Hongguo FY08 results analysis

Hongguo released their FY08 results quite some time ago, and it’s only now that I’ve the time and resolve to really sit through and pore over it in detail. Overall, it was quite a disappointing 4Q result – not terribly bad nor excellent, just so-so. It didn’t help that Hongguo did not declare dividends for FY08 too, presumably to conserve cash and stay liquid in this hard and trying times. I’ve been waiting a year for their dividends in vain.

Here are the quarterly results for Hongguo for the whole of FY08:




1) We can see that the gross margins of Hongguo’s business fell sharply over the quarters. After a sharp rise in 2Q, the 2H08 is just anaemic. There are two reasons for this.

Firstly, the price of the products sold had been reduced due to the promotional discounts granted under the Hongguo’s stock clearing activity, as well as other sales campaigns organized by departmental stores. The departmental stores had to do this so as to encourage more consumers to spend, and such activities had increased in the 4Q, resulting in the rather poor gross margins of 34.6% in the 4Q (compared to average 39.4% for the whole FY08).

Secondly, there is an increase in the cost incurred by Hongguo to support the sales campaigns organized by the departmental stores. Whether there is an increased in the cost of producing the products sold, I’m not too sure on that.

These two reasons exert a downward pressure on the profit margins relating to C.Banner product line and those under JUC. It remains to be seen if this is a chronic problem or a temporary one. C.Banner, Hongguo’s top selling product line, is still ranked no.3 in China in terms of market share.


2)Net margins dropped throughout the whole of FY08, resulting in a whole year net margins of only 12%, compared to the 14.9% net margins in FY07. The rise in Selling, distribution and administration expense (SDA) rose for every quarter. This is due to Hongguo setting up more retail outlets (addition of 125 new outlets for their in-house brand, C.Banner and E.Blan, as well as another 60 more Naturaliser outlets), resulting in higher cost and administration expense because of higher staff payroll.

Just counting the in-house brand outlets opened in FY08, there is an increase of 16.4% in the number of outlets in FY08 compared to FY07 (762 in FY07 and 887 in FY08), whereas there is a corresponding increase of 27.1% of SDA (175 mil RMB in FY07 and 223 mil RMB in FY08). To have a clearer picture, let’s take a look at the SDA/revenue increment. It increases marginally from 23.8% in FY07 to 25.3% in FY08. This means that while opening more outlets will increase the SDA, the corresponding revenues brought in by the new outlets sort of compensated for the increase in SDA.

However, more revenues do not necessary imply that more is added to the bottom line. With the management stating explicitly that they are going to add another 120 new outlets (100 for in-house brands, 20 for Naturalizer brand), I’m a little worried. I can expect the SDA to increase more in the next FY. As long as the additional outlets are opened without leveraging themselves too much (they did not borrow money to open new outlets at all) and keep inventory management, costs and cash flow tightly managed, I think all should go well.





3) Their liquidity ratios are all very well above the normal s-share companies, so I’m not worried at all. With current ratio well in excess of 3 times, and quick ratio above 1.5, I think Hongguo have a clean bill of balance sheet health. They are not highly leveraged at all, so that must have helped a lot especially now where credit lines are tight. Receivables dropped, even when revenues have increased, so no problems of Hongguo having a lot of theoretical earnings in income statement but no real money in cashflow statement. I did notice in the footnotes that the percentage of the receivables dragging over more than 1 yr had increased from around 8.7% in FY07 to around 12% in FY08. But the total amount we’re talking about is less than 1% of the total trade receivables, so I think it’s immaterial. Around 94% of the trade receivables in FY08 are not past due and not impaired, so it should translate into cash in due time.

In terms of cash flow, there are not problems as far as I can see. They are probably going to have better cash flow in the next FY because firstly, they skipped the dividends and secondly, they mentioned they are not going to expand their manufacturing facilities to boost their annual capacity since they still have excess capacity to handle it.


4) Looking forward, the management reiterated that their main focus is actually on the ladies footwear retail business in their business strategy. Currently, they are getting a higher percentage of their revenues from their contract manufacturing business. Hongguo intends to be less aggressive in their outlet expansion plan (though they are still going on with their plans to open another 100 in-house brand outlets and 20 Naturalizer outlets), which I think is prudent in case their liquidity dries up.

For the existing scale of operation, Hongguo stated that their current 6 production lines are sufficient, hence they do not need to expand further in their production facilities in the coming FY. They would instead focus on securing high margin orders to increase their profit margins. Big words, yes, but so far, the management had a track record of fulfilling what they had mentioned. I've full faith in them continuing to do so again. They have every incentive to do so, since in FY08, all the 3 founders had a total stake of direct/indirect interest amounting to 47%, compared to 46% in FY07.


5) I should be attending my first AGM on 30th April by Hongguo. They are trying to pass off some resolutions, notably the more interesting one would be the share purchase mandate. I don't mind them purchasing their own shares off the market, though at this time, I would rather they distribute it to shareholders in the form of dividends. I've no wish to invest more in ass-shares at the moment, so I would rather direct the cash from the dividends to other worthy pursuits.


6) Valuation valuation valuation…

Price at last close: $0.155
EPS: $0.061
PE ratio: 2.5x

NAV: $0.32
Current assets – total liabilities: $0.25

I’m not even going to suggest that Hongguo is a good buy now. But if you’re dying to get some ass-shares in SGX, why not consider the better ones? You’ll save yourself countless sleepless nights. Just ask those who invested in Ferrochina, beauty china, china print & dye etc.

Even considering graham’s strict current assets – total liabilities, the current price is at around 40% off it. If Hongguo survived this and does not go belly up, how wrong can you go with 2.5x PE and price way below any form of valuation? Time will tell if this is a good investment.

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Hongguo 3Q results

Hongguo released its 3Q08 results last Fri. It wasn't doing exceptionally well, but given the current state of matter, I think it's quite alright. Let's just do a quick one here.


Here's my thoughts on the statements:

1. Looking at the 3Q to 3Q results, revenue increased which is followed by an increase in both gross profit and net profit in absolute terms. However, gross and net margins fell slightly.

