After gaining over 30% earlier this year, Shanghai-listed Heilan Home (HLA) saw its stock take a nosedive in early July, erasing its first-half gains. As of August 30, the stock has fallen by more than 15% year-to-date.
The sudden downturn in HLA’s stock price left many investors puzzled. However, the release of the company’s 2024 half-year financial report on August 19 has finally provided some clarity.
Shedding light on core issues
In the second quarter of 2024, HLA reported RMB 5.193 billion (USD 729.1 million) in revenue, a 5.88% drop year-on-year (YoY), and RMB 631 million (USD 88.6 million) in net profit attributable to shareholders excluding non-recurring gains and losses, a sharp 27.52% decline from the previous year. This contrasts starkly with the first quarter, where revenue and net profit grew by 8.72% and 10.84%, respectively. This shift from growth to decline has been identified as the key driver behind HLA’s recent stock price correction.
The challenges facing HLA may not be unique. In June and July, China’s retail sales of clothing, shoes, hats, and textiles fell by 1.9% and 5.2% YoY, respectively, setting the stage for weaker financial reports across the apparel industry. For instance, Peacebird reported a loss in its second-quarter net profit excluding non-recurring gains and losses, while Joeone also posted a loss for the same period on August 27. The underperformance of these men’s fashion brands has stoked fears within the market, leading to a broader correction in the stock prices of Chinese apparel companies. Since HLA’s financial report was released, its stock has dropped nearly 8%.
Why did profits decline sharply?
A closer look at industry data for the second quarter reveals that, from April to June 2024, retail sales growth for clothing, shoes, hats, and textiles were -2%, 4.4%, and -1.9%, respectively. HLA’s 5.88% revenue drop lagged behind these industry averages.
One possible explanation is the sluggish offline consumption environment. Since the beginning of 2024, online retail sales in China have clearly outperformed offline channels. Given that HLA primarily relies on offline sales, this shift in consumer behavior has likely taken a toll on its revenue. According to HLA’s half-year report, online sales in the first half of the year reached RMB 2.212 billion (USD 310.6 million), a YoY increase of about 47%, while offline sales were RMB 8.697 billion (USD 1.2 billion), down 6.5% YoY.
On the profit side, HLA appears more sensitive to changes in the industry environment. The company’s net profit attributable to shareholders excluding non-recurring gains and losses fell by RMB 240 million (USD 33.7 million) compared to the same quarter last year, a dramatic drop of 27.52%.
Profits under pressure
HLA’s decline in profit primarily stemmed from two factors.
Firstly, the gross margin decreased compared to last year, reducing profits by approximately RMB 114 million (USD 16 million). In the second quarter of this year, HLA’s overall gross margin was around 43.43%, down about 2.2 percentage points from the same period last year. Based on the company’s Q2 revenue of RMB 5.193 billion (USD 729.1 million), this decrease impacted gross profit by RMB 114 million.
For the first half of the year, HLA’s gross margin stood at 45.21%, slightly higher than the same period last year, largely due to a strong first quarter. However, when analyzing HLA’s performance, the second-quarter figures are more telling.
Secondly, the sales expense ratio increased compared to last year, reducing profits by approximately RMB 120 million (USD 16.9 million). In Q2 of this year, HLA’s sales expense ratio was about 23.41%, up from 21.16% in the same period last year, which led to an additional RMB 120 million in sales expenses.
For the first half of the year, HLA’s sales expenses rose from RMB 2.091 billion (USD 293.6 million) in the first half of 2023 to RMB 2.388 billion (USD 335.3 million). This increase was mainly due to higher advertising and promotional expenses and rental costs for expanding direct-operated stores.
Root cause: Lower prices, or higher costs?
From a consumer price index (CPI) perspective, clothing prices rose YoY each month from April to June this year, suggesting that cost pressures may have been more significant. However, the prices of fabrics in Keqiao, a major textile market, have remained stable over the past year, with no significant changes in the prices of cotton, linen, or polyester.
