Category Archives: Results

WEEKLY COMMENTARY 2/13/17- 2/19/17

WEEKLY COMMENTARY               2/13/17- 2/19/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

PC Jeweller report Q3 FY17 results over the past week. Demonetization impacted the quarter’s results with the company estimating sales were affected for three to four weeks. Post-demonetization, sales started improving in December and returned to normal in January. Gross margin were stable but the decline is sales resulted in a decline in profitability. Year on year sales declined by 3.4%, the number of showrooms grew from 58 in FQ3 2016 to 68 FQ3 2017, or 17%, and total square feet increased by 8% year on year from 346,855 square feet to 374,481 square feet. Year on year, the company’s operating profit declined 13.7%. Assuming during the four weeks that demonetization affected sales there was a 50% decreased in sales, no impact from demonetization would have lead to an increase in sales by roughly 16% year on year.

 

It is tough to tell how good or bad the quarter was due to demonetization. The company continues to increase its showroom footprint and sales barely declined despite demonetization. The company estimates 75% of the jewelry industry is unorganized dampening competitive pressures.

 

PC Jeweller is one of the most profitable and fastest growing companies in the Indian jewelry industry illustrating the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the company’s strengths, it trades on an EV/NOPAT of 14 times and an EV/IC of 2.6 times. We will maintain our current position size.

 

In the past week, Grendene reported Q4 2016 and full year results. For the full year 2016, net sales declined by 7.2% with domestic sales falling by 1.6% and export sales falling by 16.3%.

 

Overall volume declined by 9.3% with domestic volume declining by 8.0% and export volumes falling by 13.0%.

 

ASP increased by 4.1% with domestic ASP increasing by 7.2% and export ASP falling by 3.2%. Gross profit fell by 6.7% as cost of goods sold declined by 7.6%.

 

Operating profit declined by in 7.5%. The company’s capital intensity did not change over the year with working capital at 47.9% of sales, fixed capital at 18.9% of sales, and invested capital at 66.8% of sales.

 

Grendene’s key value drivers are illustrated above. In 2016, gross margin reached a peak level of 48.7%. Selling expenses remain near its historical average relative to sales at 24.0%. General and administrative is at its peak at 4.8% of sales. EBIT margin remained at its historical peak of 20.0%. Working capital remains slightly elevated relative to historical averages. Fixed capital as a percentage is at its highest level over the past eleven years.

 

Grendene continues to struggle with economic weakness in Brazil and in export markets. The company operational efficiency allows the company to maintain its profitability during a period of declining revenue. In 2015, the company reiterated its growth targets of revenue growth of 8-12% and net income growth of 12-15%. The company continues to believe these targets are achievable but acknowledge risks of not achieving these results are increasing due to economic weakness in Brazil and in exports markets.

 

Given the new data, we update Grendene’s earnings valuation range. Grendene illustrated its ability to maintain profitability despite a period of declining revenues and increasing competitive pressures making earnings valuation the most appropriate valuation methodology.

 

Looking at Grendene’s earnings valuation, the company reaches our target return of 15% per year under the most optimistic scenarios. We would assume perpetuity growth only under scenarios when the company operates in an industry with barriers to entry and pricing power. Within the domestic market, there are clear barriers to entry with the company and its main competitor Alpargatas having economies of scale as they occupy over 50% of the market with large fixed costs in the form of distribution and advertising. Grendene also has unique capabilities in manufacturing plastic products as it modifies its own machines and can formulate plastics that are unavailable to other footwear producers. These barriers to entry do not transfer outside of Brazil. The company is a low cost producer with only China producing exports at a lower price.

 

The question is whether the barriers to entry within Brazil translate to pricing power. The barriers to entry within the segment means very few other players could sell products at the Grendene’s and Alpargatas’ price range meaning the company’s probably do have some pricing power in Brazil. Over the past ten years, the company average selling price increased by 3.8% per annum with the domestic selling price increasing by 2.6% and export selling pricing increasing by 3.9% in USD terms so there is a strong argument for potential pricing power. We assume 2.5% pricing power in our base case scenario. The company sales have grown at 6.8% over the past ten years with growth stagnating at 4.9% over the past five years. Assuming an inability to growth operating profit above sales growth a 5% growth rate seems appropriate for our five-year forecast period. Despite the company’s ability to maintain profitability during the recent industry weakness using peak margins seems aggressive therefore average margins are more appropriate. Our base case scenario is 5% forecast period growth, 2.5% terminal growth and average operating margins leading an upside to the 2021 fair value of 60% or 9.9% annualized return. Overall, the average return over the next five years under the earnings valuation is 59% or 9.7%.

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

Professor Damodaran breakdowns how to value growth, the key drivers of growth, and the importance of ROIC in determing whether growth is valuable or not. (link)

 

 

Narrative and Numbers: How a number cruncher learned to tell stories! (Musing on Markets)

 

Another post by Professor Damodaran explaining how narratives can be worked into your valuation to provide a better picture of how the market is valuing a company. (link) Professor Damodaran recently published a book Narrative and Numbers, which I have not read but is next on my list.

