Category Archives: Universal Health

WEEKLY COMMENTARY 12/13/16 – 12/19/16

WEEKLY COMMENTARY 12/13/16 – 12/19/16

 

 

POSITIONING

 

 

 

 

COMPANY NEWS

 

Grendene changed its auditor from PWC to E&Y due its requirement to change its auditor every five years.

 

We were thinking about PC Jeweller and the potential evolution of the jewelry retail industry in India. When think about industry evolution in Emerging Markets, we often look to developed markets for roadmaps. Each market has idiosyncrasies but strategic logic should hold from industry to industry across geographies. For example, the retail market structure in India should eventually look like retail market structure in the US as the industry develops. Retailing is fiercely competitive in all markets with no barriers to entry therefore all industries should have many competitors with very few if any generating significant sustained excess profits.

 

Our main reference point for the following information on the US Jewelry market is Edahn Golan Diamond Research & Data’s 2015 US Jewelry State of the Market report. You can download the report here. According to the Jewelers Board of Trade, there were 21,463 specialty jewelry retailers accounting for 43% of the US jewelry and watch retail market. The vast majority of these specialty stores are independent with Signet Jewelers being the largest retailer accounting for 4.3% of overall jewelry sales in the US and 9.8% of specialty jewelry sales. Signet Jewelers had roughly 3,000 stores at the end of 2015.  Despite market development and industry maturation, the US jewelry market remains fragmented with thousands of players illustrating a lack of barriers to entry and continued competitive pressures.

 

The lack of barriers to entry puts a cap on Signet’s and Tiffany’s ability generate excess profits with their average ROIC over the last five years below 15%.

 

Looking at the United States jewelry retail industry as a roadmap leads one to believe that fragmentation will persist within the Indian jewelry retail industry.

 

Another use of the roadmap is the potential multiple the market gives a company during maturity.  Signet’s EV/IC has ranged from 1.69 in 2012 to 2.89 at the end of 2015, while Tiffany’s EV/IC ranged from 2.54 at the end of 2016 to 3.55 at the end of 2015.

 

Signet’s EV/EBIT ranged from 6.86 in 2012 to 18.94 in 2015. Tiffany’s EV/EBIT ranged from 11.84 in 2016 to 37.19 in 2014, with operating Income in 2014 was depressed. Accounting for the depressed operating income, EV/EBIT ranged from 11.84 to 14.49.

 

We have included similar analysis on Honworld (condiments) and Universal Health (pharmacies/pharmaceutical distribution) that we did in the past at the end of the weekly commentary.

 

 

INTERESTING LINKS

 

Deep Dive into China’s Apparel Market (Fung Business Intelligence)

Fung Business Intelligence freely provide a lot of good information on China. In this multi-part report, Fung Business Intelligence provides detail on China’s Apparel Market. (Part 1) (Part 2)

 

Asahi to Buy SABMiller’s Eastern European Beers in $7.8 Billion Deal (Bloomberg)

Acquisition news is always interesting as a knowledgeable player in the market puts a value on an assets based on a detailed analysis. The problem is we do not know the assumptions the acquirer is using, which are crucial, but it gives an idea of an appropriate valuation multiple in an industry. The paragraph below is from the Bloomberg article.

 

The offer values the SABMiller assets at about 15 times Ebitda of 493.8 million euros for the year ended March 2016, according to Bloomberg calculations. That compared with the median of about 11.5 times trailing twelve-month Ebitda for 9 brewery acquisitions announced worldwide in the past five years, according to data compiled by Bloomberg.

 

We extended the sample size of acquisitions back to 1999 and the median acquisition multiple was 11.7 times not far off the 11.5 times paid over the last twelve months.

 

 

 

The table below shows the upside to the 11.7 times multiple for various brewers in Emerging Markets.

 

 

 

Median Buyout EV/EBITDA Ratios Rising (PitchBook via ValueWalk)

 

The PitchBook examines the median buyout multiple for private value investors.  (link)  What we find interesting is the disconnect between what business owners are willing to pay and the valuations public market investors are willing to pay for companies.

