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Grendene Q1 2017 Results Review May 8 2017
Grendene recently reported its Q1 2017 results. Net revenue grew by 7.2% as domestic revenue grew 23.6%, export revenue declined by 19.1%, and sales taxes and deductions increased by 22%. With regard to pricing, net ASP fell by 1.1% and volume increased by 8.5%. Within Brazil, domestic ASP increased by 7.0% and volume increased by 13.0%. In export markets, ASP declined by 19.8% in BRL terms and 0.3% in USD. In Q1 2017 Brazil was clearly much stronger than export markets.
The table above illustrates total volume, ASP, domestic market volume, domestic ASP, export volume, export ASP in BRL, and export ASP in USD. The company seems to have significant seasonality.
In volume terms, Q1 is typically an average quarter overall but it is a weak quarter in the domestic market and a stronger quarter in the export markets. Q1 2017 volume was weak overall relative to the average Q1 volume with domestic volume slightly above the average Q1 volume and export volume well below the typical Q1 volume.
The chart above illustrates volume over the trailing twelve months (TTM) for the domestic, export, and a combination of the two (overall). TTM volumes peaked for Grendene in Q4 2013 and fell by 7.7% per annum overall with both domestic and export markets declining by the roughly the same amount.
In ASP terms, there is a lot less seasonality with prices consistently increasing in both domestic and export markets at a rate of 2.9% in the domestic market and 3.8% in USD terms in export markets. The ability to raise prices in both domestic and export markets despite a falling volumes and a weak overall macro environment may be a good sign of the company’s pricing power. The company may also be stretching its ability to raise prices as the company sells lower cost shoes that may not provide as much value to customers at higher prices.
Grendene’s gross profit grew by 11.0% in Q1 2017 with its gross margin expanding by 59 basis points (bps) over Q1 2016 and 37 bps over Q4 2016. The gross margin expansion over Q1 2016 was driven primarily by a decrease in cost of goods sold per pair as the ASP decreased from BRL13.63 to BRL13.47. Cost of goods sold per pair decreased from BRL7.25 in Q1 2016 to BRL6.95 in Q1 2017. The driver was a decrease in personnel expense.
Along with higher prices during periods of weak demand, the company’s ability to increase consistently its gross margin points to pricing power.
Selling expenses increased by 2.2% year on year, while administrative expenses decreased by 11.7% leading to an increase in operating profit by 28.9%. The company’s continues to maintain a focus on operational efficiency.
The company’s increased volume and decreased costs led to a 28.9% increase in operating profit. Grendene’s working capital increased by 2.9% year on year, while PP&E increased by 4.3%.
Our initial investment thesis for Grendene was a company that built multiple competitive advantages in the domestic market. Within the domestic market, 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 and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets. The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.
We believe the quality of the business remains but the valuation is no longer as cheap as it once was. At the time of our initial recommendation, valuations were attractive with the company trading on a NOPAT yield of 10.1%, a FCF yield of 8.5%, an EV/IC of 1.6 times. Grendene is now trading at a NOPAT yield of 6.7%, a FCF yield of 6.7% and an EV/IC of 5.0 times at a time of elevated profitability. If we were to normalize margins, Grendene would be trading at a NOPAT yield of 5.3% and a FCF yield of 5.5% making a 5% growth rate into perpetuity necessary for a double-digit return.
The company‘s margin of safety has been eliminated leading us to sell our position and no longer cover Grendene. We will continue to follow its developments, in case valuation become more attractive.
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 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%.
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.
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.
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.
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.
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 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.
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.
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.
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).
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.
Decreasing Grendene Position Size July 28, 2016
We increased our position size in Grendene when its price declined below BRL15.00 per share. The price is now back around where we initiated our position (>BRL17.00) so for consistency we should have a position size close to our initial position size therefore we are decreasing our position size by USD4.5 million but we are only selling if Grendene’s price is above BRL17.00 per share.
There is no change to the investment thesis. Within the domestic market, Grendene is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets. Management are owner operators with a culture of operational efficiency. The expected return in a Grendene investment is still above 15%.
Anta Sports Product July 19, 2016
Closing Price (7/19/2016): HKD17.26
6 Month Avg. Daily Vol. (USD mn): 18.82
Estimated Annualized Return: 11-13%
Anta is the largest Chinese sportswear company with an 11.1% market share. Anta’s size gives it an advantage over all domestic peers as there are fixed costs in the form of advertising and research and development allowing the company to outspend peers on brand building and improving the company’s product. Anta’s size and strong brand allows the company to generate an average pre-tax ROIC over four times its Chinese sportswear peers. The company expected annualized return is somewhere between 11.0%-12.5% leading to an initial 2.0% position size.
Anta was founded in 1994 by Mr. Ding Siren, the father-in-law of the company’s current Executive Director Mr. Ding Shizhong. He incorporated ANTA Fujian and ANTA China in 1994 and 2000 and the company went public in 2007.
The company is a leading sportswear company with an estimated 11.1% market share at the end of 2015.
The company uses a combination of internal production and outsourced production to allow for more flexibility in periods of strong demand. The threat of vertical integration also gives the company bargaining power of its suppliers. In 2015, 49.0% of footwear and apparel is produced internally.
Advertising and research and development are done internally while distribution and retail is outsourced to exclusive partners with the company monitoring operations. At the end of 2015, Anta had 9,080 stores including 7,031 Anta stores, 1,458 Anta kids stores, and 591 FILA stores.
The company has positioned its product as a high performance, value for money brand. It partners with the Chinese Olympic Committee, Chinese Sports Delegation, and many of the Chinese Olympic teams allowing it to be perceived as the Chinese national brand. It is also the official partner of the NBA in China and endorses many NBA players including Klay Thompson, one of the best players on one of the best teams in the league, Chandler Parson, Rajon Rondo, and Luis Scola. The Anta brand is consistently voted the most valuable sportswear brand and one of the top three most valuable apparel brands in China.
In 2015, the company generated 45.6% of sales from footwear, 50.3% of sales from apparel, and the remainder from accessories. Since 2008, Anta grew sales at a compound annual growth rate of 13.4%.
In 2015, gross profit breakdown is similar to sales breakdown with footwear accounting for 45.2% of gross profit, apparel accounting for 51.5% of gross profit, and accessories accounting for the remainder of gross profit.
Anta’s three largest operating expenses are advertising, staff costs, and research and development. Anta spends heavily on advertising and research and development. Over the past four years, the company spent 11.3% of sales on advertising and 4.3% of sales on research and development.
