Hung Fook Tong is a traditional Chinese Herbal Food and Beverage company with a modern flair. The company has a leading position in the Hong Kong market with the leading shop count and a market share twice the closest competitor allowing the company to price its products 20-40% cheaper than the industry average and still generate a Return on Assets of 20%. The company has a strong growth outlook with its markets expected to growth between 7% and 20% through 2017. The major problem is the company has poor capital allocation, poor corporate governance and is fully valued.
The company plans to expand its Chinese Retail operations, which seem to be competitively disadvantaged and has not generated a profit in seven years. The company also participates in all parts of its value chain from PET bottle production to internal food production. These activities are commoditized and at best, the company will generate an ROIC equivalent to its cost of capital. The company is also very aggressive with the recent capacity expansion bringing total capacity to 2.5 to 5 times current production depending on the current product. Hung Fook Tong may never use some of the recently built capacity.
The company continues to make loans to Directors and Directors and Senior Management salaries are 18% of Operating Income. All create concerns that the owners see the company as a family asset and a piggy bank rather than a modern corporation.
Finally, the company just successfully IPO’d. The IPO was 364 time oversubscribed. The company now trades at a Operating Profit yield of 6% (EV/Operating Profit 16.56 times). If management aggressive expansion plans are a success, there is little if any upside to the current stock price.
II. FOUR KEYS TO EVALUATING A BUSINESS
1. The certainty with which the long-term economic characteristics of the business can be evaluated.
Hung Fook Tong’s Hong Kong Retail operations seems to generate very strong consistent profitability as the company is the market share is twice its closest competitor, it has the largest distribution network and it was one of the pioneers of the industry. These signs all point to a stable, above the cost of capital ROIC based on brand and cost advantages. The company can consistently generate 20% Return on Assets in this business.
The company’s wholesale business generates consistent margins and ROIC consistent with the company’s cost of capital. Wholesale is a growing business, particularly in China where the company is just starting to exploit the distribution channel.
The company’s Chinese Retail operations seem to be competitively disadvantaged due to strong regional brands and distribution networks at competitors. This disadvantage seems to destined the unit for continued loss particularly when management has misdiagnosed the problem as a scale issue rather than a poor sales issue. Recent production capacity increases may signal management’s intent to stick with the business and potentially increase losses. The assessment of the company being disadvantaged may also be wrong and management may figure out the key to success in China. Seven years of losses points to a competitively disadvantaged business.
2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
The evaluation of management is where Hung Fook Tong fails. Seven years of losses in China, a misdiagnosis of the true problem causing the losses and using the same competitive assumptions in Chinese Retail, where the company is the entrant as Hong Kong Retail, where the company is the incumbent are all signs of management’s inability to realize the full potential of the business.
Management are also poor capital allocators with continued expansion in Chinese Retail as well as a desire to occupy each part of the value chain from PET bottle production, to food production to land ownership. It seems if the company has an opportunity to bring a part of the value chain in-house it will regardless of the potential returns in the activity.
3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.
Hung Fook Tong’s loans to directors are consistently increasing reaching 60% of operating income in 2013. Management salaries in 2013 were 18% of operating income and averaged 32% of operating income over the past three years. There are unclear instances in the past where minority shareholders were potentially disadvantaged for the benefit of management. Evidence points to management seeing the business as a family piggy bank rather than a partnership with minority shareholders.
4. The purchase price of the business
Post Hung Fook Tong’s 364 times oversubscribed IPO, current market expectations fully price in management’s expansion plans with little room for disappointment with a current Operating Profit yield of 6% (EV/Operating Profit of 16.56 times).
Zensar released its FQ1 2015 results today. As a reminder, the Zensar investment thesis is primarily a valuation story. The company is a competitor in an attractive industry allowing it to generate economic profits while not dominating its industry. Zensar’s differentiates itself through strong employee and customer relations. The CEO is known to be available every day of the week for employees and customers. At the current share price, Zensar offers a 20.43% operating income/EV yield.
Assuming no growth, mid-cycle margins and historical investment requirement rates, Zensar’s current share price offers no upside.
The first upside driver of the company’s intrinsic value is continued growth.
