Tag Archives: Emerging Market Small Cap

WEEKLY COMMENTARY 3/6/17- 3/12/17

WEEKLY COMMENTARY               3/6/17- 3/12/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

A Soriano Corp (Anscor) reported 2016 results. We recently initiated on Anscor with the key points to our thesis being:

 

  • The company has a healthy balance sheet
  • The company was in a number of highly competitive businesses, but
  • The company consistently generated a return on equity (ROE) around 10% our discount rate for all companies.
  • Despite the company’s healthy balance sheet and the consistency of the company’s ROE, Anscor trades well below its book value currently at 0.55 times its tangible book value and at 5.5 times cyclically adjusted earnings.

 

In 2016, the company maintained a healthy balance sheet with total liabilities twice the company’s cash position but less than half the amount of the company’s total securities. While the company’s businesses continue to be competitive, it was able to generate a return on tangible equity of 9.9%.

 

The company’s income before tax increased by 26% driven by strong results in all subsidiaries. Anscor’s largest subsidiary, PDPI grew its revenue by 8.3% due to a strong macroeconomic environment boosting construction activity. It was able to increase its net income by 30.7% in 2016. PDPI generated a ROE of 32%, the second year in a row over 30%. The company’s resort operations increased revenue and gross operating profit by 5.7% and 8.3%, respectively, generating a ROE of 34.0%. Anscor’s US nurse staffing business, Cirrus, grew revenue by 39% and net income by 70%. It generated a ROE of 35.9%.

 

Overall, the results reinforce our investment thesis of a company with a healthy balance sheet consistently generating a ROE close to its discount rate yet trades at a substantial discount to book.

 

 

INTERESTING LINKS

 

 

Explaining a Paradox: Why Good (Bad) Companies can be Bad (Good) Investments! (Musing on Markets)

 

In an environment where finding high quality ideas with any margin of safety is difficult value investors often stray to the idea that any high quality company is worthy of an investment regardless of the company’s valuation as holding cash due to a lack of ideas is more painful than investing in high quality companies that are overvalued. Contrary to what is often heard, Professor Damodaran describes how high quality companies can be bad investments while low quality investments can be good investments. (link)

 

 

Rethinking Conventional Wisdom: Why NOT a Value Bias? (Research Affiliates)

 

This Research Affiliates article is from August 2016 but it reinforces what pretty much any research on value states that it is a investment strategy that consistently outperforms with less volatility.  (link)

 

 

The Emerging Markets Hat Trick: Time to Throw Your Hat In? (Research Affliates)

 

While we are bottom up investors, there are a few top down investors enjoy reading with Research Affiliates being one of them. December 2016 article discusses the attractiveness of Emerging Markets equities. (link)

 

Additionally, we look at Research Affiliates expected returns for different asset classes on occasion. (link) Expected returns are not used in our investment process but we find them interesting nonetheless. We have thought about using the index expected returns as a discount rate. We view the discount rate as an opportunity cost rather than a specific cost of capital for a company. In our view, the marginal cost of capital is for a company does not relate to our acceptable level of return. There are other problems with using the marginal cost of capital as the discount rate including potential estimation errors and biases in the calculation as the marginal cost of capital changes from company to company. Rather than focusing on the marginal cost of capital of a company, we care about generating a sufficient return in each investment idea. Our current thinking is that the return on any investment in the long term equals the return on invested capital as any valuation discount or premium to the intrinsic value is insignificant over longer periods making the average return on invested capital (ROIC) a good starting point for the discount rate. According to McKinsey, from 1963-2004, the average ROIC excluding goodwill was 10%. (link) Triangulating the view that ROIC roughly matches the performance of a business over the long run is the returns of the S&P 500 geometric average from 1928-2016 is 9.53% and 1967 to 2016 is 10.09%, roughly equal to the average ROIC excluding goodwill. (link)

 

The thought of using expected returns of Emerging Markets as the discount rate makes sense as any recommendation or actively managed portfolio should outperform its index in the long run otherwise you are destroying value as an investor can just buy a low cost index of the asset class. The big problem is the expected return is very difficult to forecast accurately. Also, using expected returns leads to intrinsic values moving with the market direction rather than being the ultimate anchor for a value investor. We are using 10% as a discount rate for all investments.

 

 

Return Expectations Going Forward (Ben Carlson)

 

Ben Carlson discusses his views on forward expected returns. (link)

 

 

On the Valuation of the Indian Stock Market (Latticework)

 

Samit Vartak provides his thoughts on the current valuations in the Indian equity market. (link)

 

 

Trusting Management and the Limitations of Research (MicroCapClub)

 

Mike Schellinger writes about the limitations of research and assessing management. (link)

 

 

Where companies with a long-term view outperform their peers (McKinsey)

 

McKinsey studies the performance of companies with a long-term view and find they outperform on many measures. (link) There is a link to the full report at the bottom of the article.

