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Stalexport Autostrady SA
Bloomberg Ticker: STX:PW
Closing Price (3/10/17): PLN4.30
6 Month Avg. Daily Vol. (USD mn): 0.13
Market Cap (USD mn): 262
Estimated Annualized Return: 10.5%
March 11, 2017
Stalexport Autostrady holds a concession on a 61-kilometer stretch of the A4 in Poland between Katowice and Kraków. The concession ends in 2027. The company’s management has done an excellent job of improving operations since taking over in 2006 growing toll revenue at 11.8% over the past ten years. Despite the growth in the business, and inherent operating leverage in running a toll motorway, the current market valuation is 19% below a zero growth intrinsic value making Stalexport an attractive investment opportunity. If the company is able to grow revenues at half of its historic rate, there is 67% upside to its intrinsic value. If the company is able to continue to grow its revenues at its historic rate, there is 131% upside. Given the stability of the company’s revenue and the expected return of 10.5%, we recommend a starting position of 2.0%.
Stalexport Autostrady started operations on January 1, 1963 as Przedsiębiorstwo Handlu Zagranicznego “Stalexport”. It specialized in exporting and importing steel products as well as importing raw materials for the Polish steel industry. In 1993, the Polish government privatized the company with shares listing on the Warsaw Stock Exchange in October 26, 1994. In 1997, Stalexport won a 30-year concession to construct, adapt, and operate a 61 km toll road on the A4 motorway between Katowice and Kraków.
The motorway was secondary to the steel business until 2006, when the Atlantia Group, then Autostrade S.p.A., an Italian infrastructure company, acquired 50%+1 share of Stalexport for €67 million or PLN200 million. By Polish regulation, Atlantia was forced to launch a public tender offer for up to 66% of Stalexport’s share capital. It increased its share to 56.24% at the time of the acquisition. To complete the acquisition, Atlantia required Stalexport to increase its share capital with all new shares going directly to Atlantia. It also mandated the sale of the steel business. Prior to obtaining Atlantia as a strategic investor, Stalexport was dealing with potential bankruptcy for a number of years with its auditor, BDO, issuing a statement of the going concern nature of the company in its opinion statement. Atlantia manages a network of 5,000 km of toll motorways in Italy, Brazil, Chile, India, and Poland. It is a leader with respect to automatic motorway toll collections systems.
In 2011, Stalexport reduced its share capital to PLN185.45 million to reflect the change of the of the organization and capital requirements as the company was solely an operator of a toll road.
Since the acquisition, Atlantia increased its shareholding to 61.20%. Post-acquisition, its first increase came in to 2011 with a purchase of 10.86 million shares increasing its stake to 60.63%. In 2016, the company purchased another 1.4 million shares increasing its stake to 61.20%. Management has an insignificant shareholding with Emil Wasacz, President of the Management Board, holding 59,000 shares.
Stalexport Autostrady S.A. focuses on the upgrade and expansion of motorway infrastructure. In 1997, it was the first Polish company to be granted a concession to operation, upgrade, and maintain a toll motorway wining the concession on the A4 motorway between Katowice and Kraków section. In 2004, the concession was transferred to Stalexport Autostrada Małopolska S.A.
Stalexport Autoroute S.à r.l. was establish on December 30, 2005. The entity does not conduct any operational activities apart from holding shares in SAM as well as in VIA4. The entity was established as a prerequisite to obtain a loan for a consortium of banks.
Stalexport Autostrada Małopolska S.A. (SAM) SAM was established on December 19, 1997 as a special purpose vehicle to manage the A4 motorway between Katowice and Kraków. The motorway concession was transferred to from the group to SAM on July 28, 2004. After the transfer, SAM was authorized to collect lease fees and tolls for using the above-mentioned motorway section. As stated by the concession agreement, the entity is obliged to provide ongoing maintenance of the motorway and continue other necessary investment tasks.
VIA4 (formerly Stalexport Transroute Autostrada S.A.) was established on 14 May 1998. VIA4’s only customer is SAM. Its main tasks are ongoing operation and maintenance of the A4 toll motorway section, which includes operation of the toll collection system, management of motorway traffic, and comprehensive renovation and maintenance of the motorway. VIA4 also carries out tasks related to safety and road traffic. VIA4 is 55% owned by Stalexport and 45% owned by Egis Road Operation S.A., a French company with expertise in all of aspects of motorway management.
Biuro Centrum was established on June 9, 1994. The main business of Biuro Centrum consists in management and maintenance of the office and conference building in Katowice at ul. Mickiewicza 29 co-owned by Stalexport Autostrady (40.47%) and Węglokoks S.A. (59.53%).
98% of the consolidated company’s revenues and 96% of EBIT are from SAM, the entity that collects the lease fees and tolls from the motorway.
Given the importance of the toll road, we focus our attention on this business. The A4 toll motorway between Katowice and Kraków is 61-kilometer toll road. It is part of the A4, which is one of the major motorways in Poland and one of the two motorways planned to stretch from the eastern border Poland to the western border of Poland by 2022 along with the A2 in central Poland.
The A4 from Katowice to Kraków is an open system, where money is paid at tollbooths stretching across the road based on the vehicle type. The open system is relative cheap but forces commuters to stop at each tollbooth decreasing the capacity of the motorway. The other system is a closed system where there are tolls at each interchange when entering and exiting the motorway the toll is paid based on the vehicle and the distance traveled.
According to Google Map driving directions, the A4 is the quickest way from Katowice to Kraków beating the 94 by 28 minutes. As mentioned, the only major competition to cross Poland is the A2 in central Poland. The decision is based on your starting and ending point and the quickest route of travel so in many instances there is no competition. The A4 is a fastest way to travel particularly if you are driving across southern Poland from east to west or west to east and there are very few alternatives. It would be very difficult for a competing toll road to be built over the next 10 years allowing the A4 to generate steady revenue with very little investment requirements. Additionally, if another road were to be built to compete with the A4, it would cannibalize government revenue, as the A4 from Katowice to Kraków will be handed over to the government at the end of the concession in 2027. Toll roads also have barriers to entry in the form of habitual behavior. When commuters have a road travelled on a daily basis a habit is formed as the road is travelled without any thought creating a habit that is difficult to break.
