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Page | 1 | PHILLIP SECURITIES RESEARCH (SINGAPORE) MCI (P) 075/10/2016 Ref. No.: SG2017_0205

Japfa Ltd

Fattening its cash cow SINGAPORE | CONSUMER | SITE-VISIT NOTE

We attended a site visit organised by Japfa Ltd (“Japfa”) to its Dairy Farm 3 and 4 in Dongying City, Shandong Province, China on Thursday 24th Aug-17. We had the privilege of understanding Japfa’s Dairy operations with the Group’s CFO and Head of Dairy, who shared with us their market insights and technical knowledge.

Key takeaways from the site visit 1. Ramping up raw milk production

China: Farm 7 in Inner Mongolia has started milking in Nov-16 and targets to be fully milking by end-17. It will continue its five-farm hub expansion plan in Inner Mongolia, with three new farms over the next three years.

Indonesia: Construction of the new Farm 2 in Wlingi, East Java is on track and targets to start milking in early-18. It is in discussion to acquire a site for the third farm.

2. New processing plants to build its downstream business China: A 300,000 metric tonnes p.a. capacity milk processing plant is currently

under construction and is slated for completion in Jun-18. The new plant will transform its China dairy to a fully vertically integrated business, thus capturing growth and margins across the dairy value chain, as well as accelerate the development of its Greenfields brand in Asia.

Indonesia: New 7-hectare processing plant combined with its existing plant increases fresh milk production capacity by 80%.

These new capacities will support its dairy product range expansion, adding two new product pillars, yoghurt and cheese, in the Group’s dairy portfolio.

3. Key competitive strength One of the leading producers of premium raw milk in China and Indonesia. Profitability is driven by superior milk yield amid low raw milk prices environment

in China. Replicable large-scale industrialised-dairy farms translate to consistent and

sustainable productivity, as well as economies of scale. High-quality fresh milk – Greenfields is the No.1 brand of Fresh Pasteurized Milk in

Indonesia; Choice of milk for baristas and coffee chains, such as Costa and Starbucks.

Investment Actions Japfa is undervalued relative to the peer average EV/EBITDA and P/E multiples. Company is trading at c.43% discount to its peers’ EV/EBITDA and c.23% discount to its peers’ PER.

No stock rating or price target provided, as we do not have coverage on Japfa Ltd.

Peer Comparison

Company

Mkt Cap

(SGD mn)

EV/EBITDA

TTM

EV/EBITDA

FY1

P/E P/E

FY1

Net D/E

(%)

ROA

(%)

ROE

(%)

P/B

JAPFA LTD 967.1 6.3 6.0 15.5 9.0 46.7 2.0 7.3 1.2

Indonesia

CHAROEN POKPHAND INDONESIA TBK PT 4,605.5 11.3 10.1 22.2 16.3 28.9 7.9 14.1 3.1

MALINDO FEEDMILL TBK PT 210.7 7.9 6.0 13.9 8.7 81.8 3.7 8.5 1.2

CENTRAL PROTEINAPRIMA TBK PT 205.9 N/A N/A N/A N/A 2,663.1 -26.2 -205.2 28.8

FKS MULTI AGRO TBK PT 124.6 5.4 N/A 6.5 N/A 42.5 4.4 18.1 1.1

SIERAD PRODUCE TBK PT 107.7 39.5 7.2 N/A 72.5 41.8 -10.3 -24.9 1.2

Market Cap Weighted Average (Excl. JAP) 11.1 9.3 20.2 16.1 134.8 5.9 4.6 3.9

Source: Bloomberg

31 August 2017

Not RatedLAST CLOSE PRICE

COMPANY DATA

BLOOM BERG CODE JAP SP

O/S SHARES (M N) : 1,758

M ARKET CAP (USD mn / SGD mn) : 712 / 967

52 - WK HI/LO (SGD) : 1.07 / 0.49

3M Average Daily T/O (mn) : 5.25

MAJOR SHAREHOLDERS (%)

52.80%

M orze International Limited 16.07%

Tasburgh Limited 7.21%

4.61%

PRICE PERFORMANCE (%)