 

 

Between ROIC and a hard place: The puzzle of airline economics (McKinsey)

 

McKinsey analyze the economics of the airline business through a ROIC lense with thoughts on what attributes lead to outperformance. (link)

 

 

Salvation or misleading temptation—low-cost brands of legacy airlines (McKinsey)

 

McKinsey provides a strategy for low cost airline brands under the umbrella of a full service carrier. They also discuss the differences in cost structure between the two. (link)

 

 

The economics underlying airline competition (McKinsey)

 

A short discussion on the difficulties of low cost carriers moving into long haul flights. (link)

 

 

Shipbroking and bunkering (Bruce Packard)

 

Bruce Packard compares two shipbrokers, Clarkson and Braemar. It is an excellent comparative analysis that may be useful in any investor’s process. (link)

Stalexport Autostrady SA 3/11/2017

Stalexport Autostrady SA 

Bloomberg Ticker:                               STX:PW

Closing Price (3/10/17):                       PLN4.30

6 Month Avg. Daily Vol. (USD mn):    0.13

Market Cap (USD mn):                        262

Estimated Annualized Return:           10.5%

March 11, 2017

Stalexport_Autostrady_Final_March_11_2017

 

INVESTMENT THESIS

 

Stalexport Autostrady holds a concession on a 61-kilometer stretch of the A4 in Poland between Katowice and Kraków. The concession ends in 2027. The company’s management has done an excellent job of improving operations since taking over in 2006 growing toll revenue at 11.8% over the past ten years. Despite the growth in the business, and inherent operating leverage in running a toll motorway, the current market valuation is 19% below a zero growth intrinsic value making Stalexport an attractive investment opportunity. If the company is able to grow revenues at half of its historic rate, there is 67% upside to its intrinsic value. If the company is able to continue to grow its revenues at its historic rate, there is 131% upside. Given the stability of the company’s revenue and the expected return of 10.5%, we recommend a starting position of 2.0%.

 

 

COMPANY DESCRIPTION

 

 

History

 

Stalexport Autostrady started operations on January 1, 1963 as Przedsiębiorstwo Handlu Zagranicznego “Stalexport”. It specialized in exporting and importing steel products as well as importing raw materials for the Polish steel industry. In 1993, the Polish government privatized the company with shares listing on the Warsaw Stock Exchange in October 26, 1994. In 1997, Stalexport won a 30-year concession to construct, adapt, and operate a 61 km toll road on the A4 motorway between Katowice and Kraków.

 

The motorway was secondary to the steel business until 2006, when the Atlantia Group, then Autostrade S.p.A., an Italian infrastructure company, acquired 50%+1 share of Stalexport for €67 million or PLN200 million. By Polish regulation, Atlantia was forced to launch a public tender offer for up to 66% of Stalexport’s share capital. It increased its share to 56.24% at the time of the acquisition. To complete the acquisition, Atlantia required Stalexport to increase its share capital with all new shares going directly to Atlantia. It also mandated the sale of the steel business. Prior to obtaining Atlantia as a strategic investor, Stalexport was dealing with potential bankruptcy for a number of years with its auditor, BDO, issuing a statement of the going concern nature of the company in its opinion statement. Atlantia manages a network of 5,000 km of toll motorways in Italy, Brazil, Chile, India, and Poland. It is a leader with respect to automatic motorway toll collections systems.

 

In 2011, Stalexport reduced its share capital to PLN185.45 million to reflect the change of the of the organization and capital requirements as the company was solely an operator of a toll road.

 

Since the acquisition, Atlantia increased its shareholding to 61.20%. Post-acquisition, its first increase came in to 2011 with a purchase of 10.86 million shares increasing its stake to 60.63%. In 2016, the company purchased another 1.4 million shares increasing its stake to 61.20%. Management has an insignificant shareholding with Emil Wasacz, President of the Management Board, holding 59,000 shares.

 

 

Organizational Structure

 

Stalexport Autostrady S.A. focuses on the upgrade and expansion of motorway infrastructure. In 1997, it was the first Polish company to be granted a concession to operation, upgrade, and maintain a toll motorway wining the concession on the A4 motorway between Katowice and Kraków section. In 2004, the concession was transferred to Stalexport Autostrada Małopolska S.A.

 

Stalexport Autoroute S.à r.l. was establish on December 30, 2005. The entity does not conduct any operational activities apart from holding shares in SAM as well as in VIA4. The entity was established as a prerequisite to obtain a loan for a consortium of banks.

 

Stalexport Autostrada Małopolska S.A. (SAM) SAM was established on December 19, 1997 as a special purpose vehicle to manage the A4 motorway between Katowice and Kraków. The motorway concession was transferred to from the group to SAM on July 28, 2004. After the transfer, SAM was authorized to collect lease fees and tolls for using the above-mentioned motorway section. As stated by the concession agreement, the entity is obliged to provide ongoing maintenance of the motorway and continue other necessary investment tasks.

 

VIA4 (formerly Stalexport Transroute Autostrada S.A.) was established on 14 May 1998. VIA4’s only customer is SAM. Its main tasks are ongoing operation and maintenance of the A4 toll motorway section, which includes operation of the toll collection system, management of motorway traffic, and comprehensive renovation and maintenance of the motorway. VIA4 also carries out tasks related to safety and road traffic. VIA4 is 55% owned by Stalexport and 45% owned by Egis Road Operation S.A., a French company with expertise in all of aspects of motorway management.

