Monthly Archives: December 2016

WEEKLY COMMENTARY 12/13/16 – 12/19/16

WEEKLY COMMENTARY 12/13/16 – 12/19/16

 

 

POSITIONING

 

 

 

 

COMPANY NEWS

 

Grendene changed its auditor from PWC to E&Y due its requirement to change its auditor every five years.

 

We were thinking about PC Jeweller and the potential evolution of the jewelry retail industry in India. When think about industry evolution in Emerging Markets, we often look to developed markets for roadmaps. Each market has idiosyncrasies but strategic logic should hold from industry to industry across geographies. For example, the retail market structure in India should eventually look like retail market structure in the US as the industry develops. Retailing is fiercely competitive in all markets with no barriers to entry therefore all industries should have many competitors with very few if any generating significant sustained excess profits.

 

Our main reference point for the following information on the US Jewelry market is Edahn Golan Diamond Research & Data’s 2015 US Jewelry State of the Market report. You can download the report here. According to the Jewelers Board of Trade, there were 21,463 specialty jewelry retailers accounting for 43% of the US jewelry and watch retail market. The vast majority of these specialty stores are independent with Signet Jewelers being the largest retailer accounting for 4.3% of overall jewelry sales in the US and 9.8% of specialty jewelry sales. Signet Jewelers had roughly 3,000 stores at the end of 2015.  Despite market development and industry maturation, the US jewelry market remains fragmented with thousands of players illustrating a lack of barriers to entry and continued competitive pressures.

 

The lack of barriers to entry puts a cap on Signet’s and Tiffany’s ability generate excess profits with their average ROIC over the last five years below 15%.

 

Looking at the United States jewelry retail industry as a roadmap leads one to believe that fragmentation will persist within the Indian jewelry retail industry.

 

Another use of the roadmap is the potential multiple the market gives a company during maturity.  Signet’s EV/IC has ranged from 1.69 in 2012 to 2.89 at the end of 2015, while Tiffany’s EV/IC ranged from 2.54 at the end of 2016 to 3.55 at the end of 2015.

 

Signet’s EV/EBIT ranged from 6.86 in 2012 to 18.94 in 2015. Tiffany’s EV/EBIT ranged from 11.84 in 2016 to 37.19 in 2014, with operating Income in 2014 was depressed. Accounting for the depressed operating income, EV/EBIT ranged from 11.84 to 14.49.

 

We have included similar analysis on Honworld (condiments) and Universal Health (pharmacies/pharmaceutical distribution) that we did in the past at the end of the weekly commentary.

 

 

INTERESTING LINKS

 

Deep Dive into China’s Apparel Market (Fung Business Intelligence)

Fung Business Intelligence freely provide a lot of good information on China. In this multi-part report, Fung Business Intelligence provides detail on China’s Apparel Market. (Part 1) (Part 2)

 

Asahi to Buy SABMiller’s Eastern European Beers in $7.8 Billion Deal (Bloomberg)

Acquisition news is always interesting as a knowledgeable player in the market puts a value on an assets based on a detailed analysis. The problem is we do not know the assumptions the acquirer is using, which are crucial, but it gives an idea of an appropriate valuation multiple in an industry. The paragraph below is from the Bloomberg article.

 

The offer values the SABMiller assets at about 15 times Ebitda of 493.8 million euros for the year ended March 2016, according to Bloomberg calculations. That compared with the median of about 11.5 times trailing twelve-month Ebitda for 9 brewery acquisitions announced worldwide in the past five years, according to data compiled by Bloomberg.

 

We extended the sample size of acquisitions back to 1999 and the median acquisition multiple was 11.7 times not far off the 11.5 times paid over the last twelve months.

 

 

 

The table below shows the upside to the 11.7 times multiple for various brewers in Emerging Markets.

 

 

 

Median Buyout EV/EBITDA Ratios Rising (PitchBook via ValueWalk)

 

The PitchBook examines the median buyout multiple for private value investors.  (link)  What we find interesting is the disconnect between what business owners are willing to pay and the valuations public market investors are willing to pay for companies.