1M T H 3 M T H 1Y R

COM PANY (5.9) 0.0 (33.5)

STI RETURN (0.85) 3.21 19.33

PRICE VS. STI

Source: B loomberg, PSR

KEY FINANCIALS

Y / E D ec F Y 13 F Y 14 F Y 15 F Y 16

Revenue (USD mn) 2,697 2,947 2,787 3,033

EBITDA (USD mn) 262 259 286 386

NPAT (adj.) 42 31 65 119

EPS (USD) 0.03 0.02 0.04 0.07

PER, x (adj.) 21.1 9.0 9.3

P /BV, x 1.1 1.2 1.8

DPS (USD) - - 0.36 0.71

ROE, % 11.4% 5.8% 11.2% 21.4%

Source: B loomberg

Soh Lin Sin (+65 6212 1847)

Investment Analyst

[email protected]

Rangi M anagement Limited

Tallowe Services Inc

SGD 0.550

0.40

0.60

0.80

1.00

1.20

Aug-16 Nov-16 Feb-17 May-17 Aug-17

JAP SP EQUITY FSSTI index

http://www.stocksbnb.com/

Page | 2 | PHILLIP SECURITIES RESEARCH (SINGAPORE)

JAPFA LTD SITE-VISIT NOTE

Dairy Business Overview

Japfa’s dairy operations are mainly in China and Indonesia. It owns 7 world-class fully operational dairy farms and a processing plant, that are designed, equipped and meet international standards in productivity and biosecurity.

China Operates a five-farm hub of dairy farms in Dongying city, Shandong Province, with

close to 55,000 heads of Holstein cattle.

Building a new five-farm hub in Inner Mongolia. Farm 6 started milking in Jan-16 and was fully milking in Nov-16. Farm 7 has started milking in Nov-16 and is expected to be fully milking by end-17.

Focus on upstream dairy farming to produce premium raw milk for downstream customers such as Yili, Mengniu and New Hope. Currently is one of the leading producers of premium raw milk in China.

Indonesia Operates a vertically integrated dairy business in Malang, East Java, which produces

premium raw milk that is used further downstream dairy processing plant for its Greenfields dairy products.

Its Indonesia dairy farm is the largest dairy farm operation in the country by volume of premium fresh milk produced.

Its consumer brand Greenfields, launched since 2000, is positioned in the premium segment. Greenfields is the No.1 brand of Fresh Pasteurized Milk in Indonesia and is also exported to neighbouring Southeast Asian countries, including Singapore, Malaysia and the Philippines.

As at 31 Dec-16, Japfa’s shareholdings in Dairy is held through Austasia Investment Holdings Pte Ltd (“AIH”) and AIH2 Pte Ltd (“AIH2”). Japfa Ltd owns 61.9% and 64.5% of AIH and AIH2, respectively. China 373mn kg raw milk sales volume

39,407 heads of milkable cows as at

73,678 heads of Holstein cattle in Farms 1 to 5 in Shandong province and Farms 6 and 7 in Inner Mongolia

Indonesia 24mn kg raw milk sales volume

4,553 heads of milkable cows

8,416 heads of Holstein cattle in farm in Malang, East Java

Approximate numbers as at 31 Dec-16

Source: Company Annual Report 2016

Figure 1: Japfa’s business model at a glance

Source: Company Annual Report 2016

China Dairy farming Raw milk production

Indonesia Dairy farming Milk processing Distribution of branded premium

milk and dairy products



Figure 2: Dairy’s regional footprint

Source: Company website

Ramping up capacity to capitalise the increasing demand for dairy products in China

Structural growth in consumption of milk and dairy products, driven by growing consumer affluence, technology advancement Rising consumer demand for traceable and premium dairy products.

Higher ownership of household refrigeration enables proper storage of milk and dairy products.

More and better refrigerated transportation enables fresh dairy products to be the increasingly available countrywide.

Introduction of modern processing technologies, including ultra-high temperature pasteurisation, has greatly expanded the shelf life of dairy products

Consumption of fresh dairy products per capita is set to increase to 29kg/capita in the least developed countries and to 56kg/capita in developing countries by 2025.

