About 361 Degrees International
361 Degrees International Limited is a leading Chinese manufacturer and wholesale supplier of shoes and other sports apparel. Established in 2003 and currently headquartered in the province of Fujian in the People's Republic of China, 361 Degrees currently commands a total market valuation of more than HKD3 billion. The company was listed on the Hong Kong Stock Exchange in 2009.
The company's name has always been a source of interest to curious observers, who point out that there are no more than 360 degrees in a circle. In fact, 361 Degrees began life as Bieke (Fujian) Footwear Enterprise Limited in the early 1980s, with its founder Ding Jiantong at the helm. Its flagship product, the Bieke sports shoe brand, made rapid inroads across China, to the extent that the company was emboldened to introduce a wider range of products by expanding into the garments and accessories segments.
Eventually, Bieke (Fujian) Footwear Enterprise Limited renamed itself. In embracing the '361 Degrees' name for both the company and its eponymous shoe brand, company founder Ding noted that the extra degree represents the company's dedication to innovation and creativity in the manufacturing process. 361 Degrees further underscored its commitment by changing the company slogan to 'One Love' in 2009.
A large proportion of 361 Degrees' products target the mid-market segment with shoes priced within the RMB200 to RMB500 range. The company relies on an aggressive pricing strategy; it usually prices its products slightly below those offered by its competitors. To mitigate the dampening effect that such a strategy may have on its margins, 361 Degrees relies on strategic product variations to capture revenue from other segments.
For example, while 361 Degrees might have a standard brand of running shoes that retail for RMB350, the company would also issue 'special edition' shoes from time to time that retail for RMB800. This is one of the many ways in which 361 Degrees caters to other customer segments, its focus on the low- to mid-market segment notwithstanding.
In 2010, 361 Degrees announced its foray into sports footwear and apparel for children with the inception of the '361 Degree Kids' brand. By 2016, this segment constituted 13% of the company's aggregate revenue.
Financial Highlights
Revenue growth for the year ended 31 Dec 18 was tepid, with company-wide sales gaining 0.6% to reach RMB5,187.4m (2017: RMB5,158.2m). The bulk of the company's revenue was derived from the firm's eponymous core shoe brand, which contributed 82.7% of total revenue. Products housed under the company's Kids division accounted for some 15.7% of company revenue, while other miscellaneous products accounted for 1.6% of company sales.
The lackluster revenue growth was largely due to a broad-based decline in Average Wholesale Price ('AWP') across many product segments. The AWP in the adult footwear segment declined from RMB108.1 in 2017 to RMB97.9 in 2018, a decline of almost 10% year-on-year ('YoY'). In the adult apparel segment, AWP dropped 7% to reach RMB71.3 (2017: RMB76.7).
One bright spot was the adult accessories business, which registered a gain of 23.9% in its AWP to reach RMB14.0 in 2018 (2017: RMB11.3). The AWP of products housed under the Kids division gained 12.8% during the same period.
The evolution of average wholesale prices means little in isolation, unless we examine their evolution in the context of overall revenue changes. Even though AWP at the adult footwear division declined 9.4% for the year ended 31 Dec 18, division revenue declined approximately 4.1%. We obtain the same picture at the apparel division, where division revenue registered an increase of a mere 0.6%, even though average wholesale prices dropped 7.0%.
The fragile situation becomes even more apparent when we look at the accessories division. While average wholesale prices gained more than 20%, division revenue slipped 2.3% to RMB76.0m (2017: RMB77.8m).
If the broad-based drop in wholesale prices was an attempt by 361 Degrees to maintain its market share in response to ferocious industry competition, this strategy is clearly not bearing fruit. For 2018 at least, the increase in the number of product units sold was not enough to compensate for the loss of revenue resulting from lower general pricing. Furthermore, given that it is much easier for a player to adjust prices downward than to do so upward, this does not augur well for 361 Degrees going forward.
At the group level, cost of sales increased 2.7% YoY to RMB3,081.6m in 2018 (2017: RMB3,001.8m). With group revenue increasing by a mere 0.6% during this period, the aggregate gross profit margin declined 1.2 percentage points to reach 40.6% in 2018 (2017: 41.8%).
