Description

If you’re still kicking yourself for everything you missed last March, here’s one you didn’t.  A covid impacted stock in a not particularly covid impacted country trading at last year’s low.  Low volatility branded staples business, cash rich balance sheet. 

Not surprising for Japan, we are dealing with limited disclosure.

Morinaga is a food products company in Japan founded in 1899. It is probably best known for its Hi-Chew fruit flavored chewy candies, which you can easily find in stores in the U.S. Confectionary & Foodstuffs is about 60% of revenue and also includes chocolates, such as Chocoball and Dars Milk Chocolate, and biscuits (cookies).  You’d know them if you were Japanese.

Frozen Desserts (e.g. ice cream) and Health Products (e.g. squeezable energy, vitamin, mineral, protein packets) are each about 20% of revenue.

Food Merchandise and Real Estate & Services are together about 4% of revenue.

Investment Thesis: The investment case here is fairly simple. We believe COVID19 is the only material reason for the decline in operating profit, and thus feel that it is largely a temporary setback and not a permanent loss of business. The stock has been bouncing around spring of 2020 levels, indicating the market’s unwillingness to anticipate improvement or its belief that something structural and more permanent has changed. Using a recovery EBIT of JPY22, and a pre-COVID EV/EBIT multiple average of 10x, we estimate the stock has 40% upside to about JPY5,400 per share. If we exclude the JPY31B in LT securities, then the price target would be about JPY4,800 per share, or about 25% upside.

In addition, capital investment has significantly increased for the fiscal year just ended. In the past, when they had elevated capital investment, margins expanded in the following years. Note that this potential is not explicitly baked into our valuation. Appendix 1 contains our income statement.

Risks to Investment Thesis: This could be a value trap if EBIT hovers in the JPY18B range, but it seems hard to lose a lot of money here. In other words, something secular could be hiding behind the COVID19 impact such that a post-pandemic world doesn’t lead to improved EBIT. Some Street analysts model FY22 to be down further due to higher depreciation from new plants coming online. They must believe additional sales and operating profit do not outweigh higher depreciation in the first year. We also note that many of the company’s products have been around for a very long time. We wonder how much innovation has (or has not) played a role in the product portfolio. This could be a risk or an opportunity. See Appendix 2.

Three Year Plan: The most recent three year plan (“medium term plan”) covered FY19 to FY21 ending March. The plan called for about 2.5% revenue growth and about 5% EBIT growth each year. That woud have put revenue and EBIT at JPY220B and JPY22B, respectively, in the year just ended in March 2021. But guidance was lowered at the start of COVID, as one might have expected. Much of the products they sell are convenience store items, so the reduction in activiy outside the home due to COVID19 impacted them. Thus, EBIT is instead expected to be about JPY18B for FY21. The following slide mentions three things: COVID, the end of the Indonesian JV and the end of a distribution agreement with Pringles.

It appears that the Indonesian JV ended in January 2019. So that shouldn’t affect FY21. The Pringles agreement ended in March 2020. It is unclear if they were distributing Pringles products or if Pringles was distributing Morinaga products. The one clue that makes us think it was the former is that it is discussed in the context of domestic sales. In the operating income bridge (see below) from FY20 to FY21, the footnote says “the impact from the Pringles distributorship agreement… is shown in both “Product Mix, Etc.” and “Decrease in other SG&A Expenses.” These items are positive contributors to operating income. So unless the Pringles agreement is also included in the “Decrease in Net Sales” line, the biggest negative impact to EBIT, the end of the agreement might actually be a positive impact to operating income. See below.

Thus, we conclude that the majority (if not all) of the operating income decline expected for FY21 (March) is due to COVID-19, which we tend to think is not a fully permanent impact.

COVID-19 Impact:

Balance sheet and cash flow: Morinaga has over JPY29B of cash and JPY31B of LT Securities. Debt was JPY10B. Excluding the elevated capital spending, FCF approximates net income. In terms of cash use, the dividend is about JPY3.6B, and they did a repurchase of JPY8.5B in FY19.

Geography and Customers: Overseas sales are a small part of the business. Domestic sales are about 95% of the Food Manufacturing revenue, which is 96% of total revenue. More than 90% of PPE is in Japan. The company discloses that the top two customers (likely wholesale distribution) represent 22% of revenue: Mitsubishi Shokuhin Co., Ltd. (12%) and Marubeni Corp. (10%). We note that overseas growth is a large part of the longer-term growth plans, and as such, the elevated investment may be earmarked for overseas sales.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update or revise such information at a later date. The author may hold a position in the securities discussed.

Appendix 1: Income Statement:

Appendix 2: Product History (“Mainstay Brands”)

Catalyst

Post covid normalization