- Surging share prices
- Surging Chinese demand
- Overvalued or not?

By Greg Peel

It was Singles Day in China, so called because it falls on 11/11, that really lit a fire under the Chinese-demand-for-infant-formula story. Singles Day was created by Chinese eBay lookalike Alibaba a few years ago and has now taken on a life of its own as a rival to America’s Cyber Monday online shopping bonanza.

Aussie mums were apoplectic and shopkeepers perplexed when in the lead-up to Singles Day, Chinese tourists wiped the shelves of premium infant formula. The reason became apparent when Singles Day 2015 sales more than doubled those of 2014, and high on the list of most sought after items were premium milk products made downunder, manufactured by the likes of Bellamy’s ((BAL)) in Australia and The a2 Milk Company ((A2M)) in New Zealand.

The rise and rise of Chinese demand for Australasian dairy products follows in the footsteps of the rise and rise of demand for Australian dietary supplements, as evidenced by the long surging price of Blackmores ((BKL)). Ironic, really, that more and more Australian doctors are suggesting Chinese herbal remedies for patients while the Chinese can’t get enough of pills in a tub which most local doctors suggest are unnecessary unless you actually have some sort of deficiency.

Whatever the case, the cat is now out of the bag. Early investors can currently be found on the ski slopes of Aspen or cruising the Caribbean but for those who’ve only recently woken up to the “New Poseidon” story, the question is one of just how far can these share prices go? Typically the smart money gets in first and begins to push a share price, then the momentum traders jump onto the bandwagon, and finally a FIMO stage begins (fear of missing out) which portends the top of the market. Where are we?

Credit Suisse notes a2 Milk’s share price rallied 26% in a week having rallied 32% the week prior. The broker calculates that in order to validate a2 Milk’s share price, the company would need to sell 15,500 tonnes of infant formula here and in China in FY16, when 6,100 tonnes is the current projection.

Credit Suisse had rated a2 Outperform on the premise the company could successfully execute growth in A2-type fresh milk products in Australasia, the UK and US and infant formula in Australasia and China. Just as the advent of an organic approach to food production, including dairy, created a marketing platform for products and price differentiation, the A1-A2-type milk hypothesis and digestive benefit claims are similarly generating opportunities for a2 Milk, the broker notes.

But while Credit Suisse hails management’s “exceptional execution” to date downunder, confidence in the ability to duplicate such success requires further progress in other markets as far as the broker is concerned.

The bottom line is that 15,500t in sales when 6,100t is projected is a bit of a stretch. Credit Suisse maintains its valuation of a2 and a target price of NZ$1.18 but has downgraded to Underperform straight from Outperform.

Blackmores shares opened 2015 at around $35 and are currently trading above $180. How many tonnes of vitamin B and Echinacea does the company have to sell to justify that share price?

Goldman Sachs has not provided such a calculation but the broker admits a 29x price/earnings on FY16 forecast earnings, as implied by the current share price, is a considerable premium. However another popular valuation measure is PEG, or price divided by forecast earnings growth. Here Goldman calculates a PEG of 0.44x when other high growth peers are currently trading on 0.7x.

Goldman believes Chinese demand through the cross-border channel will continue to deliver significant growth for Blackmores. The December quarter and March quarter should deliver strong results for the company thanks to demand arising from Singles Day, now passed, and Chinese New Year, yet to pass. Importantly, the broker notes strong growth from Blackmores’ direct sales into China, which supports a more sustainable model of growth.

The risk, however, is one of possible regulatory change. As always, legislation follows and never pre-empts, and the sudden burst of Chinese demand is likely to bring stricter registration requirements for the cross-border channel lest any old snake oil salesman decides the opportunity is too good to pass up. The industry is expecting stricter requirements to soon be implemented.

This would actually be a positive for brand owners like Blackmores in the longer term, Goldman believes, notwithstanding the company’s direct sales channel.

The bottom line is that while Credit Suisse feels the a2 story has run away too far, Goldman Sachs does not believe the same is true for Blackmores. The broker already had a Buy rating on the stock but rather than downgrade, has added the stock to its Conviction List, that is, Buy With Conviction.

Goldman has lifted its target price to $220 from $185.

