Nongfu Spring: Tea drinks buck the trend, has the "water grass" constitution been held back in the second half of the year?

Nongfu Spring (9633.HK) released its 2022 interim report after-hours on August 24 Beijing time, with the following core financial highlights:

1. Revenue not as bad as expected: As one of the leaders in the soft drink industry, Nongfu Spring's overall sales were greatly affected by travel and outdoor activities. Market expectations were that revenue for the first half of 2022 would collapse, but the actual performance was slightly better than expected, with revenue reaching CNY 16.6 billion, a year-on-year increase of 9.4%, and an almost double-digit positive growth.

The contributor to this success is tea drinks, which accounts for 20% of revenue, rather than bottled water, which has been missing from the market due to the epidemic. The brands of tea drinks, such as Teaπ and Oriental Leaf, continued to grow at high rates even last year, and have even accelerated. They were not affected by the epidemic at all, with a year-on-year increase of up to 52%.

2. Profits have to go through the darkest hour?: Looking only at the main operating profit of revenue - cost - sales - administration, excluding non-core related additional revenue, of CNY 5.35 billion, a year-on-year increase of 6.5%, slightly lower than the same period growth rate of revenue. This is mainly due to high petroleum prices in the first half of the year, and Nongfu's main cost, PET materials for plastic bottles, is a downstream product of petroleum, and the price has remained high, which has eroded gross profit performance.

3. Reduced marketing expenses but high administrative costs: Consumer goods, as a product with mental dominance, have their core expenses on marketing, with little administration and even fewer on research and development. Nongfu's R&D expenses are recorded as part of the administration expenses, without separate disclosure. There are fewer promotional ads during the epidemic season, and the largest item in the cost of sales, sales expenses, has saved a lot, with a year-on-year increase of only 1.6%. However, administrative expenses have continued to increase rapidly in the past year, and the company's explanation is that there are more equity incentives and research and development expenses.

4. The net profit attributable to shareholders of the parent company for the first half of the year was CNY 4.1 billion, a year-on-year increase of 15%, which seems good. In fact, CNY 750 million comes from exchange gains and interest income on fixed deposits, with a year-on-year increase of nearly 100%, resulting from the appreciation of Hong Kong dollars during the IPO financing compared to the US dollar, and is unrelated to the profitability of the main business. If the net profit attributable to shareholders of the parent company, excluding exchange gains and interest income, is CNY 3.9 billion, a year-on-year increase of 6.2%, which is low compared to the growth rate of revenue.

Dolphin Analyst's overall view:

Although Nongfu's performance is not strong under the epidemic circumstances where the consumption scenario of bottled water is missing, it has basically maintained it by relying on tea drink revenues and profits. As for the stock price, when the epidemic of lockdown level has passed, the first half of the year is already a thing of the past, and we should focus on the prospects for the second half of the year:

1) On Revenue: After the epidemic, most parts of the country enter a rare hot season of years, from July to September being a peak season for beverage sales. Coupled with the hot weather across the country, the demand for drinks in the second half of the year will increase significantly, and if looking at July production, it has already recovered by a true growth of 5%. Dolphin Analyst expects that as a leading player in the industry, Nongfu Spring is expected to fully benefit from the positive impact brought by the hot weather, and revenue may exceed expectations. 2) Cost side: PET prices have declined from their peak in June, while corrugated paper continues its downward trend. It is expected that the pressure on profits in the second half of the year will ease. If sales expenses can be relatively constrained, there is a good chance of significant improvement in performance in the second half of the year.

Overall, there is no need to worry about income in the first half of the year. The core information revealed in the first half of the year is that tea drinks have performed better than expected. If tea drinks continue to take off in the second half of the year, and packaging water returns to normal, and if there are improvements in PET material costs and transportation expenses tied to high oil prices, then Nongfu Spring's "Shuimao" brand can once again demonstrate its core strengths.

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Before starting the main content, let's quickly review some of Nongfu Spring's recent product launches:

Nongfu Spring's primary revenue comes from packaged drinking water products. Considering that tea drinks are in a period of rapid growth and represent an important source of incremental revenue, Dolphin Analyst will focus on analyzing both packaged drinking water products and tea drink products, while other products will not be discussed in detail.

1. Packaged drinking water products: Sales were affected by the pandemic, but large packaged water made up for some losses

Revenue from packaged drinking water products achieved steady growth in the first half of 2022, with revenue of 9.349 billion yuan, a year-on-year increase of 4.8%. This was mainly due to large packaged drinking water continuing to replace traditional barrelled water, achieving significant volume growth, and thus offsetting some of the sales loss caused by the pandemic.

1) The logic of price increase through product structure upgrading for small packaged drinking water products is weak

Historically, the water business is mainly based on volume, and price increases, whether by direct price hikes or through product structure upgrades, are relatively weak. However, Nongfu Spring has been attempting to achieve price increases through product structure upgrades, such as the natural snow mountain mineral water launched in the first half of 2021, and the tiger-themed glass bottled Guangquan water launched in the first half of 2022. In the past, Nongfu Spring has also launched high-priced products such as maternity water, student water, lithium-containing water, and glass bottles, but sales and ton price contributions have been mediocre.

