China Hongxing Sports - Performance worsen further; Cut 2009 profit estimates

Sales contraction and margin erosion slashed profit by 60% yoy, a result of a slowdown in retail sales and de-stocking by distributors. Turnover plunged 27% yoy. To help distributors clear inventories and to compensate for the heavy retail discounting (25% vs 15-20% last year), the Group offered a bigger wholesale discount to distributors (65% off retail price vs 60% last year), which slashed its product ASPs. In addition, sales volume for footwear and accessories plunged as distributors cut orders to destock inventories.

Retail sales of distributors dived. Same-store sales (SSS) growth dived from over 20% last year to 3-4% in 1H09 due to the economic slowdown. Store additions also slowed with points-of-sales (POS) increasing only 21 to 3,845 in 1H09.

Severe margin erosion. Gross margin was only 35.6% for 2Q09 vs 41.9% a year ago and 40.2% in 1Q09 due to lower product ASPs. Coupled with higher SG&A expenses as a percentage of turnover, EBIT margin plunged 9.3ppt yoy to 11.4% in 2Q09.

Retail inventory still high. By cutting orders in 1H09, distributors’ inventory dippedfrom a peak of over five months at the beginning of the year to fourand- a-half months as at end-Jun 09 (vs two-and-a-half months last year).

However, inventory at the Group surged from 23 days at end-08 to 34 days at end-Mar 09 and 40 days at end-Jun 09 due to order cancellations by distributors.

Collection of lease prepayment from distributors. The Group got back over Rmb550m of lease prepayment from distributors in 1H09. The balance of prepaid lease for distributors declined to Rmb605m at end-Jun 09 from Rmb1.1b at end-08.

Cut 2009-11 net profit forecasts by 27-28%. With much worse-thanexpected 1H09 results, we slash our 2009-11 net profit estimates by 27-28%.

This implies a 53% yoy earnings decline for 2009 and 6-7% yoy growth in 2010-11. While we anticipate Hongxing to resume profit growth since 2010, the Group is subject to huge earnings risk due to the still high inventory level and intensifying competition in the low-end sportswear segment.

Uncertain top-line growth. The Group has just completed the trade fair for 1Q10. Management guided a negative growth in orderbook and did not give guidance for 2010 turnover growth.

Sustained margin pressure. With more low-end sportswear companies getting listed recently, store openings are accelerating and competition intensifying. Together with the still high industry-wide inventory level, the Group may need to provide large wholesale discounts to distributors or raise advertising and promotional expenses.

Further investment in distribution network is probable. Instead of raising dividend payout, the Group intends to invest more on distribution network, such as paying the lease prepayment for distributors, buy stakes in distributors and launch M&As.

Based on our new earnings forecasts, the stock is trading at 10.5x 2009F PE vs 5-6x for S-shares consumer stocks. Given the high earnings risk, we maintain SELL with a fair price of S$0.10 based on 5.5x 2010F PE.

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