Tag Archives: Consumer Goods

WEEKLY COMMENTARY 2/13/17- 2/19/17

WEEKLY COMMENTARY               2/13/17- 2/19/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

PC Jeweller report Q3 FY17 results over the past week. Demonetization impacted the quarter’s results with the company estimating sales were affected for three to four weeks. Post-demonetization, sales started improving in December and returned to normal in January. Gross margin were stable but the decline is sales resulted in a decline in profitability. Year on year sales declined by 3.4%, the number of showrooms grew from 58 in FQ3 2016 to 68 FQ3 2017, or 17%, and total square feet increased by 8% year on year from 346,855 square feet to 374,481 square feet. Year on year, the company’s operating profit declined 13.7%. Assuming during the four weeks that demonetization affected sales there was a 50% decreased in sales, no impact from demonetization would have lead to an increase in sales by roughly 16% year on year.

 

It is tough to tell how good or bad the quarter was due to demonetization. The company continues to increase its showroom footprint and sales barely declined despite demonetization. The company estimates 75% of the jewelry industry is unorganized dampening competitive pressures.

 

PC Jeweller is one of the most profitable and fastest growing companies in the Indian jewelry industry illustrating the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the company’s strengths, it trades on an EV/NOPAT of 14 times and an EV/IC of 2.6 times. We will maintain our current position size.

 

In the past week, Grendene reported Q4 2016 and full year results. For the full year 2016, net sales declined by 7.2% with domestic sales falling by 1.6% and export sales falling by 16.3%.

 

Overall volume declined by 9.3% with domestic volume declining by 8.0% and export volumes falling by 13.0%.

 

ASP increased by 4.1% with domestic ASP increasing by 7.2% and export ASP falling by 3.2%. Gross profit fell by 6.7% as cost of goods sold declined by 7.6%.

 

Operating profit declined by in 7.5%. The company’s capital intensity did not change over the year with working capital at 47.9% of sales, fixed capital at 18.9% of sales, and invested capital at 66.8% of sales.

 

Grendene’s key value drivers are illustrated above. In 2016, gross margin reached a peak level of 48.7%. Selling expenses remain near its historical average relative to sales at 24.0%. General and administrative is at its peak at 4.8% of sales. EBIT margin remained at its historical peak of 20.0%. Working capital remains slightly elevated relative to historical averages. Fixed capital as a percentage is at its highest level over the past eleven years.

 

Grendene continues to struggle with economic weakness in Brazil and in export markets. The company operational efficiency allows the company to maintain its profitability during a period of declining revenue. In 2015, the company reiterated its growth targets of revenue growth of 8-12% and net income growth of 12-15%. The company continues to believe these targets are achievable but acknowledge risks of not achieving these results are increasing due to economic weakness in Brazil and in exports markets.

 

Given the new data, we update Grendene’s earnings valuation range. Grendene illustrated its ability to maintain profitability despite a period of declining revenues and increasing competitive pressures making earnings valuation the most appropriate valuation methodology.

 

Looking at Grendene’s earnings valuation, the company reaches our target return of 15% per year under the most optimistic scenarios. We would assume perpetuity growth only under scenarios when the company operates in an industry with barriers to entry and pricing power. Within the domestic market, there are clear barriers to entry with the company and its main competitor Alpargatas having economies of scale as they occupy over 50% of the market with large fixed costs in the form of distribution and advertising. Grendene also has unique capabilities in manufacturing plastic products as it modifies its own machines and can formulate plastics that are unavailable to other footwear producers. These barriers to entry do not transfer outside of Brazil. The company is a low cost producer with only China producing exports at a lower price.

 

The question is whether the barriers to entry within Brazil translate to pricing power. The barriers to entry within the segment means very few other players could sell products at the Grendene’s and Alpargatas’ price range meaning the company’s probably do have some pricing power in Brazil. Over the past ten years, the company average selling price increased by 3.8% per annum with the domestic selling price increasing by 2.6% and export selling pricing increasing by 3.9% in USD terms so there is a strong argument for potential pricing power. We assume 2.5% pricing power in our base case scenario. The company sales have grown at 6.8% over the past ten years with growth stagnating at 4.9% over the past five years. Assuming an inability to growth operating profit above sales growth a 5% growth rate seems appropriate for our five-year forecast period. Despite the company’s ability to maintain profitability during the recent industry weakness using peak margins seems aggressive therefore average margins are more appropriate. Our base case scenario is 5% forecast period growth, 2.5% terminal growth and average operating margins leading an upside to the 2021 fair value of 60% or 9.9% annualized return. Overall, the average return over the next five years under the earnings valuation is 59% or 9.7%.

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

Professor Damodaran breakdowns how to value growth, the key drivers of growth, and the importance of ROIC in determing whether growth is valuable or not. (link)

 

 

Narrative and Numbers: How a number cruncher learned to tell stories! (Musing on Markets)

 

Another post by Professor Damodaran explaining how narratives can be worked into your valuation to provide a better picture of how the market is valuing a company. (link) Professor Damodaran recently published a book Narrative and Numbers, which I have not read but is next on my list.

 

 

Diversification..again.. (Oddball Stocks)

 

Nate Tobik of Oddball Stocks shares his thoughts on diversification. (link) Our current thoughts on diversification and position sizing can be viewed here. (link) We have a similar thought process on the limits of one’s knowledge as an outside investor with valuation being the biggest tool to offset the limits of our knowledge.

 

 

Humility and knowledge (Oddball Stocks)

 

Related to his post on diversification, Mr. Tobik discusses how investors sometimes make the mistake of believing they know too much. (link)  We touched on a similar topic in our diversification post linked above.

 

 

Graham & Doddsville (Columbia Business School)

 

Columbia Business School put out another edition of Graham & Doddsville, which always makes for interesting reading. (link)

 

 

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

 

Base Hit Investing’s John Huber talks about how Buffett categorizes business by their return on capital and capital requirements. (link)

 

 

What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (Wall Street Journal)

 

The Wall Street Journal profiles the Steve Edmundson, the investment chief for the Nevada Public Employees’ Retirement. (link)

 

 

Howard Marks’ Letters Sorted by Topic (Anil Kumar Tulsiram)

 

Anil Kumar Tulsiram complied all Howard Marks’ letters by topic. He has compiled other documents in the past and can be followed on Twitter @Anil_Tulsiram. (link)

 

WEEKLY COMMENTARY 2/6/17-2/12/17

WEEKLY COMMENTARY               2/6/17-2/12/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

After the company’s recent share price appreciation, Grendene’s estimated five-year annualized return has fallen to roughly 10% base on scenario analysis.