 

 

The Undoing Project: A Friendship That Changed Our Minds (The Rational Walk)

 

The Rational Walk discusses Michael Lewis’ new book about pioneers in Behavioural Finance and how it relates to investing. (link)

 

 

The Story of How McDonald’s First Got Its Start (Smithsonian)
The story of the history of the McDonald brothers before McDonald’s became a multi-chain restaurant. (link)

 

 

What is Your Edge? (Base Hit Investing)

 

An article discussing three types of edges in investing. (link)  We view our biggest edge over other market participants is a time horizon edge as we are looking for stocks for the next three to five years.  This also brings an analytical edge as we are analyzing business from the view point of a business owner rather than trying to figure out if the company will beat next quarter’s expectations.

 

 

Buffett’s Three Categories of Returns on Capital (Base Hit Investing)

 

An older post discussing how Buffett categorizes businesses (link)

 

 

HONWORLD DEVELOPED MARKET ROADMAP

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out but when it does it leads to a national market similar to many developed market like the US. The cultural convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.

 

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

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

 

The table below shows the market structure of the five largest condiment markets in the US.

 

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

 

 

UNIVERSAL HEALTH DEVELOPED MARKET ROADMAP

 

Market Structure

 

The pharmaceutical retail segment in China is fragmented. According to the China Food and Drug Administration, in November 2013, there were 433,873 chain and individual drug stores in China, 10,150 more stores than 2012. There are 3,376 enterprises with multiple locations in China. Enterprises with multiple locations are more likely to manage the business for profitability and close down unprofitable stores. All though the market is fragmented, market consolidation is underway with Universal Health and Sinopharm leading the way. Retail competition comes in the form of target customer bases, business models, and product portfolios.

 

At the time of its IPO, Universal Health was the largest pharmaceutical retailer in Northeast China with 794 self operated outlets.  There is not sufficient information to get a sense of the efficiency of each store as competitors with higher revenue per store maybe a function of bigger stores, but it seems Universal Health’s may not be as efficient as competitors. This poor efficiency may be due to acquiring less efficient stores and improving operations. The pharmacy market in Northeast China has low level of concentration with a 2012 five firm concentration ratio of 44.2%.  This only tells part of the story as there could be a large number of smaller independent stores.  Universal Health has increased its estimated market share in Northeast China retail from 5.7% in 2012 to an estimated 8.8% in 2014.

 

The largest distributors in Northeast China at the time of the IPO are listed below. Universal Health is the largest private pharmaceutical distributor in Northeast China.

 

 

The largest retail pharmacy chains in China are listed below.  In 2012, the largest pharmacy operator had a 2.1% market share.  The 2012 five firm concentration ratio was 9.4%, while the ten firm concentration ratio was 16.0% indicating a very fragmented market. At the end of 2012, Universal Health’s China retail market share was 40bps.

 

The Chinese pharmaceutical distribution market is less fragmented than the retail market but still exhibits low concentration with the leading player accounting for 16.8% of the overall market.  The five firm concentration ratio is 36.5% and the ten firm concentration ratio is 44.9%. Universal Health garnered 16 bps of the total Chinese pharmaceutical distribution market.

 

While each individual country has its own idiosyncrasies leading to different development paths, the market structure of more developed markets may give a roadmap for developing countries.

 

The US pharmacy market shows moderate levels of concentration with a five firm concentration ratio of 64.4%.  There is some fragmentation but there are a significant number of small players still operating in the market.

 

According to Canada’s Office of Consumer Affairs, the Canadian pharmacy market has a 2012 four firm concentration ratio of 68.6%. The largest company is Shoppers Drug Mart with a 31.8% market share followed by Katz Group with a 16.7% market share, Jean Coutu with a 12.2% market share, and McKesson with a 7.9% market share.

 

According to the Pharmaceutical Journal, in the UK, there are 14,361 pharmacies with 4,201 independent owners, owning up to five pharmacies, operating 5,590 pharmacies and 174 multiple owners, owning six or more pharmacies, operating 8,771 pharmacies.  Large owners and supermarkets account for 52% of the overall market.

 

The US’s, Canada’s, and UK’s pharmacy market structures point to a much more consolidated market than the Chinese market but not the oligopolistic market structure you would expect if there was a significant benefit from economies of scales.  There seems to be economies of scale in purchasing but only to a point. Another reason for the fragmentation and large number of small independent operators may be that independent operators do the job for something other than profit maximization.  Just like optometrists or dentists, the ability to be your own boss and make a decent living trumps the desire to sell to a larger chain or exit when faced with a competitive disadvantage.