The increase in revenues comes from the increase in more stores (150 in total) selling both the main C.Banner brand and E.Blan. However, JUC outlets decreased by 10 in the 3Q. The Naturalizer brand also starting contributing a little to the revenue. Cost increases as there are more outlets opened, bringing down the net profits. It's good to know that the management decided to limit the expansion of more outlets in the midst of this financial crisis. It's a more prudent way of doing business.

2. A little worried about their net margins, which is declining for a few quarters. I believe their 2nd and 4th quarter is their better quarters in terms of revenue and profit. Take a look at their quarter to quarter figures.


One thing for sure is that their net margins are sliding down. SDA/revenue is getting higher too, which the management always attribute to the expansion in new outlets. So far, their expansion do not require taking any long term debts, which is safe in this kind of credit crisis. At least I know they are less likely to blow up!

3. Here's their current ratio, total debt/equity, ROE and EPS figures.


Current ratio is still alright, but there is an increase in the total debt/equity ratio. The increase in debt is due solely to an increase in short term liabilities. Two figures stand out strongly from the current liabilities section of the balance sheet : Short term loan of 40.9 mil RMB and increase in trade payables from 64 mil RMB to 104 mil RMB. Seems like they are squeezing their creditors more tightly by paying them slower. There are not increase in trade receivables though.

4. As for cash flow, there is a few things to take note of. There was around 20 mil RMB that others need to repay Hongguo. This is partly offset by the 30 mil RMB that Hongguo owed others. Overall, cash generation from operations is +ve, but after taking into account tax, it went to -ve but is generally in a better state than 3Q07. There is an increase in short term loans of 40.9 mil RMB which is mentioned earlier in the balance sheet - but there are no mention of what the loan is used for. It made up 16.7% of the total debt (they have no long term debts), so it's not a major problem. Cash flow should improve more as they plan to limit the expansion of their core retail outlets (I take it that they mean C.Banner and E.blan brands) to 150 by end of FY08. The management mentioned that they would be the productivity and the profitability of their outlets - which I think is a good move. Fight, consolidate THEN advance, that's the way of the infantry.

5. Breakdown of revenue:

C.Banner --- 56.4%
E.Blan ---- 9.6%
Contract manufacturing --- 26.2%
JUC --- 6.1%
Naturalizer footwear --- 1.7%

There is more closure of JUC to the tune of 10 more outlets. I think they are slowly divesting out from that. Another point to take note is the huge increase in the contract manufacturing segment. Compare this to 2Q revenue breakdown:

C.Banner --- 62.2%
E.Blan ---- 9.2%
Contract manufacturing --- 17.0%
JUC --- 6.9%
Naturalizer footwear --- 1.7%

Contract manufacturing is of lower margins than their in-house shoe brand, so I would expect the net margins to drop further. No more plans to expand their production capacity for their contract manufacturing. Management had stated that they wanted a revenue mix of OEM : Retail of 80:20, so that's what we should be looking at.




Value to price comparison:

Annualised EPS for FY08 is SGD $0.0606. On last count, the EPS I calculated was $0.06252. Last close is SGD $0.180 per share. This represents a PE ratio of 3x. To hell with historical PE, haha! The lowest PE was around 5x, but I think it broke all record now.

Applying Graham's strict (current assets - total liabilties)/shares outstanding, we get SGD $0.223 per share. Using NAV [(total assets - total liabilites)/shares], we get SGD 0.307 per share. Based on FY07 dividend, divided yield is around 7.8%.

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Hongguo 2Q results

2Q results

Income statement

1. There is a jump in revenue from 166 mil RMB in 2Q07 to 188 mil RMB in 2Q08, representing a jump of 13.3%. Net profit increased from 26.8 mil RMB to 27.9 mil RMB.

2. Gross profit margin increased from 41.6% to 45.2%. Net profit margins decreased from 16.1% to 14.8% quarter to quarter. I'm currently monitoring net profit margin situation.

3. Selling and distribution/admin expenses(SDA) to revenue (%) increased from 24.5% to 28.0%.

4. Net profit margin drops mostly due to share of losses of JV (580k RMB), finance cost (395k RMB) and a drop in 'other operating income'.

Here's a summary of quarterly ratios:

-------------------------1Q08-------------1Q07--------2Q08----------2Q07
Gross margin--------41.6%-------------39.4%---------45.2%----------41.6%
Net margin----------15.3%-------------16.8%---------14.8%----------16.1%
SDA to revenue------23.1%-------------19.7%---------28.0%----------24.5%


Half year results

No need to talk so much, a table of ratios will do the trick.

-------------------------1H08-------------1H07
Gross margin--------43.3%-------------40.5%
Net margin----------15.1%-------------16.5%
SDA to revenue------25.3%-------------22.0%

As mentioned, I'm a little worried over their net margins. It's to be expected while their new shops are opening and hence net margins continue to fall. As long as it stabilise around 15%, I'll be happy.

1H08 revenue is 412 mil RMB, while 1H07 revenue is 342 mil RMB. For a little perspective, the full FY07 revenue is 739 mil RMB, so the 1H08 revenue is already 56% of last FY's revenue. My full year FY08 revenue of around 890 to 1000 mil RMB is on track. Net earnings of 62 mil RMB for 1H08 also compares well with full year FY07's earnings of 110 mil RMB. Baring unforeseen circumstances, I'm sure Hongguo FY08 results will be better than last financial year.


Balance sheet

-----------------------------1H08------------1H07
Current ratio----------------3.6-------------2.8
Total debt to equity(%)------27.4------------37.1
ROE(%)-----------------------11.7------------11.4%

There's no long term liability. The notes payable to trade creditors are interest-free and secured on fixed deposits, amounting to 16.3 mil RMB in 1H08, compared to 37.8 mil RMB in 1H07. No big changes in balance sheet items for Hongguo. As usual.


Cash flow

Net cash from operating activities for 2Q08 dipped to -12.2 mil RMB, from 14.5 mil RMB 2Q07. Main culprit is the huge amount of notes payable. I think there's nothing alarming about one quarter of negative cash generated from operations, esp when it's used for paying down their notes payable. As mentioned in the balance sheet, the notes payable from their current liabilities dropped by more than 50%. Hongguo is using its cash flow generated from its operations to pay it off.

