EUR 850.00 For Business Accounts Only

Morningstar | Calbee's Overseas Margin Recovery Likely Delayed by the New Product Strategies. See Updated Analyst Note from 29 Nov 2018

We have lowered our fair value estimate of narrow-moat Calbee to JPY 4,100 from JPY 4,250 to reflect our more cautious view on its mid-term growth prospect of the overseas business. Margin recovery in the once-lucrative U.S. market was a key earnings driver behind our growth thesis. However, the company’s strategy to rely on new products, rather than the established brand, to accelerate top-line growth raises uncertainty around its earnings outlook. While we are convinced that Calbee’s dominant share and scale will allow the management to lift domestic margins through portfolio rationalization, enhanced marketing, and production efficiency as well as product invocations, we expect the efforts to correct the missteps in overseas strategies will take another year or two to bear fruit. Although we expect the company to revise down its guidance (our profit forecast for 2019 is about 5% below guidance), we see a decent 12% upside to our new fair value estimate, implying a price/earnings multiple of 29 times, about the middle of its historical trading range.

Our discussion with management has led us to believe that sales expansion of Harvest Snaps, its core better-for-you snacks brand, will be constrained by the company branding strategy. Management intends to retain Harvest Snaps’ unique brand positioning by offering the snacks in the produce sections, instead of the mainstream snack aisles, of the supermarkets. Thus, the strategy limits the shelf space available for Harvest Snaps because only some food retailers are able to accommodate Calbee’s policy. Moreover, the introduction of organic Harvest Snaps is exclusive at Costco due to limited availability of raw materials, which will allow Calbee to maintain but grow the sales volume as the organic products will replace the regular ones.

High fixed overhead resulting from low capacity utilization has been weighing on Calbee’s profits in the U.S. and Korea after it invested in second factories in both markets between 2015 and 2016. The production troubles taking place during the operation commencement of the new U.S. factory back in 2015 caused supply disruption, jeopardizing the relationship with retailers. Sales at key accounts dived as it failed to respond to the retailers’ requests for new products. As a result, sales failed to catch up the substantially added production capacity, leaving half of the capacity idled.

While the new U.S. management team manages to turn the business to breakeven by rigorous cost-cutting, it is unlikely to recuperate without a sizable volume growth to ease the overhead burden. Management plans to expand product offerings, specifically launching a new snack line, Popper Duos, to gain mainstream appeal to boost capacity utilization. Despite the fact that Calbee’s protein-based snacks are well positioned to appeal to the health-conscious millennial consumers, given a lack of track record in new product rollouts in the U.S. market, we expect expansion will take time as landing shelf space at the highly competitive snack aisles is costly and management has an urgent need to keep costs under control.

We have slashed our top-line growth of the U.S. market to an average 10% from a high-teens pace and reduced our margin assumptions to 13% from 16% by the end of the explicit forecast period given limited visibility to the sales outlook of coming new products and likely increased marketing investment in new product launches. The U.S. team is probing the possibility to bring its popular and distinguished Japanese products including Jagarico (potato sticks) and Frugra granola (renamed to Medley) into the U.S. market after obtaining the test marketing results.

Additionally, we have also lowered China’s sales growth rate to high-teens from low-20s to reflect an altered strategy to place more emphasis on the online sales channel and be more selective on distribution at the brick-and-mortar stores for the granola products. We have also trimmed our margin assumption for Korea, the other overseas market with the issue of excess production capacity, because Calbee is still struggling to come up with solutions to deter sales decline. Given that sales in Korea remain relatively sizable, Calbee may not withdraw from the market although the high fixed overhead is likely to keep the business in the red.