Tag Archives: Corporate Governance

Honworld 2016 Full Year Results Review 5/7/2017

Honworld 2016 Full Year Results Review

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Weekly Commentary 10/31/2016-11/6/2016

Weekly Commentary 10/31/2016-11/6/2016

We are starting a weekly commentary to provide more consistent updates.  It will contain the news from the companies we cover, random investment thoughts, and the top articles of the week.  Let us know what you think.

 

Company News

 

On November 2, 2016, Zensar Technologies announced the acquisition of Foolproof. Foolproof is one of Europe’s leading experience design agencies, headquartered in London with other offices in Norwich and Singapore. The company helps global brands design better digital products and services for customers based on a deep understanding of consumer behavior, their clients’ business and new technology. It has many Global500 firms amongst its clients. LTM revenue = GBP8.5 million with a mid-single digit GBP million EBITDA with expectations for continued growth rate of 10-15% post acquisition. Zensar’s digital revenue now is 30% of total revenue.

 

From a strategic standpoint, the Foolproof acquisition makes sense. Foolproof adds knowledge in a fast growing industry strengthening Zensar’s digital services business. It strengthens Zensar’s client list adding relationship with a number of Global 500 allowing Zensar to cross-sell other services. It is also a smaller bolt on acquisition making it easier to integrate into existing operations. Unfortunately, the lack of price disclosure eliminates the ability to evaluate the transaction fully.

 

We will maintain Zensar’s current 3.5% position in our model portfolio. The company is trading at roughly 6% NOPAT yield with expected growth between 5-15% over the next five years. It continues to generate strong profitability and its executing on its strategy to increase revenue from digital services. It continues to win larger and larger contracts allowing for greater profitability. Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and/or some switching costs. Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers. The Indian IT services sector is based on low cost labor or price competition. There is no sustainably differentiation on knowledge as employees hold the knowledge of the organization and employees can take this knowledge to another company.

 

Why are we maintaining Zensar Technologies 3.5% position size while decreasing PC Jeweller’s position size to 2.0%? Zensar and PC Jeweller’s both offer a NOPAT yield of roughly 6.0% and both offer growth between 5-15% over the next five years. Zensar’s business seems slightly better to us. Both industry have significant competition, but Zensar’s industry generates much higher average returns on invested capital than PC Jeweller’s, due to the asset light nature of the business. The jewelry business is very working capital intensive. Additionally, Zensar has a long history of steady growth while PC Jeweller has grown rapidly; it is in a much more cyclical industry.

 

On November 3, 2016, Miko International announced the resignation of Mr. Zhu Wenxin, an Independent Director at the company with Mr. Chan Wai Wong replacing him. The resignation is the latest in a series of director resignations. Below is a list of previous resignations.

  • On June 30, 2016, Gu Jishi resigned as Executive Director being replaced by Ms. Ding Lizhen, a member of the founder’s family.
  • On March 14, 2016, Mr. Wong Heng Choon resigned as Independent Director less than a month after being appointed.
  • On February 19, 2016, Mr. Leung Wai Yip resigned as Independent Director.
  • On September 8, 2016, Mr. Ng Cheuk Him resigned as Chief Financial Officer.

 

All the resignations follow the resignation of KPMG on April 21, 2016 and appointment of HLB Hodgson Impey Cheng Limited, an auditor of last resort for many Chinese frauds. The signs of fraud are piling up.

 

On November 4, 2016, Miko announced it signed a Memorandum of Understanding to set up a Joint Venture in the factoring business, an industry far removed from the current operations, which does not make much sense. We are already in the process of selling our position in Miko International.

 

On November 4, 2016, Credit Analysis and Research (CARE) reported first half results. Revenues grew 9% and operating profit grew 20%. The company also grew its client base by 8.5% from June 2016. It also signed a Memorandum of Understanding to start a credit rating agency in Nepal. The company also designated the first “SMART CITY” credit rating. Overall, the earnings report does nothing to move the needle either way. CARE is trading on a NOPAT yield of 3.0% but it is the most profitable company in an oligopolistic industry with significant barriers to entry and a very long runway for growth requiring no capital to grow. We entered with a 2.0% position in hopes that we could increase our position size at a cheaper price. We will maintain the current position given the barriers to entry in the industry, the runway for growth, and the lack of capital required to grow.

