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Flour Mills of Nigeria Plc - Rights issue: Grist to the mill

Proshare

Friday, January 26, 2018 /10:05 AM /ARM Research 


·    We issue a BUY recommendation on Flourmill based on a FVE of N38.33, representing 24% and 42% upside from market and Rights Issue price of N30.80 and N27.00 respectively. Our positive sentiment is supported by the recovery in earnings (FH1 18: +44.6% YoY) with FY 18 PAT estimated at N16.3 billion (+84.7% YoY). Considering the impact of capital raising on Flourmills’ finance expense, we remain optimistic on the stock going into FY 19 with a projected PAT of N23.9 billion. However, owing to the dilution from the Rights Issue, FY 19 EPS of N5.83 represents a 6% decline when compared to FY 18 estimate of N6.22. 

·  Flourmill is seeking to raise N39 billion ($127 million) by way of Rights Issue. The company is offering 1.47 billion ordinary shares of 50 kobo each at a rights price of N27.00/share to existing shareholders based on 9 new ordinary shares for every 16 ordinary shares held as at 8th December 2017. The Rights issue opened on the 15th of January 2018 and closes on the 21st of February 2018. 

·  
Proceeds from the Rights Issue will be used to pay down some of its overdrafts and short-term borrowings with the intent of deleveraging the balance sheet and strengthening the capital base of the company. Precisely, 45% of the proceeds will be used for the repayment of short term loans (N17.5 billion), 30% will be used for the repayment of overdraft facilities (N11.9 billion) while the balance (25%) will be applied towards working capital for strengthening and achieving efficiency in the company’s operations.

Earnings expansion underpinned by deleveraging
 
In estimating the impact of the rights issue on earnings, Flourmill’s debt position remains the reoccurring recital. As at FQ2 18, Flourmill’s borrowings totaled N188.2 billion, split into overdrafts (N41 billion), short-term (N93.5 billion) and long-term borrowing (N53.9 billion) - short-term borrowings and overdrafts constitute ~50% and 22% of total debts respectively. Consequently, following the repayment of N29.4 billion1, we expect its debt position to dip by 15.4% YoY to N143 billion over FY 19. 

This view is supported by a sustained recovery in operating cash flow from improving EBIT margin (FY 19E: +95bps YoY; FQ2 18: +33bps QoQ) and lesser need to prefund Letters of Credits, reflecting improved dollar liquidity. Pertinently, our discussions with management revealed that Flourmills moved to unconfirmed from confirmed LCs which eliminated the need to prefund payments for its imported inputs. 

Accordingly, we estimate a decline in debt-equity4 ratio to 0.94x (FH1 18: 1.74x; 3-year average of 2.01x). In terms of interest rate, we use an average rate of 16% over FY 19 in line with our view of a downtrend in yields over the year which would have a direct impact on its borrowing costs particularly its commercial papers. 

Overlaying the lower debt position with our interest rate expectations, we estimate a 26% YoY decline in interest expense to N23 billion (FY 18E: N30.9 billion; FY 17: N32.5 billion). In addition, we view funds allocated to working capital (N9.7 billion) as positive for finance costs as the liquidity would reduce the burden on the company to borrow expensive short-term borrowings in a bid to finance its operations. 

Tying the above-mentioned with our expectation of a recovery in gross margin to 13% (FH1 18: 11.9%; FY’17: 12.7%), we estimate earnings to print at N23 billion in FY 19 which translates to an EPS of N5.83 post dilution (FY’18E: N6.22). Underlying our view of a recovery in earnings is a successful rights issue where the intended amount is fully raised. Given our expectation of earnings recovery going forward, we recommend that qualified investors take up their rights.

Proshare Nigeria Pvt. Ltd.

Proshare Nigeria Pvt. Ltd.

Net impact of these assumptions results in a FVE of N38.33. Our FVE factors in the additional shares from the rights. Against this backdrop, we place a BUY rating on the stock. Flour Mills trades at a current P/E of 8.3x versus 13.7x for Bloomberg Middle-East & African peers.
 

In terms of other plans to reduce its interest expense burden, FMN is looking to debt restructuring as it intends to raise N70 billion in Medium Term Notes to refinance its expensive debts at a lower interest rate. Also, the company plans to generate N35 billion through the sale of some of its real estate properties for the repayment of its short-term debts.
 

Management guides to the commencement of the bond programme when interest rates are favorable and hopes to complete the sale of non-core assets this year. Our FVE does not consider the impact of these strategies thus; we view the adoption of these plans as a positive catalyst to earnings and FVE.
 

Earnings growth underpinned by non-core operations, Flourmills most recent FH1 18 results revealed a 45% YoY increase in earnings to N9.4 billion, 1.1x ahead of FY’17 earnings (N8.8 billion).
 

However, the sizable jump in earnings reflected gains from non-core operations particularly “other operating income” which printed at N5.1 billion from a loss of N8.1 billion in FH1 17. Specifically, the company reported gains on its non-deliverable forwards amounting to N2.1 billion which reflected the Naira appreciation (+3.7% QoQ) at the IEW during the quarter. Added to this, FMN reported gains of N733 million from the revaluation of its sugar plantations.
 

In terms of core performance, despite a 16.9% YoY increase in revenue, gross margin contracted by 237bps YoY owing to a faster increase in cost of sales (+20% YoY) amidst the hike in the price of Maize (+33% YoY) and negative product mix. According to management, despite higher input cost on its edible oil business, the company was unable to raise prices due to lower domestic prices for edible oil on which flourmills’ pricing is anchored.
 

Further, operating expenses rose by 21.6% YoY to N11 billion, largely driven by a 36.7% YoY increase in administrative expenses. Management stated that, the sharp increase in administrative expenses was due to the employment of workers for its newly commissioned sugar crushing plant in Sunti, Niger State. Consequently, EBIT declined by 10.6% YoY to N24.4 billion.
 

Interest expense remained elevated as it surged 48.9% YoY to N16.3 billion on account of the twin impact of high interest rates (FH1 18 effective interest rate at 20% vs 15% in FH1 17) and expanded borrowings (+11.5% YoY to N147 billion). The expansion in borrowings followed the depreciation in the currency which drove an increase in the cost of imported inputs and, by extension, liquidity to meet working capital requirements.
 

Looking ahead to FH2 18, we envisage a faster rise in earnings (+194.3% YoY) mainly due to the low base of FH2 17. However, in line with seasonality, we expect a slowdown in wheat flour demand as consumption switches to yam from bread following the just concluded harvest season.
 

This guides to a slowdown in the pace of revenue growth over FH2 18 (+8.1% YoY). However, we expect cost of sales to rise at a slower pace (+6.6% YoY) than revenue, owing to global oversupply of its key inputs including wheat and raw sugar coupled with an improvement in the domestic supply of Maize which suggests bearish prices for these commodities and softer pressures on COGS.
 

We expect finance costs to remain elevated in FH2’18 (N14.7 billion) which, however, translates to a 32.1% YoY decline from FH1’17 due to the high base of FQ4 18.

Proshare Nigeria Pvt. Ltd.

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