Monthly Archives: April 2016

Bajaj Auto

Bajaj Auto April 29, 2016

Bajaj Auto April 29 2016 RCR


BHIL Investment Thesis


Bajaj Auto is a stock we would not normally research but it accounts the majority of the value of Bajaj Holdings and Investments (BHIL).  BHIL is a holding company trading at a discount to the current market values of its investment holdings. Its main assets are a 31.49% stake in Bajaj Auto and a 29.15% stake in Bajaj Finserv. The Bajaj Auto position accounts for roughly 56% of the company’s total value and Bajaj Finserv accounts for another 27%.  The company’s remaining value is split between a large number of equity investments and fixed income investments.

BHIL SOTP April 29, 2016


At the end of March 2015, BHIL had no debt and a net cash position of INR4,514 million equal to 5.2% of its current market cap. BHIL is 54.4% owned by the Bajaj family and its associates with the remainder owned by the public. If Bajaj Auto and Bajaj Finserv’s market prices are a good approximation of fair value, there is significant upside to BHIL assuming a 30% holding company discount.  Unfortunately, the market often misprices securities and if Bajaj Auto and Bajaj Finserv are overvalued then the discount BHIL is trading at relative to the underlying investments may be warranted.  It seems Bajaj Auto is significantly overvalued therefore no position is taken in BHIL.



Bajaj AutoInvestment Thesis


Bajaj Auto is the second largest Indian and the fourth largest motorcycle manufacturer in the world. There seems to be brand advantages and economies of scale creating barriers to entry in the Indian two wheeler industry.  The company’s management is doing a good job operationally, and strategically.  There are minor corporate governance issues but nothing to eliminate Bajaj Auto as a potential investment.  At the current time, valuation is a concern.  The market is pricing in a very rosy picture with the company trading on a FCF yield of 3.3%.  Bajaj would be an attractive opportunity below INR1,300.


Bajaj Auto Key Stats 1 April 29 2016


Bajaj Auto Key Stats 2 April 29 2016


Company Description


Bajaj Auto is India’s second largest two wheeler manufacturer and the world’s 4th largest motorcycle manufacturer. It has been producing scooter and two wheelers since 1945.  Over the last decade, the company has successfully changed its image from a scooter manufacturer to a motorcycle manufacturer. The company now exports its products to over 50 countries. In 2008, Bajaj Auto demerged into three separately listed entities, Baja Auto, Bajaj Finserv Ltd, and Bajaj Holdings and Investment Limited.  These companies are all listed on the National Stock Exchange of India with an initial listing on May 26, 2008.


In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotorcycles AG) for 98.4 million euros.  KTM is known as a high performance motorcycle brand.  The company is consistently Europe’s largest motorcycle brand and is a dominant maker of off road motorcycles with 260 World Championships and 15 consecutive Dakar victories. Bajaj Auto has since increased its investment by 99.7 million euros making its total investment in KTM equal to 198.1 million euros with the company’s stake increasing from 24.5% to 48%.  Bajaj manufacturers all KTM bikes under 600ccs in India lowering the manufacturing cost for KTM’s bikes. Bajaj also distributes KTM bikes throughout its distribution network. Bajaj distributes its products throughout KTM network as well as received technological expertise from KTM’s motors. KTM is listed on the Vienna Stock Exchange.   At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros.


Bajaj Auto produces and exports motorcycles, three wheelers, and quadricycles. Its headquarters are in Pune, with plants in Akurdi and Chakan (Pune), Waluj (near Aurangabad) and Pantnagar. The Chakan plant produces Pulsars, Avengers, Ninjas, and KTM motorcycles and has annual production capacity of 1.2 million units.  The Pantnagar plant produces CT100, Platina, and Discover and has annual product capacity of 1.8 million units.   The company’s Waluj plant produces the Boxer, CT100, Platina, Discover, Pulsar, three wheelers, RE 60, and all exports.  It currently has annual production capacity of 3.06 million units.

Baja Auto Production Capacity


In the year ending March 2015 (FY2015), Bajaj Auto sold 3.81 million units. 2.01 million units were sold in India and the other 1.81 million units were exported.  Of the 3.81 million units sold, 3.29 million units were motorcycles and 0.52 million units were three wheelers.

Bajaj Volume by product and geography


Since 2010, the main driver of unit growth has been export volumes, growing at 15.2% per annum, as domestic volumes have stagnated since 2010 and contracted by 10.2% since 2012.


