What surprised us
Stella’s 1H15 net income of US$54mn (+3% yoy) was below our US$57mnforecast. With topline growth of 10% pre-announced, the miss was fromGP margin and SG&A. GP margin was down 110bps yoy, to 20.3%, largelon a much weaker retail GP margin (55.5%, down 760bps yoy) due toinventory clearance. OEM GP margin was only up 20bps versus our 70bpforecasts, as some of the costs for its migration of capacity to inland Chinwere not passed through to customers. SG&A grew 9% yoy given anadditional US$6mn provision for potential closures in its China factories.This further dampened 1H15 OP margin to 7.1% (-100bps yoy). We reduce2015/16/17E EPS by 13%/7%/6% to factor in weaker GP margin for both thretail and OEM segments and lower our 12m TP to HK$20.1 from HK$20.3as our earnings cuts are partially offset by a roll-over in valuations to2016E EV/EBITDA from 2015E; we still use a target multiple of 9X.
What to do with the stock
Maintain Neutral. Overall, we are positive on the OEM demand outlook,with forward orders pointing to c.10% 2H volume growth on strongdemand for sports fashion, along with scope for recovery in the US dressshoes business. That said, the core issue for Stella in the past 12 monthshas been translating volume growth to profitability, a key factor tocontinue to monitor in 2H. In our view, with the migration to inland Chinalargely complete in May/June, efficiency gains should drive some GPmargin yoy improvement and result in better EPS growth in 2H (GSe:16%). We do not expect retail to be a meaningful earnings driver in 2H oreven 2016, as high inventory levels of 280 days should pressure margins.Current valuation of 15X 2015E P/E is above its 13X average since IPO,suggesting that recovery potential is already partially priced in. Risks:Stronger/weaker external demand, labor cost inflation.