Kao Corp

TSE:4452

Earnings Call Analysis

Sales Growth and Margin Improvements Amid Challenges in Cosmetics

In the latest earnings call, the company reported a 5.7% increase in net sales, reaching JPY 1.19 trillion, with an operating income boost of 42.8% to JPY 101.1 billion. Operating margin recovered to 8.5%, while net income rose 41.5% to JPY 71 billion. The cosmetics division faced challenges, particularly in China, leading to a projected operating loss of JPY 3 billion for the year. However, other segments, like Health & Beauty Care and Chemicals, showed growth, with operating margins at 8.1% and 8.3%, respectively. Looking ahead, the company forecasts a total operating income of JPY 140 billion for fiscal 2024, driven by structural reforms and high-value products.

Solid Overall Performance Despite Regional Challenges

In the latest quarter, the company reported a net sales increase of 5.7%, reaching JPY 1.19 trillion, with an impressive operating income surge of 42.8%, translating to JPY 101.1 billion. This reflects a stable growth trajectory, although the company's cosmetics segment faces challenges, particularly in the Chinese market. Excluding the impact of currency fluctuations, the sales growth was a more modest 2.1%, indicating that the local market dynamics play a crucial role in revenue generation.

Operating Income Growth and Margin Improvement

The operating margin improved to 8.5%, up from 6.3% compared to the previous year's third quarter—a significant improvement of 2.2 percentage points. This growth in profitability is attributed to structural reforms and enhanced earning power across core brands. The significant increase in net income attributable to owners also rose 41.5% year-on-year, totaling JPY 71 billion.

Challenges in the Cosmetics Business

The cosmetics sector is under pressure, especially in China, where sales volume has significantly declined. The company has updated its forecasts to reflect this shift, now expecting an annual operating loss of JPY 3 billion in the cosmetics business, which had initially been projected to break even. This downward revision emphasizes the impact of external market conditions on profitability and reinforces the importance of effective inventory management.

Strong Performance in Key Segments

Despite the downturn in cosmetics, other business segments such as Fabric and Home Care thrived, achieving a 7.2% sales increase. The operating margin for this division rose to an impressive 17.8%. The health and beauty care sector contributed to overall sales; however, structural reform expenses, mainly in the Americas and Europe, impacted its operating margin, which was 8.1%. If not for these expenses, the margin would have been a stronger 9.3%.

Future Expectations and Strategic Initiatives

Looking forward, the company expects consolidated operating income for the fiscal year to reach approximately JPY 140 billion, indicating a JPY 25.3 billion increase from the previous year's JPY 114.7 billion. This projection is supported by anticipated structural reform effects of around JPY 28 billion. However, sales volumes are projected to decline due to weaknesses in the cosmetics sector, particularly from distribution inventory optimizations in China.

Global Strategy and Growth Initiatives

The company's Global Sharp Top strategy remains pivotal in enhancing its market position, particularly through high-value product offerings. The Bioré UV Care and ORIBE brands are making significant progress in establishing a market presence in the U.S. and Europe. Additionally, offerings like KANEBO are experiencing notable sales growth due to proactive product launches, which have increased sales in Japan by over 30%.

Final Thoughts and Investment Considerations

The company is clearly maneuvering through a challenging landscape with innovative strategies focused on structural reforms and high-value product enhancements. The significant profit margin improvements are reassuring for investors, but caution is warranted due to the uncertainties in the cosmetics segment, especially in China. Investors should keep an eye on the execution of strategic initiatives and market conditions as they could substantially influence future growth.

Earnings Call Transcript 2024-Q3

[Masakazu Negoro, executive]

Now please turn to Page 5 of the materials. These are the key highlights. To summarize the first 3 quarters of the fiscal year, I can say that K27 has progressed as planned. The effects of the structural reforms, which were our major target for fiscal 2024, have become clear and the competitive advantages of our core brands improved. By actively implementing capital efficiency improvement measures, ROIC improved by 4.9 percentage points year-on-year.

For structural reforms, we entrenched earning power improvement by shifting to manufacturing that enhances value. Also, we have achieved revitalization through measures such as speeding up decision-making with scrum type organization, and we have also seen the effects of career support.