 

There are barriers to entry within Grendene’s Brazilian business. Within Brazil, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good with a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets but growth in exports markets will come with lower profitability due to the weakened competitive position and excess returns.

 

Owner operators with strong operational skills, an understanding of its competitive position, and who treat all stakeholders with respect run the company. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.

 

Given the company’s expected return, the company’s competitive position, and the strength of management, we are decreasing our position size to 2.0%. Please review our initiation (link) for a more in-depth discussion on the company.

 

 

INTERESTING LINKS

 

 

My Interview with Jason Zweig (Safal Niveshak)

 

Vishal Khandelwal interviews Jason Zweig, who provides some very good ideas on improving your investment process. (link)

 

 

The Making of a Brand (Collaboration Fund)

 

In a wonderful article, Morgan Housel of the Collaboration Fund discusses the history of brands and what a brand is. (link)

 

 

Riding a retail roll out (Phil Oakley)

 

Phil Oakley discusses the difficulty in investing in retail rollouts. (link)

 

 

January 2017 Data Update 7: Profitability, Excess Returns and Governance (Musing on Markets)

 

Professor Damodaran provides some interesting statistics on ROIC across geographies and sectors. (link)

 

 

Investing Mastery Through Deliberate Practice (MicroCap Club)

 

Chip Maloney talks about the benefits of deliberate practice and how to use deliberate practice to make you a better investor. (link)

 

 

Out with the old (Investor Chronicle)

 

Todd Wenning provides insight on when to sell your investments (link)

 

 

2 Bitter Truths of Stock Valuation…and How You Can Avoid Them (Safal Niveshak)

 

Vishal Khandelwal highlights potential mistakes in valuing companies and how to avoid them. (link)

 

 

Revlon’s restructuring plan represents the future of legacy beauty (Glossy)

 

Glossy magazine writes about the beauty business. (link)

 

 

6 smart tips for micro-cap investors (Morningstar)

 

Ian Cassel gives readers 6 tips for micro-cap investors. These are useful for all investors. (link)

 

 

HAW PAR CORPORATION (HPAR:SP)

 

 

Company Description

 

Haw Par Corporation is a corporation with two operating businesses and strategic investments. The company’s two operating businesses are healthcare and leisure. The company’s healthcare business is the owner of the Tiger Balm, a well-known topical analgesic. The company’s leisure business own and operate two aquariums: Underwater World Singapore in Sentosa and Underwater World Pattaya in Thailand. The company also has investments in property and quoted securities.

 

 

Healthcare

 

Haw Par’s healthcare business manufactures and markets Tiger Balm and Kwan Loong. Tiger Balm is a renowned ointment used worldwide to invigorate the body as well as to relieve aches and pains. Its product extensions such as Tiger Balm Medicated Plaster, Tiger Balm Joint Rub, Tiger Balm Neck and Shoulder Rub, Tiger Balm Mosquito Repellent Patch and Tiger Balm ACTIVE range cater to the lifestyle needs of a new health-conscious generation..At first glance, the company’s healthcare business looks like a very attractive business. Tiger Balm is a trusted brand that has been around for over 100 years and generates very strong profitability.

 

Over the past four years, the healthcare business has increased sales by 18.4% per year while increasing its operating margin by 4.4 percentage points per annum and asset turnover by 0.14 per annum leading to an increase in its ROA from 27.7% in 2012 to 60.9% in 2015.

 

The majority of Haw Par’s health care business revenues are in Asia, but the company is growing fastest in America.

 

The company’s strategy for the healthcare business is to drive growth from further product penetration across existing markets to widen the brand franchise for Tiger Balm. The company has launched new products in several markets. Sales of Tiger Balm’s range of traditional and new products continued to grow in most of its key markets. The healthcare business’ margins improvement is due to lower commodity prices mitigating the pressures from rising staff costs amid tight labor markets.

 

 

Leisure

 

Haw Par’s leisure business owns two aquariums, Underwater World Singapore and Underwater World Pattaya.

 

In 2012, the company’s two aquariums attracted 1.48 million visitors at an average price of SGD20.50 leading to a SGD30.3 million in sales. The company generated operating profit of SGD11.80 million and a ROA of 45.8%. In 2015, the company attracted 0.76 million visitors to its two aquariums at an average price of SGD16.85 leading to SGD12.74 million in sales. The company had operating profit of SGD0.15 million, a segment profit of SGD-4.34 million and a ROA of 1.3%.  From 2012 to 2015, the number of visitors to the company’s two aquariums declined by 20% per year and the average price per visitor declined by 6.3% per year causing a sales to drop by 25.1% per year. The high level of fixed costs in the business saw operating profit fall by 76.8% per year.

 

The decline in the leisure business was caused by a decline in tourism and stiff competition from existing and new attractions, including direct competitors within the immediate vicinity of the two aquariums.

 

The leisure business is a great business as long as you are attracting a sufficient number of visitors to your property as the business is primarily fixed costs. Unfortunately, competition can easily enter the market in your vicinity decreasing the number of visitors at your property causing a decline in sales as you drop prices to attract people and an even greater decline in operating profit due to the operating leverage in the business.

 

 

Property

 

Haw Par’s owns three properties in Singapore and one in Kuala Lumpur. Of the company’s four properties, three are office buildings and one is an industrial building.

 

At the end of 2015, the company has total letable area of 45,399 square meters with an occupancy rate of 64.6%.

 

In 2015, the property division generated sales of SGD14.33 million, operating profit of SGD8.56 and ROA of 4.0%.  The division’s occupancy rate has fallen by almost 30 percentage points from 2013 to 2015, this could be due to a weaker environment or a deterioration of the properties’ competitive position as newer properties become available. I am not a big fan of property investments, as they tend to have poor return on assets and require significant leverage to generate a return near our required rate of return of 15%. On top of the poor profitability in the business, Haw Par’s occupancy rates have been falling potentially pointing to a weaker competitive position of the company’s properties.

 

 

Investments

 

Since 2012, Haw Par’s investment business accounted for 76.7% of the assets on the company’s balance sheet. At the end of 2015, United Overseas Bank (UOB:SP) accounted for 66.4% of the company’s available for sale securities, UOL Group (UOL:SP) accounted for 13.0%, and United Industrial Corp (UIC:SP) accounted for 9.5%.  United Overseas Bank, UOL Group, and United Industrial are all related parties as Wee Cho Yaw is the Chairman of Haw Par and the three other corporations.

 

Profit before tax is dividend income. Since 2012, the investment business has generated an average dividend income of 3.2%.