 

 

Diversification..again.. (Oddball Stocks)

 

Nate Tobik of Oddball Stocks shares his thoughts on diversification. (link) Our current thoughts on diversification and position sizing can be viewed here. (link) We have a similar thought process on the limits of one’s knowledge as an outside investor with valuation being the biggest tool to offset the limits of our knowledge.

 

 

Humility and knowledge (Oddball Stocks)

 

Related to his post on diversification, Mr. Tobik discusses how investors sometimes make the mistake of believing they know too much. (link)  We touched on a similar topic in our diversification post linked above.

 

 

Graham & Doddsville (Columbia Business School)

 

Columbia Business School put out another edition of Graham & Doddsville, which always makes for interesting reading. (link)

 

 

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

 

Base Hit Investing’s John Huber talks about how Buffett categorizes business by their return on capital and capital requirements. (link)

 

 

What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (Wall Street Journal)

 

The Wall Street Journal profiles the Steve Edmundson, the investment chief for the Nevada Public Employees’ Retirement. (link)

 

 

Howard Marks’ Letters Sorted by Topic (Anil Kumar Tulsiram)

 

Anil Kumar Tulsiram complied all Howard Marks’ letters by topic. He has compiled other documents in the past and can be followed on Twitter @Anil_Tulsiram. (link)

 

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

 

 

2016 ANNUAL PERFORMANCE REVIEW

 

While the annual performance review is somewhat arbitrary, it is good to review you investment process on a regular basis to find improvements.

 

In 2016, the average local currency return of our recommendations was -3.1% with the average US dollar return not far off at -3.0%. Relative performance was -5.3% as the Emerging Market Small Cap Index as measured by iShares MSCI Emerging Market Small Cap ETF (EEMS) was up 2.3% compared to our average US dollar return of -3.0%.

 

The major drag on the performance of recommendations was Miko International and Universal Health. Universal Health saw a significant decline after its founder and majority took a loan against the company’s shares leading to forced selling in the stock. Subsequently, the company’s operational performance deteriorated drastically leading us to question the validity of the company’s initial financial statements. Miko International saw a number of independent directors resign followed by its auditor resigning due to disagreements over accounts in the company’s financial statements. It hired an auditor of last resort known to work with many Chinese frauds. We also saw poor performance at another Chinese company Honworld as management’s poor capital allocation inhibits its ability to grow without raising external funds. The poor performance of the Chinese small and mid caps leads us to question the financial statements in many Chinese small and mid cap companies. Given the inability to have any conviction, we are taking a smaller position if we invest in Chinese companies. Our other Chinese investments in Peak Sports Products and Anta Sports Products were our second and third best performing stocks in 2017 making us not totally write off investing in Chinese companies. Interestingly, the poorly performing Chinese companies all recently went public and therefore we have implemented a rule of not purchasing any stock that went public in the last three years.

 

The poor performance of Universal Health and Miko International highlighted the limits to our knowledge leading us to be less aggressive with our position sizing. Our new position sizing philosophy is 1-2% for high quality watch list stocks like Credit Analysis and Research and Anta Sports, 2.0% for deep value, 2.0% for Chinese companies, and from 2.0% to 8.0% for high quality companies depending on the strength of the business and attractiveness of returns. The goal is to get 25-35 holdings. The smaller position sizes do not match with the depth of our research. Our research was deep dive taking up to a month. The depth of research clearly required the ability to take larger position sizes as you can research only 12 ideas in a year. Assuming, half that are fully researched reach our investment standard leads to a maximum of six recommendations per year. There is no way we could ever be fully invested with our new position size philosophy, therefore, we are decreasing the depth of the research so we can hopefully one day get close to fully invested. We will focus on the crucial elements of every investment but not as much in depth. Hopefully, this will also increase the value of the blog for readers as we are trying generating more ideas by researching more companies. As mentioned, we will also be looking at high quality stocks that may be slightly more expensive than our typical investment but meets all other requirements. These will be formally placed on the watch list and placed in the portfolio at a smaller position size. Credit Analysis and Research and Anta Sports fall into this category. The hope is these positions will eventual become more attractive on valuations. The side benefit is highlighting more high quality companies.

 

Since May 2014, we have made 10 recommendations generating an average outperformance of 30.9%, with three recommendations having negative absolute performance. The average time from recommendation to sale is 459 days with four of the 10 recommendations still being held.

 

Overall, 2016 was not the best year for stock selection with underperformance of 5.3%. More importantly, we feel the mistakes made have allowed us to strength our process. Despite the bad year, our recommendations are up 30.9% since May 2014.

 

The table above illustrates position sizes at the end of each half since the end of the first half of 2014.

 

In 2016, our portfolio fell be 12.8% on the back of poor performance and large positions in Universal Health, Miko International, and Honworld. Despite the poor performance in 2016, our portfolio is up 12.3% in absolute terms since inception and 24.4% relative to EEMS, while averaging 67.9% of the portfolio in cash. The large cash position is a function of our high threshold for investment and the time required in our in depth research process. Hopefully, our shorter reports will allow us to be more efficient at finding ideas allowing us to put the cash to work.

 

While 2016 was not the best year in terms of performance, the improvements made to our process due to the mistakes made should more than make up for it in the future.

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

Mrs. Kusum Jain, a non-Executive Director, resigned from PC Jeweller’s board, with effect December 30, 2016. This is the first director resignation at PC Jeweller for some time, but it is worth monitoring in case there are additional resignations from independent directors.

