Earnings Report 2023 | LI NING's Misjudgment and Adjustment

At last year's mid-year performance briefing of LI NING (2331.HK), founder LI NING expressed full confidence and a "bright outlook" for the future of the sports industry. At that time, LI NING had just delivered a performance report showing a double increase in revenue and net profit against the trend.

However, things didn't go as planned, and the anticipated consumption recovery did not happen in the second half of 2022. The situation of weak demand persisted until 2023.

On August 11th, LI NING released its financial report for the first half of 2023, recording a revenue of 14.019 billion, a year-on-year increase of 13%; however, the net profit recorded 2.121 billion, a year-on-year decrease of 3.11%.

This is the first time LI NING has experienced a negative growth in net profit since the mid-year report of 2020.

Since expressing "bright outlook" in the second half of that year, LI NING has started a massive expansion by opening new stores. In the second half of 2022 alone, a net total of 491 stores were opened, making it the most "aggressive" expansion move in the past three years of the pandemic.

It is worth noting that LI NING only opened a net total of 204 stores throughout 2021.

However, in the first half of this year, reality dealt a heavy blow to LI NING. The number of stores decreased to 7,448, with a net closure of 155 stores.

An insider from LI NING told TradeWind01 that the closed stores in the first half of the year were not new stores. LI NING's strategy for channels has always been consistent, with "benefit" being the top priority. They will dynamically observe the performance of newly opened stores and choose to close them if the future assessment shows poor benefits.

At the same time, the insider also stated that the company does not have a "stubborn" goal for the number of stores.

The side effects of expansion are gradually becoming apparent, and the pain caused by LI NING's discount clearance of inventory is real. The gross profit margin has gradually decreased from 55.89% in the mid-year report of 2021 to 48.38%.

Between expansion and contraction, LI NING's stock price has also been on a roller coaster ride.

First, in June of last year, the market value of LI NING plummeted from HKD 190 billion to HKD 100 billion. Then it rose to a year-high of HKD 82.7 per share in January of this year, with a market value exceeding HKD 200 billion, and subsequently entered a downward trend. As of the close on August 11th, LI NING closed at HKD 43.7 per share, once again experiencing a halving of its market value from the beginning of the year, with a decline of over 30% year-to-date.

The changes in market value are influenced by the overall tightening of liquidity in the Hong Kong stock market and the reflection of LI NING's own fundamental changes.

The challenge of returning to growth after misjudging the situation has once again been placed in front of LI NING, the founder. During the inventory clearance cycle in 2008, LI NING lost its position as the leading domestic sports brand. Obviously, it does not want to be tripped up by inventory problems once again.

Adjustments are taking place. In the first half of this year, LI NING's inventory turnover days increased by only 2 days, while the turnover days of accounts receivable remained unchanged. At the same time, the amount of accounts receivable with a credit period of over 90 days has also decreased.During the performance briefing after the release of the earnings report, the management maintained a target of 10% to 20% annual revenue growth and a target net profit margin of 10% to 20%.

This year, LI NING resumed its interim dividend plan after a 12-year hiatus, with a proposed dividend of 955 million yuan, accounting for approximately 45% of the net profit for the first half of the year. The management expects to "maintain dividends in the coming year and subsequent years in the event of good profitability."

Dragged down by discounts

LI NING has been in the process of destocking this year.

The first half of the year saw poor profitability for LI NING, which can be attributed to the increased discounting in online channels and retail terminals, a decrease in the proportion of DTC channels (including e-commerce and direct stores), and an increase in inventory provision (a YoY increase of 34.4% to 143 million yuan).

Compared to offline channels, discounts have not had a significant impact on e-commerce channel sales. In the first half of the year, LI NING's e-commerce channel revenue only grew by 1.7% YoY, with a decrease of 2.9 percentage points in revenue share to 25.6%. Direct store and distribution channels, on the other hand, increased by 1.8 and 0.5 percentage points, respectively.

During the performance briefing after the release of the earnings report, LI NING's management explained the poor performance of the e-commerce channel in the first half of the year. They believe that consumers have increased their offline activities and reduced their online consumption, which is a major trend.

