Volatile prices but no worries on wheat production. Prices of wheat had run up during the earlier part of the year after the UN Food & Agriculture Organization issued an alert regarding the reduction in wheat production due to China's drought, before retreating recently on reports of better weather in China and reduced demand from Japan (See Exhibit 1). With the global economy adjusting to the rise in food inflation, the volatility in wheat prices could not have come at a worse time. Market analysts were originally concerned that if the drought had succeeded in reducing wheat supplies, China would have to dramatically increase its imports to supplement the reduced production, further driving up already pressured prices. However, we noted that the run-up in prices was overdone due to two reasons: China imports a very slow percentage compared to its total production size, and the wheat produced by China is generally of lower quality and not associated to the higher quality wheat the futures prices represent.
China wheat imports insignificant. Even when Chinese wheat production dipped in 2003 after farmers switched out of grains and into other high-value crops, imports only increased by less than 2% of the total production the following year (See Exhibit 2). Furthermore, import percentage levels subsequently fell after the Chinese government introduced more incentives for farmers to continue grain production.
BreadTalk uses higher quality wheat. Raw material costs constitute about 30% of BreadTalk's cost of sales so naturally the price fluctuations of wheat futures will have implications on their margins. However, the quality of Chinese produced wheat is a lower quality grade generally associated with noodles whereas the quality of wheat associated with the traded futures is of higher quality wheat, which is used in bread and other pastries.
Margins intact; Valuations unchanged. With an unaffected supply of higher quality wheat, and potentially lower prices in the face of anticipated lower demand, we do not foresee any impact on BreadTalk's margins and continue to put faith behind BreadTalk's growing brand recognition and its continuous commitment to review and enhance its offerings. We maintain our BUY rating for BreadTalk with a fair value estimate of S$0.74 based on a discounted cash flow-to-firm valuation model with a WACC discount rate of 8.02%.
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