Agro Allied Sector H2 2018 Outlook: Smuggling to Weigh on Earnings


Tuesday, September 11, 2018    05:03 PM / Investment-One Research   

Smuggling to Weigh on Earnings

Over the last six months, performances of the companies in the agro allied sector have been plagued by the perennial challenge from the Apapa gridlock, smuggling in the North East region of the country, and volatility in the commodities market despite the improved FX liquidity. 

We highlight that companies in the agro allied space saw a lot of smuggling particularly in the North East region, which took part of their market share. This has caused these companies to cut prices to maintain market share despite the increased cost associated with the issue of Apapa gridlock. This may continue to weigh on earnings in the near term.

 Mixed Earnings Performance

In terms of Q2 2018 results, turnover for both Dangote Sugar Refinery (DSR) and Dangote Flour Mills (DFM) fell by 27.41% y/y and 15.96% y/y to N42.94billion and N30.09billion respectively on the back of the issue of smuggling in the North East. We believe the same issue of smuggling could have affected the revenue of Flour Mills of Nigeria (FMN) which fell by 10.70%y/y to N133.03billion in Q1 2019. Nonetheless, gross profit margin was still strong for DSR though it fell by 190bpsy/y to 30.30% in Q2 2018 on the back of price reduction by the company due to stability in foreign exchange market in 2018 relative to 2017 as well as the competition from low quality substitutes. 

However, the gross profit margin for FMN increased by 140bps y/y to 12.98% in Q1 2019 (corresponding period: year end March) due to the 15.43 y/y and 52.01% y/y decline in cost of raw materials and factory rent and rates respectively. This could have been supported by stability in FX market thus slowing down cost of imported raw materials. On the other hand, the gross profit margin of DFM fell to 13.48% in Q2 2018 from 24.72% in Q2 2017. 

We believe a 14.38% y/y rise in average international wheat price to US$497.79 per bushel in Q2 2018 might have contributed to the rise in average cost of sales thus reducing gross profit margin. Overall, the bottom line of both FMN and DFM were uninspiring with FMN recording a 15.82%y/y decline in PBT to N5.21billion in Q1 2019, while DFM’s PBT was down by 55.60% y/y to N2.14billion in Q2 2018. 

Similarly, DSR recorded a 36.79% y/y decline in PBT to N11.51billion in Q2 2018. On the other hand, while the leverage of both DSR and DFM have been quite good on the back of their low debt position, it could increase in the near term with the companies planning to borrow more in order to benefit from the relatively low interest rate environment for expansion and working capital. 

Elsewhere, FMN recorded a decline in finance cost due to the conversion of part of the company’s debt to equity with the proceeds from the N40billion right issue completed in Q4 2018. This reflected in the company’s finance cost in Q1 2019, which fell by 32.58% y/y. However, FMN’s leverage increased as its debt to equity ratio rose to 101.44% in Q1 2019 from 91.77% in Q4 2018 on the back of higher more loans taken in Q1 2019. 

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Similar to what we saw in Q2 2018, turnover of both Dangote Sugar Refinery (DSR) and Dangote Flour Mills (DFM) fell by 29.15% and 13.05% to N84.08billion and N56.40billion respectively on the back of the issue of smuggling in North East during H1 2018. However, gross profit margin was still strong for DSR as it rose by 505bpsy/y to 27.71% in H1 2018 on the back of lower raw sugar prices in the global commodities market. 

On the other hand, the gross profit margin of DFM fell by 899bps y/y to 15.37% in H1 2018. We believe the 14.38% y/y rise in average international wheat price to US$497.79 per bushel in Q2 2018 might have contributed to the rise in average cost of sales thus reducing gross profit margin. Overall, DFM’s and DSR’s PBT were down by 7.33% y/y and 21.18% y/y to N4.40billion and N19.91billion respectively in H1 2018. 

