GCB’s 9M15 bottomline turned to a PAT of MYR22m (9M14: MYR7.3m loss), mainly contributed by an improved ASP for cocoa solids and sales tonnage. We estimate the value of the group at MYR1.56 per shareby pegging to 1.8x FY16F P/BV, which implies 14.8x FY16F P/E. We expect the balance sheet to improve gradually as management continues to reduce inventory levels in the face of a challenging industry outlook.

A major cocoa processor in the region. Guan Chong (GCB) is one of the top 10 largest cocoa processors in the world, with a total bean grinding capacity of 200,000 tonnes pa from its Pasir Gudang and Batam plants in Malayia and Indonesia respectively. More than 90% of its cocoa products are exported under its in-house Favorich brand. GCB’s clientele base includes leading cocoa ingredient traders as well as worldrenowned chocolate manufacturers.

Continuous efforts to turn around. GCB’s bottomline turned around to a PAT of MYR22m in 9M15 (9M14: MYR7.3m loss). This was mainly contributed by improved ASPs and sales tonnage of cocoa solids (ie cake/powder). Going forward, we expect the group’s balance sheet to improve gradually as management continues to reduce inventory level s. Besides, there might be margins improvement if the combined cocoa ratio does not deteriorate and no significant depreciation of the MYRoccurs.

Industry outlook. The outlook for the global cocoa processing industryremains challenging on the back of weak cocoa demand and poor processing margins. Nevertheless, the long-term outlook for Asia as a whole remains intact. This is considering the fact that the region continues to report positive GDP growth while consumer interest in cocoa and chocolate products remains healthy.

Value GCB at MYR1.56 per share by pegging 1.8x P/BV to its FY16F BV of MYR0.87, which implies 14.8x FY16F P/E. We think our target P/BV multiple is reasonable, as it is in line with the peers’ average of 1.8xand below GCB’s historical average 1-year forward P/BV of 2.0x.

Key risks: i) tight supply of cocoa beans, ii) declining combined cocoa ratio and iii) sluggish global chocolate demand.

 

 

 

 

Key Investment Theme A potential turnaround A major cocoa processor in the region, GCB commenced its cocoa business in Pasir Gudang, Johor, in 1990, with an initial bean processing capacity of 6 ,000tonnes pa. To date, the group is one of the top 10 largest cocoa processors in the world, with a total bean grinding capacity of 200,000 tonnes pa from its plants in Pasir Gudang (Malaysia) and Batam (Indonesia). In addition, GCB also has a cocoa cake grinding factory with an annual capacity of 6,000-7,000 tonnes in Delaware, US. More than 90% of the group’s cocoa products are exported to over 60 countries under its in-house Favorich brand via a global distribution network of more than 70 multi-national trading companies and agents. Its clientele base includes leadingcocoa ingredient traders. Additionally, GCB is also working on several projects with world-renowned chocolate manufacturers to supply its cocoa products to their factorysites worldwide.

Experienced management. GCB is essentially a family business and the founding Tay family now collectively owns more than 60% of the group. GCB is currently run by a key management team that comprises CEO Mr Tay Hoe Lian, COO Mr Tay How Sik and CFO Mr Hia Cheng, all who have been with the group for more than 20 years.

 

 

 

Favourable cost structure. GCB’s main competitive advantage is its favourable cost structure, which is attributed to the locations of its manufacturing facilities. The group’s main cocoa grinding plant in Malaysia was set up a long time ago and is now running at low depreciation costs. In addition, GCB was the first foreign company to set up a cocoa beans-processing plant in Indonesia. Hence it is likely to have lower depreciation costs vis-à-vis some newly-built plants in the region. Although the raw material costs – which are denominated in USD – account for a huge portion of GCB’s cost of sales, a weaker MYR and IDR against USD suggest that the groupwould probably enjoy lower manufacturing overheads when compared to other competitors abroad.

Cocoa bean grinding remains its core. GCB expanded its downstream chocolate production – ie chocolate coatings, sauces and creams, baking chips, etc – by acquiring a new plant with an annual capacity of 10,400 tonnes nearby the Tanjung Pelepas Port in 2013. Notwithstanding this, cocoa bean grinding remains its core business activity, contributing more than 90% of group revenue. In general, one tonne of cocoa beans can yield about 0.8 tonnes of cocoa liquor, which can bepressed to extract 0.35 tonnes of cocoa butter and 0.45 tonnes of cocoa cake. Cocoa cake can be sold in solid form or pulverised to form cocoa powder. Cocoa butter is used in the production of premium chocolate while cocoa cake/powder is mainly used in lower grade chocolate, drinks, icing and so on.

Business model. Similar to other grinders, GCB sells cocoa butter mostly on a forward basis, while cocoa powder is sold on either spot or forward basis. At the same time, GCB is looking to secure the required quantity of beans at a negotiated discount/premium to the same terminal price benchmark. This back-to-back arrangement represents a natural hedge for the group against any eventual pricing volatility. However, this does not prevent GCB from any downside risks from the weakening economic conditions. This is because its customers may delay deliveries and/or cancel orders. ASPs of cocoa ingredients could also s lump due to the oversupply of such materials in the market . GCB slipped into the red for the first time since listing in FY14 on the back of such an oversupply situation in the market, particularly for cocoa powder, as well as on a slowdown in demand in both emerging and developed markets.

