Summary

Founded in 1987, GOME has become the largest national chain store company focusing on retail of household appliance and consumer electronics. By 1H2010, GOME had 740 stores in 200 large-and-medium-sized cities in China. There were also 370 stores of the Non-listed GOME Group (excluding stores in Hong Kong and Macau) and 52 stores of Dazhong Appliances under management contracts. The Group managed a total of 1,162 stores across 331 large-and-medium-sized cities nation-wide.

The interim report shows that the revenue of GOME grew by 21.6% YOY with same store sales growth (SSSG) of 24.80%. The profit attributable to owners of the parent grew significantly by 65.86%, which relayed the rebounding trend started since 2009.

China's scale of urbanization ranks No.1 in the world, leaving a consumption market capacity with full of imagination. From relative perspective, China's urbanization rate of 46.6% leaves more room to rise. The consumption upgrade brought by urbanization speeding will also benefit China's household appliance market.

Now GOME is promoting the parallel strategies including optimization and expansion. GOME draws lessons from internationally advanced management of household appliance chain store to enhance its operation ability of single store. In addition, non-first-tie markets will become GOME's main battleground for expansion.

About the current war of GOME, We believe in the long run, as a well-known captain in house appliance retails, GOME still remains huge potential to explore, the benefit of which will drive different investors to reach agreements by hard bargain and facile wisdom, no matter on the board of directors or the development and operation strategies.

We believe the current price has undervalued GOME to some extent and give it a leading PE of 22x on EPS of FY10E considering its peers` valuation. We target the 12-month price as HK$2.66, a premium of 15.74% to current price, and rate it BUY initially.

Results Review: performance of 1H2010 hit high since the end of 2008

The interim report shows that the revenue of GOME reached RMB 24873 million, growing by 21.6% YOY, in which the revenue of 651 comparable stores reached RMB 23482 million with the same store sales growth (SSSG) of 24.80%. Especially, the revenue in 2Q2010 amounted to RMB 13092 million which was the highest single quarterly revenue since GOME being listed.

In 1H2010, the cost of goods sold amounted to RMB 22200 million, accounting for 87.25% of revenue which is a little lower than the 90.19% of 1H2009. In addition, due to products differentiation, the gross profit in 1H2010 reached RMB 2674 million, growing 33.17% YOY. The consolidated gross profit margin was 17.04%, 0.56% higher than the same time of last year.

In 1H2010, GOME's profit attributable to owners of the parent amounted to RMB 962 million, growing significantly by 65.86% from the same time of last year of RMB 580 million, which relayed the rebounding trend started since 2009. The net profit margin increased by 1.04% from 2.83% of the same time last year to 3.87%. Further, the basic EPS increased by 42.22% from RMB 0.045 of the same time last year to 0064.

Industry Outlook: urbanization speeding up and consumption upgrading benefit household appliance market in China

The scale of urbanization ranks No.1 in the world, leaving a consumption market capacity with full of imagination. According to the Blue Paper named China City Development Report released by Chinese Academy of Social Sciences (CASS), China's urban population increased by more than 20 million each year from 1996 to 2005 and 15 million each year from 2006 to 2009. By the end of 2009, China's urban population reached 620 million, twice America's total population and 25% higher than the total population of EU 27, ranking No.1 in the world. In addition, the number of members per household has been declining to 3.2 in 2009, still higher than 2.6 of America however. We believe the number of members per household will continue to decline, increasing the number of households and thus consumption of household appliance. From the perspective of absolute number, the huge scale of urbanization is the result and proof of China's rapidly growing economy on one hand and triggers full imagination of further expanding the capacity of household appliance market in the future on the other.

Urbanization rate of 46.6% leaves more room to rise. From the relative perspective, China's urbanization rate reached 46.6% in 2009, presenting an upward trend. But it is the fact that China's urbanization rate has more room to rise. America's urbanization rate has exceeded 70% since 1970s and reached 80% in 2008. The blue book released by CASS expects that the process of China's urbanization will still keep a high speed for some time. It is forecasted that China's urbanization rate will reach 52% in 2015 and 65% in 2030.

Consumption upgrade benefits China's household appliance market. Compared to urban households, rural households still fall behind in expenditure on household appliance and consumption structure of household appliance. The number of household appliance per 100 households and average expenditure on household appliance in rural households are significantly lower than in urban households. Especially, the gap is more in consumer electronics and high-end household appliances. We believe that with more rural households becoming urban households, the potential and structure of household appliances consumption are expected to be improved significantly. On one hand, the speeding urbanization will bring rapid popularization of general household appliances, creating more new needs; on the other hand, in recent years, the household appliance products are updated more rapidly and consumption upgrade bring new opportunities for household appliance market.