As for investing activities, there is no disposal of subsidiary for this 2Q, so there is a dip in the net cash from this part of cash flow. Again, nothing important worth mentioning here.


Others

EPS for Hongguo in 1H is $0.1563 RMB. My target for FY08 EPS is $0.32 RMB.

Here's the contribution to revenue and by its different brands

C.Banner --- 62.2%
E.Blan ---- 9.2%
Contract manufacturing --- 17.0%
JUC --- 6.9%
Naturalizer footwear --- 1.7%

Of note is that while all other business, there is an increase in new outlets for 2Q, there is actually a close of 6 retail outlets for Jiangsu Unity Corporation (JUC). This will be something to look out for in their annual report for FY08. Naturalizer footwear also started contributing to their revenue since 1Q08.

Production capacity dedicated to contract manufacturing segment was increased to 6 production lines. The management that they believed this current level of production is adequate in satisfying demand, hence there are no immediate plans to further expand production capacity in short term. This means there are no foreseeable big capex in the near term. Cash flow should further improve.


Value to price comparison

Annualised EPS for FY08 is SGD $0.06252. Last close is SGD $0.33 per share. This represents a PE ratio of 5.3x. This is around historical low PE of Hongguo, which is 5.5x (occurred in 2005 and 2006).

Dividend paid out in FY07 is SGD 1.418 cts per share. At last close of SGD $0.33 per share, it's around 4.3% dividend yield (based on FY07's dividend). Actual amount will vary as it's subjected to the exchange rates of USD because the dividends are actually paid in USD and posted in cheque, instead of the usual direct transfer to bank account. Not that it matters, actually.

Applying Graham's strict (current assets - total liabilties)/shares outstanding, we get SGD $0.192 per share. Using NAV [(total assets - total liabilites)/shares], we get SGD 0.267 per share.

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Hongguo's 1Q08 result analysis is here.

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Hongguo - Management

Management

Three of the founders of Hongguo, Chen Yixi, Li Wei and Miao Bingwen are serving in the board as directors. Chen Yixi is the executive chairman, Li Wei is the Managing director and Miao Bingwen served as the executive director until 1st March 2007, where he became a non-executive director.

There is no employee stock options plan, hence no issues of the shareholder’s stake in Hongguo diluted. Furthermore, there is no stock buyback by Hongguo. There are no employees who are immediate family members of a director and whose renumeration exceeded S$150,000 since FY03.

Here is the breakdown of the founder’s salary indirect plus direct interest held:



We can see that the founders hold a substantial stake of their personal wealth being a stakeholder of the very own company which that set up. The executive chairman, Chen Yixi, alone holds 25.8% (direct and deemed interest combined) of the shares outstanding of Hongguo. Based on a market capitalization of SGD 204 million, that’s a cool SGD 53 million just by Chen Yixi alone. As a whole, the founders hold a 46% stake in their own company – a sure sign of confidence in their own baby.

There is ample planning and disclosure of the management’s plan for Hongguo, all stated clearly in their annual reports. It’s important to check this against what had been done over the years. Below shows the plans laid out and the check if the plans are carried out in the future:



I think the management did a very good job informing shareholders what they intend to do, so that they are no surprises. Their plans for expansion of their POS are very close to the actual POS set up in the future. Furthermore, all their design output targets and annual production targets that are set way in advance had been met uncannily.

A final look at the ROE and ROA will wrap up my analysis of the management of Hongguo. ROE is consistenly around 21-22% range, averaging 22.2% over 5 years since listing in 2003. ROA is improving from 13.66% in FY03 to 16.26% in FY07. Both of these figures show a certain level of competence in their business and management skills.

I find it very interesting that Prime Success and Belle are eagerly pursuing the sportswear segment and cited that the coming Olympics are going to ignite this sports fever in China. However, Hongguo did not once mention about going into the sportswear segment despite the show of confidence by their competitors. Doing business within their own circle of competence or too slow to respond to changing competitive landscape? Time shall tell.

What needs to be done is to attend their AGM.

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It took me some effort to get the IPO prospectus of Hongguo, since the prospectus was dated 23 May 2003. I like to look at the IPO prospectus because with the benefit of hindsight, we can see if the ‘future plans’ listed by the management in the prospectus are fulfilled. Tracking management’s plan is one thing, checking to see if there is a major shift in their plans is another, so these are the 2 areas in which I’ll be looking for.

This is their plans stated in the prospectus:

1. Expansion of retail network and consumer base
a. Expand distribution network of department store outlets in major PRC cities to capture consumers with higher purchasing power

b. Launch customer loyalty privilege card program to develop customer database and to inform customers of new designs and promotions

2. Introduction of new brands and product lines
a. Expand stable of brands

b. Acquire established brands, and possibly production facilities and distribution network that come with acquired brands

c. Develop other brands

d. Introduce new product lines such as men’s fashion shoes to target different market segments

3. Expansion of manufacturing facilities
a. Acquire new equipment to increase production capacity

b. Carry out planned expansion where there is sufficient market demand

4. Contract manufacturing
a. Increase contract manufacturing operations

5. Trading and manufacturing operations in Jordan
a. Set up production facilities in Jordan to manufacture shoes for customers in USA when conditions are favourable

Comments on:

1. Basically their game plan for growth is still the same. They did expand their retail network from 280 POS in 2002 to 840 in 2007 and they also acquired Jiangsu Unity corporation (JUC), a chain of 63 boutiques carrying mainly foreign brands. As for launching of customer loyalty privilege card, it was not mentioned in previous annual reports. However, it was stated here that repeat customers are rewarded with gold and silver privilege cards to receive a 10-20% discounts on future purchases. Not sure if it’s still valid though, as it’s dated back in July 2003.