 

On December 21, 2016, Zensar Technologies announced it appointed Manoj Jaiswal as Chief Financial Officer. Manoj Jaiswal was Chief Financial Officer for CEAT, another RPG Enterprises company. Before joining CEAT, Manoj had spent 17 years in Wipro in different roles.

 

Zensar also changed its auditor to Deloitte from PricewaterhouseCooper. Under Section 139(2) of the Companies Act, 2013, all listed companies and certain categories of unlisted public companies and private companies are mandated to rotate their auditors after 10 or more consecutive years.

 

On January 7, 2017, CARE announced that it was shutting down its Maldives operations after its license expired and decided not to renew. The Maldives operations were insignificant.

 

 

INTERESTING LINKS

 

 

Horsehead Holdings (Aquamarine Fund)

 

Guy Spier, a noted value investor, and portfolio manager of Aquamarine Fund looks back at his investment in Horsehead Holdings. It is a very good template for looking back and learning from your investment mistakes. (link)

 

Looking For the Easy Game (Credit Suisse)

 

Credit Suisse’s Michael Mauboussin discusses passive and active investing. (link)

 

A Bird in Hand is Worth More Than (Forecasted) Eggs in the Future (Latticework)

 

This is a very good article by Amit Wadhwaney of Moerus Capital Management discussing his investment philosophy. (link)

 

The Future of Retail 2016 (Business Insider)

 

Business Insider’s BI Intelligence unit created an interesting slide deck on the future of retail. The slide on the article illustrates the share of digital in different categories. Useful for understanding what segments of retail are most impacted by the internet. (link)

 

Patagonia’s Philosopher King (New Yorker)

 

The New Yorker wrote an article on Yvon Chouinard, the co-founder of the outdoor-apparel company Patagonia. (link)

 

The Irrationality Within Us (Scientific American)

 

Scientific American discusses our irrationality. (link)

 

Charlie Munger on the Paradox in Hold vs. Buy Decisions in Long Term Investing (Fundoo Professor)

 

Professor Sanjay Bakshi discusses Charlie Munger’s thoughts on the decision to continue to hold a stock vs. the decision to buy a stock. (link) The comment section should be read as well as there are many insightful comments. As illustrated by the changing of our positions sizes, we do not subscribe to the buy and hold regardless of valuation. By saying that you would continue to hold an asset at a particular price but you would not buy the same amount if you did not hold it, you are ascribing more value to the asset you hold, which is a bit irrational and is known as the endowment effect. Endowment effect is valuing an item you own more than an identical item you do not own. We try to look at all companies the same way, whether we hold them or not. First, a high percentage of companies can be ruled out as a potential investment due to poor financial health, poor management, or poor business quality. We may compromise on business quality if the company is a deep value investment but there is a limit on this compromise. Once companies pass the first investment hurdle, we assess the attractiveness of the company based on its business quality, management, growth outlook, and risk. Future returns are estimated based on scenarios giving a range of potential returns. If the market values a company so highly that very aggressive assumptions are required to meet the market’s expectations, we would not buy a company or hold a position. If on the other hand, if the market was valuing that same company so cheaply that the most conservative assumptions pointed to significant upside and there was sufficient business quality, we would take our maximum position of 8%. In between the two extremes is a spectrum of potential returns leading to a spectrum of position sizes between 0% and 8%. The decision of the position size is based on the attractiveness of the returns of a business not whether we hold a stock or not.

 

Valuation and Investment Analysis (Bronte Capital)

 

Bronte Capital wrote an article discussing how they do not use valuations in their investment process. (link) Again, please read the comments as there are some useful comments.  Clearly, we do not agree with Bronte Capital’s view.  We agree that valuation is difficult and does not provide a point estimate that is why ranges and scenario analysis needs to be used in the valuation process or reverse engineering a DCF or Residual Income model to find out the market’s expectations of key value driver assumptions. These market assumptions can be tested for reasonableness. We believe it is very difficult for anyone to call themselves an investor if they do not have some estimate of what is the value of potential investment. Investing requires understanding the fundamentals of the business, and the valuations of the business. Value investing requires an additional margin of safety to ensure you are not buying a business with sufficiently attractive returns. Not having an estimate of the potential returns of an investment is pure speculation. Bronte Capital focus on operational momentum to ensure the business will continue to grow for a long time. The problem is growth stocks often do not meet the growth expectations of the market and this is precisely why you should have an understanding of what type of growth the market is expecting. Within the Emerging Markets small cap universe, the MSCI Emerging Markets Small Cap Growth Index has underperformed the MSCI Emerging Markets Small Cap Value Index by 141.34% over the past 16 years or 5.66% per annum. Similar to Bronte Capital, growth investors are more concerned with growth than valuation leading to missing a big piece of the puzzle in understanding a business.

 

Value vs. Growth in Emerging Markets

 

Given the past two articles, we thought it be interesting to review the performance of various Emerging Market indices to see how each style has performed.

