361 Degrees’ bond now yields 21%: Is it still a buy?

About 361 Degrees

361 Degrees International Limited is a leading Chinese manufacturer and wholesale supplier of shoes and other sports apparel. Established in 2003 and currently headquartered in the province of Fujian in the People's Republic of China, 361 Degrees currently commands a market valuation of more than HKD 3.43 billion. The company was listed on the Hong Kong Stock Exchange in 2009.

For its shoes, 361 Degrees pursues an aggressive pricing strategy; it usually prices its products slightly below those offered by its competitors. To mitigate the dampening effect that such a strategy may have on its margins, 361 Degrees relies on strategic product variations to capture revenue from other segments.

For example, while 361 Degrees might have a standard brand of running shoes that retail for RMB 350, the company would also issue 'special edition' shoes from time to time that retail for RMB 800. This is one of the many ways in which 361 Degrees caters to other customer segments, its focus on the low- to mid-market segments notwithstanding.

1H19 financial highlights

In our previous article on 361 Degrees, we offered a gloomy review of the company’s overall operating results. Nevertheless, we concluded that an attractive investment thesis existed in relation to the company’s USD notes due 2021. We felt, after undertaking an analysis of its balance sheet and financial metrics, that the risk of default and permanent impairment was low.

Approximately six months have passed since the publication of our article. Pricing wise, the bonds issued by 361 Degrees have become even cheaper — they currently carry a yield to maturity (‘YTM’) of 20.7% and mature in slightly under two years’ time.

Of course, we would be remiss if we took this information at face value without considering whether the company’s fundamentals have evolved (for better or worse). In other words, with its yield at the 20.7% level, we would like to understand if the bond remains or has become a better investment opportunity, or whether it has morphed into nothing more than a yield trap to be avoided.

Since our last inspection, it is clear that the company’s fundamentals have experienced a significant improvement, rendering much of our original criticism no longer valid. For instance, the company has reversed its counterproductive strategy of resorting to price cuts in order to gain more share. In addition, staff and research costs — a major point of concern in our previous analysis — are now under control and, as a share of revenue, are declining. We will, of course, provide further details in the later part of this article.

The success of these measures is indubitable. For the first half of this year, revenue surged 7.3% YoY to reach RMB 3.24 billion (1H18: RMB 3.02 billion), while gross profit rose 5.3% to RMB 1.32 billion (1H18: RMB 1.26 billion). Operating profit recorded an uptick of 1.7% YoY to RMB 641.5m (1H18: RMB 630.6m), while profit attributable to equity shareholders jumped 9.7% to RMB 367.4m (1H18: RMB 335.0m).

To appreciate how these figures represent a remarkable turnaround for the company, we need to go back six months or one year in time. At that time, revenue growth had flatlined and was growing by less than 1% YoY. Cost of sales was also increasing — between 2017 and 2018, cost of goods sold increased 2.7%. The company had slashed average wholesale prices across a broad range of product categories, a move which only served to depress margins without providing a substantial boost to sales.

We are pleased to observe that the company has largely abandoned this policy of pursuing price cuts and is now making a concerted effort to boost prices across the board. The data shows that these efforts are clearly bearing fruit. Figure 1 provides a breakdown of the company’s revenue by product segment for the first half of the year.

Figure 1: Sales breakdown by product segment

The astute reader would notice that the company increased prices for products falling under the Adult Footwear, Adult Apparel and Kids segments. Also, it would be readily apparent that in these segments where price hikes were implemented, the income effect arising from the price hikes more than compensated for the substitution effect resulting from the decline in the number of units sold. Consequently, all three segments reported increases in revenue. The effect was most pronounced in the Adult Apparel segment, which saw segment revenue jump 12.1% YoY.

The incisive reader might point out that price hikes were not necessarily implemented across the board: average wholesale price for the Adults Accessories division actually declined in the period. Not only did the average price per unit decline, the increase in the number of units sold did not compensate to an adequate degree, resulting in total segment sales falling 5.3% YoY. This observation does not concern us because the Adults Accessories business forms an infinitesimal part of the company’s business — at about 1.2% of total revenue in 1H19. But as a matter of interest, 361 Degrees disclosed that the lower prices and sales were for the most part due to a greater proportion of low-margin accessories launched in the period.

