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Morningstar | Calbee Has Disappointing 2Q Results, but Some Positive Development Into 2019; Shares Undervalued

Narrow-moat Calbee’s second-quarter results fell short of our expectations and its internal targets with sales down 4% (like-for-like 1% excluding the impact of divestiture of the domestic bakery business) and operating profits down nearly 14% resulting from sluggish domestic granola sales and lackluster U.S. growth. While management has maintained its full-year guidance, we have lowered our profit forecasts of the explicit forecast period by 5%-7% to reflect slower margin expansion. We accordingly reduced our fair value estimate to JPY 4,250 from JPY 4,350 after taking the increased time value of money into consideration.

The shares have corrected 15% after the disappointing first-quarter results and concerns over tough comparison continues weighing on the shares. Despite a gloomy outlook for the rest of 2018, the moaty domestic potato snacks continues to hold up and we expect profit growth to pick up after efforts of new product introduction start kicking in in the overseas markets. The stock offers an attractive 24% upside to our fair value estimate and we consider a limited downside at the current level as the share price is approaching our bear-case scenario.

A sizable increase in selling and administrative expenses depressed operating margins by more than 300 basis points, wiping out all growth lifted by a more-than 210-basis-point expansion in the gross margin during the second quarter. Apart from normalized domestic selling expenses, the sales shortfall combined with increased costs in part caused by typhoons and floods in the Western Japan is responsible for the cost increase. While a solid growth in China’s granola sales may be able to offset the weakness of the domestic granola and a delayed recovery in North America, we do not think that Calbee will be able to reverse the profit shortfall given increased marketing spend in China for boosting sales volume after the new Kyoto factory commenced operations in August 2018.

Frugra (granola) sales more than doubled in China during the second quarter as the company continues expanding distribution through domestic online channel including T-mall and JD’s websites as well as brick-and-mortar stores. The company is hoping that the increased volume will help boost factory utilization and thus lower the production costs to cover increase marketing costs and lift profits in 2019.

In contrast, sales in North America remained slow, rising 5% during the second quarter. It appears the new, organic Harvest Snaps have been introduced to half of Costco stores, its largest customer, and the feedback from consumers seems positive. The company expects to introduce the organic products to at least another 40% of the Costco stores during the second half. With introduction of another two new flavors and the new Propper Duos line, we anticipate sales in North America to pick up in 2019.

Management shed some light on its next midterm plan starting from 2019. In addition to lifting the domestic operating margins to 15% from 13% by leveraging new technologies to enhance productivity, management also considers rationalizing its domestic product portfolio and revising prices of products. We take it as a positive that the company is taking a more aggressive approach to pricing issues. It also mentioned the possibility of working closely with PepsiCo in Asia, especially China. Calbee’s operation in Japan may be able to offer support to PepsiCo to reduce the business risks in the China market amid tension between China and the U.S. This development may deepen the ties between the two firms and lead to new opportunities in China or North America.