Description

IDEA

Delfi is the leading chocolate confectionery company in Indonesia with an estimated market share of 45%. A growing middle class supports revenue growth, projected to be HSD to LDD in local currency over the long term. A spectacular surge in cocoa prices from a long-term average between $2000/t~$4000/t to $10000/t in a short time, rattled investor confidence and caused a dip in the share price from a peak of SGD 1.40 last year to SGD 0.90 today.

We maintain confidence in Delfi’s prospects, as the market seems to overlook the company’s seasoned management team adept at navigating volatile pricing dynamics. Leveraging their expertise, Delfi has strategic measures at its disposal to safeguard profit margins. This includes a blend of price increases, product resizing, and ingredient modifications. Strategic initiatives in 2024 will not only protect the earnings power over the medium term, but also improve profit margins in the current year as the higher cocoa prices will only hit the company’s results in the second half of 2025.

Last year’s margins likely represent a conservative estimate for normalised margins going forward. The current share price values the company at 8.7x last year’s after-tax earnings, a very low valuation for a long-established dominant chocolate company with excellent growth prospects, a net cash balance sheet and a solid owner/operator with a good track record for capital allocation.

BUSINESS

Delfi has previously been written up on VIC and these reports offer valuable background information on the company. This report will focus on the current market environment and why we believe the risk/reward today is highly attractive. 

Delfi is a second-generation family business in chocolate confectionary located in South-East Asia. The company has been a market leader in Indonesia for decades, with a market share estimated at 45%. The crown jewel is the Indonesian “own brands”-business, complemented by an agency business representing other FMCG brands in a wider range of product categories. The company also has a presence with its own brands and agency brands in other regional markets such as the Philippines, Malaysia and Singapore, but has not yet managed to make these markets contribute meaningfully to profits. We believe Delfi's competitive advantages to be sustainable going forward. Intricate knowledge of local consumer tastes, several strong brands coupled with the scale that allows for local production and an unparalleled distribution network are formidable barriers to entry, making Delfi a local gem. 

COCOA PRICES

Source: Trading Economics

Unseasonal rains have hurt cocoa crops and caused a large shortfall. The ramifications of this can be observed in the price graph above. While we’re not experts in cocoa markets, it seems reasonable to assume that market forces will rebalance, but everyone must brace for a few years of higher prices.

Cocoa, along with milk and sugar, collectively constitute 60-70% of Delfi’s raw material costs, with cocoa alone accounting for 30-40%.  Delfi buys its raw material requirements forward and for cocoa this has been done for 18 months forward.  Consequently, the current spike in cocoa prices will start to impact Delfi’s results in the second half of 2025. Due to these forward purchases raw material costs will increase by 5-10% in 2024 compared to 2023. Cocoa prices have increased yoy in 2024, yet other raw material costs such as milk and cashew nuts have seen declines.

The forward purchasing strategy offers visibility into input costs and allows Delfi to implement measures to counteract higher expenses including gradual price increases, product resizing, and reformulation. Reformulation entails adjusting ingredients to more cost-effective alternatives, rather than entirely overhauling products.  

Price increases are implemented gradually in the Indonesian consumer market, accustomed to high inflation, while product resizing is executed in a manner to avoid a change in the consumers’ perceived value. For instance, reducing the weight of a chocolate bar by 2 or 3% is not noticed by consumers. In response to significant price increases of cocoa, Delfi assesses every SKU to determine the most suitable strategy.  Value-oriented products are more price-sensitive and typically subject to resizing while premium products may see a combination of price increases and resizing.

We anticipate multiple price increases and resizing initiatives throughout 2024 to protect profit margins in anticipation of higher input costs in the second half of 2025. Consequently, while profit margins are expected to rise in 2024, they will decline the following year.

Indonesia’s history of high inflation and FX volatility, as witnessed in 2015, makes Delfi’s management very experienced in dealing with volatile input costs. While the current cocoa price surge may be unprecedented, the strategic decisions taken by Delfi to preserve margins under such conditions are well within the realm of their established practices. 

OUTLOOK FOR REVENUE GROWTH AND MARGINS

The company anticipates 10 to 15% annual growth in revenue over the long term, driven by the rising purchasing power in Indonesia and Delfi’s other markets. Currently, only 30-35 million people out of a total population of 270 million regularly consume chocolate. As highlighted by queegs and zeke375 in their analysis, Delfi is underpinned by its ongoing growth initiatives, strong market position, and favorable demographic trends in its core markets. Continuous product innovation and targeted marketing campaigns should enable the company to capture a larger share of the growing middle-class consumer segment in Southeast Asia.

2023 was the first full year out of Covid and showed a normalised level of spending on marketing and promotions. 2023 profit margins should be a good estimate of normalised margins. Furthermore, the company plans to optimise its cost structure, including measures such as consolidating warehouses and reducing the number of contract workers.

Despite a relatively stable competitive landscape, Delfi managed to increase its market share by 2% last year, to 45%.

Margins for 2024 are expected to show improvement as the company begins to realise the benefits of its strategic initiatives, while the impact of cost increases is anticipated to materialise in the latter half of 2025. However, margins for 2025 are projected to revert to 2023 levels as the full effect of cost increases takes hold.

MANAGEMENT

The son of the founder and current CEO John Chuang, now in his seventies, took over in 1984. With the family of the founders retaining a substantial ownership stake of just over 50%, their interests are aligned with those of minority shareholders. Under John’s leadership, the management has consistently pursued a strategy that focuses on organic growth, product innovation, and expansion into new markets.

Delfi has a history of paying out 50% of after tax earnings as dividends. The pay-out ratio for 2023 was 57%.

CONCLUSION

Delfi’s share price dropped 35%, largely attributed to the challenging conditions prevailing in the cocoa market, which have adversely affected investor sentiment towards this branded chocolate confectionery producer. Historically, the company has demonstrated resilience by safeguarding its profit margins amidst rising input costs through a strategic mix of price increases, product resizing and reformulation. Leveraging decades of management experience in navigating their local markets, charaterised by significant inflation and FX volatility, Delfi remains well-prepared to address the current market challenges.

At the current share price, we pay 8.7x last year’s after-tax earnings with a dividend yield of 6.5%, a very low valuation for a long-established dominant chocolate company with excellent growth prospects, a net cash balance sheet and a solid owner/operator with a good track record for capital allocation.

Catalyst

-increase of profit margins in 2024

-revenue and profit growth demonstrating the ability to counter high cocoa prices