Description

Elevator Pitch:  Household & Personal Care (HPC) Company based in Japan with a diversified portfolio of premium brands, dominant positions in attractive categories (#1 or #2 player in most of its key categories in Japan) and growing exposure to large markets, such as China and Indonesia, where the Company has been very successful rolling out their premium diapers and sanitary napkins (Merries and Laurier, respectively).   We believe analysts are too conservative in modeling the potential for the Asia business and turnaround of the Beauty division in Japan, and they do not give the Company credit for any meaningful margin improvement beyond this year.  In addition, Kao has a clean balance sheet, shareholder friendly capital allocation policies and recently hinted at resuming M&A.  We think Kao can grow EPS 15%+ CAGR over the next three years vs. consensus expecting 7% p.a.,  which combined with a multiple rerating as investors better understand Kao’s growth potential and moats in Asia, yields close to a 3 year double.  Conversely, using 2018 consensus EPS of ¥281 (which at a minimum be augmented by buybacks and M&A) and a P/E of 18x (through was 14-15x in the midst of the 2009 crisis), yields a stock price close to today’s levels.

Market Stats: USD$13bn in sales; USD$24bn market capitalization; Net cash balance (5% of market cap); Div. yield: 2%

Diversified Consumer Product Portfolio – Kao operates under 3 segments:

• Human Health Care (18% of sales / 16% of OP) - Key products: baby diapers, sanitary napkins, toothpaste, facemasks, etc.

• Beauty Care (41% of sales / 30% of OP) - Key brands: Jergens, Biore, Molton & Brown, Kanebo, Sofina, etc.

• Fabric & Home Care (23% of sales / 48% of OP) - Key products: detergents, softeners, home cleaning products, etc.

Geographic exposure:  Japan represents 77% of sales and Asia 15% (was 12% two years ago).  After successfully entering China (2009), Kao is now expanding in Indonesia, Malaysia, Thailand and Vietnam.  

Investment Thesis

1. Kao’s Human Health Care business is levered to several secular growth drivers and has a long growth runway.  As the Company expands its premium baby care and sanitary products in Asia, where usage is low and Kao’s market share is still relatively low, we believe Kao can grow its Human Health Care sales at a 20%+ CAGR and continue to expand margins

• Kao is a structural share gainer in China, a market growing 20%+ a year:

• China, as many other markets, is transitioning from locally manufactured products to higher quality HPC products that are often imported.  These premium products are viewed as quasi-luxury goods and Japanese brands have been the primary beneficiaries of this shift.  Additional background on the diaper market in China: https://blog.abglobal.com/post/en/2016/07/emerging-market-game-changers-diaper-wars-in-china

• China is a ¥560bn+ market (2016 data) growing 20%+ CAGR.  Utilization and penetration levels are well below those of developed markets (consumption/capita 3x higher in the U.S. for instance), leaving the industry with a long runway for growth

• Kao grew its share in baby diapers from 5% in 2012 to 16% share in 2016. We believe it is one of the best positioned HPC companies to continue to grow in China

• The diaper market is moving towards premium/super premium products with higher ASP and margins.  These categories represent close to half of the market now and are dominated by Kao.

• Our diligence efforts confirmed that Kao boasts the best brand image, has the best products in the market and is the most innovative company in the space. Meanwhile, P&G and Unicharm continue to struggle, leaving the door open for Kao to continue to gain share.

• Kao’s diapers are primarily made in Japan and exported to China.  This adds cachet to the brand and allows Kao to command higher ASP.  Kao is essentially the price umbrella for the industry.

• Because Kao was a late entrant in China, it was not encumbered by legacy costs and distribution exclusively focused on traditional channels.  Instead, the Company focused on e-commerce (EC) right away, and EC is growing much faster than traditional channels.   We believe EC represents about 50% of Kao’s sales in China.