 

Pharmaceutical distribution markets are far more concentrated in developed countries than China with a three firm concentration ratio ranging from 43% to 85%.  Developed pharmaceutical distributors, economies of scale manifest themselves in high capital efficiency as operating margins often struggle to reach 2%.   The high fixed costs associated with upfront investments and low marginal cost for selling an additional unit leads to very high competitive rivalry among distributors and the need to utilize fixed costs as much as possible leading to greater profitability.

 

 

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

 

 

 

 

COMPANY NEWS

 

There was no news related to portfolio companies this week.

 

We are decreasing our Credit Analysis and Research (CARE) position to 0%. We initiated the position at 2.0% as categorizing CARE as a high quality company that was slightly overvalued. Since initiation, the share price increased by 44% making the company overvalued with significant growth needed to generate any return.

 

We are also decreasing our Anta Sports position to 0% as we initiated the company as a high quality company that met all the criteria for investment with the exception of price as we felt it was slightly overvalued. The share price appreciated by 25% since our initiation and the company is now overvalued rather than slightly overvalued.

 

 

INTERESTING LINKS

 

At Deloitte, the problems with audit quality and professionalism start at the top (Marketwatch)

 

Deloitte is facing regulatory backlash over faulty audits and misleading investigators. It is not the first time and will not be the last. (link) There have been many examples of Chinese companies listed in Hong Kong IPO’d with a big 4 auditor that turned out to be frauds.

 

The Magic in the Warehouse (Fortune)

 

An interesting article discussing Costco, its business model, and its culture (link)

 

How to Build Great Teams (Society for Human Resource Management)

 

A great discussion on how to build great teams through communication and fit (link)

 

Why is Customer Acquisition Cost (CAC) like a Belly Button? (25iq)

 

Tren Griffin illustrates the importance of knowing the CAC in your business. (link)

 

Huawei’s Hard-Charging Workplace Culture Drives Growth, Demands Sacrifice (Wall Street Journal)

 

The Wall Street Journal writes about the culture of Huawei. (link)

 

Q3 2016 Report (IP Capital Partners)

 

IP Capital Partners’ Q3 2016 Report contains a good investment case for Amazon. (link)

 

 

 

INTOUCH HOLDINGS PRE-RESEARCH REPORT

 

EXECUTIVE SUMMARY

 

Intouch Holdings is an investment holding company with Advanced Info Services (AIS) account for over 95% of its intrinsic value. AIS is the leading mobile operator in Thailand with roughly a 50% market share. The industry has barriers to entry in the form of economies of scale and brand.  The large fixed costs come in the form of investment in spectrum and infrastructure and to a lesser extent marketing and distribution. Given AIS size and the presence of economies of scale, it has a significant advantage over its peers. Regulation also limits the competition to Thai companies.

 

Thailand recently held 3G and 4G spectrum auctions. The increased cost of spectrum decreases returns on investment in the industry as capital efficiency is much weaker leading to lower intrinsic values. The market is pricing in current earnings weakness due to a strong intensity of rivalry but valuations must fall further to account for the lower capital efficiency. In our estimate, AIS would be a buy below THB70 before becoming a buying opportunity translating to a buy price of Intouch below THB30 per share.

 

 

FACTOR RATING

 

 

 

COMPANY DESCTRIPTION

 

Intouch Holdings is a telecommunications holding company in Thailand, with investments in public and private companies. The company was founded as Shinawatra Computer Service and Investment by Thaksin Shinawatra in 1983. In 2006, when Shinawatra became the Prime Minister of Thailand, he sold his family’s stake in then Shin Corporation to Temasek Holdings. Shin Corporation rebranded itself to Intouch in 2011, including its new stock symbol, but did not officially change its registered name until March 2014.

 

The company’s main assets are publicly listed. Intouch has a 40.45% stake in Advanced Info Service PLC (AIS), a 41.14% stake in Thaicom PLC, and a 42.07% share in CS Loxinfo through a 99% owned Thaicom subsidiary.

 

The vast majority of the company’s net profit and value is derived from its investment in AIS.