The company sells more three wheelers in export markets with 54.9% of three wheelers sold 0.285 million units exported.  In the domestic market, the company sold 0.234 million units three wheelers generating an EBITDA margin over 20% in the domestic market, holding 46% overall market share, 91% market share in the petrol and alternate fuel segment, and 62% market share in the small diesel segment.


Export markets have an EBITDA margin are greater than 20% above the company’s domestic EBITDA margin. Assuming a 20% EBITDA margin in the export market the domestic market’s EBITDA margin is roughly 16.5%.  The company’s exports by regions are below with the largest two wheeler export market is Nigeria, while Sri Lanka is the company’s largest three wheeler export market.

Bajaj Export Revenue by Geography


In export markets, Bajaj Auto has a unique model.  The company produces all motorcycles in India then the motorcycles are assemble locally.  Hero is taking another route of producing and assembling motorcycles locally, as illustrated by Hero’s USD38 million investment in a Columbian manufacturing plant with 150,000 unit capacity. Bajaj Auto is taking advantage of the company’s existing infrastructure and ecosystem (90% of part production is outsourced in India) as well as India’s lower cost of production. KTM’s CEO puts the cost of producing a motorcycle at 30% of the cost of production in Europe.  Bajaj Auto’s goal is to increase its share in the global motorcycle market from 10% to 20% through exports, primarily to developing markets.


The company’s main brands are the Pulsar, Discover, and Platina.  The Pulsar brand is the company’s largest brand selling 0.881 million units in FY2015 with 0.631 million units sold in the domestic market and 0.25 million units exported. In FY 2015, the Pulsar and KTM brand had a 43% market share of the domestic sport segment with roughly a 20% EBITDA margin in the segment.  The Discover brand was the company’s largest brand with 1.5 million units in FY2013. Unfortunately, the brand has not performed well and it only 429,000 units sold domestically in FY2015. 0.985 million units were sold in the domestic market and 0.191 million units were exported. The company’s third largest platform is the Platina.  Platina is a motorcycle for the entry segment, where the company has a 23% market share. In FY2015, Platina and the newer CT100 brand sold 0.518 million units in the entry segment.  Other motorcycle brands include the Avenger, which competes in the cruiser segment selling 44,000 units in FY2015. The KTM brand competes in the sports segment selling 23,000 units in the domestic market in FY2015.


Bajaj Auto’s marketing strategy is different than other two wheeler manufacturers.  Bajaj Auto creates a motorcycle brand and uses this brand across different engine sizes and customer segments. For example, the Pulsar brand has a youthful and powerful image.  The company manufactures Pulsars across many different engines sizes.  Bajaj Auto also does not use the Bajaj name on motorcycles as the company sees it as very diluted.  With the company’s Pulsar brand, it never advertised cheaper 135cc and 150cc models to avoid diluting the premium image of the brand even in the commuter segment.  A lesson learned from the marketing mistakes made on the Discover brand. Other two wheeler manufacturers use the company’s brand name such as Hero and then a model has a specific model name such as Splendor or Passion.  These model names are used on just one engine size.


Bajaj Auto believes its focus on brands over models leads to pricing power as fewer brands create less confusion among customers and creates better knowledge and intimacy with a brand.  Additionally, it is more cost effective as the company only has to market a few brand platforms rather than a number of different models brand platforms.


The company’s focus on brands is what Bajaj Auto calls the front-end, which thrives on differentiation.  Manufacturing is the back-end, which relies on synergies and economies of scale.


Bajaj Auto also has a marketing agreement with Kawasaki to sell motorcycles in ASEAN and South American markets.  The partnership started in Philippines and has spread to Indonesia and Brazil. The companies are complimentary as Kawasaki makes motorbikes mostly with over 650-cc engines at the upper end of the spectrum, while, Bajaj Auto is a mass player with bikes ranging from 100 cc to 220 cc.


Bajaj Auto’s market share by segment in H1 FY2016 is illustrated below.

 Bajaj Market Share by Segment


M1 is entry level mileage segment, which Bajaj serves with CT100 and Platina. The Sports segment is served by Pulsar.  The Supersport segment is served by Pulsar and KTM.



Bajaj Auto- Barriers to Entry


The first step is determining whether barriers to entry exist is to examine the evidence.  The evidence pointing to barriers to entry are listed below.


  1. The company consistently generates ROIC well above 15%. Over the past five year the company’s average ROIC is 359.2% and a FCF ROIC of 244.4%. The company has maintained its high profitability during industry downturns.


  1. The company has negative working capital. Negative working capital points to significant bargaining power and being the center of an ecosystem.