For the consolidated entity, since 2008, toll revenue increased by 11.6% per year with passenger vehicle toll revenue increasing by 11.4% per year and heavy goods vehicle toll revenue increasing by 11.9% per year. Average daily traffic increased by 4.5% per year with passenger vehicle traffic increasing by 5.7% per year and heavy goods traffic decreasing by 0.6% per year. The average toll increased by 6.8% per year with the average toll for passenger vehicles increasing at 5.4% per and heavy goods vehicles increasing by 12.5% per year.
Despite the growth in revenues, Stalexport’s cost of goods sold have decreased from PLN85 million in 2006 to PLN37 million in 2016. 2006 and 2012 were the two years with the highest cost of goods sold at PLN85 million. Cost of goods sold is very dependent on road works during the year, which creates a bit of lumpiness and no correlation with revenues. 2016 saw lower road works leading to much lower cost of goods sold. Since 2006, cost of goods sold averaged PLN66 million.
Administrative expenses increased steadily from PLN21 million in 2016 to PLN30 million in 2016, equal to a 3.8% annual increase, well below the rate of change in toll revenue.
Atlantia has done a good job of growing revenues while decreasing expenses as a percentage of revenues. The biggest driver of decreasing costs relative to expenses was eliminating inefficiencies from having too many subsidiaries.
The A4 concession expires in 2027. Upon expiry, the A4 will be transferred to Poland’s Treasury. If Stalexport is to grow, it will come from the existing asset. There are other potential PPP projects but it would be speculative to assume any growth from these projects as the company has not indicated there are any potential projects in the pipeline. The company has also been selective in the past and passed on projects where prospective returns were not attractive enough.
Internal growth will come from traffic growth and growth in the average toll. In 2016, Stalexport implemented its own A4Go on-board units after not being able to coordinate with the viaToll system used elsewhere in Poland. The A4Go unit allows for electronic payment at the tolls decrease traffic at tollbooths. The A4Go was implemented in only 6 months and went online in July 2016. By the end of the year, roughly 10% of morning traffic used the A4Go system. The decrease in traffic at tollbooths decreases the travel time for commuters making the A4 a more attractive route for existing and potential users.
Given the barriers to entry and the predictability of revenue, we value Stalexport using a DCF until 2026 the year before the company has to hand operations back to the treasury. We assume no cash flows in 2027 for conservatism.
We vary sales growth to get an estimated intrinsic value under different scenarios. Under the most conservative scenario, we assume no growth in sales. Sales growth is then assumed to increase by 3% as scenarios become more aggressive and we reach the most aggressive scenario of 12%, which assumes sales growth will continue at roughly the pace it has over the past ten years (11.8%).
The last ten years saw significant variability in the cost of goods sold but the variability was within a well-defined range. We assume an average of the last ten years with no inflation.
Administrative expenses have increased steadily over the past 10 years at a rate of 3.8% per year. We assume administrative expenses continue increasing at 4.0% per year. We also assume a tax rate of 20% roughly in-line with the effective tax rate of 19.8% over the past ten years.
Since 2008, the company’s average change in working capital to revenue rate is 6.3% meaning every zloty of revenue generates 6.3 grosz of positive free cash flow due to negative working capital requirements. Despite the negative working capital generating free cash flow, we assume there is no cash flow generated from working capital and there are no investments in working capital.
Also since 2008, the company has spent 26.1 grosz on capital expenditures for every 1 zloty of revenue just above the depreciation rate of 19.1 grosz for every 1 zloty of revenue. Over the past four years, the capex to depreciation rate averaged 0.8 meaning the company is spending less on capex than depreciation. The recent trend of capex below depreciation leads us to assume capex equals depreciation therefore there are no additional fixed capital requirements other than the maintenance capex.
The company has a net cash position just over PLN315 million and a share in property investments with an estimated value of PLN10 million.
We place a probability on each of the 5 revenue growth scenarios to a get a blended intrinsic value of PLN7.21 per share, which has 67.6% upside from the current price.
Under the most conservative scenario of zero revenue growth still leads to an upside of 19% illustrating the downside protection at current prices.
Stalexport’s biggest risk is regulatory risk. While a toll motorway concession is a contract, the authorities are most likely least concerned with the owner of the toll motorway and more concerned with other stakeholders such as commuters. In Poland, Stalexport was sued by the Polish government for anti-competitive practices due to high toll rates. In 2008, the company had to pay a PLN1.5 million fine. In India, populism led to abolition of tolls for an extended period. Countries may also change their previous position to void contracts.
Any new motorway running parallel to the A4 would create additional supply impacting Stalexport’s ability to attract traffic and raise toll rates.
Traffic particularly heavy goods vehicles is dependent on economic growth. Slowing macroeconomic growth could hurt traffic growth.
The company has more related party transactions than what we would like and there is potential for some corporate governance risks. The main related party transactions are with companies owned by Atlantia, which complete roadworks on the motorway.
Management remuneration has decreased substantially as a percentage of operating income. Management may increase its salaries and extract greater value in the future.
There is a risk of the company tendering for new concession and overpaying hurting returns on future projects. The company was disciplined enough to pass on past projects that did not meet the parameters needed for attractive returns.
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:
- We await receipt of the draft 2015 consolidated financial statements from management.
- 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.
- 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.
- 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.
- 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.
- 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.
Anta Sports Product July 19, 2016
Closing Price (7/19/2016): HKD17.26
6 Month Avg. Daily Vol. (USD mn): 18.82
Estimated Annualized Return: 11-13%
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.
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.
The company is a leading sportswear company with an estimated 11.1% market share at the end of 2015.
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’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.
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%.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Further evidence of Anta’s competitive advantages is seen in its profitability relative to domestic peers.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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 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.
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.
Anta’s accounting assumptions are in line with peers across the board so there are no concerns over inflated earnings due to accounting assumptions.
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.
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.
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.
The target prices for 2016 and 2021 along with their upsides are illustrates below.
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.
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%.
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.
Honworld 2015 Annual Report Review June 29, 2016
The amount of capital allocated to inventory is the biggest concern with an investment in Honworld. There is some complexity to how inventory works its way through the company’s financial statements so we thought it would help us to relook at the production process and how inventory is accounted for.
To start the production process, Honworld purchases raw materials. In the company’s IPO prospectus, it stated “Our raw materials are generally available from numerous suppliers. We minimize our reliance on any single source of supply for our raw materials by maintaining alternative sources.” The breakdown of raw materials is listed below.