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 Smuggling Challenges and Apapa Gridlock to Weigh on Topline

We believe the challenge at Apapa gridlock could have affected inventory turnover, cost of sales and eventually slowdown production, which could have negatively affected sales of the companies in the agro allied sector. This may continue in the

medium term as government tries to improve the dilapidated road network surrounding the port. 

In the same vein, we opine that the challenges posed by the illegal importation of low quality agro allied products due to insecurity in the North East could have negatively affected the turnover of DSR and DFM. Specifically, this illegal importation affected the top line performance of DSR with the company’s management highlighting the importation of cheap low quality sugar as a threat to the company’s top line performance. 

This may continue to weigh on sales and market of players in the agro allied sector in

the second half of the year. We highlight that the impact may be more if low price sugar is able to infiltrate DSR’s largest source of sales, Kano State, which accounted for about 27% of its turnover in full year 2016. 

As a result of the issue of smuggling due to insecurity in the North East and weak consumer spending, we do not expect companies in the agro allied sector to increase prices in the near term in order to remain competitive. 

Volatile Commodities Prices To Weigh on Gross Profit Margin

The movement in prices of key commodities has been mixed since the beginning of the year. While the price of raw sugar (-30.08%YTD) is falling, the price of wheat (+21.43% YTD) has been bullish. We believe the fall in raw sugar price could continue to be positive for the gross profit margin of DSR and Sugar business of FMN in the near term. However, the recent rise in price of wheat, with World Bank projecting that the price could go higher in 2019 and beyond, may be negative for cost of sales for food segment of FMN and DFM. 

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FX Stability to Support Average Cost of Sales 

The stability in the FX market has been positive for the cost of sales of import dependent companies in the agro allied sector who have to import raw commodities for production. We believe the availability of FX has made it easier for these companies to import raw materials relative to early 2017 before the introduction of IEFX window. This could have supported the gross profit margin of these companies in H1 2018. Going forward, we expect stability in the FX market to support the cost of sales in agro allied sector with about 56% and 70% of DSR and FMN’s cost respectively dependent on foreign exchange. However, we believe the recent reduction in sugar prices due to stable FX market may continue to weigh on DSR’s gross profit margin. 

Government Initiatives To Boost Long Term Performance

Similarly, the administration’s plans for self-sufficiency in Sugar by 2023 may support sugar business of these companies in the long run with government trying to channel efforts to build plantations and cane-crushing mills. It is expected that these plantations and cane-crushing mills will produce about 2million tons of sugar annually in order to meet the annual demand of about 1.5 million metric tons within a decade. 

This may be positive for the backward integration programmes of both DSR and FMN, with government planning to boost sugar output from 300,000 to 700,000 tons by 2021. Specifically, DSR plans to raise about N200billion through right issue and N2.5billion from CBN to boost its backward integration plan and expand its Sugar Plantation in order to produce 1.08million metrics tonnes of refined sugar in the next 6 years. 

This should be positive for the company’s top line and margin expansion in the long run. We believe these backward integration programmes may reduce their exposure to volatility in the commodities market in the long run. 

Capital Restructuring To Reduce Finance Cost

In the same vein, successful issuance of N40billion rights issue and the planned issuance of a N70billion Medium Term Note could be positive for the performance of FMN in the near term. This could reduce its foreign loan exposure estimated at US$20million as well as potentially decreasing the proportion of short term to total debt on the company’s balance sheet from c.74% as at Q1 2019 (Year end March). 

In the same vein, the company’s ongoing raising of N100bn through Commercial Papers may support the company’s working capital needs in the short term. While DSR’s plan to borrow N2.5billion from CBN may increase its debt position, we do not expect it to cause a spike in finance cost as the borrowing rate could be at a single digit either through the Anchor Borrowers’ Scheme or Bank of Industry. 

We highlight that this borrowing could increase the debt to equity ratio from the current level of 1.5% to 4.0%, which is quite low compared to FMN’s debt to equity ratio of 101.44% at the end of Q1 2019 (year end March). Consequently, we should see a decline in net finance cost thus improving the PBT performance of these companies within the medium term. 

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