Xtep International [1368.HK] Running Specialist

July 09, 2018 Xtep International [1368.HK] Running Specialist. Initiate with BUY. China Consumer Sector We believe that the fruits of Xtep’s business reforms will be more visible this year and that the Company will benefit from the growing market in China for sporting goods. Xtep implemented Sporting Goods reforms that transformed it into a professional running products brand. The Company radically reformed its products, marketing strategies and channels, so it is likely to capture the fast- growing demand related to the sport of running in China. Because of the transformation, its financials have suffered, and 2017 was hit hardest because of one-off items. However, we BUY believe the worst will be over in 2018E. With positive sales momentum and improving profitability per store, we expect Xtep’s EPS to achieve a CAGR of 24.4% in FY2017-FY2020E. This is a significant improvement over previous years. We believe a re-rating is justified by the Close: HK$5.15 (July 6, 2018) earnings recovery. Initiate with BUY. Our target price of HK$6.30 is based on 16x 2019E PER. Target Price: HK$6.30 (+22.3%) Investment Highlights Price Performance  Transformed into a Professional Brand. Xtep initiated a three year reform program, called “3+ Revolution”, in 2015; 2018 will be the final year. The “3+” framework refers to (HK$) (HK$ million) 7 120 Products+, Sports+ and Internet+. So far, Xtep has successfully followed the “3+ Revolu- 6 100 tion”, and this has helped it gain traction in the professional sportswear market. Currently, 5 80 4 around 50% of the product mix is professional sportswear, and the Company is targeting 60 3 professional runners. We believe the Company will benefit from the increasing participa- 40 2

tion in running competitions in China, as running is now the most popular sport in China, 1 20 according to a study conducted by JD & Nielsen. 0 0

 Healthier Physical Distributors after Channel Reforms. In addition to the strong initia- Turnover (RHS) Price (LHS) tives seen in online channels, another noteworthy Xtep reform was channel reforms, the most notable of which was network reform. Xtep flattened its distribution channel to a Source: Bloomberg much simpler structure. Another aspect of the reforms is improving per-store profitability, Market Cap US$1,471m which has resulted in improvement over time. Over the past few years, the Company has reduced the number of Xtep stores to optimize store performance. We estimate that Shares Outstanding 2,221.4m Xtep’s store count will increase by around 6% to 6,350, while we expect per store produc- Auditor EY tivity on a wholesale basis to improve by 7% in 2018E. Free Float 39.5%  Earnings Show Resiliency from 2018E Onwards. Although Xtep has introduced reforms since 2015, their impact cannot be directly seen in the overall financials. The main 52W range HK$2.395-6.140 reason is that the newly introduced products sold well, but the Company also had to deal 3M average daily T/O US$3.67m with its legacy problems: (1) the 2017 results were greatly impacted by a one-off inventory buy back; and (2) Xtep Kids dragged down the performance in the past. After dealing Chairman Ding Shui Major Shareholding with these problems, the Company should see the positive influence of the reforms re- Po (60.06%) flected in the financials. Sources: Company, Bloomberg  Initiate with BUY. Our current EPS forecast for Xtep for FY2018E/19E/2020E is RMB0.26/0.32/0.36, respectively, implying EPS growth of 40.7%/21.6%/12.6% over the three years, or an EPS CAGR of 24.4% in FY2017-FY2020E. Initiate with BUY. Our target price of HK$6.67 is based on 17x 2019E PER. The target PER multiple is higher than Tony Li, CFA—Analyst its historical valuation range, but we believe the re-rating since late 2017 will be maintained. Our 16x 2019E PER also implies a ~1x PEG ratio, based on the 17.0% EPS (852) 3698 6392 CAGR between FY2018E and FY2020E [email protected] Key Financials (RMB m) FY2016 FY2017 FY2018E FY2019E FY2020E Revenue 5,397 5,113 5,575 6,160 6,621 YoY Change 1.9% -5.2% 9.0% 10.5% 7.5% Wong Chi Man, CFA—Head of Research Net Profit After Tax 528 408 574 701 787 YoY Change -15.2% -22.7% 40.7% 22.0% 12.3% (852) 3698 6317 EPS (RMB) 0.24 0.19 0.26 0.32 0.36 YoY Change -17.5% -21.3% 40.7% 22.0% 12.3% [email protected] ROE 10.9% 8.2% 11.0% 12.9% 13.6% P/E 17.7x 22.5x 16.0x 13.1x 11.6x Dividend Yield 3.4% 4.5% 3.8% 4.6% 5.2% Sources: Company, CGIS Research 1