 

 

Random Thoughts

 

A recent FT Alphaville article discussed Sanford Berstein’s shift away from valuing companies by discounting cash flows. Bernstein argued in a zero rate world the risk free rate and the over weighted average cost of capital (WACC) is so low the importance of distant cash flows in the intrinsic value is much higher. Given an inability of analysts to forecast cash flows in the distant future, this increasing importance of the terminal value places a significant weight on highly uncertain cash flows. The following exhibits from the FT article illustrate the importance of the terminal value in Berstein’s estimation. Bernstein uses a discounted cash flow model with a five-year forecast period followed by a fade to a terminal value in year 10. Bernstein’s first charts assume a 10% growth rate for the next five years followed by a fade to a terminal growth rate of 3.5% in year 10. The second chart assumes a 5% growth rate for the five-year forecast period followed by a fade to a similar terminal growth rate.

importance-of-terminal-value-ft

 

Under the scenarios mentioned, Bernstein estimates the terminal value accounts for 55% at a 10% WACC increasing to 99% for a 3.6% WACC. WACC or discount rate is one of the many factors determining the importance of terminal value in a discounted cash flow valuation. We believe Bernstein, like many other market participants, is overlooking many other crucial factors in determining the importance of terminal value. We will discuss our view on the discount rate as well as other factors overlooked by Bernstein. We will also discuss another valuation method to overcome the shortfall of increased importance of terminal values in the discounted cash flow valuation. Whenever we value companies at Reperio, we use a similar discounted cash flow model with a five-year forecast period fading to terminal assumptions in year 10.

 

In the article, Bernstein’s main concern was lower interest rates lead to a lower discount rate leading to a lower WACC. Given the value of a corporation is driven by cash flows well into the future, the main assumption in lowering a company’s WACC is interest rates will remain low for a very long period of time. The chart below is the yield on a US 1 year treasury rate since 1953 illustrating the current rate of interest is the lowest on record.

1-yr-treasury-rate

We are bottom up investors but to assume market participants will accept 64 basis points forever in compensation for lending the US government money for one year seems aggressive, particularly, when one-year interest rates were over 1600 basis points in the early 1980s.  .

 

The treasury rate is a key input into the Capital Asset Pricing Model (CAPM) used by Bernstein and many other investors in determining a company’s WACC or discount rate. CAPM like many models in economics and finance is built with assumptions completely detached from reality. The biggest flaw in the CAPM is price equals risk. When calculating the cost of equity to determine the cost of equity, beta is multiplied by the equity risk premium. Beta is the volatility in a stock relative to a stocks benchmark meaning if a company’s share price is more volatile than its benchmark, it is assumed to be a more risky investment and therefore have a higher cost of capital. Putting aside the potential errors in measure a stock beta, a volatile stock does not equate to risk for the investor. This logic would lead you to believe a private business with the exact same characteristics of a public company listed on a stock exchange is a much safer investment, as there is not daily price volatility associated with being listed. At Reperio Capital, we view permanent loss of capital as the true risk of any investment. Permanent loss of capital comes from three risks: business risk, financial risk, and valuation risk. Business risk is the permanent loss of capital due to a permanent impairment of cash flows from competition or mismanagement. Valuation risk comes from overpaying for a security. Financial risk is when a company is has significant financial leverage that may lead to bankruptcy.

 

Another significant problem with CAPM is measuring a stock’s beta. The measurement of beta lends to significant estimation errors. Using Zensar Technologies as an example, if you calculate the company’s beta on a weekly basis since its listed in July 2002, its beta is relative to the SENSEX is -1.19. If you change the time period used in calculating beta to the last 10 years, Zenar’s beta changes to 0.77 illustrating the potential issues calculating beta.