 

Since 1987, United Overseas Bank’s average annualized return was 7.0%, UOL Group’s was 5.2%, and United Industrial’s was 1.2%, nowhere near an acceptable return.

 

 

Management

 

Members of management are owner operators with insiders owning roughly 60% of Haw Par.  Management is doing a great job operating Tiger Balm but the rest of the business is a capital allocation nightmare with poor investments in leisure and property along with significant cross holdings in other family businesses.

 

Management also extracts far too much value with the average remuneration to key management personnel over the past two years at 9.9% of operating income. Operating income is used rather than profit before tax as the investment income and property income are poor capital allocation decision and it would be best if that money were returned to shareholders.  Since the income generated below operating profit detracts value it is best if operating profit is used. There are related party transactions outside of key management compensation. The company has no related party transactions.

 

 

Valuation

 

The poor capital allocation and management value extraction makes the business nothing more than a deep value holding, which would require at least 50% upside using conservative assumptions to be investible. To value the company, we value the healthcare business based off a multiple of operating profit and value all other division based on liquidation value due to the poor trends see in those businesses.

 

Given the quality and growth in Haw Par’s healthcare business, we believe 15 times operating profit is a fair multiple for the business. The company’s leisure business is given no value as the number of visitors continues to decline due to newer attractions and the company’s operating leverage means the company was barely breaking even in 2015. Cash and net working capital is valued at 100% of balance sheet value. The company’s property is seeing declining occupancy rates. We conservatively assume this to be a sign of the property’s deteriorating competitive position. There are also fees associated with any liquidation therefore we value the property assets at 75% of current value. The company’s available for sale securities are assumed to be liquidated at 75% of current value, as the holdings are so large that they would have a market impact if Haw Par ever tried to sell its shares.

 

Overall, Haw Par would be interesting below SGD7.50 but only as a deep value holding given the poor capital allocation and high management salaries.

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

 

Company News

 position-summary-table

PC Jeweller

PC Jeweller’s share price fell by 15.1% during the week bringing the total decline to 31.7% this month as the Indian government demonetized INR500 and INR1,000 notes in an attempt to fight “black money”. On the back of the regulation, the market is speculated that gems and jewelry companies would be one of the most impacted industries as gold and jewelry is thought to be a favorite “black money” asset. The Indian jewelry industry participants speculate a potential import ban on gold is also coming.

 

After the fall in share price, PC Jeweller is now offers a 9.1% NOPAT yield causing us to increase our position to 4.0%. While the company is in an industry with no barriers to entry evident by the thousands of competitors, PC Jeweller and Titan are far more operationally efficient than competitors creating excess profits through strong management. Our initial theory on PC Jeweller’s and Titan’s excess profits was associated with weaker competition from the unorganized sector, but the continued outperformance of PC Jeweller and Titan while listed peers continue to struggle points to operational advantage over organized peers.

indian-jewelry-value-driver-comps

 

The table shows the key value drivers within the industry as well as the financial health of peers. From 2012 to 2016, PC Jeweller has the third highest gross margin with the highest operating margin. Gross margin points directly to the customers’ willingness to pay while the difference between gross margin and operating margin point to the efficiency of management in running operations. In addition to the highest operating margin, PC Jeweller also has the fastest growth in the industry. PC Jeweller has the second highest ROIC leading to the second highest value creation in the form of excess profits. PC Jeweller and Titan are the only competitors that generated any significant excess profits over the period examined. The ability to continually generate excess profits in a period of raw material constraints and weak demand points to the strength of the management teams at PC Jeweller and Titan and an ability for sustained excess profits.

 

To get to an annualized return of 15%, PC Jeweller would have to fight margin pressures through stable operating margin and capital efficiency, while growing at 10% during the forecast period fading to a 0% growth rate in perpetuity. These assumptions do not seem too aggressive given, management ability to continue to create value despite points to sustained excess profits. New store openings and franchising should provide the 10% growth with the fade to 0% growth in year ten potentially being conservative. Our big concern with the above assumptions is competitive pressures lead to ROIC contraction rather than growth. If we change our profitability assumption to marginal excess profits from superior management (ROIC = 15%, Economic Spread = 2.5%), the five year would be 10%. This profitability assumption seems much more conservative and gives us sufficient comfort that if profitability declines there is still ample upside. It seems the risk reward is balanced sufficiently to increase our position size in PC Jeweller to 4.0%. We will be increasing our position size at a price below INR375.

 

Zensar Technologies

On November 17, 2016, Zensar Technologies reported FQ2 2017 results. Revenue grew by 2.7% and operating profit declined by 9.3%. FQ2 2017 was the third straight quarter where operating profit declined as the lack of growth on the top combined with continued growth in employee benefit expense leading to margin compression. The margin compression comes with an increasing average deal size and an increasing number of customers above 1 million, Zensar are unable to grow its top line as rapidly as its employee benefit expense leading to margin contraction. The weak top line growth may be temporary as the company’s backlog is strong at USD700 million up from USD500 million in the last quarter. Zensar is now offering a NOPAT yield of 6.5% despite being a business with no competitive advantage. With very aggressive assumption of a 12.5% discount rate, stable margins and capital efficiency, 10% forecast period growth, and 5% growth into perpetuity, Zensar offers 85% upside over the next five years. Growth in perpetuity is usually only assumed for companies with sustainable competitive advantages, which seems not to be the case for Zensar. Assuming a perpetuity growth rate of 0% decreases the potential upside over the next five years to 47%. Changing the growth assumptions to a 5% growth rate over the next five years, and a 0% terminal growth rate, there is only 19% upside over the next five years. Given the lack of upside, and lack of competitive advantages, we will be selling our Zensar position at prices above INR900.

 

Other Links

 

Why Moats are Essential for Profitability (Restaurant Edition) (25iq)

A fantastic essay at 25iq discussing the importance of moats. It also discusses the amount of research needed to understand the economics of a business. (link)

 

A Narrative Narrative (Polemic’s Pains)

A good blog post discussing how the current narrative on many topics is nothing more than speculation and subject to rapid change (link)

 

Expected Return (Research Affiliates)

Research Affiliates maintains expected real returns of different asset classes including Emerging Market Equities. (link) Given our view that the discount rate is an opportunity cost it may be more appropriate to view expected returns as the discount rate rather than historical returns. The appropriate discount rate for Emerging Markets would be 7.3% expect real return. Adding an additional 2.5% for expected inflation gets to roughly 10% discount rate. Adding an additional 2.5% as a margin of error gets us to 12.5%, our current discount rate. The idea that the discount rate should be tied to expected returns needs to be flushed out, but it seems interesting.