2. They did expand their holdings of brand, especially after acquiring JUC. The brand holdings under JUC include Byford, Hugo Boss, MaxMara, Bodyline, Ermenegildo Zegna and Tommy Hilfeger. The more recent brand in which Hongguo hold exclusive distribution rights include Naughty Monkey. Naturalizer and Via Spiga rights are accorded to them via a joint venture with US-based Brown Shoe Company in 2nd half of 2007. Besides acquiring established brands under JUC, they developed another house brand called E.Blan. As for men’s shoes, Hongguo distributes Lumberjack brand of casual shoes for men and women which Hongguo had an exclusive distribution rights in China. Besides that, they plan to have urban business/casual men’s shoes brand, as stated in their FY06 slides.

3. Manufacturing facilities expanded to 4.1 million shoes per annum. Expansion of design facilities in Guangzhou enabled them to design 6000 shoes per season in 2007, compared to only 600 designs per season back in 2003.

4. Revenue coming from contract manufacturing segment increases from 10% in 2003 to around 20% in 2007, representing an increasing proportion of Hongguo’s business. Management wanted a retail to OEM ratio of 80:20 mix, which is what we see in 2007. Besides Nine west, their contract manufacturing business include other notable brands like Kenneth Cole, Guess and Colorado.

5. I do not know much about their Jordan business as not much is mentioned.

I think the management did a fine job stating in advance what they had in store of Hongguo and they had the track record to prove it. Moving forward, the managements stated in FY06 slides that their plans forward is as follows:

1. Going to propel Hongguo as a fashion goods and branding company driven mainly by footwear distribution

2. Retail vs OEM maintained at 80% : 20% mix

3. Develop a comprehensive industrial chain to build up a leading status in the market to enjoy long term competitive advantage against other players

4. Construct a brand portfolio and product portfolio
a. E.Blan – transformation from a shoes brand to a multi-brand footwear store chain brand

b. To include a series of ladies’ fashion brands covering medium to high end market, including shoes, handbags and accessories

c. Urban business/casual men’s shoes brand

5. Maintain 8% to 10% annual same store sales growth
a. Open 100-150 new stores annually from 2008 to 2010

6. Enhance logistics and information system
a. Enhance sales system and update POS system

b. Streamline logistic process

7. Form alliance with outstanding companies internationally

If all goes according to plan, we can see a greater net margins and slightly slower POS increment in the years to come. I see that the management has no plans to venture into the sportswear segment and is cutting their niche into exclusively ladies fashion wear. No institutional imperative, it seems.

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Hongguo - Financial health

Financial health of Hongguo

In the midst of analyzing the ROE, I’ve calculated the financial leverage ratio. Financial leverage ratio gives a good feel of the amount of leverage used. The figures are as shown:

Financial leverage---------Year
1.44--------------------------2003
1.43--------------------------2004
1.46--------------------------2005
1.38--------------------------2006
1.37--------------------------2007

Judging from the ratios, we can see that Hongguo isn’t overly extending itself. In fact, it should be less leveraged as the years go by. Let’s take a closer look to see if the financial status of Hongguo is as shown by the financial leverage ratio shown above.



Debt to Equity (total liabilities/share holder’s equity)

Debt to equity of Hongguo decreases steadily from 2002 to 2007, which is what is suggested by the financial leverage ratio. Looking at the balance sheet, there are only two years, 2003 and 2004, in which Hongguo had long term liabilities in the form of term loans. After that, there are no more long term liabilities.

On the other hand, Prime has a higher Debt/equity ratio (about twice as much) than Hongguo. This can also be seen by their higher financial leverage ratio shown in earlier post. Belle is harder to tell, since there is only one year since listing to compare.

On the whole, I’m very satisfied with the debt/equity that Hongguo has. It’s the second lowest among the three. A debt/equity averaging 0.43 since listing in 2003 is definitely not a sign to worry about.

Current and Quick ratio

Current ratio of Hongguo shows a slight downtrend. Considering that in FY07, its current assets are more than enough to pay off its current liabilities 2.77 times, I’m hardly worried. Even a more conservative quick ratio suggest that in the same year, the current assets without taking into account Hongguo’s inventories can pay off its current liabilities 1.46 times. Since Hongguo only has current liabilities, I think we can safely give Hongguo a clean bill of financial health.

Prime has a lower current ratio and quick ratio, with quick ratio less than 1 throughout the years. While I don’t think it is having any insolvency issues near term, I dare say that Hongguo has a stronger balance sheet than Prime. Belle has a rather strange current and quick ratio, but let’s not bother too much into it for now.

To add the cake to the icing, let’s take a look at the amount of cash that each company holds as a percentage to their total assets.

Cash/Total assets (%)--------02--------03--------04-------05-------06-------07
Hongguo-----------------------4.9------35.9------14.5------10.3-----12.2-----10.3
Belle-----------------------------------------------------------------------6.8-------38.5
Prime Success----------------16.8------18.0------11.8-----10.2------8.7-------7.7

I’ve a feeling that Hongguo management wanted to grow, but at a sustainable pace backed by a series of successful points of sales (POS) and funded by their own internal cash flow generated. They can borrow from banks to really aggressively open up new stores, but they didn’t. In fact, they are sitting on around 10% cash out of their total assets. While this might hinder their growth somewhat by not aggressively pursuing an all out approach to expand, I believe this prudence will bring about a longer and more sustainable growth in their business over time.

Here’s Hongguo’s financial health report – a strong balance sheet with around 60% equities and 40% debts on average, no long term liabilities or bank borrowings in recent years and with enough assets to pay off their liabilities at least 1.5 times over. I’m more than satisfied with them.

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Hongguo and Prime Success Price/EPS chart

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Hongguo - Profitability part 2

EPS

Looking at the graph below, we can see that for the trio, earnings are pretty good and is consistently getting higher. I do find it strange that even though Hongguo’s portfolio is behind both Belle’s and Prime’s, its EPS is actually the highest among the three.


If this trend is sustainable, it doesn’t even matter to me if Hongguo is ranked 3rd or ranked 1st, since it’s the earnings that ultimately drive the company, not the market share of their brands, though both are usually correlated.

Hongguo’s EPS historical growth is around 25%. I did some calculations based on different periods of years to derive the CAGR and found that it’s pretty consistent, always hovering around 21 to 29% since inception. The CAGR shown below is actually for 5 year period since 2002 to 2007.


