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Does Sun Art Retail Have a Strong Business Model?

Sun Art Retail Group Ltd (SEHK: 6808) is a leading hypermarket retailer. The group operates its hypermarket business under two banners — Auchan and RT-Mart. As of 30 June 2019, the group had a total of 485 outlets in China with a total gross floor area of around 13 million square metres. Sun Art’s reach extends out to 233 cities in China across 29 provinces and regions.

Sun Art’s hypermarkets are well-stocked and the group is exploring various formats to improve customers’ experience. Omni-channel formats are being tested and the group is focused on becoming a leading “phygital” (physical + digital) innovator.

A store in Shanghai was recently restructured to adopt new displays and the group greatly increased the number of SKUs (stock-keeping units of inventory) to offer customers a wider variety of merchandise and produce.

Investors may wonder, though, if Sun Art has a strong and enduring business model. Let’s have a look at three aspects to determine this.

Financial trend

Sun Art has managed to grow its revenue over the last five years, but the increase has not been consistent. Revenue fell from RMB 102.3 billion (US$14.7 billion) to RMB 99.4 billion from FY 2017 to FY 2018, and for H1 2019, revenue declined by 6.4% year-on-year to RMB 50.6 billion. This decline could be attributed to strong competition from other Chinese retailers.

A positive trend is that of rising gross margins, which signifies good pricing power on the part of Sun Art. Gross margin has seen a steady climb from 22.8% to 25.3% from FY 2014 to FY 2018, while H1 2019’s gross margin hit a high of 26.1%.

Operating and net profit margin, however, have not increased meaningfully over the years. This is probably due to higher expenses in hiring staff and in spending on selling and marketing over the years, which has offset the impact of the higher gross profit.

Free cash flow

Sun Art has demonstrated an ability to generate strong and consistent free cash flows over the years. Capital expenditure has actually fallen from a high of RMB 5.5 billion in FY 2014 to around the RMB 2.5 billion levels in FY 2017 and FY 2018.

Operating cash flow has remained steady above the RMB 6 billion mark, resulting in increasing levels of free cash flow.

Dividends

For dividends, Sun Art has increased dividends from FY 2014 to FY 2016, but this then declined over the next two years, hitting a five-year low in FY 2018 at HKD 0.14. This may be in line with a more challenging retail environment plus the reported slowdown in domestic consumption in China.

The group may be intending to retain more cash for a rainy day, thus paying out a lower level of dividends. At its share price of HK$9.75 (as of the time of writing), the shares provide a yield of around 1.4%.

Competition remains stiff

Though there are positives from the above analysis – higher gross margins and consistent free cash flow generation, competition in the retail industry in China remains stiff.

A big red flag is that of declining revenue for Sun Art. Unless this trend can be reversed, it seems the retailer may have trouble growing its net profit meaningfully over time.

While I can conclude that Sun Art has a robust business model, there are red flags that investors need to take note of should they intend to buy shares in the group.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Royston Yang doesn’t own shares in any companies mentioned.