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Morningstar | Want Want’s 2018 Earnings Fueled by Gross Margin Expansion; Shares Undervalued to Our HKD 6.60 FVE. See Updated Analyst Note from 19 Jun 2019

Narrow-moat Want Want China Holdings’ fiscal 2018 earnings (ended in March 2019) were slightly higher than our forecast, mainly owing to better-than-expected gross margins. We are raising our fair value estimate slightly to HKD 6.60 per share from HKD 6.40, as we revise up our gross margin assumptions on the prospects of lower production costs and better product mix, but partly offset by a lower revenue growth forecast and a slightly weaker Renminbi.

We consider the shares undervalued at current levels, as we think the market has underestimated the company’s capability to generate stable cash flow. Also, the company was able to improve its profitability and increase its cash dividend payout ratios to roughly 80% for the past two years. Although we expect only modest sales growth of 4.3% for the next five years, we think the implementation of prudent multibrand strategies, including offering a channel-specific product mix, will lower the risk of conflict with traditional distributors and avoid price wars with competitors.

Fiscal 2018 revenue growth of 2.8% was slightly lower than our 4.3% forecast, mainly due to sluggish volume growth in the second half (October to March). While the sales growth from the rice crackers and snack foods segments were largely in line, the biggest disappointment came from the dairy and beverages business, growing at 1.6% versus our 4.5% growth projection, as it appears the flavored milk drink “Hot Kid” is losing popularity in the high-tier regions amid intensifying competition in the dairy market.

However, higher selling prices and lower raw material costs, particularly in sugar and palm oil, helped boost gross profit by 9.2%. The gross margin jumped 3.9 percentage points in the second half and the full-year gross margin was up 2.7 percentage points from last year to 45.4%, also much higher than our 43.7% forecast. We believe the margin expansion will be sustainable and expect the margin continue to further advance to an average of 46% over the next five years due to mix shifting toward higher-end products and the positive effect of economies of scale, while the raw materials costs stabilizing.

Operating expenses as a percentage of sales, up 30 basis points year on year to 25.7%, was in line with our projection. This was mainly due to salary increases and higher logistics costs. In order to drive business growth and lower dependence on the traditional distribution network, the company will allocate more resources to developing its emerging sales channels, but will keep cost ratios stable. Operating profit grew 9.4% year on year and the operating margin increased 1.3 percentage points to 22.1%, higher than our 20.5% forecast. Overall operating performance was decent with profits dampened by non-operating factors such as lower government subsidies and foreign exchange losses.