 

Predicting the Long Term is Easier than Predicting the Short Term (Intrinsic Investing)

An interesting article discussing how it is easier to predict the long term than the short term due and why this is one of the reason investing for the long term investing outperforms short term investing. (link)

 

Value Stocks vs. Value Traps (Old School Value)

Old School Value wrote an interesting article by discussing the characteristics of Value Stock and Value Traps. (link)

 

Chris Mayers on 100-Baggers (MicroCapClub)

Chris Mayers wrote 100-Baggers, an update on Thomas Phelps 1972 book 100 to 1 in the Stock Market. In this video, he discusses the key characteristic of 100-Baggers. (link) Below are the summary points.

 

  • Start small
  • Hold for a long time
  • Prefer a low multiple
  • High returns on capital
  • Owner operators

 

Fake News (Stratechery)

A good article by Stratechery on the subject of “fake” news, Facebook’s role in the delivering the news, and the dangers of who decides what news is deemed fake. (link) The discussion of fake news is interesting with the potential to leading us down a scary path. We must not forget the masses still receive their news from a small number of news outlets creating gatekeepers who deem some information to be newsworthy and other information less newsworthy. The existing gatekeepers already create narratives and form opinions among the population.

 

How the Brain Decides Without You (Nautilus)

It may not matter what the facts are, as the brain seems to decide how the world appears based on your existing views. (link) The best way to ensure, you are not missing anything due to pre-existing biases is to seek out the other side of the argument and understand it as well as you understand your side of the argument.

 

How Headlines Change the Way We Think (New Yorker)

Tied to the previous two articles, is an older article from the New Yorker discussing how headlines change the way we think about a story (link)

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

 

Honworld recently released its H1 2016 report.  In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.

 

Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.

 

The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.

h1-2016-chinese-condiment-producers-growth

 

Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.

 

The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else.  It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.

 

Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.

 

We are moving to a new approach for position sizing.  There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base.  Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.

 

Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.

 

Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.

 

High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation.  Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.

 

The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies.   Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential  bad investments while still offer enough concentration to take advantage of upside from good investments.

Grendene Position Size August 5, 2016

Grendene Position Size August 5, 2016

 

We sold 1,040,700 Grendene shares at an average price of BRL17.2365 per share at an average exchange rate of USDBRL 3.2420 equaling just over USD5.5 million. The cost postion on our Grendene shares is BRL16.74 with an average exchange rate of USDBRL 3.8535. Grendene is now just under a 5.0% position. The goal of the sale was to decrease the position size after increasing the position size when Grendene’s shares fell earlier this year.

Miko International and Honworld Position Size July 30, 2016

Miko International and Honworld Position Size July 30, 2016

 

Miko International released its unqualified 2015 year end results after four months of delay. During the delay, the Hong Kong Stock Exchange halted trading on the company’s shares.  The company’s previous auditor KPMG resigned due to incomplete information provided by Miko International. KPMG’s statement from the resignation letter follows.

 

‘‘In respect of our audit of the Company’s financial statements for the year ended 31 December 2015, there are a number of unresolved issues relating to receipt of satisfactory evidence and information, which remain outstanding. We have been communicating since early February 2016 with management on outstanding matters. The outstanding matters have been communicated to the Company’s management, Board of Directors, and the Audit Committee, details of which are set out below.

 

As at the date of this letter, we await satisfactory information in respect of the following matters:

 

  1. We await receipt of the draft 2015 consolidated financial statements from management.
  2. We await access to original bank statements in respect of one of the group’s bank accounts to be provided directly to us by the bank, which had a year end balance of RMB400 million, together with supporting documents in respect of security given over some of the group’s bank accounts.
  3. In respect of the group’s distribution channels, information is awaited relating to how the acquisition price was determined in respect of the distribution channels acquired during 2015 at a cost of RMB107 million, the signed valuation report and supporting documents in relation thereto, as well as supporting agreements and information relating to amendments made during the year to certain other distribution arrangements.
  4. In respect of the prepayment of RMB13 million as at 31 December 2015 for the group’s enterprise resource management system supporting information is awaited relating to the determination of the purchase price.
  5. In respect of the acquisition of a property in Shanghai during 2015, information is awaited in respect of the determination of the acquisition price, signed year-end valuation report, explanations relating to the difference between the year-end valuation and the acquisition price, and other documents in respect of the acquisition.
  6. Site visit and interview with an OEM Supplier.’’

 

Miko International hired HLB Hodgson Impey Cheng Limited (HLB) to audit its financial statements. HLB seems to be an auditor of last resort for fraudulent companies.

 

HLB also stepped in and gave China Solar Energy’s financial statements a clean audit opinion when the previous auditor Deloitte resigned in February 2012. China Solar is now considered to be a fraud and the shares have not traded since 2013.

 

HLB again stepped in when Deloitte resign in July 2015 as auditor of Sound Global. Sound Global received a clean audit from HLB. The company later found RMB2 billion missing from its books.

 

Other concerning evidence includes the resignation of the CFO and three independent directors within a few month time span including an independent director that resigned a month after joining.

 

There is significant evidence that Miko International is a fraud and we will be selling all our shares at the resumption of trading.

 

What can be learned from the poor investment in Miko International? We have decreased our position sizes on all investments to reflect the limits to our knowledge.  Additionally, we are any peripheral evidence will receive more attention. We also must admit when an investment is bad a take a loss.  Our gut told us there was a problem but we ignored it due to inconsistency avoidance and loss aversion.

 

Chinese companies must also be given a discount and smaller position due to the prevalence of fraud within the country. Given this we are decreasing our position size in Honworld to 5.0% as there is significant evidence of a passion owner operator with competitive advantages and credible financial statements (recent investment by a private equity firm), but there is the China discount that needs to be used in the form of a less aggressive position size. We will only be selling Honworld shares above HKD4.75 per share.

 

 

Peak Sport Products Privatization Update July 30, 2016

Peak Sport Products Privatization Update July 30, 2016

On July 26, 2016, Peak Sport Products announced the company would purchase all free float at HKD2.60 per share.   The offer is a 5% premium to July 29, 2016 closing price.  We will sell shares during the privatization.

Decreasing Grendene Position Size July 28, 2016

Decreasing Grendene Position Size July 28, 2016

We increased our position size in Grendene when its price declined below BRL15.00 per share.  The price is now back around where we initiated our position (>BRL17.00) so for consistency we should have a position size close to our initial position size therefore we are decreasing our position size by USD4.5 million but we are only selling if Grendene’s price is above BRL17.00 per share.

