(Aug 21): One has to be as nimble when investing in upstream food commodity companies as in companies in the semiconductor supply chain. Demand for both is highly cyclical: Profit margins expand and contract swiftly, and earnings in one quarter can quickly give way to losses in the next.

Tan Yong Nang, CEO of Japfa, which produces milk, poultry and pork, says he does not know enough about the semiconductor business to comment on the similarities. But he highlights one stark difference. While farming techniques keep evolving and costs are constantly being pushed lower, people will never stop consuming food.

“Technology obsolescence is something we don’t have to deal with,” he tells <i>The Edge Singapore</i> in a recent interview. Another difference is that Japfa’s profitability is likely to become more stable once it achieves scale and a more diverse customer base. “We haven’t reached that stability in our revenue and earnings yet,” Tan says.

For 2Q2017, Japfa reported a 1% decline in revenue to US$790.2 million ($1,077 million) and a loss of US$3.4 million, versus earnings of US$44.6 million in 2Q2016. The reduced profitability was partly owing to unfavourable movements in exchange rates in the Indonesian rupiah and Vietnamese dong. But that aside, earnings for the quarter have declined 93.5% to US$3.4 million from US$51.9 million.

Japfa attributes the decline to the reduced profitability of its pork production business in Vietnam. While the company does not sell directly to China, other Vietnamese producers do. A ban imposed by China caused an oversupply in Vietnam and prices were more than halved y-o-y. For 2Q2017, Japfa’s pork business posted a 20.7% drop in revenue to US$111.5 million and a loss of US$10.4 million, versus earnings of US$18.8 million in 2Q2016.

Tan explains that Vietnam exports pork to China via “grey channels” — that is, a series of middlemen traders — which are occasionally disrupted. But he is confident China will not stop importing from Vietnam because it does not produce enough pork for its own needs. In fact, while the ban on Vietnam was in effect, China was still importing from other countries, such as Canada.

Japfa expecting rebound in pork business in Vietnam, but volatility may persist Now, Tan says the channels Vietnam uses have opened up again. That should see prices rebound, boosting Japfa’s profitability, he adds.

With luck, shares in Japfa may recover too.

Following the release of its financial results on July 27, shares in Japfa dropped 15% to 50 cents on Aug 15.

In fact, shares traded at more than $1 in February this year. At that time, the pork business in Vietnam was performing well and Japfa’s main business of producing poultry in Indonesia was delivering strong earnings.

Its poultry business — housed under a 51%-owned Jakarta-listed unit called PT Japfa Comfeed — has drawn the attention of KKR, the storied private equity firm. In June last year, KKR invested US$81 million in the business in exchange for a 10.44% stake. Of this, US$53 million was spent on 750 million new placement shares, which amounted to a 6.57% stake. An additional 3.87% was sold to KKR by Japfa for US$28 million.

Fragmented markets<br>Even if shares in Japfa were to recover in 2H2017 on the back of improved profitability in its pork business, investors should be prepared for more volatility ahead. Japfa warns that the pork industry in Vietnam remains fragmented.

Tan says producers of the same scale as Japfa — the company has about 40,000 sows — make up only 20% of the market. The remaining 80% is made up of much smaller companies and individual farmers.

Meanwhile, Japfa’s poultry business in Indonesia has also suffered from big swings in profitability. Typically, farms step up production in the early months of the year, in anticipation of a pickup in consumption during Ramadan. That has been known to lead to a glut. In 2014, for example, the Indonesian government had to implement a programme to cull excess chickens. As it happened, Japfa listed in August 2014 after an IPO at 80 cents a share. By September 2015, its shares had been pushed down to as low as 28 cents.

Indonesia has been proactive since and it even sets “reference prices” for poultry and eggs. According to analysts, there was another round of culling earlier this year, which assuaged concern in the market about a price slump on softening demand. “We are encouraged by the government’s quick response in dealing with the oversupply and price volatility [of chicken],” says Mirae Asset analyst Mimi Halimin in a July 31 note on PT Japfa Comfeed.

Further diversification?<br>Tan says periodic intervention by the Indonesian government has helped correct imbalances in demand and supply speedily. However, even if there had been no action, some equilibrium would have been reached eventually.

“The nature of this business is nothing new; the business always adjusts itself,” he says, adding that imbalances occur because Japfa’s peers are jostling for market share. “We are used to a certain high-growth trajectory; everybody’s plan — including ours — is to gear up for high growth.” Nevertheless, he is confident there is still a lot of “unmet consumption” and that the longer-term growth trend is intact.

In the end, larger players like Japfa will ultimately survive the booms and busts and gradually grow larger, Tan notes. Japfa will also hedge itself by maintaining its diversified portfolio of different products in different markets.

“The key is to be a bigger player, a stronger player, and withstand the downturn. That’s the key competitive difference.”

Japfa may now expand into seafood production.

It has established an aquaculture operation, but is keeping it small for now. Tan says aqua culture can be more volatile than chicken and pig farming, and that the company has to acquire a lot of new expertise. “This is not something you learn overnight. It is not easy for us to commercialise and grow in a big scale, which is what we do.”

Could Japfa rope in investors such as KKR to expand its aquaculture business? Is an acquisition on the horizon? Tan declines to be drawn into a discussion on this, other than to say that the time has not come to expand Japfa. For now, it is focused on ensuring that investors understand its main businesses. “Our policy is very simple: We try to be transparent and give as much information as possible, as timely as possible. Those are the things we try to do and the market will find its level. Hopefully, the more we do that, the share price fluctuation will not be so drastic,” says Tan, who bought 100,000 shares at 49.5 cents each on Aug 11 on the open market.

CIMB, the only brokerage with an updated coverage on Japfa, has a “reduce” call on the stock, with a price target of 55 cents. It is forecasting a 53.5% drop in full-year earnings to US$55.2 million for 2017, followed by a turnaround in 2018, with earnings of US$92.5 million for a gain of 67.6%. Last year, Japfa paid a dividend of one cent per share. CIMB is not expecting any payout this year. Shares in Japfa are currently trading at 8.24 times forward earnings.

Japfa expecting rebound in pork business in Vietnam, but volatility may persist

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