  1. The two wheeler market in an oligopoly. Hero, Honda, Bajaj Auto, and TVS are the four largest two wheeler manufacturers accounting for 90.9% of the market in FY2015. The Herfindahl index also points to significant concentration.

Bajaj Two Wheeler Market Share


Bajaj Auto has seen the largest decline in domestic market share as its Discover brand sales declined significantly as the brand position was diluted confusing consumers about its position. Bajaj Auto also exited scooters, a segment of the market that has grown the most over the past few years. Additionally, the company has grown significantly in export markets. Bajaj Auto’s management is focused on profitability over market share.


  1. Honda’s quick market share gains while smaller players have difficulty gaining meaningful share points to a well known brand being important in a customer’s purchase decision. Until 2010, Honda had a joint venture with Hero MotoCorp allowing consumers to have experience and trust the company’s brand. Since the joint venture ended, Honda has increased its market share from 12.7% in FY2010 to 26.6% in FY2015, while smaller brands have gained share but nothing meaningful. The average annual share gain by smaller players is 0.4% per year. Eicher Motors market share increased from 0.7% in FY2010 to 2.8% in FY2015, while the other gainer outside of the top four was Yamaha, which grew its market share from 2.4% to 3.7%.  Honda has had a much easier time increasing market share compared to smaller players due to its existing brand and infrastructure pointing to barriers to entry.


  1. Hero’s inability to gain share in the premium segment (150cc and up). Despite seven models in the segment, Hero only has a 6% share.  Hero is well known for its leadership in mileage and commuter segment. Given its position as a cheaper motorcycle that gives you good mileage, it may be difficult for consumers to view it at a premium brand that they are going to spend more on illustrating the importance of a company’s brand.


  1. There are significant fixed costs in the form of advertising and R&D. Of the top four two wheeler makers, three are publicly traded and report full financials.

Bajaj MES


The average gross profit of three largest publicly traded two wheeler manufacturers is INR12,888 per unit in FY2015.  Dividing the average fixed costs by that figure leads to a minimum efficient scale of 758,767 units or 4.1% of the market in FY2015.

Bajaj Expanded Market Share


4.1% is the minimum efficient scale required to compete as a generalist.  A company can take niche strategy similar to Eicher Motors attacking a specificsegment and just competing in that segment. The key to winning a niche segment in the Indian motorcycle segment is to create the segment.  Eicher Motor created the mid-size segment (250-750 cc) in India and holds 96% market share within the segment so smaller players can enter the market and compete but will have difficulty as a generalist.  Even large international companies such as Suzuki and Yamaha that can be subsidized by profitable international parents or local automobile companies such as Mahindra that can be subsidized by the automobile companies are having difficulty garnering the 4.1% market share required to be profitable under a generalist strategy.   Given the top four collectively hold 90.9% of the market and Eicher Motors hold 2.8% of the market through a profitable niche strategy, it would be difficult for many other players to be profitable with a generalist strategy.


  1. In the domestic market there are regulatory barriers to entry. There are high import duties with 105% import duty on new motorcycles and 100% import duty on used motorcycles. The motorcycles can only be imported through three ports. Motorcycles that are assembled in India with foreign parts have a 30% duty. The industry is fully deregulated with regard to foreign direct investment.


  1. Bajaj Auto outperforms its largest peers on almost all profitability measures.

Bajaj Per Unit Performance


Bajaj Auto has the highest ASP of its largest peers largely due to a higher focus on motorcycles and three wheelers.  Adjusting for the effect of other two wheelers and three wheelers, Bajaj Auto’s ASP (INR56,690) is still higher than Hero (43,934) and TVS (49,976) due to its lack of focus on the entry level segment, 75-110cc motorcycles, which is currently dominated by Hero with a 71% market share.  The next level up, the 125cc market, is also dominated by Hero with a 51% share.

Bajaj vs Peers product type


Given the higher cost of producing motorcycles and three wheelers, Bajaj Auto’s cost of goods sold per unit is higher.  The focus on premium products decreases the importance of price in the purchase decision.  Additionally, exports are almost half of the company’s sales.  Exports have higher margins than the domestic market. Both lead to a higher gross profit per unit relative to peers.  The premium pricing and higher gross profit per unit potentially points to Bajaj Auto having valuable brands.


Over the five year period, Bajaj Auto has been the most efficient on operating expenses.   Over both five year and during FY2015, Bajaj has used capital the most efficiently with the lowest capital requirements per unit.  The company’s management is focused on efficiency and profitability over market share. Overall, Bajaj generates the highest ROIC and FCF ROIC of its largest peers.