 

The table above illustrates the performance of MSCI Emerging Market indices across size and style biases. Indices have various inception dates so the longest time period with performance for all indices is 10 years. Over that period, the best performing index is Emerging Markets Quality index followed by Small Cap Value and the Small Cap Index. Over the past 20 years within the large and mid cap universe, value outperformed growth by 1.00% per annum. Quality seems to be the best performing index outperforming the overall index by 1.95% per annum since 06/30/1994 compared to only 0.44% per annum outperformance of value over the past 20 years, and -0.57% underperformance by growth over 20 years. There is a one and a half year difference in the long term performance figures if quality and value and growth, but given the length of the track record there would need to be a drastic underperformance of quality (roughly 35%) over that one and half years for quality’s performance to fall back to the value index’s level of performance. With some confidence, we can say quality has been the best style among the Emerging Markets large and mid cap universe.

 

Small Cap outperformed the large and mid cap index by 1.24% per annum illustrating a persistence of the size premium in Emerging Markets. Within the Emerging Markets small cap universe, value outperformed growth by 5.66% per annum over the past 16 years. The 5.66% growth translates into 141.34% additional performance over the period. There is no small cap quality index to compare the quality style.

 

Value outperforms growth in Emerging Markets with significant outperformance vs. the benchmark and growth in the Emerging Market small cap universe. Brandes Institute of Brandes Investment Partners did a study on style bias in Emerging Markets, which can be found here.

 

Alexa: Amazon’s Operating System (Stratechery)

 

Ben Thompson always writes great articles on technology therefore is a must read. We tend not to invest in technology as short product life cycles leading to disruption leading to difficulty valuing these companies. Despite the difficulties in technology, Silicon Valley and start-ups are very good at understanding all aspects of business models and therefore reading some of the best writers in the industry helps increase understanding of business models in more investable industries. In this particular article, Mr. Thompson writes the business model of operating systems. (link)

 

Tren’s Advice for Twitter (25iq)

 

Like Stratechery, 25iq is a must read. Tren Griffin works in the technology industry but is a value investor. Mr. Griffin gives his advice to Twitter. His advice is relevant for all companies. Understand your competitive advantage and continue to strengthen it while being as operationally efficient as possible. There is not much more to strategy. Understand your competitive advantage.  If it is unique advantage,  strengthen it as much as possible. If it is a shared competitive advantage, try to cooperate with competitors as much as possible to distribute fairly the benefits of the value created by the shared competitive advantage. If there are no competitive advantages, operational efficiency is the most important thing. Due to institutional imperative, which prevents firms from acting as rational as they can, operational efficiency can allow one firm to persist with excess profits for a long time. The importance to barriers to entry on strategy and profitability illustrates why the identification of competitive advantages, also known as barriers to entry, are so crucial to Reperio’s investment process. (link)

 

Amazon’s 2004 Shareholder Letter

 

Amazon’s 2004 Shareholder Letter stresses the importance of free cash flow not earnings the main metric followed by most market participants as earnings does not take into working capital and fixed capital investments required to generate additional earnings, while free cash flow accounts for the necessary investments. (link)

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

 position-summary-table

 

 

COMPANY NEWS

 

PC Jeweller

 

PC Jeweller reported FQ2 2017 results on November 23, 2016. During the quarter, the company opened five stores including a franchised showroom bringing the total number of showrooms to 68. The company also introduced the Inayat wedding jewelry collection and the Azva festive and wedding season collection, which is selling in 15 independent retailers.

 

Year on year, the company’s revenues grew by 30.2%, gross profit declined by 0.9%, and operating profit declined by 5.3%. Gross margin declined from 16.3% in FQ2 2016 to 12.4% in FQ2 2017. To review the company’s business, the mix between exports and domestic sales and the mix between diamond and gold jewelry sold drive gross margin.

pc-jeweller-business-model

The expected sales mix between domestic sales and export sales is roughly 67 % to 33% with domestic sales having an estimated gross margin of 16-17% while export sales have a gross margin of 6-8%. Gold jewelry sales is expected to represent 70-75% of domestic sales with a gross margin of roughly 10%, while diamond jewelry sales is expected to represent 25-30% of domestic sales with a gross margin of roughly 25-30%.

pc-jeweller-sales-mix-and-gross-margin

The table above illustrates the actual figures on a quarterly basis dating back to the quarter ending December 2012. Since FQ3 2013, domestic sales averaged 72.3% of sales while gold sales averaged 70.5% of domestic sales. Domestic sales averaged a gross margin of 16.4%, export sales averaged a gross margin of 10.6%, and the overall gross margin averaged 14.4%. Using expected figures, gross margins should range from 12.7% to 14.0%. Operating expense averaged 3.8% of sales leading to an expected operating margin range of 8.9% to 10.2%.

 

Regarding demonetization, 32% of sales are cash sales so the company expects short-term impact from demonetization.

 

Overall, the company is operating in an industry without barriers to entry as illustrated by the thousands of competitors, but management has been able to consistent excess profits when peers other than Titan have struggled to generate any excess profits. Given the ability generate excess profits during industry distress and when peers cannot gives us confidence that valuing the company on earnings is appropriate.

