Description

Delfi was written up on VIC back in July 2020 by Chalkbaggery at a stock price of $0.73 SGD per share. I liked both the idea and the write-up a lot, and after doing some additional work I liked it even more and bought some shares for my portfolio.  Today the stock price is 75 cents. Given the fact the most of my other ideas have gotten more expensive, Delfi is probably my favorite idea today, and certainly the first one I’d buy again at today’s price if I didn’t already own it.

I’m hoping that my write-up can provide further background and a slightly different perspective on the idea, but I encourage anyone interested to read Chalkbaggery’s original post - there has been some recent message board activity as well.

Introduction

Headquartered in Singapore, Delfi Limited manufactures and distributes branded chocolate products that are sold primarily in Indonesia, Malaysia and the Philippines. Called Petra Foods prior to 2016, Delfi has an established portfolio of chocolate confectionery brands which are household names in Indonesia.

In his write-up, Chalkbaggery described the company as “the Hershey’s of Indonesia” – and I think it is a reasonably apt description.  Delfi’s 2019 Indonesian market share in chocolate confectionary products of roughly 45% (source: Euromonitor) is almost double the share of the next competitor (Mayora, 24.7%). Given that Indonesia is the world’s fourth-largest country by population at roughly 270M people (versus the U.S. at 350M), Delfi occupies an enviable competitive position.

In addition to manufacturing and distributing its own brands, Delfi also acts as a distributor for approximately 80 other brands that complement its own product lineup, which Delfi calls “Agency brands.”  Many of these agency brands are well-known international brands, and Delfi is able to earn a distribution margin while also ensuring that it has preferred access to retail shelf space across its markets due to its increased distribution leverage.  Delfi has historically been a consistently profitable business, and prior to 2015 had also been a growing business.

Even after recovering from the short but very sharp COVID sell-off, Delfi’s stock is still trading at close to decade lows, and recently traded at $0.75 SGD, or about $0.56 in USD terms. This translates into a market cap of roughly ~$340M USD for a market leading branded consumer business that reported 2019 full year revenue of US $472M, net income of $28.2M, and generated excellent cash flow profitability with $32M of OCF and $21.7M in FCF. 

At 0.7X sales, 12X earnings, 10.5X OCF, and 15X FCF based on 2019 financials, Delfi’s valuation certainly seems reasonable if the company emerges from COVID looking like it did pre-pandemic.  Delfi also has a strong balance sheet and a history of paying out roughly 50% of its profits to investors in dividends. The stock trades at a massive discount relative to its own history and is cheap compared to similar branded consumer food companies. The company’s future profitability may also be somewhat understated due to heavy investments in recent years to modernize its business and improve its competitive position.   

Company History and Background

Delfi’s history dates to the early 1950s when the company was founded under the name Petra Foods by its current CEO, John Chuang, along with his two brothers, Joseph and William.  The company established its first production facility in Indonesia, where it produced its early branded chocolate products, SilverQueen and Ceres. Silver Queen and Ceres have now been around for more than 60 years and have achieved a deep relevance in the Indonesian culture.  In the 1970s, the Selamat line of wafers and chocolate cookie sandwiches was launched, and in the 1980s the company launched its European-style Delfi line of chocolates. Over time, the company also introduced new branded products in a wide variety of categories that included cookies, wafers, spreads, beverages, and baking ingredients. Delfi’s distinctive skier logo has also become a well-known brand in the region to such an extent that the company chose to highlight this brand when it renamed the company in 2016. 

In the late 1980s, the company embarked on a strategy to become vertically integrated and expand into the processing of cocoa beans into various intermediate ingredients such as cocoa liquor, cocoa butter, and cocoa cake and powder for its own use and for sale to other Asian food manufacturers.  Petra Foods eventually became the third largest independent supplier of cocoa ingredients in the world, and the largest in Asia. 

Delfi made a strategic move into the market in the Philippines in 2006 through the acquisition of a local chocolate manufacturer (purchased from Nestle) which brought two strong local Filipino brands, Goya and Knick Knacks. Delfi has also made efforts to expand distribution to other SE Asian countries, with the most notable success being Malaysia. After selling the cocoa ingredients business in 2013, the company today is a pure-play packaged chocolate manufacturing and distribution business.  

A Deeper Look at Delfi’s Competitive Moat

While Indonesia remains by far Delfi’s biggest market and accounted for 72% of sales and more than 90% of company EBITDA in 2019, the company has also become well established in Malaysia and the Philippines.  Delfi exports to more than 15 other countries as well, but these other countries account for less than 10% of total sales. 

Indonesia is where the company’s moat is strongest, and where its brands are most entrenched. Delfi’s 45% market share in Indonesia for branded chocolate products clearly reflects a significant competitive moat in that country, and one that Delfi has successfully defended against efforts by larger international consumer products companies to take share in the country.  According to the prior VIC write-up, global chocolate manufacturers like Mondelez and Ferraro account for only about 10% of Indonesian market share, with such stalwarts as Nestle, Mars, and Hershey’s being negligible players. Using Euromonitor data, Ceres is the number one brand in “value” priced chocolate products in Indonesia, while Silver Queen is the traditional candy bar of the middle class and Delfi is a higher-priced European-style chocolate that also comes in a variety of flavor and package options.

One of the most likely explanations for the market dominance of Delfi and its major local competitor Mayora is that each of these have substantial local manufacturing capacity. Delfi owns and operates two chocolate factories, one each in Indonesia and the Philippines, and has a combined production capacity of roughly 100,000 tonnes per year.  This local production advantage means that Delfi’s products enjoy a cost advantage in terms of distribution as well as arrive at the point of sale in better shape from a freshness perspective. The proximity of its production facilities to its key markets also provides it with the ability to quickly react to changes in market demand and consumption patterns, and to develop products tailored specifically to its local markets. Delfi has invested heavily in recent years to improve and expand its manufacturing capacity. Delfi’s 2019 annual report states that the company had invested over $110M US over the six years from 2014-2019 to expand and modernize its production facilities, improve energy and water efficiency, and to install an enterprise resource planning software system.