 

AIS is the leading mobile operator in Thailand with 39.4 million subscribers nationwide or approximately 46% of the subscriber market share. In Q2 2016, 85.2% of subscribers were pre-paid.

 

To service its subscribers, AIS has 40MHz of its own spectrum (the regulatory limit is 45MHz), and up to 30MHz of spectrum rented from TOT. The company’s own spectrum was acquired at a total cost of THB319.4 billion (USD7.8 billion) and the rented spectrum has up to an annual cost of THB3.9 billion with a potential cost of THB39 billion over the life of the lease. To support its spectrum, AIS has 32,000 3G base stations covering 89% of the population and 15,500 4G base stations covering 55% of the population. AIS’s 4G goal is to cover 80% of the population by the end of 2016. AIS mobile operations account for over than 99% of AIS revenues.

 

Thaicom provides satellite transponder leasing in both the domestic and international markets under a concession from the Ministry of Information and Communications Technology, which expires in 2021, and the Telecommunications Service License Type III granted by the NBTC, which expires in 2032. THAICOM currently operates four satellites: one broadband satellite, Thaicom 4 (IPSTAR), and three conventional satellites, Thaicom 5, 6 & 7. Another satellite (Thaicom 8) is under construction and is expected to be launched in the first half of 2016.

 

Other businesses includes a JV with Hyundai Home Shopping creating a home shopping network in Thailand, and InVent, a venture capital arm launched in 2012, with the main purpose of supporting and promoting high-potential start-up companies in Telecom, Media, IT, Digital Content and other related businesses.

 

Intouch Holdings is 41.62% owned by Temasek. On August 18, 2016, Singapore Telecommunications entered into a conditional share purchase with Temasek to purchase 21% of Intouch Holdings at a price of Bt60.83 per share. The agreement should conclude in December 2016.

 

 

INDUSTRY ANALYSIS

 

Barriers to Entry

 

There are three major mobile operators: AIS, Total Access Communications (DTAC), and True Corporation (True). In Q2 2016, AIS had a 49.9% market share, DTAC had 25.5% of the market, and True had 24.6% of the market. Two other players CAT and TOT mainly lease their mobile networks to other players and have minimal market share.

 

There is strong evidence that barriers to entry exist among mobile operators. The industry only has three players. If there were no barriers to entry, there would be many more competitors as entrants are free to enter the industry.  Additionally, there is market share stability.

 

Market share stability points to captive customers that have difficulty changing between suppliers or do not want switch suppliers making it difficult for new entrants to compete. AIS tends to be the biggest beneficiary of the barriers to entry in the industry as it consistent generates the highest average revenue per user (ARPU), and the highest profitability.

 

AIS outperforms on all key value metrics including ARPU, gross margin, operating margin, invested capital turnover, and ROIC.

 

Additionally, AIS consistently generates excess profits well above its competitors, accounting for 89% of the industry’s excess profits since 2011.

 

The evidence points to barriers to entry within the industry with AIS being the main beneficiary. Given AIS’s market share advantage, economies of scale seems to be the primary source of its advantage as there are significant fixed costs with the largest being investment in spectrum and building a network with smaller fixed costs being marketing to build a brand. Investment in spectrum and network build are made prior to acquiring customers and the more customers these fixed costs are spread across the greater the profitability. The existence of economies of scale can be tested by observing profitability across different markets and seeing whether size explains profitability. The chart below illustrates the relationship between market share and ROIC among the three largest players in Thailand, China, and Indonesia in 2015 and over the last five years. China, and Indonesia were selected because they are the largest markets in Emerging Asia and oligopolistic.

 

There seems to be a relationship between market share and profitability with an adjusted R squared of 0.60. In addition to having the highest ROIC, in all three countries, the market share leader has the highest ARPU, operating margin, and invested capital turnover.

 

Additional evidence of the presence of economies of scale is the percentage of excess profits going to the market share leader in Thailand, China, and Indonesia. The market share leader in all three markets took an extraordinary amount of excess profits in 2015 and over the past five years averaging 122% of all excess profits.

 

Given the relationship between ARPU, gross margin and size, size appears to drive pricing power and brand as AIS can spread the fixed costs of building a network over allowing it to spend more on network coverage, speed, and network quality thus customers are more willing to pay to use a better network.

