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Centron Telecom (1155.HK) Downgraded because of remarkably disappointing decline of margin

Monday, December 8, 2008

6803

Centron Telecom(1155)

Recommendation on 8 December 2008
Recommendation	Hold
Price on Recommendation Date	$0.740
Target Price	$0.680

Weekly Special - 175 Geely

Highlight

We downgraded the rating of Centron Telecom International Holding Limited (1155.HK; Centron) to Hold, and lowered its 12-month target price to HKD0.68 due to its unsatisfactory results, especially a sharp decline of its margin, showed in the 1H08, and we foresee that such situation can hardly be improved in the coming years unless the investment by the company into research and development (R&D) brings unexpected benefits the company. Yet, Centron is now traded at a 0.42x price-to-book value (BVPS: RMB1.579) and price-to-cash value at 0.81x (CVPS: RMB0.815), which is quite undervalued.

On the other hand, the expansion of the businesses of Centron to oversea market, along with the enlarged demand for its products in domestic market, because of the expectation that the 3G licenses will be granted to the telecom operators in this month, may both help it achieving a stable growth in coming years.

Our target price is based on our target price-to-earning ratio, which is equivalent to a 2008E P/E at 3x, and 2009E P/E at 2.5x, which implies a lower valuation of its global peers, to reflect its erased profitability in the competitive market. Our target price suggests potential 8.1% downside. Recommend Hold.

Financial review

Centron posted a disappointing result in the 1H08. It managed to achieve a year-on-year (yoy) 6.2% growth of revenue, from RMB347.9 million in 1H07 to RMB369.4 million in 1H08. However, its net profit tumbled remarkably from RMB90.3 million in 1H07 to RMB53.2 million in 1H08. It implied a 41.1% yoy decline, which is deeply satisfactory.

Actually, the gross profit of Centron in 1H08 dropped 10.9% yoy, despite the escalating revenue. It was mainly because of its shrinking gross profit margin, which was at 33.4% in 1H07 and rose to 33.5% in 2H07, but shed significantly to 28.0% in 1H08.

Erased profitability

The 5.4% yoy decline of gross profit margin was so sharp and totally out of our expectation, since the company maintained a relatively stable gross profit margin on and before 2005. And, because of the central procurement program advocated by the telecom operators, its gross profit margin dropped to 3x%. So the further sharp decline was unexpected.

According to the company, the decline of gross profit margin was basically because of the highly competitive market of 2G and 2.5G products. So, on the other hand, Centron expects a rebound of gross profit margin because of its enlarging proportion in sales for 3G products and other new products, as well as after-sales services, which all have a higher gross profit margin than the ones of its traditional products. Among those products, the 3G products only accounted for 11% of Centron`s revenue in 1H08, but it is expected to be increasing due to the 3G licenses to be granted to the telecom operators in the near future.

What`s more, the selling and distribution costs as well as its general and administrative expenses increased yoy rapidly by 52.5% and 117.4% respectively. The former was because of the expansion of Centron into oversea markets, which affected its profitability in early stage, while the latter was mainly due to the company investing relatively much higher proportion of its revenue into R&D, which we think would benefit the company in long term, but the negative impact for the profit margin in the year is severe.

We expect a slight rebound of gross profit margin of Centron in the future, but a further drop of net profit margin because of a expected future increasing finance cost (though Centron currently does not have any finance cost as it has no debt) and the end of current enjoying 50% tax reduction (at 2010).

What`s still valuable of Centron

Firstly, although Centron got less profitable in 1H08 compared to the past, the financial condition of the company, at the end of June 2008, was still in a satisfying condition. Centron had totally RMB497.6 million cash and bank balance on hand, and moreover it had no debt. Therefore, it got little difficulties for its expansion plan in financing, which is especially important in current economy condition.

Also, it traded at a low valuation, where its price-to-book value and price-to-cash value is only at 0.42x and 0.81x respectively (its BVPS and CVPS is RMB1.579 and RMB0.815 respectively at the end of June, 2008). It can be said that, if we buy the stock, we use “our cash” to buy “the cash of the company” together with the investment opportunity into Centron for free.

Last but not the least, the growing opportunities, in oversea markets and also domestic market, are still huge. The company grasped a contract for a construction project for a nationwide mobile network in Laos, with a total contract value exceeding USD18 million in 1H08. The contract value is more than 10% of Centron`s revenue in a single year, yet this project will be completed (and booked into P&L) in several years. We believe it will enable the company getting more contracts in oversea market.

Furthermore, the enlarged demand in domestic market because of 3G licensing should also be benefiting Centron, since the Capex of the telecom operators is expected to be enormous.

Statement of risk

We believe the major risks of Centron are as follows: (i) further decline of its profit margin; (ii) failure of research and development; (iii) unexpectedly lack of profitability from new businesses (iv) slowing demand from oversea markets due to economy recession.

Peers comparison

Centron is now trading at a discount to its global peers. However, because of its worsening profitability, we believe it is better for us to stay conservative. Although it may be traded at a low valuation, we rate it as “Hold”.

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