Delfi’s six decades of business in Indonesia also provides the advantage of having a deeply established local distribution network and logistics infrastructure.  Indonesia and other South Asian markets have both a “modern” retail footprint consisting of supermarkets, convenience stores, gas stations, etc., but also have a “traditional trade” retail channel comprised of smaller mom & pop stores, provision shops, and particularly in Indonesia, a vast network of street vending kiosks called warung. While modern retail concepts are pushing out the smaller traditional vendors in some places, Delfi focuses intently on supporting both channels to maximize availability and to ensure that it has products for a wide range of price points, tastes, and product formats.

It should be noted that due to the tropical climate, store distribution in Indonesia remains a logistical challenge for most chocolate products because the temperatures are above the melting point for much of the year and Indonesia hasn’t fully developed a cold delivery chain. For the same reason, internet sales and delivery of chocolate products is not a major distribution channel, though it is used as a marketing and advertisement tool.  Chalkbaggery’s post includes a useful description of Delfi’s deeply embedded distribution network that I can’t really improve on:

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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 this 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. Delfi boasts some 400k urban and rural point of sale across Indonesia. 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.

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Despite Delfi’s long history and embedded distribution advantages, it is likely true that rapid growth in the “modern” retail footprint over the past decade in Indonesia (with its air conditioned, modern convenience stores and supermarkets with cold storage and professional management) has probably eroded some of Delfi’s traditional network benefits and allowed an entry point for some international brands to try to crack their way into the market. Still, because Delfi’s manufacturing and marketing teams are on the ground in Indonesia, they do still likely enjoy a competitive advantage in identifying trends and responding to market demand better than the big multi-nationals for whom Indonesia is just one of many markets. 

Indonesia’s currency is a constant challenge, as it tends to weaken over time relative to the major developed market currencies, and sometimes is subject to volatile changes.  While Delfi’s reported financial results are in USD and Indonesia rupiah weakness directly impacts reported revenue in USD, the fact that Delfi also has a significant amount of its expenses in rupiah does give Delfi some natural defense to offset the currency weakness in terms of profitability.  This is not as easy for the multi-nationals, which must either pass on their strong currency costs to the Indonesian market in the form of price increases or must accept a hit to profits.

But there is also another competitive advantage that Delfi has due to its long history in Indonesia, which is that it has helped to shape the Indonesian palate with regards to flavor and texture. It appears that Indonesians do have a specific local taste in chocolate that Delfi has helped to cultivate. This is a similar dynamic to Hershey’s slightly sour “barnyard” flavor that is popular with US consumers versus the traditional chocolate flavors of European chocolate. Still, while Delfi has not yet demonstrated massive success in exporting its Indonesian brands to other markets (at least in terms of profit contributions), the company has become an important player in the Philippines through local acquisition and is working on strategies to grow its business in other Southeast Asian countries, most notably Malaysia.  In fact, in 2019 Delfi’s sales in Malaysia ($81M) were almost twice its sales in the Philippines ($43M).  Sales outside of the big three were roughly $10M. While still in the early stages, Delfi appears to be making progress outside Indonesia, and its non-Indonesian business (called Regional Markets) did produce a profit in 2019 (US $4.6M in EBITDA) which was an improvement over 2018’s EBITDA loss of $2.2M. 

Delfi does seem committed to a strategy to slowly grow its business profitably in other Southeast Asian countries outside of Indonesia. Regionally, these are attractive markets. Indonesia and the Philippines are both large countries, with populations of roughly 274M people (Indonesia) and 109M (Philippines) that have good demographic trends and a rising middle class.  To put this into perspective, Indonesia is the fourth largest country in the world by population (behind only China, India, and the US), and Indonesia and the Philippines combined has more people than the US, so this could potentially be an enormous market if living standards continue to improve in Southeast Asia.

Malaysia has only about 32.5M people in 2020, which still makes it the 45th most populous country in the world. However, Malaysia has one of the lowest per capita expenditure on confectionary products of any large country in the world, and the market was estimated at less than $300M US as of 2019 (implying roughly 25% market share for Delfi). For comparison, Canada has a similar sized population of ~37.7M but spends about 8X more on chocolate confectionary products (~$2.5B USD in 2019). Looking ahead a decade or two, Delfi’s efforts to entrench itself as a leading brand into the populous countries of Southeast Asia offers the potential for above-average long-term growth and improving profitability as the company scales.  In recent years, Delfi has been establishing joint ventures with other companies to expand into new product categories or enter new markets.  Here is a description from the 2019 annual report:

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Delfi is constantly exploring new partnerships to support the expansion of our product range into adjacent categories. We have two currently. The first is a 50-50 joint venture with South Korea’s Orion Corporation, established in 2016, to develop, market and distribute a range of jointly branded confectionery products in Indonesia. This joint venture, Delfi-Orion Pte Ltd, allows us to extend our portfolio into the soft biscuits and cakes categories and to bring Orion’s flagship Choco Pie, a chocolate-covered soft biscuit with marshmallow fillings, into our portfolio.  Our second partnership is with Japan’s Yuraku Confectionery Company Ltd called Delfi Yuraku Pte Ltd. This joint venture, which is 60% owned by Delfi, essentially combines our market knowledge and distribution network with Yuraku’s manufacturing and product expertise to produce and market a new range of chocolate snacks, Black Thunder and Big Thunder. These are targeted at young consumers in Indonesia under the Delfi brand. Delfi Yuraku facilitates the broadening of both companies’ product portfolios and market reach by serving as a launch pad for new products.

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In addition, Delfi continues to look for low-risk, strategic acquisitions to add to its brand portfolio or to expand into regional markets.  The company appears to have made a terrific small acquisition in early 2018 when it purchased the rights to Dutch chocolate brand Van Houten in certain markets from the European cocoa giant Barry Callebaut. The acquisition cost $13M in early 2018, and the Van Houten brand generated $14M in revenue in 2019 for Delfi in 2019, and the company has plans to invest further to expand the brand going forward.

Explaining the Recent Weakness: Is There Something We are Missing?

