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Morningstar | Yakult 2Q Profits Better Than Expected; Slow in China's 3Q Growth due to One-off Capital Expenditure

Narrow-moat Yakult beat its first-half guidance as expected but profits came in slightly above our expectation, boosted by a solid growth in the moaty probiotic drinks in China. The results echo our thesis that a double-digit growth in Asia led by China will sustain Yakult’s mid-term growth. We have raised our operating profit forecasts by about 2% following a 3% upward revision in its full-year guidance on the back of better-than-expected profits in the first half and adverse currency movement in the second half. We have accordingly lifted our fair value estimate to JPY 8,300 from JPY 8,000 after incorporating new operating profit estimates and a JPY 1.6 billion gain on sale of investment securities as well as increased time value of money.

As we have highlighted in our initiation report, its China volume growth often drives the shares’ short-term volatility. It appears that a substantial slowdown in China’s volume growth, down to 3% on a preliminary basis in the third quarter from 17% of the previous quarter, is responsible for a more than 4% plunge in Yakult’s shares after the announcement during trading hours. We deem the slowdown a one-off issue which does not alter our long-term view that Yakult’s brand equity and a direct-to-consumer business model, supported by more than 80,000 Yakult ladies, will sustain its competitive edge in probiotic drinks.

Gross margins widened 20 basis points thanks to price hikes in China and Mexico. The 7.5% growth in operating profits was lifted by a nearly 45% growth in Asia. Operating margins of the Asia region soared to 31.5% or expanded more than 500 basis points year on year, thanks to a more than 26% growth in China including a 9% price hike in the areas representing more than 60% of its volume sales. The number of stores carrying Yakult products increased by more than 16% from the end of 2017.

Volume growth in Indonesia and Mexico remain healthy but continue to slide in Brazil, in part caused by a sluggish economy in addition to price hikes. It has achieved a 8.6% volume growth in Indonesia by the third quarter and added 800 or a nearly 10% increase in Yakult Ladies, a key driving force in Indonesia, over the past 12 months.

On the other hand, growth momentum of the domestic probiotic drinks continues to slow. Volume declined 1.4% during the quarter compared with a 3.5% posted in 2017 and the guidance of a 2% growth. Management believes that volume growth was hurt by the heat waves as the weather became challenging for Yakult Ladies’ operation. The typhoons and flood also disrupted its supply chain. Nevertheless, we remain wary of the company’s optimistic outlook of the domestic food business as we see limited room for volume growth without large-scale new product launches.

The deceleration in China’s volume growth during the third quarter was mainly caused by the capped production capacity as demand of the July-September quarter, the peak of a year, has exceeded Yakult’s current capacity after a 20% volume growth in 2017. While management was fully aware of the issue and intended to reduce impacts by increasing production before the peak season and on weekends, it failed to adjust production to secure sufficient volume and had to halt the marketing activities as well as sales activities to new customers, which along with typhoons in Southern China and production interruption depressed growth in August and September. It appears that October volume was also depressed by the typhoon and halted marketing activities. However, the issue of capacity shortage will be resolved in next spring when it will add a maximum 30% production capacity or 3.2 million bottles a day by next summer compared with the current maximum capacity of 9.8 million bottles if factories operate six days a week.