Honworld 2016 Full Year Results Review
Honworld recently reported its 2016 full year results. The company’s revenue grew by 4.0% in 2016 and by 6.5% in the second half of 2016. The company stated growth slowed due to a weakness in the supermarket segment of the condiment industry, which makes sense as five of the largest publicly traded Chinese supermarket companies saw sales grow by 5.5% in 2016. To offset the lack of growth from the supermarket channel, Honworld is building its infrastructure to better address regional small retailers and the catering market. As mentioned in the company’s prospectus and our initiation report, Chinese cooking wine is distributed primarily through retail and catering service channels. In 2012, 50.5% of cooking wine sold through retail channels, 41.5% sold through catering service channels and 8.0% through other channels. Leading cooking wine brands tend to concentrate on retail sales channels as households generally demand higher value cooking wine products and are more brand sensitive. The company has not focused on 41.5% of the cooking wine market sold through catering channels. Additionally, the company has not made an effort to sell through smaller retailers. According to China’s National Bureau of Statistics, hypermarkets and supermarkets accounted for 23.1% of food sales through retailers meaning Honworld has only penetrated a small portion of the total potential distribution channel. The new distribution strategy resulted in an increase in distributors by 531 to 898 total distributors.
By product line, medium-range cooking wine and mass-market cooking wine grew the most. The company states the change in the product mix relates to the shift in marketing and distribution strategies.
The change in the product mix led to a compression in the company’s gross margin. By our estimates, in addition to a compression in gross margin from a product mix, there was a slight compression in product gross margins. Overall, gross margin contracted by 2.8% with 2.2% attributed to a change in product mix and 0.6% due to product margin deterioration.
Selling expense grew by RMB6.15 million or 8.2%. The company’s new distribution channel brought on a 531 new distributors. To service the new distributors, Honworld hired 179 sales employees as the sales staff increased from 61 at the end of 2015 to 240 at the end of 2016. These employees were hired over the year as illustrated by the decline in the personnel expense per year and the moderate increase in selling expenses. Honworld also devoted approximately RMB50.0 million to appoint Mr. Nicholas Tse as our brand ambassador of “Lao Heng He” cooking wine in Mainland China and sponsored Chef Nic, a cooking reality show hosted by Mr. Nicholas Tse. 2017 should see a significant increase in selling expenses. Given the company’s size advantage over competitors, the increase spending on sales and marketing expenses is a wise allocation of capital as these are fixed costs that smaller competitors will have difficulty matching while remaining profitable.
In addition to the new sales and marketing employees, the company added 60 new production employees and 18 new R&D and quality control employees. In 2016, Honworld also expanded its production facilities, acquired new production equipment. The new employees and expanded production facility point to an increase in production in 2017.
Administrative expenses saw an increased by RMB2.8 million or 3.5%. It seems the Honworld’s focus is on increased production and sales and marketing rather than R&D, which makes a lot of sense given the company’s inventory levels.
Overall, the company’s decrease in gross margin due to product mix and overall deterioration as well as the increase in operating expenses led to a RMB15.12 million or 4.8% decrease in the company’s operating income.
The company’s largest investment is in inventory, which accounted for 46% of invested capital in 2016. Honworld’s inventory turned over 0.76 times during 2016. One of the key inputs into cooking wine is base wine particularly aged base wine. The ageing process leads to the poor inventory turnover. The company states it has reached its desired inventory levels. The huge investment in inventory has been one of the major reasons for the company’s poor profitability relative to the quality of the business. Honworld no longer reports the amount of base wine required for each liter of cooking wine but the company reported the amount of base wine in each product in the IPO prospectus.
As illustrated above, there is a lot of variation in the amount of base wine, vintage base wine, and aged base wine used in each product category over the period examined. Base wine is either vintage base wine or mixer base wine is naturally brewed yellow rice wine, which is either vintage base wine or mixer base wine. Vintage base wine is base wine that has been aged over two years. Mixer base wine is base wine aged less than two years.
The company should be reporting the percentage of vintage base wine, mixer base wine, and total base wine by product category in every financial report as inventory level is one of the most important drivers of the company’s profitability. In addition, due to the nature of the product, it is not clear how inventory relates to sales without the above analysis and sales volumes by product category. The complexity of the relationship between inventory, product sales, and profitability should make management be as transparent as possible so investors can be educated about the company’s business model. Until it does, the company will have difficulty realizing the company’s intrinsic value.
The table below illustrates the amount of base wine and age of base wine in each product category as well as for 2014, 2015, and 2016 based on their product mix.
In 2013, a liter of premium cooking wine contained 0.06 liters of vintage base wine with an average age of 10 years and 0.87 liters with an assumed average age of 1 year leading to 0.93 liters of base wine with an overall average age of 1.4 years.
A liter of high-end cooking wine contained 0.06 liters of vintage base wine with an average age of 8 years and 0.81 liters with an assumed average age of 1 year leading to 0.87 liters of base wine with an overall average age of 1.2 years.
A liter of medium-range cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.81 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 0.9 years.
A liter of mass-market cooking wine contained 0.04 liters of vintage base wine with an average age of 5.5 years and 0.64 liters with an assumed average age of 1 year leading to 0.68 liters of base wine with an overall average age of 0.7 years.
Assuming 2016 product mix continues the average liter of cooking wine contained 0.045 liters of vintage base wine with an average age of 6.4 years and 0.804 liters with an assumed average age of 1 year leading to 0.85 liters of base wine with an overall average age of 1.0 years.