Since 2008, the company’s operating margin averaged 21.5% with low variability. The company’s highest operating margin was 23.3% in 2009 and the lowest was 19.3% in 2012.
Anta has low investment requirements. Since 2008, working capital averaged 6.2% of sales and fixed capital averaged 10.7% of sales meaning invested capital averaged 17.9%. Overall, Anta average return on invested capital is 127.8%.
The Chinese sportswear industry went through a rapid period of growth from 2008 until 2011 supported by the Beijing Olympics. During that period, the industry saw an increase in store count at the largest domestic players from 27,605 stores in 2008 to 40,819 stores in 2011, representing a 13.9% compound annual growth rate (CAGR). Sales at the largest seven players increased from RMB37.63 billion in 2008 to RMB58.35 billion in 2011, or 15.7% per year.
After the period of rapid growth, 2011 to 2014 saw a period of consolidation with the store count decreasing 4.6% per year from 40,819 to 35,428 and sales decreasing 2.7% per year from RMB58.35 billion to RMB53.71 billion.
2015 may have marked the end of the consolidation as started a return to growth with store count stagnating around 35,000 and sales at the seven largest players increasing by 25% from RMB53.71 billion to RMB67.18 billion.
The sportswear industry is one of the most mature segments of the apparel industry and is expected to grow around mid-single digits. Despite the maturity, the sportswear industry is still underpenetrated in China.
Barriers To Entry
In the sportswear industry, size is a key driver of profitability and growth as there are significant fixed costs in the form of advertising and promotion and research and development creating economies of scale. There are many estimates for the Chinese sportswear market size with Fitch’s estimating the market reached RMB100 billion in 2015, which is 5-10% lower than the average of estimates from Euromonitor, Fung Business Intelligence Centre, Research InChina, and ATKearney. The table below illustrates market shares of the largest players in the Chinese Sportswear market assuming a RMB100 billion market size with the market size from previous years estimated to grow at the same rate as the largest players in the market.
In 2015, Nike was the largest sportswear company in China with an estimated 17.1%. Adidas followed in second place with a 17.2% market share. The largest domestic player was Anta with an 11.1% market share. The second largest domestic player is Li Ning with a 7.1% market share. Due to its size and the presence of economies of scale, Anta is competitively disadvantaged to Nike and Adidas but has a competitive advantage to domestic players. From 2010 to 2015, Nike, Adidas, and Anta gained 5.8%, 5.6%, and 1.7%, respectively. The smaller domestic players all lost market share with a cumulative market share loss of 8.0% between 2010 and 2015. Interestingly, Li Ning lost 5.0% of market despite starting the examined period with the second highest market share. With the exception of Li Ning, market share movements point to economies of scale as larger firms spend more on the fixed costs needed to educate customers and improve the product.
The chart above plots market share for each Chinese sportswear competitor compared to their operating margin from 2010 to 2015. Adidas does not report operating margin for China. As shown, there is a strong correlation between size and operating margin with Li Ning’s poor profitability being the only outlier.
Advertising and promotional expense is partially an expense that needs to be adapted to local markets given differences in cultures and tastes creating a need to customize advertising and promotion to adhere to those local cultures and tastes eliminating the size advantage from global markets for Nike and Adidas. A big part of advertising and promotions in sportswear is endorsements of brands by athletes. Endorsements are primarily global as illustrated by Chinese domestic sportswear companies trying to sign NBA stars from the United States rather than relying on local basketball players. Given the global nature of endorsements and the fixed nature of the cost, the true measure of Nike and Adidas’s size are the companies’ global sales giving them a much bigger size advantage than estimated by looking at the local market. Similar to endorsements, research and development in the design of new products is global as the product innovations produced from one market can be used in many other markets, making the true measure of Adidas and Nike’s size their global scale. Nike and Adidas do not report fixed costs on a local basis but the tables below show spending on fixed costs by domestic peers.
Li Ning was the biggest spender on advertising and promotion from 2010 to 2015 although the pace of spending slowed in 2014 and 2015 due to RMB 2.8 billion in operating losses in 2012, 2013, & 2014 allowing Anta to overtake them as the largest spender in advertising and promotion in 2015. From 2010 to 2015, smaller domestic peers spent less than half of Li Ning on advertising and promotion and just over half of Anta.
From 2010 to 2015, Anta was by far the biggest spender on research and development spending RMB2.1 billion almost twice the amount spent by Li Ning and almost five times the average of smaller players.
Despite spending the most on advertising and the second most on research and development of domestic peers and having the highest market share, Li Ning lost 5.0% market share between 2010 and 2015 illustrating that while size is important, execution matters as well. The other big market share losers were the smaller domestic players unable to compete on fixed cost spending. Collectively, Li Ning and the smaller domestic players lost an estimated 13.0% of market share. Nike and Adidas were the largest market share gainers winning 5.8% and 5.6%, respectively. Anta increased its share by 1.7% between 2010 and 2015. Fixed cost spending, market share movements, and the relationship between size and profitability all point to the presence of economies of scale.
Brand advantage is present in the Chinese sportswear market. Brand advantage is often illustrated by premium pricing and market share as it points to a customer’s increased willingness to pay. Many companies do not give the average selling price (ASP) for products sold so tmall.com was referenced. For better comparability, footwear was categorized into running and basketball shoes, two of the most popular sports categories. The tables below illustrate the average selling price (ASP) for each companies top selling shoes.
Nike shoes have the highest average price in both categories at RMB1,083 in the running segment and RMB797 in the basketball segment. Nike’s prices in running are at a significant premium peers with the closest competitor’s ASP at a 64% discount to Nike’s ASP and the average peer price 25% of Nike’s running ASP. In basketball, Nike’s ASP is level with Adidas and roughly three times the average of its other peers. Adidas ASP is a 30% premium to running peers other than Nike and three times the average of non-Nike peers in basketball. The combination of ASP premium for Nike and Adidas and market share advantage points to a significant brand advantage over the remaining peers in the industry.
Anta ASP is at 10% premium to the average price of non-Nike and Adidas peers in running pointing to little or no ASP premium in the running segment. In the basketball segment, Anta’s price is roughly 55% higher than peers other than Nike and Adidas. Anta’s pricing premium with a market share advantage points to a potential brand advantage to competitors other than Nike and Adidas but the evidence is not as strong as the brand advantage held by Nike and Adidas.
