Tag Archives: Consumer Services

GMA Network Full Year Results Review May 13, 2017

GMA Network Full Year Results Review May 13, 2017

 

GMA Network reported its full year results. The company’s revenue grew by 21.5% and 14.6% without political advertisements. Its audience share fell from 38.0% to 33.9% as ABS CBN took the share lost by GMA increasing its audience share from 41.5% to 44.7%.

 

The company’s production costs grew by 12.0% leading to an increase in gross profit by 28.0%. GMA’s general and administrative expenses (GAEX) increased by 3.2% in 2016 allowing operating profit to increase by 69.5%.

 

GMA’s working capital increased by 8.0% while fixed capital decreased by 7.1% causing invested capital to decrease by 0.2%. The company’s ROIC increased from 23.2% to 39.4%.

 

Over the past five years, GMA increased its NOPAT by PHP1,886 and invested capital increased by PHP109 million allowing the company to generate an incremental ROIC of 1736.7%. Since 2007, the company increased its NOPAT by PHP1,342 and invested capital by PHP1,342 leading to an incremental ROIC of 100.0%.

 

Given the fixed costs in the industry associated with production costs, size is crucial, ABS is clear winner with an audience share advantage over GMA. GMA has a very large lead over the third place competitor TV5. ABS also produces the best content dominating the top 10 programs for some time. Operationally, GMA is much more efficient than ABS.

 

Per point of audience share, ABS generates much more revenue but this comes with higher production costs, other operating expenses, and assets leading to a much lower operating margin, net operating asset turnover, and ROIC.

 

Overall, the industry is dominated by ABS and GMA with the two companies controlling 78.5% of the industry. Given the huge fixed costs and customer captivity within the industry, it would be difficult for small players to compete with ABS and GMA. ABS larger spending on production costs absolutely and on a per audience share point and its domination of the top 10 programs in the Philippines illustrates its big lead in content production over GMA consistently dominating the top 10 programs, but GMA is operationally efficient. Given the reach of television, it is still the best place to reach a mass market and educated consumers. The internet has been taking share from more focused advertising markets of magazine and newspapers. Magazine reach niche interests while newspapers reach local markets.

 

The biggest threat to earnings in the future is internet distribution of content. We feel  ABS and GMA are insulated as the small market size of Philippines may make international content providers pause on spending on local content. Local content producers do not have the size to produce as much content as ABS or GMA. In addition, internet penetration is low in Philippines further insulating TV from disruption.

 

GMA reported strong results for 2016 and currently trades on a nine-year average free cash flow yield of 10.2% and with pricing power can grow by 5% per annum leading to an expected return over 15%. We will build our position size to 4.0%.

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.

GMA Holdings/GMA Networks 2/1/2017

GMA Holdings/GMA Networks

Ticker:                                                             GMAP:PM/GMA7:PM

Closing Price (1/31/17):                                PHP5.90

6 Month Avg. Daily Vol. (USD mn):             0.56

Market Cap (USD mn):                                 421

Estimated Annualized Return:                    12.5%

Suggested Position Size:                              4.0%

February 1, 2017

GMA_Research_Report_Feb_1_2017

 

FACTOR RATINGS

 

 

 

INVESTMENT THESIS

 

GMA Network is a competitively advantaged firm enjoying economies of scale with customer captivity and regulatory barriers to entry. Unfortunately, management’s operational inefficiency is creating a drag the business’s profitability. Additionally, management pay themselves 20% of operating profit.  The company is trading on a free cash flow yield of 7.5% and should grow at least at 5.0% leading to a minimum expected annualized return of 12.5%.

 

 

COMPANY DESCRIPTION

 

 

Company History

 

GMA Network, Inc. (GMA) is a free-to-air broadcasting company engaged in television and radio broadcasting, the production of programs for domestic and international audiences, and other related businesses. The company derives the majority of its revenues from advertising related to television broadcasting. GMA Network has 47 VHF and 41 UHF TV stations throughout the Philippines with its signal reaching approximately 98% of the country’s Urban TV Households.

 

Robert La Rue Stewart founded GMA in 1950 as Republic Broadcasting System (RBS) with its flagship AM radio station DZBB operating from Escolta, Manila. RBS started broadcasting on Channel 7 in the Greater Manila Area in 1961. In 1975, Felipe L. Gozon, Menardo R. Jimenez, and Gilberto M. Duavit took over management of RBS and renamed it to GMA 7.
The original meaning of the acronym “GMA” was Greater Manila Area, referring to the initial coverage area of the station. The company changed its name to Global Media Arts. Today, its corporate name is GMA Network, Inc.

Apart from its television and radio networks, the company owns many media businesses including film production, record publishing and distribution, program acquisition and syndication, international channel operation, production design, talent development and management, marketing and promotions, audio-visual production and new media.
In addition to its presence in the Philippines, GMA’s content is distributed outside the Philippines through its subscription-based international channels distributed through multiple platforms. Its content is also on many platforms through worldwide syndication sales to broadcasters/companies in China, Southeast Asia, Africa, and Europe.

 

In February 2001, Philippines Long Distance Telephone Company (PLDT) agreed to acquire 75% interest in GMA for PHP 8.5 billion. Regulatory approval for the deal was received in August 2001. In late 2001, the relationship between the parties deteriorated and PLDT pulled out of the deal stating its debt was too much of a burden to complete the deal.

 

GMA went public in 2007. As of September 30, 2016, the company had 3,361,047,000 common shares outstanding and 7,499,507,184 preferred shares outstanding. Common shares have two classes, common shares and Philippine Deposit Receipts (PDRs). Filipinos can only hold common shares, while anyone can hold PDRs. The two are fully fungible for Filipinos. The company’s preferred shares are unlisted and convertible to common shares at a rate of 5 preferred shares to 1 common share. The public float is 24.38%.