 

Biuro Centrum was established on June 9, 1994. The main business of Biuro Centrum consists in management and maintenance of the office and conference building in Katowice at ul. Mickiewicza 29 co-owned by Stalexport Autostrady (40.47%) and Węglokoks S.A. (59.53%).

 

98% of the consolidated company’s revenues and 96% of EBIT are from SAM, the entity that collects the lease fees and tolls from the motorway.

 

Given the importance of the toll road, we focus our attention on this business. The A4 toll motorway between Katowice and Kraków is 61-kilometer toll road. It is part of the A4, which is one of the major motorways in Poland and one of the two motorways planned to stretch from the eastern border Poland to the western border of Poland by 2022 along with the A2 in central Poland.

 

The A4 from Katowice to Kraków is an open system, where money is paid at tollbooths stretching across the road based on the vehicle type. The open system is relative cheap but forces commuters to stop at each tollbooth decreasing the capacity of the motorway. The other system is a closed system where there are tolls at each interchange when entering and exiting the motorway the toll is paid based on the vehicle and the distance traveled.

 

According to Google Map driving directions, the A4 is the quickest way from Katowice to Kraków beating the 94 by 28 minutes. As mentioned, the only major competition to cross Poland is the A2 in central Poland. The decision is based on your starting and ending point and the quickest route of travel so in many instances there is no competition. The A4 is a fastest way to travel particularly if you are driving across southern Poland from east to west or west to east and there are very few alternatives. It would be very difficult for a competing toll road to be built over the next 10 years allowing the A4 to generate steady revenue with very little investment requirements. Additionally, if another road were to be built to compete with the A4, it would cannibalize government revenue, as the A4 from Katowice to Kraków will be handed over to the government at the end of the concession in 2027. Toll roads also have barriers to entry in the form of habitual behavior. When commuters have a road travelled on a daily basis a habit is formed as the road is travelled without any thought creating a habit that is difficult to break.

 

For the consolidated entity, since 2008, toll revenue increased by 11.6% per year with passenger vehicle toll revenue increasing by 11.4% per year and heavy goods vehicle toll revenue increasing by 11.9% per year. Average daily traffic increased by 4.5% per year with passenger vehicle traffic increasing by 5.7% per year and heavy goods traffic decreasing by 0.6% per year. The average toll increased by 6.8% per year with the average toll for passenger vehicles increasing at 5.4% per and heavy goods vehicles increasing by 12.5% per year.

 

Despite the growth in revenues, Stalexport’s cost of goods sold have decreased from PLN85 million in 2006 to PLN37 million in 2016. 2006 and 2012 were the two years with the highest cost of goods sold at PLN85 million. Cost of goods sold is very dependent on road works during the year, which creates a bit of lumpiness and no correlation with revenues. 2016 saw lower road works leading to much lower cost of goods sold. Since 2006, cost of goods sold averaged PLN66 million.

 

Administrative expenses increased steadily from PLN21 million in 2016 to PLN30 million in 2016, equal to a 3.8% annual increase, well below the rate of change in toll revenue.

 

Atlantia has done a good job of growing revenues while decreasing expenses as a percentage of revenues. The biggest driver of decreasing costs relative to expenses was eliminating inefficiencies from having too many subsidiaries.

 

The A4 concession expires in 2027. Upon expiry, the A4 will be transferred to Poland’s Treasury. If Stalexport is to grow, it will come from the existing asset. There are other potential PPP projects but it would be speculative to assume any growth from these projects as the company has not indicated there are any potential projects in the pipeline. The company has also been selective in the past and passed on projects where prospective returns were not attractive enough.

 

Internal growth will come from traffic growth and growth in the average toll. In 2016, Stalexport implemented its own A4Go on-board units after not being able to coordinate with the viaToll system used elsewhere in Poland. The A4Go unit allows for electronic payment at the tolls decrease traffic at tollbooths. The A4Go was implemented in only 6 months and went online in July 2016. By the end of the year, roughly 10% of morning traffic used the A4Go system. The decrease in traffic at tollbooths decreases the travel time for commuters making the A4 a more attractive route for existing and potential users.

 

 

VALUATION

 

Given the barriers to entry and the predictability of revenue, we value Stalexport using a DCF until 2026 the year before the company has to hand operations back to the treasury. We assume no cash flows in 2027 for conservatism.

 

We vary sales growth to get an estimated intrinsic value under different scenarios. Under the most conservative scenario, we assume no growth in sales. Sales growth is then assumed to increase by 3% as scenarios become more aggressive and we reach the most aggressive scenario of 12%, which assumes sales growth will continue at roughly the pace it has over the past ten years (11.8%).

 

The last ten years saw significant variability in the cost of goods sold but the variability was within a well-defined range. We assume an average of the last ten years with no inflation.

 

Administrative expenses have increased steadily over the past 10 years at a rate of 3.8% per year. We assume administrative expenses continue increasing at 4.0% per year. We also assume a tax rate of 20% roughly in-line with the effective tax rate of 19.8% over the past ten years.

 

Since 2008, the company’s average change in working capital to revenue rate is 6.3% meaning every zloty of revenue generates 6.3 grosz of positive free cash flow due to negative working capital requirements. Despite the negative working capital generating free cash flow, we assume there is no cash flow generated from working capital and there are no investments in working capital.