There is no change to the investment thesis. Within the domestic market, Grendene is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements.  It produces a low priced experienced good and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets.  Management are owner operators with a culture of operational efficiency.  The expected return in a Grendene investment is still above 15%.

Anta Sports Product July 19, 2016

Anta Sports Product July 19, 2016

Anta Sports Products July 19 2016 RCR

                                                                                     

Recommendation: Buy                 

Ticker: 2020:HK

Closing Price (7/19/2016): HKD17.26

6 Month Avg. Daily Vol. (USD mn): 18.82

Estimated Annualized Return: 11-13%

 

 

INVESTMENT THESIS

 

Anta is the largest Chinese sportswear company with an 11.1% market share. Anta’s size gives it an advantage over all domestic peers as there are fixed costs in the form of advertising and research and development allowing the company to outspend peers on brand building and improving the company’s product. Anta’s size and strong brand allows the company to generate an average pre-tax ROIC over four times its Chinese sportswear peers. The company expected annualized return is somewhere between 11.0%-12.5% leading to an initial 2.0% position size.

 

 

KEY STATISTICS

Key Statistics July 19 2016

 

FACTOR RATINGS

Factor Ratings

 

 

COMPANY DESCRIPTION

 

Anta was founded in 1994 by Mr. Ding Siren, the father-in-law of the company’s current Executive Director Mr. Ding Shizhong. He incorporated ANTA Fujian and ANTA China in 1994 and 2000 and the company went public in 2007.

Group Structure

 

The company is a leading sportswear company with an estimated 11.1% market share at the end of 2015.

Chinese Sportswear Market Share 2015 Pie Chart

 

The company uses a combination of internal production and outsourced production to allow for more flexibility in periods of strong demand. The threat of vertical integration also gives the company bargaining power of its suppliers. In 2015, 49.0% of footwear and apparel is produced internally.

 

Advertising and research and development are done internally while distribution and retail is outsourced to exclusive partners with the company monitoring operations. At the end of 2015, Anta had 9,080 stores including 7,031 Anta stores, 1,458 Anta kids stores, and 591 FILA stores.

 

The company has positioned its product as a high performance, value for money brand. It partners with the Chinese Olympic Committee, Chinese Sports Delegation, and many of the Chinese Olympic teams allowing it to be perceived as the Chinese national brand. It is also the official partner of the NBA in China and endorses many NBA players including Klay Thompson, one of the best players on one of the best teams in the league, Chandler Parson, Rajon Rondo, and Luis Scola. The Anta brand is consistently voted the most valuable sportswear brand and one of the top three most valuable apparel brands in China.

 

In 2015, the company generated 45.6% of sales from footwear, 50.3% of sales from apparel, and the remainder from accessories. Since 2008, Anta grew sales at a compound annual growth rate of 13.4%.

 

In 2015, gross profit breakdown is similar to sales breakdown with footwear accounting for 45.2% of gross profit, apparel accounting for 51.5% of gross profit, and accessories accounting for the remainder of gross profit.

Anta Revenue Gross Profit Breakdown

 

Anta’s three largest operating expenses are advertising, staff costs, and research and development. Anta spends heavily on advertising and research and development. Over the past four years, the company spent 11.3% of sales on advertising and 4.3% of sales on research and development.

Anta Opex % Sales

 

Since 2008, the company’s operating margin averaged 21.5% with low variability. The company’s highest operating margin was 23.3% in 2009 and the lowest was 19.3% in 2012.

 

Anta has low investment requirements. Since 2008, working capital averaged 6.2% of sales and fixed capital averaged 10.7% of sales meaning invested capital averaged 17.9%. Overall, Anta average return on invested capital is 127.8%.

 

 

INDUSTRY ANALYSIS

 

Industry History

 

The Chinese sportswear industry went through a rapid period of growth from 2008 until 2011 supported by the Beijing Olympics. During that period, the industry saw an increase in store count at the largest domestic players from 27,605 stores in 2008 to 40,819 stores in 2011, representing a 13.9% compound annual growth rate (CAGR). Sales at the largest seven players increased from RMB37.63 billion in 2008 to RMB58.35 billion in 2011, or 15.7% per year.

Industry Sales Store Count

 

After the period of rapid growth, 2011 to 2014 saw a period of consolidation with the store count decreasing 4.6% per year from 40,819 to 35,428 and sales decreasing 2.7% per year from RMB58.35 billion to RMB53.71 billion.

 

2015 may have marked the end of the consolidation as started a return to growth with store count stagnating around 35,000 and sales at the seven largest players increasing by 25% from RMB53.71 billion to RMB67.18 billion.

 

The sportswear industry is one of the most mature segments of the apparel industry and is expected to grow around mid-single digits. Despite the maturity, the sportswear industry is still underpenetrated in China.

 Chinese Sportswear Penetration

 

 

 

Barriers To Entry

 

In the sportswear industry, size is a key driver of profitability and growth as there are significant fixed costs in the form of advertising and promotion and research and development creating economies of scale. There are many estimates for the Chinese sportswear market size with Fitch’s estimating the market reached RMB100 billion in 2015, which is 5-10% lower than the average of estimates from Euromonitor, Fung Business Intelligence Centre, Research InChina, and ATKearney. The table below illustrates market shares of the largest players in the Chinese Sportswear market assuming a RMB100 billion market size with the market size from previous years estimated to grow at the same rate as the largest players in the market.

Chinese Sportswear Market Share 2010 2015 table

 

In 2015, Nike was the largest sportswear company in China with an estimated 17.1%. Adidas followed in second place with a 17.2% market share. The largest domestic player was Anta with an 11.1% market share. The second largest domestic player is Li Ning with a 7.1% market share. Due to its size and the presence of economies of scale, Anta is competitively disadvantaged to Nike and Adidas but has a competitive advantage to domestic players. From 2010 to 2015, Nike, Adidas, and Anta gained 5.8%, 5.6%, and 1.7%, respectively. The smaller domestic players all lost market share with a cumulative market share loss of 8.0% between 2010 and 2015. Interestingly, Li Ning lost 5.0% of market despite starting the examined period with the second highest market share. With the exception of Li Ning, market share movements point to economies of scale as larger firms spend more on the fixed costs needed to educate customers and improve the product.

Size vs Operating Margin

 

The chart above plots market share for each Chinese sportswear competitor compared to their operating margin from 2010 to 2015. Adidas does not report operating margin for China. As shown, there is a strong correlation between size and operating margin with Li Ning’s poor profitability being the only outlier.

