The share price fell too much. Investors were disappointed with the contraction in Longgong's gross profit margin in the first half of the year, which reflected the company's weaker pricing power. On the positive side, however, we think this will help drive future sales growth. We cut our profit for 2018-20 by 7-8%, based on expectations of an increase in sales but a decline in gross profit margin. Our target price is reduced from HK $4.25 to HK $3.94, based on the same price-to-earnings ratio of 11 times (2018). We believe that yesterday's 15 per cent share price correction reflects risk and maintains a "buy" rating.
The reasons for the decline in gross profit margin in 2018 are broken down. Management said that gross profit margin fell 4.05 percent in the first half of 2018, of which (1) 7.49 percent decline came from higher raw material prices, and (2) 0.27 percent decline came from product portfolio changes. these exceed the 3.7% increase in gross profit margin brought about by the increase in unit prices. According to the product classification, the gross profit margin of wheel loaders decreased by 6.06 percentage points to 27.19%, and that of excavators decreased by 2.54 percentage points to 27.94%. Management said it would not set a target for gross margins in the future, but would ease the cost pressure by raising the unit price of some products.
Sales growth mitigates future gross margin risk. In the first half of 2018, sales of Longgong wheel loaders / excavators / forklifts recorded an increase of 31%, 96% and 36%, respectively. Management said that the strong sales momentum continued in the traditional off-season in July and August, and expected sales growth to continue into the fourth quarter (the peak season for the engineering business). We believe that there will be further upside in sales. The Bloomberg market consensus expects sales growth of less than 30% this year, while we expect sales growth of 46% this year.
Analysis of the reasons for the decline of operating cash flow. Longgong's operating cash flow fell 75 per cent to 230 million yuan in the first half of 2018 compared with the same period a year earlier. The management explained that (1) the purchase of spare parts increased to hedge the pressure of rising raw material prices; (2) the payment to suppliers increased to get a 7-8% discount; and (3) the income was distributed to offshore subsidiaries, resulting in an one-time tax expense of 100 million yuan. We think these methods to reduce the cost of raw materials are reasonable.
Main risk factors: (1) slow down of engineering business; (2) increased cost of spare parts; (3) loss of financial investment