To put that into perspective, the FNArena broker database shows a consensus target of $125. Goldman Sachs is not a database broker and only two database brokers cover the stock, being JP Morgan (Overweight) and Morgans (Hold).

Three database brokers cover a2 Milk, one being Credit Suisse (Underperform), with UBS on Buy and Deutsche Bank on Hold. The consensus target is NZ$1.14.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Continues to target KFC acquisitions
-Progressive dividend policy likely maintained
-Sizzler Australia gradual closure on the cards
 

By Eva Brocklehurst

Collins Foods ((CKF)) has a track record for generating cash and, in uncertain times, investors tend to target these sorts of stocks. Such is the basis on which Canaccord Genuity initiates coverage.

Same store sales growth across the company's KFC stores has averaged 4.8% since FY02, which the broker believes highlights the defensive nature of its revenue. The company's business is underpinned by the KFC chain and it is the largest KFC franchisee in Australia.

While Collins Foods has diluted its earnings margin profile by acquiring 44 KFC franchises in Western Australia, the broker envisages upside to forecasts as the company leverages its shared services structure and negotiates better terms with suppliers. Also, while growth capex requirements are high going forward, such spending is expected to deliver returns that exceed the cost of capital.

Canaccord Genuity has a Buy rating and $5.22 target. The company operates 171 KFC franchises, primarily in Queensland and Western Australia. Collins Foods owns 26 Sizzler restaurants, predominantly in Queensland, and receives royalties as a franchisor of 60 Sizzler restaurants across Asia. The company also owns six Snag Stands.

Cash flow is the key, with the broker noting a compound growth rate in cash flow of 11% or more since FY12. This provides significant reinvestment potential in the business. The company maintains an acquisition mandate, recycling capital into opportunities.

UBS is also confident the company's business will be underpinned by the robust trade in takeaway food and has a Buy rating and $3.50 target. The broker expects the company to continue to increase its share of the KFC footprint in Australia and, at this stage, is not convinced Snag Stands will be anything other than a niche offering.

Canaccord Genuity expects the company to acquire KFC stores that have scale and provide a relevant geographic footprint and notes that management has flagged potential acquisitions in a new retail vertical and the possibility of a domestic roll out.

A progressive dividend policy is also likely to be maintained, given the low pay-out ratio. Management has guided to a 50% pay-out ratio in FY16 which Canaccord Genuity estimates will translate to a 12.2c dividend, a 6.1% increase on FY15.

The broker considers the stock fundamentally cheap and trading at a significant discount to its international peers. The closest listed peer is New Zealand's Restaurant Brands, given a similar business model and earnings drivers.

Restaurant Brands owns 91 KFC franchises in New Zealand, along with 46 Pizza Huts, and recently reported a strong first half performance which should augur well for Collins Foods, in Canaccord Genuity's view.

The KFC brand is owned globally by Yum!, and is one of the world's largest chains with 14,316 outlets. Yum! also owns Taco Bell and Pizza Hut. Collins Foods is required to make annual fee payments to Yum! of 6.0% of annual sales and pay at least 6.0% of annual sales in advertising and marketing.

Collins Foods has access to the Yum! supply chain but retains an option to select its own suppliers such as Inghams, Steggles and Turi Foods. Canaccord Genuity expects the continued reduction in interest rates coupled with record low fuel prices will aid the KFC brand in the short to medium term.

What about the company's other restaurant chain, the Sizzler brand? This business has been less than stellar for Collins Foods, with Canaccord Genuity noting a very poor FY15 result. This business is now considered a non-core enterprise, a decision announced at the time of the FY15 results that was welcomed by brokers.

The book value of Sizzler Australia has been revised to zero, effectively signalling the progressive closure of the network, but Canaccord Genuity understands no disclosure has been made on the quantum of its lease liabilities.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Supported by trend to active wear as fashion
-Conservative guidance may be upgraded
-Accent Group now key driver of growth
 

By Eva Brocklehurst

Footwear distributor and retailer, RCG Corp ((RCG)), has a strong growth outlook, being exposed to the growing casual and sportswear market.

Moelis, in initiating coverage of the stock, is confident this exposure, as well as the revitalisation of its loyalty program, will underpin future growth. The broker notes sports-inspired fashion is now being worn as part of regular attire and this goes right down to the feet.