 

Advertising and promotional expense is partially an expense that needs to be adapted to local markets given differences in cultures and tastes creating a need to customize advertising and promotion to adhere to those local cultures and tastes eliminating the size advantage from global markets for Nike and Adidas. A big part of advertising and promotions in sportswear is endorsements of brands by athletes. Endorsements are primarily global as illustrated by Chinese domestic sportswear companies trying to sign NBA stars from the United States rather than relying on local basketball players. Given the global nature of endorsements and the fixed nature of the cost, the true measure of Nike and Adidas’s size are the companies’ global sales giving them a much bigger size advantage than estimated by looking at the local market. Similar to endorsements, research and development in the design of new products is global as the product innovations produced from one market can be used in many other markets, making the true measure of Adidas and Nike’s size their global scale. Nike and Adidas do not report fixed costs on a local basis but the tables below show spending on fixed costs by domestic peers.

Fixed Costs of Domestic Peers

 

Li Ning was the biggest spender on advertising and promotion from 2010 to 2015 although the pace of spending slowed in 2014 and 2015 due to RMB 2.8 billion in operating losses in 2012, 2013, & 2014 allowing Anta to overtake them as the largest spender in advertising and promotion in 2015. From 2010 to 2015, smaller domestic peers spent less than half of Li Ning on advertising and promotion and just over half of Anta.

 

From 2010 to 2015, Anta was by far the biggest spender on research and development spending RMB2.1 billion almost twice the amount spent by Li Ning and almost five times the average of smaller players.

 

Despite spending the most on advertising and the second most on research and development of domestic peers and having the highest market share, Li Ning lost 5.0% market share between 2010 and 2015 illustrating that while size is important, execution matters as well. The other big market share losers were the smaller domestic players unable to compete on fixed cost spending. Collectively, Li Ning and the smaller domestic players lost an estimated 13.0% of market share. Nike and Adidas were the largest market share gainers winning 5.8% and 5.6%, respectively. Anta increased its share by 1.7% between 2010 and 2015. Fixed cost spending, market share movements, and the relationship between size and profitability all point to the presence of economies of scale.

 

Brand advantage is present in the Chinese sportswear market. Brand advantage is often illustrated by premium pricing and market share as it points to a customer’s increased willingness to pay. Many companies do not give the average selling price (ASP) for products sold so tmall.com was referenced. For better comparability, footwear was categorized into running and basketball shoes, two of the most popular sports categories. The tables below illustrate the average selling price (ASP) for each companies top selling shoes.

ASP of domestic peers

 

Nike shoes have the highest average price in both categories at RMB1,083 in the running segment and RMB797 in the basketball segment. Nike’s prices in running are at a significant premium peers with the closest competitor’s ASP at a 64% discount to Nike’s ASP and the average peer price 25% of Nike’s running ASP. In basketball, Nike’s ASP is level with Adidas and roughly three times the average of its other peers. Adidas ASP is a 30% premium to running peers other than Nike and three times the average of non-Nike peers in basketball. The combination of ASP premium for Nike and Adidas and market share advantage points to a significant brand advantage over the remaining peers in the industry.

 

Anta ASP is at 10% premium to the average price of non-Nike and Adidas peers in running pointing to little or no ASP premium in the running segment. In the basketball segment, Anta’s price is roughly 55% higher than peers other than Nike and Adidas. Anta’s pricing premium with a market share advantage points to a potential brand advantage to competitors other than Nike and Adidas but the evidence is not as strong as the brand advantage held by Nike and Adidas.

 

Brand advantage should also show up in a gross margin advantage relative to peers as a branded company can charge a higher price as customers have an increased willingness to pay. A higher gross margin may also point to a manufacturing advantage over peers. Given all companies do not report volume statistics; it is difficult to compare manufacturing costs. It is probably difficult to have a sustained cost advantage as much the production function is outsourced. The outsourcing points to no internal costs advantage and the ability of peers to outsource production to the same provider of a competitor. If there were any unique activities within production, it could easily be replicated by peers as there is no complexity or unique processes associated with manufacturing footwear and apparel. The true cost advantage could come from lower labor costs but given the ease of outsourcing that could be obtained from any competitor. Given the production function can be outsourced, there is potential purchasing power from the larger competitors leading to lowering the cost of production.

 

Size vs Gross Margin

 

The chart above plots market share compared to gross margin for Chinese competitors between 2010 and 2015. Nike does not report gross margin for China and Adidas only started reporting it in 2014. As illustrated, there is a strong correlation between size and gross margin with an adjusted R squared equaling 0.787. Unfortunately, higher gross margins due to size can be either purchasing power on raw materials, premium pricing from the ability to spend more on fixed costs in the form of advertising and promotion and research and development, or a combination of both.

 

There are also many firms estimating brand value of Chinese companies. The Hurun Institute estimates brand value for Chinese apparel companies as illustrated below.

Most Valuable Chinese Apparel Brands Hurun

 

According to Hurun Research Institute, Anta consistently ranks as on the three most valuable apparel brands with an estimated brand value of RMB6.4 billion at the end of 2014, illustrating Anta’s brand strength relative to domestic peers.

 

Interbrand reports annually Chinese 100 most valuable brands. Anta continually shows up as the highest sportswear brand on the list. Interbrand is much more conservative with Anta’s estimated brand value of RMB3.77 billion at the end of 2015.

Anta Brand Value Interbrand

 

Further evidence of Anta’s competitive advantages is seen in its profitability relative to domestic peers.

Chinese Sportswear Players Operating Margins

 

Relative to domestic peers, Anta had the highest operating margin by 3.5 percentage point with the lowest variability by a very wide margin. Between 2010 and 2015, Anta’s operating margin only decline by 40 basis points. The next best margin decline was at Peak Sports, whose margins declined by 3.7%. The company’s operating margin saw minimal variability with a coefficient of variation of 6.3% below all peers including Nike and a third of the closest domestic peer.

Chinese Sportswear Players IC Turnover

 

Anta was also by far the most efficient user of capital with an average invested capital turnover ratio of 6.07 with the second best stability behind 361 Degrees.

Chinese Sportswear Players Working Capital and Fixed Capital Turnover

 

Anta’s efficient use of capital is driven by its working capital efficiency as there is minimal differential in fixed capital turnover among domestic peers.

Chinese Sportswear Players Working Capital Breakdown

 

Anta big differential with peers is in receivables management with the company turning over receivables 11.7 times in 2011 compared to a peer group average of 4.0 times. Similarly, in 2015, Anta turned over receivables 9.5 times compared to a peer group average of 3.4 times. Anta is almost three times more efficient than peers in managing receivables. The downturn in the industry created receivables issues at most peers but the strength of Anta’s brand, product, and pricing allowed the company to continue to push product through the channel without distributors having any issues selling the product.