• Large opportunities in other Asian markets: In addition to China, Kao is growing in Indonesia (8% share in diapers already, a market it entered in 2012-2013 – Kao has been able to leverage its 35% share in sanitary napkins there and essentially cross sell baby diapers to the same customer), Thailand (27% share in sanitary napkins, they are now pushing diapers), Malaysia (19% share in sanitary napkins, small presence in diapers) and Vietnam.  Most of these markets have been dominated by Unicharm and P&G for years, leading us to believe that Kao has significant room to grow in these regions.

• Given Kao is lapping start-up investments in Asia and capacity additions in Japan, and the company will benefit from a favorable mix shift of higher overseas margins, we believe operating margin (OPM) should continue to expand. In addition, as Kao gains scale, we believe it will better utilize its production capacity

• Kao improved Human Health Care’s OPM from 8% in 2013 to 13% in 2015 (30% incremental margins).  Even if we assume more modest incremental margins over the next 3 year, we believe Kao can reach mid to high teen margins in this division. Analysts only model modest margin improvement going forward.  

• We think margins are ~4% in Asia currently due to growth investments and subscale presence in diapers in some regions.  However, normalized margins on diapers in China alone are 2-3x higher than those in Japan (we believe Kao’s margin on diapers in Japan are around 8%), suggesting significant margin opportunity ahead of the company as volumes continue to grow.

2. Kao’s Beauty Care business has been struggling since a product recall in 2012 and margins collapsed to 4% thanks to heavy losses in Cosmetics.  The Company has since done a full product relaunch, restructured the business and culled underperforming SKUs.  After 3 years of significant investments, sales growth has resumed and margins have already materially improved.  We believe a full turnaround provides meaningful upsides to out-year numbers

• Kao expanded its beauty business in 2006 with the acquisition of Kanebo. Unfortunately, one of Kanebo’s skin-whitening products had to be recalled in 2012 after 7k people reported skin depigmentation issues.  The brand struggled for several years and margins tanked to 4% due to heavy R&D and A&P investments to reformulate products and rebuild the brand.  After a full relaunch and good reception from consumers, sales growth picked up (+6% in 2016) and margins expanded from 5% to close to 10% in 2016.  While we don’t necessarily bank on Kao being able to match Kose’s OPM of 15%, for instance, we believe it can easily double its cosmetics margins (only 5% at the moment and management said investments in Cosmetics were completed – Cosmetics is about 40% of Beauty sales) and bring total Beauty OPM to 13%, from ~10% in 2016.

• Kose playbook – Starting in 2014, Kao embarked on a restructuring plan similar to the one Kose underwent in 2010 (rationalization of sales force and distribution network, cost initiatives to reduce fixed costs and fund advertising, SKU reduction and marketing and innovation efforts reallocated to the strongest brands).  Following their restructuring, Kose was able to increase margin from 9% to 15%.

Why does the opportunity exist and why now?

1. Kao is typically very conservative in terms of setting guidance.  This creates an opportunity as analysts tend to use management’s assumptions to model earnings and wait for a beat or guidance revision to update numbers. In addition, we believe analysts think about margins too linearly as supposed to using incremental margins

• As it is often the case with Japanese companies, Kao tends to guide very conservative.   For instance, they recently guided for 10% OPM in Cosmetics by 2020, but we believe they will get there within 2-3 years, and 10% OP for a decent Cosmetics business is a not a particularly heroic assumption to underwrite.  Kao also guided for overall OPM to reach 15% by 2020 and 17% by 2030.  If we are right on Cosmetics/Beauty and as Kao continues to execute in Asia, we believe they’ll reach 15% within 2-3 years and 17% within 5 years.  This implies only 22% incremental margins vs. 40% achieved between 2013-2016.  

• Despite Kao increasing their sales growth outlook from 3-4% to 5% and guiding OPM of 15% by 2020 (vs. 14%) under their new 3-year plan released in December, analysts still model 4% top-line growth and 14% OPM in 2020.  

