Category Archives: Anta Sports

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.

 

 

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

 

 

 

 

COMPANY NEWS

 

There was no news related to portfolio companies this week.

 

We are decreasing our Credit Analysis and Research (CARE) position to 0%. We initiated the position at 2.0% as categorizing CARE as a high quality company that was slightly overvalued. Since initiation, the share price increased by 44% making the company overvalued with significant growth needed to generate any return.

 

We are also decreasing our Anta Sports position to 0% as we initiated the company as a high quality company that met all the criteria for investment with the exception of price as we felt it was slightly overvalued. The share price appreciated by 25% since our initiation and the company is now overvalued rather than slightly overvalued.

 

 

INTERESTING LINKS

 

At Deloitte, the problems with audit quality and professionalism start at the top (Marketwatch)

 

Deloitte is facing regulatory backlash over faulty audits and misleading investigators. It is not the first time and will not be the last. (link) There have been many examples of Chinese companies listed in Hong Kong IPO’d with a big 4 auditor that turned out to be frauds.

 

The Magic in the Warehouse (Fortune)

 

An interesting article discussing Costco, its business model, and its culture (link)

 

How to Build Great Teams (Society for Human Resource Management)

 

A great discussion on how to build great teams through communication and fit (link)

 

Why is Customer Acquisition Cost (CAC) like a Belly Button? (25iq)

 

Tren Griffin illustrates the importance of knowing the CAC in your business. (link)

 

Huawei’s Hard-Charging Workplace Culture Drives Growth, Demands Sacrifice (Wall Street Journal)

 

The Wall Street Journal writes about the culture of Huawei. (link)

 

Q3 2016 Report (IP Capital Partners)

 

IP Capital Partners’ Q3 2016 Report contains a good investment case for Amazon. (link)

 

 

 

INTOUCH HOLDINGS PRE-RESEARCH REPORT

 

EXECUTIVE SUMMARY

 

Intouch Holdings is an investment holding company with Advanced Info Services (AIS) account for over 95% of its intrinsic value. AIS is the leading mobile operator in Thailand with roughly a 50% market share. The industry has barriers to entry in the form of economies of scale and brand.  The large fixed costs come in the form of investment in spectrum and infrastructure and to a lesser extent marketing and distribution. Given AIS size and the presence of economies of scale, it has a significant advantage over its peers. Regulation also limits the competition to Thai companies.

 

Thailand recently held 3G and 4G spectrum auctions. The increased cost of spectrum decreases returns on investment in the industry as capital efficiency is much weaker leading to lower intrinsic values. The market is pricing in current earnings weakness due to a strong intensity of rivalry but valuations must fall further to account for the lower capital efficiency. In our estimate, AIS would be a buy below THB70 before becoming a buying opportunity translating to a buy price of Intouch below THB30 per share.

 

 

FACTOR RATING

 

 

 

COMPANY DESCTRIPTION

 

Intouch Holdings is a telecommunications holding company in Thailand, with investments in public and private companies. The company was founded as Shinawatra Computer Service and Investment by Thaksin Shinawatra in 1983. In 2006, when Shinawatra became the Prime Minister of Thailand, he sold his family’s stake in then Shin Corporation to Temasek Holdings. Shin Corporation rebranded itself to Intouch in 2011, including its new stock symbol, but did not officially change its registered name until March 2014.

 

The company’s main assets are publicly listed. Intouch has a 40.45% stake in Advanced Info Service PLC (AIS), a 41.14% stake in Thaicom PLC, and a 42.07% share in CS Loxinfo through a 99% owned Thaicom subsidiary.

 

The vast majority of the company’s net profit and value is derived from its investment in AIS.

 

AIS is the leading mobile operator in Thailand with 39.4 million subscribers nationwide or approximately 46% of the subscriber market share. In Q2 2016, 85.2% of subscribers were pre-paid.

 

To service its subscribers, AIS has 40MHz of its own spectrum (the regulatory limit is 45MHz), and up to 30MHz of spectrum rented from TOT. The company’s own spectrum was acquired at a total cost of THB319.4 billion (USD7.8 billion) and the rented spectrum has up to an annual cost of THB3.9 billion with a potential cost of THB39 billion over the life of the lease. To support its spectrum, AIS has 32,000 3G base stations covering 89% of the population and 15,500 4G base stations covering 55% of the population. AIS’s 4G goal is to cover 80% of the population by the end of 2016. AIS mobile operations account for over than 99% of AIS revenues.

 

Thaicom provides satellite transponder leasing in both the domestic and international markets under a concession from the Ministry of Information and Communications Technology, which expires in 2021, and the Telecommunications Service License Type III granted by the NBTC, which expires in 2032. THAICOM currently operates four satellites: one broadband satellite, Thaicom 4 (IPSTAR), and three conventional satellites, Thaicom 5, 6 & 7. Another satellite (Thaicom 8) is under construction and is expected to be launched in the first half of 2016.

 

Other businesses includes a JV with Hyundai Home Shopping creating a home shopping network in Thailand, and InVent, a venture capital arm launched in 2012, with the main purpose of supporting and promoting high-potential start-up companies in Telecom, Media, IT, Digital Content and other related businesses.

 

Intouch Holdings is 41.62% owned by Temasek. On August 18, 2016, Singapore Telecommunications entered into a conditional share purchase with Temasek to purchase 21% of Intouch Holdings at a price of Bt60.83 per share. The agreement should conclude in December 2016.

 

 

INDUSTRY ANALYSIS

 

Barriers to Entry

 

There are three major mobile operators: AIS, Total Access Communications (DTAC), and True Corporation (True). In Q2 2016, AIS had a 49.9% market share, DTAC had 25.5% of the market, and True had 24.6% of the market. Two other players CAT and TOT mainly lease their mobile networks to other players and have minimal market share.

 

There is strong evidence that barriers to entry exist among mobile operators. The industry only has three players. If there were no barriers to entry, there would be many more competitors as entrants are free to enter the industry.  Additionally, there is market share stability.