While there is evidence pointing to barriers to entry there is also evidence pointing to no barriers to entry.


  1. The poor performance of the Discover brand points to a lack of brand advantage. Discover brand was introduced in 2004 reaching 1.5 million units sold in FY2013. Since 2013, Discovers sales have halved with estimated total sales of 744,000 in FY2015.

Discover brand sales


If a brand advantage existed the company’s sales would not have increased as rapidly as it did from 2004 to 2013 in the face of a strong existing competition, which would have a brand advantage. If the company was able to build a brand, its sales would not have halved in two years time.


  1. Bajaj Auto’s gross margin volatility points to a lack of pricing power. If the company had pricing power it would be able to transfer raw materials cost increases to customers and gross margin would be consistent or increasing.

Bajaj Gross Margin


  1. The decreasing concentration within the top four players consistently losing market share to smaller players. From FY2007 to FY2015, the four largest two wheeler companies lost 4.1% with four firm ratio dropping from 95.0% to 90.9%.  It is still a highly concentrated market but the existence of barriers to entry should lead to the inability of players to enter the market.  Eicher Motors with its Royal Enfield brand is profitable and dominating a niche segment, the mid-size segment with 96% market share. It has increased its market share to 2.8% in FY2015 from 0.7% in 2010. Yamaha has also increased its market share to 3.7% in FY2015 from 2.7% in FY2007.  Suzuki has increased its market share to 2.0% in FY2015 from 0.8% in FY2007.  The share increases are not dramatic and it will take some time for smaller players to break the oligopoly.


  1. The lack of stability in market share among the top four players. The change in market share over the eight years among the top four players is significant. If any company had a competitive advantage, market share changes would not be as drastic. The average absolute share change over the eight year period was very high at 9.94%.  Honda’s market share gain should not be view as a new entrant but an existing player. Honda is a well known brand within the India market. Until 2010, it had a long standing joint venture with Hero. The prior existence of the brand in the market made it well known.  The quick market share gain by Honda and small market share gains by smaller players points to how a brand can influence a customer’s purchase decision.

Bajaj Two Wheeler Market Share Part 2


Overall, there is compelling evidence for and against the existence of barriers to entry in the two wheeler market.  Although there is compelling evidence against barriers to entry existing, the most compelling evidence is most often a company’s ability to consistently generate excess profitability. The ability to generate excess returns with the significant concentration in the industry, the presence of fixed costs, and inability of smaller players to gain significant market share over a long period outweighs the evidence against barriers to entry.


Given the evidence points to barriers to entry existing, the next question is what are those barriers to entry?  It seems the presence of fixed costs leads to economies of scale within the industry.  Economies of scale should lead to greater profitability with size, which is not the case as in FY2015. Including export volumes, Bajaj Auto is just over half the size of Hero yet is much more profitable on a per unit basis and overall ROIC basis.  Eicher Motors is just under a fifth of the size TVS yet much profitable.  There may be economies of scale in the industry stopping entry from smaller players but it does not drive profitability differences between the four larger players.


There seems to be a brand advantage as well. A company that gets the first mover advantage by creating a new segment retains the position in consumers’ minds as the leader in the segment. Hero is a leader in the commuter segment due to a combination of price, mileage, and resale value.  Despite others making motorcycles that are slightly more efficient Hero retains the position in consumers’ minds as the motorcycle that gets the most mileage.  Bajaj Auto created the sport and super sport segments with the Pulsar brand launch in November 2001. Before the introduction of the Pulsar, the Indian motorcycle market trend was towards fuel efficient, small capacity motorcycles (80–125 cc class) with barely any motorcycles above the entry segment. Despite competition, Bajaj Auto continues to dominate the segment with a 44% market share.  Eicher Motors created and dominates the mid-size segment (250-750 cc) with a 96% market share.  Bajaj Discover’s may provide evidence of lack of brand value within the market but it was a not the leading brand and too much like the Hero Splendor.  Bajaj Auto seems to have diluted the brand’s position confusing consumers.


In the export market, India has a large cost advantage over other locations and it has some of the largest motorcycle manufacturers in the world leading to an existing ecosystem. According to KTM’s CEO, it costs 1/3rd of the cost to produce motorcycles in India compared to Europe.


Other than economies of scale and brand in the domestic market and costs in the export market, there seems to be no other economies of scale.


Given the oligopolistic market structure, intensity of rivalry is also important to profitability. Prior to 2007, companies competed for market share leading to price wars and margin compression.  Since those price wars, industry competitors have been more disciplined on pricing.  The discipline is further shown by the invested capital growth of the three largest players.  Since 2007, total invested capital increased by 10.3% per year while domestic sales volume increased by 10.2% per year.





