ACE Hardware Indonesia (ACES:JKT) April 19, 2016
ACE Hardware Indonesia (ACES) is the leading home improvement and lifestyle products retailer in Indonesia under the ACE Hardware brand. The company is also a leading toy retailer in Indonesia under the Toys Kingdom brand. The company’s stellar profitability and growth attracted us to the company. Unfortunately, the company’s poor corporate governance and lack of concern for minority shareholders eliminates ACES as a potential investment.
ACE Hardware Indonesia (ACES) is Indonesia’s leading home improvement and lifestyle retailer and a leading toy retail in Indonesia under the Toys Kingdom brand. ACES was established in 1995 as a subsidiary company of PT. Kawan Lama Sejahtera. ACES is the master franchise/license holder of ACE Hardware brand in the country.
The first ACE Hardware Indonesia store opened in Supermal Karawaci, Tangerang, in 1995. At the end of 2014, ACES had 110 ACE Hardware stores covering 289,000 square meters. ACES is striving to be the Pioneer of “Do-It-Yourself” concept, which means providing not just products, but also the required knowledge on how to install, use, and maintain them properly. The company’s staff is always will to train customers.
In addition, ACES also holds 60% of Toys Kingdom with the other 40% is held by ACES parent company PT. Kawan Lama Sejahtera. At the end of 2014, Toys Kingdom 24 stores covering 23,900 square meters. The first store of Toys Kingdom was opened on June 4th, 2010. Like ACES in home improvement and lifestyle products, Toys Kingdom is a pioneer in the Indonesian retail toys industry. Toys Kingdom offers a range of global branded toys to customers. All products, facilities and quality service make Toys Kingdom as a family destination to get numerous products for toys of well-known brands that are available exclusively in each of the stores.
At the end of 2015, home improvement and lifestyle products accounted for 95.5% of revenue and 97.0% of assets. At the end of 2014, the average ACE Hardware store was 2,627 sqm with revenue per sqm of IDR15.13 million and assets per sqm of IDR4.35 million. Toys Kingdom average store size was 996 sqm with revenue per sqm of IDR4.98 million and assets per sqm of IDR1.60 million.
The company’s shareholder structure is illustrated above. PT Kawan Lama Sejahtera owns 59.9703% of ACE Hardware and the public owns 40.0292%. Kawan Lama Sejahtera also owns 40% of Toys Kingdom while ACE Hardware owns the other 60%. PT Kawan Lama Sejahtera was founded in 1955 and is based in Jakarta, Indonesia with a branch office in Surabaya, Indonesia. The Kawan Lama group is a conglomerate with many different businesses but started as a commercial and industrial supply company that provides tools, industrial equipment, and machinery in Indonesia.
The first thing assessed when analyzing a company is the integrity of management. Can management be trusted to treat minority shareholders equally or will all value of a good or bad business be extracted by management or majority shareholders. The easiest thing to assess the strength of a company’s corporate governance is related party transactions. While related party transactions may be arm’s length transactions, it is difficult to judge and the company may take advantage of minority shareholders with these transactions to extract value or to mask the true economics of the business. We would prefer to see no or an insignificant amount of related party transactions. Unfortunately, ACES is on the other end of the spectrum with a significant amount of related party transactions.
Since 2011, the sum of all related party transactions averaged 13.7% of sales, 83.2% of operating income, and 21.7% of assets. Over the same period, purchasing from related parties as a % of cost of goods sold has averaged 15.7%. The level of related parties is among the highest we have seen.
Other evidence of potential corporate governance issues is Kawan Lama’s 40% ownership of Toy Kingdom. Despite holding 60% of ACES and therefore 60% of Toy Kingdom, Kawan Lama needed an additional 40% of Toys Kingdom. The company purchased the 40% of Toys Kingdom for roughly IDR240 million or USD18,249 on December 29, 2010. The transaction to purchase 40% placed Toys Kingdom Enterprise Value at roughly IDR600 million or USD45,622. In 2010, Toys Kingdom revenue was IDR17,188 million, gross profit was IDR6,572 million, and assets were IDR9,970 meaning the company purchased 40% of a subsidiary from itself and minority shareholder at a valuation equal to 3.5% of sales, 9.1% of gross profit, and 6.0% of assets. Purchasing 40% of a company that generates a gross profit return on assets of 66% at a trailing twelve month valuation of 0.09 times gross profit is a good investment and abuses of the company’s position as a majority shareholder. The abuse of minority shareholders in the Toys Kingdom transaction increases the concern that the related party transactions are not arm’s length transactions.
The company’s audit committee has three members including an independent member of the board of commissioners with no accounting experience (Teddy Setiawan), a 28 year old with 7-8 years experience in accounting (Iskandar Baha), and a 34 year old with 9 years experience as an accountant primarily at ACES (Ngakan Putu Adhiriana). Clearly, the audit committee does not have the experience required to be effective.
