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Jul 31, 2012

Lilang [1234.HK]

Lilang is a menswear manufacturer, wholesaling through its own brands “Lilanz” and

“L2”. It is one of the leading business casual menswear players in China. We be-

lieve the demand for menswear will continue to be robust. With an expected yield of

7.5%, we believe the current valuation at 7x PER FY12 is undemanding. We advise

investors to accumulate once the share price stabilizes, riding on the theme of grow-

ing domestic consumption.

BUY

Close: HK$4.74 (Jul 30, 2012)

Target Price: HK$6.50 (+37%)

INITIATE COVERAGE — LOW VALUATION; HIGH YIELD

Price Performance

Market Cap US$734m

Shares Outstanding 1,201m

Auditor Ernst & Young

Free Float 37.4%

52W Range HK$4.90-11.03

3M Avg Daily T/O 1.3m

Major Shareholding

Xiao Sheng Intl 55.1%

Ming Lang Invest 6.0%

Fidelity Intl 5.0%

Vicky Lai—Analyst

(852) 3698-6515

vickylai@chinastock.com.hk

John Mulcahy—Head of Research

(852) 3698-6889

johnmul@chinastock.com.hk

Source: Company and CGIHK Research

Apparel Sector

Industry Drivers: Business casual wear will continue to grow faster than the

average menswear market which is expected to grow at 11-13% annually until

2015. Demand will be fueled by 1) rise in clothing expenditure, 2) increased

number of businessmen and professionals, and 3) change in trend and style.

Earnings Growth Drivers: 1) improving brand name and product design to

increase pricing power, 2) expansion of brand portfolio, 3) continuous store

expansion as its retail network is not the biggest among its peers, 4) wholesale

model offers flexibility of switching into hybrid model for margin expansion in the

future.

Strength in Business Model: Lilang actively manages its distribution network

to enhance its brand image through 1) standardization and monitoring, 2) in-

ventory control, and 3) continuous store upgrade.

FY12 Outlook: Despite slowing sales figures at the two sales fairs earlier this

year, we believe orders will rebound at the coming sales fair to mid-teen per-

centage growth owing to the store expansion in 2H. We will also see an im-

provement in replenishment orders for the same reason.

Valuation: we initiate coverage on Lilang with a BUY recommendation at a

price target of $6.50 on DCF basis, equivalent to 8.3x PER FY13, with forecast

earnings growth of 12.2% annually over FY12 to FY15.

Risk: no direct control of retail stores; monitoring system (ERP) not fully estab-

lished; shift in preference away from business casual wear.

Investment Highlights

RMB 2009 2010 2011 2012E 2013E 2014E

Turnover (m) 1,560 2,053 2,708 3,144 3,691 4,254

Net profit (m) 303 419 623 663 759 851

Net margin (%) 19.4 20.4 23.0 21.1 20.6 20.0

EPS 0.25 0.35 0.52 0.55 0.63 0.71

PER (x) 16.8 11.7 7.5 7.0 6.0 5.4

Yield (%) 3.3 3.6 7.0 7.5 6.7 7.5

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Figure 1: Menswear Market vs Aggregate Apparel Market

Source: Company and CGIHK Research

In China, the menswear market, including business formal, casual and sports-wear, has grown at a compound annual growth rate (CAGR) of 13.4% from RMB223.6bn in 2006 to RMB419.2bn in 2011, outperforming the 11.8% growth of aggregate apparel sales in the same period [see figure 1]. Following the rap-id economic development in China, male consumers pay more attention to the way they dress in order to reflect their social status or fashion taste. We expect this trend to be sustained, and for the menswear market to continue outper-forming in the retail sector. We estimate the market to grow at a CAGR of 11%-13% over 2011-2015 due to higher base and higher market penetration.

Industry Overview

Menswear market to achieve 11-13% CAGR over 2011-2015 as male consumers become more fashion-conscious

Menswear CAGR of 13.4% over 2006-2011 against 11.8% for aggre-gate apparel sales

Mid to high-end market dominated by domestic players from Zhejiang and Fujian regions

Business casual wear will outpace average menswear growth...