Brand advantage should also show up in a gross margin advantage relative to peers as a branded company can charge a higher price as customers have an increased willingness to pay. A higher gross margin may also point to a manufacturing advantage over peers. Given all companies do not report volume statistics; it is difficult to compare manufacturing costs. It is probably difficult to have a sustained cost advantage as much the production function is outsourced. The outsourcing points to no internal costs advantage and the ability of peers to outsource production to the same provider of a competitor. If there were any unique activities within production, it could easily be replicated by peers as there is no complexity or unique processes associated with manufacturing footwear and apparel. The true cost advantage could come from lower labor costs but given the ease of outsourcing that could be obtained from any competitor. Given the production function can be outsourced, there is potential purchasing power from the larger competitors leading to lowering the cost of production.
The chart above plots market share compared to gross margin for Chinese competitors between 2010 and 2015. Nike does not report gross margin for China and Adidas only started reporting it in 2014. As illustrated, there is a strong correlation between size and gross margin with an adjusted R squared equaling 0.787. Unfortunately, higher gross margins due to size can be either purchasing power on raw materials, premium pricing from the ability to spend more on fixed costs in the form of advertising and promotion and research and development, or a combination of both.
There are also many firms estimating brand value of Chinese companies. The Hurun Institute estimates brand value for Chinese apparel companies as illustrated below.
According to Hurun Research Institute, Anta consistently ranks as on the three most valuable apparel brands with an estimated brand value of RMB6.4 billion at the end of 2014, illustrating Anta’s brand strength relative to domestic peers.
Interbrand reports annually Chinese 100 most valuable brands. Anta continually shows up as the highest sportswear brand on the list. Interbrand is much more conservative with Anta’s estimated brand value of RMB3.77 billion at the end of 2015.
Further evidence of Anta’s competitive advantages is seen in its profitability relative to domestic peers.
Relative to domestic peers, Anta had the highest operating margin by 3.5 percentage point with the lowest variability by a very wide margin. Between 2010 and 2015, Anta’s operating margin only decline by 40 basis points. The next best margin decline was at Peak Sports, whose margins declined by 3.7%. The company’s operating margin saw minimal variability with a coefficient of variation of 6.3% below all peers including Nike and a third of the closest domestic peer.
Anta was also by far the most efficient user of capital with an average invested capital turnover ratio of 6.07 with the second best stability behind 361 Degrees.
Anta’s efficient use of capital is driven by its working capital efficiency as there is minimal differential in fixed capital turnover among domestic peers.
Anta big differential with peers is in receivables management with the company turning over receivables 11.7 times in 2011 compared to a peer group average of 4.0 times. Similarly, in 2015, Anta turned over receivables 9.5 times compared to a peer group average of 3.4 times. Anta is almost three times more efficient than peers in managing receivables. The downturn in the industry created receivables issues at most peers but the strength of Anta’s brand, product, and pricing allowed the company to continue to push product through the channel without distributors having any issues selling the product.
Anta’s superior profitability and capital efficiency leads to the highest ROIC every year with the lowest variability. Anta’s pre-tax ROIC is over four times the average of domestic peers.
Profitability well above peers states customers are either more willing to pay for the company’s products or the company manufacturers products more efficient than peers.
The evidence points to barriers to entry in the form of economies of scale and brand with the economies of scale reinforcing the brand advantage as the company can spend more on fixed costs to build its brand by having a greater size. Anta is on the right side of the virtuous feedback loop against domestic peers but on the wrong side of the feedback loop against Nike and Adidas.
Anta has a size advantage and seems to have a brand advantage over other domestic peers but the strength of its advantage is nowhere near the strength of Nike’s and Adidas’ advantages.
Competitive Advantage Period
Economies of scale combined with a brand advantage create very strong barriers to entry as they combine to create a feedback loop that is difficult to overcome. The size advantage allows a competitor to outspend its peer on fixed costs. In sportswear, the fixed costs are advertising and promotion and research and development. These costs build and reinforce a company’s brand creating a feedback loop that is difficult to overcome. Fixed costs, such as endorsements and product development, can be used in many different markets making global scale, the true measure of a competitor’s size, and making it even more difficult for local players to compete.
Nike and Adidas’ competitive advantages should persist for decades. Anta’s disadvantage to Nike and Adidas should continue but its advantage over domestic peers should strengthen over time.
Globally, the sportswear markets are fragmented with Nike and Adidas garnering a 21.1% market share in apparel and a 52.7% market share in footwear. The relative fragmentation of apparel illustrates the apparel market is much more competitive. Given the presence of economies of scale in the sportswear industry, the industry should be more consolidated given fixed costs associated with economies of scale create a minimum efficient scale to compete. It seems some customers are not willing to pay a premium price for a brand and are much more price sensitive. Customers have diverse taste and the larger organizations do not produce goods to cover all tastes in the market. The barriers to entry are not strong and companies can survive with a very lower market share due to the asset light nature of the business.
Anta’s competitive advantage over domestic peers should also continue for decades but profitability will deteriorate as it starts competing with Nike and Adidas. At the moment, it has positioned itself as a brand among the mass market segment, while Nike and Adidas are in the high-end segment making direct competition not an issue for the moment.
Other Four Forces
Intensity of rivalry is high particularly among firms competing for more price sensitive customers as these customers are only worried about price making operating efficiency the key strategic goal within this segment. For firms competing more on brand, their offering is differentiated making the intensity of rivalry less intense.
Although the sportswear industry is fragmented, suppliers in the form of sportswear manufacturers are typically smaller, more fragmented, and at risk of vertical integration leaving them with very little bargaining power. In the case of companies that manufacture their own products, raw material suppliers are commodity producers that are very fragmented and sell their product solely on price.
Suppliers of labor seem to have bargaining power over the sportswear companies. From 2010 to 2015, Staff costs have increased as a percentage of sales at all Chinese sportswear companies by a minimum of 2.3%. The rise in cost points to employees having bargaining power over suppliers.
Customers in the form of distributors are fragmented and in the case of Anta are exclusive sellers of Anta’s products. The fragmentation and exclusivity greatly decreases the bargaining power of customers. While the bargaining power of distributors is low, Anta relies on the distributors to sell their products; therefore, they are more partners whose health is vital to Anta.
The threat of substitutes is high for more casual sportswear as customers can easily switch and buy similar product from more fashion oriented companies. More performance oriented sportswear has a lower threat of substitution as athletes are less likely to give up on performance features.
Anta’s executives are owner-operators with five of the executive directors owning at least 6% of the company allowing management incentives to be aligned with minority shareholders.
The company’s strategy is to be the leader in the value for money segment by having a stronger brand and more innovative products than peers competing in the value for money segment. The company strategy has been consistent since their IPO. Management understands the key strategic drivers in the industry spending the most among domestic peers on fixed costs to build a brand and improve products allowing the company to continually win market share allowing the feedback loop of greater size allowing for greater spending on fixed costs to build a brand and improve products to continue.
