Category Archives: Peak Sport

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

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.

Anta Sports Product July 19, 2016

Anta Sports Product July 19, 2016

Anta Sports Products July 19 2016 RCR

                                                                                     

Recommendation: Buy                 

Ticker: 2020:HK

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

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

Estimated Annualized Return: 11-13%

 

 

INVESTMENT THESIS

 

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

 

 

KEY STATISTICS

Key Statistics July 19 2016

 

FACTOR RATINGS

Factor Ratings

 

 

COMPANY DESCRIPTION

 

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

Group Structure

 

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

Chinese Sportswear Market Share 2015 Pie Chart

 

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

 

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

 

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

 

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

 

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

Anta Revenue Gross Profit Breakdown

 

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

Anta Opex % Sales

 

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

 

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

 

 

INDUSTRY ANALYSIS

 

Industry History

 

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

Industry Sales Store Count

 

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

 

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

 

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

 Chinese Sportswear Penetration

 

 

 

Barriers To Entry

 

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

Chinese Sportswear Market Share 2010 2015 table

 

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

Size vs Operating Margin

 

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

 

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

Fixed Costs of Domestic Peers

 

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

 

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

 

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

 

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

ASP of domestic peers

 

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

 

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

 

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

 

Size vs Gross Margin

 

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

 

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

Most Valuable Chinese Apparel Brands Hurun

 

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

 

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

Anta Brand Value Interbrand

 

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

Chinese Sportswear Players Operating Margins

 

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

Chinese Sportswear Players IC Turnover

 

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

Chinese Sportswear Players Working Capital and Fixed Capital Turnover

 

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

Chinese Sportswear Players Working Capital Breakdown

 

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

Chinese Sportswear Pre Tax Roic

 

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

 

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

 

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

 

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

 

 

Competitive Advantage Period

 

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

 

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

Global Sportswear Market Share 2011

 

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

 

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

 

 

Other Four Forces

 

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

 

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

 

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

Chinese Sportswear Staff Costs

 

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

 

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

 

 

 

MANAGEMENT

 

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

 

Strategy

 

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

 

Operations

 Chinese Sportswear Key Value Drivers

 

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

 Chinese Sportswear Pre Tax Roic

 

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

Chinese Sportswear Operating Margin IC Turnover

 

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

 

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

 

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

 

Capital Allocation

Anta Capital Allocation

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Corporate Governance

Anta Related Party

 

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

 

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

 

Chinese Sportswear Top 5 Salaries

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

 

 

VALUATION

 

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

Anta Asset Based Valuation

 

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

 

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

Anta Constant Valuation Assumptions

 

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

 

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

Anta Valuation Scenarios

 

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

Earnings Based Valuations

 

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

 

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

 

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

Expected Return

 

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

 

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

 

 

RISKS

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Peak Sport Products Potential Privatization May 25, 2016

Peak Sport Products Potential Privatization May 25, 2016

On May 24, 2016, Peak Sport Products was looking into the potential privatization of the company by the controlling shareholders.  The announcement was vague and came with no other information, therefore the merits of a privatization offer cannot be evaluated.

The talk of an offer points to ownership that believes in the business and the financial statements.  The company has a significant amount of cash on the balance sheet and there were questions surrounding whether the cash on the balance sheet was real as the company issued shares despite a large net cash position.

There is no concrete offer and this could be management just talking up the stock. There is no change to our position and we await more concrete information.

Peak Sport Products Position Size May 7, 2016

Peak Sport Products Position Size May 7, 2016

 

We have decreased our position size in Peak Sport products by just under USD2.9 million slightly below our intended target of USD3.0 million at an average price of HKD1.92. Peak Sport is now a 2.0% cost position.

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.

 

Peak Sport Products Position Size April 15, 2016

Peak Sport Products Position Size April 15, 2016

We have completed the sale of just under USD3.639 million of Peak Sport Products or 13,716,110 shares at an average price of HKD2.058 bring our position size to just under USD9.858 million or a 9.2% cost position.

We are going to sell another USD4.5 million to bring Peak Sport Products more inline with our new position sizing philosophy.  We will only sell if the price remains above HKD1.90. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. The company is somewhere between a deep value and high quality investment therefore the position size probably should be closer to 5.0%.

 

Peak Sport Products Position Size April 7, 2016

Peak Sport Products Position Size April 7, 2016

We are decreasing Peak Sports Products position size by USD3.5 million assuming the share price remains above HKD1.75 per share. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. A smaller position size is warranted.

 

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.

Honworld, Peak Sport Products, and Company 11/19/15 positions January 21 2016

Honworld, Peak Sport Products, and Company 11/19/15 positions January 21 2016

We have been selling Honworld and Peak Sport Products in our model portfolio.  Despite the recent share price correction, we will continue to decrease our Honworld position as the risk of owning the company has increased. The shareholder has recently taken a loan against a portion of his shares, which is a red flag and the company continues to be unresponsive to our requests to speak with them. The share price decline is even more concerning as the shareholder’s may have to put more shares or money up to cover the decline in the value of the recent shares pledged towards the loan. If the shareholder fails to put more collateral against the loan there could be forced selling. It is a currently a 9.0% cost position and we are trying to get it down to a 5.0% position before making our next decision on the company’s position.

 

We are stopping our selling in Peak Sport Products as the company is now trading at 88% of NCAV and recently reported a mid-single digit same store sales growth for Q4 2015.  The company continues to perform well operationally but is now trading below its NCAV.  There are some capital allocation issues but the company continues to perform well and is more insulated than competitors from competition due to is focus on performance and value.  The market also has concerns over the company’s cash position given the recent share issuance but the fact the company was paying a dividend payout over 100% during the industry’s contraction points to cash on the balance sheet actually being there.

 

We are increasing our position in Company 11/19/15 by 1.5% to bring the position back to 5.0% as the company is now trading at an EV/EBIT 7.3 times and an EV/FCF of 9.6 times despite the company’s strong competitive position and growth outlook.