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Morningstar | Surprisingly Weak 1H for Blackmores; Downgrading FVE to AUD 105

Narrow-moat Blackmores’ share price fell heavily after the company reported soft first-half results and downgraded full-year guidance. Despite strong growth in volumes, which translated to an 11% increase in revenue to AUD 319 million, NPAT was flat at AUD 34 million. Flat first-half profit reflected higher costs from higher raw material prices, higher rebates in China relating to stock clearance and the changing channel mix, increased marketing spend particularly in China, and higher operating costs as the firm ramps up capability in Asia. While some issues may be temporary, there is risk that margins are being eroded by increasing competition, weaker consumer sentiment and strong distribution partners.

Management cited an even softer start to the second half in China and expects second-half profit to be lower than first half. We downgrade our fiscal 2019 NPAT forecast 16% to AUD 63 million, and also assume longer-term volume growth won’t generate the operating leverage we had previously factored in. Our fair value estimate falls 22% to AUD 105 per share. The stock screens as marginally undervalued.

Australian and New Zealand, or ANZ, sales rose 19% to AUD 144 million. This was driven by underlying growth of around 6% and the increasing trend of Australian retailers exporting Blackmores products to China. EBIT increased 28% to AUD 33 million, representing a margin of 23.1%, compared with 21.5% in the pcp. We see this as a good result in an increasingly competitive market, helped by new product launches and online sales growth.

Conversely, China revenue fell 11% to AUD 65 million and EBIT nearly halved to AUD 12 million, as the higher amount of sales to China through Australian retailers, which benefited the ANZ segment, dampened results here. Combining China with ANZ to look through the impact of indirect sales, we see revenue increased 8% while EBIT fell 4%, showing volumes continue to grow solidly but there is pressure on margins.

Management estimates underlying sales to Chinese customers increased 8%. This compares with 18% growth in the first quarter, suggesting second-quarter sales decelerated sharply. We believe this reflects general weakness in Chinese consumer sentiment, as well as company-specific issues stemming from a change in channel mix--that is, how the product gets to the end consumer. Management noted that it has pulled back on the number of export partners in the period due to heightened credit risk. At the same time, costs were higher because of rebates relating to clearance of ageing stock and channel mix, as well as higher marketing expense to drive sales and operating expense to ramp up capabilities. The firm is conducting a review of its China strategy to ensure resources are being optimised. Given the significant deterioration in EBIT margin, to 17.8% from 28.2% in the pcp, we’ve reduced our long run margin expectations.

Other Asia performed well with revenue up 34% to AUD 53 million and EBIT increasing to AUD 4.6 million from AUD 1.2 million, driven by strong volume growth in Korea, Taiwan, and Hong Kong. EBIT margin in this division was 8.6% in the half, up strongly from 3.1% in the pcp but still well below ANZ margins. We continue to expect margins in this division to improve as Blackmores gains scale in these markets.

BioCeuticals revenue increased 7% to AUD 57 million and EBIT increased 8% to AUD 8.5 million, with EBIT margin remaining relatively flat at 15%. This business faces headwinds from April 2019 as private health insurance rebates will no longer be available for a range of natural therapies including treatment from naturopaths.

Pleasingly, financial leverage remains conservative, allowing the firm to debt-fund organic expansion and bolt-on acquisitions, while maintaining a relatively high-dividend payout ratio. We forecast net debt/EBITDA of just 0.4 times in fiscal 2019.