China Flavors & Fragrances acquires four tobacco flavoring companies to expand market share

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Interim results for 2016, total revenue of RMB400 million, up 17.0% y-o-y, gross profit of 207 million, up 24.9%, gross margin of 51.8%, improved by 3.2 percentage points y-o-y. SG&A expenses accounted for 31.1% of the total revenue, reduced by 9.2 percentage points compared to the same period. Operating profit of 87 mil, up 54.2%. Finance costs surged by 7 mln. Profit for the period from continuing operations increased by 39.1% to 58.8 mln. Profit attributable to shareholders was 48.3 mln, up 55.3%. Earnings per share were RMB0.07.

Segment results:

Cigarette Flavors: Revenue of RMB222 million, up 4.6% year-on-year, gross margin of 50.8%, profit of 35 million, up 5.0%, accounting for 55.5% of total revenue, average selling price of products of RMB247 per kg, down 3.1%, sales volume increased by 7.5% to 889 tons, capacity utilization rate of 41%

Edible flavors and fragrances: revenue of RMB82 million, up 16.7% year-on-year, gross margin of 60.6%, profit of RMB21 million, up 69.0%, accounting for 20.4% of total revenue, average selling price of RMB67 per kg, up 3.1%, sales volume up 10% to 1,218 tons, capacity utilization rate of 36%

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Daily Spice: Revenue of RMB62 million, up 3%, gross margin of 44.5%, profit of RMB8.7 million, up 641.0%, accounting for 15.3% of total revenue, average selling price of RMB85 per kilogram, up 11.8%, sales volume down 0.3% to 722 tons, capacity utilization rate of 45%

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E-cigarettes (healthcare products): revenue of RMB34 million, gross margin of 49.8%, new business, profit of RMB6.2 million, accounting for 8.4% of total revenue

Investment properties: revenue of RMB1 million, profit of 35 million, accounting for 0.3% of total revenue

Costs: Raw materials accounted for about 84.8% of costs, followed by wages at 3.8%. R&D has accounted for about 4 to 5% of expenses over the past few years, and 3.9% in the first half of the year.

Assets grew 67.8% from end of last year to 2,909 million, total liabilities increased 286.4% to 1,426 million, cash increased 4.4% to 224 million, long term loans increased 29 times from 18 million to 561 million, short term loans increased 78% to 265 million, of which RMB accounted for 31.3%, HKD accounted for 44.7% and USD accounted for 24.0%. Net debt (cash)/shareholders' equity (%) rose to 40.7% from -3.3% at year-end, and leverage ratio (total liabilities/total assets) rose to 49.0% from 20.5%.

SBI View:

Smoke flavors growth rate benefited from e-cigarette oil production. Acquisition of 4 cigarette flavor companies can expand the company's market share and enable the company to increase its bargaining power. Sales volume of both cigarette and food flavors rose 7% to 10% in terms of data

The acquisition of Kimree is to increase the source of income, electronic cigarette revenues for the time being only come to Europe and the United States and other places, such as strengthening the development of business in China, I believe that multiplying the profit is absolutely not a problem. In addition, if the future research and development is successful, it can be used for medical purposes, the use and business opportunities are unlimited.

The company in the acquisition of four cigarette flavor companies and kimree at the same time, will set a minimum profit guarantee, a total of 169.0 million in 2017, 2018 for 173.8 million.

The share option expense was reduced significantly, the new plant is less than three years old and fails to get the hi-tech tax credit, and the income tax expense increased by 1.1 percentage points from 25.5%.

From the acquisition of Kimree, 4 cigarette flavor companies, the construction of Dongguan Bolton new plant and other instruments, capital expenditure of about 1,444.6 million to 2018. As a result, finance costs increased significantly mainly for, but the company has increased from simple RMB to lower interest rates of HKD and USD and new buildings, etc. as collateral to reduce interest costs.

Total revenue for the year is expected to be 45% higher than last year, as the financials of the newly acquired businesses were largely consolidated around mid-year, so the company's financials do not fully reflect the full-year revenue of the newly acquired companies. The target price is HKD 3.60, with a 2016 forecast P/E of 15.5x.