Category Archives: Consumer Discretionary

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.

PC Jeweller Position Size July 31, 2016

PC Jeweller Position Size July 31, 2016

We are decreasing our position size in PC Jeweller to 4.0% from 6.3%. The company continues to perform very well operationally, management is very innovative and entrepreneurial, and the company has a long run way for growth but the expected return under the aggressive base case has fallen to 14.9% per year while a more conservative base case is 9.73% annualized return over the next five years. The company’s competitive position seems to be strong as it was able to maintain strong profitability during the recent industry downturn while all competitors except Titan had an extremely tough time staying profitable and it maintains very strong return on invested capital, but retailing is a very tough business to build a sustainable competitive advantage. Additionally, PC Jeweller’s position size was not altered to reflect our new position sizing philosophy.

 

The company has raised over INR60 billion in capital to finance future growth. On May 24, 2016, DVI Fund Mauritius received 4,269,984 Compulsory Convertible Debentures with a face value of INR1,000. The convertible bonds are convertible into shares at a conversion price of INR380 within 18 months.

 

Fidelity received 257.373 million Compulsory Convertible Preferred Shares. The conversion price is INR382.54 per share. Fidelity has 12 months from July 22, 2016 to convert the preferred shares. Until conversion, the preferred shares are paid 13% dividend yield. Assuming full conversion of preferred shares, Fidelity will hold 3.62% of the shares outstanding.

 

Assuming full conversion from DVI Fund and Fidelity, total dilution would be roughly 11 million new shares equal to 6.14% dilution for existing shareholders leading to total shares outstanding of roughly 190 million shares.

 

We are only selling if the company’s share price is above INR400 per share.

 

Miko International and Honworld Position Size July 30, 2016

Miko International and Honworld Position Size July 30, 2016

 

Miko International released its unqualified 2015 year end results after four months of delay. During the delay, the Hong Kong Stock Exchange halted trading on the company’s shares.  The company’s previous auditor KPMG resigned due to incomplete information provided by Miko International. KPMG’s statement from the resignation letter follows.

 

‘‘In respect of our audit of the Company’s financial statements for the year ended 31 December 2015, there are a number of unresolved issues relating to receipt of satisfactory evidence and information, which remain outstanding. We have been communicating since early February 2016 with management on outstanding matters. The outstanding matters have been communicated to the Company’s management, Board of Directors, and the Audit Committee, details of which are set out below.

 

As at the date of this letter, we await satisfactory information in respect of the following matters:

 

  1. We await receipt of the draft 2015 consolidated financial statements from management.
  2. We await access to original bank statements in respect of one of the group’s bank accounts to be provided directly to us by the bank, which had a year end balance of RMB400 million, together with supporting documents in respect of security given over some of the group’s bank accounts.
  3. In respect of the group’s distribution channels, information is awaited relating to how the acquisition price was determined in respect of the distribution channels acquired during 2015 at a cost of RMB107 million, the signed valuation report and supporting documents in relation thereto, as well as supporting agreements and information relating to amendments made during the year to certain other distribution arrangements.
  4. In respect of the prepayment of RMB13 million as at 31 December 2015 for the group’s enterprise resource management system supporting information is awaited relating to the determination of the purchase price.
  5. In respect of the acquisition of a property in Shanghai during 2015, information is awaited in respect of the determination of the acquisition price, signed year-end valuation report, explanations relating to the difference between the year-end valuation and the acquisition price, and other documents in respect of the acquisition.
  6. Site visit and interview with an OEM Supplier.’’

 

Miko International hired HLB Hodgson Impey Cheng Limited (HLB) to audit its financial statements. HLB seems to be an auditor of last resort for fraudulent companies.

 

HLB also stepped in and gave China Solar Energy’s financial statements a clean audit opinion when the previous auditor Deloitte resigned in February 2012. China Solar is now considered to be a fraud and the shares have not traded since 2013.

 

HLB again stepped in when Deloitte resign in July 2015 as auditor of Sound Global. Sound Global received a clean audit from HLB. The company later found RMB2 billion missing from its books.

 

Other concerning evidence includes the resignation of the CFO and three independent directors within a few month time span including an independent director that resigned a month after joining.

 

There is significant evidence that Miko International is a fraud and we will be selling all our shares at the resumption of trading.