A look at Delfi’s long term stock chart would make one immediately think that something has gone horribly wrong with the company in recent years.  The company went public in 2004 and traded at roughly 77 cents SGD as of December 31st of that year.  The stock hit a low of ~30 cents in March 2009 at the bottom of the bear market at the time of the GFC (great financial crisis) of 2008-2009, but immediately recovered to over $1 per share by November of 2009.  The stock then went on a multi-year tear from mid-2011 to March 2013 as emerging markets rallied, reaching a high of $3.87 per share. The stock showed a high of $2.89 as recently at June 2016, but by June of 2017 the stock had dipped below $2 per share and has been pretty much sliding down ever since. The stock traded between $1 and $2 for all of 2018 and 2019 but closed at exactly $1 per share on December 31, 2019. The COVID reports in January caused the stock to take a further tumble in early 2020, and the stock hit a post GFC all-time low on in late April of 29 cents per share. The stock has rallied a bit in the back half of 2020 and early 2021 but as of this writing is still hovering right at 75 cents per share. 

In my experience it is quite rare, even in emerging markets, for a company of this quality and profitability to trade in liquid public markets at the kind of multiples Delfi currently trades for.  Chalkbaggery offered some reasons to explain why Delfi’s stock has suffered what seems like an outsized negative re-rating relative to the company’s fundamentals. The biggest take-away seems to be that the combination of high insider ownership, small public float, and concentrated institutional ownership has led to a liquidity imbalance that has been caused by two institutions trying to exit material positions into a weak market over the same period.  

My initial reaction to the motivated seller theory was that it had to be way too simple, but after looking into to it further it feels like it has a lot of validity to it.  Delfi has very high insider ownership and very low free float.  According to the 2019 annual report, as of March 16, 2020, the Chuang family owned over 50% of the shares outstanding, and four institutions owned roughly 30% of the remaining shares, such that the total float amongst smaller investors was only 20% of the shares outstanding.  It certainly seems plausible that if not one but two of these major owners wanted liquidity for their stock, they would likely move the price a lot given the limited float unless a motivated buyer of similar size materialized.    

However, I am still not entirely satisfied that the “big seller and small float” is the full explanation.  It does help explain the recent share price weakness from maybe mid-2019 to the present.  But in my view, it doesn’t adequately explain the much bigger and longer move from $2.89 per share back in June 2016 to the $1 that the stock sold for in December 2019.  Looking back to June 2016, I did find that the company announced a special return of capital to investors in the amount of $60M USD (probably close to $80-85M SGD at the time) that I thought might contribute to the explanation. But this capital return only accounts for about 14-15 cents per share of stock price decline, and obviously does not reflect any loss of shareholder value. I would expect that there might be other reasons to explain why more buyers in the market didn’t step up to fill the liquidity gap at higher prices, given how cheap the stock currently trades relative to comps and its own history.  So I did a little more digging…

The Trouble with Emerging Markets

Despite the Singapore listing, Delfi’s business exposure is almost entirely to Indonesia, Malaysia, and the Philippines, which are very much still emerging markets and entail the typical emerging market challenges. Delfi has gone through a bumpy transition over the past several years as the business became challenged by a combination of factors, including an economic slowdown in Indonesia accompanied by high inflation and currency weakness that resulted in a significant consumer spending recession in that country.  Despite the defensive nature of its products, Delfi was negatively impacted by this macro environment as retailers across the spectrum reduced orders and cut back on in-store inventory levels.  In addition, it appears that the modernization of the retail industry in Delfi’s key markets brought increased competition from global packaged consumer goods suppliers looking for ways to grow beyond their developed markets. The local currency weakness across Delfi’s markets magnified the company’s top line revenue weakness when translated into the US dollar reporting currency, though the underlying profits weren’t impacted to the same degree since many of the company’s costs are also in those local currencies.  Raw materials prices, however (cocoa, sugar, nuts, etc.) are typically priced in USD, which does require Delfi to manage the FX risk related to its commodity purchases and likely compressed gross margins.  Below is a discussion of this dynamic from the 2019 annual report:

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With more than 70% of the Group’s revenue generated from Indonesia, the movement of the Indonesian Rupiah against the USD contributed significantly to the negative translational impact.  The Indonesian Rupiah devalued by more than 6% against the USD over the last five years. The weakening of the operating currencies of our regional businesses (i.e. the Philippines Peso, the Malaysian Ringgit and the Singapore Dollar) during the 2015-2019 period against the US Dollar, which is the reporting currency for the Group, also had a negative translational impact on our financial results and concealed the actual physical sales that were achieved. Consequently, the local sales reported in USD did not necessarily represent the underlying performance of our businesses. For example, comparing 2019 to 2015, our revenue in the USD reporting currency was higher by 3.8% compounded annually, while from a constant currency perspective, the growth achieved would have been higher by 560 basis points.

Another key change in these earlier years was the evolution in Indonesia’s retail landscape which included the significant growth of the Modern Trade retail channel, especially in the minimart and convenience store formats, and the increased level of competition, especially from foreign brands looking to further build their market position and also brands looking to enter the market.

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It appears that Delfi management confronted these challenges and reacted with several counter measures to help improve profitability and work to improve manufacturing, supply chain and distribution efficiencies. Below is a description of some of these initiatives from the 2019 annual report:

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In the face of these negative external changes we implemented strategic initiatives to critically change our business model in Indonesia to position it for long term growth. The changes included eliminating from our portfolio of Own Brands underperforming SKUs and revising our route-to-market strategy and our supply chain approach in order to improve the service levels to our key retail customers to increase the speed to market for our products whilst securing a higher level of product availability and ensuring that our products continue to maintain significant shelf space presence. To put the magnitude of this rationalization exercise into perspective, we reduced our Own Brands portfolio in Indonesia by almost one-third which, together with the SKUs eliminated from our portfolio in the Philippines, totaled more than 180 SKUs (or 40% of our total portfolio).

To mitigate the higher input costs, pricing adjustments and product resizing for selected products in Indonesia were implemented in late 3Q 2015. These changes, coupled with the macroeconomic headwinds encountered in Indonesia in 2015, had a negative impact on our sales during 2015 to 2017. After the lower sales over the 2015 to 2017 period, the benefits of our restructuring started to show and the Group’s revenues have resumed its upward growth trajectory since then, driven mainly by higher Own Brands sales. The growth achieved essentially reflected the successful implementation of our strategic initiatives to position our business for long term sustainable growth.