As for Prime’s, EPS historical growth rate is much higher and also less consistent compared to Hongguo. It grows at a 5-year CAGR of 62%, but the fluctuations of the CAGR for different periods vary from 22% to 41%. In other words, Prime’s EPS growth rate is high but less consistent than Hongguo.

Based on my previous post on Hongguo’s valuation, I projected the EPS in 2020 to be $2.04 and I know that the EPS for FY07 is $0.28. That gives us a projected CAGR of 16.5% over 13 years into the future. Comparing my projection with the historical EPS growth rate of 25%, I think it’s quite reasonable, considering that the historical EPS of Belle and Prime is well in excess of 60%. Even Prime’s more recent earnings growth rate of 33% (from 2006 to 2007) is way higher than my projected CAGR of 16.5% for Hongguo.

PE of Prime Success vs Hongguo

Prime’s historical PE ratio is shown below. It goes from a low PE of 1.1 times to a high PE of 42 times. But let’s just look at the more recent PE, it’ll be around 16.2 to 42 times. Last close of Prime Success is HKD 4.55, which gives it a PE (based on FY07 earnings) of 19.2 times. Prime’s FY06 to FY07 earnings is 32%.


On the other hand, Hongguo current PE is 10 times, with FY06 to FY07 earnings growing at 22%. According to Peter Lynch, PE of a fairly valued stock should be the same as the earnings growth rate. Dividing earnings growth rate by PE, a stock having 1.5 is considered good but having above 2 is a possible bargain. Following his line of thought, Hongguo will be quite undervalued at the current price, having a PE of 10x but an earnings growth rate of 22%. It should be more fairly valued around PE of 22 times. (22/10 = 2.2)

Similarly we can do the same for Prime. It is trading at PE of 19 times, but with earnings growth rate of 32%. (32/19 = 1.7).

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Hongguo - Profitability part 1

Profitability

Let’s take a closer look on the profitability of Hongguo. To really see how good/bad Hongguo is, it’s inevitably that I’ll have to look through its main competitors – Belle and Prime Success again. Below is my calculated data, after spending days poring hunting down annual reports and compiling them.


Prime Success is the longest listed company out of the trio, while Belle is the youngest, having been listed only in May 2007 (though it had been in business for a far longer time). As such, do take Belle’s data with more skepticism than your normal dosage.

Here, I’ll just focus on ROE, ROA and the margins.

ROE

We can see that for the trio, all ROE is relatively high as it should be, given their market position in PRC. Hongguo has a more consistent and steadily increasing ROE, while Prime success’s ROE peaks at 2004 and is steadily declining ever since. In ascending average ROE, Belle is ranked first, followed by Hongguo then Prime. Since Prime success is touted as Hongguo’s main competitor (see previous posting), we ought to do a closer comparison between the two.

As mentioned earlier, Prime has a spottier ROE compared to Hongguo. On average over the same period of time, Prime has a lower ROE of 24.50% compared to Hongguo’s 25.77%. It seems like Hongguo is better at investing retained earnings than Prime does. It’s not surprising given that Hongguo has the smallest market share among the trio, and the bigger competitors will always find it harder to invest in themselves than when they are much smaller.

I am quite pleased with the stability of Hongguo’s ROE though, it definitely makes valuation much more predictable.

ROA

Actually, whatever had been mentioned for ROE can be copied directly to this part. In ascending average ROA, again we have Belle ranked as the top, followed by Hongguo and finally Prime.

Hongguo showed steadily improving ROA, while Prime shows a spottier ROA record, like what we’ve seen earlier on its ROE. Again, I’ll attribute this partly to the smaller size of Hongguo. The management must also play a certain part in creating these figures, since not all can be explained by just the size of the company. In this aspect, Hongguo is once again ranked highly by being consistent.

Gross and net margins

Net margin for Hongguo is showing a decline, though its gross margins increases. Since gross margins didn’t decline along with net margins, I believe that it is the increasing expenses of maintaining a greater sales force and expansion plans that causes the decline in net margins. I would start to worry if after the expansion plans slows down, the net margins still didn’t improve, or if the gross margins start to drop. If this scenario actually plays out, I’ll have reasons to believe that somehow, the brand of Hongguo is no longer as attractive as it is now, so they can’t pass the rising costs down to consumers. As it is now, it’s more reasonable to adopt a wait-and-see attitude to see if the net margins can improve in the future.

Prime is also expanding rapidly, yet their net margins didn’t drop. In fact, for Prime, gross margins increases while net margins remain more or less constant. Strange isn’t it? I’ll keep a lookout on this point for Hongguo.

Thoughts

Earnings come from two parts – volume of sales and price of sales. A company with low net margins, selling huge volume can rival that of another company with high margins but with lesser volume.

Prime seems to be the low net margins, high turnover kind, judging from its asset turnover of 1.69 (highest among the three) and net margins of 8.06% (lowest among the three). Prime gives me a mental image of them selling lower priced items to mass consumer. The higher volume because of the lower price compensates for the lower net margins, giving Prime their earnings.

Hongguo, on the other hand, has a higher net margins but with lower asset turnover. Is is interesting to take note that while net margins drop over the years, the asset turnover increases more. This gives me a mental image of Hongguo selling higher priced items but with lower volume. The Average selling price of Hongguo shoes compared to Prime seems more or less to confirm this observation. If that indeed is the case, then Hongguo’s management is right; they do not have to worry much about Prime’s Daphne brand as it caters to a different crowd and have lower selling price.

Belle’s net margin is the highest, based on 2007, yet their asset turnover is also the lowest in the same year. It is stated that Hongguo will follow this model of going for the higher end consumer where there is more emphasis on brands than the more cutthroat mass market. If that is the case, we only have to see the margins of Belle to have a rough guide on where the net margins of Hongguo will go in the near future – around 16% and above. Since Belle and Prime (except Hongguo) indicated interest in growing their sportswear brands, it will be crucial to see what the margins for sportswear and the ladies fashion shoes are. That should shed more light on what the margins for Hongguo will be like.

Points of sales (POS) analysis

I thought this could be a good way to analyse retail business – by analyzing the revenue, expense and earnings stream of each company with reference to their POS. I came out with this table.