The premium menswear market is dominated by international players such as Armani, Boss and Zegna. Mid to high-end menswear, however, is dominated by domestic brand names. For example, Youngor [600177.CH], Shanshan [600884.CH] and Boxiniao [002154.SZ] from Zhejiang province are the key players in the formal wear segment; while Joeone [601566.CH], Septwolves [002029.SZ] and Lilang from Fujian are the key brands in the business causal segment.

According to Euromonitor International retail market for business casual wear increased from RMB20.8bn in 2004 to RMB58.1bn in 2009, representing a CAGR of 22.8%, higher than the average growth of the menswear market. Mar-ket size is expected to reach RMB100bn in 2012. In our view, Lilang will benefit from the robust demand for business casual wear driven by the following fac-tors:

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Rise in clothing expenditure. Expenditure on clothing per capita has

increased by a CAGR of 15.7% over 2006-2011 in China [see figure 2]. The expenditure was fuelled by the rise in annual disposable income per capita of 15.4% over the same period, making the clothing items more affordable to general public. The proportion of middle class (households with annual income RMB60,000 - RMB500,000) to the total population rose from 3.6% in 2005 to 10.8% in 2010, supporting consumption of mid to high-end apparel and shoes.

Increased number of businessmen and professionals. The continuing

industrialization of China has changed the profile of employment, with more companies requiring “formal” dress code, due to 1) shift from manu-facturing to service- oriented employment in higher tier-cities; 2) increase in urbanization rate from 36.2% to 51.3% over 2000-2011 [see figure 3], creating more office employment. The rapid economic development has substantially increased the population of businessmen and professionals in recent years, leading to strong demand for business and “business-casual” office wear.

A Growing Sector

Clothing expenditure increased by 15.7% annually over 2006-2011 fueled by 1) increase in income 2) increase in middle class population

Rising population of businessmen and professionals linked to urbani-zation, driving demand for office wear

Business casual wear growing fast-er than business formal wear

Figure 2: Clothing Expenditure Per Capita

Source: Wind and CGIHK Research

Figure 3: Urbanization Rate in China

Source: Wind and CGIHK Research

Change in trend and style. Business-casual wear stresses variety, per-

sonality and comfort, while maintaining the “smartness” of formal wear. As a result, it has gained wide popularity among the working class and has replaced business formal wear in some cases. The lower CAGR of busi-ness formal (i.e. 15.5%) compared to business casual (i.e. 22.8%) over 2004-2009 suggests that formal wear has been losing share in the mens-wear market.

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In the mid to high-end business casual wear segment, there are five big players with a similar retail network of 2,500-3,500 stores and an annual turnover in the RMB2-3bn range: Septwolves, Lilang, Joeone, Seven Brand and K-boxing [see figure 4]. Points of differentiation among the brands include:

Product focus and design. Septwolves specializes in jackets, with col-

ourful store display resembling Ralph Lauren. Joeone is known as an ex-pert tailor for quality trousers. K-boxing is famous for its Chinese collar design. Lilang adopts a “European” style in its design, emphasizing sim-plicity.

Price Point. Products sold at K-boxing and Seven Brand are generally

10% cheaper than Lilang. Specific products in Joeone and Septwolves are more expensive. For instance, trousers at Joeone sell at ~RMB700 per pair, compared to RMB500 from Lilang. With increased brand and design improvement, we believe there is still room for Lilang to catch up with Joeone and Septwolves in pricing terms.

Business Model. Lilang adopts a wholesale model, while most of its peers

have a hybrid model, operating some of its own retail stores. The ad-vantage of a wholesale model includes lower capital expenditure for store expansion, enabling Lilang to allocate more resources to product and brand development – which we think is key to differentiation. By focusing on wholesale, Lilang can avoid the rapid increase in rental and labor cost at the retail level, hence achieving better margin improvement than its peers [see figure 5]. This model should also enable margin expansion in the future if the company develops the necessary expertise to operate its own retail network, and so enhancing earnings growth.

Competitive Landscape

Five big players in the mid to high-end business casual wear seg-ment...

Lilang adopts simple European de-sign...

