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Morningstar | Hengan’s 1H Operating Profit Slightly Ahead of Our Forecast; HKD 70 FVE Is Intact

Despite the adverse impact of rising raw material costs, no-moat Hengan International Group, or Hengan, reported first-half 2018 results slightly ahead of our forecasts, with revenue and operating profit up 16% and 2.5% year on year, respectively, to CNY 10.14 billion and CNY 2.68 billion, thanks to effective implementation of its small sales team strategy and increasing coverage of its e-commerce channel. Gross profit margin slightly missed our estimate, declining 4 percentage points from last year to 39.6%, owing to significant price hikes for wood pulp, a key raw material for tissue papers. However, the company’s small sales team operating model has improved sales efficiency, resulting in the selling, general, and administrative expense/sales ratio declining 1.4 percentage points to 17.2%. Accordingly, net profit of CNY 1.95 billion, up 5% from the prior year, was slightly better than we anticipated.

Hengan has raised its selling prices since June to mitigate the pressure from high wood pulp prices. In addition to price hikes, we think the company’s profitability will be improved in the second half through better product mix with stronger sales from high-end and upgraded products. We retain our no-moat rating for Hengan and maintain our fair value estimate at HKD 70 per share. Our 7.8% five-year net profit growth forecast is intact, as we expect sales growth to decelerate in the second half of 2018, while we project margin to recover from the first half. The current share price amounts to 0.93 times our fair value estimate, and we think the shares are fairly valued.

On the revenue front, the tissue paper segment was still the largest income source for the company, accounting for 50% of total sales. Revenue from the tissue paper business came in strong at CNY 5.08 billion, surging 21% from the year-ago period. We attributed the robust growth to the benefits of the small sales team strategy and lower selling price relative to competitors, while other rivals have raised their prices by about 5%-10%. The e-commerce channel has also helped revenue growth, increasing more than 60% year on year, and contribution from the online sales channel accounted for 12.7%, from 9.2% in first-half 2017. As a result of rising wood pulp costs and not increasing its selling price, the margin was lower than we expected, down 3.8 percentage points to 25.8%.

Revenue from the sanitary napkin business grew 5% year on year to CNY 3.22 billion, accounting for 32% of total sales, which was in line with the industry growth. The Space 7 series, which launched in the second half of 2017, targeting the white-collar market in higher-tier cities, has received positive response from the market. Despite the higher costs of petrochemical raw materials, the gross margin of the sanitary napkins business was managed to improve by 60 basis points to 69.3%, driven by better product mix of high-end and upgraded products.

Hengan seemed unable to remedy the disposable diaper business, as revenue further declined 10% year on year to CNY 811 million, given its weak brand position in the diaper market and weak development in the online sales channel, although the company has sped up its development in the e-commerce channel. The gross margin only slightly decreased to 39.9% from 40.4% last year. Going forward, the company will further promote its omnichannel strategy through increasing exclusive products for the e-commerce channel and maternity stores in order to increase their contribution to diaper sales.