Description

Disclaimer: This report is the work of an investment adviser affiliated with the author. The report is the result of the adviser executing its investment strategy. The adviser holds a position in the security, however there is no assurance that the adviser will continue to hold the investment, or make additional investments and will not update the information to reflect future changes in the adviser’s assessment of the investment.

“When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business. The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business."

Warren Buffett, 1991 Annual Meeting

Delfi (DELFI SP) is a ~320 mm USD market cap pure-play branded chocolate business based out of Indonesia with 40-50% market share, effectively the equivalent of Hershey in that country. The business today trades at ~10-12x LTM PE and ~6-6.5x EV/EBITDA but continues to have momentum preimmunizing + executing and even growing despite the Covid-situation with 5-10% organic USD growth the past few years. Given global branded chocolate peers still trade at 18-30x PE today but has only LSD organic growth, we believe Delfi shares can easily 2x on valuation alone – with a long-term 5-10% USD organic growth path and an eventual potential strategic exit in the next 5-10 years as a 4-5 bagger. The opportunity exists as the company went from a small-cap (1+ Bn @ 35x PE in 2015) to a micro-cap deterred investors, while overblown covid fears + likely 2 forced sellers exiting ~20-30% of the float pressed the shares down further. This is a rare strategic asset (perhaps last of its kind in the chocolate category) at trough multiples on trough earnings, and our checks suggest strategic interest had been evident throughout history.

Dominant position as Hershey of Indonesia

• As the fourth most populous country in the world with a median age of 30 and a historical annualized GDP growth of 4-5% / nominal disposable income growth of 7-8%, Indonesia had been one of the most enticing emerging snack market for MNCs for years – and for a country with a sweet-tooth and a ~1 Bn USD domestic chocolate industry, it may shock you that global MNCs like Mondelez and Ferraro only own ~10% market share, with firms like Nestle, Mars, and Hersheys barely registering on the map.
• 2 local players – Delfi and Mayora – occupy almost 65-70% of the Indonesian chocolate market, with Defli having a historically stable & increasing 40-50% market share.
• Founded by the Chuang family in the 1950's as a chocolate manufacturer in Indonesia and after divesting its cocoa processing business to Barry Callebaut in 2013-15, Delfi is now a pure-play branded chocolate business with a strong presence in the core markets of Indonesia and the Philippines. The 2 iconic brands -- Silver Queen and Ceres – had been around 60 years ago, with a long-standing history that makes it the first taste of chocolate for almost 3-4 generations of Indonesians. With >400k urban and rural point of sale and a broad product catalogue, Delfi is the definition of chocolate for local Indonesians, with its Silver Queen brand basically synonymous to “Hershey’s” to Americans.

Aside from the brand awareness / taste bud memory, Delfi enjoys another competitive advantage somewhat unique to Indonesia that many MNCs don’t – a strong distribution network / relationship built through generations in an Island-based country that’s often hot enough above the typical melting point of chocolate. Typical western MNCs enjoy well-established cold-chains with selected few points of contact – and tailored their products in such environments – but with Indonesia’s temperature consistently above 33’C, above melting point across almost all chocolates with high mix of milk / coca butter, and still an under-developed cold chain, product quality & integrity generally is hard to maintain. Couple such with the high presence of “general trade” (which is mom-and-pop grocery stores, as opposed to “modern trade” like the supermarkets we know in the west) that are not only fragmented but sees tiers of distribution structure that stack to 3-4 layers and make up ~50-60% of Indonesian packaged goods sales. With generational relationships w/ general trade partners (often exclusive) and a large portfolio (which means automatic on-shelf for modern trade), Delfi’s tailored local formula allows it to place the products on every shelf still in solid form.

Well-respected management team that is increasingly professionalizing

As usual, investing in founder-controlled (John the Chairman’s family owns 53%+ of Delfi) company in emerging countries usually mean getting comfort around the corporate governance standards / shareholder-friendliness of the company. Our checks across the industry suggest that John’s family is something we can trust – both capability-wise and ethically:

• Former A: “John family has a very good reputation in the region, there is no doubt about it. You can trust him to be fair, the total package. This is consensus in the industry, John and his 2 brothers are known as the 3 musketeers and have very good reputation in the business. You are dealing with the right guy. Very good history.”
• Competitor A: “ Superb, super credible. True gentleman, high capability, top notch executive. I have not heard anything funny about corporate governance, he's just about the only guy that does thing right in the country.”
• Competitor B: “ We have never had direct contact with them. He is pretty well-known in Singapore. I think the reputation is not bad. Never been involved in big scandals.”
• Competitor C: “ Have met some of their BoD. As far as I know they have a positive reputation. Started recruiting a lot of professionals. Previously BoD was from family, but since 2010 they started really hiring professionals in the business, and now the mix is quite professional.”

