Monthly Archives: June 2016

Honworld 2015 Annual Report Review June 29, 2016

Honworld 2015 Annual Report Review June 29, 2016

Honworld Annual Report Review 2015 June 29 2016 RCR

The amount of capital allocated to inventory is the biggest concern with an investment in Honworld. There is some complexity to how inventory works its way through the company’s financial statements so we thought it would help us to relook at the production process and how inventory is accounted for.

 

To start the production process, Honworld purchases raw materials. In the company’s IPO prospectus, it stated “Our raw materials are generally available from numerous suppliers. We minimize our reliance on any single source of supply for our raw materials by maintaining alternative sources.” The breakdown of raw materials is listed below.

Honworld Raw Material costs

 

Raw materials with the exception of packaging are pure commodities where the purchasing decision is based on price readily available from many suppliers.

 

Base wine production is the next step in the production of inventory. Rice is soaked and steamed to increase moisture content. The rice is then fermented, which takes place in cool weather, generally from every October to next May each year. Sometimes, there is a second fermentation process. The fermented product is then filtered and sterilized. Depending on weather conditions, it typically takes 30 to 35 days to complete the above production steps. Following base wine production, base wine is aged, seasoned and blended, and packaged to create the final cooking wine product.

 

The final cooking wine product is a mixture of vintage base wine, mixer base wine, water, seasoning, and spices. Vintage base wine is aged to deliver the desirable aroma and taste, while mixer base wine is added to adjust the ABV, sweetness, and acidity. Mixer base wine is aged less than two years. The final cooking wine product comes in four grades classified by the amount of base wine used in the end product and the age of vintage base wine used.

Honworld product characteristics by product range

 

  • In 2013, premium cooking wine was 6% vintage base with an average age of 10 years and 87% mixer base wine with an alcohol by volume of 15%.
  • High-end cooking wine is 6% vintage base with an average age of 8 years and 81% mixer base wine with an alcohol by volume of 15%.
  • Medium-range cooking wine is 4% vintage base with an average age of 5-6 years, and 81% mixer base wine with an alcohol by volume of 10%.
  • Mass-market cooking wine is 4% vintage base with an average age of 5-6 years, and 64% mixer base wine with an alcohol by volume of 10%.

 

Honworld has not reported its volume sold or base wine used since its IPO prospectus. Volume sold for 2013, 2014, and 2015 is estimated, by assuming ASPs do not change over those periods, while, 2010 to 2012 are from the company’s prospectus.

ASP by product

 

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

Volume Sold

 

Base wine usage in 2013, 2014, and 2015 is assumed to remain the same as the first eight months of 2013. Base wine as a percentage of cooking wine volume sold increased from 35% to 86% as Honworld sold more premium products, which require more base wine, and the amount of mixer base wine per liter of cooking wine increased. Since base wine represented 86% of volume sold, the estimated base wine inventory of 180 million translates to 211 million liters of potential sales volume or 2.87 years of inventory based on 2015 estimated sales volume. Honworld’s target base wine inventory of 225 million liters, expected to be reached in June 2016, translates to 263 million liters of sales volume or 3.58 years of inventory based 2015 estimated sales volume.

 

Honworld did not report base wine inventory at the end of 2015 but at the end of 2014, the company had 158.4 million liters of base wine inventory. The company has repeatedly stated its target is to reach 225 million liters of base wine inventory. The question becomes does the company continue to build inventory past the 225 million liters level at a rate equivalent to sales, which will lead to a continued cash flow drain, or does the company remain at its target level of 225 million liters. At the end of 2016, we will know if the company continues to build inventory or if it continues to throw off cash flow. The company has been raising money by selling shares and bank loans leading us to believe it will continue to build inventory with revenue growth. If the company was going to stop building inventory, it would make sense to use debt to maintain ownership as the company is not too levered with net debt to EBIT at 1.54 times.

Key Inventory Statistics

 

The above table illustrates base wine inventory from 2010 to 2015. At the end of 2015, Honworld had 180 million liters of base wine and a total inventory cost of RMB945 million for an estimated cost of RMB5.24 per liter of base wine. The cost of goods sold per liter of volume sold equaled RMB3.26, while the cost of goods sold per liter of base wine used equaled RMB3.81. The ratio of cost of goods sold per liter of volume sold to the cost of goods sold per liter of base wine equaled the ratio of base wine used to volume sold.

