EUR 850.00 For Business Accounts Only

Morningstar | Unicharm's Growth Decelerates on High Hurdle; Fundamentals Remain Healthy

Narrow-moat Unicharm’s third-quarter results were largely in line with our expectations, with sales up 5.8% and core operating profits (gross profits less 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 2018 profit estimates marginally to reflect an expectation of increased marketing investment in the fourth quarter, but we leave our fair value estimate of JPY 3,500 unchanged as the reduced profits are offset by the impact of the time value of money. Our forecasts remain a touch above the guidance.

Unicharm's shares have corrected nearly 20% from the recent peak as a result of rising concerns about China/Asia growth caused by escalating U.S.-China tensions. While slower economic growth in the region may dent the company's near-term outlook, it does not alter our view that brand equity and entrenched retail relationships, the key moat sources, will sustain its long-term growth in Asia. Our fair value estimate holds 12% upside to the current share price.

As we had expected, management announced a repurchase program of up to JPY 15.5 billion, or 0.92% of outstanding shares, as a part of its targeted 50% return to shareholders. It is preparing to list its Indonesian subsidiary on the Indonesia Stock Exchange but will retain a controlling stake. While we do not see the need for equity financing, given plenty of cash sitting on the balance sheet, it appears that Unicharm intends to reduce its foreign exchange exposure to the volatile Indonesian rupiah and hopes that going public will raise its profile and facilitate recruiting.

While top-line growth has slowed after the impact of increased exports of premium baby diapers in China is cycled, improved profitability in China and Indonesia shored up the group’s profit growth. However, strong profit growth in Indonesia was largely attributable to a one-off tax refund. Despite accelerating input cost inflation, Unicharm managed to maintain the gross margin thanks to a favorable product mix with increased contribution of high-margin feminine care, led by growth in China and Indonesia. It appears that the ability to launch innovative products contributed to the strong growth.

On the other hand, increased ad spending, logistic costs, and other fixed expenses depressed operating margin by 40 basis points. Management has maintained its full-year guidance, implying a slight 2% decline in the core operating profits in the fourth quarter, as it plans to boost marketing investment ahead of the start of 2019.

Growth remained solid in China during the reported quarter, with 8% growth in sales and 28% growth in core profits in local currency terms. Product premiumization combined with new product launches and continued area expansion of feminine-care products was the key driver, posting more than 20% growth. The company's share in China’s feminine-care market has gained 1 percentage point year on year to 19%. Despite a high hurdle, growth in baby diapers including exports from Japan remained healthy, with nearly double-digit growth during the quarter. Imported diapers currently make up more than 60% baby diaper sales in China. In contrast, local baby diaper operations remain in the red, given the continuous volume decline. There seems to be no sign of a sales pickup in locally produced products.