Key financials

Income Statement (RMB m) FY2016 FY2017 FY2018E FY2019E FY2020E Balance Sheet (RMB m) FY2016 FY2017 FY2018E FY2019E FY2020E Revenue 5,397 5,113 5,575 6,160 6,621 Bank Balances and Cash 2,847 3,832 3,643 3,464 4,334 COGS (3,065) (2,869) (3,144) (3,474) (3,720) Restricted Bank Deposits 1,399 952 952 952 952 Gross Profit 2,331 2,244 2,431 2,685 2,901 Trade Receivables 1,916 1,719 1,809 2,089 2,101 SG&A (1,513) (1,678) (1,598) (1,718) (1,800) Inventories 460 718 574 796 671 Other Operating Items 99 158 163 172 179 Other Current Assets 596 661 427 757 502 Operating Profit 917 725 996 1,139 1,280 Total Current Assets 7,217 7,882 7,405 8,057 8,560 Finance Costs, Net (51) (54) (70) (17) (23) Other Items 99 158 163 172 179 PP&E 618 646 725 811 905 Net Profit Before Tax 866 671 926 1,123 1,257 Goodwill & Intangible Assets 5 8 8 8 8 Income Tax (293) (224) (310) (376) (421) Other Non Current Assets 334 398 390 382 374 Net Profit After Tax 528 408 574 701 787 Total Non Current Assets 957 1,052 1,122 1,201 1,286 Minority Interest (After Tax) 45 38 42 46 49 Total Assets 8,174 8,934 8,527 9,258 9,846 EPS (RMB) 0.24 0.19 0.26 0.32 0.36 DPS (RMB) 0.14 0.19 0.16 0.19 0.22 Trade Payables 896 1,028 1,081 1,249 1,246 Short-term Borrowings 1,502 831 510 1,073 149 EBITDA 976 793 1,060 1,209 1,354 Other Current Liabilities 632 630 732 801 859 EBIT 917 725 996 1,139 1,280 Total Current Liabilities 3,029 2,489 2,323 3,122 2,253 Long-term Borrowings - 1,019 510 - 1,000 Revenue Growth 1.9% -5.2% 9.0% 10.5% 7.5% Other Non-current Liabilities 122 97 134 163 182 Operating Profit Growth -0.4% -21.0% 37.4% 14.4% 12.3% Total Non-current Liabilities 122 1,116 644 163 1,182 Net Profit Growth -15.2% -22.7% 40.7% 22.0% 12.3% Total Liabilities 3,151 3,605 2,966 3,285 3,435 EPS Growth -17.5% -21.3% 40.7% 22.0% 12.3% Total Common Equity 4,953 5,221 5,411 5,777 6,166 Gross Margin 43.2% 43.9% 43.6% 43.6% 43.8% Minority Interest 69 108 149 195 245 Operating Margin 17.0% 14.2% 17.9% 18.5% 19.3% Total Equity 5,023 5,329 5,561 5,973 6,411 Net Profit Margin 9.8% 8.0% 10.3% 11.4% 11.9% Total Equity & Liabilities 8,174 8,934 8,527 9,258 9,846