Since Rajiv Bajaj took over as managing director, management has done well strategically and operationally. Strategically, the company narrowed its focus leaving the scooter segment focusing on motorcycles and three wheelers allowing the company to become more efficient in marketing and manufacturing.  It also allowed the company to better exploit the global market through low cost manufacturing.  Within the domestic market, the company’s unique marketing strategy allows it to build stronger brands and greater efficiencies in marketing.  Although it has lost market share domestically, it is now a global company with almost half its revenues from global markets, primarily in developing markets.


Operationally, Bajaj Auto is the most profitable company in the two wheeler industry due to the strength of its strategy. Over the past five years, the company’s gross margin is slightly higher than it large peers due to the company’s premium products. Operating margins are well above peers due to the company’s strategic focus allowing for efficiencies in marketing and manufacturing.

Bajaj Margins vs peers


The company has not made any capital allocation missteps.  The company’s core operations continue to generate very strong profitability. Since 2011, total operating cash flow before working capital INR127,176 million.  Working capital generated an additional INR5,773 million.  The largest capital allocation decision was the decision to retain cash leading to an increase in cash by INR62,860 million. At the end of FY2010, the company had a net debt position of INR12,558 million. At the end of FY2015, the company had a net cash position of INR62,809 million.  The company only spent INR17,208 million on capex over the last five years so there is more than enough cash on the company’s balance sheet and it should return cash to shareholders.  At the current valuation, dividends would probably be the best option.

Bajaj Capital Allocation


In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotocycles AG) for 98.4 million euros.  Bajaj Auto increased its investment by 99.7 million euros to 198.1 million euros with the company’s stake increasing from 24.5% to 48%.  KTM is listed on the Vienna Stock Exchange.   At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros representing a 200% return on investment, a very shrewd investment.



Corporate Governance


In FY2014, Bajaj gave former Citi banker Nanoo Pamnani, an independent director serving on the board of four Bajaj companies, a Rs1.5 million bonus.  The additional payment puts into the question the independence of the Nanoo Pamnani. Proxy advisory firm Stakeholders Empowerment Services believes the bonus payment is unfair and recommended shareholders vote against it.


The company was the principal sponsor of the Positive Health Awards run by Mukesh Batra’s the proprietor of a chain of homeopathy clinics. Mr. Batra is a good friend of Bajaj Auto’s managing director Rajiv Bajaj, who is passionate about yoga and homeopathy.  The sponsorship does not seem to add much value and seems to be frivolous and not in the best interest of all shareholders.


Management does not extract too much value with directors and senior management renumeration remaining consistently around 1.0% of operating profit.



Management’s Language


Management’s language gives you strong understanding of how they view their business and the assumptions used in the business. Below are selected quotes illustrating management’s views and assumption of its business.


FY2011 Annual Report


“In other words, there was more to Bajaj Auto’s performance than riding with the tide. It was about combining a highly focused brand-centered strategy with production efficiency, quality, costs and logistics.”


“Discover and Pulsar do not ‘buy’ market share through eventually debilitating price competition. They gain share by their brand, quality and performance – so that customers are pleased to pay more for obviously better value.”


FY2010 Annual Report


“For the last few years, your Company has been working at developing a brand-centered strategy especially of its two key brands, the Discover and the Pulsar.”


“What pleases me is that Bajaj Auto is leveraging its key brands to maximize profits. Your Company’s performance has not been about ‘buying’ market share through various pricing deals. Instead, it is about gaining share through better quality and branding – thus having the customer willing to pay higher prices for better value.”


“Your managing director often says that while products may generate market share, brands            provide pricing power and create higher profits. I am increasingly tending to agree with him.”


Other sources


“Management believes its ability to build very strong brands is the reason for its above industry returns on invested capital.”


“Less of technology industry and more of a marketing industry.  More less all players have the same technology and quality.  It is all about being first to market. Second to market with no differentiation”


“Bajaj Auto Mass manufacturer not a niche manufacturer.”


“Three wheeler segment low barriers to entry no capital requirements to develop a three wheeler, no technology requirements to manufacture, no elaborate arrangements to distribute.  Absence of barriers to entry market will become commoditized.”


