Falling again and again, China Duty Free has become a "bottomless pit"

On the evening of August 30th, China International Travel Service Corporation Limited (CITS) released its interim report for 2024. Key financial data had been disclosed in the previous interim report, but we will still combine the detailed disclosure in the interim report to observe the reasons behind the company's continuously declining performance. The main points are as follows:

1. Endless Decline in Revenue Growth: On the revenue front, in the second quarter, CITS recorded a revenue of 12.5 billion RMB, a year-on-year decrease of 17.4%, with the decline further expanding. Looking at the distribution of sales, in the first half of the year, duty-free sales revenue was 21.7 billion RMB, a nearly 10% decrease year-on-year, while sales subject to tax saw an even higher decline of 21.6% year-on-year. The relatively smaller decline in duty-free sales is a somewhat comforting point. As cross-border travel gradually returns to normal, the company is reducing the proportion of taxable sales, and the return to the word "duty-free" is to some extent an active choice by the company.

2. Island sales plummet, outbound travel recovery, but no offset: At the industry level, the overall sales situation of duty-free shops on Hainan Island deteriorated even more severely, with the total retail sales in the second quarter plummeting by a full 40% year-on-year. In terms of driving factors, the decline in the number of duty-free sales was even higher, reaching 41% year-on-year. In other words, the average spending per customer slightly increased year-on-year, not dragging down the performance. It is purely due to insufficient demand, "unable to sell out."

Taking a closer look, the number of duty-free shopping trips on Hainan Island decreased by 18% year-on-year, while the average shopping amount per person decreased by 26%. The decline in purchase frequency is more severe than the reduction in the number of shoppers. It is calculated that the average number of items purchased per person this quarter is only 5.3, compared to over 10 items per person during the peak in 2021-2022. However, the removal of bulk buyers such as daigou clearly also dragged down the average purchase indicator.

Furthermore, the overall revenue decline of CITS is significantly smaller than that of duty-free shops on the island, clearly reflecting the restoration of domestic and international travel, the erosion of duty-free sales on the island, and the growth in revenue from other channels such as airports partially compensating for the decline in duty-free sales on the island.

3. Gross Margin Recovery, but Significant Increase in Marketing Expenses: Despite the decline in revenue, in the second quarter, CITS achieved a gross margin of 33.9%, which increased both year-on-year and quarter-on-quarter. Considering that the average spending per customer at duty-free shops on the island slightly increased year-on-year, and the proportion of high-margin duty-free sales in the revenue structure also increased, the increase in gross margin is reasonable.

However, due to the recovery of traffic at ports such as airports and duty-free sales, CITS's leasing expense ratio in the first half of the year increased by 2.2 percentage points year-on-year, and other marketing expense ratios also increased by 0.7 percentage points year-on-year. The growth in marketing expenses led to a 2.1 percentage point year-on-year decrease in CITS's gross profit margin (gross profit minus sales expenses) as a percentage of revenue in the second quarter.

4. Rigid Expenses, Profits Plunge: In terms of other expenses, although administrative expenses and tax payments decreased both year-on-year and quarter-on-quarter, financial expenses confirmed a net income of 350 million RMB due to the growth in interest income. This reflects some efforts in cost control. However, the cost control of state-owned enterprises is still too slow, as the decrease in expenses lags behind the decrease in revenue, leading to a passive expansion of the expense ratio **

In the end, although the gross profit margin increased, marketing expenses significantly grew, and other expenses were passively amplified, resulting in a nearly 1.2 percentage point year-on-year decrease in net profit margin attributable to the parent company. Coupled with a nearly 18% decline in revenue, the second-quarter net profit attributable to the parent company was only 980 million, a nearly 38% year-on-year decrease.

Dolphin Research Viewpoint:

From this interim report, Dolphin Research believes that the following industry and company operational and development trends can be explored:

Firstly, at the macro or industry level, the weak consumer demand is vividly reflected in optional consumption such as duty-free shopping. Although the company has improved the "health" of this business to some extent by reducing discounts, clearing out daigou (overseas personal shoppers), and maintaining gross profit margins, no matter how well or poorly the company performs, it cannot escape the headwinds of the overall environment, which are difficult to fully counter.

At the structural level, with the detailed recovery of outbound and inbound passenger flows in the second quarter, we can clearly see the trade-off between Hainan offshore duty-free and entry-exit port duty-free. However, the two are not completely offsetting each other, as the duty-free purchasing power lost overseas is something China Duty Free Group cannot make up for.

Another impact of the change in revenue structure is the trade-off between higher-profit offshore sales and relatively lower-profit airport channels, leading to not only a decline in total revenue but also a deterioration in profit margins.

Despite the company's market value and valuation continuously declining in recent years, China Duty Free's profits have also "fallen and fallen again". The continuous decline in the numerator (profit) prevents the company's valuation from ever truly becoming "cheap".