Approximately 40% of the company's manufacturing output is produced in-house whilst the rest originate from third-party outsourced facilities. The cost of sales of self-produced footwear and apparel declined 2.3%, on the back of lower labor and raw material costs.
What contributed to the rise in overall cost of sales were costs incurred by outsourced production, particularly by third-party suppliers that produced apparel for 361 Degrees. Costs at this segment jumped from RMB979.1m in 2017 to RMB1,090.1m in 2018, a gain of 2.8%. Since more than two-thirds of the company's production capacity is outsourced, few would be surprised at its oversized impact on the company's overall cost structure.
We are quickly disabused of the idea that the above figures were a one-time occurrence, after taking a look at the company's financials over a longer period. The company's gross profit margin has remained largely stagnant over the past five years, whilst its operating profit margin experienced significant deterioration during the said period.
In 2015, operating profit margin came in at 20.5%. By 2017, the margin had been reduced to 19.1%. In 2018, the operating margin was 15.1%.
We see the depressed operating margins as evidence of 361 Degrees' poor cost discipline over a long period of time, particularly in the management of fixed operating expenses. In its 2018 annual report, the company's management noted that staff salaries had increased by 22.5% as the hiring of new marketing staff gained pace and the company further increased existing staff salaries. This occurred in the backdrop of a general increase in advertising expenditure, which reached RMB557.3m in 2018 and accounted for 10.7% (2017: 9.8%) of group revenue.
While advertising and marketing is a necessary expense, we think that an increase of more than 20% in staff costs in a single year reflects a general lack of cost discipline, especially in the context of flat revenues. There is little doubt that advertising and marketing efforts have the potential to boost sales, but any such impact is usually transient in nature.
Furthermore, we are also concerned with 361 Degrees' deteriorating ability to move inventory and manage outstanding receivables. In 2018, inventory on the company' books reached RMB1,051m, an increase of 29.2% (2017: RMB813.7m). The firm's working capital cycle for the year ended 31 Dec 18 was 75 days, a sharp increase from the 2017 figure of 60 days. The trade receivables cycle in 2018 was 160 days, an increase of five days against the 155 days registered in 2017.
Debt Servicing and Cash-Flow Related Metrics
361 Degrees experienced a marked deterioration in its cash-flow profile in 2018. For the year ended 31 Dec 18, free cash flow ('FCF') [cash generated from operations less capital expenditure] came it at RMB515.7m, a drop of 48.3% relative to FCF of RMB998.3m generated in 2017.
In relation to debt servicing, financing costs remained largely stable at RMB211.6m in 2018 (2017: RMB213.7m). However, as profit from operations declined to RMB782.3m in 2018 (2017: RMB987.6m), EBIT/interest declined from 4.62x in 2017 to 3.69x in 2018. EBIT/interest is a measure of a company's ability to service its debt; it broadly corresponds to the firm's ability to rely on current-year earnings to pay the costs associated with its current debt load.
Should We Write off the 361 Degrees Bond Issue?
At present, 361 Degrees has a single outstanding issue (DEGREE 7.250% 03Jun2021 Corp (USD)), which matures in 2.2 years and carries an annual yield to maturity ('YTM') of approximately 13.7%.
Admittedly, given the relatively dispiriting analysis of the company's fundamentals in the earlier sections, one might be inclined to believe (erroneously) that we are not in favour of any bond issued by the firm. On the contrary, with the bond yielding in excess of 10%, a closer look at the company's fundamentals as well as the underlying structure of the bond issue appears to be in order.