 

What can be learned from the poor investment in Miko International? We have decreased our position sizes on all investments to reflect the limits to our knowledge.  Additionally, we are any peripheral evidence will receive more attention. We also must admit when an investment is bad a take a loss.  Our gut told us there was a problem but we ignored it due to inconsistency avoidance and loss aversion.

 

Chinese companies must also be given a discount and smaller position due to the prevalence of fraud within the country. Given this we are decreasing our position size in Honworld to 5.0% as there is significant evidence of a passion owner operator with competitive advantages and credible financial statements (recent investment by a private equity firm), but there is the China discount that needs to be used in the form of a less aggressive position size. We will only be selling Honworld shares above HKD4.75 per share.

 

 

Honworld 2015 Annual Report Review June 29, 2016

Honworld 2015 Annual Report Review June 29, 2016

Honworld Annual Report Review 2015 June 29 2016 RCR

The amount of capital allocated to inventory is the biggest concern with an investment in Honworld. There is some complexity to how inventory works its way through the company’s financial statements so we thought it would help us to relook at the production process and how inventory is accounted for.

 

To start the production process, Honworld purchases raw materials. In the company’s IPO prospectus, it stated “Our raw materials are generally available from numerous suppliers. We minimize our reliance on any single source of supply for our raw materials by maintaining alternative sources.” The breakdown of raw materials is listed below.

Honworld Raw Material costs

 

Raw materials with the exception of packaging are pure commodities where the purchasing decision is based on price readily available from many suppliers.

 

Base wine production is the next step in the production of inventory. Rice is soaked and steamed to increase moisture content. The rice is then fermented, which takes place in cool weather, generally from every October to next May each year. Sometimes, there is a second fermentation process. The fermented product is then filtered and sterilized. Depending on weather conditions, it typically takes 30 to 35 days to complete the above production steps. Following base wine production, base wine is aged, seasoned and blended, and packaged to create the final cooking wine product.

 

The final cooking wine product is a mixture of vintage base wine, mixer base wine, water, seasoning, and spices. Vintage base wine is aged to deliver the desirable aroma and taste, while mixer base wine is added to adjust the ABV, sweetness, and acidity. Mixer base wine is aged less than two years. The final cooking wine product comes in four grades classified by the amount of base wine used in the end product and the age of vintage base wine used.

Honworld product characteristics by product range

 

  • In 2013, premium cooking wine was 6% vintage base with an average age of 10 years and 87% mixer base wine with an alcohol by volume of 15%.
  • High-end cooking wine is 6% vintage base with an average age of 8 years and 81% mixer base wine with an alcohol by volume of 15%.
  • Medium-range cooking wine is 4% vintage base with an average age of 5-6 years, and 81% mixer base wine with an alcohol by volume of 10%.
  • Mass-market cooking wine is 4% vintage base with an average age of 5-6 years, and 64% mixer base wine with an alcohol by volume of 10%.

 

Honworld has not reported its volume sold or base wine used since its IPO prospectus. Volume sold for 2013, 2014, and 2015 is estimated, by assuming ASPs do not change over those periods, while, 2010 to 2012 are from the company’s prospectus.

ASP by product

 

Honworld’s volume sold and base wine used is shown in the table below.

Volume Sold

 

Base wine usage in 2013, 2014, and 2015 is assumed to remain the same as the first eight months of 2013. Base wine as a percentage of cooking wine volume sold increased from 35% to 86% as Honworld sold more premium products, which require more base wine, and the amount of mixer base wine per liter of cooking wine increased. Since base wine represented 86% of volume sold, the estimated base wine inventory of 180 million translates to 211 million liters of potential sales volume or 2.87 years of inventory based on 2015 estimated sales volume. Honworld’s target base wine inventory of 225 million liters, expected to be reached in June 2016, translates to 263 million liters of sales volume or 3.58 years of inventory based 2015 estimated sales volume.

 

Honworld did not report base wine inventory at the end of 2015 but at the end of 2014, the company had 158.4 million liters of base wine inventory. The company has repeatedly stated its target is to reach 225 million liters of base wine inventory. The question becomes does the company continue to build inventory past the 225 million liters level at a rate equivalent to sales, which will lead to a continued cash flow drain, or does the company remain at its target level of 225 million liters. At the end of 2016, we will know if the company continues to build inventory or if it continues to throw off cash flow. The company has been raising money by selling shares and bank loans leading us to believe it will continue to build inventory with revenue growth. If the company was going to stop building inventory, it would make sense to use debt to maintain ownership as the company is not too levered with net debt to EBIT at 1.54 times.