The company is increasingly intent on providing sports shoes that have a greater focus on fit and innovation and incorporate the trend to more casual dress and active wear as a fashion statement.

The popularity of running events has increased demand for such footwear, with the broker noting people are now increasingly wanting footwear product that is recommended and properly fitted. In tandem, manufacturers have introduced sole technology to provide less strain on feet and a more comfortable fit.

The broker notes the depreciation of the Australian dollar is also making domestic retailers more attractive for consumers versus the recent inroads made by online operators.

On this basis Moelis takes up coverage with a Buy rating and $1.70 target. Beyond FY17 further growth is expected to be underpinned by the roll out of stores, an improvement in the online offering and the implementation of the revitalised loyalty program across all divisions including The Athlete’s Foot, RCG Brands and Accent Group.

The management team has strong track record of creating shareholder value, Moelis observes. The company has historically maintained a net debt position but increased its debt to acquire Accent Group in May this year. Accent is also a vertically integrated distributor and retailer which, in the broker's opinion, will be a key driver of growth. That business owns and operates 120 stores with plans to open at least 20 in FY16.

Morgans observed at the time of the FY15 results that if the Accent business continued to grow sales at the same strong rate seen at the beginning of FY16, management's guidance could prove very conservative. Morgans has an Add rating and $1.41 target.

Consensus estimates have the stock trading on a FY16 enterprise value/earnings ratio of 12.5 and a price/earnings ratio of 23.3, a premium to its peers, and Moelis suspects an upgrade to estimates is in the offing, given the strong operating momentum.

The broker's FY16 earnings estimate is $60.8m, 8.6% above the mid point of management's guidance. Moelis considers its growth assumptions are achievable but the target is reliant on an earnings upgrade being realised. The dividend yield on the broker's FY16 estimates is 3.9% and on FY17 estimates it is 5.2%.

The risks are centred a reliance on the continuation of this trend to more casual footwear. As a distributor, RCG also relies on manufacturers to develop appealing products. The company is exposed to the premium end of the market and therefore changes in consumer confidence, household income and discretionary expenditure can have an impact on sales. A loss of a major distribution licence could also impact profitability substantially.

The company has over 290 stores in Australia and New Zealand across various retail chains, with exclusive distribution rights to 13 brands. The wholesale business is expected to generate around 29% of FY16 sales. The Athlete's Foot is one of the well known business brands, encompassing both company-owned and franchised stores.

The Athlete's Foot has invested in fitting technology and customer service to differentiate itself from competitors. Moelis considers this a mature business but positioned to increase its profit growth by a revamped offering online and through loyalty programs.

The broker is confident in the near term that, via the weaker Australian dollar and consumers' desire for fitting services, the business can maintain its position as a premier retailer without significant margin pressure. Moreover, Moelis expects customer will increasingly return to bricks and mortar stores to try on products and obtain services and experiences outside of online offerings.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Benefit from housing upswing continues
-Focus on fashion in furnishings increases
-Consensus starting to price in upgrades
 

By Eva Brocklehurst

Home furnishing retailer, Adairs ((ADH)) provided an upbeat assessment of its first quarter, delivering like-for-like sales growth of 17%, well ahead of prospectus forecasts. Brokers expect there is more to come. The unwinding of the Australian residential building cycle is not expected to impact the company just yet, as it is a late-cycle beneficiary of residential building growth.

UBS observes there is some pressure building in gross margins and, as the September quarter is the smallest quarter of the year, makes no changes to FY16 forecasts. The broker expects any slowing in the housing cycle is more likely to affect the company in the second half of FY17, or FY18.

Moreover, a focus on fashion in home furnishings could continue to drive above-market growth, the broker maintains. These products grew 39% in FY15 and now represent 57% of Adairs' sales. UBS forecasts a gross margin of 61.4% in FY16. The company's sales growth would need to fall below 8.1% and margins below 60% before gross profit in the prospectus forecast is at risk, UBS estimates. Hence, a Buy rating and $3.30 target.

Morgans suspects an upgrade to forecasts could be in the wings, although not just yet. Earnings in the quarter were up 41% on the prior corresponding quarter and the potential to exceed prospectus forecasts is high, with earnings tracking well above the required run rate.

