Daphne:Inventory Situation Improved; Maintain Neutral Retail Sector

What’s new.Followingtheprofit warningissued inJanuary, Daphne reported FY14E EPS of HK￠10.7,down 45% y/y. No final dividend was declared. While revenues decreased only 1% y/y, net profit decreased 47% y/y to HK$176m in FY14, driven by drastic clearance sales in 2H14 and 3% y/y increase in SG&A, which resulted in a 2.5ppts decrease in grossmargins y/y for Daphne’s core brands in FY14 and 79% y/y overall EBIT decrease in 2H14. ROE dipped 3ppts y/y to 3.5% in FY14. While inventory clearance also resulted in improving cash flowwithnet cash increasing32% y/y to HK$745m at the end of FY14(including structured bank deposits).

Improving inventorymix. More aggressive inventory clearancein 2H14 resulted in 14% y/y decrease in inventory value, while inventory turnover day improved only decreased by 4 days to 194 days in FY14. Clearance of old Spring/Fall/Winter products wasalmost completed, but there are still some old Summer products of 2013/2014 requiringfurther clearance sales, which is expected toexert pressure on margins in the upcoming Spring/Summer sales season. However the improving product mix could help ease ASP and margin pressure. Management targets to reduce inventory turnover days to 180 days, which is a healthy level consideredin footwear retailing, by the end of this year.

Sales growth remains weak in 1Q15. The company posted a-7.5% SSSG in 4Q14, and theweak SSSG trend is likely to continue in 1Q15 driven by thetime difference of CNY this year, which resulted in shorter sales period during CNY holidays compared to last year. Management expects gross margin to improve on soft raw material cost (mainly plastic and synthetic leather) and ASPs touptick on more stylish products launched this year. However, continuousinventory clearance in 1H15 and weak1Q15SSSG poses risk on margins and earnings improvementin 1H15, in our view.Weexpect y/y earningimprovement tobe more visiblein 2H15on easier comparables.

Estimates and valuation.This set of results came largely in line with our estimation. We maintain our forecastsfor now. We maintain our target P/E multiple of 10X FY16E P/Ewith FY16E EPS of HK￠25.5 andTP of HK$2.55, representing 13% upside from current level. We maintain our Neutral rating for Daphne.Risks for our TP include worsening 1Q15 SSSG driven by weak consumer sentiments and further cannibalizationof online retailers in Daphne’s mass footwear market.