Peak Sport Products Annual Results Review March 23, 2016
On March 15, 2016, Peak Sport Products (1968:HK) reported its annual results. It then released its annual report on March 21, 2016. Peak was able to increase its revenues by 9.4%, operating income by 34.6%, and net income by 22.3%. The company closed five stores over the year so efficiency of stores drove the increase. The efficiency came as the company introduced new products in new categories (tennis and running). Selling expenses decreased by 8.0% while administrative expenses increased by 1.0%. Both expenses lagging sales growth lead to the increase in operating income of 34.6%.
Compared to 2014, the company’s gross margin increased by 70 basis points in 2015. It is also well above the average of 2012 to 2015 and 2006 to 2015. Gross margin increase points to the industry being past the sharp downturn seen in 2012 and 2013.
Peak’s operating margin increased by 340 basis points in 2015 as the company decreased spending on selling and distribution and administrative expenses barely increased. Overall, the company’s return on invested capital increased from 19.6% in 2014 to 27.8% in 2015.
During the industry’s consolidation, gross margin and operating margins decline slightly and have since recovered, but invested capital turnover declined drastically and has not recovered.
As illustrated above, both working capital turnover and fixed capital turnover declined significantly from peaks and have recovered slightly but not fully as the industry continues to cope with working capital and capacity issues.
In June 2015, the company raised capital increasing its share count by 290.761 million shares or 13.86% of the previous share count. The company mentioned the share raising was for international marketing expenses and to avoid Chinese withholding tax by moving cash in China overseas. The company decreased marketing expenses this year despite the share issuance. Despite the cost of raising capital being lower than the withholding tax the company would have paid for shipping money overseas, the share issuance was perplexing as the company has so much cash on the balance sheet. At the end of 2015, the company net cash position is equal to 92.6% of the company’s market capitalization and 5.9 times 2015 operating income. The question becomes does the company actually have the cash reported on the balance sheet. The company has been paying steady dividends pointing to having the cash. The main shareholders have maintained their shareholding without any share sales illustrating their confidence in the company.
Brand building through advertising is a key value driver within the sportswear industry so hopefully we will see a significant increase decreasing the cash on the balance sheet. Regardless, the share issuance was confusing and at best a very, very poor capital allocation decisions.
Overall, the sportswear industry is recovering after a period of significant contraction. Peak is insulated from competition within the industry from fast fashion players as the company’s focus is performance products rather than fashion allowing it to retain the leading market share in basketball for six straight years. The company is increasing its focus on international markets and other sports (tennis and running) giving it further growth opportunities.
The company is currently trading just above its net cash position, just below its liquidation value, and 38% below its reproduction value.
On an earnings basis, we used key value drivers during the recent industry downturn assuming it is the new normal and the industry boom of 2006 to 2011 will not be replicated. Assuming no growth, trough margins, and trough capital efficiency, the company has 89% upside to its estimated 2021 fair value. Assuming 5% growth and average margins the company has 215% upside to an estimated 2021 fair value.
Despite, the extremely poor capital allocation, the company is very cheap and growing. It is now trading just above its net cash position, just below net current asset value, and just below book value despite generating an average return on invested capital of 20% during an industry slump. We will maintain our current position size.