The following is a sample equity research report, presented here for illustrative purposes only.
Ticker: 2331 (HK)
Share Price: 5.37 HKD
Shares Outstanding: 1.944B
Market Cap: 10.57B HKD
EV: 10.16B HKD
Final Target Price: 6.80 HKD Upside: 26.6% Time Frame: 2 years
Composition of Final Target Price: 50% probability each assigned for DCF and comparable companies target prices.
Portfolio Allocation Strategy: 3-5% of long portfolio depending on existing gross exposure and portfolio concentration, with a maximum exposure of 6%.
Company and Industry Background – Li Ning is a Chinese sports goods, equipment, footwear, and apparel company. It focuses on three sports: basketball, badminton, and running. The company also holds a large minority stake in Double Happiness, one of the largest table tennis equipment company in the world. Li Ning competes against international brands like Nike, and Adidas. Its biggest domestic competitor is Anta, which also carries Fila in China. Li Ning is also expanding into fast fashion retailing and competes against Zara, Gap, Uniqlo, and H&M. Looking forward, Li Ning is in the process of transforming itself into a lifestyle brand, which includes sporting and casual.
The chart below shows the market share of the 5 largest sports brands in China.
Capital Structure Considerations – As of June 30, 2016, Li Ning has cash and cash equivalent of 1.54B RMB, borrowings of 0.21B RMB (0.2B in long term, 0.01B in short term), and convertible bonds of 0.74B. Hence, a net cash position of 0.59B RMB.
Assumptions - No acquisitions will be made, and the only change in capital structure is the repayment of convertible bond in 1H 2017, and conversion of 225,439,882 shares at $4.092HKD per share, which translates to a total proceeds of 0.92B HKD.
Investment Thesis
1. Growth of e-commerce - In H1 2016, Li Ning doubled its e-commerce portion of its overall revenue from 6.5% to 13%. Comps for e-commerce also increased in the high 60s to low 70s percentage range. E-commerce also delivers higher gross margins in the low 50s to low 60s percentage range. Given Li Ning’s increased social media presence through Wechat, and Weibo, revenue growth from e-commerce is expected to increase as the purchasing process becomes more convenient. In addition, Li Ning also recently established its e-commerce platform for its badminton products, one of its three main sport categories. This is also expected to drive higher e-commerce revenue growth.
2. Limited edition/custom products not only creates artificial product demand, but it also increases the hype of the brand – Li Ning has been experimenting with limited edition, and custom designed products for its basketball related product line. This creates artificial product demand because consumers would not have made those purchases if not for its rarity. These products are also price inelastic given that demand outstrips supply. More importantly, these products create unparalleled hype in social media, traditional press, online gossip, and general public attention. This improves the brand standing among consumers as consumers become more familiar with the brand, and associate the
brand with exclusive products. This is very important as Li Ning needs to improve its brand standing to compete effectively against direct international competitors like Nike, and Adidas, whose products compete in the same price range as Li Ning. Limited edition/custom products strategy is also scalable as Li Ning could easily use the same marketing tactic on its running, and badminton product lines. Ultimately, as a consumer discretionary company, Li Ning’s brand is the strongest pillar of the company’s economic moat.
3. Secular growth in the sports/lifestyle sector in China – China’s economy is government led, and government policy support is the strongest tailwind in any industry. As China becomes a more developed economy, sporting and exercising becomes more important as the government advocates for an active and healthy lifestyle. In September 2014, Premier Li unveiled a plan to speed up the development of the sports industry, boost consumption related to sports, and promote public fitness. The State Council (equivalent to the cabinet) released policy guidelines to support the plan. Revenue for the sports goods industry in 2015 was 25.7B USD. That translates to 19USD per capita consumption. Based on the per capita consumption of 302USD in the US, this translates to 0.6% of US GDP per capita. Applying the same proportion to China’s GDP per capita, China’s per capita sports goods consumption should be 48USD. This is in between Taiwan’s 57USD and Brazil’s 39USD, which is a reasonable estimate given China’s phase of economic growth. Thus, revenue for China’s sports goods industry could reach 65B USD. Assuming the industry reaches this size by 2020, this translates to a 5-year CAGR of 20.3%.
The chart below shows the per capita consumption of sports goods across different countries.
4. Growth of the lifestyle concept – Li Ning coins this as the “Sports +” concept where Li Ning acts as a conduit to embed the culture of exercise, and sporting into the daily lives of its consumers. Borrowing from Apple’s and Lululemon’s playbook, Li Ning turned its POS for running into a small community hub where the public can come together and organize running activities together. Not only does this concept drive foot traffic, but it also turns periphery consumers who do not have the intention of buying Li Ning products into making unplanned purchases. This strategy entrenches Li Ning deeply in the daily lives of China’s urban population (56% of the population live in urban areas). The scalability of this strategy means that Li Ning could expand this concept to other sports such as badminton, and basketball (although it has already started making playing basketball a lifestyle activity through its summer league called “ Shot to Fame”. Essentially, Li Ning is building a new pillar to support its economic moat.