The industry’s sales prices and cost trends alone do not fully explain HLA’s gross margin decline. Given the company’s increased sales expense ratio in the second quarter, it seems that HLA was under greater pressure on the pricing front.
Additionally, in an apparent bid to make its financial report look more favorable, HLA consolidated a subsidiary through the acquisition of minority equity in the second quarter, generating over RMB 100 million (USD 14 million) in investment income. This accounting maneuver involves revaluing the equity held in the subsidiary when it is converted from an associate to a subsidiary, leading to an increase in investment income.
However, this gain is more akin to a numbers game and does not generate actual cash flow for the company, as it falls under non-recurring gains and losses. Therefore, when analyzing HLA’s performance, net profit attributable to shareholders excluding non-recurring gains and losses provides a more accurate picture of its financial health.
Inventory impairment
Alongside its half-year report, HLA also issued a notice regarding provisions for impairment and asset write-offs.
According to the notice, HLA recorded an inventory impairment of RMB 285 million (USD 40 million) in the first half of 2024, while writing off RMB 217 million (USD 30.5 million) in provisions for devaluation, which typically reduces operating costs upon successful sale of the inventory. These operations impacted HLA’s profits by RMB 68.5615 million (USD 9.6 million) in the first half of the year.
Many investors consider inventory impairment to be the main reason for HLA’s sharp profit decline. However, the actual impact is less significant than it appears.
Firstly, most of the RMB 285 million in inventory impairment was recorded in the first quarter. According to HLA’s quarterly profit statements, the company’s asset impairment losses were RMB 261 million (USD 36.7 million) and RMB 24 million (USD 3.4 million) in Q1 and Q2 of 2024, respectively. Therefore, the impact of inventory impairment should have already been reflected in the stock price when the Q1 report was released.
Secondly, HLA’s historical inventory impairment losses show that this year’s impairment remains within the normal range. Reviewing the company’s asset impairment losses since 2022, it regularly records inventory impairments at the end of the year and in the first quarter. The 2023 interim report also included announcements about impairment provisions and asset write-offs.
As such, this time, HLA’s inventory impairment notice should not be construed as a black swan event. Looking ahead, concerns about HLA’s future inventory levels might be the primary factor affecting its stock price.
As of Q2 2024, HLA’s total inventory amounted to RMB 9.553 billion (USD 1.3 billion), with finished goods inventory subject to return clauses (with very low impairment risk) totaling RMB 6.806 billion (USD 955.6 million), and non-returnable inventory (with higher impairment risk) totaling RMB 2.457 billion (USD 345 million). At the end of 2023, HLA’s total inventory was RMB 9.337 billion (USD 1.3 billion), including RMB 7.205 billion (USD 1 billion) in returnable inventory and RMB 1.74 billion (USD 244.3 million) in non-returnable inventory.
The significant increase in HLA’s non-returnable inventory, compared to the end of last year, is a cause for concern. Given HLA’s current declining revenue growth, the increase in non-returnable inventory raises investor worries about the company’s future.
Overall, the changes in HLA’s financial metrics, including gross margin, sales expense ratio, and inventory levels, are part of a systemic shift in the industry following a market downturn. The core reason for HLA’s performance decline this quarter primarily stems from external, rather than internal, factors.
To boost market confidence, HLA made an unusual move by announcing a dividend distribution in its interim report. The company plans to distribute a cash dividend of RMB 2.30 (USD 0.3) per 10 shares (including taxes) to all shareholders, accounting for 67.5% of its net profit attributable to shareholders for the first half of 2024.
However, current market investors are looking beyond dividend yield to assess the certainty and stability of earnings. As a result, despite the release of HLA’s financial report, the market response has been lukewarm.
KrASIA Connection features translated and adapted content that was originally published by 36Kr. This article was written by Fan Liang for 36Kr.