Over the last five years, ANTA outperformed peers on all key value drivers. It comes out on top in sales growth, operating profit growth, operating margin, capital efficiency and its ROIC is more than double its closest competitor. It comes in second only in gross margin to Li Ning.
As illustrated, with the exception of Li Ning, Chinese sportswear companies were able to generate an average pre-tax return on invested capital of 51.9% between 2010 and 2015. Anta’s average pre-tax ROIC was four times the average of its peers over that time due to higher margins and capital efficiency.
From 2010 to 2015, the average operating margin in the Chinese sportswear industry averaged 13.1% with Anta averaging 21.0% and its peers averaging 11.0%. Peers were dragged down by Li Ning with Anta having only a few percentage points edge over XTEP and Peak Sports. Although Anta had a small advantage in average operating margin, the company’s stability is far superior to the peer group.
Anta’s IC turnover surpassed domestic peers IC turnover by a wide margin, averaging 6.07 times compared to a peer group average of 3.00 times.
Overall, management is executing its value for money strategy much better than peers leading to market share gains and profitability much higher than peers.
Capital allocation cash flow is operating cash flow + working capital + advertising and promotion expense + research and development expenses. Capital allocation cash flow is the amount of cash flow available for capital allocation decisions.
Advertising is the largest capital allocation decision at 34% of capital allocation cash flow. Given the company’s size advantage over peers and the importance of brand in the industry, advertising expenses should be maximized. The company is doing a good job taking advantage of its market share and outspending peers on fixed costs but with a net cash position of roughly 2.25 times operating profit the company could increase advertising expenses.
The second largest capital allocation decision is the payment of dividends accounting for 33% of capital allocation cash flow. Given the asset light nature of the business and the company’s net cash position, higher dividends could be paid.
The third largest capital allocation decision is research and development accounting for 11% of capital allocation cash flow. Research and development is a fixed cost to improve the product and the company’s brand, given the company’s size advantage and the ability to build a brand from product innovations, Anta could increase its research and development as it has a large net cash position.
All other capital expenses are minimal with working capital investment and capital expenditures combine to 10% of capital allocation cash flow.
The company made two acquisitions between 2008 and 2015 equaling 2% of capital allocation cash flow. Both times the company paid book value. In 2009, the company purchased the right to distribute FILA in the greater China area. At the time, the acquired company was losing making. The company does not segment out sales and profits by brand so we unable to determine how good of an acquisition it was. The acquisition does not makes sense strategically. FILA is a high end brand that is more fashion oriented. The high end nature puts in direct competition with Nike and Adidas, while its fashion orientation makes it more open to competition from more fashion oriented clothing. If the company’s goal is to be the leading value for money brand, the FILA acquisition brings the distraction of worrying about a high end product that does not provide any additional size advantage. Also, given you have little or no input into product innovation and marketing, the key activities in the sportswear value chain are out of the company’s control.
Overall, the company has made no major capital allocation missteps. The biggest misstep is having a net cash position equal to 2.25 times 2015 operating profit. The company has a size advantage over all players within its segment and ideally the company would increase spending on either advertising and promotion or research and development. If the company believes it is at the optimal level of spending on fixed costs it could increase dividends paid.
The company’s related party transactions are insignificant. Quanzhou Anda is a related company that provides packaging, while the service fee to Mr. Ding Shijia is related to lease payments for the use of facilities.
Since 2010, the top five highest paid employees’ average pay was only 0.75% of operating profit. The company’s management is not extracting too much value from salaries on an absolute basis. Below 1.0% is actually extremely good value given the strength of management strategically and operationally. Relative to the industry, Anta has the lowest salaries relative to operating profit and sales.
Anta’s accounting assumptions are in line with peers across the board so there are no concerns over inflated earnings due to accounting assumptions.
Given Anta is competitively advantaged against the Chinese sportswear companies, the best valuation method is an earnings based valuation. In case of Anta competitive advantage does not exist, reproduction value would be the best method of valuing the company. If the industry were not viable, liquidation value would be the best valuation technique.
As illustrated above there is 83% downside to liquidation value and 55% downside to reproduction value.
The key assumptions used in the earnings based valuations are the discount rate, sales growth, operating margin, tax rate, working capital turnover, and fixed capital turnover. The discount rate, tax rate, working capital turnover, and fixed capital turnover are assumed to be constant at the values below.
We always assume a discount rate of 10%, a regulatory tax rate of 25%, an average working capital turnover of 40.9 times, an average fixed capital turnover of 9.5 times. Working capital turnover and fixed capital turnover averages are from 2008 to 2015.
Sales growth and operating margin are assumed to vary to get an understanding of what the market is pricing in. The values of sales growth and operating margin for each scenario are listed below.
The target prices for 2016 and 2021 along with their upsides are illustrates below.
The worst case scenario is assumed to be zero growth into perpetuity with operating margin compressing from the current 22.5% to a 19.3%. Under the worst case scenario, the 2016 target price is HKD11.76 leading to 32% downside and the 2021 target price is HKD14.65 leading to 15% downside. The most optimistic scenario assumed 15% growth over the next five years before fading to a 5% terminal growth rate with average operating margins since 2008. Under the most optimistic scenario, the 2016 target price is HKD31.60 representing 83% upside and the 2021 target price is HKD50.58 representing 193% upside.
Overall, the average 2016 target price is HKD19.12 representing 11% upside and the average 2021 target price is HKD27.11 representing 57% upside. There company offers a decent average return. The average return seems a bit conservative with a more reasonable base case between 5% perpetuity growth and average margins and 10% forecast period growth fading to 5% terminal growth with average margins. The 2016 target price and 2021 target price for the lower end of the base case is HKD21.87 and HKD30.59 representing 27% and 77% upside, respectively. The 2016 target price and 2021 target price for the upper end of the base case is HKD26.14 and HKD39.34 representing 51% and 128% upside, respectively. Under the base case, there is just about 15% annualized return, the company is slightly undervalued.
On an expected return basis, assuming a return on reinvested earnings of 50% and an organic growth rate of 2.5%, less than half of the company’s current ROIC, the company’s expected return in 16.5% as the company has a NOPAT yield of 5.1%, 2.8% of which is paid in dividends and the remaining 2.2% is reinvested.
The company has a current free cash flow yield of 3.3% with expected growth of roughly 7.5% leads to a 10.8% expected return.
The company is slightly undervalued and offering roughly a 12% annualized return at the lower end of the base case scenario, which is confirmed with expected return of roughly 10.8%.
