Category Archives: Corporate Governance

Miko International and Honworld Position Size July 30, 2016

Miko International and Honworld Position Size July 30, 2016


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


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


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


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


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


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


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


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


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


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


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



Honworld 2015 Annual Report Review June 29, 2016

Honworld 2015 Annual Report Review June 29, 2016

Honworld Annual Report Review 2015 June 29 2016 RCR

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.

Honworld Raw Material costs


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.

Honworld product characteristics by product range


  • 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.

ASP by product


Honworld’s volume sold and base wine used is shown in the table below.

Volume Sold


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.

Key Inventory Statistics


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.

Base wine breakdown



Capital Allocation


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.

Inventory buffer for price increases


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.

Raw material price increases vs current ROIC


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.

Base whine characteristics by product with potential scenarios


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 ageing


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:


  • ASP
  • 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.

Top 5 cooking wine producers in china


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.

Honworld Share Sale June 3, 2016

Honworld Share Sale June 3, 2016


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


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


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


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


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


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

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?


On May 9, 2016, Universal Health agreed to purchase 36.38% of Jilin Wenhui Capsules Limited for RMB270.3 million placing an enterprise value on Jilin Wenhui of RMB743.0 million.  The company is a new high-tech enterprise that conducts research and development, manufactures, and sells hollow capsules, and is a leading capsule manufacturing enterprise in terms of scale in northeastern China. Jilin Wenhui Capsules current annual output of medical hollow capsule was approximately 15.0 billion, with plant capsule capacity of approximately 6.0 billion and plant gelatin (modified starch) capacity of approximately 5,000 tonnes. To complete the transaction, Universal Health issued 400,000 shares at a price of HKD0.725.


In 2015, Jilin Wenhui had a net asset value of RMB26 million, profit before tax of RMB6.99 million, and profit after tax of RMB5.34 million.  Universal Health purchased price places a valuation on Jilin Wenhui at 28.4 times book value and 139.1 times earnings.  These are astronomical figures in the absence of further information to analyze Jilin Wenhui. It seems the company is just throwing money away and paying anything to main growth something that is often seen with serial acquirers.  Universal Health is all over the place with its capital allocation.  We will be exiting our position in Universal Health as soon as possible.


While it is unfortunate we made mistakes on Universal Health and Miko International, the best teacher is pain and these mistakes will strengthen our investment process. There are a number of lessons that we have taken from the Universal Health and Miko International mistakes.


  1. Entry positions should be less aggressive allowing us to gain a better understanding of the company over time. This strategy would have prevented the gains we saw in PC Jeweller but downside protection is just as important if not more important than upside potential.   Less aggressive position sizes also pay respect to our ignorance and the limits of our knowledge.  We still believe in concentrated portfolios but small cap investing particularly in Emerging Markets bring additional risks and additional diversification is needed.  We still believe in concentrated portfolios 20-30 companies but oversized positions that investors can take in larger, well established companies may not be as prudent in smaller companies.
  2. We need to put more emphasis on why a stock is cheap. If it has tremendous operating history and good current earnings yet is extremely cheap, it may be a value trap, particularly in China.
  3. Focus needs to be on companies with long history of operations and being publicly traded. Both Miko International and Universal Health IPO’d over the past few years and they had not been operating for decades.
  4. Capital allocation is crucial and missteps should be viewed with extreme caution. Miko International issued shares at extremely cheap valuations with significant net cash balance.  A major red flag, which we overlooked.
  5. Along these lines, while strong financial health is crucial to any investment case, very large net cash positions is a potential sign of poor capital allocation at best and fraud at worst.
  6. When management starts selling your should probably start selling too as they have much more information about the company than you.
  7. Stay away from serial acquirers particularly in industries where there is n strategic logic for acquisitions.
  8. Chinese companies seem to be a different breed where financial statements cannot always be trusted. As outside investors, the primary evidence is financial statements of the company and competitors.  We look for additional evidence from independent sources to corroborate financial statements but it is not always there.  If financial statements cannot be trusted, you cannot invest.  Given the risk, we will be requiring additional evidence with Chinese companies and holding them at lower weights.

Peak Sport Products Position Size May 7, 2016

Peak Sport Products Position Size May 7, 2016


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

Peak Sport and Universal Health Position Sizes May 3 2016

Peak Sport Products and Universal Health Position Sizes May 3 2016

We have reduced our position in Peak Sport Products by USD4.64 million slightly above our target sales of USD4.5 million at an average sale of HKD2.1098 or inital blended cost on Peak Sport positions is HKD2.0826 so we are able to reduce our positions without a loss.   We are reducing our position size by a further USD3.0 million.  The company reported weaker than expected operational data in China, and after the Miko International fiasco, the share issuance in June 2015 with a significant amount of net cash on the balance sheet raises concerns about the cash.  Given we view Peak Sport as a deep value position, a 2.0% position size is a more appropriate given the concerns over management credibility and slowing growth.


Universal Health is another Hong Kong listed Chinese company that we described as Company 9/18/15 in the past. This is another deep value holding where we put too much faith in financial statements.  Management pledged shares without notifying the stock exchange and subsequently were forced sellers causing the share price to fall by just under 60% on one day. The company also sold 20% of the company to a financial buyer who subsequently sold almost half its position the following.  It seems as if the shares were pledged to the financial buyer who promptly sold the shares. The company followed this by reporting poor 2015 results.  Loss aversion stopped us from selling earlier.  It probably is the culprit in why we held Miko as long as we did.  We are decreasing our position size in Universal Health by USD2.0 million to roughly a 2.0% position size.


ACE Hardware Indonesia April 19, 2016


ACE Hardware Indonesia (ACES:JKT)                     April 19, 2016

ACE Hardware Indonesia April 19 2016



Investment Thesis


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.



Key Statistics

Key Stats April 19 2016




Company Description


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.



Shareholder Structure


Shareholder Structure April 19 2016

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.

PT Kawan Lama Structure April 19 2016



Corporate Governance


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.

Related Party Transactions April 19, 2016


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.

 Audit Committee April 19 2016


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.

Internal Audit Committee April 19 2016


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.



Competitive Position


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.




 Valuation Key Stats April 19 2016


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.