2. 2016 was a difficult year for Kao in China. We think the situation has normalized and the set up for 2017 looks very attractive.  Our work suggests diaper volume in China could be up 50% this year, vs. 20% last year  

• While Kao couldn’t meet demand in China in 2015, several factors led to a temporary oversupply situation in 2016 that negatively impacted prices. As the Yen was rapidly strengthening, parallel importers (they make up about 25% of Kao’s sales in China) stocked up aggressively but stopped buying all together starting in May 2016, and started dumping their excess inventory in China.  In turn, Kao had to lower its official price and because Kao is the price setter for the industry, all the other premium players follow suit. In addition, Kao’s big e-commerce push late 2015/early 2016 cannibalized some grey market sales and compounded the inventory issue for parallel importers.  

• Our checks suggest that the inventory situation has normalized in China (which mgmt. confirmed) and both market share trends in Japan (50% of Merries sales in Japan end up in China) and ASP in China suggest that Kao is recovering nicely.   Interestingly, some analysts are of the view that China is a permanently impaired market.  We disagree with this view and actually believe that China is a profitable market for most players with scale (see comments made by KMB on their margins in China during their last earnings call)

• The Yen, which was a headwind through 2016, has significantly weakened and should help exporters like Kao

• We don’t believe Kimberly Clark, which has benefited from Kao’s woes last year and was also very aggressive on price, has any desire to wreck the market by implementing another round of price cuts.  Our understanding is that Kimberly follows Kao’s pricing and prices their premium diapers at a 20% discount to Kao and their super premiums at a slight discount.

3. The stock de-rated from 28x EPS to 20x due to the diaper slow down last year and recent rotation out of Japan staples.  Given Kao’s superior growth profile, potential in Asia, and ability to compound EPS by at least 15% a year organically, we believe the stock could meaningfully rerate.   PG, KMB and CL for instance are barely growing, and yet they trade at 19-22x EPS.

Historical Sales & Margin Trends and Assumptions (2017e-2019e)

• Beauty Care sales grew at a 3% CAGR between ’13-‘16* (+5% in ‘16 ex-currency) and Kao improved OPM from 4.2% to ~9% over the period (+400bps in ‘16 alone), or 72% incremental margins.  We think sales growth will accelerate to 4% p.a. over the next 3 years due to renewed growth in Cosmetics and expansion overseas.  We expect Cosmetics OPM to reach 10% by ‘19, and with modest margin improvements in the rest of the Beauty division, we expect segment OPM to reach 13% (40% incr. margins).    

• Human Health Care grew sales at a 45% CAGR between ‘13 and ‘15 and Kao improved OPM from 8.0% to 12.6% over the period (25% incremental margins).  We think Human Health care sales will be down -1% in 2016* (still positive ex-currency) and margins down as much as 300bps to 9.5-10% due to the issues discussed above.  However, we expect sales and margins to strongly rebound in ‘17 and continue to grow afterwards, and model a 15% sales CAGR between ‘16-‘19 (+18% in ‘17, including more favorable FX trends). Using incremental margins of 25% (again margins in 2017 should be up meaningfully on better volumes, growth in higher margin EC, some ASP recovery and easy comps), we expect OPM to reach 15% by ‘19.

• Fabric/home Care is the cash cow of the Company and we don’t expect the competitive landscape to change here.  While we believe sales growth should pick up as Kao is growing nicely in several Asian markets (+5% in 2016 ex-currency vs. +3% historically), we conservatively model sales growing at a 3% CAGR between ‘16-‘19, in-line with historical trends.  OPM improved by nearly 300bps to 22.8% (48% incremental margins) between ‘13-‘16 as Kao successfully introduced higher ASP products.  We model a more modest 20% incremental margins going forward and are not banking on any additional margin expansion in this segment.  We think this could be conservative.   

• Based on these assumptions, we believe overall OPM will be close to 15.5% by ‘19 (30% incremental margins vs. 40% between ‘13-‘16, which includes a down year in diapers), leading Kao to grow EBIT at a 12%+ CAGR.   This, combined with a declining tax rate and share buybacks, will drive EPS growth in excess of 15% p.a. over the next 3 years.  

*Kao has yet to report 4Q16/FY16 results but a Nikkei article suggests Kao will report FY16 EBIT of ~¥190bn (cons’s is at ¥187bn) so we used it as our starting base to model the next 3 years

Catalyst

Earnings