Morgans also believes the earnings margin will expand more meaningfully from the second quarter, particularly as operating leverage on strong top line outcomes flows through. As a benchmark and reminder, Morgans notes the prospectus forecasts are underpinned by 9.6% like-for-like sales growth, 11 new stores and a gross margin of 61.5%.

Any negatives? Morgans points to some areas of concern such as the cooling housing market but believes this is overplayed. There is also some gross margin pressure, the broker acknowledges. The broker is also mindful that consensus forecasts are pricing in upgrades to prospectus forecasts already. The broker considers the stock price is undemanding and retains an Add rating and $3.18 target.

Goldman Sachs also highlights the fashion decorator range, category extensions and a greater online presence as supportive initiatives, which should deliver strong sales growth. The lower Australian dollar is expected to be a headwind in FY16 but this should be offset by positive operating leverage.

Goldman's forecast for FY16 profit is now 7.0% above prospectus and the broker expects the company to deliver 14-15% compound revenue and earnings growth over FY15-17. Goldman has a Neutral rating and $2.90 target. Its target implies an 11% total return on the recent share price, excluding dividends.

See also, Adairs Furnishes Strong Start To FY16 on August 27 2015.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Sells main fixed price retail exposure
-Volatility highlighted in earnings
-Several sources of growth
 

By Eva Brocklehurst

Online auction platform Grays eCommerce ((GEG)) is re-positioning its offering in the industrial business-to-business (B2B) and business-to-consumer (B2C) market. Moelis initiates coverage on the stock, highlighting the company's established brand name and scalable infrastructure that enables efficient and profitable growth.

Grays has announced the sale of its fixed price retail (FPR) business to MySale this month for $5.2m, a positive development in the broker's view. The transaction includes dealsdirect.com.au, OO.com.au and topbuy.com.au.

Work is still to be done to rationalise the existing high fixed cost base of this business and a full exit is likely to take some time. The company will continue to operate the FPR business over Christmas and Moelis expects earnings from this segment will be separately reported as discontinued.

Grays will continue to operate auction-based B2B and B2C but exit the majority of its fixed price retail consumer exposure, selling just a small amount on graysonline.com and grayswine.com.au. Moelis calculates that Grays wine sales contributed $30m in revenue with a 10% earnings margin. While profitable as a stand-alone business, Moelis suspects a spin off is possible for the right price. 

Moelis is cautious about a lack of historical trading records and the potential for earnings to be "lumpy", but notes the company's strong cash-flow conversion and net cash position.

Typically, in the case of used equipment, sales are counter cyclical, driven by period of lower demand across industries that lead to idle capacity and excess inventory. This volatility can be mitigated, Moelis expects, via operating in a broader range of markets. The net effect is the broker anticipates some volatility in earnings over the longer term.

There are several sources of growth on offer, particularly in the business to business segment and margin leverage from a relatively fixed employee and warehousing cost base. Bolt-on acquisitions are also a potential source of additional scale, Moelis maintains. In July Grays acquired DMS Davlan, a company auctioning agricultural machinery in Australia and which currently operates a physical marketplace.

Moelis has a Buy rating and target of $1.40. The broker calculates valuation on a diluted basis that includes potential bonus shares to be issued next month, with upside considered eminently achievable.

Grays was established in 1989 and listed in November 2014 via the amalgamation with Mnemon. The company has the largest online auction-based B2B business in Australia and has the third largest online wine sales website in Australia.

B2B involves industrial and commercial equipment, with significantly higher margins and a fairly fragmented market, Moelis contends, while B2C is typically more competitive and driven by high volume and a low margin business model.

Earnings contributions vary, with B2C contributing 71% of Gray's FY15 revenue but negative earnings in the most recent numbers. Moelis expects a modest FY16 contribution from B2C to earnings, driven by the wine business. B2B earnings margins improved to 23% in FY15 from 17.5% and are expected to remain in this vicinity in the medium term.

Typically, Grays operates on consignment, taking minimal inventory and working capital risk but receiving lower average margins. There is therefore no obsolescence or sale risk attached to the inventory.

The majority of the company's supply is from insolvency practitioners, state and local governments and financiers as a result of situations like site and plant closures, relocations and excess inventory. Companies such as Coates Hire and Fitness First provided excess or used equipment for sale as well.

