Kao Likely to Miss Profit Guidance but Cosmetics Strength Indicates Good Restructuring Progress

Wide-moat Kao posted mixed third-quarter results. The profit weakness spotted in the household and toiletry categories, in part caused by greater-than-expected cost inflation, was a key negative while its outperformance in the cosmetics segment was a positive surprise. As expected, the coronavirus surge in Japan and Southeast Asia, apart from cost inflation, was a key drag on third-quarter performance with sales up 2.3% year on year but operating profits down 16.5%. We have reduced our profit forecasts for mainly 2021 and 2022 by around 5% to reflect higher costs, JPY 4 billion or 50% above 2021 guidance. Despite the profit shortfall, we remain positive about Kao’s progress in brand reorganization and operation restructuring of consumer products including cosmetics and thus its long-term outlook. A strong rebound in its market share of the bathtub cleaner category, followed by the launch of value-added products (Airjet), again demonstrates Kao’s research and development capability, a key moat source behind our wide moat rating. While cost inflation and the coronavirus might continue to weigh on Kao’s profits into 2022, we expect double-digit growth once these external negatives dissipate. Our profit adjustments are largely offset by increased time value of money, leaving an immaterial impact on our fair value estimate of JPY 8,700, implying a handsome 33% upside to the current share price.