Nonetheless, with the Indonesian channel rapidly shifting towards the modern-trade side, the MNCs increasingly mounting the pressure with a holistic snack-portfolio approach (instead of being chocolate-only), and increasingly diversified marketing / customer outreach venues in the digital age, even a brand as dominant as Delfi needs to learn new tricks to remain relevant.

• Competitor A: “In 2019 they hired a new exec for the business, professional. The structure of the organization is refreshed and turnover is high. New expectation and new way of working that's different vs. old employees. But overall they really know what's going on, solid execution, resilient in driving display and promotion. I heard they are struggling w/ turnover, but generally today still maintaining great execution.

Over the past 5 years, the company took a string of actions to prepare itself in the face of modern retail & marketing: since 2015, the company pruned its unprofitable / low-volume / low-quality products by as much as 30-40% of SKUs. The distributor list was reshuffled to further incentivize placements & organic growth, and the company retooled its sales + distribution approach to service national key account modern trade distributors. Since 2017, the company also started bringing in experienced industry experts from other MNC competitors (Nestle, Heineken, Mondelez, etc) to modernize the way company approaches product development, marketing, distribution. The results started to show through with 5-10% USD organic growth in 2018/19 after a lull of 2-3 years.

Covid, macro, and FX impact overblown

We believe that the 3 main reasons that the stock traded down recently are due to Covid likely impacting sales, weak economic activities in Indonesia hurting consumer sentiment, and the volatility around USDIDR. Our checks suggest that while Covid may have impacted Delfi’s general trade channel sales (~30% of revenue) with longer-lead time + destocking, the modern channel is largely unaffected as locals stock up and even snack more during quarantine:

• Competitor A: “People's spending had indeed declined, but the retailer however benefited in this environment -- they stock up in their home due to Covid with fear of lock-down -- so far by talking to our distributor and my colleagues – our organic growth is still on-trend. So far it's still doing quite well, decline is only in the Bali area due to tourism. In other areas where it's more residential we are still on-track and growing (not much but growing). A lot of stores closed at the moment in GT. Delfi is actually pretty modern-trade focused. Mayora could be hit hard.”
• Competitor B: “Most impact happens in traditional trade -- who shops in traditional trade comes from middle-lower-class, the hit to lower-end is harder which hurts demand there. Some distributors can't fulfill distribution to the stores. Modern trade consumption increased as people stock up + people tend to snack more when they are home…For Delfi -- I think it's 80% modern trade, 20% GT. Their modern trade should grow from the data I see. Their 1Q is quite strong. Their GT could take a hit @ 5-10%. They should be growing 10% IDR also this year. Feb festival makes an impact -- they are investing in a lot in promotion, grew strong double digit. Don't know about bottom-line. They are doing quite well today -- the festival happened before the festival. During Covid they maintained the momentum.”
• Competitor C: “In 1Q Indonesia had incredible sales. A few days ago I spoke with my team and the #'s are still good. I think the street-sellers and general trade would be more impacted, but in-home + modern trade are doing great. I'm sure Delfi is actually benefiting -- better opportunity for sharing offering. The consumer demand is still very strong.”

From our conversation with management and channel checks, we believe Delfi’s revenue is only down LSD in 1H20 and will hopefully further stabilize in 2H20.

While it is true that Delfi needs to adjust its IDR pricing amidst USDIDR swing given raws being mostly USD denominated (mostly cocoa, sugar, and nuts), the company had historically managed such impact well and experienced generally no more than a quarter of volatility. Taking out the agency gross margin at a consistent ~25%, Delfi’s branded portfolio historically managed ~35-40% gross margin (inline to slightly lower than global FMCG peers) and had been remarkably consistent. Looking over the long-term, as long as volume keeps growing (which it should), the margin profile of Delfi should remain highly stable through the cycle.

Forced Seller / Why does this opportunity exist + Insider buying

Notably, Delfi even underperformed its Indonesian peers (MYOR, ROTI, GOOD, UNVR) in recent months, despite its growth profile and portfolio strength being no worse than its peers (and in fact has a much lower multiple which we will get into later). The USD underperformance since Jan 1st is as much as 15-30 points, or suggesting Delfi should be ~15-20% higher.

On top of such, the business had meaningfully derated vs. its peers since late-2017, going from a ~35x PE business to only 10-12x today, but still 10-turns lower than its Indonesian peers.

