1. Domestic integrated knitwear manufacturers have maintained steady growth in performance

The company is an industry-leading knitwear manufacturer, covering women's clothing, men's clothing and other products (children's clothing, scarves, hats and gloves). It uses a vertically integrated operating model to provide customers with one-stop solutions for raw material development, product design, sample manufacturing, quality production, quality control and product distribution, consolidating the existing high-quality customer base, and continuously expanding the customer base to bring an increase in new customer orders.

In the 2014-2017 fiscal year (ending March 31, 2017), the company's operating revenue increased from HK$2,347 million to HK$2,803 million, an average compound annual growth rate of 6.11%; net profit attributable to the mother increased from HK$219 million to HK$328 million, an average compound annual growth rate of 14.36%.

In the six months ending September 30, 2017, the company achieved operating revenue of HK$2,114 million, an increase of 19% over the previous year, mainly due to an increase of 13.7% in the average unit sales price (ASP) of knitted products (ASP) and a 4.6% increase in menswear sales; gross profit was HK$484 million, an increase of 15.3% over the previous year; due to changes in the product mix and a strong RMB exchange rate, the company's comprehensive gross margin fell slightly by 0.92 pcts to 22.9% year on year; net profit attributable to the parent company was 292 million The Hong Kong dollar increased 29.6% year over year, thanks to increased sales and effective control of various costs and expenses.

In terms of the cost rate for the period, the sales expense ratio decreased by 0.49 pcts to 1.16% year on year, the management expense ratio decreased by 0.86 pcts to 6.63% year on year, and the financial expense ratio decreased by 0.15 pcts to 0.42% year on year. Mainly due to the implementation of cost control measures, streamlining production processes, production efficiency improved, and technical equipment continued optimization. Inventory turnaround days were reduced by 5 to 45 days year over year, production cycles were shortened, and inventory turnover was accelerated. The share of the company's quick orders increased by 10 pcts to 30%. Net cash from operating activities was HK$179 million, down 36.6% year on year, mainly due accounts receivable from centralized sales in August-September.

2. Uniqlo, the largest customer, is gaining strength in the European and domestic markets, with sales surging 24.5% and accounting for more than 60% of revenue.

According to downstream customers, the company's main customers include internationally renowned leisure brands such as Uniqlo, TommyHilfiger, and Lands' End. Among them, the revenue of Uniqlo, the company's largest customer, increased 24.5% year-on-year to HK$1.3 billion, accounting for 61.5% of total revenue, an increase of 2.74 pcts over the previous year. However, Tommy Hilfiger, the second-largest customer, fell 14.1% year-on-year to 305 million yuan, accounting for 14.4% of total revenue. Although Tommy Hilfiger's sales revenue has declined among major customers, the company has developed new customers one after another with its excellent manufacturing quality and rapid supply chain response capabilities. The company's current revenue share of the company's top five customers is 85.2%, down 3.4 pct from 88.6% in fiscal 2016. The share of new customers has increased, and the capacity utilization rate has remained saturated.

In terms of sales regions, Japan, North America (mainly the US), and Europe are the company's top three sales markets. For the six months ending September 30, 2017, Japan, Europe, North America, mainland China, and others accounted for 33.7% (+7.74% of sales year on year), 22.11% (+41.7%), 20.12% (+7.82%), 12.82% (+23.17%), and 11.24% (+39.17%). The European and mainland China markets grew rapidly, matching the market expansion direction of Uniqlo, the company's largest customer.

3. Accelerate the deployment of Vietnam's production capacity, reduce production costs, and have more room to improve capacity utilization

From April to July 2017, the total value of China's knitwear exports fell slightly by 0.9% to US$48.7 billion, while Vietnam's total textile and garment exports increased 7.8% year on year to US$13.6 billion. Vietnamese companies are exempt from operating income tax for 2 years from the first year of profit, and enjoy a 50% reduction in the operating income tax rate for the next 4 years. The operation of the company's Vietnam Phase II plant is gradually maturing, enjoying the scale effects and low cost advantages brought about by the expansion of production capacity. The production efficiency of the Vietnamese plant is expected to continue to improve.

Currently, the company's annual production capacity exceeds 46 million pieces, including 30 million pieces in Huizhou and 16 million pieces in Vietnam. Currently, the company's domestic factories are mainly responsible for the production of complex products with short delivery times. Due to the recent launch of the second phase of production capacity in Vietnam, its capacity utilization rate is expected to be only about 60% of the domestic capacity utilization rate. We expect the actual output of the Huizhou plant in FY2018 (up to the end of March 2018) and FY2019 to reach about 27 million pieces, while the Vietnamese factory will produce 8.5 million and 11 million pieces in FY2018 and 2019 respectively, based on the existing main product structure (women's clothing accounts for about 64%, men's clothing 35%) and average unit price (women's clothing is about HK$93 per piece, men's clothing is expected to be HK$105 per piece). Revenue reached 2.1 billion (21% increase) and HK$1.3 billion (+24%) respectively; reached 2.3 billion (+11%) and HK$1.5 billion (+11%) in FY2019, while further release of production capacity in Vietnam will further drive steady revenue growth in Vietnam in the future.

