Category Archives: Consumer Discretionary

PC Jeweller FY2017 Results 6/1/17

PC Jeweller FY2017 Results Review June 1, 2017

 

PC Jeweller reported FQ4 2017 & FY2017 results. The company continues to perform well in a difficult operating environment due to regulatory measures. FY2017 saw demonetization and a stricter regulatory environment including high value purchases require a pan card, and imposition of an excise duty. The company also issued preferred shares to DVI Mauritus and Fidelity investments with a guaranteed dividend yield of 13.0% along with a conversion option. Despite, the regulatory environment PC Jeweller grew by 15.7%. Gross profit grew by 0.3% while operating profit increased by 12.1%.

 

The company’s gross margin declined as exports were a larger portion of sales. The table below illustrates management’s estimates of gross margin by geography and product within the domestic market. Based on the midpoint of the assumptions below gross margin should be roughly 13.37%.


The company improved capital efficiency with inventory only growing by 8.3% in the year. The slight decline in the company’s NOPAT margin combined with the improved capital efficiency saw ROIC increase to 24.7% from 20.9%.  A measure used commonly used in the retail industry is gross margin on inventory. Given the biggest investment within the Indian Jewelry industry is inventory, 57% of PC Jeweller’s 2017 assets was inventory. Since 2008, inventory has accounted for 58% of assets. The typical formula is gross profit divided by average inventory. We modify it slightly by subtracting interest expense from gross profit as the company purchases inventory using gold leases that comes with an interest component.

 

Unfortunately, the GMROI continues to decline. Compared to its peers, PC Jeweller is at the lower end of GMROI. This is particularly concerning when compared to Titan Company, whose GMROI is almost three times higher than PC Jeweller’s as the company generates a higher gross margin and pays less on interest.

 

The company’s declining and poor gross margin return on inventory points to a lack of pricing power.

 

PC Jeweller increased its showroom count to 75 from 60 in FY2017, while the square footage grew by 10% from 352,313 square feet to 386,923 square feet. The company’s average store size decreased to 5,159 square feet.

 

In FY2017, domestic sales per store and square foot decreased by 15.8% and 4.2%, respectively.

 

Since, the government took drastic measures in 2013 to stunt the growth of the gold industry, the primary growth driver for PC Jeweller is new showrooms.

 

The company trialed its first franchise operations and will continue to add additional franchises fueling growth with little additional investment requirements.

 

Overall, PC Jeweller continues to execute and is one of the most profitable and fastest growing companies in the Indian jewelry industry due to the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the strengths of the company and management, government is continually bringing new regulation to the detriment of the industry. Additionally, the industry is fiercely competitive with evidence pointing to no barriers to entry. As discussed in a weekly commentary, the jewelry industry evolution in more developed countries points to no barriers to entry and a compression of profitability towards the cost of capital.

 

Given our research on industry evolution, our base case involves elimination of excess profits by the end of the terminal year as competition intensifies. PC Jeweller is able to grow by 10% over the next five years before fading to 0% terminal growth leading to an estimated annualized return of 2.6%.

 

The optimistic scenario assumes the company to grow its sales by 15.0% over the next five years inline with PC Jeweller’s target of doubling its store count over the same period. In the terminal assumptions, there is assumed to be continued grow of 2.5%. Also, the company is not impacted by competitive forces allowing the company to maintain its profitability leading to an estimated annualized return of 25.4%.

 

The pessimistic scenario assumes no growth and immediate decline in profitability as well as no excess profits in the terminal assumption as competition impacts the company.  The estimated annualized return under the pessimistic scenario is -4.0%.

 

At current valuation levels, the risk rewards is no longer drastically in our favor and a sustained continuation of the company’s excess profits is needed to justify much higher valuations. We will cut our position size to 2.0% as long as the share price is above INR450.

Turk Tuborg 2016 Full Year Results May 11, 2017

Turk Tuborg 2016 Full Year Results May 11, 2017

Turk Tuborg reported 2016 results. The company’s consolidated net sales increased by 29.6% from TRY742.68 million in 2015 to TRY962.7 million in 2016. ASP increases were the main driver of revenue growth as ASP per hectoliter (hl) increased by 30.9% from TRY245.12 in 2015 to TRY320.92 in 2016, while volume decreased by 1.0% from 3.03 million hectoliters (mhl) in 2015 to 3.00 million hectoliters in 2016. Despite the ASP increase and the volume decrease, Turk Tuborg still gained share from Anadolu Efes. Its volume share increased from 31.4% to 33.3% and its market share increased from 33.3% to 40.1%. Turk Tuborg and Anadolu control over 99% of the market so any share gain by one is at the expense of the other.

 

The table illustrates volume, volume share within Turkey, ASP, and market share within Turkey from 2008 to 2016. Since 2008, Turk Tuborg’s volume grew by 13.2% per annum, Anadolu’s volume decreased by 4.3% per annum, and the overall industry volume decline by -0.9% per annum. Since 2008, Turk Tuborg’s ASP increased by 9.9% per annum, Anadolu’s ASP increased by 7.0% per annum, and the overall industry ASP increased by 8.4% per annum.

 

In our initiation report, we believed Turk Tuborg’s product innovation and focused operations along with Anadolu Efes debt load is driving Turk Tuborg’s share gains.

 

In 2016, Turk Tuborg launched Tuborg Amber, the first and only beer in amber category of Turkey illustrating the company’s continued focus on product innovation. Anadolu continues to have operations all over Europe while Turk Tuborg remains focused on Turkey. Anadolu’s extended operations decrease the importance of Turkey on overall operations leading to less management attention. It also adds diseconomies of scale associated with administrating all the different entities. Anadolu improved its financial position to 3.6 times operating profit but capex is lower than depreciation meaning the company is unable to even maintain its current asset base, never mind spending on growth, while, Turk Tuborg grew and modernized its facilities.

 

Since 2011, Turk Tuborg’s average capex to depreciation ratio is 185% compared to Anadolu Efes’s average capex to depreciation ratio of 114%. The capex allowed it to modernize its facilities decreasing the average age of assets from 18.8 years in 2011 to 7.4 years almost on par with Anadolu Efes.

 

Despite Anadolu’s debt load, economies of scale persist. Distribution is crucial as over 50% of Turkish beer sales are through a two-way distribution system where bottles and kegs are returned. Advertising is another important fixed cost that benefits the largest players. These costs are included in the selling expense line on both companies’ income statements. Anadolu does not report Turkish beer expenses but assuming a similar split in operating expenses between administrative and selling expenses, the company’s selling expense can be determined.

 

Despite Anadolu spending almost three times as much on distribution and marketing, Turk Tuborg has made significant share gains. The company seems to be much more efficient with a much better feel for the desires of Turkish customers. Turk Tuborg’s superior management will be very difficult for Anadolu to overcome. Can Anadolu increase its marketing and distribution expense to win back share? The recent past would suggest increasing spending would not do much good. It is also particularly difficult when the company’s debt load is on the higher side. The restrictions on alcohol promotions and advertisements as well as the restrictions on alcohol producers sponsoring events greatly reduces the ability of increased marketing expenses.

 

Turk Tuborg’s saw its gross profit increase by 34.3% and its gross margin expand by 197 bps. Despite, the company increasing its ASP at an average annual rate of 9.9% since 2008, its gross margin has expanded by over 2675 basis points pointing to pricing power. Over the same period, industry volume declined by 0.9% strengthening the case of pricing power.

 

Administrative expenses increased in line with revenue 27.7% at remaining at roughly 5.0% of sales, while selling expenses increased by 26.0% decreasing slightly as a percentage of sales from 25.5% of sales to 24.7% of sales.

 

Operating profit increased by 44.3% from TRY180.78 million in 2015 to TRY260.85 million in 2016. The company’s working capital is negative at –TRY64 million and fixed capital turnover remained roughly the same at 2.82 times. The company’s capital efficiency declined slightly to 3.47 times. Overall, ROIC decreased slightly from 76.1% to 75.2%.

 

Turk Tuborg continues to perform extremely well growing at a fast pace, taking a significant amount of share, and remaining very profitable with an ROIC of 75.2%.  Given the poor liquidity in the company’s stock and political concerns, Turk Tuborg trades on a NOPAT yield of 7.4% with the potential for continued ASP increases of at least 5% per year leading to expected return of at least 12.5% and potentially more. Our weekly commentary dated 12/13/16-12/19/16, looked at acquisition multiples in the beer industry since 1999 and over the last twelve months. The average transaction multiple was 11.7 times EV/EBITDA and 11.5 times EV/EBITDA, respectively.  Assuming a multiple of 12 times EV/EBITDA, Turk Tuborg has 43% upside.