The main assets on the company's balance sheet are listed in the table below:
Table 1: Major assets of 361 Degrees
Asset |
Value (RMB’000) |
Property, Plant, Equipment and Interests In Leasehold Land |
1,146,519 |
Other Financial Assets / Deposits / Prepayments and Deferred Tax Assets |
168,439 |
Inventories |
1,051,099 |
Trade Debtors and Bills Receivables |
2,399,271 |
Deposits, Prepayments and Other Receivables |
720,980 |
Bank Deposits and Other Cash Equivalents |
6,478,686 |
Source: 361 Degrees 2018 Annual Report, iFAST compilation |
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The estimated recovery value of each of these items is further represented in the table below:
Table 2: Liquidation analysis
Asset |
Value (RMB’000) |
Estimated Recovery Percentage* (%) |
Estimated Recovery Value (RMB’000) |
Property, Plant, Equipment and Interests In Leasehold Land |
1,146,519 |
60 |
687,911 |
Other Financial Assets / Deposits / Prepayments and Deferred Tax Assets |
168,439 |
100 |
168,439 |
Inventories |
1,051,099 |
50 |
525,549 |
Trade Debtors and Bills Receivables |
2,399,271 |
80 |
1,919,416 |
Deposits, Prepayments and Other Receivables |
720,980 |
100 |
720,980 |
Bank Deposits and Other Cash Equivalents |
6,478,686 |
100 |
6,478,686 |
Total |
10,500,981 |
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Source: 361 Degrees 2018 Annual Report, iFAST estimates |
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The issue size of the DEGREE 7.25% '21s is USD400m and is carried on the company's balance sheet as non-current interest-bearing liabilities at a value of RMB2,714.3m (as at 31 Dec 18).
Apart from these bonds which are carried on 361 Degrees' balance sheet as senior unsecured liabilities, the company also has RMB2,766m in current trade and other payables together with RMB112m of bank loans and RMB478m in taxation and deferred tax liabilities. Even if we were to assume that all these liabilities had to be paid off first before the bonds could be satisfied, it is clear that the estimated recovery value of the available assets is well in excess of the bond liabilities.
The skeptical reader may point out that the above analysis is premised on the company's balance sheet as of 31 Dec 18, and that cash holdings would probably not be at the same level at the point of default. While there is merit to this argument, we recall that the outstanding bonds mature in just about two years.
In addition, cash holdings make up a very large part of the company's total assets. We think that it is very unlikely that these cash holdings would vary by a significant degree during this short period, short of a drastic change in operating strategy or major acquisition.
Furthermore, there is a very low risk of default in relation to the 361 Degrees bonds. A Bloomberg default-risk measure pegs the two-year cumulative risk of default of the company at just 1.08%. Relative to the bond's yield to maturity of more than 10%, it is clear that investors are being well-compensated for the credit risk involved.
Conclusion
It is undeniable that 361 degrees faces a number of challenges at the operational level. These observations notwithstanding, a positive investment case can be made in relation to the DEGREE 7.250% 03Jun2021 Corp (USD).
The risk of default remains low. Furthermore, the double-digit annual yield that the bond carries more than compensates for 361 Degrees' credit risk. Even in the unfortunate situation of a default, the assets carried by the company should provide sufficient coverage for its liabilities, and the notes are unlikely to suffer significant permanent impairment.
Appendix: Probability of Early Redemption
Certain covenants provide for 361 Degrees to redeem the DEGREE 7.25% '21s, at the company's option, at any time before the stated maturity date of 3 Jun 21. If the company exercises this right on or after 3 Jun 19, the applicable redemption price would lie in the range of 101.8125 cents (if called before 3 Jun 20) to 103.625 cents on the dollar (on or after 3 Jun 20). Given the bond's current trading price of 89.713 (as of 1 Apr 19), this would result in significant gains for the investor.
We think it is unlikely that the company will exercise its right to prematurely redeem the outstanding issue over the coming two years. The bond was issued to the public on 3 Jun 16. At the end of the same year (i.e. as of 31 Dec 16), the company had a current ratio (current assets/current liabilities) of 3.58x. During the intervening period to the present moment, the company's liquidity position has not improved.
As of 31 Dec 18, 361 Degrees had a current ratio of 3.17x. Redeeming the bonds without raising new capital would bring the company's current ratio to a mere 2.36x, significantly reducing its liquidity.
Given that YTM on its bond is currently in excess of 10%, the cost of raising new funds either through an equity offering or other means is likely to be prohibitive. Such a move would make little financial sense since return on shareholders' equity in 2018 was just 5.3%.
Given that the management felt that they should raise cash in 2016 whilst its current ratio was then at a higher level than it is presently, an early redemption of the notes at this point seems to be an unlikely occurrence. Of course, this possibility cannot be totally excluded, especially if financing costs for the company fall significantly. But if a redemption were to occur, that would be a very optimal outcome for noteholders.
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.