EUR 850.00 For Business Accounts Only

Morningstar | One-Time Air Freight Expenses Weighed Down on Shenzhou's 2H Results, FVE Maintained at HKD 76. See Updated Analyst Note from 26 Mar 2019

Narrow-moat Shenzhou’s shares were down about 6% after reporting 2018 second half earnings below both Morningstar and the Street’s estimates. For the full year, the firm booked a 16% increase in top line, driven almost entirely by volume growth. Weaker Chinese yuan during the second half brought average-selling-price growth to positive territory, up from a negative 4% reported for the interim. We maintain our HKD 76 fair value estimate for Shenzhou and continue to see the shares as overvalued.

During the latter six months of 2018, Shenzhou booked a gross profit margin of 31%, in line with the ratio reported for the same period last year. Positive gross margin impact from increased productivity across all the manufacturing plants was offset by rising labor and raw material expenses. At the same time, Shenzhou’s retail business, Maxwin, wrote off some old inventories, leading to a negative 30 basis points impact to gross margin. The firm’s adjusted EBIT margin (excluding non-operating income, exchange gains/losses, and finance costs) is 20.6%, marginally lower than the same period last year. The setback in EBIT margin was caused by a one-time rush air shipment cost (HKD 190 million), leading to an almost 80% jump in selling and distribution expenses. One of Shenzhou’s clients experienced a supply chain shortage, which put pressure on Shenzhou to manufacture more than its capacity limit. Managers lower down the command chain accepted such a request without fully understanding the firm’s capacity limit. As a result, Shenzhou had to ship final products using air freight (rather than ocean freight) to ensure timely delivery. It is understood the decided not to pass on additional shipping costs to its customer out of goodwill.

During 2019, management guided a capacity expansion between high-single-digit percentages to 10%, slightly below our previous expectation. However, with more information being made available by management about the opening timeline of its new factories in Vietnam and Cambodia, we pushed back some of our top-line growth forecasts into 2020 and 2021. With the new Vietnam garment plant set to open in mid-2019, the amount of top-line contribution it can provide to the group in 2019 depends on the speed of the hiring and training processes. Moving to Cambodia, Shenzhou decided to add an extra floor to its new garment factory, currently under construction. Adding a new floor means additional capital expenditure, but also higher capacity potential. It is understood the USD 160 million factory will specialize in producing Nike goods in 2020 and run at full capacity in 2021. With Shenzhou strengthening its ties with Nike, the company’s future will be closely tied to the ups and downs of the world’s largest sportswear company. While we forecast Nike’s top-line to growth at a CAGR of 8.1% over the next five years, market share gains will most likely drive Shenzhou’s sales to grow at a faster rate. We now believe the apparel manufacturer will expand its sales and operating income at an average rate of 11.5% over the next five years. We think that significant expansion of margins will be difficult for Shenzhou because potential efficiency gains will most likely be offset by rising environmental and labor costs, something the firm’s management has alluded to multiple times.

Lastly, we continue to welcome the company’s efforts to craft a profitable and sustainable business. The firm compensates its workers at above market rates while providing some of the best working and living conditions. Our impression of the group’s CEO, Ma Jianrong, remains positive. But at the current price, shares of Shenzhou are less compelling to long-term investors