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While reported sales have been negatively impacted by the reduction in SKUs and the FX impact, the company’s gross margins have been improving dramatically in recent years, reflecting the improved product lineup, price increases to offset currency weakness, and increased sales of Delfi’s owned brands relative to its distributed agency brands.  From 2015 to 2018, Delfi increased the gross profit margins improved by roughly 520 bps. 

The efforts Delfi has made across its business to improve its profitability and counter both economic weakness and currency headwinds in its main market seem to have resulted in a leaner and more profitable company coming out of 2019.  That doesn’t mean that there is not any reason for the stock to have declined over the past couple of years – most notably, the company’s cash flow numbers were quite weak in 2017 and 2018, and the need to modernize the business has cost some money (installing an SAP system for enterprise data, etc.)  COVID likely is all the explanation required for the drop in the stock from $1 to the 0.65-0.70 range in 2020, but I don’t think the business performance was sufficient reason for the stock to get cut in half from $2 in late 2017 to $1 as of December 2019 prior to COVID.  If anything, Delfi was already showing turnaround momentum in 2018 and posted what I thought was a strong year in 2019. 

Some Other Risks to Consider

In doing my risk assessment on Delfi, I discovered a couple of items that bear mentioning, though none of them would seem substantial enough to dramatically impact the value of the business in a negative way.  The first is some legal liability in Brazil that stems from the 2013 sale of the cocoa ingredients business to Barry Callebaut.  This sale was an important (and I think very positive) event in the company’s history, and I think it would be quite helpful to offer a more in-depth review of that deal because it offers some insight into the management team at Delfi.  As noted previously, Delfi began as a branded consumer manufacturing and distribution business, but in the 1980’s the company moved to vertically integrate into cocoa ingredients and eventually grew into the largest cocoa ingredient provider in Asia and the fourth largest in the world.  The business appears to have been successful from a profitability standpoint as well, but it was very capital-intensive and somewhat cyclical.  Apparently, the sale to Barry Callebaut was the result of an unsolicited offer, with a price that was too good to refuse. Below is an excerpt from CEO John Chuang’s 2012 annual letter to shareholders:

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This year we have some momentous news to report to you. Having traveled a long way down the road of development of our twin businesses, Petra Foods has reached a fork in that road. In 2012 we received several unsolicited offers for our Cocoa Ingredients business. After a most comprehensive evaluation, and after careful deliberation, the Board approved the divestment of our Cocoa Ingredients business to Barry Callebaut AG. The SPA was signed on 12 December 2012 for a total consideration of US$950 million, subject to adjustments at completion which is expected to take place in June or July of this year.

The strategy followed over the last several years included developing a global position in the Cocoa Ingredients business. This is something your company executed very well, reaching the position of fourth in the world with leading manufacturing and marketing positions in the Americas, Europe and Asia. Our position in the key growing markets of Brazil, Mexico and Asia gave us an attractive advantage over our competitors. In addition, we had developed inroads into cocoa-growing areas with procurement facilities and technology partnerships.  

The strategic rationale that the Board took into consideration included the significant investments needed to continue to grow our Cocoa Ingredients business organically. Our opportunities to grow in our existing and new Branded Consumer markets also require major financial and human resources. The duty of the Board of Directors is to consider what path is the best to take in order to provide value for our shareholders. This decision has come with an emotional cost. We have been ambitious for our Cocoa Ingredients business, and with judicial investments and much management attention we have been able to grow that business to the point where it is a world-class global business, serving demanding customers on five continents from a network of seven factories. But in evaluating the offer received from Barry Callebaut AG, the Board has balanced the opportunity provided by this offer against the investments already mentioned. After comprehensive evaluation and careful deliberation, the decision was taken by the Board to accept the offer from Barry Callebaut and the SPA was signed on 12 December 2012. The transaction is expected to be completed in June or July this year, after certain tasks (such as the separation of the cocoa ingredients business from the Petra Foods businesses, and the receipt of regulatory approval from the EU competition authorities) have taken place.

The consideration of US$950 million translates to an EV to EBITDA (“EV/EBITDA”) of 14.4x and 41.1x based on the Cocoa Ingredients Division’s 2011 EBITDA of US$65.8 million and 2012 EBITDA (before exceptional items) of US$23.1 million, representing an attractive premium to other listed companies such as Archer Daniels Midland. The Board also believes that the Barry Callebaut Group will be an excellent custodian for the Company’s Cocoa Ingredients Division. 

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The timing of the sale proved to be exceptionally good, as the cocoa ingredients business had been coming off a strong cycle but was already starting to be impacted by the twin impacts of slowing global demand and overcapacity in the industry as new facilities were brought online in 2012.   

The sale went through in mid-2013 despite the significant decline in profits for the business during the first half of the year, and the sales price turned out to be a top-of-the-market multiple on near-peak 2011 earnings.  This proved to be very strategic for Petra at the time because the company had roughly $789M in total debt at the end of 2012 supporting its cocoa ingredients business. Instead of suffering through a multi-year downturn in a cyclical, capital-intensive business already heavy with debt, Petra was able to clear $165M US after receiving the $950M cash price and paying off all the related debt.

Unfortunately, that wasn’t the end of the story. Callebaut and Petra apparently later had a big disagreement when it came time to settle up on the “adjustments at completion” part of the sale agreement. Barry Callebaut took the position that Petra owed them some money and maybe wanted some concessions from Petra before closing the deal completely. Petra initially refused to play along and apparently triggered the arbitration clause of the deal contract, which dragged on for another two years until the two companies finally decided to work to a compromise outside of the arbitration structure.  In August 2015, the companies settled their dispute and Petra paid a one-time lump sum to Callebaut of $38M.  The two companies also extended their cocoa supply agreement to June of 2020 (note that this just expired). 

But that still wasn’t quite the end of the story; under the original purchase agreement and maintained in the settlement agreement there was a clause requiring Petra to indemnify Callebaut against certain outstanding tax disagreements prevailing between Petra and the tax authority in Brazil. Apparently, in February 2015, Callebaut had notified Petra of several claims against the acquired subsidiary of Petra’s former cocoa processing business in Brazil, Delfi Cocau Brazil, Ltd.  It is not clear from my reading of the disclosure whether these claims were the result of Brazil’s tax treatment of the transaction, or whether some or all of them pre-dated the acquisition.