 

Market share stability points to captive customers that have difficulty changing between suppliers or do not want switch suppliers making it difficult for new entrants to compete. AIS tends to be the biggest beneficiary of the barriers to entry in the industry as it consistent generates the highest average revenue per user (ARPU), and the highest profitability.

 

AIS outperforms on all key value metrics including ARPU, gross margin, operating margin, invested capital turnover, and ROIC.

 

Additionally, AIS consistently generates excess profits well above its competitors, accounting for 89% of the industry’s excess profits since 2011.

 

The evidence points to barriers to entry within the industry with AIS being the main beneficiary. Given AIS’s market share advantage, economies of scale seems to be the primary source of its advantage as there are significant fixed costs with the largest being investment in spectrum and building a network with smaller fixed costs being marketing to build a brand. Investment in spectrum and network build are made prior to acquiring customers and the more customers these fixed costs are spread across the greater the profitability. The existence of economies of scale can be tested by observing profitability across different markets and seeing whether size explains profitability. The chart below illustrates the relationship between market share and ROIC among the three largest players in Thailand, China, and Indonesia in 2015 and over the last five years. China, and Indonesia were selected because they are the largest markets in Emerging Asia and oligopolistic.

 

There seems to be a relationship between market share and profitability with an adjusted R squared of 0.60. In addition to having the highest ROIC, in all three countries, the market share leader has the highest ARPU, operating margin, and invested capital turnover.

 

Additional evidence of the presence of economies of scale is the percentage of excess profits going to the market share leader in Thailand, China, and Indonesia. The market share leader in all three markets took an extraordinary amount of excess profits in 2015 and over the past five years averaging 122% of all excess profits.

 

Given the relationship between ARPU, gross margin and size, size appears to drive pricing power and brand as AIS can spread the fixed costs of building a network over allowing it to spend more on network coverage, speed, and network quality thus customers are more willing to pay to use a better network.

 

ARPUs are converging with True gaining on DTAC and AIS, but AIS was able to increase its ARPU relative to DTAC.

 

Gross margins are diverging with AIS expanding its gross margin by 5.7 percentage points while DTAC’s and True’s gross margins contracted by a minimum 4.1 percentage points.

 

As illustrated below, AIS has much better throughput than peers on 4G.

 

The company also has better 3G coverage.

 

The evidence points to size is a crucial competitive variable and barrier to entry among mobile operators.

 

The other barrier to entry is regulatory. In the latest 4G spectrum auction, only companies that are majority owned by a Thai could participate. Telecom companies outside of Thailand have the capital and desire to enter the market but the inability to find a suitable local partner to meet the spectrum auction requirements of being a local firm.

 

There was a threat of a new entrant when Jasmine International won a spectrum auction in December 2015. Fortunately for the industry, Jasmine was unable to raise the necessary capital illustrating the difficulty in entering the industry.

 

 

Other Four Forces

 

The industry is in a period of intense rivalry as competitors invested heavily in upfront fixed costs of acquiring spectrum and building out 3G and 4G networks. In a quest to generate as much profit as possible on their upfront investment, competitors are marketing aggressively through handset subsidies and marketing expenses to gain subscribers on their networks. Since 2010, AIS invested THB43.205 billion in spectrum, DTAC invested THB13.615 billion, and True invested THB48.602 billion.

 

In October 2012, Thailand auctioned 3G spectrum with AIS, DTAC and True all winning 15MHz of 2100MHz spectrum. AIS paid THB14.63 billion for its spectrum, while DTAC and True both paid THB13.50 billion for their spectrum. Thailand then auctioned 1800MHz spectrum in November 2015 with AIS and True winning 15MHz of spectrum. AIS paid THB41.00 billion while True paid THB39.80 billion. In December 2015, Thailand auctioned 20MHz of 900MHz spectrum. Initially, True and a new entrant Jasmine International won the spectrum. True paid THB76.30bn for its 10MHz allocation but Jasmine was unable to pay for the spectrum it won so the spectrum was re-auctioned in July 2016 with AIS winning the spectrum auction by bidding THB75.70 billion. Cumulatively, DTAC has paid for its entire spectrum. AIS paid THB43.205 billion of its THB131.33 billion spectrum obligations so the company has THB88.125 of spectrum payments that still need to be made. True paid THB48.602 of its THB129.60 billion spectrum obligations meaning the company has roughly THB81.00 billion in spectrum payments to be made. DTAC’s has 45MHz (3x15MHz) of spectrum with a license expiring in September 2018. This spectrum will be auctioned in July 2018 with a reserve price of THB3 billion per MHz or THB45 billion per 15MHz block of spectrum.

 

The investment in spectrum is followed by the need to build out an infrastructure to allow the company to sell the spectrum to customers. The more capex spent building infrastructure creates greater supply as well as a greater desire to get a return on the upfront investment in spectrum and infrastructure leading to more aggressive marketing campaign to acquire customers.

 

AIS has guided capex of THB40 billion in 2016 to build out its 3G and 4G networks with half going to 4G. The company had already spent THB14bn in 2015 on 4G network spend bringing the total capex to THB54 billion to build a 4G network will cover 80% of the country. According to the Bangkok Post, AIS will spend a total of THB60 billion to build out is 4G network. True estimates it will cost THB56 billion to provide 4G LTE to 97% of the country.

 

The chart above shows capex since 2010 with Q1 2016, Q2 2016, and Q3 2016 capex annualized. Combined capex increased from THB 14 billion in 2010 to roughly THB100 billion on an annualized basis in Q1 2016, Q2 2016, and Q3 2016. The increase in capex should continue for at least the next year as competitors continue to build out their 4G networks.

