Tag Archives: Portfolio Construction

Turk Tuborg & GMA Holding Position Sizes 11/6/2017

Turk Tuborg & GMA Holding Position Size 11/6/2017

 

Turk Tuborg’s position decreased 5.1% on May 12, 2017 when there was the first sales with a goal of reaching 2.0%.  The share price has increased and the stock is illiquid. The current position is 3.2%. There will be no further selling.

There is a similar liquidity issue with GMA Holding.  There will be no more buying and the GMA Holding position.  It is a 6.4% position.

Both are high quality companies that can be held for five years regardless of stock market liquidity.

The latest recommendation size of 6.0% was completed over 7 days.

Future recommendations will be in more liquid stocks. The lower limit for 6 month average daily volume will be USD100,000 in the most attractive of situations but more likely it will be above USD250,000 average daily volume.

 

 

 

New Research Report October 19, 2017

I have produced a new research report on a very liquid high quality retailer with seems to have a few competitive advantages and offers a 16.3% expected return using conservative assumptions. It will start with a 6% position size in our model portfolio.  If you are interested in the report please contact me at marcmelendez@reperiocapital.com

GMA Holdings Position Size 10/2/17

GMA Holdings Position Size 10/2/17

GMA Holdings position size is increasing to 10.0% with Reperio Capital’s model portfolio as the company is an industry that has strong barriers to entry in the form of economies of scale from content creation costs. Profit growth and free cash flow growth within the industry should mirror GDP growth due to barriers to entry and a mature industry.  Currently, revenues, operating profit, and free cash flow are showing negative growth year on year due to one-off political advertisements last year.

The market currently values the company on a EBIT yield and FCF yield of 18.4%.  Assuming the company grows below expected GDP growth (6.5%) at 5%, the expected return is over 23%.

PC Jeweller & Anscor Position Size 10/2/17

PC Jeweller & Anscor Position Size 10/2/17

The company continues to execute with strong growth in showrooms leading to good growth in sales and profitability. PC Jeweller’s share price increased by 33% over the past four months leading to an increase in valuations. The company now trades on an NOPAT yield of 4.4%.

 

The fragmentation in the market points to a lack of barriers to entry. PC Jeweller’s gross margin similar to its competitors indicates its products are undifferentiated and customer are not willing to pay a premium. The company’s capital efficiency is also on par with competitors meaning capital efficiency is not the source of excess returns. Gross margin return on inventory tells a similar story. Meaning, operational efficiencies are the driver of the PC Jeweller’s excess returns. Its operating expenses averaged 4.1% of sales over the last five years lower than any other jewelry company analyzed.

 

Operational efficiency is replicable but it is very difficult as processes and values within an organization are difficult to change, therefore, PC Jeweller’s excess profitability should persist for some time. This is backed up by the ability of the company to maintain strong profitability during the latest industry downturn. Further, the organized portion of the segment accounts for only 30% of the industry so competition is currently primarily against weaker peers. Despite the likely persistence of excess profitability, a NOPAT yield of 4.4% requires a persistence growth over 10% into perpetuity with no working capital or fixed capital investment for an investment in PC Jeweller to meet the required rate of return of 15%. The PC Jeweller position is being sold.

 

A Soriano Corporation is also very illiquid. Reperio’s model portfolio has been purchasing shares since inception and it has only reached 0.5% of the portfolio.  There will be no futher purchases or posts until the position size changes. All recommendations will meet minimum liquidity requirements.

PC Jeweller FY2017 Results 6/1/17

PC Jeweller FY2017 Results Review June 1, 2017

 

PC Jeweller reported FQ4 2017 & FY2017 results. The company continues to perform well in a difficult operating environment due to regulatory measures. FY2017 saw demonetization and a stricter regulatory environment including high value purchases require a pan card, and imposition of an excise duty. The company also issued preferred shares to DVI Mauritus and Fidelity investments with a guaranteed dividend yield of 13.0% along with a conversion option. Despite, the regulatory environment PC Jeweller grew by 15.7%. Gross profit grew by 0.3% while operating profit increased by 12.1%.