Key Inventory Statistics

 

The above table illustrates base wine inventory from 2010 to 2015. At the end of 2015, Honworld had 180 million liters of base wine and a total inventory cost of RMB945 million for an estimated cost of RMB5.24 per liter of base wine. The cost of goods sold per liter of volume sold equaled RMB3.26, while the cost of goods sold per liter of base wine used equaled RMB3.81. The ratio of cost of goods sold per liter of volume sold to the cost of goods sold per liter of base wine equaled the ratio of base wine used to volume sold.

 

The ratio of the cost of base wine used to balance sheet inventory on a per liter basis fluctuated between 227.5% in 2010 to 59.3% in 2013 with 2015 ratio of 72.6%. The company uses weighted average method so a shift in raw materials costs will not create a differential between inventory valuation on the balance sheet and inventory valuation on the income statement in cost of goods sold. The shift in cost of goods sold per liter of base wine to base wine inventory valuation per liter is related to an increase in vintage wine in inventory relative to the amount of vintage base wine used in volume sold as there are costs to storing and holding base wine during the aging process leading vintage base wine to have a higher valuation. Vintage base wine will continue to increase as a proportion of inventory held while vintage base wine as a percentage of cost of goods sold not increase drastically meaning cost of base wine sold per liter should decrease relative to the cost of base wine inventory per liter.

Base wine breakdown

 

 

Capital Allocation

 

Other than understanding how the company’s main product flows through the financial statements, the central question to the analysis of inventory is whether allocating significant amounts of capital to inventory is in the best interest of shareholders.

 

Management states it can guard against the increase of raw material price from holding a higher level of base wine. Raw materials are commodities in the truest sense of the word so as long as a certain quality threshold is reached price is the only consideration in the purchase decision. These commodities are available from many producers. Suppliers of raw materials have no bargaining power so there will be no price increases due to supplier strength. If raw material prices increase all competitors will be affected equally allowing raw material price increases to be passed on to customers. Furthermore, Honworld has a brand, illustrated by its leading market share with premium pricing, meaning any increase in commodity prices can be passed on to customers.

Inventory buffer for price increases

 

Assuming that the company is unable to increases in raw material prices, to analyze the effects of increased inventory and associated working capital, we assume that the company carries half as much base wine to eliminate the company’s inventory protecting against raw material prices. We assumed base wine inventory is halved from 180 million liters to 90 million liters, which translates to 105 million liters of end product or 1.43 years of 2015 estimated sales volume. Total inventory costs decrease from RMB945 million to roughly RMB475 million leading to an increase in inventory turnover from 0.84 to 1.69. In addition, fixed capital is tied to inventory as much of the company fixed costs are storage facilities to age base wine; therefore, fixed capital is assumed to decrease by 25%. Other working capital is assumed to have no connection to inventory levels and therefore remains the same leading to overall invested capital decrease from RMB1,782 million in 2015 to an estimated RMB1,145 million without inventory and necessary infrastructure to protect against raw material increases. Raw material price increases lead to increased cost of goods sold with every other income statement account remaining the same.

Raw material price increases vs current ROIC

 

As illustrated above, if Honworld halved its inventory as well as associated fixed costs,  raw material prices need to increase by 30% for return on invested capital (ROIC) to reach the level seen in 2015. Commodity prices are difficult to forecast but a 30% increase in a deflationary environment does not seem like a high probability event. Additionally, there is a high probability (80-85%) that Honworld would be able to pass on increases in raw material prices due to its brand, and/or competitors would see the same increase in commodity prices leading to an industry wide increase in prices. The statement that management is building inventory to protect against rising assume that two low probability events occur rising raw material prices in a deflationary world (<20-25%) and an inability to pass on price increases leading to a decrease in profitability (<15-20%).

 

Management’s other reason for building inventory is to support future growth. The company’s current inventory is sufficient cover 2.87 years of 2015 sales volume. In addition, the company believes it will reach 225 million liters of base wine inventory at the end of the first half of 2016. The company can also produce enough base wine to cover 2015 in one year’s sales as while increasing its base wine inventory it is still producing sufficient inventory to cover current period sales.

