Tag Archives: Position Size Decrease

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

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

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

 

 

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

 

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

 

 

Diversification..again.. (Oddball Stocks)

 

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

 

 

Humility and knowledge (Oddball Stocks)

 

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

 

 

Graham & Doddsville (Columbia Business School)

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

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

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

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

 

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

 

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

 

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

 

 

INTERESTING LINKS

 

 

My Interview with Jason Zweig (Safal Niveshak)

 

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

 

 

The Making of a Brand (Collaboration Fund)

 

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

 

 

Riding a retail roll out (Phil Oakley)

 

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

 

 

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

 

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

 

 

Investing Mastery Through Deliberate Practice (MicroCap Club)

 

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

 

 

Out with the old (Investor Chronicle)

 

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

 

 

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

 

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

 

 

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

 

Glossy magazine writes about the beauty business. (link)

 

 

6 smart tips for micro-cap investors (Morningstar)

 

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

 

 

HAW PAR CORPORATION (HPAR:SP)

 

 

Company Description

 

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

 

 

Healthcare

 

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

 

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

 

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

 

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

 

 

Leisure

 

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

 

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

 

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

 

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

 

 

Property

 

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

 

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

 

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

 

 

Investments

 

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

 

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

 

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

 

 

Management

 

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

 

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

 

 

Valuation

 

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

 

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

 

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

WEEKLY COMMENTARY JAN 9, 2017 – JAN. 15, 2017 (M. DIAS BRANCO)

WEEKLY COMMENTARY JAN 9, 2017 – JAN. 15, 2017 (M. DIAS BRANCO)

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

On January 6, 2017, Honworld received approval from the National Office of Leading Group for Administration of Hi-tech Enterprise Recognition to be a New and Advanced Technology Enterprise. A New and Advanced Technology Enterprise is entitled to certain tax benefits including a reduced enterprise income tax rate of 15% for three consecutive years commencing from 2016. The company’s New and Advanced Technology Enterprise status expired in 2016. From 2013 to 2015, Honworld paid an average effective tax rate of 15.6% since 2013. A decrease in the tax rate from the normal corporate tax rate of 25% to the lowered tax rate of 15% into perpetuity adds about 10% to the company’s intrinsic value.

 

Honworld seems to have multiple competitive advantages in the form of economies of scale related to R&D, and marketing within its key regions. The company’s products are frequently purchased, low priced and ingested creating customer captivity due to these habit forming characteristics. Aside from the customer captivity from habitual use, the low price also increases search costs as a 10% difference in price between Honworld’s products and a competitors will not induce customers to change meaning competitors need to undercut Honworld’s price significantly to increase the probability of acquiring Honworld’s customers. Honworld has a price premium and market share advantage pointing to a brand advantage. The company also has superior profitability relative to competitors making it difficult for those competitors to undercut Honworld’s pricing and stay profitable.

 

While the company business seems to be very high quality, management’s capital allocation decision of investing heavily in inventory is deteriorating returns and decreasing cash flows to the point where the company cannot finance growth from internal cash flows. Holding inventory allows Honworld to age its base wine allowing the company to sell more premium products. If the company was able to generate sufficient profitability from premium products to cover the cost of ageing inventory, it would not be a concern but the ageing of inventory is a drag on the company’s returns. In a previous post (link), there was a detailed calculation on this issue. The other side of the inventory debate is maintaining high levels of inventory allows the company to age that inventory to sell more premium products and be ready for any expansion. Selling more premium products provides a higher gross margin but the gross margin is not high enough to cover the cost of holding the inventory required for premium products. The argument of being ready for growth does not make sense, as the majority (57%) of the company’s sales is medium range product, which does not require base wine to be aged. The company has also been able to grow over the past few years without as much base wine inventory as the company has now. The true benefit of ageing inventory is it makes it difficult for competitors to replicate the aged inventory strengthening the company’s competitive position. The passion of the owner as illustrated by holding base wine inventory before he got into the business may actually be a detriment as his goal may not be running the business optimally but building as much base wine inventory as possible.

 

An additional concern arose in the company’s H1 2016 results. The company’s growth slowed and investment in inventory slowed, which should have led to positive free cash flow, as there is not a significant amount of fixed capital investment required for the business. Unfortunately, the company made significant pre-payment for fixed assets. These are very concerning accounts to see on a balance sheet.  We are selling trying to reach a 2% position size due to our concerns over capital allocation will permanently depress profitability not allowing the company to reach the intrinsic value, it would if it had proper capital allocation.

 

Miko International issued a profit warning. It did not cause a large drop in the company’s share price, which may be a signal that all the bad news is priced in. This may be the case but the weakness in the corporate governance overrides the company’s cheapness. We are in the process of selling our position.

 

We completed the sale of our Credit Analysis and Research position.

 

 

INTERESTING LINKS

 

A Chat with Daniel Kahneman (Collaboration Fund)

 

An article by Morgan Housel discussing his notes from a dinner he attended with Daniel Kahneman.  Kahneman along with Amos Taversky are pioneers in the behavior finance world. (link)

 

The Art of Looking Stupid (Eric Cinnamond)

 

A blog post discussing the investment management industry and how looking stupid is beneficial to returns. (link)

 

Normalized Earnings Yield (Eric Cinnamond)

 

A discussion of a simple valuation calculation that is a good approximation of the potential return of an investment (link)

 

Investing Narratives (csinvesting)

 

A blog post with a number of links discussing the topic du jour, narratives (link)

 

Ben Graham’s 1932 Forbes Articles (Old School Value)

 

Three articles written by Ben Graham for Forbes in 1932 (link)

 

Alibaba Offers To Buy Out Intime Retail For $2.5 Billion, At 42% Premium (Barron’s)

 

Alibaba is making a shift offline buying Intime Retail, an owner of 29 department stores and 17 shopping malls. The transaction provides a private market value for retailers. (link) The table below illustrates the valuation of Intime Retail based on Alibaba’s takeover bid.

 

We are not experts in real estate and tend not to look at businesses in the industry, but the following are some thoughts on the acquisition. Intime Retail purchases land, develops the site, and the either sells or rents the shopping mall or department store. Price to book is often used for real estate companies as the process of developing sites can take years making earnings lumpy. Private market value assumes the price paid is a reasonable one, but is 1.7 times book value reasonable for Intime Retail. For 1.7 times book value to be reasonable, at a 12.5% discount rate and no growth, we must assume that the company will be able to generate a return on equity (ROE) of roughly 21.0% into perpetuity. If we assume a 5% growth rate, it would need to generate a ROE of roughly 17.0% into perpetuity. Since 2007, the company generated an average return on equity of 13.54% so something would need to change to make the company generate higher revenue to justify the purchase price. Unfortunately, the industry does not have any barriers to entry so excess profitability would be very difficult to sustain. There are many real estate developers. There are no economies of scale, no customer captivity or no sustainable cost advantages. Given the lack of barriers to entry within the industry, Alibaba could have hired the expertise needed and completed the projects at a cheaper price assuming cost inflation within the industry does not lead the company to pay 1.7 times the construction costs of Intime Retail.

 

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

 

An interesting blog post discussing the outperformance of publicly listed airports (link)

 

Amazon Stock’s Exceptional Price History Meets Value Investing (The Conservative Income Investor)

 

There are a number of thoughts with agree with in this article discussing a potential investment in Amazon from the perspective of a value investor. (link)

 

A Fee Structure for Fund Managers Who Put Their Money Where Their Mouth Is (Jason Zweig)

 

An article written by Jason Zweig discussing the fee structure of fund managers. (link) The rise of ETFs are completely understandable when the vast majority of mutual funds charge a much higher fee than ETFs yet have a difficult time outperforming the ETF. The article discusses a much better fee structure.

 

 

M. DIAS BRANCO 

 

The following is a research report we nearly published on M. Dias Branco in late January, early February 2016. We liked the business but disliked management’s capital allocation decisions. Management is increasing vertical integration by moving back into raw materials, which are primarily commodities. These commodity business may not dilute returns now but they should be a drag on the more consumer oriented businesses. Additionally, rather than expanding its distribution channel at the margins, M. Dias Branco is making acquisitions where it does not have a size advantage or its own distribution leading to weaker returns. This is illustrated by the percentage of sales to smaller retail outlets where it is the sole supplier. The company is also under spending on R&D and advertising. The company should be spending heavily on theses fixed costs as well as its distribution network to make it more difficult for smaller players to compete. In areas where its distribution network eliminates competition, there is no need for advertising as there are not alternatives. In markets where the company does not have a distribution advantage, without advertising the only way to attract customers is pricing. This is not an effective method of competing when products are low cost meaning a small differential in pricing is not going to cause a customer to change. In addition, taste and texture are probably more important than a small differential in pricing.

 

Our decision to not to recommend M. Dias Branco was clearly wrong. The company’s share price was between BRL60-65 per share at the time of writing the research report. M. Dias Branco closed at BRL130 on Friday January 13, 2017 meaning we missed a 100% return opportunity in one year. We were far too greedy on price as the company had a history of growth in an industry with barriers to entry, yet, was trading on a no growth valuation. At the time of the report, our position sizing philosophy was aggressive and we only wanted to invest in a stock if it was able to be a large position >5%. Missing the investment opportunity in M. Dias Branco is one of the reasons of adding high quality stocks that may be slightly expensive and taking advantage of portfolio management skills to add to or reduce the position as the share price moves. We do not know if the change in position sizing philosophy would have changed our decision to pass on M. Dias Branco. If we had recommended the company, we most likely would have sold out due to valuation before realizing the full 100% return, as we were already skeptical of the company’s capital allocation strategy. The change in the position sizing philosophy did provide opportunity for returns in Credit Research and Analysis and Anta Sports, two of our top three recommendations in 2016.

 

The valuation section of the report reflects the investment opportunity at the time rather than the current pricing. We left out the investment thesis, as we did not complete it at the time.

 

 

COMPANY DESCRIPTION

 

M. Dias Branco is a Brazilian manufacturer, marketer, and distributor of cookies and crackers, pasta, flour and wheat bran, margarines and vegetables fats, and cakes and snakes.

 

 

HISTORY

M. Dias Branco was founded by Manuel Dias Branco when he started baking and biscuit production in the 1940’s in the Brazilian state of Ceara. Mr. Dias Branco first established M. Dias Branco & Cia Ltda in 1951 before founding M. Dias Branco in 1961. In 1953, Mr. Francisco Ivens de Sá Dias Branco joined M. Dias Branco & Cia. Ltda. providing strategic direction with an emphasis on investments in industrial technology to produce and sell cookies, crackers, and pasta on large scale.

 

In the early 1960’s, the company started operating its current distribution model of focusing on supplying micro, small, and medium retailers. The company’s distribution model along with its large-scale production allowed expansion initially in Ceara then in neighboring states. The company created its Fortaleza brand created in the 1950’s and its Richester brand created in 1978.

 

During 1990’s, Brazilian government deregulated wheat market. M. Dias Branco took advantage of the deregulation by opening its first wheat mill plant in the state of Ceara in 1992. The new plant allowed the company to backward integrate into its supplying its main raw material, wheat. In 2000, the company expanded its raw material production capacity with a second wheat mill plant in the state of Rio Grande do Norte. The plant increased the integration of the production process as it also has pasta production capabilities.

 

To vertically integrate its production process, in 2002, M. Dias Branco opened its first shortening and margarine plant. The plant produced shortening needs for the production cookies and crackers.

 

In 2003, the company opened a third wheat mill and acquired Adria, a traditional cookies, crackers, and pasta manufacturer. Adria was a leader in both South and Southeast regions giving M. Dias Branco national coverage and making it the leader in the Brazilian market. Adria had a turnover of R$400mil in 2002, up 29.45% on 2001. The acquisition increased M. Dias Branco’s market share by 14% in the cookies segment and 20% in the pasta segment. The company also acquired Adria’s brands Adria, Basilar, Isabella, and Zabet as well as three industrial plants in the state of Sao Paulo and one plant in Rio Grande do Sul. These plants include three pasta factories and two cookies and crackers factories.

 

In 2005, the company started its fourth cookies and crackers facility and its sixth pasta facility, both are integrated with the wheat mill opened in 2003. It is also integrated to a private port so the company can import wheat grain at a lower cost relative to public ports. The Bahia factory adopted a model that eliminated the cost of wheat flour transportation to the cookies, crackers, and pasta factories. It also created a platform for expansion into the South and Southeast regions. In the same year, in the state of Paraíba, the company opened its fourth wheat mill and its seventh pasta factory adopting the same vertical integration model to eliminate the costs of wheat flour transportation.

 

With the expansion of its production in the South and Southeast regions, M. Dias Branco also expanded its distribution network with a focused on the micro, small and medium retailers in the regions.

 

In October 2006, the Company made its IPO listing in the Novo Mercado with the ticker MDIA3.

 

In April 2008, M. Dias Branco acquired Vitarella, a cookies, crackers, and pasta company located in the state of Pernambuco. Vitarella has a strong position in the Northeast region, particularly in states where the M. Dias Branco does not have leadership. The acquisition expanded the company’s national and Northeast region leadership in sales volume of cookies, crackers, and pasta. M Dias Branco paid BRL595.5 million for the Vitarella’s plant and brands Vitarella and Treloso. According to AC Nielsen, at the end of February 2008, Vitarella held 5.5% of the cookies market and 2.9% of the pasta market in Brazil in terms of volume. In 2007, Vitarella had net revenue of BRL323.2 million.

 

In April 2011, M. Dias Branco acquired NPAP Alimentos S.A, a manufacturer of cookies, crackers, and pasta with the brand Pilar, located in the state of Pernambuco. NPAP recorded net revenue of BRL107.5 million in 2010 with 56% from cookies and crackers and 44% from pasta. With The acquisition, M. Dias Branco increased its share of the national cookie and cracker market by 1.2% from 22.2% to 23.4%, and by 2.3% in the pasta market from 22.4% to 24.7%. M. Dias Branco paid roughly BRL70 million for NPAP.

