Tag Archives: Capital Allocation

Honworld 2016 Full Year Results Review 5/7/2017

Honworld 2016 Full Year Results Review

 

Honworld recently reported its 2016 full year results. The company’s revenue grew by 4.0% in 2016 and by 6.5% in the second half of 2016. The company stated growth slowed due to a weakness in the supermarket segment of the condiment industry, which makes sense as five of the largest publicly traded Chinese supermarket companies saw sales grow by 5.5% in 2016. To offset the lack of growth from the supermarket channel, Honworld is building its infrastructure to better address regional small retailers and the catering market. As mentioned in the company’s prospectus and our initiation report, Chinese cooking wine is distributed primarily through retail and catering service channels. In 2012, 50.5% of cooking wine sold through retail channels, 41.5% sold through catering service channels and 8.0% through other channels. Leading cooking wine brands tend to concentrate on retail sales channels as households generally demand higher value cooking wine products and are more brand sensitive. The company has not focused on 41.5% of the cooking wine market sold through catering channels. Additionally, the company has not made an effort to sell through smaller retailers. According to China’s National Bureau of Statistics, hypermarkets and supermarkets accounted for 23.1% of food sales through retailers meaning Honworld has only penetrated a small portion of the total potential distribution channel. The new distribution strategy resulted in an increase in distributors by 531 to 898 total distributors.

 

By product line, medium-range cooking wine and mass-market cooking wine grew the most. The company states the change in the product mix relates to the shift in marketing and distribution strategies.

 

The change in the product mix led to a compression in the company’s gross margin. By our estimates, in addition to a compression in gross margin from a product mix, there was a slight compression in product gross margins. Overall, gross margin contracted by 2.8% with 2.2% attributed to a change in product mix and 0.6% due to product margin deterioration.

 

Selling expense grew by RMB6.15 million or 8.2%. The company’s new distribution channel brought on a 531 new distributors. To service the new distributors, Honworld hired 179 sales employees as the sales staff increased from 61 at the end of 2015 to 240 at the end of 2016. These employees were hired over the year as illustrated by the decline in the personnel expense per year and the moderate increase in selling expenses. Honworld also devoted approximately RMB50.0 million to appoint Mr. Nicholas Tse as our brand ambassador of “Lao Heng He” cooking wine in Mainland China and sponsored Chef Nic, a cooking reality show hosted by Mr. Nicholas Tse. 2017 should see a significant increase in selling expenses. Given the company’s size advantage over competitors, the increase spending on sales and marketing expenses is a wise allocation of capital as these are fixed costs that smaller competitors will have difficulty matching while remaining profitable.

 

In addition to the new sales and marketing employees, the company added 60 new production employees and 18 new R&D and quality control employees. In 2016, Honworld also expanded its production facilities, acquired new production equipment. The new employees and expanded production facility point to an increase in production in 2017.

 

Administrative expenses saw an increased by RMB2.8 million or 3.5%. It seems the Honworld’s focus is on increased production and sales and marketing rather than R&D, which makes a lot of sense given the company’s inventory levels.

 

Overall, the company’s decrease in gross margin due to product mix and overall deterioration as well as the increase in operating expenses led to a RMB15.12 million or 4.8% decrease in the company’s operating income.

 

The company’s largest investment is in inventory, which accounted for 46% of invested capital in 2016. Honworld’s inventory turned over 0.76 times during 2016. One of the key inputs into cooking wine is base wine particularly aged base wine. The ageing process leads to the poor inventory turnover. The company states it has reached its desired inventory levels. The huge investment in inventory has been one of the major reasons for the company’s poor profitability relative to the quality of the business. Honworld no longer reports the amount of base wine required for each liter of cooking wine but the company reported the amount of base wine in each product in the IPO prospectus.

 

As illustrated above, there is a lot of variation in the amount of base wine, vintage base wine, and aged base wine used in each product category over the period examined. Base wine is either vintage base wine or mixer base wine is naturally brewed yellow rice wine, which is either vintage base wine or mixer base wine. Vintage base wine is base wine that has been aged over two years. Mixer base wine is base wine aged less than two years.