 

 

The Undoing Project: A Friendship That Changed Our Minds (The Rational Walk)

 

The Rational Walk discusses Michael Lewis’ new book about pioneers in Behavioural Finance and how it relates to investing. (link)

 

 

The Story of How McDonald’s First Got Its Start (Smithsonian)
The story of the history of the McDonald brothers before McDonald’s became a multi-chain restaurant. (link)

 

 

What is Your Edge? (Base Hit Investing)

 

An article discussing three types of edges in investing. (link)  We view our biggest edge over other market participants is a time horizon edge as we are looking for stocks for the next three to five years.  This also brings an analytical edge as we are analyzing business from the view point of a business owner rather than trying to figure out if the company will beat next quarter’s expectations.

 

 

Buffett’s Three Categories of Returns on Capital (Base Hit Investing)

 

An older post discussing how Buffett categorizes businesses (link)

 

 

HONWORLD DEVELOPED MARKET ROADMAP

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out but when it does it leads to a national market similar to many developed market like the US. The cultural convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.

 

The significant fixed costs in the form of advertising and distribution allows a brand to be built by larger competitors as more customers can be reached and educated. A brand is particularly important in an industry with a low priced product as the brand decreases search costs for customers leading to potential habit forming behavior. For example in the US, customers have acquired a taste for Heinz Ketchup.  When a customer goes to the store given Heinz may cost as little $2.50 a bottle and the Heinz brand represent a known and liked product that customer is not going to spend anytime even thinking about another brand given very little benefit.

In addition, retailers only have so much shelf space and are unlikely to place 15 to 20 different cooking wines on the shelf as a good number of the 15 or 20 cooking wines will not sell leading to waste shelf space.  The biggest players have a tremendous advantage as retailers now they will sell.

 

The table below shows the market structure of the five largest condiment markets in the US.

 

The US condiment industry is a great example of industry consolidation in a more developed market and a good roadmap for the Chinese Cooking Wine industry. The lowest concentration ratio among the largest five US condiment markets is the Hot Sauce market with a 52.2% four firm concentration ratio, while the highest is Ketchup with a 78.6% three firm concentration ratio. The four firm concentration ratio in the Chinese Cooking Wine segment is only 26.8% so there is potential for significant consolidation. The low four firm concentration ratio reiterates the fragmented regional nature of the market.

 

 

UNIVERSAL HEALTH DEVELOPED MARKET ROADMAP

 

Market Structure

 

The pharmaceutical retail segment in China is fragmented. According to the China Food and Drug Administration, in November 2013, there were 433,873 chain and individual drug stores in China, 10,150 more stores than 2012. There are 3,376 enterprises with multiple locations in China. Enterprises with multiple locations are more likely to manage the business for profitability and close down unprofitable stores. All though the market is fragmented, market consolidation is underway with Universal Health and Sinopharm leading the way. Retail competition comes in the form of target customer bases, business models, and product portfolios.

 

At the time of its IPO, Universal Health was the largest pharmaceutical retailer in Northeast China with 794 self operated outlets.  There is not sufficient information to get a sense of the efficiency of each store as competitors with higher revenue per store maybe a function of bigger stores, but it seems Universal Health’s may not be as efficient as competitors. This poor efficiency may be due to acquiring less efficient stores and improving operations. The pharmacy market in Northeast China has low level of concentration with a 2012 five firm concentration ratio of 44.2%.  This only tells part of the story as there could be a large number of smaller independent stores.  Universal Health has increased its estimated market share in Northeast China retail from 5.7% in 2012 to an estimated 8.8% in 2014.

 

The largest distributors in Northeast China at the time of the IPO are listed below. Universal Health is the largest private pharmaceutical distributor in Northeast China.

 

 

The largest retail pharmacy chains in China are listed below.  In 2012, the largest pharmacy operator had a 2.1% market share.  The 2012 five firm concentration ratio was 9.4%, while the ten firm concentration ratio was 16.0% indicating a very fragmented market. At the end of 2012, Universal Health’s China retail market share was 40bps.