 

In December 2011, M. Dias Branco acquired Pelágio and J.Brandão (both known as Fábrica Estrela) a manufacturer of cookies, crackers, pasta, and snacks with a focus on the country’s North and Northeast regions under the brands Estrela, Pelaggio, and Salsito. In 2010, the company generated BRL190.6 million in net revenue from two industrial units located in the state of Ceará. The acquisition increased M. Dias Branco’s market share in Brazil grew by 1.2% from 24.1% to 25.3% in the cookies and crackers segment and by 0.7% from 24.5% to 25.2% in the pasta segment. The company paid BRL240 million for Fábrica Estrela.

 

In May 2012, M. Dias Branco acquired Moinho Santa Lúcia Ltda., a company located in the state of Ceará that produces wheat flour, cookies, crackers, and pasta under the brands Predilleto and Bonsabor. In 2011, Moinho Santa Lucia had net revenue of BRL88.1 million. M. Dias Branco paid BRL90 million for Moinho Santa Lucia.

 

In 2014, M. Dias Branco increased investments in production line expansion of cookies, crackers and pasta as well as introducing new products (cake mix and toast). It also started the construction of three new wheat mills in the state of Ceará, Pernambuco, and Rio Grande do Sul allowing the company to fully integrate the production process with wheat flour, the company’s main raw material. In a public auction, the company also acquired a new wheat mill factory in the state of Paraná to accelerate the vertical integration of its facilities in the Southeast region.

 

 

CORPORATE STRUCTURE

 

Tergran was founded on September 22, 1996 and is scheduled to shut down on September 2026. It was established to carry on port operations related to the import, export, and trading of grain. Tergran’s other shareholders are J. Macêdo S.A. and Grande Moinho Cearense S.A., both are competitors. Each shareholder holds an equal equity stake in Tergran. M. Dias Branco operates Tergran with the goal of increasing the efficiency of the import and export of wheat at the Fortaleza Port. Tegran sells its products to shareholders.

M. Dias Branco Argentina S.A. is a wholly owned subsidiary that purchases, imports, and exports wheat grain, wheat flour, and its derivatives. The company has not yet started its activities.

M. Dias Branco International Trading LLC is a wholly owned subsidiary that purchases raw materials (principally wheat and vegetable oil)

M. Dias Branco International Trading Uruguay S.A. is its wholly owned subsidiary that purchases raw materials, particularly wheat.

 

 

SHAREHOLDER STRUCTURE

 

DIBRA Fundo de Investimentos em Participações (DIBRA) is 99.82% owned by Francisco Ivens de Sá Dias Branco. DIBRA and managers sold shares in 2010 to increase free float to the required 25%.

 

 

REVENUE

 

Over the trailing twelve months, cookies and crackers accounted for 52% of revenue, pasta accounted for 23% of revenue, wheat flour and brand accounted for 19% of sales, margarine and vegetable shortening accounted for 5% of revenue, and new products like cakes, snack, and packaged toast accounted for the remainder of revenues.

 

Over the past five years, the company grew its revenue by 14.3% per annum. The 14.3% compound annual growth rate represents a total increase in revenues of BRL2,232 million with BRL278.1 million or 12.5% of incremental revenue acquired from the Pilar and Fabrica Estrela acquisitions and the remainder from organic growth.

 

Over the past twelve months, M. Dias Branco has produced 1,692 tonnes of product at an average price of BRL2.71/kg. Since 2009, the company volume sold increased by 8.0% per annum or 550 tonnes. Over the same period, M. Dias Branco has increased prices by 5.7% per annum. The increases in weight sold and average selling price were even across products.

 

In 2014, revenue from the Northeast Brazil accounted for 72.2% of sales up from 63.4% of sales in 2004 growing at 14.7% per year over the period. The increased proportion of sales from Northeast Brazil came at the expense of Southeast Brazil. Revenue in the company’s second largest region increased by 8.9% per annum over the last ten years leading to a decrease from 22.3% of sales in 2004 to 15.0% of sales in 2014.

 

 

BRANDS

 

 

The company has a large portfolio of brands with 23 brands across four product lines.

M. Dias Branco’s largest brand is Vitarella, a cookie and cracker and pasta brand accounting for an estimated 17.4% of 2014 revenue. The company acquired the brand along with Treloso in April 2008. Until 2014, the company disclosed the Vitarella and Treloso brands separately but combined revenues in 2014. Assuming the Treloso brand had BRL225 million in 2014, the Vitarella brand would have recorded revenues of BRL798 million representing a 14% compound annual growth rate since 2009. Vitarella is the cookie and cracker brand leader in Northeast Brazil.

 

The company’s second largest brand is Fortaleza, the company’s oldest brand. Fortaleza is a cookies and cracker and pasta brand created in the 1950’s that accounted for 12.3% of 2014 revenues. Over the past five year, the Fortaleza brand’s revenues have grown at 13.8% per annum.

M. Dias Branco’s third largest brand is the Richester brand, which has the perception of modern, young, and fun brand. It is the company’s second oldest brand with products in cookies and crackers and pasta segments. The brand accounts for 11.0% of the company’s 2014 revenue and has grown by 11.7% per year over the past five years.

 

Meldaha de Oro is the company’s largest wheat flour and margarine brand. The brands focus is bakery customers in wheat flour and food service customers in the margarine and shortening segment. It accounted for 10.5% of the company’s revenues in 2014 and grew by 15.4% per year over the past five years.

 

All other brands account for less than 10% of the company’s sales. Other notable brands include the company’s other wheat flour brand Finna serving retail customers with a focus on economic class A to E.

Based on household gross monthly income, class A household gross monthly income is above BRL 10,200, class B is above BRL 5,100, class C is above BRL 2,040, class D is above BRL 1,020, and class E is below BRL 1,020. Finna accounted for 5.4% of revenue in 2014. The company’s margarine product Amorela targets economic classes A and B, while shortening brands Puro Sabor and Adorita target economic classes B, C, and D.

 

In the cakes and snacks market, the company has a specific product range for the children’s segment marketed under the Pelagio and Richester brands, and a family product range marketed under the Pelaggio brand. The company has a licensing agreement with Disney for the use of Disney’s characters on some of Pelagio’s packaging.

 

The company has a diverse portfolio of brand but do the brands add any value. Indicators can be used to determine the strength of a company’s brands including market share, pricing power, relative pricing, advertising, frequency of customer purchase, and cost of an item.

 

Since 2008, through organic growth and acquisitions, M. Dias Branco has increased its cookies and crackers volume share from 19.8% in 2008 to 28.1% in 2014 and its pasta volume share increased from 21.9% to 28.9%. The company is the leader in both the cookies and crackers market and pasta market.

 

In 2014, M. Dias Branco had a 20.8% market share in Brazil almost twice as large as the company’s closest competitor Nestle and second largest competitor Marilan. The company is three times the size of its third and fourth largest competitors Mondelez and Pepsico. Within its home region of Northeast Brazil, the company has even larger market share advantage with 55.6% of the market. In the Southeast, the company is the fourth largest competitor behind Marilan, Nestle, Pepsico, and Arcor.

 

In 2014, M. Dias Branco had a 25.8% of the Brazilian pasta market. Similar to the cookies and cracker market, the company has roughly twice the market share of its largest competitor. Also similar to the cookies and cracker market, the company has a significant advantage in Northeast Brazil at almost five times the size of its closest competitor. In the southeast region, the company is the second largest company right behind the market share leader

 

On a global scale, M. Dias Branco is the seventh largest cookie maker in the world with a 1.7% market share in 2012. The company was also the sixth largest pasta maker in the world with a 1.7%.

 

 

PRODUCTION

 

M. Dias Branco has 14 manufacturing units and several commercial units distributed in major Brazilian cities.

 

The company just took control of the wheat mill in Rolandia, Parana in the second half of 2015 after recently winning the wheat mill at an auction.

M. Dias Branco’s capacity and production by product is listed above. Since 2005, cookies and crackers capacity has grown by 12.8% per annum, pasta capacity by 6.0% per annum; wheat flour and brand by 9.9%, and margarines & fats have grown by 9.7% per annum.

 

At the end of 2014, Wheat flour and bran accounted for the largest portion of production capacity at 50.5% followed by cookies and crackers at 26.5%, pasta at 16.9%, margarines and fats at 5.8%, and cakes at 0.3%.

 

The cost of building a new ton of capacity at existing facilities based on management estimates in both US dollars and Brazilian reals is illustrated above. The cost of reproducing capacity is lowest for wheat mill at USD120 per tonne increasing to USD300 per tonne for pasta and USD350-400 per tonne for cookies and crackers. Management did not have an exact figure for margarine and shortening but stated it was between the cost of wheat mill and pasta.

 

M. Dias Branco has a strategy of vertical integration by increasing its reliance in production of raw materials of wheat and vegetable shortening with a goal of reaching 100% vertical integration.

 

In the trailing twelve months, the company consumed 6.1 percentage points more internally produced wheat than in 2008 at 56.1% in the trailing twelve months compared to 50.0% in 2008. It increased reliance on internally produced wheat has also increased by 6.9 percentage points up from 72.2% in 2008 to 79.1% in the trailing twelve months.

 

Vegetable shortening production consumed internally has increased by 19.4 percentage points from 35.7% in 2008 to 54.1% in the last twelve months. Of the company’s total vegetable shortening consumption, 88.5% in internally produced up from 48.9% in 2008.

 

 

DISTRIBUTION

 

 

M. Dias Branco has 28 distribution centers in 16 states throughout Brazil with a concentration of distribution centers in Northeast Brazil. The company distribution system had been built over 60 years. The distribution systems caters to all customers but is focused on micro, small, and medium retailers through door to door sales and weekly customer visits leading to strong customer relationships.

 

In the early 1960’s, the company started to operate its current distribution model of focusing on supplying micro, small, and medium retailers. Company representatives make at least one visit per week to every client creating very strong relationships with clients and a constant feedback loop allowing the company to adjust its positioning and strategies as needed. Two marketing systems are used to meet the direct channels: the immediate delivery to the traditional retail (small and medium traders) and the pre-sale for serving large networks and average retail supermarkets.

 

The company’s distribution is primarily through road transport via the company’s fleet of 554 vehicles and an average of 2,662 outsourced vehicles per month. The company also uses 122 motorcycles used by pre-sale vendors.

 

Outside of larger cities infrastructure is poor so the company’s distribution channel gives it an advantage over competitors. The company estimates 40% of direct sales are to smaller mom and pop outlets that no other competitor can reach and there is very little competition. This reach and lack of competition allows the company’s brand to be the standard in their respective product category that all future products are compared. Given the company’s market share, its distribution network is extremely difficult to replicate particularly in the Northeast where the company has a 55.6% market share in cookies and crackers and a 61.6% market share in pasta. In regions where the company has lower market share such as the Southeast, the company relies on distributors as the fixed costs associated with distribution is too much of a burden. Additionally, margin on products sold through direct sales are higher than sales through indirect distribution.

 

The company’s extensive network of direct sales and close relationship with indirect channels ensures strong presence throughout the country and close contact with its customers creating customer loyalty and an increased customer base. More importantly, it is very difficult to replicate as it is a fixed cost and scale is needed to cover those fixed costs. For example in the Southeast region, M. Dias Branco has a 10.8% cookies and cracker market share and a 16.8% pasta market share yet the fixed costs associated with creating a distribution network to cover the region is too expensive.

 

The company’s sales from direct distribution decreased from 52.4% in 2005 to 40.7% in 2014. At last disclosure, the company had over 70,000 active clients and 110 distribution partners. Since 2005, direct sales grew at 12.6% per year compared to an 18.6% compound annual growth rate at intermediaries. The company’s direct sales network does not even cover half of the Northeast region so the company has plenty of room to build out its distribution network.

 

In 2014, 40.7% of sales were to smaller retail chains, wholesale distribution accounted for 44.2% of sales, large retail chains accounted for 12.5% of sales, and industrial customers accounted for 2.0% of sales. The company’s top 100 clients only account for 41.6% of sales, while the remaining clients accounted for 58.4% of sales.

 

The company stated it can economically ship basic crackers and pasta 1,000 kilometers before logistic costs puts the company at a disadvantage and higher value added products can be shipped 1,500-2,000 kilometers

 

 

INNOVATION

 

Since 2006, M. Dias Branco spent BRL25.5 million on new products with an average new product R&D spend is 0.1% of sales. Over that period, the company’s R&D spend translated to 373 total new products generating new product sales of BRL254 million or 1.0% of sales over the period.

 

R&D includes new products as well as slight modification such as new product shapes, new packaging, and improving product recipes. Some of the new products launched by the company include new flavors in pasta and cookies. The company’s goal for any innovation is to reach a minimum of 5% market share in the first year. The company believes it has a 60% success rate.

 

Tastes and cultures within Brazil are very regional making large international competitors’ international R&D not as useful in Brazil therefore much of their R&D has to be recreated for the country decreasing the potential competitive advantage from being global players.

 

Relative to international food and beverage companies, M. Dias Branco spends significantly less as a percentage of sales.

 

All large international food and beverage companies spend at least 1.0% of sales or ten times the amount that M. Dias Branco spends on R&D pointing to significant under spending by the company.

 

R&D is very important for two reasons. First, it is a fixed cost allowing the company to exploit its size advantage over competitors in Brazil creating a virtuous feedback loop. If the company is under spending it is negating the company’s size advantage allowing smaller competitors to compete on R&D and remaining profitable. Second, the company’s large distribution network comes with fixed costs that are better utilized if the company can push as many products through that distribution channel making creating new products very important.

 

 

COST OF GOODS SOLD

 

 

Total raw materials costs have increased from 28.3% of sales in 2005 to 46.8% of sales in 2014, accounting for the vast majority of the increase in the company’s cost of goods sold as a percentage of sales. M. Dias Branco lack of segment disclosure by product line or region leads to less information on segment gross margin but the increased importance of lower margin products in the form of wheat flour and margarine and shortening as well as the increased reliance on external distribution has lead to weaker margins. Wheat flour and margarine and shortening gross margins are probably higher than Bunge and ADM’s gross margins of 5% but well below the gross margin for cookies and crackers. The use of external distribution decreases gross margin on products through competition. Direct distribution comes with much less competition as the company has built an infrastructure than cannot be matched by competitors leading to less competition in small mom & pop retail outlets where infrastructure is poor.