 

The company should be reporting the percentage of vintage base wine, mixer base wine, and total base wine by product category in every financial report as inventory level is one of the most important drivers of the company’s profitability. In addition, due to the nature of the product, it is not clear how inventory relates to sales without the above analysis and sales volumes by product category. The complexity of the relationship between inventory, product sales, and profitability should make management be as transparent as possible so investors can be educated about the company’s business model. Until it does, the company will have difficulty realizing the company’s intrinsic value.

 

The table below illustrates the amount of base wine and age of base wine in each product category as well as for 2014, 2015, and 2016 based on their product mix.

 

In 2013, a liter of premium cooking wine contained 0.06 liters of vintage base wine with an average age of 10 years and 0.87 liters with an assumed average age of 1 year leading to 0.93 liters of base wine with an overall average age of 1.4 years.

 

A liter of high-end cooking wine contained 0.06 liters of vintage base wine with an average age of 8 years and 0.81 liters with an assumed average age of 1 year leading to 0.87 liters of base wine with an overall average age of 1.2 years.

 

A liter of medium-range cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.81 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 0.9 years.

 

A liter of mass-market cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.64 liters with an assumed average age of 1 year leading to 0.68 liters of base wine with an overall average age of 0.7 years.

 

Assuming 2016 product mix continues the average liter of cooking wine contained 0.045 liters of vintage base wine with an average age of 6.4 years and 0.804 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 1.0 years.

 

Mixer base wine is anything under 2 years so the assumption of 1-year age of mixer base wine is not necessary. The company could mix base wine and use it shortly after producing it. Typically, it takes 35-40 days to produce base wine, which can only be done during cooler weather months of October to May.

 

Management has not reported ASP and volume by product since its IPO prospectus, but assuming no change to ASP of each product, volume sold can then be calculated.

 

We can see cooking wine sales reached an estimated 86 million liters in 2016. Sales are estimated base wine age of 1 year. Assuming the company keeps an additional 1 years of inventory as a buffer for growth. Some inventory also needs to be aged for premium products. The 2016 product mix required only 4.5% of vintage wine for every liter of cooking wine. Assuming another 0.5 years of inventory for aging or ten times the required amount each year leads to a potential of eleven years of aged inventory, the very highest average age of vintage base wine used is premium products at 10 years of ageing. 84% of estimated volume sold in 2016 was for medium-range and mass-market products that use vintage wine with 5.5 years of aging, half the eleven years of inventory. Total inventory with a buffer of 2.5 years of sales is roughly 215 million liters of inventory. Unfortunately, the company does not provide gross margin by product to allow us to estimate the cost of carrying the inventory. Gross margin can be estimated by making slight changes to gross margins by product each year to equate the estimated gross margin to the reported gross margin.

 

With the gross margin for each product, cost of goods sold per liter can be calculated to estimate to total inventory levels required for 2.5 years worth of sales volume.

 

As illustrated in the table above, the estimated cost of goods sold per liter was RMB3.2. With 2.5 years of sales volume or 215 million liters of inventory deemed sufficient, total inventory should be RMB692 million. Adding 1 years inventory for soy sauce and vinegar, total inventory on the balance sheet should be closer to RMB775 million well below actually inventory levels of RMB1,088 million meaning the over invested in inventory is just over RMB300 million.

 

2.5 years of inventory should be sufficient but Honworld could probably get away with a level much lower as mixer base wine does not need to be aged and the company should be making sufficient mixer base wine. In addition, another 50% of base wine should be produced for growth and aging to create vintage base wine as the company only needs about 4.5% of volume sold in vintage base wine. The company loaded up on inventory to age well above its vintage base wine requirements, particularly when the product mix is shifting to medium-range and mass-market products that do not need as much vintage base wine. The upfront investment destroys profitability and puts into question the capital allocation skills of the management team.

 

The increase in inventory requirements may not be a function of poor capital allocation skills but a function of deteriorating quality of the business. This would be even more concerning that poor capital allocation skills as management can change its capital allocation but it can’t change the competitive dynamics of the industry. Honworld was the leader in naturally brewed cooking wine. If competitors followed the company’s path eliminating alcohol and artificial ingredients, competition based on product quality with an increased the amount of vintage base wine and base wine ageing profitability in the industry could remain depressed for some time.

