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Morningstar | Revising Down Profit Forecasts After 1Q Weakness; Shares Remain Attractive. See Updated Analyst Note from 08 Aug 2018

We have revised our profit forecasts downward by 3%-5% for 2018 onward following Meiji’s disappointing first-quarter results. Sales fell 1% (reported negative 1.6% including the impacts of revision of trade terms), while operating profits plunged 19% from weakness in the moaty food business, in part due to hot weather. While management retains its full-year guidance, the second-half targets look challenging. As hot weather is likely to continue depressing demand for dairy and chocolate products through the second quarter, we expect Meiji to revise down its full-year guidance. We have lowered our fair value estimate to JPY 9,900 from JPY 10,300, implying 27% upside, but maintain our narrow moat and stable moat trend ratings. Our current operating profit forecasts are 5% below consensus and 14% below the company’s 2020 target of JPY 125 billion.

While we agree with management’s strategy to focus on profitability and avoid using pricing to drive short-term sales, the decline in sales volume has dampened its margins and profits when there is limited room for cost-cutting. The firm hopes that new product launches will boost sales in the second half. We expect it to leverage its strengths in product development and marketing innovation to counter price competition and regain share.

Weakness in the lucrative probiotics yogurt and chocolate sales, coupled with the impact of NHI price revision of drugs, led to a double-digit profit decline. Gross margins fell 110 basis points due to a deteriorated product mix, in addition to price cuts in drugs and loss of royalty income, although lowered input costs and price hikes of Bulgaria yogurt contributed about a 20-basis-point increase in gross margins. Thus, we have lowered our food sales growth and gross margin assumptions. While the revision of trade terms depressed confectionery sales by 7%, it did not affect profits, as volume rebates booked as part of marketing expense are removed directly from the top line.

We think the main causes of the soft food sales in the first quarter were 1) a lack of new products; 2) hot weather; 3) increased price competition; and 4) soft convenience-store sales. It appears that Meiji intends to avoid price competition and thus does not aggressively increase its sales at the drug store channel, where retailers often use processed food products as a loss leader to lure customers. Instead, it focuses on product categories, such as infant formula and sports nutrition, to avoid price competition. However, such a strategy is likely to depress its short-term sales and profit growth. The company will need to keep up new product rollout to lift sales, but striking a balance between sales growth driven by products and marketing investment to optimize its profits will be a challenge facing management when there is little leeway for cost-cutting.

The pharmaceutical business, on the other hand, posted solid 5% sales growth, despite the negative impact of the drug price cut, which lowered sales by about 8%. The pharmaceutical business apparently achieved profit growth if we exclude the loss of royalties earned in the previous first quarter. It appears that cost reduction in raw materials and healthy sales of its new brand-name drugs helped offset the negative impact of the drug price cut. Given health growth in new drugs and generic drugs overseas, profits of the pharmaceutical business will likely beat the target and offset some shortfall in the food business.