 

FLG Management & Development Corp. is an investment vehicle of Felipe L. Gozon, the Chairman of the Board and CEO of GMA Network. Mr. Gozon is an attorney graduating from Yale Law School. Aside from GMA Network, he is a Senior Partner at the Law Firm of Belo Gozon Elma Parel Asuncion & Lucila.

 

M.A. Jimenez Enterprises and Television International Corporation are investment vehicles of Menardo Jimenez was the former President and CEO of the GMA Network. He gave up the position to brother-in-law Felipe Gozon in 2000.

 

The company’s approved dividend policy entitles holders of common shares to receive annual cash dividends equivalent to a minimum of 50% of the prior year’s net income based on the recommendation of the Board of Directors.

 

 

Business Model

 

GMA Network creates and purchases content aggregates the content into channels. Channels are transmitted to audiences directly or over the internet. GMA generates revenue primarily by selling time within programs to advertisers. Advertisers pay based on the size and type of audience. Advertising accounted for roughly 90% of revenues over the past three years. The company also generates revenue from selling content internationally and via its websites.

In 2015, over 90% of the company’s revenue was from television and radio airtime with the remaining revenues coming from content production and others. In the first six months of 2016, Channel 7/RTV accounted for 94% of television and radio airtime revenue while GMA’s news station, GNTV, accounted for 2% of television and radio airtime revenue and radio accounted for 4% of television and radio airtime revenue.

 

The costs of creating content and purchasing local or international content are fixed and are the same regardless of audience size. For GMA, production costs or content creation costs equates the cost of goods sold.

 

The production cost structure is shown above. Talent fees account for roughly half of the company’s total production costs. The next largest expense is rentals and outside services,, which has decreased as a percentage of total production costs indicating the company is slowing moving more production in-house. Overall, the company’s gross margin has averaged 55.0% over the past three years.

 

The general and administrative expenses (GAEX) required to generate revenue averaged 37.9% of revenue over the past three years with personnel costs being the largest expense accounting for 50% of total GAEX. At 12% of GAEX, facilities costs were the next largest cost and only other cost accounting for more than 10% of GAEX.

 

Over the past three years, the total amount of operating expenses were relatively stable over the past three years while revenue fluctuated potentially pointing to the vast majority of operating expenses being fixed.

 

We estimate that roughly 70% of operating expenses are fixed. We assume all production costs are fixed along with 25% of GAEX personnel expenses. The fixed portion of GAEX personnel expenses is sales staff. Additionally, all depreciation and facilities costs are assumed to be fixed. All other expenses under GAEX are assumed to be variable.

 

Since 2007, to generate one peso of revenue, GMA needs to spend 34 centavos on working capital and 40 centavos on fixed capital leading to 74 centavos of total investment. For every peso of revenue, the company generates 24.4 centavos of operating profit leading to an average ROIC of 23.3%.

 

 

INDUSTRY ANALYSIS

 

 

Industry History

 

A predecessor of ABS CBN’s, ABS introduced television to the Philippines in 1953. ABS started broadcasting DZAQ-TV3 on a four-hour-a-day schedule from six to ten in the evening. At the start, programs were American as it was cheaper to purchase international programming than produce programming locally. ABS CBN’s other predecessor CBS started in 1955. The industry continued to grow in popularity with many new television channels broadcasting until 1972 when Ferdinand Marcos placed Philippines under martial rule and took control over the media. The industry was under government control until 1986. ABS-CBN began satellite and international broadcasts in 1989. During the 1990s and 2000s, there was a proliferation of new channels and Filipino programming started to be exported to other countries. In 2009, ABS-CBN started testing digital terrestrial television and SkyCable launched the first HD television channel. In 2010, Philippines adopted the Japanese ISDB-T standard.

 

According to CASBAA, the association for the multi-channel audio-visual content creation and distribution industry across Asia, in 2010 the number of television households in the Philippines was 13.5 million. 1.5 million households subscribed to cable television and another 100,000 subscribed to direct to home (DTH) services. Metro Manila has the highest pay TV penetration rate was Metro Manila at 27% of households.

 

 

Industry Value Chain

 

 

 

Evidence of Barriers to Entry

 

We believe barriers to entry are the most significant force in determining the underlying quality and economics of a business. Barriers to entry stops competition from entering the market allowing a company to sustain excess profitability. The absence of barriers to entry allows competition to enter the market competing away all excess profitability. In practice, excess profitability can persist for a prolonged period without barriers to entry. The institutional imperative can lead to less than optimal decision by some competitors allowing other competitors to take advantage of the poor management and generate excess profits. Also, demand can outpace supply in the short term leading to an ability to take advantage of the disequilibrium through price hikes leading to excess profitability. As supply catches up with demand, usually when demand growth slows, excess profitability will be eliminated.

 

There are indicators that provide evidence of the existence of barriers to entry within an industry. The first is the number of competitors within the industry. Many competitors within an industry means competitors can freely enter the market, while a small number of competitors means entry and survival within the industry is difficult.

 

There are a number of firms competing in the Philippines television industry but the top two firms dominate the industry with almost 80% of the audience share in 2015. Since 2010, the top three firms’ average audience share was 85% pointing very high industry concentration. Over the same period, the industry’s Herfindahl Index averaged 0.30 also pointing to very high industry concentration. Only the audience share of the top three firms were used to calculate the Herfindahl Index as estimating the number and market share of smaller firms does not meaningfully change the industry’s Herfindahl Index. As illustrated by concentration ratios, the Philippines television Industry is extremely concentrated pointing to the existence of barriers to entry.

 

The next indicator we look at to determine whether barriers to entry exist is market share stability. If there are barriers to entry, market share should be stable as potential entrants find it difficult to take share from incumbents. In the absence of barriers to entry, new entrants can use many strategies to take market share from incumbents.

 

As illustrated in the table above, the average absolute share change since 2010 is 1% pointing to share stability and additional evidence that barriers to entry exist. If over a period of at least five years the absolute average share change within an industry is two percentage points or less, barriers to entry exist. If the absolute average share change exceeds five percentage points, it is unlikely that barriers to entry exist.