In any case, there were nine different claims related to the Brazilian operation in which Brazil claimed Callebaut/Petra owed taxes, and it added up to a lot of money (roughly 87M Brazilian real, or more than $25M US).  Fast forward to 2020, and Delfi continues to be on the hook for any of these claims that ultimately prove out, though Delfi’s management believes the tax claims are not valid and believes it has strong grounds to defend them, which it has requested that Callebaut assert through the Brazilian judicial process.  These cases are ongoing, and the ultimate resolution is obviously uncertain.  One good piece of news for 2020, though, is that because Brazil’s currency has been so weak over the past year, the value of these claims (if they are upheld in their entirety) are now much lower in USD terms.  The 87M Brazilian real would have translated to $25M as of year-end 2018 and $21.7M as of year-end 2019 FX rate, but as of June 30, 2020, the amount in USD is only $15.9M. As there have been no new claims made by the Brazilian tax authorities since 2016, it seems reasonable to believe that the worst case for Delfi is that it has to pay the full value of the claims, which would be roughly $16M US (plus some legal fees). This would of course not be good news, but it isn’t tremendously damaging and maybe represents 2-3 quarters of normalized free cash flow.

There was also a mini-accounting scandal in Delfi’s operations in the Philippines that was discovered in mid-2018.  I think it’s probably easier if I let the company explain (below is the disclosure from the 2018 annual report): 

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Improper and Unsubstantiated Transactions uncovered in the Philippines operations

In June 2018, the Group discovered improper transactions in one of its wholly owned subsidiaries, Delfi Marketing, Inc. (“DMI”) in the Philippines. Immediately on becoming aware of these transactions apparently carried out by certain employees, DMI subjected these employees to administrative disciplinary proceedings, and imposed sanctions, including dismissal. The Group also implemented a thorough restructuring of DMI’s finance function and tightened its systems control and operating procedures. The Group also carried out an internal investigation assisted by Ernst & Young Advisory Pte Ltd and assigned a team from head office to take over the leadership of DMI’s finance function. With assistance from Delfi’s internal auditors and a professional accounting firm, the Group completed a thorough review of DMI’s financials in 4Q 2018.

To date, the forensic investigation into these activities resulted in the identification of improper transactions between 2013 and 2018 amounting to Philippine Peso 165.0 million (equivalent to US$3.1 million). In addition, a thorough review of DMI’s financials identified unsubstantiated transactions over this same period totalling Philippine Peso 106.6 million (equivalent to US$2.1 million).

The improper and unsubstantiated transactions identified totalled US$5.2 million (FY2018: US$1.6 million; FY2017: US$2.0 million; and from FY2013- 2016: US$1.6 million). For the year under review, the Group recognized an exceptional charge for the improper and unsubstantiated transactions of US$2.1 million. Included in the exceptional charge were professional fees incurred for the investigation and financial review carried out amounting to US$0.6 million for FY2018. The Group’s FY2017 income statement was also restated to record an exceptional charge of US$2.0 million for the improper and unsubstantiated transactions uncovered pertaining to the year 2017.  For the improper transactions, the Company engaged law firms, Angara Abello Concepcion Regala & Cruz and Poblador, Bautista & Reyes in the Philippines, to pursue legal action and all remedies available. The matter is now in the hands of the lawyers. For the unsubstantiated transactions, the Company will carry out further investigations, assisted by an independent forensic and disputes advisory firm.

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Any accounting related scandal is of course going to be of concern when one is considering making an investment in a company headquartered on the other side of the world that does business in emerging markets.  It’s obviously always important to be able to have confident that the company’s management is trustworthy and will be good stewards for shareholders, and this takes on added importance when the company is headquartered beyond the reach of US securities law.  Nonetheless, after doing further research on the company and how it has been historically managed, I see no reason to believe that this was nothing other than an isolated incident.  The damage done has already been reflected in the company’s financial statements, and the amount wasn’t particularly material in any case.  Given that John Chuang and his family owns ~53% of the business, it would be much more concerning to me if they were trying to skim off the shareholders. This feels more like local finance people not being sufficiently monitored, and it seems the company responded appropriately. I expect that going forward the risk of such events is now lower than it would have been absent this problem, since the company has likely instituted enhanced financial control and monitoring procedures. Still, it is a concern.

2019 Full Year Results

Despite the stock price decline in 2019, I was surprised to see that Delfi’s business performance was quite strong in both 2018 and 2019, though cash flow was weak in 2018 due largely to working capital changes.  For 2019, however, all the financial metrics reflect a picture of robust recovery from Delfi’s difficult years of 2015-2017.  I want to quickly walk through the 2019 full year results, which I thought were quite impressive and would have seemed to offer plenty of reason for optimism regarding Delfi’s future prospects prior to the COVID outbreak in early 2020.

Delfi’s annual reports are lengthy and extremely detailed, and I will paste in segments directly from the report that covers all the important details of the 2019 financial performance:

------------------------------------------------------------------------------------------------------------------------- Building on the positive momentum of the previous year, the Group’s 2019 revenue of US$471.6 million, representing Y-o-Y growth of 10.5% in the Group’s US Dollar reporting currency. This is the highest level achieved in five years and well above the levels seen during 2015 to 2017 despite the 6% devaluation in the Indonesian Rupiah over the same period. Our Own Brands sales account for more than 60% of Group revenue. Following on from the momentum in 2018, sales of our Own Brands products in 2019 were higher Y-o-Y by 9.5% with the growth driven mainly by our portfolio in Indonesia from: (i) higher sales growth of our products in the premium format category; and (ii) benefits from our direct shipment initiative to certain mini-mart retail customers. In FY2019, revenue of our Agency Brands business achieved Y-o-Y growth of 12.3% generated.  

The Van Houten brand has been successfully integrated into our portfolio of brands following last year’s acquisition of the perpetual and exclusive license to the Van Houten brand for markets in Asia (excluding India, Korea and the Middle East). In 2019, Van Houten contributed US$14.7 million (or close to 5%) to our Own Brands sales. Our growth strategy for this iconic brand will be to strengthen the Van Houten business and customer base in its existing markets. This will be followed by brand development programmes.