 

Under our pessimist case scenario, which assumes a 12.5% discount rate, no growth into perpetuity and profitability fading to the discount rate in year 10, PC Jeweller has 4.3% annualized downside over the next five years. Under our base case scenario, PC Jeweller grows at 10% for a five-year forecast period (store openings) before fading to 0% in the terminal value in year 10. Current excess profits remain over the forecast period before halving in the terminal. Excess profits persist in our base case because of the strength of management and evidence that the company can generate excess profits when competitors cannot. Under the base case, PC Jeweller’s estimated annualized return is 9.1% over the next five years. Under the optimistic case, there is no change to profitability with growth increasing to 15.0% over the forecast period and 2.5% growth in the terminal value leading to an annualized return of 16.0% over the next five years.

 

The table below illustrates our assumptions under each scenario as well as historical averages for each key value driver.

pc-jeweller-scenario-assumptions

 

The company’s management is very strong and continues to generate excess returns in a fragmented industry where competitors struggle to generate excess profits. We will maintain our 4.0% position size.

 

 

PRE-RESEARCH REPORT

 

Executive Summary

 

ABS-CBN is a Filipino media conglomerate with three business segments: TV and Studios, Pay TV Networks, and New Business. The TV and Studios business generates 73.6% of revenue and 92.1% of EBITDA. Economies of scale exist in the form of content creation and distribution creating an advantage for the largest competitors. ABS-CBN is the largest. Unfortunately, the company is operationally inefficient generating an average of roughly 10% return on net operating assets over the past three years. The company’s Pay TV Network business only generates an average return on net operating asset of 2.3% over the past three years despite having a 45% cable market share in the Philippines. New businesses are a disparate group of organizations with no strategic connection pointing to extremely poor capital allocation. The average NOPAT margin of new businesses over the past three years is -253.4%.

 

Given the inability of the company to generate a reasonable return on a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would potentially warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business. To reach an acceptable buy price, the company’s share price would need to fall to PHP15.00 per share.

 

 

Company Description

 

ABS-CBN Corporation is the Philippines’ leading media and entertainment organization. Primarily involved in television and radio, the company has expanded owning the leading cinema and music production/distribution companies in the country as well as operating the largest cable TV service provider.

 

ABS-CBN has business interests in merchandising, licensing, mobile and online multimedia services, publishing, video and audio postproduction, overseas telecommunication services, money remittance, cargo forwarding, TV shopping services, food and restaurant services, theme park development and management, and property management.

 

 

History

 

ABS-CBN Corporation traces its roots from Bolinao Electronics Corporation (BEC), an assembler of radio transmitting equipment, established in 1946. In 1952, BEC adopted the business name Alto Broadcasting System (ABS) and began setting up the country’s first television broadcast by 1953. On September 24, 1956, Chronicle Broadcasting Network (CBN), owned by Don Eugenio Lopez Sr. of the Lopez family, was organized primarily for radio broadcasting. In 1957, Don Eugenio Lopez Sr. acquired ABS and on February 1, 1967, the operations of ABS and CBN were integrated and BEC changed its corporate name to ABS-CBN Broadcasting Corporation. On August 16, 2010, the Philippine Securities and Exchange Commission approved the change of the corporate name to ABS-CBN Corporation reflecting the company’s diversified businesses in existing and new industries. ABS-CBN achieved many firsts since it started the television industry in the country in 1953. However, with the imposition of martial law in September 1972, ABS-CBN ceased operations as the government forcibly took control. ABS-CBN resumed commercial operations in 1986 after the People Power or EDSA revolution. Despite being shut for 14 years, ABS-CBN recaptured leadership in the Philippine television and radio industries by 1988. During the 1990s and the early part of the new millennium, the company expanded and ventured into complementary businesses in cable TV, international distribution, mobile services, and magazine publishing among others.

 

 

Shareholder Structure

 

The top 20 shareholders own 98.57% of the business.

abs-cbn-shareholder-structure

 

Lopez Inc. is the largest shareholder at 55.15%. Lopez Inc. is a Filipino business conglomerate owned by the López family of Iloilo. Oscar M. López is the Chairman Emeritus and his brother Manuel M. López is the current Chairman and Chief Executive Officer of the López Group. It was first established by Eugenio Lopez, Sr. in 1928. It has holdings in many industries including media, power, energy, real estate, infrastructure, and manufacturing.

 

PCD Nominee Corporation is a wholly owned subsidiary of Philippine Central Depository. Shares are held at PCD Nominee Corporation for other shareholders.

 

 

Current Business

In 2015, ABS-CBN’s generated PHP38,278 million with 73.6% of revenue from the TV and Studio business, 21.1% from Pay TV Networks and 5.2% from new businesses.

abs-cbn-revenue-by-segment

 

In 2015, ABS-CBN generated PHP8,083 million in EBITDA. The TV and Studio business generated 92.1% of EBITDA, Pay TV Networks generated 20.7%, and new businesses generated -12.8%.

abs-cbn-ebitda-by-segment

 

As illustrated above, ABS-CBN has three business segments: TV and Studio, Pay TV Networks, and new businesses.

 

TV and Studio

 

The TV and studio segment is comprised of broadcast, global operations, film and music production, cable channels and publishing. This consists of local and global content creation and distribution through television and radio broadcasting.

 

abs-cbn-tv-and-studio-revenue

 

In 2015, free to air TV accounted for 63.4% of revenue, global operations accounted for 19.2% of revenue, with films and music, narrowcast, and others accounting for the remaining 17.4% of revenue.

