China Flavors & Fragrances: Acquires Four Tobacco Flavoring Companies to Expand Market Share

Latest Focus:

In mid-2016, total revenue was RMB 400 million, a year-on-year increase of 17.0%, with a gross profit of RMB 207 million, up 24.9%, and a gross margin of 51.8%, improving by 3.2 percentage points year-on-year. SG&A expenses accounted for 31.1% of total revenue, a decrease of 9.2 percentage points compared to the same period. Operating profit was RMB 87 million, an increase of 54.2%. Financial costs surged by RMB 7 million, with profits from continuing operations increasing by 39.1% to RMB 58.8 million, and net profit attributable to shareholders rising by 55.3% to RMB 48.3 million. Earnings per share were RMB 0.07.

Segment Performance:

Tobacco flavoring: Revenue was RMB 222 million, a year-on-year increase of 4.6%, with a gross margin of 50.8%, and profit of RMB 35 million, up 5.0%, accounting for 55.5% of total revenue. The average selling price per kilogram was RMB 247, down 3.1%, with sales volume increasing by 7.5% to 889 tons, and capacity utilization at 41%.

Food flavoring: Revenue was RMB 82 million, a year-on-year increase of 16.7%, with a gross margin of 60.6%, and profit of RMB 21 million, up 69.0%, accounting for 20.4% of total revenue. The average selling price per kilogram was RMB 67, up 3.1%, with sales volume increasing by 10% to 1,218 tons, and capacity utilization at 36%.

Daily flavoring: Revenue was RMB 62 million, a year-on-year increase of 3%, with a gross margin of 44.5%, and profit of RMB 8.7 million, up 641.0%, accounting for 15.3% of total revenue. The average selling price per kilogram was RMB 85, up 11.8%, with sales volume down 0.3% to 722 tons, and capacity utilization at 45%.

E-cigarettes (health products): Revenue was RMB 34 million, with a gross margin of 49.8%, a new business, and profit of RMB 6.2 million, accounting for 8.4% of total revenue.

Investment properties: Revenue was RMB 1 million, with a profit of RMB 35 million, accounting for 0.3% of total revenue.

In terms of costs, raw materials accounted for about 84.8% of costs, followed by wages at 3.8%. In recent years, R&D expenses have accounted for about 4 to 5% of expenditures, with 3.9% in the first half of the year.

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

SBI View:

The growth rate of tobacco flavoring benefits from the production of e-cigarette e-liquids. Acquiring four tobacco flavoring companies can expand the company's market share and enhance its bargaining power. Data shows that sales of both tobacco and food flavorings have increased by 7% to 10%.

The acquisition of Kimree aims to increase revenue sources; currently, e-cigarette revenue mainly comes from Europe and the U.S. If the business in China is strengthened, it is believed that profit doubling is absolutely not a problem. Additionally, if successful in R&D in the future, it could be used for medical purposes, with unlimited applications and opportunities.

While acquiring four tobacco flavoring companies and Kimree, the company will set a minimum profit guarantee of RMB 169.0 million for 2017 and RMB 173.8 million for 2018.

Stock option expenses have significantly decreased, and the new factory has not been operational for three years, failing to obtain high-tech tax incentives, with income tax expenses increasing by 1.1 percentage points from 25.5%.

From the acquisition of Kimree, four tobacco flavoring companies, and the construction of the new Dongguan Boton factory and other instruments, the capital expenditure until 2018 is approximately RMB 1,444.6 million. Therefore, the significant increase in financial expenses is mainly used for this purpose, but the company has reduced interest costs by using lower interest rates in HKD and USD and using new buildings as collateral.

It is expected that total revenue for the year will increase by 45% compared to last year, as the financial status of the newly acquired businesses will largely be consolidated around mid-year, so the company's financial data may not fully reflect the annual revenue of the newly acquired companies. The target price is HKD 3.60, with a forecasted P/E ratio of 15.5 times for 2016.