 

The next and probably the most important test of barriers to entry is sustained excess profits as measured by ROIC minus the cost of capital. If a company is able to generate at least 15% ROIC on a regular basis, it is strong evidence of potential barriers to entry. ROIC cannot be used in isolation as a company can generate excess profits in the short to medium term without the existence of barriers to entry. To calculate ROIC, we attempt to separate any operating performance from capital allocation decisions leading to only using net operating assets to calculate the amount of invested capital (net working capital + PP&E + other operating assets).

 

Since 2007, GMA’s ROIC averaged 23.3%, well above the 15% threshold, with the lowest ROIC of 10% in 2014. The strength of GMA’s profitability points to barriers to entry.

 

The final test to see if barriers to entry exist is looking at potential pricing power. We assess pricing power by looking at company’s gross margin. If a company has pricing power, it should be able to raise prices to cover its raw material costs leading to a stable to increasing gross margin.

 

GMA’s gross margin has declined from 61.2% in 2007 to 57.4% in 2015. Although the company’s gross margin is high, there is very little stability with a step change in 2011 with gross margin declining by 7.0%. The lack of gross margin stability points to no pricing power and a lack of barriers to entry.

 

Overall, the evidence of barriers to entry existing is strong with three of the four tests pointing to barriers to entry existing.

 

 

Barriers to Entry

 

Given the evidence pointing to the existence of barriers to entry, the next question is what are those barriers to entry? We believe there are four barriers to entry; supply advantages, demand advantages, economies of scale with some form of customer captivity, and/or government regulation.

 

Within the Philippines and globally, the Television Industry’s barriers to entry take the form of economies of scale with customer captivity, and regulatory barriers.

 

Economies of scale comes from high fixed costs associated with producing and purchasing content as viewership of content is not known at the time of producing the program. Production costs represented 41.9% of sales. The fixed cost nature of content production/purchasing allows larger companies to produce/purchase higher quality content as they can outspend competitors. There is a wide gap in audience share from the two largest competitors, ABS CBN and GMA, and all other peers allowing ABS CBN and GMA to outspend peers by a noticeably amount. In the nine months ending 2016, ABS CBN had a 44% audience share, GMA had a 34% audience share, and third place TV5 had a 7% audience share. Assuming audience share and market share equate, TV5 would have to be twice its current size to spend as much on production costs and be break even at a gross margin level. This does not account for fixed costs below the gross margin line including depreciation and amortization, facilities, and personnel related to sales of advertising space. We estimated non-production fixed costs represented an additional 13.0% of GMA’s sales.

 

Customer captivity comes from continuous programming such as news and long running television shows, such as soap operas and sitcoms. Consumers tend to watch the same news station and get addicted to television shows. Continuous programming also requires fixed infrastructure leading to the previously mentioned economies of scale.

 

Like many countries, the Philippines restricts ownership of media assets. According to Article 16, Section 11 of the Philippine Constitution   “The ownership and management of mass media shall be limited to citizens of the Philippines…”

 

Economies of scale combined with customer captivity and regulatory restrictions are very difficult barriers to entry to overcome. Audience share is stable and the industry is becoming more concentrated pointing to a stable to expanding barriers to entry while the declining ROIC points to deteriorating barriers to entry.

 

A good way of understanding the competitive advantage is determining the length of time it would take a new entrant to replicate GMA competitive position. To replicate GMA’s competitive position, any new entrant would first have to obtain regulatory licenses associated with owning and operating mass media. This requirement is restricted to Filipinos A new entrant would have to spend over PHP5.5 billion annual in content production. This content then needs to be packaged and distributed. Advertising slots also need to be sold via building a sales force. GMA’s audience share and time in the business has created relationships that are difficult to replicate. Additionally, a new entrant would need to acquire all the expertise associated with running the business. The company would also need to advertise heavily in an attempt to attract customers from rivals. Despite, the heavy spending the share stability in the industry points an inability to attract an audience. If we assume 1% share can be acquired every year, equal to the average absolute share change over the past five years, it would take 34 years to reach GMA’s current position. Assuming all share gains are taken from GMA, despite evidence of industry concentration increasing, it would take 17 years to reach GMA’s position.

 

Given the barriers to entry, it seems GMA’s competitive position within the Filipino Television industry will remain very strong. A more likely scenario is over the top takes hold or some other technology disrupts the importance of television. Overall, GMA’s barriers to entry seem to be very difficult to overcome and should be sustained for a long period.

 

 

GROWTH

 

Ad spending is linked to GDP. The table below shows ad spending as a percentage of GDP for a number of different countries at a number of stages of development.

 

For most countries ad spend as a percentage of GDP has remained relatively stable. There is little correlation between ad spend to GDP and GDP per capita so growth in ad spend to GDP should not necessarily increase as GDP per capita increases.

 

The scatter plot graph above shows the relationship across countries and years. A linear trend only has an R squared of 0.2599, while a power trend has the highest R squared of 0.4492 illustrating while there is relationship it is not strong.

 

Looking at the United States as it has the most data, ad spend as a percentage of GDP has been consistently between 1-2% over the past 100 years, as illustrated by the chart from Bloomberg Businessweek. The consistency and lack of growth in ad spend relative to GDP supports the argument that ad spend as a percentage of GDP does not increase with development.

 

Since 2007, the Philippines ad spend to GDP has remained between 0.57% and 0.75% but seemingly on an upward trend.

 

Given the evidence, it seems appropriate to assume a stable ad spend as a percentage to GDP meaning the overall advertising market will grow with GDP growth.

 

The table above shows the growth of Philippines GDP in current local currency terms over various periods along with IMF forecasts through 2021. IMF is forecasting 6.8% growth per year until 2021.