Raw materials with the exception of packaging are pure commodities where the purchasing decision is based on price readily available from many suppliers.
Base wine production is the next step in the production of inventory. Rice is soaked and steamed to increase moisture content. The rice is then fermented, which takes place in cool weather, generally from every October to next May each year. Sometimes, there is a second fermentation process. The fermented product is then filtered and sterilized. Depending on weather conditions, it typically takes 30 to 35 days to complete the above production steps. Following base wine production, base wine is aged, seasoned and blended, and packaged to create the final cooking wine product.
The final cooking wine product is a mixture of vintage base wine, mixer base wine, water, seasoning, and spices. Vintage base wine is aged to deliver the desirable aroma and taste, while mixer base wine is added to adjust the ABV, sweetness, and acidity. Mixer base wine is aged less than two years. The final cooking wine product comes in four grades classified by the amount of base wine used in the end product and the age of vintage base wine used.
- In 2013, premium cooking wine was 6% vintage base with an average age of 10 years and 87% mixer base wine with an alcohol by volume of 15%.
- High-end cooking wine is 6% vintage base with an average age of 8 years and 81% mixer base wine with an alcohol by volume of 15%.
- Medium-range cooking wine is 4% vintage base with an average age of 5-6 years, and 81% mixer base wine with an alcohol by volume of 10%.
- Mass-market cooking wine is 4% vintage base with an average age of 5-6 years, and 64% mixer base wine with an alcohol by volume of 10%.
Honworld has not reported its volume sold or base wine used since its IPO prospectus. Volume sold for 2013, 2014, and 2015 is estimated, by assuming ASPs do not change over those periods, while, 2010 to 2012 are from the company’s prospectus.
Honworld’s volume sold and base wine used is shown in the table below.
Base wine usage in 2013, 2014, and 2015 is assumed to remain the same as the first eight months of 2013. Base wine as a percentage of cooking wine volume sold increased from 35% to 86% as Honworld sold more premium products, which require more base wine, and the amount of mixer base wine per liter of cooking wine increased. Since base wine represented 86% of volume sold, the estimated base wine inventory of 180 million translates to 211 million liters of potential sales volume or 2.87 years of inventory based on 2015 estimated sales volume. Honworld’s target base wine inventory of 225 million liters, expected to be reached in June 2016, translates to 263 million liters of sales volume or 3.58 years of inventory based 2015 estimated sales volume.
Honworld did not report base wine inventory at the end of 2015 but at the end of 2014, the company had 158.4 million liters of base wine inventory. The company has repeatedly stated its target is to reach 225 million liters of base wine inventory. The question becomes does the company continue to build inventory past the 225 million liters level at a rate equivalent to sales, which will lead to a continued cash flow drain, or does the company remain at its target level of 225 million liters. At the end of 2016, we will know if the company continues to build inventory or if it continues to throw off cash flow. The company has been raising money by selling shares and bank loans leading us to believe it will continue to build inventory with revenue growth. If the company was going to stop building inventory, it would make sense to use debt to maintain ownership as the company is not too levered with net debt to EBIT at 1.54 times.
The above table illustrates base wine inventory from 2010 to 2015. At the end of 2015, Honworld had 180 million liters of base wine and a total inventory cost of RMB945 million for an estimated cost of RMB5.24 per liter of base wine. The cost of goods sold per liter of volume sold equaled RMB3.26, while the cost of goods sold per liter of base wine used equaled RMB3.81. The ratio of cost of goods sold per liter of volume sold to the cost of goods sold per liter of base wine equaled the ratio of base wine used to volume sold.
The ratio of the cost of base wine used to balance sheet inventory on a per liter basis fluctuated between 227.5% in 2010 to 59.3% in 2013 with 2015 ratio of 72.6%. The company uses weighted average method so a shift in raw materials costs will not create a differential between inventory valuation on the balance sheet and inventory valuation on the income statement in cost of goods sold. The shift in cost of goods sold per liter of base wine to base wine inventory valuation per liter is related to an increase in vintage wine in inventory relative to the amount of vintage base wine used in volume sold as there are costs to storing and holding base wine during the aging process leading vintage base wine to have a higher valuation. Vintage base wine will continue to increase as a proportion of inventory held while vintage base wine as a percentage of cost of goods sold not increase drastically meaning cost of base wine sold per liter should decrease relative to the cost of base wine inventory per liter.
Other than understanding how the company’s main product flows through the financial statements, the central question to the analysis of inventory is whether allocating significant amounts of capital to inventory is in the best interest of shareholders.
Management states it can guard against the increase of raw material price from holding a higher level of base wine. Raw materials are commodities in the truest sense of the word so as long as a certain quality threshold is reached price is the only consideration in the purchase decision. These commodities are available from many producers. Suppliers of raw materials have no bargaining power so there will be no price increases due to supplier strength. If raw material prices increase all competitors will be affected equally allowing raw material price increases to be passed on to customers. Furthermore, Honworld has a brand, illustrated by its leading market share with premium pricing, meaning any increase in commodity prices can be passed on to customers.
Assuming that the company is unable to increases in raw material prices, to analyze the effects of increased inventory and associated working capital, we assume that the company carries half as much base wine to eliminate the company’s inventory protecting against raw material prices. We assumed base wine inventory is halved from 180 million liters to 90 million liters, which translates to 105 million liters of end product or 1.43 years of 2015 estimated sales volume. Total inventory costs decrease from RMB945 million to roughly RMB475 million leading to an increase in inventory turnover from 0.84 to 1.69. In addition, fixed capital is tied to inventory as much of the company fixed costs are storage facilities to age base wine; therefore, fixed capital is assumed to decrease by 25%. Other working capital is assumed to have no connection to inventory levels and therefore remains the same leading to overall invested capital decrease from RMB1,782 million in 2015 to an estimated RMB1,145 million without inventory and necessary infrastructure to protect against raw material increases. Raw material price increases lead to increased cost of goods sold with every other income statement account remaining the same.