...pricing in middle of market price range...

...pure wholesale model, reducing capex and helping cost control

Ranked second by revenue in FY11, signaling room for growth

Unique business model underpins market-leading margin improve-ment

Figure 4: Market Share of Each Brand in the Menswear Market

Revenue in FY11

(million RMB) % Mkt Share

Septwolves 3715.2 0.9%

Lilang 2708.0 0.6%

Joeone 2257.3 0.5%

Seven Brands 2135.9 0.5%

Net Margin FY08 Net Margin FY11 Change

Septwolves 9.3% 14.2% 4.9%

Joeone 15.7% 23.2% 7.5%

Lilang 13.6% 23.0% 9.4%

Figure 5: Net Margin Improvement for Each Brand

Source: Bloomberg, Company and CGIHK Research

Source: Bloomberg and CGIHK Research

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Founded in the 1990s, Lilang offers a wide range of menswear including busi-ness formal, business casual, fashion casual and sportswear. In the early 2000s Lilang was the first menswear company to offer a business casual col-lection in China, leading to the shift in product focus towards its current range.

Lilang sells its products through core brand “Lilanz” [see figure 6]. A new brand “L2” was added in mid-2010 to widen the company’s product range and capture more market share.

Accounting for 95.2% of Lilang’s total revenue, “Lilanz” targets the mid to

high-end business casual segment in lower-tier cities (i.e. Tier 2 and Tier 3) for customers aged 30 to 40. The selling prices of T-shirts usually range from RMB400-700, around RMB900 for a jacket and RMB1, 300-1,500 for a winter coat.

“L2”, accounts for 4.8% of total revenue in 2011, is a relatively new brand

that aims at younger customers aged from 20 to 30 in Tier 1 and Tier 2 cities. This brand offers more fashion casual wear. Selling prices of T-shirts range from RMB200-300.

The company’s long-term objective is to increase its market share by adding new brands. The company has been in talks with several premium brands op-erating in Tier 1 and Tier 2 cities for acquisition opportunities, but nothing has yet been concluded. Lilang has only two brands in its portfolio, so the expan-sion can help it penetrate different sub-segments in the menswear sector, pos-sibly enhancing future growth.

Brand Positioning

Lilang first menswear producer to offer business casual collection in China

“Lilanz” targets lower-tier cities for 30-40 age group

“L2” targets higher-tier cities for younger customers

Long-term strategy is to expand brand portfolio to add market share

“Lilanz” is the company’s core brand...

Figure 6: Revenue Breakdown between “Lilanz” and “L2” in 2011

Source: Company and CGIHK Research

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Product Offering

Autumn/ winter sales account for 70% of Lilang’s total revenue as winter coats are the core products for Lilang. Tops accounted for over 72% of total sales in 2011 [see figure 7]. Proportion of contribution from trousers increased slightly from 15.3% to 17.6%. We believe the strong performance of trouser sales will persist, given 1) the company continues to focus more on improving the design and material selection for this category; 2) the existing price gap between trou-sers from Lilang and its peers (i.e. Joeone) enables further growth in average selling price (ASP).

Mainly driven by the change in product mix, the company’s ASP rose 23.1% in 2010 and 13.6% in 2011. We believe the increase will moderate in the future as the management does not see a dramatic change in its product mix in the com-ing years. ASP growth in the future will be supported by 1) change in cost (i.e. labour cost), 2) change in product design (i.e. more expensive raw material), 3) upgrade of brand image.

Product

Figure 7: Revenue Breakdown by Product Types

Source: Company and CGIHK Research

Product Design

Lilang is eager to turn product design into one of its core competitive ad-vantages. A design and product development (D&PD) team was established in the early 2000s, led by Mr. Ji Wen Bo, the first Chinese designer participating in Milan’s fashion show and the winner of “Golden Award – China’s Most Hon-orable Designer”. There are over 100 staff in the D&PD team for “Lilanz” in Jinjiang and 35 staff for “L2” in Shanghai in 2011. In addition, a team of special-ists was set up recently to conduct market research on latest fashion trends and consumers’ preferences.

