SGX:P34 - Delfi Limited

[ANP301191]

First time doing this, so all feedback is helpful :D

 

Company Synopsis:

Delfi Limited operates in the confectionary business in Indonesia, Philippines, Malaysia and Singapore (management says it has sales in Vietnam, India and South Korea but those have never shown up in any filings so I would presume they are too small to be of any significance). It produces and distributes both “Own Brand” and “Agency Brand” chocolates and wafers. It owns two factories (Indonesia and Philippines) which it uses to manufacture most of its products, but it also outsources certain production to contract manufacturers in other markets.

 

Industry Synopsis:

The Indonesian industry is quiet concentrated, it is controlled by Delfi and Mayora Indah, two local manufacturers and distributors, with Delfi being between 32-35% of the market. Additional competitions is provided by the regular global players (Nestle, Modelez, Hersheys etc.) but that is specifically in the higher income stratas of the population. In the Philippines, which is a grower of cocoa beans, the business is divided between 2 local player Universal Robina and Commonwealth Foods with Goya (a Delfi owned brand) a distant third. As there has historically been several large multinationals with exposure to Philippines due to their manufacturing or procurement requirements, the market has a higher degree of penetration from these competitors, with the largest being Nestle selling its international brands. Malaysian market is actually a more splintered market with several participants including large multinationals all competing for space.

 

Investment Thesis:

1) Strong moat in Indonesian business which provides around 2/3rds of the revenue and nearly the entire EBITDA for 2020 – the whole business is valued at the fair value of just this segment of the business

2) Ability to utilize its sales channels to sell other non-owned brands (“Agency Brands” segment) which adds operating leverage to the business at minimal extra costs

3) Potential growth in Philippines & Malaysian markets are basically unaccounted for at current price of shares, but should be present due to both economic tailwinds and Delfi’s market know how.

 

Base case:

1) Indonesian confectionary market is supposed to grow at 6.5% CAGR from 2019 to 2024 as per research reports (circa 2019). Accepting this premise, I model out a rebound of 10% in 2021 to return to something close to 2019 numbers and then a 6.5% growth for the following 3 years

2) Delfi maintains its current position of the Indonesian market and does not add any new brands or products that will significantly change either its operating efficiency/profitability

 

The base case is simply the continuation of the market as is for the next 5 years, with average Indonesians spending more money on confectionaries as the economy improves and people have more disposable income. Additionally it supposes that Delfi retains its market leading position in the confectionary business in Indonesia and is not supplanted by either Mayora Indah or a foreign player.

 

There are several reasons I am comfortable in that assumption: (a) Delfi’s brands have been in the market for 70 years and become ubiquitous in Indonesia, (b) the confectionary business is a “impulse purchase” business, especially as a higher % of Indonesians shop in hypermarkets or supermarkets, if Delfi maintains its relationships with these large “Modern Trade” customers, it should retain its sales from their consumers, © Delfi specifically targets middle to lower income Indonesians and not the upper income stratas that may travel outside of Indonesia often and bring back new taste, its customer-base should be more immune to changing tastes and also less able to afford these higher priced international brands.

 

Using this as our base case and running a very simple DCF model, I arrive to a S$0.79 price per share. In the valuation model, I have used a 20% discount to add additional protection from other non-business related risks (Indonesian budget deficit is extremely high – could cause tax hikes or currency weakness, price of cocoa may go up causing margin pressure). In the DCF I have split out the balance sheet items (cash/debt/prop/AR/AP etc.) based on revenue as the business does not disclose exact break ups of several key lines, so I may be slightly over/undervaluing this business segment.

 

Key Risks and Concerns

1) Pricing Power – in all of the conversations I have had with retailers about Delfi and its products, price was the one of key selling point versus its international competitors. While I think its brand has some value, it is still seen as the "cheaper" option and as a result probably does not have any significant pricing power. While management is actively spending money on marketing and launching new flavors which may add some more brand value, in the medium term, I doubt this will change.