 

The barriers to entry within the Turkish beer industry are extremely strong, with Turk Tuborg and Anadolu maintaining over 99% of the market for over a decade, eliminating any concerns over competitive risks. Additionally, restrictions on alcohol promotions and advertising reduces the risk of increased competitive rivalry. The company has a net cash position at 1.2 times the company’s 2016 operating profit eliminating potential financial risk. The biggest risk is political as Erdogan consolidates his power in Turkey. The consolidation of power eliminates checks and balances typically seen in democracy and Erdogan’s conservative nature may lead to continued attempt to stifle the industry. The government continues to increase excise taxes in attempt to stamp out drinking. The current consumption tax rate on beer is 63%. In 2013, the Turkish government imposing a series of new alcohol restrictions including banning shops from selling alcohol from 10 p.m. to 6 a.m. and prohibited all forms of advertising and promotion of alcohol. Alcohol producers are also barred from sponsoring events, and television broadcasters were required to blur images of alcohol in movies, soap operas and music videos. In a 2010 survey commissioned by the Health Ministry, Ankara’s Hacettepe University found that only 23% of Turkish men and 4% of Turkish women drank alcohol so there may be a tolerance for prohibition. Turkish annual alcohol consumption is the lowest in Europe at 1.55 liters per capita compared to over 10 liters in most European countries.

 

Despite the company’s strong operating performance, strong competitive position, net cash position, and slightly cheap valuation, growth is bound to slow as ASP increase are the driver of growth with industry volumes declining at 1.0% per year. The increasing consolidation of power by Erdogan is worrisome for the industry leading us to decrease our position size to 2.0% as long as the price is above TRY9.00.

 

 

Grendene Q1 2017 Results Review May 8 2017

Grendene Q1 2017 Results Review May 8 2017

Grendene recently reported its Q1 2017 results.  Net revenue grew by 7.2% as domestic revenue grew 23.6%, export revenue declined by 19.1%, and sales taxes and deductions increased by 22%. With regard to pricing, net ASP fell by 1.1% and volume increased by 8.5%. Within Brazil, domestic ASP increased by 7.0% and volume increased by 13.0%. In export markets, ASP declined by 19.8% in BRL terms and 0.3% in USD.  In Q1 2017 Brazil was clearly much stronger than export markets.

 

The table above illustrates total volume, ASP, domestic market volume, domestic ASP, export volume, export ASP in BRL, and export ASP in USD. The company seems to have significant seasonality.

 

In volume terms, Q1 is typically an average quarter overall but it is a weak quarter in the domestic market and a stronger quarter in the export markets. Q1 2017 volume was weak overall relative to the average Q1 volume with domestic volume slightly above the average Q1 volume and export volume well below the typical Q1 volume.

 

The chart above illustrates volume over the trailing twelve months (TTM) for the domestic, export, and a combination of the two (overall). TTM volumes peaked for Grendene in Q4 2013 and fell by 7.7% per annum overall with both domestic and export markets declining by the roughly the same amount.

 

In ASP terms, there is a lot less seasonality with prices consistently increasing in both domestic and export markets at a rate of 2.9% in the domestic market and 3.8% in USD terms in export markets. The ability to raise prices in both domestic and export markets despite a falling volumes and a weak overall macro environment may be a good sign of the company’s pricing power. The company may also be stretching its ability to raise prices as the company sells lower cost shoes that may not provide as much value to customers at higher prices.

 

Grendene’s gross profit grew by 11.0% in Q1 2017 with its gross margin expanding by 59 basis points (bps) over Q1 2016 and 37 bps over Q4 2016. The gross margin expansion over Q1 2016 was driven primarily by a decrease in cost of goods sold per pair as the ASP decreased from BRL13.63 to BRL13.47. Cost of goods sold per pair decreased from BRL7.25 in Q1 2016 to BRL6.95 in Q1 2017. The driver was a decrease in personnel expense.

 

 

Along with higher prices during periods of weak demand, the company’s ability to increase consistently its gross margin points to pricing power.

 

Selling expenses increased by 2.2% year on year, while administrative expenses decreased by 11.7% leading to an increase in operating profit by 28.9%. The company’s continues to maintain a focus on operational efficiency.

 

The company’s increased volume and decreased costs led to a 28.9% increase in operating profit. Grendene’s working capital increased by 2.9% year on year, while PP&E increased by 4.3%.

 

Our initial investment thesis for Grendene was a company that built multiple competitive advantages in the domestic market. Within the domestic market, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets. The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.
We believe the quality of the business remains but the valuation is no longer as cheap as it once was. At the time of our initial recommendation, valuations were attractive with the company trading on a NOPAT yield of 10.1%, a FCF yield of 8.5%, an EV/IC of 1.6 times. Grendene is now trading at a NOPAT yield of 6.7%, a FCF yield of 6.7% and an EV/IC of 5.0 times at a time of elevated profitability.  If we were to normalize margins, Grendene would be trading at a NOPAT yield of 5.3% and a FCF yield of 5.5% making a 5% growth rate into perpetuity necessary for a double-digit return.

 

The company‘s margin of safety has been eliminated leading us to sell our position and no longer cover Grendene. We will continue to follow its developments, in case valuation become more attractive.

 

Honworld 2016 Full Year Results Review 5/7/2017

Honworld 2016 Full Year Results Review

 

Honworld recently reported its 2016 full year results. The company’s revenue grew by 4.0% in 2016 and by 6.5% in the second half of 2016. The company stated growth slowed due to a weakness in the supermarket segment of the condiment industry, which makes sense as five of the largest publicly traded Chinese supermarket companies saw sales grow by 5.5% in 2016. To offset the lack of growth from the supermarket channel, Honworld is building its infrastructure to better address regional small retailers and the catering market. As mentioned in the company’s prospectus and our initiation report, Chinese cooking wine is distributed primarily through retail and catering service channels. In 2012, 50.5% of cooking wine sold through retail channels, 41.5% sold through catering service channels and 8.0% through other channels. Leading cooking wine brands tend to concentrate on retail sales channels as households generally demand higher value cooking wine products and are more brand sensitive. The company has not focused on 41.5% of the cooking wine market sold through catering channels. Additionally, the company has not made an effort to sell through smaller retailers. According to China’s National Bureau of Statistics, hypermarkets and supermarkets accounted for 23.1% of food sales through retailers meaning Honworld has only penetrated a small portion of the total potential distribution channel. The new distribution strategy resulted in an increase in distributors by 531 to 898 total distributors.

 

By product line, medium-range cooking wine and mass-market cooking wine grew the most. The company states the change in the product mix relates to the shift in marketing and distribution strategies.

 

The change in the product mix led to a compression in the company’s gross margin. By our estimates, in addition to a compression in gross margin from a product mix, there was a slight compression in product gross margins. Overall, gross margin contracted by 2.8% with 2.2% attributed to a change in product mix and 0.6% due to product margin deterioration.

 

Selling expense grew by RMB6.15 million or 8.2%. The company’s new distribution channel brought on a 531 new distributors. To service the new distributors, Honworld hired 179 sales employees as the sales staff increased from 61 at the end of 2015 to 240 at the end of 2016. These employees were hired over the year as illustrated by the decline in the personnel expense per year and the moderate increase in selling expenses. Honworld also devoted approximately RMB50.0 million to appoint Mr. Nicholas Tse as our brand ambassador of “Lao Heng He” cooking wine in Mainland China and sponsored Chef Nic, a cooking reality show hosted by Mr. Nicholas Tse. 2017 should see a significant increase in selling expenses. Given the company’s size advantage over competitors, the increase spending on sales and marketing expenses is a wise allocation of capital as these are fixed costs that smaller competitors will have difficulty matching while remaining profitable.

 

In addition to the new sales and marketing employees, the company added 60 new production employees and 18 new R&D and quality control employees. In 2016, Honworld also expanded its production facilities, acquired new production equipment. The new employees and expanded production facility point to an increase in production in 2017.

 

Administrative expenses saw an increased by RMB2.8 million or 3.5%. It seems the Honworld’s focus is on increased production and sales and marketing rather than R&D, which makes a lot of sense given the company’s inventory levels.

 

Overall, the company’s decrease in gross margin due to product mix and overall deterioration as well as the increase in operating expenses led to a RMB15.12 million or 4.8% decrease in the company’s operating income.

 

The company’s largest investment is in inventory, which accounted for 46% of invested capital in 2016. Honworld’s inventory turned over 0.76 times during 2016. One of the key inputs into cooking wine is base wine particularly aged base wine. The ageing process leads to the poor inventory turnover. The company states it has reached its desired inventory levels. The huge investment in inventory has been one of the major reasons for the company’s poor profitability relative to the quality of the business. Honworld no longer reports the amount of base wine required for each liter of cooking wine but the company reported the amount of base wine in each product in the IPO prospectus.

 

As illustrated above, there is a lot of variation in the amount of base wine, vintage base wine, and aged base wine used in each product category over the period examined. Base wine is either vintage base wine or mixer base wine is naturally brewed yellow rice wine, which is either vintage base wine or mixer base wine. Vintage base wine is base wine that has been aged over two years. Mixer base wine is base wine aged less than two years.

 

The company should be reporting the percentage of vintage base wine, mixer base wine, and total base wine by product category in every financial report as inventory level is one of the most important drivers of the company’s profitability. In addition, due to the nature of the product, it is not clear how inventory relates to sales without the above analysis and sales volumes by product category. The complexity of the relationship between inventory, product sales, and profitability should make management be as transparent as possible so investors can be educated about the company’s business model. Until it does, the company will have difficulty realizing the company’s intrinsic value.

 

The table below illustrates the amount of base wine and age of base wine in each product category as well as for 2014, 2015, and 2016 based on their product mix.

