Category Archives: Buy

Peak Sport Products Privatization Update July 30, 2016

Peak Sport Products Privatization Update July 30, 2016

On July 26, 2016, Peak Sport Products announced the company would purchase all free float at HKD2.60 per share.   The offer is a 5% premium to July 29, 2016 closing price.  We will sell shares during the privatization.

Credit Analysis and Research June 20, 2016

Credit Research and Analysis                          June  20, 2016

Ticker: CARE:IN

Closing Price (6/20/2016): INR993.50

1 Year Avg. Daily Vol. (USD): 530,269

Estimated Annualized Return: 8-9%

Credit Analysis and Research June 20 2016 RCR

 

INVESTMENT THESIS

 

Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market.  The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case.  We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.

 

 

KEY STATISTICS

CARE Key Statistics June 20 2016

 

 

FACTOR RATINGS

CARE Factor Ratings June 20 2016

 

 

COMPANY DESCRIPTION

 

Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue.  Rating assignments generates two types of revenue: rating revenue and surveillance revenue.  Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.

CARE Volume of Debt Rated June 20 2016

 

Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt.   Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan.  If a loan it not rated, it retains a capital risk weight of 100%.

CARE Bank Loan Rating Capital Savings June 20 2016

 

The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital.  Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.

CARE Credit Penentration June 20 2016

 

As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.

 

Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits.  Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.

CARE Bond Market Penentration June 20 2016

 

As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers.  It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.

CARE Domestic Credit vs GDP per capita June 20 2016

 

CARE Bond Market vs GDP per capita June 20 2016

 

Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets.  New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures.  The company can also move into adjacent product market like research and advisory services.   CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.

 

CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.

CARE Shareholder Structure June 20 2016

 

IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.

 

 

INDUSTRY

 

CRISIL, the first India credit rating agency, was established in 1987.  ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.

 

In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.

 

In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.

 

Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.

 

Barriers to Entry

 

The industry structure points to barriers to entry.  There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market.  The market share among the top three players since FY2006 is illustrated below.

CARE Top 3 maket share June 20 2016

 

CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).

 

The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.

 

CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million.  The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.

CARE Profitability June 20 2016

 

The rating agencies seem to lack pricing power pointing to no barriers to entry.  The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power.  The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.

CARE Employee Expense June 20 2016

 

CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.

 

Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies.  ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms.  The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.

 

Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment.  If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.

 

Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.

 

Other Four Forces

 

The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA.  In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue.  Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.

 

The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense.  The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market.  Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699  to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline.   CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.

 

The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated.  A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.

CARE Bank Loan Rating Capital Savings June 20 2016

 

Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power.  The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.

 

The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings.  Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm.  Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.

 

 

MANAGEMENT

 

Operational Performance

 

Operationally, management has performed very well.  It is increased its market share among the top three rating agencies by almost 10% over the past ten years.

CARE Top 3 maket share June 20 2016

 

The company is also the best performing credit rating agency in terms of operating profit per employee.

CARE vs Peers Per Employee stats June 20 2016

 

ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.

 

Capital Allocation

 

Management has done a good job on focusing on the ratings business.  CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses.  These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital.  CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years.  ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.

 

The only other capital allocation decision made by management is whether to hold cash or payout cash.  Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.

CARE Return on Financial Assets June 20 2016

 

Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.

 

Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.

 

Corporate Governance

 

There are no related party transactions other than management remuneration.   Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.

 

There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.

 

Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.

 

 

 VALUATION

 

Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense.  The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.

 

Under the blended valuation, we use different scenarios to determine potential upsides and downsides.  The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.

CARE Key Stagnant assumptions June 20 2016

 

Sales growth and operating margin are changed to determine upside under different scenarios.  The scenarios and assumptions for both value drivers are listed below.

CARE Key Variable assumptions June 20 2016

 

The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.

CARE Scenario Valuations June 20 2016

 

The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.

 

The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside.  The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.

 

The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.

 

The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.

 

Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation.  The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India.  Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.

 

CARE seems to be slightly undervalued to fairly valued.

