Sunday, July 10, 2011

Gudang Garam Tbk - Price increases in June

by CIMB Securities : GGRM

GG implemented selective price increases of 1-2% in late June in anticipation of cost pressure from rising tobacco and clove prices. Amid buoyant consumption and limited stock buffers for the other tobacco producers, it’s a tactical trading of volume for margins in the near term, while buffering its inventory in case tobacco and clove harvests in Sep-Nov 11 are disastrous. If harvests are fine on the other hand, GG would enter the following year with margins to spare for the next round of excise increases. A win-win move altogether, we believe, besides reflecting management’s comfort with its branding and revamped distribution. This supports our view of 15-18% sustainable earnings growth for the next three years. No change to our FY11-13 earnings forecasts, Outperform rating or target price of Rp56,500, pegged at 1x PEG and implying 18.5x CY12 earnings. Catalysts are further price increases, low excisetax adjustments and interim dividends.

Extra padding for margins

Price increases of 1-2%. Late last month, GG implemented yet another round of 1- 2% price increases, in anticipation of higher input costs amid elevated tobacco and clove prices. We noted sharper price increases for hand-rolled cigarettes, at 9% YTD or 16% yoy, than for machine-rolled cigarettes at 7-8% both yoy and YTD, arguably because: 1) hand-rolled cigarettes are priced 28% lower than machine-rolled cigarettes; and 2) hand-rolled cigarettes use more cloves than machine-rolled cigarettes. Machine-rolled cigarettes contribute 84% to GG’s revenue. Amid poor tobacco and clove harvests. Tobacco substitutes are easier to find given plenty of supplies, but clove is hard to replace. The biggest producers are Indonesia and Zanzibar/Madagascar. Indonesia’s clove production is expected to be poor, based on government forecasts, to the extent that the yoy decline could be 90%. Exacerbating the problem is not enough inventory carried by some cigarette producers, probably complacent after the stable prices and production of the past few years. Consequently, clove purchases were reportedly done at Rp150k-160k/kg recently, more than 3x the price in 2010. The next harvests for tobacco and clove are expected to be in Sep and Nov 11 respectively. November’s clove harvest would be critical, as most producers’ inventories would be depleted by then.


GG has sufficient inventory to ride through. Management has confirmed that its clove inventory is good enough for production through 2011 and if November’s harvest is poor, it could ride out 2012. GG is certainly in an enviable position, with the ability to grab more market share over the medium term. But management has decided instead to increase prices, noting firstly buoyant demand, and confident that competitors would follow suit given their cost squeeze. They have. The rationale for such a tactical move is to conserve precious inventory should harvests again be poor, clearly with longer-term production in mind. If harvests turn out to be ok, padded margins going into 2012 is not a bad idea, since excise taxes would be increased, probably by 5-7%. We would add that this also reflects management’s comfort over its branding and revamped distribution. GG has been gaining market shares over the past two years.

Valuation and recommendation

Maintain Outperform and target price of Rp56,500, still based on 1x PEG. Management’s reassurance that GG’s clove supply would be sufficient for this year (and possibly next) while some of its competitors are struggling gives us confidence that production would be uninterrupted this year. This and GG’s growing market share mean that volume growth of 2-3% is achievable. Furthermore, with its new pricing ahead of cost pressures, margins should fare well this year. Altogether, this is a win-win move for GG. Despite rising 250-300% so far, cloves comprise a mere 3-5% cost of sales for machine-rolled cigarettes and 6-10% for hand-rolled cigarettes. Hence, we reiterate Outperform.

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