As a bit of history, Delfi used to trade at ~1-1.5 Bn USD market cap back when EM/FM was all the rage in 2015 with a punchy 35x-50x PE. Ever since then, somewhat lukewarm performance as well as the frenzy of EM fading pulled meaningful liquidity out of these markets – with Delfi now trading at a meager ~300 mm USD market cap and 500k-1.5 mm USD of daily volume, both of which far below the hurdle for any “typical” EM investors, thereby capping the valuation it receives despite the world is flooded with liquidity.

Notably, after some digging and discussion with brokers, we believe as much as 2 sellers holding up to a total of 10-15% of shares outstanding (or ~30%+ of float if we exclude John’s family) had been looking to dump the stock ever since mid-2018 and only accelerated with recent covid events mandating EM/FM risk reduction:

• Mitsubishi acquired First State in 2019 and there had been internal changes. The Delfi position from what we know is getting sold.
• Aberdeen had some top level turnovers and had been a seller.

We believe that for any long-term investors that believe in Chocolate as a category and able to look past the short-term volume + margin volatility should be able to capitalize on these funds’ situation. Importantly, once the overhang is cleared as the business recovers to a more normalized earning power of ~30-40 mm USD, the company itself clearing the 500-600 mm market cap hurdle would attract liquidity as the undisputed EM FMCG champion.

For one thing, the chairman John certainly think so. Recently in March / April, John went out and bought shares in open market.

Cheapest valuation for branded chocolate asset globally

No matter how an investor cuts it, the Indonesia Hershey equivalent with no corp gov issues at ~1.3x P/B and ~10-12x “normalized” PE / ~6-6.5x EV/EBITDA is simply too cheap.

Western / Japan snack & chocolate guys trade at 18-30x PE and generally 8.5-17x EV/EBITDA. These average out to be 2-4% organic topline growth. Indonesian FMCG companies are similar. They are generally projected to grow 8-10% in IDR terms.

Globally, the only 2 outliers that seem to be cheaper are Lotte Confectionary (Korean micro-cap, just did a Russian M&A), and Ulker (which is a Turkish business). Lotte does trade at ~0.5 PB with ~3% ROE and Bourbon in Japan (2208 JP) trades at 0.9x PB with 5-7% ROE; everybody else trades at 1.0x with an average of 2-3x.

Our current #’s point to ~12.5x FY20 PE and ~6.0x EV/EBITDA, close to ~1.3x PB. This is likely trough multiple on trough earnings.

Going forward, I’m using ~4-5% USD topline organic growth (given Delfi’s branded did 4-5% USD organic did over the past 9-10 years compounded + normalization of macro should prompt faster growth in the first few years). With operating leverage, the business should be growing bottom-line ~10% per annum. Over the past 2 years, Delfi compounded organically @ 10% topline per annum in USD terms. IDR depreciation is ~5% per annum over the past 10 years. 

So by 2024, Delfi should have fully recovered back to its FY19 level with ~9-10 SGD cents of EPS. @ 20x + 4 years of dividend (15 cents) = ~2.00-2.25 SGD / share, or ~3x over 4 years with a ~30% USD IRR.

Without rerating this would be a solid 10-15% compounder, and with rerating to its rightful price of maybe 25-35x PE, it could easily be a 4-5 bagger in 4 years. 

Long-term strategic value for branded FMCG

In particular, we believe the situation is ideal for (a) an experienced, western FMCG focused fund to step in and take out the overhang, further help the management modernize / growth, and (b) eventually aid the business in a sale to MNCs in the next 5-10 years.

While John the Chairman is still involved in day to day operation, he is already 70+ years old pushing 80 – he still looks great, but we know intimately that succession planning had started as early as FY10 – prompting first the divestment of the cocoa processing business (at 18.4x EV/EBITDA for a commodity, what a sale) and likely eventually this branded chocolate business.

From our conversation with various industry executives and bankers, a prime asset like this in such a populous country is just about the last sizable chocolate deal out there.  Almost everyone in any top FMCG snack company knows the asset, and the company had been approached countless times. We believe it’s only a matter of time it gets taken out – and whoever buys it instantly achieves the dominant status in Indonesia, can realize massive synergies with the relationships, cross-sells, and product upgrades, and immediately become a market leader in the Philippines (whereby no one owns > 10% share).

• Competitor 1: “I think he should really think about the exit plan, maybe sell x% now, y% later etc, and have a total exit plan. I got to really know the asset because we thought about buying them.”
• Competitor 2: “They were not discussing in 2015/16. They were open to a sale, but they clearly said "in the coming years". Scouting the market to see how interested buyers are. Considering the stock price today if you say it's 1x PB I don't believe they would be interested in selling here…I recommended it before and I would still recommend buying them to the HQ -- they have something we don't have that I think we need that in any portfolio. With good distribution, marketing, you can put it in a lot of cheap markets. A lot of synergies.”

Catalyst

Earnings normalization, eventual sale of the business