Could "Tax-Free" Defeat "Water Reversal"? Will It Take A "Last-Ditch Counterattack" To Turn The Tables?

On the evening of March 30th, China Duty Free Group released its 2022 annual report, reporting revenue of 54.4 billion yuan, a YoY drop of nearly 20%, and a net profit of 5.03 billion yuan attributable to shareholders, a YoY decrease of 48%. As the company had issued earnings guidance earlier and was influenced by macroeconomic factors last year, poor past performance will not garner too much market attention.

This time, the Dolphin is mainly concerned with the detailed operating data disclosed only in the annual report and the confidence conveyed behind it. The key points are:

1. Significant damage to offline duty-free sales, supported by online duty-free sales: Due to the repeated spread of the virus, online duty-free sales channels were more severely impacted in 2022, and the total duty-free retail sales fell by 39% YoY, with the second half of the year experiencing a greater impact, declining by 46.5%.

In the face of adversity, the company successfully leveraged the online sales channel that is not restricted by physical location, partially offsetting the loss of the online channel. Furthermore, duty-paid sales realized a revenue growth of 16.5% contrary to the trend, reaching 28 billion yuan for the year, and the scale has surpassed that of duty-free sales, truly supporting half of the company's revenue. During the second half of the year, when the duty-free channel was even more sluggish, the growth rate of duty-paid sales also accelerated to 25%. The significant contribution of duty-paid sales to stabilizing the company's revenue scale is apparent.

2. The decline in gross profit is entirely due to duty-paid products, and the actual gross profit margin of duty-free products bottomed out and rebounded: In 2022, the company realized a gross profit of 15.5 billion yuan, a YoY decrease of 32%, with the degree of loss being higher than that of revenue. The overall gross profit margin of the company has also fallen from its peak of 49% in 2019 to 28% this year.

However, the core gross profit margin of duty-free product sales has bounced back from 37.8% in 2022 to 39.4%. The continuous decline in overall gross profit is entirely due to the increase in the proportion of duty-paid products and the decline in gross profit margin.

The Dolphin believes that offline duty-free stores have instead reduced the willingness of duty-free operators to offer discounts and compete due to the significant reduction in foot traffic. Furthermore, the competition in online retail channels is even more intense, and China Duty Free has provided considerable discounts, while actually absorbing the taxes payable by users under the duty-paid model, resulting in a significant decrease in the gross margin of duty-paid sales.

3. Expenses passively expanded, and profits were eroded layer by layer: In 2022, the company's total marketing expenses amounted to 4.03 billion yuan, which was roughly the same YoY. Specifically, due to renegotiating rental contracts with airports such as Baiyun Airport, a rent refund of 720 million yuan was received in 2022. However, advertising and marketing expenses increased by 50 million yuan YoY in opposition to the trend. Although the scale remained stable, due to the decrease in revenue, the expense ratio also passively increased from 7% to 8.7%.

In addition, China Duty Free is not sensitive to cost control. In 2022, the company's administrative expenses (including R&D expenses) amounted to 2.25 billion yuan, which was basically the same as in 2021. Similarly, due to the decline in economies of scale, the expense ratio also increased by nearly 0.8 pct YoY to 4.1%. Due to shrinking income, declining gross profit, and passive cost expansion, the erosion of profits was magnified layer by layer, causing the company's operating profit and net profit to decrease by about 48% year-on-year. The net profit attributable to shareholders dropped from 9.7 billion in 2021 to approximately 5 billion last year.

Longqiao Dolphin's view:

Overall, 2022 can be called the "tough year of China Duty Free". Under the severe impact of the macro environment, revenue, gross profit, and profit have all significantly deteriorated.

However, the macro environment is not a problem for the company. After careful examination, it can be seen that the continuous and substantial decline in the company's gross profit margin is entirely due to the increase in the proportion of tax revenue. The core tax-free gross profit margin reflects that China Duty Free seems not to have deteriorated significantly due to the opening of tax-free licenses and the competition pattern.

Looking to the future, the number of passengers and shopping amounts for the Hainan offshore duty-free in January and February this year have both decreased. Other duty-free channels such as airports are also gradually recovering. The company's performance in 2023 is expected to see considerable improvement. With the scale of high-gross-margin tax-free consumption rebounding, the company's overall profit level will naturally improve.

Therefore, 2023 will be a year for the company to gradually return to normal. But under normal circumstances, will the competition for offshore duty-free worsen? Will tax-free shopping crowds be diverted overseas after the border is opened? Can current tax-free shops maintain their special operating rights after Hainan is fully closed in 2025? Can the long-rumored policy for indoor duty-free shops be substantially relaxed? The above core issues that are crucial to China Duty Free still require time to observe.

Therefore, Dolphin believes that it is more reasonable and objective to evaluate whether the company can match the current market value of nearly 400 billion only after the company's performance returns to the normal level.

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See below for details:

I. Offline Damaged, Online Holding Up Half the Sky

Throughout 2022, due to the repeated spread of the pandemic and the subsequent control measures, tax-free sales relying on specific sales locations were severely impacted. Among them, the Hainan market which the company relied on the most saw a nearly 26% decrease in the total number of tourists in 2022. Faced with such difficulties, the management relied on online sales channels that are not limited by physical locations to reduce the impact on the company.

However, since most of the online channels belong to taxable sales, even though the company is called China Duty Free, over half of the revenue in 2022 was actually contributed by taxable sales. The huge change in revenue structure, and the corresponding impact, is the most noteworthy point in this financial report. Specifically, the company achieved tax-free sales of 26 billion yuan in 2022, a year-on-year decrease of nearly 40%, while taxable sales achieved a revenue growth of 16.5% in the adverse market environment.