2) Modern Trade Business – Delfi’s core strength is working in Indonesia’s non-structured retail market. With a nearly 40 year history in the business, the CEO (who has been running the business the whole time) and his team have developed a long history with many distributors who in turn had the relationships with small mom-and-pop grocery stores. With the rise of supermarkets and hypermarkets, Delfi’s business model has changed and as a result there are operational risks of not adjusting to that change. Additionally, the unstructured nature of the Indonesian grocery market actively provided an additional moat against foreign competitors who were often unable to navigate and understand the market and hence penetrate it. With the rise of supermarkets and hypermarkets, foreign competitors may be more able to get into the market. I would note that management has actively focused on this risk and developed a team and a go-to-market strategy around it.

3) Management team – the CEO (who also owns 50% of the business indirectly) and his brothers who are in management as well (and who indirectly own another 14% I think) are all over 65. While I am actually happier to invest with such a large % of inside ownership and that ownership being a significant part of their net worth (especially for such a long time) I am concerned about the future management team and whether its vision will continue to be as long-term as the current management team.

 

Upside:

1) Philippines and Malaysian markets – in both of these markets, Delfi’s sales stood up much better than their larger competitors – sales were flat for 2020, whereas larger competitors saw sales down by 10-15% for 2020. It needs noting that part of the reason their sales were better was because they are a much smaller sub-set of the market in both countries and probably have a more niche following which probably makes their demand more inelastic and as a result more valuable to us as shareholders. Additionally, in the above base case valuation, I have completely removed these markets and their earnings, so at the current price any income from these markets (of which there should be a lot) are free.

2) “Agency Brands” – this segment of the business offers a ton of upside to the company as it is able to bring in large international confectionary players (Yuraka of Japan for example) which increases its operating leverage, instead of building brands, it can focus on what it does best in terms of manufacturing and distribution into Indonesia and its surrounding markets. In the case of Yuraka, Delfi actively invested in a JV, but in other cases, Delfi has operated through a license agreement, so there is flexibility within the operation.

3) Distribution Network – one of Delfi’s most valuable assets is its relationships with its distributors and the network it has created. In terms of the confectionary space, the only real competitor is Mayora Indah in Indonesia. The question becomes, why limit it to the confectionary space, why can’t Delfi utilize its distribution network for other similar business segments. To be very clear, management has made no indications of such a shift and I have no reason to believe that is in the works, but that is the pie-in-the-sky dream.

4) Insider ownership/Management – as discussed in Risks point 3, the CEO is indirectly a 50% shareholder (through his wife’s holdings in 2 investment trusts) and his brothers indirectly control another 14% through their wives and several investment trusts. While figuring that all out was a little confusing, I think it is a large positive. The business constitutes a huge (from what I can tell nearly 80%) of the CEO/largest shareholders net worth. Furthermore, the business has been forthright with all disclosures (see the 2019 annual report with the under/overinvoicing in Philippines). And the business has actively provided a decent dividend consistently (currently 4%) averaging at just over 3% over the past 5 years.

 

The last point I would leave open is what happens when the current ownership decides to retire - Delfi looks like a very attractive option to buy out for a large conglomerate. It offers the distribution network that could easily sell other items, a strong position in Indonesia (295m person market by 2030 or the worlds 4th largest country by population) and a relatively clean balance sheet in a very transparent jurisdiction (Singapore). Never having worked in the acquisitions department of any large food company, I may be wrong here, but food for thought either way.

 

[Cicero]

I looked at this in the past and agree with many of the points. In my mind this is a bit of a gamble on a takeover by someone who wants to enter Indonesia. Difficult to handicap.

 

A few points I picked up:

1. been told that one of the historical strengths was that some of their products have a higher melting point which was particularly advantageous in the traditional trade (no AC). As you point out the trend is towards modern trade

2. Lots of crooks in Indonesia, but the management has actually a good reputation for what it is worth

3. Cost control: they moved offices a few years ago and the new one is pretty fancy. Not sure this makes much sense. Have zero sense if this is a one off or points to fat elsewhere in the organisation, but makes you wonder

[thowed]

Don't quote me on this, but you might want to look at the children of the CEO & brothers.  From memory, there are question marks about the new generation of management, which might spoil the other things that make the company interesting.

