GGRM:The best margin in a decade - Mandiri

Gudang Garam posted 1Q11 net income of Rp1.1tn (+18.6%yoy, -3.2%qoq), which was in line with our and consensus estimates. Its net margin expanded from 10.8% in 1Q10 to 11.6% in 1Q11, which was the highest 1Q margin since 2001, partly due to some 8%yoy ASP increase, based on our observation. We also like GGRM as it is relatively defensive to this year commodity prices fluctuation. Supported by strong brand equity investment with 50.1%yoy increase in advertising expense, we think GGRM’s long-term growth could exceed industry growth as consolidation may occur in the cigarette industry as a result of the excise policy that is less favorable for small players. We maintain our Buy stance on GGRM that is trading at PER11-12F of 15.9-13.9x.

1Q11 results were in line with our and consensus estimates. GGRM posted FY10 net profit of Rp1.1tn (+18.6%yoy, -3.2%qoq). The net profit represented 22.4%-22.6% of of our and consensus estimates; therefore we consider it in line with estimates, considering seasonality factors. Note that GGRM usually increases ASP gradually until year end; in addition, sales volume is generally stronger in 2H.

Highest 1Q margin since 2001. GGRM expanded its gross margin and net margin from 22.1% and 10.8% in 1Q10 to be 23.8% and 11.6% in 1Q11, which were in line with our estimates. The 1Q11 margins were the highest 1Q margin since 2001. During 1Q11, the company increased its ASP 3 times for about 8%yoy, based on our observation on major products. We atrribute the company’s strong pricing power partly to its brand equity investment with 50.1% increase in advertising expense. Note that QoQ slight margin contraction is normal in 1Q every year as the company needs time to fully pass on excise rate increase to customers.

Faster than industry growth rate. Even though cigarette industry’s volume grew slowly, we think the growth rate for major player, such as GGRM, could exceed industry growth as we think industry consolidation will continue. Small players are facing greater challenges after the introduction of the new excise regulation that is in favor of big players, and and implementation of better excise collection mechanism that reduces excise evasion done by a lot of small players.

Maintain Buy. We maintain Buy on GGRM with TP of Rp48,000/share, derived from DCF valuation with 12.7% WACC and 5.0% TG. At current market price, the stock trades at PER11-12F of 15.9-13.9x. Main risks are regulatory and competition risks.