 

In 2013, a liter of premium cooking wine contained 0.06 liters of vintage base wine with an average age of 10 years and 0.87 liters with an assumed average age of 1 year leading to 0.93 liters of base wine with an overall average age of 1.4 years.

 

A liter of high-end cooking wine contained 0.06 liters of vintage base wine with an average age of 8 years and 0.81 liters with an assumed average age of 1 year leading to 0.87 liters of base wine with an overall average age of 1.2 years.

 

A liter of medium-range cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.81 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 0.9 years.

 

A liter of mass-market cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.64 liters with an assumed average age of 1 year leading to 0.68 liters of base wine with an overall average age of 0.7 years.

 

Assuming 2016 product mix continues the average liter of cooking wine contained 0.045 liters of vintage base wine with an average age of 6.4 years and 0.804 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 1.0 years.

 

Mixer base wine is anything under 2 years so the assumption of 1-year age of mixer base wine is not necessary. The company could mix base wine and use it shortly after producing it. Typically, it takes 35-40 days to produce base wine, which can only be done during cooler weather months of October to May.

 

Management has not reported ASP and volume by product since its IPO prospectus, but assuming no change to ASP of each product, volume sold can then be calculated.

 

We can see cooking wine sales reached an estimated 86 million liters in 2016. Sales are estimated base wine age of 1 year. Assuming the company keeps an additional 1 years of inventory as a buffer for growth. Some inventory also needs to be aged for premium products. The 2016 product mix required only 4.5% of vintage wine for every liter of cooking wine. Assuming another 0.5 years of inventory for aging or ten times the required amount each year leads to a potential of eleven years of aged inventory, the very highest average age of vintage base wine used is premium products at 10 years of ageing. 84% of estimated volume sold in 2016 was for medium-range and mass-market products that use vintage wine with 5.5 years of aging, half the eleven years of inventory. Total inventory with a buffer of 2.5 years of sales is roughly 215 million liters of inventory. Unfortunately, the company does not provide gross margin by product to allow us to estimate the cost of carrying the inventory. Gross margin can be estimated by making slight changes to gross margins by product each year to equate the estimated gross margin to the reported gross margin.

 

With the gross margin for each product, cost of goods sold per liter can be calculated to estimate to total inventory levels required for 2.5 years worth of sales volume.

 

As illustrated in the table above, the estimated cost of goods sold per liter was RMB3.2. With 2.5 years of sales volume or 215 million liters of inventory deemed sufficient, total inventory should be RMB692 million. Adding 1 years inventory for soy sauce and vinegar, total inventory on the balance sheet should be closer to RMB775 million well below actually inventory levels of RMB1,088 million meaning the over invested in inventory is just over RMB300 million.

 

2.5 years of inventory should be sufficient but Honworld could probably get away with a level much lower as mixer base wine does not need to be aged and the company should be making sufficient mixer base wine. In addition, another 50% of base wine should be produced for growth and aging to create vintage base wine as the company only needs about 4.5% of volume sold in vintage base wine. The company loaded up on inventory to age well above its vintage base wine requirements, particularly when the product mix is shifting to medium-range and mass-market products that do not need as much vintage base wine. The upfront investment destroys profitability and puts into question the capital allocation skills of the management team.

 

The increase in inventory requirements may not be a function of poor capital allocation skills but a function of deteriorating quality of the business. This would be even more concerning that poor capital allocation skills as management can change its capital allocation but it can’t change the competitive dynamics of the industry. Honworld was the leader in naturally brewed cooking wine. If competitors followed the company’s path eliminating alcohol and artificial ingredients, competition based on product quality with an increased the amount of vintage base wine and base wine ageing profitability in the industry could remain depressed for some time.

 

The vast majority of PP&E is tied to investment in inventory as facilities were created to store base wine or produce more cooking wine. Since 2010, each additional RMB spent on inventory required an addition RMB0.7 in PP&E. The RMB300 million in excess inventory requires an additional RMB210 million investment in PP&E. Eliminating the RMB510 million in inventory and additional PP&E investments, invested capital is closer to RMB1,855 with an operating income of RMB281 million, Honworld’s pre-tax ROIC should be above 15.2% rather than actual pre-tax ROIC of 11.8% in 2016.

 

If the company were able to get inventory levels down to 2 years and eliminate associated investments in PP&E, Honworld’s ROIC would be 18.0% rather than 11.8%. The higher the company’s ROIC the higher the EV/IC the company should trade on as illustrated by our recent post ROIC vs. EV/IC.

 

In addition to the poor capital allocation due to overinvestment in inventory and related PP&E, pre-payments for land leases and non-current assets have increased from 0 in 2013 to RMB386 million in 2016. These soft accounts are very concerning as it is a serious misallocation of capital and may point to fraud. Making pre-payments for non-current assets equal to 16% of invested capital to lock in raw material costs and equipment costs does not make much sense when you have pricing power as illustrated by the recent price increases and your inputs are pure commodities. The timing of the allocation to soft asset accounts is particularly concerning as the company just finished overinvesting in inventory depressing free cash flow and profitability.

 

As illustrated above, Honworld’s total debt increased by RMB204 million from RMB645 million to RMB849 million leading to finance costs of RMB40.6 million or an effective interest rate of 5.4% on debt. The company has a net cash position of RMB520 million up from RMB189 billion at the end of 2015 with RMB1.02 million in cash leading to an effective interest rate on cash is 0.3%. The increasing cash balance with the increasing debt balance does not make much sense. If the company has that much cash on the balance sheet why is it holding it and earning such a poor return, when the company can pay down a large portion of its debt and decrease the company’s finance cost by roughly RMB22.7 million per year, assuming no change in the effective interest rate of debt.

 

Overall, Honworld has a strong business with economies of scale in sales and marketing and R&D. The product habit-forming characteristics include low price, which increases search costs, and is a key ingredient in dishes. The company has a strong growth outlook serving a small amount of its potential market and infrastructure build to service a greater portion of the market. Valuations are not demanding with a 10% NOPAT yield and an EV/IC of 0.95. Unfortunately, management’s overinvestment in inventory, related PP&E, pre-payments for non-current assets and not paying down debt are too much of a concern, particularly the timing of allocation of capital to soft asset accounts. The misallocation will continue to lead to poor ROIC. If the company was not located in China, where frauds occur regularly, the misallocation of capital would be less of a concern and more patience would be warranted. We are no longer recommending the stock and selling our position in our model portfolio, but will continue to follow the company with a hope that capital allocation and profitability improves.

WEEKLY COMMENTARY 2/6/17-2/12/17

WEEKLY COMMENTARY               2/6/17-2/12/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

After the company’s recent share price appreciation, Grendene’s estimated five-year annualized return has fallen to roughly 10% base on scenario analysis.

 

There are barriers to entry within Grendene’s Brazilian business. Within Brazil, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good with a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets but growth in exports markets will come with lower profitability due to the weakened competitive position and excess returns.

 

Owner operators with strong operational skills, an understanding of its competitive position, and who treat all stakeholders with respect run the company. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.

 

Given the company’s expected return, the company’s competitive position, and the strength of management, we are decreasing our position size to 2.0%. Please review our initiation (link) for a more in-depth discussion on the company.

 

 

INTERESTING LINKS

 

 

My Interview with Jason Zweig (Safal Niveshak)

 

Vishal Khandelwal interviews Jason Zweig, who provides some very good ideas on improving your investment process. (link)

 

 

The Making of a Brand (Collaboration Fund)

 

In a wonderful article, Morgan Housel of the Collaboration Fund discusses the history of brands and what a brand is. (link)

 

 

Riding a retail roll out (Phil Oakley)

 

Phil Oakley discusses the difficulty in investing in retail rollouts. (link)

 

 

January 2017 Data Update 7: Profitability, Excess Returns and Governance (Musing on Markets)

 

Professor Damodaran provides some interesting statistics on ROIC across geographies and sectors. (link)

 

 

Investing Mastery Through Deliberate Practice (MicroCap Club)

 

Chip Maloney talks about the benefits of deliberate practice and how to use deliberate practice to make you a better investor. (link)

 

 

Out with the old (Investor Chronicle)

 

Todd Wenning provides insight on when to sell your investments (link)

 

 

2 Bitter Truths of Stock Valuation…and How You Can Avoid Them (Safal Niveshak)

 

Vishal Khandelwal highlights potential mistakes in valuing companies and how to avoid them. (link)

 

 

Revlon’s restructuring plan represents the future of legacy beauty (Glossy)

 

Glossy magazine writes about the beauty business. (link)

 

 

6 smart tips for micro-cap investors (Morningstar)

 

Ian Cassel gives readers 6 tips for micro-cap investors. These are useful for all investors. (link)

 

 

HAW PAR CORPORATION (HPAR:SP)

 

 

Company Description

 

Haw Par Corporation is a corporation with two operating businesses and strategic investments. The company’s two operating businesses are healthcare and leisure. The company’s healthcare business is the owner of the Tiger Balm, a well-known topical analgesic. The company’s leisure business own and operate two aquariums: Underwater World Singapore in Sentosa and Underwater World Pattaya in Thailand. The company also has investments in property and quoted securities.