The Group’s Gross Profit Margin (“GPM”) was higher Y-o-Y by 1.6% point to 36.2% for FY2019 on the back of higher Own Brands margins achieved. The improved margin can be attributed to the increased sales of our higher margin premium products in Indonesia, and production efficiencies amidst ongoing cost containment initiatives. With the combination of higher sales and GPM achieved, FY2019 EBITDA of US$59.6 million (Y-o-Y growth 16.4%) was generated by the Group. The strong growth at the EBITDA level for FY2019 was driven by the strong performance from our Regional Markets which generated EBITDA of US$4.6 million, compared to a loss in the previous periods.  

PATMI (profit after tax minus interest) growth of 35.3% was achieved for FY 2019 on the back of higher revenue and margins driven mainly by Own Brands sales. Excluding the exceptional item in FY2018, PATMI growth for the year would have been 23.8%. The positive results were achieved despite intensified competition and higher input cost inflation during the year.  For FY2019, PATMI of US$28.2 million (higher Y-o-Y by 35.3%) reflected the increase in operating profit achieved and a lower effective tax rate.  Our Group generated a Return on Equity of 13.0%, an improvement of 280 basis points from a year ago. In addition, we ended the year having generated a higher free cashflow of US$22.1 million and a stronger balance sheet.

During 2019, the Group generated operating cash flow before working capital changes of US$60.3 million which was higher Y-o-Y by US$9.3 million due to the stronger operating results in 2019. The higher operating cash flow resulted in the Group’s net cash generated from operating activities to increase from US$12.0 million to US$32.1 million. The Group generated free cash flow of US$22.1 million, higher by US$14.6 million compared to 2018, which was sufficient to fund the US$12.6 million that was paid out as dividends to Shareholders during the year as well as reduce its borrowings.

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2020 First Half Results

Delfi reported mixed results for 1H2020, as the lockdown measures imposed during the COVID pandemic throughout Southeast Asia impacted the company’s retail customers substantially.  However, given the chocolate snack category’s inherent defensiveness and increased at-home snacking necessitated by the lockdowns, the results were not at all bad relative to most other businesses.  Total revenue declined 12.1% in USD to $211.4M, but Delfi still increased its gross margins slightly (to 36.3%).  Additional costs did hit Delfi a bit harder on the EBITDA line (-18.7% YOY to $25.6M) and the after-tax profit ($10.8M, down 29.6%) was impacted by a higher tax rate.  EPS was 1.77 US cents in 1H2020 versus 2.51 US cents in 1H2019.

It is important to understand the impact of the weaker Indonesian rupiah and other regional currencies in terms of translating to USD profits in the 1H 2020; the Singapore dollar declined by 3.5%, the Indonesian rupiah by nearly 3%, and the Malaysian ringgit by nearly 5% versus the USD.  Only the Philippine peso bucked the trend and gained against the dollar by 1.8%.  As a result, the company’s 1H 2020 result when translated into USD caused a comprehensive FX loss of $10.9M.

In its press release, Delfi noted that sales in Q1 were largely unaffected by the pandemic, and sales were up modestly YOY.  However, during April and May, many of Delfi’s markets were in lock-down, with stores closed or operating with reduced hours.  Sales in these two months were “substantially lower” YOY for chocolate confectionary products, offset partially by growth in some categories (spreads and baking products) as people stocked up for home meals.  Sales in Indonesia were down 16.9% in 1H2020 ($145.6M), while sales in the regional markets were actually up 0.6% to $65.7M due to higher sales in Malaysia and the contribution of Van Houten brand sales in the regional markets, where sales were $3M in 1H2020 outside of Indonesia.

Sales of Delfi’s own brands were down 14.9% in 1H2020, while Agency brand sales declined 6.7%, which is largely due to the agency brands being primarily in the snacking, breakfast, and healthy eating categories, versus Delfi’s own brands, which are mostly confectionary products. 

One positive note was that due to favorable working capital swings (lower inventory and collection of accounts receivable of $15M and $12M, respectively) Delfi’s cash flow was much higher in 1H2020 versus the prior year.  OCF for 1H2020 was $26.7M vs. $21.2M in 1H2019, capex was less than $1M in 1H2020, and FCF was $25.7M US in 1H2020 versus $19.0M in 1H 2019. 

Due to the strong 1H2020 cash flow, Delfi’s cash balance increased to $68.7M USD as of June 30th, up from $57.6M at Dec 31, 2019.  Total borrowings also declined by nearly $5M to $53.4M.  Delfi declared a 1H2020 dividend of US 0.127 cents per share that paid out in early September 2020.

Q3 2020 Update

In November Delfi issued a press release providing a brief update on business developments for Q3.  The company normally only does a full report half-yearly, but the update was helpful and showed some recovery from the Q2 period that was significantly impacted by COVID. For the 9M period, Delfi’s total sales were $305.2M US, with EBITDA of $30.8M and FCF of $29.5M.   

Below are the useful portions of the press release:

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With the progressive easing of the various lockdown measures at the end of the 2nd quarter, our business improved. Our 3Q 2020 revenues continued to reflect this trend, higher by 25.4% compared to 2Q 2020 with Indonesia the key driver of this growth. The improvement was mainly due to the strength of our Own Brands portfolio with high double-digit growth achieved by our Premium format category and as we relaunched our Value products in 3Q 2020. Despite the challenges during this period, we continue to innovate new products and we launched our SilverQueen Very Berry in the 3rd quarter. Our Gross Profit Margin (GPM) has held up with the 9 months GPM averaging close to 36%. This reflects: (1) higher contribution from our Premium format category; and (2) our ongoing initiatives to mitigate higher costs through selected price increases and our on-going cost containment initiatives. Our spending on Advertising & Promotion expenses in 2020 will be relatively high as a significant number of the promotional activities for the year had been committed with our retail customers in the pre-COVID period which impacted our 3Q 2020 EBITDA.

As soon as we saw the virus starting to spread outside China, we also tightened our collections and cut back on our capital spending. On the back of these actions, the Group generated substantial Free Cash Flow of US$29.5 million for the 9 months of 2020 resulting in a strong balance sheet with a cash balance of US$60.0 million at 30 September 2020.

