Sun East @ 49.5 cts ( Personal care / China ) 9 comments
Final Poll Results: 7:0
(P.S: Sorry for any disturbances the advertisements above may have caused you)
1.Weakness in breast cream selling price highlights possible margin unsustainability
2.Excessively high valuation
Two buying themes here: firstly, which woman wouldn't want to have prettier faces, and in particular, more beautiful busts; secondly, given that the size of the China population of 1B of which half are women, the sky's the limit for personal grooming products that can capture this market. So Sun East has doubled on its IPO price of $0.26 to its current ~$0.50, along with the upward tide of China stocks.
According to the latest results in its IPO prospectus, Sun East derives ~70% of its revenue from its beauty products segment (mainly breast creams), ~20% from its skincare segment and ~10% from its hygiene (disinfectant) segment. It makes sense to do an individual assessment of the main business segments, from the most important downwards, to get a feel for the potential of the business before assessing the current valuation of the stock.
For the breast creams segment, I will try not to be too judgmental about the potential of the business. On a sidenote, I actually tried some consumer research by asking a female friend what she thinks of the potential of breast creams, but she gave me such a look that I decided I had better not pursue it further; so let's just look at the figures (pardon the pun). Sun East bought the legal rights to the product formulae and trademarks to the 3-Yuan line of beauty/skincare/hygiene products in FY03 and did a great job in promoting it such that beauty product revenue (the only segment then) surged from RMB4M FY03 to RMB115M in FY04. However, one can perceive a slowing down of demand in this segment in FY05 because revenue actually fell by RMB$10M; the overall revenue rose because of new product segments in skincare and hygiene. Also note that average selling prices for the breast cream probably dropped precipitously in this segment, because production of the breast creams actually rose from 0.7M in FY04 to 1.3M packets in FY05; coupled with the drop in actual revenue off these products the selling price of the breast creams in FY05 probably dropped to 50% of their FY04 selling price (won't show the maths here; relatively straightforward). The company explained this off as "discounts given to our major distributors" in return for them to "undertake more local promotions for our beauty products"; however the drop in selling price is too great to ignore and underlines the competitiveness of the beauty products industry despite the undoubted huge market potential.
Which is why the company management seems to be looking at the skincare segment to drive future growth. The IPO proceeds appear to be mainly used to manufacture and launch its new Mielle range of skincare products. A typical feature of these beauty products companies is their high gross margins because the largest cost component is not raw materials, but sales and marketing costs. It is difficult to assess how the new line of products will perform but suffice to say that substantial additional advertising and distribution costs will be incurred (hence the need for the IPO proceeds) and potential investors must judge for themselves whether they feel the ability of the company to leverage on its existing distribution channels for its new brand promotions, as well as the ability of the management to create a unique and desirable image for its new product lines (on the basis of their undoubted earlier success in promoting their breast creams), could live up to the high expectations. (Note that its revenue base for skincare products is ~RMB30M (S$6M), a limited operational base on which to leverage off)
For these high expectations are reflected in the market valuation of the stock. Post-IPO diluted FY05 PE is 20X, surely exorbitant given the abovementioned uncertainty in its main segments, implied high competitiveness in the sector and its rather small scale of operations (as shown in its ~S$30M revenue base). The nearest comparable must be Beauty China which is now trading at 12X FY05 PE. A long time ago the same stock was trading at 18X PE (FY04 earnings) when I identified it as a hot-stock-not; the market and the fund managers subsequently identified its overvaluation and knocked it down heavily; now brokers like Merrill Lynch will think twice before affixing overly high valuations, on the basis of successes ike Avon, to these beauty products companies. Those who want to read my views of the China beauty products market would also want to refer to my previous writeup of Beauty China.
I notice that the market tends to have a very optimistic view of these beauty care companies. Perhaps it is the high profit margins that are attractive, but frankly I don't really think the operating leverage of this business is that high, because sales and marketing costs are hardly fixed costs as new product lines have to be continually advertised. At best, the company performs to the high expectations like Best World (and price still gets slightly knocked down) and if the company fails to launch new products successfully it ends up like Lifebrandz. Unless the company has shown a sustainable competitive advantage in brand equity or distribution network which can for example, enable it to fight off foreign competition with more established and desirable brands (surely the main concern in China's liberalising post-WTO retail and distribution market), the company should not be trading at >15X PE (trailing), in view of the risks (potential be damned, everything has potential in China). As an IPO with a limited track record (which is not that great except for one year of great growth of breasts oops I mean breast creams segment), Sun East has a long way to go.