Getting Closer to our Strike Zone
Health Supplement player Blackmores (ASX:BKL) released a trading update this morning covering its cumulative nine-month (9M) performance for fiscal 2018 as well as its most salient updates. We have avoided providing a buy recommendation on the shares previously, given lofty valuations but we are revisiting the case as we believe that the shares are getting closer to our strike zone.
Recap and What’s New
It has been about 3 months since our last coverage of Blackmores (ASX:BKL) back in January (FAT-AUS-857) where we initially traffic lighted the company given the positive developments in the infant milk formula sector (FAT-AUS-816).
In that same report we also looked into the company’s background, product lines and the markets it serves. But more importantly we also covered its investment case and the key factors in the company’s favour which we believe has remained unchanged.
Starting the list is the (i) defensive nature of the stock and its products. Having been in operations for over 80 years is a mark of achievement in and of itself while also having a strong recurring revenue stream as customers most often purchase the same familiar supplements. Furthermore, this defensiveness will also be in its favour given the rising volatility in the market following the end of easy central-bank monetary policies.
Other factors include (ii) growing sales where despite being in an old and fragmented market, sales have grown circa 30% year-on-year over the last 4 years and are set to accelerate with the company’s entry to China. Next is the company’s (iii) extensive reach and diverse customer base having a global market covering Australasia, Asia, and the United States. Finally, the company’s (iv) expanding product line which is tailor fit to its respective market and supported by the company’s R&D and prudent acquisitions.
Following that Traffic Light report, we’ve been closely monitoring the developments in the company, including the Interim Results released in February which indicated that there have been some bumps in the road.
The 1H earnings result was disappointing as the company’s growth slowed down slightly as domestic sales fell 2%, though sales in China remained strong (+27.2% yoy), offsetting the declines with group level revenue up 9.3% year-on-year to $287.38 million. Net Profit After Tax growth was also slower than expected, up only 18.3% year-on-year to $33.33 million when the market was expecting and used to growth above 30%.
It didn’t help that the company, then, was trading at over 30 times Price-to-Earnings (P/E) given the high growth expectations. Growth stocks trading at a premium cannot afford to cast doubts on their ability to grow earnings – hence the significant (-14.73%) drop in the share price the day following its release.
All that said, this morning, the company provided a trading update, releasing its 3Q FY18 earnings results along with some salient updates which will be the focus of today’s report.
Acquisition of Catalent
Today, the company announced its acquisition of tablet and soft-gel manufacturer, Catalent Australia, for a consideration of A$43.2 million.
The acquisition is expected to be completed by 31 October 2019 and will be fully funded by debt. Note that the deal is not subject to any regulatory involvement which implies a quicker turnover. The facility is located in Braeside, Victoria and is pictured below:
Source: 24 April 2018 Company Filing
The manufacturing facility already provides circa 50% of the company’s manufacturing requirements and produces circa 3.6 billion soft-gel capsules per annum while also producing about 1.2 billion per annum solid dose tablets.
We like that this acquisition will strengthen the company’s supply chain as it allows full control over production giving it more flexibility in addressing the changing market conditions. This fact is more important given the company’s recent push towards expansion in Asia.
Its financial impact, though, is what we’re eager to look at deeper. According to management, the deal is expected to have a positive impact on earnings from year 1 while the debt amount of $43.2 million will not be too burdensome.
Given that the 3Q results do not include balance sheet data, we will take management’s word on the issue that this transaction is well within banking covenant limits. Then again, management has always been conservative with its approach to debt management so adverse issues stemming from this are unlikely in our view.
Brief Review of 9M FY18 Results
Moving on, the company also disclosed its cumulative 9M results for the fiscal year 2018. At a glance, it seems progress seems to have decelerated a tad as revenues for the 9M period were up 8.5% to $434.45 million with slower than expected sales in China, up 21% year-on-year to $102 million. Domestic sales though have started to recover, according to CEO Richard Henfrey.
The drag in China, though, was mainly due to ‘timing’ issues given current negotiations with suppliers in China. This has disrupted supply and seen adjustments to customer trading terms. Given that, management noted that the 4Q will be stronger. We will watch this space closely.
Source: 24 April 2018 Company Filing
Moving on to other parts of Asia, sales growth (in same currency terms) expanded 20% year-on-year as the company is making solid progress in Indonesia, South Korea, Taiwan and Hong-Kong.
Profitability was still reasonable during the nine-month period with net profit attributable to owners up 19.3% year-on-year to $51.57 million. Going forward, management maintained FY18 expectations and noted that supply constraints will have significantly improved by the 4Q to match the demand in China.
Summary
Overall, Blackmore’s reported decent, though admittedly slower, results in the 9M18 period. We are also encouraged by recent developments, with the company vertically integrating one of its major suppliers to address issues in the supply chain.
On the bigger picture side, we also find the company as a highly attractive addition to the portfolio, given the aforementioned strengths of its business and thematic appeal in Asia. However, for us to become more positive on Blackmores’ (ASX:BKL) shares (and thus transition it from a Traffic Light to a Buy), we would need to see more positive developments in China and in Asia, and also further moderation of the lofty valuation which is currently trading at circa 28.4x FY18 estimates versus the sector median of 18.7x.
Accordingly, we maintain our Traffic Light rating on Blackmores (ASX:BKL) and we will continue to monitor developments and look for an appropriate entry point.
