3Q results in line with our expectations

Changyu announced its 3Q13 results: Revenue declined 27.2% YoY and netprofit dropped 46.9% YoY; its sales momentum stayed weak despite last year’slow base due to the significant decrease of mid-range/high-end wine revenue(+40% YoY drop of Chateau and Castel wine; +20% YoY decline of Cabernet).

The product mix downgrade dragged down gross margin by 8.0ppt YoY to61.0%; while the selling expenses/sales ratio returned to a high level of 35.3%(+13.2ppt QoQ, but -1.8ppt YoY).

Trends to watch

Weakness will extend into 4Q: Considering 1H’s distribution channelstuffing, 3Q’s sluggish sales performance could be partially due to channelclearing. However, distributors’ inventory level is still high, especially formid-range/high-end wines. We think it will take at least another quarter tocomplete the channel clearance, given no meaningful demand recovery formid-range/high-end wines, especially in their major distribution channels(high-end restaurants & hotels).

No effective strategy to counter the cycle. Different from high-end wines, wesee consumption growth for mid-range/low-end wine showed initial signs ofrecovery in the peak season, and we believe domestic players have moregrowth potential in the mass wine market given their extensive distributionnetwork. However, so far Changyu has not initiated an effective strategy tobetter cater to mass market demand, and is sticking to mid-range/high-end winesales.

Expect a mild recovery in 2014, but a core competitive edge will take timeto build. We expect the company to deliver 7% revenue growth in 2014 on thelow comparison base and after channel stuffing was gradually reduced.

However, the core competitive advantages of a mid-range/high-end winecompany are quality and brand value, and we do not think Changyu will top itsmajor foreign peers in these regards in the short-/medium-term.

Earnings revisions

We largely maintain our earnings forecasts.

Valuation and recommendation

We maintain our HOLD rating and end-2014 TP of HK$27.2. Although itscurrent stock valuation is low (11x 2014e EPS) compared to its peers, itscompetitive disadvantage as a company positioned as high-end wine playercould be an overhang on its long-term performance. The main risk is a furtherdecline in high-end wine consumption.