China Hongxing - Costs hit bottom line

Below. 2Q09 net profit was 50% below our expectation and consensus (-60% yoy to Rmb47.2m) on lower-than-expected GP margins and higher-than-expected costs. As expected, revenue fell 27.2% yoy to Rmb499.0m. GP margins were 35.6% (- 6.3% pts) vs. our forecast of 38.7%. The cost surprise came from advertising and promotion (A&P) expenses related to the ATP Shanghai Masters partnership. A&P rose to 21% of sales from 18.2% yoy. 1H09 net profit was Rmb103.2m (-55.5% yoy) on a revenue decline of 20% to Rmb1,066.7m, accounting for only 27% of our fullyear estimate. Hongxing declared an interim dividend of Rmb1ct. As at end-1H09, Hongxing had a cash hoard of Rmb2.7m.

Expect better 2H. Our FY09 earnings estimate has been cut by 24% to reflect higher advertising and promotion expenses. We expect 2H to be stronger than 1H as we believe the worst is over for the sportswear sector. Based on improving retail sales, we expect Hongxing to be able to cease product discounts to distributors by 3Q09. While demand is recovering gradually, order value could continue to decline yoy at the 1Q10 trade fair which will be held in August, given a record performance a year ago. We expect Hongxing to perform below the industry average due to its weaker brand name and conservatism.

Maintain Neutral. Hongxing’s closest competitor, Anta, is trading at 18.0x CY10 P/E. We believe Hongxing should trade at a discount to Anta, given its smaller size and weaker earnings visibility. Our target price remains S$0.18, still pegged at 6x CY10 P/E, at a discount to its larger peers. Maintain Neutral given the limited upside to our share price.

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