 

Given it seems ad spend will growth with GDP, the question now becomes how will the ad spend be divided among different types of media. Television accounted for 75% of total ad spend in the Philippines in 2006, 74% in 2010, 77% in 2011, 78% in 2013, and 71% in 2015. As illustrated, television has long been the dominant form of advertising in the Philippines. Outside of the Philippines, TV is far less dominant as shown in the graphic below.

 

While television is far less dominant outside of the Philippines, it still holds a leading share of ad spend as it is the easiest and most cost effective way to reach the masses. Internet advertising is growing the fastest and taking a larger piece of the pie. Television continues to gain share increasing its slice of the advertising pie from 36.8% in 2005 to 40.2% in 2013. The growth of the internet and television’s share of ad spend is coming at the expense of everything else with newspapers and magazines being the biggest losers. The resilience of television means it continues to play an important role for advertisers in reaching a mass-market audience. The internet has not been able to take the role of reaching mass markets as audiences on the internet are much more fragmented. The internet is now doing the jobs for audiences that newspapers and magazines used to do therefore is taking their share of the advertising budgets. This makes sense as newspapers and magazines audience is much more fragmented with magazines catering to niche interests while newspaper catered to local interests therefore could never garner the national audience that major television stations.

 

While internet advertising should continue to grow, the importance of television within the Philippines will allow it to maintain a large portion of the advertising market. TV may not be the best for targeting a specific audience, but it provides an opportunity to reach an audience that other media cannot reach making it a perfect venue to educate the masses about your product.

 

Within TV, GMA and ABS CBN’s maintaining roughly 80% audience share with an increasing audience share concentration in the industry have been stable with barriers to entry allowing the companies to maintain their share of TV’s advertising.

 

Overall, ad spend should remain stable as a percentage of GDP. IMF forecasts GDP growth of 6.8% until 2021. TV currently accounts for 71% of advertising within the Philippines and has oscillated in the 70-80% region over the past decade. It should continue to maintain a strong position among other mediums particularly when digital and internet advertising is taking share from other media rather than TV. Within TV, GMA and ABS CBN’s position will be difficult to overcome and could potentially further consolidate.

 

 

MANAGEMENT

 

To judge the strength of a management team we assess management’s incentives and its ability in operations, strategy, capital allocation, and corporate governance.

 

 

Incentives

 

The current chairman of the board and CEO, Felipe Gozon owns 25.3% of the company via FLG Management & Development Corp. GMA’s management team incentives seem to be aligned with minority shareholders as members of the board and management team are the largest shareholders in the company.

 

 

Operational Efficiency

 

Regardless of the existence of barriers to entry, operational efficiency is crucial. In an industry with barriers to entry, a firm can fully exploit its advantage. Without barriers to entry, operationally inefficient firms would be forced out of the industry due to persistent losses.

 

The metrics listed above are averages over the last five years in a millions of Philippine pesos per percentage point of audience share. ABS CBN is a media conglomerate with many unrelated business segments. Its most comparable business segment is its TV and Studio segment, which releases partial accounts. ABS CBN generates much higher revenue per percentage point of audience share but also spends more on the production of content leading to a slightly higher gross margin than GMA. ABS CBN’s audience share advantage was already mentioned but it also dominates the top 10 most watched programs over the past five years, with GMA only getting a Manny Pacquiao fight in 2012 and another in 2014 into the top 10 most watched programs. The audience share and domination of the top 10 programs points to superior content of ABS CBN and ability to charge higher prices than GMA.

 

Operationally, GMA’s operational expenses are much lower than ABS CBN’s on both a per percentage point of audience share and as a percentage of sales. GMA’s operating expenses per percentage of audience share are less than half of ABS CBN’s and 7.6% less as a percentage of sales.

 

GMA’s has much higher capital efficiency with net operating asset turnover of 1.35 times compared to 0.84 times for ABS CBN. The operating efficiency and capital efficiency allows GMA to be much more profitable with a return on net operating assets of 24.3% compared to 10.7%. GMA is far more operationally efficient than ABS CBN allowing it to exploit the barriers to entry within the industry.

 

The table above illustrates the key value drivers of a number of television broadcasters around the world. ABS CBN’s figures are different from the previous discussion as this is the whole company rather than just the TV and Studio business.

 

GMA outperforms on gross margin relative to its peers with only Surya Citra Media, Media Nusantara, and Television Broadcasts having a higher gross margin meaning the company is spending less than peers on content, which could be efficiency or under spending. The company has the highest spending on GAEX relative to its peers. The company could be shifting costs from gross margin to operating expenses or it could be inefficient relative to peers. The company has the second lowest operating margin of all peers, ahead of only ABS CBN.

 

The company is middle of the pack in capital efficiency with four peers being more efficient at turning over invested capital and four peers being worse at turnover invested capital.

 

Overall, GMA has the second lowest ROIC of all peers ahead of only ABS CBN. Despite performing poorly relative to peers, GMA still generates an ROIC well above the benchmark rate of 15%. It is interesting that the two Filipino companies performed so poorly on profitability as the country has one of the most favorable market structures with essentially a duopoly. GMA has a strong gross margin pointing to an ability to extract more value from its content than peers. The key driver to GMA’s profitability weakness is administrative expenses as the company pointing to weaker operational efficiency than global peers. It is also not a capital efficiency issue as the company is also middle of the pack in invested capital turnover.

 

 

Strategy

 

Evidence points to the existence of barriers to entry within the industry with GMA being a competitively advantaged firm within the industry. The company’s management team has been in place since they took ownership in 1975. During that time, they have built and maintained their competitive position, which deserves praise.

 

The current barriers to entry are economies of scale and customer captivity. Strategy should be to strengthen those barriers to entry. The company currently spends a roughly 45% of sales on production costs. The largest competitor outside of ABS CBN, TV5, has an audience share of 7% roughly 1/5th of GMA’s 34% audience share. Assuming market share and audience share are equal, TV5 needs to increase its audience share by 217% before it was able to produce the same amount and quality and reach break-even at the gross margin level. The company is spending the necessary amount on fixed costs to ensure its smaller competition has a difficult time gaining share.

