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Consumer
The theme: dealing with excess liquidity
This will impact the consumer sector through interest rates, price
controls and (high) valuations
Key ideas: Gome, Intime, Anta
2011 outlook
Dealing with excess liquidity
For 2010, we wrote that the big theme in Chinese
consumers was the regional diversification of the
consumer landscape. Consumer markets would
move from a few (Chinese) people with a lot of
money to spend to many with less money to spend.
Consumer markets in tier 2 and 3 cities would
become the driver of overall consumer spending.
This has happened and is likely to continue to be a
theme in the coming year. Growth in tier 3 and 4
cities has outpaced tier 1 cities across China. For
example, Hengdeli, a luxury watch retailer,
indicated that growth in its stores was as high as
>30% in the lower-tier cities while growth in tier
1 cities (Shanghai, Beijing, Guangzhou) was
about 15-20%.
In our view, a new theme for the consumer sector
in 2011 will be the impact of excess (monetary)
liquidity on the sector.
Excess liquidity impacts investors in the consumer
sector in various ways. We expect the market will
toy with the impact of (1) higher interest rates, (2)
inflation and price controls, (3) exchange rate
movements, and (4) stock valuations.
First of all, there is a risk of further interest rate
increases across Asia Pacific, which could impact
consumer spending, most likely more so on
products that need to be financed (cars, highticket items). Note also that Chinese consumers,
having a strong net-cash position backed by
plenty of savings, might actually find a positive
income effect from higher interest rates – they
simply earn more interest on savings.
Meanwhile, excessive liquidity and inflation
could also lead to intervention in markets.
Especially in China, there is an increasing risk of
price controls in food-related industries.
A change in the exchange rate will also have an
impact, especially on those companies that either
import or export their products. In our universe,
pulp and paper companies are probably most
impacted by these rate movements.
The last effect of excessive liquidity on consumer
stocks could come through valuations. Already,
we believe that investors need to be very careful
and selective when investing in Asian consumer
stocks. A common argument is that valuations for
the sector are high against their own history.
While this is true, loose liquidity conditions and
low (perceived) risk to earnings can, at times,
sustain such high valuations.
Practically, what this means is that consumer
stocks can run a little further than what we believe
would be reasonable valuations, but also that
downside risk to the sector is most likely to come
from either higher interest rates and the
introduction of price controls.
Below we provide a very quick snapshot of the
key themes playing in various sub-sectors in
Asian consumers (Chinese sub-sectors first,
followed by SEA, Korea and India):
Chinese department stores
This sector deals with rapid expansion of new
department stores across many cities in China.
The fastest-growing sector within department
stores are those that offer new, fresh shopping
formats with a larger variety of stores and services
within the hypermarket or department stores.
These new services can be anything from a
children’s playground to a larger variety of brands
surrounding a traditional supermarket, all within
one large complex.
These new format department and hypermarket
stores are often also located in new, high-growth
locations. These new locations are not always in
the centre of a city, where they traditionally have
been. Better infrastructure and higher car
ownership allow consumers to travel to areas on
the periphery of a city.
Hence, ‘new format, new location’ department
stores have in the last year started to grow faster
and offer better margins than the traditional
hypermarkets located in the centre of a city.
Companies that have adapted to these new trends
and have come with new, innovative ideas and
formats are Intime and Golden Eagle.
F&B
Rising food prices have become a concern to the
market in late 2010. Although China is selfsufficient in rice, wheat and corn, products like
palm oil and soybean are imported. Lower
acreage and limits to supply of many of these
foodstocks have been some of the reasons why
food prices have increased in late 2010.
Whether this continues and is the start of a trend
of sustained inflationary pressures is questionable.
Indeed, our economists believe this is a near-term
phenomenon and headline inflation is likely to
ease after Chinese new Year. However, short
supply in various specific food items (palm oil,
vegetables) is likely to continue to put upward
pressure on some food items.
For F&B companies that deal with rising raw
materials, the best way to deal with this is to either:
raise retail prices and pass on these costs to
the consumer, or
improve their product mix so that their ASPs
increase, even if retail prices for various
goods remain stable.
This is exactly what companies such as Mengniu
are doing – gradually introducing new, higherpriced dairy products. This will continue to be a
key feature for earnings growth in this Chinese
sub-sector in 2011.
Chinese sportswear
In this sector, the key earnings driver is entrance
into tier 2-5 cities. This is where penetration of
the larger brands is still relatively low and where
income growth is sufficient to support higher sales
and higher sales productivity.