[ANP301191]

I looked at this in the past and agree with many of the points. In my mind this is a bit of a gamble on a takeover by someone who wants to enter Indonesia. Difficult to handicap.

 

A few points I picked up:

1. been told that one of the historical strengths was that some of their products have a higher melting point which was particularly advantageous in the traditional trade (no AC). As you point out the trend is towards modern trade

2. Lots of crooks in Indonesia, but the management has actually a good reputation for what it is worth

3. Cost control: they moved offices a few years ago and the new one is pretty fancy. Not sure this makes much sense. Have zero sense if this is a one off or points to fat elsewhere in the organisation, but makes you wonder

 

I agree that investing into Indonesia (ASEAN ex-Singapore as a whole really) is pretty difficult due to the amount of weak oversight from local regulators and the lack of transparency. I think we have a little more safety here simply because it is a Singapore entity, and at least in recent history, management has been pretty forthright with any internal problems (internal fraud in Philippines circa 2017-18). For the cost control part, I honestly dont have a really good handle on it, I only have anecdotal stories of their factories and offices being pretty efficient (from outside the building of course).

 

Don't quote me on this, but you might want to look at the children of the CEO & brothers.  From memory, there are question marks about the new generation of management, which might spoil the other things that make the company interesting.

 

Yeah I agree, its one of my main long-term concerns about the business. I dont know how to get comfortable with this risk other than actually attending the annual meetings and meeting them - any suggestions would be helpful.

 

Also this is a really small position, so trying to manage risk that way as well.

[Ilyich]

I read both writeups on VIC and Asian Century Stocks. Haven't opened a position but its compelling. I asked people smarter than me to have a look into it and I hope they will. The pricing power and more comp are really my only concerns but if the total market keeps growing, which seems to be the global consensus on chocolate in Asia, then there will be more for everyone. 

Attaching a snapshot from VIC message board talking about Mondelez's recent statements about cocoa, Asia and acquisitions.

[Ilyich]

Hi @ANP301191,

I have been digging into the co after the VIC writeups and I just want to sum up my concerns and positives

[Edit]: One item which is in neither category is that they are helping distribute competitor products. I suppose the positive revenue balances out the negative impact on the market share. I understand that this part of the business is declining which is a good thing. Can someone confirm this?

Cons:

I think currency risk, pricing power risks and modern trade expansion risks were covered.

My other concern is that we are projecting only 2 years (2018/19) of their growth strategy into the future. 

Another concern is that their 2 partnerships only expand their portfolio within Indonesia. Would like to see them enter Japan or South Korea based on the existing partnerships. Perhaps this is already being done and I am missing the point.

Another concern timeframe for consumer normalization since vaccinations are terrible in Indonesia. 2.5% fully vaccinated. 1.8% partially vaccinated according to CNN.

Another one is that they have to keep advertising to promote the products -> competition is fierce.

Pros: sales normalize to pre-covid levels through 2022. Combine that with lower capex and we have good cash flows, good chunk of which will be dividends. The assumption "capex will be lower" is taken from their 2020 annual report and based on the fact that a major investment of $110mil was completed in 2019.

"Looking ahead to FY2021,  the  Group  remains  steadfast  in its discipline on our capital expenditure and will spend only  where  necessary.  Our current  installed  capacities  are  sufficient  to  meet  expected  market  demands  in  the  foreseeable future.”"

Another positive is that cost of goods sold has decreased by ~$100mil in the past 5 years compared to the 5 yrs prior. I haven't found an explicit reason for this but I am assuming it is due to their modernizations 2014-2019 and cutback of the SKUs.

btw there is also another write-up with details to complement the VIC ones:

https://www.asiancenturystocks.com/p/deep-dive-2012-7-delfi-ltd

Welcome all constructive criticism.

Cheers!

Edited April 26, 2021 by Ilyich

[ANP301191]

Hi @Ilyich,

Answering your cons:

1) I think currency risk (especially Indonesian Rupiah) is a huge risk, but honestly looking at it from a macro level, I want to be invested in ASEAN so I have take a slightly optimistic (my friends tell me over-optimistic) view on it.