 

 

OPERATING COSTS

 

 

The company fastest growing expense, and only expense to grow faster than revenue, is freight expense growing at 21.0% CAGR over the past five years as the company has increased the percentage of sales through indirect distribution channels. The largest expense is employee benefits, which grew at 11.2% over the past five years. Overall, operating expenses have grown at 11.1% since 2009 below the pace of revenue growth over the same period pointing to operating leverage. Unfortunately, cost of goods sold has increased at 16.1% per annum over the past five years lead to gross margin and operating margin compression.

 

 

PROFITABILITY

 

 

 

With the exception of 2007, M. Dias Branco has consistently generated a return on invested capital above 10% and since 2009, the company has consistently generated a return on invested capital above 15%.

 

On a per unit basis (tonne), since 2006, M. Dias Branco has increased volumes by 8.5% per annum, average selling price (ASP) by 7.5% per annum, and gross profit by 6.7% per annum as cost of goods sold has outpaced ASP. Operating income has increased at 12.8% per year as sales expense has grown below ASP increases, while administrative and tax expenses have decrease since 2006.

 

Working capital has increased at 12.8% per year driven primarily by a 12.0% per year increase in accounts receivable. PP&E has only increased by 3.4% per year. Given the company’s recent acquisitions, intangibles increased by 22.2% per year.

 

 

To determine marginal unit economics, all income statement and balance sheet accounts that move with sales as measured by a very low coefficient of variation are deemed to be variable. Variable accounts are cost of goods sold, sales expenses, working capital, and property, plant and equipment. Since 2006, the company’s contribution margin averaged 20.1% with a standard deviation of 2.2%. The company’s variable ROIC averaged 44.1% with a standard deviation of 7.8%.

 

 

 TAX INCENTIVES

 

M. Dias Branco receives state and federal subsidies when the company makes investments falling under public programs that encourage development.

State tax incentives come in the form of a deduction against ICMS (value added sales tax). These incentives are accounted for in the company’s cost of goods sold on the income statement. The state income tax incentives are illustrated above.

 

The company also receives federal tax subsidies as a result of investments in the Northeast of Brazil, through the installation, modernization, extension or diversification of industrial units located in the Superintendency for the Development of the Northeast (SUDENE) operates. Tax incentives are granted for a period of ten years and a 75% deduction is received.

 

 

Since 2009, the company has paid 13.0% of gross sales in sales tax while receiving state tax incentives equal to 3.3% of gross sales. The company receives tax incentives equivalent to 25.6% of the company’s value added tax. The company also reports a tax expense of 0.5% of gross sales in operating expenses. Income tax and social contribution as a percentage of operating income has averaged 9.4% since 2009.

 

 

STRATEGY

M. Dias Branco’s strategy includes increasing market share through diversifying its customer base through geographical expansion via acquisitions and organic growth. The company plans on increasing sales to non-residential food service and processing markets including restaurants, hotels, bars, hospitals, clubs, pastry shops, and bakeries. It also plans to expand its distribution network to increasing the fragmentation of its client base and sell new products.

 

The company also plans to improve operational efficiency and costs controls by optimizing its infrastructure, increasing the flexibility of the production chain, maintain full up to date production facilities with high-end technology and state of the art operations. The company also plans to increase vertical integration in order to meet 100% of its wheat flour and shortening needs.

 

M. Dias Branco will continue to focus on higher value-added products, such as new product lines or complementary product targeting markets in which it already operates.

 

The company also intends to grow organically through the expansion of production capacity. It also plans to acquire businesses with strong brands, a solid customer base, and an extensive distribution network.

 

 

INDUSTRY

 

Brazilian Wheat and Wheat Milling Industry

 

Currently, the Brazilian government intervenes into the wheat production sector through loans and minimum price guarantees. Brazilian wheat production is well below international standards due to unfavorable weather conditions for the winter crop in most parts of the country and poor soil conditions leading to poor quality of wheat and higher production costs. Consumers are often able to import higher quality wheat from Argentina and the United States at better prices than sourcing wheat from Brazil. In addition, domestic production is insufficient to meet domestic consumption needs making Brazil dependent on Argentinean imports. Currently, imports account for about half of domestic consumption. Given import requirements, Brazilian wheat mills have a strong vulnerability to price fluctuations of international commodity.

 

The Brazilian wheat mill industry is very fragmented with a large number of small mills and a large amount of idle capacity. According to ABITRIGO, at the end of 2012, there were 229 mills with 77.3% of wheat mills in the Southern region, 10.0% of wheat mills in the Southeast region, 6.1% in the Northern region, 5.2% in the Midwest region, and 1.3% in the North region. The South has a 44.0% market share of wheat milled, the Southeast has a 24.8% market share, the North and the Northeast have a 27.5% market share, and the Midwest has a 3.6% market share. Domestic wheat mills account for 93% of flour consumption.

 

The bakery sector is the largest consumer of the Brazilian Wheat mill industry consuming 55.3% of flour produced. According to ABIP – Association Brazilian of Bakery and Confectionery Industry, the bakery sector is among the largest industries of Brazil and consisting of more than 63,000 bakeries with an average 41.5 million daily customers in 2014.

 

According to the ABIP – Brazilian Association of Bakery and Confectionery Industry, Per capita bread consumption in Brazil is on average 33 kg per year half of the consumption recommended by the WTO. It is also lower than the bread consumption in Argentina at 70 kg per capita and Chile at 90 kg per capita. Purchasing power of the population is one of the most factors that contribute to the low per capita consumption.

 

 

The Pasta Industry in Brazil

 

According to ABIMA, there are over 80 small, medium, and large companies and more than 100 micro enterprises operating about 140 factories in the Brazilian pasta industry. The installed capacity of the pasta industry in Brazil is around 1.3 million tons behind only Italy’s installed capacity of 3.3 million tonnes and the US’ installed capacity of 2.0 millions of tons.

 

The pasta production process allows producers to manufacture any type of pasta with minor adjustments. Pasta is also a low added value product making shipping costs a significant portion final price making pasta markets regional. The company believes basic crackers and pasta can be shipped 1,000 kilometers before logistic costs affect the product’s competitiveness.

 

Brazil is the third largest pasta consumer behind Italy and the United States. On a per capita basis, Brazil is behind many more industrialized countries at 6.2 kg per year.

 

Brazilian consumes much more rice (26.5 kg per year) than pasta (6.2 kg per year). As illustrated below, as Brazilian’s monthly income increases pasta and cookie consumption increases.

 

Many companies in the sector have integrated process to wheat mill with a broad portfolio of other wheat products such as flour, cake mixes, cookies, and cake mix.

 

According to AC Nielsen, in 2014, the Southeast region is largest pasta region by volume sold accounting for 43.4% of total pasta volume sold in Brazil, down from 49.7% in 2006. The Northeast is the second largest region accounting for 28.8% of volume sold in 2014 up from 25.9% in 2006. The South is the third largest region at 19.4% of volume sold up from 18.1% in 2006. The Midwest accounted for 6.9% of pasta volume sold in 2014 up from 6.3% in 2006. The North accounted for 1.4% of the pasta volume sold in Brazil. AC Nielsen just started accounting for the North region of Brazil in its survey of the pasta market.

 

The table above illustrates 2014 volume share and market share by region along with market share change over the past five years of the six largest pasta companies in Brazil. In 2014, M. Dias Branco was the largest pasta maker, on both volume and market share terms, in Brazil. The company’s share lead is driven by its market share dominance in the Northeast where it holds a 61.6% market share almost five times its closest competitor J. Macedo. The Northeast is where the company started and where it has its own distribution network. In the Southeast, the largest region in Brazil, is much more competitive with the five players holding over 10.0% market share. M. Dias is tied for second place with 15.2% behind Santa Amalia the market share leader with 15.8% of the market.

 

Since 2009, M. Dias Branco has increased its market share by 2.5% in all of Brazil driven by a 19.7% increase in market share in the Northeast. In the Southeast, the company lost 4.7% of market share. This increase in market share in the Northeast was primarily organic as since 2009 the company only acquired 3.0% market share.

 

The five firm concentration ratio is points to medium to high concentration across all pasta markets in Brazil. The Herfindahl index points to high concentration in the Northeast and very little concentration in Brazil and the Southeast.

 

 

The Cookies and Crackers Industry in Brazil

 

The cookies and crackers industry in Brazil has 593 companies. According to ABIMAPI and Euromonitor, in 2014, Brazilian companies sold 1,227 million tons of cookies and crackers meaning Brazilian cookies and crackers sold the 4th largest amount in the world. About 60% of companies are concentrated in the Southeast region the largest and highest per capita income region in the country.

 

In 2014, the Southeast accounts for 45.0% of the cookies and crackers market down from 47.3% in 2006. The Northeast was the second largest region in Brazil accounting for 30.2% similar to its share for 30.2% in 2006. The South is the third largest region accounting for 15.1% in 2014 down from 16.2% in 2006. The Midwest was the fourth largest region accounting for 7.7% in 2014 up from 6.3% in 2006 and the North accounted for 2.0% in 2014.

 

Logistic costs play a part in localizing the market. In lower value added products like basic crackers, products can be shipped 1,000 kilometers before logistic costs affect competitiveness. In higher value added products like cookies, products can be shipped 1,500 kilometers before logistic costs affect competitiveness.

 

Brazilian per capita cookie consumption is below developed markets and its neighbor Argentina.

 

 

Monthly household income is a large driver of demand for cookies and crackers as well as pasta. In both cookies and crackers and pasta, consumption starts increasing rapidly when monthly income reaches BRL2,490 to BRL4,150.

 

In 2014, M. Dias Branco is also the cookies and crackers market leader, both in volume and market share terms, in Brazil. The company market share is almost twice as large as its closest competitor in Brazil. Similar to pasta, M. Dias Branco’s market share lead is driven by its dominance in the Northeast where its market share is nine times its closest competitor. In the Southeast, the company is the fifth largest competitor with a 7.7% market share.

 

Since 2009, M. Dias Branco market share in Brazil increased by 3.0% driven by 12.3% market share gain in the Northeast and a 0.2% market share increase in the Southeast.

 

Similar to the pasta industry, the cookies and crackers industry shows moderate concentration with the Northeast being highly concentrated.

 

 

Barriers to Entry

 

Barriers to entry for food and beverage producers usually come in the form of brand and/or economies of scale with the fixed costs of advertising, distribution, and research and development. Evidence is analyzed to determine if M. Dias Branco’s brands create a barrier to entry. Signs are then evaluated to determine if economies of scale create a barrier to entry. Consistent returns on invested capital above are the best piece of evidence of potential barriers to entry. It does not always point to the existence of barriers to entry as growing markets often ease competitive pressures allowing demand to outpace supply leading to elevated profitability in the short term.

 

With the exception of 2007, M. Dias Branco has consistently generated double digit ROIC with an average ROIC since 2009 of 19.4%. The market has been growing at a healthy pace alleviating competitive pressures but additional evidence points to the company to sustainably resist competition.

 

In food and beverage products, market share leadership is usually a sign of a strong brand as many consumers choose a particular product in these markets based on a characteristic other than price. In the case of M. Dias Branco’s products, the customer’s decision is probably based more on the taste of the product or lack of alternatives rather than price. The customer focus on product characteristics such as taste increases the importance of a brand as customers identify the taste of the product with the brand.

 

Brand is particularly important as the company sells low cost products that are purchased frequently. The low cost of the product makes the small difference in price between brands less important leading the consumer to continually purchase its preferred brand. Products purchased more frequently are more likely to have brand loyalty as customers create a habit of purchasing the product particularly when taste is important product characteristic. Also in developing countries, customers are less likely to switch from a tried and true product to something new due to a lack of discretionary income. In AC Nielsen’s November 2013 Global Report of Loyalty Sentiment, Julie Currie of AC Nielsen stated “In developing economies, we see evidence of highly price-sensitive consumers choosing brands that are not always the lowest-price alternative. Making a switch from a tried-and-true product to something new can represent a tradeoff that consumers with little discretionary income are not willing to make. On the flip side, the cachet of new brands can be appealing for consumers with rising upward mobility status.” According to Strativity, frequency of interaction builds loyalty and advocacy with 87% of customers delighted with daily interaction, 64% with weekly interaction, 49% with monthly interaction, and 33% with a few times per year interaction. Also according to Strativity, 30% of less frequent customers wouldn’t miss a company or brand if they were gone or would leave for a better offer. M. Dias Branco’s high market share within Brazil points to valuable brands with pricing power.

 

The table above illustrates the relative prices of different companies within the pasta and cookie and crackers segments. M. Dias Branco is indexed to 100 and competitors prices are relative to M. Dias Branco. Competitors in red compete with M. Dias Branco in the pasta market while competitors in green compete in the cookies and crackers market. While this is an aggregation of all the brands of each company, it should be representative of M. Dias Branco brand position given the diversity of its brand portfolio. As illustrated, the company has the lowest price offering in both pasta and cookies and crackers. The pricing differential is particularly wide in the cookies and crackers market where the company’s price is 25% below the closest competitor in 2014. The low price of the company’s products points to a no brand value and a market share advantage based on lower cost. A strong brand should command a premium price as customers are willing to pay more for a strong brand. A combination of premium pricing and a leading market share is a sign of a very strong brand.

 

Another sign of a strong brand in consumer products is pricing power as customers are willing to accept price increases as there are not alternatives with the product characteristics that customers covet. To determine the extent of M. Dias Branco’s pricing power, the stability of the company’s cash gross margin. All tax effects are also removed. Cash gross margin is used to eliminate any potential manipulation of accounting assumptions. The company’s cash gross margin has deteriorated from 53.2% in 2005 to 31.5% in 2014, while raw materials expense as a percentage of sales has increased from 28.3% in 2005 to 46.8% in 2014. It seems the company has not been able to pass on raw materials expenses.