 

To recoup the investment in spectrum and infrastructure build, Thai telcos are aggressively marketing. Handset gross margins are a good indicator of the current level of marketing aggressiveness. Recently, AIS has been heavily subsidizing handsets to migrate from 2G to 3G as it license for its 2G spectrum expired near the end of 2015, while DTAC is subsidizing handsets to slow market share losses as it has gotten a reputation for having a low quality network due to underinvestment. All competitors are subsidizing handsets to acquire 4G customers as companies roll out their 4G network. Companies are also subsidizing smart phones for postpaid subscribers as postpaid subscribers use much more data and voice leading to an ARPU over 3 times the ARPU of prepaid subscribers. AIS’s guidance is for continued subsidies and negative handset gross margins in 2016. The industry handset gross margin declined from 5.1% in Q1 2013 to -18.9% in Q3 2016, making Q3 2016 handset gross margin the lowest since 2013.

 

In addition to handset subsidies, competitors are aggressively on pricing and marketing. Marketing expenses among all players are on an increasing trend as illustrated by the chart below, Q1, Q2, & Q3 2016 marketing expenses are annualized. In 2010, industry marketing expenses totaled THB9.5 billion. In Q3 2016, annualized marketing expenses reached THB55.2 billion.

 

Despite lower regulatory costs, higher marketing expenses led AIS to guide for a 2016 EBITDA margin of 37%-38% in 2016 down from 45.6% in 2015. The regulatory costs for 2G were the highest in the world at 20-30% of revenue. The 3G and 4G regulatory costs are much more lenient with up to 5.25% of revenue going to regulatory costs. DTAC also expects its EBITDA margin to decrease to 27%-30% in 2016 from 31.8% in 2015. Industry regulatory costs decreased from 26.5% of industry sales in Q1 2013 to 8.8% of industry sales in Q2 2016.

 

Further fueling the rivalry is TRUE’s market share gains (+9.1%) since Q1 2013 at the expense of DTAC (-5.2%) and AIS (-3.8%). Given the importance of economies of scale, it makes sense for firms to increase the rivalry to maintain market share.

 

True’s also recent recently raised capital. In December 2013, True spun off its infrastructure assets through an IPO raising THB58.1 billion or USD1.8 billion. The infrastructure fund allows investors to benefit from the revenues generated by telecom towers, a core fibre-optic network and related transmission equipment, and a broadband access system located in provincial areas of Thailand. In January 2015, True sold 350 towers and 8,000km of fiber to its infrastructure fund for THB14 billion or USD424 million. In September 2014, China Mobile purchased 18% of True for THB28.6 billion or USD880 million in a private share placement. Despite the fund raising, True’s net debt to ttm operating profit is still at 6.05 as the company has generated cumulative free cash flows of THB-113.81 billion since the beginning of 2011. The continuous fund raising fueled by negative cash flows points to the competitive advantage held by AIS.

 

As illustrated above from 2010 to the end of 2015, True’s operating cash before any investments just covered investment in working capital and investment in spectrum. With external capital needed for almost all of the company’s investment in network. AIS’s generated the highest operating cash flow before any investment and free cash flow. DTAC generated a strong operating cash flow before any investments but spent significantly less than its peers on its network and spectrum. If DTAC spent a similar amount on spectrum and network build its free cash flow as AIS and True, its free cash flow would have been slightly negative. The lack of investment in its network and spectrum has hurt DTAC brand leading to market share losses to True.

 

Weak economic growth in Thailand and continued decline in voice revenues also add to the intensity of the rivalry in the industry.

 

 

Threat of Substitutes

 

The threat of substitutes for voice revenue is high as users are shifting away from voice to text, messaging apps or cheap voice services like Whatsapp or Skype leading to a continual decline in voice revenues.

 

The decline in voice revenue is a trend among more mature mobile markets as illustrated by the chart/table above.

 

The threat of substitutes for data revenue is low as mobile phones are a necessity and the trend continues to shift towards an increasing reliance on mobile phones for many aspects of daily life. The shift away from voice revenue is to substitutes that generate data revenue for mobile operators.

 

The overall threat of substitution to mobile operators’ products is low as the mobile phone is now such an important part of everyday life.

 

 

Bargaining Power of Suppliers

 

The bargaining power of suppliers is low. The main supplier are handset providers and SIM card producers as AIS creates its own infrastructure. SIM card manufacturers make a commodity product and the industry is much more fragmented than the mobile operator industry. The handset industry is also more fragmented than the mobile operator industry giving operators bargaining power when discussing handset purchases. The only supplier with any bargaining power is probably Apple given the brand associated with its product.

 

 

Bargaining Power of Customers

 

Customers have some bargaining power as they can freely switch providers particularly when so many subscribers are pre-paid meaning there are no contracts and there is number portability. Additionally, the information of all operators offering are readily available allowing customers to easily compare competitors increasing the bargaining power of customers. The ease of comparing competitors’ offerings along with the increasing cost of mobile services makes customers very focused on pricing.

 

Mobile operators compete on network quality as much as price. The difference in network quality creates a cost of switching from a good network to a bad network. Hindering bargaining power is the presence of only three mobile operators creating a significant amount of concentration at the mobile operator level while customers lack concentration. Overall, customers seem to have a fair bit of bargaining power due to number portability and the ease of comparing competitors’ offerings.

 

 

Industry Growth

 

In Thailand, mobile penetration reached 126% in 2015 meaning there is relatively little growth potential from an increase in subscribers. Since Q1 2013, subscribers grew at a CAGR of 1.9%. At the end of Q3 2016, smartphone penetration reached 70% while 4G handsets penetration reached 19% meaning future growth will not come from subscriber growth or even increased smartphone penetration but from increase in 4G penetration, which comes with increased data usage. In Q3 2016, AIS data subscribers accounted for 57% of total subscribers averaging 2,960 MB of data used per month up from 34% and 240 MB in Q1 2013 representing 17% CAGR in data subscribers and a 95% CAGR in data usage. Over the same period, the estimated price per MB has declined from THB0.2046 in Q1 2013 to THB0.0201 in Q3 2016.

 

The growth of data usage now makes non-voice revenue a larger portion of revenues than voice revenue with non-voice accounting for 56.5% of service revenue in Q3 2016 up from 27.3% in Q1 2013. Since the Q1 2013, non-voice revenue grew at a CAGR of 23.0% compared to voice revenue declining at 11.7% per year.

