Monthly Archives: September 2015

Honworld and Miko International Positions 9/25/2015

Honworld and Miko International Positions 9/25/2015

 

We completed our purchases in Honworld Group and Miko International today.  After purchasing 24,958,340 shares in our model portfolio at an average price of RMB4.74 over 78 trading days, Honworld accounts for 11.9% of our portfolio.  We were happy to continue to purchase shares while the stock lingers well below our recommendation price.  At roughly 12% of our portfolio, Honworld is now nearing our upper limit for initial position sizes.  The company has strong growth outlook, unit economics, management, and balance sheet but the push to build inventory is driving down company returns and management seems intent on continuing to build inventory.

 

After purchasing 59,226,333 shares in our model portfolio at an average price of RMB0.89 over 64 trading days, Miko International accounts for 4.2% of our portfolio.  While the company is generating strong returns on invested capital and is valued below the cash on the balance sheet, growth decelerated and liquidity has dried up.  We like to keep deep value situations at the lower end of our position range of 5-15% particularly when there is no liquidity.

Company Initiated on 9/8/2015 Initial Position Built September 19, 2015

Company Initiated on 9/8/2015 Initial Position Built September 19, 2015

 

We completed our initial purchase of the company we initiated on 9/8/2015. Over the past eight days, we have purchased just over 49 million shares at an average price of HKD2.63. Company 9/8/2015 accounts for 14.6% of our model portfolio.  Company 9/8/2015 trades on an EV/EBIT of 4.1 times with an extremely strong management team that is consolidating a fragmented industry and a potential for double digit growth for years to come. The company is growing faster and far more profitable than its industry peers with many unique activities creating a strong competitive position over the medium term. Additionally, the main shareholder continues to increase his stake in the company purchasing 1.07% on September 18, 2015 and 2.0% on March 31, 2015.

 

Our upper limit of an initial position size is 15.0% for small and mid cap companies. While we like concentration, small and mid cap companies particularly in Emerging Market have inherent risks, such as lack of management depth that keep us from feeling comfortable with an initial position size above 15%.  Comfort with a position size allows for a mental state that keeps us disciplined with our investment process and investment approach. For this reason, we do not build our position any further despite our 45% cash position and clear attractiveness of the company relative to cash.

 

The lower limit of an initial position size is 5.0% as anything below does not make much of an impact.  The depth and time required to produce our research also requires position sizes above 5.0%.

 

Honworld accounts for 11.2% of our model portfolio.  The company trades on an EV/EBIT of 7 times with a potential size advantage that strengthens its competitive position.  The economics of the business are tremendous with per liter ROIC of 78.3% over the past five years.  The company continues to grow at 20% per year with a huge runway for growth.  The management team is extremely passionate and the only downside to the investment is the misallocation of capital to a huge inventory build. We will continue to build our position assuming prices do not increase drastically.

 

Miko International now accounts for 4.1% of our model portfolio.  The company is extremely profitable with an average ROIC of 39% over the past five years and operates in the less mature children’s apparel sector.  The company’s first half of 2015 results were good in terms of profitability but weak in terms of grow as the company’s growth slowed to -8% top line growth and -14% operating profit growth.  The company mentioned slower orders from distributors as well as renovation of some shops.  The growth is not concerning given the continued strength in profitability (H1 2015 ROIC = 15%) and the company’s cheap valuation with the company trading at 75% of its net cash position.  We will continue to build up to a 7.5% position as long as the company remains below its net cash and net current asset value.

New Distribution Partners and New Position 9/8/2015

We are now distributing our research through BK Research Partners therefore most of our ideas will not be posted.  All previous ideas, we will continue to post updates as they come. Also, if we find a very illiquid idea we may post but it will be a very brief posting without the depth of research.

If you are interested in finding out more about our research please feel free to contact us.  It is an Emerging Market Research product. We will be providing 12 ideas a year with the similar depth of research illustrated on the website.

We initiated on a new company today.  Company 9/8/2015 is a best class operator and capital allocator that is more profitable and growing faster than its peers.  It is growing above 20% per year with an average ROIC over the past four years of 43% yet is only trading on a EV/EBIT of 4.2 times.  It reminds me very much of the PC Jeweller at the time of entry.

It has a net cash postion, management who are owner operators, and no corporate governance issues.  It is a small cap Chinese stock located in Hong Kong, which is creating the opportunity as Chinese macro is creating huge concerns.

Our initial position size will be 15%.

Honworld Group H1 2015 Results Review 9/1/2015

Honworld Group H1 2015 Results Review 9/1/2015

 

Honworld Group                                                                                             

Recommendation: Buy                                   

Ticker: 2226:HKG

Closing Price (9/1/2015): HKD4.02

6 Month Avg. Daily Vol. (USD): 1,190,945

Estimated Annualized Return: 20.3%

 

 

Honworld Group reported first half of 2015 results on August 31, 2015. The company’s key value drivers are illustrated below.

 

Key Value Drivers Table H1 2015

 

In the first half of 2015, Honworld’s revenue grew by 19.9% and its operating profit grew by 23.7%. The macro concerns surrounding China are not affecting Honworld.  The company continues to introduce new products to its distribution channel and it is aggressively building its distribution channel.

 

The company’s gross margin is stable averaging 58.0% over the past three years after two years of an increasing gross margin associated with improving product mix. The stability in gross margin and the company’s premium pricing with a significant market share advantage over peers illustrates the company’s pricing power.  The company is the first to sell naturally brewed cooking wine and other naturally brewed condiments giving its brand a healthy position in the consumer mind allowing for premium pricing.  Its largest competitors produce their cooking wine with a chemically based product.

 

The company continues to spend heavily on distribution and on administrative expenses (primarily R&D) with both expenses amounting to 16.5% of sales in the first half of 2015.  Given the company is the largest cooking wine producers in the country continued investment in the distribution channel, advertising, new products, and new processes is strategically the right thing to do to take advantage of its economies of scale. According to its IPO prospectus, Honworld market share is two times is largest competitor and equal to the market share of the four closest competitors.  Given Honworld sells a premium product, its gross profit advantage over peers is even greater.  Honworld’s size advantage over its closest peer increases from 2.15 times using sales to 2.86 times using gross profit.  The four closest competitors’ cumulative share is 104% of Honworld’s market share but is only 75% of Honworld’s gross profit share.

 

Despite heavy investment is base wine inventory, Honworld still generated an annualized ROIC of 17.6% in H1 2015. Heavy investment in inventory is the main concern associated with an investment in Honworld.  Management seems determined to continue to investment in base wine despite raw materials being commodity products available from many producers. If there are increases in raw material costs the whole industry will feel the pain.  Given the company’s premium position in the consumer’s mind, Honworld is the most likely competitor to be able to pass on prices increases. Holding inventory and ageing it allows the company to sell a premium product. Unfortunately, the gross margin associated with the higher price does not compensate for the inventory investment required leading to depressed ROIC with higher inventory.

 

Inv Req per Liter of Base Wine

 

The table above shows Honworld’s investment in base wine.  Fixed capital is primarily facilities associated with storing base wine so it is should be included in calculations for cost of base wine.  Other working capital requirements are minimal and therefore are used to add conservatism.  According to the company’s balance sheet in 2014, each liter of base wine cost RMB9.2.

 

Inventory Used and Sold

 

Each bottle of cooking wine is a mixture of spices, base wine, and water meaning each liter of base wine translates to multiple liters of what is actually sold. Lower quality product uses lower amounts of base wine. Vinegar uses cooking wine while Soy Sauce products do not.  2014 is estimated as the company did not provide this information.  In 2013, each liter of base wine translated to 2.8 liters of output. At 2.5 liters of output for each base wine of input, the 225 million liters of base wine the company is targeting for 2015 translates to 562.50 million liters of sales volume or 5.64 years of 2015 sales volume assuming a 20% growth rate in 2015.

 

Economics Per Litre

 

The table above shows the economics of the business on a per unit basis.  2013 is data from the IPO prospectus while 2014 is estimated.  Even with heavy investment in fixed costs the company generates an ROIC on a per liter basis close to 90%.  The contribution margin per liter is above 100%.  The company should spend heavily on acquiring customers through increased distribution and new products. The heavy spending on fixed costs also allows the company to cement its competitive position by taking advantage of its size. Inventory build on the other hand drags down 2014 ROIC from 86% on a per liter basis to the company ROIC of 18.1%.

 

Gross Margin by product

 

The table above illustrates gross margin by product.  Premium cooking wine products generate a gross margin close to 75% while medium-range cooking wine products generate a gross margin of 45%.  Medium-range products generate a lower gross margin compared to mass market due to packaging.

 

Base Wine by Product Category

 

The table above shows the amount of base wine for each product and the number of years it needs to be aged.  Assuming the company can sells all it products at premium cooking wine gross margins and inventory is 10 years current year sales equal to the average age of vintage wine in premium cooking wine.

 

Economics All Premium Products

 

As illustrated ageing inventory and selling 100% premium products leads to a per liter ROIC averaging 135% but holding inventory for 10 years increases investment requirements leading to an overall company ROIC average of 13.5% half the current average of 27.2% and well below the per liter ROIC average of 78.3%.  The main problem is management views EBITDA margin as the key indicator of profitability rather than ROIC.  The heavy investment in inventory shifts it from a consumer product company to something similar to a car dealership where profitability is tied up in inventory.

The company is financially strong with H1 2015 net debt to operating profit of 0.89.

 

Overall, Honworld has a potential to build a strong competitive advantage given its brand positioning among consumers and its economies of scale.  The company is generating strong returns on invested capital despite heavy investments in fixed costs to cement its competitive position and poor investments in inventory.

 

The company is growing its top line and profitability at 20% despite macro-concerns in China.

 

It has a very passionate management team with integrity. The founder transferred his family’s secret recipes to the company for RMB1 and donated his personal stock of cooking wine valued at RMB7.0 million. He built his personal cooking wine inventory since 1990 when he first entered the industry but well before he founded Honworld and purchased its cooking wine subsidiary. His family also owned Honworld’s key brand before the communist revolution.

 

At the close of business on September 1, 2015, Honworld is valued at 6.8 times EV/ttm EBIT offering a conservatively estimated return of 20.3% for the foreseeable future.  If the management is able to eliminate inventory build it could generate a much higher return as the franchise value used in the calculation assumes 15% ROIC indefinitely.  Given heavy investments in fixed costs and inventory this figure should eventually be higher. It’s growth, potential competitive advantage, strong returns, and passionate management with integrity makes it our current top pick.

Estimated Returns 9 1 2015