Erajaya Swasembada Renegotiating With Goliath
We reinitiate coverage of PT Erajaya Swasembada Tbk (ERAA) with a NEUTRAL and a DCF-derived TP of IDR900 (implying 9.7x FY15F P/E). 2015 may be rough for ERAA due to: i) heavy inventory of Samsung products, ii) proposed regulation requiring 4G smartphones to have 40% local components, and iii) product pricing amidst a weak IDR. On a positive note, ERAA will keep pursuing its strategy of retail business expansion and selling higher margin products.
Heavy inventory of Samsung products
The current over-supply of Samsung products has caused aggressive promotions among distributors. Under the full distribution scheme with Samsung, ERAA is required to order six to eight weeks of inventory in advance. Thus, ERAA is renegotiating with Samsung to change its current full distribution scheme back to the old fulfillment scheme prior to 2014.
Product pricing amidst weak IDR
ERAA purchases its Apple, Blackberry, and Nokia inventory stocks with USD, accounting for c.30% of its COGS. While Blackberry offers limited price protection, Apple does not.
Local content regulation to be issued mid-2015
The proposed rule requiring local content, possibly at 40%, for 4G handsets, will likely affect ERAA’s earnings as some of its principals, such as Apple and Blackberry, do not have production facilities in Indonesia.
Retail business expansion
As the retail business generates higher margin than distribution, it is the key for ERAA’s future growth. ERAA aims to increase its retail revenues contribution from 38% in FY14 to 50% within the next two years. It also plans to become a regional player.
Selling higher margin products
ERAA is pushing increased sales from higher-margin brands (such as Asus, Lenovo, and Xiaomi) and accessories sales to help to offset the margin pressure from carrying Samsung smartphones.
Reinitiating coverage with a NEUTRAL and a TP of IDR900 (a 1% upside). Our DCF-based TP is derived using a WACC of 11.9% and TG of 5%, which will imply a 9.7x FY15F P/E.
Risks
These include: intense competition among distributors, dependence on product principals, and regulatory risks.
Investment Thesis
Heavy inventory of Samsung products
ERAA is the leading distributor and retailer of mobile communication in Indonesia. It benefits from the rising demand for mobile communication devices in Indonesia as those devices are the current trendy lifestyle products with short replacement periods. Its mobile communication product brand portfolio includes Acer, Apple iPhone, Asus, Blackberry, Dell, HTC, Huawei, Lenovo, LG, Motorola, Nokia, Samsung, Sony, and Venera. ERAA is also an authorized distributor of reload vouchers, SIM starter packs and other products for all major Indonesian mobile network operators.
Excess inventory of Samsung products
The current over-supply of Samsung products has caused aggressive promotions among distributors. Under the full distribution scheme with Samsung, ERAA is required to order six to eight weeks of inventory in advance. Thus, ERAA is renegotiating with Samsung to change its current full distribution scheme back to the old fulfillment scheme prior to 2014. Should the negotiation be successful, ERAA’s margin could recover faster.
A brief history on ERAA-Samsung relationship
Prior to 2014, ERAA distributed Samsung’s product on a fulfillment scheme, in which Samsung was the one responsible for sales generation and ERAA just distributed Samsung products via its vast network of master and independent dealers. Encouraged by the potential higher margin of distributing Samsung’s products, in 1Q14, ERAA decided to switch to the full distribution scheme, in which ERAA would take inventory, be responsible for sales generation and the eventual distribution to its customers.
About the same time in late 1Q14, Asus entered the low- and mid-range smartphone markets in Indonesia with its Asus ZenFone 4, 5, and 6 products, ranging from IDR1-3m. At the low-end segment, Samsung Galaxy 5 is currently head to head with Asus ZenFone 4S. Then, Xiaomi entered Indonesia, with its budget Redmi 1S, in Sep 2014 (via online channel) and via offline channel, through Eraphone in late Oct 2014.