A few trends I noticed:

1. Belle is getting the most bang for its buck. Revenue per POS of 1.90 RMB million beats Prime and Hongguo hands down. Revenue per POS for Prime is coming down steadily while Hongguo is climbing up. It’s important that revenue per POS is at least constant or improving because it shows us how each dollar of revenue is generated from each point of sales being set up, even as the company expands. We certainly do not want to see more stores but less revenue generated – could be a sign of expanding too fast or too aggressively into regions outside their target market.

2. Belle again wins hands down for the net profit generated per POS. Here, we see an increasing trend of net profit per POS for Hongguo and a decreasing trend for Prime. Can you imagine it – in 2007, an average POS for Hongguo earns the same net profit as an average POS for Prime?

3. Selling & Distribution (S&D) expense per POS for Belle is the highest, so here we see that the higher net margins comes at a higher cost. The high selling and distribution cost per POS for Belle seems to confirm the earlier image of Belle as the high end seller. To create a perceived difference in their shoes, Belle must necessary spend more on advertising, which chalks up their S&D expenses. Surprisingly, Hongguo has the lowest cost per POS. Why surprising? Because given their decreasing net margins, I would expect the cost to run up faster than the earnings they get from opening new POS. Hmm, this is indeed an interesting point to investigate further – why did net margins of Hongguo drop over the years?

I do hope that Hongguo can increase their advertising further, yet this will cause the S&D to increase higher too. The only way around this is that the advertising will eventually generate enough consumer goodwill which will make the consumers pay more for the branding, thus improving margins in the long run.

Thoughts

I think Prime Success is in some sort of a trouble. Something isn’t just quite right when we look at its numbers – the story seems a bit bleak for Prime. As for Hongguo, I think they do have the potential to maintain or even improve its market position. It’s good that while Hongguo seeks to expand over as many POS as possible, they did it from their own cash flows and didn’t borrow excessively to achieve this. When times are bad, this kind of cautionary and prudent expansion plans will bode well for the company’s long term future.

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Hongguo - Valuation

Valuation

I did up several analysis to determine a ballpark range of which the price of Hongguo can be expected to appreciate in the coming years. The first one which I did was the constant ROE analysis, with projected EPS shown below.


As the name suggests, I assumed that the ROE for Hongguo is constant at 22.19%, which is the 5 year average value from 2003 to 2007. I also assumed that the payout ratio (dividends per earnings) is 25%. Sparing you the details, I get an EPS of SGD $1.50 in year 2018, ten years from now. The table above shall be the guide in which the yearly results of Hongguo will be checked against. I’ll be looking out for the EPS for subsequent reports, to ensure that Hongguo is performing within my expectations.

I also checked the projected EPS against the actual EPS, shown below


It’s not amazing that the projected and actual are around the same, since my model is based on historical results (2003 to 2007). It’s more important to look forward to 2008 quarterly results to see if the projection yearly EPS can be hit.

I tabulated the historical PE for Hongguo since their IPO in June 2003 below. Based on the closing price and earnings for that particular year in question, the lowest PE ratio for Hongguo is 5.5 and the highest is 26.3.



This is what I did:

Assumptions

1. Projected EPS for 2018 is RMB $1.50
2. Currency exchange of 1 RMB to 0.2 SGD
3. Highest PE of 26.3
4. Lowest PE of 5.5
5. Dividend payout ratio of 25% to earnings

Projected price for Hongguo in 2018 range from $1.65 to $7.89

Based on a price of $0.540, we can expect a return of 11.8% to 30.8% pa compounded for 10 years. Since dividends are paid out, we can also get a total dividend per share of $0.67 in ten years time, more than the original purchase price of $0.540.

As a rough guide, PE for Belle is currently around 31 times, Prime success around 23 times and Hongguo is around 10 times.

Let’s calculate our total returns (including dividends),

Total expected earnings (including dividends) in 2018 = 1.65 + 0.67 = $2.32
Based on a price of $0.540 gives us a return of 15.7% compounded annually over a period of 10 years, pretty good for me.

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Hongguo - Growth prospects

Growth prospects

In the annual report for FY2007, Hongguo mentioned that their future plans are:

1. To build a multi-brand portfolio in order to cater for diversifying market niches, by forming 6 to 8 brand package in next 2- 3 years OR through in-house brand development or collaborations with renowned foreign partners

2. Sales network will be enlarged to support 260 more stores, comprising 200 for in-house brands and 60 for cooperative brands with Brown shoe

3. Production capacity will be expanded to 12 production lines, of which 6 will be for the production of in –house brands and the remaining 6 for supporting contract manufacturing business.

Their plans are based on their core beliefs that China’s economy will continue to grow and they will be more affluent consumers waiting to get their products. As a result of these core beliefs, they are increasing their production lines to make more shoes in anticipation of this rising demands. At the same time, they are collaborating with international partners to build up their brand portfolio, presumably to increase their market share.

Are these core beliefs valid? If it is valid, is it possible to gauge how much the increased demand will be like? Let’s have a go.

China GDP grew at a CAGR of 11.9% per annum from 1995 to 2006, which can lead to an emergence of a middle class which is both quality conscious and have the purchasing power to drive PRC consumer market. China’s footwear sales volume reached 2.1 billion in 2006 and is forecasted to increase to 3.5 billion by 2009. The sales volume per capita for china is forecasted to increase from 1.6 pairs to 2.2 by end of 2009, while leather shoes sales are forecasted to grow at 15% per year from 2006 onwards (from annual report FY07).

The national bureau of statistics revealed that China’s middle-income group (with annual income between RMB 60k to 500k) is likely to increase from 65.5 million (5% of total population) to 45% in 2020, with annual incomes per household of RMB 60k to 500k. With average salaries of RMB 2100-2300 for employees in major cities, there is a high proportion of workers belonging to the middle income group and this figure is still increasing.



The following shows the shoes sold per capita in different countries (from China International Capital Corp):

China – 2.3 pairs per year
South Korea – 3.9 pairs per year
US – 7.3 pairs per year

As disposable income rises, it’s very likely that China will increase its shoes sold per capita. Perhaps not as much as U.S but at least it’s likely to see that approaching more mature markets like South Korea.

