Nippon Indosari Corpindo Banking on Dough

Being the largest bread manufacturer in Indonesia – supplying in our estimate some 90% of the mass market – PT Nippon Indosari Corpindo Tbk (Indosari) we believe is in the right position to fulfill huge demand in the segment. Backed up by strong shareholders, it is set to break out of its traditional markets in Java, Bali and Lampung and target major population centers in Indonesia.

Given its geographical expansion and increasing bread consumption in Indonesia, we are positive on the outlook of Indosari and forecast 2009-12F earnings CAGR of 50% and higher EBITDA margin of 26-27%. Our valuation exercise suggests a market capitalization of IDR 1.4trn to 1.5trn which implies 12.6x-13.6x 2010F earnings.

Solid foundation
Indosari is the largest bread manufacturing company with a footprint covering most of Java. Its relationship with Shikishima Baking Co. Ltd of Japan has given it a competitive advantage over its competitors as the latter provides technical guidance on bread making, which enables the company to mass produce high quality bread, which its competitors lack. The company commands some 90% market share in the mass market segment, thanks mainly to: (i) 13 years of strong branding, (ii) a wide distribution network spanning a 200km radius from its factory, and (iii) a wide variety of products catering to all income levels.

Planning for the future
In order to fulfill huge unmet demand (especially in the mass market segment), due to Indonesia’s low bread consumption per capita and change of people’s mobilization, Indosari is looking to expand capacity in Cikarang as well as build new plants in Semarang, Medan, West Jakarta, Palembang and Balikpapan/Makassar over four years. This will widen the reach of its bakery products to at least another 63m Indonesians.

Strong earnings CAGR and higher margins
We forecast a robust 2009-12F earnings CAGR of 50% and higher EBITDA margin of some 26-27% (vs. historical 20-22%) on the back of new capacity invested and brand building exercise to continue to drive sales as well as (i) economies of scale in terms of logistic as it can fully utilize the delivery trucks, and (ii) lower raw material cost expected in the near term.

Equity value Rp1.4-1.5tn
We estimate a market capitalization in the range of IDR 1.4trn to 1.5trn, using a discounted cashflow (DCF) model approach at a cost of equity range of 15.5% to 16.5% and a terminal growth rate of 2.5%, with an implied PER of 12.6x to 13.6x. We think this is fair given that the weighted average peers PER is 15.1x.

Risk factors
Key risks to our valuation estimate may include 1) higher raw material cost, 2) competition from foreign entrant, and 3) competition from in house private labels.

SOLID FOUNDATION

Background – A bread story
PT Nippon Indosari Corporation (Indosari), established in 1995, has grown into the largest mass bread producers in Indonesia. It is the first and only bread maker in Indonesia to utilize modern technology from Japan to produce in a hygienic and healthy environment. Indosari is the largest bread manufacturer in Java with three factories – in Cikarang Industrial Park (2 plants) Jakarta and Pasuruan Industrial Park (1 plant), East Java. It markets its bread under the brand names Sari Roti and Boti. Its current product range comprises 33 different varieties mainly white bread and sweet bread as well as cakes.

Solid shareholders…
Bonlight Investments and Treasure East Investments each own 40% of Indosari. Bonlight Investments is managed by Ms. Wendy Sui Cheng Yap, who also sits on Indosari’s board. Ms. Wendy Yap’s father, Piet Yap, was one of the founders of PT Bogasari Flour Mills, which is a pioneer in modern flour milling in South-East Asia. Although he has since retired from the board of Bogasari, he still maintains a good relationship with Bogasari. Treasure East Investments, on the other hand, is a company controlled by the Salim Group.

The remaining 20% stake in Indosari is held by Sojitz Corporation and Shikishima Baking Co. Ltd. Sojitz Corp is a Japanese conglomerate involved in the trading of consumer food products, including wheat flour. Piet Yap’s strong ties with Sojitz Corp brought Shikishima into Indosari. With 10% market share in bakery products, Shikishima, through its Pasco brands, ranks second in Japan’s bakery industry.