 

Despite the company’s size advantage over smaller peers, GMA is competitively disadvantaged to ABS CBN. ABS CBN dominating the top 10 programs with GMA having the odd showing when it broadcasts a Manny Pacquiao fight illustrates GMA’s lack of quality programming and inability to match ABS CBN in production costs due to its smaller size. The poor quality programming impacts customer captivity, as customers are less likely to create habit with poorer quality programming.

 

 

Capital Allocation

 

We start our discussion on capital allocation by looking at the company’s financial health. If management takes on too much debt, it is taking a significant risk for minimal reward. At the end of September 2016, GMA had a net cash position of PHP1,596 million.

 

At the end of 2015, GMA Network’s short-term loans amounted to PHP1,152.97 million. 100% of debt was in USD at an interest rate of 1.73%. At the end of 2014, GMA Network had PHP1,922.96 million in USD debt at an interest rate of 1.68% and PHP300 million in PHP debts at an interest rate of 1.90%. Foreign currency debt adds risk without any additional reward, particularly when there is a marginal difference in interest rates in USD debt and PHP debt. The unnecessary risk is nothing more than currency speculation. GMA Network has sufficient cash to buffer an increase in USD relative to PHP so other than poor judgment by management the company’s FX debt is not a major concern.

 

Next, we look at the company’s balance sheet to estimate the amount of operating assets and non-operating assets. We would like to see all assets as operating assets as the non-operating assets are not part of the company’s core business and should be returned to shareholders. Since 2011, 83% of assets have been operating assets, the best of the peer group.

 

The company has not made any expensive acquisitions in the recent past. It also was willing to sell itself in 2001 to PLDT at PHP12.5 billion or 10 times EBITDA. The 2001 valuation is roughly 75% of the company’s current enterprise value.

 

The company’s approved dividend policy entitles holders of common shares to receive annual cash dividends equivalent to a minimum of 50% of the prior year’s net income based on the recommendation of the Board of Directors.

 

Other than the excess non-operating assets on the company’s balance sheet, it is doing a good job of allocating capital to fixed costs that are crucial to the company’s size advantage. The company is also doing a good job of not straying from its core competency in a quest for growth.

 

 

Corporate Governance/Value extraction

 

With most emerging market small cap companies run by owner operators, the board and management is dominated by the owner operator making benevolence crucial.

 

To assess corporate governance we start by looking at the company’s related party transactions.

 

The majority of related party transactions are legal, consulting, and retainers’ fees paid to Belo, Gozon, Elma Law, the Chairman and CEO’s law firm. These transactions are less than 1% of operating profit and seem to be reasonable. All other related party transactions are much smaller advances to associates and joint ventures. Overall, related party transactions do not point to any corporate governance issues or excess value extraction by management.

 

After related party transactions, the compensation to key management personnel is assessed to determine if wages are excessive.

 

Compensation to key management personnel averaged 20% of operating profit and 3.2% of sales, which is very high. Typically, we would want to see salaries at less than 5% of operating profit. This is a big negative as key management is already significant shareholders meaning the excessive salaries are just extracting value from minority shareholders. Management are no way creating the value extracted from salaries as the barriers to entry in the industry are so strong that pretty much anyone can run the company and generate the level of profitability the company is generating. The massive value extraction in the form of salaries is a big negative and significantly decreases the quality of the company.

 

VALUATION

 

We start by valuing GMA at its liquidation value. Liquidation value is the most appropriate valuation method for a company that is no longer viable therefore should be liquidated. Given GMA’s competitively advantaged position in a viable industry, liquidation value is not too relevant. We estimated GMA’s liquidation value to be PHP1.32 per share representing 79% downside.

 

Using a more conservative net current asset value per share, GMA’s liquidation value is PHP0.99 per share leading to a liquidation value of roughly PHP0.99 to PHP1.32 per share.

 

Next, GMA is valued at its reproduction value. Reproduction is the appropriate valuation method in an industry lacking any barriers to entry, which eliminates excess profitability leading any investment not creating any additional value. The value of any asset under this condition is the cost to recreate the assets.

 

To calculate GMA’s reproduction value, we assess what assets would need to be reproduced to reach GMA’s competitive position. We start by looking at the company’s balance sheet. The vast majority of balance sheet values are assumed a fair representation of the cost to reproduce the asset. Trade and other receivables come with bad debt that would need to be incurred to reproduce the company’s level of receivables. GMA’s bad debt provision is 7% of the company’s trade and other receivables account. We assume a new entrant would need to match the company’s level of bad debt. Additionally, a few expenses need to be recreated. Advertising and marketing are assumed to educate the population about the company’s programming therefore in the process of recreating the company’s position advertising and marketing is necessary to reach the company’s audience share. Many television programs run for more than one year forcing a new entrant to spend a multiple of GMA’s advertising and marketing expense as advertising and marketing may create value beyond one year, but to be conservative we assumed only one year of advertising would need to be recreated. Similarly, research and surveys create knowledge that is an asset to the business and not reflected on the balance sheet. This knowledge would probably take years to replicate but we assume that two years of research and survey expense would do a good job at replicating the asset. It also costs to hire personnel and talent. We assume that any new entrant would have to spend 20% of one year’s personnel expense on agent’s fees, recruiter’s fee, and building the infrastructure to hire.

 

We also assume the non-interest bearing liabilities of trade payable and other current liabilities as well as current portion of obligation for program and other rights are spontaneously created decreasing the amount of funds required to invest in the business. Overall, we estimate GMA’s reproduction value to be PHP3.79 per share or 39% downside.