 

Also since 2008, the company has spent 26.1 grosz on capital expenditures for every 1 zloty of revenue just above the depreciation rate of 19.1 grosz for every 1 zloty of revenue. Over the past four years, the capex to depreciation rate averaged 0.8 meaning the company is spending less on capex than depreciation. The recent trend of capex below depreciation leads us to assume capex equals depreciation therefore there are no additional fixed capital requirements other than the maintenance capex.

 

The company has a net cash position just over PLN315 million and a share in property investments with an estimated value of PLN10 million.

 

We place a probability on each of the 5 revenue growth scenarios to a get a blended intrinsic value of PLN7.21 per share, which has 67.6% upside from the current price.

 

 

Under the most conservative scenario of zero revenue growth still leads to an upside of 19% illustrating the downside protection at current prices.

 

 

RISKS

 

Stalexport’s biggest risk is regulatory risk. While a toll motorway concession is a contract, the authorities are most likely least concerned with the owner of the toll motorway and more concerned with other stakeholders such as commuters. In Poland, Stalexport was sued by the Polish government for anti-competitive practices due to high toll rates. In 2008, the company had to pay a PLN1.5 million fine. In India, populism led to abolition of tolls for an extended period. Countries may also change their previous position to void contracts.

 

Any new motorway running parallel to the A4 would create additional supply impacting Stalexport’s ability to attract traffic and raise toll rates.

 

Traffic particularly heavy goods vehicles is dependent on economic growth. Slowing macroeconomic growth could hurt traffic growth.

 

The company has more related party transactions than what we would like and there is potential for some corporate governance risks. The main related party transactions are with companies owned by Atlantia, which complete roadworks on the motorway.

 

Management remuneration has decreased substantially as a percentage of operating income. Management may increase its salaries and extract greater value in the future.

 

There is a risk of the company tendering for new concession and overpaying hurting returns on future projects. The company was disciplined enough to pass on past projects that did not meet the parameters needed for attractive returns.

WEEKLY COMMENTARY 2/27/17 – 3/5/17

WEEKLY COMMENTARY               2/27/17 – 3/5/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news this week.

 

 

INTERESTING LINKS

 

 

The Fervent Loyalty of a Costco Member (Scuttlebutt Investor)

 

The Scuttlebutt Investor does an excellent job writing about Costco. The company is not an Emerging Market company, but it is always interesting to see business models that work, particularly in the retail industry. The first quote by Peter Lynch is an excellent way to look at industries with no barriers to entry. (link)

 

 

Why Facts Don’t Change Our Mind (New Yorker)

 

The New Yorker discusses research and reasoning for flaws in our ability to change our minds or think critically about our own ideas. (link)

 

 

How Indian families took over the Antwerp diamond trade from orthodox Jews (Quatrz)

 

Quartz takes a look at how Indians took over the Antwerp diamond trade from Hasidic Jews. The success story sounds like many new entrants within a market by starting at the parts of the industry that are overlooked by competitors, typically due to lower margins. Added to the successful strategy were cheap labor in India, large families, and a strong work ethic. (link)

 

 

3G Purchases and Their Profit Margins (Economist)

 

The Economist writes a short article discussing 3G, their history, and operating model.  The most interesting takeaway is the improvement in profit margins post acquisition. (link)

 

 

Notes from Howard Marks’ Lecture: 48 Most Important Things I Learned on Investing (Safal Niveshak)

 

Vishal Khandelwal talks about the 48 most important take aways from Howard Marks lecture in Mumbai. (link)

 

 

How Signet Jewelers Puts Extra Sparkle on Its Balance Sheet (New York Times)

 

The New York Times provides some insight on Signet’s business model and use of in-house credit. (link)

 

 

Tools We Use to Forecast the Future Prospects of a Business (Latticework)

 

Michael Shearn, author of the great book The Investment Checklist, contributes to Latticework by discussing what he looks for in businesses to increase the odds of correctly forecasting the future. (link)

 

 

Can YouTube TV Get You to Cut the Cord for $35 a Month? (Bloomberg)

 

Bloomberg looks at Youtube’s new service of providing a cable television product for $35 per month. The internet continues to disrupt traditional media. (link)

 

 

India’s Battle With Booze Isn’t Stopping Johnnie Walker (Bloomberg)

 

Bloomberg wrote an good article looking at India’s Spirits Market and recent regulation. (link)

 

WEEKLY COMMENTARY 2/20/17 – 2/26/17

WEEKLY COMMENTARY               2/20/17 – 2/26/17

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news.

 

 

INTERESTING LINKS

 

 

Founder-Led Companies Return Three Times S&P 500 Average (Mason Myer)

 

Mason Myer discusses how owner operators outperform the S&P 500. (link)

An HBR article from the Bain Consultant mentioned in the previous article. (link)

The original research paper by Purdue professors used in both articles. (link)

 

 

The $143bn flop: How Warren Buffett and 3G lost Unilever (CNBC)

 

FT looks at 3G’s failed bid of Unilever. (link) In the article, sources state Unilever thought the bid had no merit and thought a 3G takeover was the worst-case scenario as illustrated by following statement.