Its flagship product, Choujuku, commands the largest market share for white pan bread in Japan. Shikishima also has presence in America, Hong Kong, Korea and Taiwan. Its main business is wholesale bread but it also manufactures cakes and frozen dough as well as operates bakery shops and produces savoury food such as lunch boxes, sushi, rice balls and delicatessen. It holds 10% equity interest in Indosari.

..and solid management as well
The company’s directors have had experience in multinational corporations involved in the consumer and food industry, which we believe will continue to drive growth going forward. Ms. Wendy Yap, who previously started and operated Wendy’s Hamburgers fast food franchise in Indonesia, China and Hong Kong. She has vast experience in the food industry and has close rapport with its suppliers.

Well-known Sari Roti and Boti
Indosari mainly sells two main products, white bread which is also known as “roti tawar” and sweet bread (“roti manis”), marketed under the brand names Sari Roti and Boti. There are seven varieties under Sari Roti white bread and “special white bread” is its best selling white bread. It makes 22 varieties of sweet bread, with chocolate garnering the highest sales volume. The Boti brand also has a white bread and sweet bread range.

Sari Roti’s tagline is “Empuk Bergizi Lezat Berisi” which translates to soft, nutritious, delicious with fillings. It has three features – hygienic, healthy and halal. Apart from the Sari Roti and Boti brands, Indosari also manufactures a variety of cakes called Sari Cake. Currently, it produces three flavours – Pandan Chiffon, Chocolate cupcake and Pandan cupcake.

Strong branding
Indosari was ranked first in the Top Brand award in 2009 by Frontier Consulting Group and selected as Indonesia’s Favourite Food by poll from Bogasari and Jawa Pos. On average, Indosari spends ~7% of revenue on advertising and promotion. Given the strong brand awareness, the company is likely to enlarge its market share. Moreover, it also conducts bread factory tours for public as well as sponsors programs to inculcate bread consumption among school children.

Strong ties with Bogasari
As bread production utilizes substantial amounts of wheat flour, relationships with flour mills are important. The company is also ranked number one among Bogasari’s bakery clients in terms of sales. Aside from its strong relationship with Bogasari, the company’s factory location is strategically located near two of Bogasari’s flour milling plants, which are located in North Jakarta and Surabaya would surely be an advantage to Indosari as this ensures regular supply of wheat flour and timely delivery of its key raw materials.

Technology from Shikishima
Shikishima Baking Co. Ltd has been in operation since 1921 and is the second largest bread manufacturer in Japan behind Yamazaki Baking Co. Its Pasco brand, via Choujuku bread, is the number one pan white bread in Japan. Through its relationship with Sojitz Corporation, Indosari formed a partnership with Shikishima to transfer bread technology, technical guidance and training in bread making. With assistance from Shikishima, Indosari is able to mass produce high quality bread unmatched by its competitors.

Innovation to cater to different consumers
Indosari is also considering innovating on its bakery products by incorporating more flavours and extending to product types such as cakes and healthier bread. Shikishima also manufactures Japanese-style cakes, which represents a new product line that Indosari can invest in.

HACCP certified
It is also considered an advantage that Indosari has attained Hazard Analysis and Critical Control Points (HACCP) certification as HACCP performs strict monitoring and inspection involving all stages of food production. This ensures that bread produced by Indosari are of a certain quality.

Indosari’s bread is also halal certified, which renders it suitable for Muslims, who dominate 86% of the country’s population. The halal certification also helps the Company to cater all Indonesian people. In addition, both Cikarang and Pasuruan plants are registered at the Worldwide Directory of Sanitarily Approved Food Establishment for Armed Forces Procurement, Department of The Armed Forces, United States of America.

Boti brand
Indosari’s cheaper range of products comes under the “Boti” brand, which is priced at a 30% discount to Sari Roti brands. These products cater to the bottom 40% of the population. Lower priced bread products which offer flavours similar to Sari Roti are more affordable to this group. These are usually sold through tricycles that travel to remote areas.

Extensive distribution network
The bread is marketed and distributed to Java Island, Madura Island, Bali Island and Lampung. It has three distribution channels comprising the modern channel, traditional channel and institutions. It distributes to 725 supermarkets/hypermarkets and 8,290 mini-markets, including Indomart and Alfamart, the two largest retail convenience store chains in Indonesia. Its products are also distributed by 7,587 small shops and 2,022 tricycles via traditional distribution. Indosari also manufactures for 38 institutions.

