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Morningstar | Hengan’s 2H 2018 Results Largely in Line With Margins Hit by Higher Paper Pulp Prices

No-moat Hengan International Group’s 2018 full-year results were largely in line with our forecasts, with revenue and net profit up 13.5% and 0.2% year on year, respectively, to CNY 20.5 billion and CNY 3.8 billion. Although revenue growth remained strong at 11% year on year in the second half, as we expected, its operating profit was down nearly 2 percentage points to 26.5% due to higher raw material costs. As a result, operating profit grew only 3% year on year in the second half.

We are keeping our fair value estimate unchanged at HKD 70 per share for now, but we will review our forecasts when we roll over our model. We also maintain our no-moat and stable trend ratings.

Despite the company improving its mix toward higher-end products through launching upgraded and repackaging products, gross margin deteriorated 3.6 percentage points year on year to 38.2%, which was lower than we anticipated. This was mainly attributable to the increasing wood pulp prices and product mix changes, with the lower-margin tissue paper sales growing faster than the high-margin sanitary napkins.

The tissue paper segment was still the largest revenue source of the company, accounting for nearly 50% of total sales, and remained robust in the second half, with revenue up 16.6% year on year. The upgraded products such as wet wipe series were popular in the market and posted strong growth. That said, wood pulp price increase weighted on its profitability, with the gross margin down 4 percentage points year on year to 22.5%.

Sanitary napkin sales increased 7.2% year on year in the second half and retained its leading position in the market. Hengan upgraded its products by rolling out super slim series, super long 420 night series, and sweet sleeping panty series. It also repackaged the products to meet the needs of consumers in different age groups. This segment was still the most profitable business for the company, and the segment gross margin improved slightly to 69%, as a result of increase in the high-end and upgrade products mix in the product portfolio to offset the impact of increasing petrochemical raw material costs.

However, the disposable diaper business worsened in the second half, with revenue down 19% year on year. Although the company expedited its sales on e-commerce platforms, the diaper business continued to suffer from strong competition from other e-commerce channels, which negatively affected the firm’s traditional sales channels. Sales through the e-commerce channel increase 10% year on year, which was around 35% of its total diaper sales.

Encouragingly, Hengan has managed its operating costs more effectively, thanks to effective implementation of its small sales operating model. The operating expense ratios were better than we projected, as the selling costs and administrative costs as percentage of sales improved 1.5 and 1.1 percentage points year on year, respectively, from the year-ago period to 10.6% and 6.1%.

We remain cautious on the company holding a large amount of cash while having substantial short-term debts without guiding for significant capital expenditure investment. The 2018 cash balance was CNY 21.6 billion, accounting for 47% of its total assets. Meanwhile, the short-term borrowings amounted for CNY 20 billion. We think the company should improve its financial health by redeeming its debts with its cash balance for the interests of all shareholders.