 

 

RISKS

 

The biggest risk to CARE’s business is reputational.  After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated.  During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value.  S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.

 

Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.

 

Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.

 

There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.

 

Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.

 

After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.

 

CARE is managed by external agents rather than owner operators.  If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.

 

CARE investment thesis and price paid is based on the development of banking and credit markets.  If banking and credit markets do not develop, there may be permanent loss of capital.

 

CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital.  To combat this risk, we are taking a small starting position.

 

 

Honworld Share Sale June 3, 2016

Honworld Share Sale June 3, 2016

 

After trading hours on June 1, 2016, Honworld sold 11.57% of the company’s existing share capital and 10.37% of the company’s expanded share capital for HKD6.00 per share.  New shares were issued with no existing shareholders selling.  HKD6.00 is a 27.66% premium to the June 1, 2016 closing price of HKD4.70 per share. The subscriber is a wholly owned subsidiary of Lunar Capital, a private equity fund focused on investing in the Chinese consumer businesses in the PRC. The subscriber’s guarantor’s principal activity is owning and operating companies or businesses focused in the condiments market in the PRC.

 

The aggregate net proceeds from the subscription are estimated to be approximately HKD356.1 million representing a net price of HKD5.935 per share. The company intends to utilize the net proceeds for general working capital of the Group.

 

The HKD6.00 price puts Honworld on an EV/2015 EBIT of 10.37 times and EV/2015 NOPAT of 12.29 times meaning shares were sold at cheap to fair value but not a no brainer sale price and not a ridiculously cheap price.

 

Lunar Capital has investments in a number of consumer goods companies in China.  Lunar Capital often takes a controlling interest from older founder who have succession challenges.  Lunar Capital is only buying 10.37% of Honworld so it is not taking control but it should bringing additional operational expertise given its numerous investments in consumer products.  Additionally, it should provide additional perspective on other important aspects such as capital allocation.

 

As mentioned in the initiation report and most subsequent updates, Honworld is going to need to continue to raise capital due to inventory needs associated with growth. The company’s inventory is raw materials, which can be purchased solely on price and ageing the product into premium products does not generate sufficient margin to make up for the ROIC drag associated with holding inventory for additional length of time.  This is the second consecutive fund raising that potentially involves selling shares leading to dilution of existing shareholders, which was not a particularly high price.  The recent sale/loan allowed the company to raise RMB133 million. This transaction allowed the company to raise net proceeds of HKD356.1 million or RMB420 million leading to RMB553 million raised over the past month.  Assuming working capital turnover remains at 0.71, the RMB553 million will allow the company to grow by an additional RMB393 million or 50% from current levels.  Assuming a 15% growth rate, the RMB553 million will be sufficient to finance growth until the end of 2018.

 

This development brings outside capital and credibility at a significant premium to the current market price and at a cheap/fair value.  Capital allocation continues to be an issue as illustrated by the continuous need for fundraising. As of Friday May 27, 2016, Honworld was an 8.5% position, which we were trying to sell down to 7.5% but given the share price dropped below HKD5.00 per share we stopped selling.  We will maintain the current position of 8.5% given the credibility, operational expertise, and perspective of the external buyer.  Additionally, the owner operator is passionate about the business and may see it as a family legacy. The business has a very strong competitive position and is growing rapidly while trading below and EV/EBIT of 10 times. This transaction also puts a private market value on Honworld well above the current share price.  If Lunar Capital is purchasing at HKD6.00, it must expect to get at least 15% IRR from the investment maybe more given the premium required for a Chinese investment.

Honworld May 6, 2015 Cheap Financing or Something Else?

Honworld May 6, 2015 Cheap Financing or Something Else?

 

On May 6, 2016, Honworld Group announced a RMB133 million investment in its wholly owned subsidiary Lao Heng He from CD Fund in exchange for an estimated 3.5% of Lao Heng He’s capital. The actual percentage that CD Fund receives will be determined by a valuation report that will be released over the next three months.   The funds will be used to construct a natural ecological brewing production base in Wuxing Area, Huzhou City, Zhejiang Province, PRC (the investment project).

