Hongguo Int: Inventories Still High

4Q08 results were slightly below expectations, with net earnings falling 30% yoy to RMB25m. Margins narrowed due mainly to lower ASP in sales promotion, higher staff costs and rentals for more POS. Management plans to maintain its expansion momentum in FY09 and is not paying final dividend for FY08. Going forward, we expect store sales to decline on weaker consumer sentiment in FY09, and margins will continue to decline during inventory sell-down. Hence, despite more POS, we are projecting lower earnings over the next 2 years and downgrade our call to FULLY VALUED, and target price to S$0.12, pegged to 3.0x FY09 PER.

4Q08 revenue jumped 21% yoy to RMB279m, net profit fell 30% yoy to RMB25m. On the full year basis, earnings declined 3% to RMB106m, on the back of a 20% yoy growth of revenue to RMB884m. The decline in earnings was mainly attributable to higher distribution expenses related to staff costs and rentals for more POS.

Inventories still high. The company made RMB8m allowance for inventories in FY08, and by end-FY08, there was still RMB344m inventories on the B/S. We expect the mounting inventories would hurt gross margin and may incur some write-off in FY09.

Management plans to open another 120 POS in FY09 vs 129 new POS in FY08. Looking ahead, we expect store sales to decline due to poor consumer sentiment, mitigating the expansion of distribution network, thus leading to flattish revenue growth in FY09. In addition, gross margin is expected to narrow further, resulting in a forecast c. 35% drop in net earnings in FY09.

The counter is currently trading at 4.2x FY09 PER. Considering its uninspiring earnings prospects over the next 2 years, and a lack of near term catalyst, we are downgrading our recommendation to FULLY VALUED, and target price to S$0.12, pegged to 3.0x FY09 PER, which is in line with our valuation for small consumer goods player in the PRC.

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