 

 

Healthcare

 

Haw Par’s healthcare business manufactures and markets Tiger Balm and Kwan Loong. Tiger Balm is a renowned ointment used worldwide to invigorate the body as well as to relieve aches and pains. Its product extensions such as Tiger Balm Medicated Plaster, Tiger Balm Joint Rub, Tiger Balm Neck and Shoulder Rub, Tiger Balm Mosquito Repellent Patch and Tiger Balm ACTIVE range cater to the lifestyle needs of a new health-conscious generation..At first glance, the company’s healthcare business looks like a very attractive business. Tiger Balm is a trusted brand that has been around for over 100 years and generates very strong profitability.

 

Over the past four years, the healthcare business has increased sales by 18.4% per year while increasing its operating margin by 4.4 percentage points per annum and asset turnover by 0.14 per annum leading to an increase in its ROA from 27.7% in 2012 to 60.9% in 2015.

 

The majority of Haw Par’s health care business revenues are in Asia, but the company is growing fastest in America.

 

The company’s strategy for the healthcare business is to drive growth from further product penetration across existing markets to widen the brand franchise for Tiger Balm. The company has launched new products in several markets. Sales of Tiger Balm’s range of traditional and new products continued to grow in most of its key markets. The healthcare business’ margins improvement is due to lower commodity prices mitigating the pressures from rising staff costs amid tight labor markets.

 

 

Leisure

 

Haw Par’s leisure business owns two aquariums, Underwater World Singapore and Underwater World Pattaya.

 

In 2012, the company’s two aquariums attracted 1.48 million visitors at an average price of SGD20.50 leading to a SGD30.3 million in sales. The company generated operating profit of SGD11.80 million and a ROA of 45.8%. In 2015, the company attracted 0.76 million visitors to its two aquariums at an average price of SGD16.85 leading to SGD12.74 million in sales. The company had operating profit of SGD0.15 million, a segment profit of SGD-4.34 million and a ROA of 1.3%.  From 2012 to 2015, the number of visitors to the company’s two aquariums declined by 20% per year and the average price per visitor declined by 6.3% per year causing a sales to drop by 25.1% per year. The high level of fixed costs in the business saw operating profit fall by 76.8% per year.

 

The decline in the leisure business was caused by a decline in tourism and stiff competition from existing and new attractions, including direct competitors within the immediate vicinity of the two aquariums.

 

The leisure business is a great business as long as you are attracting a sufficient number of visitors to your property as the business is primarily fixed costs. Unfortunately, competition can easily enter the market in your vicinity decreasing the number of visitors at your property causing a decline in sales as you drop prices to attract people and an even greater decline in operating profit due to the operating leverage in the business.

 

 

Property

 

Haw Par’s owns three properties in Singapore and one in Kuala Lumpur. Of the company’s four properties, three are office buildings and one is an industrial building.

 

At the end of 2015, the company has total letable area of 45,399 square meters with an occupancy rate of 64.6%.

 

In 2015, the property division generated sales of SGD14.33 million, operating profit of SGD8.56 and ROA of 4.0%.  The division’s occupancy rate has fallen by almost 30 percentage points from 2013 to 2015, this could be due to a weaker environment or a deterioration of the properties’ competitive position as newer properties become available. I am not a big fan of property investments, as they tend to have poor return on assets and require significant leverage to generate a return near our required rate of return of 15%. On top of the poor profitability in the business, Haw Par’s occupancy rates have been falling potentially pointing to a weaker competitive position of the company’s properties.

 

 

Investments

 

Since 2012, Haw Par’s investment business accounted for 76.7% of the assets on the company’s balance sheet. At the end of 2015, United Overseas Bank (UOB:SP) accounted for 66.4% of the company’s available for sale securities, UOL Group (UOL:SP) accounted for 13.0%, and United Industrial Corp (UIC:SP) accounted for 9.5%.  United Overseas Bank, UOL Group, and United Industrial are all related parties as Wee Cho Yaw is the Chairman of Haw Par and the three other corporations.

 

Profit before tax is dividend income. Since 2012, the investment business has generated an average dividend income of 3.2%.

 

Since 1987, United Overseas Bank’s average annualized return was 7.0%, UOL Group’s was 5.2%, and United Industrial’s was 1.2%, nowhere near an acceptable return.

 

 

Management

 

Members of management are owner operators with insiders owning roughly 60% of Haw Par.  Management is doing a great job operating Tiger Balm but the rest of the business is a capital allocation nightmare with poor investments in leisure and property along with significant cross holdings in other family businesses.

 

Management also extracts far too much value with the average remuneration to key management personnel over the past two years at 9.9% of operating income. Operating income is used rather than profit before tax as the investment income and property income are poor capital allocation decision and it would be best if that money were returned to shareholders.  Since the income generated below operating profit detracts value it is best if operating profit is used. There are related party transactions outside of key management compensation. The company has no related party transactions.

 

 

Valuation

 

The poor capital allocation and management value extraction makes the business nothing more than a deep value holding, which would require at least 50% upside using conservative assumptions to be investible. To value the company, we value the healthcare business based off a multiple of operating profit and value all other division based on liquidation value due to the poor trends see in those businesses.

 

Given the quality and growth in Haw Par’s healthcare business, we believe 15 times operating profit is a fair multiple for the business. The company’s leisure business is given no value as the number of visitors continues to decline due to newer attractions and the company’s operating leverage means the company was barely breaking even in 2015. Cash and net working capital is valued at 100% of balance sheet value. The company’s property is seeing declining occupancy rates. We conservatively assume this to be a sign of the property’s deteriorating competitive position. There are also fees associated with any liquidation therefore we value the property assets at 75% of current value. The company’s available for sale securities are assumed to be liquidated at 75% of current value, as the holdings are so large that they would have a market impact if Haw Par ever tried to sell its shares.

 

Overall, Haw Par would be interesting below SGD7.50 but only as a deep value holding given the poor capital allocation and high management salaries.

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

 position-summary-table

 

 

COMPANY NEWS

 

PC Jeweller

 

PC Jeweller reported FQ2 2017 results on November 23, 2016. During the quarter, the company opened five stores including a franchised showroom bringing the total number of showrooms to 68. The company also introduced the Inayat wedding jewelry collection and the Azva festive and wedding season collection, which is selling in 15 independent retailers.

 

Year on year, the company’s revenues grew by 30.2%, gross profit declined by 0.9%, and operating profit declined by 5.3%. Gross margin declined from 16.3% in FQ2 2016 to 12.4% in FQ2 2017. To review the company’s business, the mix between exports and domestic sales and the mix between diamond and gold jewelry sold drive gross margin.

pc-jeweller-business-model

The expected sales mix between domestic sales and export sales is roughly 67 % to 33% with domestic sales having an estimated gross margin of 16-17% while export sales have a gross margin of 6-8%. Gold jewelry sales is expected to represent 70-75% of domestic sales with a gross margin of roughly 10%, while diamond jewelry sales is expected to represent 25-30% of domestic sales with a gross margin of roughly 25-30%.

pc-jeweller-sales-mix-and-gross-margin

The table above illustrates the actual figures on a quarterly basis dating back to the quarter ending December 2012. Since FQ3 2013, domestic sales averaged 72.3% of sales while gold sales averaged 70.5% of domestic sales. Domestic sales averaged a gross margin of 16.4%, export sales averaged a gross margin of 10.6%, and the overall gross margin averaged 14.4%. Using expected figures, gross margins should range from 12.7% to 14.0%. Operating expense averaged 3.8% of sales leading to an expected operating margin range of 8.9% to 10.2%.

 

Regarding demonetization, 32% of sales are cash sales so the company expects short-term impact from demonetization.

 

Overall, the company is operating in an industry without barriers to entry as illustrated by the thousands of competitors, but management has been able to consistent excess profits when peers other than Titan have struggled to generate any excess profits. Given the ability generate excess profits during industry distress and when peers cannot gives us confidence that valuing the company on earnings is appropriate.

 

Under our pessimist case scenario, which assumes a 12.5% discount rate, no growth into perpetuity and profitability fading to the discount rate in year 10, PC Jeweller has 4.3% annualized downside over the next five years. Under our base case scenario, PC Jeweller grows at 10% for a five-year forecast period (store openings) before fading to 0% in the terminal value in year 10. Current excess profits remain over the forecast period before halving in the terminal. Excess profits persist in our base case because of the strength of management and evidence that the company can generate excess profits when competitors cannot. Under the base case, PC Jeweller’s estimated annualized return is 9.1% over the next five years. Under the optimistic case, there is no change to profitability with growth increasing to 15.0% over the forecast period and 2.5% growth in the terminal value leading to an annualized return of 16.0% over the next five years.

 

The table below illustrates our assumptions under each scenario as well as historical averages for each key value driver.

pc-jeweller-scenario-assumptions

 

The company’s management is very strong and continues to generate excess returns in a fragmented industry where competitors struggle to generate excess profits. We will maintain our 4.0% position size.