 

Instead of calculating the weighted average cost of capital, we have used a constant discount rate as we assume there is an opportunity cost associated with making any investment. We are increasing our discount rate to 12.5% discount rate (from 10%) for all companies, roughly the average annualized return generated by the MSCI Emerging Market Index since inception and slightly more than the S&P 500 average annualized return is 9.5% since inception. If we can generate 12.5% annual return elsewhere then cash flows from any potential investment should discounted at that particular rate regardless of what the cost of capital is for each individual company. A constant discount rate also eliminates some of the subjectivity in valuation.

 

Other than lower interest rates and faulty measures of risk, Bernstein’s assumptions seem very optimistic. The FT article only mentioned growth and discount rate assumptions meaning the other important value drivers of operating margin and capital efficiency must have remained constant assuming no competitive pressures over the life of the company. The vast majority of companies succumb to competitive pressures leading to a fall in profitability and/or capital efficiency eliminating any excess returns. If excess returns are eliminated, growth does not add value making it an irrelevant discounted cash flow assumption. A small number of companies can hold off competitive pressures making profitability and capital efficiency irrelevant assumptions. The FT has a great free equity screener. In its universe, there are 13,799 stocks with a market capitalization above USD100 million and a 5-year average return on investment. Of the 13,799 stocks, only 2,001 stocks or 14.5% of the universe averaged a 15% return on investment over the past five years, which a very, very crude approximation of a company with a competitive advantage illustrating the difficulty in fending off competitive pressures and maintaining excess returns. Given the vast majority of companies face competitive pressures the assumption of constant operating margin and capital efficiency and any growth in terminal cash flows is very optimistic. An example is PC Jeweller, the company is operating efficiently generating excess returns but jewelry retailing is a fiercely competitive industry with thousands of competitors with little ability to sustain differentiation. We assume a 10% growth over the first five-year forecast period with growth fading to 0% in year 10 and competition eliminating excess profits.

1-scenario-terminal-value-total-value

 

As illustrated, at a 5% discount rate, the cash flows in the terminal value account for 51.0% total value. At a 15% discount rate, cash flows in the terminal value account for 31.6%. At a 5.0% WACC, Bernstein estimated 91% of a firm’ value is in the terminal value, while our estimate is much lower at 51.0% as we are more conservative on our assumptions for the vast majority of companies. The failure to account for competition makes terminal value a much larger percentage of total value.

 

Changing our initial assumptions to view PC Jeweller as competitive advantaged with sustainable margins and capital efficiency but with no growth in the terminal value, at a 5% discount rate, the cash flows in the terminal value account for 73.6% total firm value. At a 15% discount rate cash flows in the terminal value account for 39.1% of the total firm value still well below Bernstein’s estimates.

3-scenario-terminal-value-total-value

 

Being competitively advantaged and adding terminal value growth of 3.5% similar to Bernstein’s calculations further increases the importance of the terminal value assumptions. Again, growth in the terminal value is aggressive, as the vast majority of companies do not generate excess returns. Assuming a competitive advantage and 3.5% terminal growth, at a 5% discount rate the importance of cash flows in the terminal value increases to 90.5% of total firm value, while at a 15% discount rate 46.1% of the of the total firm value is derived from the cash flows in the terminal value.

 

The assumption of permanent low interest rates, no competitive pressures, and perpetual growth are all flaws in Bernstein’s assumptions that increase the importance of terminal value in a discounted cash flow valuation and probably are over aggressive. Like Bernstein, many investors make the same mistakes in their discount cash flow assumptions, which leads to the question why? The biggest reason is institutional constraints and the focus on asset gathering rather than performance making the vast majority of investors short term oriented and trying to outperform every quarter and every year. This short-term orientation leads to focus on next quarter’s earnings and whether a company will beat earnings estimates rather than focusing on a company’s competitive environment, management, financial health and valuation. The charts below from Andrew Haldane’s Patience and Finance illustrate the short-term orientation of market participants with the average holding period of a stock on the many different stock exchanges decreasing.

nyse-lse-holding-period

other-exchange-holding-periods

 