4. Promote overall new clothing technology, continuously strengthen the level of automation, and promote productivity improvement

In recent years, with the continuous increase in domestic labor costs and stricter environmental protection policies, the textile and garment industry has been transformed and upgraded in the direction of high efficiency and refinement. The company took the lead in introducing advanced full-molding knitting machines and streamlined stitching production procedures. The level of automation was continuously improved. While improving overall production efficiency and reducing labor costs, a fashion product line was added. The overall garment production machine is a complete knitted product produced through specific programming. It produces clothes that are molded once without any cutting or stitching. On the one hand, fully molded knitting machines are more automated and the weaving time is shorter; on the other hand, they can reduce the number of starts, corner waste, and labor input of traditional looms and sewing equipment, thereby reducing production costs, and the design pattern is more personalized and diversified; in addition, the unit price of overall woven products is higher - the average sales price of seamless clothing produced is $16, which is 39% higher than the average selling price of traditional clothing of 11-12 US dollars, and the gross margin is higher than that of ordinary products.

Currently, the company's overall annual production capacity of garment machines is about 700,000 pieces. In the future, as demand for products increases, the number of machines sold is expected to increase from 180 to 250 units, and production capacity is expected to reach 1.5 to 2 million pieces. The overall use of clothing production machines can be expanded from sneakers and casual shoes to bags, auto parts, household items, etc. The application range is wide, but the purchase cost of professional looms is high, creating a high barrier to entry.

5. Acquire Polycom to enter the high-growth sneaker fabric market and promote product and customer structure optimization

On September 28, 2017, the company announced that it intends to use HK$550 million to acquire 100% of the shares of Polygraph Group held by the company's chairman and shareholders, and enter the manufacturing business of knitted uppers and knitted shoes using HK$206 million in cash and HK$344 million to issue shares. The acquisition is expected to be completed by the end of December. At that time, the majority shareholders' shareholding ratio in the company will increase from 72.3% to 74.7%. According to the share transfer agreement, Polyson promised to achieve a net profit of HK$66 million in fiscal year 2018 (ending March 31, 2018). Compared with the net profit of HK$32.9 million in 2017, the growth was driven mainly by sales growth brought about by the doubling of the number of orders; the corresponding PE was 8.33 times, and the purchase price was reasonable.

Polyson Group factories are located in Huizhou, China and Vietnam. Huizhou has more than 1,400 machines and Vietnam has more than 600 machines. Polyson's knitted uppers business has a total production capacity of about 19 million pairs. Since the Vietnam factory is in the early stages of operation, it is conservatively estimated that the average capacity utilization rates for FY2018 and FY2019 were 60% and 70%, respectively, corresponding to the total output of 8 million and 13.3 million pairs. Assuming a unit price of 6 US dollars per pair (about HK$46.88), each of the two years contributed to revenue of 94 million (3 months combined) and HK$622 million. Net profits were achieved for the full year of FY2018 and FY2019 At HK$100 million (net profit margin of 20%), it is safe to meet performance promises.

After completing the acquisition, Nanxuan Holdings' original business will reach multi-faceted collaboration with Polyvision:

(1) Optimize the product portfolio to achieve diversified development. Nanxuan's main business is casual wear, while Polyson Group specializes in sportswear. The main downstream customers are Puma, UA, etc. Among them, Puma accounts for more than half of its revenue. In the future, the two sides are expected to share customer resources, product development, etc.

(2) Increased profitability. From April to the end of July 2017, Polycom's gross margin was 43.8%, and the net interest rate was 20.2%, far higher than Nanxuan's gross margin of 22.9% and net interest rate of 13.8%. After the acquisition is completed, the company's comprehensive gross margin and net interest rate levels are expected to increase.

(3) Smooth off-peak season production capacity. Generally speaking, every year from June to July is the low season for Polyson knitwear production, and it also happens to be the peak season for Nanxuan sweater production, which helps to allocate production capacity to improve capacity utilization.

(4) Collaboration in supply chain management and other aspects to improve operational efficiency.

Investment advice: The company is a leading knitwear manufacturer in the industry. It has acquired Polycom to promote the diversification of its business to knitted uppers and knitted shoes, and its market share is expected to increase further. With the expansion of production capacity in Vietnam and investment in automated production equipment and design and development, the company's cost control was effective and production efficiency continued to improve. The company was included in the MSCI Hong Kong Small Stock Index, which had a certain catalytic effect on stock prices. We expect the company to achieve net profit of HK$462 and HK$634 million in the 2018-2019 fiscal year, up 40.7% and 37.3% year-on-year. The corresponding EPS was HK$0.21 and HK$0.29 respectively. PE was 13.4 times and 9.8 times respectively, covering the “buy” rating for the first time.

Risk factors: Low overseas demand; release of overseas production capacity lower than expected; risk of exchange rate fluctuations, etc.