2) I agree that their growth strategy has not really had much time to show results - however, from my research into the market, they have piqued peoples interest and for me that is a start. What I am waiting for is real news about the actual successes/failures of their new lines of product - green tea chocolates and the likes. The reason I am interested in specifically these lines (healthy chocolates) is that I dont see them being too successful in other "developing" markets and even in developed markets like Benelux. If this doesnt produce the types of results that they want, their SKU counts will have grown tremendously, they will have probably killed their gross margins/efficiencies etc. and they will have to invest new money into new products again.

3) I havent heard of any partnerships outside of Indonesia or Philippines either, though we could both be missing out on something. I don't think management is actually very interested in going into other markets - which for me is a positive, I dont want them to go and burn cash to become the world leaders in chocolates, I would prefer them to spend that money in protecting their moat in Indonesia/Philippines, grow in Malaysia maybe, or pay me back the cash in dividends :).

4) Completely agree with you with regards to the vaccinations - the more I read about Indonesia or Philippines the more I think "normalized" earnings will have to be pushed back another quarter or maybe even 2.

5) While they dont specifically split out advertising quarterly, their Selling and Distribution costs have been steady at around 18-22% for the last 3 years (pre-covid), I would imagine that this will not change going forward, at least in the near term.

Another con that maybe you should consider as well is the price of cocao which has been rising alongside all commodity prices, along with the price of all of their other ingredients. I dont really know enough to model out their exact production costs but I would expect to see costs of goods sold as a % of revenue to increase rather significantly in the near term. I dont want to take too much of a macro view on the business, but I am guessing that inflation would probably be a big negative for this business due to the elasticity of demand in such a competitive category.

Pros:

1) Capex should be lower - I also think that their factories have a much larger capacity than is currently being used and I dont see them growing their items sold by 10-15% annually after reaching normalization, so I think we should have 4-5 years of nice low capex.

2) I think its SKUs and also I think part of it is commodity prices - if I am not mistaken from 2015-2019 Cocao prices trended downwards. Total decline was around 20% in the time I measured it. I also would point you towards them restating their 2018/2019 financials due to incorrect calculations of COGS and Sales and Distribution Costs. Their net margins from FY 2016 to FY 2019 were around 4-7% so I would argue that the actual savings are not so great.

Just my two cents - I take the partnership brands as a benefit. I think if the company is truly able to understand the manufacturing and sales of these new items (specifically in the non-chocolate categories) then the opportunity to produce and launch its own products are present. Additionally, as I argued in my initial thesis, for me this is a company that could be an interesting buy-out for a large confectionary player who wants a foot-print in ASEAN. If the company is able to execute the production and distribution of agency brands, it provides some sort of operational risk mitigation for those potential suitors.

Please do let me know your thoughts.

[Ilyich]

Hi @ANP301191,

Thanks for your response!

re: Cons

1. I think there are very few emerging markets with low currency risk. I am already invested in markets with uncertain currency risk such as Russia and China. Also, if Pabrai is not afraid of currency risk when a good business is cheap, then I can see myself getting over it.

2. Do they break down the new product sales in the annual report or you have some specific market visibility into these new products and can identify how they are performing? Latest Mondelez earnings were encouraging for the Asian snacking market.

3. I like your point about them staying put in Indonesia. Its better to be a big fish in a small pond than an average fish in a big pond. My concern was saturation of the Indonesian market with all these various types of snacks but I am going to trust the management's experience to position these products.

Don't have much to add on 4 and 5.

Regarding the price of cocoa/milk,

Cocoa and milk prices seem to be around avg. Am I looking at the correct ones?

https://tradingeconomics.com/commodity/cocoa

https://tradingeconomics.com/commodity/milk

Sugar price seems to be near 6-7yr avg but rising. Nuts are another input but hard to track due to their variety.

https://tradingeconomics.com/commodity/sugar

They say they buy their inputs with forward contracts, which I understand means they buy a large amount when the prices are low/avg so they can buy less when the prices are higher. However, this may not be possible with milk since its perishable. I'm gonna have to trust the management on this.

responding to your comments on the pros:

Not much to add on #1, thanks for your thoughts!

