HONGGUO

Step #1: Strong consistent sales & earnings growth that looks predictable into the future...


Hongguo has demonstrated consistent growth over the years, growing at an annual compounded rate of 28% for profit after tax and 17% in growth in sales for the period from 2001 – 2005.

Hongguo’s revenue grew 44.2% to RMB424 mil in FY 2005 from RMB294 mil in FY 2004 as a result of increased sales from C.Banner and E.Blan (which grew 47%). Net profit also grew 33%. The expanding network of retail stores also grew from 487 to 615, a total increase of 26%.

Step #2: Conservative Financing with total debt less than a single year's net earnings...
For FY 2005, the total liability stands at RMB146.5mil, which is current liabilities, no long term loans. Cash and Bank balances plus fixed deposits stands at RMB60.9 mil, and with earnings of RMB70mil, Hongguo fails the debt test marginally.


Step #3: Consistently high ROE, above 15% each year...
For 4 years (2002 to 2005), the company has been consistently able to deliver outstanding returns on equity, exceeding 19% per year.



Step #4: Intelligent Capital Allocation, where retained earnings are used for growth not maintenance...
Investment of RMB 8 Million (SGD 1.6 Million) Design & Logistics Centre in Guangzhou, to be completed by Dec 2006 – providing for design capacity of up to 4000 shoe models per annum from the current 1000 shoe models.

Expansion of retail network – to reach 730 points of sale (POS) by Dec 2006 from the current 615.

To meet growing demand for both its in-house ladies’ footwear labels C.Banner and E.Blan, as well as Original Equipment Manufacturing (“OEM”) orders, RMB 18 million will be invested for the expansion of the Nanjing and Dongguan facilities which currently have three production lines each. With the proposed capacity expansion, two new lines will be added to the Dongguan facility, while one new line will be added to the Nanjing manufacturing facility. Completion of the works is expected in end-June 2007, upon which, the Company’s combined annual production capacity will be raised by 50% from 2.52 million pairs currently to 3.90 million pairs of shoes.

Cash flow ratio: (current assets - cash) / (current liabilities - interest bearing short term loans) = (349784 – 47769) / (146597 – 20315) =
- 2.39 for FY 2005
- 2.86 for FY2004
- 2.39 for FY2003
- 1.61 for FY2002

The management has shown an improvement on the management of inventories from previous financial year of 2005, with the best performance in FY2002, though the management is still not near the desired cash flow ratio of 1.5. However, this is expected to be a norm in the fashion industry where products are kept in inventories for a long period of time before it is sold off the shelves.

Step #5: The Business is easy to understand, and Management is open, honest and competent...
Hongguo is primarily a ladies shoe maker, which is a very easy business for anyone (especially women) to understand. It is a well known fact that women love their shoes. The company’s 3-pronged strategy of
(1) Growing in-house brands,
(2) Securing exclusive distributorships and
(3) Taking on OEM contract manufacturing business
provide business and revenue from all areas of the apparel business.

The executive director Chen Yixi, owns about 1/3 of the company (29.08%), with the other 2 directors Li Wei and Miao Bingwen owning about 9.81% and 8.92% of the company respectively, making up a combined stake of 47.81%. It can be expected that the directors will run the company as if it were their own. The director Chen Yixi, uses his own shares as share options for employees. This does not dilute existing shares and also demonstrates the director’s commitment to the company.

Step #6: 2x5y= Business/Industry Prospects indicate Earnings could Double in 5 years...
Hongguo’s own developed brand, C-Banner achieved 2nd position leaping past the 3rd position that she had held for the past few years, demonstrating its ability to increase market share. In addition, with more and more internationally recognized brands coming within the distributorship of Hongguo, it is well placed to grow as a company dealing in premium apparel.

Hongguo is well placed in the China consumer industry as rising affluence would lead to greater spending power that will attract the ladies to spend more on their shoes. With 2008 Beijing Olympics drawing near, the affluence of the Chinese will increase as increase in spending on infrastructure in preparation for Olympics, pumping an increased liquidity flow in the China’s economy. Taking account into possible appreciation of the RMB against the world’s currencies, the value of business and income generated by Hongguo is considerable and significant.

Hongguo embarks on an aggressive strategy of expanding the number of point of sales within China. It has increased the number of outlets from 487 to 615, which equates to an increase of about 25%. In addition, it ties up with established foreign brands such as Zegna, HUGO Boss, Bianco and Byford through partial distributorships via the Jiangsu Unity Corporation (JUC) acquired recently. The latest being Lumberjack, which is a 3 year exclusive distributorship. Jiangsu Unity Corporation JUC will also be introducing, to its stable of brands, renowned American label Tommy Hilfiger, for which 2 stores will open in FY 2006

Its own brand C-Banner and E-Blan are also doing quite well, with C-Banner leaping past Prime Success’s Daphne brand to grab the 2nd best selling brand in China.

Step #7: Sustainable Competitive Advantages are in place...
Hongguo has managed to build its 2 in-house brands C.Banner and E.Blan from nothing to the #2 in China now. If they manage to build it into successful brands, it will provide a competitive moat around their business.

Step #8: Attractive Valuation...
Based on a growth rate of 15% and zero terminal value for 10 years, the estimated discounted cash flow from the business is $0.561. At the current price of $0.525, the value of the business is fully valued in its price. If the basis is 20% growth rate, the current price represents a 25% discount from the DCF value of the business.

With Hongguo needing to pay 50% of the corporate tax rate of 33% from this year onwards for the next 3 years and then subsequently the full corporate tax rate, it is expected that the DCF value Hongguo will decrease as a result of this factoring in. Factoring in this in, the current share price is fully valued with the growth rate to be at 20%.

Unless Hongguo can substantially increase its growth, it is expected that the current price will stagnate for a long time between $0.50 and $0.70 as it is already fully valued.

The recent three-fold surge in the price of Hongguo shares has also fully factored in the growth potential of the company.

Decision: The business is good and fundamentally sound, with lots of growth potential. Management is also a key owner of the business and manages the business in a transparent fashion. However, the price at which it is valued now is on the high side at Forward PE of 13X. SELL

Trigger to buy: When price hits $0.25 - $0.30, we would have a margin of safety of up to 40%-50%, which would be a good price for entry into Hongguo.