Initially, Samsung was slow to react to these newcomers. As customers were becoming aware that these two new brands had lower prices with comparable, if not better, features than Samsung, they began buying Asus and Xiaomi. This resulted in lower overall market share, each month from Jun to Nov 2014, for Samsung in Indonesia. Challenged by losing market share both in Indonesia and globally, Samsung was determined to protect its turf in Indonesia.
Thus, Samsung put pressure on ERAA’s margins as Samsung required ERAA and other distributors, operating under the full distribution scheme, to take up six to eight weeks of inventories, resulting in higher working capital requirements for its distributors. Given the current intense competition atmosphere, every distributor (including ERAA) with high inventories has started to do aggressive promotions and discounting to reduce excess inventories, resulting in margin squeeze.
According to the company, under the full distribution scheme with Samsung, ERAA is barely breakeven in selling Samsung smartphones. Understandably, ERAA is renegotiating with Samsung to change back to the fulfillment distribution scheme (from the current full distribution scheme) as it did prior to 2014.
As previously mentioned, under the fulfillment distribution scheme, ERAA was not required to hold six to eight weeks of Samsung inventory and, hence margin recovery can be expected if the negotiation with Samsung is successful, given that Samsung accounted for c.35%-40% of ERAA’s FY14 total revenue.
Product pricing amidst IDR depreciation
ERAA purchases its Apple, Blackberry, and Nokia inventory stocks with USD, accounting for c.30% of its COGS. While most brands carried by ERAA do offer limited price protection, Apple does not. As such, ERAA stands to lose as a depreciating IDR will force it to raise Apple prices, potentially impacting sales volume.
Pricing mechanism. For mobile communication products, brand principals set prices, following discussions and negotiations with ERAA, to allow it to realise an agreed margin, or set a suggested retail price following the advice of ERAA. Discounts or rebates, designed to increase market share or reduce inventories of unpopular products, can affect net sales in a given period.
If ERAA is unable to sell its inventory of a certain product at the set price, brand principals usually allow ERAA to lower the set price to reduce inventory and will provide ERAA with a partial rebate to cover ERAA’s lower gross margin on the product.
Local content regulation to be issued mid-2015
The Ministry of Communications and Informatics is preparing a ministerial decision to regulate the mandatory local content (TKDN) for 4G smartphones in Indonesia. It will be issued sometime in mid-2015. Failing to comply with TKDN requirements, a vendor’s handset import permit will not be issued by the Commerce Ministry. The regulation will govern preparedness of the Indonesian handset industry in complying with TKDN obligation starting 1 Jan 2017.
The proposed rule requiring local content, possibly at 40%, for 4G handsets might affect ERAA’s earnings as some of its principals, such as Apple and Blackberry, do not have production facilities in Indonesia. According to media reports, Samsung has announced on several occasions that it will operate its manufacturing plant in Indonesia with a capacity of 1.6m units per year, but this plan has not yet been put into motion. It has been negotiating with the Indonesian Government to reduce the 40% local content requirement to only 20%. Lenovo, ZTE, Huawei, Asus, Xiaomi, Haier, and LG are reportedly to follow suit.
For the low-end segment, ERAA also sells its own brand, Venera, with total sales of c.600,000 units per year. A serious competitor for ERAA’s Venera is Oppo, the Chinese smartphone maker that has been doing well in Indonesia with its best-selling Oppo Joy smartphones. Its 27,000 sq m factory in Tangerang has a capacity to produce 500,000 units per year and is expected to commence operations once the machines are installed within the next couple of months.
Retail business expansion
As the retail business generates higher margins than the distribution, it is the key for ERAA’s future growth. ERAA aims to increase its retail sales contribution from 38% in FY14 to 50% within the next two years. It also plans to become a regional player.
Store formats
At present, there are three format stores: i) branded stores (such as Samsung Store, iBox); ii) multi-brand stores (such as Erafone, Android Nation); and iii) joint-business stores (ie part of larger retail stores, such as Carrefour, Hypermart, Best Denki). ERAA plans to open more owned retail stores. To gain more productivity from its owned multi-brand stores, ERAA will focus on its megastore format (ie 300 sqm-1,000 sq m). It already operates 14 stores as at Dec 2014.
