WEEKLY COMMENTARY 12/13/16 – 12/19/16
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.
Deep Dive into China’s Apparel Market (Fung Business Intelligence)
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
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.