 

 

PRE-RESEARCH REPORT

 

Executive Summary

 

ABS-CBN is a Filipino media conglomerate with three business segments: TV and Studios, Pay TV Networks, and New Business. The TV and Studios business generates 73.6% of revenue and 92.1% of EBITDA. Economies of scale exist in the form of content creation and distribution creating an advantage for the largest competitors. ABS-CBN is the largest. Unfortunately, the company is operationally inefficient generating an average of roughly 10% return on net operating assets over the past three years. The company’s Pay TV Network business only generates an average return on net operating asset of 2.3% over the past three years despite having a 45% cable market share in the Philippines. New businesses are a disparate group of organizations with no strategic connection pointing to extremely poor capital allocation. The average NOPAT margin of new businesses over the past three years is -253.4%.

 

Given the inability of the company to generate a reasonable return on a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would potentially warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business. To reach an acceptable buy price, the company’s share price would need to fall to PHP15.00 per share.

 

 

Company Description

 

ABS-CBN Corporation is the Philippines’ leading media and entertainment organization. Primarily involved in television and radio, the company has expanded owning the leading cinema and music production/distribution companies in the country as well as operating the largest cable TV service provider.

 

ABS-CBN has business interests in merchandising, licensing, mobile and online multimedia services, publishing, video and audio postproduction, overseas telecommunication services, money remittance, cargo forwarding, TV shopping services, food and restaurant services, theme park development and management, and property management.

 

 

History

 

ABS-CBN Corporation traces its roots from Bolinao Electronics Corporation (BEC), an assembler of radio transmitting equipment, established in 1946. In 1952, BEC adopted the business name Alto Broadcasting System (ABS) and began setting up the country’s first television broadcast by 1953. On September 24, 1956, Chronicle Broadcasting Network (CBN), owned by Don Eugenio Lopez Sr. of the Lopez family, was organized primarily for radio broadcasting. In 1957, Don Eugenio Lopez Sr. acquired ABS and on February 1, 1967, the operations of ABS and CBN were integrated and BEC changed its corporate name to ABS-CBN Broadcasting Corporation. On August 16, 2010, the Philippine Securities and Exchange Commission approved the change of the corporate name to ABS-CBN Corporation reflecting the company’s diversified businesses in existing and new industries. ABS-CBN achieved many firsts since it started the television industry in the country in 1953. However, with the imposition of martial law in September 1972, ABS-CBN ceased operations as the government forcibly took control. ABS-CBN resumed commercial operations in 1986 after the People Power or EDSA revolution. Despite being shut for 14 years, ABS-CBN recaptured leadership in the Philippine television and radio industries by 1988. During the 1990s and the early part of the new millennium, the company expanded and ventured into complementary businesses in cable TV, international distribution, mobile services, and magazine publishing among others.

 

 

Shareholder Structure

 

The top 20 shareholders own 98.57% of the business.

abs-cbn-shareholder-structure

 

Lopez Inc. is the largest shareholder at 55.15%. Lopez Inc. is a Filipino business conglomerate owned by the López family of Iloilo. Oscar M. López is the Chairman Emeritus and his brother Manuel M. López is the current Chairman and Chief Executive Officer of the López Group. It was first established by Eugenio Lopez, Sr. in 1928. It has holdings in many industries including media, power, energy, real estate, infrastructure, and manufacturing.

 

PCD Nominee Corporation is a wholly owned subsidiary of Philippine Central Depository. Shares are held at PCD Nominee Corporation for other shareholders.

 

 

Current Business

In 2015, ABS-CBN’s generated PHP38,278 million with 73.6% of revenue from the TV and Studio business, 21.1% from Pay TV Networks and 5.2% from new businesses.

abs-cbn-revenue-by-segment

 

In 2015, ABS-CBN generated PHP8,083 million in EBITDA. The TV and Studio business generated 92.1% of EBITDA, Pay TV Networks generated 20.7%, and new businesses generated -12.8%.

abs-cbn-ebitda-by-segment

 

As illustrated above, ABS-CBN has three business segments: TV and Studio, Pay TV Networks, and new businesses.

 

TV and Studio

 

The TV and studio segment is comprised of broadcast, global operations, film and music production, cable channels and publishing. This consists of local and global content creation and distribution through television and radio broadcasting.

 

abs-cbn-tv-and-studio-revenue

 

In 2015, free to air TV accounted for 63.4% of revenue, global operations accounted for 19.2% of revenue, with films and music, narrowcast, and others accounting for the remaining 17.4% of revenue.

 

The Free to air TV business includes content creation and distribution mainly through free TV and radio with Channel 2 and DZMM as its flagship platforms. The content created is predominantly in Filipino and is aimed at the mass Filipino audience. The company’s leading position in the Philippine television broadcasting industry is largely due to the popularity of its entertainment programs, while the news and public affairs programs have developed a reputation for the quality of news coverage that includes national, local and international events.

php-ratings-and-audience-share

 

In 2015, ABS-CBN 41.5% audience share in all of Philippines. There is significant barrier to entry in the form of economies of scale with content creation being a large fixed cost required to acquire an audience. The industry is very concentrated pointing to the existence of a barrier to entry. The top two players ABS-CBN and GMA Network have roughly an 80% market share.

 

The global business pioneered the international content distribution through Direct to Home, cable, Internet Protocol Television, mobile and online through The Filipino Channel. It is available in all territories where there is a significant market of overseas Filipinos such as the Unites States, Middle East, Europe, Australia, Canada and Asia Pacific. Other activities include international film distribution, remittance, retail, sponsorships and events. Similar to free to air, there are economies of scale in the form of content creation with much of the content created for the free to air business can be used in global operations. Distribution is another fixed cost in the global segment intensifying economies of scale. Efficient scale also comes into play, as the global market for Filipino content is not that large therefore the market cannot support many players. GMA Network also produces content for the international market.

 

The films and music business is composed of movie production, film distribution, audio recording and distribution and video and audio postproduction. Films and music needs are generally produced through ABS-CBN Film Productions Inc. (AFPI), more popularly known as Star Cinema. Other movies are co-produced with other local or international producers or are simply distributed by AFPI. Music needs are also managed by AFPI to complement the recording needs of the company’s multi-talented artists and handle music publishing and composing requirements, respectively.

 

The Narrowcast and sports business caters to the needs of specific or targeted audiences or markets not normally addressed by the broadcast business. Included in this line of business are cable programming and channel offerings such as Filipino movie channel, music channel, animé, upscale male sports content and upscale female lifestyle content. It also covers print, sports, and other niched programming via its UHF (Ultra High Frequency) channel. Narrowcast includes the following subsidiaries: Creative Programs, Inc., ABS-CBN Publishing, Inc., and Studio 23, Inc. As part of the company’s goal to elevate boxing as a sport in the country, it entered into a joint venture agreement with ALA Sports Promotions, Inc., a world class boxing organization and promotional company.

 

In the whole TV and Studio segment, economies of scale as content creation or acquiring content is a significant upfront fixed cost. Being the market leader in free to air TV with a 41.5% audience share illustrate the strong competitive position of ABS-CBN.

tv-studio-key-drivers

 

Despite the existence of economies of scale and market share leadership, ABS-CBN’s is only able to generate an average return on net operating assets of 9.9% over the past three years point to operational inefficiency.

 

 

Pay TV Networks

 

ABS-CBN owns 59.4% of Sky Cable Corporation. Sky Cable provides cable television services in Metro Manila and in certain provincial areas in the Philippines. As of December 2015, Sky Cable held a 45% market share in the Philippines. Sky Cable’s main competitor in the pay TV business is Cignal. The company also competes with other small local operators in certain cities it operates in, but no other operator has the same scale and geographic reach as Sky Cable. Given the fixed cost associated with infrastructure needed for cable coverage, size is a key competitive factor. Size also helps with bargaining power.

 

The company also provides broadband internet services through Sky Broadband. PLDT dominates the broadband industry with 65% market share.

pay-tv-network-key-value-drivers 

 

Cable television requires infrastructure, which is an upfront fixed expense. Despite its size advantage, Sky Cable is unable to generate a reasonable return pointing to operational inefficiency.

 

 

New Business

 

ABS-CBN’s new businesses include wireless telecommunications business, digital terrestrial television, theme parks and home shopping.

 

ABS-CBN mobile’s network sharing agreement with Globe Telecom enables the company to deliver content in addition to traditional telecommunication services on mobile devices. Through the network-sharing agreement, Globe provides capacity and coverage on its existing cellular mobile telephony network to ABS-CBN Convergence, Inc. (ABS-C) on a nationwide basis. The parties may also share assets such as servers, towers, and switches.

 

In February 2015, ABS-CBN commercially launched the digital terrestrial television (DTT). The company continues to invest in DTT equipment to improve clarity of signal in certain areas of Mega Manila and Central Luzon with a belief that the transition from analogue to digital will result in an increase in its audience share.

 

ABS-CBN invested in a theme park more popularly known as KidZania Manila. KidZania provides children and their parents a safe, unique, and very realistic educational environment that allows kids between the ages of four to twelve to do what comes naturally to them: role-playing by mimicking traditionally adult activities. As in the real world, children perform “jobs” and are either paid for their work (as a fireman, doctor, police officer, journalist, shopkeeper, etc.) or pay to shop or to be entertained. The indoor theme park is a city built to scale for children, complete with buildings, paved streets, vehicles, a functioning economy, and recognizable destinations in the form of “establishments” sponsored and branded by leading multinational and local brands.