Cash Flow Statement (RMB m) FY2016 FY2017 FY2018E FY2019E FY2020E Ratios FY2016 FY2017 FY2018E FY2019E FY2020E Net Profit After Tax 528 408 574 701 787 ROE 10.9% 8.2% 11.0% 12.9% 13.6% D&A Add-back 59 68 64 70 74 ROA 6.5% 5.0% 6.4% 8.2% 8.5% Net Change in Working Capital (510) (119) 480 (566) 441 Other Operating Items 268 201 24 30 34 Net Debt / Equity Net Cash Net Cash Net Cash Net Cash Net Cash CFO 346 558 1,142 235 1,336 EBITDA Interest Coverage 19x 15x 15x 73x 60x

CAPEX (95) (123) (134) (151) (160) Rec. Turnover Days 119 130 115 115 115 Other Investing Items (472) 398 64 66 64 Inventory Turnover Days 51 75 75 72 72 CFI (567) 275 (71) (85) (96) Payables Turnover Days 107 122 122 122 122 Other Payables Turnover Days 64 70 70 70 70 Dividends Paid (394) (271) (430) (383) (446) Net Change in Debt (228) 421 (831) 53 76 Current Ratio 2.38x 3.17x 3.19x 2.58x 3.80x Issue of Shares 62 7 - - - Quick Ratio 2.23x 2.88x 2.94x 2.33x 3.50x Other Financing Items 79 4 - - - Valuation FY2016 FY2017 FY2018E FY2019E FY2020E CFF (542) 154 (1,261) (329) (370) P/E 17.7x 22.5x 16.0x 13.1x 11.6x Total Cash Flow (764) 987 (190) (179) 870 P/B 1.9x 1.8x 1.7x 1.6x 1.5x Free Cash Flow 142 369 1,156 208 1,316 Dividend Yield 3.4% 4.5% 3.8% 4.6% 5.2%

Sources: Company, Capital IQ, CGIS Research estimates 2

Investment Thesis

(1) Transformation to a Professional Sportswear Brand Paying Off

Xtep is a Chinese sportswear brand, which started in 2002, with an initial focus on the fashion sportswear. However, given the intensified competition and changing consumer preferences, Xtep has proactively rebranded itself into a professional sportswear brand since 2015. This has been a successful transformation, and it is paying off in terms of positive consumer perception and financial returns.

Xtep has transformed into a run- Xtep chose to focus on running as its specialization, and as a result, has become a ning brand well-recognized brand among runners in China. Running is now one of the most popular sports in China, and its popularity is on a rising trend. Xtep has not just benefited from changing consumer preferences; it is proactively reshaping them. We believe this strategy will continue to pay off for Xtep.

Three-Year Reform Plan Well Executed

Xtep initiated a three-year reform plan called “3+ Revolution” in 2015; 2018 will be the final year in the reform program. The “3+” framework relates to Products+, Sports+ and Internet+. So far, Xtep has successfully followed the “3+ Revolution” framework, which has helped the Company gain traction in the professional sportswear market.

Sports+: The Rise of Professional Sportswear and Product Improvement

Now ~50% of its product mix is Throughout the history of Xtep, affordable fashion sportswear has been the focus of professional sportswear the Company. This can be seen partly in their reported revenue mix: apparel accounted for >50% of total revenue before the reforms. After their brand repositioning, we estimate that fashion sportswear still accounts for around 50% of total revenue, with professional sportswear accounting for the other 50%.

Figure 1: Xtep’s Focus Changed from Fashion Sportswear (Left: 2014 Edition) to Professional Sportswear (Right: 2018 Edition)

Sources: Company 3

Figure 2: Revenue Mix of Xtep – by Product Category

100% 90%

80% 35.3% 36.4% 32.7% 34.4% 49.5% 46.3% 70% 52.9% 54.3% 53.3% 60% 50% 40% 30% 63.7% 61.5% 65.3% 63.7% 51.7% 45.7% 48.6% 20% 43.9% 44.9% 10% 0% FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017

Footwear Apparel Accessories

Sources: Company, CGIS Research

The focus of Xtep’s professional sportswear is mainly footwear for runners. Three key product series have been introduced to consumers: Dynamic Foam, Reactive Coil, and Air Mega. These are products designed for routine runners, emphasizing shock ab- sorption. At the same time, Xtep has cooperated with leading materials companies, such as 3M, Dow Chemical and Toray, in designing proprietary materials for sportswear. This has created a distinction between its products and those of other domestic brands with similar sales prices.