2) Sales were affected by the pandemic, but the prospects of recovery in the second half of the year are high. Just now, I said that bottled water is the main source of revenue for Nongfu Spring, and the growth in volume has always been the main driver of the bottled water business. Last time, the negative growth in water revenue during the epidemic was mainly due to the negative growth in volume. Similarly, the core reason for the decrease in sales volume this time is most likely the impact of the epidemic. After all, eating is already a problem, and people tend to stockpile food instead of heavy and cumbersome packaged water. During the epidemic, the short-term living standards of people at home have decreased, and boiling water has replaced packaged water. However, the obstruction of short-term consumption scenarios is not a problem, because this summer is a rare hot and fiery weather, and after the epidemic, it is almost certain that water sales will rise. As a leading company, the certainty of Nongfu Spring's recovery in revenue from bottled water in the second half of this year is almost 100%.

2. Tea Beverage Products: High Sales Growth in the First Half of the Year, New Growth Point After Bottled Drinking Water

In the first half of 2022, the revenue of tea beverage products reached 3.307 billion yuan, a year-on-year increase of 51.6%, which exceeded expectations! Dolphin Analyst believes that tea beverage products have become the next important core growth point for Nongfu Spring. After all, tea beverages satisfy the new demand for consumer health consciousness, and Nongfu Spring has accumulated many years of experience in this field. The core products, Tea π and Eastern Leaves, have high brand recognition among consumers, supporting major sales in the first half of this year. In addition, Nongfu Spring's new tea drink, QQ, which was launched in the first half of 2022 has also performed well.

1. Tea π: New Flavors Cater to New Trends and Large Sizes Meet Different Consumption Scenarios

Nongfu Spring launched two new flavors of Tea π in the first half of 2022, and launched a 900ml drinking package for Grapefruit Jasmine Tea and Pomelo Green Tea. So far, Tea π has 7 flavors, including Peach Oolong Tea, Lemon Black Tea, Grapefruit Jasmine Tea, and Pomelo Green Tea, covering multiple specifications of 250ml, 500ml, and 900ml to meet the needs of different consumption scenarios.

A) Orange Pu-erh Lemon Tea Flavor: It closely follows the trend of taste and forms a differentiated taste experience by mixing lemon, Xinhui citrus peel, and Pu-erh tea;

B) Green Plum Oolong Tea Flavor: Green Plum Oolong Tea Flavor is paired with Qingti NFC juice and Oolong Tea. It has a fruity and tea taste, which conforms to the trend of taste.

2. Eastern Leaves: The increase in penetration rate and distribution rate drives sales, and new products cater to taste trends

In the first half of the year, Nongfu Spring increased the penetration rate and distribution rate of Eastern Leaves and launched Super Dragon Well Tea, which provided momentum for sales.

A) Strengthen Operations, Bring Incremental Benefits: Eastern Leaves, Nongfu Spring's single product with the highest market share of sugar-free tea, can fully enjoy the expansion of the sugar-free tea drink market. In addition, Nongfu Spring has been continuously increasing the penetration rate and distribution rate of Eastern Leaves in the first half of the year, striving to promote sales volume and bring incremental benefits. B) Keep Innovating and Meeting Demand: Nongfu Spring is constantly expanding the SKU for Dongfang Shuye, from traditional green tea, black tea, and oolong tea to Qinggan puer tea and brown rice tea. They have also introduced seasonal limited edition products such as the Osmanthus Oolong tea in the autumn of 2021, and the Super Dragon Well tea in the spring of 2022. Despite high market share and brand recognition, Nongfu Spring is continuously keeping up with taste trends.

3. Soda Tea: Targeting Young Consumers, Early Sales Performance is Promising but Beware of Fading Quickly

In the first half of 2022, Nongfu Spring introduced soda tea products, which includes three flavors: Huangpi Jasmine, Qinggan Puer, and Passionfruit Oolong. This product line adds carbonation to traditional tea, creating a low-sugar carbonated beverage that appeals to young people. The early sales performance is promising, but the company must remain cautious of its long-term success.

III. Functional and Juice Beverage Products: Performance is Average, Lacking Exceptional Operations

In the first half of 2022, functional beverage products generated revenue of 2 billion CNY, a year-on-year increase of 0.9%, while juice beverage products generated revenue of 1.3 billion CNY, a year-on-year increase of 4.2%. Due to the impact of the pandemic, sales performance was average. However, the Dolphin Analyst believes that NFC low-temperature juice products may bring incremental growth.

1. Functional Beverage Products: Public company Bull currently dominates the functional beverage market, with second-tier players differing very little. The main competition lies in product differentiation, including taste, brand, and marketing. Competition is fierce, and it may be a while before Nongfu Spring emerges as a leader in the industry.