Chinese Sportswear Pre Tax Roic

 

Anta’s superior profitability and capital efficiency leads to the highest ROIC every year with the lowest variability. Anta’s pre-tax ROIC is over four times the average of domestic peers.

 

Profitability well above peers states customers are either more willing to pay for the company’s products or the company manufacturers products more efficient than peers.

 

The evidence points to barriers to entry in the form of economies of scale and brand with the economies of scale reinforcing the brand advantage as the company can spend more on fixed costs to build its brand by having a greater size. Anta is on the right side of the virtuous feedback loop against domestic peers but on the wrong side of the feedback loop against Nike and Adidas.

 

Anta has a size advantage and seems to have a brand advantage over other domestic peers but the strength of its advantage is nowhere near the strength of Nike’s and Adidas’ advantages.

 

 

Competitive Advantage Period

 

Economies of scale combined with a brand advantage create very strong barriers to entry as they combine to create a feedback loop that is difficult to overcome. The size advantage allows a competitor to outspend its peer on fixed costs. In sportswear, the fixed costs are advertising and promotion and research and development. These costs build and reinforce a company’s brand creating a feedback loop that is difficult to overcome. Fixed costs, such as endorsements and product development, can be used in many different markets making global scale, the true measure of a competitor’s size, and making it even more difficult for local players to compete.

 

Nike and Adidas’ competitive advantages should persist for decades. Anta’s disadvantage to Nike and Adidas should continue but its advantage over domestic peers should strengthen over time.

Global Sportswear Market Share 2011

 

Globally, the sportswear markets are fragmented with Nike and Adidas garnering a 21.1% market share in apparel and a 52.7% market share in footwear. The relative fragmentation of apparel illustrates the apparel market is much more competitive. Given the presence of economies of scale in the sportswear industry, the industry should be more consolidated given fixed costs associated with economies of scale create a minimum efficient scale to compete. It seems some customers are not willing to pay a premium price for a brand and are much more price sensitive. Customers have diverse taste and the larger organizations do not produce goods to cover all tastes in the market. The barriers to entry are not strong and companies can survive with a very lower market share due to the asset light nature of the business.

 

Anta’s competitive advantage over domestic peers should also continue for decades but profitability will deteriorate as it starts competing with Nike and Adidas. At the moment, it has positioned itself as a brand among the mass market segment, while Nike and Adidas are in the high-end segment making direct competition not an issue for the moment.

 

 

Other Four Forces

 

Intensity of rivalry is high particularly among firms competing for more price sensitive customers as these customers are only worried about price making operating efficiency the key strategic goal within this segment. For firms competing more on brand, their offering is differentiated making the intensity of rivalry less intense.

 

Although the sportswear industry is fragmented, suppliers in the form of sportswear manufacturers are typically smaller, more fragmented, and at risk of vertical integration leaving them with very little bargaining power. In the case of companies that manufacture their own products, raw material suppliers are commodity producers that are very fragmented and sell their product solely on price.

 

Suppliers of labor seem to have bargaining power over the sportswear companies. From 2010 to 2015, Staff costs have increased as a percentage of sales at all Chinese sportswear companies by a minimum of 2.3%. The rise in cost points to employees having bargaining power over suppliers.

Chinese Sportswear Staff Costs

 

Customers in the form of distributors are fragmented and in the case of Anta are exclusive sellers of Anta’s products. The fragmentation and exclusivity greatly decreases the bargaining power of customers. While the bargaining power of distributors is low, Anta relies on the distributors to sell their products; therefore, they are more partners whose health is vital to Anta.

 

The threat of substitutes is high for more casual sportswear as customers can easily switch and buy similar product from more fashion oriented companies. More performance oriented sportswear has a lower threat of substitution as athletes are less likely to give up on performance features.

 

 

 

MANAGEMENT

 

Anta’s executives are owner-operators with five of the executive directors owning at least 6% of the company allowing management incentives to be aligned with minority shareholders.

 

Strategy

 

The company’s strategy is to be the leader in the value for money segment by having a stronger brand  and more innovative products than peers competing in the value for money segment. The company strategy has been consistent since their IPO. Management understands the key strategic drivers in the industry spending the most among domestic peers on fixed costs to build a brand and improve products allowing the company to continually win market share allowing the feedback loop of greater size allowing for greater spending on fixed costs to build a brand and improve products to continue.

 

Operations

 Chinese Sportswear Key Value Drivers

 

Over the last five years, ANTA outperformed peers on all key value drivers. It comes out on top in sales growth, operating profit growth, operating margin, capital efficiency and its ROIC is more than double its closest competitor. It comes in second only in gross margin to Li Ning.

 Chinese Sportswear Pre Tax Roic

 

As illustrated, with the exception of Li Ning, Chinese sportswear companies were able to generate an average pre-tax return on invested capital of 51.9% between 2010 and 2015. Anta’s average pre-tax ROIC was four times the average of its peers over that time due to higher margins and capital efficiency.

Chinese Sportswear Operating Margin IC Turnover

 

From 2010 to 2015, the average operating margin in the Chinese sportswear industry averaged 13.1% with Anta averaging 21.0% and its peers averaging 11.0%. Peers were dragged down by Li Ning with Anta having only a few percentage points edge over XTEP and Peak Sports. Although Anta had a small advantage in average operating margin, the company’s stability is far superior to the peer group.

 

Anta’s IC turnover surpassed domestic peers IC turnover by a wide margin, averaging 6.07 times compared to a peer group average of 3.00 times.

 

Overall, management is executing its value for money strategy much better than peers leading to market share gains and profitability much higher than peers.

 

Capital Allocation

Anta Capital Allocation

 

Capital allocation cash flow is operating cash flow + working capital + advertising and promotion expense + research and development expenses. Capital allocation cash flow is the amount of cash flow available for capital allocation decisions.

 

Advertising is the largest capital allocation decision at 34% of capital allocation cash flow. Given the company’s size advantage over peers and the importance of brand in the industry, advertising expenses should be maximized. The company is doing a good job taking advantage of its market share and outspending peers on fixed costs but with a net cash position of roughly 2.25 times operating profit the company could increase advertising expenses.

 

The second largest capital allocation decision is the payment of dividends accounting for 33% of capital allocation cash flow. Given the asset light nature of the business and the company’s net cash position, higher dividends could be paid.

