Eratat Lifestyle – 1HFY11 Net Profit surged 94%; Stock trades at 2xFY11F PE

Eratat Lifestyle[1] reported a sterling set of 1HFY11 results for the period ended 30 June 2011. 1HFY11 sales and net profit surged 25% and 94% respectively to RMB523m and RMB90m. Gross margins have held steady above 30%, in line with management guidance. However, its share price only showed a positive one day response to the results before resuming its precipitous downward decline.
Year to date (“ytd”), Eratat share price has declined 44%. To put this in perspective, STI and FTSE China Index’s ytd performance fell about 14% and 27% respectively. Besides the lackluster equity markets and the weak market sentiment on S chips, what had happened to Eratat for this poor performance?
Based on my observation, I believe the following two factors (rightfully or wrongfully) contributed to the above average decline in Eratat’s share price.
Firstly, its large (and increasing) trade and other receivables
Based on its 1HFY11 results ended 30 June 2011, Eratat’s trade and other receivables ballooned 27% and 124% respectively to RMB465m and RMB172m from half a year ago. Cash conversion cycle has also lengthened from 118 days to 136 days. This naturally sparked some concern from the investors.
According to management, Eratat’s trade receivables have increased as they extend credit terms to those distributors who are opening more direct owned shops to expand the distribution network. Management firmly believed that this method of extending credit terms is better than to provide distributors with sales discounts, or rebates, or renovation subsidies.
Furthermore, Eratat’s other receivables have risen due to trade deposits of RMB163m  (As at 31 December 2010: RMB71m) being paid to apparel suppliers during the current quarter to place order for Autumn/Winter Season apparel products to be delivered from July to December 2011. Eratat outsources the manufacture of their apparel to mid to large sized apparel makers. These apparel makers also manufacture apparel for high end local and international brands. As Eratat’s orders are not sizeable, they have to “pay faster” so as to secure delivery of products. Typically, Eratat pays about 50-60% as trade deposits at the time of placing orders and another 30-40% upon delivery. The remaining balance of 10-20% has to be settled within a month’s time. As Eratat increases its proportion of its apparel to footwear, it is likely that the other receivables portion will continue to be high (at least) in the near future.
Notwithstanding the above, Eratat has not experienced any bad debt for the past five years.
Secondly, two placements in a month
Eratat attempted a placement in January 2011 where it sought to issue shares to Mr. Khoo Boo Kok and Best Increase Limited, an investment fund managed by CMIA Capital Partners Pte. Ltd. However, this was rejected by SGX on the basis that the issuance of the New Shares will exceed the maximum 10% discount allowed under Rule 811(1) after taking into account the value of the Subscription Options and the portion of the Placement Agent’s Fee to be paid to Khoo Boo Kok.
As Eratat requires cash for its working capital, it continued to seek placement options. In April, Eratat placed out 60m new shares at $0.202 in two tranches which is outlined in Table 1 below.

Table 1: Placement summary
Details
Placement 20 Apr 11
Placement 9 May 11
Number of new shares
45m new shares.
15m new shares.
Placement Price
$0.202
$0.202.
Placees
Not specified.
Delta Lloyd Azie Deelnemingen Fonds – a mutual fund managed by Delta Lloyd Asset Management.
Placement Agent
Stirling Coleman
Stirling Coleman
Amt raised, ex placement expenses
S$8.78
S$3.0m.
Reasons
Working capital to increase the Group’s revenue and expand the distribution network for its ERATAT brand products.
Working capital to increase the Group’s revenue and expand the distribution network for its ERATAT brand products.

Source: Ernest’s compilations
These two placements (which occurred in a single month) stoked investors’ concerns that Eratat requires cash for its operations. Against the backdrop of a lengthening cash conversion cycle, investors are also worried that the cash call may not be the last that they have seen.
Not all is gloom and doom…
Significant inroads for its Eratat Premium products
Eratat has made significant steps to develop their Eratat Premium Products. Currently, Eratat distributors have opened 50 stores in Zhejiang, Guangdong, Henan, Shandong, Anhui and Shanxi. For Shanghai, there are 11 new ERATAT Premium specialty stores that have commenced operation. According to management, the commencement of operation in Shanghai is a significant milestone as it opens doors to other tier 1 malls in other cities.
Order book visibility – just a meager y-o-y increase?
Eratat received new orders for 2011 Autumn / Winter Season (to be delivered from Jul to Dec 2011) amounting to RMB550m, representing an increase of 5% y-o-y. Although this seems like a marginal improvement, (as usual) the devil is in the details.
Firstly, the proportion of apparel to footwear in 2011 Autumn / Winter Season is 65%:35%. This was a sharp improvement from 2010 Autumn / Winter Season of 52%:48%. As apparel products carry higher gross margins, this is expected to be positive for Eratat’s 2HFY11.
Secondly, Eratat Premium products comprised 24% of their 2011 Autumn / Winter Season orders vis-à-vis none in 2010 Autumn / Winter Season orders. Eratat Premium products carry higher gross margin than Eratat Classic thus, this is expected to bode well for Eratat 2HFY11 too.
Proactive in creating investor awareness
Management understands that being an S chip warrants a deeper connection with the investment community so that investors can understand Eratat better and (hopefully) differentiate Eratat from some of the other S chips. It hosted a site visit for analysts to visit their Eratat Premium stores in Shanghai in late July. In late August, it hosted a team of analysts and fund managers to Jinjiang for its Spring / Summer Trade Fair. In early September, Eratat will be hosting a luncheon presentation at CIMB.

Scored 3rd among S chips in 2011 GTI Index
In a study published by the Business Times on 12 July 2011, Eratat scored 3rd for the Governance and Transparency Index (“GTI”) 2011 amongst the S chips listed on SGX. It also obtained a joint 52nd position amongst a total of 657 SGX listed companies being assessed. Although this does not guarantee that there is definitely no audit / corporate governance issue in Eratat, it does add a layer of assurance to investors.
Conclusion – May see re-rating if company continues to deliver
According to Bloomberg, Eratat trades at a 2x FY11F PE. In view of the lackluster equity market and poor sentiment on S chips, it is likely that Eratat may have to take some time to convince investors (by consistently delivering on its results) before it can be re-rated.
This is an amended version of the write-up which I sent to my clients recently.

Appendix 1: Description of Eratat

Source: Bloomberg as of 2 Sep 11
Appendix 2: Analyst target price of Eratat
Source: Bloomberg as of 2 Sep 11

[1] Please refer to the Appendices 1 & 2 for more information on Eratat.

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