 

The ratio of the cost of base wine used to balance sheet inventory on a per liter basis fluctuated between 227.5% in 2010 to 59.3% in 2013 with 2015 ratio of 72.6%. The company uses weighted average method so a shift in raw materials costs will not create a differential between inventory valuation on the balance sheet and inventory valuation on the income statement in cost of goods sold. The shift in cost of goods sold per liter of base wine to base wine inventory valuation per liter is related to an increase in vintage wine in inventory relative to the amount of vintage base wine used in volume sold as there are costs to storing and holding base wine during the aging process leading vintage base wine to have a higher valuation. Vintage base wine will continue to increase as a proportion of inventory held while vintage base wine as a percentage of cost of goods sold not increase drastically meaning cost of base wine sold per liter should decrease relative to the cost of base wine inventory per liter.

Base wine breakdown

 

 

Capital Allocation

 

Other than understanding how the company’s main product flows through the financial statements, the central question to the analysis of inventory is whether allocating significant amounts of capital to inventory is in the best interest of shareholders.

 

Management states it can guard against the increase of raw material price from holding a higher level of base wine. Raw materials are commodities in the truest sense of the word so as long as a certain quality threshold is reached price is the only consideration in the purchase decision. These commodities are available from many producers. Suppliers of raw materials have no bargaining power so there will be no price increases due to supplier strength. If raw material prices increase all competitors will be affected equally allowing raw material price increases to be passed on to customers. Furthermore, Honworld has a brand, illustrated by its leading market share with premium pricing, meaning any increase in commodity prices can be passed on to customers.

Inventory buffer for price increases

 

Assuming that the company is unable to increases in raw material prices, to analyze the effects of increased inventory and associated working capital, we assume that the company carries half as much base wine to eliminate the company’s inventory protecting against raw material prices. We assumed base wine inventory is halved from 180 million liters to 90 million liters, which translates to 105 million liters of end product or 1.43 years of 2015 estimated sales volume. Total inventory costs decrease from RMB945 million to roughly RMB475 million leading to an increase in inventory turnover from 0.84 to 1.69. In addition, fixed capital is tied to inventory as much of the company fixed costs are storage facilities to age base wine; therefore, fixed capital is assumed to decrease by 25%. Other working capital is assumed to have no connection to inventory levels and therefore remains the same leading to overall invested capital decrease from RMB1,782 million in 2015 to an estimated RMB1,145 million without inventory and necessary infrastructure to protect against raw material increases. Raw material price increases lead to increased cost of goods sold with every other income statement account remaining the same.

Raw material price increases vs current ROIC

 

As illustrated above, if Honworld halved its inventory as well as associated fixed costs,  raw material prices need to increase by 30% for return on invested capital (ROIC) to reach the level seen in 2015. Commodity prices are difficult to forecast but a 30% increase in a deflationary environment does not seem like a high probability event. Additionally, there is a high probability (80-85%) that Honworld would be able to pass on increases in raw material prices due to its brand, and/or competitors would see the same increase in commodity prices leading to an industry wide increase in prices. The statement that management is building inventory to protect against rising assume that two low probability events occur rising raw material prices in a deflationary world (<20-25%) and an inability to pass on price increases leading to a decrease in profitability (<15-20%).

 

Management’s other reason for building inventory is to support future growth. The company’s current inventory is sufficient cover 2.87 years of 2015 sales volume. In addition, the company believes it will reach 225 million liters of base wine inventory at the end of the first half of 2016. The company can also produce enough base wine to cover 2015 in one year’s sales as while increasing its base wine inventory it is still producing sufficient inventory to cover current period sales.

 

Mixer base wine and vintage base wine are two types of base wine used in the production of cooking wine. Mixer base wine is less than two years old, so does not need any ageing, while vintage base wine is over two years old, and therefore needs ageing. The table below illustrates the amount of base wine, vintage base wine, mixer base wine, the average age of vintage base wine, the percentage of 2015 cooking wine revenue of each category of base wine, and estimated gross margin for each category.

Base whine characteristics by product with potential scenarios

 

The table also illustrates the 2015 blended average and two scenarios assuming an increase in sales of higher-end and premium products.

 

Given mixer base wine can be produced without ageing, the inventory build is to allow the company to produce more vintage base wine to allow the company sell more premium products.

