Cosmetics(Overweight/Initiate)
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[Korea] January 25, 2021 Cosmetics (Overweight/Initiate) Chinese market to transition to quantitative growth Mirae Asset Daewoo Co., Ltd. Junghan Yoon [email protected] Initiate coverage with Focus on cosmetics names with high exposure to China Overweight recommendation In 2021, we expect China’s aggregate demand for cosmetics to recover. We advise investors to focus on Korean OEMs/OD Ms, which previously faced uncertainties over growth. Our top pick is Cosmax, which holds the largest share in China’s cosmetics OEM/ODM market at 4.9%. Cosmetics consumption to see Focus on quantitative growth of China ’s cosmetics consumption amid improving economic growth reminiscent of 2017 conditions Since 2H20, China has recorded the highest disposable income growth (excluding transfer income) among major countries. Financial conditions supportive of the Chinese yuan suggest the Chinese government will pursue an urbanization policy that is supportive of rational consumption. Rapid urbanization and growing income should support the quantitative growth of China’s cosmetics consumption. We believe China’s cosmetics consumption environment is reminiscent of 2017, when retail cosmetics sales rapidly increased. OEMs/ODMs in China have Overall environment positive to OEMs/ODMs, whose valuations are driven by top -line plenty of room for growth; growth valuation gap with global brands While China’s retail cosmetics market is around five times bigger than that of Korea, its appears excessive cosmetics OEM/ODM market is only 1.5 times larger than Korea’s. Chinese authorities have begun regulating installment purchases facilitated by online small loan platforms (which have played an important role in shaping young consumers’ cosmetics consumption). We believe demand for cosmetics will extend to value-for-money s egments, which rely on OEM/ODM manufacturing. OEMs/ODMs in China are trading at a more than 50% discount to global brands on a 12-month forward P/E basis. We view such a valuation gap as excessive, considering China’s improving economic conditions and rebounding PPI in the household & personal care (HPC) category. Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including t he US. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES AND DISCLAIMERS IN APPENDIX 1 AT THE END OF REPORT. January 25, 2021 Cosmetics C O N T E N T S Executive summary 3 I. Chinese demand holds the key 4 Korean cosmetics industry is largely driven by Chinese consumer behavior 4 China’s 2021 domestic consumption growth to match the 2017 level 13 Millennials and Gen Z drive the luxury cosmetics market in China 22 II. Potential changes in consumption patterns 25 Post-pandemic changes in Gen Z’s cosmetics consumption behavior 25 Korean cosmetics OEM/ODM players stand to benefit from the rise of C-beauty 34 AmorePacific 36 LG H&H 41 Cosmax 46 Mirae Asset Daewoo Research 2 January 25, 2021 Cosmetics Executive summary We initiate our coverage of the cosmetics sector with an Overweight rating. In our view, investors should focus on companies with high revenue exposure to China, given that the country’s aggregate demand for cosmetics is likely to pick up this year. We highlight Korean OEMs/ODMs, which appear well-positioned to shake off the uncertainties surrounding their growth outlook. (During 2018-20, the concentration of demand in the luxury category raised concerns over their prospects.) Our top pick is Cosmax, which holds the largest share in China’s cosmetics OEM/ODM market at 4.9%. When economic growth slowed after 2018, China’s cosmetics consumption became bifurcated. Korean companies failed to respond effectively to this shift, as their value-for- money/volume-oriented strategies were at odds with the direction of the Chinese market. Incremental demand was largely confined to the luxury segment, and brands realized growth by raising their pricing. In the masstige space, where competition intensified amid slowing growth, Korean firms lost ground to local brands, whose localized marketing campaigns appealed to young consumers. Currently, there are doubts over whether Korean brands still have an advantage over local Chinese brands in the value-for-money category. Chinese consumers no longer choose cosmetics brands based on their country of origin; confidence in product quality and brand stories are more important considerations. In light of this, we do not believe that a potential rebound in Chinese inbound tourism would have a significant impact on the fundamentals of the Korean cosmetics industry. In 2021, we look for quantitative growth in China’s cosmetics consumption on the back of improving economic conditions. China’s industrial production data and manufacturing sector have already rebounded sharply from the impact of COVID-19. While consumer spending has been slower to recover, we note that China has seen the highest disposable income growth (excluding transfer income) among major countries since 2H20. Financial conditions supportive of the Chinese yuan also suggest the Chinese