 

Another insider said: “When they put something on the table, Paul was just utterly categorical that there was no merit. He gave a number of reasons why there was no interest in such an offer.” The offer was rejected immediately.

 

Completely dismissing the bid without analyzing the proposal feels as if shareholders are irrelevant and an entrenched management team is worrying about their own positions. A FT article from 2010 echo’s this. (link)

 

Mr. Polman said: “I do not work for the shareholder, to be honest; I work for the consumer, the customer . . . I’m not driven and I don’t drive this business model by driving shareholder value.”

 

In 2016, FT published another interview with Mr. Polman. (link) If the link is behind a pay wall google “FT interview with Unilever.” The narrative is Mr. Polman is concerned about all stakeholders including shareholders. He has no concern for short-term oriented shareholders but long-term investors as his focus is the next 100 years.  There are a number of other interviews with Mr. Polman essentially saying the same thing. This is another interview with The Guardian where  he says shareholder value is not the most important focus. (link) Here is another recent interview with Fortune. (link) Unilever’s focus is the customer not the shareholder. The customer should be the focus when making products, but the company is owned by shareholders and management has a fiduciary duty to them.

 

Illustrated above is Unilever’s relative performance over the past five years. Unilever has the fourth lowest operating margin with the second highest capital efficiency leading to the third highest ROIC. Growth has slowed among all peers. Over the last five years, Unilever’s sales grew by 0.7%, its operating profit grew by 2.8%, and invested capital grew by 2.7%. The focus on the customers has not lead to drastic underperformance or outperformance.

 

Kraft Heinz bid $50 per share or €47.30 for all Unilever shares. The company has a strong competitive position with economies of scale being the biggest competitive driver along with customer captivity in the form of habit. ROIC also has very little dispersion making so it is a safe assumption that its average ROIC over the past five years will persist. The €47.30 bid placed Unilever’s market cap at €134.32 billion and an enterprise value at €146.26 billion. In 2016, the company generated €5.17 billion leading to a cash flow yield of 3.5%. Since 2012, the company grew its free cash flow at 3.8% per year creating a total return of 7.3%.  Using a residual income model, a ROIC of 127% with a growth of 2.5%, similar to operating profit growth and invested capital growth over the past four years, and a discount rate of 10% into perpetuity, Unilever’s fair value is 26% below the offer price. Using a lower discount rate of 7.5% and the same profitability and growth assumptions, Unilever’s fair value is 10% above the offer price.

 

Kraft Heinz’s bid did not undervalue Unilever given its recent growth. Rejecting Kraft Heinz’s bid without analysis along with numerous management statements points to a management team at Unilever that are more concerned with the benefits of their position over focusing on shareholder value.

 

 

Shareowner’s Rights Across the Markets (CFA Institute)

 

A 2013 CFA Institute report on shareowner’s rights across markets (link)

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

There was an error in the shareholder structure table in Anscor initiation.  The total outstanding shares was incorrect.  The corrected table is below.  We also corrected the table in the initial post.

A. Soriano Corporation 2/23/17

A. Soriano Corporation

Bloomberg Ticker:                              ANS:PM

Closing Price (2/23/17):          PHP6.34

6 Month Avg. Daily Vol. (USD mn):    0.017

Market Cap (USD mn):           156

Estimated Annualized Return:            18.0%

February 23, 2017

 

A_Soriano_Corp_Feb_23_2017_Final

 

INVESTMENT THESIS

A. Soriano Corporation (Anscor) is a Filipino investment holding company with investments in many different industries. The company has a healthy balance sheet and consistently generates a return on equity around its discount rate. Despite the healthy balance sheet and the consistency of the company’s ROE, Anscor trades well below its book value currently at 0.56 times book and at 5.46 times cyclically adjusted earnings. There is significant upside to the company’s earnings valuation (110% upside) and asset valuation (77% upside). We are taking a 2.0% starting position as the stock is very illiquid.

 

 

COMPANY DESCRIPTION

 

Anscor was incorporated on February 13, 1930. It is an investment holding company located in the Philippines. Anscor’s largest investments are Phelps Dodge International Philippines, Inc. and Seven Seas Resorts and Leisure, Inc. Other investments include Cirrus Medical Staffing, KSA Realty, Prople Limited, and Enderun College among others.

 

 

Phelps Dodge International Philippines

 

Phelps Dodge International Philippines, Inc. (PDIPI) was incorporated in 1955 and started production in 1957. Its products are primarily copper-based wires and cables including building wires, telecommunication cables, power cables, automotive wires and magnet wires. PDIPI has a technical assistance contract with General Cable Company (GCC), the second largest cable company in the world. GCC was also a shareholder in PDIPI until December 2014 when Anscor acquired GCC’s 60% shareholding for PHP3.0 billion. The Philippine wire and cable industry is comprised of both imported and domestically manufactured products. The four largest manufacturers are Phelps Dodge, American Wire and Cable Co., Inc., Columbia Wire and Cable Corp., and Philflex Cable Corp.

