SMC , PF – The winners and losers in the re-creation of the San Miguel Food & Beverage giant

On November 3, 2017, San Miguel Corporation (SMC) disclosed to the public the re-creation of the San Miguel Food & Beverage giant.  (For a copy of the PSE disclosure please click – PSE-SMC-Consolidation of Food and Beverage Business [11.03.17]).

SMC will swap its 7,859,319,270 shares of San Miguel Brewery Inc. (SMB) representing 51.16% of SMB and its 216,972,000 shares of Ginebra San Miguel (GSMI) representing 78.26% of GSMI for an additional 4,242,549,130 shares of San Miguel Pure Foods Company Inc. (PF) with a total value of 336 Billion Pesos based on an expert valuation report of ING Bank N.V.  The transaction will raise SMC’s ownership over PF to 95.87% from 85.37%.

After the share swap PF will rename itself into San Miguel Food & Beverage Inc. after which SMC will sell up to 30% of PF to raise 150 Billion Pesos as reported (Inquirer Business Report 08Nov2017 and BusinessMirror Report 18Jan2018).

Prior to the announcement, PF was trading at a 300 level. After the disclosure, PF went as high as 640 a share and as of 24Jan2018 was trading at a range of 602-612.  We believe it is time to sell and unlock the value.  It is now trading at twice the value of where it was once, so reap the reward.

PF will be the loser in this consolidation game. PF will be buying SMB and GSMI at a hefty price and its balance sheet will be saddled with intangibles/goodwill.  The 336 Billion price of SMB (GSMI valuation is neglible if lumped with SMB) will translate to 37X Price to Earnings (PE) ratio. In 2016 SMB earned 17.7 Billion of which 9 Billion is attributable to SMC’s 51% ownership. 336 Billion divided by  9 Billion results to around 37X.  Please see SMC 2016 IR Briefing.

The hefty price for the assets will erode future earnings of the company in the form of goodwill impairments.  We believed that their will be impairments as cash flows from the units will be roughly the same (beer/beverage is a mature market) but the price paid for such cash flows are higher. Future returns will be lower as the asset-based is overvalued with goodwill. The net assets of the recreated food and beverage giant will be inflated with goodwill as a result of the hefty price it paid to acquire the said assets. The overprice/goodwill could have been deployed to acquire other earnings and cash flows accretive assets so growth might be slower in the future as resources have been tied up in goodwill. This will shrink the value of PF. Don’t wait for it, encash your gains now.

SMC is also setting a new 52-week high when it reached 141 on 23Jan2017 trading.  But its gain is not as remarkable as that of PF.  SMC is only up 39.39% in a one year period while PF is up 142.04% in the same period.  SMC has still more room to grow.  After the execution of the share swap, SMC will sell 30% of PF to comply with the float requirement for a total of 150 Billion Pesos.  The 150 Billion will be new money for SMC that can be used to grow further its earning assets.  SMC will be able to invests more in high profit margin and fast growing industries such as power and infrastructure and this will expand SMC’s earnings.  Currently SMC’s PE ratio is low at 19.84 as compared to Ayala Corp.’s (AC) 23.26, Aboitiz Equity Venture’s (AEV) 20.45 and JG Summit Holding’s (JGS) 62.11. We conclude that SMC at 140 is still a good buy given its new fire power.

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EMP – Valuation Growth on Premiumization and Buy-back

On January 19, 2018 EMP closed at 7.97, just -5.12% below its 52-week high of 8.40 set on July 11, 2017.  We believed EMP can still go higher that its 52-week high of 8.40.  Following is a discussion on why we believe EMP can soar beyond its recent high.

The “premiumization” strategy of EMP will bear fruits in this TRAIN regime.  TRAIN imposes a new excise tax of 12 Pesos per liter on drinks using high-fructose corn syrup.  This affected the major beverage companies like Coke and Pepsi.  In reaction, Coke and Pepsi will reformulate their beverages to utilize local sugar.  This, we believe, will increase the demand for local sugar, thus, increasing local sugar prices. To take advantage of this sugar boom, sugar millers will have to make their plant more efficient.  That means they will extract more sugar from the production leaving little molasses for the production of ethanol.  Short supply in ethanol will cause its prices to increase.

While we project that TRAIN law will make ethanol in short supply another law is projected to shore demand for ethanol. The Biofuels Act of 2006 mandates the blending of locally-produced bio-ethanol into fuels.  The demand from fuel companies will further fuel the rise of the prices of ethanol.

How this will result to the positive impact of the “premiummization” of EMP?  EMP domestically is mainly competing on liquor companies utilizing ethanol as raw materials. Those ethanol-based liquors are generally cheaper than EMP’s “premium” products. Those ethanol-based liquor products will have to increase their prices.  The price increases of the ethanol-based products will make the EMP’s “premium” product price competitive.  We see a switch by the consumers to EMP’s “premium” product.