As illustrated above, if Honworld halved its inventory as well as associated fixed costs, raw material prices need to increase by 30% for return on invested capital (ROIC) to reach the level seen in 2015. Commodity prices are difficult to forecast but a 30% increase in a deflationary environment does not seem like a high probability event. Additionally, there is a high probability (80-85%) that Honworld would be able to pass on increases in raw material prices due to its brand, and/or competitors would see the same increase in commodity prices leading to an industry wide increase in prices. The statement that management is building inventory to protect against rising assume that two low probability events occur rising raw material prices in a deflationary world (<20-25%) and an inability to pass on price increases leading to a decrease in profitability (<15-20%).
Management’s other reason for building inventory is to support future growth. The company’s current inventory is sufficient cover 2.87 years of 2015 sales volume. In addition, the company believes it will reach 225 million liters of base wine inventory at the end of the first half of 2016. The company can also produce enough base wine to cover 2015 in one year’s sales as while increasing its base wine inventory it is still producing sufficient inventory to cover current period sales.
Mixer base wine and vintage base wine are two types of base wine used in the production of cooking wine. Mixer base wine is less than two years old, so does not need any ageing, while vintage base wine is over two years old, and therefore needs ageing. The table below illustrates the amount of base wine, vintage base wine, mixer base wine, the average age of vintage base wine, the percentage of 2015 cooking wine revenue of each category of base wine, and estimated gross margin for each category.
The table also illustrates the 2015 blended average and two scenarios assuming an increase in sales of higher-end and premium products.
Given mixer base wine can be produced without ageing, the inventory build is to allow the company to produce more vintage base wine to allow the company sell more premium products.
Base wine inventory in liters is estimated by assuming the cost of base wine remained the same in 2015 as the company reported base wine inventory in liters in 2014. Mixer base wine is assumed to be the change in inventory from the previous two years as mixer base wine is any base wine under two years. The remaining base wine is considered vintage base wine. Vintage base wine’s age is estimated by taking the vintage base wine not used in the year and adding mixer base wine added to inventory two years ago. All new mixer base wine is considered to be 2.5 years and vintage base wine from previous years is considered to age by a year. Vintage base wine inventory estimated age reached 4.0 years at the end of 2015. The vintage base wine inventory’s age continues to fall as the mixer base wine re-classified as vintage base wine increases as a proportion of vintage base wine inventory.
The company now has estimated base wine inventory of 180.3 million liters consisting of 87.7 million liters of base wine inventory and 92.7 million liters of vintage base wine inventory. In 2015, Honworld used an estimated RMB3.3 million liters of vintage base wine meaning the vintage base wine inventory of 68.4 million liters is sufficient for almost 21 years assuming sales remain at 2015 levels. Mixer base wine can be easily produced as it does not have to be aged creating a situation where vintage base wine will continue to grow.
Assuming similar sales volume to 2015 and product mix of 50% of sales volume is premium, 25% is high-end, and 25% is medium-range, base wine would be 88.0% of a liter of cooking wine with vintage base wine would need to be 5.5% of inventory sold or 4.4 million liters of vintage base wine. At current inventory levels, vintage base wine inventory would have just less than 17 years of vintage base wine inventory. It seems the company is over building its vintage base wine inventory, which may not be used for decades and is well above the amount required. Vintage base wine could probably be closer to 10-12 years as in the most aggressive scenario of selling 100% premium cooking wine base wine only needs to be ten years old. Additionally, the company can produce an estimated additional 100 million liters in mixer base wine per year with the vast majority going to current period sales. The company is building inventory and should be effectively spread over ages, unfortunately the company does not provide disclosure on the age of its inventory. The company could effectively half its vintage base wine inventory and still have 10 years of vintage base wine inventory, while mixer base wine inventory should no more than a year as the company produces about 150% of its current period mixer base wine needs. Overall, base wine inventory could be decreased by 50% and still have sufficient inventory for current period and growth meaning ROIC could increase from 16.6% in 2015 to 25.8%.
The analysis above was not created to verify my past views on Honworld’s inventory levels but to use a new angle to see if my existing view were inappropriate. Unfortunately, the outcome of the analysis points to the same view that inventory is bloated and holding down returns of the company with inventory at twice the size it needs to be.
After reviewing Honworld’s 2015 annual report, the company will not be able to realize its full value if it does not do a better job on disclosure. Analysts need more information to get a much more accurate picture of the company and fully understand how inventory flows through the company’s financial statements. Additionally, the company should give better disclosure on product mix and profitability of each product. Our desire is to see the following disclosed:
- Volume by product
- Gross margin by product
- Base wine inventory in liters
- Base wine inventory ageing
- Inventory ageing by base wine and vintage base wine
- Estimated inventory cost by age
- Base wine production capacity
- Base wine storage capacity
- Bottling capacity
- Sales by geography
- Sales by distribution channel
Overall, Honworld is one of our top ideas. There is a high probability that the company is building a multi-faceted competitive advantage in the form of economies of scale and brand. Over the past three years, the company spent 7.0% of revenue in research and development and another 7.1% in selling and distribution expenses meaning fixed costs were 14.1% of revenue. In 2012, the last reported data, Honworld was the largest Chinese cooking wine producer with a 13.8% market share. The company is the only top four cooking wine producer using a naturally brewed, traditional production process allowing the company to garner premium pricing. This premium pricing amplifies the company’s size advantage over its top four competitors, as 95% of cost of goods sold is raw materials in the form of agricultural commodities. As illustrated below in 2012 (latest available data), Honworld’s sales are 2.16 times and its gross profit is 2.86 times its largest competitor. Sales are 3.21 times and gross profit is 4.21 times its second largest competitor.
The 14.1% of revenue in fixed costs translates to 24.4% of gross profit. The company’s nearest competitor is the only competitor that can match the fixed costs and still be profitable as Honworld’s fixed costs equate to 70% of the largest competitor’s gross profit and 103% of the second largest competitor’s gross profit. Honworld expects to increase advertising expenses and continue to increase the penetration of its distribution channel to third and fourth tier cities within its key sales regions. The company also has brand advantage illustrated by market share advantage and premium pricing. Additionally, it sells the lower priced product where the customer is less likely to search for alternatives with a small price increase as the increase is not as noticeable and search costs are much higher.
The company is run by a passionate, owner-operator and recently there was an investment by a private equity company with significant resources to conduct due diligence giving credibility to the company’s financial service. The private equity company is an expert in Chinese consumer companies so it brings additional relevant expertise. The major concern with Honworld is the investment in inventory. As illustrated above, inventory is running at twice what it should and dragging on profitability leading to financing issues. The company is increasing its debt load and selling part of the company to finance its growth as it is growing at 20% per year. The company is targeting 225 million liters of base wine inventory at the end of the first half of 2016. Hopefully, the company slows down the aggressive inventory build and if it continues to build inventory it does so at a slower pace than revenue growth.