government will pursue an urbanization policy that is supportive of rational consumption. Rapid urbanization and growing income should support quantitative growth in cosmetics consumption. We believe China’s cosmetics consumption environment is reminiscent of 2017, when retail cosmetics sales rapidly increased. We believe China’s shift to quantitative consumption will provide positive momentum to companies operating at the lower end of the value chain (OEMs/ODMs, packaging, materials, etc.), as the valuations of such companies are largely driven by top-line growth rather than profit margins. In particular, the OEM/ODM sector is where Korean firms enjoy a competitive edge over local suppliers. While China’s retail cosmetics market is around five times the size of Korea’s, its cosmetics OEM/ODM market is only 1.5 times larger than Korea’s. Thus, we see plenty of room for growth. Furthermore, young Chinese consumers’ habits are expected to change in ways that are favorable to the business environment of OEMs/ODMs. Chinese authorities have begun regulating installment purchases facilitated by online microlending platforms (which have played an important role in shaping young consumers’ cosmetics consumption). This should help extend demand beyond the luxury segment to the value-for-money segment, which relies on OEM/ODM manufacturing. Notably, we think recent trends such as cosmeceuticals (cross between cosmetics and pharmaceuticals) and guochao (preference for homegrown brands) are all part of the broader transition toward value-for-money. To be sure, the long-term structural growth of China’s cosmetics sector will come largely from the luxury segment as Chinese consumers’ tastes become more sophisticated. However, the valuation gap between OEMs/ODMs operating in China and global brands—which began to widen in 2H18—now stands at more than 50% on a 12-month forward P/E basis. We view such a gap as excessive, given China’s improving economic conditions and rebounding PPI for HPC goods (daily-use articles). From a trading perspective, we thus see greater upside to OEMs/ODMs than brand names in 2021. Mirae Asset Daewoo Research 3 January 25, 2021 Cosmetics I. Chinese demand holds the key Korean cosmetics industry is largely driven by Chinese consumer behavior Following a period of growth through 2016, Korea’s cosmetics market (not including duty- free purchases by foreigners) expanded at 2.9% CAGR between 2017 and 2019, which indicates essentially zero growth after adjusting for inflation. The country’s annual cosmetics spending per capita is around US$210, similar to the levels of developed markets. Against this backdrop, it appears that the domestic market has reached maturity. In addition, aggregate demand was curtailed by a drop in Chinese group tourists (one of the industry’s biggest customers) in the wake of the THAAD dispute in late 2016. This coincided with fears of chemicals in beauty products highlighted on social media, which caused many consumers to simplify their beauty routines. As the cosmetics market has matured, domestic consumers’ tastes have become more diversified, with a greater emphasis on individuality. The widespread adoption of OEM/ODM manufacturing has also significantly lowered market barriers for new entrants. AmorePacific, Korea’s leading cosmetics company, saw its share in the stagnant domestic market decline rapidly from 32.9% in 2015 to 19.4% in 3Q20. Figure 1. Estimated size of domestic cosmetics market Figure 2. AmorePacific: Domestic M/S trend (excl. duty-free purchases by foreigners) (Wbn) (%) 35% 32.9% 6,000 Domestic cosmetics market (L) YoY (R) 20 31.9% 30% 29.0% 27.2% 5,000 10 25% 22.8% 4,000 0 19.4% 20% 3,000 -10 15% 2,000 -20 10% 1,000 -30 5% - -40 0% 1Q16 4Q16 3Q17 2Q18 1Q19 4Q19 3Q20 2015 2016 2017 2018 2019 3Q20 Source: KDFA, Statistics Korea, Mirae Asset Daewoo Research Source: Kantar, Mirae Asset Daewoo Research In a sign of how fragmented the market has become, the number of registered cosmetics sellers increased by a record 3,034 YoY to 15,707 in 2019. The diversification of consumer preferences has also led to changes in cosmetics distribution channels, with demand gradually shifting away from mono-brand shops (so-called road shops) and door-to-door channels, which focus on single brands, to health & beauty (H&B) stores and online channels, which offer access to a more diverse range of products and categories. During the market’s previous growth period, domestic cosmetics firms sold their products through mono-brand shops (key examples being Missha, Etude House, and Aritaum) to capture retail margins. Able C&C, the company behind the brand Missha, earned an OP margin of around 20% in 2003-04. This underscores the strong operating leverage cosmetics firms enjoyed, as costs were generally 30% of selling prices due to the outsourcing of manufacturing. Mirae Asset Daewoo Research 4 January 25, 2021 Cosmetics After 2016, however, Chinese inbound tourism—a key growth driver of mono-brand shops— dropped dramatically, forcing out many companies that struggled to adapt to changes in distribution channels.