In our core brands, we are continuing to expand the trend of improving profit margins and increasing market share at the same time. One example of this is our entry into the premium hair care market in Japan, launching THE ANSWER as a second new brand following melt. It has made a good start. This can also be said to be the result of our scrum type organization. We also upgraded our marketing methods, including using DX to visualize progress in establishing loyal users.

With these measures, we firmly established the foundations of our earning power, and we ramp up global rollout of high value-added products. That is a basic strategy of K27. Its focal areas include skin protection with 6 focal cosmetics brands, ORIBE products for hair salons in the Americas and Europe and the highly functional chemicals. I'd like to touch on the progress of these areas a little at the end.

In the Chemical Business, we are responding to market recovery with expansion of high value-added products and growing as we improved operating margin by 1.6 points. While overall progress is being made as planned, a negative factor is Cosmetics Business in China. Although China's share in the overall Cosmetics Business is small, as explained at the time of the interim earnings, the market conditions which we expected would recover from the second half now seem to continue to slow down, and we are optimizing distribution inventory in response to this.

Although transitory, fiscal 2024 Cosmetics Business operating income, which we previously forecast at the interim earnings to be breakeven has deteriorated by about JPY 3 billion since then. And we now expect an annual operating loss of about JPY 3 billion. Regarding the K27 priority target of improving capital efficiency, ROIC management is permeating. And at the end of the third quarter, ROIC improved by 4.9 points to 8.4%.

Next, please take a look at the highlights of the consolidated financial results on Page 6. Net sales increased by 5.7% to JPY 1,190,000,000,000. Excluding the impact of currency translation, net sales increased by 2.1%. The gross margin improved by 2.3 percentage points year-on-year to 38.6%. Operating income was JPY 101.1 billion. This was a year-on-year increase of 42.8% or JPY 30.3 billion. Operating margin recovered to 8.5%. Net income attributable to owners of the parent was JPY 71 billion, a year-on-year increase of 41.5% or JPY 20.8 billion. Basic earnings per share were JPY 152.85 per share, a significant increase of 41.5% year-on-year.

Next, Page 8. These are the key points of the Q3 year-to-date results. As a result of structural reform, the earning power improvement became more entrenched. And there were a transfer of businesses and the lower depreciation expenses as well as the effect of fixed cost reductions through career support, leading to an operating income of JPY 101.1 billion despite some increases in expenses. In Fabric and Home Care, by introducing new high-value-added products centered on core brands such as Attack, CuCute, and Magiclean, we improved our market share and achieved a 7.2% increase in net sales and our operating margin increased to 17.8%.

In the Sanitary Products Business, the gain on the transfer of business was recorded in the second quarter, but even excluding this, the business remained profitable as a result of structural reforms and improvements in earnings power. For Health and Beauty Care, in addition to incurring some structural reform costs for our European and American subsidiaries in the third quarter, we also actively invested in growth, particularly in the skin care and hair care. As a result, our operating margin went down by 2.5 percentage points year-on-year to 8.1%.

In the Chemical Business, in addition to the recovery of the market, efforts to add value to products such as tertiary amines and semiconductor chemicals contributed to an improvement in the operating margin by 1.6 points to 8.3%. Cosmetics sales grew by 3.1%, excluding China. But due to the impact of inventory optimization in China, the operating margin was down 3.6 points year-on-year to minus 4.6%. We will continue this inventory optimization in China in the fourth quarter, and we aim to normalize inventory by the end of the year.

Please turn to Page 9. This is the third quarter year-to-date net sales. Net sales for Consumer Products Business as a whole grew by 1.5%. But when looking at sales by region, Japan grew by 4% and Europe grew by 9.5% due to the addition of Bondi Sands sales and strong hair care sales, while sales in the Americas grew by 3.8%. Asia continued to see declining net sales, down 10.8%, mainly due to significant slowdown in China centered around cosmetics. Excluding China, Asia's total Consumer Products Business net sales were down 2.7% but profitability improved with operating income growing 25%.

In Japan, the Fabric and Home Care Business grew significantly, and the cosmetics and skin care businesses also performed well. In the Chemical Business, falling prices of natural fats and oils in the first half led to price revisions, resulting in sales growing by only 3.8%, but both volume and profits are growing steadily.

Next, please refer to the results by segment on Page 10. The operating margin for the Fabric and Home Care Business improved by 5.3 percentage points year-on-year to 17.8%. Sanitary's year-to-date operating income was up JPY 13.6 billion. This includes a JPY 4.3 billion gain on the transfer of the pet care business. Of the 1.5% increase in net sales for the Consumer Products Business as a whole, contribution from price increases was 2.1%.