 

The transaction is conditional upon the satisfaction of the following conditions:

 

  1. from the date of the Investment Agreement to the date of the Completion, there is no material adverse event that will adversely impact on the business prospects, assets, and financial condition of Lao Heng He;
  2. the articles of association of Lao Heng He has been amended according to the terms of the Investment Agreement;
  3. all internal approvals of Lao Heng He, Huzhou Chen Shi, Honworld, and Huzhou Nantaihu with respect to the entry of the Investment Agreement have been obtained;
  4. Lao Heng He has obtained the relevant undertaking documents from Huzhou City Wuxing Finance Bureau for the Investment Project;
  5. Lao Heng He has obtained the approval from the relevant local government authorities for the Investment Project; and
  6. CD Fund completing its due diligence on Lao Heng He. Use of Proceeds Lao Heng He shall ensure that all proceeds of the Capital Investment to be used in the implementation of the Investment Project.

 

Honworld’s wholly owned subsidiary, Huzhou Chen Shi agreed to repurchase the equity interest of Lao Heng He to be owed by CD Fund within 8 years after the payment of the Capital Investment.  CD Fund is according to the repurchase schedule under the Investment Agreement. Under the agreement, the CD Fund with receive minimum returns of a dividend at an annual rate of return amounted to 1.2% of the Capital Investment. No dividend payments need to be made by Lao Heng He until 20 March 2018. On 20 March 2018, the CD Fund shall be paid the total dividend accumulated then the CD Fund will be paid a yearly dividend on or before 20 September every year after 20 March 2018.

 

Lao Heng He is a wholly-owned subsidiary principally engaged in the manufacturing of cooking wine, soy sauce, vinegar, soybean sauce products and other condiments products. Lao Heng He’s unaudited key income statement accounts are below.

May 6 2016 Lao Heng He Results

 

In 2016, the company accounts for 97% of Honworld’s revenue, 97% of its net profit before tax, and 89% of its total assets.

 

CD Fund, a wholly-owned subsidiary of China Development Bank, was established on 25 August 2015 and is principally engaged in the investment of financial bonds.

 

The investment will be reported as a financial liability on the company’s balance sheet as there will be no gain or loss as the company can repurchase the equity interest.

 

Assuming it was a straight investment in the company, it values Lao Heng He at just over 14 times pre-tax profit. The deal seems like a very cheap way of funding the company’s investment assuming it can repurchase the investment at a cost in eight years.  It also avoids diluting the company’s existing shareholders through rights issues or issuing additional shares to raise capital needed.   The company provided no additional details about the investment project.

 

As highlighted before, the company’s focus on maintaining such a high inventory level is not allowing the company to self fund its growth.  The vast majority of the company’s inventory is work in progress and the gross margin generated on aged products does not cover the cost of ageing products leading to a lower ROIC for the company, as illustrated in our initiation report.

 

This event has little change on our view that Honworld has a strong brand and economies of scale giving it a very strong competitive advantage.  The company is growing very rapidly and is run by a passionate owner operator with the only downside being the allocation of capital to inventory. We are in the process of decreasing our position size but as stated we are not selling below HKD5.00 per share.

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.

 

Company 9/8/15 Position Size April 13, 2016

Company 9/8/15 Position Size April 13, 2016

We have completed the sale of just over USD3.3 million of Company 9/8/15.  Its current position size of 4.7% better reflects the deep value nature of the position as the risk associated with the position.

Honworld Annual Results Review April 7, 2016

Honworld Annual Results Review April 7, 2016

Honworld report 2015 results on March 31, 2016.  The company’s grew its revenue by 19.5%, gross profit by 16.7%, and operating profit by 11.6%.  The drag in gross profit was primarily due to the application of new brewery method in premium soy sauce products in order to improve the quality and flavor. Operating profit was due to increased selling expenses as administrative expenses were flat year on year. Selling expenses increased as Honworld conducted more extensive marketing and promotional activities to better penetrate its distribution network to third tier and fourth tier cities, restaurants, and e-commerce platforms.

