Description

This one feels like a catching a falling knife and is not for the faint hearted, but I think the risk-reward is very favorable today.

Li Ning is one of the 2 large native sportswear brands in China, along with Anta. The primary competitors are NKE and Adidas, with Puma and various Chinese brands like 361* and XTEP being second tier competitors.

The brand is iconic and has plenty of heritage, being associated with one of the most iconic athletes in Chinese history. Operationally however, there have been a bunch of ups and downs.

The brand hit its first peak a couple of years after the 2008 Olympics. Li Ning (the founder) at that time stepped away. There were various execution missteps and competition picked up. They got over distributed and stuffed the channel which led to a downward spiral. Ultimately Li Ning came back to lead the business and turned it around.

Li Ning bottomed around 2014-2015. During and after this time, management professionalized, operations became more standardized, design improved. The business was on the mend.

The brand gradually recovered 2016-2019, and then it caught fire. They had a zeitgeist moment with the launch of China Li Ning, which caught the guochao or "patriotic" fashion trend. COVID helped them. Foreign brands got smoked by various issues, but particulary controversies around Xinjiang Cotton. The result was a stratosphereic boom -- they benefitted from premiumization, strong demand, and were able to sell everything they made at full price. The company pulled forward 5-6 years of margin gains into a single year.

Then the boom unwound, which led the stock to correct ~80% top to bottom. Demand faltered due to the very poor macro. The guochao fashion trend got tired and the China Li Ning subbrand died. Nike and Adidas bottomed and started to claw back some share. Channel inventory became too high -- which encouraged discounting and distributors "dumping" products in "unauthorized" ways, messing up the pricing structure. Sales slowed sharply and margins will take a major hit.

On top of all that, mgmt lost a lot of credibility, both due to the poor operations and due to bizarre capital allocation. Recently the shares plunged when they announced a 2b HKD purchase of a new HK headquarters building. This is tone deaf at best and malicious at worst.

The bull thesis though is that the stock is horrific today but the fundamentals are nowhere as bad as the stock chart would have you think. Valuations are very low, and the fundamentals are about 2 quarters from inflecting upwards. The brand is fundamentally healthy and the company will improve it. On the management front, I think they've been chastened by the market reaction and immediately announced a large buyback plan and have already executed about 1/4 of that plan at low valuations. Sentiment on the mgmt will improve with fundamentals and incremental improvements to capital allocation. I think there is reasonable downside protection, driven by the fortress balance sheet and low valuations.

To bring it home, you are buying a strong company at something like 7x EV/ Normalized EBIT, that is buying back stock at very depressed levels. The stock has never traded this low. I think this company will grow low teens in the base case. It's certainly not impossible to lose money here, but I think a reasonable base case is a double or triple in the next 3-4 years.

Brand

The market seems to be implying that the brand is impaired. You are welcome to do your own investigations here but I've done mine and I'm comfortable that this is not the case. I think the brand remains very safely the top 1-2 sportswear brands in China and is not being challenged meaningfully. I think brands in CHina are almost uninvestible -- because consumers are fickle and competition insane. Sportswear is better protected. We are still talking about the same few brands as 10 years ago and barriers to entry are very high. In fact, on a SELL THRU level at retail, I don't think Li Ning is doing materially worse than any other major brand (excluding new stuff like Arcteryx). This is a bit of a faith driven point but nontheless critical to the thesis.

Cycle

No surprise that sell throughs have deceled across the entire complex driven by the bad macro. However, Li Ning was impacted more than most because (1) channel inventories were too high, in part of bad forecasting and in part because of execution issues and it didn't police its distributors as well as it should have and (2) margins were way above normal.

Near term earnings will be horrible and the market knows this. The company is buying back inventory from the channel in Q4 which is undoubtedly the right thing to do but creates a big hole in the P/L. It's quite possible Q1 will be bad too, as the 2023 comp was strong and there will be lingering issues.

