DUKANG DISTILLERS: Investor sentiment weak, too early to enter stock

Jack Phang, CFA (left), is a remisier at Maybank Kim Eng Securities. This article was first published in his blog, and is reproduced with permission.

DUKANG DISTILLERS reported a very disappointing result, right after it issued a profit warning on 2QFY14 report.

Revenue in 2QFY14 dropped a significant 45% y-o-y, with only RMB402.8M revenue recorded.

The product mix has changed with Luoyang Dukang regular brand becoming more significant and this eroded the gross profit margin.

Worse, surging A&P expenses which amounted to more than 20% of revenue had caused the net profit to be reduced to RMB10M in this quarter.

400_billboard-at-Zhengzhou-

Dukang billboard at Zhengzhou. File photoAccording to the management, this is not the time for the company to cut A&P expenses as well as working capital needs. Instead, the company would increase its capex (you can see that the inventories have increased) in preparation for fierce competition among peers.

The baijiu industry currently is the midst of intense competition (mainly due to the government's curb on luxurious consumption), as many companies reduce their average selling prices to gain market share.

While Dukang is still in a net cash position, no doubt the company would not distribute dividends to shareholders as it has to conserve cash for capex and opex requirements.

The cash flow from operating activities turned negative this year, as the company increased inventories (mainly grain alcohol).

Company's growth strategies remain:

* Enhance brand value by participating in promoting baijiu, especially the Dukang premium brand

* Strengthen distribution networks as none of the top 5 distributors accounts for more than 10% of sales.

However, I noticed that the number of distributors was lower compared to FY2013 and I believe that is mainly due to the curb by the Chinese government on luxury spending in banquets.

* Improve capacity and utilization. The utilization rate was 105% for 2QFY14.

Looking ahead:

With 2Q2014 EPS of 1.26 RMB cents or annualized 5.04 RMB cents / 1.05 Singapore cents, Dukang Distillers is trading at annualized PE of more than 20X, which I believe is very expensive.

Things can turn better if the sales volume increases from the positive impact of A&P activities.

Nonetheless, the group remains positive on the long run as the management believes demand for baijiu will remain resilient in the long run.

I believe the sentiment for this counter is weak now, and it may take quite some time for the company to turn around as revenue and net profit issues are experienced by the industry players.

I may re-look at this counter only after the free cash flow has improved (e.g. through a reduction in the % of A&P expenses vs revenue, better cash conversion cycle days, etc).

Maybe, this may take a few years.

P/S: I would think of entering the stock (recently at 24.5 cents) if the price falls to 13c and below -- that would be a safe bet. The PE would then be about 13X on an annualised EPS.

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DUKANG DISTILLERS: Investor sentiment weak, too early to enter stock

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