“At the base of all human problems lies ego. And every shareholder is human. We always have our moments when greed gets the better of us. But one must draw a line between growth and greed. Growth for the sake of growth is an ideology of a cancerous cell. This is how most companies destroy themselves. How does one grow without being greedy? We feel the best way to do that is to listen to your brands. If I want to be greedy, I can introduce a 100cc Pulsar.  It will grow for 6-12 months. But over a period of three years, it will diffuse the brand. The ill-effects take time to play out. If companies look back, whenever they have line extended in some way, it has not worked. We don’t manage our brand.

Our brand manages us.”



“Of the global volume of roughly 50 million two wheelers, 30-35 million are motorcycles. This year, we will sell around 3.8 million motorcycles. We have a 10% share, so we have no business to look at something like scooters. We should go up to 20-25%. In exports, there is a lot of headroom to grow. In the past five years, we have grown six times; today, exports comprise 35% of total sales. A day should come when 20% of our sales are in India and 80% outside.”


“By end of fiscal 2016, we should enter a dozen new export markets,” said Sharma, declining to give further details. This will help the firm report a growth of 13-15% in export volumes over the next 3-4 years”





Assuming a 15% discount rate, 5.0% sales growth into perpetuity, 18.9% operating margin, and historical average capital efficiency, there is 22% downside to the company’s FY2021 intrinsic value per share of INR2,039 per share.  Assuming 10% growth over the forecast period fading to a 5% perpetuity growth rate, there is 1% downside to the company’s FY2021 intrinsic value per share of INR2,595. Assuming 15% growth over the forecast period fading to a 5% perpetuity growth rate, there is 27% upside to the company’s FY2021 intrinsic value of INR3,314.


The company currently offers a 3.4% FCF yield assuming a 7% growth rate the company offers an expected return of 11.4% per year.


The ideal time to buy Bajaj Auto is when the share price is below INR1,300.




The biggest risk to an investment in Bajaj Auto is currently valuation risk as there is little to no margin of safety.


Domestically, the biggest concern is continued stagnation in demand.


Currently, the industry is undergoing a period of competitive discipline.  If companies shifted its focus back to market share over profitability, it could lead to price wars and margin pressure.


Dilution of the company’s brands is a concern.  While other two wheeler manufacturers have one model and engine per brand, Bajaj Auto manufacturers many different models and engine size in a brand creating the risk of diluting a brand’s position, which happened with the Discover brand.


Another concern is regulation.  The company has created a quadricycle to replace three wheelers.  The company has not been allowed to sell the product domestically or in Sri Lanka, the company’s largest three wheeler market outside of India, due to perceived safety issues.

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.


New Report Format April 19, 2016

New Report Format  April 19, 2016

We are changing our report format from deep dive research to shorter reports providing a preliminary assessment that is a broad overview of the company. This will allow us to research more companies and business models. Our goal is to build a database of high quality Emerging Market Micro, Small, and Mid-cap companies and their management teams.  We will be providing an assessment of all companies we look at both good and bad.  Our goal is to provide at least one a week and hopefully much more. Given our more conservative position sizing, deep dive research that takes a month would never allow us to be fully invested.




Peak Sport Products Position Size April 15, 2016

Peak Sport Products Position Size April 15, 2016

We have completed the sale of just under USD3.639 million of Peak Sport Products or 13,716,110 shares at an average price of HKD2.058 bring our position size to just under USD9.858 million or a 9.2% cost position.

We are going to sell another USD4.5 million to bring Peak Sport Products more inline with our new position sizing philosophy.  We will only sell if the price remains above HKD1.90. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. The company is somewhere between a deep value and high quality investment therefore the position size probably should be closer to 5.0%.


Company 9/8/15 Position Size April 13, 2016

Company 9/8/15 Position Size April 13, 2016

We have completed the sale of just over USD3.3 million of Company 9/8/15.  Its current position size of 4.7% better reflects the deep value nature of the position as the risk associated with the position.

Peak Sport Products Position Size April 7, 2016

Peak Sport Products Position Size April 7, 2016

We are decreasing Peak Sports Products position size by USD3.5 million assuming the share price remains above HKD1.75 per share. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. A smaller position size is warranted.


Honworld Annual Results Review April 7, 2016

Honworld Annual Results Review April 7, 2016

Honworld report 2015 results on March 31, 2016.  The company’s grew its revenue by 19.5%, gross profit by 16.7%, and operating profit by 11.6%.  The drag in gross profit was primarily due to the application of new brewery method in premium soy sauce products in order to improve the quality and flavor. Operating profit was due to increased selling expenses as administrative expenses were flat year on year. Selling expenses increased as Honworld conducted more extensive marketing and promotional activities to better penetrate its distribution network to third tier and fourth tier cities, restaurants, and e-commerce platforms.