Look forward to Q2 and H2 2024 though things get brighter. I can't speak to overall macro and the China consumer, but they will be going against weaker comps and the channel will be cleaned up.

Improvements to Operations / Brand

I think the company is doing the strategically and operationally smart thing here:

1) They hired a Chief marketing officer. Amazingly the company didn't have a CMO before and their brand level marketing was poor. (This was a legacy of the post 2008 crisis that they never fixed). They had been criticized for losing important sports sponsorships to Anta for example. They will increase spend here and have a more holistic and integrated branding strategy, which makes sense. It's kind of amazing they've been to do as well as they have without this function... but maybe that's a testament to the fact that the brand is strong and there are good "bones" here.

2) They will deepen penetration in lower tier cities. This is still comparatively virgin territory for Li Ning which historically is known for being "high end" for a Chinese brand. They are opening up the price band as well, introducing some lower end SKUs as well as more premium / professional SKUs.

3) Invest more in "professional" products, for niche sports, and in outdoors where pricing / margins are higher.

4) Improve systems for monitoring distributor inventory and true sell through, to make sure the 2023 issues never repeat. 

Execution is to be seen but on a high level all of their ideas make a lot of sense.

Management

Management is hated because they really shat the bed in 2023 and they topped it off by buying an office building in HK for 2 billion (about 10% of their net cash). In my convo with them, I believe they made this office building purchase not because of some malicious intent but rather because they really thought they needed the building and got a good deal on it, and because they are very unsophisticated in capital allocation. This latter point, unfortunately, is common in Asia. The market reaction to this office building purchase was swift and vitriolic and they responded by initiating a 3bn HKD repo program which is the first in corporate history. They already executed on a sizable portion of this.

Bottom line is that I'd give them the benefit of the doubt for the moment. I think cap allocation gets better from here not worse. I would not be surprised if they re-up the buyback program in 6 months.

China Backdrop

Overhanging all this is a horrific China backdrop. You've seen the headlines. There's nothing good happening in China right now. Accordingly the market is left for dead and valuations in absolute terms, vs its own history, and vs other global benchmarks are at lows. I saw some Bloomberg article the other day that says equity earnings yields vs Chinese bonds are at the highest levels in 20 years. There are a lot of superlatives you can use here. Uninvestable or opportunity? You can decide. Personally I would be contrarian here. Big countries have a way of muddling through.

Valuation

Round numbers, the company is trading for about 1x EV/ NTM rev. (Note, Factset/Bloomberg cash position is understated because they have 10bn in "long term bank deposits"). Peak EBIT margins are 21% which is probably unsustainable. You can put in your own assumptions here but I think 13-16% are reasonable in the next few years. To put this in context, the business made 8-10% margins during its turnaround phase, but I think there has been huge improvements to scale, mix, channels, and operational rigor in the mean time and margins will stabilize above those levels. Core Anta, which is a very well run company, makes 20%++ margins and NKE reportedly makes well over 20%+ margins in China. Tier 2 comps XTEP and 361 regularly make HSD to mid teens type Ebit margins. The operations are not apples to apples comps, but I think these are helpful reference points.

The company remains extremely cash generative under these assumptions. If these figures are broadly correct the stock is plainly cheap. They pay a dividend and the stock yields about 4%.

Bottom line is that you are playing for a cycle turning + sentiment improving / narrative improving story. Li Ning is a show me stock now and hopefully I've analyzed the cycle correctly. Macro is kind of out of our control, but if it gets incrementally better you can win big. If it's still crappy hopefully you don't lose much from here. Give this stock about 2-3 quarters. If it doesn't show significant signs of life by then, I've probably made a big mistake somewhere above.

Risks:

Macro

brand has problems / competition

They do something really big and foolish internationally. This is my top concern. The reason they made the HK office building purchase is that they want to expand more internationally, particularly in SE Asia. Chinese brands going overseas is always super risky. I don't sense they are going to burn enormous money doing this in the next year or two... but if they surprise here it would be bad.

Catalyst

Just have to show revs/earnings