 

ARPUs are converging with True gaining on DTAC and AIS, but AIS was able to increase its ARPU relative to DTAC.

 

Gross margins are diverging with AIS expanding its gross margin by 5.7 percentage points while DTAC’s and True’s gross margins contracted by a minimum 4.1 percentage points.

 

As illustrated below, AIS has much better throughput than peers on 4G.

 

The company also has better 3G coverage.

 

The evidence points to size is a crucial competitive variable and barrier to entry among mobile operators.

 

The other barrier to entry is regulatory. In the latest 4G spectrum auction, only companies that are majority owned by a Thai could participate. Telecom companies outside of Thailand have the capital and desire to enter the market but the inability to find a suitable local partner to meet the spectrum auction requirements of being a local firm.

 

There was a threat of a new entrant when Jasmine International won a spectrum auction in December 2015. Fortunately for the industry, Jasmine was unable to raise the necessary capital illustrating the difficulty in entering the industry.

 

 

Other Four Forces

 

The industry is in a period of intense rivalry as competitors invested heavily in upfront fixed costs of acquiring spectrum and building out 3G and 4G networks. In a quest to generate as much profit as possible on their upfront investment, competitors are marketing aggressively through handset subsidies and marketing expenses to gain subscribers on their networks. Since 2010, AIS invested THB43.205 billion in spectrum, DTAC invested THB13.615 billion, and True invested THB48.602 billion.

 

In October 2012, Thailand auctioned 3G spectrum with AIS, DTAC and True all winning 15MHz of 2100MHz spectrum. AIS paid THB14.63 billion for its spectrum, while DTAC and True both paid THB13.50 billion for their spectrum. Thailand then auctioned 1800MHz spectrum in November 2015 with AIS and True winning 15MHz of spectrum. AIS paid THB41.00 billion while True paid THB39.80 billion. In December 2015, Thailand auctioned 20MHz of 900MHz spectrum. Initially, True and a new entrant Jasmine International won the spectrum. True paid THB76.30bn for its 10MHz allocation but Jasmine was unable to pay for the spectrum it won so the spectrum was re-auctioned in July 2016 with AIS winning the spectrum auction by bidding THB75.70 billion. Cumulatively, DTAC has paid for its entire spectrum. AIS paid THB43.205 billion of its THB131.33 billion spectrum obligations so the company has THB88.125 of spectrum payments that still need to be made. True paid THB48.602 of its THB129.60 billion spectrum obligations meaning the company has roughly THB81.00 billion in spectrum payments to be made. DTAC’s has 45MHz (3x15MHz) of spectrum with a license expiring in September 2018. This spectrum will be auctioned in July 2018 with a reserve price of THB3 billion per MHz or THB45 billion per 15MHz block of spectrum.

 

The investment in spectrum is followed by the need to build out an infrastructure to allow the company to sell the spectrum to customers. The more capex spent building infrastructure creates greater supply as well as a greater desire to get a return on the upfront investment in spectrum and infrastructure leading to more aggressive marketing campaign to acquire customers.

 

AIS has guided capex of THB40 billion in 2016 to build out its 3G and 4G networks with half going to 4G. The company had already spent THB14bn in 2015 on 4G network spend bringing the total capex to THB54 billion to build a 4G network will cover 80% of the country. According to the Bangkok Post, AIS will spend a total of THB60 billion to build out is 4G network. True estimates it will cost THB56 billion to provide 4G LTE to 97% of the country.

 

The chart above shows capex since 2010 with Q1 2016, Q2 2016, and Q3 2016 capex annualized. Combined capex increased from THB 14 billion in 2010 to roughly THB100 billion on an annualized basis in Q1 2016, Q2 2016, and Q3 2016. The increase in capex should continue for at least the next year as competitors continue to build out their 4G networks.

 

To recoup the investment in spectrum and infrastructure build, Thai telcos are aggressively marketing. Handset gross margins are a good indicator of the current level of marketing aggressiveness. Recently, AIS has been heavily subsidizing handsets to migrate from 2G to 3G as it license for its 2G spectrum expired near the end of 2015, while DTAC is subsidizing handsets to slow market share losses as it has gotten a reputation for having a low quality network due to underinvestment. All competitors are subsidizing handsets to acquire 4G customers as companies roll out their 4G network. Companies are also subsidizing smart phones for postpaid subscribers as postpaid subscribers use much more data and voice leading to an ARPU over 3 times the ARPU of prepaid subscribers. AIS’s guidance is for continued subsidies and negative handset gross margins in 2016. The industry handset gross margin declined from 5.1% in Q1 2013 to -18.9% in Q3 2016, making Q3 2016 handset gross margin the lowest since 2013.