 

The Free to air TV business includes content creation and distribution mainly through free TV and radio with Channel 2 and DZMM as its flagship platforms. The content created is predominantly in Filipino and is aimed at the mass Filipino audience. The company’s leading position in the Philippine television broadcasting industry is largely due to the popularity of its entertainment programs, while the news and public affairs programs have developed a reputation for the quality of news coverage that includes national, local and international events.

php-ratings-and-audience-share

 

In 2015, ABS-CBN 41.5% audience share in all of Philippines. There is significant barrier to entry in the form of economies of scale with content creation being a large fixed cost required to acquire an audience. The industry is very concentrated pointing to the existence of a barrier to entry. The top two players ABS-CBN and GMA Network have roughly an 80% market share.

 

The global business pioneered the international content distribution through Direct to Home, cable, Internet Protocol Television, mobile and online through The Filipino Channel. It is available in all territories where there is a significant market of overseas Filipinos such as the Unites States, Middle East, Europe, Australia, Canada and Asia Pacific. Other activities include international film distribution, remittance, retail, sponsorships and events. Similar to free to air, there are economies of scale in the form of content creation with much of the content created for the free to air business can be used in global operations. Distribution is another fixed cost in the global segment intensifying economies of scale. Efficient scale also comes into play, as the global market for Filipino content is not that large therefore the market cannot support many players. GMA Network also produces content for the international market.

 

The films and music business is composed of movie production, film distribution, audio recording and distribution and video and audio postproduction. Films and music needs are generally produced through ABS-CBN Film Productions Inc. (AFPI), more popularly known as Star Cinema. Other movies are co-produced with other local or international producers or are simply distributed by AFPI. Music needs are also managed by AFPI to complement the recording needs of the company’s multi-talented artists and handle music publishing and composing requirements, respectively.

 

The Narrowcast and sports business caters to the needs of specific or targeted audiences or markets not normally addressed by the broadcast business. Included in this line of business are cable programming and channel offerings such as Filipino movie channel, music channel, animé, upscale male sports content and upscale female lifestyle content. It also covers print, sports, and other niched programming via its UHF (Ultra High Frequency) channel. Narrowcast includes the following subsidiaries: Creative Programs, Inc., ABS-CBN Publishing, Inc., and Studio 23, Inc. As part of the company’s goal to elevate boxing as a sport in the country, it entered into a joint venture agreement with ALA Sports Promotions, Inc., a world class boxing organization and promotional company.

 

In the whole TV and Studio segment, economies of scale as content creation or acquiring content is a significant upfront fixed cost. Being the market leader in free to air TV with a 41.5% audience share illustrate the strong competitive position of ABS-CBN.

tv-studio-key-drivers

 

Despite the existence of economies of scale and market share leadership, ABS-CBN’s is only able to generate an average return on net operating assets of 9.9% over the past three years point to operational inefficiency.

 

 

Pay TV Networks

 

ABS-CBN owns 59.4% of Sky Cable Corporation. Sky Cable provides cable television services in Metro Manila and in certain provincial areas in the Philippines. As of December 2015, Sky Cable held a 45% market share in the Philippines. Sky Cable’s main competitor in the pay TV business is Cignal. The company also competes with other small local operators in certain cities it operates in, but no other operator has the same scale and geographic reach as Sky Cable. Given the fixed cost associated with infrastructure needed for cable coverage, size is a key competitive factor. Size also helps with bargaining power.

 

The company also provides broadband internet services through Sky Broadband. PLDT dominates the broadband industry with 65% market share.

pay-tv-network-key-value-drivers 

 

Cable television requires infrastructure, which is an upfront fixed expense. Despite its size advantage, Sky Cable is unable to generate a reasonable return pointing to operational inefficiency.

 

 

New Business

 

ABS-CBN’s new businesses include wireless telecommunications business, digital terrestrial television, theme parks and home shopping.

 

ABS-CBN mobile’s network sharing agreement with Globe Telecom enables the company to deliver content in addition to traditional telecommunication services on mobile devices. Through the network-sharing agreement, Globe provides capacity and coverage on its existing cellular mobile telephony network to ABS-CBN Convergence, Inc. (ABS-C) on a nationwide basis. The parties may also share assets such as servers, towers, and switches.

 

In February 2015, ABS-CBN commercially launched the digital terrestrial television (DTT). The company continues to invest in DTT equipment to improve clarity of signal in certain areas of Mega Manila and Central Luzon with a belief that the transition from analogue to digital will result in an increase in its audience share.

 

ABS-CBN invested in a theme park more popularly known as KidZania Manila. KidZania provides children and their parents a safe, unique, and very realistic educational environment that allows kids between the ages of four to twelve to do what comes naturally to them: role-playing by mimicking traditionally adult activities. As in the real world, children perform “jobs” and are either paid for their work (as a fireman, doctor, police officer, journalist, shopkeeper, etc.) or pay to shop or to be entertained. The indoor theme park is a city built to scale for children, complete with buildings, paved streets, vehicles, a functioning economy, and recognizable destinations in the form of “establishments” sponsored and branded by leading multinational and local brands.