The company maintained approximately the same absolute level of research and development at RMB46.77.  Over the past three years, research and development has average RMB46.08 million. Selling expenses and research and development are key to maintaining the company’s competitive position given its size advantage over peers.

Our biggest concern with Honworld is inventory levels. Management stated it has reached its desired level of inventory. At the end of 2015, Honworld’s inventory days stood at 432.5 days compared to 453.5 days at the end of 2014. As illustrated it is an extremely working capital intensive business and working capital turnover as settled at roughly 0.70 times with 0.71 in 2015 and 0.72 in 2014.

The company’s financial health deteriorated slightly as growth lead to higher inventory requirements and the inventory may putt constraints on the company’s ability to grow. At the end of 2015, net debt to operating income stood at 1.54 times up from 0.75 times with operating income to interest at 9.06 times.

Overall in 2015, Honworld generated a ROIC of 13.8% with inventory accounting for 53% of invested capital. It is a business with very good economics apart from the inventory the business carries.  The owner is extremely passionate about the business and sees it as a family asset.  The biggest shareholder’s holding company charged shares for a loan creating a bit of concern but given his passion for the business and family legacy associated with the business it seems highly unlikely he would put ownership of the business at risk. The company offers an estimated return of roughly a 14% at current prices assuming 2.5% organic growth and 15% sustainable ROIC.  Assuming 10% growth over the next five years and 2.5% terminal growth in year ten with 13% sustainable ROIC, the company’s 2020 fair value is HKD10.26 or 15% annualized return.  The current EV/EBIT is 8.4 times

 

Given our modified position sizing on the back of Company 9/8/15 and Miko International mistakes, we are decreasing our position size by roughly USD2.0 million bringing our cost base to roughly 7.5%. Sales will be made as long as Honworld’s share price is above HKD5.00 slightly above our initial cost base of HK4.64 per share.

 

Pros

  • Great business with good economics
  • Industry leader with economies of scale and a strong brand creating pricing power
  • Low priced product allowing for greater pricing power
  • Passionate owner operator whose family has significant history with the business
  • Cheap valuation IRR = 15%

 

Cons

  • Inventory levels are a big drag on profitability particularly when inventory is commodity raw materials and the gross margins from products made with older age base wine does not make up for the cost of holding inventory
  • Shareholder charged shares in a loan

Peak Sports Product Annual Results Review March 23, 2016

Peak Sport Products Annual Results Review March 23, 2016

 

On March 15, 2016, Peak Sport Products (1968:HK) reported its annual results. It then released its annual report on March 21, 2016.  Peak was able to increase its revenues by 9.4%, operating income by 34.6%, and net income by 22.3%.  The company closed five stores over the year so efficiency of stores drove the increase.  The efficiency came as the company introduced new products in new categories (tennis and running). Selling expenses decreased by 8.0% while administrative expenses increased by 1.0%. Both expenses lagging sales growth lead to the increase in operating income of 34.6%.

 

Peak Profitability 2015 Result Review

 

Compared to 2014, the company’s gross margin increased by 70 basis points in 2015.  It is also well above the average of 2012 to 2015 and 2006 to 2015.  Gross margin increase points to the industry being past the sharp downturn seen in 2012 and 2013.

 

Peak’s operating margin increased by 340 basis points in 2015 as the company decreased spending on selling and distribution and administrative expenses barely increased. Overall, the company’s return on invested capital increased from 19.6% in 2014 to 27.8% in 2015.

 

During the industry’s consolidation, gross margin and operating margins decline slightly and have since recovered, but invested capital turnover declined drastically and has not recovered.

 

Peak Capital Efficiency 2015 Result Review

 

As illustrated above, both working capital turnover and fixed capital turnover declined significantly from peaks and have recovered slightly but not fully as the industry continues to cope with working capital and capacity issues.

