格力电器(000651)

Gree reported a strong set of 3Q18 results, with revenue and EPS growing 38.2% and 38% YoY, respectively, led by strong results in air conditioning. While the results were solid, investor concern is focused on the sustainability of the strong performance, as rising channel inventory levels may account for a significant portion of the growth. In comparison, Gree’s main competitors, Midea and Qingdao Haier,had reported deteriorating China AC sales in 3Q18. Excess inventory could weigh on 2019 sales and profitability, thus impeding share price performance. We reduce ourtarget price from RMB43 to RMB40.

Investment Highlights

Strong 3Q18 growth, but concerns about channel inventory: Gree indicated that channel inventory is at least 15 million units, which we estimate accounts for ~5 months of annual production. This compares unfavourably with Midea, which holds 5 million units of channel inventory, or 2-2.5 months of annual production by our estimates. Unlike Midea, Gree does not warehouse inventory for its distributors, which provides the Company with less clarity over channel inventory levels.

Gree anticipates continued strength in 4Q18: Gree indicated that it expects 4Q18growth to be roughly in line with that of Q3, but that the AC segment is difficult to predict. For 2019, Gree believes double-digit revenue growth should be achievable. We remain concerned that continued strong sales in a weak market may result in increased channel inventory levels, which may hamper growth in 2019.

Continued dividend uncertainty: Gree announced a proposed interim dividend of 3.6Bn, or RMB0.6 per share, indicating a ~30% payout ratio for 1H18. This was less than our and market expectations of ~50% payout , and below Gree’s historical payout ratio of 60-70%. Gree has not provided clear guidance on whether it intends to continue this payout ratio for 2H18 earnings. Nor has Gree provided further clarity on where it intends to invest its cash reserves.

Inexpensive valuation. In spite of a strong 9M18 top line, we remain cautious about Gree’s future growth in light of increasing channel inventory, the lack of new discernible long-term growth drivers, and an inconsistent corporate strategy. Gree derives ~88% of its revenue from China, making its earnings almost wholly reliant on the domestic China market. On this basis, we believe Gree warrants a discount relative to its peers Haier and Midea. We raise our 2018 EPS estimates by 4.3% on the back of strong 3Q18, but cut our 2019 EPS estimates by 5%. Our 2018/2019 EPS estimates are 8%/14% below consensus. We value the Company at 9.5x 2019EPER, implying a 12-month target price of RMB40, or ~5% upside.