Shenzhou Reports Mixed Results, but Demand Recovery Is in Sight; Shares Undervalued

We see Shenzhou International’s 02313 second-half 2022 results as a mixed bag. On the positive side, revenue growth remained healthy despite operating under a challenging industry environment. With key clients reporting a gradual recovery in China, we think Shenzhou’s demand outlook will gradually improve. On the negative side, profitability fell more than our expectations as capacity utilization rates fell, and this headwind will likely remain in the first half of 2023. We are maintaining our HKD 140 fair value estimate for the narrow-moat company and see the shares as materially undervalued from a long-term perspective.

In the second half of 2022, Shenzhou recorded 14% revenue growth. Based on management’s additional disclosures, revenue grew 30% year over year in the third quarter before reversing to a decline of 1% in the fourth quarter. We attribute revenue decline in the fourth quarter to weak global sportswear demand and elevated inventory levels that necessitated brand clients to reduce their orders.

Shenzhou’s profitability in the second half was noticeably below our and Refinitiv’s consensus expectations. The gross margin for the period came in at just 21.6%, below the 30% we used to see from this company before the pandemic. We attribute the decline to a lower production utilization rate resulting from the capacity expansion that outstripped demand growth.

Looking ahead, management’s guidance for 2023 slightly fell short of our expectations but was above PitchBook consensus expectations. The company guided to full-year production capacity growth of 10%-15%. Assuming a 3% average selling price increase, we expect revenue to grow 14% this year. The firm attributed lackluster guidance to excess inventory and weak sportswear demand. That said, as retail inventory gradually come down from peak levels, demand for Shenzhou’s capacity should improve toward the second half of 2023. Full capacity utilization should be achieved in 2024.