 

The company has been pursuing a strategy of increased vertical integration by producing more raw materials internally. Gross margins on wheat flour and margarine should be much lower given the commodity nature of the products. Revenues from non-cookies and crackers and pasta products have decreased from 26.7% in 2005 to 25.2% over the trailing twelve months so sale of lower margin products is not the reason for the lower gross margins. The proportion of wheat consumed from internal production has decreased from 89.6% in 2006 to 79.1% over the trailing twelve months. The proportion of shortening consumed from internal production has increased from 66.8% in 2006 to 79.1% over the trailing twelve months. Management states increased vertical integration will increase gross margins as the company can produce raw materials at a 15-20% discount to the price it can buy them on the market meaning the decreased internal wheat production may have affected over gross margins. Assuming a 10% increase in internal production at a 10% discount to purchasing external, M. Dias Branco’s gross margin would increase by 1% so the decrease in gross margin is primarily due to a lack of pricing power indicating weak brand strength.

 

 

A brand needs to be built and supported with advertising and promotion. M. Dias Branco currently spends 2% of sales on advertising with a target of increasing the expense in the future. The company’s current marketing spend of 2% of sales is well below the spending of other food and beverage companies. Most of the company’s 2% advertising expense is promotion at the point of sale rather than advertising. Without advertising, it is difficult to build a brand and the lack of marketing spending by M. Dias Branco points to a weak brand.

 

According to AC Nielsen, the lowest levels of loyalty on a global scale (respondents said they were not loyal and likely to switch) were found with the food and beverage categories. 43% of customers are not loyal to alcoholic beverage brands, 39% of customers are not loyal to snack brands, 38% are not loyal to carbonated beverages, and 37% are not loyal to cereal brands.

 

The company believes brand plays a much bigger role in the cookies and crackers market then in the pasta market. This makes sense as product characteristics other than price play a much more important role in the cookies and crackers market. In the pasta market, the difference in taste between different pasta brands is negligible. Pasta is also usually not the main taste in a particular meal. It is usually mixed with something like a pasta sauce or vegetables to provide flavor. Other product characteristics such as durability during cooking plays a role but it may not be central to the customer’s purchasing decision. With cookies and crackers, taste is different between products and is the main reason for eating the product making it that much more important during the purchasing decision. Additionally, price plays a much more important role with lower economic classes.

 

Although the company’s brands may create a small barrier to entry in cookies and crackers, the lack of pricing power, low relative price compared to peers, and low advertising to support the brand all point to no barrier to entry related to the company’s brands.

 

Economies of scale gives an incumbent a competitive advantage over peers due to is sized allowing it to spread fixed costs over many more units decrease the total cost per unit.

M. Dias Branco has a clear size advantage over peers as it is the largest cookies and crackers producer and the largest pasta producer. The company’s size advantage is even larger in the Northeast, where M. Dias Branco is almost five times it closest competitor in pasta and almost nine times larger than its closest competitor in cookies and crackers. In the Southeast, M. Dias Branco has no advantage in pasta and is the fifth largest player in cookies and crackers so the company is at a size disadvantage.

 

The relevant fixed costs are distribution, advertising, and research and development. In parts of the Northeast, M. Dias Branco owns its own distribution network, which would be very difficult for any competitor to replicate given the fixed costs associated with owning the distribution network. The company’s own distribution channel allows the company to reach retail outlets that competitors cannot decreasing competition and increasing profitability. 40% of sales through the company’s distribution channel are to smaller outlets where very few competitors can reach leading to a maximum of two to three competing brands. The company’s distribution network allows strong customer relationships ensuring customers’ needs are met and the company’s always has shelf space. It also allows the company to take advantage of the operating leverage associated with owning a distribution network through pushing multiple products through its distribution channel. The company’s distribution channel could possibly be expanded as direct sales for 65% of cookie, crackers, and pasta sales in the Northeast region in 2014.

 

Advertising is another fixed cost that allows the company to take advantage of its size. Spending more on advertising allows the company to educate and recruit more customers than peers through building and supporting its brands leading to pricing power from brand strength. Within Brazil, tastes and cultures are still very regional leading to market share within specific regions being the key determinant of economies of scale in advertising. Unfortunately, M. Dias Branco under spends on advertising and could increase this strategic cost as a percentage of sales to take advantage of its size advantage. The company plans on increasing advertising as a percentage of sales.

 

Research and development is another fixed cost allowing M. Dias Branco to take advantage of its size and outspend peers. Research and development in the food and beverage industry includes new products, flavors, recipes, packaging, nutritional benefits, and much more. Similar to advertising, the company under spends relative to food and beverage peers.

 

Barriers to entry exist in the industry in the form of brands and economies of scale with fixed costs in distribution, advertising, and research and development. The evidence points to M. Dias Branco lacking any brand advantage. The company clearly has a size advantage and is taking advantage of it through owning its own distribution channel in parts of the Northeast but is failing to take full advantage of its size with under spending on advertising and research and development. It would take decades for another competitor to replicate the company’s size and position in the Northeast. Outside of the Northeast, the company lacks any size advantage.

 

 

Other Four Forces

M. Dias Branco’s suppliers have no bargaining power. The company’s raw materials are commodity products that are not unique and are available from many different suppliers with no switching costs. It is also the largest producer of both cookies and crackers and pasta within Brazil giving it purchasing power. This purchasing power is magnified by the ability of the company to store up to five months raw materials.

 

M. Dias Branco’s customers seem to be very fragmented eliminating their bargaining power. The company has over 70,000 active clients with 40.7% of revenue coming from direct distribution.

 

Sales through indirect distribution account for 59.3% of sales. Indirect distribution sales are to larger customers and carry lower margins. The company’s cookie and crackers products are unique due to taste. Pasta, wheat flour, margarine, and shortening are all commoditized products that do not differ that much between competitors.

 

With the exception of the Northeast of Brazil, M. Dias Branco’s markets are highly competitive with low levels of concentration. With the exception of cookies and crackers, the company’s product markets are primarily driven by price competition. The wheat flour market is characterized by a large amount of unutilized production capacity. Cookies and crackers and pasta have the potential for high fixed costs to drive out smaller players but this advantage is not being fully utilized allowing smaller players to survive increasing competitive rivalry. All signs point to a medium to high competitive rivalry within the company’s product markets.

 

With the exception of wheat flour, M. Dias Branco’s products have many readily available substitutes. With many of the company’s products price is the main driver of the purchasing decision leading to a greater threat of substitution.

 

 

MANAGEMENT TEAM

 

Members of management are owner operators. The largest shareholder (63.1%) is Francisco Ivens de Sá Dias Branco, the Chairman of the Board. Managers own another 11.4%. The Board of Directors and the Board of Executive Officers are primarily family members of Francisco Ivens de Sá Dias Branco including Francisco Ivens de Sá Dias Branco Junior, the CEO. Seven of the eleven Board members and Executive Officers are part of the Dias Branco family.

 

Francisco Ivens de Sa Dias Branco, the current Chairman of the Board helped build the company his father joining in 1953. He led the modernization and expansion of the company and was CEO until 2014 when his son Francisco Ivens de Sa Dias Branco Junior took over the role. Being a family oriented business has pros and cons. Holding almost 75% of the shares, the family can take a very long-term wealth maximizing view and disregarding short-term advice of financial markets. Given the large shareholding, a large portion of the family’s wealth is tied to the company’s performance therefore the family’s incentives are aligned with minority shareholders. Members of management are not agents trying to further their career but family members trying to increase the family wealth through company performance. The potential cons are the company was built by the current Chairman over the past 60 years. He is the patriarch of the family and the largest shareholder. He may be unwilling to listen to dissenting views. The company is full of family members that may not have strategic expertise or diversity of views to see the necessary perspectives and strategic logic to maximize shareholder value. The family may look at the company as their asset rather than an asset that is part owned by minority shareholders allowing them to take advantage of their position in the company. This is partially evident by the company leasing airplanes from a related party.

 

Corporate Culture

 

The company has created a strong corporate culture and scores highly in employee reviews. On Indeed.com, the company scored 3.5 to 4.0 stars on work/life balance, salary/benefits, security/advancement, management, and corporate culture.

 

Strategy

 

M. Dias Branco’s strategy includes increasing market share through diversifying its customer base through geographical expansion via acquisitions and organic growth. The company plans to acquire businesses with strong brands, a solid customer base, and an extensive distribution network. The company also intends to grow organically through the expansion of production capacity. The company will increase sales to non-residential food service and processing markets including restaurants, hotels, bars, hospitals, clubs, pastry shops, and bakeries. Given the potential economies of scale in the industry, increasing market share is one of the key drivers of excess returns within the industry therefore the priority of the company. The other key driver of excess returns is spending as much as possible on fixed costs to take advantage of the potential size advantage and put competitors at a disadvantage.

 

M. Dias Branco plans to expand its distribution network to increasing the fragmentation of its client base and sell new products. The company’s distribution network is a significant competitive advantage for the company and should be expanded at the margins of the current distribution network in the Northeast as cheaply as possible. The company will have difficulty recreating its distribution network in other regions given its insufficient size to cover the fixed costs and remain profitable. Outside of the Northeast, the company would be wise to select small regions with a very strong competitive position and build out its distribution network there before expanding at the margins. Another option would be acquiring existing distribution networks.

 

The company plans to improve operational efficiency and costs controls by optimizing its infrastructure, increasing the flexibility of the production chain, maintain full up to date production facilities with high-end technology and state of the art operations. In areas where there is no potential for a competitive advantage, operational efficiency is vital for survival. It should be the priority in not competitive advantaged activities.

 

M. Dias Branco will continue to focus on higher value-added products, such as new product lines or complementary product targeting markets in which it already operates allowing for higher margin products and greater ability to differentiate the company’s products.

 

The company plans to increase vertical integration in order to meet 100% of its wheat flour and shortening needs. This is the one strategic initiative that does not make much sense. Wheat flour and shortening are commodity products with little potential for sustainable excess returns. Similar to oil refining, a plant (wheat mill) is build. In that plant, a commodity is refined into another commodity and a margin in earned based on supply and demand. A manufacturer is a price taker with no differentiation. The only way to generate excess returns is through low cost operations.

 

The company states it is able to produce wheat flour at a 15-20% discount to what it can purchase it at on the market due to technological advantages in its equipment. Currently, there are over 100 small wheat mills with old production technology and a lot of unused capacity in the industry. Eventually the sector will consolidate and modernize when it does M. Dias Branco will no longer have a cost advantage. The company will also have to make additional investments to stay cost competitive and not destroy value as its current advantage is due to having latest technology and most productive equipment, which will no longer be an advantage when the rest of the sector modernizes. The company states it is able to generate double digit EBITDA from wheat flour in Brazil.

 

The company can store up to five months raw material inventory. Along with its size, this storage capability allows for bulk purchasing giving the company bargaining power over its suppliers decreasing profitability of a vertical integration strategy. The company states the vertical integration strategy allows for better planning but the ability to keep five months of raw material should be sufficient to improve planning.

 

Looking at M. Dias Branco’s peers in each business segment provides insight into the quality of each line of business. Food producers such as Bunge and Archer Daniels Midland (ADM) are the company’s competitors in raw materials that the company is integrating. Bunge is a competitor in Brazil and ADM participates in similar activities of buying, processing, and selling agricultural commodities. In cookie and crackers, the company competes with global food companies such as Nestle, Mondelez, and PepsiCo. In addition, other food and beverage companies are listed as key success factors of economies of scale in advertising, research and development, and distribution are similar.

As illustrated above, the food and beverage companies generate much higher gross margins and operating margins with similar if not higher invested capital turnover leading to ROIC much higher than simple commodity processing companies, Bunge and ADM. The food and beverage companies share prices also reflect the strong operating performance while Bunge and ADM’s share prices have lagged significantly over both five and ten years.

 

The vertical integration strategy does not make much sense. You are processing commodity products into another commodity product. Bunge and ADM are two of the largest and most efficient companies in the commodity processing business and both have very small operating margins. It would be very difficult for M. Dias Branco to have sustainable operating margins much higher than Bunge and ADM. The company can process the commodity at a 15-20% discount to what the company can purchase from potential suppliers but the company is one of the largest, if not the largest, wheat consumers in the country giving it tremendous bargaining power a fragmented supply base. Given the company’s ability to store up to five months raw materials, this drastically increases the company’s purchasing power and ability to control it raw material requirements. The 15-20% discount is not sustainable as it is merely a technological advantage that any competitor with capital can catch up to. It seems very unlikely that M. Dias Branco can generate sustainable excess returns in commodity processing business.

 

Capital Allocation

M. Dias Branco is in a very strong financial position with a net debt to equity of 0.10 times and net debt to EBIT of 0.57 times.

 

The company has remained conservative with its financing with net debt to EBIT never breaching 3.1 times.

 

The company reinvests the majority of the company’s earnings with an average dividend payout just over 22% since 2009. The company shares outstanding have remained stable at 113.45 million shares outstanding since 2009. Given the stock exchange requires 25% free float and the company maintaining a free float just above it meaningful share buybacks are unlikely. The company maintains a very healthy financial position but is wise enough not have too much cash on the balance sheet.

 

 

Since the end of 2006, M. Dias Branco has generated operating income before research and development and advertising of BRL3,941 million. The largest outlay during the period was acquisitions, which accounted for BRL1,068 million or 27% of operating income. The next largest outlay was dividends of BRL586 million or 15% of operating income. Followed by growth capex and advertising both just above BRL500 million or 13% of operating income.

 

There have been some issues with capital allocation. As mentioned before, the company should be spending much more on strategic fixed costs of research and development, advertising, and distribution to take advantage of its size and create a virtuous cycle that competitors cannot replicate. The company sales through its own distribution should be continuing to grow rather than receding for sales outside its own distribution network where the company faces more competition and weaker profitability. The company should be spending much more on advertising as the company is competing on price at the moment with pasta price at an average discount of 10% and cookies and crackers prices at an average discount of 35%. Advertising should be focused on cookies and crackers where there is more potential to build brand loyalty and pricing power. The company should also be spending much more on research and development.