Base wine ageing

 

Base wine inventory in liters is estimated by assuming the cost of base wine remained the same in 2015 as the company reported base wine inventory in liters in 2014. Mixer base wine is assumed to be the change in inventory from the previous two years as mixer base wine is any base wine under two years. The remaining base wine is considered vintage base wine. Vintage base wine’s age is estimated by taking the vintage base wine not used in the year and adding mixer base wine added to inventory two years ago. All new mixer base wine is considered to be 2.5 years and vintage base wine from previous years is considered to age by a year. Vintage base wine inventory estimated age reached 4.0 years at the end of 2015. The vintage base wine inventory’s age continues to fall as the mixer base wine re-classified as vintage base wine increases as a proportion of vintage base wine inventory.

 

The company now has estimated base wine inventory of 180.3 million liters consisting of 87.7 million liters of base wine inventory and 92.7 million liters of vintage base wine inventory. In 2015, Honworld used an estimated RMB3.3 million liters of vintage base wine meaning the vintage base wine inventory of 68.4 million liters is sufficient for almost 21 years assuming sales remain at 2015 levels. Mixer base wine can be easily produced as it does not have to be aged creating a situation where vintage base wine will continue to grow.

 

Assuming similar sales volume to 2015 and product mix of 50% of sales volume is premium, 25% is high-end, and 25% is medium-range, base wine would be 88.0% of a liter of cooking wine with vintage base wine would need to be 5.5% of inventory sold or 4.4 million liters of vintage base wine. At current inventory levels, vintage base wine inventory would have just less than 17 years of vintage base wine inventory. It seems the company is over building its vintage base wine inventory, which may not be used for decades and is well above the amount required. Vintage base wine could probably be closer to 10-12 years as in the most aggressive scenario of selling 100% premium cooking wine base wine only needs to be ten years old. Additionally, the company can produce an estimated additional 100 million liters in mixer base wine per year with the vast majority going to current period sales. The company is building inventory and should be effectively spread over ages, unfortunately the company does not provide disclosure on the age of its inventory. The company could effectively half its vintage base wine inventory and still have 10 years of vintage base wine inventory, while mixer base wine inventory should no more than a year as the company produces about 150% of its current period mixer base wine needs. Overall, base wine inventory could be decreased by 50% and still have sufficient inventory for current period and growth meaning ROIC could increase from 16.6% in 2015 to 25.8%.

 

The analysis above was not created to verify my past views on Honworld’s inventory levels but to use a new angle to see if my existing view were inappropriate. Unfortunately, the outcome of the analysis points to the same view that inventory is bloated and holding down returns of the company with inventory at twice the size it needs to be.

 

After reviewing Honworld’s 2015 annual report, the company will not be able to realize its full value if it does not do a better job on disclosure. Analysts need more information to get a much more accurate picture of the company and fully understand how inventory flows through the company’s financial statements. Additionally, the company should give better disclosure on product mix and profitability of each product. Our desire is to see the following disclosed:

 

  • ASP
  • Volume by product
  • Gross margin by product
  • Base wine inventory in liters
  • Base wine inventory ageing
  • Inventory ageing by base wine and vintage base wine
  • Estimated inventory cost by age
  • Base wine production capacity
  • Base wine storage capacity
  • Bottling capacity
  • Sales by geography
  • Sales by distribution channel

 

Overall, Honworld is one of our top ideas. There is a high probability that the company is building a multi-faceted competitive advantage in the form of economies of scale and brand. Over the past three years, the company spent 7.0% of revenue in research and development and another 7.1% in selling and distribution expenses meaning fixed costs were 14.1% of revenue. In 2012, the last reported data, Honworld was the largest Chinese cooking wine producer with a 13.8% market share. The company is the only top four cooking wine producer using a naturally brewed, traditional production process allowing the company to garner premium pricing. This premium pricing amplifies the company’s size advantage over its top four competitors, as 95% of cost of goods sold is raw materials in the form of agricultural commodities. As illustrated below in 2012 (latest available data), Honworld’s sales are 2.16 times and its gross profit is 2.86 times its largest competitor. Sales are 3.21 times and gross profit is 4.21 times its second largest competitor.

Top 5 cooking wine producers in china

 

The 14.1% of revenue in fixed costs translates to 24.4% of gross profit. The company’s nearest competitor is the only competitor that can match the fixed costs and still be profitable as Honworld’s fixed costs equate to 70% of the largest competitor’s gross profit and 103% of the second largest competitor’s gross profit. Honworld expects to increase advertising expenses and continue to increase the penetration of its distribution channel to third and fourth tier cities within its key sales regions. The company also has brand advantage illustrated by market share advantage and premium pricing. Additionally, it sells the lower priced product where the customer is less likely to search for alternatives with a small price increase as the increase is not as noticeable and search costs are much higher.