The D&PD department works closely with upstream suppliers to develop new unique fabrics to further enhance the company’s products. With continuous improvement in design and material selection, ASP and sales in certain product categories showed significant improvement. For example, ASP for trousers rose 12.4% in 2010. Sales of trousers climbed 51.4% in 2011. With this focus on design, Lilang should be able to improve its products to differentiate from its peers and enhance its pricing power to further expand margins.

Winter coats Lilang’s core product. Trouser sales will drive future sales growth...

Change in product mix the key to previous ASP growth. Future ASP growth likely to be more modest…

Contribution from trousers in-creased from 15.3% to 17.6% in 2011

Lilang eager to build its own design capability

Continuous upgrade in design and materials will drive up ASP and sales

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48.9% of Lilang’s total products were produced in-house in 2011 [see figure 8]. In some cases, a certain manufacturing process is sub-contracted to other pro-ducers, with the company providing the raw materials. Raw material cost ac-counts for 80% of total self-production cost, with 95% sourced domestically and 5% from Taiwan and Korea. Most fabric used is polyester, 20% cotton and a few percent from leather. The remaining 12% of self-production cost comes from labour and 8% from overheads.

51.1% of its product is from OEM purchases, especially for products requiring special production capability. The company has three-five OEM suppliers for each product category (i.e. trousers, suits, etc.) to dilute risk concentration on a particular supplier, optimizing product quality control and production efficiency.

Production

About half of all products produced in-house — some aspects out-sourced...

...other half of production from OEM

Proportion of self-production will decline

Hybrid production model allows more flexibility in supply chain

By adopting such a hybrid production model [see figure 9], the company can reduce its investment on production capabilities while being able to offer a wide range of products. Since fashion trends change frequently, the model can en-hance supply chain flexibility. For now, the company has no plans to expand its own production capacity, and sales growth will be supported by increased OEM purchases.

Figure 8: COGS Breakdown between Self-Production & OEM Purchase

Source: Company and CGIHK Research

Figure 9: Production Flow

Source: Company and CGIHK Research

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As of FY11, Lilang had 3,032 “Lilanz” and 236 “L2” stores in China [see figure 10], of which 60% are at county level or below. Over 59.7% of revenue was de-rived from Eastern China, Central and Southern China in 2011 [see figure 11]. The company has a goal to establish 5-10 stores at each provincial capital and open more than 200 stores every year. We believe there is still room for store expansion as Lilang’s total number of store still lag behind Septwolves, which had 3,976 stores in FY11.

Two flagship stores in Xian and Zhengzhou are operated by Lilang, while others are run by distributors and sub-distributors.

There are 65 first-tier distributors for “Lilanz” and 52 for “L2” with whom the

company has over six years of association. Each distributor is entitled to an exclusive distribution right in a particular region (usually provincial level), which may contain one or multiple cities. The company sells its products at 40% of the retail price to the first-tier distributors. Every year Lilang will set a minimum annual sales target for each distributor, and the distribution area is cut if target is not met.

There are 1,416 sub-distributors for “Lilanz” and 51 for “L2” under the man-

agement of the first-tier distributors. Very often, they are store owners who are interested in being the franchisees for Lilang. After gaining approval from the distributors and the company, sub-distributors will decorate their stores and train their staff according to the strict guidelines provided. Promo-tion consideration (to first-tier distributors) may be given to sub-distributors who have consistently delivered strong performance.

Distribution Model

Lilang’s retail stores mainly located in lower tier cities...

All of its stores operated by distrib-utors...

Two-layer distribution model with first-tier distributors managing sub-distributors

Figure 10: Number of Retail Stores Under “Lilanz” and “L2”

Source: Company and CGIHK Research

Figure 11: Geographical Breakdown of Retail Stores

Source: Company and CGIHK Research

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Standardization and Monitoring

Lilang has been actively managing its retail network through its distributors and sub-distributors:

All distributors and sub-distributors are required to comply with the compa-

ny’s display standards, pricing and discount policies.

Every year Lilang will send a team of specialists to different cities to moni-

tor the performance of each store. They will also give suggestions on loca-tions for new stores and old store relocation.