Acquisition of CG Computers in Malaysia
In Aug 2014, as part of its plan to become a regional company, ERAA acquired 49% of CG Computers in Malaysia, which operates 23 outlets under the name Switch, primarily selling Apple products such as laptop computers, handsets, monitors, and speakers. Going forward, ERAA also plans to become a multi-brand player in Malaysia.
E-Commerce
Recently, Xiaomi and ERAA launched its trial e-commerce website (www.mi.com/id) to market Xiaomi products in Indonesia, which it expects to be filled with upcoming devices in the coming weeks. Furthermore, ERAA has its own e-commerce site, which was redesigned and relaunched in 4Q14.
Selling higher margin products
ERAA is pushing sales from higher-margin brands (such as Asus, Lenovo, and Xiaomi) and accessories sales (via its Eraplus store format, which sells 85% gadgets). However, we believe that all these initiatives to sell higher-margin products will need more time to bring in margin improvement for ERAA as market shares of Asus, Lenovo, and Xiaomi are still relatively low currently. Likewise, sales contribution from accessories is still currently less than 2% of ERAA’s total sales.
Business Overview
Massive networks. ERAA has been popular with various foreign brand principals due to its massive distribution network, which comprises 95 distribution channels and more than 500 owned retail outlets.
Smartphone sales are the key driver
Mobile communication products (eg smart phones) were the major sales contributor at 85% of ERAA’s total sales in FY14, followed by Vouchers at 11% and Others at 4%. The margins declined in FY14 due to: i) aggressive promotion to reduce excess Samsung inventory; and ii) higher financing cost to finance the required larger working capital.
Business core strategy
As shown in Figure 14 and 15 below, ERAA is properly situated in Quadrant 1, the high asset turnover low margin business. As ERAA does not have its own quality brand that can differentiate itself from its competitors, it is unlikely for ERAA to have higher margins again as it did in 2010. The key concern here is ERAA’s margins have been declining, due to: i) consumers having many ways to purchase smartphones via e-commerce or through ERAA’s competitors; and ii) aggressive discounting/promotion to reduce Samsung’s inventory since 2Q14.
Average selling price (ASP) and sales volume of handsets
Smartphones’ ASP in Indonesia has been declining, which is consistent with the global declining ASP. On a global basis, International Data Corporation expects the ASP of smartphones to reach USD241 in 2018 from USD297 in 2014.
In ERAA’s case, we believe its mobile handsets ASP was flat in FY14 compared to FY13, instead of declining. This is caused by ERAA having a supply issue for its own low-end segment brand, Venera. Accordingly, FY14 Venera sales volume declined, causing the flat ASP. Going forward, we forecast for a constant ASP due to a weakening IDR.
Working capital and leverage
Inventory shot up to IDR2trn in FY14. Hence, higher working capital costs put pressure on earnings as the working capital was financed by short-term loans. As mentioned previously, under the current full distribution scheme with Samsung, ERAA is required to order 6-8 weeks of inventory in advance.
Thus, ERAA is renegotiating with Samsung to change its current full distribution scheme back to the old fulfillment scheme, as it did prior to 2014. If the negotiation is successful, ERAA will be able to reduce its inventory, stop frequent discounting, and grow back its margins. We think it will take another year for ERAA’s inventory days to return to a similar level to the one in FY13.
Decentralized warehouse plan
ERAA plans to decentralize its current warehouse in Jakarta to four main regional warehouses in Medan, Surabaya, Semarang, and Makassar. That way it can avoid business interruptions from the chronic flooding during the raining season as it experienced in Jan 2013. ERAA lost approximately two weeks of sales due to the warehouse flooding in Jan 2013.
Key Risks
Rivalry among distributors is very intense, which can result in aggressive promotion and high marketing expense. Furthermore, ERAA also faces competition from the black market. ERAA’s agreements with its product principals are non-exclusive and subject to renewal at the option of both parties. The proposed rule requiring local content, possibly at 40%, for 4G handsets, will likely affect ERAA’s earnings as some of its principals, such as Apple and Blackberry, do not have production facilities in Indonesia.