In the US, the average holding period of equities dropped from 7 years in 1940 to 7 months in 2007. In the UK, the average holding period of equities dropped from 5 years in the mid-1960s to 7.5 months in 2007. Looking at stock exchanges around the world the average holding period of equities has dropped to under 1 year on all exchanges with the exception of the Toronto Stock Exchange and Euronext. It seems evident that equity investors have a shorter and shorter investment horizon leading to focusing on the next few quarters making the discounted cash flow a useless tool for many investors. For long-term investors, a discounted cash flow with conservative assumptions it is still very useful. Another use for a discounted cash flow is to reverse engineer the market’s expectations of key value drivers, which eliminates the need for forecasting and makes judgment of the assumptions of key value drivers, the main determinant of the margin of safety associated with an investment.

 

If the use of a discounted cash flow still concerns you, a residual income model provides the same valuation while eliminating the importance of cash flow forecasts in the distant future. At Reperio Capital Research, we also use a residual income model with a five-year forecast period followed by a fade to the terminal value in year 10, with the current invested capital as the book value and return on invested capital and the discount rate as other key inputs. Residual income = (ROIC – discount rate) * invested capital. The residual income stream is then discounted back and added to the beginning of the year’s invested capital. The theory is every company has an asset base to generated returns. The asset base comes with an opportunity cost as the money invested in the asset base can be allocated elsewhere. If the company cannot generate its discount rate, it is destroying value and the company will be valued at less than its asset base. If the company generates excess profit, it will be valued above its asset base. Revisiting PC Jeweller using a residual income valuation and the same three scenarios illustrated above, we can see the residual income valuation method relies less on the discounted cash flows from the terminal. Under a scenario of no competitive advantage, no excess returns are generated in the terminal value assumptions therefore; the terminal value adds no value. Under the scenario of a competitive advantage but no growth, at a 5% discount rate, the terminal value accounted for 57.1% of the total firm value while a 15% discount rate 14.6% of the total firm value is derived from the terminal value. Finally, under the scenario of competitive advantage and terminal value growth, at a 5% discount rate, the terminal value accounts 83.4% of the terminal value and 21.0% of the total value at a 15% discount rate.

residual-income-terminal-value

 

The residual income method does a much better job at decreasing the reliance on terminal value calculations, but provides the same valuation outcome.

 

Discounting cash flows to value companies is still a valuable for any investor with a long-term orientation. Unfortunately, a model is only as good as its inputs. In a world with increasing short term thinking, garbage in will lead to garbage out.

 

 

Other Interesting Links

 

Jim Chanos’ and Kyle Bass’ views on China (link)

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

  • They talk about a potentially interesting idea within the Emerging Market Small Cap space: ABS CBN in the Philippines.
  • They also discuss other ideas First Pacific Holdings in Hong Kong and Rallye SA in France. Both are based on management track records.

 

Apple Should Buy Netflix (link)

A very interesting post at Stratechery discussing the media value chain.

 

Competitive Advantage of Owner Operators (link)

Base Hit Investing goes into detail into the advantages of owner operators.

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

Value Investing using Enterprise Multiples — Is the Premium Due to Risk and/or Mispricing? (link)

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

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.

Honworld Share Sale June 3, 2016

Honworld Share Sale June 3, 2016

 

After trading hours on June 1, 2016, Honworld sold 11.57% of the company’s existing share capital and 10.37% of the company’s expanded share capital for HKD6.00 per share.  New shares were issued with no existing shareholders selling.  HKD6.00 is a 27.66% premium to the June 1, 2016 closing price of HKD4.70 per share. The subscriber is a wholly owned subsidiary of Lunar Capital, a private equity fund focused on investing in the Chinese consumer businesses in the PRC. The subscriber’s guarantor’s principal activity is owning and operating companies or businesses focused in the condiments market in the PRC.

 

The aggregate net proceeds from the subscription are estimated to be approximately HKD356.1 million representing a net price of HKD5.935 per share. The company intends to utilize the net proceeds for general working capital of the Group.

 

The HKD6.00 price puts Honworld on an EV/2015 EBIT of 10.37 times and EV/2015 NOPAT of 12.29 times meaning shares were sold at cheap to fair value but not a no brainer sale price and not a ridiculously cheap price.