Given Zensar’s above cost of capital ROIC (5-year average ROIC = 25%), growth increases the company’s value. Zensar’s quarterly number reiterates that the company is growing. The top line grew by 14.7% and operating profit grew by 12.2% as operating margins contracted by 27bps. The chart below illustrates the quarterly YoY growth rates. 2012 growth rates were high as the company acquired Akibia and the numbers were inflated. As the company rationalized the acquisition, growth slowed with operating leverage profits slowed at a faster pace.
The business unit driving sales growth is Zensar’s Application Management division, which saw 19.6% year. IMS saw top line growth of 7.5% while Product & License revenues declined by 5.7% in June 2014.
Management’s longer-term target is $1 billion in revenues by the end of FY2018. Management expects mid-double digit organic top line growth over the next few years.
Management target revenue split by FY2016 is 70% Application Management Services and 30% Infrastructure Management Services. Within Infrastructure Management Services, 70% of revenues are non-product margins and 30% are product and licensing revenues. This distinction is important due to the difference in operating margins. The company is right at its FY2016 as far as revenue breakdown.
Zensar’s management tends to be optimistic on its forecasts. Despite management’s optimism, the market is pricing in no growth so there seems to be a margin of safety. For Residual Income and DCF models, a 5-year forecast period and a 5-year fade to terminal growth is used allowing for changes in competitive environments and growth rates. The sensitivity table below illustrates Zensar’s target price sensitivity to changes in the forecast period sales growth and terminal growth.
For every percent increase in forecast sales period growth, the target price increase by 2-3% and for every percent increase in terminal sales growth, the target price increases between 3.6-6.7%. If management is able to hit the bottom end of its target and achieve a 5% terminal growth rate, the company’s FY2015 target price is Rs830 representing almost 90% upside.
The second intrinsic value driver upside is operating margin expansion.
Zensar’s FY2014 operating margin came is at 13.7%. FQ1 2015 operating margin came in at 11.9%, 27 basis points (bps) lower than the FQ1 2014 operating margin.
Similar to revenues, Application Management is the key driver of overall margins. In June 2014, it accounted for 93% of overall operating profit.
Application Management’s operating margins increased by 75 bps over the past year. Since the current business segment reporting started, Application Management trailing twelve-month (TTM) operating margins averaged 17.36%, with an average quarterly operating margin expansion of 23bps. Given the seasonality of the business, TTM operating margins eliminate seasonality and provide a better picture of margin stability.
Infrastructure Management and Product operating margins continue to disappoint with margins falling by 600bps and 400bps relative to June 2013. While Application Management Operating Margins reached new highs in FQ1 2015, Infrastructure Management and Product margins reached new lows.
Zensar’s management is expecting overall operating margins to improve to the 15% region by FY2016. Application Management Services’ operating margin should continue to increase as Zensar’s deal size continues to increase.
Management expects Infrastructure Management Services’ operating margin will reach 12-12.5% by FY2016 and Product’s operating margin will increase to 5-6% leading to a non-Application Management operating margin around 10%.
The table below illustrates various operating margin scenarios at no growth with the Intrinsic Value per share and the upside from the current price to the Intrinsic Value. The operating margins were plugged in an EVA Residual Income and a DCF model into perpetuity.
In a no growth scenario, assuming Application Management’s operating margin is in line with historical averages and no profitability from either the Infrastructure Management or the Product division, Zensar’s intrinsic value is 2.6% lower than the current price.
Assuming Management’s operating margin targets are hit, there is almost 30% upside. The company’s target price is much more sensitive to growth rates than operating margins.
Using the base case assumption illustrated below, the company’s FY2015 intrinsic value per share is 83% above the company’s current share price.
The top line growth rate assumption of low double digits rather than the current mid-teens seems conservative. The assumption of current margins rather than higher margins as management may improve weak divisions, the existence of growth and operating leverage, and Application Management growing importance as a percentage of revenue will contribute a greater portion of operating profit meaning overall corporate margins will converge with Application management margins.
Zensar’s intrinsic value is growing at a double digit pace, yet the current share price offers a 20% operating income yield providing a significant margin of safety.