 

Launced in October 2013, A CJ O Shopping Corporation is a joint venture between ABS-CBN and CJ O Shopping Corporation of Korea to provide TV home shopping in the Philippines.

new-business-key-value-drivers

 

ABS-CBN’s new businesses generate significant losses and there seems to be no strategic logic when allocating capital. New businesses are from a variety of industries where the company does not have any particular competitive advantage, which leads to the losses. The poor capital allocation will affect the ability of the company to grow its intrinsic value. Capital allocation is unlikely to change with the current management and ownership.

 

 

Valuation

 

Given the inability of the company to generate a reasonable return in a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business.

 

 

INTERESTING LINKS

 

A Dozen Things Warren Buffett and Charlie Munger Learned From See’s Candies (25iq)

A discussion about the lesson from See’s Candies (link)

 

Mental Model: Price Incentives (Greenwood Investors)

An good article by Greenwood Investors discussing discounting and brands (link)

 

Two Powerful Mental Models: Network Effects and Critical Mass (A16Z)

The title speaks for itself, an excellent essay on network effects and critical mass. (link)

 

The Reason We Underperform – Markets Have Evolved Faster Than Humans (Acquirer’s Multiple)

An article discussing potential behavioral reasons for the underperformance of fund management. (link)

 

Anatomy of a Failed Investment (Tom Macpherson- Gurufocus)

A great reminder to never be too confident of one’s views as there is only so much that one can prove to be absolute truth. Understand the counter to your argument and always remember looking for evidence confirming either side. (link)

 

Frozen Accidents: Why the Future Is So Unpredictable (Farnam Street)

The must read blog Farnam Street discusses how complexity and randomness make prediction a difficult if not impossible task. (link) We agree with the difficulty associated with forecasting and attempt to make as few forecasts as possible. Instead, we wait until the key value drivers being priced into by the market are so pessimist that there is little downside.

 

WEEKLY COMMENTARY NOV 7 2016 – NOV 14 2016

WEEKLY COMMENTARY NOV 7 2016 – NOV 14 2016

 

COMPANY NEWS

 

PC Jeweller declined by 14% over the last three days of the week as the Indian Government decided to ban all INR500 and INR1,000 notes to fight black money. Roughly, 80% of the industry sales are in cash. In the short term, there will be an impact. In the longer term, it may increase the attractiveness of gold and jewelry as a store of value as credibility of the government and its potential actions decrease. It may also help consolidate the market in the organized sector. PC Jeweller offers a 7.8% NOPAT yield. We are maintaining the current position size of 2.0% for now with any further price declines probably prompting a position size increase.

 

Turk Tuborg reported Q3 2016 results with revenue increasing 39% while net profit increased by 55%. It remains extremely profitable with a Q3 2016 annualized ROIC of 151%. Turk Tuborg continues to gain share on Anadolu Efes with Anadolu Efes Turkish beer revenue increasing by 2.5% in Q3 2016. Over the past 12 months, Turk Tuborg gained 7 percentage points of market share (34% to 41%). These two players have accounted for over 99% of the industry for many years. It also is much more profitable generating 1.14 times the EBITDA of Anadolu’s Turkish beer operations on 70% of the sales. Turk Tuborg net profit was six times Anadolu’s Turkish beer operations net profit due to the financial leverage employed by Anadolu. The combined market share, a two-way distribution system (bottles and kegs account for over half the market), and the economies of scale within the industry alleviate concerns of entry from new players. Competitive rivalry is also weak despite Turk Tuborg’s share gains due to Anadolu Efes financial leverage (6.1 times EBIT in 2015), currently a big concern of the company. Anadolu is also a much bigger entity with operations all over Eastern Europe diverting their attention while Turk Tuborg is focused solely on the Turkish market. The big risk to the investment case is the increased centralized control within Turkey may decrease secularism in the country leading to prohibition. The Turkish government taxes the Turkey’s beer market heavily making it a steady stream of revenue for the government, which it may not want to lose through prohibition. Turk Tuborg now trades at an EV/ttm EBIT of 7.8 times with a net cash position almost two times ttm EBIT. We will maintain our 4.4% position potentially increasing if there are any significant share price declines.

 

 

COMPANY IN FOCUS

 

Veto Switchgears and Cables

 

Executive Summary

Veto operates in a commodity business with low barriers to entry yet only offers a NOPAT yield of 6.1%. The commodity nature of the business means growth does not add value and therefore does not generate any additional return, therefore the current expected return is 6.1% well below the required return for a commodity business.

 

Company Description

 

Veto Switchgears and Cable manufactures wires & cables, electrical accessories, industrial cables, fans, CFL lamps, pumps, modular switches, LED lights, immersion heater, MCB and distribution boards.

Veto has a distribution network of 2,500 dealers across the country with a majority of revenues coming from Rajasthan with growth opportunities in the rest of India and the Middle East. Given it growth potential, the company purchased 10,312.99 square meters in SEZ Jaipur to increase manufacturing capacity. The company’s targets reaching more than Rs.1,000 crores in sales by FY2021. The company’s current capacity and capacity utilization is illustrated below.

capacity-and-capacity-utilization

The company’s main raw materials are copper, PVC resin, and aluminum.

raw-materials

 

The company listed on the public stock exchange in 2012. The promoters own 58.19% of the company down from 71.76% at the end of December 2015.

 

Industry

The company describes the industry as fragmented with low barriers to entry therefore the only way to generate excess returns is through operating efficiency. Given the difficulties maintaining a competitive advantage, it will be difficult sustaining excess profits and therefore the company should trade at reproduction value.

 

A volatile ROIC averaging 15.8% over the past five years seems to confirm the lack of competitive advantage but the company’s capacity utilization is low providing an opportunity for the company to double its ROIC. An inconsistent gross margin is evidence of a lack of pricing power.

 

Management

Management has not overly levered the company with current net debt to 5-year average operating income of 1.95 times.

 

Management remuneration is reasonable at 2.0% of operating income in FY16 and FY15.

 

Related party transactions are relatively insignificant at 2% of sales.

 

Given the lack of barriers to entry, the company’s number one strategic focus should be operational efficiency.

 

Valuation

Assuming an 12.5% discount rate, cyclically adjusted operating margin, and cyclically adjusted capital efficiency, for the company to generate over a 10% annualized return, the company needs to grow by 20% over the next five years fading to 5% terminal growth rate in year 10. Given the lack of barriers to entry in the industry, any growth should not generate any value therefore is irrelevant making the market’s current assumptions very aggressive.

 

Veto currently offers a NOPAT yield of 6.1%. As mentioned the commodity nature of the business means growth does not add value and therefore does not generate any additional return, therefore the current expected return is 6.1% well below the required return for a commodity business.

 

Risk

Continued growth in the market alleviates competitive pressures allowing the company to main elevated returns.

 

The company fills capacity and is able to double its ROIC through much better capital efficiency.

 

Key Areas of Research Focus

  1. Operating costs relative to peers

 

 

INVESTMENT THOUGHT

 

Whether an industry has a barrier to entry or not is a key question in our investment process. In an industry with barriers to entry, competition cannot freely enter limiting the potential supply in the market allowing excess profits to be sustained. The sustainability and predictability of earnings or cash flows means an earnings or cash flow based valuation is a more appropriate valuation methodology. If barriers to entry do not exist in the industry, competition will freely enter the market leading to a reversion of profitability to the cost of capital. In times of elevated profitability, supply will increase until profitability reverts to the cost of capital. In an industry with no barriers to entry, the appropriate valuation methodology is reproduction value or the value of a new competitor to reproduce the assets of the company.

 

In a scenario of no barriers to entry, we also take into account barriers to exit. An industry with no entry barriers and no exit barriers, profitability will revert to the cost of capital as new supply enters and exits the industry. The speed of the reversion of profitability will depend on the time to add new supply, the time to eliminate supply from the market, and the growth in demand in the market. If exit barriers exist, it will be harder for supply to exit the market slowing or even halting the reversion to the mean of profitability during periods of underperformance when supply should be exiting the market. A state where industry returns persist below the cost of capital occurs and is rectified when demand growth catches up to the supply in the industry or supply exits the market.

 

In an industry with barriers to entry, growth is an important assumption in determining the value of a company. Assuming 25% ROIC and a 12.5% discount rate, every $1 invested creates $2 in value illustrating the importance of growth. In an industry with no barriers to entry, ROIC will eventually revert to the cost of capital meaning $1 invested will create no additional value making growth an irrelevant assumption.

 

The crucial strategic questions in industries with barriers to entry are what is the barrier to entry, and then is the barrier to entry strengthening or weakening. The crucial strategic questions in an industry without barriers to entry are do exit barriers exist, is supply increasing or decreasing, how long does it take to bring on supply or shut down supply,  and is the company at the low end of the cost curve as operational efficiency provides an opportunity for potential excess profits.

