Corporate Watch: Looking to make a bigger footprint

By Alan Lok,
FRM Investment Analyst
SIAS Research

Jinjiang, on the southeastern coast of Fujian, has evolved over 20 years from a rural county into one of China's largest production base for sports and leather shoes. Together with the city of Dongguan, they are regarded as the world's primary production base for sport shoes.

The city is home to a number of dominant enterprises and prominent brands, including Anta, Bieke, Aiqi and China Eratat. Currently, there are more than 3,200 enterprises manufacturing sport shoe related products in the city with an annual output value worth about RMB 27.9 billion. (S$1 = 5.017 RMB)

The city was officially conferred with the title of "National Sports Industry Base" by the General Administration in Sport of China at the end of 2007, further strengthening its position as a sport product manufacturing hub. In fact, Jinjiang current annual production output accounts for a quarter of China's total output or one-eighth of the world's total output.

In the midst of such intensive competition, China Eratat has grown into a full-fledged sport shoe manufacturer with an annual production capacity of approximately 7.2 million pairs of sport shoes as of June 2008. Its products are sold across 21 provinces and cities in China at approximately 1400 retail locations, of which 800 are specialty stores.

From OEM to OBM

Initially an original equipment manufacturer (OEM), Eratat has fully transformed itself into an original brand manufacturer (OBM). For the financial year ended 31 March 2008 (FY08), OEM production accounts for only 10.7% of Eratat's sport footwear revenue of RMB 297 million.

Unlike OEMs, OBM players tend to have greater control over their pricing power and do not rely on a single or few major customers for their price sensitive orders.

The jump from OEM to OBM however had not been easy for Eratat though. It required tremendous amount of commitment in terms of time and effort to build up distribution relationships as well as embarking on a coherent series of marketing campaigns.

Following the transition, regular spending on advertising and promotion (A&P) activities has become an essential item, which if mismanaged may not have the desired marketing effect and could result in margin erosion. So far, over the previous four years, Eratat has spent around an average of 9% of its revenue on selling & distribution expenses, a figure that is well below the safety line.

But, what is impressive is the way the company launched their China Olympic 2008 marketing campaign. Eratat is the sole sponsor of the making of the Beijing Olympics theme song – "Jia You Zhong Guo" which was commissioned by the Beijing Olympics Committee to rally the entire nation to support its Olympics athletes.

This song has been broadcast since April 2008 on 150 television stations and 18 satellite stations throughout China. The music video showcases eight Chinese Olympic athletes who donned the T-shirt with Eratat brand name emblazoned on it. Eratat has also secured the rights to use any of the eight athletes over the next two years for its own advertising campaigns and promotional activities. The cost of production was only a fraction of what any advertiser would pay for 10-20 seconds footage on any single TV station during prime time for a limited period of time.

As for the distribution network, Eratat's approximately 1400 outlets since the end of FY08 comprises mainly specialty stores, shop-in-shops and other retail locations in the provinces of Anhui, Zhejiang, Guangdong, Fujian, Guangxi, Hebei, Beijing, Jiangxi & Tianjin. The retail outlets are mainly concentrated along the coastal provinces where purchasing power and acceptance to newer fashion are relatively higher.

Marketing issues aside, Eratat strategic locations within the city of Jingjiang and Quangang directly translate into close proximity to essential supporting industries enabling the company to source raw materials at more reasonable prices.

Challenges ahead

On the macro side however, Eratat certainly has challenges ahead.

The rising cost of raw materials, appreciation of the RMB, the resurgence of the anti-dumping lobby in the US and the shortage of skilled labour are some of the issues facing sport shoes manufacturers in China. In fact, we have witnessed a softening in the total export value of Chinese sport shoes during the first half of the year.

With further appreciation of RMB and antidumping lobbyist activity in the pipeline, it would be wiser for existing OBM players to focus on domestic consumption.

And with more than 40,000 shoe manufacturing plants churning an annual output of 6.5 billion pair of shoes in China, the market is virtually flooded with hoards of local brands. It has even been labeled as a "red sea" competition with many expecting price wars to erupt among the various OBM players after the 2008 Olympics.

Nevertheless, given that Eratat is selling between 7 to 10 pairs of sport shoes (Relative to 36 pairs of a major rival brand) on a per outlet per day basis, there is still potential for further growth especially in the light of the booming middle class in China which accounts for 22% of the Chinese urban population as of 2005, according to a McKinsey Global Institute report. Based on a projection from the same report, this figure is expected to reach 71% by 2015.

Based on this 71% projection, we can further assume that if each person uses about 3 pairs of sports shoes per year which is conservative when compared to the USA (7.6) and UK (5.6), that would work out to a demand of 3,945 million pairs of sport shoes per year!

Increased production capacity

By the end of FY09 (Mar 2009), Eratat will have 10 sports footwear production lines up and running, manufacturing about 11.5 million pairs of shoes per year. As for the sport apparel segment, the group will be setting up 50 production lines in-house that will give them a capacity of 6.2 million pieces of apparel per year.

Even then, Eratat total sport shoes production will only occupy about 0.5% of total sport shoes consumed in China based on 2005 figures and an even smaller 0.29% based on 2015 projected figures. All capital expenditure required will come from the recent IPO proceeds as well as internally generated funds.

By producing the bulk of their sports apparel in-house, Eratat would have a better control on product quality while at the same time widen the profit margin of this business segment. As this is Eratat’s maiden attempt at producing sports apparel, one should remain mindful of any execution hiccups, by extending some discount with regards to revenue and profit contribution from this business division.

Source: Bloomberg

On a comparative basis, Eratat’s 15.5% net profit margin is higher than industry leaders such as Li Ning and Nike. This gives the company some cushion in event of price wars after the 2008 Olympics. Based on market cap alone, Eratat ($73 millipn) is one of the smallest OBM sport shoes players in China.

However, at a price earnings ratio (PER) of just 3.7 times, the counter still looks cheap for any OBM player, regardless of size. This greatly limits the down side risk of this counter and when the current financial turmoil in the market clears up, we expect to see some upward movement.

Going forward, the ability to keep costs down below industrial average level will be the key factor that will determine whether China Eratat can remain lean and healthy during any future price war while at the same time buying itself sufficient time to build up brand equity.

*This article will be reproduced in Mandarin in the August issue of the Fortune Times magazine. www.FortuneTimes.sg