 

The vast majority of PP&E is tied to investment in inventory as facilities were created to store base wine or produce more cooking wine. Since 2010, each additional RMB spent on inventory required an addition RMB0.7 in PP&E. The RMB300 million in excess inventory requires an additional RMB210 million investment in PP&E. Eliminating the RMB510 million in inventory and additional PP&E investments, invested capital is closer to RMB1,855 with an operating income of RMB281 million, Honworld’s pre-tax ROIC should be above 15.2% rather than actual pre-tax ROIC of 11.8% in 2016.

 

If the company were able to get inventory levels down to 2 years and eliminate associated investments in PP&E, Honworld’s ROIC would be 18.0% rather than 11.8%. The higher the company’s ROIC the higher the EV/IC the company should trade on as illustrated by our recent post ROIC vs. EV/IC.

 

In addition to the poor capital allocation due to overinvestment in inventory and related PP&E, pre-payments for land leases and non-current assets have increased from 0 in 2013 to RMB386 million in 2016. These soft accounts are very concerning as it is a serious misallocation of capital and may point to fraud. Making pre-payments for non-current assets equal to 16% of invested capital to lock in raw material costs and equipment costs does not make much sense when you have pricing power as illustrated by the recent price increases and your inputs are pure commodities. The timing of the allocation to soft asset accounts is particularly concerning as the company just finished overinvesting in inventory depressing free cash flow and profitability.

 

As illustrated above, Honworld’s total debt increased by RMB204 million from RMB645 million to RMB849 million leading to finance costs of RMB40.6 million or an effective interest rate of 5.4% on debt. The company has a net cash position of RMB520 million up from RMB189 billion at the end of 2015 with RMB1.02 million in cash leading to an effective interest rate on cash is 0.3%. The increasing cash balance with the increasing debt balance does not make much sense. If the company has that much cash on the balance sheet why is it holding it and earning such a poor return, when the company can pay down a large portion of its debt and decrease the company’s finance cost by roughly RMB22.7 million per year, assuming no change in the effective interest rate of debt.

 

Overall, Honworld has a strong business with economies of scale in sales and marketing and R&D. The product habit-forming characteristics include low price, which increases search costs, and is a key ingredient in dishes. The company has a strong growth outlook serving a small amount of its potential market and infrastructure build to service a greater portion of the market. Valuations are not demanding with a 10% NOPAT yield and an EV/IC of 0.95. Unfortunately, management’s overinvestment in inventory, related PP&E, pre-payments for non-current assets and not paying down debt are too much of a concern, particularly the timing of allocation of capital to soft asset accounts. The misallocation will continue to lead to poor ROIC. If the company was not located in China, where frauds occur regularly, the misallocation of capital would be less of a concern and more patience would be warranted. We are no longer recommending the stock and selling our position in our model portfolio, but will continue to follow the company with a hope that capital allocation and profitability improves.

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.

Peak Sport Products Position Size May 7, 2016

Peak Sport Products Position Size May 7, 2016

 

We have decreased our position size in Peak Sport products by just under USD2.9 million slightly below our intended target of USD3.0 million at an average price of HKD1.92. Peak Sport is now a 2.0% cost position.

Universal Health Position Size May 6 2016

Universal Health Position Size May 6 2016

 

Yesterday, we completed the sale of just over USD2.0 million in Universal Health shares that we previously announced we would make.  We sold 21.573 shares at an average price of HKD0.735. As of yesterday’s close, Universal Health is now a 2.5% position, which is more appropriate for the risk reward associated with the investment.

Peak Sport and Universal Health Position Sizes May 3 2016

Peak Sport Products and Universal Health Position Sizes May 3 2016

We have reduced our position in Peak Sport Products by USD4.64 million slightly above our target sales of USD4.5 million at an average sale of HKD2.1098 or inital blended cost on Peak Sport positions is HKD2.0826 so we are able to reduce our positions without a loss.   We are reducing our position size by a further USD3.0 million.  The company reported weaker than expected operational data in China, and after the Miko International fiasco, the share issuance in June 2015 with a significant amount of net cash on the balance sheet raises concerns about the cash.  Given we view Peak Sport as a deep value position, a 2.0% position size is a more appropriate given the concerns over management credibility and slowing growth.

