Goldman Sachs maintains ‘buy’ rating for CTG Duty Free amid probable Chinese downtown duty free breakthrough

CHINA. Global financial institution Goldman Sachs has cited two key factors in maintaining its ‘buy’ rating on China Tourism Group Duty Free (CTG) stock, after the China Duty Free (CDFG) parent company posted robust 2023 financial results late last week.

In a note, Goldman Sachs Global Investment Research said: “We are Buy-rated on CTGDF, based on two potential sources of earnings upside in relation to the airports: (1) lower revenue sharing paid to the airports from 2024E onward per regulations; (2) opening up of downtown duty-free stores to outbound Chinese travellers which we expect to be approved in 2024E.

“Pre-departure shops just a matter of time”

As reported, CTG’s 2023 revenue rose +24.1% year-on-year to RMB67,540 million (US$9.3 billion), while net profit increased +32.8% to RMB6,790 million (US$939.4 million).

“At the current share price, the stock’s valuation looks less demanding, with A-shares FY24E P/E below mid-cycle levels. Key catalysts include (1) policy relaxation of pre-departure downtown DFS stores to outbound Chinese travellers; and (2) margin recovery in the coming quarters,” said Goldman Sachs.

The positive view was mirrored by HSBC Global Research, which also maintained its Buy rating. Looking ahead to 2024, sales growth in Hainan may still face challenges, but profitability will improve, the firm said, elevating its target price on CTG’s H shares from HK$116.5 to HK$120.3.

The opening of South Korean-style downtown duty free shops – whereby Chinese travellers can purchase pre-departure, collecting at the airport – has been widely touted in Chinese travel retail circles over recent years.

The likelihood of such a breakthrough gained traction in early 2023 when CTG took a 49% stake in fellow state enterprise China National Service Corporation (CNSC), a subsidiary of Sinopharm, which (besides its airport, offshore and land border shops) operates a diverse array of post-arrivals downtown duty free stores in Mainland China. Those stores could easily be adapted to a pre-departures model.

CNSC operates 29 stores at home and one abroad. Its downtown network is the big prize and will be particularly attractive to CDFG given the likely imminent introduction of traditional pre-departure downtown duty free shops in China. – The Moodie Davitt Report, 16 March 2023

Following its participation in a post-results investment call on 29 March with CTG senior management, Goldman Sachs reported:  “As for the timing of potential pre-departure downtown DFS policy relaxation, management still believes it is just a matter of time that it will get approved and is hopeful it will get announced soon now that international travel has been on track to a full recovery (i.e., ~70% recovery as of late). They are still working to renovate and upgrade their stores to prepare for it.”

The opening of pre-departure downtown shops fits with central government’s desire to maximise domestic consumption and repatriate overseas spending where possible. Any such development would, however, alarm foreign duty free retailers with a heavy reliance on Chinese travelling shoppers.

Airport sales rebound, Hainan “steady”

Looking at Q4 2023 results, Goldman Sachs noted group revenue grew +12% quarter-on-quarter to RMB16.7 billion (US$2.3 billion) driven by a ~20% quarter-on-quarter recovery of airport duty free sales. It estimated Hainan’s contribution as a “relatively steady” +5% quarter-by-quarter.

Gross margin contracted by -2.4 points quarter-on-quarter to 32% (vs. 34.5% in 3Q23) on typical promotional efforts during a peak holiday season, but improved considerably from 26.4%/21% in Q421/Q422. This reflected a revenue mix shift toward offline airport duty free business where the group generates better margin vs. online sales, the report said.

EBIT margin was steady quarter-on-quarter at 10.6% in Q423 thanks to savings in selling expenses (-7% quarter-on-quarter), driven by a revised rental contract with Shanghai Airport Group effective from December 2023.

Other key findings

* Sunrise Shanghai’s net profit improved from barely break-even in H123 to a RMB249 million positive contribution in H223 on the back of a +17% half-on-half revenue increase.