 

Given the barriers to entry in the industry and GMA’s competitively advantage position, valuing the company based off its earnings is the most appropriate valuation methodology. We value GMA using a variety of earnings based valuations. The first earnings based valuation is simply FCF yield plus growth. The Philippines advertising industry is very cyclical with political advertising distorting revenue generated by firms in some years. To eliminate this cyclicality associated with political advertisements, we average GMA’s FCF over the past five years leading to a FCF yield of 7.5%. Given FCF takes into account working capital and fixed capital investment, any potential growth can be added to estimate a company’s FCF yield to estimate its total return. It seems growth of industry will mirror the GDP growth rate as ad spend as a percentage of GDP tends to be relatively stable. Television’s share of ad spend is increasing and the share within the industry is relatively stable. All evidence points to a growth rate equal to GDP or higher. The IMF forecasts that the Philippines will grow at a rate of 6.8% through 2021. If we use a growth rate of 5.0%, to add a bit of conservatism, GMA should return 12.5% per annum over the next five years.

 

The next earnings based valuation method assumes various competitive scenarios by changing key value driver assumptions used in a residual income/DCF with the output being a range of valuations. The key value driver assumptions we use for every residual income/DCF valuation is cost of capital, sales growth, operating margin, tax rate, working capital turnover, and fixed capital turnover. With our residual income/DCF valuation, we have a five-year forecast period followed by a fade to a terminal value in year 10.

 

The key value drivers that remain stable are discount rate, tax rate, working capital turnover and fixed capital turnover at the values listed above.

 

Sales growth and operating margin are the key variables that change under different scenarios. We use three states of sales growth 0%, 2.5%, and 5% into perpetuity. There are four scenarios for operating margin: 2007-2015 trough = 12.0%, current = 21.9%, 2007-2015 average = 24.0%, and 2007-2015 peak = 32.8%.

The average 2017 target price is PHP7.42 or 19% upside, while the average 2020 target price is PHP9.74 or 56% upside. The maximum downside over the next five years is 41% under the no growth and trough operating margin scenario. This scenario points to a deterioration of the competitive environment where barriers to entry are eliminated and television share of ad spend is succeeded to the internet. The maximum upside is 228% under the 5% growth and peak operating margin scenario. This scenario points television maintaining its share of total ad spend and more benign competitive environment allowing for stronger profitability. The more likely of the two scenarios is the most optimistic scenario as this was the norm prior to 2011. Our base case scenario is 2.5% perpetuity growth with average operating margins leading to 55% upside over the next five years.

 

In summary, earning base valuation is the most appropriate valuation methodology for GMA as its industry has barriers to entry and the company is competitively advantaged. FCF yield and average of all the earnings scenarios lead to 10-12.5% annualized return.

 

 

RISKS

 

We classify the risks to an investment into four main categories: financial risk, business risk, macro risk, and valuation risk. Financial risk is the risk of permanent loss of capital due to an inability to pay its debts. Business risk is the risk a permanent loss of capital due to an impairment of a company’s earning power from competition, poor management, a disruptive technology, or government regulation. Macro risk is the risk of permanent loss of capital due to macroeconomic troubles of a country. Valuation risk is the risk of permanent loss of capital from paying too much for a company.

 

 

Financial risk

 

GMA is very conservatively financed with a net cash position of PHP1,596 million and has a competitively advantaged position making the probability bankruptcy very low. The company does finance itself with USD debt rather than PHP debt making the company susceptible to any significant moves in the USDPHP exchange rate. It is not a concern as the company has sustainable earnings stream and a net cash position.

 

 

Business Risk

 

Given GMA benefits from its competitively advantaged position, the biggest risk to the company’s business is if those barriers to entry were to weaken allowing competitively disadvantaged peers to catch up with GMA. GMA’s strongest barrier to entry is economies of scale due to the large fixed costs associated with production costs. If the company’s relative size advantage were to deteriorate, the competitive environment would be come much tougher. If fixed costs were to turn variable or not be crucial to creating value, it would also weaken GMA’s competitive position.

 

The Philippines has a regulation stating that only Filipinos can own mass media companies. If this law were to change, the number of broadcasters could increase leading to a potential pricing war via declining ad rates.

 

GMA’s content seems to lower quality than ABS CBN as illustrated by ABS CBN dominating the top 10 most viewed shows in Philippines for a number of years and ABS CBN’s high revenue per percentage of audience share. If the relative weakness in content production and sourcing continues, GMA may relinquish share.

 

Cable may increase its penetration providing more options for viewers and fragmenting audience share leading to a fragmentation of advertising revenue. At the end of 2015, cable TV penetration stood at 17% of all homes with televisions up from 15% in 2012 and 11% in 2010. Cable TV penetration is well below international standards with pay TV in Asia at 54% so there is potential for increased penetration if cable operators can improve their offering.

 

The internet is changing distribution in many industries including television. The biggest threat to television broadcasters is content producers going direct to consumers or over the top (OTT). If the OTT offering is more attractive, audiences will shift their viewing habits to providers of content via the internet. We are seeing content aggregators such as Netflix and Hulu make significant inroads in the developed world. Content aggregators acquire content from content producers and sell subscriptions. These are more of a threat to cable as they are essentially performing the same job of bundling niche content and selling it to the consumer for a subscription fee. Internet penetration in the Philippines is at 43.5%. While GMA and ABS CBN are at risk, these two produce their own local content. If the content aggregators are able to disrupt the distribution part of GMA’s and ABS CBN’s business, there will always be value in their local content. These aggregators have started producing content but not niche language content.

 

The internet is taking over traditional roles that the television used to perform. News, which is continuous content that creates customer captivity, is being consumed via the internet rather than the traditional television in many parts of the world. An increasing shift of audience towards the internet will severely affect GMA’s profitability.

 

The production of content leads to a high level of fixed costs creating operating leverage. Operating leverage is a double edge sword as growth leads to greater profitability while decline in profitability leads to a greater fall in profits. If TV broadcasting as matured and is in the decline phase of its lifecycle it may not take long before profitability is eliminated.

 

 

Macro Risk

 

Our goal with assessing macro risk is not to forecast the path of macroeconomic indicators but to eliminate risks from a poor macroeconomic position.

