Chinese Consumers Love This Brand

David Sterman's picture

Thursday, March 25, 2010 - 2:40pm

by David Sterman

As the Japanese economy developed in the 1970s and 1980s, U.S. companies such as Coca-Cola (NYSE: KO) and McDonald's (NYSE: MCD) made major headway into the hearts and minds of local consumers. But a similar trend may not emerge in China. Western nations caution that it has been difficult to crack the fast-growing Chinese market, and local brands appear to be the biggest beneficiary of that country’s consumer boom.

That’s good news for China's Deer Consumer Products (Nasdaq: DEER), which designs and builds kitchen appliances for global manufacturers and also sells eponymously-branded products into the local market. And domestic sales are rising at a fast clip. When you consider the size of the emerging middle class in China, Deer might have a very long runway for growth.

Deer arrived on the scene just a few years ago, posting $33 million in sales in 2007. Fast forward to 2010, and sales look set to exceed $150 million. The company initially gained traction as a developer of juicers, blenders, coffee makers and other counter-top appliances for customers such as Stanley Black & Decker (NYSE: SWK), Toastmaster, and Wal-Mart (NYSE: WMT). But management soon realized that higher profit margins could be gained by selling directly to Chinese consumers. They were right.

In 2007, the company had gross margins of around 22%, roughly in line with private-label appliance makers. Two years later, with an increasing exposure to direct sales, gross margins had risen to 25%. And judging by management guidance, they should approach 30% this year.

That leads to a trend that every investor should watch for: rising sales and even faster-rising profits. Based on current trends, management expects sales to rise more than +70% this year, but net income looks set to nearly double. It’s important to note that per-share profits won’t grow quite as fast, as the share count has risen nearly 40% thanks to a 2009 secondary stock offering. The capital-raise, along with money generated from operations, has pushed the company’s cash balance up from $3 million at the end of 2008 to $79 million ($3.40 a share) at the end of 2009.

With all that money in the bank, management promises that no more capital raises will be necessary. That also means that interest from Wall Street analysts will be limited, as research coverage of small companies often relates to potential banking opportunities. So management will need to find other ways to get the attention of investors.

And a sure-fire attention getter is profitable strong growth, augmented by continuous new contract signings. In recent months, Deer has:

  • Announced a contract to sell high-end espresso makers under a leading unnamed European brand.
     
  • Poured greater sales efforts into Chinese online sites -- especially through the leading Taobao.com portal.
     
  • Entered into a sales agreement to sell Deer-branded products in Wal-Mart’s Chinese stores.
     
  • And made modest so-called tuck-in, or complementary acquisitions of local appliance makers.

To be sure, the bullish 2010 sales forecasts are a reflection of those deals, and don’t reflect the organic growth in the Chinese market. Without these kinds of moves, investors should expect more moderate +15% to +30% sales growth. Yet as noted above, gross margins are steadily expanding, so bottom-line growth beyond 2010 should remain robust.

Against that backdrop, shares trade for about 21 times trailing profits, and around 15 times projected 2010 profits. As profits look set to grow at a +20% to +30% clip for the next few years, that multiple seems quite reasonable. More than likely, the pile of cash will continually be spent on accretive acquisitions, so +30%-plus profit growth may be the norm.

Of course, the Chinese economy is white hot right now, and could cool at any moment. But that would likely prove to be a temporary hiccup, as the economy should be on a sustainable growth path for some time to come, particularly with the respect to a growing middle class. Deer Products looks to be a logical platform for foreign investors seeking exposure to this rising Asian tiger.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.