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Morningstar | We Expect Margins to Erode in 2H 2018 From Hengan, Shares Slightly Undervalued to Our HKD 70 FVE. See Updated Analyst Note from 28 Feb 2019

While we anticipate no-moat Hengan International Group’s revenue to grow at a high-single-digit rate in the second half of 2018, driven by strong sales volume from the tissue paper segment, we expect profitability to deteriorate due to increasing raw material (paper pulp) prices. Although we lower our 2018 full-year operating profit forecast to CNY 5.21 billion (down 1.2% from last year) from CNY 5.33 billion previously, our fair value estimate for Hengan remains at HKD 70 per share, given the negative impact from lower earnings is completely offset by the time value of money. We forecast the operating margin to drop 2.7 percentage points from 2017 to 23.9%.

Hengan’s share price dropped to its 18-month low in December 2018 due to an accusation of fabricating earnings from a short-seller report. Management has denied all the allegations and attempted to enhance the shareholders’ interests and investors’ confidence through share buybacks. We think the negative sentiment has been fully digested by the market, and the attention seems to have moved back to the fundamentals, as the stock price has increased about 20% since then. The shares are trading at a price/earnings ratio of 15.7 times, and we view them as slightly undervalued at current levels.

We forecast the company’s full-year 2018 revenue to arrive at CNY 21.77 billion, up 9.8% from 2017. While its competitors raised their tissue paper prices several times to pass on the higher production costs to consumers, Hengan decided to keep its prices largely unchanged in order to boost its sales and seize more market share to strengthen its leading position (market share was up 2 percentage points to 22% in 2018). As a result, this low-pricing strategy did drive the tissue paper business to grow 20% in the first half, and we expect it to grow solidly at low-teens rate in the second half. Due to the increasing cost pressures, we think the low-pricing strategy will not sustain its rapid growth. The company already increased its selling prices at the end of 2018 to improve its profitability, but we expect volume growth will be negatively affected amid intensifying competition.

We forecast sanitary napkins sales to grow moderately at a mid-single-digit rate in the second half. Although the market is getting matured, management expects the business will maintain its steady growth, bolstered by expanding product offerings to other female beauty-related products, such as makeup cottons and masks. As for its diaper business, we expect the business will fail to recover in 2018, as sales will decline at 10% year on year due to weak brand strength versus other multinational brands.