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 profita- bility 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 re- forms 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 invento- ry 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 tar- get 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 main- tained. 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.