Case Study: The Winter of the Sportswear CFO

It’s not exactly a set of numbers that a CFO would be happy to announce. But it could have been worse.
Last month, Chinese sportswear company Xtep International Holdings reported 2013 profit attributable to equity shareholders of  RMB606 million (US$98 million) on sales of RMB4.3 billion (US$703 million) – down 25.2% and 21.7%, respectively, from 2012.
But CFO Terry Ho has an explanation. He says the entire industry has been hit by overcapacity and excess inventory. Indeed, key competitor Li Ning lost RMB392 million in 2013 while sales fell 13% to RMB5.8 billion.  
Even market leader Anta saw 2013 profits decline 3.2% to RMB1.3 billion on sales of RMB7.3 billion, down 4.5% from 2012. So did Nike (down 3% to sales of US$2.4 billion), although Adidas did eke out a gain (sales up 6% to €1.6 billion), after falling 16% in 2009.
The CFO says Xtep had bitten the bullet and addressed its inventory problems by, among other things, closing 236 retail outlets in the past two years. Leading local brands Xtep, Anta, Li Ning, Peak Sportswear and China Dongxiang shed a combined 2,284 stores last year.
The fewer retail outlets are raising hopes that the overcapacity and associated price wars sparked by the euphoria over China’s hosting of the 2008 Summer Olympics are finally waning. Actual demand had fallen short of the inflated expectations, although China’s sportswear market is now estimated to be worth US$24 billion.
“Over recent months, both Xtep and sportswear companies in China have been reporting improving operational performance,” analysts at J.P.Morgan wrote in a report last month. They set a target of HK$3.90 per share for Xtep, up 18% from where the stock closed on 9 April.
Case study
The way the 48-year-old Ho and his finance team are handling the challenges serves as a useful case study for other finance executives. Xtep’s situation is not uncommon in fast-growth emerging Asia, where domestic consumption is becoming a key economic driver – and fuelling demand for sportswear and other lifestyle goods and services.
China’s GDP, for example, has been growing at a rapid clip, although it moderated to 7.7% in 2013 from 10.4% in 2010. According to business intelligence group Euromonitor International, consumer expenditures in China surged 65% to US$3.4 trillion from 2010 to 2013.
The Philippine economy grew 7.2% last year, second only to China. Consumer expenditures jumped 42% to US$201.6 billion from 2010 to 2013. Domestic consumption is on the upswing as well in Indonesia, where consumer expenditures rose 21% to US$486 billion from 2010 to 2013, and in India (up 17% to US$1.1 trillion in the same period).
But the rapid growth tends to attract new entrants, both local and foreign, even as the incumbents rapidly expand. It could all turn into a free-for-all that results in overcapacity, heavy discounting, brand erosion and, in the case of Li Ning, outright losses.
Plan of action
This is what happened in China. Two years ago, says Ho, you had 15 sportswear stores jostling for customers in the same street. “Everybody was selling the same things and eventually had to bring down their prices from RMB500 to RMB200 to RMB100,” he recalls. “Everybody made a loss and so many had to close.”
It was, as Anta CFO Ling Shing Ping told CFO Innovation in 2012, “the winter of the sportswear industry.” Anta’s sales that year fell 14% from 2011. Turnover at Xtep, on the other hand, basically stayed the same (it rose by 0.2%).
Now it is Ho’s turn to become a winter CFO. “Everybody is learning the hard way,” he says philosophically. First it was Adidas in 2009, then Li Ning two years later, Anta in 2012 and now Xtep.
But Ho is confident that Xtep’s a strategy will see it through. The plan of action includes:
  • Remaining focused on branding
  • Protecting margins
  • Closer partnership with distributors and retailers
Branding is king
Xtep was started in 1999 as an original equipment manufacturer (OEM) by entrepreneur Ding Shui Po, 42, who is chairman and CEO. A member of the Institute of Chartered Accountants in England and Wales and the Hong Kong Institute of Certified Public Accountant, Ho was hired in 2007 and helped the company list in Hong Kong the next year.