 

The company is run by a passionate, owner-operator and recently there was an investment by a private equity company with significant resources to conduct due diligence giving credibility to the company’s financial service. The private equity company is an expert in Chinese consumer companies so it brings additional relevant expertise. The major concern with Honworld is the investment in inventory. As illustrated above, inventory is running at twice what it should and dragging on profitability leading to financing issues. The company is increasing its debt load and selling part of the company to finance its growth as it is growing at 20% per year. The company is targeting 225 million liters of base wine inventory at the end of the first half of 2016. Hopefully, the company slows down the aggressive inventory build and if it continues to build inventory it does so at a slower pace than revenue growth.

 

The company offers a 12.7% EBIT yield and 5.0% organic growth through pricing power for almost 18% expected annual return. Additionally, the company’s debt load is inflated due to its inventory build and if the company changes direction with inventory it can pay down that debt quickly or increase dividends.

Credit Analysis and Research June 20, 2016

Credit Research and Analysis                          June  20, 2016

Ticker: CARE:IN

Closing Price (6/20/2016): INR993.50

1 Year Avg. Daily Vol. (USD): 530,269

Estimated Annualized Return: 8-9%

Credit Analysis and Research June 20 2016 RCR

 

INVESTMENT THESIS

 

Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market.  The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case.  We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.

 

 

KEY STATISTICS

CARE Key Statistics June 20 2016

 

 

FACTOR RATINGS

CARE Factor Ratings June 20 2016

 

 

COMPANY DESCRIPTION

 

Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue.  Rating assignments generates two types of revenue: rating revenue and surveillance revenue.  Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.

CARE Volume of Debt Rated June 20 2016

 

Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt.   Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan.  If a loan it not rated, it retains a capital risk weight of 100%.

CARE Bank Loan Rating Capital Savings June 20 2016

 

The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital.  Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.

CARE Credit Penentration June 20 2016

 

As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.

 

Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits.  Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.

CARE Bond Market Penentration June 20 2016

 

As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers.  It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.

CARE Domestic Credit vs GDP per capita June 20 2016

 

CARE Bond Market vs GDP per capita June 20 2016

 

Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets.  New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures.  The company can also move into adjacent product market like research and advisory services.   CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.

 

CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.

CARE Shareholder Structure June 20 2016

 

IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.

 

 

INDUSTRY

 

CRISIL, the first India credit rating agency, was established in 1987.  ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.

 

In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.

 

In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.

 

Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.

 

Barriers to Entry

 

The industry structure points to barriers to entry.  There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market.  The market share among the top three players since FY2006 is illustrated below.

CARE Top 3 maket share June 20 2016

 

CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).

 

The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.

 

CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million.  The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.

CARE Profitability June 20 2016

 

The rating agencies seem to lack pricing power pointing to no barriers to entry.  The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power.  The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.

CARE Employee Expense June 20 2016

 

CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.

 

Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies.  ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms.  The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.

 

Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment.  If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.

 

Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.

 

Other Four Forces

 

The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA.  In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue.  Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.

 

The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense.  The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market.  Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699  to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline.   CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.

 

The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated.  A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.

CARE Bank Loan Rating Capital Savings June 20 2016

 

Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power.  The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.

 

The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings.  Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm.  Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.

 

 

MANAGEMENT

 

Operational Performance

 

Operationally, management has performed very well.  It is increased its market share among the top three rating agencies by almost 10% over the past ten years.

CARE Top 3 maket share June 20 2016

 

The company is also the best performing credit rating agency in terms of operating profit per employee.

CARE vs Peers Per Employee stats June 20 2016

 

ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.

 

Capital Allocation

 

Management has done a good job on focusing on the ratings business.  CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses.  These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital.  CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years.  ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.

 

The only other capital allocation decision made by management is whether to hold cash or payout cash.  Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.

CARE Return on Financial Assets June 20 2016

 

Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.

 

Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.

 

Corporate Governance

 

There are no related party transactions other than management remuneration.   Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.

 

There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.

 

Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.

 

 

 VALUATION

 

Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense.  The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.

 

Under the blended valuation, we use different scenarios to determine potential upsides and downsides.  The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.

CARE Key Stagnant assumptions June 20 2016

 

Sales growth and operating margin are changed to determine upside under different scenarios.  The scenarios and assumptions for both value drivers are listed below.

CARE Key Variable assumptions June 20 2016

 

The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.

CARE Scenario Valuations June 20 2016

 

The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.

