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Morningstar | Sun Art First Half Below Expectations, but Company Amid Business Transformation

Sun Art’s first-half result was below our expectations on a run-rate basis, with both revenue and underlying operating profit broadly flat. Reported operating profit fell 7.7%, but the previous period included revenue from aged unutilized prepaid phone cards, which had accrued over several years, whereas this half-year included only the usual six months of this revenue. Revenue from food and fast-moving consumer goods, or FMCG, increased while electronic appliances was down. Sun Art has entered into a partnership with leading Chinese electronics retailer Suning to address its acknowledged weakness in electronics. In collaboration with Suning, it will renovate 287 stores before the “8.18 Suning Festival,” with the remaining stores renovated by the end of September. Indeed, the company is revamping much of its operations to also transform its offerings in partnership with Alibaba. The Taoxianda initiative will see it provide one-hour delivery within three kilometers of designated stores. By end June, 165 stores had launched the project, with all stores expected to be rolled out by year-end.

We make minor adjustments to our forecasts, lowering our 2018 forecasts slightly but also lowering our capital expenditure forecasts in line with management guidance. Our fair value estimate remains at HKD 7.80. We retain our no-moat and negative moat trend ratings, with online retail continuing to take share from offline retail. Total retail sales growth in China in the first half was 9.4%, but the 50 key retailers’ sales growth averaged under 1%, according to China Nation Commercial Information. The stock looks quite expensive on a price/earnings ratio of nearly 30 times, which we believe is driven by high expectations for the outcome of the Alibaba partnership.

Management indicated that 2018 capital expenditure would be between CNY 3 billion and CNY 4 billion, lower than the CNY 4 billion-CNY 5 bilion that it forecast in March. Only 40 stores will get the full automated “flying baskets” upgrade, instead of the 80 stores budgeted at the beginning of the year. Management also indicated that around CNY 4 billion per year was a reasonable estimate for ongoing capital expenditure, which is slightly higher than the trailing three-year average of around CNY 3.6 billion. This is due to maintenance and refurbishment expenses on an increased store count and further planned initiatives to improve the company’s competitive position. Management mentioned at the results briefing that it was in discussions with a large player in the nondiscretionary nonfresh retail space on another collaboration.