 

Lunar Capital has investments in a number of consumer goods companies in China.  Lunar Capital often takes a controlling interest from older founder who have succession challenges.  Lunar Capital is only buying 10.37% of Honworld so it is not taking control but it should bringing additional operational expertise given its numerous investments in consumer products.  Additionally, it should provide additional perspective on other important aspects such as capital allocation.

 

As mentioned in the initiation report and most subsequent updates, Honworld is going to need to continue to raise capital due to inventory needs associated with growth. The company’s inventory is raw materials, which can be purchased solely on price and ageing the product into premium products does not generate sufficient margin to make up for the ROIC drag associated with holding inventory for additional length of time.  This is the second consecutive fund raising that potentially involves selling shares leading to dilution of existing shareholders, which was not a particularly high price.  The recent sale/loan allowed the company to raise RMB133 million. This transaction allowed the company to raise net proceeds of HKD356.1 million or RMB420 million leading to RMB553 million raised over the past month.  Assuming working capital turnover remains at 0.71, the RMB553 million will allow the company to grow by an additional RMB393 million or 50% from current levels.  Assuming a 15% growth rate, the RMB553 million will be sufficient to finance growth until the end of 2018.

 

This development brings outside capital and credibility at a significant premium to the current market price and at a cheap/fair value.  Capital allocation continues to be an issue as illustrated by the continuous need for fundraising. As of Friday May 27, 2016, Honworld was an 8.5% position, which we were trying to sell down to 7.5% but given the share price dropped below HKD5.00 per share we stopped selling.  We will maintain the current position of 8.5% given the credibility, operational expertise, and perspective of the external buyer.  Additionally, the owner operator is passionate about the business and may see it as a family legacy. The business has a very strong competitive position and is growing rapidly while trading below and EV/EBIT of 10 times. This transaction also puts a private market value on Honworld well above the current share price.  If Lunar Capital is purchasing at HKD6.00, it must expect to get at least 15% IRR from the investment maybe more given the premium required for a Chinese investment.

Peak Sport Products Potential Privatization May 25, 2016

Peak Sport Products Potential Privatization May 25, 2016

On May 24, 2016, Peak Sport Products was looking into the potential privatization of the company by the controlling shareholders.  The announcement was vague and came with no other information, therefore the merits of a privatization offer cannot be evaluated.

The talk of an offer points to ownership that believes in the business and the financial statements.  The company has a significant amount of cash on the balance sheet and there were questions surrounding whether the cash on the balance sheet was real as the company issued shares despite a large net cash position.

There is no concrete offer and this could be management just talking up the stock. There is no change to our position and we await more concrete information.

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

 

On May 9, 2016, Universal Health agreed to purchase 36.38% of Jilin Wenhui Capsules Limited for RMB270.3 million placing an enterprise value on Jilin Wenhui of RMB743.0 million.  The company is a new high-tech enterprise that conducts research and development, manufactures, and sells hollow capsules, and is a leading capsule manufacturing enterprise in terms of scale in northeastern China. Jilin Wenhui Capsules current annual output of medical hollow capsule was approximately 15.0 billion, with plant capsule capacity of approximately 6.0 billion and plant gelatin (modified starch) capacity of approximately 5,000 tonnes. To complete the transaction, Universal Health issued 400,000 shares at a price of HKD0.725.

 

In 2015, Jilin Wenhui had a net asset value of RMB26 million, profit before tax of RMB6.99 million, and profit after tax of RMB5.34 million.  Universal Health purchased price places a valuation on Jilin Wenhui at 28.4 times book value and 139.1 times earnings.  These are astronomical figures in the absence of further information to analyze Jilin Wenhui. It seems the company is just throwing money away and paying anything to main growth something that is often seen with serial acquirers.  Universal Health is all over the place with its capital allocation.  We will be exiting our position in Universal Health as soon as possible.

 

While it is unfortunate we made mistakes on Universal Health and Miko International, the best teacher is pain and these mistakes will strengthen our investment process. There are a number of lessons that we have taken from the Universal Health and Miko International mistakes.