The internal audit committee has far more experience with the lead member of the Internal Audit team having 23 years of accounting experience (Petrus Rudy Prakoso), another member with 21 years accounting experience (Irawaty), and the other member has 12 years accounting experience (Ramli Phoa). The experience level of the Internal Audit team is far more acceptable.
As illustrated by collective accounting experience (Audit committee = 17 years vs. Internal Audit = 57 years), ACES places more importance on the Internal Audit team and internal numbers, while Audit Committee for investors seems to have very little importance.
Management are also not owner operators but agents owning little or no shares meaning they are dependent on a salary and will likely not stand up for minority shareholders over the parent company as they risk losing their position in the company and hurting their career.
Overall corporate governance is very poor as illustrated by the number of related party transactions and the Toys Kingdom transaction. Until corporate governance, ACES is eliminated as a potential investment and requires no additional analysis.
We will have a quick look at the company’s competitive position in case corporate governance improves (and for intellectual curiosity) but as of now corporate governance issues rule the company out as an investment.
There is a lot of evidence pointing to ACES having a competitive advantage. First, the company consistently generates a very strong return on invested capital. Since 2011, the company has generated ROIC of 34% based on as reported data. After capitalizing operating leases, the company’s ROIC has averaged 15% providing less evidence of a competitive advantage. The company’s ROIC comes with very little variance as reported ROIC’s standard deviation is 0.082, while ROIC after capitalizing operating leases’ coefficient of variation is 0.063.
The market structure of the Indonesian home improvement and lifestyle products market is difficult to find. Typically, an oligopolistic market structure with little change in market share and few entries into the industry point to barriers to entry.
ACES also exhibited pricing power. In 2006, the company’s gross margin was 34.0%. In 2015, the company’s gross margin increased by 12.8% to 46.8%. ACES gross margin peaked in 2013 at 49.0% and has since decreased to 46.8% potentially signaling a waning of pricing power as the market develops, competition increases. It could also be just the slowing economic growth has increased the discounts required to get customers in the shop or increase competition in a slowing market.
Evidence points to either a competitive advantage or strong returns in a growing market with unsophisticated customers where supply is having difficult time catching up with demand leading to a temporary decrease in competitive rivalry.
If a competitive advantage does exist what is ACES competitive advantage? There are two ways retailers can generate a sustainable competitive advantage by offering unique products or low price. It is very difficult to maintain unique products as producers of those products naturally want to put their products in as many locations as possible or wanted products get replicated. The other way to generate a unique product other have a unique tangible product that others cannot supply is by creating a brand. Very few retailers have created a sustainable brand that does not take advantage of short lived fashion trends. A brand is nothing more than a promise to deliver a certain experience. Within retail there are very few brands for a number of reasons. First, many retailers are selling branded products therefore the customer gets the promise and the trust they need from the product rather than the retailer eliminating any chance for a retailer to build a brand with pricing power. An example is branded food products in grocery stores. Second, the product the retailer sells are search goods meaning the consumer can determine the features, characteristics, and quality before purchase. It is much more difficult to build a brand in search goods as customers can see the all the necessary criteria for a purchase decision. It can be done if the product provides status or is aspirational such as Tiffany’s or sells a good that requires trust (grocery store selling produce).
Given the difficulty in a retailer building a brand, it is highly unlikely that ACES has a brand. The company is highly unlikely to have a cost advantage as it has no unique technology that competitors cannot get a hold of. If the company has a competitive advantage, it is derived from economies of scale in purchasing and distribution as it is the largest home improvement and lifestyles company in Indonesia. The inability to create a brand causes economies of scales in advertising not to accrue into brand value. Given the weak corporate governance at the company and the amount of related party transactions, the value from economies of scale from purchasing may not be extracted but held at related companies. Unfortunately, the lack of information on the industry’s market structure, to determine the company’s relative size advantage, and weak corporate governance means an assumption of no competitive advantage must be made.
Few retailers have been successful in building a sustainable competitive advantage. Companies such as Home Depot, Lowes, Wal-Mart, Costco and Tiffany’s have created sustainable competitive advantages but given the number of retailers, it is a low probability event. More likely companies are able to grow rapidly by increasing the number of locations leading to an increasing intrinsic value. Profitability can be strong particularly in newer segments, such as home improvement, lifestyle products, and toys in Indonesia as customers are not sophisticated allowing retailers to extract more value due to the customers’ lack of knowledge in the segment, there is little competition, and demand outpaces supply. Eventually, the industry matures, customers grow more sophisticated better understanding the offerings of each competitor, competition increases, and best practices and products are copied leading to a convergence of offerings meaning customer shop more on price.
The market values ACES at a FCF yield of 3.8% with same store sales growth and store opening slowing 10% growth rate seems appropriate leading to an expected return of 13.8%. These are very high multiples for a company with corporate governance issues and a questionable competitive advantage. If corporate governance was not an issue, we would have taken a deeper look at valuations.