The running-series products Xtep created are well-perceived by runners. According to Joyrun, a Chinese social network for runners, Xtep’s products are widely worn by runners in Chinese marathon races. In certain races, Xtep is among the top brands worn by top runners. On top of that, Xtep is the most popular domestic brand. This shows that Xtep’s products are competitive enough to stand out among various brands with years of history designing running shoes.

Figure 3: Number of Top Runners Wearing Xtep Shoes in Selected Marathon Races in China 2018 Chongqing Marathon 2017 Xiamen Marathon 2016 Guangzhou Marathon

Finished in 3 Passed 37.5 km Passed 37 km Brand Brand Brand Hours within 3 Hours within 3 Hours

Adidas 40 ASICS 239 ASICS 152 Asics 34 Xtep 170 Xtep 107 Nike 29 adidas 96 Do-win 94 Xtep 21 Nike 94 Adidas 87 Xtep's Share 15.10% 20.00% 17.10% Sources: Company, CGIS Research 4

Sports+: Professional Sports-Oriented Marketing

Another distinct strategy adopted by Xtep is professional sports-oriented marketing. While it continues to deploy traditional advertising and promotion tactics, like using Chinese celebrities for endorsement, it has started to strengthen its investment in sports events. The scope is not limited to sponsoring sports events like marathons; Xtep also organizes sports events. This has promoted brand awareness among professional runners, and it also complements other aspects of the Company’s strategies.

Xtep has been very active in executing its new marketing strategy. It was a partner of Xtep: Most Active Sponsors of the Chinese Athletic Association in the strategic development of a marathon in August Running Races in China 2016. The Chinese Athletic Association is a national sport association that administers athletics events recognized by the Chinese Olympic Committee, so the partnership helped increase brand recognition among runners. Subsequently, it was the most active sportswear sponsor in China, as it sponsored 29 major marathons in China in 2017, the most of all brands.

Figure 4: Xtep is one of the Partners of Chinese Athletic Association on the Strate- gic Development of Marathons

Sources: Chinese Athletic Association

We believe this strategy will pay off well for Xtep, as marathons are becoming more We expect the no. of active runners common in China. In 2017, there were nearly 1,100 marathon or similar races held in to grow at a CAGR of 26% in China, with close to 5 million runners participating. The Chinese Athletic Association 2017-2020E aims to increase the number of races to 1,900 in 2020, with 10 million participants. This means the number of active runners will grow at a CAGR of 26% in 2017-2020E if the target is achieved.

Figure 5: Number of Participants in Marathon and Related Races in China Targeted by the Chinese Athletic Association (Unit: million)

10 10

8 8

7 6 5 4 2.8

1.5 2 0.9

0 2014 2015 2016 2017 2018E 2019E 2020E

Sources: Chinese Athletic Association, CGIS Research estimates 5

Figure 6: Number of Marathon Races in China Targeted by the Chinese Athletic Associa- tion 2,000 1,900 1,800

1,600 1,400 1,200 1,100 1,000

800 600 350 400 256 200 - 2017 2018E 2019E 2020E

No. of Marathon & Related Races No. of Marathon & Related Races Accredited by Chinese Athletic Association

Sources: Chinese Athletic Association, CGIS Research estimates

We expect this to be achievable, as marathons and other road races are still relatively new in China. Developed markets have many more active runners and road races or- ganized each year. For example, in the US last year, 30,400 road races were orga- nized, and 17 million runners participated. Considering the population difference between China and the USA, the penetration rate of marathons in China still has plenty of room to catch up. We expect rising income and increasing health awareness to be the main drivers.

