billion. Our prognosis for higher leverage largely stems from expected rise in prepayments. In our view, whilst sustained FX liquidity and unchanged 2 months tenor on CBN’s forward contract should keep deposits for forward contract largely in check, we believe the nil reading of “letters of credit” is unsustainable given the company’s huge dependence on imports.

Against this backdrop, aided by comparison with the relatively stable FY 16 reading, we estimate a N13.2 billion deposit for imports over the year. Overlaying the increase in debt with the company’s current effective interest rate of 16.5%, we forecast a tepid rise (+3.4% YoY) in finance charges to N34 billion over FY 18.  

Nonetheless, the impact of high borrowing cost should be tempered by other income of N4.2 billion (FY 17 other loss: N1.5 billion) largely driven by FX-induced gains reported in FQ1 18.

On core operating fronts, we expect higher YoY prices and resilient volume increases to sustain top-line growth. Based on the foregoing, we project a 16% YoY growth in FY 18 revenue to N608.3 billion. Elsewhere, we expect the stronger naira to keep growth in COGS (FY 18E: +18% YoY to N540 billion) relatively contained compared to the prior two years.  

Consequently, we forecast an 11% YoY expansion in gross profit to 74.3 billion while EBIT is estimated to increase to N47.2 billion (+10.0% YoY) as management continues to keep OPEX (FY 18E: +14.1% YoY to N27.1 billion) in check. 

Post these adjustments, PAT now comes in 48% higher YoY at N13.1 billion. FMN trades at discount to peers, both on a current (P/E: FMN: 8.5x, Bloomberg EMEA: 11.8x) and forward basis (P/E: FMN: 5.7x, Bloomberg EMEA: 10.2x).  

The company’s attractive P/E, robust core performance and cutback in debt levels underpin our BUY rating on the stock with a FVE of N35.07. 

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