 

Launced in October 2013, A CJ O Shopping Corporation is a joint venture between ABS-CBN and CJ O Shopping Corporation of Korea to provide TV home shopping in the Philippines.

new-business-key-value-drivers

 

ABS-CBN’s new businesses generate significant losses and there seems to be no strategic logic when allocating capital. New businesses are from a variety of industries where the company does not have any particular competitive advantage, which leads to the losses. The poor capital allocation will affect the ability of the company to grow its intrinsic value. Capital allocation is unlikely to change with the current management and ownership.

 

 

Valuation

 

Given the inability of the company to generate a reasonable return in a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business.

 

 

INTERESTING LINKS

 

A Dozen Things Warren Buffett and Charlie Munger Learned From See’s Candies (25iq)

A discussion about the lesson from See’s Candies (link)

 

Mental Model: Price Incentives (Greenwood Investors)

An good article by Greenwood Investors discussing discounting and brands (link)

 

Two Powerful Mental Models: Network Effects and Critical Mass (A16Z)

The title speaks for itself, an excellent essay on network effects and critical mass. (link)

 

The Reason We Underperform – Markets Have Evolved Faster Than Humans (Acquirer’s Multiple)

An article discussing potential behavioral reasons for the underperformance of fund management. (link)

 

Anatomy of a Failed Investment (Tom Macpherson- Gurufocus)

A great reminder to never be too confident of one’s views as there is only so much that one can prove to be absolute truth. Understand the counter to your argument and always remember looking for evidence confirming either side. (link)

 

Frozen Accidents: Why the Future Is So Unpredictable (Farnam Street)

The must read blog Farnam Street discusses how complexity and randomness make prediction a difficult if not impossible task. (link) We agree with the difficulty associated with forecasting and attempt to make as few forecasts as possible. Instead, we wait until the key value drivers being priced into by the market are so pessimist that there is little downside.

 

Miko International and Honworld Position Size July 30, 2016

Miko International and Honworld Position Size July 30, 2016

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

PC Jeweller FY2016 Results Review June 6, 2016

PC Jeweller FY2016 Results Review June 6, 2016

 

 

Key Value Drivers

 

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

 

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

 

6 6 2016 Sq Ft Average Store Size

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

PC Jeweller Store Economics

 

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

 

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

 

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

 

 

Competitive Position

 

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

6 6 2016 Gross Margin

 

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

6 6 2016 ROIC

 

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

 

 

Management

 

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

 

 

Performance vs Peers

6 6 2016 Performance vs Peers

 

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

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.

 

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

Company 9/8/15 Position Size and Results April 6, 2016

Company 9/8/15 Position Size and Results April 6, 2016

 

We have sold just under USD5.4 million of our position in Company 9/8/15 just over the USD5 million stated on March 24, 2016.  The company is now a 7.6% position.

 

On March 31, 2016, Company 9/8/15 reported annual results.  Revenue increased by 10% for the full year with a 120 basis point decline in gross margin from 29.10% to 27.90% due to weakness in high gross margin products. The big concern was the 96% increase in selling expenses and the 92% increase in administrative expenses. Selling expenses increased by RMB484 million and administrative expense increased by RMB71 million.  The largest increase in selling expenses was advertising and other marketing expenses, which increased by RMB395 million or 366.4% as the company injected more resources in TV, network and vehicle advertisement for the purpose of promoting the Yushi brand and held large membership promotion activities and brand promotion activities. The next largest increase was employee benefit expense, which increased by RMB103 million or 44.6%. The increase was mainly due to the one-off payment of share incentives..  Other expenses such as transportation and related charges increased by RMB12 million or 15%.  Rental expenses also increased by RMB19 million or 21.9%.  These expenses account for the vast majority of increases in operational expenses.   Additionally, Company 9/8/15 took a RMB109 million impairment charge related to previous acquisitions within its retail business.

 

Overall, the company’s operating income decreased by 70% from RMB688 million in 2014 to RMB206 million in 2015.  Working capital increased by RMB183 million driven by a RMB86 million increase in prepayments and other receivables as well as a RMB75 million decrease in accounts payable.  Fixed capital decreased from RMB125 million to RMB107 million. Despite the increase in expenses, Company 9/8/15 was able to generate a ROIC of 16%.

In the second half of 2015 revenue decreased by 3% compared to H2 2014. The company’s gross margin declined by 154 basis points from 28.59% in H2 2014 to 27.05% in H2 2015. The company generated an operating loss of RMB125 million in H2 2015 as the increase in operating expenses mentioned above only started in the second half of the year.

 

Within the retail business, the pharmacy count increased by 1 from 953 to 954 while sales grew by 16.3%. Retail gross margin declined by 199 basis points from 39.7% in 2014 to 37.7% in 2015. Operating margin also declined 1200 basis points from 21.9% in 2014 to 9.9% in 2015 as operating expenses ballooned to from 17.8% of sales in 2014 to 27.8% in 2015. Asset turnover increased from 1.31 to 1.43 illustrating assets are still being used efficiently and the increased in operating expenses are the main driver of weakness in the retail segment.

 

Within the retail segment, Company 9/8/15 started reported two sub segments Retail I and Retail II. Retails I segment are retail business with higher future development potential and strategic focus, while Retails II segment are retail business located in the areas without strategic importance and high growth potential.  The RMB108.9 million impairment charge came in the Retail II segment.  Retail I segment accounts for 91% of assets, 85% of revenues, 85% of gross profit and 93% of adjusted EBITDA.