In recent policy developments, the long-rumored indoor duty-free policy has finally been implemented, potentially bringing incremental channels and revenue. However, the restriction that only allows pick-up at exit ports leads Dolphin Research to believe that indoor duty-free is currently just a supplement to airport channels, and its potential revenue scale is unlikely to significantly exceed that of airport channels. Whether this incremental market can offset the headwinds of the overall market remains to be seen.

Below is a detailed financial report analysis:

I. Deeper Lows After the Low Point

In terms of growth indicators, China Duty Free achieved revenue of 12.5 billion yuan in the second quarter, a 17.4% year-on-year decline, further widening the decline. This is only 1.6 billion yuan higher than the low point when Hainan stores were temporarily closed in 2022.

Looking at sales types, for the entire first half of the year, the company's duty-free product sales revenue was 21.7 billion yuan, a nearly 10% year-on-year decrease, while taxable sales saw an even higher decline of 21.6%. Structurally, it was mainly taxable sales dragging down performance, while the relatively smaller decline in duty-free sales was a somewhat comforting aspect.

On the one hand, the gross profit margin of tax-free sales is lower, with a relatively smaller impact on profits, while on the other hand, as cross-border travel gradually returns to normal, the company reduces the proportion of tax-free sales, returning to being a "true" duty-free retailer to a certain extent as an active choice by the company.

Comparing the company's performance, the overall sales situation of Hainan offshore duty-free shops has deteriorated more severely, with the overall retail sales in the second quarter dropping by a whopping 40% year-on-year. In terms of driving factors, the year-on-year decline in the number of duty-free sales is even higher at 41%. In other words, although the average transaction value has slightly increased, the weakness in sales is not due to pricing factors, but purely because "goods are not selling".

Taking a closer look, the number of duty-free shopping trips in Hainan has decreased by 18% year-on-year, and the average shopping amount per person has decreased by 26%. The reason for the decrease in sales volume is that there are fewer shoppers (relatively minor impact) and the quantity of goods purchased per person has also decreased (greater impact). According to Dolphin Research, the average number of items purchased per person this quarter is only 5.3 items, compared to over 10 items per person during the peak in 2021-2022, more than halved. This clearly reflects the weakening consumption power of domestic duty-free shopping. However, the industry is also affected by the removal of bulk buyers such as "daigou" which naturally drags down the average purchase quantity per person.

The significant decline in duty-free sales in Hainan is clearly also being eroded by the gradual recovery of domestic cross-border travel. This is evident from the fact that the decline in income from domestic duty-free is significantly smaller than that of offshore duty-free. The company's income growth in other channels such as airports has to some extent offset the decline in offshore duty-free sales.

II. While there is a slight increase in gross profit, with the rise in airport rent, profits are still declining

Despite the decline in revenue, China International Travel Service Corporation Limited (CITS) achieved a gross profit margin of 33.9% in the second quarter, which increased both year-on-year and quarter-on-quarter. As mentioned earlier, the average spending per customer for offshore duty-free shopping actually slightly increased year-on-year, and the proportion of high-margin duty-free sales in the revenue structure has increased, both of which are favorable for the gross profit margin.

In terms of gross profit margin by sales type, the gross profit margin for duty-free sales in the first half of 24 was 39.5%, which was basically flat compared to the full year of 23. Additionally, the gross profit margin for taxable goods sales has increased from 15% in 23 to 17.4%. Therefore, it can be seen that with the stabilization of average spending per customer and the company's reduction of discounts, the sales gross profit margin has stopped declining and started to rise again. However, the decline in demand is to some extent a problem that the company cannot solve.

Despite the slight increase in gross profit margin, the sales expense ratio of CITS in the second quarter reached 17.8%, which was 3 percentage points higher than the same period last year. Due to the significant increase in marketing expenses, the company's gross profit margin still decreased by 2.1 percentage points year-on-year in this quarter.

Looking at the composition of sales expenses disclosed in the semi-annual report, the leasing expense ratio in the first half of the year increased by 2.2 percentage points year-on-year, and other marketing expense ratio also increased by 0.7 percentage points. However, with the recovery of inbound and outbound passenger flows contributing to increased revenue at airport ports, it is reasonable for the commissions paid to airports to increase. CITS and major airports such as Beijing and Shanghai have renegotiated contracts to reduce leasing fees, so the expense level will not return to the high levels of 20.

III. Passive Growth in Fixed Costs Leads to a Sharp Decline in Net Profit

In addition to the significant increase in marketing expenses, CITS has been relatively "frugal" in other expenses, with reductions in administrative expenses and tax payments both year-on-year and quarter-on-quarter. Financial expenses increased due to the growth in interest income, resulting in a net income of 350 million. However, the adjustment flexibility of state-owned enterprises' expenses is relatively limited, and as the decline in revenue is greater, the expense ratio has passively expanded

Overall, although the gross profit margin is increasing, due to the significant growth in marketing expenses and the passive amplification of other expenses caused by income shrinkage, the net profit margin attributable to the mother decreased by nearly 1.2 percentage points year-on-year. In addition, coupled with a nearly 18% decline in revenue, the second-quarter net profit attributable to the mother was only 980 million, a decrease of nearly 38% year-on-year.