Lilang provides training for distributors to enhance their knowledge of the

brands and products, and to strengthen their management skills in areas such as data analysis and inventory control.

Inventory Control in the Distribution Network

To understand more about the operation in each store the company has recent-ly introduced its enterprises resource planning (ERP) system to over 1,000 out-lets. The system collects data such as sales figures, providing the company with information on the retail performance of its products on a more frequent basis. The company can also manage the inventory level in the supply chain more efficiently by obtaining data on stock turnover at each store. Lilang is planning to expand the use of the system in the future.

Continuous Store Upgrade

Lilang will renovate its retail stores starting from July. The project aims to change the store’s display design as a part of brand upgrading project. The company will be subsidizing the distributors’ cost with a budget of 150k-200k per store. If a significant number of stores agree to carry out the upgrading we believe it will be beneficial for the company’s brand, providing room for the com-pany to increase retail and wholesale prices.

Sales Fair

Lilang has three sales fairs each year:

1) Spring/ summer collection sales in Aug-Nov,

2) Autumn fair in Mar-May,

3) Winter fair in May-Jul.

The spring/summer sales account for 30% of the group’s total revenue com-pared to 70% for autumn/winter. Distributors are not allowed to cancel or reduce orders after finalizing their orders. To ensure flexibility in the sales channel dis-tributors are advised to place orders of 85% of their estimated sales at each sales fair. Distributors can then place replenishment orders to top up the original orders.

Retail Network Management

The company monitors its retail stores closely to ensure compli-ance with standards…

Lilang pays close attention to in-ventory management at retail lev-el…

The company is eager to enhance its brand image through continuous store upgrades…

Three sales fairs a year…

...with autumn/ winter sales ac-counting for 70% of total revenue

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FY12 Outlook

SSSG slowed to 10% in June, and expected to stay at low-teen level for the year…

250 new stores planned for “Lilanz”. Plan for opening 150 “L2” stores will be revised…

Sales in the first two fairs this year slowed due to 1) macro condition 2) lower ASP increase 3) change in order policy

Rebound likely in next sales fair due to more new stores opening in 2H

Replenishment order weak for the spring/ summer collection but or-ders should rebound due to 1) change in order policy 2) store ex-pansion in 2H

Slowing SSSG figures at Retail Level

For the first four months, retail stores operated by distributors saw a 3-4 per-centage points (ppt) decline in same store sales growth (SSSG) to 14%. Sales growth decelerated in May and June to SSSG of 12% and 10%, along with the general weakening in retail sales growth. Softer June sales was partially at-tributable to the bigger promotions (25% off this year compared to 18-20% in the previous year) launched during the month. Inventory leftover rate from last autumn/ winter collection was 15-20%, 30% for this spring and 50% this sum-mer. The management expects bigger discount sales in July to help distributors maintain a healthy inventory level. We believe the SSSG figure this year will remain in low teens if there is no significant stimulus package launched to drive domestic consumption.

Revising Plan for New Store Openings

The company plans to open 250 stores this year under its “Lilanz” brand with more than 80 completed in the 1H. For “L2”, more than 30 stores were opened in the 1H with the initial plan to open 150 stores in total. But a single- digit retail sales growth figure in Tier 1 and Tier 2 cities is pointing to a less buoyant out-look for retailing. The company is thus considering revising down its expansion plan for “L2”.

Slowing Order Growth at Sales Fair to Rebound in 2H

The company posted growth of 16% and 11.5% year on year (YoY) respective-ly for the autumn and winter fairs for “Lilanz” [see figure 12]. Sales for “L2” rose by 61% and 40.5% during the same period. Slower growth this year is attributa-ble to: 1) uncertainty in macro conditions, leading to negative consumer senti-ment; 2) A mid-single digit increase in ASP compared to double-digit growth last year; 3) Instead of 85%, distributors are advised to place orders equivalent to 80% of estimated sales this year to prevent inventory pile-up in the distribu-tion channel caused by a possible slowdown in demand. We think the growth of the coming spring/ summer sales fair will rebound from the low in the winter fair to a low to mid-teen figure for “Lilanz” due to the planned store expansion, while the growth for “L2” will remain strong in the 40-50% range due to its smaller base.