Companies such as Xstep and Anta are key
beneficiaries of this trend. And this growth in
earnings and cash flow is reinvested into brandbuilding through advertising and promotions of
their new products. Indeed, some of these
companies have allocated large parts of their
budgets to sponsor local Chinese sport teams
(Olympic teams). However, this growth in tier 3
and 4 cities will continue to be a key driver of
earnings in 2011.
Emerging Chinese brands
A group of companies in China is now trying to
build local brands. This is not easy and, for many,
this will be a multi-year programme of investing
in brand awareness and product quality.
The issue for these newly emerging Chinese
brands is their ability to manage growth and
formulate a correct strategy.
For example, Bawang, a shampoo brand, has
struggled with rapid diversification in (too many?)
new products and sudden weakness in their core
product, men’s shampoo.
Meanwhile, menswear maker Lilang aims to build
a brand that appeals to higher-end consumers
instead of low-income consumers.
Expect continued investment in advertisements
and promotions in local brands in the coming
year. Companies that appear to be successful in
building strong, homegrown brands should
continue to receive plenty of attention in the
markets in 2011.
Paper
The paper sector in 2011 is likely to be
characterised by continuous demand growth and a
shift in the industry structure.
On the demand side, we expect packaging paper
consumption to grow at over 8% per annum on
rising domestic demand and a rebound in exports.
On the supply side, we expect the government to
announce a new round of environmental and
emission control initiatives under its 12th FiveYear Plan, which is likely to result in an
accelerated shutdown of small paper mills.
Under this macro background, we expect large
manufacturers like Nine Dragons (2689 HK,
OW(V), HKD11.76, TP HKD18.00) and Lee &
Man Paper (2314 HK, OW(V), HKD6.14, TP
HKD7.40) to benefit through continuous capacity
expansion and diversification into higher-end
packaging paper.
The major headwind faced by the paper
manufacturers is rising interest rates in China.
Nine Dragons and Lee & Man Paper have net
gearings of around 0.6-0.7x in 2010. With higher
interest expenses related to RMB rate hikes, Nine
Dragons is particularly affected, as about 70% of
its borrowings are in RMB. According to Nine
Dragon, a 100bps increase in effective interest
rate would hurt the bottom line by 3%. Lee &
Man is less affected as all of its borrowings are
denominated in HKD or USD.
Southeast Asia
SEA consumer markets are undergoing substantial
changes. Incomes are rising and, in some markets,
new emerging local rivals are threatening the
position of local and international incumbents.
Meanwhile, other multinationals are positioning
themselves strategically to secure long-term
exposure in these rapidly growing markets. Most
focus goes, for now, to Indonesia, which has
proven to offer strong growth in consumer demand
and a stable political environment for investment.
We prefer Southeast Asian stocks that are strong
incumbents trading at reasonable valuations. Our
top pick in this respect is Thai Beverage (THBEV
SP, OW, SGD0.29, TP SGD0.35)
India
For investors, there are two issues at play in India.
First, raw material prices are rising and although
many companies can pass this on to consumers
via higher prices, it might take time to raise retail
prices. As such, margins might face a temporary
squeeze.
In addition, India’s consumer stocks are
expensive. India is the only Asian country where
consumer stocks are trading back at levels seen in
2007. In China and Korea, valuations are still
below previous peaks. We believe these high
valuations against their own history will keep
further performance in check.
Korea
For Korean consumer companies, the domestic
market is nearly saturated and shows low demand
growth. While there are some changes in
consumer behaviour that take place in Korea, the
core issue is how the Koreans can benefit from
growth elsewhere, especially in China.
Many have entered the Chinese market in an
attempt to build fast-growing businesses, but
experiences have been mixed.
In general, the product offering in China is
different, supply chains are different and brands
that are popular in the Korean market are
relatively unknown in the Chinese market.
Some, however, seem to have been able to get to
grips with practices in the Chinese department
store market and are starting to see a meaningful
contribution from their China operations. Of
these, our top pick is Lotte Shopping (023530 KS,
OW, KRW473,500, TP KRW600,000)
2011 high conviction idea
Gome (493 HK, OW(V), HKD3.06,
TP HKD3.76)
Our research on multiple performance measures,
such as single store efficiency and margins, shows
Gome is now either overtaking or closing the gaps
with Suning. We expect Gome to stop losing
market share to Suning from 2H10 as it has
returned to positive network expansion. We also
expect margins to improve on investments in
management systems, distribution capacity and
reduction in restructuring related costs.
We are ahead of FY12 consensus, and our 2010-
12e net profit CAGR of 28% is above the peer
group average of 21%.
In the past, the issue for Gome has been corporate
governance. We now believe the current structure
provides a balance of power between the largest
shareholder, management and institutional
investors. Share options issued to key
management and other employees have increased
management stability and reduced succession risk.