 

The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside.  The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.

 

The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.

 

The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.

 

Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation.  The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India.  Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.

 

CARE seems to be slightly undervalued to fairly valued.

 

 

RISKS

 

The biggest risk to CARE’s business is reputational.  After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated.  During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value.  S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.

 

Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.

 

Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.

 

There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.

 

Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.

 

After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.

 

CARE is managed by external agents rather than owner operators.  If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.

 

CARE investment thesis and price paid is based on the development of banking and credit markets.  If banking and credit markets do not develop, there may be permanent loss of capital.

 

CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital.  To combat this risk, we are taking a small starting position.

 

 

Zensar FY2016 Results Review June 8, 2016

Zensar FY2016 Review June 8, 2016

We are decreasing our position size in Zensar Technologies to 4.0%.  Zensar Technologies continue to performing well with revenues growing by 12.8%, gross margin expanding by 170 basis points and operating profit increasing by 18.4%. The company has been a very consistent in its growth with revenue growing by 21.1% per year over the past five years and 21.3% per annum over the past ten years. Operating income has increased by 20.6% per year over the past five years and 25.3% over the past ten years.

 

The company is shifting its business model from traditional IT services to a digital strategy to drive further growth. Zensar is executing the shift with digital revenues at 27% of total revenues in FY2016 up from only 5% three year ago.  Digitial revenues are expected to continue to grow at over 20% for the next few years.  The company also continues to increase deal size with the number of large deals over 64 clients over USD1 million in FY2016 up from 51 in FY2013.  It also won USD130 million in contracts in FY2016 with expectations for a much higher number in FY2017.

 

Zensar expects margin expansion from increasing significance of digital and decreasing significance of product and license revenue. The company also is decreasing the number of low margin, low revenue accounts with the total number of accounts decreasing from 211 to 194.   Unfortunately, the industry suffers from an inability to grow margins drastically as more business requires more employees.  There are low barriers to entry leading to significant fragmentation within the industry as illustrated by the industry fragmentation.  Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and some switching costs.  Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers.

 

Our initial investment was due to very cheap valuations along with strong profitability, strong growth, execution, and a strong culture.  The company continues to execute on all fronts but valuations are no longer extremely cheap and therefore we will be taking our profits and nearly halving our position size to around 4.0%.  The company is trading on an NOPAT yield of 6.6% and conservative growth of 10% over the next few years. While the company expected return is over 15%, the lack of barriers to entry leading to fragmentation within the industry and eliminating pricing power increases the risk to earnings.

PC Jeweller FY2016 Results Review June 6, 2016

PC Jeweller FY2016 Results Review June 6, 2016

 

 

Key Value Drivers

 

PC Jeweller reported FY2016 (March 2015-March 2016) results on May 30, 2016, with results affected by a month long strike in March 2016 by the Gems & Jewelry industry. Following the government’s proposal for a 1% excise duty on non-silver manufactured, the entire industry went on a 43 days strike, which further deteriorated the demand during the quarter. Sanjiv Agarwal, CEO, Gitanjali Exports estimates the strike has resulted in losses of Rs 500 bn to 600 bn for the overall jewelry industry. The company’s revenue increased by 15.2% with domestic revenue increasing by 13.9% and export revenue increasing by 18.6%.

 

In domestic operations, PC Jeweller increased its store count by 11 stores from 50 at the end of FY2015 to 61 at the end of FY2015.  Oddly, the company’s retail area increased from 313,296 square feet at the end of FY2015 to 319,891 square feet at the end of FY2016 leading the average store size decreasing from 6,266 square feet at the end of FY2015 to  5,244 square feet at the end of FY2016.

 

6 6 2016 Sq Ft Average Store Size

 

A decrease in average store size in not unprecendented but the decline in FY2016 was drastic.  The company is piloting smaller stores targeting new geographical and customer markets (middle/lower class) but this is a pilot that should not have an effect as of yet.

 

Overall, domestic sales accounted for 70.5% of sales in FY2016. Sales per square feet increased from INR144,869 in FY2015 to INR161,553 in FY2016. Despite the increase, sales per square feet have yet to recover to the FY2013 peak before regulation and taxation set the industry back.

 

 

In export markets, sales grew by 18.6% despite weakness in key export markets (Middle East) due to lower oil prices.

