20140428-高盛-Off_CL_on_worker_benefit_uncertainty__still_Buy_on_margin_recovery_13页_429kb

Yue Yuen Industrial (0551.HK) Summary

Core Content

Yue Yuen Industrial (0551.HK) has been removed from the Asia Pacific Conviction Buy List due to uncertainty surrounding retroactive charges from historical under-contributions to employee benefits, particularly from the Dongguan labor disputes. Despite this, the firm maintains a Buy rating, citing margin recovery and attractive valuations as key positive factors.

Key Points

What Happened

• 80% of Dongguan workers have returned to work, but uncertainty remains regarding the size of retroactive charges.
• The firm forecasts $25mn in charges (5% of 2014E operating profit), but a bear-case scenario could result in ~20% of OP.
• Adidas has expressed concerns about supply-chain disruptions but has no plans to completely exit the Dongguan factory.

Current View

• The firm remains constructive on Yue Yuen, highlighting positive factors for margin recovery and valuations.
• Historical data from labor disputes in China's manufacturing sector shows share prices typically rebound by 5% within 6 months post-resolution, despite a 3% drop during the event.
• OEM operating margins (excluding one-offs) are expected to recover to 7.1% in 2014E from 6.8% in 2013, leading to 17% EBIT CAGR (2013-2015E).
• Dongguan accounts for only 15% of total capacity, with contingency plans in place to shift production to Vietnam and Indonesia (70% of total capacity).

Valuation

• Current share price is at 10X NTM P/E, which is at the low end of its historical range (since 2007).
• The 12-month price target is HK$28.60, implying a 22% upside from the current price.
• The EV/EBITDA multiple remains at 8X, unchanged from previous estimates.
• Dividend yield is at 5.5%, also considered attractive.

Financial Impact of Labor Disputes

• The firm estimates a 13% cut to 2014E OEM operating profit, driven by:
  1. Higher labor costs (USD$32mn).
  2. Partial pass-through to customers (75% of labor cost hikes, USD$24mn).
  3. One-off retroactive contributions (USD$25mn).
  4. Loss of future orders from Adidas/Nike (USD$28mn).
• In a bear-case scenario, the impact could be as high as 33% cut to 2014E OEM OP, but the current share price already reflects this scenario.
• A bull-case scenario assumes no one-off payments and no production disruption, resulting in a 2% impact to 2014-15E OP.

Earnings and Growth

• EPS is revised downward by 11% / 6.3% / 4.9% for 2014-16E, reflecting higher labor costs and order disruptions.
• Sales growth is expected to rise from 4.1% in 2013 to 6.0% / 6.7% / 6.3% in 2014-16E.
• EBITDA margin is forecast to increase from 8.7% to 9.1% / 10.0% / 10.4% in 2014-16E.

Cash Flow and Balance Sheet

• Net income is expected to grow from HK$434.8mn in 2013 to HK$610.5mn in 2016E.
• Free cash flow yield is at 8.0% in 2013 and is projected to increase to 9.2% in 2016E.
• Net debt/equity is expected to rise from -1% to 6.4% in 2016E, reflecting increased capital expenditures and debt.

Key Risks

• Sizable one-off payments due to retroactive charges.
• Further order disruptions that could affect production and profitability.

Investment Highlights

• Price (HK$): 23.45
• 12-month price target (HK$): 28.60
• Market cap (HK$ mn / US$ mn): 38,719.3 / 4,993.7
• Foreign ownership (%): Not disclosed
• EPS (diluted, post-except): 0.25 / 0.26 / 0.31 / 0.35
• P/E (analyst): 11.4 / 10.9 / 9.2 / 8.1
• EV/EBITDA: 8.1 / 7.4 / 6.0 / 5.3

Performance

• Share price performance (3/6/12 months): -3.3% / 12.2% / -13.3%
• Relative to MSCI Hong Kong (3/6/12 months): -5.6% / 11.1% / -15.2%

Summary of Earnings Impact

Scenario	2014E OEM OP % Cut	2015E OEM OP % Cut	Implied Fair Value (HK$)	% Change from Old TP
Bear Case	-34%	-18%	24.7	-19%
Base Case	-13%	-7%	28.6	-6%
Bull Case	-2%	-2%	29.8	-2%

Conclusion

Despite the labor disputes and associated financial impact, Yue Yuen Industrial is still viewed as a Buy due to margin recovery, attractive valuations, and potential for earnings rebound. The firm's diversified production base and strong forward orders from Nike further support its positive outlook. The risk/reward is considered skewed to the upside, with the current price already reflecting a bear-case scenario.