Source: OECD/FAO (2016), “OECD-FAO Agricultural Outlook”, OECD Agriculture statistics (database).

Figure 3 & 4: China’s Dairy Consumption Pattern in 2016

0

20

40

60

80

Fresh dairy products

2016 Human consumption per capita (kg/capita)

World China

Source: OECD

0

1

2

3

4

Cheese Skim milkpowder

Whole milkpowder

2016 Human consumption per capita (kg/capita)

World China

Source: OECD



Figure 5-8: China’s Milk and Dairy Products 2015-2025 Outlook

40,000

42,000

44,000

46,000

48,000

50,000

15 16 17 18 19 20 21 22 23 24 25

China Milk Production ('000 tonne)

Source: OECD

14.0% growth over 2015-25

10-yr CAGR: 1.3%

0

1,000

2,000

3,000

4,000

5,000

15 16 17 18 19 20 21 22 23 24 25

China Milk Producer Price (RMB/tonne)

Source: OECD

41.0% growth over 2015-2510-yr CAGR: 3.5%

29

30

31

32

33

34

35

15 16 17 18 19 20 21 22 23 24 25

China Fresh Dairy Products: Human consumption per capita (kg/capita)

Source: OECD


0.0

0.1

0.2

0.3

0.4

15 16 17 18 19 20 21 22 23 24 25

China Cheese: Human consumption per capita (kg/capita)

Source: OECD


China Adding Farm 8 to 10 into the new five-farm hub in Inner Mongolia, with one new farm

each year until 2020.

Paving path for its future downstream business in China

(a) Mid-2014: Appointed a third party contract packer in China to pack the premium raw milk from its dairy farms under Greenfields brand for distribution in China.

(b) 2015: Entered into a joint venture with Food Union (Asia) Limited, a European based dairy and milk processing company, to build, own and operate a premium milk processing plant in Shandong Province, China.

Located at c.5km from its dairy farms in Dongying, with 300,000 metric tonnes p.a. milk processing capacity

Currently under construction and is slated for completion in Jun-18

AustAsia will enter into a long term (five-year renewable) off-take contract to supply premium raw milk to the plant, which will in turn manufacture high value-added dairy products for the Group, Food Union, as well as leading third party international food companies.

Leveraging on Food Union’s expertise in milk processing and distribution, Japfa could capture growth and margins across the dairy value chain, as well as accelerate the development of its Greenfields brand in Asia.

Southeast Asia Scarce competition within the industrialised dairy farm space in Indonesia adds to the

Group’s advantage.

Construction of the new Farm 2 in Wlingi, East Java is on track. It has completed its earthworks, started construction in end-16, and targets to start milking in early-18. Similar to Farm 1, the new Farm 2 is designed for 4,000 heads of milking cows and a population of 9,850 heads.

Japfa owns 19% share in the joint venture company, Food Union AustAsia Holdings Pte Ltd



Management shared that it is in discussion to acquire a site for Farm 3.

Continue to build its downstream processing operations and its Greenfield brand

The new 7-hectare processing plant in Desa Palaan, Malang, East Java is 4 times larger than the existing plant located at Desa Babadan. It has commenced operations on 4 May-17.

It has an infrastructure to cater up to 3 farms output and is expected to run more cost efficiently, thus lowering conversion cost and enhancing economies of scale.

It has an annual processing capacity of 32mn litres, bringing Indonesia’s total processing capacity to 72mn litres per year. With this capacity expansion, Greenfields is now the largest fresh milk producer in Indonesia.

Its strategy of consumer goods business for next 5 years is to focus on liquid milk, yoghurt and fresh cheeses, and capitalise on Greenfields Premium Brand positioning.

Figure 9-11: Operational Commencement of New Dairy Processing Plant at Desa Palaan, Malang, East Java

Source: Company 2Q17 Results Presentation Slides



Efficiency to drive profitability

The Dairy segment is the most profitable business within the Group. Despite only contributing 9% to the Group’s FY16 Revenue, its high operating margin of 18% translated it into 17% of the Group’s FY16 Operating Profit.