* Hainan duty free net profit dropped ~-43% half-on-half to ~RMB1.0 billion in H223 with a 7.9% net margin against a -32% half-on-half revenue decline. This reflects the local crackdown on daigou activities since March 2023.

* After more than a year since opening (28 October 2023 -Ed), the cdf Haikou International Duty Free Shopping Complex posted a small net profit of RMB33 million (US$4.6 million) last year. Revenue was quarter of that generated by the long-established cdf Sanya International Duty Free Shopping Complex (RM6.8 billion/US$940 million vs. RMB28 billion/US$3.9 billion in FY23).

Conference call highlights CTG management maintained a “cautiously optimistic” tone on business outlook, noting steady improvement in international air passenger numbers, shopper conversion rate and average per-shopper spending at airport duty free stores in recent months. CTG is seeing month-on-month improvement of international flight capacity. For instance, February’s international passenger traffic at Shanghai Pudong/Beijing Capital/Guangzhou airports has further recovered to 79%/40%/75% of FY19 levels Shopper conversion has been improving amid an increase in leisure travellers. Average spend per passenger at select airports is recovering to near FY19 levels. Stronger sales recovery for tobacco and alcohol, while beauty products recovery has been gradual. Renovation of Hong Kong International Airport wines, spirits, tobacco and gourmet foods stores is complete with similar plans for Shanghai Pudong International. The company plans to introduce new categories such as mobile phones and other electronics to the store network. Further margin upside expected driven by ongoing revenue mix shift toward higher-margin offline channels especially after the enhancing of key airport retail contracts. In Hainan, the company saw strong demand during the recent CNY holidays, boosting daily duty free sales run-rate to RMB210 million (US$29 million) in February compared with RMB116 million/US$116 million) in January. Sales contribution from cosmetics in Hainan has fallen to 38% as of late (vs. 60-70% in FY20), while contributions from accessories (e.g. jewellery and watches) and apparel have risen significantly to 30% and 23% respectively. Rising demand for high-end luxury brands and ‘China chic’ noted. More new and exclusive brands, as well as limited-edition products to be added. After opening Block C at cdf Sanya International Duty Free Shopping Complex in late 2023, anchored by the Global Beauty Plaza, the company aims to introduce more high-end luxury brands, alcohol and F&B stores at Blocks A & B. More luxury stores to be added this year at cdf Haikou International Duty Free Shopping Complex, including Prada, Miu Miu and Gucci. A 3,000sq metre Whiskey Museum is scheduled to launch in Q3. Inventory management has improved with inventory days having reversed an upward trend, dropping to 177 days in Q423 (vs. 228/220 days in Q2/Q323) with further lowering targeted by continued supply chain management. In response to intense online competition from the likes of Douyin and Tmall International, CTGDF has been adjusting its pricing strategy and has refrained from participating in an intense price war since FY22. The group is negotiating with brand owners closely to resolve irrational pricing and/or mispricing issues. Some bigger brands have already narrowed their pricing discounts offered in duty-paid sales channels, which serves as a positive signal, the group noted. Management is hopeful a pre-departure downtown duty free policy relaxation will be announced soon now that international travel is on track to a full recovery (i.e., ~70% recovery as of late compared to pre-pandemic levels). The company is working to renovate and upgrade their stores to prepare for such a policy change. Source: Goldman Sachs Investment Research

Upbeat prospects

Goldman Sachs forecasts +16% year-on-year core earnings growth for the group to RM7.7 billion (US$1.1 billion) in FY24E driven mostly by increased contribution from airport duty free (RM1.8 billion vs. RMB0.2 billion in FY23).

In Hainan, the firm forecasts +10% year-on-year growth (industry-wide) to RMB61 billion (US$8.4 billion) in FY24E (vs. RM55 billion in FY23 or the peak year of RM60 billion in FY21) – “assuming no significant relaxation of daigou crackdown as some investors anticipate”.

The report added: “We expect Hainan’s duty-free sales growth rate to look more favourable on a year-on-year basis as the impact of daigou crackdown starts to lapse from Q2-Q324.” ✈