What’s more interesting is that China’s luxury market is predominantly male-driven. In fact, it is the only market in the world where men consume more luxury than women (Feb 2008, Issue 12, Industry Series). They are also much younger than their western counterparts, with males aged 25 to 40, compared to 40 to 70 in western markets. These are young professionals, entrepreneurs and businessmen. Female consumerism is set to rise and there’s plenty of scope for growth in the ladies shoes market. So confident that Belle’s CEO mentioned during their IPO that shoes are a necessity hence they are not subjected to the whims of macro-economic trends.

Let’s summarise the main findings

1. Female consumerism is set to rise. Current luxury goods consumers are males.

2. Emergence of a middle-income class – forecasted to reach 45% of total population in 2020. Population of China at 2020 is forecasted to be 1.4 billion (UN world population 2004 revision)

3. Rising disposable income, especially from urban households. From 1990 to 2006, disposable income of urban household increases at a CAGR of 11.8%. This is against a backdrop of strong GDP growth of China with CAGR of 11.9% per annum from 1995 to 2006. GDP of China in 2007 revised to 11.9% (Shanghai Daily, 11th April)

4. Per capita sales of shoes set to increase from current 2.2 pairs to reach closer to South Korea 3.9 or U.S 7.3 pair per annum

Let’s do some rough estimation:

Assumptions (conservative, I must add):

Estimated population size of China in 2020 = 1.4 billion
Middle class proportion in 2020 = 45%
Market share of Hongguo in 2020 = 5%
Shoe sales per capita = 2.3 pairs per year
Average Selling Price of shoes = 300 RMB

Estimated revenue for Hongguo in 2020 = 1.4 x .45 x .05 x 2.3 x 300 = RMB 22 billion
Given 2007 revenue for Hongguo is RMB 7.39 billion,
Forward CAGR of revenue from 2007 to 2020 = 29.8%

Historical CAGR of revenue from 2003 to 2007 = 35.3%
Estimated revenue in 2020 based on CAGR of 35.3% = RMB 32.9 billion

Belle’s and Daphne market share is around 7-8%, with the top 10 brands making up 50% of total market share. I assume Hongguo having a market share of 5% despite being the top 2nd or 3rd brand in China for so many years. I also assumed that the shoe sales per capita remained at 2007 level, possible though unlikely.

I think this estimate is helpful because we know that if assumptions are met, we can conservatively expect Hongguo to continue growing their revenue at around 30% from year to year until 2020. If assumptions are more than catered for, we can expect an even greater revenue growth for Hongguo (in fact for the whole industry as well), perhaps around its historical CAGR of 35%. Any more optimistic than that is just pure speculation.

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Hongguo - signs of monopoly

Signs of monopoly

Hongguo does show signs of having a good business. Earnings is consistently increasing since they were listed in 2003, with a compounded annual growth rate (CAGR) of 20.3% since 2003 to 2007. The key word here is consistent; Hongguo has never dropped its earnings since IPO in 2003, and in fact it has been steadily increasing.

ROE is also pretty consistent (in fact showing a slight uptrend), around 20 to 22% since listing, giving a very respectable 5 year average ROE of 22.2%. By breaking down ROE into 3 components, we can see exactly what drives ROE over the years. Hongguo did not do it through debts as the financial leverage ratio went down from 1.61 in 2003 to 1.37 in 2007. Hongguo did not do it through net margins (more about that later) as net margins shows a decline from 19.3% to 14.9% in 2007. Instead, Hongguo increased asset turnover from 0.71 in 2003 to 1.09 in 2007 – a sign that they are pretty efficient at generating revenue from their assets.


A look at the ROA shows the same picture. The drop in net margins is compensated by the increment in asset turnover, causing ROA to rise up since 2003 to 2007 with a 5 year average of 15.1%.

So why do consumers buy Hongguo’s shoes? By finding out the answer to this, we can understand if Hongguo has a consumer monopoly. If it does, is the economic moat that prevents other competitors from eroding its profit deep and wide?

Hongguo has 2 core businesses:

1. Design, production and retail of their two in-house brands, C.Banner and E.Blan for the domestic market in PRC

2. Original equipment manufacturer (OEM) for global footwear brands for the international market

For their in-house brand C.Banner, it is a ladies’ fashion footwear label aimed not at the general mass market but more at the quality upmarket side. C.Banner is ranked 2nd in 2005, 3rd from 2002-2004 in terms of market share from CIIIC (national statistics board of PRC). C.Banner replaces Qianbaidu in 2002 as the equivalent of brand name. Qianbaidu was previously ranked 6th in terms of market share in 1999, but is aimed at the medium price range, unlike the new C.Banner.

Most notably, C.Banner is also recognized as National Famous Brand in 2005. According to the State Bureau of Quality and Technical Supervision which governs the assessment of national-level brand name products, a national brand name must satisfy the following basic criteria:

1. The product must be a national quality award-winning item whose quality is among the best of its kind in the country and has reached advanced international standards.

2. The product must meet market needs and have won widespread recognition. The manufacturer must have the necessary technical know-how and have achieved economy of scale in its production capacity. Its annual sales and economic benefits must be among the top in the industry for over five consecutive years.

3. The manufacturer must possess advanced and reliable production facilities and have the ability to conduct research and development.

4. The product must have good market rating and after-sales service.

5. The product must have met all the quality requirements in spot checks by all the relevant government departments over the past three years, and none of the product for export has have ever been rejected or involved in quality-related claim for damages.

As can be seen, the criteria stated are not easy to meet and is in fact quite strict. The fact that C.Banner is a national brand name must testify to the fact that the branding is not just widely known, it actually brought in tangible economic benefits to Hongguo.

From what I read, there are only 8 major players whose ranking rotates throughout the years. As such, I consider them possible competitors to Hongguo, even though their product mix and target audience might be different. These are the competitors (not arranged in any order):

1. Daphne –Prime Success or Yong’en

2. Belle – Belle International Holdings

3. Senda – Jiangsu Senda Footwear

4. Fuguiniao – Shishi Fuguiniao shoes development

5. Harson – Jiangsui Kunshan Zhen Zing Footwear

6. Teenmix – Belle International Holdings

7. Basto – Shanghai Basto Footwear

Of course, the 8th is C.Banner (or Qianbaidu, their older name).