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Note that Delfi had generated FCF of $25.7M through the first half of 2020, so the company must have generated an incremental ~$3.3M in FCF in Q3. This is not too bad considering that they probably needed working capital to replenish inventory.  Delfi provided a very condensed Q3 balance sheet that showed cash of $60M, (down from $68.7M) and debt of $49.7M (down about $3.7M) such that net cash on the balance sheet was about $10.3M. The company did pay out its dividend during Q3 so that reduced cash as well.  Delfi reported EBITDA of $5.3M in Q3 (down from $6.4M in Q2 and $19.1M in Q1) on total revenue of $93.8M (up 25% from Q2).   

Management Track Record / Capital Allocation

In terms of evaluating the company management, if I just look at what the three top guys (the Chuang brothers) have achieved, it seems clear that they have good entrepreneurial and business management skills. But in looking over the history of major capital allocation decisions, I was   surprised to find that they also look to be very sharp in terms of recognizing opportunity and generally have made very sensible capital allocation decisions.  To start with, I think the company went public at a good time (2004) and managed that process well.  The local Singapore investment community and financial media certainly seemed to have an affinity for both the business and the management team. 

And the company has made obvious efforts to produce both attractive and extremely detailed annual reports and other investor materials to the market; they are certainly not overly promotional presentations but do a good job in telling the company’s story.  Even now, a visitor to Delfi’s investor relations page can download every single annual report the company has produced since going public; I find this highly commendable and view it as a sign of regard for investors who might want to dig deeper into the company’s history. The management team and board has also been highly visible in Singapore and has been recognized for its achievements and quality in the local media.  Here is a sampling of the awards received by various media outlets:

·        The Group was awarded the top spot in the annual Singapore Enterprise 50 Award in 2003 and was recognized as the "Best Newly Listed Singapore Company in 2004" in AsiaMoney's Best Managed Companies Poll 2004.

·        The company was named the “Enterprise of the Year 2004” by the 20th Singapore Business Awards on 30 March 2005 and was named one of “Singapore’s 15 Most Valuable Brands” in November 2005 by IE Singapore.

·        Over the years, Delfi Limited has clinched awards in various categories at the annual Singapore Corporate Awards. The Group won a Silver award for its inaugural annual report in the “Best Annual Report/Newly Listed Company” category in 2006. In April 2009, it clinched a Gold award in the “Best Annual Report/Companies with $300 million to less than $1 billion in market capitalization” category. In May 2010, it bagged two Silver awards for “Best Managed Board” and “Best Investor Relations” under the “companies with $300 million to less than $1 billion in market capitalization” category. In 2015, the Group begged a Bronze award for “Best Managed Board” under the “companies with S$1 billion and above in market capitalization” category.

·        Delfi Limited’s Chief Executive Officer, Mr John Chuang, was also recognized for his leadership and management of the Group. He was named “Best Chief Executive Officer” at the 2011 Singapore Corporate Awards, “Businessman of the Year” at the 2012 Singapore Business Awards and he was one of the recipients of the SG50 Outstanding Chinese Business Pioneers Awards in 2015.

In looking at the major financial moves, consider this: after the company went public in 2004, it did a follow-on offering in 2010, raising $60M US through the issuance of about 78.9M shares.  This capital was used to invest in both the company’s branded consumer business as well as the cocoa ingredients operations.  In 2012, the company responded to the extremely good offer (particularly in hindsight) to sell its cocoa ingredients business for a terrific price, and then took the proceeds, paid off essentially all the unit’s debt, enabling it to move forward as a capital light consumer branded products business with a strong balance sheet and excellent cash flow.  In 2015, the company did have to pay out $38M back to Barry Callebaut related to the transaction, but this was likely a wise move to reach an amicable agreement with what is now probably one of Delfi’s biggest suppliers. 

In 2016, after the dispute was settled, Delfi’s board decided to make a special distribution to shareholders of $60M.  The company communicated the capital distribution as a way to “distribute excess cash to shareholders and allow the company to achieve a more efficient capital structure.” 

The opportunistic acquisition of Van Houten for $13M in early 2018 already looks like a terrific decision. Incidentally, it is worth noting that the seller was the same Barry Callabaut that Delfi sold its cocoa ingredient business to back in 2013, making the company’s efforts to find an amicable solution to the dispute between the companies very much worthwhile.  The other attractive element of the company’s capital allocation approach is that it is heavily weighted towards paying out profits to shareholders in dividends, with the company historically targeting a 50% profit payout.  This seems very reasonable and quite attractive to me in terms of the stock offering a combination of income and growth. (Note that US investors pay a 15% dividend withholding tax to Singapore).

In terms of ownership, the founding Chuang family owns roughly 53% of the shares, so they are true owner/operators, which I generally find a favorable structure that promotes alignment of interests.  The Chuangs make far more money from the dividends paid out by the company than they do from their annual salaries.  Like most Asian small and mid-cap public companies, the senior management is not paid like rock stars: the three brothers combined take home roughly ~$3M per year for serving in their senior operational roles; the next top five officers combined make about $2M, and the board of very qualified and experienced directors are paid less than $1M per year in aggregate. There are no stock options or other stock compensation schemes that I can find in the annual report disclosure. 

As it is in the UK, Singapore companies often feature a highly qualified chairman who is typically independent of the management team, and Delfi’s annual reports feature separate letters from each of the CEO and chairman.  Delfi’s chairman is a gentleman by the name of Pedro Mata-Bruckmann, and he seems highly qualified and experienced. Here is his bio:

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Pedro is the Chairman of Delfi Limited. He began his career at W.R. Grace & Co., in 1968 where he served as President and CEO of several divisions. Through a series of promotions, in 1989, he rose to the position of Chief Executive Officer of Grace Cocoa, a division of W.R. Grace & Co. Grace Cocoa (subsequently sold to ADM and renamed ADM Cocoa) was the world’s leading and premier supplier of cocoa ingredients to the confectionery, dairy, bakery and beverage industries on a global basis. After leaving W.R. Grace & Co., in 1995, Pedro established MGS Mata Global Solutions, advising companies on strategic growth and joint venturing. Between 2000 and 2012, Pedro was a senior advisor to Quad-C (a USA based private equity fund). Between 2009 and 2012, he served as CEO of Classic Party Rentals. Headquartered in Los Angeles, Classic Party Rentals (a Division of Quad C) was the leading US party and event rental company. Pedro has served in several not- for- profit organizations including Trustee and Chairman of Zamorano University and Director of TransFair USA, a fair-trade organization.

