Honworld Group H1 2015 Results Review 9/1/2015
Closing Price (9/1/2015): HKD4.02
6 Month Avg. Daily Vol. (USD): 1,190,945
Estimated Annualized Return: 20.3%
Honworld Group reported first half of 2015 results on August 31, 2015. The company’s key value drivers are illustrated below.
In the first half of 2015, Honworld’s revenue grew by 19.9% and its operating profit grew by 23.7%. The macro concerns surrounding China are not affecting Honworld. The company continues to introduce new products to its distribution channel and it is aggressively building its distribution channel.
The company’s gross margin is stable averaging 58.0% over the past three years after two years of an increasing gross margin associated with improving product mix. The stability in gross margin and the company’s premium pricing with a significant market share advantage over peers illustrates the company’s pricing power. The company is the first to sell naturally brewed cooking wine and other naturally brewed condiments giving its brand a healthy position in the consumer mind allowing for premium pricing. Its largest competitors produce their cooking wine with a chemically based product.
The company continues to spend heavily on distribution and on administrative expenses (primarily R&D) with both expenses amounting to 16.5% of sales in the first half of 2015. Given the company is the largest cooking wine producers in the country continued investment in the distribution channel, advertising, new products, and new processes is strategically the right thing to do to take advantage of its economies of scale. According to its IPO prospectus, Honworld market share is two times is largest competitor and equal to the market share of the four closest competitors. Given Honworld sells a premium product, its gross profit advantage over peers is even greater. Honworld’s size advantage over its closest peer increases from 2.15 times using sales to 2.86 times using gross profit. The four closest competitors’ cumulative share is 104% of Honworld’s market share but is only 75% of Honworld’s gross profit share.
Despite heavy investment is base wine inventory, Honworld still generated an annualized ROIC of 17.6% in H1 2015. Heavy investment in inventory is the main concern associated with an investment in Honworld. Management seems determined to continue to investment in base wine despite raw materials being commodity products available from many producers. If there are increases in raw material costs the whole industry will feel the pain. Given the company’s premium position in the consumer’s mind, Honworld is the most likely competitor to be able to pass on prices increases. Holding inventory and ageing it allows the company to sell a premium product. Unfortunately, the gross margin associated with the higher price does not compensate for the inventory investment required leading to depressed ROIC with higher inventory.
The table above shows Honworld’s investment in base wine. Fixed capital is primarily facilities associated with storing base wine so it is should be included in calculations for cost of base wine. Other working capital requirements are minimal and therefore are used to add conservatism. According to the company’s balance sheet in 2014, each liter of base wine cost RMB9.2.
Each bottle of cooking wine is a mixture of spices, base wine, and water meaning each liter of base wine translates to multiple liters of what is actually sold. Lower quality product uses lower amounts of base wine. Vinegar uses cooking wine while Soy Sauce products do not. 2014 is estimated as the company did not provide this information. In 2013, each liter of base wine translated to 2.8 liters of output. At 2.5 liters of output for each base wine of input, the 225 million liters of base wine the company is targeting for 2015 translates to 562.50 million liters of sales volume or 5.64 years of 2015 sales volume assuming a 20% growth rate in 2015.
The table above shows the economics of the business on a per unit basis. 2013 is data from the IPO prospectus while 2014 is estimated. Even with heavy investment in fixed costs the company generates an ROIC on a per liter basis close to 90%. The contribution margin per liter is above 100%. The company should spend heavily on acquiring customers through increased distribution and new products. The heavy spending on fixed costs also allows the company to cement its competitive position by taking advantage of its size. Inventory build on the other hand drags down 2014 ROIC from 86% on a per liter basis to the company ROIC of 18.1%.
The table above illustrates gross margin by product. Premium cooking wine products generate a gross margin close to 75% while medium-range cooking wine products generate a gross margin of 45%. Medium-range products generate a lower gross margin compared to mass market due to packaging.
The table above shows the amount of base wine for each product and the number of years it needs to be aged. Assuming the company can sells all it products at premium cooking wine gross margins and inventory is 10 years current year sales equal to the average age of vintage wine in premium cooking wine.
As illustrated ageing inventory and selling 100% premium products leads to a per liter ROIC averaging 135% but holding inventory for 10 years increases investment requirements leading to an overall company ROIC average of 13.5% half the current average of 27.2% and well below the per liter ROIC average of 78.3%. The main problem is management views EBITDA margin as the key indicator of profitability rather than ROIC. The heavy investment in inventory shifts it from a consumer product company to something similar to a car dealership where profitability is tied up in inventory.
The company is financially strong with H1 2015 net debt to operating profit of 0.89.
Overall, Honworld has a potential to build a strong competitive advantage given its brand positioning among consumers and its economies of scale. The company is generating strong returns on invested capital despite heavy investments in fixed costs to cement its competitive position and poor investments in inventory.
The company is growing its top line and profitability at 20% despite macro-concerns in China.
It has a very passionate management team with integrity. The founder transferred his family’s secret recipes to the company for RMB1 and donated his personal stock of cooking wine valued at RMB7.0 million. He built his personal cooking wine inventory since 1990 when he first entered the industry but well before he founded Honworld and purchased its cooking wine subsidiary. His family also owned Honworld’s key brand before the communist revolution.
At the close of business on September 1, 2015, Honworld is valued at 6.8 times EV/ttm EBIT offering a conservatively estimated return of 20.3% for the foreseeable future. If the management is able to eliminate inventory build it could generate a much higher return as the franchise value used in the calculation assumes 15% ROIC indefinitely. Given heavy investments in fixed costs and inventory this figure should eventually be higher. It’s growth, potential competitive advantage, strong returns, and passionate management with integrity makes it our current top pick.