Prada:High volatility,low visibility

Top-line still under pressure on the back of store rationalisation. Amidthe weak consumption sentiment and the volatile stock market in China, thecompany is having a deteriorating sales performance in 3QFY16 with theSSSg of the group was at a negative high single digit level. The terroristattack in France and the strengthening of US dollar made the situation evenworse. The Paris attack drove tourists away from Europe as managementsaw cancellation of hotel bookings and trips while the stronger US dollardeterred domestic consumption. Albeit the abovementioned factors,management will continue store optimisation; therefore, we think thecompanys revenue will bear higher pressure.

Increase in the expense ratio outweighs the supply chain improvement.

The company has invested in additional manufacturing capacity by adding twonew factories in Italy and France. More production process can be done inhouse.

Also, it has bought a farm in France, which can secure the source ofraw material at a better price. 3QFY16 GPM therefore improved 1.7ppts YoYto 74%. However, the company is still expanding their retail network;operating expenses, in particular selling and advertising cost, increased 6%YoY this quarter. Taking all above effects into consideration, operatingdeleverage prevailed with EBIT margin dropped 5ppts YoY to 10.6%.

Inventory clearance good for brand? The company has launched pricemarkdown in Asia and US to clean up the stock as management sawinventory turnover days remain high. From the news, the price-cut in HongKong was as much as 50% for some products. The markdown successfullydrove sales volume, yet we are concerned about its negative impact to thebrand equity. Besides, management plans to widen the price range of theproducts offered so as to attract more customers and boost sales. However,the actual benefit remains unknown as it is still at a preliminary stage.

We reiterate Underperform on Prada and lower our earnings estimates forFY16 and FY17 by 10% and 13% respectively. Our target price is lowered toHK$20.0/sh at 19x FY18E from HK$25.0/sh previously as we see negativeoperating leverage with increasing expense ratio. In view of the persistentlyweak retail environment, the volatility in Chinas stock market, the stronger USdollar and the terrorist attack in France cast a shadow on the luxury industry.

Despite the improvement in supply chain efficiencies and cost control, thecompany might still stay at operating deleverage given the top lines are weak.