The company offers a 12.7% EBIT yield and 5.0% organic growth through pricing power for almost 18% expected annual return. Additionally, the company’s debt load is inflated due to its inventory build and if the company changes direction with inventory it can pay down that debt quickly or increase dividends.
Credit Research and Analysis June 20, 2016
Closing Price (6/20/2016): INR993.50
1 Year Avg. Daily Vol. (USD): 530,269
Estimated Annualized Return: 8-9%
Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market. The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case. We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.
Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue. Rating assignments generates two types of revenue: rating revenue and surveillance revenue. Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.
Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt. Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan. If a loan it not rated, it retains a capital risk weight of 100%.
The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital. Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.
As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.
Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits. Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.
As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers. It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.
Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets. New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures. The company can also move into adjacent product market like research and advisory services. CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.
CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.
IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.
CRISIL, the first India credit rating agency, was established in 1987. ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.
In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.
In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.
Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.
Barriers to Entry
The industry structure points to barriers to entry. There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market. The market share among the top three players since FY2006 is illustrated below.
CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).
The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.
CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million. The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.
The rating agencies seem to lack pricing power pointing to no barriers to entry. The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power. The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.
CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.
Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies. ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms. The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.
Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment. If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.
Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.
Other Four Forces
The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA. In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue. Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.
The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense. The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market. Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699 to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline. CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.
The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated. A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.
Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power. The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.
The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings. Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm. Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.
Operationally, management has performed very well. It is increased its market share among the top three rating agencies by almost 10% over the past ten years.
The company is also the best performing credit rating agency in terms of operating profit per employee.
ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.
Management has done a good job on focusing on the ratings business. CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses. These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital. CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years. ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.
The only other capital allocation decision made by management is whether to hold cash or payout cash. Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.
Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.
Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.
There are no related party transactions other than management remuneration. Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.
There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.
Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.
Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense. The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.
Under the blended valuation, we use different scenarios to determine potential upsides and downsides. The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.
Sales growth and operating margin are changed to determine upside under different scenarios. The scenarios and assumptions for both value drivers are listed below.
The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.
The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.
The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside. The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.
The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.
The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.
Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation. The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India. Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.
CARE seems to be slightly undervalued to fairly valued.
The biggest risk to CARE’s business is reputational. After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated. During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value. S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.
Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.
Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.
There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.
Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.
After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.
CARE is managed by external agents rather than owner operators. If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.
CARE investment thesis and price paid is based on the development of banking and credit markets. If banking and credit markets do not develop, there may be permanent loss of capital.
CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital. To combat this risk, we are taking a small starting position.
Honworld Share Sale June 3, 2016
After trading hours on June 1, 2016, Honworld sold 11.57% of the company’s existing share capital and 10.37% of the company’s expanded share capital for HKD6.00 per share. New shares were issued with no existing shareholders selling. HKD6.00 is a 27.66% premium to the June 1, 2016 closing price of HKD4.70 per share. The subscriber is a wholly owned subsidiary of Lunar Capital, a private equity fund focused on investing in the Chinese consumer businesses in the PRC. The subscriber’s guarantor’s principal activity is owning and operating companies or businesses focused in the condiments market in the PRC.
The aggregate net proceeds from the subscription are estimated to be approximately HKD356.1 million representing a net price of HKD5.935 per share. The company intends to utilize the net proceeds for general working capital of the Group.
The HKD6.00 price puts Honworld on an EV/2015 EBIT of 10.37 times and EV/2015 NOPAT of 12.29 times meaning shares were sold at cheap to fair value but not a no brainer sale price and not a ridiculously cheap price.
Lunar Capital has investments in a number of consumer goods companies in China. Lunar Capital often takes a controlling interest from older founder who have succession challenges. Lunar Capital is only buying 10.37% of Honworld so it is not taking control but it should bringing additional operational expertise given its numerous investments in consumer products. Additionally, it should provide additional perspective on other important aspects such as capital allocation.
As mentioned in the initiation report and most subsequent updates, Honworld is going to need to continue to raise capital due to inventory needs associated with growth. The company’s inventory is raw materials, which can be purchased solely on price and ageing the product into premium products does not generate sufficient margin to make up for the ROIC drag associated with holding inventory for additional length of time. This is the second consecutive fund raising that potentially involves selling shares leading to dilution of existing shareholders, which was not a particularly high price. The recent sale/loan allowed the company to raise RMB133 million. This transaction allowed the company to raise net proceeds of HKD356.1 million or RMB420 million leading to RMB553 million raised over the past month. Assuming working capital turnover remains at 0.71, the RMB553 million will allow the company to grow by an additional RMB393 million or 50% from current levels. Assuming a 15% growth rate, the RMB553 million will be sufficient to finance growth until the end of 2018.
This development brings outside capital and credibility at a significant premium to the current market price and at a cheap/fair value. Capital allocation continues to be an issue as illustrated by the continuous need for fundraising. As of Friday May 27, 2016, Honworld was an 8.5% position, which we were trying to sell down to 7.5% but given the share price dropped below HKD5.00 per share we stopped selling. We will maintain the current position of 8.5% given the credibility, operational expertise, and perspective of the external buyer. Additionally, the owner operator is passionate about the business and may see it as a family legacy. The business has a very strong competitive position and is growing rapidly while trading below and EV/EBIT of 10 times. This transaction also puts a private market value on Honworld well above the current share price. If Lunar Capital is purchasing at HKD6.00, it must expect to get at least 15% IRR from the investment maybe more given the premium required for a Chinese investment.
Turk Tuborg: A Turkish Brewer in a Duopoly offering an 8.0% NOPAT Yield
Türk Tuborg is the second largest company in a Turkish Beer market that is a duopoly. Along with Anadolu (Anadolu), the two companies have controlled over 99% of the market for many years. There are significant barriers to entry in the form of economies of scale and brand as the Turkish Beer market requires a two way distribution system and there are restrictions on advertising. Türk Tuborg has outperformed Anadolu increasing its market share from 11.5% in 2010 to 31.4% in 2015. The company also increased its pre-tax ROIC significantly from -3.3% in 2010 to 95.2% in 2015. These improvements came just after new ownership introduced a number of new products to the market. The company offers an 8.0% EBIT yield with pricing power leading to an expected return of 13.0% per year, which is attractive given the barriers to entry in the market and the company’s outperformance under current management.