If perceived barriers to entry do not exist, the company’s profitability would be less sustainable than originally expected and the company’s valuation would suffer potentially causing a permanent loss of capital as the company is trading above its reproduction value.
If Adidas and Nike are able to attack the mass market segment without hurting their premium brand image, Anta could find itself on the wrong side of economies of scale.
Li Ning was once larger than Anta but lost market share over the past five years and is suffered significant losses over the past few years. These losses forced Li Ning to cut back on advertising and research and development. In 2015, the company returned to profitability and soon it could find the formula that made it a market share leader increasing competition for Anta.
Given economies of scale are present in the industry, market share is one of the most important variables in profitability. If Anta loses market share, it will not be able to spend on crucial fixed costs of advertising and R&D leading to weaker brand and product and more market share loses.
Management has done a good job of allocating capital and executing operationally but if they stop taking advantage of their size over smaller domestic peers by decreasing spending on fixed costs or become inefficient operationally, profitability will suffer.
Advertising and brand building is a crucial to achieving excess returns. If the company overpays endorsers, excess returns could fade.
Anta is in the consumer goods industry and if the macroeconomic situation deteriorates in China, consumers could stop buying sportswear.
The more fashion oriented sportswear faces competition from non-sportswear apparel makers.
Anta outsources part of its production and all of its distribution and retail activities. If value chain partners do not perform then the company’s image may be hurt.
Anta’s corporate governance is not an issue. If management starts extracting more value from related party transactions and high executive pay, the company’s multiple will suffer.
Credit Research and Analysis June 20, 2016
Closing Price (6/20/2016): INR993.50
1 Year Avg. Daily Vol. (USD): 530,269
Estimated Annualized Return: 8-9%
Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market. The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case. We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.
Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue. Rating assignments generates two types of revenue: rating revenue and surveillance revenue. Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.
Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt. Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan. If a loan it not rated, it retains a capital risk weight of 100%.
The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital. Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.
As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.
Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits. Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.
As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers. It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.
Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets. New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures. The company can also move into adjacent product market like research and advisory services. CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.
CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.
IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.
CRISIL, the first India credit rating agency, was established in 1987. ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.
In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.
In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.
Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.
Barriers to Entry
The industry structure points to barriers to entry. There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market. The market share among the top three players since FY2006 is illustrated below.
CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).
The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.
CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million. The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.
The rating agencies seem to lack pricing power pointing to no barriers to entry. The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power. The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.
CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.
Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies. ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms. The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.
Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment. If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.
Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.
Other Four Forces
The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA. In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue. Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.
The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense. The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market. Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699 to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline. CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.
The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated. A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.
Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power. The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.
The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings. Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm. Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.
Operationally, management has performed very well. It is increased its market share among the top three rating agencies by almost 10% over the past ten years.
The company is also the best performing credit rating agency in terms of operating profit per employee.
ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.
Management has done a good job on focusing on the ratings business. CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses. These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital. CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years. ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.
The only other capital allocation decision made by management is whether to hold cash or payout cash. Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.
Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.
Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.
There are no related party transactions other than management remuneration. Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.
There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.
Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.
Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense. The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.
Under the blended valuation, we use different scenarios to determine potential upsides and downsides. The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.
Sales growth and operating margin are changed to determine upside under different scenarios. The scenarios and assumptions for both value drivers are listed below.
The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.
The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.
The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside. The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.
The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.
The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.
Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation. The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India. Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.
CARE seems to be slightly undervalued to fairly valued.
The biggest risk to CARE’s business is reputational. After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated. During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value. S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.
Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.
Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.
There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.
Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.
After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.
CARE is managed by external agents rather than owner operators. If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.
CARE investment thesis and price paid is based on the development of banking and credit markets. If banking and credit markets do not develop, there may be permanent loss of capital.
CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital. To combat this risk, we are taking a small starting position.
Turk Tuborg: A Turkish Brewer in a Duopoly offering an 8.0% NOPAT Yield
Türk Tuborg is the second largest company in a Turkish Beer market that is a duopoly. Along with Anadolu (Anadolu), the two companies have controlled over 99% of the market for many years. There are significant barriers to entry in the form of economies of scale and brand as the Turkish Beer market requires a two way distribution system and there are restrictions on advertising. Türk Tuborg has outperformed Anadolu increasing its market share from 11.5% in 2010 to 31.4% in 2015. The company also increased its pre-tax ROIC significantly from -3.3% in 2010 to 95.2% in 2015. These improvements came just after new ownership introduced a number of new products to the market. The company offers an 8.0% EBIT yield with pricing power leading to an expected return of 13.0% per year, which is attractive given the barriers to entry in the market and the company’s outperformance under current management.
- Expected annual return between 13.0%-15.5%
- We will initiate a 4.0% position in Turk Tuborg.
Türk Tuborg was founded in İzmir-Pınarbaşı in 1967 with production starting in 1969 through a partnership between Tuborg and Yasar Holding Production. Carlsberg took a majority shareholding of Türk Tuborg in 2001 increasing its stake from 2.24% to 50.01% after purchasing 47.77% from Yasar Holding. This transaction valued Türk Tuborg at roughly USD110 million (DKK960 million). Over the course of the next few years, Carlsberg continued to increase its stake until reaching 95.69% in 2003. In 2008, Israel Beer Breweries Ltd, a Carlsberg partner in Israel and Romania, purchased 95.69% stake from Carlsberg for USD44.5 million valuing Türk Tuborg at USD80 million. After the purchase, Türk Tuborg retained its license to continue to produce Carlsberg and Tuborg brands. The 4.31% not owned by Israel Beer Breweries is free float with the company listed on the Borsa Istanbul.
Türk Tuborg owns one of the largest breweries in Turkey with 36,000 tons of malt and 333 million liters of beer capacity. The company produces Tuborg (Gold/Amber/Special/Fici), Carlsberg, Skol, Venus Pilsner, and Troy Light for both Turkey and export markets. The company also produces Vole, Thelch, and F5 for export markets. Türk Tuborg also imports Leffe, Hoegaarden, Guiness, Corona, Weihenstephan, Kilkenny, and Somersby.
Türk Tuborg’s products are sold through direct sales and dealers all over Turkey. Corona, Leffe Brune, Leffe Blonde, Leffe Radieuse, Hoegaarden, Weihenstephan, Kilkeny, and Guinness brands are positioned at the super premium beer segment. Carlsberg brand is positioned at the premium beer segment. Tuborg Gold, Tuborg Fici, and Tuborg Special brands are positioned at the standard segment, while, Skol and Venus brands are positioned at the economical beer segment in 2015.