It can be said that the company has successfully made up for some of the offline sales losses through online replacement. However, due to the significantly lower gross profit margin of taxable sales, it is still difficult to make up for the lack of tax-free sales at the profit level.

However, despite the overall market downturn, due to the relaxation of the barrier of offshore duty-free license, many new duty-free stores have opened in Hainan since 2021 . Whether the more intense competition in the industry has eroded China Duty Free Group's market share and amplified the company's revenue decline is also one of the issues of concern in the market.

At the industry level, tax-free sales in Hainan's offshore islands decreased by 29% year-on-year in 2022, seemingly higher than the decline in the company's tax-free sales. However, as China Duty Free Group's airports and other channels were more affected last year, the above comparison is unfair.

In fact, the company disclosed that its revenue in Hainan last year decreased by about 26% year-on-year, which was similar to the decline in the overall tax-free amount in Hainan. Therefore, China Duty Free Group's performance in offshore duty-free sales last year was basically in line with the industry average, neither good nor bad.

Looking ahead to the performance prospects of 2023, from the latest data, the year-on-year decline in the number of tax-free shoppers in Hainan from January to February this year has narrowed to 26%, and the decline in sales has also narrowed to 31%. The Dolphin believes that with the complete relaxation of personnel mobility, Hainan's duty-free sales is expected to see a considerable recovery.

2. Is it all due to taxable sales dragging down the actual gross profit margin?

In 2022, China Duty Free Group achieved a gross profit of 15.5 billion yuan, a year-on-year decrease of 32%, still higher than the revenue decline. The company's overall gross profit margin has also fallen from its peak of 49% in 2019 to 28% this year. But in fact, the company's core tax-free product sales gross profit margin has rebounded from 37.8% to 39.4% in 2022. The sustained decline in the company's overall gross profit is entirely due to the increase in the proportion of taxable product sales and the decrease in the gross profit margin of taxable products. During the outbreak, the reduction in traffic to offline duty-free stores led to a decrease in the willingness of duty-free operators to offer discounts and compete (as even significant discounts cannot create considerable incremental demand for consumption). On the other hand, to compete in the more fierce online retail channels that naturally lift the distribution barriers of offline duty-free stores, Central China Duty Free (CCDF) offered consumers on the online platform competitive prices, with the selling price of taxed goods comparable to the duty-free channel prices. This is because the company internally absorbed the taxes paid, causing the gross profit margin of taxed sales to drop significantly.

However, as offline consumption recovers and international flights resume, CCDF's duty-free channel will gradually return to pre-outbreak conditions, bringing up the overall gross margin rate. After traffic recovers, whether CCDF can maintain the gross profit margin of duty-free sales will be the key issue in the face of competition.

In 2022, CCDF's total marketing expenses were CNY 4.03 billion, basically unchanged year on year. However, considering that revenue significantly declined in 2022, the marketing expense rate increased from 5.7% YoY to 7.4% YoY. Specifically, last year, due to the resigned rental contracts with airports such as Baiyun, the company actually received CNY 720 million in rental refunds, comparable to the scale of CNY 21 and above.

Among them, advertising and marketing expenses increased by CNY 50 million YoY against the trend, and the fee rate also increased from 7% to 8.7%. Online media buying and the opening of Hainan Duty Free City may have contributed to the increase in marketing expenses, in our view.

Finally, as the proportion of low-gross-margin taxed goods sales in the company's revenue structure increased, dragging down the overall gross margin, and marketing expenses also passively expanded due to the weakening scale effect, CCDF's gross profit difference plummeted from 28% in 2021 to 21% last year.

Three, Cost Inflation and Profit Squeezed

Apart from revenue contraction caused by the overall economic environment and gross profit decline due to income structure impairment, China Duty Free Group, as a state-owned enterprise, is not sensitive to cost control under the circumstances of an economic downturn. The company's management and R&D expenditure for 2022 amounted to RMB 2.25 billion, which is basically consistent with that of 2021.

Although the absolute amount has not increased, the management expense ratio has increased by nearly 0.8% to 4.1% on a year-on-year basis due to a lack of economies of scale caused by the income decline.

Finally, due to income contraction, gross profit decline, and cost inflation, the erosion of profits has been magnified layer by layer, resulting in a year-on-year decrease of about 48% in both operating profit and net profit attributable to the parent company shareholders. The net profit attributable to parent company shareholders has dropped from approximately RMB 9.7 billion in 2021 to around RMB 5 billion, which is a dismal performance.

Four, Summary of 4Q Performance

As the earnings report previously released had already disclosed the 2022 fourth quarter performance and due to the impact of a virus outbreak, the 4Q performance is not comparable to that of a typical year. Here, we will briefly describe the performance of the fourth quarter.

In terms of revenue, it declined by 17% year-on-year in the fourth quarter. Compared to the 44% decline in offshore duty-free sales in Hainan, the decline in China Duty Free Group's revenue was still relatively low. The online taxation channel should still be the main contributor.
However, the gross margin continued to decline significantly, which, in our view, was due to the increase in the proportion of online channels. In addition, during the Double Eleven promotion period in the fourth quarter, the company should have given considerable discounts to attract customers.

Not only did gross margin decline, but the marketing expense ratio also significantly increased to 9.2% on a month-on-month basis, reflecting the considerable promotion or sales activities carried out by the company during the 4Q period.

In addition, due to the year-end settlement in the fourth quarter, the company had to pay higher management fees. Therefore, although the appreciation of the Chinese yuan brought the company approximately RMB 410 million in financial income, the company's overall expenses and net profit attributable to parent company shareholders still declined significantly. Final 4Q only achieved a profit of 900 million, hitting a historical low except for the first quarter of 20 years.