 

Mixer base wine and vintage base wine are two types of base wine used in the production of cooking wine. Mixer base wine is less than two years old, so does not need any ageing, while vintage base wine is over two years old, and therefore needs ageing. The table below illustrates the amount of base wine, vintage base wine, mixer base wine, the average age of vintage base wine, the percentage of 2015 cooking wine revenue of each category of base wine, and estimated gross margin for each category.

Base whine characteristics by product with potential scenarios

 

The table also illustrates the 2015 blended average and two scenarios assuming an increase in sales of higher-end and premium products.

 

Given mixer base wine can be produced without ageing, the inventory build is to allow the company to produce more vintage base wine to allow the company sell more premium products.

Base wine ageing

 

Base wine inventory in liters is estimated by assuming the cost of base wine remained the same in 2015 as the company reported base wine inventory in liters in 2014. Mixer base wine is assumed to be the change in inventory from the previous two years as mixer base wine is any base wine under two years. The remaining base wine is considered vintage base wine. Vintage base wine’s age is estimated by taking the vintage base wine not used in the year and adding mixer base wine added to inventory two years ago. All new mixer base wine is considered to be 2.5 years and vintage base wine from previous years is considered to age by a year. Vintage base wine inventory estimated age reached 4.0 years at the end of 2015. The vintage base wine inventory’s age continues to fall as the mixer base wine re-classified as vintage base wine increases as a proportion of vintage base wine inventory.

 

The company now has estimated base wine inventory of 180.3 million liters consisting of 87.7 million liters of base wine inventory and 92.7 million liters of vintage base wine inventory. In 2015, Honworld used an estimated RMB3.3 million liters of vintage base wine meaning the vintage base wine inventory of 68.4 million liters is sufficient for almost 21 years assuming sales remain at 2015 levels. Mixer base wine can be easily produced as it does not have to be aged creating a situation where vintage base wine will continue to grow.

 

Assuming similar sales volume to 2015 and product mix of 50% of sales volume is premium, 25% is high-end, and 25% is medium-range, base wine would be 88.0% of a liter of cooking wine with vintage base wine would need to be 5.5% of inventory sold or 4.4 million liters of vintage base wine. At current inventory levels, vintage base wine inventory would have just less than 17 years of vintage base wine inventory. It seems the company is over building its vintage base wine inventory, which may not be used for decades and is well above the amount required. Vintage base wine could probably be closer to 10-12 years as in the most aggressive scenario of selling 100% premium cooking wine base wine only needs to be ten years old. Additionally, the company can produce an estimated additional 100 million liters in mixer base wine per year with the vast majority going to current period sales. The company is building inventory and should be effectively spread over ages, unfortunately the company does not provide disclosure on the age of its inventory. The company could effectively half its vintage base wine inventory and still have 10 years of vintage base wine inventory, while mixer base wine inventory should no more than a year as the company produces about 150% of its current period mixer base wine needs. Overall, base wine inventory could be decreased by 50% and still have sufficient inventory for current period and growth meaning ROIC could increase from 16.6% in 2015 to 25.8%.

 

The analysis above was not created to verify my past views on Honworld’s inventory levels but to use a new angle to see if my existing view were inappropriate. Unfortunately, the outcome of the analysis points to the same view that inventory is bloated and holding down returns of the company with inventory at twice the size it needs to be.

 

After reviewing Honworld’s 2015 annual report, the company will not be able to realize its full value if it does not do a better job on disclosure. Analysts need more information to get a much more accurate picture of the company and fully understand how inventory flows through the company’s financial statements. Additionally, the company should give better disclosure on product mix and profitability of each product. Our desire is to see the following disclosed:

 

  • ASP
  • Volume by product
  • Gross margin by product
  • Base wine inventory in liters
  • Base wine inventory ageing
  • Inventory ageing by base wine and vintage base wine
  • Estimated inventory cost by age
  • Base wine production capacity
  • Base wine storage capacity
  • Bottling capacity
  • Sales by geography
  • Sales by distribution channel

 