Weak Replenishment Orders to be Improved in 2H

Management saw a decline in replenishment orders for spring/ summer collec-tion to 1-2% compared to 10% of total sales from previous years. As the com-pany lowered the order / estimated sales ratio from 85% to 80% for distributors this year, the order growth in the autumn and winter fairs slowed. Combined with the opening of new retail stores we are expecting to see an improvement in demand for replenishment orders in 2H.

Figure 12: Growth in Order at Sales Fair for “Lilanz”

Source: Company and CGIHK Research

FY09 FY10 FY11 FY12

Autumn Mar-May 25% 25% 28% 16%

Winter May-Jul 33% 33% 34% 12%

Spring'Summer Aug-Nov 25% 27% 29% NA

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Peers Comparison

In the past three years Lilang has delivered the strongest top-line growth with a CAGR of 33.6% compared to its peers, achieving growth of 59.3% in earnings. The company has also demonstrated the strongest profitability as reflected by its high ROE of over 30% in 2011. The stock is trading at a 6.2x PER FY13, which we think is undemanding given its high expected dividend yield of 6.3% and continued growth/expansion.

Valuation

Company demonstrated strong top-line and bottom-line growth in the past, with highest sector ROE

We initiate with a BUY rating at a target price of $6.50

Negative impact from tax increase partially offset by gross margin im-provement...

Valuation

Our price target of HK$6.50 is based on a three-year revenue CAGR of 15.6% during 2012-15E, higher than overall growth for menswear (12-13%) as busi-ness casual wear sub-segment continues to gain market share. This implies a targeted 8.3x PER FY13 with an earning CAGR of 12.2% over the period.

We believe the current weak share price performance is suppressed by the slower orders for the first two sales fairs this year, and the significant increase in the tax rate (i.e. 17% to 24-25%) which has restricted earnings growth. How-ever, increased orders from store expansion this year and improvement in gross margin are expected to partially offset this effect. With an expected yield of 6.7%, we believe the current valuation at 6.0x PER FY13 is undemanding. We advise investors to accumulate once the share price stabilizes.

Figure 14: Peer Comparison Table 1

Figure 15: Peer Comparison Table 2

Source: Bloomberg and CGIHK Research

Source: Company and CGIHK Research

Figure 13: Peer Comparison Table 1

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Investment Risk

No direct control on retail stores. Almost all the retail shops are operat-

ed by distributors (except the two flagship stores). This implies that Lilang relies on its distributors to a huge degree to communicate with its custom-ers. Although the company has set a strict guideline for its distributors on staff training and store display, there is still a risk of distributors not comply-ing with company policy.

Monitoring system not fully established. So far, only 1,000 retail stores

have adopted the ERP system, which helps Lilang track sales and invento-ry data at each sales point. Data from the remaining retail stores is submit-ted to Lilang on a less frequent basis and is prepared by the store owner weekly.

Shift in preference. Since the company’s core offerings lie mainly in the

business casual segment, a sudden shift in fashion trend will have sub-stantial impact on the demand for the company’s product. We think, how-ever, such sudden change is quite unlikely given the fact that business casual has become the substitute for office wear.

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Key Valuation Metrics

Metric 1: Turnover and Net Profit Growth Metric 2: COGS Breakdown

Metric 3: Gross Margin & Profit Margin Metric 4: ROE & ROA

Metric 5: Forward P/E Band Metric 6: Forward P/B Band

Source: Company and CGIHK Research

0

100

200

300

400

500

600

700

800

0%

20%

40%

60%

80%

100%

FY08 FY09 FY10 FY11Turnover Net Profit Turnover Growth Net Profit Growth

0%

10%

20%

30%

40%

50%

60%

FY08 FY09 FY10 FY11Direct Labour Raw MaterialOverhead Subcontracting chargesOutsourced OEM purchase

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Key Financials

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Explanation on Equity Ratings

BUY – share price will increase by >20% within 12 months in absolute terms

SELL – share price will decrease by >20% within 12 months in absolute terms

HOLD – no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL