Monthly Archives: July 2015

Honworld Questions July 24, 2015

Honworld Questions July 24, 2015

A reader asked a number of questions about Honworld.  The majority did not provide any new insights above my report but a few questions and answers are below.

 

  • What is your view on management’s strategy to build up significant inventory at the moment?

 

Inventory build is a major flaw in Honworld’s strategy and the one real concern with management and the investment thesis. The company finished 2014 with 158 million liters of base wine equal to roughly two years our estimates of sales volume. The company is targeting 225 million liters of inventory at the end of 2015.

 

Assuming one year of inventory is sufficient for continuing operations, the company should generate ROIC close to 30% and significant cash flow that could be reinvested in fixed costs to strengthen its competitive position or returned to shareholders.  At three years inventory the company generates no excess profits.

 

The company mentions it is building inventory to buffer against raw material costs, which makes little sense as the company is essentially taking a view on commodity prices. Very few people are able to make a macroeconomic assessment and be accurate.   It is unlikely there will be shortages of raw materials as the company’s raw materials are pure commodities that are readily available from many sellers. Prices may increase but that would only be a temporary factor as commodity producers would be incentivized to bring on new supply and within a year or two any supply issues would be solved. The company’s pricing power would allow it to pass on any raw material price increases to customers.

 

If the company believes it can generate a higher gross margin on premium products using aged base wine, at two years of base wine inventory, the lower capital efficiency associated with the higher asset level requires operating margin to increase from the current 40% to 75% to compensate for the lower turnover levels, which will be very difficult to do given only the gross margins on premium products are anywhere near that level.

 

 

  • I spoke with a few of my Chinese friends – they indicated that local brands predominate in the regional markets. Price is not an issue – it seems to be more a brand awareness exercise. What gives you confidence that Honworld will be able to successfully penetrate other markets?

 

I would agree in the regional nature of the market as tastes are still regional in nature.  Honworld is clearly a regional company with 88% of sales at the date of the IPO prospectus from its key regions of Zhejiang Province, Shanghai, Guangdong Province, Liaoning Province, Shandong Province, and Beijing.

 

With Honworld currently valued at 8.1 times EV/EBIT and 1.5 times EV/IC, we feel there is a significant margin of safety if Honworld remains a regional company that can continue to grow and consolidate its leadership position within its current markets, so no confidence is needed in a transformation of markets from regional to national.  If the transformation takes place, there will be even greater upside from longer term growth.

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out. This has happened in many develop markets including the US. The increasing convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.  This consolidation has occurred throughout many industries as the life cycle matures.  Below are two good articles on the topic of consolidation.

 

 

The significant fixed costs in the form of advertising and distribution allows a brand to be built buy the larger competitors as more customers can be reached and educated. A brand is particularly important in an industry with a low priced product as the brand decreases search costs for customers leading to potential habit forming behavior. For example in the US, customers have acquired a taste for Heinz Ketchup.  When a customer goes to the store given Heinz may cost as little $2.50 a bottle and the Heinz brand represent a known and liked product that customer is not going to spend anytime even thinking about another brand given very little benefit.

In addition, retailers only have so much shelf space and are unlikely to place 15 to 20 different cooking wines on the shelf as a good number of the 15 or 20 cooking wines will not sell leading to waste shelf space.  The biggest players have a tremendous advantage as retailers now they will sell.

 

The tables below show the market structure of the five largest condiment markets in the US.

 

US condiments market structure

 

The US condiment industry is a great example of industry consolidation in a more developed market and a good roadmap for the Chinese Cooking Wine industry. The lowest concentration ratio among the largest five US condiment markets is the Hot Sauce market with a 52.2% four firm concentration ratio, while the highest is Ketchup with a 78.6% three firm concentration ratio. The four firm concentration ratio in the Chinese Cooking Wine segment is only 26.8% so there is potential for significant consolidation. The low four firm concentration ratio reiterates the fragmented regional nature of the market.

 

 

Honworld Position Size July 24, 2015

Honworld Position Size July 24, 2015

 

We have reached a 7.4% position in Honworld close to our initial desired position size of 7.5%.  Over 34 trading days, we purchased 14.156 million shares equating to $9.07 million at an average purchase price of HKD4.97 per share.  We got very fortunate with the correction in stock prices pulling our average purchase price well below our recommendation price.   With that said, we will continue to increase our position size to 10% as Honworld seems very cheap. The market is valuing an industry leader with a potential for a strong multi-faceted (cost $ demand) competitive advantage that is growing at a double digit pace with pricing power and a very passionate owner operator running the company on an EV/EBIT of 8.4 times.   This is a company that has the potential to be a true compounder with the only problem being managements desire to build inventory.

 

Our Model Portfolio is a better performance benchmark as it accounts for low liquidity of our recommendations. It also accounts for increased conviction in the form of additional purchases such as the Peak position size increase.  We never purchase more than a third of the market at prices worse than VWAP.

Peak Sport Products Position Size Increase Completed July 9, 2015

Peak Sport Products Position Size Increase Completed

July 9, 2015

 

We completed the increase in position size for Peak Sport Products. We nearly doubled our position size by purchasing 31,463,333 shares at an average price of HKD1.62 per share. The reasons for increasing the position size remain.

The company has a very strong niche position being the largest basketball sportswear player in China for the last six years, is very profitable with a return on invested capital of 32% in 2014, should grow between 5-10% for the near future, and is valued at 84% of the company’s liquidation value (NCAV). The company issuing shares at a very cheap valuation hurts the assessment of the quality of management but it seems to be only a misjudgment. There are no other corporate governance issues and it is a first offence therefore can be overlooked given the company trading at 84% NCAV or EV/EBIT of 2.28 times.

Peak Sport Products Position Size Increase July 6, 2015

Peak Sport Products Position Size Increase July 6, 2015

Since the company’s share issuance announcement on June 23, 2015, Peak’s share price has fallen by 44% and fell by almost 12% today. The company now trades below its liquidation value, at 80% of its net current asset value, and on an EV/EBIT of 0.7 times. The recent share issuance announcement significantly alters the assessment of Peak’s management, but the company now seems to be very cheap considering it should grow between 5-10% and generates an ROIC above 20%. We will increase our position in Peak Sport Products by 5.0%.

PC Jeweller Position Size July 3, 2015

PC Jeweller Position Size July 3, 2015

We have completed the position adjustment of PC Jeweller. We sold 1,037,176 shares at an average price of Rs392.11. Having sold 82% of our original position, the company now accounts for 6.1% of the portfolio.  We are very happy with the company’s continued execution, capital allocation, growth outlook, and reasonable valuations. We will most likely maintain the current position for some time.

Miko International Update July 3, 2015

Miko International Post July 3, 2015

 

Miko International made two interesting announcements on June 25, 2015. The company announced it would be issuing 85 million new shares receiving approximately HKD86.7 million. It also stated the main shareholder sold 75 million shares at an average cost of HKD1.03.

 

The company announcing the placement of 85 million new shares, similar to Peak Sport Products, is an extremely poor capital allocation decision because of the company’s net cash position and the price of the transaction.

 

The company has a significant amount of net cash on the balance sheet with HKD562 million at the end of 2014, roughly 2.7 times operating profit. The company recently acquired 51 stores from a distributor for HKD89.4 million. The placement shares just about covers the transaction so the company will still have a significant amount of cash on the balance sheet.

 

The company sold the shares at HKD1.03 per share translating to roughly liquidation value (NCAV), EV/IC of 0.56, a PE of 5.44, and an EV/EBIT of 1.25. This seems to be extremely cheap for a company with a ROIC of 33% and is growing at 20% per year.

 

Both Peak Sport and Miko operations are in China and the owners are Chinese. The recent volatility in the Chinese stock market and news surrounding it may have lead the owners to feel the stock market bubble is popping and financial markets will be closed for a few years. Rather than leveraging up their family business, they made sure there was a sufficient cash pile for years to come or they just got bad advice and listened. Investment bankers are paid to influence company management into making poor decisions with their and shareholders’ money. With regard to financing decision, the level of sophistication of investment bankers can present usually far outweighs a business owner with little financial experience. The ability to be influenced illustrates a lack of discipline and sophistication hurting the assessment of the management team.

 

In addition to the share placement, the CEO and founder sold 75 million shares or 9.1% of the company decreasing his ownership from 38.7% pre-placement to 26.9% post-placement and sale.

 

Shareholder Structure Pre and post placement and sale June 25 2015

 

This is Mr. Ding’s first sale post-IPO. Mr. Ding did not sell at the IPO and has not cashed in on his newly created wealth. The timing of the sale, on the same day as the placement of shares by the company, may point to a view from management that the stock market crash may be coming and the financial markets may be closed.

 

The share sale does not necessarily mean the owner foresees operational weakness in the company. Founder’s and CEOs have the right to diversify their holdings.  Mr. Ding built a business and created substantial wealth for himself and his family. He is still maintaining a very large shareholding in the company, which should keep his incentives aligned with minority shareholders.

 

In addition to Mr. Ding’s sale, insiders have been selling a significant amount of shares since the IPO. The table below illustrates Miko’s ownership post-IPO and post-recent share sale and placement.

 

Shareholder Structure post IPO and placement and sale June 25 2015

 

Including the recent placement, insiders and the company have sold over 350 million shares equaling 27.4% of the total volume in the shares. This is a huge supply of shares depressing the market.

 

Do the share sales from insiders put us on the wrong side of the trade? Perhaps, but it is not necessarily the case.

 

Shareholder Structure H1 2014 and end 2014

 

If insider sales pointed to operational weakness then the insiders would not have been large sellers in the second half of 2014 when the company grew its top line by 18% and operating income by 9.1%. The continued strength of the top line points to continued growth in the market, while the decelerating growth in operating profit may point to weakness. Although, 2011 saw operating profit grow by only 1.1% before growing by 48.6% in 2012 and 45.3% in 2013.

 

Valuation provides support for against potential operational weakness.

 

The only way the company is not undervalued is if it is a fraud and the numbers are not real. What are the potential indicators of a short sale which a stock fraud in included in. Answers to the question are listed next to the question in italics.

 

  1. Reverse merger rather than IPO leading to no transparency and disclosure = No, recent IPO
  2. Executives leaving = No
  3. Insider selling = Yes
  4. Low insider ownership = nothing to lose = No
  5. High price to sales = No
  6. Deteriorating fundamentals = No
  7. Poor capital discipline = No
  8. High leverage = No
  9. No dividends or share buyback = No
  10. No free cash flow = No
  11. Overly promotional management = No
  12. Auditor (Not big 5 and high turnover) = No, KPMG since IPO
  13. CFO not right experience and high turnover = No
  14. Unnecessary equity dilution = monetization of fraud = Yes
  15. Poor corporate governance = No
  16. Management tied to past fraud = No

 

There has been no management turnover nor has there any previous ties to fraudulent companies. The CFO also has sufficient experience for the role. Although there were some red flags such as unnecessary equity dilution and insider selling, there are no other signs pointing to fraud. In the case of unnecessary equity dilution, over conservatism and poor decision-making are to blame. In the case of insider selling, it is probably the first significant amount of wealth by management and they are just transferring it from shares to cash at a time when their home country stock market is seeing a significant pull back that is all over the news.

 

The recent IPO, which comes with extensive due diligence, the Frost & Sullivan report validating Miko’s position in the industry, the high insider ownership, and the general good corporate governance all point to Miko not being a fraud.

 

 

Management Bios

 

Mr. Ding Peiji, aged 44, is the founder, CEO, and Chairman of the Board of Miko. He was appointed as an executive Director on 15 March 2013. He is also the Chairman of Board of directors of Red Kids (China) Co., Ltd. (“Red Kids China”), a principal operating subsidiary. Mr. Ding has over 14 years of experience in the apparel and retail industry and is primarily responsible for overall corporate strategies, planning, and business development.

 

His social undertakings include the vice Chairman for the second term of the Children’s Wear Expert Committee of China National Garment Association appointed in September 2009, the vice president for the first and second term of the Quanzhou Textile & Garments Commerce Chamber appointed in May 2002 and November 2008, respectively, a standing council member for the first term of the Federation of Industry & Commerce of Quanzhou Qingmeng Scientific & Technological Industrial Zone appointed in August 2002, and a Supervisor of Qingmeng Scientific & Technological Industrial Zone for Honest and Efficient Governance appointed in July 2002. He completed the Advanced Management Programme by China Europe International Business School in 2010.

 

Mr. Ding is the brother of each of Mr. Ding Peiyuan and Ms. Ding Lizhen, both of whom are executive Directors.

 

Mr. Ding seems to be held in esteem in the industry. He was the vice Chairman of the Children’s Wear Expert Committee of China National Garment Association, he was also vice President of the Quanzhou Textile & Garment Commerce Chamber, he was a Supervisor of Qingmeng Scientific & Technological Industrial Zone for Honest and Efficient Governance among many other industry roles. He built the company to the size it is today, which is a significant accomplishment. It is a family company but that does not equate to fraud. Management takes a salary in line with the peer group and there are no significant corporate governance issues.

 

 

Mr. Ding Peiyuan, aged 41, was appointed as an executive Director and chief operating officer on 16 December 2013. He is also the vice general manager of Red Kids China. Mr. Ding has over 9 years of experience in the production and sales of apparel and retail industry and is primarily responsible for the formulation and execution of business development strategies. He completed the Advanced Management Programme by China Europe International Business School in 2009.

 

Mr. Ding Peiyuan is the brother of Mr. Ding and Ms. Ding Lizhen both are executive Directors.

 

Mr. Ding Peiyuan as no background with any other company besides Miko International

 

 

Ms. Ding Lizhen, aged 48, was appointed as an executive Director and vice president on 16 December 2013. She is also the vice general manager of Red Kids China. Ms. Ding has over 14 years of experience in the apparel and retail industry and is primarily responsible for production management and product development.

 

Ms. Ding Lizhen is the sister of Mr. Ding and Mr. Ding Peiyuan, both of whom are executive Directors.

 

Ms. Ding Lizhen has no background with any other company besides Miko International.

 

 

Mr. Gu Jishi, aged 44, was appointed as an executive Director and vice president on 16 December 2013. He is also a vice general manager. Mr. Gu has approximately 11 years of experience in the apparel and retail industry and is primarily responsible for brand development, domestic sales channels, and customer management. Before joining Miko, Mr. Gu worked as a manager of business development department and a brand manager for sport products for Pou Sheng International (Holdings) Limited, a company listed on the Main Board of the Stock Exchange (stock code: 3813), from 2003 to 2008, and was mainly responsible for the relationship management of key clients. He graduated from Sichuan University with a major in law in January 2006 through distance learning.

 

Mr. Gu Jishi worked at Pou Sheng, a Hong Kong listed company that manufactures and retails footwear. Although it has difficulty maintaining profitability, there is no history of fraud at the company.

 

 

Mr. Leung Wai Yip, aged 38, was appointed as an independent non-executive Director of Miko on 16 December 2013. Currently, Mr. Leung serves as the chief financial officer and company secretary of Chaowei Power Holdings Limited, a company listed on the Stock Exchange (stock code: 951) since December 2010. He obtained a bachelor’s degree in commerce from the University of Alberta, Canada in June 1998 and a master degree of business administration from the Hong Kong University of Science and Technology in November 2010. He is a member of the American Institute of Certified Public Accountants, and an associate member of the Hong Kong Institute of Certified Public Accountants.

 

Chaowei Power is loss making, but not a fraud.

 

 

Mr. Mei Wenjue, aged 44, was appointed as an independent non-executive Director on 16 December 2013. Mr. Mei served as a manager of safety management system office, the secretary of safety committee and safety information manager of China Southern Airline Company Limited, a company listed on both the Stock Exchange (stock code: 1055) and the Shanghai Stock Exchange (stock code: 600029), the deputy representative of CSA in the safety security and quality functional executives of Skyteam and the chief representative of Shenzhen Office of China Europe International Business School. Currently, he is the chief executive officer of Reocar Car Rental Group. He has been an independent non-executive director of Country Garden Holdings Company Limited, a company listed on the Stock Exchange (stock code: 2007) since May 2013. He graduated from Sun Yat-Sen University with bachelor’s degree in English language and literature and a master degree in public administration, and from School of Management of Cranfield University in United Kingdom with a master’s degree in business administration.

 

None of the companies Mr. Mei Wenjue is associated with are frauds.

 

 

Mr. Zhu Wenxin, aged 42, was appointed as an independent non-executive Director of on 16 December 2013. Mr. Zhu has held the position of the Chairman of the Board of directors System of Expert Consultancy Group since 1999. Currently, he also serves as an independent Director of Zuoan Fashion Limited, a company listed on the New York Stock Exchange (stock symbol: ZA) and a clothing industry senior consultant of Alibaba (China) Network Technology Co., ltd.

 

Zuoan Fashion has not been identified as a fraud but has persistently low valuations due to poor sentiment towards US listed Chinese companies.

 

 

Mr. Ng Cheuk Him, aged 40, is the chief financial officer and was appointed a joint company secretary on 16 December 2013. Mr. Ng joined Miko in August 2013 and is primarily responsible for financial management and company secretarial affairs. Prior to joining the company, he worked as the chief financial officer and company secretary of China Sunshine Paper Holdings Company Limited (stock code: 2002), a company listed on the main board of the Stock Exchange. Prior to such appointment, he held a senior position in BNP Paris Capital (Asia Pacific) Limited, served as managerial position in China Ting Group Holding Limited (stock code: 3398), and was an audit manager in Ernst & Young. Mr. Ng has over 14 years of experience in corporate financial management, accounting and auditing. He is an associate member of the Hong Kong Institute of Certified Public Accountants and the Hong Kong Institute of Chartered Secretaries.

 

Mr. Ng Cheuk Him has sufficient experience to be the company’s CFO with a previous position as CFO as well as positions in BNP Paribas and Ernst & Young, two of the most well respected financial institutions. The previous companies Mr. Ng Cheuk Him worked at are not frauds and still listed with active operations.

 

 

Ms. Ding Wanwan, aged 40, is the head of the production center and is primarily responsible for our supply chain management. Ms. Ding joined in March 2000. She completed the training program for senior manager by Executive Development Program Center, School of Management, Xiamen University in June 2012.

 

 

Mr. Wu Chentong, aged 40, is a finance manager. Mr. Wu has over 16 years of experience in financial management and is primarily responsible for corporate financial management. He joined in September 2011. He graduated from Sanming Vocational University in July 1998 with a major in accounting.

 

 

Conclusion

 

Overall, while the company unnecessarily sold shares it seems to be a nothing more than a poor asset allocation decision. The company is cheap because there has been intense selling pressure from insiders and general weak sentiment towards the Chinese apparel sector. The children’s apparel segment remains a safe haven in the Chinese apparel sector growing at a double-digit rate, which is expected to continue for some time. The company is extremely cheap valued below its NCAV, at EV/IC = 0.56, and an EV/EBIT = 1.1 time, therefore it warrants a 10% intial position. The lack of quality in the business and management are weighting on the decision to further increase the position to 15%.

Reperio Capital H1 2015 Review

Reperio Capital H1 2015 Review

 

Reviews on a quarterly basis are too focused on the short term, therefore, going forward; reviews will be made on semi-annual basis.

 

H1 2015 Performance

 

As illustrated above, the second quarter of 2015 saw our model portfolio decline by 0.9% leading to overall first half of 2015 performance of 2.7%. Since inception (5/23/2014), the model portfolio is up 15.6%.

 

 

Holdings

H1 2015 Positions

 

PC Jeweller was the largest position at the end of the first quarter of 2015 and the first half 2015. It remains an extremely strong performer up 76.8% in the first half of 2015 and 199.7% in US dollar terms since recommendation. In the second quarter, we sold 25% of our PC Jeweller position with a goal of selling half our position size and reaching roughly a 5% portfolio position. The company continues to execute very strongly and there is a clear path for growth with new store openings and continued efficiencies, but the level of undervaluation is not as outrageous. We plan to maintain at least a 5% position given the company’s strong operational execution, growth outlook, and reasonable valuations.

 

Peak Sport Products is the second largest position at 7.0% at the end of June 2015. We built a 9.8% position only to see the share price decline due to a share issuance announcement and a general decline in all China related stocks. We will maintain our holding without any increase or decrease. The company has a 5-10% per year growth outlook with a strong ROIC and is trading below its liquidation value but the recent share issuance announcement with the amount of cash on the balance sheet is baffling and dents management’s reputation.

 

Zensar Technologies is the third largest holding at 5.1% at the end of June 2015. The company continues to perform well improving margins after a few weak years following a large acquisition.  In addition, digital as a share of revenues continues to grow. The company expects to grow it top line at a double digit pace with improving margins.  Despite this growth, the company trades on an EV/EBIT of 8.2 times.

 

Honworld Group is a position we are building. The company is the leading cooking wine producer in a market growing at 20% per year. The company has strong management who are leveraging their size advantage to outspend peers on marketing, distribution, and R&D. The company has a high quality product that garners a price premium due to a unique naturally brewed production process. Honworld has traded lower since our initial recommendation as Chinese related stocks are being affected by the fall in Chinese stock markets. The company trades on an EV/EBIT of 9.2 times. Given the growth in the market, the company’s profitability (ROIC = 16%, suppressed due to growth expenditures), and the potential for a sustainable competitive advantage, if the company’s valuation remains below 10 times EV/EBIT, we will continue to build up to a 10% position.

 

Miko International  is our latest recommendation. It is a brand company in the fast growing children’s apparel market. The company’s top line grew by 20% in 2014 and the company is very profitable with an ROIC of 33%. The company’s profitability will probably wane as competitive pressures increase as the market slows but the current valuation is too attractive. The company is trading on an EV/EBIT of 1.21 times and trading at its liquidation value. We will continue to build a 10% position.