The Hygiene and Living Care Business had a particularly large contribution of 4%. Also, consolidated operating income was JPY 101.1 billion, a significant increase of JPY 30.3 billion compared to the same period last year. The breakdown shows that the Hygiene and Living Care Business made a significant contribution. The operating margin improved by 2.2 points from 6.3% in the third quarter year-to-date last year to 8.5% this year.

Health and Beauty Care Business contributed to increased sales in terms of volume. Operating income was JPY 25.6 billion, down JPY 4.9 billion year-on-year. And the operating margin was 8.1% but this includes JPY 3.7 billion in structural reform expenses for subsidiaries in the Americas and Europe. Excluding structural reform expenses, the operating margin would be 9.3%.

In the Life Care Business, the transfer of beverage business in August generated a gain of JPY 6.3 billion. As a result, operating income was JPY 5.6 billion. Net sales for the Cosmetics Business was down by 3.7%. Although we made price revisions, the impact of the sales volume drop in China was significant and operating losses increased, resulting in a Q3 year-to-date operating loss of JPY 7.9 billion.

As mentioned, sales in the Chemical Business only increased by 3.8%, but due to an increase in volume and improved margins, operating margin improved by 1.6 points and operating income was up JPY 6.6 billion to JPY 25.1 billion. Please refer to Page 13 for analysis of change in operating income in Q3 year-to-date. The analysis shows a difference of JPY 30.3 billion between FY 2023 Q3 year-to-date core operating income and FY 2024 Q3 year-to-date operating income.

The effect of structural reforms, mainly the improvement of earning power in core brands, including selling price adjustments to promotion of high value-added products, made a significant contribution of JPY 25 billion. In the Chemical Business, gross margins also recovered due to a recovery in market conditions as well as price revisions through promotion of high value-added and differentiated products.

Specifically, raw material costs decline contributed by JPY 3 billion, and selling price revision that is mainly reflective of higher value-added products in H&BC and Cosmetics achieved contribution of JPY 20 billion. Furthermore, gross profit in Chemical improved by JPY 8 billion. Other cost of sales includes a decrease of about JPY 3.1 billion in amortization costs due to the impairment of Merries Japan and China as a result of structural reforms plus the TCR effect and some special career support.

The increase in SG&A expenses of JPY 12 billion consists of Bondi Sands joining the Kao Group that accounts for about 40%, marketing expenses by approximately 30%, and other costs such as personnel expenses. As for impact of currency translation, other incomes and expenses, although the transfer of business generated a large gain of JPY 10.6 billion, total resulted at JPY 4.8 billion due to one-off expenses such as JPY 3.7 billion in restructuring costs for European and U.S. subsidiaries and JPY 3 billion in land disposal and other costs.

Of the approximately JPY 25 billion of Q3 year-to-date effect of structural reforms, the earning power reform is included in selling price in this presentation deck while the fixed cost reduction benefits of Merries are included in other cost of sales.

Next, please refer to Page 14 for improvement of profit margin through progress of earning power reforms. The price revision due to promotion of high value-added products has progressed better than planned, mainly in Japan. The gross margin improved by 2.3 percentage points to 38.6% in the first 9 months of 2024 compared with 36.3% in the first 9 months of 2023.

Internally, more than ever before, business research, production, and sales are working together strongly to improve and monitor the marginal profit ratio for each and every brand. This has resulted in this improvement in the gross profit margin. Our sales activities through a sales company structure has also been strengthened by linking profit targets to remuneration as KPIs in addition to the introduction of a management system from this year.

Please refer to Page 15 for forecast of factors in operating income. The analysis shows a difference of JPY 25.3 billion between core operating income of JPY 114.7 billion in FY '23 and the forecast of JPY 140 billion for FY '24. Structural reform effects are expected to be around JPY 28 billion. The price of raw materials such as natural oils and fats and petrochemicals is expected to rise in the fourth quarter, but raw material prices are expected to be plus or minus 0 for the year.

On the other hand, the increase in selling prices due to promotion of high value-added products is expected to continue in the fourth quarter with a total annual increase of JPY 21.5 billion compared to the previous year. The overall sales volume is expected to be negative by JPY 4.5 billion. Consumer Products volumes are expected to grow by H&BC, but volumes are expected to decrease due to a slowdown in the Cosmetics Business in China and the optimization of distribution inventories.