 

In addition to handset subsidies, competitors are aggressively on pricing and marketing. Marketing expenses among all players are on an increasing trend as illustrated by the chart below, Q1, Q2, & Q3 2016 marketing expenses are annualized. In 2010, industry marketing expenses totaled THB9.5 billion. In Q3 2016, annualized marketing expenses reached THB55.2 billion.

 

Despite lower regulatory costs, higher marketing expenses led AIS to guide for a 2016 EBITDA margin of 37%-38% in 2016 down from 45.6% in 2015. The regulatory costs for 2G were the highest in the world at 20-30% of revenue. The 3G and 4G regulatory costs are much more lenient with up to 5.25% of revenue going to regulatory costs. DTAC also expects its EBITDA margin to decrease to 27%-30% in 2016 from 31.8% in 2015. Industry regulatory costs decreased from 26.5% of industry sales in Q1 2013 to 8.8% of industry sales in Q2 2016.

 

Further fueling the rivalry is TRUE’s market share gains (+9.1%) since Q1 2013 at the expense of DTAC (-5.2%) and AIS (-3.8%). Given the importance of economies of scale, it makes sense for firms to increase the rivalry to maintain market share.

 

True’s also recent recently raised capital. In December 2013, True spun off its infrastructure assets through an IPO raising THB58.1 billion or USD1.8 billion. The infrastructure fund allows investors to benefit from the revenues generated by telecom towers, a core fibre-optic network and related transmission equipment, and a broadband access system located in provincial areas of Thailand. In January 2015, True sold 350 towers and 8,000km of fiber to its infrastructure fund for THB14 billion or USD424 million. In September 2014, China Mobile purchased 18% of True for THB28.6 billion or USD880 million in a private share placement. Despite the fund raising, True’s net debt to ttm operating profit is still at 6.05 as the company has generated cumulative free cash flows of THB-113.81 billion since the beginning of 2011. The continuous fund raising fueled by negative cash flows points to the competitive advantage held by AIS.

 

As illustrated above from 2010 to the end of 2015, True’s operating cash before any investments just covered investment in working capital and investment in spectrum. With external capital needed for almost all of the company’s investment in network. AIS’s generated the highest operating cash flow before any investment and free cash flow. DTAC generated a strong operating cash flow before any investments but spent significantly less than its peers on its network and spectrum. If DTAC spent a similar amount on spectrum and network build its free cash flow as AIS and True, its free cash flow would have been slightly negative. The lack of investment in its network and spectrum has hurt DTAC brand leading to market share losses to True.

 

Weak economic growth in Thailand and continued decline in voice revenues also add to the intensity of the rivalry in the industry.

 

 

Threat of Substitutes

 

The threat of substitutes for voice revenue is high as users are shifting away from voice to text, messaging apps or cheap voice services like Whatsapp or Skype leading to a continual decline in voice revenues.

 

The decline in voice revenue is a trend among more mature mobile markets as illustrated by the chart/table above.

 

The threat of substitutes for data revenue is low as mobile phones are a necessity and the trend continues to shift towards an increasing reliance on mobile phones for many aspects of daily life. The shift away from voice revenue is to substitutes that generate data revenue for mobile operators.

 

The overall threat of substitution to mobile operators’ products is low as the mobile phone is now such an important part of everyday life.

 

 

Bargaining Power of Suppliers

 

The bargaining power of suppliers is low. The main supplier are handset providers and SIM card producers as AIS creates its own infrastructure. SIM card manufacturers make a commodity product and the industry is much more fragmented than the mobile operator industry. The handset industry is also more fragmented than the mobile operator industry giving operators bargaining power when discussing handset purchases. The only supplier with any bargaining power is probably Apple given the brand associated with its product.