Indosari has the largest bread making facilities in Indonesia via its three factories in Java covering a radius of about 200km from its factories (refer to Figure 6). The remaining five large mass bread producers only cover a 50km radius from their factories. There are 5,000 small and medium sized bread makers operating in Indonesia with long standing operations and traditional products that were developed prior to Indonesia’s independence. Some of these names include Lauw bakeries and Tan Ek Tjoan, which uses street carts and vendors to deliver bread to households, thus limiting its customer reach to only within a 5km to 20km radius.

Although the Indonesian bread market is generally fragmented, Indosari is the largest mass producer of high quality breads in Indonesia with some 90% market share in the mass category. It also has an extensive distribution network encompassing the whole of Java and stretching as far as Bali. Indosari outsources 100 trucks to distribute its white and sweet bread from its plants in Cikarang and Pasuruan to their final destinations. These trucks operate exclusively for Indosari, which manages the logistics to ensure timely delivery of bread.

Minimal threat from competitors
Given that Indosari is the dominant bread maker in Indonesia, threats from its competitor are minimal. The Indonesian market comprises 5,000 small and medium sized players and less than five mass bread producers. In 2008 when the price of wheat flour peaked at ~USD1112 per bushel, many of the small players were squeezed by expensive raw material cost.

As these players, which are relatively smaller than Indosari, distribute via traditional channels such as tricycles and small shops, their customer reach is confined to within a 5 to 20km radius from their factories. Furthermore, they do not have the extensive production capability to produce a variety of flavours nor achieve economies of scale. Some are home-made products catering only to their neighbourhoods and they do not have the facilities to deliver efficiently (and on time) to their customers.

Unlike Indosari, the boutique retail bread makers, such as Bread Talk, The Harvest, Delifrance, Daily Bread, Delicious and many others all cater to retail markets and hence are more expensive as they target the higher income segment of the market. As 40% of the population is in the lower income group, their minimum wages average about IDR819,100 a month. Therefore, premium bread – which usually cost around IDR25,000 per purchase in the store – would appeal less to the lower income group as the price makes up 3% of the income of a minimum wage worker.

Stale bread sold as animal feed
As freshness is vital, Indosari’s bread is supplied daily to its distribution channels early in the morning and on time for the end consumers to pick up from the shelves before work. To maintain that its products are consistently fresh, the delivery man will collect unsold bread that has been on display for four days and returns it to the factory for processing into animal feed to reduce wastage. The return from such sales usually account for about 9% of total sales in 2009, compared with a higher 10% previously.

We believe the sales return should continue to come down as more advertising campaigns are launched to create awareness of its brands. As Indosari continues to improve the skills of its marketing staff, Indosari will be able to analyze sales trends to accurately allocate the right product mix to each of its customers.

FUTURE PROSPECTS

New plants
Indosari is looking to expand capacity at its Cikarang plant as well as new plants to extend its reach to untapped areas. Currently, there is strong brand awareness in Java but beyond that, its current facilities are unable to reach beyond 200km given that bread has a shelf life and has to be delivered fresh daily (current factory location as represented by yellow arrows). Due to still unmet demand for its products in many areas, maximum production is reached shortly after new lines or plants are completed, hence creating an urgent need for new plants in the near future.

The company is looking to build new plants in five new areas, namely Semarang, Medan, West Jakarta, Palembang and Balikpapan/Makassar over four years to cover Indonesia (new factories are marked by brown arrows – Figure 12). Medan is the capital of the province of North Sumatera and the fourth most populous city in Indonesia with an estimated population of 2m people, while Semarang is the fifth largest city following Medan located in the north coast of Java.

Semarang has a strong potential market given the stronger consumer spending as it is home to many industrial parks and factories and most major banks and shopping malls are there. To the east, the company is also looking to expand to Balikpapan/Makassar which is a totally new market for Indosari, which we believe has great potential growth. Indosari intends to extend its market to most parts of the archipelago and post-expansion, this will extend its bakery products to a further 63m Indonesians.