 

Universal Health is another Hong Kong listed Chinese company that we described as Company 9/18/15 in the past. This is another deep value holding where we put too much faith in financial statements.  Management pledged shares without notifying the stock exchange and subsequently were forced sellers causing the share price to fall by just under 60% on one day. The company also sold 20% of the company to a financial buyer who subsequently sold almost half its position the following.  It seems as if the shares were pledged to the financial buyer who promptly sold the shares. The company followed this by reporting poor 2015 results.  Loss aversion stopped us from selling earlier.  It probably is the culprit in why we held Miko as long as we did.  We are decreasing our position size in Universal Health by USD2.0 million to roughly a 2.0% position size.

 

Honworld Annual Results Review April 7, 2016

Honworld Annual Results Review April 7, 2016

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

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

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

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

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

 

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

 

Pros

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

 

Cons

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

Miko International and Position Sizing April 7, 2016

Miko International and Position Sizing April 7, 2016

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Peak Sports Product Annual Results Review March 23, 2016

Peak Sport Products Annual Results Review March 23, 2016

 

On March 15, 2016, Peak Sport Products (1968:HK) reported its annual results. It then released its annual report on March 21, 2016.  Peak was able to increase its revenues by 9.4%, operating income by 34.6%, and net income by 22.3%.  The company closed five stores over the year so efficiency of stores drove the increase.  The efficiency came as the company introduced new products in new categories (tennis and running). Selling expenses decreased by 8.0% while administrative expenses increased by 1.0%. Both expenses lagging sales growth lead to the increase in operating income of 34.6%.

 

Peak Profitability 2015 Result Review

 

Compared to 2014, the company’s gross margin increased by 70 basis points in 2015.  It is also well above the average of 2012 to 2015 and 2006 to 2015.  Gross margin increase points to the industry being past the sharp downturn seen in 2012 and 2013.

 

Peak’s operating margin increased by 340 basis points in 2015 as the company decreased spending on selling and distribution and administrative expenses barely increased. Overall, the company’s return on invested capital increased from 19.6% in 2014 to 27.8% in 2015.

 

During the industry’s consolidation, gross margin and operating margins decline slightly and have since recovered, but invested capital turnover declined drastically and has not recovered.

 

Peak Capital Efficiency 2015 Result Review

 

As illustrated above, both working capital turnover and fixed capital turnover declined significantly from peaks and have recovered slightly but not fully as the industry continues to cope with working capital and capacity issues.

 

In June 2015, the company raised capital increasing its share count by 290.761 million shares or 13.86% of the previous share count.  The company mentioned the share raising was for international marketing expenses and to avoid Chinese withholding tax by moving cash in China overseas.  The company decreased marketing expenses this year despite the share issuance.  Despite the cost of raising capital being lower than the withholding tax the company would have paid for shipping money overseas, the share issuance was perplexing as the company has so much cash on the balance sheet.  At the end of 2015, the company net cash position is equal to 92.6% of the company’s market capitalization and 5.9 times 2015 operating income.  The question becomes does the company actually have the cash reported on the balance sheet.  The company has been paying steady dividends pointing to having the cash. The main shareholders have maintained their shareholding without any share sales illustrating their confidence in the company.

 

Peak Shareholder Structure 2015 Result Review

 

Brand building through advertising is a key value driver within the sportswear industry so hopefully we will see a significant increase decreasing the cash on the balance sheet.  Regardless, the share issuance was confusing and at best a very, very poor capital allocation decisions.

 

Overall, the sportswear industry is recovering after a period of significant contraction.  Peak is insulated from competition within the industry from fast fashion players as the company’s focus is performance products rather than fashion allowing it to retain the leading market share in basketball for six straight years.  The company is increasing its focus on international markets and other sports (tennis and running) giving it further growth opportunities.

 

The company is currently trading just above its net cash position, just below its liquidation value, and 38% below its reproduction value.

