Nongfu Spring: Drinking Water Leader - Initiate with Buy [3/3]
The market has priced in its dominance in packaged drinking water, its potential in high-end beverage products, and, most importantly, its likely growth in an uncertain world.
► Challenges ahead: land defects risks, dividend policy management and competition from smaller ones.
Investors' concerns and challenges ahead
Nongfu Spring, which takes its water source and production base as its competitive advantage, has problems with land defects. According to the prospectus, as of the latest practicable date, the company has one parcel of land that has not yet obtained a land use right certificate, two buildings that have not yet obtained real property certificates, and 43 leased buildings that have not obtained relevant property certificates provided by the owners. 398 leased buildings have not been registered with the relevant competent authorities in accordance with the applicable laws and regulations in China.
Large dividends have caused many data fluctuations for Nongfu. In 2017 and 2018, the company spent CNY 2.04 billion and CNY 3.6 billion to purchase financial products to form structured deposits, and distributed CNY 367 million in dividends in both fiscal years. However, the company's dividend payment in 2019 surged to CNY 9.60 billion and even applied for a CNY 1 billion interest-bearing loan from the bank to fill the funding gap for dividend distribution.
The dividend distribution of nearly CNY 10 billion has impacted many financial data of Nongfu Spring. The company's cash, bank balances, and structured deposits in 2019 have fallen sharply to CNY 1.08 billion and CNY 200 million, respectively. The total current assets fell from CNY 8.84 billion at the end of 2018 to CNY 4.37 billion in 2019, and the total current liabilities increased from CNY 6.16 billion at the end of 2018 to CNY 7.44 billion in 2019. As a result, it faced a deteriorating asset structure. The current ratio and quick ratio decreased from 1.43 and 1.13 at the end of 2018 to 0.59 and 0.35 at the end of 2019, respectively, and the debt-to-asset rate increased from 31.19% at the end of 2018 to 44.47% at the end of 2019.
Competition from smaller ones foraying into a niche market. The marginal growth of the packaged water market is decreasing, putting pressure on Nongfu Spring, where packaged water accounts for 60% of total revenue. But we remain positive on low-tier city penetration given its efforts compared to peers like CR Beverage. And we believe in popular categories such as tea beverage, low-sugar and sugar-free beverages. The battlefields are crowded. Popular standalone brands like Genki Forest are likely to invade the ground Nongfu Spring is holding on – for now.
Revenue assumptions and valuation
Consumer staples and consumer discretionary are suffering the severe impact of COVID-19. We believe it has dampened functional beverage, tea and juice beverage products most severely, as sales dropping 13%, 7%, 4% over a year ago. In 2020, we assume Nongfu will show its resilience against the outbreak with 3% YoY sales growth due to 1. more exposure to consumer staples, 2. its sound and stable distribution channels. We expect the company to see a bounce-back needs on its main category products, driving business growth from 2021-2024, given its consistently solid customer acquisition through its product mix.
1. The distribution channels it shaped in the past decade allow the company to enjoy high gross margins in selling low-price water products. Its branding strategy gives mid-to-high-end drinking water products a high premium. The distribution of packaged drinking water and beverage products through the same distributors helps increase their business scale and profitability and retain distributors given the high gross margins they can benefit from.
2. Sparkling water, NFC juice, and other high-end products are on the company's product brochure, and we expect the company to build the next best sellers from its product pipeline. On the other hand, high brand awareness of its packaged drinking water products drives ex-water category growth.
3. The company also reinvests profits into penetrating lower-tier cities, especially prefecture-level administrative divisions across China, online e-commerce channels, which in our view, is ahead of other competitors.
As such, our view is that Nongfu will grow sales at 17%, 16%, 15%, 14% from 2021/22/23/24. Gross margin improvement in 2020 is highly correlated with the dropped price of PET. It will sit at 57.5% in 2020 but will be back to normal levels and be stable in the coming years due to 1. PET prices are moving cyclically, so we only take its effects on gross margin a one-time effect 2. Nongfu does not have a new product timeline in twelve months. We expect gross margin to reach 56.4%, 56.4%, 55.9%, 55.8% in 2021-2024. SG&A is expected to decrease thanks to improving operating leverage, representing 77.0%, 67.0%, 66.0%, 66.0%, 66.0% of COGS in 2020.21/22/23/24.
We use a three-stage DCF as our valuation methodology and derive a Dec-20 PT of HKD 37.4, with a 59x implied 2021 P/E multiple. Key assumptions in our DCF valuation include: (1) a risk-free rate of 3.44%; (2) an equity risk premium of 5.5% in the China market; (3) a beta of 0.86 using Tingyi (Cayman Islands) Holding Corp. (0322:HK) ; (4) a discount rate of 7.78%; (5) a medium-term growth of 15%; (6) a medium-term period of 10 years; (7) a terminal growth rate of 3%.