Replicating success
Due to the urgent need to meet the demand, Indosari need to expand its capacity to reach new areas. Without a doubt, Indosari has the ability as well as the expertise to easily replicate its current business model in these areas. Management is confident and has the necessary capability to build the plants and be ready for production in 6 months’ time.

Two new plants by 2011
In the next two years, Indosari is looking to start new plants in Medan and Semarang, targeting to bring in two new production lines each for white bread and sweet bread, with 60,000 packs per day capacity for white bread and 200,000 packs per day for sweet bread. The new factory in Semarang will intensify Sari Roti’s penetration in Central Java, which is currently served by the factories in Cikarang and Pasuruan, while at the same time allowing the Cikarang and Pasuruan factories to focus on the West and East Java markets respectively. Given that Sari Roti has a strong presence in Central Java, we think contribution from this factory should help enhance its revenue.

Capex funding analysis
As mentioned in the paragraph above, Indosari intends to set up new factories to extend its reach to Indonesia. As the company’s presence is currently limited to mainly Java, it takes time to develop into an established household name throughout Indonesia as it extends its arm to other parts of the country and after which, the company would enjoy economies of scale. Hence, funding would be crucial to achieve that objective quickly and to achieve economies of scale. Management has also tabled a five year plan to achieve that plan as seen in Figure 14.

Shortfall of ~IDR77bn
Based on the four-year capex plan in Figure 14, Indosari has an estimated short fall of IDR71.7bn on its FY10 cash pile if there is no fund raising exercise. Its current cash position is not sufficient to finance the expansion that is urgently and immediately needed to meet demand, however, this can be financed by either equity or debt.

FINANCIAL FORECASTS

Profit & loss forecast
We expect Indosari’s net profit to grow steady over the next few years with a CAGR of 50% over 2009 to 2012. Few key points that will drive its earnings growth are: (i) higher sales from its new lines and strong promotions made over the years to build a wider product range, (ii) economies of scale, particularly from lower distribution cost as it can fully optimize its trucks to cover more areas, and (iii) lower raw material cost such as wheat price which has eased some 57% since its peak in March 2008.

However, we see lower earnings growth in 2011 as we take into account new start-ups cost for both its Semarang and Medan plants, which will be ready by 2011. Hence, we have conservatively forecast that the group would potentially achieve a net profit growth of 98.1% and 30.7% for FY10 and FY11 respectively.

Production cost breakdown
As 83% of the production cost is coming from raw materials and packaging, we should focus our forecast on the price volatility of the raw materials especially wheat prices and sugar prices. We expect wheat prices to move sideways in 2010, trading around USD600 per bushel due to good harvest lately in Europe and Russia (see Figure 19).

Meanwhile sugar price is facing downward pressure as the favourable weather boosts cane crop production but assuming global speculators who anticipate and accumulate at lower prices the impact of high sugar prices in the future should be insignificant. Hence, we think gross margins can be sustained at this current level ~40%.

Balance sheet forecast
As the company is a cash business, cash conversion cycle is naturally within 4-5 days. Hence, with the increase in the bottomline, we expect its cash flow from operations to rise as well.

Sensitivity analysis
We have performed several sensitivity analyses on several variables: average selling price (ASP), wheat price, sugar price, and utilization rate.

1. Average selling price (ASP)
Our sensitivity analysis suggests that for every 5% change in our 2010-11F ASP assumptions, our 2010-11F earnings forecasts will change by 23.5% and 22.4%, respectively.

2. Wheat price
Our sensitivity analysis suggests that for every 5% change in our 2010-11F wheat price assumptions, our 2010-11F earnings forecasts will change by 4.9% and 6.0%, respectively.

3. Utilization rate
Our sensitivity analysis suggests that for every 5% change in our 2010-11F utilization rate assumptions, our 2010-11F earnings forecasts will change by 11.7% and 6.9%, respectively.

