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Morningstar | Offshore Growth and Improving Distribution Segment Drive Breville’s Strong Fiscal 2018 Performance. See Updated Analyst Note from 16 Aug 2018

Narrow-moat-rated Breville delivered a strong fiscal 2018 result with underlying net profit up 9% to AUD 59 million, broadly in line with our expectations. Performance varied between segments, as the core global product segment (85% of group earnings) increased EBIT by just 1%, whereas the distribution segment, which distributes third-party designed products, increased EBIT by over 100%, albeit off a relatively small base. The board declared a final dividend of AUD 16.5 cents per share, taking the total for the year to AUD 33 cents per share (partially franked), an 8% increase on the prior year.

We’ve lifted our fair value estimate by AUD 1 per share to AUD 10 to reflect the time value of money, stronger sales growth in North America and the rest of world region, or ROW (a reflection of the increasing investment into marketing and research and development, or R&D), and a sustained margin recovery in the distribution segment. Despite the increase in our fair value estimate, shares in Breville remain overvalued. Breville shares currently trade at around 26 times fiscal 2019 EPS, which we believe assumes global product revenue and group earnings increase by almost 20% on average for at least the next five years. This is an unlikely outcome, given the high-single-digit earnings growth generated during the past three years on average. The market’s bullish assumption would imply that the company’s success in Europe exceeds that of North America, which took the better part of a decade to achieve. This is an overly aggressive view, given the extremely competitive European electronic appliance market.

We project global product revenue growth of around 10% per year during the next five years, which captures the additional return on the increased investment into marketing and R&D. Our estimates incorporate: (1) moderate mid-single-digit growth in Australia and New Zealand, given the maturity and competitive nature of this market; (2) around 10% annual growth in North America, underpinned by new product launches and expansion into new categories; and (3) a continuation of the current low- to midteens growth in ROW, which assumes a successful launch of the Sage brand in Germany, Austria, Benelux, Switzerland, and neighbouring countries.

Revenue in the core global product segment was strong during fiscal 2018, growing by 13% in constant currency, but the profit contribution was slightly disappointing. Global products’ EBIT margin contracted by 150 basis points to 13.9%. However, this is no cause for alarm, as this reflected increased marketing and R&D expenditure, along with the European expansion, which is still in its infant stage. This increased marketing and R&D expenditure is a key component of the ongoing acceleration program. Management is increasing marketing/R&D investment to 12% of sales, compared with 10.5% in fiscal 2018. While the additional marketing and R&D will constrain near-term margins, we still believe that in the long term, this strategy will pay off. The firm’s commitment to reinvestment into product innovation and its brand should drive continued market share gains, while allowing it to maintain its price premium (particularly in North America), and continue to support its narrow economic moat.

Within the global product segment, North America and ROW did most of the heavy lifting, growing by 16% and 11%, respectively. Whilst we had expected the continued strong performance in North America, the ROW performance was stronger than expected. While the company doesn’t separate out the regions within ROW, we believe Europe was the main driver, and management indicated it delivered around AUD 62 million in revenue, equivalent to around two thirds of the ROW revenue.

Whilst we had expected the distribution segment to improve, we were surprised at how quickly this has taken place. Distribution revenue fell by 8%, but EBIT margin more than doubled to 11%. This margin improvement exceeded our expectations and results from portfolio restructuring and efficiency gains. We believe the ongoing investment into cost efficiencies should allow the company to sustain margins at this level for the foreseeable future.