 

 

MANAGEMENT

 

All director and executives of Intouch Holdings have very small share ownership and therefore are hired hands rather than owner operators. Neither Intouch’s management nor AIS’s management do not extract too much value with the remuneration of directors and executives only 0.18% of operating income at Intouch Holdings and 0.25% of operating income at AIS.

 

 

Capital Allocation

 

Despite Intouch’s goal of achieving 25% of value from non-AIS businesses, AIS currently accounts for over 95% of Intouch’s market value therefore the focus will primarily be on AIS’s capital allocation decision.

 

To determine the strength of capital allocation decisions, we will attempt to determine a return on investment. The majority of AIS’s business is 3G but the company is building out its 4G network. For conservatism, we assume no change in the current competitive environment and no growth in AIS business to get a perpetuity cash flow figure. AIS spent THB131.33 billion on 3G and 4G spectrum. Additionally, the high end of the company’s 3G network build is THB90 billion. The company also estimates 4G network build will cost THB60 billion. The total investment in spectrum and network build THB281.33 billion.

 

Assuming a 15 year useful life on the investment, no change in subscribers, no growth in ARPU, an operating margin of 25%, a tax rate of 25%, and no salvage value; the overall investment in 3G and 4G generates a return on investment of 14.3%. It is not the returns that the company is used to generating, as the investment cost in 4G spectrum was expensive, but it still creates value for the company. The investment is a necessity for the company to stay competitive.

 

Looking at the assumptions, AIS currently has 39.8734 million subscribers so there is no change to the number of subscribers in the market or to market share. Depreciation is assumed to have a 15 year useful life, in-line with the license period leading to an annual depreciation expense of THB18.755 billion. Depreciation is 16.3% of sales well above the average rate of 12.5% over the past five years. ARPU is expected to remain stable at THB240 per month as the increased data usage is offset by cheap data prices. AIS’s ARPU has averaged THB240 per month since Q1 2013 with no particular trend. The 25% tax rate equals the company’s historical tax rate. The operating margin of 25% is well below historical rates. It is assumed that competition continues into perpetuity with negative handset margins and elevated marketing expenses with lower regulatory expenses from 3G and 4G networks as Q3 2016 saw operating margin at 24.3% with gross margin at 44.0%, selling expense at 10.3% of revenue, administrative expenses at 9.3% of sales, and depreciation and amortization at 16.9% of revenue. The table below illustrates the sensitivity of the investment in 3G & 4G to various assumptions.

 

Other than mobile, AIS is investing in fixed broadband with a goal of full coverage of Bangkok by end of 2016 and having significant market share in three years. The investment is insignificant relative to the investment in mobile.

 

Both Intouch and AIS are very shareholder friendly with an 100% dividend payout policy.

 

Other than the investment in AIS, Intouch also has smaller investments in Thaicom and a number of private equity investments related to media and telecommunications. The company’s stated goal is for non-AIS investments to reach 25% of the value of the portfolio. Many of the private equity investments are for to aid AIS of strategy of providing more content and digital applications. Intouch’s largest investment outside of AIS and Thaicom is a home shopping network in Thailand called High Shopping Co. Ltd. It is 51% owned by Intouch and 49% owned by Hyundai Home Shopping and has total capital THB500 million. The TV home shopping market in Thailand is expected to double in market value to 20 billion baht by 2020. Intouch forecasts it share of the market will reach THB4.5 billion in 2020, or of 20% of the TV home shopping market in Thailand.

 

 

VALUATION

 

Currently, AIS is overvalued as the market has yet to factor in decreased capital efficiency from the size of the recent investment.  The total investment will reach 282 billion while estimated revenues are less than half of that. In order to get the market’s current valuation for AIS, assuming an alleviation of competitive pressures leading to average historical margins and no growth, invested capital turnover needs to remain near historical levels. Even with these assumptions, there is 10% downside.  Assuming no growth, a persistence of competitive pressures along with a decline in invested capital turnover to 1.1 times, half of the historical average of 2.2 times, AIS intrinsic value is closer to THB70.00.

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.

Anta Sports Product July 19, 2016

Anta Sports Product July 19, 2016

Anta Sports Products July 19 2016 RCR

                                                                                     

Recommendation: Buy                 

Ticker: 2020:HK

Closing Price (7/19/2016): HKD17.26

6 Month Avg. Daily Vol. (USD mn): 18.82

Estimated Annualized Return: 11-13%

 

 

INVESTMENT THESIS

 

Anta is the largest Chinese sportswear company with an 11.1% market share. Anta’s size gives it an advantage over all domestic peers as there are fixed costs in the form of advertising and research and development allowing the company to outspend peers on brand building and improving the company’s product. Anta’s size and strong brand allows the company to generate an average pre-tax ROIC over four times its Chinese sportswear peers. The company expected annualized return is somewhere between 11.0%-12.5% leading to an initial 2.0% position size.

 

 

KEY STATISTICS

Key Statistics July 19 2016

 

FACTOR RATINGS

Factor Ratings

 

 

COMPANY DESCRIPTION

 

Anta was founded in 1994 by Mr. Ding Siren, the father-in-law of the company’s current Executive Director Mr. Ding Shizhong. He incorporated ANTA Fujian and ANTA China in 1994 and 2000 and the company went public in 2007.

Group Structure

 

The company is a leading sportswear company with an estimated 11.1% market share at the end of 2015.

Chinese Sportswear Market Share 2015 Pie Chart

 

The company uses a combination of internal production and outsourced production to allow for more flexibility in periods of strong demand. The threat of vertical integration also gives the company bargaining power of its suppliers. In 2015, 49.0% of footwear and apparel is produced internally.

 

Advertising and research and development are done internally while distribution and retail is outsourced to exclusive partners with the company monitoring operations. At the end of 2015, Anta had 9,080 stores including 7,031 Anta stores, 1,458 Anta kids stores, and 591 FILA stores.