Overview of historical financial performance

Strong revenue growth
Indosari has sustained strong double digit revenue growth from 2005 to 2009, for a three-year CAGR of 36%. Revenue surged 53% in 2008, mainly due to a 25% increase in the selling prices of its bread products, which was necessary as wheat price peaked during that period. The jump in revenue was also partly contributed by a 6.3% increase in sales from 163,885 packs per day to 174,224 packs per day in 2008.

Capacity for an additional 60,000 white bread packs per day and 180,000 packs per day of sweet bread at its Jababeka Block U plant also partly drove sales in 2009. However, we believe Indosari’s FY10 sales will soar based on existing high demand and on the massive advertising campaigns last year to market Indosari’s products and create brand awareness. Furthermore, new capacity at Block U (which is now fully operational) as well as new capacity in new areas will further fuel sales growth.

Earnings CAGR at 89.7%
Meanwhile, earnings grew at a faster three-year CAGR of 89.7%. Although the industry suffered losses when wheat price spiked in 2007/08, Indosari’s bottomline still expanded a whopping 112% and 138% in 2007 and 2008 due to: (i) increased product demand and higher product average selling prices, (ii) an increase of 38.6% in other income from the sale of scrap (sales return), (iii) cutting down in overall spending on selling, distribution and administrative costs, and (iv) lower interest expense from a reduced effective interest rate of 26.9% in 2006 to 19.3% in 2007 and 7% in 2008. In 2009, however, growth in net profit was a slightly slower 34.7% as more spending was allocated to marketing and promotions and higher administrative costs compared to 2008. Although costs in 2009 were higher, its margins were spared as this was supported by stronger sales that year.

However, we expect the group to return to its strong growth trend and report another strong set of numbers for 2010 as we anticipate: (i) higher sales from its new lines and strong promotions last year, and (ii) lower overall costs, particularly from distribution cost as it can fully optimize its trucks to cover more areas.

Margins growth
Overall net profit margin for FY08 and FY09 stood at 11.1% and 11.8% respectively on improved selling prices and growing brand awareness as well as savings on economies of scale from lower raw material expenses (raw material cost, the largest component, comprises 83% of production cost) on bulk purchasing. EBIT margins were also more robust, rising from 10.7% in 2005 to 18.8% in 2009.

We see EBIT margins widening as wheat flour and sugar prices have eased some 57% and 33% respectively from their previous peaks in March 2008 and February 2010. We expect the current expansion programs which have already started to meet the unmet demand as well as aggressive advertising and promotions to translate into better sales.

Better financial performance than its peers
As can be seen from Figures 27 and 28, Indosari has consistently chalked up double digit growth in revenue and net profit compared to its peers. QAF Ltd, a Singapore-based company which manufactures Gardenia bread, Silverbird, the manufacturer of High 5 in Malaysia, and Indofood saw revenue declines in 2009 while Indosari out-shone its peers with a convincing 26.7% growth the same year.

In terms of net profit growth, QAF Ltd (excluded from Figure 26) registered a substantial loss of SGD35.2m in 2008 from a net profit of SGD4.6m the previous year, for a total 874.3% loss. Indosari’s 2008 growth was substantially stronger than its peers’, advancing by 138.6%, followed by a modest 34.7% growth in 2009.

Superior ROE
Indosari commands superior margins of 11.8% compared with its closest peers such as QAF Ltd, Silverbird, Mayora Indah and Breadtalk Ltd, for which margins range from 0% to 7.8%, except for Kawan Food, which is slightly higher at 15.5%. This may be due to the fact that some of its peers are involved in the other businesses such as snacks and eatery outlets, which usually fetch lower margins given that this is a highly competitive business and is easily replaceable by other snacks or restaurants.

However, we have no doubts over Indosari’s ability to perform as it still did better than its two closest peers, Silverbird and QAF – which manufacture white bread and sweet bread – with 0.2% and 6.6% respectively. With the new plants and a larger network going forward, Indosari would be able to tap into new areas. Also due to efficient capital management, the Group commands a superior ROE of 34% compared with its peers (see Figure 33).