 

Given economies of scale and size are so important in the industry, the company could be more acquisitive. The company has mentioned that deals are available but not at a price that interested them pointing to a disciplined approach to acquisitions. The company targets a payback period of five years or 15% IRR for all investment decisions.

 

Since the beginning of 2008, M. Dias Branco has disclosed information on five acquisitions. The company spent BRL1,068 million or 27% of operating income on these five acquisition making acquisition the largest outlay since 2007.

 

The company’s first acquisition was Vitarella in April 2008. Vitarella had two brands Vitarella and Treloso was the leader in the states of Paraíba, Pernambuco, and Alagoas in the Northeast of Brazil. In 2007, Vitarella generated revenue of BRL323.2 million, gross profit of BRL100.7 million, EBITDA of BRL57.5 million, and net income of BRL45.5 million. According to AC Nielsen, in 2007, Vitarella had 5.5% cookies and crackers market share in Brazil and 2.9% pasta market share in Brazil. M. Dias Branco paid BRL595.5 million equal to 1.8 times sales, 10.4 times EBITDA, or 8.1 times reproduction value. Vitarella was a very profitable company at the time of acquisition with a gross margin of 31.2%, an EBITDA margin of 17.8%, a net margin of 14.1%, and an estimated return on reproduction value of 62.0%. Assuming no organic growth or operational synergies, Vitarella had average net income of BRL53.4 million in the two calendar years prior to the acquisition leading to an earning yield of 9.0%.

 

In the two years prior to the acquisition, Vitarella had net revenue of BRL293 million in 2006 and BRL323 million in 2007 and EBITDA of BRL74 million in 2006 and BRL58 million in 2007. In 2014, Vitarella’s net revenue reached BRL1,023.2 representing a 216.6% increase or 17.9% CAGR, estimated EBITDA increased by 205.0% to BRL175.4 million or 17.3% CAGR, and estimate net income increased by 194.2% or 16.7% per annum.

 

84% of the increase in revenue, 89% of the increase in EBITDA, and 94% of the increase in net income is associated with an increase in capacity with the remaining increase related to operational improvements. M. Dias Branco increased cookie and cracker capacity at the Vitarella’s plant by 198,200 tons and pasta capacity increased by 29,300 tons for a total increase in capacity of 227,500 tons.

 

Using estimated reproduction cost per ton at existing facilities of USD375 per ton for cookies and crackers and USD300 per ton for pasta and the average exchange rate from the beginning of 2008 to the end of 2014, the estimated investment costs for the increased capacity is BRL164 million. Since 2009, the company’s average working per capital to sales is 16.2% multiplying this figure by the increase in sales leads to an additional investment in working capital of BRL113.2 million. Assuming Vitarella’s net margin converged with M. Dias Branco’s average net margin, which is below Vitarella’s net margin at the time of acquisition, the average net income of Vitarella brands averaged BRL127.1 million in 2013 and 2014 representing a BRL73.7 million increase from the average net income of Vitarella in the last two years as an independent company leading to a return on investment in capacity and working capital of 26.6%. Overall, the total return on the acquisition and additional investment in Vitarella is 11.9%. Vitarella’s initial acquisition was at a fair to cheap price with additional investment providing a very good return to shareholders.

 

In April 2011, M. Dias Branco purchased NPAP Alimentos (NPAP) for BRL69.922 million. NPAP’s main brand was Pilar. In 2010, the company had 71,000 tons of total capacity with 30,000 tons of cookie and cracker capacity and 41,000 tons of pasta capacity. The company’s main activities are in the Northeast of Brazil.

 

In 2010, NPAP generated revenue of BRL107.5 million, gross profit of BRL29.8 million, EBITDA of BRL7.6 million, operating income of BRL3.5 million, and a net loss of BRL3.6 million. The company had a 1.2% Brazilian cookies and crackers market share and a 2.4% Brazilian pasta market share. The acquisition price of BRL69.922 million equates to 0.7 times sales, 9.2 times EBITDA, and 1.9 times reproduction value.

 

Since acquisition, NPAP’s main brand Pilar’s revenues have increased from BRL107.5 million in 2010 to BRL141.9 million in 2014 representing a 7.2% CAGR. The company’s capacity has decreased from 71,000 tons in 2010 to 27,300 tons in 2014 so there were no additional investments in capacity. The increased revenues came with an estimated working capital investment of BRL5.6 million leading to a total investment of BRL75.5 million to reach BRL141.9 million in revenues.

 

NPAP’s margins are well below M. Dias Branco’s margins. Assuming NPAP’s margins have converged to M. Dias Branco’s margins, the company’s net income in 2014 was BRL18.6 million leading to an earnings yield of 24.6% on estimated total investment in NPAP. The 24.6% earnings yield is driven primarily by synergies and improvements in operations. Assuming NPAP’s margins only converged half way with M. Dias Branco’s margins and 5% organic growth is achievable, the earnings yield would be 12.3% and total IRR would be 17.3%, a good return for shareholders.

 

In December 2011, M. Dias Branco acquired all the shares of J. Brandão Comércio e Indústria Ltda. and of Pelágio Participações S.A.(Fabrica Estrela) owner of the brands Estrela, Pelaggio, and Salsito for BRL240 million. At the time of acquisition, Fabrica had 87,600 tons of cookies and crackers capacity, 51,600 tons of pasta capacity, and 7,000 tons of snacks and cakes capacity in Northeast and North of Brazil. In 2010, Fabrica Estrela generated BRL190.6 million in sales, BRL11.6 million in EBITDA, BRL8.9 million in operating income, BRL4.8 million in net income leading to acquisition multiples equivalent to 1.3 times sales, 20.7 times EBITDA, and 2.6 times reproduction value. In 2010, Fabrica Estrela had a 1.2% market share of the Brazilian cookies and crackers market and a 0.7% market share in the Brazilian pasta market.

 

Since the acquisition, revenues from Fabrica Estrela’s brand increased from BRL190.6 million in 2010 to BRL281.5 million in 2014 representing a 10.2% CAGR. Since acquisition, total capacity increased marginally with cookie and cracker capacity increased by 500 tons, pasta capacity increased by 100 tons, and snacks and cakes capacity increased by 2,100 tons leading to an estimated investment in capacity of BRL2.0 million. With an estimated working capital investment of BRL12.1 million, the estimated total investment in Fabrica Estrela is BRL104.1 million.

 

Similar to NPAP, prior to the acquisition, Fabrica Estrela’s margins were well below M. Dias Branco’s. Assuming a full convergence to M. Dias Branco’s margins Fabrica Estrela would have provided a 35.4% earnings yield before accounting for any growth. Assuming a half convergence, Fabrica Estrela’s earnings yield would be 17.7%. The key driver of the return is the improvement in operations after integration as the company was acquired at a no growth estimated return of 5.1%.

 

In May 2012, M. Dias Branco acquired Moinho Santa Lúcia Ltda, owner of brands Predilleto and Bonsabor. At the time of the acquisition, Moinho had 21,600 tons of cookies and cracker capacity, 30,000 tons of pasta capacity, and 30,000 tons of wheat flour and bran capacity. In 2011, Moinho generated BRL88.1 million in revenue, BRL14.0 million in EBITDA, and BRL7.3 million in net losses. Predilleto and Bonsabor had 0.2% market share in the cookies and crackers market and 0.5% pasta market share in the Northeast region. Predilleto and Bonsabor are not large enough for M. Dias Branco to report revenues separately. In 2014, the smallest brand reported was Amoreal, which recorded BRL8.66 million in revenues. Given the lack of size of Moinho’s brands, it seems the purchase was more about Moinho’s capacity meaning price to reproduction value is a better measure of value. The company purchased Moinho’s capacity at a price to estimated reproduction value of 2.1 times, which seems expensive.

 

In December 2014, M. Dias Branco won an auction to purchase the Rolandia wheat mill from a creditor of the former owner. The mill has 146,000 tons of wheat flour and bran capacity. Given the commodity nature of wheat mills, capacity should be value at roughly reproduction value. The company paid more than 1.6 times reproduction value for the wheat mill, which is expensive. The company acquired the wheat mill in an auction. Auctions are well known and you are competing against many informed bidders leading to a low probability of acquiring assets cheaply during an auction.

 

The company has done a great job acquiring cookies and crackers, and pasta brands at fair valuations and then improving the top line. It also seems that the company should be able to improve margins at these companies dramatically as the majority of acquisitions had margins well below the company’s. The company does not do as well when purchasing capacity, which has been well above reproduction value.

 

 

Capital Expenditures

 

The growth capex number is slightly different than the number reported on the company’s cash flow statement. The breakdown can be seen above. Since 2007, an estimated 55.7% of capex was spent on growth capex with the remainder on maintenance capex. 70% of capex was spent on machinery and equipment with the remainder spent on construction in progress.

 

Since 2007, cookies and crackers is the largest change in capacity followed closely by wheat flour and bran. M. Dias Branco does not breakdown investment costs by segment but the company did provide estimated replacement costs per tonne at existing facilities. This is the cheapest way to expand capacity therefore it is used as an estimate of the investment costs since 2007 and total reproduction cost of capacity. The company made the largest investment in cookies and cracker capacity with BRL779 million or 57.4% of total investment from 2007 to 2014 being spent on cookies and cracker capacity. Wheat flour and brand and pasta capacity received similar investment over the period roughly BRL243 million and BRL240 million, respectively.

 

Unfortunately, the company neither gives sufficient segment reporting by geography or product line to allow for proper evaluation but strategic logic can aid in assessing investments in various product lines and geographies. The investments in cookies and crackers and pasta, particularly in the Northeast where the company owns its own distribution channel and there is a huge size gap between the company and its competitors allowing it to outspend on fixed costs are very wise and probably generate a very high rate of return. As the company moves away from its base in the Northeast where the company is not as dominate, is competing with many similar size players, and does not own its distribution network, the rate of return most likely decreases drastically as the firm no longer has economies of scale advantages over competitor.

 

Investments in wheat mills and margarine and shortening seem to capital misallocated. The activity of milling wheat is nothing more than refining a commodity into another commodity, a task that will earn a margin determined by supply and demand. Over the course of a cycle, the industry as a whole will not earn excess return. In commodity businesses, some players within the industry may earn excess returns from having a lower cost position than peers. M. Dias Branco states it can produce wheat flour at 15-20% discount to the price it can buy it on the market due to technological advantage of having the latest production facilities and equipment. The company states it generates double digit EBITDA margins in wheat milling operations. The ability to generate excess returns will only continue as long as the wheat mill industry remains littered with smaller mills without resources to upgrade equipment. The Brazilian wheat mill industry is fragmented with many small mills and significant unutilized capacity. The fragmentation in a commodity industry points to no barriers to entry. The fragmentation along with significant unutilized capacity points to high competitive rivalry. Both point to an inability to generate sustainable excess returns. The returns at the largest commodity processors Bunge and ADM also point to an inability to generate excess returns.

 

The company can store up to five months raw material inventory. Along with its size, this storage capability allows for bulk purchasing giving the company bargaining power over its suppliers decreasing profitability of a vertical integration strategy. The company states the vertical integration strategy allows for better planning but the ability to keep five months of raw material should be sufficient to improve planning.

 

Looking at M. Dias Branco’s peers in each business segment provides insight into the quality of each line of business. Food producers such as Bunge and Archer Daniels Midland (ADM) are the company’s competitors in raw materials that the company is integrating. Bunge is a competitor in Brazil and ADM participates in similar activities of buying, processing, and selling agricultural commodities. In cookie and crackers, the company competes with global food companies such as Nestle, Mondelez, and PepsiCo. In addition, other food and beverage companies are listed as key success factors of economies of scale in advertising, research and development, and distribution are similar.

As illustrated above, the food and beverage companies generate much higher gross margins and operating margins with similar if not higher invested capital turnover leading to ROIC much higher than simple commodity processing companies, Bunge and ADM. The food and beverage companies share prices also reflect the strong operating performance while Bunge and ADM’s share prices have lagged significantly over both five and ten years.

 

The vertical integration strategy does not make much sense. You are processing commodity products into another commodity product. Bunge and ADM are two of the largest and most efficient companies in the commodity processing business and both have very small operating margins. It would be very difficult for M. Dias Branco to have sustainable operating margins much higher than Bunge and ADM. The company can process the commodity at a 15-20% discount to what the company can purchase from potential suppliers but the company is one of the largest, if not the largest, wheat consumers in the country giving it tremendous bargaining power a fragmented supply base. Given the company’s ability to store up to five months raw materials, this drastically increases the company’s purchasing power and ability to control it raw material requirements. The 15-20% discount is not sustainable as it is merely a technological advantage that any competitor with capital can catch up to. It seems very unlikely that M. Dias Branco can generate sustainable excess returns in commodity processing business.

 

Given the inability to earn excess returns in wheat milling, and margarine and shortening, investment in capacity in these sectors would be better spent on activities where the company can take advantage of its size to put competitors at a greater disadvantage. These activities include advertising, research and development, and expanding the company’s distribution network. The company does not report investments by segment, but at the end of 2014, the company had 1,556.6 thousand tonnes of wheat mill capacity and 180 tonnes of margarine and shortening capacity. Assuming replacement costs are BRL480 per tonne for each, the minimum misallocation of capital by management is BRL833.6 million. The money spent on vertical integration would be better spent on taking advantage of economies of scale present in the industry and building a strong brand that does not compete solely on price.

 

M. Dias Branco does a good job of acquiring companies at reasonable valuation then improving operations by using its infrastructure and relationships. The company does not provide details of profitability post acquisition but if the company is able to improve, profitability to a level similar to the company’s acquisitions would provide a really strong rate of return.

 

Corporate Governance

M. Dias Branco’s useful life estimates are in line with Brazilian food peers. It is very close to the average estimated life for some categories, above the average for others, and below the average for others, but there is nothing to cause concern.

M. Dias Branco’s management does not extract too much value only receiving 1.7% of operating income, above the peer group average but well below most of its smaller peers. Peers with operating income below BRL1 billion had average management remuneration to operating income of 9.1%. M. Dias Branco’s management does receive short term benefits or participate in any profit sharing program. Given the large ownership of the company, these are welcome signs.