 

The third largest capital allocation decision is research and development accounting for 11% of capital allocation cash flow. Research and development is a fixed cost to improve the product and the company’s brand, given the company’s size advantage and the ability to build a brand from product innovations, Anta could increase its research and development as it has a large net cash position.

 

All other capital expenses are minimal with working capital investment and capital expenditures combine to 10% of capital allocation cash flow.

 

The company made two acquisitions between 2008 and 2015 equaling 2% of capital allocation cash flow. Both times the company paid book value. In 2009, the company purchased the right to distribute FILA in the greater China area. At the time, the acquired company was losing making. The company does not segment out sales and profits by brand so we unable to determine how good of an acquisition it was. The acquisition does not makes sense strategically.  FILA is a high end brand that is more fashion oriented. The high end nature puts in direct competition with Nike and Adidas, while its fashion orientation makes it more open to competition from more fashion oriented clothing. If the company’s goal is to be the leading value for money brand, the FILA acquisition brings the distraction of worrying about a high end product that does not provide any additional size advantage. Also, given you have little or no input into product innovation and marketing, the key activities in the sportswear value chain are out of the company’s control.

 

Overall, the company has made no major capital allocation missteps. The biggest misstep is having a net cash position equal to 2.25 times 2015 operating profit. The company has a size advantage over all players within its segment and ideally the company would increase spending on either advertising and promotion or research and development. If the company believes it is at the optimal level of spending on fixed costs it could increase dividends paid.

 

 

Corporate Governance

Anta Related Party

 

The company’s related party transactions are insignificant. Quanzhou Anda is a related company that provides packaging, while the service fee to Mr. Ding Shijia is related to lease payments for the use of facilities.

 

Since 2010, the top five highest paid employees’ average pay was only 0.75% of operating profit. The company’s management is not extracting too much value from salaries on an absolute basis. Below 1.0% is actually extremely good value given the strength of management strategically and operationally. Relative to the industry, Anta has the lowest salaries relative to operating profit and sales.

 

Chinese Sportswear Top 5 Salaries

Anta’s accounting assumptions are in line with peers across the board so there are no concerns over inflated earnings due to accounting assumptions.

 

 

VALUATION

 

Given Anta is competitively advantaged against the Chinese sportswear companies, the best valuation method is an earnings based valuation. In case of Anta competitive advantage does not exist, reproduction value would be the best method of valuing the company. If the industry were not viable, liquidation value would be the best valuation technique.

Anta Asset Based Valuation

 

As illustrated above there is 83% downside to liquidation value and 55% downside to reproduction value.

 

The key assumptions used in the earnings based valuations are the discount rate, sales growth, operating margin, tax rate, working capital turnover, and fixed capital turnover. The discount rate, tax rate, working capital turnover, and fixed capital turnover are assumed to be constant at the values below.

Anta Constant Valuation Assumptions

 

We always assume a discount rate of 10%, a regulatory tax rate of 25%, an average working capital turnover of 40.9 times, an average fixed capital turnover of 9.5 times. Working capital turnover and fixed capital turnover averages are from 2008 to 2015.

 

Sales growth and operating margin are assumed to vary to get an understanding of what the market is pricing in. The values of sales growth and operating margin for each scenario are listed below.

Anta Valuation Scenarios

 

The target prices for 2016 and 2021 along with their upsides are illustrates below.

Earnings Based Valuations

 

The worst case scenario is assumed to be zero growth into perpetuity with operating margin compressing from the current 22.5% to a 19.3%. Under the worst case scenario, the 2016 target price is HKD11.76 leading to 32% downside and the 2021 target price is HKD14.65 leading to 15% downside. The most optimistic scenario assumed 15% growth over the next five years before fading to a 5% terminal growth rate with average operating margins since 2008. Under the most optimistic scenario, the 2016 target price is HKD31.60 representing 83% upside and the 2021 target price is HKD50.58 representing 193% upside.

 

Overall, the average 2016 target price is HKD19.12 representing 11% upside and the average 2021 target price is HKD27.11 representing 57% upside. There company offers a decent average return. The average return seems a bit conservative with a more reasonable base case between 5% perpetuity growth and average margins and 10% forecast period growth fading to 5% terminal growth with average margins. The 2016 target price and 2021 target price for the lower end of the base case is HKD21.87 and HKD30.59 representing 27% and 77% upside, respectively. The 2016 target price and 2021 target price for the upper end of the base case is HKD26.14 and HKD39.34 representing 51% and 128% upside, respectively. Under the base case, there is just about 15% annualized return, the company is slightly undervalued.

 

On an expected return basis, assuming a return on reinvested earnings of 50% and an organic growth rate of 2.5%, less than half of the company’s current ROIC, the company’s expected return in 16.5% as the company has a NOPAT yield of 5.1%, 2.8% of which is paid in dividends and the remaining 2.2% is reinvested.

Expected Return

 

The company has a current free cash flow yield of 3.3% with expected growth of roughly 7.5% leads to a 10.8% expected return.

 

The company is slightly undervalued and offering roughly a 12% annualized return at the lower end of the base case scenario, which is confirmed with expected return of roughly 10.8%.

 

 

RISKS

 

If perceived barriers to entry do not exist, the company’s profitability would be less sustainable than originally expected and the company’s valuation would suffer potentially causing a permanent loss of capital as the company is trading above its reproduction value.

 

If Adidas and Nike are able to attack the mass market segment without hurting their premium brand image, Anta could find itself on the wrong side of economies of scale.

 

Li Ning was once larger than Anta but lost market share over the past five years and is suffered significant losses over the past few years. These losses forced Li Ning to cut back on advertising and research and development. In 2015, the company returned to profitability and soon it could find the formula that made it a market share leader increasing competition for Anta.

 

Given economies of scale are present in the industry, market share is one of the most important variables in profitability. If Anta loses market share, it will not be able to spend on crucial fixed costs of advertising and R&D leading to weaker brand and product and more market share loses.

 

Management has done a good job of allocating capital and executing operationally but if they stop taking advantage of their size over smaller domestic peers by decreasing spending on fixed costs or become inefficient operationally, profitability will suffer.

 

Advertising and brand building is a crucial to achieving excess returns. If the company overpays endorsers, excess returns could fade.

 

Anta is in the consumer goods industry and if the macroeconomic situation deteriorates in China, consumers could stop buying sportswear.

 

The more fashion oriented sportswear faces competition from non-sportswear apparel makers.

 

Anta outsources part of its production and all of its distribution and retail activities. If value chain partners do not perform then the company’s image may be hurt.

 

Anta’s corporate governance is not an issue. If management starts extracting more value from related party transactions and high executive pay, the company’s multiple will suffer.