VALUATION

DCF assumptions
In our view, we think DCF valuation is the most appropriate approach for Indosari because the company is involved in a staple food business which offers stable recurring income. It captures the longer term impact of sustained growth in Indosari. The DCF valuation is derived by the following inputs:

A risk free rate of 8.6%
An equity risk premium of about 7%
A terminal beta of 1.0x
A cost of equity range of 15-17%

We estimate a market capitalization in the range of IDR 1.4trn to 1.5trn, using a discounted cashflow (DCF) model approach at a cost of equity range of 15.5% to 16.5% and a terminal growth rate of 2.5%.

Sensitivity analysis
We have performed several sensitivity analyses on several variables: average selling price (ASP), wheat price, utilization rate, discount rate, and terminal value growth rate.

1. ASP
Our sensitivity analysis suggests that for every 5% change in our ASP assumptions, our estimate of Indosari equity value will change by ~23%.

2. Wheat price
Our sensitivity analysis suggests that for every 5% change in our wheat price assumptions, our estimate of Indosari equity value will change by around 5%.

3. Utilization rate
We have assumed 100% utilization rate in our financial projections. Our sensitivity analysis suggests that for every 5% decrease our utilization rate assumptions, our Indosari equity value estimate will change by 11.7%.

Implied PER of 12.6 to 13.6x
Based on our DCF valuation, the implied PER for Indosari is in the range of 12.6x to 13.6x based on FY10 numbers. As there are no listed bread companies in Indonesia, we compare against its regional peers such as QAF Ltd, Silverbird, Mayora Indah, Kawan Food and Breadtalk Ltd (see Figure 32) as most of these companies are involved in the bread and pastries business. As set out below, given its peers’ forward PE range from 6.0x to 26.6x, we think the implied PER range of 12 to 13x is fair given that peers’ weighted PER is also 13.4x

INDUSTRY

Huge population equals huge market
With a population of 237.5m people, Indonesia is the fourth most populous country in the world. Currently, Indosari’s total white bread production capacity of 217,000 packs per day supplied mainly to Java only satisfies 5%-7% of Indonesia’s bread market. There is an unmet demand for all the products as existing plants are almost at maximum production capacity. Hence, with forward planning, the company has a high likelihood of making market share gains. Indonesia’s population growth is expected to average ~1.2% p.a. between 2009 and 2013

Consumption per capita
Indonesians consume an average 15 kg per capita of wheat-based food each year. There is still enormous room for growth as this consumption per capita is far behind the world’s bread consumption per capita of 41kg to 303kg per capita. Furthermore, unlike other Asian countries like China and India which has their own signature wheat flour based food products in the form of mantao, pao, pratha, chappati and others, Indonesia does not have signature bread products. Hence we see the potential for bread consumption in the country to rise as reports from Bakery Indonesia claim that average annual consumption would go up to 20 kg per person in the next five years.

Consumer sentiment improves
After a dip in buying sentiment from 84 points to 61 points during the economic crisis in 2008/09, consumer confidence has improved, reaching 90 points in February, which is above the 84 pts pre-crisis. As such, we are likely to see higher sales this year as buying sentiment improves.

White bread is a cheaper source of carbohydrates but as the country develops and the standard of living rises, consumers will correspondingly opt for healthier options. Indosari has started to come up with healthier options such as whole wheat bread enriched with vitamins and minerals, which commands a premium over white bread.

RISK FACTORS

Raw material cost
As the company’s raw material cost makes up the bulk of production cost (~80% of the cost of goods sold), Indosari faces risks related to the supply of raw materials as well as their price increase. For instance, the whole bread industry was hit when wheat price reached USD1,112 per bushel in 2008 (please refer to figure 38). Nonetheless, we believe Indosari is able to weather the storm of costlier raw materials, as evidenced from its 2007/08 numbers, which were impressive indeed.

Competition from foreign entrant
Given the large population in Indonesia, there is a possibility of other foreign bread companies entering the market as this industry does not have barriers to entry and it does not require extensive capital expenditure to start a bread manufacturing plant in Indonesia. Furthermore, bread prices in Indonesia are not regulated or capped at a ceiling price, which allows for fairer competition.

Competition from in-house private labels
As the hypermarkets and supermarkets become more vertically integrated, Indosari may face the threat of private labels. Supermarkets may set up bakery stores and bake in-house, which is generally cheaper than branded bread.