- Expected annual return between 13.0%-15.5%
- We will initiate a 4.0% position in Turk Tuborg.
Türk Tuborg was founded in İzmir-Pınarbaşı in 1967 with production starting in 1969 through a partnership between Tuborg and Yasar Holding Production. Carlsberg took a majority shareholding of Türk Tuborg in 2001 increasing its stake from 2.24% to 50.01% after purchasing 47.77% from Yasar Holding. This transaction valued Türk Tuborg at roughly USD110 million (DKK960 million). Over the course of the next few years, Carlsberg continued to increase its stake until reaching 95.69% in 2003. In 2008, Israel Beer Breweries Ltd, a Carlsberg partner in Israel and Romania, purchased 95.69% stake from Carlsberg for USD44.5 million valuing Türk Tuborg at USD80 million. After the purchase, Türk Tuborg retained its license to continue to produce Carlsberg and Tuborg brands. The 4.31% not owned by Israel Beer Breweries is free float with the company listed on the Borsa Istanbul.
Türk Tuborg owns one of the largest breweries in Turkey with 36,000 tons of malt and 333 million liters of beer capacity. The company produces Tuborg (Gold/Amber/Special/Fici), Carlsberg, Skol, Venus Pilsner, and Troy Light for both Turkey and export markets. The company also produces Vole, Thelch, and F5 for export markets. Türk Tuborg also imports Leffe, Hoegaarden, Guiness, Corona, Weihenstephan, Kilkenny, and Somersby.
Türk Tuborg’s products are sold through direct sales and dealers all over Turkey. Corona, Leffe Brune, Leffe Blonde, Leffe Radieuse, Hoegaarden, Weihenstephan, Kilkeny, and Guinness brands are positioned at the super premium beer segment. Carlsberg brand is positioned at the premium beer segment. Tuborg Gold, Tuborg Fici, and Tuborg Special brands are positioned at the standard segment, while, Skol and Venus brands are positioned at the economical beer segment in 2015.
In 2015, Türk Tuborg was the second largest player in the market with a 31.4% volume share of the Turkish beer market behind Andalou’s 68.4% volume share.
In 2011, Türk Tuborg launched the Türk Tuborg Brewmaster project with the goal of delivering product variety to Turkish consumer. The company introduced super premium brands Corona, Guinness, Leffe, Weihenstephan, Kilkeny, and Hoegaarden. The project has help increase the company’s volume share in the Turkish beer market from an estimated 11.0% in 2010 to 31.4% in 2015.
Barriers to Entry
Within the Turkish beer market the evidence points to significant barriers to entry.
- Türk Tuborg and Anadolu have accounted for over 99% of the Turkish beer market for many years. At the end of 2015, these two companies represented 99.8% of the market. The high and consistent market share points to no significant new entrants or exits from the market. The duopolistic market structure with a no significant entry or exit from the industry points to significant barriers to entry. Heineken attempted to enter the Turkish beer market, but withdrew in 2006 as it was unable to reach the minimum efficient scale needed to compete.
- Distribution is a significant barrier to entry. In 2012, 64% of Turkish beer volume was returnable bottles and kegs making a two way distribution system a requirement to compete in the Turkish beer market increasing the investment requirements and complexity of the required distribution network.
- The distribution network required to compete also points to economies of scale as distribution is a fixed cost independent of units sold. Over the past five years, Türk Tuborg has averaged roughly TRY155 million per year in selling, distribution, and marketing expenses. In 2015, both Türk Tuborg (TRY134.3) and Anadolu (TRY137.6) had a gross profit of roughly TRY135 per hectoliter. Just to cover the fixed costs associated with Türk Tuborg’s distribution, a competitor would need to achieve 12% market share.
- There are significant advertising restrictions on beer and other alcohol decreasing a new entrant’s ability to building a brand. There is no alcohol advertising on television or radio. Also, alcohol companies cannot sponsor any sports team and, similar to smoking, all alcohol on television or in movies is blurred.
- Türk Tuborg seems to have significant pricing power. Since 2008, Türk Tuborg has been able to increase its average selling price by 7% per year. The company’s cash gross margin has increased from 49.0% in 2008 to 60.1% in 2015.
- Total Turkish beer market volume has not grown since 2008, decreasing the attractiveness of the market, and increasing the difficulty of entering the market as lower growth often leads to increased competitive rivalry.
- Türk Tuborg has little or no working capital requirements. In 2014 and 2015, working capital per unit has been negative and averaged TRY63 million. Negative working capital is a strong sign of a company’s bargaining power over both its suppliers and customers.
While the evidence pointing to barriers to entry are strong, there is evidence against barriers to entry.
- Türk Tuborg’s recent profitability has been strong with a ROIC averaging over 100% over the past two years, but from 2008 to 2011 ROIC averaged 0%. The lack of inconsistent ROIC is evidence against a competitive advantage.
Overall, the evidence overwhelmingly points to significant barriers to entry that would take years for a new competitor to reach the necessary scale to compete.
Given the evidence points to the presence of barriers to entry, what form do they take? Barriers to entry take the form of economies of scale and brand. Economies of scale are in the form of a two way distribution network that requires a minimum efficient scale of roughly 12.0% just to replicate the smaller of the two large competitors’ annual spend on selling and distribution expenses. Additionally, large breweries require expensive equipment that is much cheaper on a per unit basis if the depreciation is spread over many units. Additionally, larger brewers can acquire raw materials and package goods cheaper due to the size of their purchases.
Brand advantage also exists. The restrictions on advertising help existing brands as new entrants cannot build a brand to displace incumbents making brands with an existing relationships and positions more resilient and less resistant to change.
Intensity of Rivalry
Given the duopoly within the Turkish beer market, the intensity of the rivalry between will be a significant factor in determining industry profitability. The industry rivalry seems low. Since 2011, Türk Tuborg has raised prices on average by 8.4% per year while Anadolu has raised prices on average by 8.0% per year. Since 2008, Türk Tuborg has raised prices on average by 7.2% per year while Anadolu has raised prices on average by 7.1% per year. Price inflation has been during a period of increasing excise tax. If the intensity of the rivalry was high, both firms would not have increased prices in an attempt to gain market share given the importance of economies of scale in the industry.