 

Over the past three years, PDIPI’s average return on assets of 16% is well above its discount rate pointing to potential barriers to entry within the industry. Despite the strong returns, the industry is fragmented. There are no supply side barriers to entry as copper cables are a relatively simple product to manufacture and there is no favorable access to raw materials as raw materials are commodities that can be purchased from many suppliers. There are no demand side barriers to entry as purchasing copper cables does not create habit and there are no switching costs, search costs, or network effects.  There may be some economies of scale but with gross margin at only 14%, it seems the cost structure of the business is primarily variable eliminating any real barriers to entry from economies of scale.

 

 

Seven Seas Resorts and Leisure

 

Seven Seas Resorts and Leisure, Inc. (SSRL) was incorporated on August 28, to plan, develop, operate and promote Pamalican Island as a world-class resort. The resort is named Amanpulo and started commercial operations on January 1, 1994. SSRL inventory is 103 rooms with 40 original casitas and 63 rooms in villas. SSRL is a joint venture between Anscor, Palawan Holdings, Inc., and Aboitiz & Co with Anscor owning 62% of the resort.

 

The resort’s services are offered through the worldwide Amanresort marketing group based in Singapore, accredited travel agents, reservation sources/systems, and direct selling. Amanpulo is in competition with all other small 5 star resort companies in other destinations that are generally better known than the Philippines, such as Indonesia, Thailand, and Malaysia.

 

According to reviews on Tripadvisors.com, 90% of Amanpulo’s reviews were excellent, the highest rating. It is rated as the #1 hotel in Palawan Province.

 

Until 2015, SSRL failed to earn a reasonable return on assets. The company also failed to generate any meaningful growth with revenue increasing from PHP517 million in 2011 to PHP645 million in 2016. Similar to PDIPI, there does not seem to be any barriers to entry. There are thousands of luxury resorts around the world illustrating the lack of barriers to entry within the industry. There are no supply side advantages in owning a luxury resort. There are no demand side advantages. If there are economies of scale within the industry, SSRL is a smaller resort, which would be disadvantaged.

 

 

Cirrus Medical Staffing, Inc.

 

Cirrus Medical Staffing (Cirrus) is a US-based nurse and physical therapist staffing business. It places registered nurses on contracts of twelve weeks or longer. In January 2008, Anscor acquired Cirrus. Cirrus has a preferred vendor relationship with the US’s largest home health company. Anscor owns 94% of Cirrus.

 

Similar to SSRL, Cirrus did not generate an acceptable on assets until 2015. Unlike SSRL, Cirrus has been growing its business at a rapid pace. Since 2011, service income growing by 16.7% per annum, gross profit grew by 21.3% per year, and EBITDA grew by 90% per year.

 

The nurse and physical staffing business is very fragmented and there are no supply side advantages. Potentially, there are demand side advantages in the form of switching costs. When using a staffing agency for a large number of employees as long as the staffing agent is doing a good job, the client should continue to use the agent and the agent has a bit of pricing power due to the cost of switching providers. The client can easily offset the staffing agent’s bargaining power by using multiple providers. For small clients, it seems like the potential for a demand side advantage is much smaller as it is easier to find the necessary supply of labor.  Economies of scale do not exist in the industry.

 

 

KSA Realty Corporation

 

Anscor exchanged its old building located at acquired a 11.42% stake in KSA Realty Corporation (KSA) 1990 in exchange for Paseo de Roxas in Makati. KSA develop The Enterprise Center, a two tower, grade A office building located in Makati.

 

In 2015, KSA had an occupancy rate of 96%, generating PHP992 million in revenue, and PHP1,300 million in net income including a PHP517 million revaluation gain. Despite a decrease in the occupancy rate from 2013, KSA was able to increase revenue by 20% over the past two years. KSA’s assets have been revalued twice in the past three years. There are no competitive advantages in the property business.

 

 

Enderun Colleges, Inc.

 

In October 2008, Anscor acquired 20% equity stake in Enderun Colleges, Inc. Enderun was established in 2005 by a group of business leaders, including senior executives from Hyatt Corporation in the U.S., Enderun offers a full range of bachelor’s degree and non-degree courses in hospitality management, culinary arts, and business. Enderun has close to 1,200 full time and certificate students spread almost evenly across the school’s three main degree offerings.

 

Enderun recently launched Enderun Extension, a continuing education unit that is the college’s language training and tutorial business. In 2014, Enderun launched a hotel and management consultancy unit. Several hotels and resorts are under Enderun’s management.

 

Management expects Enderun to deliver double-digit growth in the coming years.

 

Within education, there is a brand advantage at the very elite schools but Enderun does not have that advantages.

 

 

Prople Limited

 

In December 2007, Anscor acquired 20% of Prople for US$800,000. In November 2013 acquired 100% of the non-audit business of US-based Kellogg and Andelson Accountancy Corporation (K&A). Founded in 1939, K&A is a well- established accounting firm that provides tax, general accounting, and consulting services to thousands of small to medium sized companies in California and the Midwest. It operates out of five locations in Los Angeles, Woodland Hills, San Diego, Kansas City and Chennai (India). Following its acquisition of K&A, Prople now employs 373 people serving over 5,500 clients from operations located in six cities worldwide. In 2015, Prople closed K&A’s San Diego office and client attrition in the Midwest. Prior to the acquisition of K&A, Prople’s services included business process outsourcing, knowledge process outsourcing, and content services. K&A tripled the company’s revenue.