M. Dias Branco’s consolidated related party transactions are not significant. The one concern is until 2014, the company leased an airplane from a related party called Rowena SA. The leasing expense was insignificant averaging BRL4.29 million from 2009 to 2013. Leasing a plane could be seen as a wasteful expense and something you would not see in a company focused on extreme operational efficiency.

M. Dias Branco’s common shares have 100% tag along rights and any buyout offer to the majority shareholder would need to be made to minority shareholders.

M. Dias Branco is relatively transparent and provides a wealth of useful information in its annual reference forms. Unfortunately, it does not provide sufficient information to analyze the company’s strategy. Segment disclosure related to different products and geographies would be extremely useful. At a minimum, revenues by product line and geography, gross profit by product line and geography, and assets by product line and geography should be reported to better allow analysis of the company’s vertical integration strategy and geographical expansion.

M. Dias Branco measures performance with EBITDA margin and payback period. In the 2015 reference form released in December 2015, the company stated EBITDA margin was the most appropriate measure for understanding its financial conditions and operating results. The company’s statement on EBITDA is translated form Portuguese.

 

EBITDA is a financial indicator used to evaluate the result of companies without the influence of its capital structure, tax effects and other impacts accounting without direct impact on your cash flow, such as depreciation. We believe that EBITDA is an important measure for understanding the financial capacity and cash generation capabilities required to understand operating performance. EBITDA is commonly used by investors and analysts. In the opinion of management, the importance of EBITDA comes from the fact that it is one of the non-accounting measures more appropriate to reveal the potential for cash generation as it excludes the operating results accounting items with no impact in the period of cash, such as depreciation and amortization.

 

EBITDA margin as a key metric is severely flawed and creates significant concern whenever a company uses this measure to assess performance. The biggest flaw of EBITDA margin is that it does not account for investment requirements. If BRL100 million in assets are required to generate BRL1 million in EBITDA and BRL5 million in revenues, it probably is not a good investment despite the BRL20 million EBITDA margin. The second problem with assessing investments with EBITDA margin is depreciation is not accounted for. While depreciation is not a cash expense, it is a real expense as assets wear down during use and eventually need to be replaced. EBITDA margin is a very poor measure to assess the quality of an investment and operations.

M. Dias Branco attempts to get five year payback period for any investment. Unfortunately, payback period is another poor metric for assessing investment quality as it does not take into account for cash flows past the payback period. For example, if an investment is made in an industry or geography where short term profitability is elevated due to lack of competition or an easily replicated advantage, cash flows in the short term will be elevated but will fall quickly once competition is entered. This type of investment may register a good payback period but a poor ROIC or IRR. The company should be using more sophisticated measures of profitability, such as ROIC, EVA, or IRR to assess investment opportunities.

 

 

 

Valuation

 

When valuing any company strategic questions must be asked first if the industry is viable. If the industry is not viable the company should be valued assuming a liquidation of the company. M. Dias Branco exists in viable industries with no threat of extinction therefore liquidation is not an important measure. To determine M. Dias Branco’s liquidation value, net working capital plus property plant and equipment is used, which is calculated be discounting accounts receivables on the balance sheet by 75%, inventory on the balance sheet by 50%, and PP&E on the balance sheet by 50% minus all liabilities at 100%.

 

The company’s liquidation value is BRL830 million or BRL7.32 per share representing 89% downside.

 

Given M. Dias Branco’s industry is viable, the next question is do barriers to entry exist? If barriers to entry do not exist, theoretically competition should compete away all excess profits and the value of the company should be equal to the cost to reproduce the company’s assets. On the asset side, cash, accounts receivables, inventory, other current assets (pre-paid expenses), and investments are valued at book value.

 

Property, plant, and equipment are valued at the cost to reproduce capacity.

 

The company’s capacity breakdown by product line is illustrated above.

 

The reproduction value per tonne is listed in US dollars as equipment is bought from international suppliers and is quoted in US dollars. Reproduction value per tonne is translated to Brazilian real with the depreciation of the Brazilian real verse the US dollar making it more costly for the competitors to reproduce the company’s assets.

 

The cost to reproduce the company’s production capacity has increased from BRL 675 million or BRL5.94 per share in 2007 to BRL2,737 million or BRL24.12 per share today driven by both capacity increases and depreciation of the Brazilian real.

 

Any investment in research and development, and distribution is amortized over five years to reflect the true economics of the expenses. Typically, advertising would also be capitalized and amortized over five years but M. Dias Branco’s advertising is primarily promotional activities, which is not building a brand but driving short term sales therefore expensing promotional activities is a better reflection of the economics of the expense. On the liabilities side of the balance sheet, non-interest bearing liabilities and deferred taxes are liabilities that spontaneously occur through the course of business therefore reduce the cost of reproducing assets. In addition, debt reduces the value of reproduced assets to shareholders therefore is subtracted. All liabilities are valued at book value and subtracted from assets to get to equity value.

 

Under the assumptions mentioned before, it would take BRL11.8 million or BRL0.10 per share to reproduce research and development and BRL2,461 million or BRL21.70 per share to reproduce its distribution assets.

 

The total estimated cost to reproduce M. Dias Branco’s assets is BRL6,740 million with debt or liabilities naturally occurring during business of BRL1,253 million. The reproduction cost per share is BRL51.99 representing 24% downside from M. Dias Branco’s current share price. Reproduction cost is the best method of valuation for companies that compete in industry where barriers to entry do not exist. The best time to buy companies valued with reproduction cost is at a 50% discount to reproduction cost.

 

Another form of measuring reproduction cost is looking at valuation multiples of recent acquisition. The assumption is companies making the acquisition completed a detailed build vs. buy analysis.

 

The table above shows M. Dias Branco’s acquisitions, a Brazilian food and beverage acquisitions, a rumored acquisition of M. Dias Branco, and a number of wheat mill acquisitions. At the end of 2007, Kraft was rumored to be in talks to acquire M. Dias Branco for 1.3 times sales and 13.1 times EBITDA. Using the 13.1 times EBITDA multiple, M. Dias Branco’s fair value is BRL78.20 per share representing 14.2% upside.

 

The median acquisition multiple for non-M. Dias Branco acquisitions was at an EV/Sales of 1.7 times, and an EV/EBITDA multiple of 11.8 times. Using this median multiple of 11.8 times, M. Dias Branco’s fair value is BRL70.44 per share representing 2.8% upside.

 

The median wheat mill acquisition was at USD233.3 per tonne of capacity. Replacing the USD120 per tonne with a more conservative figure of USD200 per tonne increases the value of M. Dias Branco’s wheat flour and bran capacity from BRL6.70 per share to BRL11.60 per share leading to an increase in total reproduction value from BRL51.99 per share to BRL56.46 per share.

 

 

The table illustrates acquisition multiples (EV/EBITDA) within the food and beverage industry from 2009 to 2014. M. Dias Branco falls under Baked/Snacked foods, a segment where the average EV/EBITDA multiple was 10.7 times with a high of 13.4 times in 2014 and a low or 8.9 times in 2009. Assuming the average acquisition multiple of 10.7 times EBITDA, M. Dias Branco’s fair value is BRL63.87 per share or 6.7% downside.

 

If the company has barriers to entry and can sustainably earn excess returns, the best valuation technology is to determine the company’s sustainable earnings power to determine a fair value. To derive a value from M. Dias Branco’s earnings power we use an Earnings Power Valuation, a DCF, and a Residual income valuation. The key static assumptions used in earnings power valuations are  a discount rate of 10%, an effective tax rate of 12.1%, working capital turnover of 5.6 times, and fixed capital turnover of 2.5 times.

 

A discount rate of 10% is used as the discount rate is viewed more as a hurdle rate or opportunity cost rather than a company specific cost of capital. The typical method of determining a company’s cost of capital is subject to estimation errors as a company’s beta may change by up to 0.5 in a matter of six months leading to significant swings in the company’s cost of equity rendering the calculation useless. Include potential estimation errors in determining the risk free rate and equity risk premium, the cost of capital calculation is subject to large swings and potential behavioral biases.

 

A 12.1% tax rate is consistent with historical averages and assumes the company will continue to receive tax incentives for investing in improving or expanding facilities.

 

Capital efficiency is assumed to remain similar to the past seven years with 2007, 2008, and 2015 representing cyclical downturns.

The table above is estimated fixed capital turnover based on the cost of reproducing capacity as the company does not report assets by segment. The concern is the decrease in capital efficiency is due to competition and a lack of barriers to entry rather than cyclicality.

 

The key variable assumptions are sales growth and operating margin. In the earnings power valuations, there are three stages, the first five years, a second four years, and terminal assumptions. The second four years represent a fade from the assumption over the first five years to the terminal assumptions.

 

At current prices, there are only three scenarios where M. Dias Branco meets the 15% annualized return requirement over the next five years. These scenarios assume 2.5% perpetuity growth and peak margins or 5% perpetuity growth and average or peak margins. Using conservative assumptions the company looks more attractive below BRL50 per share, which coincides with the estimated reproduction cost of the company.

 

At current share prices, an investment in M. Dias Branco only reaches the 15.0% target return if it can generate return on reinvestment of 25.0%. With the company investing heavily in vertical integration and regions outside of the reach of its distribution network, it will be very difficult for the company to reach a 20.0% return on reinvested earnings never mind a 25.0% return on reinvested earnings. 0% organic growth is assumed as it has been illustrated that the company does not have pricing power.

 

The ideal valuation method would take into account the barriers to entry in some of the company’s segments valuing those segments on the company’s earnings power, while valuing segments in more commodity businesses at reproduction value. Unfortunately, M. Dias Branco’s reporting is not transparent enough, therefore the company’s earnings power is the most appropriate valuation technique given the company’s consistent excess returns, economies of scale, and potential for a brand.

 

RISKS

 

Brazilian macroeconomics poses a large risk to any investment within the country. Brazil is a large exporter of commodities and the weakness in commodity prices lead to a downgrade of the country’s credit rating to junk. The macroeconomic concerns caused the Brazilian real from a low of 1.5252 in June 2011 to a high of 4.2411 in August of 2015. The weakness of the Brazilian real leads to increased cost of goods sold as raw materials are quoted in dollars.

 

The company’s raw materials are commodities with extremely volatile prices.

 

The company moving away from its traditional stronghold of the Northeast, where it has a huge market share advantage as well as an unrivalled distribution network. This move away from a region where it is competitively advantage brings with it competition and little if any advantage over peers leading to potentially weaker returns.

 

The company’s vertical integration strategy brings with it a potential decrease in returns. The company is backward integrating into pure commodity industries. The company can currently produce its integrated raw materials cheaper than buying them on the market due to having the most technologically advanced equipment. The industries of the company’s vertically integrated raw materials are characterized by many small players and significant unutilized production capacity. These smaller players do not have access to capital to modernize their facilities. As the market consolidates, competition will become more intense and these facilities will then acquire the latest production technologies and M. Dias Branco will have to invest to keep up with the newer competition or returns will lag competitors.

 

The company is facing increasing competition from Multinationals corporations with significant resources and expertise.

 

Increased concentration of retailers will bring increased bargaining power of customers. Increased concentration of the retail segment also brings increased risk of competition from private label. There was  a big private label push in 2002 and 2003 but was not able to gain a substantial piece of the market.

 

  1. Dias Branco is acquisitive with acquisition comes the risk of overpaying, integration risks, and antitrust risks. The company has shown to be a good integrator with most acquired brands showing strong improvement in revenues. The company has overpaid assuming no improvement to the acquired company earnings. In commodity markets, the company has paid well above estimated replacement cost.

 

The company profitability is tied to tax incentives. If the company loses tax incentives profitability will deteriorate.

 

  1. Dias Branco admits to under spending on advertising spending about 2% of revenue primarily on promotions. To build a brand, the company will need to increase advertising decreasing profitability. It runs the risk of advertising not leading to a stronger brand allowing for price increases and pricing power in the long run.

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17

 

 

2016 ANNUAL PERFORMANCE REVIEW

 

While the annual performance review is somewhat arbitrary, it is good to review you investment process on a regular basis to find improvements.

 

In 2016, the average local currency return of our recommendations was -3.1% with the average US dollar return not far off at -3.0%. Relative performance was -5.3% as the Emerging Market Small Cap Index as measured by iShares MSCI Emerging Market Small Cap ETF (EEMS) was up 2.3% compared to our average US dollar return of -3.0%.

 

The major drag on the performance of recommendations was Miko International and Universal Health. Universal Health saw a significant decline after its founder and majority took a loan against the company’s shares leading to forced selling in the stock. Subsequently, the company’s operational performance deteriorated drastically leading us to question the validity of the company’s initial financial statements. Miko International saw a number of independent directors resign followed by its auditor resigning due to disagreements over accounts in the company’s financial statements. It hired an auditor of last resort known to work with many Chinese frauds. We also saw poor performance at another Chinese company Honworld as management’s poor capital allocation inhibits its ability to grow without raising external funds. The poor performance of the Chinese small and mid caps leads us to question the financial statements in many Chinese small and mid cap companies. Given the inability to have any conviction, we are taking a smaller position if we invest in Chinese companies. Our other Chinese investments in Peak Sports Products and Anta Sports Products were our second and third best performing stocks in 2017 making us not totally write off investing in Chinese companies. Interestingly, the poorly performing Chinese companies all recently went public and therefore we have implemented a rule of not purchasing any stock that went public in the last three years.