 

The company has positioned its product as a high performance, value for money brand. It partners with the Chinese Olympic Committee, Chinese Sports Delegation, and many of the Chinese Olympic teams allowing it to be perceived as the Chinese national brand. It is also the official partner of the NBA in China and endorses many NBA players including Klay Thompson, one of the best players on one of the best teams in the league, Chandler Parson, Rajon Rondo, and Luis Scola. The Anta brand is consistently voted the most valuable sportswear brand and one of the top three most valuable apparel brands in China.

 

In 2015, the company generated 45.6% of sales from footwear, 50.3% of sales from apparel, and the remainder from accessories. Since 2008, Anta grew sales at a compound annual growth rate of 13.4%.

 

In 2015, gross profit breakdown is similar to sales breakdown with footwear accounting for 45.2% of gross profit, apparel accounting for 51.5% of gross profit, and accessories accounting for the remainder of gross profit.

Anta Revenue Gross Profit Breakdown

 

Anta’s three largest operating expenses are advertising, staff costs, and research and development. Anta spends heavily on advertising and research and development. Over the past four years, the company spent 11.3% of sales on advertising and 4.3% of sales on research and development.

Anta Opex % Sales

 

Since 2008, the company’s operating margin averaged 21.5% with low variability. The company’s highest operating margin was 23.3% in 2009 and the lowest was 19.3% in 2012.

 

Anta has low investment requirements. Since 2008, working capital averaged 6.2% of sales and fixed capital averaged 10.7% of sales meaning invested capital averaged 17.9%. Overall, Anta average return on invested capital is 127.8%.

 

 

INDUSTRY ANALYSIS

 

Industry History

 

The Chinese sportswear industry went through a rapid period of growth from 2008 until 2011 supported by the Beijing Olympics. During that period, the industry saw an increase in store count at the largest domestic players from 27,605 stores in 2008 to 40,819 stores in 2011, representing a 13.9% compound annual growth rate (CAGR). Sales at the largest seven players increased from RMB37.63 billion in 2008 to RMB58.35 billion in 2011, or 15.7% per year.

Industry Sales Store Count

 

After the period of rapid growth, 2011 to 2014 saw a period of consolidation with the store count decreasing 4.6% per year from 40,819 to 35,428 and sales decreasing 2.7% per year from RMB58.35 billion to RMB53.71 billion.

 

2015 may have marked the end of the consolidation as started a return to growth with store count stagnating around 35,000 and sales at the seven largest players increasing by 25% from RMB53.71 billion to RMB67.18 billion.

 

The sportswear industry is one of the most mature segments of the apparel industry and is expected to grow around mid-single digits. Despite the maturity, the sportswear industry is still underpenetrated in China.

 Chinese Sportswear Penetration

 

 

 

Barriers To Entry

 

In the sportswear industry, size is a key driver of profitability and growth as there are significant fixed costs in the form of advertising and promotion and research and development creating economies of scale. There are many estimates for the Chinese sportswear market size with Fitch’s estimating the market reached RMB100 billion in 2015, which is 5-10% lower than the average of estimates from Euromonitor, Fung Business Intelligence Centre, Research InChina, and ATKearney. The table below illustrates market shares of the largest players in the Chinese Sportswear market assuming a RMB100 billion market size with the market size from previous years estimated to grow at the same rate as the largest players in the market.

Chinese Sportswear Market Share 2010 2015 table

 

In 2015, Nike was the largest sportswear company in China with an estimated 17.1%. Adidas followed in second place with a 17.2% market share. The largest domestic player was Anta with an 11.1% market share. The second largest domestic player is Li Ning with a 7.1% market share. Due to its size and the presence of economies of scale, Anta is competitively disadvantaged to Nike and Adidas but has a competitive advantage to domestic players. From 2010 to 2015, Nike, Adidas, and Anta gained 5.8%, 5.6%, and 1.7%, respectively. The smaller domestic players all lost market share with a cumulative market share loss of 8.0% between 2010 and 2015. Interestingly, Li Ning lost 5.0% of market despite starting the examined period with the second highest market share. With the exception of Li Ning, market share movements point to economies of scale as larger firms spend more on the fixed costs needed to educate customers and improve the product.

Size vs Operating Margin

 

The chart above plots market share for each Chinese sportswear competitor compared to their operating margin from 2010 to 2015. Adidas does not report operating margin for China. As shown, there is a strong correlation between size and operating margin with Li Ning’s poor profitability being the only outlier.

 

Advertising and promotional expense is partially an expense that needs to be adapted to local markets given differences in cultures and tastes creating a need to customize advertising and promotion to adhere to those local cultures and tastes eliminating the size advantage from global markets for Nike and Adidas. A big part of advertising and promotions in sportswear is endorsements of brands by athletes. Endorsements are primarily global as illustrated by Chinese domestic sportswear companies trying to sign NBA stars from the United States rather than relying on local basketball players. Given the global nature of endorsements and the fixed nature of the cost, the true measure of Nike and Adidas’s size are the companies’ global sales giving them a much bigger size advantage than estimated by looking at the local market. Similar to endorsements, research and development in the design of new products is global as the product innovations produced from one market can be used in many other markets, making the true measure of Adidas and Nike’s size their global scale. Nike and Adidas do not report fixed costs on a local basis but the tables below show spending on fixed costs by domestic peers.

Fixed Costs of Domestic Peers

 

Li Ning was the biggest spender on advertising and promotion from 2010 to 2015 although the pace of spending slowed in 2014 and 2015 due to RMB 2.8 billion in operating losses in 2012, 2013, & 2014 allowing Anta to overtake them as the largest spender in advertising and promotion in 2015. From 2010 to 2015, smaller domestic peers spent less than half of Li Ning on advertising and promotion and just over half of Anta.

 

From 2010 to 2015, Anta was by far the biggest spender on research and development spending RMB2.1 billion almost twice the amount spent by Li Ning and almost five times the average of smaller players.

