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Morningstar | Shenzhou Misses on Bottom Line but Margin Expansion Is Encouraging; Shares Remain Overvalued

Shenzhou’s net profit narrowly missed forecast as result of currency headwind in the first half of 2018. The company’s outlook is within our expectations, with business expansion mainly driven by sales volume growth of 15%. However, 4% setback in average selling price (ASP) as a result of a strong CNY during the first half brings total revenue growth to 11% for the period. We are maintaining our HKD 76 fair value estimate on Shenzhou and view company shares as overvalued at current levels.

While the company does not report currency-neutral numbers, management disclosed during after-market analyst briefing that ASP for the first half was up around 1% in U.S. dollar terms. However, with much weaker CNY expected for the second half, we think the company is on track to achieve 1% ASP growth for 2018. Gross margin was up slightly to 32.3% despite currency headwinds (recall that majority of costs are booked in RMB while sales are in USD). Barring any change in demand for sportswear, improving operating leverage coupled with efficiency gains should continue to support moderate margin expansion over the next few years. The effective tax rate for the period ran at 11.3%, lower than 14.2% for the year prior. This is the result of the group’s tax-free Vietnamese operations now contributing more significantly. The company will enjoy tax-exempt status on its Vietnamese profit for the next three years, followed by a preferential tax rate of 10% tax over the following nine years.

Over the past few years, the company has pushed away potential orders due to limited manufacturing capacity. To further ramp up production, Shenzhou will build another 5,000-worker garment factory in Vietnam next year, and a 10,000 worker Cambodia-based garment factory is also in the planning process. While we share management’s view that Shenzhou’s near-term sales growth depends mostly on capacity expansion, business will settle at a normalized and sustainable level over the long term, given the improvement in automation technology moving some production volume back to developed countries like the U.S.

On the cost side of the equation, despite some pressures on the raw materials front, Shenzhou manages to keep labor cost in check. We attribute the reported 3% year-over-year increase in total employee expense to a rising percentage of lower-wage workers outside of China. At the same time, the company disclosed that on an absolute basis, compensation was up around 6% in China and Vietnam, along with high-single-digit for Cambodia.

Lastly, the impacts of Sino-U.S. trade war will be muted for Shenzhou. With 25% of its products made outside of China, Shenzhou will not have a problem having those factories to supply its U.S. demand (~14% of total revenue).