China Packaged Food and Beverage Sector： snacks the main course as drinks lose fizz

See important disclosures, including any required research certifications, beginning on page 72 ■ Investment case We initiate coverage of the China Packaged Food and Beverage Sector with a Neutral rating. While the companies in the sector are trading at high valuations, we believe this is justified for some of them by high earnings visibility and their resilience to macroeconomic headwinds. Among the different sub-segments, we prefer the snack and instant-food companies to the non-alcoholic beverage (soft drinks) ones given less fierce competition in the former. Want Want, on which we initiate coverage with a Buy (1) rating, is our top sector pick on the back of the recent share-price sell-off (it is down 22% from its peak in April this year) and the acceleration we expect in revenue over 2H14. We forecast the company to maintain an operating margin of more than 22% over 2014-16, compared with 4-6% for the soft-drink players and a range of -3% to 13% for the instant-noodle makers. In the drinks segment, we expect the bottled-water players to fare better than the juice-drink and carbonated-drink producers over the near term, on the back of downtrading by consumers and increased health awareness. We prefer Tingyi, on which we initiate coverage with an Outperform (2) rating, to UPCH – Hold (3) rating – as Tingyi has a more diverse soft-drink portfolio. ■ Catalysts China has a low per-capita consumption rate for snacks, at less than 10% of the global average. Given this, and the significant room we see for product diversification through new product launches, we expect sales growth in the country’s snack market to maintain momentum over the next 3 years (2006-12 sales CAGR of 16%), while we expect single-digit sales growth for the instant-noodle and soft-drink markets over the same period. We believe the success of new products will be important in driving earnings and serve as positive share-price catalysts for stocks. Want Want and Tingyi have begun launching new products to diversify their customer bases, supported by their strong execution capabilities and distribution networks. Further declines in the costs of raw materials, such as imported milk powder, sugar, and PET chips, should continue and be favourable for the snack and some soft-drink producers. We expect the pricing power of the leading instant-noodle players to rise in 2015 as their market shares increase. ■ Valuation Our target PERs are based on, or at a premium to, the companies’ average past-5-year 12-month forward PERs, as we see operating margins improving gradually and restoring earnings growth. Trading at 27% below its past-5-year PER average, we believe Want Want is the most attractively valued among the companies in the sector.  China Packaged F&B Sector: target PERs Company Target PER (x) 2014-15E EPS averageWant Want 24.6 USD0.068Tingyi 27.0 USD0.109UPCH 30.0 CNY0.151Source: Daiwa ■ Risks The main downside risks to our view are food-safety issues, sharp rises in commodity costs, and aggressive promotions and discounts. The main upside risks are falls in raw-material costs and successful price rises. 25 June 2014 Initiation: snacks the main course as drinks lose fizz • Although expensive, China F&B companies offer strong earnings growth and resilience to macroeconomic headwinds • We prefer the snack producers to beverage brands given better competitive landscape and product-mix diversification potential • Want Want is our top pick in the sector China Packaged Food and Beverage Sector Key stock calls Source: Daiwa forecasts. Consumer Staples / ChinaPositiveNeutral(initiation)NegativeAnson Chan(852) 2532 4350anson.chan@hk.daiwacm.comAlison Law, CFA(852) 2532 4308alison.law@hk.daiwacm.comNewPrev.Want Want China (151 HK)RatingBuyTarget13.00Upside27.2%Tingyi Cayman Islands (322 HK)RatingOutperformTarget22.90Upside8.8%Uni-President China (220 HK)RatingHoldTarget5.60Downside3.4%How do we justify our view?How do we justify our view? China Packaged Food and Beverage Sector 25 June 2014 - 2 - How do we justify our view?  Growth outlook  Valuation  Earnings revisions  Growth outlook  China Packaged F&B Sector: revenue and reported net profit Revenue. Due to its exposure to snacks, we believe Want Want will see the greatest revenue-growth momentum in the sector over 2014-16. We expect Tingyi’s revenue to grow faster than UPCH’s on the back of market-share gains in the instant-noodle segment. Margin and profit. We forecast Tingyi’s net profit to rise at a 26% CAGR over 2014-16 on the back of efficiency gains in the Pepsi unit and reduced promotion expenses for noodles. For Want Want, we forecast a 2014-16 EPS CAGR of 18% on the back of price rises and new product launches. We forecast UPCH’s adjusted EPS CAGR over the period to be 20% (excluding one-off items) as the noodles segment turns around in 2015E. Reported EPS gr