Credit Suisse Asia Equity Focus Turning less bullish on China's domestic sportswear sector in H2

Preview of the China sportswear sector ahead of H1 results
Investors generally expect the China sportswear sector as a whole to report robust H1 results, based on the strong pre-order sales recorded last year. While we agree with this view, our position on H2 is less bullish, despite market talk of the sales boost in Q4 from the Guangzhou Asian Games. With Nike revealing plans to enter the low-end China sportswear market by introducing inexpensively priced footwear as early as Q2 2011 (which means advance orders could began in Q3 2010), we expect the competition to intensify rapidly in H2, possibly causing domestic brands' advertising and promotion (A&P) expenses to ratchet upwards. This is a concern that might prove true if H1 operating margins turn out to be high due to subdued A&P expense ratios. In fact, China Dongxiang (DX) (3818 HK, BUY, TP HKD 5.2) was the first company to announce a huge marketing campaign in August, which management claims could alter its full-year A&P budget.

DX's disappointing May same-store sales (SSS) due to abnormal weather events also cast a shadow on replenishment orders and the order book execution situation among other sportswear players. Worse still, the inventory buyback (with a retail value of CNY 200 million) announced by DX management seems to highlight the possibility that the retail inventory-stuffing problem, which haunted the sector in the post-Beijing Olympics period, may be creeping back. It is worth noting that the inventory-to-sales ratios of Li Ning (2331 HK, HOLD, TP HKD 26) Anta (2020 HK, HOLD, TP HKD 14) and Belle (1880 HK, BUY, TP HKD 11) are not much better than the 5.3x reported by DX's management. Li Ning's distributors, in particular, must be eager to clear old inventories following the company's rebranding and logo change.

We believe the rise in labor costs accelerated in May with the hike in the minimum wage across many provinces and cities, yet H1 gross margins should remain stable if not increase. Li Ning and DX's supply chain are 100% outsourced, while Anta and Belle have retained substantial in-house manufacturing. Higher labor costs as a percentage of sales should begin to feed through to the profit and loss of the latter group and to a lesser extent to the former group (many inland populous provinces also hiked the minimum wage by 20%) as early as H2 2010. Considering Li Ning and Anta are currently trading at foward P/E 2010E of 20– 22x, we believe investors' risk tolerance with respect to negative surprises should be very limited. The same is true of Belle, despite the solid improvement in SSS year-to-date, which exceeded management's conservative guidance of 10% in H1.

Overall, we believe investors would be well advised to exercise caution when accumulating related sector names, even if the forthcoming H1 results are stronger than expected.