China Hongxing's 2Q report

China Hongxing gave a strong 2QFY08 report. Here's the highlights of the reports:

1. Revenue increased 53.1% for the quarter ending 30 June 08. For the 1HFY08, revenue increased by 48.4% compared to 1HFY07. Gross margin dropped from 42% in 1H07 to 40% in 1H08. For the same period, net margins also dropped from 18.8% to 17.4%.

My take:

The revenue growth of Hongxing is always admirable. They are on the fast track to increase their points of sales (POS) rapidly, and this contributes to their top line exponentially. Just for the first half of FY08, they increased their POS by 397 to 3,648 in China. In the whole of FY07, the revenue is RMB 2,046 million. Just for 1H08, the revenue is already RMB 1,333 million. If we annualised the 1HFY08 revenue figure, we're going to see a 30% increase in revenue from FY07 to FY08. Probably more than this, since 4Q is their strongest in sales for the entire year.

There is strong revenue growth in all segments of their business, something to cheer for. Footwear makes up 68.5% of their revenue, while apparel makes up 26.8% in 1H08, compared to 59.4% of revenue in footwear and 33.2% in apparel for 1H07.

For the margins, there is an appreciably drop in both gross margins and net margins quarter to quarter. In FY07, gross margin and net margin are 41.4% and 20.4% respectively, compared to 1H07's 42% and 17.4%. I think this is normal, as the new POS are just starting up and needed some time to bring in the crowd and add in to the top and bottom line. I think one needs to be more mindful of the expenses chalked up in the meantime - Selling and distribution in 1H08 is now at 257 mil RMB, compared to 312 mil RMB for the whole of FY08. If management carries on the pace of their expansion of new POS, their gross and net margins will definitely be squeezed by higher expenses.

I think I would exercise caution in building the brand empire. Too much too soon will breed redundancy, which will cost them dearly if economic situation isn't as rosy as they forecasted.


I found something ironic in the footnotes of the results. It mentioned on pg 9 of 13 that the strong growth in revenue is mainly attributed to:

"(iii) our ability to raise our selling prices; and"

But a few lines down, under the heading of "Cost of goods sold and gross profit margin", it mentioned that the gross profit margin went down because

"This was mainly due to product discounts of approximately RMB 78.0 million provided to our distributors and retailers".

While this is probably nothing worth alarming over, the ironic of the situation struck me. If they are able to raise their selling prices, why offer discounts to sell to distributors and retailers? Their business strategy?


2. Current ratio for 1H08 is 15.6. Quick ratio is 14.8. For the same period, total liabilities to equity is 13.6%. Cash flow from operation went down to - 248 million RMB in 1H08, compared to 90.8 mil RMB in 1H07.

My take:

Hongxing always had very good gearing and low borrowings. In FY07, current, quick and total liabilities to equity are 14.7, 14.2 and 14.4% respectively. I don't think they have much problems of insolvency in the short term, nor in the long run.

For their cash coming from operation, the huge shortfall should be due to the increase in prepayments, deposits and the receivables - to the tune of 592 mil RMB. There is also a corresponding big increase in the inventories held (which they mentioned is for the commencement of their new manufacturing facilities). I believe this is normal for a company that is on the fast track to increase their POS, so they needed to increase their supplies to facilitate the setting up of these new POS. Indeed, they mentioned this on pg 11 of 13.


3. EPS (diluted) increased from 7.57 cts RMB to 8.61 cts RMB in 1H08. For non diluted basic EPS, it increased from 8.44 cts RMB to 9.14 cts RMB for the same period.

My take:

For FY07, EPS (basic) is 16.4 cts RMB. If we annualised 1H08 EPS, we can roughly get around 18 cts RMB, representing around 10% growth in EPS. At current price of 0.485, this represents a FY07 PE of 14.7x. Forward FY08 PE will be around 14x. While it did come down from a PE of 20x just 3 months ago, I think at least at 14-15x PE, it's a more reasonable price to enter. Reasonable but not necessarily giving a wide margin of safety.

Assuming a pessimistic scenario, I think a growth of 10% EPS is what I can accept. So perhaps a PE of 10x, with a price of around 0.34-0.35 seems to offer more margin for a deeper and better sleep at night.