3Q12 results review

Changyu reported net profit of Rmb242mn in 3Q12 (-37.5% YoY),and a 16% drop in revenue, significantly lower than our and the market’s expectations. Sales declined ~10%/~20% YoY in July/August, and stayed flat YoY in September. The weak performance was due to the negative impact of the p esticide incident, which delayed and decreas ed distributors’ order placement during the consumption peak season of mid-Autumn festival and the N ational Day holiday. Gross margin expanded 1.5ppts to 68.9% as the company purchased lower priced grapes from northwest China, while the p roduct mix deteriorated given the decline of Castel wines. Selling exp./sales ratio jumped 10.3ppts to 37.1% as Changyu increased marketing and promotion investment after the pesticide scandal, in a bid to stabilize sales.

Factors to watch

Sales could record a moderate YoY decline in October, as the impact of the pesticide incident lingers, and we expect flat sales growth in 4Q. Gross margin could edge up slightly given the lower cost grapes, but selling exp./sales ratio could rise as the company is still investing in promotions, which could lead to net profit decline in 4Q.

We think the impact of the pesticide incident will gradually fade and Changyu could bottom out from 2013, especially on a low comparison base. Internally, Changyu is restructuring its sales system and improving its sales force assessment system, through which Changyu could find new growth drivers and enhance its sales efficiency. The company will launch three new Chateau wines overend-2012~beginning-2013, aiming to boost revenue and compensate for the weak performance of Castel wines. In 2013, we expect 17% sales growth and 25% net profit increase on new product launchesand the ramping up of imported wine business, gross margin is expected to edge up slightly and SG&A/sales ratio to narrow down.

Valuation and recommendations

We maintain our BUY rating given its recovering outlook from 2013. We roll forward our HK$52.7 target price to end-2013. The B-share is trading at 10.6x 2013e EPS vs. its historical average of 18.1x and the F&B average of 22.3x; its PEG is low at 0.51.

Risks

Lower-than-expected industry growth.