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Morningstar | Yanghe's 1Q Results Slightly Higher Than Expected; Shares Undervalued vs. Our CNY 140 FVE

Wide-moat Jiangsu Yanghe’s 15.7% net profit growth in the first quarter was slightly ahead of our estimate, driven by strong sales growth for the brewery's premium Dream Blue liquor. Revenue growth of 14.2% was better than our expectation, fueled by double-digit growth outside of Jiangsu province, while sales growth decelerated to single digits in Jiangsu province. We’re raising our fair value estimate to CNY 140 per share from CNY 136 after tweaking our revenue and gross margin assumptions. We maintain our wide moat rating and view the shares as undervalued at current levels. The sales slowdown in Yanghe's home market recently had raised market concerns, resulting to a pessimistic growth outlook from the Street. However, we think the market is not fully factoring in the strong revenue growth from non-Jiangsu markets (now contributing more than 50% mix), which should boost revenue in the medium term, underpinned by strong brand equity and a good management record.

Gross margin in the first quarter, down 2.5 percentage points to 72.3%, was lower than we anticipated. We attributed the higher production costs to higher packaging and labor costs but expect the margin erosion will fade, bolstered by the increasing mix of high-end liquors, with Dream Blue accounting for 25%-30% of total sales. The operating expense/sales ratio increased 20 basis points year on year, lower than our forecast. However, we expect a rising ratio going forward due to higher marketing and advertising costs for Yanghe's aggressive non-Jiangsu market sales channel expansion strategies, coupled with its sales reform in Jiangsu province. Thanks to lower sales tax expenses, Yanghe’s operating profit and net profit rose 14.9% and 15.7% year on year, respectively, with operating margin and net margin up 30 and 50 basis points.