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Morningstar | Launching Coverage of Yakult Honsha With Narrow Moat and Stable Moat Trend Ratings, FVE of JPY 8,000

We initiate coverage of Yakult with a fair value estimate of JPY 8,000, and assign it narrow moat and stable moat trend ratings. The stock is trading at a 2% discount to our fair value estimate, while our earnings forecasts are 4%-7% below consensus over the next three years. Our cautious view on domestic margin expansion is responsible for the earnings gap. In contrast, we are optimistic about Yakult's rosy growth prospects in Asia, particularly China, where rising penetration combined with geographic expansion should sustain double-digit growth. We suggest investors wait for a greater margin of safety to accumulate shares in this high-quality name with a strong footprint in highly populated emerging markets. Our fair value estimate implies fiscal 2019 price/earnings of 33 times and enterprise value/EBITDA of 16 times, trading toward its historical average

We think the probiotic beverage business has a narrow moat underpinned by intangible assets, including a trusted brand name backed by consistent investment in probiotics and a crew of 81,000 Yakult Ladies. These sales ladies act as the brand’s ambassadors to promote its proprietary bacteria and communicate the products’ health benefits directly to customers. The moat trend is stable because we expect Yakult will continue to convey the value of probiotics and its products to consumers through investment in research and development, or R&D, and marketing activities, including Yakult Ladies, to sustain its intangible assets.

We project a 10% EPS CAGR over the next five years on the premise that the lucrative overseas food business, led by a double-digit growth in Asia, will drive margin expansion and fuel profit growth. Area expansion and increasing penetration in the existing markets, the two wheels of growth, will serve as a volume driver not only in China, but potentially also in India and Vietnam. While we expect that increased premium offerings will lift domestic margins, we find the target of raising operating profits by nearly 50% over a span of three years, mainly through top-line growth, to be challenging.

Yakult is trading largely in line with our fair value estimate of JPY 8,000 with merely 2% upside after the recent rebound. Danone’s divestiture, lowering its stake from 20% to 6.2%, triggered a more than 20% correction from the near-term peak, causing a slight underperformance relative to the Topix Food Index over the past six months. As the valuation premium is shored up by the healthy growth outlook in Asia, overseas volume growth, particularly in China, will remain a key driver behind the short-term share volatility.