 

The poor performance of Universal Health and Miko International highlighted the limits to our knowledge leading us to be less aggressive with our position sizing. Our new position sizing philosophy is 1-2% for high quality watch list stocks like Credit Analysis and Research and Anta Sports, 2.0% for deep value, 2.0% for Chinese companies, and from 2.0% to 8.0% for high quality companies depending on the strength of the business and attractiveness of returns. The goal is to get 25-35 holdings. The smaller position sizes do not match with the depth of our research. Our research was deep dive taking up to a month. The depth of research clearly required the ability to take larger position sizes as you can research only 12 ideas in a year. Assuming, half that are fully researched reach our investment standard leads to a maximum of six recommendations per year. There is no way we could ever be fully invested with our new position size philosophy, therefore, we are decreasing the depth of the research so we can hopefully one day get close to fully invested. We will focus on the crucial elements of every investment but not as much in depth. Hopefully, this will also increase the value of the blog for readers as we are trying generating more ideas by researching more companies. As mentioned, we will also be looking at high quality stocks that may be slightly more expensive than our typical investment but meets all other requirements. These will be formally placed on the watch list and placed in the portfolio at a smaller position size. Credit Analysis and Research and Anta Sports fall into this category. The hope is these positions will eventual become more attractive on valuations. The side benefit is highlighting more high quality companies.

 

Since May 2014, we have made 10 recommendations generating an average outperformance of 30.9%, with three recommendations having negative absolute performance. The average time from recommendation to sale is 459 days with four of the 10 recommendations still being held.

 

Overall, 2016 was not the best year for stock selection with underperformance of 5.3%. More importantly, we feel the mistakes made have allowed us to strength our process. Despite the bad year, our recommendations are up 30.9% since May 2014.

 

The table above illustrates position sizes at the end of each half since the end of the first half of 2014.

 

In 2016, our portfolio fell be 12.8% on the back of poor performance and large positions in Universal Health, Miko International, and Honworld. Despite the poor performance in 2016, our portfolio is up 12.3% in absolute terms since inception and 24.4% relative to EEMS, while averaging 67.9% of the portfolio in cash. The large cash position is a function of our high threshold for investment and the time required in our in depth research process. Hopefully, our shorter reports will allow us to be more efficient at finding ideas allowing us to put the cash to work.

 

While 2016 was not the best year in terms of performance, the improvements made to our process due to the mistakes made should more than make up for it in the future.

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

Mrs. Kusum Jain, a non-Executive Director, resigned from PC Jeweller’s board, with effect December 30, 2016. This is the first director resignation at PC Jeweller for some time, but it is worth monitoring in case there are additional resignations from independent directors.

 

On December 21, 2016, Zensar Technologies announced it appointed Manoj Jaiswal as Chief Financial Officer. Manoj Jaiswal was Chief Financial Officer for CEAT, another RPG Enterprises company. Before joining CEAT, Manoj had spent 17 years in Wipro in different roles.

 

Zensar also changed its auditor to Deloitte from PricewaterhouseCooper. Under Section 139(2) of the Companies Act, 2013, all listed companies and certain categories of unlisted public companies and private companies are mandated to rotate their auditors after 10 or more consecutive years.

 

On January 7, 2017, CARE announced that it was shutting down its Maldives operations after its license expired and decided not to renew. The Maldives operations were insignificant.

 

 

INTERESTING LINKS

 

 

Horsehead Holdings (Aquamarine Fund)

 

Guy Spier, a noted value investor, and portfolio manager of Aquamarine Fund looks back at his investment in Horsehead Holdings. It is a very good template for looking back and learning from your investment mistakes. (link)

 

Looking For the Easy Game (Credit Suisse)

 

Credit Suisse’s Michael Mauboussin discusses passive and active investing. (link)

 

A Bird in Hand is Worth More Than (Forecasted) Eggs in the Future (Latticework)

 

This is a very good article by Amit Wadhwaney of Moerus Capital Management discussing his investment philosophy. (link)

 

The Future of Retail 2016 (Business Insider)

 

Business Insider’s BI Intelligence unit created an interesting slide deck on the future of retail. The slide on the article illustrates the share of digital in different categories. Useful for understanding what segments of retail are most impacted by the internet. (link)

 

Patagonia’s Philosopher King (New Yorker)

 

The New Yorker wrote an article on Yvon Chouinard, the co-founder of the outdoor-apparel company Patagonia. (link)

 

The Irrationality Within Us (Scientific American)

 

Scientific American discusses our irrationality. (link)

 

Charlie Munger on the Paradox in Hold vs. Buy Decisions in Long Term Investing (Fundoo Professor)

 

Professor Sanjay Bakshi discusses Charlie Munger’s thoughts on the decision to continue to hold a stock vs. the decision to buy a stock. (link) The comment section should be read as well as there are many insightful comments. As illustrated by the changing of our positions sizes, we do not subscribe to the buy and hold regardless of valuation. By saying that you would continue to hold an asset at a particular price but you would not buy the same amount if you did not hold it, you are ascribing more value to the asset you hold, which is a bit irrational and is known as the endowment effect. Endowment effect is valuing an item you own more than an identical item you do not own. We try to look at all companies the same way, whether we hold them or not. First, a high percentage of companies can be ruled out as a potential investment due to poor financial health, poor management, or poor business quality. We may compromise on business quality if the company is a deep value investment but there is a limit on this compromise. Once companies pass the first investment hurdle, we assess the attractiveness of the company based on its business quality, management, growth outlook, and risk. Future returns are estimated based on scenarios giving a range of potential returns. If the market values a company so highly that very aggressive assumptions are required to meet the market’s expectations, we would not buy a company or hold a position. If on the other hand, if the market was valuing that same company so cheaply that the most conservative assumptions pointed to significant upside and there was sufficient business quality, we would take our maximum position of 8%. In between the two extremes is a spectrum of potential returns leading to a spectrum of position sizes between 0% and 8%. The decision of the position size is based on the attractiveness of the returns of a business not whether we hold a stock or not.

 

Valuation and Investment Analysis (Bronte Capital)

 

Bronte Capital wrote an article discussing how they do not use valuations in their investment process. (link) Again, please read the comments as there are some useful comments.  Clearly, we do not agree with Bronte Capital’s view.  We agree that valuation is difficult and does not provide a point estimate that is why ranges and scenario analysis needs to be used in the valuation process or reverse engineering a DCF or Residual Income model to find out the market’s expectations of key value driver assumptions. These market assumptions can be tested for reasonableness. We believe it is very difficult for anyone to call themselves an investor if they do not have some estimate of what is the value of potential investment. Investing requires understanding the fundamentals of the business, and the valuations of the business. Value investing requires an additional margin of safety to ensure you are not buying a business with sufficiently attractive returns. Not having an estimate of the potential returns of an investment is pure speculation. Bronte Capital focus on operational momentum to ensure the business will continue to grow for a long time. The problem is growth stocks often do not meet the growth expectations of the market and this is precisely why you should have an understanding of what type of growth the market is expecting. Within the Emerging Markets small cap universe, the MSCI Emerging Markets Small Cap Growth Index has underperformed the MSCI Emerging Markets Small Cap Value Index by 141.34% over the past 16 years or 5.66% per annum. Similar to Bronte Capital, growth investors are more concerned with growth than valuation leading to missing a big piece of the puzzle in understanding a business.

 

Value vs. Growth in Emerging Markets

 

Given the past two articles, we thought it be interesting to review the performance of various Emerging Market indices to see how each style has performed.

 

The table above illustrates the performance of MSCI Emerging Market indices across size and style biases. Indices have various inception dates so the longest time period with performance for all indices is 10 years. Over that period, the best performing index is Emerging Markets Quality index followed by Small Cap Value and the Small Cap Index. Over the past 20 years within the large and mid cap universe, value outperformed growth by 1.00% per annum. Quality seems to be the best performing index outperforming the overall index by 1.95% per annum since 06/30/1994 compared to only 0.44% per annum outperformance of value over the past 20 years, and -0.57% underperformance by growth over 20 years. There is a one and a half year difference in the long term performance figures if quality and value and growth, but given the length of the track record there would need to be a drastic underperformance of quality (roughly 35%) over that one and half years for quality’s performance to fall back to the value index’s level of performance. With some confidence, we can say quality has been the best style among the Emerging Markets large and mid cap universe.

 

Small Cap outperformed the large and mid cap index by 1.24% per annum illustrating a persistence of the size premium in Emerging Markets. Within the Emerging Markets small cap universe, value outperformed growth by 5.66% per annum over the past 16 years. The 5.66% growth translates into 141.34% additional performance over the period. There is no small cap quality index to compare the quality style.

 

Value outperforms growth in Emerging Markets with significant outperformance vs. the benchmark and growth in the Emerging Market small cap universe. Brandes Institute of Brandes Investment Partners did a study on style bias in Emerging Markets, which can be found here.

 

Alexa: Amazon’s Operating System (Stratechery)

 

Ben Thompson always writes great articles on technology therefore is a must read. We tend not to invest in technology as short product life cycles leading to disruption leading to difficulty valuing these companies. Despite the difficulties in technology, Silicon Valley and start-ups are very good at understanding all aspects of business models and therefore reading some of the best writers in the industry helps increase understanding of business models in more investable industries. In this particular article, Mr. Thompson writes the business model of operating systems. (link)

 

Tren’s Advice for Twitter (25iq)

 

Like Stratechery, 25iq is a must read. Tren Griffin works in the technology industry but is a value investor. Mr. Griffin gives his advice to Twitter. His advice is relevant for all companies. Understand your competitive advantage and continue to strengthen it while being as operationally efficient as possible. There is not much more to strategy. Understand your competitive advantage.  If it is unique advantage,  strengthen it as much as possible. If it is a shared competitive advantage, try to cooperate with competitors as much as possible to distribute fairly the benefits of the value created by the shared competitive advantage. If there are no competitive advantages, operational efficiency is the most important thing. Due to institutional imperative, which prevents firms from acting as rational as they can, operational efficiency can allow one firm to persist with excess profits for a long time. The importance to barriers to entry on strategy and profitability illustrates why the identification of competitive advantages, also known as barriers to entry, are so crucial to Reperio’s investment process. (link)

 

Amazon’s 2004 Shareholder Letter

 

Amazon’s 2004 Shareholder Letter stresses the importance of free cash flow not earnings the main metric followed by most market participants as earnings does not take into working capital and fixed capital investments required to generate additional earnings, while free cash flow accounts for the necessary investments. (link)

WEEKLY COMMENTARY 12/13/16 – 12/19/16

WEEKLY COMMENTARY 12/13/16 – 12/19/16

 

 

POSITIONING

 

 

 

 

COMPANY NEWS

 

Grendene changed its auditor from PWC to E&Y due its requirement to change its auditor every five years.

 

We were thinking about PC Jeweller and the potential evolution of the jewelry retail industry in India. When think about industry evolution in Emerging Markets, we often look to developed markets for roadmaps. Each market has idiosyncrasies but strategic logic should hold from industry to industry across geographies. For example, the retail market structure in India should eventually look like retail market structure in the US as the industry develops. Retailing is fiercely competitive in all markets with no barriers to entry therefore all industries should have many competitors with very few if any generating significant sustained excess profits.

 

Our main reference point for the following information on the US Jewelry market is Edahn Golan Diamond Research & Data’s 2015 US Jewelry State of the Market report. You can download the report here. According to the Jewelers Board of Trade, there were 21,463 specialty jewelry retailers accounting for 43% of the US jewelry and watch retail market. The vast majority of these specialty stores are independent with Signet Jewelers being the largest retailer accounting for 4.3% of overall jewelry sales in the US and 9.8% of specialty jewelry sales. Signet Jewelers had roughly 3,000 stores at the end of 2015.  Despite market development and industry maturation, the US jewelry market remains fragmented with thousands of players illustrating a lack of barriers to entry and continued competitive pressures.

 

The lack of barriers to entry puts a cap on Signet’s and Tiffany’s ability generate excess profits with their average ROIC over the last five years below 15%.

 

Looking at the United States jewelry retail industry as a roadmap leads one to believe that fragmentation will persist within the Indian jewelry retail industry.

 

Another use of the roadmap is the potential multiple the market gives a company during maturity.  Signet’s EV/IC has ranged from 1.69 in 2012 to 2.89 at the end of 2015, while Tiffany’s EV/IC ranged from 2.54 at the end of 2016 to 3.55 at the end of 2015.

 

Signet’s EV/EBIT ranged from 6.86 in 2012 to 18.94 in 2015. Tiffany’s EV/EBIT ranged from 11.84 in 2016 to 37.19 in 2014, with operating Income in 2014 was depressed. Accounting for the depressed operating income, EV/EBIT ranged from 11.84 to 14.49.

 

We have included similar analysis on Honworld (condiments) and Universal Health (pharmacies/pharmaceutical distribution) that we did in the past at the end of the weekly commentary.

 

 

INTERESTING LINKS

 

Deep Dive into China’s Apparel Market (Fung Business Intelligence)

Fung Business Intelligence freely provide a lot of good information on China. In this multi-part report, Fung Business Intelligence provides detail on China’s Apparel Market. (Part 1) (Part 2)

 

Asahi to Buy SABMiller’s Eastern European Beers in $7.8 Billion Deal (Bloomberg)

Acquisition news is always interesting as a knowledgeable player in the market puts a value on an assets based on a detailed analysis. The problem is we do not know the assumptions the acquirer is using, which are crucial, but it gives an idea of an appropriate valuation multiple in an industry. The paragraph below is from the Bloomberg article.

 

The offer values the SABMiller assets at about 15 times Ebitda of 493.8 million euros for the year ended March 2016, according to Bloomberg calculations. That compared with the median of about 11.5 times trailing twelve-month Ebitda for 9 brewery acquisitions announced worldwide in the past five years, according to data compiled by Bloomberg.

 

We extended the sample size of acquisitions back to 1999 and the median acquisition multiple was 11.7 times not far off the 11.5 times paid over the last twelve months.

 

 

 

The table below shows the upside to the 11.7 times multiple for various brewers in Emerging Markets.

 

 

 

Median Buyout EV/EBITDA Ratios Rising (PitchBook via ValueWalk)

 

The PitchBook examines the median buyout multiple for private value investors.  (link)  What we find interesting is the disconnect between what business owners are willing to pay and the valuations public market investors are willing to pay for companies.

