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Morningstar | Weakness in Probiotics Caused Meiji's Profit Miss; Share Price Reflects Market's Low Expectation

Narrow-moat Meiji’s fourth-quarter results fell short of its guidance and our expectation due to underperformance of the moaty food business. The newly announced 2019 guidance, indicating an 8% growth in operating profits, is above our forecasts of flat profits. We have maintained our forecasts given that the company has not factored in any impact of a drug price cut that should be announced by the government during the summer. We continue to find that the midterm profit target of JPY 125 billion for the three-year period ended in 2020, about 15% above our forecasts, looks challenging. However, the weakness seems to have been priced in. The shares remain undervalued, presenting an attractive 22% return to our fair value estimate target of JPY 10,000 after we take concerns over the pharmaceutical profitability into consideration and factored in a low-single-digit growth in profits beyond 2021.

Fourth-quarter sales were nearly flat while operating profits fell nearly 17%. Despite a 3% growth in food profits, the shortfall was attributable to continued weakness in the lucrative probiotic sales that saw a nearly 6% decline during the quarter. On the other hand, sales of the high-margin functional chocolate products, Cacao Kouka (meaning effect in Japanese), advanced more than 40%. China also continued 20%-plus top-line growth. Gross margins contracted by more than 110 basis points as a result of deteriorated mix in addition to rising input costs. The expected inventory return of influenza vaccine also hurt product mix, causing a loss in the pharmaceutical business during the quarter.

The guidance of a 4.4% growth in the top line and nearly 10% growth in operating profits is led by price hikes of the food business and reduced goodwill amortization and reduced one-off expenses associated with the acquisition of KM Biologics, in addition to sales growth. Meiji has written down the goodwill of its India subsidiary Medreich by JPY 11 billion to reflect sluggish sales in the U.K. A more than 40% increase in food capital expenditure in 2019, mostly for the domestic new production lines, combined with increase marketing investment, will offset the benefit of price hikes.

While the company seems to have priced in a 4% decline in milk and yogurt products, the target of 3.2% growth in food sales seems somewhat aggressive. While the company recently obtained the functional food certification for its PA3 probiotic yogurt that can help reduce uric acids, the authorization is unlikely to have a material impact on probiotic sales. It will need another innovative product getting at a wider customer base to regain growth momentum. Additionally, the company has not yet factored in the impacts of a drug price cut that is scheduled for October 2019 along the tax hike. We intend to revisit our estimates after achieving better visibility of the impacts of price hikes on sales volume.