 

In June 2015, the company raised capital increasing its share count by 290.761 million shares or 13.86% of the previous share count.  The company mentioned the share raising was for international marketing expenses and to avoid Chinese withholding tax by moving cash in China overseas.  The company decreased marketing expenses this year despite the share issuance.  Despite the cost of raising capital being lower than the withholding tax the company would have paid for shipping money overseas, the share issuance was perplexing as the company has so much cash on the balance sheet.  At the end of 2015, the company net cash position is equal to 92.6% of the company’s market capitalization and 5.9 times 2015 operating income.  The question becomes does the company actually have the cash reported on the balance sheet.  The company has been paying steady dividends pointing to having the cash. The main shareholders have maintained their shareholding without any share sales illustrating their confidence in the company.

 

Peak Shareholder Structure 2015 Result Review

 

Brand building through advertising is a key value driver within the sportswear industry so hopefully we will see a significant increase decreasing the cash on the balance sheet.  Regardless, the share issuance was confusing and at best a very, very poor capital allocation decisions.

 

Overall, the sportswear industry is recovering after a period of significant contraction.  Peak is insulated from competition within the industry from fast fashion players as the company’s focus is performance products rather than fashion allowing it to retain the leading market share in basketball for six straight years.  The company is increasing its focus on international markets and other sports (tennis and running) giving it further growth opportunities.

 

The company is currently trading just above its net cash position, just below its liquidation value, and 38% below its reproduction value.

 

Peak Valuation 2015 Result Review

 

On an earnings basis, we used key value drivers during the recent industry downturn assuming it is the new normal and the industry boom of 2006 to 2011 will not be replicated.  Assuming no growth, trough margins, and trough capital efficiency, the company has 89% upside to its estimated 2021 fair value.  Assuming 5% growth and average margins the company has 215% upside to an estimated 2021 fair value.

 

Despite, the extremely poor capital allocation, the company is very cheap and growing. It is now trading just above its net cash position, just below net current asset value, and just below book value despite generating an average return on invested capital of 20% during an industry slump.   We will maintain our current position size.

Company 9/8/2015 Position Size

Company 9/8/2015 Position Size

On January 29, 2016, the share price of Company 9/8/2015 declined by roughly 60%.  We now know that the decline in the company’s share price was due to forced selling by a new strategic shareholder as well as the company’s chairman. In total at least 11.6% of total shares outstanding were sold to forced selling. At the time of the forced selling, the company also announced that it was going to place shares.

The forced selling temporarily decreases the share price but eventually the company’s valuation will revert towards the value derived from business fundamentals. More concerning is the company not disclosing insiders’ pledged shares.  Also, the cancelled placement is evidence of the company’s desire to raise more capital, which does not make sense given the cash on the balance sheet and the company trading at its net cash position. The size of placement is slightly larger than the Chairman’s current shareholding so it raises the question is he trying to cash out.  Although the share placement was cancelled, the concern will remain over future share placements.

Despite the concerns surrounding transparency and the share placement, the company is trading just above its net cash level.  The current valuation is appropriate if the company is a fraud.  Evidence points to the company not being fraudulent.  Forensic accounting analysis does not show any red flags. The company just received investment from a strategic shareholder with significant resources and expertise in due diligence. The company’s sales were also validated by a credible third party using point of sales data.  Given there is a high probability that the company is not fraudulent, we see significant upside given the company is trading just above net cash and below its net current asset value.  We purchased just under USD10 million on February 1, 2016 and February 11, 2016 increasing the position size back to our maximum position of 15%.

We planned on increasing the company’s position size by USD16 million but the lack of transparency on the chairman’s share pledge and the announcement of a canceled placement decreased our confidence in management.

Company 11/19/15 Position Size

Company 11/19/15 Position Size

We have completed our additional purchase of Company 11/19/15.  We purchased USD2,039,939 or 545,433 shares at an average price of BRL15.1665 per share. Our new cost position is roughly 8.0% given the fall in the remainder of the portfolio due to the 60% drop in Company 9/8/15.