Overall, Honworld is one of our top ideas. There is a high probability that the company is building a multi-faceted competitive advantage in the form of economies of scale and brand. Over the past three years, the company spent 7.0% of revenue in research and development and another 7.1% in selling and distribution expenses meaning fixed costs were 14.1% of revenue. In 2012, the last reported data, Honworld was the largest Chinese cooking wine producer with a 13.8% market share. The company is the only top four cooking wine producer using a naturally brewed, traditional production process allowing the company to garner premium pricing. This premium pricing amplifies the company’s size advantage over its top four competitors, as 95% of cost of goods sold is raw materials in the form of agricultural commodities. As illustrated below in 2012 (latest available data), Honworld’s sales are 2.16 times and its gross profit is 2.86 times its largest competitor. Sales are 3.21 times and gross profit is 4.21 times its second largest competitor.

Top 5 cooking wine producers in china

 

The 14.1% of revenue in fixed costs translates to 24.4% of gross profit. The company’s nearest competitor is the only competitor that can match the fixed costs and still be profitable as Honworld’s fixed costs equate to 70% of the largest competitor’s gross profit and 103% of the second largest competitor’s gross profit. Honworld expects to increase advertising expenses and continue to increase the penetration of its distribution channel to third and fourth tier cities within its key sales regions. The company also has brand advantage illustrated by market share advantage and premium pricing. Additionally, it sells the lower priced product where the customer is less likely to search for alternatives with a small price increase as the increase is not as noticeable and search costs are much higher.

 

The company is run by a passionate, owner-operator and recently there was an investment by a private equity company with significant resources to conduct due diligence giving credibility to the company’s financial service. The private equity company is an expert in Chinese consumer companies so it brings additional relevant expertise. The major concern with Honworld is the investment in inventory. As illustrated above, inventory is running at twice what it should and dragging on profitability leading to financing issues. The company is increasing its debt load and selling part of the company to finance its growth as it is growing at 20% per year. The company is targeting 225 million liters of base wine inventory at the end of the first half of 2016. Hopefully, the company slows down the aggressive inventory build and if it continues to build inventory it does so at a slower pace than revenue growth.

 

The company offers a 12.7% EBIT yield and 5.0% organic growth through pricing power for almost 18% expected annual return. Additionally, the company’s debt load is inflated due to its inventory build and if the company changes direction with inventory it can pay down that debt quickly or increase dividends.

PC Jeweller FY2016 Results Review June 6, 2016

PC Jeweller FY2016 Results Review June 6, 2016

 

 

Key Value Drivers

 

PC Jeweller reported FY2016 (March 2015-March 2016) results on May 30, 2016, with results affected by a month long strike in March 2016 by the Gems & Jewelry industry. Following the government’s proposal for a 1% excise duty on non-silver manufactured, the entire industry went on a 43 days strike, which further deteriorated the demand during the quarter. Sanjiv Agarwal, CEO, Gitanjali Exports estimates the strike has resulted in losses of Rs 500 bn to 600 bn for the overall jewelry industry. The company’s revenue increased by 15.2% with domestic revenue increasing by 13.9% and export revenue increasing by 18.6%.

 

In domestic operations, PC Jeweller increased its store count by 11 stores from 50 at the end of FY2015 to 61 at the end of FY2015.  Oddly, the company’s retail area increased from 313,296 square feet at the end of FY2015 to 319,891 square feet at the end of FY2016 leading the average store size decreasing from 6,266 square feet at the end of FY2015 to  5,244 square feet at the end of FY2016.

 

6 6 2016 Sq Ft Average Store Size

 

A decrease in average store size in not unprecendented but the decline in FY2016 was drastic.  The company is piloting smaller stores targeting new geographical and customer markets (middle/lower class) but this is a pilot that should not have an effect as of yet.

 

Overall, domestic sales accounted for 70.5% of sales in FY2016. Sales per square feet increased from INR144,869 in FY2015 to INR161,553 in FY2016. Despite the increase, sales per square feet have yet to recover to the FY2013 peak before regulation and taxation set the industry back.

 

 

In export markets, sales grew by 18.6% despite weakness in key export markets (Middle East) due to lower oil prices.

