China Hongxing Sports - Inventory build-up at distributors

Hongxing's 1Q09 net profit (13% of our FY09 forecast) was 52% below our expectation and consensus on higher-than-expected selling & distribution expenses. We expect further declines in volume and ex-factory ASPs due to high inventory levels at distributors. We have cut our FY09 earnings estimate by 12.5% in view of the higher A&P expenses in 1Q09. On the other hand, our target price has been raised to S$0.18 from S$0.10, now pegged at 6x CY10 P/E (previously at a 40% discount to cash) in light of increased market risk appetite. Maintain Neutral given the limited upside to our share price.

As warned by management 1Q ‘09 net profit plunged 51% yoy and 49% qoq to RMB56mln on the back of 13% yoy and 34% qoq decline in sales to RMB568mln. Gross profit margin was steady at 40%.

However, due to aggressive promotional activities, selling and distribution expenses rose 33% yoy and 31% qoq to RMB171mln, dragging down operating margin to only 11.4% versus 19.2% last year and 16% last quarter. If not for a forex gain of RMB16.4mln, bottomline would have been worse.

One positive aspect is that management delivered on their promise to collect prepayments of RMB219.2mln during the quarter, reducing their prepayments to RMB939.9mln as well as collectingRMB91mln worth of receivables, thereby generating operating cash flows of RMB303mln. We would continue to monitor prepayment and receivable collections as the consumer sentiments deteriorate in China.

Financial position remains robust with cash of RMB2.265bln versus little debts, but until management start to buy back shares or restart their dividend payments, the market would likely pay little regard to their cash holdings.

Looking ahead, management maintained their Feb ’09 cautious guidance and expect the near term market conditions to remain challenging as the weak economic climate continues to negatively impact consumer demand.

At 21 cents a share, market cap is $588mln with 77% of it represented by cash, trailing PE is 7.5x, price to sales is 1x and price to book is 0.7x. Our last call in Feb ’09 was HOLD when the stock was at 18 cents, but with the stock having rebounded by 282% (to 21 cents currently) from its Mar ’09 low (of 5.5 cents) and coming close to the upper end (about 25 cents) of its 9 month trading range, we would be looking to sell on further strength.

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