The company maintained approximately the same absolute level of research and development at RMB46.77.  Over the past three years, research and development has average RMB46.08 million. Selling expenses and research and development are key to maintaining the company’s competitive position given its size advantage over peers.

Our biggest concern with Honworld is inventory levels. Management stated it has reached its desired level of inventory. At the end of 2015, Honworld’s inventory days stood at 432.5 days compared to 453.5 days at the end of 2014. As illustrated it is an extremely working capital intensive business and working capital turnover as settled at roughly 0.70 times with 0.71 in 2015 and 0.72 in 2014.

The company’s financial health deteriorated slightly as growth lead to higher inventory requirements and the inventory may putt constraints on the company’s ability to grow. At the end of 2015, net debt to operating income stood at 1.54 times up from 0.75 times with operating income to interest at 9.06 times.

Overall in 2015, Honworld generated a ROIC of 13.8% with inventory accounting for 53% of invested capital. It is a business with very good economics apart from the inventory the business carries.  The owner is extremely passionate about the business and sees it as a family asset.  The biggest shareholder’s holding company charged shares for a loan creating a bit of concern but given his passion for the business and family legacy associated with the business it seems highly unlikely he would put ownership of the business at risk. The company offers an estimated return of roughly a 14% at current prices assuming 2.5% organic growth and 15% sustainable ROIC.  Assuming 10% growth over the next five years and 2.5% terminal growth in year ten with 13% sustainable ROIC, the company’s 2020 fair value is HKD10.26 or 15% annualized return.  The current EV/EBIT is 8.4 times


Given our modified position sizing on the back of Company 9/8/15 and Miko International mistakes, we are decreasing our position size by roughly USD2.0 million bringing our cost base to roughly 7.5%. Sales will be made as long as Honworld’s share price is above HKD5.00 slightly above our initial cost base of HK4.64 per share.



  • Great business with good economics
  • Industry leader with economies of scale and a strong brand creating pricing power
  • Low priced product allowing for greater pricing power
  • Passionate owner operator whose family has significant history with the business
  • Cheap valuation IRR = 15%



  • Inventory levels are a big drag on profitability particularly when inventory is commodity raw materials and the gross margins from products made with older age base wine does not make up for the cost of holding inventory
  • Shareholder charged shares in a loan

Miko International and Position Sizing April 7, 2016

Miko International and Position Sizing April 7, 2016

Miko International has delayed reporting its annual results on March 31, 2016 as the company requires additional time to collect and prepare the required information, including information or valuation in relation to certain assets during the year, for the auditors (KPMG) to finalize the audit of the 2015 financial statements.  The company’s shares have been suspended.  It seems Miko’s share price may fall to zero. The company’s valuation at the time of the initial investment pointed to the market being very skeptical of the company’s financial statements. There were some red flags along the way the potentially could have allowed us to exit the position with less of a loss.  The CFO resigned in September 2015, which we did not think too much about.  Then three independent directors have resigned since the middle of February.  Overall, it seems the Miko International investment will turn out to be worthless.  It illustrates the limits of our knowledge particularly in the small cap space.  We felt the financial statements were accurate give a big four auditor and little other evidence of financial manipulation. The current review should provide a strong assessment of the company’s current financial position and the state of operations as the auditors seems to be taking a very good look at the company’s books.


The fall in Company 9/8/15’s share price as the largest shareholder and Chairman and CEO pledged shares without notifying minority shareholders is another example of the limits to our knowledge. Peak Sport’s share issuance is another good example.  Despite Peak’s long operating history and lack of missteps, the company suddenly makes a major capital allocation mistake and issues shares despite a significant net cash position.


Given the recent missteps, we are modifying our research process and position sizes.  We will be spending a lot more time on high quality businesses rather than just good businesses. Regardless of valuation, we will aim to highlight high quality companies within the Emerging Market Small Cap Universe.  These are companies with unique activities that generate strong profitability with management with integrity and strong capital allocation skills. We have been very concerned with valuation and this has lead to buying good but not great businesses at cheaper valuations.  We will still look at deep value or good business but management integrity and capital allocation skills need to be flawless.


Our new smallest position size will be 1.0%-2.5% for high quality companies that offer less than 10% expected return.  This tracking position allows a more active monitoring process as these companies or the markets have hiccups, we will increase our position or eliminate them from the portfolio. High quality stocks offering a 10-15% expected return will be a 2.5%-5.0% position.  High quality stocks offering more than a 15% expected return will be a 5.0%-7.5% position.  We may go up to 10% if the circumstance warrant but most likely our top position will be 7.5%.  These are all cost base positions rather than current prices.