 

Not understanding the importance of barriers to entry leads investors to make mistakes. The thought that all growth generates value and is therefore relevant being the biggest mistake. Another mistake investors often make is assuming an industry in its early stages with strong profitability means barriers to entry exist. Often in the early stages of an industry’s life cycle, companies are able to generate excess profits as demand is growing at such a rapid pace that supply cannot keep up. The supply demand imbalance allows producers to be price takers. In most industries, the excess profits from the early stages of the industry eventually dissipate as demand growth slows and supply catches up eliminating the tightness in the market causing profitability reverts towards the cost of capital as pricing power of suppliers is eliminated. Only a small number of industries will be able to limit the supply allowing for sustained excess profits. The short-term thinking in the industry is the main culprit for the errors listed above. If an investor has focus on whether next quarter’s earnings will beat expectations, barriers to entry and industry life cycle is irrelevant, as these events may not occur for quarters or years.

 

Whether barriers to entry exist or not is an important question in our investment process determining the type of industry analysis and the valuation method used.

 

 

INTERESTING LINKS

 

CVS Warns of Prescriptions Shift, Shares Tumble on Profit Warning (Wall Street Journal)

An interesting article discussing the differences in business models of CVS and Walgreens. It is a reminder that strategy involves choosing not only what to do, but what not to do. (link)

 

Why Warren Buffed Does Not Believe in EBITDA (S&C Messina Capital Management)

While market participants regularly use EBITDA as a proxy for cash flow, we find it to be a very flawed metric therefore we use it only we there is no other option. The linked article by S&C Messina Capital Management discusses the main reasons for our suspicion of the EBITDA metric. (link)

 

Joel Greenblatt on Wealthtrack (Hurricane Capital)

Hurricane Capital took notes on Joel Greenblatt’s recent visit to Wealthtrack. Mr. Greenblatt is always insightful and a very articulate value investor. He discusses many of the key tenets of value investing. (link) You can watch the full interview here on YouTube.

 

Reader’s Questions (CSInvesting)

CSInvesting answered some readers’ questions on reproduction value and EPV with some very interesting insights. (link) CSInvesting has a lot of useful resources so it is worth the time to have a look around the website. Reproduction value and EPV are valuation techniques made famous by Bruce Greenwald. His book Value Investing: From Graham to Buffett and Beyond is one of the best value investing books ever written. Professor Greenwald also wrote Competition Demystified another invaluable resource on thinking about the competitive environment. Professor Greenwald teaches a value-investing course at Columbia Business School. A playlist of his course can be found here on YouTube. It is well worth the time to watch multiple times.

Don’t Confuse Cheap With Value (Broyhill Asset Management)

Broyhill Asset Management put together an interesting presentation on valuation multiples and what a multiple actually represents. (link)

 

Interesting Tweet Comparing Nike and Under Armour (Connor Leonard)

Apparel much more prone to trends and higher margins but a weaker competitive position as performance footwear is much more complex requiring more R&D. Additionally, performance footwear is crucial to the activity it is bought for therefore much more loyalty. Apparel is much more fashion oriented so significantly less loyalty. These views conform to our views mentioned in our Peak Sport Products and Anta Sports reports. (link)

 

Common Mistakes Made When Investing in Quality Companies (Lawrence A. Cunningham)

Mr. Cunningham was the co-author of Quality Investing: Owning the Best Companies for the Long Term. A wonderful book that is a must read for all investors thinking about investing in quality businesses. As stated in the title, the article discusses the common mistakes made when investing in quality companies. (link)

Weekly Commentary 10/31/2016-11/6/2016

Weekly Commentary 10/31/2016-11/6/2016

We are starting a weekly commentary to provide more consistent updates.  It will contain the news from the companies we cover, random investment thoughts, and the top articles of the week.  Let us know what you think.

 

Company News

 

On November 2, 2016, Zensar Technologies announced the acquisition of Foolproof. Foolproof is one of Europe’s leading experience design agencies, headquartered in London with other offices in Norwich and Singapore. The company helps global brands design better digital products and services for customers based on a deep understanding of consumer behavior, their clients’ business and new technology. It has many Global500 firms amongst its clients. LTM revenue = GBP8.5 million with a mid-single digit GBP million EBITDA with expectations for continued growth rate of 10-15% post acquisition. Zensar’s digital revenue now is 30% of total revenue.

 

From a strategic standpoint, the Foolproof acquisition makes sense. Foolproof adds knowledge in a fast growing industry strengthening Zensar’s digital services business. It strengthens Zensar’s client list adding relationship with a number of Global 500 allowing Zensar to cross-sell other services. It is also a smaller bolt on acquisition making it easier to integrate into existing operations. Unfortunately, the lack of price disclosure eliminates the ability to evaluate the transaction fully.

 

We will maintain Zensar’s current 3.5% position in our model portfolio. The company is trading at roughly 6% NOPAT yield with expected growth between 5-15% over the next five years. It continues to generate strong profitability and its executing on its strategy to increase revenue from digital services. It continues to win larger and larger contracts allowing for greater profitability. Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and/or some switching costs. Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers. The Indian IT services sector is based on low cost labor or price competition. There is no sustainably differentiation on knowledge as employees hold the knowledge of the organization and employees can take this knowledge to another company.

 

Why are we maintaining Zensar Technologies 3.5% position size while decreasing PC Jeweller’s position size to 2.0%? Zensar and PC Jeweller’s both offer a NOPAT yield of roughly 6.0% and both offer growth between 5-15% over the next five years. Zensar’s business seems slightly better to us. Both industry have significant competition, but Zensar’s industry generates much higher average returns on invested capital than PC Jeweller’s, due to the asset light nature of the business. The jewelry business is very working capital intensive. Additionally, Zensar has a long history of steady growth while PC Jeweller has grown rapidly; it is in a much more cyclical industry.

 

On November 3, 2016, Miko International announced the resignation of Mr. Zhu Wenxin, an Independent Director at the company with Mr. Chan Wai Wong replacing him. The resignation is the latest in a series of director resignations. Below is a list of previous resignations.

  • On June 30, 2016, Gu Jishi resigned as Executive Director being replaced by Ms. Ding Lizhen, a member of the founder’s family.
  • On March 14, 2016, Mr. Wong Heng Choon resigned as Independent Director less than a month after being appointed.
  • On February 19, 2016, Mr. Leung Wai Yip resigned as Independent Director.
  • On September 8, 2016, Mr. Ng Cheuk Him resigned as Chief Financial Officer.

 

All the resignations follow the resignation of KPMG on April 21, 2016 and appointment of HLB Hodgson Impey Cheng Limited, an auditor of last resort for many Chinese frauds. The signs of fraud are piling up.

 

On November 4, 2016, Miko announced it signed a Memorandum of Understanding to set up a Joint Venture in the factoring business, an industry far removed from the current operations, which does not make much sense. We are already in the process of selling our position in Miko International.

 

On November 4, 2016, Credit Analysis and Research (CARE) reported first half results. Revenues grew 9% and operating profit grew 20%. The company also grew its client base by 8.5% from June 2016. It also signed a Memorandum of Understanding to start a credit rating agency in Nepal. The company also designated the first “SMART CITY” credit rating. Overall, the earnings report does nothing to move the needle either way. CARE is trading on a NOPAT yield of 3.0% but it is the most profitable company in an oligopolistic industry with significant barriers to entry and a very long runway for growth requiring no capital to grow. We entered with a 2.0% position in hopes that we could increase our position size at a cheaper price. We will maintain the current position given the barriers to entry in the industry, the runway for growth, and the lack of capital required to grow.

 

 

Random Thoughts

 

A recent FT Alphaville article discussed Sanford Berstein’s shift away from valuing companies by discounting cash flows. Bernstein argued in a zero rate world the risk free rate and the over weighted average cost of capital (WACC) is so low the importance of distant cash flows in the intrinsic value is much higher. Given an inability of analysts to forecast cash flows in the distant future, this increasing importance of the terminal value places a significant weight on highly uncertain cash flows. The following exhibits from the FT article illustrate the importance of the terminal value in Berstein’s estimation. Bernstein uses a discounted cash flow model with a five-year forecast period followed by a fade to a terminal value in year 10. Bernstein’s first charts assume a 10% growth rate for the next five years followed by a fade to a terminal growth rate of 3.5% in year 10. The second chart assumes a 5% growth rate for the five-year forecast period followed by a fade to a similar terminal growth rate.

importance-of-terminal-value-ft

 

Under the scenarios mentioned, Bernstein estimates the terminal value accounts for 55% at a 10% WACC increasing to 99% for a 3.6% WACC. WACC or discount rate is one of the many factors determining the importance of terminal value in a discounted cash flow valuation. We believe Bernstein, like many other market participants, is overlooking many other crucial factors in determining the importance of terminal value. We will discuss our view on the discount rate as well as other factors overlooked by Bernstein. We will also discuss another valuation method to overcome the shortfall of increased importance of terminal values in the discounted cash flow valuation. Whenever we value companies at Reperio, we use a similar discounted cash flow model with a five-year forecast period fading to terminal assumptions in year 10.

 

In the article, Bernstein’s main concern was lower interest rates lead to a lower discount rate leading to a lower WACC. Given the value of a corporation is driven by cash flows well into the future, the main assumption in lowering a company’s WACC is interest rates will remain low for a very long period of time. The chart below is the yield on a US 1 year treasury rate since 1953 illustrating the current rate of interest is the lowest on record.