 

With the acquisition of K&A, Prople is primarily a tax, accounting, and consulting provider. Professional services, like tax and accounting, have some switching costs as the provider is embedded in the company’s operations becoming an integral part of the team. Despite the switching costs, the industry is fragmented and bargaining power of the provider can be decreased by using multiple suppliers.

 

 

AGP International Holdings Ltd.

 

AGP International (AG&P) is Southeast Asia’s leading modular fabricator of refinery and petrochemical plants, power plants, liquid natural gas facilities, mining processing, offshore platforms, and other infrastructure. AG&P has 110 years of experience serving clients like British Petroleum, Shell and Total.

 

Anscor made its first investment in AG&P in December 2011. In June 2013, Anscor subscribed to 83.9 million series C, voting preferred shares in AG&P. Series B and Series C preferred shares are convertible at the option of the holder, into class A common shares. The subscription increased Anscor’s holdings to 27%.

 

Similar to cable manufacturing there are no barriers to entry within the modular fabrication.

 

Anscor’s businesses do not appear to be competitively advantaged. The lack of barriers to entry makes industry analysis irrelevant.

 

Listed above is the company’s shareholder structure. 50.7% of the shares issued are held by a 100% owned subsidiary. Insiders own another 27.1% of shares issued, affiliates own 3.2% of shares issued, and the public own 19.0% of shares issued.

 

 

VALUATION

 

The lack of barriers to entry within Anscor’s businesses and the management team is deeply entrenched the company’s earnings power is the best method of measuring the company’s value as the earnings generated are likely to continue. Assuming average management and a lack of barriers to entry means the value of the company’s assets should be close to the company’s earnings valuation as excess returns are unlikely and cyclical adjusted earnings should be close to the company’s discount rate.

 

Given the company’s large investments in securities and associates, we use net income as the best measure of the company’s earnings and equity as the best measure of investment capital. Since 2010, Anscor has generated an average net income of PHP1,423 on an average tangible equity of PHP12,106 equating to a roughly 11.8% return on equity.

 

Given the lack of barriers to entry in Anscor’s businesses, growth does not create value and therefore is irrelevant; therefore, assuming a 10% discount rate Anscor should be trading at roughly 1.18 times tangible book value representing a 110% upside.

 

Anscor is trading on a cyclically adjusted PE of 5.46 times meaning in the absence of growth, the company’s expected annualized return in 18.3%.

 

Given the company’s ability to generate a consistent return on equity equal to the company’s discount rate, the reproduction value of the company’s assets should equal the company’s tangible book value. It is difficult to say a collection of assets are impaired if they generate a return equal to the discount rate.

 

Anscor’s fair value is between tangible book (77% upside) and 1.18 times tangible book (110% upside).

 

 

RISKS

 

A company with a dominant shareholder (A. Soriano III) brings potential corporate governance issues. Anscor only material related party transactions are key management remuneration, which averaged 8.8% of net income over the past five years. Key management remuneration is a little high but the absence of any other related party transactions and the cheap valuations means it can be overlooked.

 

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

 

The investment is based on Anscor’s strong financially health. If the company were to leverage its balance sheet, the attractiveness of the investment opportunity would decline.

 

The investment is also based on Anscor’s consistently generating net income around its cost of capital. If earnings in the business were to permanently decline, the investment would become much less attractive.

 

If earnings were to decline making a liquidation value a more appropriate valuation methodology, there is still 30% upside meaning there is significant downside protection.

 

If Anscor were to make expensive acquisitions, it would decrease the returns in the business through the write down of income and equity.

 

Given the nature of Anscor’s businesses, they all lack barriers to entry and therefore are at risk of increased supply depressing profitability.

 

Most of Anscor’s businesses are cyclical in nature and subject to macroeconomic risks.

 

At the end of Q3 2016, 47% of Anscor’s assets were in available for sale securities or fair value through the profit and loss investments making the company exposed to the fluctuations of the Philippines Stock Exchange.

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

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

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

 

 

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

 

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

 

 

Diversification..again.. (Oddball Stocks)

 

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

 

 

Humility and knowledge (Oddball Stocks)

 

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

 

 

Graham & Doddsville (Columbia Business School)

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

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

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

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

 

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

 

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

 

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

 

 

INTERESTING LINKS

 

 

My Interview with Jason Zweig (Safal Niveshak)

 

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

 

 

The Making of a Brand (Collaboration Fund)

 

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

 

 

Riding a retail roll out (Phil Oakley)

 

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

 

 

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

 

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

 

 

Investing Mastery Through Deliberate Practice (MicroCap Club)

 

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

 

 

Out with the old (Investor Chronicle)

 

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

 

 

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

 

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

 

 

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

 

Glossy magazine writes about the beauty business. (link)

 

 

6 smart tips for micro-cap investors (Morningstar)

 

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

 

 

HAW PAR CORPORATION (HPAR:SP)

 

 

Company Description

 

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

 

 

Healthcare

 

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

 

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

 

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

 

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

 

 

Leisure

 

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

 

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

 

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

 

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

 

 

Property

 

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

 

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

 

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

 

 

Investments

 

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

 

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

 

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

 

 

Management

 

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

 

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

 

 

Valuation

 

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

 

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

 

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

WEEKLY COMMENTARY 1/30/17-2/5/17

WEEKLY COMMENTARY               1/30/17-2/5/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news over the past two weeks.