 

The company’s gross margin declined as exports were a larger portion of sales. The table below illustrates management’s estimates of gross margin by geography and product within the domestic market. Based on the midpoint of the assumptions below gross margin should be roughly 13.37%.


The company improved capital efficiency with inventory only growing by 8.3% in the year. The slight decline in the company’s NOPAT margin combined with the improved capital efficiency saw ROIC increase to 24.7% from 20.9%.  A measure used commonly used in the retail industry is gross margin on inventory. Given the biggest investment within the Indian Jewelry industry is inventory, 57% of PC Jeweller’s 2017 assets was inventory. Since 2008, inventory has accounted for 58% of assets. The typical formula is gross profit divided by average inventory. We modify it slightly by subtracting interest expense from gross profit as the company purchases inventory using gold leases that comes with an interest component.

 

Unfortunately, the GMROI continues to decline. Compared to its peers, PC Jeweller is at the lower end of GMROI. This is particularly concerning when compared to Titan Company, whose GMROI is almost three times higher than PC Jeweller’s as the company generates a higher gross margin and pays less on interest.

 

The company’s declining and poor gross margin return on inventory points to a lack of pricing power.

 

PC Jeweller increased its showroom count to 75 from 60 in FY2017, while the square footage grew by 10% from 352,313 square feet to 386,923 square feet. The company’s average store size decreased to 5,159 square feet.

 

In FY2017, domestic sales per store and square foot decreased by 15.8% and 4.2%, respectively.

 

Since, the government took drastic measures in 2013 to stunt the growth of the gold industry, the primary growth driver for PC Jeweller is new showrooms.

 

The company trialed its first franchise operations and will continue to add additional franchises fueling growth with little additional investment requirements.

 

Overall, PC Jeweller continues to execute and is one of the most profitable and fastest growing companies in the Indian jewelry industry due to the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the strengths of the company and management, government is continually bringing new regulation to the detriment of the industry. Additionally, the industry is fiercely competitive with evidence pointing to no barriers to entry. As discussed in a weekly commentary, the jewelry industry evolution in more developed countries points to no barriers to entry and a compression of profitability towards the cost of capital.

 

Given our research on industry evolution, our base case involves elimination of excess profits by the end of the terminal year as competition intensifies. PC Jeweller is able to grow by 10% over the next five years before fading to 0% terminal growth leading to an estimated annualized return of 2.6%.

 

The optimistic scenario assumes the company to grow its sales by 15.0% over the next five years inline with PC Jeweller’s target of doubling its store count over the same period. In the terminal assumptions, there is assumed to be continued grow of 2.5%. Also, the company is not impacted by competitive forces allowing the company to maintain its profitability leading to an estimated annualized return of 25.4%.

 

The pessimistic scenario assumes no growth and immediate decline in profitability as well as no excess profits in the terminal assumption as competition impacts the company.  The estimated annualized return under the pessimistic scenario is -4.0%.

 

At current valuation levels, the risk rewards is no longer drastically in our favor and a sustained continuation of the company’s excess profits is needed to justify much higher valuations. We will cut our position size to 2.0% as long as the share price is above INR450.

Stalexport Autostrady Q1 2017 Results May 14, 2017

Stalexport Autostrady Q1 2017 Results May 14, 2017

Stalexport Autostrady reported Q1 2017 results. Traffic increased by 8.0% with light vehicles increasing by 7.4% and commercial vehicles increasing by 10.9%. Revenue increased by 8.2%, while operating profit declined by 4.8% as Q1 2017 saw an increase of accrued cost of provision for motorway resurfacing.  The company increased toll rates for heavy vehicles category 2 and 3 by 9.1% from PLN 16.50 to PLN 18.00 and heavy vehicles category 4 and 5 by 13.2% from PLN 26.50 to PLN 30.00.