Figure 12: Snapshot of Dairy’s 2Q17 Financial Performance


Higher 2Q17 profits amid continuing pressure on raw milk prices; driven by improvement in milk yields and higher sales volume Revenue and profit generation continued to be driven by China. Improvement in milk

yields cushion cushioned the 7% drop in China raw milk prices. Overall operating margin only dipped 2.6 percentage points to 18.5%.

On the other hand, Extended Shelf Life Branded Milk sales in Southeast Asia continued to record strong volumes. SEA dairy operations continued to show improvement in profitability even as the Group is investing in brand building.

In near term, the higher milk sales volumes and better milk yields should continue to mitigate the sluggish raw milk prices in China.

Figure 13-15: China Dairy Operational Performance

1 Number of milkable cows as at end of the quarter


Figure 16-18: Southeast Asia Dairy Operational Performance



1 Number of milkable cows as at end of the quarter




Getting it right at the source

A replicable, large-scale, industrialised-dairy farms with a standardised 10,000 head farm blueprint translates to consistent and sustainable productivity

(a) Infrastructure and standardised systems, which are designed to maximise cattle welfare, operational efficiency and generate high and quality yields Advanced technology provides a competitive advantage to the Group. Automation and ease of operations reduce staff costs, increase productivity and

efficiency. Its 80-stall rotary milking parlour enables fast and efficient milking for large

numbers of cows. We noted that the cows seemed to enjoy the trip on the rotary parlour.

(b) Advanced and industrialised farm management practices with experienced farm managers

(c) High-yielding livestock High-quality Holsteins cattle are imported from Australia and New Zealand; cross

bred with the good fertility and size genetics from the United States.

Its China farms could now support heifer replacements as well as to supply heifers for its new farm. Farm 7 in China completely uses its own-bred dairy heifers.

(d) Scientific development of feed formulation for optimal nutrition for cow health and quality milk output. Feed mix: corn (c.60%), grain, hay, alfalfa, soybean meal and silage

Feed cost is major costs component, at about one-third of its ASP for China raw milk.

While 98% of the ingredients could be sourced locally, the remaining 2% are imported.

The Group also has cropping paddocks surrounding the farm, mainly for plantation of corn, which supplies 20-30% of its feed mix.

(e) Strategic farm locations where environmental factors are ideal and supportive local government Targeted areas within optimal environmental parameters (factors such as

weather, altitude, and natural resources, etc.)

For example, Dongying, located in latitude and weather comparable to California, which is perfect for cow breeding. The Yellow River Delta provides water resources for the cropping paddock surrounding its farms. The Dongying port will also help to keep transportation cost low for imported feed ingredients.

A supportive government enabled Japfa to accelerate its expansion plan in China. Management shared that roads, power lines, and other infrastructures were all built at the local Chinese provincial government’s expense.

Nationalistic policies in Indonesia could also underpin demand and favourable business environment for Japfa. The Indonesian government is considering to quadruple the import duty for skimmed milk products to 20% to encourage big dairy firms to partner with local farms and increase the use of locally produced milk for their production.

CAPEX per farm = US$90mn, including cows and infrastructure

Target milk yield China: 45kg/head/day Indonesia: 40kg/head/day

Biogas digester in dairy farms Cow manure will be separated into solid and liquid – Solid will be used as organic compost and fertiliser in its crop fields, while liquid will be diverted into a lagoon. Biogas-generated electricity will be used for farm operations and staff dormitory.

Long land lease of 30-40 years in China

In 2016, 77% of industrial demand for milk powder is imported. The government aims to increase its nation milk production to 41% of national industrial demand by 2021.



Figure 19: Rotary milking parlour

State-of-the-art milking technology c.7 minute per cycle; c.5 hours to milk 5,000 cows; Each cow

are milked 4 times a day Less milking labour – only requires 1 staff to attach the

milking cluster Milking cluster is automatically retracted at the end of the

milking process, allowing the milked cow to exit and the next cow to enter easily

Short entry and exit times; Designed to enable cow traffic with minimal human intervention, and keep a constant and steady flow of cows moving through the system

Milk recording to check a cow's yield and milking time

Figure 20: Front of milking parlour

Raw milk is transferred from the cow through the receiver, cooled and stored at -5 degree Celsius in bulk tanks before being transported to the processing plant. No or minimal air contamination from udders to tank trucks.