The parallel strategies: optimization and expansion

Draw lessons from internationally advanced management of household appliance chain store to enhance its operation ability of single store. On one hand, GOME speeds up store re-modeling into “XinHuo Guan” or “new-model stores”. As such, its stores are not only centers for purchasing products, but also acquire knowledge and consumption experience, thereby partnering with consumers in their experience with electrical appliances. As of the end of 1H2010, the GOME's “Xin Huo Guan” and “new-model stores” amounted to 11 and 91 respectively. On the other hand, GOME carefully studied leading international electrical appliance retail chains and remodeled the shopping environment of its outlets in terms of product display, location of showcases, and promotional items. In addition, after studying consumer demands, it focused on improving the customer's one-stop shopping experience, increasing product variety, and satisfying the demands of different customer groups. Under the new model, customer traffic and purchase rate have been increased significantly.

Non-first-tie markets will become GOME's main battleground for expansion. Adhering to the principle of “opening high quality mega stores” set at the beginning of the year, GOME strengthens its effort in opening new stores. In line with the rapid urbanization and urban transformation, GOME means to quickly seize the emerging regions and opened 39 stores in areas with emerging customer demands and minimal competition. GOME considers the second-tier cities as the main regions to expand its store network. Compared to Suning, GOME's main rival in China, currently GOME's store proportion opened in non-first-tie cities is significantly lower. We believe GOME still have huge potential to expand in non-first-tie cities.

The war of GOME: our views

On GOME's Extraordinary Genaral Meeting held on Sep 28 2010, the proposal of canceling general authority to the board of directors for allotting, issuing and transacting stocks was passed, which eliminated the uncertainties in stock ownership. But the proposals of removing directorship of Chen Xiao and Sun Dingyi and appointing Zou Xiaochun and Huang Hongyan as executive directors were not passed, still leaving uncertainties in the board of directors.

(1) Will Mr. Wong separate the 370 unlisted stores from listed company? We believe that considering Wong's position of large shareholder, separating the 370 unlisted stores from the listed company to operate solely makes against the listed company, 30.65% of which is held by Wong as well as the unlisted stores which is fully held by Wong. From the long view, separating is not the best choice in benefit maximization. However, Wong's key appeal to restructure the board don`t come true by now, so we can`t exclude the possibility that Mr. Wong means to keep up pressure on present managements and Bain Capital, GOME's second large holder, by the separation.

(2) Will Chen Xiao leave? No doubt, no matter Bain buying into GOME or the present managements supporting Bain, they all stand on consideration of their benefit maximization. However, they have to take large shareholder's attitudes and benefit into account. We believe Chen's leaving or not will be the key factor to determine whether Mr. Wong give more pressure such as separating unlisted stores. As a finance investor, Bain will have to consider the large shareholder's appeal and the effect produced by large shareholder's behavior. We believe the route, schedule of Chen's quit and his successor will become the focal point of negotiation. It is the key to solving the problem that a successor that large holder, present managements and Bain all appreciate can be chosen.

(3) How does it affect GOME's stock price? The solution to the war remains to be found, which is interpreted as negative by market, giving pressures on GOME's stock price in short term. However, we must realize that in the capital market, as an investor, each shareholder is pursuing benefit maximization. About the current war of GOME, We believe in the long run, as a well-known captain in house appliance retails, GOME still remains huge potential to explore, the benefit of which will drive different investors to reach agreements by hard bargain and facile wisdom, no matter on the board of directors or the development and operation strategies.

Earnings Estimates

The managements of GOME proposed its strategic goal for developing: the number of stores will reach 1400 by the end of 2014. We assume that its number of stores will reach 770, 900 and 1100 in FY10-12 respectively, the average operating area per store is 3700 s.q.m and the average revenue per operating area is RMB 18000. By calculation, we expect the revenue will reach RMB 51282 million, 59940 million and 73260 million in FY10-12 respectively, growing by 20.19%, 16.88%, 22.22% YOY, with CAGA of 18.74%.

By calculation, we expect GOME's net profit will reach RMB 1661 million, 2037 million and 2550 million in FY10-12 respectively, growing by 17.85%, 22.65%, 25.17% YOY, with CAGA of 21.85%.

Risks

GDP growth can`t reach expectations.

Consumer confidence drops unexpectedly.

Overseas and domestic competitors emerge strongly.

The implementation of expansion plan can`t reach expectations.

The war of GOME heats up, which affects normal operation and expansion decision-making.

Valuation

Driven by the speeding up of Urbanization and consumption upgrade, we overweight the extensive potential of electrical appliance retail industry in China, and believe the industry competitive landscape won`t change in the short time. Despite that GOME is still facing uncertainties of the war and vigorous competition from rivals such as Suning, we still overweight GOME's long-term perspective because it has plenty and mature experience in operating electrical retails and broad store network in China. We expects its EPS will reach RMB 0.121, 0.149, 0.186 respectively in FY10-12, growing by 27.37%, 23.14%, 24.83% YOY with CAGA of 25.10%.

GOME's latest closed price (08 Oct 2010) is HK$2.3, which is 16x and 13x PE on EPS of FY10E and FY11E, significantly lower than the average of retail stocks listed on HK Exchange: 27x and 22x. We believe the current price has undervalued GOME to some extent and give it a leading PE of 22x on EPS of FY10E considering its peers` valuation. We target the 12-month price as HK$2.66, a premium of 15.74% to current price, and rate it BUY initially.

Financial Data

Click Here for PDF format...