On 13th Nov, Belle international acquired 5 companies from Jiangsu Senda Group, which includes Jiangsu Senda group sanxia footwear and shanghai basto footwear. In other, words, Belle basically acquired nearly all the competition (Belle, Senda, Teenmix and Basto are all under Belle international now), giving rise to 3 major players (not arranged in any order):

1. Prime success (1880.HK)
2. Belle International Holdings (0210.HK)
3. Hongguo International (H14.SI)

In terms of market cap (22nd April, 2008):

1. Belle International – SGD 10.8 billion
2. Prime Success – SGD 739 million
3. Hongguo – SGD 204 million

In terms of Points of sales (POS) as of 31st Dec, 2007:

1. Belle International – 6,090 from PRC alone, 6,143 in total
2. Prime success – 2,374 from Daphne, 2859 in total in PRC
3. Hongguo – 540 for C.Banner, 840 in total in PRC

In terms of EPS (RMB) as of 31st Dec, 2007:

1. Hongguo – 27.76 cents
2. Belle International – 25.03 cents
3. Prime success – 21.08 cents

In terms of net margins based on FY2007:

1. Belle International – 17.0%
2. Hongguo – 14.9%
3. Prime success – 10.1%

Without doubt, Belle International is the major competitor for Hongguo in PRC market. It is also stated in an interview dated 16th Sept, 2003 that Belle international is their main competitor. Prime Success (Daphne) is not a direct competitor as they are in a different shoe segment and their shoes are selling at half or two-thirds the price of Hongguo’s shoes, hence Daphne is in a different market segment from Hongguo. I did some sleuthing and found that the average selling price (ASP) of Daphne shoes range from RMB 200-250 (SGD 40 – 50) per pair in 2007, which is exactly what Hongguo had mentioned. Daphne is the No.1 brand in Chinese ladies footwear market for the past 10 consecutive years.

Are they concerned about foreign brands competing with them? They mentioned no, because the pricing tends to be very high (above 1,500 RMB or SGD 300 per pair), hence they are targeted at very high-end customers. On the contrary, Hongguo shoes ranged around 300 to 400 RMB (SGD 60 – 80 per pair).

It seems that tiny Hongguo is able to fight off the competitors pretty well, despite its limited market cap. They possibly have something that consumers like about their brand. Or rather, I propose that Hongguo is able to carve a little niche out of selling shoes to a group of people who are left behind by Daphne’s middle class range and foreign players’ high-end range.

But as I read more, I realized that both Prime Success and Belle International had substantial exposure to sportswear. For FY07, Belle’s business is split into 2 main divisions – footwear and sportswear. The footwear division is responsible for 53.1% of FY07 revenue stream while sportswear consists of 46.9% of revenue. The sportswear growth rate for Belle from 2006 to 2007 is a staggering 244.9% while the growth rate for footwear is only 34.8%.

Prime Success FY07 revenue consists of 75% Daphne and Shoebox brand (both are ladies’ fashion footwear brand) and 8% Adidas. Shoebox brand has ASP of RMB 75 – 100 per pair, so it is catered to the low-price market segment. Prime Success also mentioned repeatedly that Adidas is a renowned brand and are planning to grow that segment. Hence, we can see that the two major players are concentrating their firepower on growing their sportswear segment.

In other words, we see the following situation:

Belle – covering all the market segment, concentrating on growing their sportswear business. Belle and Staccato (brand under Belle International) ASP is about RMB 600-700 per pair.

Prime Success – covering low-price end (Shoebox) and middle-price range (Daphne), as well as sportswear (Adidas). They obtained distribution rights for Nike products in China too and mentioned they are going to focus on growing Daphne and sportswear brands. Daphne ASP is around RMB 200-250 per pair.

Hongguo – focusing only on designing, production and retailing of in-house and international brands of shoes, mainly aimed at middle to high end ladies fashion footwear. They do retailing for fashion apparel too. Think Byford, Hugo Boss, MaxMara, Bodyline, Ermenegildo Zegna, Guess, Colorado and Nine West. C.Banner ASP is around RMB 300-400 per pair.

I think with this, I have found Hongguo’s situational monopoly in the cutthroat consumer market in PRC. They have found their niche on a group of people not covered extensively by the major competitors. Belle can be a worthy competitor, but they are focusing their fight on the sportswear segment. Prime Success’s Daphne continues to be a major contender for market share with Hongguo’s C.Banner, but Prime success also seems to be more interested in growing their sportswear brands. Besides, Daphne ASP of RMB 200-250 per pair puts it at a different league with the ASP of C.Banner, which is around RMB 300-400 per pair.

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Hongguo - initiating coverage

I'm interested in this Singapore listed China company named Hongguo. Hongguo is a manufacturer and retailer of fashion ladies shoes and clothing, best known for their 'C.banner' and 'E.Blan' lines of ladies shoes. Though I never heard of these 2 brands before, do take note that Hongguo is one of the 2 largest ladies shoe brands in China, with their own manufacturing facilities in Nanjing and Dongguan.

Besides their own well recognised brand in China, they also do contract manufacturing over other brands of shoes. 'Nine west' is one of them. I read that they could be bringing in other brands to expand their portfolio, including international ones like Tommy Hilfiger.

Outlook: Women drive the economy. Looking at how my significant other buys her shoes every month and hearing how other 'more normal' women buy new shoes every week, we could be looking at a fast expanding market. As china get more affluent, we could be looking at a shift in the earning power of women there. Hence in their own market in which they are ranked the top 2, there could be tremendous growth.

Risk: Shoes can be commoditized. Branding plays a good part in holding the pricing and selling power of Hongguo. If that fails, they can only resort to reducing the price of their shoes, will be ultimately erode their margins and earnings.

Ratios: Margins is around 17 to 19% from 2003 to 2007. ROE is around 20-22 for the same period. PE is slightly less than 10 (based on FY07 earnings). Possible bargain in this company.

Need to analyse more in depth, considering this is a china company. Management needs to be scrutinized more carefully than usual.

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