What's new: Yurun's 2012 interim revenue decline by 23.9% YoY (down 21.0% HoH) to HK$ 12,529M, broadly in line with our expectation. Gross profit margin contracted by 10.5 ppt YoY and 2.4 ppt HoH to 2.1%. SG&A expenses ratio jumped to 6.8%, up 2.4 ppt YoY and 1.6 ppt HoH. As a result, operating profit declined by 88.5% YoY to HK$ 199M, while higher effective tax rate led reporting net profit to decline further by 93.3% YoY to HK$ 107M. No interim dividend was declared, and dividend payout ratio in 1H11 was 25% and no final dividend was paid at the end of 2011.
Valuation and TP: We expect earnings recovery to be slower than previously expected and expect to see the company resume normal operation in 2013 in terms of sales growth and profitability. For FY12, pricing in slow GPM improvement and increasing SG&A ratios, as well as a higher effective tax rate. As a result, we revise down our FY12/13/14 earnings forecasts to HK$0.42/0.55/0.67 from HK$1.13/1.62/1.90, and revise down 6 month TP to HK$ 6.8, representing 14x 2H11/1H12 earnings. We maintain our Outperform rating.
Key Assumption: 1) the average hog price will continue to be relatively stable for the rest of 2012, slaughtering volume will record a low-single digit growth while LTMP will still see a full-year volume decline. 2012's GPM recovers to 6.3% but still lower than 8.6% in 2011; 2) thanks to the low base of 2012 and expansion of sales channels, the company will see slaughtering volume growth close to 20% and margin recovery in 2013; 3) higher SG&A expenses ratios of 6.5%/6.1% for 2012/13 as the company attempts to restore brand image through increasing marketing/PR activities and increased management costs from new plants expansion, and effective tax rate remain high at 13% in 2012; 4) lower yet stable government subsidies going forward.
How we differ from consensus:
In terms of turnover breakdown, chilled meat and LTMP continued to be the company's two major products, accounting for 78%/9% of total revenue. Revenue of chilled meat declined 17.9% YoY to HK$ 9,951M mainly caused by a 17.1% volume contraction and 0.9% ASP drop, and its GPM dropped to 2.4%, comparing to 10.2% in 1H11 and 3.0% in 2H11. Revenue of LTMP declined 41.3% YoY to HK$ 1,169M, primarily caused by a 47.4% decrease of sales volume. GPM was 15.6%, lower than 19.1% in 1H11 but indicates an improvement over 13.3% in 2H11. The contraction of revenue/margin of these key products was attributable to decrease in sales volume and low utilization rate. In 1H12, Utilization rates of mature plants and new plants have dropped to 45% and 23% from 84% and 34% in 1H11. Furthermore, amid harshening macro environment and the aftermath of food-safety scandals last year, Yurun carried on discounted sales in 1H12 which sacrificed GPM, in order to maintain its relationship with clients and explore new sales channels.
Loss in recurrent profit is worse than expectation. In fact 2012 interim results are not far below market expectation; however, the higher-than-expected "other operating income" reading of HK$754 M (of which 96% is gained in form of government subsidy) implies the company actually incurred a recurrent loss of HK$678 M, which surprises the market on the downside. The main reasons behind the poor profitability are drop in GPM and increasing operating expenses. In fact, we think the pain of slow recovery is somewhat amplified by the unchanged fast expansion, which increase fixed overhead costs (then "numerator") while overall revenue (the "denominator") is declining, resulting in higher unit cost and lower GPM. GPM improvement may come from penetration of new sales channels (such as chained restaurants) and ASP increases in 2H12. Furthermore, dramatic increase of SG&A expenses of HK$ 134M (or from 4.4% of sales in 1H1 to 6.8% in 1H12), which alone is more than report net profit, is another reason behind low profitability. However, these two factors tend to improve simultaneously when the company resume normal operation, hence we think we will probably see a large improvement in profitability in 2013.
Yurun maintains its 5-year expansion plan: by 2015, upstream slaughtering capacity is expected to reach 70M heads and downstream to reach 600,000 tons, with a total RMB 14B Capex budget over the period of 2011 - 2015. We agree on the logic of fast expansion to benefit from government's tighter control over slaughtering licenses, however, capacity utilization rate continues to deteriorate in 1H12, which missed management's previous guidance of increase of utilization rate.
Hog price to remain relatively stable before the end of 2012. In 1H12, the average hog procuring price was RMB 14.99/kg, which is 6% lower than the 2011 average cost of RMB 15.88/kg, while it declined 17% HoH due to abundant hog supply, which gives room for potential margin improvement once the company resume normal operation in 2H12. However, looking forward, on the back of rising crops prices and diminishing confidence of pig farmers, 2013 would see hog price on the rise again. The management expects a 10-15% increase in such cost, and we think the chance of steep increase of hog price is unlikely thanks to flexible government policies.
Torn between poor short-term recovery visibility and positive long-term industry outlook. The recent trading activities of some major investors indicate that market is torn between the company's short-term slow recovery and positive long-term industry outlook, as we find Yurun's share price lack of support from a clear, although predictable, fundamental recovery. However, the slaughtering sector prospect is positive as the government will continue to encourage consolidation in the upstream slaughtering industry and close down small-scale slaughter houses. According to the 5-year government plan ending 2015, the number of licensed slaughter houses will be reduced from over 17,000 in June this year to approx. 3,000. Hence, the market may turn to look for other indicators, besides fundamentals, as votes of confidence to Yurun's prospects, such as an increasing of shareholding by large/major shareholders. We will not be surprised if there are some investors accumulate a significant position in the company in the following trading days, while we think before the market agrees on either direction there will be potential share price fluctuation.
Catalysts for stock price performance: GPM recovery; stable or mildly increasing hog price; stricter industrial regulation; increase of shareholding from major shareholders.
Risks to central scenario: poor visibility of recovery; potential negative media coverage; shortage in supply of hogs; corporate governance issues