Xtep started to move away from OEM in 2002 when it launched its own brand of sports shoes and sportswear, marking them with a stylized ‘X’ and ‘Xtep.’ It was clear to the company that the days of the OEM were on the wane as the sportswear action shifted to domestic consumption. In such an environment, branding is king.
Indeed, in 2013, the seven largest sportswear companies in China all had their own distinctive logos – led by global giants Adidas and Nike (see chart below).
Running for Gold
FY2013 Sales, in RMB billion
Revenues for Adidas (€1.6 billion) and Nike (US$1.5 billion) are for Greater China (Mainland, Hong Kong, Macau and Taiwan) and are converted to renminbi at the current exchange rate. Sources: 2013 annual reports of the respective companies  
The Xtep brand appears on apparel – shirts, jackets, shorts, pants, kidswear – and on footwear, mainly running and cross-training shoes. They are sold mainly in China’s second- to fourth-tier cities. Xtep has effectively ceded Beijing, Shanghai and other metropolitan areas to the likes of Adidas and Nike (and Anta’s upscale Fila, the Italian trademark it acquired for use in China).   
 “You don’t need to play a sport to wear our products,” says Ho. The market for running shoes is much bigger than for basketball shoes, for example. “Marathons are more affordable to sponsor” – Ho says sponsoring a basketball league can cost at least RMB1 million.
To strengthen the brand, Xtep sponsors sports events – it supported China’s 12th National Games and has five-year sponsorship deal with the Xiamen International Marathon and a three-year deal with the Standard Chartered Hong Kong Marathon – and hires sports stars and celebrities as endorsers. Ho allocates 11% to 13% of revenues on sponsorship, promotions and advertising.
Actual spending on branding fell last year given the 25% fall in sales, but the CFO is keeping to the 11%-13% discipline. “There’s always something you can cut,” he says. For example, the main endorser of Xtep’s running shoes is US sprinter Justin Gatlin, who won a silver and a bronze at the 2012 Olympics. Xtep decided against hiring the gold medalist. “It was the price point,” says Ho.
Protecting Margins
He could have increased marketing spend, but Ho is determined to protect Xtep’s margins. It was able to sustain gross profit margin at the 40% level last year despite the revenue decline and its decision to grant a bigger discount to distributors (to 62% from 60% in 2012). The operating profit margin was likewise kept stable at 20.6% (2012: 20.4%).
Sales down, but gross profit margin stable
% of turnover
Source: Xtep 2013 Annual Report 
How did Xtep manage it? In addition to controlling marketing expenses, the company tweaked the product mix, made more of its products itself rather than outsourced production, and implemented cost management measures.
Apparel used to account for 60% of sales. Today, 52% of revenues come from shoes, which enjoy more resilient pricing power than the clothing line. Despite the glut, Xtep has been able to raise the price of the shoes it sells to its wholesale distributors by around 10%, says Ho.
Discounting on apparel has been much more severe, but Xtep limited the damage to pricing and branding by allowing retailers to heavily discount only in selected discount outlets. The other clearance channel was the Internet; excess inventory of the retailers were centralized and sold through Xtep’s official website. 
From seven months, retailers now have only around five months’ worth of inventory, says Ho. “Less than four months, that means there’s a lot of stock-outs and you lose the opportunity to earn more. Close to six months is unhealthy. More than five months is still reasonable.”
Xtep was also helped by the stable prices of cotton and oil, which kept a lid on materials and production costs, and by lower OEM fees. The outsourcing providers were cutting prices as the smaller sportswear companies closed down, says Ho.
But Xtep is making more of its products itself to further lower production costs and maintain margins. “It’s actually more expensive to outsource than producing internally,” says Ho, pointing to “hidden costs” in OEM such as test checking and warehousing. “Some of my staff are actually full time in someone else’s factory.”
From 51% in 2012, in-house production of shoes rose to 64% of total pairs sold last year, while in-house production of apparel increased to 28% from 15%. Xtep expanded its production facilities in Anhui province in the north, which together with the main factory in Fujian province in the south turned out 17 million pairs of shoes and 8.5 million pieces of apparel.