Figure 7: Number of Road Races and Participants – China & the US

35,000 18 17 16 30,000 14 25,000 30,400 12

20,000 10

15,000 8 6 10,000 5 4 5,000 2 1,100 - 0 China (2017) USA (2016) No. of Road Races (LHS) No. of Participants (m; RHS) Sources: Chinese Athletic Association, Running USA, CGIS Research

Xtep, as an active road race organizer, will benefit from its continuous investment in 6 this area, and we believe this will help drive its sales of professional sportswear.

Internet+: Top Performer among Domestic Brands

Like other retailers, Xtep has embraced the megatrend of e-commerce and introduced reforms to its online channels. So far, Xtep has been successful in its implementation. The strong performance of its online channels supports its overall growth, and we believe Xtep will continue to benefit from this, as e-commerce usually provides higher margins.

By introducing measures such as signing a cooperative agreement with Tmall, Xtep has distinguished itself from its peers in the area of e-commerce. In terms of revenue 21% of revenue from e-commerce, contribution, we estimate that Xtep’s e-commerce sales contributed to 21% of total the highest in the sector revenue in 2017, which is the highest among major domestic sportswear companies. We expect the e-commerce contribution to remain at a similar level, since the productivity of physical stores is catching up.

We also consider this to be a major achievement for Xtep, which is a second-tier domestic brand. Compared to 361 Degrees’ 8%, we believe Xtep has been more successful in implementing its O2O strategy and product upgrades. Xtep also stands out by being a top seller in various online platforms; it is a top seller of sports footwear in Tmall in terms of volume, for example.

Figure 8: Revenue Contribution from E-commerce, 2017

25% 21% 20% 19%

15% 15%

10% 8%

0% Xtep Li Ning Anta 361 Degrees

Sources: Company, CGIS Research estimates

Investment Thesis (Continue)

(2) Healthier Physical Distributors after Channel Reforms

Other noteworthy Xtep reforms were channel reforms, which were launched as part of the “3+ Revolution”. The reforms have been successful in improving the condition of its distributors, which is the key to long-term, sustainable growth.

Distribution Network Optimization

Among all things, the most notable channel reform was network reform. Xtep flattened its distribution channel to a much simpler structure. Instead of relying on multiple layers of distributors to expand, its 40 exclusive distributors take more responsibility for direct- ~60% of stores are now directly ly managing the stores. In 2017, approximately 60% of all Xtep stores (around 6,000) operated by exclusive distributors were directly operated by exclusive distributors. The ratio of stores directly operated by exclusive distributors has increased since the reform was introduced, as exclusive distributors are more experienced in managing the stores and knowledgeable about local markets.

Figure 9: Channel Reforms Introduced in 2016: Before (left) & After (right)

Xtep Group

Exclusive Distributors Xtep Group Layer 2 Distributors 40 Exclusive Distributors Layer 3 Distributors ~3,600 Authorized Stores Retailers Layer 4 Distributors ~2,400 Stores Authorized Retailers

Store Operators

Sources: CGIS Research 8

Another aspect of the reforms was improving per-store profitability, resulting in im-

provement over time. Xtep has faced intense competition since the industry down cycle in 2011, and it has affected the profitability of each store at the micro level. Like other retailers, Xtep has taken measures to resolve the issue to improve the financial position of distributors and provide sustainability for Xtep’s sell-in (wholesale sales at the Company level).