The presence of economies of scale in the industry points to increased intensity of rivalry as one of the drivers of profitability is your size or market share leading competitors to attempt to maintain or increase their share to maintain profitability.
(Capex)/depreciation ratio is used to determine the amount of supply in the industry. If capex exceeds depreciation, industry participants are increasing supply. If supply increases outpace demand profitability will suffer. Currently, the Turkish beer industry volumes are not growing with total volume estimated at 9.67 million hectoliters since 2008. The lack of growth in and of itself typically increases rivalry but with the duopoly it is easier to keep track your one competitor making coordination easier. Despite the lack of growth, the industry capex/depreciation ratio has averaged 134%. A more appropriate capex/depreciation ratio for a no growth, mature industry is somewhere below 75% as less investment goes to the industry leading to depreciation exceeding capex. The capex/depreciation ratio may point to increased rivalry as competitors attempt to fill their new capacity.
The participants sell products that are similar but are differentiated in the form of taste and brand decreasing competitive rivalry as price is an important but not the sole factor in purchasing the good.
Anadolu net debt has ballooned from 0.8 times EBIT in 2011 to 6.1 times EBIT in 2015. The change in fortunes occurred when SAB Miller and Anadolu created an alliance with Anadolu acquiring some of SAB Miller’s assets in the region and SAB Miller taking a 26.5% stake in Anadolu. The increase geographical presence and increased debt decreases the Anadolu’s flexibility, but it may lead to an increase intensity of rivalry as Anadolu’s Turkish beer operations are not generating sufficient operating profit to cover interest expenses.
Türk Tuborg’s market share gains also can just after the launch of Türk Tuborg’s Brewmaster project. The increased product offerings may be striking a cord with customers that Anadolu is unable to replicate.
Overall, the intensity of rivalry in the industry is low and expected to remain low but this may change given Anadolu’s market share losses, profitability declines, and increasing debt load.
Bargaining Power of Suppliers
Suppliers have very little bargaining power. The main inputs into beer are commodity products sold by many sellers where the customers are pure price takers. This bargaining power is reduced further by the duopolistic nature of the market. Barley largest use is not beer but animal feed, which accounts for 67% of consumption. Industrial uses such as beer are the next largest consumer of barley accounting for 21% of total consumption. The variety of uses for barley increases the bargaining power of suppliers. Hops on the other hand are primarily used for beer. The United States is seeing high demand for hops due to the trend towards craft beer, as craft beer uses much more hops that traditional beer. Turkey is not seeing the trend toward craft beer therefore there is a lot less pressure. Hops have less uses and there is much fewer uses for the product decreasing its bargaining power. Overall, due to the commodity nature of inputs, the numerous suppliers of these products, the limited uses of the products, and the duopoly in the Turkish beer market suppliers have very little bargaining power.
Bargaining Power of Customers
The customers of Anadolu and Türk Tuborg are dealers, distributors and large retail chains. In 2012, off-premise accounted for 61.5% of sales in the Turkish Beer market, on-premise accounted for 23.2% of sales, and key accounts accounted for 15.2% of sales. Off-premise and on-premise are serviced by dealers and distributors. In 2014, Anadolu had a network of 170 dealers and 27 distributors in 15 sales regions. The number of dealers and distributors illustrated the fragmented nature of the customer base decreasing the bargaining power of customers.
Similar to bargaining power of suppliers, the duopoly and differentiated products decreases the bargaining power of customers combined with the fragmentation of the customer base leads to low bargaining power of customers.
Threat of Substitute
The main alcohol substitutes for beer are wine and spirits. In 2012, Beer accounted for 58% of alcohol consumption within Turkey, spirits accounted for 33% of alcohol consumption, and wine accounted for 9% of alcohol consumption. Beer is the cheapest of all alcohol at a cost of TRY11.26 per liter, wine is the next cheapest at TRY54.67 per liter, and spirits are the most expensive with raki costing TRY73.48 per liter. While wine and spirits are substitutes for beer, personal preferences are probably the biggest impediment to substitution. Additionally, the significantly higher cost of wine and spirits makes substitution unlikely.
As mentioned, volumes in the Turkish Beer market have stagnated at 9.66 million hectoliters since 2008. During this period, Türk Tuborg’s revenue increased by 23.69% per year driven by increased volumes (15.41% CAGR) and increased price (7.17% CAGR). Despite the lack of volume growth, Türk Tuborg’s volumes increase from 1.1 million hectoliters in 2008 to 3.0 million hectoliters in 2015 with growth coming at the expense of Anadolu’s volumes (8.5 mhl in 2008 to 6.6 mhl in 2015). Given the lack of volume growth in the market, growth from volume increases will eventually slow as Anadolu should retaliate in an attempt to win back volume share given the importance of economies of scale on profitability.
Türk Tuborg’s ASP (7.2% since 2008) increases are more sustainable given the duopoly in the Turkish Beer market and the relative cheapness of beer to substitutes.
Many often quote Turkey’s low per capital consumption of beer and alcohol as a potential source of growth. Turkey consumes beer at 17% of the EU average. This statistic is misleading as Turkey is predominantly Muslim and there are estimates between 40% and 80% of the population do not drink alcohol, which is unlikely to change. Assuming 75% of the population does not drink alcohol, the per capita consumption is 67% of the EU average for beer consumption. With a religion that forbids alcohol consumption playing a large role in the society, there is not going to be a significant growth from increased per capita consumption. Additionally, the current ruling party has a religious slant and has increasing excise tax and advertising restrictions in an attempt to “protect” the public from themselves.
There is a potential for increased penetration of beer companies’ distribution channel as there are only 1.1 off-premise outlets per 1,000 people well below regional peers.
In 2008, Israel Beer Breweries Ltd, a Carlsberg partner in Israel and Romania, purchased 95.69% stake from Carlsberg from USD44.5 million giving Türk Tuborg a total enterprise value of USD80 million. The company is owned by Central Bottling Company, which has held the Israel franchise for Coca Cola products since 1968.