 

The Chinese pharmaceutical distribution market is less fragmented than the retail market but still exhibits low concentration with the leading player accounting for 16.8% of the overall market.  The five firm concentration ratio is 36.5% and the ten firm concentration ratio is 44.9%. Universal Health garnered 16 bps of the total Chinese pharmaceutical distribution market.

 

While each individual country has its own idiosyncrasies leading to different development paths, the market structure of more developed markets may give a roadmap for developing countries.

 

The US pharmacy market shows moderate levels of concentration with a five firm concentration ratio of 64.4%.  There is some fragmentation but there are a significant number of small players still operating in the market.

 

According to Canada’s Office of Consumer Affairs, the Canadian pharmacy market has a 2012 four firm concentration ratio of 68.6%. The largest company is Shoppers Drug Mart with a 31.8% market share followed by Katz Group with a 16.7% market share, Jean Coutu with a 12.2% market share, and McKesson with a 7.9% market share.

 

According to the Pharmaceutical Journal, in the UK, there are 14,361 pharmacies with 4,201 independent owners, owning up to five pharmacies, operating 5,590 pharmacies and 174 multiple owners, owning six or more pharmacies, operating 8,771 pharmacies.  Large owners and supermarkets account for 52% of the overall market.

 

The US’s, Canada’s, and UK’s pharmacy market structures point to a much more consolidated market than the Chinese market but not the oligopolistic market structure you would expect if there was a significant benefit from economies of scales.  There seems to be economies of scale in purchasing but only to a point. Another reason for the fragmentation and large number of small independent operators may be that independent operators do the job for something other than profit maximization.  Just like optometrists or dentists, the ability to be your own boss and make a decent living trumps the desire to sell to a larger chain or exit when faced with a competitive disadvantage.

 

Pharmaceutical distribution markets are far more concentrated in developed countries than China with a three firm concentration ratio ranging from 43% to 85%.  Developed pharmaceutical distributors, economies of scale manifest themselves in high capital efficiency as operating margins often struggle to reach 2%.   The high fixed costs associated with upfront investments and low marginal cost for selling an additional unit leads to very high competitive rivalry among distributors and the need to utilize fixed costs as much as possible leading to greater profitability.

 

 

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

 

On May 9, 2016, Universal Health agreed to purchase 36.38% of Jilin Wenhui Capsules Limited for RMB270.3 million placing an enterprise value on Jilin Wenhui of RMB743.0 million.  The company is a new high-tech enterprise that conducts research and development, manufactures, and sells hollow capsules, and is a leading capsule manufacturing enterprise in terms of scale in northeastern China. Jilin Wenhui Capsules current annual output of medical hollow capsule was approximately 15.0 billion, with plant capsule capacity of approximately 6.0 billion and plant gelatin (modified starch) capacity of approximately 5,000 tonnes. To complete the transaction, Universal Health issued 400,000 shares at a price of HKD0.725.

 

In 2015, Jilin Wenhui had a net asset value of RMB26 million, profit before tax of RMB6.99 million, and profit after tax of RMB5.34 million.  Universal Health purchased price places a valuation on Jilin Wenhui at 28.4 times book value and 139.1 times earnings.  These are astronomical figures in the absence of further information to analyze Jilin Wenhui. It seems the company is just throwing money away and paying anything to main growth something that is often seen with serial acquirers.  Universal Health is all over the place with its capital allocation.  We will be exiting our position in Universal Health as soon as possible.

 

While it is unfortunate we made mistakes on Universal Health and Miko International, the best teacher is pain and these mistakes will strengthen our investment process. There are a number of lessons that we have taken from the Universal Health and Miko International mistakes.

 