 

GMA Network business is primarily in the Philippines, a country that seems to be in very good financial health. In 2015, the country’s current account was 2.6% of GDP and its structural balance was 0.18% of GDP allowing the country to self-finance all the domestic initiatives as well as decrease the country’s debt load. The country does not have too much credit in the system with domestic credit provided by the financial sector at 59.1% at the end of 2015, which is well below the Emerging Markets average of 97.5% and the High Income countries average of 205%. Gross government debt as a percentage of GDP stood just under 35% with External Debt to GDP at 36%. The one concerning macroeconomic indicator is the level of growth in credit in the Philippines. Over the past five years, the amount of domestic credit provided by the financial sector has increased at a rate 12% per annum. When a country is growing its banking assets at this pace, there is a high probability of an increase in non-performing loans. The country’s banking system has a healthy capital balance with capital to assets at 10.6%.

 

 

Valuation Risk

 

The key valuation risk is the assumptions used in our scenario analysis are too optimistic. We looked at GMA’s operating history back to 2007. If we reviewed 2011 to 2015 rather than 2007 to 2015, there would be a difference in valuations. Using 2011 to 2015, the average operating margin would decrease from the current 24.0% to 18.3%. The peak operating margin would decline to the current operating margin of 21.0%. We used the operating history since 2007 as the company’s profitability in the trailing twelve months ending in September 2016 returned to levels not seen before 2011.

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.

ACE Hardware Indonesia April 19, 2016

 

ACE Hardware Indonesia (ACES:JKT)                     April 19, 2016

ACE Hardware Indonesia April 19 2016

 

 

Investment Thesis

 

ACE Hardware Indonesia (ACES) is the leading home improvement and lifestyle products retailer in Indonesia under the ACE Hardware brand. The company is also a leading toy retailer in Indonesia under the Toys Kingdom brand.  The company’s stellar profitability and growth attracted us to the company. Unfortunately, the company’s poor corporate governance and lack of concern for minority shareholders eliminates ACES as a potential investment.

 

 

Key Statistics

Key Stats April 19 2016

 

 

 

Company Description

 

ACE Hardware Indonesia (ACES) is Indonesia’s leading home improvement and lifestyle retailer and a leading toy retail in Indonesia under the Toys Kingdom brand. ACES was established in 1995 as a subsidiary company of PT. Kawan Lama Sejahtera. ACES is the master franchise/license holder of ACE Hardware brand in the country.

The first ACE Hardware Indonesia store opened in Supermal Karawaci, Tangerang, in 1995. At the end of 2014, ACES had 110 ACE Hardware stores covering 289,000 square meters.  ACES is striving to be the Pioneer of “Do-It-Yourself” concept, which means providing not just products, but also the required knowledge on how to install, use, and maintain them properly. The company’s staff is always will to train customers.

 

In addition, ACES also holds 60% of Toys Kingdom with the other 40% is held by ACES parent company PT. Kawan Lama Sejahtera.  At the end of 2014, Toys Kingdom 24 stores covering 23,900 square meters. The first store of Toys Kingdom was opened on June 4th, 2010.  Like ACES in home improvement and lifestyle products, Toys Kingdom is a pioneer in the Indonesian retail toys industry. Toys Kingdom offers a range of global branded toys to customers. All products, facilities and quality service make Toys Kingdom as a family destination to get numerous products for toys of well-known brands that are available exclusively in each of the stores.

 

At the end of 2015, home improvement and lifestyle products accounted for 95.5% of revenue and 97.0% of assets.  At the end of 2014, the average ACE Hardware store was 2,627 sqm with revenue per sqm of IDR15.13 million and assets per sqm of IDR4.35 million. Toys Kingdom average store size was 996 sqm with revenue per sqm of IDR4.98 million and assets per sqm of IDR1.60 million.

 

 

Shareholder Structure

 

Shareholder Structure April 19 2016

The company’s shareholder structure is illustrated above. PT Kawan Lama Sejahtera owns 59.9703% of ACE Hardware and the public owns 40.0292%.  Kawan Lama Sejahtera also owns 40% of Toys Kingdom while ACE Hardware owns the other 60%. PT Kawan Lama Sejahtera was founded in 1955 and is based in Jakarta, Indonesia with a branch office in Surabaya, Indonesia. The Kawan Lama group is a conglomerate with many different businesses but started as a commercial and industrial supply company that provides tools, industrial equipment, and machinery in Indonesia.

PT Kawan Lama Structure April 19 2016

 

 

Corporate Governance

 

The first thing assessed when analyzing a company is the integrity of management.  Can management be trusted to treat minority shareholders equally or will all value of a good or bad business be extracted by management or majority shareholders.  The easiest thing to assess the strength of a company’s corporate governance is related party transactions.  While related party transactions may be arm’s length transactions, it is difficult to judge and the company may take advantage of minority shareholders with these transactions to extract value or to mask the true economics of the business.  We would prefer to see no or an insignificant amount of related party transactions. Unfortunately, ACES is on the other end of the spectrum with a significant amount of related party transactions.

Related Party Transactions April 19, 2016

 

Since 2011, the sum of all related party transactions averaged 13.7% of sales, 83.2% of operating income, and 21.7% of assets.  Over the same period, purchasing from related parties as a % of cost of goods sold has averaged 15.7%.  The level of related parties is among the highest we have seen.

 

Other evidence of potential corporate governance issues is Kawan Lama’s 40% ownership of Toy Kingdom.  Despite holding 60% of ACES and therefore 60% of Toy Kingdom, Kawan Lama needed an additional 40% of Toys Kingdom.  The company purchased the 40% of Toys Kingdom for roughly IDR240 million or USD18,249 on December 29, 2010.  The transaction to purchase 40% placed Toys Kingdom Enterprise Value at roughly IDR600 million or USD45,622.  In 2010, Toys Kingdom revenue was IDR17,188 million, gross profit was IDR6,572 million, and assets were IDR9,970 meaning the company purchased 40% of a subsidiary from itself and minority shareholder at a valuation equal to 3.5% of sales, 9.1% of gross profit, and 6.0% of assets.  Purchasing 40% of a company that generates a gross profit return on assets of 66% at a trailing twelve month valuation of 0.09 times gross profit is a good investment and abuses of the company’s position as a majority shareholder. The abuse of minority shareholders in the Toys Kingdom transaction increases the concern that the related party transactions are not arm’s length transactions.

