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Morningstar | Sales Recovery in Moaty Domestic Foods Despite Expected Downward Revision. See Updated Analyst Note from 07 Nov 2018

Narrow-moat Ajinomoto’s second-quarter results came in above our expectations. Management has revised down its full-year guidance due to the first-quarter shortfall and adverse foreign exchange movement but the 6%-9% profit downward revision was greater than our expectation of 5%. A recovery in the moaty domestic food business and healthy growth in the moaty overseas foods were the positives of the quarter. We have lowered our fair value estimate to JPY 2,400 from JPY 2,420 to reflect the profit cuts.

Management plans to revise down the targets for 2019 later and we believe the downward revision has been largely priced in. Our forecast of 2019 business profits is about 9% below the company’s guidance. Ajinomoto is making progress in solving three out of four critical issues facing its moaty domestic and overseas food businesses and will continue to leverage its strengths in product development and entrenched retail relationship to reinvigorate growth. We think the company has passed the worst and the share price is offering an attractive 27% margin of safety.

Gross margins shrank less than 20 basis points, greatly lessened from a more than 150-basis-point decrease, as the product mix improved on the back of a sales recovery in the lucrative domestic food business and improved production yield of the U.S. frozen foods. Cost inflation may linger over the next quarter or two as prices of tapioca, a key fermentation ingredient for many core products, remains nearly 30% higher than the level of the same period last year. The trend of tapioca price may alter after the harvest in November. It is most likely to affect costs after the fourth quarter if tapioca prices drop.

There are four major setbacks hampering its profit growth since 2017 including: 1) sales decline in the domestic instant coffee resulting from a shrinking household demand; 2) volume decline in Birdy canned coffee drinks caused by fierce price competition in Thailand and sin tax hikes; 3) rising costs in the U.S. frozen food business due new plant migration and production troubles in addition to increased logistic costs; and 4) increased competition in domestic frozen foods. We have seen consistent improvement in the latter three issues although the long-term solution to halt the sales decline in the domestic coffee business is not yet in sight.

The volume decline in Birdy canned coffee beverage has lessened to a low-single digit while a 10% price hike has been fully passed on. Sales of core frozen food items in Japan also picked up during the second quarter and the company has strengthened the product lineup and will launch marketing campaigns to promote the core dumpling line. The newly announced 2%-10% price hikes on 335 items of the domestic frozen food products for professional use will lift margins from the first quarter of 2019.

In the U.S. frozen food business, Ajinomoto has reached agreement with most of retailers to pass on higher logistic costs, expecting price hikes to kick in from the third quarter. Moreover, mounting costs associated with plant migration and production troubles as well as additional outsourcing costs should fall steadily from the third quarter.

On the other hand, Ajinomoto continues working on solutions to reverse the volume decline trend in coffee products at home and revive growth in Thailand. As the markets are facing drastic changes, we consider product and marketing innovations the most crucial means to fight competition. It is most likely to take a few quarters to create products with new marketing concepts or targeting at new customer segments.