 

In FY2016, gross margin declined to 13.9% from 15.2% in FY2015 due to a combination of export sales increasing (29.5% vs 28.5% in FY2015) and decreased percentage of diamond jewelry sales (28.2% vs 31.5% in FY2015). Domestic steady state gross margin is expected to be between 16-17%, while export gross margin is expected to be between 6-8%.   Domestic margins assume diamond jewelry is 30% of overall sales with a gross margin of 30-35%, while gold jewelry has gross margin of 9-10%.

 

Since the beginning of FY2012, employee costs averaged 0.90% of sales, advertising expense averaged 0.91%, rental expense averaged 0.61%, and other expenses averaged 2.18%. In FY2016, all operating expenses were roughly in line with historical averages with the exception of other expenses, which were only 0.81% of sales. Other expenses have trended down since averaging 2.96% of sales in the three years ending FY2014.  In FY2015 and FY2016, other expenses averaged 1.01%.

 

Overall, the company’s operating margin of 10.9% was the lowest since 2009 when the company’s operating margin reached 10.1% with a tax rate close of 25.5% leading to a NOPAT margin of 8.1%. The company’s invested capital turnover decreased to 2.6 from 2.8 in FY2015 leading to a FY2016 ROIC of 21.0%.  Assuming a full 12 months instead of 11 due to the protest, the company’s invested capital turnover in FY2016 would have been 2.8 leading to a normalized ROIC of 22.9%, a decline from 25.1% in FY2015 and is the lowest reported level. We believe the decline in profitability is driven by a combination of economic weakness and increased regulation rather than increased competition.

 

The company’s model for domestic large format showrooms is illustrated below.

PC Jeweller Store Economics

 

The company expects to open 20-25 stores in FY2017 and open 100 stores over the next five years.  The company is also exploring franchising. This growth comes at the expense of the unorganized sector as organized jewelry retail is growing at 25% per year and will reach 35% of the market in the next few years from the current 22%.   The government introduced a number of regulations allowing for better regulation of the industry which should speed up the share gain of the organized sector. These regulations include compulsory hallmarking of gold jewelry, requirement of PAN Card for all purchases above INR 2 lakhs, and 1% excise duty on jewelry sales. These regulations may also negatively affect demand in the short term.

 

PC Jeweller currently focuses on large format showrooms on high street location catering to the rich and upper middle class and is piloting smaller format showrooms with a smaller size (1,000-1,500 sq ft) to cater to the middle and lower classes. It is also piloting franchise stores that will require little to no capital allowing the company to expand beyond its current presence in Tier 1 and Tier 2 cities.

 

Althought the company’s financial health deteriorated slightly with Net Debt to NOPAT increasing to 1.0 from 0.66 in FY2015, PC Jeweller is in strong financial health.

 

 

Competitive Position

 

The industry is very fragmented with over 4,500 participants at the time of initiation pointing to low barriers to entry.  The company’s gross margin is not particularly high pointing a potentially commodity product. Consumers purchase decision is based on not only on price but design points to the potential for differentiation but the fragmentation of the industry and a lack of stability in gross margins point to a lack of pricing power.

6 6 2016 Gross Margin

 

Despite the lack of barriers to entry and pricing power, PC Jeweller has maintained a ROIC of 36.1% since 2009, although there has been significant variability in the profitability metric.

6 6 2016 ROIC

 

The excess profitability is most likely down to the company’s operational efficiency and weak competition from the unorganized sector rather than a competitive advantage.  As the organized sector gains shares, competition should intensify and profitability should deteriorate.

 

 

Management

 

Management has not sold any shares and continues to allocate capital solely to expansion and toward minimum dividends.   Management also continues to innovate with the Flexia jewelry line, a smart jewelry line, and wearyourshine.com.  The company is also focused on exploring new markets and franchising which should increase the addressable market for the company.

 

 

Performance vs Peers

6 6 2016 Performance vs Peers

 

PC Jeweller has the second highest gross margin and highest operating margin in the sector. Only PC Jeweller and Titan were able to generate ROIC above 12.3% for FY2016.  Sales declined at all competitors except Rajesh Exports whose results were boosted by an acquisition.   Despite the strong profitability and growth relative to peers, PC Jeweller is one of the cheapest companies within the sector trading at an EVEBIT of roughly 10 times.  The company has proven to be one of the best operators in the industry.  The company has a long runway for growth opening 100 stores over the next five years with franchising and new markets as well as operational efficiency and weak competition excess profitability should be sustained for some time. We will maintain our current position size.