Historical earnings review. GCB’s revenue increased with a CAGR of 17.9% between FY05 and FY14. This was on the back of a higher sales tonnage, which rose in tandem with the global consumption of cocoa -based food & beverage (F&B) products. Nevertheless, the group’s EBITDA yields fell below its historical average levels in FY13 and FY14. This was mainly attributable to: i) depressed selling prices (particularly for cocoa powder due to an excess supply situation), ii) write-downs of inventory levels, and iii) forex losses arising from a weakening MYR. For 9M15, however, GCB’s bottomline turned to a PAT of MYR22m from a loss of MYR7.3m in 9M14. This was mainly contributed by improved cocoa cake and powder ASPs and sales tonnage, as well as higher gross margins as the group was able to clear out its cocoa solids inventory.

 

 

 

Continuous efforts to turn around. Substantial portions of GCB’s cost of sales and borrowings are denominated in USD, which are mainly attributable to the costs of its main raw material, cocoa beans. The group normally enters into short-term trade financing in order to meet its raw materials requirement. Over the last two years, GCB suffered from huge working capital requirements on the back of higher cocoa bean prices and forex losses. This was the result of increased debt settlement as the USD strengthened against the MYR. To make matters worse, GCB had to provide for inventory write-downs due to the depressed prices of cocoa solids. That said, going forward, we expect the group’s working capital days and net gearing ratio s to improve gradually as management continues to reduce inventory levels. Besides, there might be margins improvement if: i) the combined cocoa ratio does not fall further, and ii) there is no significant depreciation of the MYR.

 

 

 

 

Industry Outlook The outlook remains uncertain Over the past decade, expectations for a rise in chocolate demand, especially in Asia, led to a rush in the building of processing facilities. Since 2012, the cocoa processing industry has been facing excess grinding capacity and weak cocoa demand. This, in turn, has led to an oversupply of cocoa products and lower ASPs across the board. In addition, many global cocoa processors, especially those in developed markets, are struggling to maintain profitability as the cocoa combined ratio – or the processing margins for both cocoa butter and powder – fell below the breakeven level.

The International Cocoa Organisation (ICCO) forecasted for global grindings to fall by about 4.6% YoY to 4.1m tonnes in 2014/2015. This was as weak cocoa demand and poor processing margins deterred grinders from building up inventory (Figure 2).Nevertheless, as the industry de-stocking activities continue, it might provide some grounds for improving processing activities in the coming months. On the Asia front, grinding activities has shown a slight improvement in 3Q15, reportig a 4.8% QoQrise in grinding tonnage after declining from the peak level in 4Q13 . This was partly driven by improved processing margins (Figure 3). The Cocoa Association of Asia(CAA) believes that the outlook for the Asian region as a whole is cautiously optimistic. This is because the region continues to report positive GDP growth, while consumer interest in cocoa and chocolate products remains healthy.

 

 

Valuations Investment case. We expect GCB to turn profitable again in FY15 and record netearnings of about MYR29m-61.3m for FY15F-F17F. This is on the back of a revenue CAGR of 11.6% during this timeframe. Key assumptions to our forecasts include:

i. Cocoa bean prices per tonne of USD3,135/USD2,910/USD2,820 for FY15/FY16/FY17 respectively, which are in line with concensus and the World Bank’s commodities price forecasts (released on 20 Jul 2015) ii. Average cocao butter ratio of 2x for FY15-17 iii. Average cake/powder selling prices of USD2,200-2,400 per tonne for FY15-17 iv. USD/MYR of 3.91/4.3/4.3 for FY15/FY16F/FY17F respecively. GCB also has a dividend policy of a minimum 25% of net profit to shareholders, and we expect this yield to be around 1.5-3.1% pa for FY15-17.

We value GCB at MYR1.56 by pegging 1.8x P/BV to its FY16F BV of MYR0.87. We think our target P/BV multiple is reasonable as the multiple is in line with the peers’ FY16F P/BV average (Figure 8) and remains below GCB’s 2.0x 1-year forward P/BV between FY09 and FY13 (Figure 9). The FV implies 14.8x FY16F P/E, which is alsoin line with peers’ FY16F P/E average. We used the P/BV methodology to value the stock, as the group’s historical forward P/E has been distorted by net losses in FY14. GCB has 89.7m outstanding warrants, which have an exercise price of MYR1.34 and are going to expire on 20 Feb. Currently, the warrants are out-of-money. Peers comparison. The past few years have seen consolidation among the cocoa processors, with Barry Callebaut’s acquisition of Petra Foods’ cocoa ingredients division and Olam acquiring the global cocoa business of Archer Daniels Midland Co(ADMC). Post acquisitions, Barry Callebaut and Olam are now the leading and third largest cocoa processors – in terms of cocoa grinding capacity – in the worldrespectively. We exclude the smaller cocoa grinders in our peers comparison, as there are no forecast estimates available.

 

 

 

 

 

Key Risks Tight supply of cocoa beans. The supply of cocoa beans could be disrupted by factors such as: i) adverse weather, ii) political upheaval, iii) ageing cocoa trees, and iv) lack of government support for new planting s, amongst others. A sharp decline in cocoa beans could result in a hike in prices, which in turn increases the working capital requirements for cocoa processors like GCB.

Declining combined cocoa ratio. The profitability of cocoa processors like GCB would be adversely impacted by a declining combined cocoa ratio, ie the price of cocoa butter and cocoa powder relative to the futures price for cocoa beans. The downside risk can be somewhat mitigated via active price management, ie anticipating the price movements of cocoa ingredient products and push ing/refraining product sales accordingly. As such, an experienced management team that has market intelligence is critical.

Sluggish global chocolate demand. Demand for cocoa products would be adversely impacted as a result of sluggish global demand for chocolate. Nevertheless, we believe that the long-term growth of consumer demand for this product, especially in this region, remains intact.