 

 

Bargaining Power of Customers

 

Customers have some bargaining power as they can freely switch providers particularly when so many subscribers are pre-paid meaning there are no contracts and there is number portability. Additionally, the information of all operators offering are readily available allowing customers to easily compare competitors increasing the bargaining power of customers. The ease of comparing competitors’ offerings along with the increasing cost of mobile services makes customers very focused on pricing.

 

Mobile operators compete on network quality as much as price. The difference in network quality creates a cost of switching from a good network to a bad network. Hindering bargaining power is the presence of only three mobile operators creating a significant amount of concentration at the mobile operator level while customers lack concentration. Overall, customers seem to have a fair bit of bargaining power due to number portability and the ease of comparing competitors’ offerings.

 

 

Industry Growth

 

In Thailand, mobile penetration reached 126% in 2015 meaning there is relatively little growth potential from an increase in subscribers. Since Q1 2013, subscribers grew at a CAGR of 1.9%. At the end of Q3 2016, smartphone penetration reached 70% while 4G handsets penetration reached 19% meaning future growth will not come from subscriber growth or even increased smartphone penetration but from increase in 4G penetration, which comes with increased data usage. In Q3 2016, AIS data subscribers accounted for 57% of total subscribers averaging 2,960 MB of data used per month up from 34% and 240 MB in Q1 2013 representing 17% CAGR in data subscribers and a 95% CAGR in data usage. Over the same period, the estimated price per MB has declined from THB0.2046 in Q1 2013 to THB0.0201 in Q3 2016.

 

The growth of data usage now makes non-voice revenue a larger portion of revenues than voice revenue with non-voice accounting for 56.5% of service revenue in Q3 2016 up from 27.3% in Q1 2013. Since the Q1 2013, non-voice revenue grew at a CAGR of 23.0% compared to voice revenue declining at 11.7% per year.

 

 

MANAGEMENT

 

All director and executives of Intouch Holdings have very small share ownership and therefore are hired hands rather than owner operators. Neither Intouch’s management nor AIS’s management do not extract too much value with the remuneration of directors and executives only 0.18% of operating income at Intouch Holdings and 0.25% of operating income at AIS.

 

 

Capital Allocation

 

Despite Intouch’s goal of achieving 25% of value from non-AIS businesses, AIS currently accounts for over 95% of Intouch’s market value therefore the focus will primarily be on AIS’s capital allocation decision.

 

To determine the strength of capital allocation decisions, we will attempt to determine a return on investment. The majority of AIS’s business is 3G but the company is building out its 4G network. For conservatism, we assume no change in the current competitive environment and no growth in AIS business to get a perpetuity cash flow figure. AIS spent THB131.33 billion on 3G and 4G spectrum. Additionally, the high end of the company’s 3G network build is THB90 billion. The company also estimates 4G network build will cost THB60 billion. The total investment in spectrum and network build THB281.33 billion.

 

Assuming a 15 year useful life on the investment, no change in subscribers, no growth in ARPU, an operating margin of 25%, a tax rate of 25%, and no salvage value; the overall investment in 3G and 4G generates a return on investment of 14.3%. It is not the returns that the company is used to generating, as the investment cost in 4G spectrum was expensive, but it still creates value for the company. The investment is a necessity for the company to stay competitive.

 

Looking at the assumptions, AIS currently has 39.8734 million subscribers so there is no change to the number of subscribers in the market or to market share. Depreciation is assumed to have a 15 year useful life, in-line with the license period leading to an annual depreciation expense of THB18.755 billion. Depreciation is 16.3% of sales well above the average rate of 12.5% over the past five years. ARPU is expected to remain stable at THB240 per month as the increased data usage is offset by cheap data prices. AIS’s ARPU has averaged THB240 per month since Q1 2013 with no particular trend. The 25% tax rate equals the company’s historical tax rate. The operating margin of 25% is well below historical rates. It is assumed that competition continues into perpetuity with negative handset margins and elevated marketing expenses with lower regulatory expenses from 3G and 4G networks as Q3 2016 saw operating margin at 24.3% with gross margin at 44.0%, selling expense at 10.3% of revenue, administrative expenses at 9.3% of sales, and depreciation and amortization at 16.9% of revenue. The table below illustrates the sensitivity of the investment in 3G & 4G to various assumptions.