Specifically, these measures include introducing an enterprise resource planning (ERP) system to monitor in-store inventory levels and improve the in-store experience. To put more emphasis on the customer experience, Xtep also closed down smaller shops and opened bigger stores to cater for consumers who prefer to try on more products in physical stores Figure 10: Store of“6s” Generation – Better Customer Experience and Equipped with ERP System

Sources: Company

Store number reduced but revenue Over the past few years, the number of Xtep stores has been reduced to optimize store per store improved performance. The total store count dropped from 7,360 in 2013 to around 6,000 in 2017. Per-store revenue has fluctuated, but the growth momentum resumed in 2017, showing the results of the “3+ Revolution”, with professional sports gear driving perfor-

Figure 11: Number of Xtep Stores

8,000 7,360 8% 7,110 7,000 6,800 6% 7,000 6,350 6,600 6,000 4% mance 6,000 2% . 5,000 0% -2% 4,000 -4% 3,000 -6% 2,000 -8% -10% 1,000 -12% 0 -14%

Store Counts YoY (RHS)

Sources: Company, CGIS Research estimates 9

Figure 12: Wholesale Revenue Per Xtep Store (RMB’000 / year)

800 757 20% 721 683 700 658 651 674 15% 590 10% 600 5% 500 0% 400 -5% 300 -10% 200 -15% 100 -20%

0 -25% FY2013 FY2014 FY2015 FY2016 FY2017 FY2018EFY2019E Revenue per store (RMB'000 / year) YoY (RHS)

Sources: Company, CGIS Research estimates

We believe that the momentum will continue and that the Company will resume growth in both store numbers and store productivity. For 2018E, the Company aims to expand the number of stores. We estimate Xtep’s store count will increase by around 6% to 6,350 and that wholesale revenue per store per year will increase by 7% to RMB721k. This should be in line with Xtep’s SSSG momentum.

Figure 13: Same Store Sales Growth (In Terms of Retail Value) of Xtep

16% mid-teens 16%

14% 14%

12% low-teens 12%

10% high S.D. 10% high S.D.high S.D. 8% mid S.D. 8% mid S.D. mid S.D. mid S.D. mid S.D. mid S.D. mid S.D. 6% 6% mid S.D.

4% low S.D. 4%

2% 2%

0% 0% 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018

SSSG (in terms of retail value)

Sources: Company, CGIS Research

O2O Model to Co-ordinate E-commerce and Distributors

Unavoidably, Xtep’s well-performing online channel, which contributed >20% of revenue in 2017, will put pressure on the Company’s distributors. The competition between online and offline channels has always been a problem for brand owners, but Xtep has adopted an O2O business model to tackle the problem. At end-2017, >50% of the exclusive distributors had joined the O2O programme. We expect the increasing partici- pation rate to benefit the Company in both store efficiency and inventory turnover.

~50% of SKUs in e-commerce is online-exclusive First, on the product side, Xtep introduced exclusive online products, which account for ~50% of total SKUs. This prevents online products from cannibalizing the sales of its physical stores. Online-exclusive products are also more easily produced and enjoy higher turnover. The more popular products can also be made available in physical stores later, allowing distributors to enjoy the benefits as well.

Second, Xtep’s online channels are also a means to improve inventory turnover. If certain items experience slow turnover in physical stores, Xtep’s headquarters can allow these items to be moved to the e-commerce platform for special promotions. Mean- while, Xtep has adopted an inventory-sharing system, whereby HQ and distributors co- ordinate to optimize inventory levels. For example, its e-commerce channel carries low inventory of certain products that are available on all channels. With co-ordination, products ordered by consumers online can be delivered by nearby offline distributors. This results in faster delivery and optimizes inventory turnover.

Investment Thesis (Continue)

(3) Earnings Show Resiliency from 2018E Onwards

Although Xtep has introduced reforms since 2015, their impact cannot yet be directly seen in the overall financials. The main reason is that even though the newly introduced products were selling well, the Company had to deal with its legacy problems. After dealing with these problems, we expect the positive influence of the reforms to be reflected in the financials.

We expect both revenue and profit to return to positive growth from 2018E onwards. We expect OP in 2018E to grow We currently forecast revenue growth in FY2018E of 9%, but operating profit could 37.4% YoY grow by 37.4%. Subsequently, we expect operating margins to continue to expand as the Company can achieve operating leverage as revenue recovers.