Deep value stocks and good businesses will come in at 2.0%-4.0% as these are more trading stocks where the main driver of returns will be improvement in valuations rather than the company’s operating performance. It is also more difficult to build conviction with lower quality businesses.


We will continue to report on all companies prior to taking a position.

Company 9/8/15 Position Size and Results April 6, 2016

Company 9/8/15 Position Size and Results April 6, 2016


We have sold just under USD5.4 million of our position in Company 9/8/15 just over the USD5 million stated on March 24, 2016.  The company is now a 7.6% position.


On March 31, 2016, Company 9/8/15 reported annual results.  Revenue increased by 10% for the full year with a 120 basis point decline in gross margin from 29.10% to 27.90% due to weakness in high gross margin products. The big concern was the 96% increase in selling expenses and the 92% increase in administrative expenses. Selling expenses increased by RMB484 million and administrative expense increased by RMB71 million.  The largest increase in selling expenses was advertising and other marketing expenses, which increased by RMB395 million or 366.4% as the company injected more resources in TV, network and vehicle advertisement for the purpose of promoting the Yushi brand and held large membership promotion activities and brand promotion activities. The next largest increase was employee benefit expense, which increased by RMB103 million or 44.6%. The increase was mainly due to the one-off payment of share incentives..  Other expenses such as transportation and related charges increased by RMB12 million or 15%.  Rental expenses also increased by RMB19 million or 21.9%.  These expenses account for the vast majority of increases in operational expenses.   Additionally, Company 9/8/15 took a RMB109 million impairment charge related to previous acquisitions within its retail business.


Overall, the company’s operating income decreased by 70% from RMB688 million in 2014 to RMB206 million in 2015.  Working capital increased by RMB183 million driven by a RMB86 million increase in prepayments and other receivables as well as a RMB75 million decrease in accounts payable.  Fixed capital decreased from RMB125 million to RMB107 million. Despite the increase in expenses, Company 9/8/15 was able to generate a ROIC of 16%.

In the second half of 2015 revenue decreased by 3% compared to H2 2014. The company’s gross margin declined by 154 basis points from 28.59% in H2 2014 to 27.05% in H2 2015. The company generated an operating loss of RMB125 million in H2 2015 as the increase in operating expenses mentioned above only started in the second half of the year.


Within the retail business, the pharmacy count increased by 1 from 953 to 954 while sales grew by 16.3%. Retail gross margin declined by 199 basis points from 39.7% in 2014 to 37.7% in 2015. Operating margin also declined 1200 basis points from 21.9% in 2014 to 9.9% in 2015 as operating expenses ballooned to from 17.8% of sales in 2014 to 27.8% in 2015. Asset turnover increased from 1.31 to 1.43 illustrating assets are still being used efficiently and the increased in operating expenses are the main driver of weakness in the retail segment.


Within the retail segment, Company 9/8/15 started reported two sub segments Retail I and Retail II. Retails I segment are retail business with higher future development potential and strategic focus, while Retails II segment are retail business located in the areas without strategic importance and high growth potential.  The RMB108.9 million impairment charge came in the Retail II segment.  Retail I segment accounts for 91% of assets, 85% of revenues, 85% of gross profit and 93% of adjusted EBITDA.


Within the distribution segment, revenue grew by 5.2%, gross profit decreased by 2.3%, and operating profit decreased by 85.2% due to the increased advertising and promotional expenses.


The company is in a strong financial position with a net cash position of RMB1,299 million yet has not decided to pay a dividend.  The company also mentioned it was about to raise cash through a share issuance putting in question the cash on the balance sheet.


Company 9/8/15’s problems are not industry related as the largest Chinese pharmaceutical retailer and distributor Sinopharm grew its revenue by 13% and operating profit by 17% in 2015.  Zhongzhi Pharmaceutical also saw revenue growth of 19% and gross profit growth of 12%.


The results are disappointing. Revenue increased, a slight decrease in gross margin, and working capital not increasing significantly, operational momentum seems to be continuing but at a cost as increased advertising costs drastically reduced profitability.  The company did not disclosure a share pledge and then sold shares to a financial institution that was immediately forced to sell.  Overall management credibility and integrity is highly questionable and the business quality is in question.  The results in the first half of 2016 will be crucial to determining whether the elevated expenses were a one off or normalized earnings are significantly lower. The company is trading just above net cash. We will decrease our position by another USD3.0 million to bring the position size down to 5.0% closer to the risk associated with the position as it is now a deep value position with management with questionable integrity and capital allocation skills.