In Chemicals, expanded facilities for tertiary amines, fragrances and others in Europe will start operating and contribute to profits. In addition, the gross profit margin is expected to improve by JPY 10.5 billion due to the promotion of high value-added products in functional products and information materials as well as further price revisions and volume increases.

Other cost of sales includes the effects of the structural reforms and others in FY '23. The increase in SG&A includes investments in marketing and personnel expenses with the aim to achieve growth, while marketing expenses are to be strengthened with a focus on the core brands of skin protection, cosmetics, and fabric care. In addition, we expect the expenses to increase by JPY 20 billion in anticipation of higher logistic costs and others.

Impact of currency translation, other income and expenses are expected to amount to JPY 4.8 billion in the third quarter and JPY 2 billion in the fourth quarter. As a result, operating income is expected to be JPY 140 billion.

Please now move to Page 16 for the raw material price outlook. In terms of raw material prices, although crude oil prices have stabilized at a lower level, an increase of JPY 3 billion is expected in the fourth quarter, mainly due to an increase in prices linked to the natural oils and fats market. The impact for the year is expected to be the same as last year.

Next is progress of Global Sharp Top strategy on the following 3 pages starting from Page 17. I would now like to share some of the progress of the Global Sharp Top strategy set out in the K27 strategy. Bioré UV Care, the core of the skin protection business is accelerating its global expansion centered on Kao's unique technologies. In Japan, we further promoted our high value-added proposals and achieved the #1 market share position for the fourth consecutive year.

In the United States where we are focusing our efforts, we are steadily making progress towards establishing the business by expanding a number of doors of brick-and-mortar stores. In the premium proposition of the hair care business, ORIBE is leveraging its brand power to grow its business in the U.S. and Europe, mainly through its own e-commerce.

The company has also started to generate positive results in manufacturing efforts through strong easy sales of a new product jointly developed by ORIBE brand and Kao. The KANEBO brand in the Cosmetics Business has increased sales in Japan by more than 30% through proactive new product launches. The brand is making steady progress towards global growth by strengthening cooperation between Japan and Asia, including the simultaneous launch of a new flagship beauty serum in autumn.

Next is hair care. The key point here is product development through DX, more sophisticated marketing and super-fast speed. A prime example of this approach is the first high-premium product, melt, which has more than doubled its market share with an increase in the number of sales channels since this autumn. The second product, THE ANSWER was also launched this autumn. The product is off to a good start with leading retailers and customers on word-of-mouth websites giving it a high score. At Kao Group as a whole, we continue to further improve marketing through DX and turn the hair care business into one of its growth drivers.

Finally, progress of Global Sharp Top strategy in Chemicals Business on Page 19. In oils and fats, sales of tertiary amines which are representative of the Global Sharp Top business are growing steadily in this inspection and cleaning applications with a 15% year-over-year increase in volume terms. In addition to the new plant in Germany, which came on stream last year, a further new facility in the U.S. is scheduled to start its operation in the middle of the next year.

We are also trying to expand sales of our agrochemical product, ADJUVANT in China. In the current year, sales have grown by 80% year-over-year although they are still not large in terms of scale. We expect further growth by signing a strategic partnership with the largest distributor in China.

In the area of Performance Chemicals, the group is working on developing standards for highly durable asphalt modifiers for adoption on public roads. At the same time, we are also strengthening our cooperation with local governments. Our initiative to utilize waste fishing nets, PET in Miyagi Prefecture, was highly regarded as an effective use of PET waste, which is difficult to process and was awarded the Minister of Economy, Trade and Industry prize. Through these initiatives, we expect further sales growth in the coming year.

In addition, the company maintains the top share of the market for foundry sand binders in Japan and Thailand and is also expanding into India, where sales are growing at 25% year-over-year. In the information materials, sales of semiconductor chemicals have recovered, and sales have increased significantly by 40% year-over-year due to increased demand for AI. Further sales growth is expected in the coming year as a result of the decision to adopt our new process chemicals. As for inkjet inks, expansion in industrial and commercial printing sectors in Europe is progressing steadily with sales growing by about 10%. This concludes my presentation.

[Statements in English on this transcript were spoken by an interpreter present on the live call.]