China Hongxing – Feb trade fair sparks the beginning of earnings downtrend

Following the recent luncheon with China Hongxing, we got a sense that the business is facing mounting pressure in a difficult operating environment. The IR addressed key concerns with regards to the huge idling cash pile, stressing that the management is being prudent to set aside hefty working capital needs. As a form of assurance, she presented the bank statements issued by HSBC and China Construction Bank.

The group’s latest trade fair in February garnered RMB 800m worth of orders (-20% yoy). Total orders received for 9M09 have grown by approximately 9% yoy. Rising sales volumes of apparels (+12%) were insufficient to offset a 19% volume decline for sports footwear. The ASPs have also fallen due to the swift towards low-pricing items.

Despite a 20% same-store-sales growth in Jan 09, the combined same-store-sales for Jan and Feb were a mere 5-6%, suggesting that Feb’s same-store-sales growth was already in the red. Declining same-store-sales undermine operating efficiencies and will lead to rapid cash depletion. Besides, the group will likely continue its product discount program which will erode its gross margins. Orders delivery will also be delayed as a form of inventory control. This will further dampen topline.

Huge working capital will deplete the excess cash rapidly. Dwindling demand from mass market due to rising job losses could stretch its inventory days by 2 to 3 months. After which worsen credit terms will follow. CHHS also do not rule out rising difficulties in repayment from distributors and provisions will have to be made. We estimate that such working capital needs could potentially amount to RMB 958m. This will deplete its net cash by 49%, reducing its net cash per share to 8 cents.

We have lowered our earnings estimates for FY09/10 by 16-21% to reflect topline weakness. The beginning of earnings deterioration coupled with overhang from the conversion of the remaining RCPS could impede any potential re-rating. Although the group is considering paying dividends, we doubt it will be enticing given the huge working capital needs. We are downgrading the stock to a Sell and revised our new target price to 8 cents (peg to the net cash per share after adjustment for potential working capital needs).

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