Kao Earnings: Profit Dive Caused by Inventory Adjustment and Slow Demand but Worst Might Have Passed

Wide-moat Kao’s 4452 profit plunge in the first quarter was worse than our expectation, in part due to negative inventory movement of cosmetics and increased household stockpiling in Japan. Despite the ugly results, there are a couple of positive developments including a step-up of price hike endeavors and a strong start of new product launches. We have lowered our profit forecasts, mainly for 2023, by 12% to reflect the unexpected restructuring impacts of the cosmetics business. The adjustment is largely offset by increased time value of money, leaving an immaterial impact on our fair value estimate of JPY 7,800. The robust performance of recent product launches instills some confidence in new management that we anticipate Kao’s moat underpinned by its brand equity and product development capabilities will allow it to restore margins and return to a growth trajectory. We continue to view shares as undervalued, indicating 47% upside to our intrinsic value.

First-quarter sales rose 0.3% (3.8% declined currency neutral), while operating profits plummeted 68% year on year. Sales and profits of the consumer product business appear largely in line with the company’s internal targets, while chemical profits fell short due to high inventory at clients. Gross margin fell 335 basis points, although 90% of consumer product cost increases were offset by price hikes. Apart from sluggish demand for chemicals in the western markets, the inventory return of the phased-out cosmetic brands in Japan and inventory clearance of Free Plus skincare items in China before the brand renewal are attributable to the margin contraction. As we have stressed, cost pressure will persist through the first half, although Kao might have passed the worst of cost inflation. Encouragingly, Kao has raised the guidance of price hike benefits to JPY 25 billion, up from JPY 20 billion. It plans to further raise prices because it has become easier to persuade retailers to accept price hikes.