Mixer base wine is anything under 2 years so the assumption of 1-year age of mixer base wine is not necessary. The company could mix base wine and use it shortly after producing it. Typically, it takes 35-40 days to produce base wine, which can only be done during cooler weather months of October to May.
Management has not reported ASP and volume by product since its IPO prospectus, but assuming no change to ASP of each product, volume sold can then be calculated.
We can see cooking wine sales reached an estimated 86 million liters in 2016. Sales are estimated base wine age of 1 year. Assuming the company keeps an additional 1 years of inventory as a buffer for growth. Some inventory also needs to be aged for premium products. The 2016 product mix required only 4.5% of vintage wine for every liter of cooking wine. Assuming another 0.5 years of inventory for aging or ten times the required amount each year leads to a potential of eleven years of aged inventory, the very highest average age of vintage base wine used is premium products at 10 years of ageing. 84% of estimated volume sold in 2016 was for medium-range and mass-market products that use vintage wine with 5.5 years of aging, half the eleven years of inventory. Total inventory with a buffer of 2.5 years of sales is roughly 215 million liters of inventory. Unfortunately, the company does not provide gross margin by product to allow us to estimate the cost of carrying the inventory. Gross margin can be estimated by making slight changes to gross margins by product each year to equate the estimated gross margin to the reported gross margin.
With the gross margin for each product, cost of goods sold per liter can be calculated to estimate to total inventory levels required for 2.5 years worth of sales volume.
As illustrated in the table above, the estimated cost of goods sold per liter was RMB3.2. With 2.5 years of sales volume or 215 million liters of inventory deemed sufficient, total inventory should be RMB692 million. Adding 1 years inventory for soy sauce and vinegar, total inventory on the balance sheet should be closer to RMB775 million well below actually inventory levels of RMB1,088 million meaning the over invested in inventory is just over RMB300 million.
2.5 years of inventory should be sufficient but Honworld could probably get away with a level much lower as mixer base wine does not need to be aged and the company should be making sufficient mixer base wine. In addition, another 50% of base wine should be produced for growth and aging to create vintage base wine as the company only needs about 4.5% of volume sold in vintage base wine. The company loaded up on inventory to age well above its vintage base wine requirements, particularly when the product mix is shifting to medium-range and mass-market products that do not need as much vintage base wine. The upfront investment destroys profitability and puts into question the capital allocation skills of the management team.
The increase in inventory requirements may not be a function of poor capital allocation skills but a function of deteriorating quality of the business. This would be even more concerning that poor capital allocation skills as management can change its capital allocation but it can’t change the competitive dynamics of the industry. Honworld was the leader in naturally brewed cooking wine. If competitors followed the company’s path eliminating alcohol and artificial ingredients, competition based on product quality with an increased the amount of vintage base wine and base wine ageing profitability in the industry could remain depressed for some time.
The vast majority of PP&E is tied to investment in inventory as facilities were created to store base wine or produce more cooking wine. Since 2010, each additional RMB spent on inventory required an addition RMB0.7 in PP&E. The RMB300 million in excess inventory requires an additional RMB210 million investment in PP&E. Eliminating the RMB510 million in inventory and additional PP&E investments, invested capital is closer to RMB1,855 with an operating income of RMB281 million, Honworld’s pre-tax ROIC should be above 15.2% rather than actual pre-tax ROIC of 11.8% in 2016.
If the company were able to get inventory levels down to 2 years and eliminate associated investments in PP&E, Honworld’s ROIC would be 18.0% rather than 11.8%. The higher the company’s ROIC the higher the EV/IC the company should trade on as illustrated by our recent post ROIC vs. EV/IC.
In addition to the poor capital allocation due to overinvestment in inventory and related PP&E, pre-payments for land leases and non-current assets have increased from 0 in 2013 to RMB386 million in 2016. These soft accounts are very concerning as it is a serious misallocation of capital and may point to fraud. Making pre-payments for non-current assets equal to 16% of invested capital to lock in raw material costs and equipment costs does not make much sense when you have pricing power as illustrated by the recent price increases and your inputs are pure commodities. The timing of the allocation to soft asset accounts is particularly concerning as the company just finished overinvesting in inventory depressing free cash flow and profitability.
As illustrated above, Honworld’s total debt increased by RMB204 million from RMB645 million to RMB849 million leading to finance costs of RMB40.6 million or an effective interest rate of 5.4% on debt. The company has a net cash position of RMB520 million up from RMB189 billion at the end of 2015 with RMB1.02 million in cash leading to an effective interest rate on cash is 0.3%. The increasing cash balance with the increasing debt balance does not make much sense. If the company has that much cash on the balance sheet why is it holding it and earning such a poor return, when the company can pay down a large portion of its debt and decrease the company’s finance cost by roughly RMB22.7 million per year, assuming no change in the effective interest rate of debt.
Overall, Honworld has a strong business with economies of scale in sales and marketing and R&D. The product habit-forming characteristics include low price, which increases search costs, and is a key ingredient in dishes. The company has a strong growth outlook serving a small amount of its potential market and infrastructure build to service a greater portion of the market. Valuations are not demanding with a 10% NOPAT yield and an EV/IC of 0.95. Unfortunately, management’s overinvestment in inventory, related PP&E, pre-payments for non-current assets and not paying down debt are too much of a concern, particularly the timing of allocation of capital to soft asset accounts. The misallocation will continue to lead to poor ROIC. If the company was not located in China, where frauds occur regularly, the misallocation of capital would be less of a concern and more patience would be warranted. We are no longer recommending the stock and selling our position in our model portfolio, but will continue to follow the company with a hope that capital allocation and profitability improves.