Synear Food - Expect flat gross margin in 2Q09

Stagnant sales in 2Q09. Given fierce competition and weak demand, Synear did not raise its ASP in 2Q09. Although the company continued to launch new products with higher margins, the blended ASP for Synear in 2Q09 was continuously under pressure as more sales were generated by mid-tier to lowend products. Despite the low base of comparison caused by the Sichuan earthquake in the previous year, sales volume for Synear was still disappointing, which resulted in a decrease in turnover growth by over 20% yoy in 2Q09. Since 3Q is traditionally the low season for the frozen food industry, a meaningful turnaround for Synear might take place only from 4Q09 onwards.

Expect flat gross margin in 2Q09. The gross margin pressure in 1H08 is no longer a major challenge this year as most input prices have been on a downtrend since 1Q09. The lower input cost will help to offset some of the negative effects from a shift in product mix towards mid-tier to low-end products. However, as Synear’s raw material purchases are based on wholesale prices, which experience fewer fluctuations than retail prices, Synear is not expected to benefit significantly from the raw material price corrections. Together with the seasonal effect (due to the Dragon Boat Festival, 2Q is a peak season for selling rice dumplings, which command higher margins than the savoury dumplings and glutinous sweet dumplings), Synear is expected to record flat or slightly wider gross margin in 2Q09, compared with 1Q09.

Net profit decline might continue in 2Q09. In order to boost sales and maintain its market share, Synear’s marketing expenses remained at a high level even after the Beijing Olympic Games. The percentage of selling and distribution expenses over turnover in 2Q09 might be higher than that in 2Q08, partially due to the lower turnover growth. Operating margin expansion was unlikely in 2Q09 as the utilisation rate for its two new plants (Huzhou and Chengdu) lingered at 20-30% levels, and the utilisation rate for its Zhengzhou plant dropped significantly from a historical average of over 80% to approximately 50% in 2Q09. The decrease in turnover growth, high operating expenses and low utilisation rate will cause Synear to experience another 30-40% yoy earnings decline in 2Q09.

Maintain HOLD on Synear Food. Although a meaningful turnaround might only take place from 4Q09 onwards, Synear appears to be reasonably valued as it is trading at a 40% discount to Singapore- and Hong Kong-listed F&B counters. Synear’s strong brand name, nationwide distribution channel and leadership position also support its long-term growth potential. Maintain HOLD with a fair price of S$0.27, based on 10x 2010 PE. Entry price is S$0.21.

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