 

In FY2016, gross margin declined to 13.9% from 15.2% in FY2015 due to a combination of export sales increasing (29.5% vs 28.5% in FY2015) and decreased percentage of diamond jewelry sales (28.2% vs 31.5% in FY2015). Domestic steady state gross margin is expected to be between 16-17%, while export gross margin is expected to be between 6-8%.   Domestic margins assume diamond jewelry is 30% of overall sales with a gross margin of 30-35%, while gold jewelry has gross margin of 9-10%.

 

Since the beginning of FY2012, employee costs averaged 0.90% of sales, advertising expense averaged 0.91%, rental expense averaged 0.61%, and other expenses averaged 2.18%. In FY2016, all operating expenses were roughly in line with historical averages with the exception of other expenses, which were only 0.81% of sales. Other expenses have trended down since averaging 2.96% of sales in the three years ending FY2014.  In FY2015 and FY2016, other expenses averaged 1.01%.

 

Overall, the company’s operating margin of 10.9% was the lowest since 2009 when the company’s operating margin reached 10.1% with a tax rate close of 25.5% leading to a NOPAT margin of 8.1%. The company’s invested capital turnover decreased to 2.6 from 2.8 in FY2015 leading to a FY2016 ROIC of 21.0%.  Assuming a full 12 months instead of 11 due to the protest, the company’s invested capital turnover in FY2016 would have been 2.8 leading to a normalized ROIC of 22.9%, a decline from 25.1% in FY2015 and is the lowest reported level. We believe the decline in profitability is driven by a combination of economic weakness and increased regulation rather than increased competition.

 

The company’s model for domestic large format showrooms is illustrated below.

PC Jeweller Store Economics

 

The company expects to open 20-25 stores in FY2017 and open 100 stores over the next five years.  The company is also exploring franchising. This growth comes at the expense of the unorganized sector as organized jewelry retail is growing at 25% per year and will reach 35% of the market in the next few years from the current 22%.   The government introduced a number of regulations allowing for better regulation of the industry which should speed up the share gain of the organized sector. These regulations include compulsory hallmarking of gold jewelry, requirement of PAN Card for all purchases above INR 2 lakhs, and 1% excise duty on jewelry sales. These regulations may also negatively affect demand in the short term.

 

PC Jeweller currently focuses on large format showrooms on high street location catering to the rich and upper middle class and is piloting smaller format showrooms with a smaller size (1,000-1,500 sq ft) to cater to the middle and lower classes. It is also piloting franchise stores that will require little to no capital allowing the company to expand beyond its current presence in Tier 1 and Tier 2 cities.

 

Althought the company’s financial health deteriorated slightly with Net Debt to NOPAT increasing to 1.0 from 0.66 in FY2015, PC Jeweller is in strong financial health.

 

 

Competitive Position

 

The industry is very fragmented with over 4,500 participants at the time of initiation pointing to low barriers to entry.  The company’s gross margin is not particularly high pointing a potentially commodity product. Consumers purchase decision is based on not only on price but design points to the potential for differentiation but the fragmentation of the industry and a lack of stability in gross margins point to a lack of pricing power.

6 6 2016 Gross Margin

 

Despite the lack of barriers to entry and pricing power, PC Jeweller has maintained a ROIC of 36.1% since 2009, although there has been significant variability in the profitability metric.

6 6 2016 ROIC

 

The excess profitability is most likely down to the company’s operational efficiency and weak competition from the unorganized sector rather than a competitive advantage.  As the organized sector gains shares, competition should intensify and profitability should deteriorate.

 

 

Management

 

Management has not sold any shares and continues to allocate capital solely to expansion and toward minimum dividends.   Management also continues to innovate with the Flexia jewelry line, a smart jewelry line, and wearyourshine.com.  The company is also focused on exploring new markets and franchising which should increase the addressable market for the company.

 

 

Performance vs Peers

6 6 2016 Performance vs Peers

 

PC Jeweller has the second highest gross margin and highest operating margin in the sector. Only PC Jeweller and Titan were able to generate ROIC above 12.3% for FY2016.  Sales declined at all competitors except Rajesh Exports whose results were boosted by an acquisition.   Despite the strong profitability and growth relative to peers, PC Jeweller is one of the cheapest companies within the sector trading at an EVEBIT of roughly 10 times.  The company has proven to be one of the best operators in the industry.  The company has a long runway for growth opening 100 stores over the next five years with franchising and new markets as well as operational efficiency and weak competition excess profitability should be sustained for some time. We will maintain our current position size.

Honworld Share Sale June 3, 2016

Honworld Share Sale June 3, 2016

 

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

 

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

 

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

 

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

 

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

 

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