1-yr-treasury-rate

We are bottom up investors but to assume market participants will accept 64 basis points forever in compensation for lending the US government money for one year seems aggressive, particularly, when one-year interest rates were over 1600 basis points in the early 1980s.  .

 

The treasury rate is a key input into the Capital Asset Pricing Model (CAPM) used by Bernstein and many other investors in determining a company’s WACC or discount rate. CAPM like many models in economics and finance is built with assumptions completely detached from reality. The biggest flaw in the CAPM is price equals risk. When calculating the cost of equity to determine the cost of equity, beta is multiplied by the equity risk premium. Beta is the volatility in a stock relative to a stocks benchmark meaning if a company’s share price is more volatile than its benchmark, it is assumed to be a more risky investment and therefore have a higher cost of capital. Putting aside the potential errors in measure a stock beta, a volatile stock does not equate to risk for the investor. This logic would lead you to believe a private business with the exact same characteristics of a public company listed on a stock exchange is a much safer investment, as there is not daily price volatility associated with being listed. At Reperio Capital, we view permanent loss of capital as the true risk of any investment. Permanent loss of capital comes from three risks: business risk, financial risk, and valuation risk. Business risk is the permanent loss of capital due to a permanent impairment of cash flows from competition or mismanagement. Valuation risk comes from overpaying for a security. Financial risk is when a company is has significant financial leverage that may lead to bankruptcy.

 

Another significant problem with CAPM is measuring a stock’s beta. The measurement of beta lends to significant estimation errors. Using Zensar Technologies as an example, if you calculate the company’s beta on a weekly basis since its listed in July 2002, its beta is relative to the SENSEX is -1.19. If you change the time period used in calculating beta to the last 10 years, Zenar’s beta changes to 0.77 illustrating the potential issues calculating beta.

 

Instead of calculating the weighted average cost of capital, we have used a constant discount rate as we assume there is an opportunity cost associated with making any investment. We are increasing our discount rate to 12.5% discount rate (from 10%) for all companies, roughly the average annualized return generated by the MSCI Emerging Market Index since inception and slightly more than the S&P 500 average annualized return is 9.5% since inception. If we can generate 12.5% annual return elsewhere then cash flows from any potential investment should discounted at that particular rate regardless of what the cost of capital is for each individual company. A constant discount rate also eliminates some of the subjectivity in valuation.

 

Other than lower interest rates and faulty measures of risk, Bernstein’s assumptions seem very optimistic. The FT article only mentioned growth and discount rate assumptions meaning the other important value drivers of operating margin and capital efficiency must have remained constant assuming no competitive pressures over the life of the company. The vast majority of companies succumb to competitive pressures leading to a fall in profitability and/or capital efficiency eliminating any excess returns. If excess returns are eliminated, growth does not add value making it an irrelevant discounted cash flow assumption. A small number of companies can hold off competitive pressures making profitability and capital efficiency irrelevant assumptions. The FT has a great free equity screener. In its universe, there are 13,799 stocks with a market capitalization above USD100 million and a 5-year average return on investment. Of the 13,799 stocks, only 2,001 stocks or 14.5% of the universe averaged a 15% return on investment over the past five years, which a very, very crude approximation of a company with a competitive advantage illustrating the difficulty in fending off competitive pressures and maintaining excess returns. Given the vast majority of companies face competitive pressures the assumption of constant operating margin and capital efficiency and any growth in terminal cash flows is very optimistic. An example is PC Jeweller, the company is operating efficiently generating excess returns but jewelry retailing is a fiercely competitive industry with thousands of competitors with little ability to sustain differentiation. We assume a 10% growth over the first five-year forecast period with growth fading to 0% in year 10 and competition eliminating excess profits.

1-scenario-terminal-value-total-value

 

As illustrated, at a 5% discount rate, the cash flows in the terminal value account for 51.0% total value. At a 15% discount rate, cash flows in the terminal value account for 31.6%. At a 5.0% WACC, Bernstein estimated 91% of a firm’ value is in the terminal value, while our estimate is much lower at 51.0% as we are more conservative on our assumptions for the vast majority of companies. The failure to account for competition makes terminal value a much larger percentage of total value.

 

Changing our initial assumptions to view PC Jeweller as competitive advantaged with sustainable margins and capital efficiency but with no growth in the terminal value, at a 5% discount rate, the cash flows in the terminal value account for 73.6% total firm value. At a 15% discount rate cash flows in the terminal value account for 39.1% of the total firm value still well below Bernstein’s estimates.

3-scenario-terminal-value-total-value

 

Being competitively advantaged and adding terminal value growth of 3.5% similar to Bernstein’s calculations further increases the importance of the terminal value assumptions. Again, growth in the terminal value is aggressive, as the vast majority of companies do not generate excess returns. Assuming a competitive advantage and 3.5% terminal growth, at a 5% discount rate the importance of cash flows in the terminal value increases to 90.5% of total firm value, while at a 15% discount rate 46.1% of the of the total firm value is derived from the cash flows in the terminal value.

 

The assumption of permanent low interest rates, no competitive pressures, and perpetual growth are all flaws in Bernstein’s assumptions that increase the importance of terminal value in a discounted cash flow valuation and probably are over aggressive. Like Bernstein, many investors make the same mistakes in their discount cash flow assumptions, which leads to the question why? The biggest reason is institutional constraints and the focus on asset gathering rather than performance making the vast majority of investors short term oriented and trying to outperform every quarter and every year. This short-term orientation leads to focus on next quarter’s earnings and whether a company will beat earnings estimates rather than focusing on a company’s competitive environment, management, financial health and valuation. The charts below from Andrew Haldane’s Patience and Finance illustrate the short-term orientation of market participants with the average holding period of a stock on the many different stock exchanges decreasing.

nyse-lse-holding-period

other-exchange-holding-periods

 

In the US, the average holding period of equities dropped from 7 years in 1940 to 7 months in 2007. In the UK, the average holding period of equities dropped from 5 years in the mid-1960s to 7.5 months in 2007. Looking at stock exchanges around the world the average holding period of equities has dropped to under 1 year on all exchanges with the exception of the Toronto Stock Exchange and Euronext. It seems evident that equity investors have a shorter and shorter investment horizon leading to focusing on the next few quarters making the discounted cash flow a useless tool for many investors. For long-term investors, a discounted cash flow with conservative assumptions it is still very useful. Another use for a discounted cash flow is to reverse engineer the market’s expectations of key value drivers, which eliminates the need for forecasting and makes judgment of the assumptions of key value drivers, the main determinant of the margin of safety associated with an investment.

 

If the use of a discounted cash flow still concerns you, a residual income model provides the same valuation while eliminating the importance of cash flow forecasts in the distant future. At Reperio Capital Research, we also use a residual income model with a five-year forecast period followed by a fade to the terminal value in year 10, with the current invested capital as the book value and return on invested capital and the discount rate as other key inputs. Residual income = (ROIC – discount rate) * invested capital. The residual income stream is then discounted back and added to the beginning of the year’s invested capital. The theory is every company has an asset base to generated returns. The asset base comes with an opportunity cost as the money invested in the asset base can be allocated elsewhere. If the company cannot generate its discount rate, it is destroying value and the company will be valued at less than its asset base. If the company generates excess profit, it will be valued above its asset base. Revisiting PC Jeweller using a residual income valuation and the same three scenarios illustrated above, we can see the residual income valuation method relies less on the discounted cash flows from the terminal. Under a scenario of no competitive advantage, no excess returns are generated in the terminal value assumptions therefore; the terminal value adds no value. Under the scenario of a competitive advantage but no growth, at a 5% discount rate, the terminal value accounted for 57.1% of the total firm value while a 15% discount rate 14.6% of the total firm value is derived from the terminal value. Finally, under the scenario of competitive advantage and terminal value growth, at a 5% discount rate, the terminal value accounts 83.4% of the terminal value and 21.0% of the total value at a 15% discount rate.

residual-income-terminal-value

 

The residual income method does a much better job at decreasing the reliance on terminal value calculations, but provides the same valuation outcome.

 

Discounting cash flows to value companies is still a valuable for any investor with a long-term orientation. Unfortunately, a model is only as good as its inputs. In a world with increasing short term thinking, garbage in will lead to garbage out.

 

 

Other Interesting Links

 

Jim Chanos’ and Kyle Bass’ views on China (link)

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

  • They talk about a potentially interesting idea within the Emerging Market Small Cap space: ABS CBN in the Philippines.
  • They also discuss other ideas First Pacific Holdings in Hong Kong and Rallye SA in France. Both are based on management track records.

 

Apple Should Buy Netflix (link)

A very interesting post at Stratechery discussing the media value chain.

 

Competitive Advantage of Owner Operators (link)

Base Hit Investing goes into detail into the advantages of owner operators.

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

Value Investing using Enterprise Multiples — Is the Premium Due to Risk and/or Mispricing? (link)

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

 

Honworld recently released its H1 2016 report.  In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.

 

Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.

 

The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.

h1-2016-chinese-condiment-producers-growth

 

Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.

 

The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else.  It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.

 

Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.

 

We are moving to a new approach for position sizing.  There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base.  Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.

 

Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.

 

Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.

 

High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation.  Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.

 

The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies.   Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential  bad investments while still offer enough concentration to take advantage of upside from good investments.