In 2015, Türk Tuborg was the second largest player in the market with a 31.4% volume share of the Turkish beer market behind Andalou’s 68.4% volume share.
In 2011, Türk Tuborg launched the Türk Tuborg Brewmaster project with the goal of delivering product variety to Turkish consumer. The company introduced super premium brands Corona, Guinness, Leffe, Weihenstephan, Kilkeny, and Hoegaarden. The project has help increase the company’s volume share in the Turkish beer market from an estimated 11.0% in 2010 to 31.4% in 2015.
Barriers to Entry
Within the Turkish beer market the evidence points to significant barriers to entry.
- Türk Tuborg and Anadolu have accounted for over 99% of the Turkish beer market for many years. At the end of 2015, these two companies represented 99.8% of the market. The high and consistent market share points to no significant new entrants or exits from the market. The duopolistic market structure with a no significant entry or exit from the industry points to significant barriers to entry. Heineken attempted to enter the Turkish beer market, but withdrew in 2006 as it was unable to reach the minimum efficient scale needed to compete.
- Distribution is a significant barrier to entry. In 2012, 64% of Turkish beer volume was returnable bottles and kegs making a two way distribution system a requirement to compete in the Turkish beer market increasing the investment requirements and complexity of the required distribution network.
- The distribution network required to compete also points to economies of scale as distribution is a fixed cost independent of units sold. Over the past five years, Türk Tuborg has averaged roughly TRY155 million per year in selling, distribution, and marketing expenses. In 2015, both Türk Tuborg (TRY134.3) and Anadolu (TRY137.6) had a gross profit of roughly TRY135 per hectoliter. Just to cover the fixed costs associated with Türk Tuborg’s distribution, a competitor would need to achieve 12% market share.
- There are significant advertising restrictions on beer and other alcohol decreasing a new entrant’s ability to building a brand. There is no alcohol advertising on television or radio. Also, alcohol companies cannot sponsor any sports team and, similar to smoking, all alcohol on television or in movies is blurred.
- Türk Tuborg seems to have significant pricing power. Since 2008, Türk Tuborg has been able to increase its average selling price by 7% per year. The company’s cash gross margin has increased from 49.0% in 2008 to 60.1% in 2015.
- Total Turkish beer market volume has not grown since 2008, decreasing the attractiveness of the market, and increasing the difficulty of entering the market as lower growth often leads to increased competitive rivalry.
- Türk Tuborg has little or no working capital requirements. In 2014 and 2015, working capital per unit has been negative and averaged TRY63 million. Negative working capital is a strong sign of a company’s bargaining power over both its suppliers and customers.
While the evidence pointing to barriers to entry are strong, there is evidence against barriers to entry.
- Türk Tuborg’s recent profitability has been strong with a ROIC averaging over 100% over the past two years, but from 2008 to 2011 ROIC averaged 0%. The lack of inconsistent ROIC is evidence against a competitive advantage.
Overall, the evidence overwhelmingly points to significant barriers to entry that would take years for a new competitor to reach the necessary scale to compete.
Given the evidence points to the presence of barriers to entry, what form do they take? Barriers to entry take the form of economies of scale and brand. Economies of scale are in the form of a two way distribution network that requires a minimum efficient scale of roughly 12.0% just to replicate the smaller of the two large competitors’ annual spend on selling and distribution expenses. Additionally, large breweries require expensive equipment that is much cheaper on a per unit basis if the depreciation is spread over many units. Additionally, larger brewers can acquire raw materials and package goods cheaper due to the size of their purchases.
Brand advantage also exists. The restrictions on advertising help existing brands as new entrants cannot build a brand to displace incumbents making brands with an existing relationships and positions more resilient and less resistant to change.
Intensity of Rivalry
Given the duopoly within the Turkish beer market, the intensity of the rivalry between will be a significant factor in determining industry profitability. The industry rivalry seems low. Since 2011, Türk Tuborg has raised prices on average by 8.4% per year while Anadolu has raised prices on average by 8.0% per year. Since 2008, Türk Tuborg has raised prices on average by 7.2% per year while Anadolu has raised prices on average by 7.1% per year. Price inflation has been during a period of increasing excise tax. If the intensity of the rivalry was high, both firms would not have increased prices in an attempt to gain market share given the importance of economies of scale in the industry.
The presence of economies of scale in the industry points to increased intensity of rivalry as one of the drivers of profitability is your size or market share leading competitors to attempt to maintain or increase their share to maintain profitability.
(Capex)/depreciation ratio is used to determine the amount of supply in the industry. If capex exceeds depreciation, industry participants are increasing supply. If supply increases outpace demand profitability will suffer. Currently, the Turkish beer industry volumes are not growing with total volume estimated at 9.67 million hectoliters since 2008. The lack of growth in and of itself typically increases rivalry but with the duopoly it is easier to keep track your one competitor making coordination easier. Despite the lack of growth, the industry capex/depreciation ratio has averaged 134%. A more appropriate capex/depreciation ratio for a no growth, mature industry is somewhere below 75% as less investment goes to the industry leading to depreciation exceeding capex. The capex/depreciation ratio may point to increased rivalry as competitors attempt to fill their new capacity.
The participants sell products that are similar but are differentiated in the form of taste and brand decreasing competitive rivalry as price is an important but not the sole factor in purchasing the good.
Anadolu net debt has ballooned from 0.8 times EBIT in 2011 to 6.1 times EBIT in 2015. The change in fortunes occurred when SAB Miller and Anadolu created an alliance with Anadolu acquiring some of SAB Miller’s assets in the region and SAB Miller taking a 26.5% stake in Anadolu. The increase geographical presence and increased debt decreases the Anadolu’s flexibility, but it may lead to an increase intensity of rivalry as Anadolu’s Turkish beer operations are not generating sufficient operating profit to cover interest expenses.
Türk Tuborg’s market share gains also can just after the launch of Türk Tuborg’s Brewmaster project. The increased product offerings may be striking a cord with customers that Anadolu is unable to replicate.
Overall, the intensity of rivalry in the industry is low and expected to remain low but this may change given Anadolu’s market share losses, profitability declines, and increasing debt load.