In contrast, the Adult Footwear and Adult Apparel businesses contributed 43.7% and 41.9% of total 1H19 revenue, respectively. The Kids division accounted for 12.0% of total revenue. For these substantial revenue-contributing divisions, it is heartening to see rising wholesale prices and decent revenue growth.

We would like to spend a bit of time discussing the profit margins of the Adult Footwear and Adult Apparel divisions, given their importance to the company. The gross profit margin of the Footwear section expanded 0.4 percentage points (“ppt”) from 42.0% in 1H18 to 42.4% in 1H19, following the introduction of some signature products during the period.

On the other hand, the gross profit margin of the Adult Apparel division slipped 1.9 ppt to 40.2% for the first half of 2019. This was largely due to intense competition and we understand that 361 Degrees opted not to fully transfer the incremental increase in production costs to consumers. Going forward, we would be keeping an attentive eye on production costs specific to this division, but given its robust revenue growth in 1H19, we see little cause for concern at this stage.

Speaking of costs, earlier in the article we briefly alluded to the company’s spending on R&D and staff costs. Readers who consulted our previous article would recall that we criticized the company’s runaway advertising expenditure and burgeoning staff costs. Much has changed since then, and it is clear that the management has taken active steps to rein in spending on these items.

Advertising and promotional expenses — as a percentage of total revenue — declined 0.2 ppt to 8.5% for the first half of 2019 (1H18: 8.7%). Staff costs as a percentage of revenue also registered a decline, down 0.7 ppt to 7.8% (1H18: 8.5%). Research and development expenditure dropped 0.5 ppt to 3.1% in the period.

Credit metrics and cash flow

361 Degrees reported earnings before interest and taxes (‘EBIT’) of RMB 641.5m for the first half of 2019, up 1.7% YoY. On its face, the reader might conclude that this is hardly remarkable, but we would suggest that this anodyne number actually belies the sizeable improvement in the company’s operating performance.

All we need to do is to strip away the impact of two items on the company’s income statement: other revenue and other losses. The reason why we do so is because these two items incorporate government subsidies, grants and FX losses, items that do not relate to the company’s core operating performance in our view.

Once we do that, we find that adjusted EBIT — EBIT with other revenue and losses stripped out — actually jumped 10.2% from RMB 492.5m in the first half of 2018 to RMB 542.7m in the first half of 2019. In addition, interest coverage — as measured by dividing adjusted EBIT by finance costs — improved to 5.02x for the first half of 2019 (1H18: 4.88x).

Gearing has also declined for 361 Degrees. The gearing ratio — calculated by dividing interest-bearing debt by total assets — fell 1.2 ppt to 22.4% as of end-June 2019 (31 Dec 18: 23.6%).

On the liquidity front, we observe a similar improvement. 361 Degrees reported a quick ratio of 2.73x as of the end of June (31 Dec 18: 2.65x). The analytical reader might, of course, query the rationale of using the quick ratio, as opposed to other measures of liquidity such as the current ratio. The answer is simple: 361 Degrees is in the business of manufacturing shoes and the bulk of its inventory is in finished products i.e. manufactured shoes.

We would think that these shoes are customized with the company’s branding and design. It would be reasonable to assume that the liquidation of these inventories would not necessarily be a straightforward affair. Thus, we are of the opinion that in accessing the liquidity position of 361 Degrees, it is preferable to exclude the value of inventory.

At this juncture, we would like to focus the reader’s attention on the company’s cash flow statement and its free cash flow (‘FCF’), in particular. FCF is important because it represents the amount of cash generated from operations after deducting cash outflows to maintain production capacity and capital assets. In some sense, it is a proxy for the quality of earnings.

