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Morningstar | Unexpected Weakness in Domestic Foods Dragged Profits; Negative Surprise Priced In

Narrow-moat Ajinomoto’s first-quarter results were disappointing with sales above our expectations but profits 5% below our forecasts, owing to a significant drop in domestic consumer products as a result of intensified competition in addition to increased input costs. While sales of seasonings, its key moat source, held up, a sizable profit decline in frozen foods dragged the overall consumer profits. Given that some negative impacts are caused by the timing issue and the production trouble of the U.S. frozen foods should come to an end, we maintain our full-year forecasts and fair value estimate of JPY 2,420. Our current profit forecasts are about 2% below the company’s guidance and 3% below consensus. The share price is now at an attractive level, with a 20% discount to our fair value estimate after a 6% correction post-announcement. Still, recent weakness in the moaty consumer business is likely to remain an overhang until notable improvement is in sight, likely toward the third quarter.

Gross margins shrank more than 150 basis points, stemming from a deteriorated mix as a result of sales decline in the lucrative domestic food business, in addition to increased input cost (55 basis points) of fermentation products and a lowered production yield of overseas frozen foods. The cost inflation may continue through the next two quarters, as the price of tapioca, a key fermentation ingredient for many core products, remains nearly 50% higher than in the year-ago period and may not fall and normalise until November after the harvest.

The negative surprise in domestic food business which saw profit fall by nearly half was attributable to 1) a sales decline in frozen foods, resulting from reduced promotion campaign (year on year) and intensified competition; 2) continued weakness in coffee sales resulting from a shrinking market and intensified competition; and 3) increased input costs of seasonings/processed foods for professional use. Sales of frozen foods were particularly weak in April and May as the company channeled marketing resources toward new products from the core products, which generate much higher sales. Sales in June apparently turned positive after the firm launched a marketing campaign with beer company Suntory to promote its new frozen appetizers. We think investment in new products is necessary for the firm to nurture new growth sources and move away from the commoditized category, although investment will depress short-term profits and success is not guaranteed. Ajinomoto intends to pass on higher costs through renewals of some products in August. In contrast, we expect weakness in coffee sales to continue.

On the overseas consumer business, the troubled canned coffee business in Thailand has seen sales turn positive, and the price hike, driven by a 10% "sin tax" hike, was fully passed on, although a nearly double-digit decline in volume continues. Brazil posted an impressive 9% like-for-like growth rate thanks to solid sales of seasoning mix products. On the other hand, growth in Indonesia and Vietnam slowed to the low single digits. Fewer shipment days due to the extended Lebaran holidays in 2018 caused a slowdown in growth in Indonesia year on year, while price hikes implemented in Vietnam in May appear to have depressed sales volume. We expect growth in Indonesia to rebound in the second quarter but growth in Vietnam to pick up in the third quarter, given another round of price hikes in July.

The U.S. frozen food business, a growth driver in our assumption, continued to suffer from cost increases caused by production troubles in the new appetizer factory and posted a loss during the quarter. The third and last production line commenced operation in late June, and costs should fall along with improved production yields if operation of all three lines stabilizes. Furthermore, converting outsourcing of the Mexican foods to in-house manufacturing could lead to cost-cutting opportunities, although an increase in costs during the transition may depress the second-quarter profits. Still, we expect profits from U.S. frozen foods to recover from the second quarter. The firm also successfully passes on higher logistic costs to retailers, which should also be a positive to lift margins from the second quarter.