Bargaining Power of Suppliers
Suppliers have very little bargaining power. The main inputs into beer are commodity products sold by many sellers where the customers are pure price takers. This bargaining power is reduced further by the duopolistic nature of the market. Barley largest use is not beer but animal feed, which accounts for 67% of consumption. Industrial uses such as beer are the next largest consumer of barley accounting for 21% of total consumption. The variety of uses for barley increases the bargaining power of suppliers. Hops on the other hand are primarily used for beer. The United States is seeing high demand for hops due to the trend towards craft beer, as craft beer uses much more hops that traditional beer. Turkey is not seeing the trend toward craft beer therefore there is a lot less pressure. Hops have less uses and there is much fewer uses for the product decreasing its bargaining power. Overall, due to the commodity nature of inputs, the numerous suppliers of these products, the limited uses of the products, and the duopoly in the Turkish beer market suppliers have very little bargaining power.
Bargaining Power of Customers
The customers of Anadolu and Türk Tuborg are dealers, distributors and large retail chains. In 2012, off-premise accounted for 61.5% of sales in the Turkish Beer market, on-premise accounted for 23.2% of sales, and key accounts accounted for 15.2% of sales. Off-premise and on-premise are serviced by dealers and distributors. In 2014, Anadolu had a network of 170 dealers and 27 distributors in 15 sales regions. The number of dealers and distributors illustrated the fragmented nature of the customer base decreasing the bargaining power of customers.
Similar to bargaining power of suppliers, the duopoly and differentiated products decreases the bargaining power of customers combined with the fragmentation of the customer base leads to low bargaining power of customers.
Threat of Substitute
The main alcohol substitutes for beer are wine and spirits. In 2012, Beer accounted for 58% of alcohol consumption within Turkey, spirits accounted for 33% of alcohol consumption, and wine accounted for 9% of alcohol consumption. Beer is the cheapest of all alcohol at a cost of TRY11.26 per liter, wine is the next cheapest at TRY54.67 per liter, and spirits are the most expensive with raki costing TRY73.48 per liter. While wine and spirits are substitutes for beer, personal preferences are probably the biggest impediment to substitution. Additionally, the significantly higher cost of wine and spirits makes substitution unlikely.
As mentioned, volumes in the Turkish Beer market have stagnated at 9.66 million hectoliters since 2008. During this period, Türk Tuborg’s revenue increased by 23.69% per year driven by increased volumes (15.41% CAGR) and increased price (7.17% CAGR). Despite the lack of volume growth, Türk Tuborg’s volumes increase from 1.1 million hectoliters in 2008 to 3.0 million hectoliters in 2015 with growth coming at the expense of Anadolu’s volumes (8.5 mhl in 2008 to 6.6 mhl in 2015). Given the lack of volume growth in the market, growth from volume increases will eventually slow as Anadolu should retaliate in an attempt to win back volume share given the importance of economies of scale on profitability.
Türk Tuborg’s ASP (7.2% since 2008) increases are more sustainable given the duopoly in the Turkish Beer market and the relative cheapness of beer to substitutes.
Many often quote Turkey’s low per capital consumption of beer and alcohol as a potential source of growth. Turkey consumes beer at 17% of the EU average. This statistic is misleading as Turkey is predominantly Muslim and there are estimates between 40% and 80% of the population do not drink alcohol, which is unlikely to change. Assuming 75% of the population does not drink alcohol, the per capita consumption is 67% of the EU average for beer consumption. With a religion that forbids alcohol consumption playing a large role in the society, there is not going to be a significant growth from increased per capita consumption. Additionally, the current ruling party has a religious slant and has increasing excise tax and advertising restrictions in an attempt to “protect” the public from themselves.
There is a potential for increased penetration of beer companies’ distribution channel as there are only 1.1 off-premise outlets per 1,000 people well below regional peers.
In 2008, Israel Beer Breweries Ltd, a Carlsberg partner in Israel and Romania, purchased 95.69% stake from Carlsberg from USD44.5 million giving Türk Tuborg a total enterprise value of USD80 million. The company is owned by Central Bottling Company, which has held the Israel franchise for Coca Cola products since 1968.
Israel Beer Breweries has done a good job of increasing the intrinsic value of the company since acquiring its ownership position. Since 2008, revenues have increased by 23.69% per year as volumes increased by 15.41% per year and prices increased by 7.17% per year. The volume increases are particularly impressive given volumes have not grown in the Turkish Beer since 2008.
The company has significantly outperformed its main rival Anadolu. Since 2011, Türk Tuborg has taken almost 19% volume share, increasing its share from 12.5% to 31.4%. Over that period, the company’s ROIC increased from 1.1% to 95.2% while Anadolu’ Turkish Beer operation’s ROIC decreased from 76.5% to 29.3%, illustrating the importance of economies of scale on profitability.
Since 2008, Türk Tuborg’s ASP premium averaged 5.9%.
Türk Tuborg’s market share gains came during a period where the ASP premium declined.
It seems Türk Tuborg’s products are viewed as premium products by the public given the consistent ASP premium relative to Anadolu. With Türk Tuborg prices decreasing relative to Anadolu, consumers may see themselves getting a higher quality product at a more attractive price. The price premium returned in 2015, yet Türk Tuborg continued to gain market share, which seems to invalidate the theory of consumers purchasing due to the decrease in Türk Tuborg’s premium.
Over the review period, Türk Tuborg’s cost of goods per unit increased by 3.7% while Anadolu’ cost of goods sold increased by 14.3%. Anadolu’ Turkish Beer operations still produce goods cheaper than Türk Tuborg but there has been a significant convergence of costs. Anadolou producing goods cheaper makes sense given the presence of economies of scale in the industry allowing the company to obtain a discount for raw materials purchased in bulk and spread depreciation over a greater number of units.
Since 2011, Türk Tuborg has been able to decrease operating expenses per unit by 1.9% per year while Anadolu’ operating expenses have increased by 10.1% per year. Türk Tuborg is much more operational efficient with operating expenses per unit at TRY74.6 compared to Anadolu TRY93.4. In 2011 and 2008, Anadolu’ operating efficiency was well ahead of Türk Tuborg’s but declining volumes and cost inflation lead to the increase in operating expenses per unit increased.
Türk Tuborg’s operating efficiency is the key differentiator allowing the company to generate an operating profit per hectoliter that is 35% greater than Anadolu, not an insignificant gap.
Türk Tuborg also has a big advantage on capital efficiency in 2015 as working capital per unit is TRY-23.4 compared to TRY76.5 at Anadolu. Fixed assets are similar with Anadolu having a slight advantage as expected given the presence of economies of scale as larger breweries can spread fixed capital investments over a larger number of units. As the volume differential has shrunk, so has the difference in fixed capital efficiency.
Overall, Türk Tuborg’s ROIC is much higher than Anadolu in 2015 at 95.2% compared to 29.3%, a change from 2011 and 2008 where Anadolu’ ROIC averaged 82.4% compared to an average ROIC of -6.2% at Türk Tuborg in 2011 and 2008.