 

The report does nothing to change our view on the company. Autostrady has a 30 year concession agreement on 60 kilometers of the A4 between Katowice (junction Murckowska, km 340.2) to Krakow (junction Balice I, km 401.1) ending March 2027. Since 2008, traffic grew at an average annual rate of 4.5% with light vehicles growing by 5.7% and heavy goods declining 0.5% per year. In 2012, there was a decline in traffic by 6.5% driven by a 23.2% decline in heavy goods vehicles. Since 2012, both light vehicles and heavy goods vehicles grew by 9.2% per year. Since 2008, the toll rates have increased by 6.8% per year with the toll rate for light goods vehicles increasing by 5.4% and the toll rate for heavy goods vehicles increasing by 12.5%. The increase in traffic and toll rates has lead to an average annual increase in revenue of 11.6% per year. Additionally, honest and competent management run the company.

 

Despite the continued growth, the company trades at a 37.4% discount to a DCF value that assumes no growth in revenue and 4% increase in administrative expenses. We will increase our target position size to 3.0% at share price below PLN4.00. Assuming a 6% growth rate, the company’s fair value is PLN7.19, 90.6% above the company’s current share price.

Turk Tuborg 2016 Full Year Results May 11, 2017

Turk Tuborg 2016 Full Year Results May 11, 2017

Turk Tuborg reported 2016 results. The company’s consolidated net sales increased by 29.6% from TRY742.68 million in 2015 to TRY962.7 million in 2016. ASP increases were the main driver of revenue growth as ASP per hectoliter (hl) increased by 30.9% from TRY245.12 in 2015 to TRY320.92 in 2016, while volume decreased by 1.0% from 3.03 million hectoliters (mhl) in 2015 to 3.00 million hectoliters in 2016. Despite the ASP increase and the volume decrease, Turk Tuborg still gained share from Anadolu Efes. Its volume share increased from 31.4% to 33.3% and its market share increased from 33.3% to 40.1%. Turk Tuborg and Anadolu control over 99% of the market so any share gain by one is at the expense of the other.

 

The table illustrates volume, volume share within Turkey, ASP, and market share within Turkey from 2008 to 2016. Since 2008, Turk Tuborg’s volume grew by 13.2% per annum, Anadolu’s volume decreased by 4.3% per annum, and the overall industry volume decline by -0.9% per annum. Since 2008, Turk Tuborg’s ASP increased by 9.9% per annum, Anadolu’s ASP increased by 7.0% per annum, and the overall industry ASP increased by 8.4% per annum.

 

In our initiation report, we believed Turk Tuborg’s product innovation and focused operations along with Anadolu Efes debt load is driving Turk Tuborg’s share gains.

 

In 2016, Turk Tuborg launched Tuborg Amber, the first and only beer in amber category of Turkey illustrating the company’s continued focus on product innovation. Anadolu continues to have operations all over Europe while Turk Tuborg remains focused on Turkey. Anadolu’s extended operations decrease the importance of Turkey on overall operations leading to less management attention. It also adds diseconomies of scale associated with administrating all the different entities. Anadolu improved its financial position to 3.6 times operating profit but capex is lower than depreciation meaning the company is unable to even maintain its current asset base, never mind spending on growth, while, Turk Tuborg grew and modernized its facilities.

 

Since 2011, Turk Tuborg’s average capex to depreciation ratio is 185% compared to Anadolu Efes’s average capex to depreciation ratio of 114%. The capex allowed it to modernize its facilities decreasing the average age of assets from 18.8 years in 2011 to 7.4 years almost on par with Anadolu Efes.

 

Despite Anadolu’s debt load, economies of scale persist. Distribution is crucial as over 50% of Turkish beer sales are through a two-way distribution system where bottles and kegs are returned. Advertising is another important fixed cost that benefits the largest players. These costs are included in the selling expense line on both companies’ income statements. Anadolu does not report Turkish beer expenses but assuming a similar split in operating expenses between administrative and selling expenses, the company’s selling expense can be determined.

 

Despite Anadolu spending almost three times as much on distribution and marketing, Turk Tuborg has made significant share gains. The company seems to be much more efficient with a much better feel for the desires of Turkish customers. Turk Tuborg’s superior management will be very difficult for Anadolu to overcome. Can Anadolu increase its marketing and distribution expense to win back share? The recent past would suggest increasing spending would not do much good. It is also particularly difficult when the company’s debt load is on the higher side. The restrictions on alcohol promotions and advertisements as well as the restrictions on alcohol producers sponsoring events greatly reduces the ability of increased marketing expenses.