Source: PSR

Figure 21 & 22: Cow barns

Average size and yield of a Dairy Farm in China c.5,000 milking cows c.300 staff Milk yield of 39kg/head/day; lower during summer (Jul-Aug)

at 38kg/head/day

In general, the heifers are inseminated when heifers reach an age of approximately 14 months old. After an approximately 9-month pregnancy term, a calf is born, and the dairy cow begins to produce raw milk. c.10% of milk are used to feed new born calf before they are weaning.

A comfortable home for the cows and efficient design for farm management.

Barns are washed when cows are being milked. The cow beddings are slightly sloped so that waste can be easily rinsed off and dirt can run into the groove outside the barn. Waste water then flows away via this groove.

Two lines of fans to promote air ventilation and sprinkler system for cooling effect during summer.

Source: PSR



Figure 23: Silage bunkers

If processed and stored properly, silage could last for years.

Figure 24: Silage and hay barn

Source: PSR



Going downstream

Leveraging on its quality raw milk and the Greenfields brand name, Japfa intends to expand its dairy food product range targeting at the premium market consumer.

Indonesia The new Desa Palaan plant in Indonesia not only increased its fresh milk production

capacity by 80% to 72mn litres p.a., but also provide additional capacity for the Group to ramp up its fresh dairy products, e.g. Whipped Cream, Yoghurt and Fresh Cheeses.

95% of its raw milk from its dairy farms are sold as Greenfields products.

70% of its sales in Greenfields Indonesia are domestic; while the remaining 30% are from exports to seven cities and countries, namely, Hong Kong, Singapore, Malaysia, Brunei, the Philippines, Myanmar and Cambodia.

China Without a self-owned processing plant, AustAsia currently depends on a third party

contractor to process and distribute its fresh milk. These caused limitations to (i) production volume; (ii) range of products – only pasteurised milk and UHT milk; and (iii) market penetration – only distributed in China.

With the new upcoming plant in Jun-18, the Group will be able (i) introduce more dairy products such as cheese and yoghurt; and (ii) increase capacity to cater to the demand in Great China. Japfa could then capture growth and margins across the dairy value chain, as well as accelerate the development of its Greenfields brand in Asia.

Management shared that China’s yoghurt market has been growing at a fast pace over the past 2-3 years. Greenfields will position itself under the premium yoghurt segment, offering quality yoghurt products which will have a different taste compared to the existing yoghurt products in the market.

On that note, we think that a low-sugar and more concentrated yoghurt products could capture the growing health conscious consumers in China. We also noted that the yoghurt market in China market is driven by the fast growing drinking yoghurt, especially the ambient yoghurt segment. Ambient yoghurt has penetrated hotels and casual dining places, in addition to the normal distribution channels via retail outlets.

The Group plans to allocate half of the raw milk from its dairy farms for downstream production in the new processing plant, and the remaining half to be sold as raw milk to downstream industrial customers.

Figure 25: Rebranded Greenfields to AustAsia and changed packaging with cleaner look in China

Source:

http://www.sohu.com/a/135758695_700834

Figure 26: Greenfields’ product offerings in China

Source: http://www.sohu.com/a/135758695_700834

Figure 27: Greenfields’ product offerings in Southeast Asia markets

Source: Company website



Barista milk quality. Greenfield’s quality milk in Indonesia and China in terms of nutritional standards has put it as the top frothing milk choice for baristas and coffee chains, such as Costa and Starbucks. It is also the designated milk for 2017 P.C.A (Professional Coffee Athletics) Coffee Masters Tournament in China.

Greenfields has the frothing characteristics (foamability and foam stability) to create the perfect foam due to its protein concentration (milk protein of >3.2g), as well as fats content.

Cattle fattening farm in Shandong

Dongying Japfa Beef Company is the Group’s integrated beef division in China. The feedlot operation was established since 2014.

As the dairy cows in its farms give birth annually to produce milk, the unwanted young bull calves will provide the source of cattle for its beef feedlot, thereby providing integration across its dairy and animal protein beef segments.



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