Eratat Lifestyle

Kim Eng on 18 May 2012

Background: Eratat Lifestyle designs, manufactures and distributes retail attire and footwear, which are
marketed under its brand “ERATAT”. The products are sold in 830 specialty shops and shop-in-malls located
in first- and second-tier cities in China.

Why are we highlighting this stock? Worries mount for Eratat as investors are shaken by several events
occurring in the past year, namely, a lump-sum payment of CNY52m to its distributors, adjustment of receivable terms from 61-90 days to 90-120 days and renovation subsidy costs which could persist until 2Q12. Despite management’s reassurances and consistent internal audits, investor confidence is at an all-time low.

Sales incentive amounted to 35% of net profit in FY11. Eratat achieved record sales in FY11, breaking the CNY1b mark for the first time in its history. As a bonus, the group paid CNY4.3m to each of its 12 distributors. This sales incentive totalled CNY51.7m and effectively accounted for 35% of its FY11 profit. Eratat cited two reasons for its action: (1) distributors’ loyalty to the group and (2) their valiant efforts in achieving record sales. Subsequently, dividend payout was lowered to 8% against 12% in FY10, while cash pile remained high at CNY222m as of 4Q11. For investors, this was understandably a difficult pill to swallow.

Receivables lengthened. Questions were raised when receivable terms were extended from 61-90 days to 90-120 days. Management explained that the move was in line with its brand repositioning from footwear to lifestyle and premium apparel, as well as to encourage distributors to open more specialty shops, thereby strengthening its distribution network. It stressed that no receivables have defaulted to-date.

Slow sales with change in product mix. Eratat’s 1Q12 results showed that the change in product mix has slowed down sales by 19% YoY to CNY187.7m. The 64.1% YoY plunge in net profit to CNY13.5m was
attributed to renovation subsidy costs of CNY20.9m for distributors to renovate 370 shops in 1H12, as well
as higher salary adjustments. While the stock trades at dirt-cheap valuations, better business execution to enhance shareholder value and a higher degree of transparency would serve as positive catalysts at this stage.