 

Turk Tuborg’s saw its gross profit increase by 34.3% and its gross margin expand by 197 bps. Despite, the company increasing its ASP at an average annual rate of 9.9% since 2008, its gross margin has expanded by over 2675 basis points pointing to pricing power. Over the same period, industry volume declined by 0.9% strengthening the case of pricing power.

 

Administrative expenses increased in line with revenue 27.7% at remaining at roughly 5.0% of sales, while selling expenses increased by 26.0% decreasing slightly as a percentage of sales from 25.5% of sales to 24.7% of sales.

 

Operating profit increased by 44.3% from TRY180.78 million in 2015 to TRY260.85 million in 2016. The company’s working capital is negative at –TRY64 million and fixed capital turnover remained roughly the same at 2.82 times. The company’s capital efficiency declined slightly to 3.47 times. Overall, ROIC decreased slightly from 76.1% to 75.2%.

 

Turk Tuborg continues to perform extremely well growing at a fast pace, taking a significant amount of share, and remaining very profitable with an ROIC of 75.2%.  Given the poor liquidity in the company’s stock and political concerns, Turk Tuborg trades on a NOPAT yield of 7.4% with the potential for continued ASP increases of at least 5% per year leading to expected return of at least 12.5% and potentially more. Our weekly commentary dated 12/13/16-12/19/16, looked at acquisition multiples in the beer industry since 1999 and over the last twelve months. The average transaction multiple was 11.7 times EV/EBITDA and 11.5 times EV/EBITDA, respectively.  Assuming a multiple of 12 times EV/EBITDA, Turk Tuborg has 43% upside.

 

The barriers to entry within the Turkish beer industry are extremely strong, with Turk Tuborg and Anadolu maintaining over 99% of the market for over a decade, eliminating any concerns over competitive risks. Additionally, restrictions on alcohol promotions and advertising reduces the risk of increased competitive rivalry. The company has a net cash position at 1.2 times the company’s 2016 operating profit eliminating potential financial risk. The biggest risk is political as Erdogan consolidates his power in Turkey. The consolidation of power eliminates checks and balances typically seen in democracy and Erdogan’s conservative nature may lead to continued attempt to stifle the industry. The government continues to increase excise taxes in attempt to stamp out drinking. The current consumption tax rate on beer is 63%. In 2013, the Turkish government imposing a series of new alcohol restrictions including banning shops from selling alcohol from 10 p.m. to 6 a.m. and prohibited all forms of advertising and promotion of alcohol. Alcohol producers are also barred from sponsoring events, and television broadcasters were required to blur images of alcohol in movies, soap operas and music videos. In a 2010 survey commissioned by the Health Ministry, Ankara’s Hacettepe University found that only 23% of Turkish men and 4% of Turkish women drank alcohol so there may be a tolerance for prohibition. Turkish annual alcohol consumption is the lowest in Europe at 1.55 liters per capita compared to over 10 liters in most European countries.

 

Despite the company’s strong operating performance, strong competitive position, net cash position, and slightly cheap valuation, growth is bound to slow as ASP increase are the driver of growth with industry volumes declining at 1.0% per year. The increasing consolidation of power by Erdogan is worrisome for the industry leading us to decrease our position size to 2.0% as long as the price is above TRY9.00.

 

 

Grendene Q1 2017 Results Review May 8 2017

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.

 

Honworld 2016 Full Year Results Review 5/7/2017

Honworld 2016 Full Year Results Review

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

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

 

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

 

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

 

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

 

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

 

 

INTERESTING LINKS

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

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

 

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

 

 

Return Expectations Going Forward (Ben Carlson)

 

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

 

 

On the Valuation of the Indian Stock Market (Latticework)

 

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

 

 

Trusting Management and the Limitations of Research (MicroCapClub)

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

 

The economics underlying airline competition (McKinsey)

 

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

 

 

Shipbroking and bunkering (Bruce Packard)

 

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