 

Peak Valuation 2015 Result Review

 

On an earnings basis, we used key value drivers during the recent industry downturn assuming it is the new normal and the industry boom of 2006 to 2011 will not be replicated.  Assuming no growth, trough margins, and trough capital efficiency, the company has 89% upside to its estimated 2021 fair value.  Assuming 5% growth and average margins the company has 215% upside to an estimated 2021 fair value.

 

Despite, the extremely poor capital allocation, the company is very cheap and growing. It is now trading just above its net cash position, just below net current asset value, and just below book value despite generating an average return on invested capital of 20% during an industry slump.   We will maintain our current position size.

Reperio Capital Research’s Edge 11/6/2015

This is an excerpt from our October 2015 monthly review.

What is Our Edge?

At Reperio, we are firm believers that to produce extraordinary results, you have to do something different from everyone else.  What do we do different in an attempt to produce superior results?

It is something we think about a lot and we believe there are three key differentiating factors for our research.  First, we have a business owner mentality focusing on competitive position, management (not focused on by traditional research providers), corporate governance (not focused on by traditional research providers), absolute intrinsic value (not focused on by traditional research providers more focused on earnings momentum and companies beating expectations), and ensuring there is a margin of safety before recommendation (traditional research providers top picks are what is currently loved by the market due to earnings momentum are their top picks the opposite of our approach.)  We look for high quality stocks with poor sentiment.

 

Second, we have a long term investment horizon.  Jean Marie Eveillard once estimated that 95% of market participants are focused on the short term.  Given 95% of participants are focused on the short term; the vast majority of research providers will be catering to those participants in an effort to win their commission dollars.  Theses traditional research providers are obsessed with the next three to six months and companies with earnings momentum that can beat consensus. Our long term investment horizon coupled with our business owners approach gives us a tremendous advantage.

 

Third, we attempt to play a game where the competition is the weakest, i.e. Emerging Market Small and Mid Cap companies.  Just like any competition, if you play a game against very strong competition, it will be much harder than playing against weaker competition. When you are looking at US large caps you are competing against large buy side, sell-side, and hedge funds.  This is very difficult competition and while there are inefficiencies in these markets they are relatively small.  When looking at small and mid caps in Emerging Markets, competition is from the sell side, the buy side, and the public. Many of the names in the small and mid cap space have very little if any analyst coverage.  Analysts that do cover the names are more likely to be less experienced as most traditional research providers take the approach of trying to gain a small slither of a big pie and therefore put their best analysts on the bigger names.  The combination of short term orientation, and weaker experience leads to little competition. With buy side institutions, the vast majority has 100 or more names in their portfolio and has to know three to four times the number of companies.  This puts little emphasis on in-depth, independent research on smaller companies within Emerging Markets.  Additionally, 95% of buy side institutions are closet benchmark funds (over 100 stocks in the portfolio with big overweights and underweights being 1 to 2%).  This place a greater emphasis on the larger names that are in the index decreasing the importance of small and mid caps even more.  So buy side is very little competition.  The public typically are traders and have very little understanding of business so they are not much competition.

 

Our edge is illustrated by our PC Jeweller recommendation.  At the time of our recommendation in PC Jeweller, no large sell side institution covered the company and the smaller sell-side institutions were focused on the short term regulatory concerns leading to potential weakness in the short term and downside to earnings expectations. Our business owner mentality with a long term view saw a company that showed incredible resilience during an industry downturn (stable and high profitability) with a very strong balance sheet and innovative management with skin in the game.  There was short term looked uncertain due to regulation but the long term growth rate potential was tremendous given limited competition from organized retailers and a store opening target of 15-20% growth per year.  Despite the strengths of the company, it was valued under 5 times EV/EBIT.

 

Zensar Technologies is a similar story. It was a company that was coming off a period of indigestion after a large acquisition, which happens often.  Growth had slowed a bit which potentially put often the very few sell-side institution covered the company with no coverage from any big institutions.  The business owner with a long term investment horizon saw a company with very strong leadership in an industry with incredible profitability due to switching costs with industry low turnover due to a differentiated activity in an industry where the key resource is people and management was guiding 15% top line and operating profit growth for the foreseeable future. Zensar was also trading at under 5 times EV/EBIT eliminating a lot of the risk associated with the investment thesis but in the short term there were concerns putting off the sell-side.