  1. Entry positions should be less aggressive allowing us to gain a better understanding of the company over time. This strategy would have prevented the gains we saw in PC Jeweller but downside protection is just as important if not more important than upside potential.   Less aggressive position sizes also pay respect to our ignorance and the limits of our knowledge.  We still believe in concentrated portfolios but small cap investing particularly in Emerging Markets bring additional risks and additional diversification is needed.  We still believe in concentrated portfolios 20-30 companies but oversized positions that investors can take in larger, well established companies may not be as prudent in smaller companies.
  2. We need to put more emphasis on why a stock is cheap. If it has tremendous operating history and good current earnings yet is extremely cheap, it may be a value trap, particularly in China.
  3. Focus needs to be on companies with long history of operations and being publicly traded. Both Miko International and Universal Health IPO’d over the past few years and they had not been operating for decades.
  4. Capital allocation is crucial and missteps should be viewed with extreme caution. Miko International issued shares at extremely cheap valuations with significant net cash balance.  A major red flag, which we overlooked.
  5. Along these lines, while strong financial health is crucial to any investment case, very large net cash positions is a potential sign of poor capital allocation at best and fraud at worst.
  6. When management starts selling your should probably start selling too as they have much more information about the company than you.
  7. Stay away from serial acquirers particularly in industries where there is n strategic logic for acquisitions.
  8. Chinese companies seem to be a different breed where financial statements cannot always be trusted. As outside investors, the primary evidence is financial statements of the company and competitors.  We look for additional evidence from independent sources to corroborate financial statements but it is not always there.  If financial statements cannot be trusted, you cannot invest.  Given the risk, we will be requiring additional evidence with Chinese companies and holding them at lower weights.

Universal Health Position Size May 6 2016

Universal Health Position Size May 6 2016

 

Yesterday, we completed the sale of just over USD2.0 million in Universal Health shares that we previously announced we would make.  We sold 21.573 shares at an average price of HKD0.735. As of yesterday’s close, Universal Health is now a 2.5% position, which is more appropriate for the risk reward associated with the investment.

Universal Health Initiation Report September 8, 2015

Universal Health Initiation Report September 8, 2015

Below is a link to the Universal Health Initiation Report, formerly Company 9/8/2015, from September 8, 2015, along with the initial investment thesis.

Universal Health 2211 HKG Initiation Sept 8 2015 RCR

 

 

INVESTMENT THESIS

 

Universal Health International Holding Group (Universal Health) is a Chinese pharmaceutical distributor and pharmacy operator. The company trades on an EBIT/EV yield of 24.0% despite above industry growth, in an industry growing at 20% per annum, and superior profitability with a four year average ROIC of 43%.

 

Universal Health is best in class among Chinese pharmaceutical distributors and pharmacy operators in terms of growth, profitability (ROIC), and acquisitions, a key activity in the consolidating pharmaceutical distribution and retail market.  The company has a number of unique, complimentary activities strengthening its competitive position ensuring profitability can be sustainable.  The company has high quality management with significant share ownership, no significant corporate governance issues, and a net cash position equal to 37% of the company’s market cap and 2.41 times trailing twelve month (ttm) operating profit.

 

The market is pricing in no growth and a reversion from a 2014 ROIC of 39% to the cost of capital within ten years creating little downside but tremendous upside if the company can maintain its profitability and continue to grow at 20% per for the next five years.

Peak Sport and Universal Health Position Sizes May 3 2016

Peak Sport Products and Universal Health Position Sizes May 3 2016

We have reduced our position in Peak Sport Products by USD4.64 million slightly above our target sales of USD4.5 million at an average sale of HKD2.1098 or inital blended cost on Peak Sport positions is HKD2.0826 so we are able to reduce our positions without a loss.   We are reducing our position size by a further USD3.0 million.  The company reported weaker than expected operational data in China, and after the Miko International fiasco, the share issuance in June 2015 with a significant amount of net cash on the balance sheet raises concerns about the cash.  Given we view Peak Sport as a deep value position, a 2.0% position size is a more appropriate given the concerns over management credibility and slowing growth.

 

Universal Health is another Hong Kong listed Chinese company that we described as Company 9/18/15 in the past. This is another deep value holding where we put too much faith in financial statements.  Management pledged shares without notifying the stock exchange and subsequently were forced sellers causing the share price to fall by just under 60% on one day. The company also sold 20% of the company to a financial buyer who subsequently sold almost half its position the following.  It seems as if the shares were pledged to the financial buyer who promptly sold the shares. The company followed this by reporting poor 2015 results.  Loss aversion stopped us from selling earlier.  It probably is the culprit in why we held Miko as long as we did.  We are decreasing our position size in Universal Health by USD2.0 million to roughly a 2.0% position size.