The evolution of 361 Degrees’ FCF is probably the metric that most vividly illustrates the turnaround of its operating performance. FCF — net cash generated from operating activities less net payment for property, plant and equipment — swung from a negative RMB 5.6m for 1H18 to a positive RMB 26.0m for 1H2019. Before capital expenditures (‘capex’), net cash from operating activities jumped to RMB 28.0m, up 28.0% YoY.

One area that is of a certain importance, in the context of a manufacturing business the likes of 361 Degrees, is the firm’s investment in production capability. Specifically, it is important to understand whether a company is spending enough to maintain its production capability. To this end, analysts like to measure a company’s capex in relation to depreciation charges on property, plant and equipment. Figure 2 provides data on this particular metric for the benefit of our readers.

Figure 2: Capital expenditure relative to depreciation

Ostensibly, capital expenditure for the first half of this year has fallen below what we might regard as the historical average. While this is an area that we would keep an eye on going forward, it has not become a major point of concern given the improved operating cash flow (recall that net cash from operating activities was up 28% YoY), and so long as the company continues to maintain the capacity to invest in capital expenditure as and when it chooses. Nonetheless, we would have preferred capex to be at a higher level.

Another reason why we are not preoccupied with manufacturing capex is because 361 Degrees outsources a significant part of its production activity to third parties, even though the company has two factories in China. We think this is an excellent practice: relying on multiple third-party manufacturers on top of having its own production facilities allows 361 Degrees to mitigate production related risk.

With the considerable improvement in operating cash flow, the management felt confident enough to allocate RMB 66.1m to repurchase some of its USD notes. The reader taken aback by this move should understand that this was by no means an imprudent step. During the period, the company did not pay a final dividend for 2018, something it habitually does. While some might argue that the decision to repurchase debt and forgo paying dividends is somewhat symbolic, the increased financial conservatism should only be interpreted positively by bondholders.

For bond investors, the timing of the repurchase is especially relevant. At the time of the repurchase, the bond was trading in the secondary market in the region of 88 cents on the dollar, possibly indicating that at that price, the management was of the view that the bond was undervalued. The bond is currently offered at 82.29 cents on the dollar.

Liquidation analysis update

In our previous article, we took a look at the major assets and liabilities of 361 Degrees, providing an estimated liquidation value. We also noted that its liabilities were dwarfed by its cash holdings, which led us to conclude that the risk of default and permanent impairment was minimal.

In Figure 4, we provide an update on our estimated liquidation value of the company.

Figure 4: Liquidation analysis

Maintaining the same valuation approach adopted six months ago, we observe that our estimated recovery value of the company’s assets has increased to RMB 10.8 billion. The reader should note that the company’s liabilities only totaled some RMB 6.05 billion.

Certainly, the skeptical reader might point out that asset valuation is subjective and that the estimated liquidation value might not be accurate. Perhaps. However, cash actually made up almost 60% of the aggregate estimated liquidation value of 361 Degrees’ assets. We would respectfully point out that the valuation of cash and cash equivalents is hardly subjective.

With 361 Degrees’ strong cash position and its improved operating metrics, we think the likelihood of default and impairment is even lower than before.

The DEGREE 7.25% USD bond

At present, 361 Degrees has a single outstanding note (DEGREE 7.250% 03Jun2021 Corp (USD)), which matures in 1.6 years and carries a YTM of approximately 20.7%. We strongly recommend this bond due to its significantly more attractive pricing and the company’s improved credit metrics. Furthermore, we like the fact that the bond has a short remaining maturity of less than 2 years, mitigating duration risk.

If our last call on the 361 Degrees bond was a ‘Buy’, our current call would be a ‘Strong Buy’. Investors with a current position in the 361 Degrees bond, and who have the ability to maintain a well-diversified portfolio, might consider increasing their allocation to take advantage of the significantly more attractive pricing that we are currently seeing in the market.

Related article: The Hidden Beauty of 361 Degrees Bonds

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a principal position in DEGREE 7.250% 03JUN2021 CORP (USD). The analyst who produced this report hold a NIL position in the abovementioned securities.