2. Juice Beverage Products: Currently, NFC low-temperature fruit juice still has the highest market share. However, Nongfu Spring has effectively solved the storage problem of pure fruit juice through constant temperature preservation technology. This is why Nongfu Spring's constant temperature storage (CTS) 100% NFC fruit juice products occupy a dominant position in the segmented market. In the future, as consumers' demand for high-purity fruit juice increases, Nongfu Spring's NFC constant temperature products may benefit and achieve volume growth.

IV. PET Bottle Is Dragging Down Net Profit Recovery

As the "Maotai in water" industry, Nongfu Spring relies on high gross margins, making up for the lack of costs in "water," driving the gross margin up to 60%.

Although water has no cost, the company's core costs are in packaging materials, including PET and corrugated paper. Since last year, PPI has been continuously rising, which has led to Nongfu Spring's gross margin falling by nearly 2-3 percentage points.

In the first half of this year, PET, as a downstream product of petroleum, was hovering at a high price due to the high oil prices. The gross margin of PET decreased by 1.6% year-on-year. However, compared with the high inflation of PPI in the second half of last year, the gross margin is still on the road to recovery.

Five, cost drag, farmer profit creation speed is still lower than income growth

When Dolphin Analyst calculates the profit, he mainly looks at the operating profit of income-cost-expense. In the first half of the year, due to the drag of packaging costs, the company's main operating profit in the first half of the year was 5.4 billion, a year-on-year increase of 6.5%; the operating profit margin was 32.2%, which, after falling below 30% in the second half of last year, still stood at above 30%.

In terms of operating expenses, the overall situation of Nongfu Spring in the first half of the year remained relatively stable, but the structure did change: administrative expenses still grew at a high rate, a year-on-year increase of 32%, with expenses of CNY 900 million in the first half of the year, and the expense ratio rose by nearly one percentage point year-on-year. The company explained that the growth in equity incentives and research and development expenses was relatively large, which seems to be quite rigid.

The main reason for the cost-saving on the expense side in the first half of the year was the reduction in advertising due to the pandemic. Therefore, sales expenses only increased by 1.6% year-on-year to CNY 3.6 billion, and the expense ratio was close to 22%, a decrease of nearly 2 percentage points year-on-year.

However, spending on continuous product promotion, such as a "capital" investment in consumer goods, can help to build a long-term barrier to consumer goods. While it is understandable that sales expenses are low in the short term in the face of a downturn in the economy, in the long run, the market should not rely on low growth in sales expenses to make profits, but rather rely on opening sales volume and revenue to dilute sales expenses.

Six, the second half of the year: will only get better

Dolphin Analyst sees that Nongfu Spring has given various cautious judgments in its forecast for the market in the second half of the year, especially talking about the high price of PET materials under high oil prices.

However, in Dolphin Analyst's view, the first half of the year has already turned around, and the second half of the year will only get better. The stock price trades on expectations. If we look at expectations:

(1) This year's hot days are not only too hot, but also long-lasting. It is highly likely that the peak season sales volume will be guaranteed. In this situation, both water and beverages are likely to perform well. If Nongfu continues to see high growth in tea drinks and packaged water returns as a relatively rigid product, it is very hopeful that the water and beverage segment will return to and even exceed the normal growth rate of 20% in the second half of the year.

(2) Cost: The cost of PET material has recently fallen back from the absurdly high point in June, but it still seems relatively high. However, with the cooling of oil prices, it seems hopeful that it will further decline.

(3) On the expense side, administrative expenses are unlikely to change much with a high opening trend. It's just that the base in the second half of last year was relatively high, so it shouldn't look so exaggerated. The largest expense is sales expenses. After coming out of the pandemic, advertisement spend should recover, but in the macroeconomic downturn, it should not be too exaggerated. **

Therefore, overall, the greater hope for the second half of the year should be a rapid return of income, the cost side cannot be worse, coupled with relatively restrained expenses, and there is hope for revenue repair and profit to return more quickly while maintaining Shuimao's vitality.

Here ends the section.

**Dolphin Analyst's historical articles on "Nongfu Spring":

Earnings season

March 28, 2022 "[Nongfu Spring: The return of the king of 'Shuimao'] (https://longbridgeapp.com/topics/2201674?channel=t2201674&invite-code=2IKBO5)"

August 25, 2021 "[Nongfu Spring: The return of the king of 'Shuimao', but valuation risk cannot be ignored] (https://longbridgeapp.com/topics/1079379?channel=t1079379&invite-code=2IKBO5)"

In-depth

July 14, 2021 "[Nongfu Spring (Part 1): A story about drinking water and thinking of its source] (https://longbridgeapp.com/topics/946318?channel=t946318&invite-code=2IKBO5)"

July 20, 2021 "[Nongfu Spring (Part 2): How much room is there for the 'rational' rise?] (https://longbridgeapp.com/topics/924821?channel=t924821&invite-code=2IKBO5)"

Risk disclosure and statement for this article: [Dolphin Analyst's Disclaimer and General Disclosure] (https://support.longbridge.global/topics/misc/dolphin-disclaimer)