Zhihua Group (01842), which started with bag trading, has experienced an arduous process from "overturning" to contract manufacturing, from contract manufacturing to design, and from design to its own brand in 30 years. Today, it has become a medium-sized backpack and suitcase manufacturer with an annual income of more than HK $677 million and passed the listing hearing of the Hong Kong Stock Exchange on June 5.

From 2016 to 2018, Zhihua Group's adjusted net profit grew at a compound annual rate of 27.28 per cent, but in 2017, due to a dividend of HK $40 million, the asset-liability ratio soared to 110 per cent from 58.3 per cent in 2016, according to Zhitong Financial APP. As a traditional small and medium-sized manufacturing enterprise, what has Zhihua Group done for listing?

Business strategy under saturated capacity

In the face of fierce competition in the domestic market, Zhihua Group decisively chose the overseas market. In 2018, the Chinese market accounted for only 7% of the company's total revenue, with the vast majority of revenue coming from North America and Europe, accounting for 48.4% and 34.1%, respectively, for a total of 82.5%.

The advantage of giving priority to overseas markets is that the domestic production cost is lower, and the products have a price advantage over foreign countries. However, with the disappearance of population and land dividends, Zhihua Group has had to transfer its production capacity from Shenzhen to Jiangxi.

The largest capacity of the Shenzhen plant fell from 239700 in 2016 to 157000 in 2018, a drop of 34.5 per cent. On the contrary, the number of factories in Jiangxi has grown sharply, increasing by 23.7% to 8.438 million pieces from 6.821 million in 2016.

Even if there is a substantial transfer of capacity to Jiangxi, the capacity utilization rate of Zhihua Group is close to saturation. The company's total capacity utilization was more than 90 per cent in 2016-2018 and 97 per cent in 2017 and 2018. The lack of factory capacity obviously restricts the growth of the company's income. From 2016 to 2018, Zhihua Group's revenue increased from HK $630 million to HK $677 million, representing a compound annual growth rate of only 3.68 per cent.

But the effect of capacity transfer was perfectly reflected in 2018. In 2018, the production capacity of Zhihua Group in Shenzhen was 157000 units, down 33.76% from the same period last year. At the same time, while the cost of inventory sold (including raw material costs, manufactured goods costs and subcontracting costs) accounted for a slight increase in revenue, the proportion of labor costs in sales costs of Zhihua Group fell from 14.7% in 2017 to 13.8% in 2018, a drop of nearly 1 percentage point.

Reflected in the gross profit margin, the result of reducing cost and increasing efficiency is more obvious. Zitong Financial APP found that the gross profit margin of Zhihua Group's own label products rose from 11.1% in 2017 to 14.7% in 2018, an increase of 3.6 percentage points.

Of course, the improvement of gross profit margin of brand products based on high premium is more obvious, which is mainly franchised brand products, which adopts ODM model to design products for brands. From 2016 to 2018, the gross profit margin of the licensed brand increased from 44.3 per cent to 52.1 per cent in 2018. In addition, the own-brand product Ellehammer has also helped to improve the gross profit margin, which rose from 22.1% in 2016 to 28.4% in 2018.

As a result, under the dual catalysis of capacity transfer and high gross margins of brand products, the overall gross profit margin of Zhihua Group increased from 19.5% in 2016 to 22.9% in 2018. And during these three years, the company's sales expenses remained stable, financial expenses increased but accounted for less, and management expenses also decreased due to the transfer of production capacity. In the end, Zhihua Group achieved an adjusted net profit from HK $24.618 million in 2016 to HK $40.114 million in 2018, with an annual compound growth rate of 27.28%.

Cooperation with franchisee C is the key?

But whether Zhihua Group can maintain a good momentum of development in the future, we may have to consider the following factors.

First of all, from the past data, although the proportion of factory capacity in Shenzhen is small, but the production costs and management costs are not low, the transfer of production capacity from Shenzhen to Jiangxi can increase gross profit margin to a certain extent.

Second, due to the constraints of overall production capacity, Zhihua Group's income grew at a compound annual rate of less than 4 per cent from 2016 to 2018. Although the company has made it clear in the purpose of raising funds that it will expand production, the production line will not be put into use until January 2021 at the earliest, that is, the company's total capacity cannot be expanded from 2019 to 2020, and the growth of total revenue will continue to be limited by production capacity.

When production capacity is limited, it is all the more important to adjust the product portfolio to increase gross profit margins. However, judging from the current situation, it is not small. From 2016 to 2018, the fastest growth in revenue was in low-margin proprietary label products, which accounted for 75.9% of the company's total revenue, up from 63.1% in 2016.

Ellehammer, a private-brand product, has been in decline, with revenues falling by as much as 80 per cent, from HK $124 million in 2016 to HK $24 million in 2018. Revenue from franchised brands with the highest gross margins fell slightly in 2018, mainly due to a failure to sign up after a partnership agreement with a franchisee ended in 2017.

So far, Zhihua Group has cooperated with three franchisees. In 2018, the gross profit margin from franchisees was as high as 52.1%, and there is limited room for gross profit margin to continue to rise. And franchisee C, a global music-themed restaurant chain, has not generated revenue since it signed a contract with Zhihua Group on September 21, 2017. Even if the franchisee makes a deal with Zhihua Group this year and next year, it may be difficult to achieve the same high gross profit as the other two franchisees because of the cooperation time.

The dividend of HK $40 million led to a big increase in the debt ratio.

In addition, it is also worth noting that the dividend payout of Zhihua Group has led to a substantial increase in the company's debt. In 2017, when the company's accounts payable and bank loans soared, the company announced a dividend of HK $40 million, causing the current asset-liability ratio to soar to 110% from 58.3% in 2016. In 2018, as a result of factoring loans, the asset-liability ratio increased to 117.5%.

According to Zhitong Financial APP, Zhihua Group will issue 250 million shares at HK $0.50 each from June 13 to 18, with 4000 shares per share, which is expected to be listed on June 28.

By calculation, the market capitalization of Zhihua Group is HK $500m, which corresponds to 12.5 times the PE of 2018. It is optimistic that 10 per cent adjusted net profit growth will be achieved in 2019, corresponding to 11.36 times PE in 2019. In the current market, such valuations are not cheap. Companies with certain brands, such as Urban Beauty (02298) and Xtep International (01368), are all valued at less than 11.36 times in 2019.

On the whole, under the restriction of total production capacity, Zhihua Group has realized the rapid growth of adjusted net profit through the transfer of production capacity and the high gross margin of licensed brand products. However, under the circumstances that the production capacity can not be expanded in the short term, the gross profit margin of licensed brand products is limited, and the revenue of own brands continues to shrink, it may be difficult to have a significant increase in follow-up profits. And the high debt caused by dividends and high valuations have lowered the texture of the company, while a small market capitalization of HK $500m may exacerbate share price volatility.