For #2, I read in the 2020 report that they recalculated the financials but I didn't understand exactly what the issue was and what changed. Do you happen to have some more details and new vs old numbers?

I agree with your final thoughts regarding this being a potential takeover but I am trying to leave that aside and just understand/value the existing business. If a buyout comes along then it will be free upside. There are other big players in the market that MNCs could decide to takeover for whatever reason (thus overlooking Delfi), such as Mayora or the company that's dominating in the Philippines (I don't know the name, is it Mayora?). I think my next step is investigating those two companies.

Could you elaborate how you ran DCF with 20% discount and ended up with S$0.79/share?

In my DCF I assumed 2021 $30mil owner's cash flow ($40mil less maint. capex of $10mil) with 6% growth for the next 10yrs and only ended up with 11% discount rate for the current price.

I did open a small position today so I can keep a close watch on this and understand it better as business evolves. Also, recent quarter's Mondelez earnings were encouraging for Asia.

Hope that makes sense, welcome all questions and feedback.

All the best!

[Ilyich]

Here is someone on SA who thinks the management has to change. This is from 2017.

https://seekingalpha.com/article/4059061-hershey-and-delfi-ltd-comparison

[Cicero]

No position in this, but came across a few anecdotes I wanted to share:

# I live in Asia and you can buy their stuff here in the supermarket. Sells mainly on price. We bought some of the products (Tops, Van Houten). My wife is the sweet tooth of the family and in blind testing (removed the wrapper) she thought that it tasted "cheap" mainly because she felt the chocolate quality was lower than say a Mars bar and there more "fillers" rice puffs instead of nougat, caramel. She also thought the products were not very well balanced 

# The products Delfi sells here, are pretty clear copy cats of Western brands. Perhaps the new products will be different. Naturally a bit problematic from a branding perspective  

# we have a domestic helper from the Philippines. She knew and liked Goya, but prefers Western brands at the same price point 

# Also anecdotal, but there shops here that specifically cater to domestic helpers where they buy presents for the loved ones home and such. One of the best sellers is Toblerone (yes, really); apparently because it is cheaper in Hong Kong / Singapore vs. Philippines/ Indonesia + very popular 

As I said, anecdotes, so don't put too much weight on this, but thought I'd share. 

[Cicero]

One more that I forgot: Our domestic helper's monthly pay cheque is modest (less than USD 1000), but one of the things she buys regularly are these big Nutella jars at about USD 10 a jar. Interestingly Delfi sells a competing product for about half the price and it is available at the local super market right next to Nutella  

[ANP301191]

Hi @Ilyich

Regarding the new products - honestly no objective way to track it. I know a few people in the Indonesian grocery business so I take their word for certain things. But seeing as a ton of their 2017-2018 Chairman's and CEO's letters focused on these new items, I would suppose that at some point they would have to show some sort of results or something.

As for the price of Cocao - I used the free Nasdaq portal - https://www.nasdaq.com/market-activity/commodities/cj%3Anmx . I honestly started my analysis from 2015 and did not go back further simply because that was the time that they divested their cocao processing businesses to Barry Callebaut, so I may have missed a trick there. Either way, I really dont believe that management has materially reduced the cost of goods its fluctuated at the 70% mark since 2015. Even though the price of some of their raw materials have come down (at least according to the chart I referenced).

There were a couple of issues that they had to restate about in the last 3 years. First in 2018 they uncovered fraud in their Philippines distribution unit - by my calculations that cost the company around $3.5m (restated new revenues/new profit + legal fees/admin expenses). The second thing is a little bit more technical and I would urge you to recheck this because I am no accountant - but its a technical change in accounting in Singapore. From what I can understand, new guidelines implemented in 2019-2020 pushed accountants to reclassify incentives and how they are dealt with. As a result Delfi's incentive program - they provide counterparties discounts based on how much of their product they sell, they give incentives to sales people, managers if allowed, they provide "marketing and branding" items - had to be removed from both the revenue and the sales and marketing numbers. From what I understand, Delfi was booking the revenue higher as it was adding in this cost while selling the items, and then was increasing their Selling and Distribution Costs when those incentives were hit. Under the new guidelines certain amounts of that incentive program needs to go into COGS and certain amount is reduced equally from the Revenue and the Selling and Distribution Costs. I asked a friend who is an actual accountant and he tells me that the new guidelines ask if the costs are specifically needed to sell the product then it needs to go into COGS and not another operating expense line. But again, no accountant so if you figure it out - please do let me know.