"Online, in order to maintain overall consumer demand, we have appropriately increased discounts to improve conversion rates and lowered some shopping thresholds. In fact, in the past few years, LI NING's e-commerce discount rates and profit margins have been relatively good, even excellent. The deepening of discount rates does not mean that LI NING's e-commerce profit margins are poor. Building more convenient shopping channels for consumers may be the focus of e-commerce development in the future." The management stated that the performance in July and August is in line with their expectations.

Another reason that suppressed LI NING's profitability was the side effects of opening a large number of stores in the second half of last year.

In the second half of 2022, out of the 491 new stores opened by LI NING, 265 are directly operated stores, which means no distributors are involved. Rent, labor, and other costs will be borne by LI NING, and opening more stores also means that LI NING will have more stores that need to clear inventory through discounts.

Reflected in this year's first-half financial report, LI NING's sales and distribution expenses increased by 16.7% YoY to 3.948 billion yuan, with a 0.9 percentage point increase in the proportion of revenue; administrative expenses increased by 14% YoY to 591 million yuan.

Adjusted Metaphor

Compared to the industry inventory crisis fifteen years ago, LI NING appears more composed this time.

By the end of the first half of this year, LI NING's inventory level reached 2.12 billion yuan, a year-on-year increase of 7.3%. Among them, finished products increased by 8.14% compared to the same period last year, while work-in-progress decreased by 18.05%. The inventory turnover days increased by 2 days to 57 days.

From 2020 to 2022, thanks to the distribution channel maintaining a revenue share of 48% and distributors sharing inventory risks, as well as the increase in the proportion of e-commerce channels driving faster inventory turnover, LI NING's inventory turnover days continued to decrease even during the three years of the pandemic, from 67.3 days in 2020 to 56.77 days in 2022.

In the first half of the year, LI NING's accounts receivable structure also underwent corresponding adjustments.

Overall, accounts receivable increased by 6.5%, but the proportion of accounts receivable aged over 90 days beyond the credit period decreased by 1.06 percentage points to 15.66%, while the proportion of accounts receivable aged less than 60 days increased by 3.72 percentage points compared to the same period last year.

Reducing the proportion of high-aged accounts receivable means that LI NING has a higher chance of recovering funds from distributors, and the amount of provisions for bad debts is correspondingly reduced. During the reporting period, the provision for accounts receivable decreased by 26.78% year-on-year to 153 million yuan.

Active or passive adjustments are also reflected in LI NING's product structure.

Since the mid-year report of 2022, the revenue share of LI NING's footwear products has surged from 42.1% to 54.5% compared to the previous year, and has maintained a revenue share of over 50% for footwear products. In the first half of this year, LI NING's footwear products contributed revenue of 7.515 billion yuan, a year-on-year increase of 11.2%, accounting for 53.6%; while clothing products contributed revenue of 5.64 billion yuan, accounting for 40.2%.

This change in product structure has both advantages and disadvantages.

The disadvantage is that the gross profit margin of footwear products is generally lower than that of clothing.

The advantage is that sports shoes can better reflect the functionality of the products and the professionalism of the brand. Sports brands are more likely to focus on athletes or runners, demonstrating how their products enhance the performance of athletes through sponsorship, rather than focusing on apparel. For example, Nike's achievements with Michael Jordan have contributed $6.6 billion in revenue to the AJ brand.

Fashion and trends are only temporary, as evidenced by the growth bottleneck encountered by LI NING's fashion-oriented products. The once popular "China LI NING" sub-brand has also become a concern in sell-side research reports, questioning whether it can make a comeback. According to a report from China International Capital Corporation, China LI NING's revenue declined by 6% year-on-year last year.

Whether LI NING's professional sports products can continue to drive growth will also face severe challenges.

Adjustments are taking place, at least as shown in the earnings report.

In this mid-year report, LI NING made some changes in its outlook, for the first time proposing to "continuously increase the proportion of professional products" and no longer emphasizing "injecting fashion elements into professional products" in terms of marketing, but instead stating the goal of "becoming the preferred professional sports brand for consumers".