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Morningstar | Meiji Posting Another Quarter of Solid Growth; Shares Undervalued

Narrow-moat Meiji posted another quarter of solid growth, beating our expectations, thanks to rigorous cost control and contribution of newly consolidated KM Biology. Meiji seems on track to meet its profit guidance although the size of inventory return of influenza vaccines remains a swing factor of the fourth-quarter profits. Despite the recent weakness in its probiotic yogurt sales, we expect the company will leverage its product development and marketing capabilities as well as brand equity to restore growth over the mid-term. This include the roll out of new products with novel concepts. We have made minor adjustments in our profit forecasts which have marginal impacts on our fair value of JPY 10,000, implying an attractive 20% upside.

Reported sales grew 4% (estimated 0.7% excluding the impacts of KMB consolidation and revision of trade terms) with profits up 32% (like-for-like 22%). Despite from a low base, overseas sales growth accelerated to 20-plus% with profits nearly doubled. Growth in China remains healthy, led by a 32% growth in confectionaries. It has introduced the Hello Panda crackers to Costco in North America with a large-scale promotion event. Sales of domestic confectionary continue to improve, with sales turning nearly flat year on year during the quarter. On the other hand, sales decline in the lucrative probiotic yogurt widened to more than 6%. Yet, management indicated the spread of flu has led to a pick-up in R1 sales in the recent month. Given increasing offerings of rival products emphasizing the same concept of immunity enhancement as R1, we do not expect the category will return to a growth path until the roll-out of the new line, most likely in 2020.

While a deteriorated product mix depressed the food gross margin, a sizable cut in marketing spend and overhead, along with increased sales of influenza vaccines, restrained the increase in selling and administrative expenses, lifting the operating margin by 225 basis points. It has slashed advertisement spend for confectionaries particularly after shifting to online ads from TV commercials along with changing behavior of target consumers, usually the millennials and generation Z. We have factored in limited cost reductions in 2019 given management’s plan to add new products to boost top-line growth but do not expect profit growth to accelerate until 2020. Input costs are likely to remain stable by the first half of 2019. Unlike most of its food peers hitting hard by the surging logistic costs, impacts on Meiji is relatively minor thanks to the efforts of integrating distribution centers over the past three years. Yet, the growing costs is likely to remain a drag on profits.

Meiji has announced another round of price hikes on dairy products including all the milk (by 1.5-3.5%), yogurt (by 4%), and probiotic (by 2.3%) to reflect an 3.5-4.5% cost increase in fresh raw milk in addition to rising logistic and labor costs. While the other key national-brand players including Morinaga and Snow Brand have followed suit, given that retailers often use milk as a loss leader to lure customers and the private label products own a sizable share, we expect a drop in volume of commoditized products.

The pharmaceutical business saw a 4.5% like-for-like sales growth albeit the negative impact of the drug price cut which lowered sales by about 7%. Operating profits are more than doubled as a result of a delay in R&D spending into the fourth quarter and inventory revaluation which is expected to be reversed in the first half of 2019. The size of inventory return of influenza vaccines, usually taken place in the fourth quarter, may greatly affect the profit result.