 

Within the distribution segment, revenue grew by 5.2%, gross profit decreased by 2.3%, and operating profit decreased by 85.2% due to the increased advertising and promotional expenses.

 

The company is in a strong financial position with a net cash position of RMB1,299 million yet has not decided to pay a dividend.  The company also mentioned it was about to raise cash through a share issuance putting in question the cash on the balance sheet.

 

Company 9/8/15’s problems are not industry related as the largest Chinese pharmaceutical retailer and distributor Sinopharm grew its revenue by 13% and operating profit by 17% in 2015.  Zhongzhi Pharmaceutical also saw revenue growth of 19% and gross profit growth of 12%.

 

The results are disappointing. Revenue increased, a slight decrease in gross margin, and working capital not increasing significantly, operational momentum seems to be continuing but at a cost as increased advertising costs drastically reduced profitability.  The company did not disclosure a share pledge and then sold shares to a financial institution that was immediately forced to sell.  Overall management credibility and integrity is highly questionable and the business quality is in question.  The results in the first half of 2016 will be crucial to determining whether the elevated expenses were a one off or normalized earnings are significantly lower. The company is trading just above net cash. We will decrease our position by another USD3.0 million to bring the position size down to 5.0% closer to the risk associated with the position as it is now a deep value position with management with questionable integrity and capital allocation skills.

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.

Reperio Capital Research’s Edge 11/6/2015

This is an excerpt from our October 2015 monthly review.

What is Our Edge?

At Reperio, we are firm believers that to produce extraordinary results, you have to do something different from everyone else.  What do we do different in an attempt to produce superior results?

It is something we think about a lot and we believe there are three key differentiating factors for our research.  First, we have a business owner mentality focusing on competitive position, management (not focused on by traditional research providers), corporate governance (not focused on by traditional research providers), absolute intrinsic value (not focused on by traditional research providers more focused on earnings momentum and companies beating expectations), and ensuring there is a margin of safety before recommendation (traditional research providers top picks are what is currently loved by the market due to earnings momentum are their top picks the opposite of our approach.)  We look for high quality stocks with poor sentiment.

 

Second, we have a long term investment horizon.  Jean Marie Eveillard once estimated that 95% of market participants are focused on the short term.  Given 95% of participants are focused on the short term; the vast majority of research providers will be catering to those participants in an effort to win their commission dollars.  Theses traditional research providers are obsessed with the next three to six months and companies with earnings momentum that can beat consensus. Our long term investment horizon coupled with our business owners approach gives us a tremendous advantage.

 

Third, we attempt to play a game where the competition is the weakest, i.e. Emerging Market Small and Mid Cap companies.  Just like any competition, if you play a game against very strong competition, it will be much harder than playing against weaker competition. When you are looking at US large caps you are competing against large buy side, sell-side, and hedge funds.  This is very difficult competition and while there are inefficiencies in these markets they are relatively small.  When looking at small and mid caps in Emerging Markets, competition is from the sell side, the buy side, and the public. Many of the names in the small and mid cap space have very little if any analyst coverage.  Analysts that do cover the names are more likely to be less experienced as most traditional research providers take the approach of trying to gain a small slither of a big pie and therefore put their best analysts on the bigger names.  The combination of short term orientation, and weaker experience leads to little competition. With buy side institutions, the vast majority has 100 or more names in their portfolio and has to know three to four times the number of companies.  This puts little emphasis on in-depth, independent research on smaller companies within Emerging Markets.  Additionally, 95% of buy side institutions are closet benchmark funds (over 100 stocks in the portfolio with big overweights and underweights being 1 to 2%).  This place a greater emphasis on the larger names that are in the index decreasing the importance of small and mid caps even more.  So buy side is very little competition.  The public typically are traders and have very little understanding of business so they are not much competition.

 

Our edge is illustrated by our PC Jeweller recommendation.  At the time of our recommendation in PC Jeweller, no large sell side institution covered the company and the smaller sell-side institutions were focused on the short term regulatory concerns leading to potential weakness in the short term and downside to earnings expectations. Our business owner mentality with a long term view saw a company that showed incredible resilience during an industry downturn (stable and high profitability) with a very strong balance sheet and innovative management with skin in the game.  There was short term looked uncertain due to regulation but the long term growth rate potential was tremendous given limited competition from organized retailers and a store opening target of 15-20% growth per year.  Despite the strengths of the company, it was valued under 5 times EV/EBIT.

 

Zensar Technologies is a similar story. It was a company that was coming off a period of indigestion after a large acquisition, which happens often.  Growth had slowed a bit which potentially put often the very few sell-side institution covered the company with no coverage from any big institutions.  The business owner with a long term investment horizon saw a company with very strong leadership in an industry with incredible profitability due to switching costs with industry low turnover due to a differentiated activity in an industry where the key resource is people and management was guiding 15% top line and operating profit growth for the foreseeable future. Zensar was also trading at under 5 times EV/EBIT eliminating a lot of the risk associated with the investment thesis but in the short term there were concerns putting off the sell-side.