 

Despite spending the most on advertising and the second most on research and development of domestic peers and having the highest market share, Li Ning lost 5.0% market share between 2010 and 2015 illustrating that while size is important, execution matters as well. The other big market share losers were the smaller domestic players unable to compete on fixed cost spending. Collectively, Li Ning and the smaller domestic players lost an estimated 13.0% of market share. Nike and Adidas were the largest market share gainers winning 5.8% and 5.6%, respectively. Anta increased its share by 1.7% between 2010 and 2015. Fixed cost spending, market share movements, and the relationship between size and profitability all point to the presence of economies of scale.

 

Brand advantage is present in the Chinese sportswear market. Brand advantage is often illustrated by premium pricing and market share as it points to a customer’s increased willingness to pay. Many companies do not give the average selling price (ASP) for products sold so tmall.com was referenced. For better comparability, footwear was categorized into running and basketball shoes, two of the most popular sports categories. The tables below illustrate the average selling price (ASP) for each companies top selling shoes.

ASP of domestic peers

 

Nike shoes have the highest average price in both categories at RMB1,083 in the running segment and RMB797 in the basketball segment. Nike’s prices in running are at a significant premium peers with the closest competitor’s ASP at a 64% discount to Nike’s ASP and the average peer price 25% of Nike’s running ASP. In basketball, Nike’s ASP is level with Adidas and roughly three times the average of its other peers. Adidas ASP is a 30% premium to running peers other than Nike and three times the average of non-Nike peers in basketball. The combination of ASP premium for Nike and Adidas and market share advantage points to a significant brand advantage over the remaining peers in the industry.

 

Anta ASP is at 10% premium to the average price of non-Nike and Adidas peers in running pointing to little or no ASP premium in the running segment. In the basketball segment, Anta’s price is roughly 55% higher than peers other than Nike and Adidas. Anta’s pricing premium with a market share advantage points to a potential brand advantage to competitors other than Nike and Adidas but the evidence is not as strong as the brand advantage held by Nike and Adidas.

 

Brand advantage should also show up in a gross margin advantage relative to peers as a branded company can charge a higher price as customers have an increased willingness to pay. A higher gross margin may also point to a manufacturing advantage over peers. Given all companies do not report volume statistics; it is difficult to compare manufacturing costs. It is probably difficult to have a sustained cost advantage as much the production function is outsourced. The outsourcing points to no internal costs advantage and the ability of peers to outsource production to the same provider of a competitor. If there were any unique activities within production, it could easily be replicated by peers as there is no complexity or unique processes associated with manufacturing footwear and apparel. The true cost advantage could come from lower labor costs but given the ease of outsourcing that could be obtained from any competitor. Given the production function can be outsourced, there is potential purchasing power from the larger competitors leading to lowering the cost of production.

 

Size vs Gross Margin

 

The chart above plots market share compared to gross margin for Chinese competitors between 2010 and 2015. Nike does not report gross margin for China and Adidas only started reporting it in 2014. As illustrated, there is a strong correlation between size and gross margin with an adjusted R squared equaling 0.787. Unfortunately, higher gross margins due to size can be either purchasing power on raw materials, premium pricing from the ability to spend more on fixed costs in the form of advertising and promotion and research and development, or a combination of both.

 

There are also many firms estimating brand value of Chinese companies. The Hurun Institute estimates brand value for Chinese apparel companies as illustrated below.

Most Valuable Chinese Apparel Brands Hurun

 

According to Hurun Research Institute, Anta consistently ranks as on the three most valuable apparel brands with an estimated brand value of RMB6.4 billion at the end of 2014, illustrating Anta’s brand strength relative to domestic peers.

 

Interbrand reports annually Chinese 100 most valuable brands. Anta continually shows up as the highest sportswear brand on the list. Interbrand is much more conservative with Anta’s estimated brand value of RMB3.77 billion at the end of 2015.

Anta Brand Value Interbrand

 

Further evidence of Anta’s competitive advantages is seen in its profitability relative to domestic peers.

Chinese Sportswear Players Operating Margins

 

Relative to domestic peers, Anta had the highest operating margin by 3.5 percentage point with the lowest variability by a very wide margin. Between 2010 and 2015, Anta’s operating margin only decline by 40 basis points. The next best margin decline was at Peak Sports, whose margins declined by 3.7%. The company’s operating margin saw minimal variability with a coefficient of variation of 6.3% below all peers including Nike and a third of the closest domestic peer.

Chinese Sportswear Players IC Turnover

 

Anta was also by far the most efficient user of capital with an average invested capital turnover ratio of 6.07 with the second best stability behind 361 Degrees.

Chinese Sportswear Players Working Capital and Fixed Capital Turnover

 

Anta’s efficient use of capital is driven by its working capital efficiency as there is minimal differential in fixed capital turnover among domestic peers.

Chinese Sportswear Players Working Capital Breakdown

 

Anta big differential with peers is in receivables management with the company turning over receivables 11.7 times in 2011 compared to a peer group average of 4.0 times. Similarly, in 2015, Anta turned over receivables 9.5 times compared to a peer group average of 3.4 times. Anta is almost three times more efficient than peers in managing receivables. The downturn in the industry created receivables issues at most peers but the strength of Anta’s brand, product, and pricing allowed the company to continue to push product through the channel without distributors having any issues selling the product.

Chinese Sportswear Pre Tax Roic

 

Anta’s superior profitability and capital efficiency leads to the highest ROIC every year with the lowest variability. Anta’s pre-tax ROIC is over four times the average of domestic peers.

 

Profitability well above peers states customers are either more willing to pay for the company’s products or the company manufacturers products more efficient than peers.

 

The evidence points to barriers to entry in the form of economies of scale and brand with the economies of scale reinforcing the brand advantage as the company can spend more on fixed costs to build its brand by having a greater size. Anta is on the right side of the virtuous feedback loop against domestic peers but on the wrong side of the feedback loop against Nike and Adidas.

 

Anta has a size advantage and seems to have a brand advantage over other domestic peers but the strength of its advantage is nowhere near the strength of Nike’s and Adidas’ advantages.

