1H22 results in line with our expectations

Zhang Xiaoquan Inc. announced its 1H22 results: Revenue increased 32.8% YoY to Rmb439mn, net profit attributable to shareholders dropped 22.5% YoY to Rmb34mn, and recurring net profit fell 35.3% YoY to Rmb28mn. Non-recurring gains and losses were mainly contributed by higher government subsidies, and the results were largely in line with our expectations. The decline in profit was mainly due to the disruptions in product delivery and offline traffic caused by COVID-19 resurgence. Also, Yangjiang capacity ramp-up and higher raw material prices have led to higher unit costs.Specifically, in 1Q22 and 2Q22, revenue rose 28.1% and 37.4% YoY, net profit attributable to shareholders dropped 46.0% YoY and rose 3.0% YoY, and recurring attributable net profit declined 47.2% and 21.9% YoY.

Trends to watch

Strong products, distribution channels and brand power contributed to rapid revenue growth. In 1H22, revenue from knives and scissors, kitchenware and kitchen appliances, and household hardware products grew 18.2%, 105.4%, and 1.7% YoY. The company is sticking to its policy of developing high-end knives and scissors and is further diversifying its kitchenware and kitchen appliance product portfolio. The company maintained rapid revenue growth. In 1H22, revenue from domestic and overseas channels increased 30.18% and 459.4% YoY. In 1H22, revenue from domestic online platforms such as Tmall and Douyin grew 26.3% and 2,592.6% YoY. The company has proactively expanded the online market and it has become one of the top five merchants in the kitchenware category on Douyin, consolidating the traditional e-commerce leader position and vigorously developing new e-commerce channels. The company continued to improve its offline channels, setting up 12,500 new stores and innovatively creating a franchise model. Meanwhile, the company has successfully fostered overseas high-quality customers and we expect it will enter overseas markets. The company continues to develop its brand, with its total brand exposure reaching over 110 million visits on its online marketing platform.

Yangjiang capacity ramp-up, rising raw material and marketing costs weighed on the company’s profitability. In 1H22, the company's gross margin declined 4.8ppt YoY to 36.8%, mainly due to the continuing raw material price hikes. Meanwhile, production capacity of the Yangjiang plant is still ramping up, resulting in a YoY increase in unit manufacturing cost. In terms of expenses, the company's selling, G&A and R&D, and financial expense ratios increased 2.2ppt, 0.5ppt, and 0.2ppt YoY to 17.2%, 9.9%, and 0% in 1H22. The increase in selling expense ratio was mainly due to the increase in the proportion of direct sales and the increase in the customer acquisition cost in traditional e-commerce channels. Under the combined pressure, the company's 1H22 net profit margin dropped 5.6ppt YoY to 7.8%.

Upbeat on medium and long-term growth potential on diversified product portfolio, improved channels and smooth capacity ramp-up. 1) Products: For the knives and scissors segment, the company focuses on its core products and on developing high-end new products such as forged round-headed slicing knives and blade series sets. We expect the proportion of new, high-end products to keep increasing, driving up overall sales growth. In the kitchenware and kitchen appliances segment, the company continues to promote the R&D of new products and the application of new materials and processes and continues to improve the matrix of categories such as cutting boards and meat grinders, which has strong revenue performance. 2) Channels: The company continues expanding its presence in online and offline channels and developing new marketing models based on consolidating its existing channel advantages. We expect it will continue to strengthen its channel advantages and achieve a future breakthrough in the export business. 3) Production: The company's capacity ramp-up in the Yangjiang plant may dilute unit costs in the future, and its profitability is likely to further improve.

Financials and valuation

Given the short-term negatives such as COVID-19 resurgence, we lower our 2022 and 2023 earnings forecasts 10% and 9% to Rmb85mn and Rmb110mn. The stock is trading at 28x 2022e and 22x 2023e P/E. We maintain OUTPERFORM and cut our TP 7% to Rmb20 based on lower earnings forecasts. Our TP implies 36x 2022e and 28x 2023e P/E with 29% upside.

Risks

Sharp fluctuations in raw material prices; intensifying competition; risksrelated to outsourced manufacturing.