Placement of 400m new shares
Hongxing placed out 400m new shares at S$1.18 each (5.14% discount to last traded
price of S$1.24) to raise net proceeds of S$457.8m for the following purposes:
1. Rmb1,000m to secure retail locations for mid-sized stores
2. Rmb500m for advertising space on CCTV
3. Rmb200m for renovation and refurbishment of older retail outlets
4. Rmb100m for setting up four logistics centres
5. Rmb250m for capacity expansion
6. Rmb296m for working capital.
Plans for expansion include:
1. Opening at least 600 new stores in FY08 with at least 300 mid-sized stores.
Funds will be used to secure the leases of mid-sized stores from distributors and
sub-let these stores back to distributors who will continue to bear operating
expenses and inventory risks. Hongxing’s rationale for doing this is to secure
key retail locations. The group will be advancing 2-year rental deposits to
retailers who will be subject to a 2-year payback period. Retailers pay by
instalments over the two years. The cost of securing each mid-sized store is
estimated at Rmb3m.
2. Increasing advertising and promotion expenses. Hongxing will be stepping
up A&P to capitalise on the upcoming Beijing 2008 Olympics Games and raise
brand visibility in China. As previously guided by the group, A&P expenses as a
percentage of revenue will not be more than 20% in FY08 and FY09.
3. Renovate and/or relocate older Erke speciality stores. Currently, there are
2,000 first- to third-generation Erke stores and 1,700 stores which are smaller
than the average store size of 60-70 sq m. The group will be extending subsidies
to the retailers of the above stores for renovation according to the fourthgeneration
store layout and format and/or expand store size.
4. Establish four logistics centres. Hongxing is aware of the risks associated
with accelerated retail network expansion. As such, it plans to set up logistics
centres in Xi’an to monitor the northwest region, Beijing to monitor the Hua Bei
region, Guangzhou to monitor the Hua Nan region and Nanjing to monitor the
central region. Each centre will have 10-20 personnel to monitor the
performance of retailers and carry out market research.
5. Capacity expansion. Hongxing will be supporting its accelerated retail
expansion with 33.5% production-capacity expansion to 23.9m pairs of shoes. It
plans the build a fourth plant to house an additional line for 6m pairs of shoes.
The other three plants are running at a blended utilisation rate of 70%. Based on
our projections, utilisation will hit 92% in FY08. Hence, it is necessary for
Hongxing to increase capacity.
The new shares represent some 15.7% of the group’s enlarged share capital.
Comments
Expansion is vital for building brand equity. Hongxing’s performance has been
consistent in the last 1.5 years. Plans to open logistics centres should allow it to prevent
brand erosion while opening stores aggressively. Similarly, efforts to ramp up A&P
expenses are reflective of its commitment to building the Erke brand.
Selling and distribution costs will be increased in FY08-09. A&P typically makes up
83-85% of selling and distribution costs. These costs in turn, make up 18-20% of total
revenue. As subsidies will be given to retailers for renovation/relocation in addition to
earlier anticipated A&P expenses, we have raised our assumptions for selling and
distribution costs to 21.2-21.5% of total revenue for FY08-09.
EPS dilution and higher costs slightly offset by revenue increase. The placement will
dilute FY08-09 EPS by 16.7%, in our estimation. However, we expect revenue to
increase by 1-3% after expansion. We have also increased gross margin assumptions to
reflect lower outsourcing costs. The overall impact on our EPS estimates is an 11-15%
downgrade for FY08-09.
Valuation and recommendation
Target price lowered to S$1.32 from S$1.48; downgrade to Neutral from
Outperform. Our new target continues to price the stock at 27 CY09 fully-diluted
earnings, which is at a slight premium to the average valuation for the sports-shoe sector.
Given the limited upside to our target price, we downgrade the stock to a Neutral.
However, we continue to like Hongxing as a key beneficiary of the Olympics and China’s
rising consumption spending.
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