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Chalkbaggery also provided some “channel check” type diligence notes in his original write-up of the company, and his scuttlebutt reports are almost uniformly positive, even from competitors.

One last positive attribute to mention is that I do feel that the company is a legitimate take-out candidate.  This is highly unusual for Asian family-owned, deep-value stock ideas, because in most such companies it is the family’s wish that the younger generations continue to manage (or at least oversee) the operation of the business indefinitely. I don’t think Delfi follows that pattern; while the three brothers are still directly involved in the day-to-day management of the business, I don’t see any Chuang progeny listed in executive positions or on the board (though I am aware that there are family members involved in the business).  Secondly, the fact that Delfi was willing to sell the cocoa ingredients business, which must have been a personally difficult decision for John Chuang, shows that they strive to be rational about their assets.  Finally, a sale to a multi-national corporation would likely come at a huge premium to the current stock price, and given the respective ages of the three Chuangs, they may well be at a point in their lives where they are thinking of spending their golden years doing things other than selling chocolates. There is no doubt in my mind that Delfi would be a hugely appetizing acquisition for any number of large multi-national packaged consumer food businesses, and that given its modest size, brand value, and dominant market position in Indonesia it could fetch a surprisingly high price in a bidding war.   

Valuation

Now I will look at the valuation. The first important thing to note when looking at financial metrics and valuation for Delfi is that while the stock trades in Singapore in SGD, roughly 70% of the company’s sales and more than 90% of profits come from Indonesia, which are denominated in rupiah. However, Delphi reports its financials in USD, so we will need to convert the stock from SGD to USD for purposes of calculating the market cap and EV in order to align the valuation with the financial results reported in USD.  Note that many public company data sources may not be reporting correct valuation ratios if they are not adjusting for the SGD stock price and the USD base currency financial statements.

As of midyear 2020 there were 611.157M shares outstanding, and this has been the same figure for the last ten years.  The current stock price is around $0.75 in SGD, translating into a per-share USD price of right around $0.56 per share USD.  The market cap in USD is ~$342M.  All the rest of the figures that follow will now be in USD.

As of Q3, Delphi carried net cash of about $10M.  There is an employee pension obligation liability of about $13M USD as of December 31, 2019, which I will ignore for now but you could add to EV if you felt strongly about it.

On a TTM basis through June 30, 2020, sales were $442.4M, operating income was $40.7M, net income was $23.7M, OCF was $37.6M, and FCF was $29.0M.  Using these figures, the relevant multiples would be (assuming an EV of US $330M) as follows: EV/sales of 0.75X, EV/Operating income would be about 8.1X, the P/E would be 14.3X, the EV/OCF would be about 9X, and the EV/FCF would be 11X.   

Assuming normalization from the COVID issues, I would guess that “normalized” annual sales for Delfi might be something like $460-500M, with EBITDA of somewhere between $55-60M and net income of $25-30M.  Future free cash flow should likely fall in a range of $20-30M, with perhaps an average of $25M, but hopefully growing over time.  I am hoping to be conservative with these assumptions. 

Note that Delfi generally pays out ~50% of its profits in cash dividends.  I find the company’s long term dividend record to be quite impressive. Since its IPO 16 years ago, the company has paid out US $317M in dividends (through year-end 2019), which is more than the company’s current enterprise value. This includes the one-time $60M distribution paid in 2016.   Assuming the company were able to duplicate this feat over the next 15 years (and they should be able to do so), an investor at today’s price will receive the entire investment back in cash by 2037.  The yield at 2.415 US cents per share (based on last year’s 3.22 Singapore cents) is 4.3%. 

Assuming all of the above, the current EV of $330M or so seems extremely reasonable, particularly given the strong asset backing and the high dividend payout.  Some other observations not having to do with multiples: recall from my earlier business description that Delfi invested over $110M in plant and distribution system improvements in the six years from 2014-2019. Also, the company spent over $50M in marketing and advertising in 2019, and likely spent somewhere around $200M in this category over the last 5-6 years. When one thinks of the 60 years of effort it has taken to develop the brands, build out the distribution and logistics network, etc., it seems clear that there is no way this business could be re-created at anything close to $340M US.

My guess is that the minimum price Delfi would fetch in an auction process would be $500M US, or well over $1.10 SGD on a per-share basis.  I think a more realistic price would be higher than that.  I am under no illusions that an acquisition is a near-term likelihood, but I do think it is plausible.  If I were running a big multi-national consumer branded foods company, I know I’d try to take advantage of the current currency weakness and COVID-related uncertainty to try to get a great price right now. 

Overall, my view is that Delfi is almost a textbook example of what I look for in a small-cap Asia “deep value” idea. It’s a high-quality business with a dominant competitive position in an attractive industry in populous countries.  The company is run by owner/operators with large percentage ownership, which in this case does not preclude a future sale of the company.  Delfi has a capital-light business model; strong cash flow profile, and clear policy of distributing cash to investors via a dividend.  Finally, the valuation is extremely reasonable relative to the quality of the assets, and extremely cheap when compared to prior company history or other public market comps. Of course, an investment in Delfi requires the assumption of legitimate emerging market-type risk factors: currency risk, country risk, etc., and in this case (as is often the case with Asia deep value stocks) the small float creates price vulnerability if there are motivated sellers.

Catalyst

• Any remaining selling shareholders complete their sales and overhang lifts; stock returns to trading based on fundamentals rather than short term supply/demand imbalance.

• Delfi recovers from the pandemic-related economic weakness and bounces back to 2019-levels of profitability.

• Delfi’s significant recent year investments in plant improvements, ERP systems, brand acquisitions, and marketing begin to show up in the form of revenue and profit growth

• Market simply re-rates Delfi and valuation multiples revert to be closer in line with peer group.

• Potential for partial or full sale of the business.