 

 

Competitive Advantage Period

 

Economies of scale combined with a brand advantage create very strong barriers to entry as they combine to create a feedback loop that is difficult to overcome. The size advantage allows a competitor to outspend its peer on fixed costs. In sportswear, the fixed costs are advertising and promotion and research and development. These costs build and reinforce a company’s brand creating a feedback loop that is difficult to overcome. Fixed costs, such as endorsements and product development, can be used in many different markets making global scale, the true measure of a competitor’s size, and making it even more difficult for local players to compete.

 

Nike and Adidas’ competitive advantages should persist for decades. Anta’s disadvantage to Nike and Adidas should continue but its advantage over domestic peers should strengthen over time.

Global Sportswear Market Share 2011

 

Globally, the sportswear markets are fragmented with Nike and Adidas garnering a 21.1% market share in apparel and a 52.7% market share in footwear. The relative fragmentation of apparel illustrates the apparel market is much more competitive. Given the presence of economies of scale in the sportswear industry, the industry should be more consolidated given fixed costs associated with economies of scale create a minimum efficient scale to compete. It seems some customers are not willing to pay a premium price for a brand and are much more price sensitive. Customers have diverse taste and the larger organizations do not produce goods to cover all tastes in the market. The barriers to entry are not strong and companies can survive with a very lower market share due to the asset light nature of the business.

 

Anta’s competitive advantage over domestic peers should also continue for decades but profitability will deteriorate as it starts competing with Nike and Adidas. At the moment, it has positioned itself as a brand among the mass market segment, while Nike and Adidas are in the high-end segment making direct competition not an issue for the moment.

 

 

Other Four Forces

 

Intensity of rivalry is high particularly among firms competing for more price sensitive customers as these customers are only worried about price making operating efficiency the key strategic goal within this segment. For firms competing more on brand, their offering is differentiated making the intensity of rivalry less intense.

 

Although the sportswear industry is fragmented, suppliers in the form of sportswear manufacturers are typically smaller, more fragmented, and at risk of vertical integration leaving them with very little bargaining power. In the case of companies that manufacture their own products, raw material suppliers are commodity producers that are very fragmented and sell their product solely on price.

 

Suppliers of labor seem to have bargaining power over the sportswear companies. From 2010 to 2015, Staff costs have increased as a percentage of sales at all Chinese sportswear companies by a minimum of 2.3%. The rise in cost points to employees having bargaining power over suppliers.

Chinese Sportswear Staff Costs

 

Customers in the form of distributors are fragmented and in the case of Anta are exclusive sellers of Anta’s products. The fragmentation and exclusivity greatly decreases the bargaining power of customers. While the bargaining power of distributors is low, Anta relies on the distributors to sell their products; therefore, they are more partners whose health is vital to Anta.

 

The threat of substitutes is high for more casual sportswear as customers can easily switch and buy similar product from more fashion oriented companies. More performance oriented sportswear has a lower threat of substitution as athletes are less likely to give up on performance features.

 

 

 

MANAGEMENT

 

Anta’s executives are owner-operators with five of the executive directors owning at least 6% of the company allowing management incentives to be aligned with minority shareholders.

 

Strategy

 

The company’s strategy is to be the leader in the value for money segment by having a stronger brand  and more innovative products than peers competing in the value for money segment. The company strategy has been consistent since their IPO. Management understands the key strategic drivers in the industry spending the most among domestic peers on fixed costs to build a brand and improve products allowing the company to continually win market share allowing the feedback loop of greater size allowing for greater spending on fixed costs to build a brand and improve products to continue.

 

Operations

 Chinese Sportswear Key Value Drivers

 

Over the last five years, ANTA outperformed peers on all key value drivers. It comes out on top in sales growth, operating profit growth, operating margin, capital efficiency and its ROIC is more than double its closest competitor. It comes in second only in gross margin to Li Ning.

 Chinese Sportswear Pre Tax Roic

 

As illustrated, with the exception of Li Ning, Chinese sportswear companies were able to generate an average pre-tax return on invested capital of 51.9% between 2010 and 2015. Anta’s average pre-tax ROIC was four times the average of its peers over that time due to higher margins and capital efficiency.

Chinese Sportswear Operating Margin IC Turnover

 

From 2010 to 2015, the average operating margin in the Chinese sportswear industry averaged 13.1% with Anta averaging 21.0% and its peers averaging 11.0%. Peers were dragged down by Li Ning with Anta having only a few percentage points edge over XTEP and Peak Sports. Although Anta had a small advantage in average operating margin, the company’s stability is far superior to the peer group.

 

Anta’s IC turnover surpassed domestic peers IC turnover by a wide margin, averaging 6.07 times compared to a peer group average of 3.00 times.

 

Overall, management is executing its value for money strategy much better than peers leading to market share gains and profitability much higher than peers.

 

Capital Allocation

Anta Capital Allocation

 

Capital allocation cash flow is operating cash flow + working capital + advertising and promotion expense + research and development expenses. Capital allocation cash flow is the amount of cash flow available for capital allocation decisions.

 

Advertising is the largest capital allocation decision at 34% of capital allocation cash flow. Given the company’s size advantage over peers and the importance of brand in the industry, advertising expenses should be maximized. The company is doing a good job taking advantage of its market share and outspending peers on fixed costs but with a net cash position of roughly 2.25 times operating profit the company could increase advertising expenses.

 

The second largest capital allocation decision is the payment of dividends accounting for 33% of capital allocation cash flow. Given the asset light nature of the business and the company’s net cash position, higher dividends could be paid.

 

The third largest capital allocation decision is research and development accounting for 11% of capital allocation cash flow. Research and development is a fixed cost to improve the product and the company’s brand, given the company’s size advantage and the ability to build a brand from product innovations, Anta could increase its research and development as it has a large net cash position.

 

All other capital expenses are minimal with working capital investment and capital expenditures combine to 10% of capital allocation cash flow.