 

The company’s audit committee has three members including an independent member of the board of commissioners with no accounting experience (Teddy Setiawan), a 28 year old with 7-8 years experience in accounting (Iskandar Baha), and a 34 year old with 9 years experience as an accountant primarily at ACES (Ngakan Putu Adhiriana).  Clearly, the audit committee does not have the experience required to be effective.

 Audit Committee April 19 2016

 

The internal audit committee has far more experience with the lead member of the Internal Audit team having 23 years of accounting experience (Petrus Rudy Prakoso), another member with 21 years accounting experience (Irawaty), and the other member has 12 years accounting experience (Ramli Phoa).  The experience level of the Internal Audit team is far more acceptable.

Internal Audit Committee April 19 2016

 

As illustrated by collective accounting experience (Audit committee = 17 years vs. Internal Audit = 57 years), ACES places more importance on the Internal Audit team and internal numbers, while Audit Committee for investors seems to have very little importance.

 

Management are also not owner operators but agents owning little or no shares meaning they are dependent on a salary and will likely not stand up for minority shareholders over the parent company as they risk losing their position in the company and hurting their career.

 

Overall corporate governance is very poor as illustrated by the number of related party transactions and the Toys Kingdom transaction. Until corporate governance, ACES is eliminated as a potential investment and requires no additional analysis.

 

 

Competitive Position

 

We will have a quick look at the company’s competitive position in case corporate governance improves (and for intellectual curiosity) but as of now corporate governance issues rule the company out as an investment.

 

There is a lot of evidence pointing to ACES having a competitive advantage.  First, the company consistently generates a very strong return on invested capital. Since 2011, the company has generated ROIC of 34% based on as reported data.   After capitalizing operating leases, the company’s ROIC has averaged 15% providing less evidence of a competitive advantage.  The company’s ROIC comes with very little variance as reported ROIC’s standard deviation is 0.082, while ROIC after capitalizing operating leases’ coefficient of variation is 0.063.

 

The market structure of the Indonesian home improvement and lifestyle products market is difficult to find.  Typically, an oligopolistic market structure with little change in market share and few entries into the industry point to barriers to entry.

 

ACES also exhibited pricing power.  In 2006, the company’s gross margin was 34.0%. In 2015, the company’s gross margin increased by 12.8% to 46.8%.  ACES gross margin peaked in 2013 at 49.0% and has since decreased to 46.8% potentially signaling a waning of pricing power as the market develops, competition increases.  It could also be just the slowing economic growth has increased the discounts required to get customers in the shop or increase competition in a slowing market.

 

Evidence points to either a competitive advantage or strong returns in a growing market with unsophisticated customers where supply is having difficult time catching up with demand leading to a temporary decrease in competitive rivalry.

 

If a competitive advantage does exist what is ACES competitive advantage? There are two ways retailers can generate a sustainable competitive advantage by offering unique products or low price. It is very difficult to maintain unique products as producers of those products naturally want to put their products in as many locations as possible or wanted products get replicated.  The other way to generate a unique product other have a unique tangible product that others cannot supply is by creating a brand.  Very few retailers have created a sustainable brand that does not take advantage of short lived fashion trends. A brand is nothing more than a promise to deliver a certain experience.  Within retail there are very few brands for a number of reasons. First, many retailers are selling branded products therefore the customer gets the promise and the trust they need from the product rather than the retailer eliminating any chance for a retailer to build a brand with pricing power. An example is branded food products in grocery stores. Second, the product the retailer sells are search goods meaning the consumer can determine the features, characteristics, and quality before purchase. It is much more difficult to build a brand in search goods as customers can see the all the necessary criteria for a purchase decision.  It can be done if the product provides status or is aspirational such as Tiffany’s or sells a good that requires trust (grocery store selling produce).

 

Given the difficulty in a retailer building a brand, it is highly unlikely that ACES has a brand.  The company is highly unlikely to have a cost advantage as it has no unique technology that competitors cannot get a hold of.  If the company has a competitive advantage, it is derived from economies of scale in purchasing and distribution as it is the largest home improvement and lifestyles company in Indonesia.  The inability to create a brand causes economies of scales in advertising not to accrue into brand value. Given the weak corporate governance at the company and the amount of related party transactions, the value from economies of scale from purchasing may not be extracted but held at related companies.  Unfortunately, the lack of information on the industry’s market structure, to determine the company’s relative size advantage, and weak corporate governance means an assumption of no competitive advantage must be made.

 

Few retailers have been successful in building a sustainable competitive advantage.   Companies such as Home Depot, Lowes, Wal-Mart, Costco and Tiffany’s have created sustainable competitive advantages but given the number of retailers, it is a low probability event. More likely companies are able to grow rapidly by increasing the number of locations leading to an increasing intrinsic value.  Profitability can be strong particularly in newer segments, such as home improvement, lifestyle products, and toys in Indonesia as customers are not sophisticated allowing retailers to extract more value due to the customers’ lack of knowledge in the segment, there is little competition, and demand outpaces supply. Eventually, the industry matures, customers grow more sophisticated better understanding the offerings of each competitor, competition increases, and best practices and products are copied leading to a convergence of offerings meaning customer shop more on price.

 

 

Valuation

 Valuation Key Stats April 19 2016

 

The market values ACES at a FCF yield of 3.8% with same store sales growth and store opening slowing 10% growth rate seems appropriate leading to an expected return of 13.8%.  These are very high multiples for a company with corporate governance issues and a questionable competitive advantage. If corporate governance was not an issue, we would have taken a deeper look at valuations.