Investment thesis
Currently thriving under second-generation entrepreneurs, PT Ultrajaya Milk Industry & Trading Co. Tbk (ISX:ULTJ, Financial) has a clear path for organic growth, driven by structural tailwinds in Indonesia’s dairy industry.
Ultrajaya currently trades at 12 times EBITDA, below the median of its regional industry peers (16.5 times). We attribute this to the market’s expectations of a considerable jump in capital expenditure for the development of its dairy farm and new factory in Greater Jakarta.
Ultrajaya is worth anywhere between 1,560 Indonesian rupiah (12 cents) and 1,760 rupiah. Based on its last close of 1,200 rupiah per share, we have a margin of safety in the range of 23% to 32%. We believe this discount should narrow as the market recognizes its value.
A market leader with a track record established over 50 years
Ultrajaya began as a pure producer of milk in 1960. Over time, the company developed its portfolio to include other ultra-high-temperature (UHT) beverages such as teas and health drinks.
Source: Company website
In spite of this growth, Ultrajaya has stayed true to its roots. Today, it is the leader in Indonesia’s milk products segment with market share of 23% by value. We do not find this surprising; results from a survey we conducted suggest consumers see Ultrajaya’s products as the choice of milk for Indonesia’s middle class.
Low per capita consumption of milk presents attractive growth opportunities
Drinking milk products in Indonesia have significant room for growth as consumption per capita is still lower than in other emerging countries. From this low base, Indonesia’s taste for milk is expected to grow with the rise of its middle class.
Cognizant of the ongoing battle for the hearts and growing wallets of Indonesian consumers, Ultrajaya’s advertising and promotion expenses increased from 197.1 billion rupiah in 2013 to 288 billion rupiah in 2016, representing a compound annual growth rate (CAGR) of 14% over three years. The company has been actively educating Indonesian consumers on the benefits of drinking milk over consuming powdered or condensed milk. In 2016, the company frequently held event promotions, such as “Tour de farm” (visiting the Ultrajaya farm in Bandung), in cooperation with mass media outlets like Tabloid Nova and Net TV. In the same year, Ultrajaya also organized Preschool Roadshow Ultra Mimi Carafun in Medan, North Sumatera province.
At just 6.2% of fiscal 2016 net revenue, there is room for Ultrajaya to allocate more capital to advertising. As a rule of thumb, companies in the West spend between 8% and 15% of their revenue on advertising. Spending more will develop Ultrajaya’s corporate image and customer loyalty and raise the mental barriers to entry.
Consistent revenue growth and high ROIC
Ultrajaya’s impressive revenue growth (three-year CAGR of 11%) from 2013 to 2016 has been accompanied by an increase in gross margins, from 29% to 34.6%, and core EBIT margins, from 12.3% to 18.1%.
Even more impressive is the company’s return on invested capital, a stellar 32% in 2016; weighted-average ROIC from 2013 to 2016 was 23%. With a 15% cost of capital, Ultrajaya has clearly been creating shareholder value.
High-ROIC companies should focus on growth, which brings us to Ultrajaya’s construction of a new factory in the Greater Jakarta area. To be completed in 2018, the new factory will exclusively produce UHT products. Funds will be invested in new technology to improve efficiency and effectiveness. Once it is operational, this new factory should reduce logistics costs for deliveries around Greater Jakarta.
Successful execution of new dairy farm joint venture is key to containing costs
Historically, Indonesia has been beset by economic nationalism, and milk supply is no exception. Other than a possible rise in import duties for milk, the country’s Ministry of Agriculture is pushing for milk processors to reduce their reliance on imported milk from about 82% currently to just 60% within three years and 50% by 2025.
Ultrajaya is in the process of completing a new dairy farm establishment in Berastagi, North Sumatra, a 50-50 joint venture with a local partner, PT Karya Putrajaya Persada. Through this deal, the company plans to raise 11,800 milking cows in five phases. During the first phase, Ultrajaya will import 2,000 cows from Australia.
We see this as a positive development that will help Ultrajaya insulate itself from supply interruptions, reduce its dependency on imported products, secure higher-quality raw milk and keep its costs under control.
Competitive advantage in superior distribution
As the world’s largest archipelago with over 18,000 islands, distribution across Indonesia can be a challenge. Yet Ultrajaya’s extensive distribution network, driven by 300 sales professionals, more than 100 vehicles and 20 sales representative offices, ensures the company’s milk products are transported from the farm to its network of 25,000 grocery stores, 65,000 modern and traditional outlets, hotels and commercial users.
Ultrajaya' distribution system has taken years to establish and it would be difficult for competitors to replicate, making it a significant barrier to entry.
Valuation
| Â | Low | High |
| Maintainable EBIT | 910,007,884,706 rupiah | 935,522,124,464 rupiah |
| EBIT multiple | 18 times | 20 times |
| Enterprise value | 16,380,141,924,703 rupiah | 18,710,442,489,276 rupiah |
| Cash | 1,775,675,130,461 rupiah | 1,775,675,130,461 rupiah |
| Debt | (125,385,157,403) rupiah | (125,385,157,403) rupiah |
| Non-controlling interests | (122,517,386,010) rupiah | (122,517,386,010) rupiah |
| Investments | 89,188,673,230 rupiah | 89,188,673,230 rupiah |
| Equity value | 17,997,103,184,981 rupiah | 20,327,403,749,554 rupiah |
| Number of shares | 11,553,530,000 | 11,553,530,000 |
| Equity value per share | 1,560 rupiah | 1,760 rupiah |
| Current share price | 1,200 rupiah | 1,200 rupiah |
| Discount to intrinsic value | 360 | 560 |
| Margin of safety | 23% | 32% |
Catalysts
Regulatory change
As mentioned above, all milk processors have to reduce their reliance on milk imports by 2020. Ultrajaya has responded through its plans to import 2,000 cows from Australia from 2017-18 and consequently, investors have placed a lower multiple on Ultrajaya; the company is expected to cut its dividend as cash flows will be used to fund expansion.
Investors are missing the scalability of Ultrajaya’s business model. Once major capital expenditure is incurred in 2018, we believe the concentration of the liquid milk industry in four players, revenue growth driven by higher milk consumption and prudent cost control will have a powerful effect on earnings.
Demand for alternative dairy products
Ultrajaya’ s associate stake of 30% in PT Kraft Ultrajaya Indonesia (PT Kraft) is potentially undervalued.
An early entrant to the Indonesian cheese sector, Kraft is the leading brand, commanding a 61% share of sales by value. While cheese retail sales is small at $74.2 million, industry watchers believe this category will break the $100 million barrier in 2017.
As more consumers take to cheese products, Ultrajaya's equity interest in PT Kraft will become more valuable.
Risks
Failure to secure stable sources of milk supply
As Ultrajaya’s regulatory environment changes and its production capacity ramps up, central to the company’s success is its ability to secure stable sources of milk supply.
Should the dairy farm joint venture be unable to meet production demands, there will be significant escalation in production costs and delays in bringing products to market.
An overvalued market
While Ultrajaya’s undervaluation is expected to correct itself over the next two to three years, we cannot ignore the recent bull run in global stock market indices. Any market shocks may cause the company’s share price to decline in spite of its undervaluation.
Disclosure:Â No position in this stock.
