Hengan (1044.HK): TP Raised to HK$98.60; Upgrade to Buy

What’s new.Hengan’s FY14 EPS was up 5.4% y/y to HK$3.18, 4% higher than market expectation on higher gross margin and subsidies income from government. A final dividend of HK$1.15/share was declared, with total dividendof HK$2/sharefor FY14, compared to HK$1.85/share in FY13. While revenue growth continued to slow in 2H14, improving profitability was observed. Driven by decreasing raw material cost (particularly petrochemicals and wood pulp) in 2H14, gross margin increased 2ppts h/h, plus stable SG&A as % of revenue,EBIT was up 20% y/y in 2H14, with EBIT margin increased 4.5ppts h/h to 26.4% 2H14. We believe the margin expansion indicates clearer earnings growth outlook for Hengan. We raise our TP to HK$ 98.60 (previously HK$89.20) and upgrade the stock to Buy.

Sanitary napkins.Thesegmentposted a solid 24% revenue growth in FY14 with 24% y/y increase in segment EBIT, which offsets the y/y EBIT decrease of the tissue paper and diaper segments. Gross profit margin improved 3ppts h/h to 70% in 2H14 thanks to soft petrochemical prices and further optimised product mix. Management expects growth to remainsolid in FY15, given higher end products continue to deliverfavourable sales growth. Additionally, management indicated that the overnight sanitary napkin product remains an untapped market in China.Sanitary napkin segmentcontributes 67% of Hengan’s EBIT in FY14 (58% in FY13). The segment will be the main growth driverfor Hengan, resulting ingrowth and margin expansion.

Diapers. Revenue growth in the diaper businessslowedfrom8% in 1H14 to 3% in 2H14due to clearance of old low-end products, and segment EBIT dropped 11% y/y in FY14,partly due to higher initial expenses as the firm is penetrating maternity specialty storesand cooperating with online channels. Hengan’s mid-rangeandmid-to-high-end products posted 11% sales growthin FY14 vs. 5% of overall segment revenue growth. We expect both growth and margin to further improve in FY15 on contribution from new channels, improving product mix and lower raw material costin the diaper segment.

Tissue paper.Revenue growth slowed from11%y/y in 1H14 to only 2% y/y in 2H14, as management prioritised probabilityover revenue growth without increasing promotions in 2H14. Soft wood pulp price in 2H14 and cutback on promotion helpedEBIT marginsstayat 8% in 2H14. In order to provide better service to distributors and boost sales growth, Hengan divided its sales force to tissue paper and non-tissue paper business. While we believe it is too early to call it a success, given revenue growth for thetissue business has been decreasing in the past three years, and overcapacity remains. After cutting back new capacity by half to 120k ton for FY14,Hengan haltedits 240k ton of new tissue capacity in FY15, which indicated thatthe growth outlook remainsuncertain.

Forecastsand valuation.We revise down ourFY15E EPS estimates by 5% to HK$3.83due to further slowdownof revenue growth across business segments of Hengan in 2H14. However, the improving profitability in 2H14 driven by gross margin expansion and company’s cutback in promotion give us faith in the earnings growth outlook going forward. Stock is trading at the bottom of three year forward P/Erange. The optimised product mix should result in better margins and a positive trajectory for ROE. Wemaintain our target P/E multiple of 22x and roll over to our FY16E EPS of HK$4.48, which gives our new TPof HK$98.60, representing 13% upside. We upgrade Hengan from Neutral to Buy. Further upside could come from growth improvement for the diaper and tissue businesses.