 

Other than mobile, AIS is investing in fixed broadband with a goal of full coverage of Bangkok by end of 2016 and having significant market share in three years. The investment is insignificant relative to the investment in mobile.

 

Both Intouch and AIS are very shareholder friendly with an 100% dividend payout policy.

 

Other than the investment in AIS, Intouch also has smaller investments in Thaicom and a number of private equity investments related to media and telecommunications. The company’s stated goal is for non-AIS investments to reach 25% of the value of the portfolio. Many of the private equity investments are for to aid AIS of strategy of providing more content and digital applications. Intouch’s largest investment outside of AIS and Thaicom is a home shopping network in Thailand called High Shopping Co. Ltd. It is 51% owned by Intouch and 49% owned by Hyundai Home Shopping and has total capital THB500 million. The TV home shopping market in Thailand is expected to double in market value to 20 billion baht by 2020. Intouch forecasts it share of the market will reach THB4.5 billion in 2020, or of 20% of the TV home shopping market in Thailand.

 

 

VALUATION

 

Currently, AIS is overvalued as the market has yet to factor in decreased capital efficiency from the size of the recent investment.  The total investment will reach 282 billion while estimated revenues are less than half of that. In order to get the market’s current valuation for AIS, assuming an alleviation of competitive pressures leading to average historical margins and no growth, invested capital turnover needs to remain near historical levels. Even with these assumptions, there is 10% downside.  Assuming no growth, a persistence of competitive pressures along with a decline in invested capital turnover to 1.1 times, half of the historical average of 2.2 times, AIS intrinsic value is closer to THB70.00.

Weekly Commentary November 28, 2016 – December 4, 2016

Weekly Commentary November 28, 2016 – December 4, 2016

 

Current Model Portfolio 

12-2-2016-portfolio

 

Company News

 

There was no company news this week.

 

 

Interesting Links

 

Elliott Management Corp’s letter to Cognizant Technologies (Elliott Management Corp.)

Activist investor Elliott Management recently wrote Cognizant Technologies board discussing its view of value creating policies. (link) The letter gives another perspective of the IT services business and potential value creating strategies.

 

Competitive Advantage Period: The Neglected Value Driver (Credit Suisse)

An older research report by Michael Mauboussin discussing the Competitive Advantage Period. (link)  Given our preference for quality, we believe this is a must read.

 

12 Ways How the”Ideal Company” Should be Run (value&opportunity)

A useful 12 point checklist on how an ideal company is run. (link)

 

A Century of Ideas (Columbia Business School)

This book goes through some of the ideas generated at Columbia Business School. Chapter 2 discusses value investing. (link)

 

Musing on Markets (Aswath Damodaran)

In a number of recent posts, Professor Damodaran of NYU discusses the myths of DCFs. (link)

 

Business Quality: The Great, the Good, and the Gruesome (Hurricane Capital)

A good reminder of the 4 questions asked by Charlie Munger and Warren Buffett when analyzing an investment opportunity (link)

 

Walter Schloss One Page Investment Manual (Jae Jun)

From quality on the previous link to deep value, Jae Jun of Old School Value tweeted Walter Schloss’s one page investment manual. Walter Schloss was very quantitative looking at deep value stocks trading below book value (link)

 

Two Investment Principles (Base Hit Investing)

Base Hit Investing two key investment principles: Focus on the quality of the business and position sizing (link)

 

 

Fair &Fine??? (Manufactured Luck)

An article discussing the importance of a partner with integrity.  Unfortunately, everyone does not have it. (link)

 

 

Excessive Diversification is Pointless & Damages Returns (Intrinsic Investing)

A blog post by Intrinsic Investing discussing portfolio diversification and risk.  It has an excellent chart, from A Random Walk Down Wall Street, illustrating that at the 20th security, a portfolio is diversified and adding an additional stock does little to reducing risk, assuming all stocks are in not the same sector. (link) Our goal is to build a portfolio of 25-30 stocks with no residual cash. We elect for a slightly higher number of stocks. As illustrated by our investment in Miko International and Universal Health, Emerging Market small cap investing comes with some risks that warrant a slightly higher number of stocks, but 25-30 stocks should be sufficiently diversified but not too diversified.

 

It also discusses why the quest for assets rather than performance leads so many funds to excess diversification, while performance oriented funds tend to close.