NCB Capital maintains strong long-term outlook for Saudi food and agriculture sector

Reporting on theSaudi Food and Agriculture sector, NCB Capital, the GCC’s leading wealth manager and the Kingdom’s largest asset manager, expects the long-term outlook to remain strong.

Covering market leaders Almarai and Savola, Farouk Miah, Head of Equity Research at NCB Capital, said: “A young and growing population, expansions into new segments and high market share for Almarai and Savola positions these companies strongly in the sector.  However, food price inflation, lack of pricing power and execution risks are key concerns for these companies.”

Summarizing NCB Capital’s coverage of the two companies, Mr. Miah said: “We remain overweight on Savola with a PT of SR47. Savola was one of the strongest performers in 2012 with the stock up 39%, outperforming the TASI by 33% and key strengths of the company include the strong growth outlook of its Retail business (Panda), leading market shares in its Food business (Edible oil and sugar), as well as its plans to divest non-core assets and focus on food. Risks include exposure to Egypt and Iran, margin pressure from any global food price inflation, as well as low absolute margins in its Retail business.”

“We remain Neutral on Almarai with a PT of SR72. Almarai is a quality company and key strengths include its dominant market share in dairy, its expansion plans into new segments and its strong distribution reach. Key concerns on Almarai include lack of pricing power, execution risk on new ventures and margin pressure from global food price inflation.”

Both Almarai and Savola have recorded margin pressure in the past due to their reliance on imported food items. NCB Capital believes continued global food price inflation is a key risk for margin outlook on both stocks. 2013E should see some stability in prices and thus margins, although the longer term outlook indicates continued pressures

Key imported items by Almarai include corn and soya bean with Savola reliant on imports of raw sugar and edible oils. Since NCB Capital’s last update in December, prices of these products have on the whole been flat/down YoY, suggesting margin expansion in 1H13, although the longer term outlook indicates continued inflation and thus possible further margin pressures.

“We believe both Savola and Almarai have some limitation in terms of pricing flexibility of their products,” stated Mr. Miah. “This pressure is most acute for Almarai on some of its core products such as fresh milk and was highlighted in its unsuccessful attempts to increase prices over the past two years.

“Savola has more flexibility in its Foods and Retail businesses, and due to multiple brands, it is able to be more flexible on prices for its high quality brands targeting higher income customers who are less price sensitive. Nevertheless, we believe the limits on pricing power exacerbates the potential margin pressure from increased food prices as it makes it difficult for these companies to pass on all of the inflation to consumers.”

Commenting that increase in margins is a near-term catalyst for both covered companies, Mr. Miah said: “We believe there is potential for margin expansion for both Savola and Almarai in the short term. Savola should benefit from continued volume driven growth in its Retail business, leading to margin expansion. Given the net margins in this business are the lowest in absolute terms in the group but with a high top-line, any increase here also has a disproportional impact on the overall Savola margin. Expansions in its Food business should also help margins through economies of scale.

Mr. Miah went on to say that “Expansions in existing businesses, as well as new segments, is a key theme for both Almarai and a Savola, a move we believe makes strategic sense. Both companies have built strong brands and are able to leverage their distribution capabilities, as well as supply chain management strengths by entering new segments.”

Almarai is planning to spend capex of SR15.7bn over the coming five years with SR2bn on new product development, and the remaining on enhancing its presence in existing businesses. Savola is expecting to spend SR5.2bn in the same period and is planning to expand its Sugar and Edible oils facilities by 33% and 38%, with Panda looking to add around 20 stores per year in the coming three years to its current 146 stores.

“We believe such expansions make sense, enabling both firms to take advantage of their existing market presence and brand loyalty,” added Mr. Miah. “However, successful execution of these expansion plans, coupled with ensuring attractive returns, is key to adding value to shareholders.”

Savola is currently trading at 13.3x 2013E P/E, although once stakes in Herfy and Almarai are stripped off i.e. core Savola operations, the company trades at a much more attractive 11.6x 2013E P/E. Almarai trades on 15.9x P/E, a premium for its perceived quality.