Company Reports

Narrow-moat Kose reported another robust quarter, with sales and operating profits up more than 7% and 27% year on year, respectively. Despite China and travel retail headwinds, growth in domestic sales and Tarte, a United States makeup brand, remained healthy in the second quarter. Yet, fear of a deteriorated China outlook and an absence of upward revision sent shares down 15% in two days. While comparison hurdles will become easier from the third quarter, management’s attempt to reduce excess inventory will depress shipment. Yet, we expect the company to revise up profit guidance on the back of rigorous cost control and solid domestic and Tarte sales.

Narrow-moat Kose’s robust first-quarter profit growth, with operating profits up more than 35% year on year, was a surprise. Despite ongoing China and travel retail headwinds, solid domestic recovery coupled with continued strength in Tarte, a US makeup brand, lifted the top line and profits, but growth was inflated by favorable currency movement and delayed timing of marketing spending. Our expectation that destocking in China’s retail channels and Hainan’s travel retail will end in the second quarter is unchanged. The results echo our view that Kose's prestige beauty strength, a key moat source, will shore up its profit growth and cash flow. We marginally adjusted our assumptions, which are largely offset by increased time value of money. We continue to view shares, trading at 30% discount to out fair value estimate of JPY 12,000, as undervalued. Our operating and net profit estimates for 2024 are 13% and 25%, respectively, above the guidance.

We reiterate our long-term view that Kose's prestige beauty strength, a key moat source, will shore up its profit growth and cash flow, although the greater-than-expected China headwinds have prompted us to cut our estimates. We have lowered our fair value estimate to JPY 12,000 from JPY 12,500. We welcome management's endeavors to correct China’s business model relying on discounting, specifically online, and focus on migrating consumers to its more premium lines. Management appears to have taken a more cautious stance on the profit guidance but given a business model of high operating leverage and thus high marginal profits, we believe margins will recover once inventory correction ends. We continue to view shares, trading at 32% discount to our new intrinsic value, as undervalued. Our operating profit for 2024 is 13% above the guidance.

Accelerating international growth, boosting unique product offerings, and expanding the business reach and customer base are three pillars of Kose’s growth strategies. The financial targets including JPY 500 billion in sales, 16% operating margin, and a 15% return on equity for the Vision 2026 midterm plan look challenging without acquisitions while uncertainties surrounding China present the greatest downside risk, in our view. Kose aims to raise overseas sales contribution to 50% from 43% and to generate at least 25% of sales from the e-commerce and travel retail channels by 2026.

Narrow-moat Kose's profit resilience, bolstered by the domestic strength, was a surprise. In contrast with Shiseido's profit slump and downward revision, Kose saw sales rise 6.2% year on year, with operating profits up 6.4% in the third quarter. Despite better-than-expected profits, the 40% decline in China's sales is largely in line with our projection. Given the greater impact of China's sales decline on profits in the fourth quarter, we have maintained our profit forecasts, in which our operating profit estimate is 5.5% above the 2023 guidance. As we noted in the recent initiation report, prestige cosmetics in Japan, the key source of Kose's moat, alongside the recovery of midprice cosmetics, will serve as a near-term growth driver and offset the weakness in China and travel retail. Despite our projection of a 36% decline in operating profits in the fourth quarter, a 27% upside to our fair value estimate of JPY 12,600 indicates limited downside risk and attractive valuations.

We initiate coverage of Kose, the third-largest Japanese cosmetics company by sales, with a fair value estimate of JPY 12,500, and assign it narrow moat and Medium Uncertainty ratings. Our fair value estimate implies a fiscal 2024 price/earnings of 30 times and enterprise value/EBITDA of 13.5 times, trading in line with the 10-year historical average and leading global peers. Rising uncertainty surrounding China and travel retail has triggered a sizable correction in its share price, sending shares to the bottom of the five-year trading range. While the daigou crackdown in Hainan and Chinese consumers’ boycott of Japanese brands might weigh on earnings through the first half of 2024, we deem the negatives to be temporary. Our projection of a more than 20% decline in operating profits in the second half of 2023 and the upside to our fair value estimate suggest the downside risk has been largely priced in. We reckon the dip creates opportunities to accumulate shares. Meanwhile, demand recovery of midprice cosmetics and the continued strength of prestige brands in Japan will serve as a key growth engine of near-term profits.

Accelerating international growth, boosting unique product offerings, and expanding the business reach and customer base are three pillars of Kose’s growth strategies. The financial targets including JPY 500 billion in sales, 16% operating margin, and a 15% return on equity for the Vision 2026 midterm plan look challenging without acquisitions while uncertainties surrounding China present the greatest downside risk, in our view. Kose aims to raise overseas sales contribution to 50% from 43% and to generate at least 25% of sales from the e-commerce and travel retail channels by 2026.