Outperform

Key Data
Market Price (as at 17 March 03):	HK$0.54
Target Price:	HK$0.69
Stock Code:	0264.HK
No. of outstanding shares	307.7M
Market Capitalisation:	HK$166.1M
Major Shareholders:
Mr. Edwin Chan	22.01%
Mr. Stanley Chan	22.01%
Ms. Rebecca Chan	12.74%
Mr. Chan	12.74%

A Compelling Industrial Play

Strong customer base Chanco has established close relationship with customers including renowned brands such as Uniqlo, Calvin Klein, Armani Exchange, Polo Ralph Lauren, Gap, and Esprit.

Proven track record The management has more than two decades of experience in the industry. Turnover and net profit have grown substantially between FY00 and FY02.

Expansion of markets Tapping the huge retail market of the mainland, the group will increase sales in mainland. The growth of customers such as Esprit in Europe and Gap in the US will also contribute to sales increase.

Undemanding valuation With the expected FY03 and FY04 P/E at 4.7x and 3.5x respectively, valuation is undemanding among industrial peers.

($’000)	FY00A	FY01A	FY02A	FY03E	FY04E
Turnover	88,611	102,113	150,388	153,395	181,006
Gross Profit	32,516	26,715	58,648	52,154	65,162
Net Profit	19,700	12,951	41,748	35,625	47,061
EPS(HK$cents)	6.4	4.2	13.6	11.6	15.3
PER(x)	9.4x	14.3x	4.4x	4.7x	3.5x

Source: Chanco, Tung Tai estimates

Company Backgound

Based in Dongguan, Chanco is principally engaged in design and manufacture of men’s and ladies’ leather accessories on OEM and ODM basis. Chanco was established in the 1970s and has more than 20 years of expertise in the leather belts business. In FY02, belts accounted for 98% of the group’s turnover. Small leather goods and leather took 1% shares respectively.

Chanco has developed a broad customer base. Major customers include Uniglo, Calvin Klein, Gap, Armani Exchange and Esprit. The group aims to target middle to high-end markets. Besides manufacturing on OEM basis, Chanco develops its own brand-STRANGER, which was launched in November 2002.

Through various fashion apparel retailers, Chanco’s products were sold around the world. Japan is Chanco’s biggest export market, accounted for 62% of turnover in FY02.

Chanco uses different types of leather including genuine leather, synthetic leather, bonded leather and webbing belts for manufacturing belts. Genuine leather is the major raw material used by Chanco. The Group sources genuine leather from various countries such as Brazil, Italy, USA, South Korea, Hong Kong and Taiwan.

Competitive Strengths

Strong Customer Base Chanco has a broad customer base that customers are renowned fashion brands. The group has maintained close relationship with customers in which Calvin Klein, Armani Exchange, Polo Ralph Lauren, Uniqlo, Liz Claiborne, Esprit, Bossini, Tough, and Baleno have been buying Chanco’s products for over five years. Uniqlo, the group’s largest customer, has 570 chain stores in Japan, giving extensive presence to Chanco’s products.

Design Capability Chanco’s senior management has over 20 years of experience in manufacturing leather goods. We believe the experience will be invaluable for sourcing good quality raw materials and quick response to market trends. The design team, comprising 20 members, has about 3 to 7 years in design and product development and is capable of innovating new products according to customers’ needs.

Proven track record Turnover of the group has grown remarkably by 70% from 2000 to $150M in 2002. Net profit also increased 112% between 2000 and 2002.

Future Plan and Prospects

Expansion to the PRC market The group also plans to tap the market opportunity in the PRC. It has obtained sales licenses in February 2003. Sze Cheik Factory, which was expanded last year, has commenced operation in August 2002. Ngai Luen Leather Goods, which is for production of domestic sales, is expected to commence operation in 1Q 03. The group will establish sales offices, appoint marketing agents in major cities, actively participate in various trade fairs and advertise in trade magazines in the PRC.

Retail sales in China amounted to 440.44B yuan last year, up 9.2%. In the past four years, retail sales has grown by 8.9% on average . At this rate, retail sales after five years can reach 674B yuan. We expect the vast growth of mainland consumption market can be sustained. Therefore, Chanco is on the right direction and we expect Chanco can generate significant turnover in the coming years.

Product Diversification Chanco plans to increase the high profit margin (about 90%, due to the use of scrap leather which has been written off in previous years) small leather goods in its product mix. By doing so, the group can diversify its products and optimize the use of raw materials. The group can also gain presence in the growing accessories market. The group estimates the sales of small leather goods would increase to 3% of turnover in FY03.

Vertical Intergration Chanco intends to acquire leather processing factories in the mainland, which can enable the group to maintain more stable supply of cowhides and increase the profit margin

Risk factors

Reliance on a single market Chanco’s biggest market is Japan, accounting for 62% of the group’s turnover in FY02. Uniqlo is the major customer of Chanco, accounting for about 40% of the group’s revenue. In the event of any adverse changes in Japan’s economy affecting the retail market and/or the business relationship between Chanco and Uniqlo, the group’s profitability and performance may be adversely affected.

However, Chanco will develop the PRC market through customers such as Bossini and Baleno and later will add its own brand. Potential growth in other markets, such as Esprit in Europe and Gap in the US, can enable the group to have a more balanced portfolio. Japan market is expected to account for 50% of revenue in FY03.

Fluctuation in costs Cost of raw materials accounted for about 70% of the group’s total costs and expenditures. It may fluctuate due to various reasons, such as change in suppliers and natural disasters. Any fluctuation on raw material prices will have effect on profit. The outbreak of mad cow disease in 2000 drove up the price of leather by nearly 30%. Due to reduced leather supply and uneven quality of cowhides, production loss increased substantially, causing the overall gross profit to drop by nearly 30%.

As the group will acquire leather processing factories to purchase raw hides and skins for all of its finished products, the group can better control the quality and prices of raw materials.

Conclusion

Though net profit decreased to $13M in 2001 due to the outbreak of mad cow disease, it rebounded to $41M in 2002. In 2003, we expect net profit to be about $36M.

Gross profit margin of the group is about 35-38%. It would be lowered by 2% due to the relocation of production facilities in July 2002. However, the increase in sales order will raise utilization rate of the larger new factory and thus economies of scale can be achieved. Added by the potential acquisition of leather processing factories, profit margin is expected to be further improved.

Payout ratio decided by the group would be 30%, representing a prospective yield of 5%. Expected P/E is only 4.7X and 3.5X for FY03 and FY04. Valuation is undemanding among industrial stocks given the lower P/E than its peers and the high yield.