As for the DCF - I just relooked at it yesterday (built in December) and I think a) my assumptions of growth were kinder than yours at that time, optimism of the vaccines and all; b) I utilized the excess cash on the balance sheet as working capital - for some reason my original post missed a small paragraph where I argued that due to the healthy cashflow, over the course of the next few months the business should increase leverage to generate better returns for shareholders, I tried to implement this by using the cash as working capital. I think if you were to plug in the cash as NWC in your DCF you should come to approx the same value as I did.

In terms of management - I would love to see some changes - a more responsive management or board - but its 65% owned by the family (I think) so I wouldn't hold out hope for that. I think larger risk is transition to next generation which will happen at some point. Also just in reading their 2020 Annual report again, I think a ton of their officers are also getting up their in age, so the transition may be a tad more painful than I previously believed.

Also I completely agree with Cicero, that Delfi's products are for lower income consumers, and that they are in an extremely competitive landscape in terms of pricing. His anecdotal experience is probably played out over 100,000s of consumers, and it is a big risk that as income grows in these countries, Delfi's products will no longer be as big a player. Another anecdote - I tasted the Delfi chocolate bar and wasnt the biggest fan of it - and if you were to offer me a Cote D'Or or a Lindt at the same price there is no way I would opt for Delfi - and I am probably willing to pay a lot more for these brands against Delfi myself.

That being said, still a fan of the business because of its relative undervaluation and the belief that it has a long runway.

Also check out DBS's write up on Delfi - its a tad old (Feb 2021) but I think they are one of the only major banks that follow Delfi.

https://www.dbs.com.sg/private-banking/aics/stock-coverage/templatedata/article/equity/data/en/DBSV/012014/DELFI_SP.xml

[ACooke]

Just a small note re preferences for X brand over Delfi produced brands.

Don't forget that the reason - at least purported - that certain food-brands may seem to hold a foothold in one country/region versus another is commonly stated to be taste preferences and nostalgia instilled in a customer from childhood/many years of consumption.

This is why (I believe) you see brands like Korfola dominate soft drink sales vs coke in their relevant market. Why in Australia Cadbury's chocolate is head and shoulders above the rest in regards to sales (as far as I'm aware) and perceived (I can vouch for this) taste and why vegemite is widely loved. However the notion that Cadbury's is by far the best tasting (big-brand) chocolate and Vegimite taste great is certainly not an internationally held 'truth' - and that's not for want of trying.

I'm yet to try Delfi's, it's difficult to get here in Australia and I'm confident that it's likely not as 'quality' as Cadbury's, Hersheys, Lindtt etc. - and I think that's debatably an objective statement - but how much that matters to Indonesian's - I'm really not sure -- and I'd be lying if i said that didn't concern me.

At some point I have no doubt that 'superior taste' and 'quality' trample taste-memory and nostalgia especially with increased availability to new generations - presumably through the ever increasing 'modern' retail segment. (There's seem to have been a slowing here due to push-back from the local vendors - but I'm sure 'westernization' is pretty inevitable).

Delfi does with most brands, state they target the more affordable market sector - at least vs Hersheys et el. but does this endure with a growing middle-class.

Also a note re. copy cat products - this is literally food industry wide and runs the entire century plus history of the chocolate industry as well as the cereal and many other industries so I don't see this as an issue. 

 

Anyway - I do like the 'brand edge' Delfi (seemingly) has. 

I'll need to work a little harder tracking down some SilverQueen or similar. I'm concerned even after the above, that the taste may throw me off this idea.