There were two major issues that Xtep had to deal with: (1) old inventory that was in- consistent with the new brand image, and (2) repositioning of an underperforming seg- ment (Xtep Kids). These issues were tackled in 2017 and will not affect the Company starting in 2018E.

Figure 14: Revenue of Xtep and Forecast Figure 15: Operating Profit of Xtep and Forecast

7,000 15% 1,200 1,131 1,139 50% 6,160 6,000 10% 996 40% 5,550 5,575 1,000 5,295 5,397 921 917 5,113 895 5% 30% 5,000 4,778 809 4,343 800 725 0% 20% 4,000 -5% 600 10% 3,000 -10% 0% 400 2,000 -15% -10% 200 1,000 -20% -20%

0 -25% 0 -30% FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 FY2018E FY2019E

Revenue (RMB m) YoY (RHS) Operating Income (RMB m) YoY (RHS)

Sources: Company, CGIS Research estimates Sources: Company, CGIS Research estimates

No More One-off Items Dragging Down Operating Profit

Xtep’s 2017 results were greatly impacted by a one-off item: inventory buy backs. Be- cause of its transformation, there was inconsistency between the new and old inventory. Xtep decided to buy back the old inventory produced prior to 31 Dec 2015 from distributors, which caused a loss of RMB120.8m in 2017. However, this will not be repeat- ed in the years ahead. We believe the product and marketing strategy was effective, and Xtep’s inventory at the distributor level was reduced gradually as well. 12

Xtep Kids Will Not Be a Drag

Xtep also undertook a series of reforms for other non-performing units during the “3+ Revolution”. Xtep Kids was a key unit for restructuring. Instead of expanding aggres- sively, Xtep decided to scale back the Xtep Kids unit, and this is expected to continue in 2018E and beyond. The revenue contribution from Xtep Kids in 2017 has been mini- mal, so we believe this will enhance the Company’s margins.

Initiate with BUY

Our current EPS forecast for Xtep for FY2018E/19E/2020E is RMB0.26/0.32/0.36, respectively, implying EPS growth of 40.7%/21.6%/12.6% over three years, or an EPS CAGR of 24.4% in FY2017-FY2020E. The Company is also financially sound as it has been in a net cash position since its IPO in 2008 (net cash in 2017: HK$2.87bn).

We believe Xtep is a resilient domestic company, which will benefit from the growing market in China for sporting goods. Initiate with BUY. Our target price of HK$6.67 is based on 17x 2019E PER. The target PER multiple is higher than its historical valuation range, but we believe the re-rating since late 2017 will be maintained. The re- rating started in 2017, when the market realized Xtep’s results had bottomed. Our 16x 2019E PER also implies a ~1x PEG ratio, based on the 17.0% EPS CAGR between FY2018E and FY2020E. Figure 16: Forward PER Band

HKD 7

6 19x 5 16x 4 13x

3 10x

2 7x

1/1/2013 1/2/2014 4/3/2015 3/4/2016 4/5/2017 4/6/2018

11/7/2016 10/4/2013 18/7/2013 11/5/2014 18/8/2014 11/6/2015 18/9/2015 25/1/2017 11/8/2017 25/2/2018

25/10/2013 25/11/2014 26/12/2015 18/10/2016 18/11/2017

Sources: Bloomberg, CGIS Research

Risks

1. Slowdown in SSSG Our forecast is based on the assumption that Xtep’s SSSG will remain positive, so that overall revenue will continue to expand, and operating leverage will improve.

If SSSG is flat or even negative, it could hurt both overall revenue and operating profit. The slowdown in SSSG can be caused by factors such as unsatisfactory product launches, unfavourable reaction to marketing campaigns, or intensified competition among different brands.

This is particularly applicable to Xtep, as it relies on professional sports products for growth. Running is the area Xtep specializes in, but other brands are diverting more resources to this sport, making Xtep more vulnerable if the competition is tougher than expected.

2. Risk of Inventory Position Worsening, Leading to Another Inventory Buy-back Xtep’s inventory position has improved over past few years, but it could worsen in 2018E and onwards. Factors affecting overall sales, such as intensified competition, could cause this potential problem.

