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Morningstar | Lowering Unicharm's Profit Outlook on Cost Inflation; China Growth Slowing and Shares Fairly Valued

Narrow-moat Unicharm’s fourth-quarter results came in a touch above its guidance and our expectation, with sales up 5.8% and core operating profits (gross profits minus selling, general, and administrative expense) up 3.1%. Growth decelerated from the pace of the first half mainly due to a high comparison hurdle resulting from increased exports of premium Japanese diapers to China from the last third quarter. We have lowered our profit estimates for the explicit forecast period by about 2% to reflect lowered gross margin assumptions as a result of increased costs but leave our fair value of JPY 3,500 unchanged as the reduced profits are largely offset by the increased time value of money. We view the shares as fairly valued with mere 2% upside. Our sales and profit forecasts remain a touch above company guidance.

Fourth-quarter sales grew 8% (organic growth excluding acquisition of DSG estimated at 4.6%) with operating profits down 4.5%. A drop in domestic and China profits is attributable to the profit decline during the quarter. Rising input and logistic costs combined with increased marketing spending for exported Moony diapers in China depressed domestic margins while inventory adjustment for China’s e-commerce channel turned the China business into a loss. It appears that sales of baby diapers including exports from Japan fell 5% compared with double-digit growth during the third quarter. It is unclear whether Unicharm’s growth has been hit by China’s economic slowdown as the undisclosed impact of inventory adjustment blurs visibility on fundamental growth.

Management is guiding to 6% growth (9% at constant foreign exchange) in the top line and 5% growth (7% at constant forex) in operating profits, slightly below our revised forecasts. Input cost inflation will continue through the first half of 2019 and may linger into the second half, depressing full-year profits by JPY 6.5 billion. Growth in healthcare including adult incontinence will lead domestic sales expansion, although guidance for 5%-10% growth looks optimistic to us. On the other hand, management is taking a cautious stance on growth in China and Indonesia, its largest overseas markets, with low- to mid-single-digit growth targets. Baby diapers remain a key to profits in these markets. It appears that Unicharm has not yet come up with a solution to curb the sales decline of locally produced diapers in China while competition remains fierce in Indonesia. On the other hand, sales of its feminine care and adult incontinence products remain healthy. The target of 5%-10% growth in Asia will be driven by India and consolidation of DSG.

To our surprise, management announced another round of a JPY 15 billion share buyback following the completion of a JPY 15.5 billion repurchase program in the third quarter. However, given that the repurchase period will be extended to 10 months as opposed to three months and the size is up to only 0.84% of outstanding shares, the impact on the share price could be limited. Unicharm also hiked the annual dividend by JPY 4 to JPY 28 per share, lifting the dividend payout ratio to 26% from 23%. We take the acceleration in dividend growth as a positive, although there is still ample room for raising the payout ratio.