 

 

INTERESTING LINKS

 

 

Expectations Investing: Reading Stock Prices for Better Returns (Michael Mauboussin)

 

A 2006 report by Michael Mauboussin when he was at Legg Mason discussing what he calls Expectations Investing. The report also discusses the link between ROIC and PE. (link) Mr. Mauboussin discusses how investors often only look at a company’s fundamental when investors should be assessing company fundamentals then comparing them to market expectations. He argues that any returns will be driven by a change in the markets expectations. Given there are many types of value investing (quality, deep value), value investing itself is the act of ensuring the market’s expectations are well below the probable path of a company’s fundamentals.

 

In the article, Mr. Mauboussin discusses the theoretical link between ROIC and PE. We studied the relationship between ROIC and EV/EBIT and EV/IC. Growth is eliminated from our study, as it is the most difficult value driver to forecast. We feel EV/EBIT is a more appropriate measure of earnings than PE as it eliminates all non-operating items and it takes into account the whole capital structure something that ROIC takes into account. We studied a number of different Emerging Market companies in a number of different industries from 2011 to 2015. We used a company’s estimated ROIC for the year (operating profit/ (net working capital + PP&E)) and the company’s valuation at the end of the year. As illustrated below, our study found no correlation between ROIC and EV/EBIT, with the adjusted R squared at 0.01, and a strong correlation between ROIC and EV/IC, with an adjusted R squared of 0.65

 

The scatter plots graphs below visualize the correlation between ROIC and the two EV valuation multiples.

 

As you may have noticed, EV/IC is not really mentioned in our reports as we use more in-depth valuation methods. We use EV/IC vs. ROIC as a shortcut when screening companies to determine whether there may be sufficient margin of safety to spend addition time analyzing the company. Using a 10% discount rate and no growth, you can easily determine the appropriate EV/IC given a company’s ROIC by multiplying the company’s ROIC by 10.

 

 

Thirty Years Reflections on the Ten Attributes of Great Investors (Michael Mauboussin)

 

A more recent report by Michael Mauboussin discussing the ten attributes of great investors. (link)

 

 

Ten Attributes of Great Fundamental Investors

 

The top ten attributes discussed in the paper are:

 

  1. Be numerate (and understand accounting)
  2. Understand value (the present value of free cash flow)
  3. Properly assess strategy (or how a business makes money)
  4. Compare effectively (expectations versus fundamentals)
  5. Think probabilistically (there are few sure things)
  6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected)
  7. Beware of behavioral biases (minimizing constraints to good thinking)
  8. Know the difference between information and influence
  9. Position sizing (maximizing the payoff from edge)
  10. Read (and keep an open mind)

 

 

7 Deadly Sins of Investing…..!!! (Tortoise Wisdom)

 

Given the previous link discussed the 10 attributes of great fundamental investors, it seems appropriate to include a link discussing what not to do in investing. Tortoise Wisdom discusses the seven deadly sins of investing. (link)

 

The seven deadly sins of investing are:

 

  1. Following the herd
  2. Overconfidence
  3. Trading too much
  4. Envy
  5. Keeping Unrealistic Expectations
  6. Uncontrolled Emotions
  7. Focusing on outcome, Not on Process

 

 

The truth about pricing power (and chocolate) (Intelligent Investor)
Graham Witcomb of the Intelligent Investor provides insight into pricing power. (link)

 

 

Video Library (Hedge Fund Conversations)

 

Hedge Fund Conversations created a library of videos of hedge fund investors. It may be a useful resource. (link)

 

 

Video Library (Ben Graham Centre for Value Investing)

 

While on the topic of video libraries, The Ben Graham Centre for Value Investing at Ivey Business School has a tremendous video library of presentation given to its students by practitioners. (link)

 

 

Understanding the Role of Emerging Markets in Your Portfolio (Fortune Financial)

 

Fortune Financial discusses Emerging Markets and their role in a complete portfolio. (link)

 

 

 A Profitable Industry You’ve Likely Never Considered (Fortune Financial)

 

Fortune Financial write an article discussing Mexican airports as a potential investment. (link)

 

 

How YouTube could capitalize on its rivals’ mistakes, and conquer the future of TV (Business Insider)

 

Business Insider discusses Youtube’s potential to take ad spend from television. (link)

 

 

Rolex is suddenly battling one of the biggest threats in history (Business Insider)

 

Business Insider examines the threats to Rolex and the watch industry. (link)

 

 

Conversation with Irish Hotel Mogul Pat McCann (Independent)

 

The Independent talks with Pat McCann on the hotel industry. (link)

 

 

Curing the Addiction to Growth (Harvard Business Review)

 

Harvard Business Review discusses retailers and strategies for when growth. Interestingly, they find the key metric in determining the winners and losers is ROIC as management teams that follow ROIC do not try to grow just to grow. Their focus is only growing when it creates value. The researchers focus on two other key metrics revenue per store and estimated revenue added per new store. (link)

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.