 

  1. Entry positions should be less aggressive allowing us to gain a better understanding of the company over time. This strategy would have prevented the gains we saw in PC Jeweller but downside protection is just as important if not more important than upside potential.   Less aggressive position sizes also pay respect to our ignorance and the limits of our knowledge.  We still believe in concentrated portfolios but small cap investing particularly in Emerging Markets bring additional risks and additional diversification is needed.  We still believe in concentrated portfolios 20-30 companies but oversized positions that investors can take in larger, well established companies may not be as prudent in smaller companies.
  2. We need to put more emphasis on why a stock is cheap. If it has tremendous operating history and good current earnings yet is extremely cheap, it may be a value trap, particularly in China.
  3. Focus needs to be on companies with long history of operations and being publicly traded. Both Miko International and Universal Health IPO’d over the past few years and they had not been operating for decades.
  4. Capital allocation is crucial and missteps should be viewed with extreme caution. Miko International issued shares at extremely cheap valuations with significant net cash balance.  A major red flag, which we overlooked.
  5. Along these lines, while strong financial health is crucial to any investment case, very large net cash positions is a potential sign of poor capital allocation at best and fraud at worst.
  6. When management starts selling your should probably start selling too as they have much more information about the company than you.
  7. Stay away from serial acquirers particularly in industries where there is n strategic logic for acquisitions.
  8. Chinese companies seem to be a different breed where financial statements cannot always be trusted. As outside investors, the primary evidence is financial statements of the company and competitors.  We look for additional evidence from independent sources to corroborate financial statements but it is not always there.  If financial statements cannot be trusted, you cannot invest.  Given the risk, we will be requiring additional evidence with Chinese companies and holding them at lower weights.

Universal Health Position Size May 6 2016

Universal Health Position Size May 6 2016

 

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

Universal Health Initiation Report September 8, 2015

Universal Health Initiation Report September 8, 2015

Below is a link to the Universal Health Initiation Report, formerly Company 9/8/2015, from September 8, 2015, along with the initial investment thesis.

Universal Health 2211 HKG Initiation Sept 8 2015 RCR

 

 

INVESTMENT THESIS

 

Universal Health International Holding Group (Universal Health) is a Chinese pharmaceutical distributor and pharmacy operator. The company trades on an EBIT/EV yield of 24.0% despite above industry growth, in an industry growing at 20% per annum, and superior profitability with a four year average ROIC of 43%.

 

Universal Health is best in class among Chinese pharmaceutical distributors and pharmacy operators in terms of growth, profitability (ROIC), and acquisitions, a key activity in the consolidating pharmaceutical distribution and retail market.  The company has a number of unique, complimentary activities strengthening its competitive position ensuring profitability can be sustainable.  The company has high quality management with significant share ownership, no significant corporate governance issues, and a net cash position equal to 37% of the company’s market cap and 2.41 times trailing twelve month (ttm) operating profit.

 

The market is pricing in no growth and a reversion from a 2014 ROIC of 39% to the cost of capital within ten years creating little downside but tremendous upside if the company can maintain its profitability and continue to grow at 20% per for the next five years.

Peak Sport and Universal Health Position Sizes May 3 2016

Peak Sport Products and Universal Health Position Sizes May 3 2016

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

 

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

 

Miko International Resignation of Auditor May 3, 2016

On April 22, 2016, Miko International’s Auditor KPMG resigned due to disagreements over Miko’s annual results.   In its resignation letter KPMG was awaiting satisfactory information relating to the following matters:

1. Receipt of the draft 2015 consolidated financial statements from management.

2. 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 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.’’

 

On April 29, 2016, Miko International appointed Hodgson Impey Cheng Limited (HLB).  HLB has been involved with signing off of financial statements of other frauds such as China Solar Energy Holdings.  http://www.bloomberg.com/news/articles/2013-10-19/china-solar-energy-says-directors-detained-amid-fraud-probe

The resignation of KPMG, the less credible auditor, CFO resignations, director resignations, and share issuance with a significant cash balance all point to Miko being a fraud.  We will be selling all shares at the time of resumption of trading.