5. Improvement in operating efficiencies – From both 2015 Annual Report, and 2016 Interim Report, Li Ning has demonstrated its ability to learn from past mistakes. Operating metrics have improved from past years. Inventory levels have decreased, discount on old inventory has decreased as the product mix improves, working capital as a proportion of revenue has decreased, and cash conversion days have decreased as well. There is still room for Li Ning to improve its operating efficiencies, which leads to better operating performance.
Conclusion for Investment Thesis – Li Ning has been very innovative with both its product development (smart shoes, limited edition/custom products) and its marketing strategy. If there were a Chinese version of Nike or Adidas, Li Ning would be the brand. Although Nike and Adidas are miles ahead in terms of market share in China, as a Chinese company, Li Ning understands the Chinese consumer better than any international brand. They are willing to experiment with new marketing strategies that targets the Chinese consumer exclusively. This is a constraint for international brands as they usually plan for global marketing campaigns. Hence, Li Ning is on a growth trajectory where it strengthens the pillars of its economic moat. As China become a more developed economy, and household disposable income increases, more consumers can afford (and given the Chinese mentality of flocking to popular brands, will also desire) a premium brand. Thus, Li Ning is more well positioned than Anta, and Xtep as Chinese consumers move up the income ladder.
Management History – Li Ning was very successful in riding the 2008 Beijing Olympics sports wave, and expanding its stores, product line, and operations very quickly. However, the company expanding too quickly, and operational execution did not follow. Inventory piled up, and eventually had a large write-off. In 2012, the company brought back its founder, Li Ning (the company is named after him because he was a famous Olympic gold medalist), replacing long-time CEO Zhang Zhi Yong, who was CEO since the company’s IPO in 2004. In addition, the company also elevated Kim Jin Goon, a partner at private equity firm TPG, and a nonexecutive director to Vice Chairman. Kim, a longtime consultant, had experience transforming Dell’s operations in Korea and Chinese women shoes company, Daphne International Holdings. The reintroduction of the founder bears striking similarities with previous corporate restructuring, such as Michael Dell with Dell Computers, and Howard Schultz with Starbucks. In Li Ning’s case, Li Ning had the help of an external turnaround specialist wher Kim became interim CEO subsequently, and played an instrumental role in restructuring the business, and eventually stepped down in November 2014. Li Ning is now the interim CEO of the company. Management talent is the biggest wild card to the continuous success of the company. While operating metrics have improved substantially, the annual, and interim reports make no mention of senior executives of the firm. The only senior management mentioned by the IR webpage is the CFO. I suspect that the company lacks a deep bench of management talent, and the current talent pool may not be qualified enough to be made public as to avoid questions by investors. Also, the continuous use of “interim” as part of the CEO title suggests that the company is still looking for a permanent replacement for Li Ning. A well known, and qualified seasoned executive as Li Ning’s successor could be the next catalyst for the stock price.
Thesis Tracking – To track Li Ning’s e-commerce sales, the investment team can look up rankings on JD.com, Tmall to gauge how well Li Ning fairs compared to peers. Logging into Weibo and Wechat to check the frequency, and quality of Li Ning’s social media marketing efforts, and the unveiling of limited edition/custom products. Channel checks and brand survey as discussed in the due diligence section can be done in regular intervals (with varying degree of intensity) to verify operating efficiencies. Occasionally, the investment team can visit Li Ning’s different types of POS to have a first hand feel of foot traffic for different product groups.
Key Risks
1. Validity of financial statements – There is always a chance that the financial statements do not truly reflect the real financial status of the company. Auditors in China do not adhere to the same standards as the US. Although all US listed companies are adhered to the same accounting standards, enforcing these standards in China is difficult. Investors can only trust that the financial statements are prepared with management’s integrity.
2. Corporate transparency – Investors will never have a clear idea of the personal dealings of key executives, and insiders. There may be potential conflicts of interests that the public investor may never discover without access to Chinese insider connections. US based investors can only trust that the disclosures are accurate.
3. Change in consumer tastes – The herd mentality is extremely strong in China. Consumer tastes, and preferences could change dramatically in a short period of time. Once something gains some popularity, its popularity spreads very quickly, especially with the advent of social media. Hence, there is always the likelihood that a competitor brand unveils a product that is suddenly widely popular, and draws consumers away from Li Ning’s product lines. However, given Li Ning’s wide array of product lines, the impact will be limited on overall revenues unless there is a macro decline in Li Ning’s brand equity.
