Biostime International:Cautiously optimistic on profitability improvement

Performance deterioratedfurther in 1H16.The Group’s revenue grew 53.3% YoY, mainly becauseSwisse’s 1H15 result was not consolidated in the corresponding periodlast year. However, if we factor in Swisse’s revenuein 1H15, the Group’s revenue growth in 1H16 would only be 3.21% YoY. Revenue of the milk formula business fell 13.98% YoY and combined revenue attributable to Biostime businesses also declined by 12.18% YoY. It is evident that the adultnutrition product segment was not a sufficient growth driver for the Group.

Overall profitability improvedalthough Swisseunderperformed. The Group’s overall GPM increased from 61.94% in FY15 and 58.23% in 1H15 to 64.09% in 1H16. The GPM of the combinedBiostime business was 65.35% as the milk formula segment’s GPM improved to 65.54%. However, even though the reported GPM of Swisse improvedfrom 61.29% in FY15 to 62.4% in 1H16, it is still lower than Biostime’s traditional business. Assuming GPM of Swisse’s business remainsat similar level, if the Group expands the adult nutrition business and revenue contribution from the segment increases, the Group’s overall GPM would suffer. In addition, the Group’s OPM was 28.88% and NPM was 11.86%in 1H16 (FY15:OPM: 11.41% and NPM: 5.22%). Apparently, Swisse’s business contributed to the higher OPM and NPM by achieving a lower S&D/Sales ratio of 22.75% (Biostime: 38.43%). Yet, managementin the 1H16 resultsmeeting stated that certain marketing and promotion costs incurred in 1H16 will be booked to 2H16 and marketing and promotion effortswould increasein 2H16 for the Swisse products. Hence, the margin improvementmay not sustain.

Lower revenue growth outlook with a slightly higher profitability.We are still cautious on the Group’s growth outlook as the infant milk formula and adult nutrition products would not receivemuch support from the consumer market. Also, Swisse’s expansion in China entails certain implementation risks. Hence, we revise down our revenue projections. Overall revenue growth would be 31.41% YoYand 4.66% YoY in FY16E and FY17E;Swisse business comparable revenue growth would be 21.25% YoY in FY16E and 17.24% YoY in FY17E. However, we believe that the product mix diversification with the addition ofadult nutrition products has the potential to boost profitability at the OPM and NPM level. We projectnet profit and EPS would grow by 73.63% and 97.01% YoY in FY16Eand 20.10% YoY and 20.10% YoY in FY17E;NPM would be6.9% and 8.83% in FY16Eand FY17E

Change rating to HOLDwith TP of HK$ 22.83.Despite headwinds in the short term,we change rating to HOLD to reflect the potential for higher bottom line growth and better profitability. TP was adjustedto HK$ 22.83, representing 2016E P/E of 23.53x or2017E P/E of 19.57x, and2016E P/B of 2.87x or2017E P/Bof 2.41x.