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Digital China (861.HK) - Continuing to benefit from IT market`s rapid growth

Monday, December 28, 2009

4757

Digital China(861)

Recommendation on 28 December 2009
Recommendation	BUY
Price on Recommendation Date	$9.550
Target Price	$11.660

Weekly Special - 425 Minth Group

Summary

Digital China Holdings Limited (Digital China or the company) is the largest IT products dealer and integrating IT service supplier, with all businesses benefit from the electronic information industry promoting plan by the GOC. In 1H09/10, it recorded turnover and net profit of 15.9% and 69.1% growth y/y, again higher than the average of domestic industry level.

Given the high certainty of future performance growth, we expect EPS in FY09/10 and FY10/11 will be HK$0.898 and HK$1.165, and give 12-month TP of HK$12.66 initiatively, Buy rating.

Profitability dropped while performance slightly climbed

Digital China recorded turnover and net profit growth of 15.9% and 69.1% y/y in 1H09/10, and net profit growth for sustained operating of 10.6% excluding the gain on disposal of subsidiary. The second quarter performed obviously better than the first one, with turnover and net profit (excluding one-off gain) increased 29.5% and 25.0% q/q.

The gross margin in the first two quarters dropped to 6.24% versus 6.93% in last year, due to larger sales promotion and fiercer competition. Offset by the 5.6% cut of operating expenses for the tighter control, the net profit margin (excluding one-off gain) only declined 0.05ppt to 1.10% from last year`s 1.15%.

We expect its gross margin to stop falling in 3Q09/10 with the macro economy recovery and sales promotion`s normalization. Furthermore, high-profit business`s fast growth will also help the stabilization of gross margin.

Its cash flow circumstance also tuned well obviously in this fiscal year due to larger A/P amount. Cash flow from operating reached to HK$568million in 1H09/10 versus HK$14million in last year. At present, its cash cycle days is 19.20 days, excellent in peers.

Penetrating distribution channel and 3G launching enhance its handset business

In this fiscal year, Digital China continued to develop and penetrate its distribution channels, obtaining 40% growth in its effective channels numbers. Meanwhile, it also spin-off its fast growth supply chain service business for operating independently, creating a new model to serve high-tech industry customers. Its distribution and supply chain service business increased 14.9% and 93.0% respectively in the first two quarters, yet the combined EBIT declined 10.7% y/y dragged by large cut of distribution profitability.

We believe its EBIT margin will rebound as an intermediary supported by the starts of domestic demand. Furthermore, the penetrating of distribution channel will help in seizing the opportunity of rapid expanding rural market. Its sales in the 4th -6th tie cities in this year increased largely 59% y/y.

Furthermore, domestic 3G launching propels the cooperation of carriers and IT distributors, which help its handset business` rally. The company has become the top agent of China Mobile, the national partner of iPhone and the excluding distributor of Blackberry domestically.

Combined, though its distribution channel`s expanding, it has flat pricing right in this industry chain under the strong press from core suppliers. We expect its profit CAGR in this business will be only 7%-12% in the next three years.

Systems business expanding stably driven by the rapid increasing Chinese economy

Digital China`s systems business bottomed up leading its peers, and turned to increase under the harsh circumstances, due to the largely rebound of its performance in 2Q09/10. Turnover in 6 months reached HK$6.52billion, 1.73% increase y/y, including a 8.92% increase in the latter 3 months. Versus to the distribution, its system resolution has more voice in this sector, and has brought better profit margin (as table 1).

Generally speaking, we acknowledge its sales model focusing on regional market development which rose largely by 41.34% y/y. We also expect its systems business will stably expand and most likely continue the leading role in this sector due to the long-term rapid growth of Chinese economy and fast urbanization.

IT services` profitability increases and the purchasing of SJI Inc enhances its software development strength

Digital China starts to change its IT service strategy in 09/10, spinning-off simple hardware relative business to system business, and focusing on software and IT service. Though IT services business sales dropped 17.6% y/y in the first two quarters, its gross margin only cut 4.3% and EBIT rocketed 27.8%, due to gross margin increased to 15.1% from 13.0%.

On Nov. 4th, 2009, the company announced to purchase 30.6% share of SJI Inc, a IT service supplier listed on Japanese market with total HK$242million, suggesting 11.3x PE on FY09 and 1.0x PB on FY08. We think this purchase will enhance its software development strength and efficiently promote its overall competitiveness in software outsourcing. Meanwhile, it also lays foundation for its IT service sector to spin-off and list on A stock market in 2011-2012.

In general, we expect its profit CAGR in IT service business will reach 30% in the next three years, even excluding the one-off promotion brought by SJI purchase.

Risks

Up risks

1. Rapid RMB appreciation increases exchanges profit.

2. Further to purchase excellent asset with reasonable price.

3. Handset distribution develops than expected.

Down risks

1. Profitability rebound lower than expected.

2. Chinese economy recovers below expectation.

3. Business shares in market declines.

Performance growth with high certainty brings up-room for valuation

Given its distribution and systems business strength improving as well as the outlook of IT services business, we believe in its high certainty of future performance growth. Furthermore, efficient operating expense control supplies safe margin guard for this increase. Therefore, we think it is reasonable to give 12x PE to its distribution and systems business and 25x PE to its IT services business on FY09/10 EPS.

We expect Digital China`s EPS in FY09/10 and FY10/11 will be HK$0.898 and HK$1.165, and give 12-month TP of HK$12.66 initiatively, Buy rating.

Financial Data Ⅰ

Financial Data Ⅱ

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