4. Inventory write-downs – Although Li Ning has improved the composition of its inventory to carry more new products, there is always a likelihood that Li Ning miscalculates the predicted demand of its product lines, which leads to inventory write-downs and clearance sale. The increasingly shorter product cycles, and Li Ning’s wide range of products within the same product line (product cannibalization may increase) increases the chance of inventory obsolescence.
5. Loss of celebrity/team endorsement – Consumer brands, especially sports related ones, depend on celebrity and prominent team endorsements to build their brand awareness. The loss of celebrity and team endorsement deals will adversely affect Li Ning’s brand image in the sport of the team/celebrity. This is especially the case for Dwayne Wade, and CBA for basketball, China National Badminton team for badminton, and China National Table Tennis Team (table tennis is a major sport in China), and China National Diving Team (renown Olympic medalist team).
6. Macro economic slowdown – As a consumer discretionary product company, the demand for Li Ning’s products is highly income elastic. Sportswear and sporting equipment are one of the first purchases consumers avoid making when household income becomes more uncertain. However, given that Li Ning’s products are considered more premium than the mass market, Li Ning may feel less of an impact as compared to domestic competitor, Anta, which mainly targets the mass market segment.
7. International brands are formidable competitors – Li Ning competes directly against Nike, and Adidas in the China
market. Both brands have global resources, larger economies of scale, a stronger brand standing, more experienced and skillful marketing teams, and more formidable endorsement campaigns. These brands have more resources to invest into their brands, and product R&D. Li Ning must continue to execute flawlessly to remain as a serious competitor against the two international brands.
Due Diligence
1. Evaluating Li Ning’s brand equity in China – As a consumer discretionary products company, Li Ning’s brand equity is the most important asset of the company. The popularity, and brand image determines how well the brand fairs in the mind of the consumer. This ultimately will be the decisive factor when consumers make purchasing decisions if all
else is equal when compared to competitors’ products. To have an unbiased knowledge of Li Ning’s brand power, a survey needs to be conducted through both online and offline channels. The survey questions include Li Ning’s brand standing (popularity), product quality, perception of the brand (is it perceived purely as a sports brand, lifestyle brand, both, others), perception of innovation as compared to its peers, and preferred purchasing channel. This survey will address the validity of revenue growth rates compared secular sector growth, and the extent to which e- commerce adds to revenue growth. Weibo, and Wechat should also be used as channels of survey as the consumer population spends more time on mobile.
2. Sales channel checks, inventory inspection, receivables and payable checks, related party transactions, and corporate visit as an unknown small time investor (not as a major investor) – To address key risks 1 and 2, independent verification of the company’s sales channels, inventories, receivable and payable counterparties needs is essential. This entails the engagement of private investigators to blend into the employee crowd to learn about key operational information of the company, especially undisclosed related party transactions. Private investigators may also call up trade counterparties (suppliers, distributors, authorized resellers) to learn more about the above information. Lastly, the analyst team should conduct a company visit to have a first hand assessment of the company’s operations, and management without identifying themselves as a major investor, but as small-time investors to ensure that the company is presenting the “real” operations as much as possible, rather than just putting up a show for investors. This verification process will address the validity of assumptions built into the financial models for operating efficiencies, and balance sheet items.
3. Call with management (as a major investor) – To evaluate the management’s tone, and confidence, the investment team should conduct a conference call with the management to ask about their brand investment strategy, market strategy, and fast retailing strategy. The purpose of the call is to understand if the management has a clear and coherent business strategy that it can articulate and sell to investors. The investment team could also try to ask about related party transactions, and other more sensitive topics to gauge if the management is trying to hide certain information from investors based on their tone of conversation. Notes from the call should be compared to notes from point 2 to see if there are any discrepancies of information.
Risk Reward Analysis
Based on the target price of 6.80 HKD, which indicates an upside of 22.6%, a 3 to 1 risk-reward ratio would indicate a downside potential of 8.9%. This translates to a target cut loss price of 4.89 HKD per share. This is an appropriate cut loss point because it has a long term support of the 250MA for the weekly chart. Thus, if this support level is breached, the stock is highly likely to hit the next support level around 4.50 HKD. This implies that once this support level is breached, the amount of downside risk increases dramatically. However, if the support level around 4.89 HKD holds well (which I think is very likely the case), the investor could still hold the position without being further exposed to downside risk, while he waits for the consolidation to complete before rallying further.
-Gugnir and Partners
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