Despite the new capex, Xtep does not intend to give up on its asset-light strategy, says Ho. “If you look at my balance sheet, only 20% of assets are fixtures and machinery,” he notes. “I don’t think that’s too heavy. And 60% is pure cash.”
Happy retailers
There are no plans to build self-owned retail outlets, either. Like most retailers in China, Xtep works with exclusive distributors that own their own stores and franchise to other parties. This arrangement means Xtep does not need to worry about capex and opex for distribution, but it does present challenges on branding, inventory, pricing, service quality and other issues.
Each of Xtep’s 28 wholesale distributors has exclusive rights to sell the company’s products in a defined geography, but Xtep controls store expansion and closure plans. The company also controls the look and displays of the retail stores – all outlets had to upgrade to the “6th generation store” design last year – and how much discounts retailers can give to their customers.      
Many Xtep distributors have been partners for more than a decade, representing historical memory and connections that had taken Xtep time and effort to cultivate. The two-percentage-point increase in the wholesale discount rate is meant to help them (and their retailers) get through the current slump.     
Xtep has also lengthened the accounts receivable terms with its distributors and allowed higher retail discounts, although that flexibility has now been dialed back following recent operating data that indicate the retail inventory turnover period has become shorter.
That information filtered down to headquarters via Xtep’s real-time Distribution Resource Planning (DRP) System, which was customized from the SAP ERP solution whose “initial cost was huge,” in Ho’s words, when implemented four years ago.
DRP is now deployed in 80% of the retail network’s point-of-sale terminals, allowing Xtep to analyze sales, inventory and other trends at the store level. “It helps us educate the shop owner by showing the statistics,” says Ho.
“For example, we might say: You sold all the 400,000 pairs of shoes you ordered last year, but only half of the 600,000 units of apparel. Why don’t you increase the percentage of shoes and reduce the percentage of apparel?”    
The DRP system also helps Xtep advise distributors what items are likely to sell in their areas when they place orders every quarter. And of course, it is an integral part of the production cycle. Because Xtep can detect the trends in near real time, it can plan to continue producing best-selling items and reduce or tweak the design of products that are not moving as fast.  
“DRP tells you how to produce more effectively,” says Ho. “It reduces what I call the ‘wastage’ in the human factor, like design. You don’t need to design so many products. You get to know what works, so you narrow down your focus.”
Hoping for spring
In theory, all this should bring Xtep back on the growth path for revenue and profit. Ho says he is confident that spring will eventually replace the sportswear industry’s current frost. “2014 is still a year to recover,” he says. “But 2015 should see a reasonable increase, at least by single digits, and then hopefully double-digit growth onwards.”
Could Xtep have helped head off the glut by not engaging in the expansion wars and helped keep its powder dry in the process? “In hindsight, everybody knows what should have been done,” says Ho. “Maybe we could have expanded by just 50%, 60%.”
But sitting it out altogether was not an option. “If we do that, the market will ask: ‘Why does Xtep have only 3,000 stores while ABC has 8,000? Are you inferior?’ You have to keep up with others to prove that you are as good. Otherwise you will lose.”  
If you go to some areas in China, he adds, “something like 20% to 30% of the total players just disappeared. To us, the competition is easier now than it was five years ago, when anybody can create some brand – Bstep, Cstep – and make a good living.”
For now, the remaining players have tempered their exuberance. In part because of the slowdown in Chinese GDP growth, Xtep expects “10-15% in steady annual growth for sportswear, in line with [growth in demand] in the consumer sector” – a climb-down from the towering 30-40% expectations of the recent past.
Still, hope springs eternal. The company is expanding its Xtep Kids line “in light of the growing opportunities arising from the recent one-child policy reform,” Xtep said in its 2013 annual report. It is partnering with the Walt Disney Company and Marvel Entertainment to make and sell Spider-Man and Avengers sneakers in China.
“Urbanization is still going on and people are becoming more health conscious,” says Ho. “In the US, people buy five or six pairs of sneakers every year. In China, it’s only one or two pairs . . . After you satisfy the basic needs, you would exercise more and would need to protect your feet.”
And that’s where Xtep and its peers stand ready to step in.
About the Author

Cesar Bacani is Editor-in-Chief of CFO Innovation.


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