We also believe Bain will continue to play a key
role in improving corporate transparency. Gome
now trades at an average 30-40% discount (on
HSBC earnings) to the leaders in retail subgroups, which we think will close as historic
perceptions of governance problems fade.
As such, we believe Gome will be one of the
best-performing stocks in the Asian consumer
space in 2011.
Winners from Chinese growth
Stocks that benefit from this are obviously the
Chinese consumer stocks. But the Korean retailers
are increasingly building businesses in China and
investors should also think about companies such
as Genting in Malaysia, which benefit from
Chinese gambling in Southeast Asia.
Intime (1833 HK, OW(V), HKD12.10,
TP HKD15.21)
In our view, one of the best ways to play this is
through Chinese retailers such as Intime. This
company is at the bottom of the profitability
cycle, as its fast expansion in 2007-09 diluted
profitability.
Being very active in industry consolidation
opportunities, it just recently acquired 50% of
Yansha, a famous department store chain in
Beijing. We take this as a very positive move as
Yansha only has four stores now but has already
been able to build a strong brand name.
For Intime, this is an excellent way to enter
Beijing, which is traditionally not where the
company is strong. Intime originates from
Zhejiang province and while it is widely known in
those regions, it is a relative newcomer with little
brand visibility in Beijing.
Stock most at risk:
Bawang (1338 HK, N(V), HKD3.15,
TP HKD3.10)
Shampoo company Bawang is in an excellent
position to benefit from Chinese growth, but a
small management team and fast diversification
into new products (skincare, herbal teas) raises
execution risks. A recent incident where it was
suggested that some of its shampoo carried too
much dioxane, a substance that is allowed only
within certain limits, has hurt its image. While the
allegations have been refuted, such newsflow has
severely damaged the brand and sales have
subsequently fallen.
Thus, a relative small management team has
wound up trying to rebuild their core brand while
also diversifying into new markets, such as for
skincare and herbal teas. This, we argue, will keep
execution risk high in 2011.
Pricing anomalies
Gome
We think the biggest example of a stock price
anomaly is Gome. This stock is slowly shrugging
off the corporate governance issues that plagued it
in the past. For more details, see the previous
paragraphs on Gome.
Valuations and risks
Gome
Valuation
Our HKD3.76 target price is based on 20.9x
2011e EPS and implies a 23% potential return.
The forward multiple is the average of 1) our bull
case, which assumes Gome shares return to
trading in line with peers as corporate governance
issues are resolved, and 2) our bear case, which
assumes boardroom battles continue to drag on
the shares and the 40% discount to peers remains.
Taking the midpoint of these scenarios reflects the
most likely outcome, which is that the recovery of
investor confidence in the company will be slow
but the market will eventually respond to the
improved earnings that we forecast to result from
its operational restructuring.
Catalysts: formal announcement of Gome’s
strategy based on a plan mutually agreed between
the largest shareholder and the board and stronger
than expected industry sales at above an FY08-10
CAGR of 10%.
Risks
Changes in the shareholding structure, changes in
the management team that might slow or change
the decision-making process or corporate strategy,
competitive pressures in retailing.
Intime
Valuation
We rate this stock OW(V) with a TP of HKD15.21.
We use a target multiple of 30x to reflect: 1) 30%
core earnings CAGR for FY10-12e, and 2) a strong
store opening pipeline in 2013 in the company’s
home market, Hangzhou, and new market, Hefei,
with total GFA of about 400,000sqm. Intime
currently has about 815,000sqm GFA.
Risks
In our view, key risks include delays in store
openings and weaker than expected sales.
Bawang
Valuation
We use a multiple of 15.5x forward earnings,
which represents the average PE between July and
November 2009, and set a TP of HKD3.1. We
have a N(V) rating on the stock. Note that if we
used the lowest-ever PE that Bawang shares have
traded on (12.7x in September 2009), our fair
value would fall to HKD2.5.
Risks
The key risk is the aftermath of the dioxane
incident. On 12 November we lowered our 2H
profit forecast to reflect weaker sales and rising
advertising costs to rebuild Bawang’s brand.
At that time, we maintained our EPS forecast for
2011, which implied a return to normality next
calendar year, on two key assumptions:
Monthly run rate for Bawang shampoo would
recover from RMB90m in October 2010 to
the 2009 normal level of RMB120m by April
2011.
Herbal tea sales would reach RMB306m in
FY11 from RMB84m in FY10. It is the
largest sales growth driver in 2011,
contributing 35% to overall sales growth.
There is now a risk that weak sales performance
might extend into 2011 if the brand remains
tainted by the 2010 dioxane incident. This
illustrates how fragile new brands can be in
China. Upside risks include sell-through of herbal
tea and new product launches.
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