In addition, some old inventory may be unsellable even at deep discounts. This would put pressure on the financial position of retailers and franchises. If the problem intensi- fies, it may have a negative financial impact, such as the need to write off inventory or buy back inventory from retailers, causing a one-off loss. Xtep carried out a one-off inventory buyback in 2017. There is no guarantee that the Company will not do this again in the years ahead if the inventory position worsens.

3. Worse-than-expected SG&A Control Our estimate of Xtep’s turnaround rests on the assumption that the Company is able to control its costs well. The sponsorship of marathons and endorsements by various celebrities are major expense items for Xtep. If the Company has to spend more than expected on additional promotional and marketing activities to match its competitors, it may cause its SG&A ratio to go up unexpectedly, trimming its OPM.

Company Description In 2002, Xtep International established its own sportswear brand, XTEP, which is a leading professional sports brand in China. The Company manages an extensive distribution network, with exclusive distributors that operate approximately 6,000 stores nationwide, covering 31 provinces, autonomous regions and municipalities across Chi- na. Xtep International is engaged principally in the design, development, manufactur- ing, sales and marketing, and brand management of sports footwear, apparel and accessories. Xtep International was listed in Hong Kong in June 2008. Ding Shui Po & Family owns 60.06% of the Company.

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All opinions and estimates reflect the judgment of the analyst on the date of this report and are subject to change without notice. China Galaxy Interna- tional and/or the Relevant Parties hereby disclaim any of their liabilities arising from the inaccuracy, incorrectness and incompleteness of this report and its attachment/s and/or any action or omission made in reliance thereof. Accordingly, this report must be read in conjunction with this disclaimer. Disclosure of Interests China Galaxy Securities Co., Ltd. (6881.HK; 601881.CH) is the direct and/or indirect holding company of the group of companies under China Galaxy International. China Galaxy International may have financial interests in relation to the subjected company(ies) the securities in respect of which are reviewed in this report, and such interests aggregate to an amount may equal to or more than 1 % of the subjected company(ies)’ market capitalization. One or more directors, officers and/or employees of China Galaxy International may be a director or officer of the securities of the company(ies) mentioned in this report. China Galaxy International and the Relevant Parties may, to the extent permitted by law, from time to time participate or invest in financing transactions with the securities of the company(ies) mentioned in this report, perform services for or solicit business from such company(ies), and/or have a position or holding, or other material interest, or effect transactions, in such securities or options thereon, or other investments related thereto. China Galaxy International may have served as manager or co-manager of a public offering of securities for, or currently may make a primary market in issues of, any or all of the entities mentioned in this report or may be providing, or have provided within the last 12 months, significant advice or investment services in relation to the investment concerned or a related investment or investment banking services to the company(ies) mentioned in this report. Furthermore, China Galaxy International may have received compensation for investment banking services from the company(ies) mentioned in this report within the preceding 12 months and may currently seeking investment banking mandate from the subject company(ies). Analyst Certification The analyst who is primarily responsible for the content of this report, in whole or in part, certifies that with respect to the securities or issuer covered in this report: (1) all of the views expressed accurately reflect his or her personal views about the subject, securities or issuer; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific views expressed by the analyst in this report. Besides, the analyst confirms that neither the analyst nor his/her associates (as defined in the code of conduct issued by The Hong Kong Securities and Futures Commission) (1) have dealt in or traded in the securities covered in this research report within 30 calendar days prior to the date of issue of this report; (2) will deal in or trade in the securities covered in this research report three business days after the date of issue of this report; (3) serve as an officer of any of the Hong Kong-listed companies covered in this report; and (4) have any financial interests in the Hong Kong-listed companies covered in this report. Explanation on Equity Ratings BUY : share price will increase by >20% within 12 months in absolute terms SELL : share price will decrease by >20% within 12 months in absolute terms HOLD : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL

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