Israel Beer Breweries has done a good job of increasing the intrinsic value of the company since acquiring its ownership position. Since 2008, revenues have increased by 23.69% per year as volumes increased by 15.41% per year and prices increased by 7.17% per year. The volume increases are particularly impressive given volumes have not grown in the Turkish Beer since 2008.
The company has significantly outperformed its main rival Anadolu. Since 2011, Türk Tuborg has taken almost 19% volume share, increasing its share from 12.5% to 31.4%. Over that period, the company’s ROIC increased from 1.1% to 95.2% while Anadolu’ Turkish Beer operation’s ROIC decreased from 76.5% to 29.3%, illustrating the importance of economies of scale on profitability.
Since 2008, Türk Tuborg’s ASP premium averaged 5.9%.
Türk Tuborg’s market share gains came during a period where the ASP premium declined.
It seems Türk Tuborg’s products are viewed as premium products by the public given the consistent ASP premium relative to Anadolu. With Türk Tuborg prices decreasing relative to Anadolu, consumers may see themselves getting a higher quality product at a more attractive price. The price premium returned in 2015, yet Türk Tuborg continued to gain market share, which seems to invalidate the theory of consumers purchasing due to the decrease in Türk Tuborg’s premium.
Over the review period, Türk Tuborg’s cost of goods per unit increased by 3.7% while Anadolu’ cost of goods sold increased by 14.3%. Anadolu’ Turkish Beer operations still produce goods cheaper than Türk Tuborg but there has been a significant convergence of costs. Anadolou producing goods cheaper makes sense given the presence of economies of scale in the industry allowing the company to obtain a discount for raw materials purchased in bulk and spread depreciation over a greater number of units.
Since 2011, Türk Tuborg has been able to decrease operating expenses per unit by 1.9% per year while Anadolu’ operating expenses have increased by 10.1% per year. Türk Tuborg is much more operational efficient with operating expenses per unit at TRY74.6 compared to Anadolu TRY93.4. In 2011 and 2008, Anadolu’ operating efficiency was well ahead of Türk Tuborg’s but declining volumes and cost inflation lead to the increase in operating expenses per unit increased.
Türk Tuborg’s operating efficiency is the key differentiator allowing the company to generate an operating profit per hectoliter that is 35% greater than Anadolu, not an insignificant gap.
Türk Tuborg also has a big advantage on capital efficiency in 2015 as working capital per unit is TRY-23.4 compared to TRY76.5 at Anadolu. Fixed assets are similar with Anadolu having a slight advantage as expected given the presence of economies of scale as larger breweries can spread fixed capital investments over a larger number of units. As the volume differential has shrunk, so has the difference in fixed capital efficiency.
Overall, Türk Tuborg’s ROIC is much higher than Anadolu in 2015 at 95.2% compared to 29.3%, a change from 2011 and 2008 where Anadolu’ ROIC averaged 82.4% compared to an average ROIC of -6.2% at Türk Tuborg in 2011 and 2008.
Overall, management has done well operationally increasing volumes, ASP, operating margins, capital efficiency, and ROIC.
The company has not allocated capital to anything but the business. There have been no dividends meaning net debt has decreased from TRY42 million to a net cash position of TRY313 million. Cash is starting to build up on the balance sheet at almost 2 times operating income so the company could start returning that cash to shareholders in the form of a dividend.
There are no corporate governance issues other than related party transactions at 5.8% of sales and 4.8% of assets but it is nothing too significant.
Given the existence of the barriers to entry, the best method of valuing Türk Tuborg is based on earnings. Our preferred valuation method is IRR, using the company’s current free cash flow yield plus expected growth. At the close of business on May 20, 2016, the company was trading on a current free cash flow yield of 5.4%. Given the pricing power in the industry the company can expect at least 5.0% increases in prices and if it can continue to grow volumes at 5.0% per year than it offers a 15.3% expected return.
Valuing the company using current EBIT yield plus and organic growth rate, the company is trading on an EBIT yield of 8.0% with pricing growth of 5.0% bring the current expected return to 13.0%. Given the strength of the barriers to entry within the industry, a 13.0-15.0% return using conservative estimates is very attractive.
Why is it Cheap
The stock is cheap due to economic and political issues within Turkey. It also has a very small free float and illiquid with an average trading volume of USD137,000 over the past six months.
Türk Tuborg has been gaining market share and outperforming Anadolu significantly. Anadolu Turkish beer operations have seen deteriorating profitability. The combination of market share gains and deterioration of profitability may lead to Anadolu increasing the intensity of rivalry to win back market share and profitability.
Turkey has one of the highest excise taxes on alcohol in Europe, which is 3.91 times the European average. This is making alcohol more expensive and suppressing demand in the country leading to the stagnation in volume since 2008. From 2002 to 2013, Turkish excise tax increased by 6.63% per year. Given the ruling party’s religious slant, it would not be a surprise to see a continuation of excise tax increases.
There are increasing restrictions on alcohol in Turkey. Retail alcohol sales licenses are limited between the hours of 10 am and 6 pm, as well as completely ban alcohol advertising and promotions of alcohol-related products. New licenses for the sale of alcohol are restricted. There is an ever increasing shift towards prohibition.
There is political risk in Turkey with it becoming more dictatorial. The increasing restrictions on freedom may bring a reaction.
A slowdown in macroeconomic growth or tourism is a short term risk.
Universal Health Initiation Report September 8, 2015
Below is a link to the Universal Health Initiation Report, formerly Company 9/8/2015, from September 8, 2015, along with the initial investment thesis.
Universal Health International Holding Group (Universal Health) is a Chinese pharmaceutical distributor and pharmacy operator. The company trades on an EBIT/EV yield of 24.0% despite above industry growth, in an industry growing at 20% per annum, and superior profitability with a four year average ROIC of 43%.
Universal Health is best in class among Chinese pharmaceutical distributors and pharmacy operators in terms of growth, profitability (ROIC), and acquisitions, a key activity in the consolidating pharmaceutical distribution and retail market. The company has a number of unique, complimentary activities strengthening its competitive position ensuring profitability can be sustainable. The company has high quality management with significant share ownership, no significant corporate governance issues, and a net cash position equal to 37% of the company’s market cap and 2.41 times trailing twelve month (ttm) operating profit.
The market is pricing in no growth and a reversion from a 2014 ROIC of 39% to the cost of capital within ten years creating little downside but tremendous upside if the company can maintain its profitability and continue to grow at 20% per for the next five years.