As of year-end of 2016, revenue fell by 6.02% yet revenue increased 10.54%.  This means margin is improving.  In 2018, we see volume growth and revenue growth from the switch. We see no factors that can cause an increase in the costs of EMP so we believe margin will be sustained.  Revenue growth with a sustained high profit margin will result to a much more improve bottomline of EMP.

Another factor that will shore up the valuation of EMP, is its buy-back program.  EMP maybe committed to buy-back up to 480 Million of its shares, but so far as of December 29, 2017 only 45.2 Million shares have been bought-back from the market.  Of the total 5 Billion Pesos appropriated for the buy-back, only 0.32 Billion has been spent purchasing its own shares.  Further exercise by EMP of the buy-back is expected to increase the stock price of EMP.

We believe EMP at below 8.0 is a good buy.

TEL – A Culture of Under-Investment in Telco Capabilities

TEL (PLDT) has for quite sometime has hovered at around 1,450 – 1,500 level. This is despite frequent press releases by the company of good news about it. It is imminent that TEL will still have to go down.

The woes at TEL can be traced back to its culture. When First Pacific took over TEL from Antonio “Tonyboy” Cojuangco, Manuel V. Pangilinan (MVP), the present TEL CEO, was criticising TEL’s previous management group as like the “government.” It was said that the first order of business of the previous management was the capital expenditure/capex rather than advertising and creating a brand. It was like a government because in the government it is usually capital projects that is being sought first by the politicians. There is a culture of entitlements among politicians in government.

MVP then change its culture and increased its advertising budget then relegated the capex to a lesser priority. At that time there was an explosion in the usage of mobile data then limited to SMS and ringtones and mobile calls. It was a bonanza for TEL. MVP then stepped-up the dividend pay-out ratio of TEL. From 2007 t0 2013 pay-out ratio was 100% of “core earnings,” before slowing it down to 90% in 2014.

First Pacific at the time of its TEL take-over was also reeling the effects of the “Asian Currency Crisis.” First Pacific executives in Hong Kong tried to sell its TEL stake to the Gokongwei Group behind the back of MVP. MVP fought back and vowed that TEL will be the saviour of First Pacific.

True to his words, MVP made TEL profitable, thanks to the SMS addicted Filipinos, and repatriated most of the profits of TEL to First Pacific. The cash flows from the dividend pay-out of TEL reinvigorated the then diminished First Pacific. MVP was made the CEO of First Pacific. At that time, it was boasted that marketing savviness was the key to the profitability and that it had killed the “government-like” culture of capital expenditure first in TEL. This will come to haunt back MVP and TEL.

The killing of the “government-like” culture of capital expenditure firsts in TEL led to under-investments in the capabilities of TEL. The under-investments allowed TEL to pay-out most of its earnings to its stockholders, the largest of which is the First Pacific Company. Technological innovations and disruptions fueled the demand for more data capability out of telcos. Because TEL under-invested in its capabilities it was not able to satisfy it customers. No matter how savvy its advertising and branding is, customers can’t just be appeased by TEL’s lack of capability to satisfy customer demands.

At the outset of LTE, TEL failed to immediately expand its capability to LTE. Instead it bought a telco, Digitel, with also less capabilities. It bought Digitel only to pare down the number of towers it owns because many became redundant. The Gokongweis sold out Digitel because it was capital intensive and that it may not have the resources to compete and transition it to a more digital telco.

Because most of the profits TEL had earned during the good years was paid-out as dividend, it has now to dig deep on its resources to fund its transformation. It is now reaching on its MERALCO stake to fund its capex.

Most of TEL’s investments have already been sold out to fund its capex to date. As of end of 3Q 2017, the only significant investments left are MediaQuest PDRs with a carrying value of 13.16 Billion and Rocket Internet with a carrying value of 12.74 Billion. MediaQuest spans newspapers (Business Word, Philippine Star), radio broadcasting, TV Broadcasting (ABC 5), and pay-TV (Cignal). TEL has planned to spend 50 Billion for capex in 2018. TEL may need more than that amount in the future as demand for data has been increasing year to year as people, homes, and enterprises adopts internet of things. TEL may have to sell also MediaQuest and Rocket Internet stakes to fund further its capex in the coming years. This is why we recommend that you sell.

Proceeds from asset divestments may not enough to fund further its capital expenditures to make its capabilities at par with the best in the world (a capability which the government and its customer demands from them). So TEL may have to reduce further its dividend pay-out. Its dividend pay-out stands at 60% from 100% in 2013 and 90% in 2014. As dividend from TEL get smaller, market might react to maintain the dividend yield of TEL which is currently at 6.41%. This means, market will have to price TEL also lower. So if you are holding it now, it it is time to cut your losses and sell.