The broker notes online auctions have grown by 8.0% compound between 2010 and 2014 and represent 20% of the auction market. The company's platform supports international expansion, with Moelis singling out South East Asia as a particular area of potential. Auctions in that region are significantly lower than in Australia.

The company operates a single warehouse and distribution centre in Homebush, NSW. Customer support in Manila, Philippines, is likely to be reduced post the MySale transaction.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-October extremely soft, guidance lowered
-Promotions ramped up to tackle inventory
-Issues may be more structural
 

By Eva Brocklehurst

Electronics retailer Dick Smith Holdings ((DSH)) has experienced a sharp downturn in sales performance, prompting a substantial downgrade to guidance at its AGM.

Sales growth on the surface was strong enough in the September quarter, up 6.9%, but was delivered on the back of some hefty discounting. October trading was extremely soft. Brokers have downgraded ratings and target prices accordingly.

The company's commentary suggests to Macquarie that like-for-like sales in the month were down 5.0%, with poor marketing decisions seen producing a large reduction in foot traffic. Stock levels are elevated and promotional activity will now be ramped up to arrest the sales declines and protect market share, as well as reduce inventory levels and improve cash flow. Such activity, the broker highlights, will undoubtedly impact profitability.

Dick Smith now expects FY16 profit to be $5-8m below prior guidance of $45-48m, which represents a 14% downgrade. Macquarie observes the balance sheet is not yet overly stretched, so earnings trajectory and operating leverage are the main issues.

The company is cautious about the outlook for Christmas and maintains it will prioritise sales growth. Still, the magnitude of the downgrade is of concern so early in the financial year, as the broker believes it raises doubts about the underlying capacity of the business. Macquarie suspects there is a brand and price perception issue which needs to be addressed. The broker downgrades to Neutral from Outperform, lowering the target to $1.00 from $2.10.

Improving the company's share of voice product could be a short term solution to drive traffic, but Credit Suisse emphasises that this is short term. The company needs to differentiate itself from competitors and improve returns on invested capital to sustain medium term growth, the broker asserts. Moreover, operating leverage is being compromised, in the broker's opinion, as the company continues with its store roll out.

Margin headwinds are being driven by higher promotional intensity and the cost of obtaining growth is rising. There is also the risk of online cannibalisation as marketing is redirected to stores. Credit Suisse continues to believe the medium-term earnings risk is skewed to the downside, despite a seemingly attractive valuation, and retains an Underperform rating.

Deutsche Bank struggles to understand how just one month can play havoc with earnings forecasts and result in such a sharp downgrade. There must be deeper issues, the broker contends, such as a format which faces difficulty in generating traffic without aggressive discounting and help from lower-margin online sales. The inventory build-up is also likely to require even deeper discounting to rectify the problem, the broker suspects.

One aspect of the inventory issue is private label accessories, mainly sold in store and recommended as an extra by sales staff to complement a primary purchase. The shift in channels to online results in a lower rate of attachment for these products, making this private label inventory an issue.

Private label products may have margins of more than 80% but it is difficult to generate sales growth on the strength of these accessories alone. The broker understands this means foot traffic has now been emphasised as a priority in coming months but, in turn, that relies on promotional activity.

There is also a bigger structural issue in consumer electronics, in Deutsche Bank's opinion. Homogenous products such as phones and tablets, and some TVs, are being sold widely by manufacturers as well, and price competition is fierce. Discounting is often led by one business and routinely followed by others to protect their market share, which means improving foot traffic may not be easy.

Were there any positives in the update? Deutsche Bank notes the strong phone sales in September following the launch of the new iPhone, although these are low-margin sales. New Zealand also reported the best quarterly sale performance since acquisition of the business, although base comparables are low.

All up, the trading multiple is low but there is little confidence that both sales growth and stable margins can be delivered simultaneously, particularly when the benefit of cost cutting realised in FY16 passes through. Hence, Deutsche Bank makes downgrades of 20-30% to estimates and expects a significant deterioration in gross margin. The broker downgrades to Hold from Buy, cutting its target to $1.00 from $2.30.

FNArena's database has two Hold ratings and one Sell for Dick Smith. The consensus target is 92c, suggesting 17.6% upside to the last share price. This compares with $2.00 ahead of the news. The dividend yield on FY16 and FY17 forecasts is 13.4% and 12.5% respectively.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.