 

The company made two acquisitions between 2008 and 2015 equaling 2% of capital allocation cash flow. Both times the company paid book value. In 2009, the company purchased the right to distribute FILA in the greater China area. At the time, the acquired company was losing making. The company does not segment out sales and profits by brand so we unable to determine how good of an acquisition it was. The acquisition does not makes sense strategically.  FILA is a high end brand that is more fashion oriented. The high end nature puts in direct competition with Nike and Adidas, while its fashion orientation makes it more open to competition from more fashion oriented clothing. If the company’s goal is to be the leading value for money brand, the FILA acquisition brings the distraction of worrying about a high end product that does not provide any additional size advantage. Also, given you have little or no input into product innovation and marketing, the key activities in the sportswear value chain are out of the company’s control.

 

Overall, the company has made no major capital allocation missteps. The biggest misstep is having a net cash position equal to 2.25 times 2015 operating profit. The company has a size advantage over all players within its segment and ideally the company would increase spending on either advertising and promotion or research and development. If the company believes it is at the optimal level of spending on fixed costs it could increase dividends paid.

 

 

Corporate Governance

Anta Related Party

 

The company’s related party transactions are insignificant. Quanzhou Anda is a related company that provides packaging, while the service fee to Mr. Ding Shijia is related to lease payments for the use of facilities.

 

Since 2010, the top five highest paid employees’ average pay was only 0.75% of operating profit. The company’s management is not extracting too much value from salaries on an absolute basis. Below 1.0% is actually extremely good value given the strength of management strategically and operationally. Relative to the industry, Anta has the lowest salaries relative to operating profit and sales.

 

Chinese Sportswear Top 5 Salaries

Anta’s accounting assumptions are in line with peers across the board so there are no concerns over inflated earnings due to accounting assumptions.

 

 

VALUATION

 

Given Anta is competitively advantaged against the Chinese sportswear companies, the best valuation method is an earnings based valuation. In case of Anta competitive advantage does not exist, reproduction value would be the best method of valuing the company. If the industry were not viable, liquidation value would be the best valuation technique.

Anta Asset Based Valuation

 

As illustrated above there is 83% downside to liquidation value and 55% downside to reproduction value.

 

The key assumptions used in the earnings based valuations are the discount rate, sales growth, operating margin, tax rate, working capital turnover, and fixed capital turnover. The discount rate, tax rate, working capital turnover, and fixed capital turnover are assumed to be constant at the values below.

Anta Constant Valuation Assumptions

 

We always assume a discount rate of 10%, a regulatory tax rate of 25%, an average working capital turnover of 40.9 times, an average fixed capital turnover of 9.5 times. Working capital turnover and fixed capital turnover averages are from 2008 to 2015.

 

Sales growth and operating margin are assumed to vary to get an understanding of what the market is pricing in. The values of sales growth and operating margin for each scenario are listed below.

Anta Valuation Scenarios

 

The target prices for 2016 and 2021 along with their upsides are illustrates below.

Earnings Based Valuations

 

The worst case scenario is assumed to be zero growth into perpetuity with operating margin compressing from the current 22.5% to a 19.3%. Under the worst case scenario, the 2016 target price is HKD11.76 leading to 32% downside and the 2021 target price is HKD14.65 leading to 15% downside. The most optimistic scenario assumed 15% growth over the next five years before fading to a 5% terminal growth rate with average operating margins since 2008. Under the most optimistic scenario, the 2016 target price is HKD31.60 representing 83% upside and the 2021 target price is HKD50.58 representing 193% upside.

 

Overall, the average 2016 target price is HKD19.12 representing 11% upside and the average 2021 target price is HKD27.11 representing 57% upside. There company offers a decent average return. The average return seems a bit conservative with a more reasonable base case between 5% perpetuity growth and average margins and 10% forecast period growth fading to 5% terminal growth with average margins. The 2016 target price and 2021 target price for the lower end of the base case is HKD21.87 and HKD30.59 representing 27% and 77% upside, respectively. The 2016 target price and 2021 target price for the upper end of the base case is HKD26.14 and HKD39.34 representing 51% and 128% upside, respectively. Under the base case, there is just about 15% annualized return, the company is slightly undervalued.

 

On an expected return basis, assuming a return on reinvested earnings of 50% and an organic growth rate of 2.5%, less than half of the company’s current ROIC, the company’s expected return in 16.5% as the company has a NOPAT yield of 5.1%, 2.8% of which is paid in dividends and the remaining 2.2% is reinvested.

Expected Return

 

The company has a current free cash flow yield of 3.3% with expected growth of roughly 7.5% leads to a 10.8% expected return.

 

The company is slightly undervalued and offering roughly a 12% annualized return at the lower end of the base case scenario, which is confirmed with expected return of roughly 10.8%.

 

 

RISKS

 

If perceived barriers to entry do not exist, the company’s profitability would be less sustainable than originally expected and the company’s valuation would suffer potentially causing a permanent loss of capital as the company is trading above its reproduction value.

 

If Adidas and Nike are able to attack the mass market segment without hurting their premium brand image, Anta could find itself on the wrong side of economies of scale.

 

Li Ning was once larger than Anta but lost market share over the past five years and is suffered significant losses over the past few years. These losses forced Li Ning to cut back on advertising and research and development. In 2015, the company returned to profitability and soon it could find the formula that made it a market share leader increasing competition for Anta.

 

Given economies of scale are present in the industry, market share is one of the most important variables in profitability. If Anta loses market share, it will not be able to spend on crucial fixed costs of advertising and R&D leading to weaker brand and product and more market share loses.

 

Management has done a good job of allocating capital and executing operationally but if they stop taking advantage of their size over smaller domestic peers by decreasing spending on fixed costs or become inefficient operationally, profitability will suffer.

 

Advertising and brand building is a crucial to achieving excess returns. If the company overpays endorsers, excess returns could fade.

 

Anta is in the consumer goods industry and if the macroeconomic situation deteriorates in China, consumers could stop buying sportswear.

 

The more fashion oriented sportswear faces competition from non-sportswear apparel makers.

 

Anta outsources part of its production and all of its distribution and retail activities. If value chain partners do not perform then the company’s image may be hurt.

 

Anta’s corporate governance is not an issue. If management starts extracting more value from related party transactions and high executive pay, the company’s multiple will suffer.