Overall, management has done well operationally increasing volumes, ASP, operating margins, capital efficiency, and ROIC.
The company has not allocated capital to anything but the business. There have been no dividends meaning net debt has decreased from TRY42 million to a net cash position of TRY313 million. Cash is starting to build up on the balance sheet at almost 2 times operating income so the company could start returning that cash to shareholders in the form of a dividend.
There are no corporate governance issues other than related party transactions at 5.8% of sales and 4.8% of assets but it is nothing too significant.
Given the existence of the barriers to entry, the best method of valuing Türk Tuborg is based on earnings. Our preferred valuation method is IRR, using the company’s current free cash flow yield plus expected growth. At the close of business on May 20, 2016, the company was trading on a current free cash flow yield of 5.4%. Given the pricing power in the industry the company can expect at least 5.0% increases in prices and if it can continue to grow volumes at 5.0% per year than it offers a 15.3% expected return.
Valuing the company using current EBIT yield plus and organic growth rate, the company is trading on an EBIT yield of 8.0% with pricing growth of 5.0% bring the current expected return to 13.0%. Given the strength of the barriers to entry within the industry, a 13.0-15.0% return using conservative estimates is very attractive.
Why is it Cheap
The stock is cheap due to economic and political issues within Turkey. It also has a very small free float and illiquid with an average trading volume of USD137,000 over the past six months.
Türk Tuborg has been gaining market share and outperforming Anadolu significantly. Anadolu Turkish beer operations have seen deteriorating profitability. The combination of market share gains and deterioration of profitability may lead to Anadolu increasing the intensity of rivalry to win back market share and profitability.
Turkey has one of the highest excise taxes on alcohol in Europe, which is 3.91 times the European average. This is making alcohol more expensive and suppressing demand in the country leading to the stagnation in volume since 2008. From 2002 to 2013, Turkish excise tax increased by 6.63% per year. Given the ruling party’s religious slant, it would not be a surprise to see a continuation of excise tax increases.
There are increasing restrictions on alcohol in Turkey. Retail alcohol sales licenses are limited between the hours of 10 am and 6 pm, as well as completely ban alcohol advertising and promotions of alcohol-related products. New licenses for the sale of alcohol are restricted. There is an ever increasing shift towards prohibition.
There is political risk in Turkey with it becoming more dictatorial. The increasing restrictions on freedom may bring a reaction.
A slowdown in macroeconomic growth or tourism is a short term risk.
Honworld May 6, 2015 Cheap Financing or Something Else?
On May 6, 2016, Honworld Group announced a RMB133 million investment in its wholly owned subsidiary Lao Heng He from CD Fund in exchange for an estimated 3.5% of Lao Heng He’s capital. The actual percentage that CD Fund receives will be determined by a valuation report that will be released over the next three months. The funds will be used to construct a natural ecological brewing production base in Wuxing Area, Huzhou City, Zhejiang Province, PRC (the investment project).
The transaction is conditional upon the satisfaction of the following conditions:
- from the date of the Investment Agreement to the date of the Completion, there is no material adverse event that will adversely impact on the business prospects, assets, and financial condition of Lao Heng He;
- the articles of association of Lao Heng He has been amended according to the terms of the Investment Agreement;
- all internal approvals of Lao Heng He, Huzhou Chen Shi, Honworld, and Huzhou Nantaihu with respect to the entry of the Investment Agreement have been obtained;
- Lao Heng He has obtained the relevant undertaking documents from Huzhou City Wuxing Finance Bureau for the Investment Project;
- Lao Heng He has obtained the approval from the relevant local government authorities for the Investment Project; and
- CD Fund completing its due diligence on Lao Heng He. Use of Proceeds Lao Heng He shall ensure that all proceeds of the Capital Investment to be used in the implementation of the Investment Project.
Honworld’s wholly owned subsidiary, Huzhou Chen Shi agreed to repurchase the equity interest of Lao Heng He to be owed by CD Fund within 8 years after the payment of the Capital Investment. CD Fund is according to the repurchase schedule under the Investment Agreement. Under the agreement, the CD Fund with receive minimum returns of a dividend at an annual rate of return amounted to 1.2% of the Capital Investment. No dividend payments need to be made by Lao Heng He until 20 March 2018. On 20 March 2018, the CD Fund shall be paid the total dividend accumulated then the CD Fund will be paid a yearly dividend on or before 20 September every year after 20 March 2018.
Lao Heng He is a wholly-owned subsidiary principally engaged in the manufacturing of cooking wine, soy sauce, vinegar, soybean sauce products and other condiments products. Lao Heng He’s unaudited key income statement accounts are below.
In 2016, the company accounts for 97% of Honworld’s revenue, 97% of its net profit before tax, and 89% of its total assets.
CD Fund, a wholly-owned subsidiary of China Development Bank, was established on 25 August 2015 and is principally engaged in the investment of financial bonds.
The investment will be reported as a financial liability on the company’s balance sheet as there will be no gain or loss as the company can repurchase the equity interest.
Assuming it was a straight investment in the company, it values Lao Heng He at just over 14 times pre-tax profit. The deal seems like a very cheap way of funding the company’s investment assuming it can repurchase the investment at a cost in eight years. It also avoids diluting the company’s existing shareholders through rights issues or issuing additional shares to raise capital needed. The company provided no additional details about the investment project.
As highlighted before, the company’s focus on maintaining such a high inventory level is not allowing the company to self fund its growth. The vast majority of the company’s inventory is work in progress and the gross margin generated on aged products does not cover the cost of ageing products leading to a lower ROIC for the company, as illustrated in our initiation report.
This event has little change on our view that Honworld has a strong brand and economies of scale giving it a very strong competitive advantage. The company is growing very rapidly and is run by a passionate owner operator with the only downside being the allocation of capital to inventory. We are in the process of decreasing our position size but as stated we are not selling below HKD5.00 per share.
Below is a link to the Grendene, formerly known as Company 11/29/2015, initiation report from November 19, 2015.
Grendene is a Brazilian plastics manufacturer and one of the largest footwear producers in the world. The company built multiple competitive advantages in the domestic market and the company is trying to replicate these advantages in the export market. Within the domestic market, 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 and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets.
The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.
Despite the company’s strengths, there is upside to the bear case scenario of no growth and trough margins with the company trading on a 10.1% NOPAT yield and an 8.5% FCF yield. Total estimated annualized return over the next five years is 15-17%. Grendene seems to be undervalued.