 

 

The Undoing Project: A Friendship That Changed Our Minds (The Rational Walk)

 

The Rational Walk discusses Michael Lewis’ new book about pioneers in Behavioural Finance and how it relates to investing. (link)

 

 

The Story of How McDonald’s First Got Its Start (Smithsonian)
The story of the history of the McDonald brothers before McDonald’s became a multi-chain restaurant. (link)

 

 

What is Your Edge? (Base Hit Investing)

 

An article discussing three types of edges in investing. (link)  We view our biggest edge over other market participants is a time horizon edge as we are looking for stocks for the next three to five years.  This also brings an analytical edge as we are analyzing business from the view point of a business owner rather than trying to figure out if the company will beat next quarter’s expectations.

 

 

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

 

An older post discussing how Buffett categorizes businesses (link)

 

 

HONWORLD DEVELOPED MARKET ROADMAP

 

As mobility increases in China, cultures converge leading to a more homogenous tastes and markets.  This will take generations to play out but when it does it leads to a national market similar to many developed market like the US. The cultural convergence leads to the ability to apply fixed costs to a larger market increasing consolidation and dominance of larger players as smaller players cannot reach the minimum efficient scale required to compete.

 

The significant fixed costs in the form of advertising and distribution allows a brand to be built by larger competitors as more customers can be reached and educated. A brand is particularly important in an industry with a low priced product as the brand decreases search costs for customers leading to potential habit forming behavior. For example in the US, customers have acquired a taste for Heinz Ketchup.  When a customer goes to the store given Heinz may cost as little $2.50 a bottle and the Heinz brand represent a known and liked product that customer is not going to spend anytime even thinking about another brand given very little benefit.

In addition, retailers only have so much shelf space and are unlikely to place 15 to 20 different cooking wines on the shelf as a good number of the 15 or 20 cooking wines will not sell leading to waste shelf space.  The biggest players have a tremendous advantage as retailers now they will sell.

 

The table below shows the market structure of the five largest condiment markets in the US.

 

The US condiment industry is a great example of industry consolidation in a more developed market and a good roadmap for the Chinese Cooking Wine industry. The lowest concentration ratio among the largest five US condiment markets is the Hot Sauce market with a 52.2% four firm concentration ratio, while the highest is Ketchup with a 78.6% three firm concentration ratio. The four firm concentration ratio in the Chinese Cooking Wine segment is only 26.8% so there is potential for significant consolidation. The low four firm concentration ratio reiterates the fragmented regional nature of the market.

 

 

UNIVERSAL HEALTH DEVELOPED MARKET ROADMAP

 

Market Structure

 

The pharmaceutical retail segment in China is fragmented. According to the China Food and Drug Administration, in November 2013, there were 433,873 chain and individual drug stores in China, 10,150 more stores than 2012. There are 3,376 enterprises with multiple locations in China. Enterprises with multiple locations are more likely to manage the business for profitability and close down unprofitable stores. All though the market is fragmented, market consolidation is underway with Universal Health and Sinopharm leading the way. Retail competition comes in the form of target customer bases, business models, and product portfolios.

 

At the time of its IPO, Universal Health was the largest pharmaceutical retailer in Northeast China with 794 self operated outlets.  There is not sufficient information to get a sense of the efficiency of each store as competitors with higher revenue per store maybe a function of bigger stores, but it seems Universal Health’s may not be as efficient as competitors. This poor efficiency may be due to acquiring less efficient stores and improving operations. The pharmacy market in Northeast China has low level of concentration with a 2012 five firm concentration ratio of 44.2%.  This only tells part of the story as there could be a large number of smaller independent stores.  Universal Health has increased its estimated market share in Northeast China retail from 5.7% in 2012 to an estimated 8.8% in 2014.

 

The largest distributors in Northeast China at the time of the IPO are listed below. Universal Health is the largest private pharmaceutical distributor in Northeast China.

 

 

The largest retail pharmacy chains in China are listed below.  In 2012, the largest pharmacy operator had a 2.1% market share.  The 2012 five firm concentration ratio was 9.4%, while the ten firm concentration ratio was 16.0% indicating a very fragmented market. At the end of 2012, Universal Health’s China retail market share was 40bps.

 

The Chinese pharmaceutical distribution market is less fragmented than the retail market but still exhibits low concentration with the leading player accounting for 16.8% of the overall market.  The five firm concentration ratio is 36.5% and the ten firm concentration ratio is 44.9%. Universal Health garnered 16 bps of the total Chinese pharmaceutical distribution market.

 

While each individual country has its own idiosyncrasies leading to different development paths, the market structure of more developed markets may give a roadmap for developing countries.

 

The US pharmacy market shows moderate levels of concentration with a five firm concentration ratio of 64.4%.  There is some fragmentation but there are a significant number of small players still operating in the market.

 

According to Canada’s Office of Consumer Affairs, the Canadian pharmacy market has a 2012 four firm concentration ratio of 68.6%. The largest company is Shoppers Drug Mart with a 31.8% market share followed by Katz Group with a 16.7% market share, Jean Coutu with a 12.2% market share, and McKesson with a 7.9% market share.

 

According to the Pharmaceutical Journal, in the UK, there are 14,361 pharmacies with 4,201 independent owners, owning up to five pharmacies, operating 5,590 pharmacies and 174 multiple owners, owning six or more pharmacies, operating 8,771 pharmacies.  Large owners and supermarkets account for 52% of the overall market.

 

The US’s, Canada’s, and UK’s pharmacy market structures point to a much more consolidated market than the Chinese market but not the oligopolistic market structure you would expect if there was a significant benefit from economies of scales.  There seems to be economies of scale in purchasing but only to a point. Another reason for the fragmentation and large number of small independent operators may be that independent operators do the job for something other than profit maximization.  Just like optometrists or dentists, the ability to be your own boss and make a decent living trumps the desire to sell to a larger chain or exit when faced with a competitive disadvantage.

 

Pharmaceutical distribution markets are far more concentrated in developed countries than China with a three firm concentration ratio ranging from 43% to 85%.  Developed pharmaceutical distributors, economies of scale manifest themselves in high capital efficiency as operating margins often struggle to reach 2%.   The high fixed costs associated with upfront investments and low marginal cost for selling an additional unit leads to very high competitive rivalry among distributors and the need to utilize fixed costs as much as possible leading to greater profitability.

 

 

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

 

 

 

 

COMPANY NEWS

 

There was no news related to portfolio companies this week.

 

We are decreasing our Credit Analysis and Research (CARE) position to 0%. We initiated the position at 2.0% as categorizing CARE as a high quality company that was slightly overvalued. Since initiation, the share price increased by 44% making the company overvalued with significant growth needed to generate any return.

 

We are also decreasing our Anta Sports position to 0% as we initiated the company as a high quality company that met all the criteria for investment with the exception of price as we felt it was slightly overvalued. The share price appreciated by 25% since our initiation and the company is now overvalued rather than slightly overvalued.

 

 

INTERESTING LINKS

 

At Deloitte, the problems with audit quality and professionalism start at the top (Marketwatch)

 

Deloitte is facing regulatory backlash over faulty audits and misleading investigators. It is not the first time and will not be the last. (link) There have been many examples of Chinese companies listed in Hong Kong IPO’d with a big 4 auditor that turned out to be frauds.

 

The Magic in the Warehouse (Fortune)

 

An interesting article discussing Costco, its business model, and its culture (link)

 

How to Build Great Teams (Society for Human Resource Management)

 

A great discussion on how to build great teams through communication and fit (link)

 

Why is Customer Acquisition Cost (CAC) like a Belly Button? (25iq)

 

Tren Griffin illustrates the importance of knowing the CAC in your business. (link)

 

Huawei’s Hard-Charging Workplace Culture Drives Growth, Demands Sacrifice (Wall Street Journal)

 

The Wall Street Journal writes about the culture of Huawei. (link)

 

Q3 2016 Report (IP Capital Partners)

 

IP Capital Partners’ Q3 2016 Report contains a good investment case for Amazon. (link)

 

 

 

INTOUCH HOLDINGS PRE-RESEARCH REPORT

 

EXECUTIVE SUMMARY

 

Intouch Holdings is an investment holding company with Advanced Info Services (AIS) account for over 95% of its intrinsic value. AIS is the leading mobile operator in Thailand with roughly a 50% market share. The industry has barriers to entry in the form of economies of scale and brand.  The large fixed costs come in the form of investment in spectrum and infrastructure and to a lesser extent marketing and distribution. Given AIS size and the presence of economies of scale, it has a significant advantage over its peers. Regulation also limits the competition to Thai companies.

 

Thailand recently held 3G and 4G spectrum auctions. The increased cost of spectrum decreases returns on investment in the industry as capital efficiency is much weaker leading to lower intrinsic values. The market is pricing in current earnings weakness due to a strong intensity of rivalry but valuations must fall further to account for the lower capital efficiency. In our estimate, AIS would be a buy below THB70 before becoming a buying opportunity translating to a buy price of Intouch below THB30 per share.

 

 

FACTOR RATING

 

 

 

COMPANY DESCTRIPTION

 

Intouch Holdings is a telecommunications holding company in Thailand, with investments in public and private companies. The company was founded as Shinawatra Computer Service and Investment by Thaksin Shinawatra in 1983. In 2006, when Shinawatra became the Prime Minister of Thailand, he sold his family’s stake in then Shin Corporation to Temasek Holdings. Shin Corporation rebranded itself to Intouch in 2011, including its new stock symbol, but did not officially change its registered name until March 2014.

 

The company’s main assets are publicly listed. Intouch has a 40.45% stake in Advanced Info Service PLC (AIS), a 41.14% stake in Thaicom PLC, and a 42.07% share in CS Loxinfo through a 99% owned Thaicom subsidiary.

 

The vast majority of the company’s net profit and value is derived from its investment in AIS.

 

AIS is the leading mobile operator in Thailand with 39.4 million subscribers nationwide or approximately 46% of the subscriber market share. In Q2 2016, 85.2% of subscribers were pre-paid.

 

To service its subscribers, AIS has 40MHz of its own spectrum (the regulatory limit is 45MHz), and up to 30MHz of spectrum rented from TOT. The company’s own spectrum was acquired at a total cost of THB319.4 billion (USD7.8 billion) and the rented spectrum has up to an annual cost of THB3.9 billion with a potential cost of THB39 billion over the life of the lease. To support its spectrum, AIS has 32,000 3G base stations covering 89% of the population and 15,500 4G base stations covering 55% of the population. AIS’s 4G goal is to cover 80% of the population by the end of 2016. AIS mobile operations account for over than 99% of AIS revenues.

 

Thaicom provides satellite transponder leasing in both the domestic and international markets under a concession from the Ministry of Information and Communications Technology, which expires in 2021, and the Telecommunications Service License Type III granted by the NBTC, which expires in 2032. THAICOM currently operates four satellites: one broadband satellite, Thaicom 4 (IPSTAR), and three conventional satellites, Thaicom 5, 6 & 7. Another satellite (Thaicom 8) is under construction and is expected to be launched in the first half of 2016.

 

Other businesses includes a JV with Hyundai Home Shopping creating a home shopping network in Thailand, and InVent, a venture capital arm launched in 2012, with the main purpose of supporting and promoting high-potential start-up companies in Telecom, Media, IT, Digital Content and other related businesses.

 

Intouch Holdings is 41.62% owned by Temasek. On August 18, 2016, Singapore Telecommunications entered into a conditional share purchase with Temasek to purchase 21% of Intouch Holdings at a price of Bt60.83 per share. The agreement should conclude in December 2016.

 

 

INDUSTRY ANALYSIS

 

Barriers to Entry

 

There are three major mobile operators: AIS, Total Access Communications (DTAC), and True Corporation (True). In Q2 2016, AIS had a 49.9% market share, DTAC had 25.5% of the market, and True had 24.6% of the market. Two other players CAT and TOT mainly lease their mobile networks to other players and have minimal market share.

 

There is strong evidence that barriers to entry exist among mobile operators. The industry only has three players. If there were no barriers to entry, there would be many more competitors as entrants are free to enter the industry.  Additionally, there is market share stability.

 

Market share stability points to captive customers that have difficulty changing between suppliers or do not want switch suppliers making it difficult for new entrants to compete. AIS tends to be the biggest beneficiary of the barriers to entry in the industry as it consistent generates the highest average revenue per user (ARPU), and the highest profitability.

 

AIS outperforms on all key value metrics including ARPU, gross margin, operating margin, invested capital turnover, and ROIC.

 

Additionally, AIS consistently generates excess profits well above its competitors, accounting for 89% of the industry’s excess profits since 2011.

 

The evidence points to barriers to entry within the industry with AIS being the main beneficiary. Given AIS’s market share advantage, economies of scale seems to be the primary source of its advantage as there are significant fixed costs with the largest being investment in spectrum and building a network with smaller fixed costs being marketing to build a brand. Investment in spectrum and network build are made prior to acquiring customers and the more customers these fixed costs are spread across the greater the profitability. The existence of economies of scale can be tested by observing profitability across different markets and seeing whether size explains profitability. The chart below illustrates the relationship between market share and ROIC among the three largest players in Thailand, China, and Indonesia in 2015 and over the last five years. China, and Indonesia were selected because they are the largest markets in Emerging Asia and oligopolistic.

 

There seems to be a relationship between market share and profitability with an adjusted R squared of 0.60. In addition to having the highest ROIC, in all three countries, the market share leader has the highest ARPU, operating margin, and invested capital turnover.

 

Additional evidence of the presence of economies of scale is the percentage of excess profits going to the market share leader in Thailand, China, and Indonesia. The market share leader in all three markets took an extraordinary amount of excess profits in 2015 and over the past five years averaging 122% of all excess profits.

 

Given the relationship between ARPU, gross margin and size, size appears to drive pricing power and brand as AIS can spread the fixed costs of building a network over allowing it to spend more on network coverage, speed, and network quality thus customers are more willing to pay to use a better network.

 

ARPUs are converging with True gaining on DTAC and AIS, but AIS was able to increase its ARPU relative to DTAC.

 

Gross margins are diverging with AIS expanding its gross margin by 5.7 percentage points while DTAC’s and True’s gross margins contracted by a minimum 4.1 percentage points.

 

As illustrated below, AIS has much better throughput than peers on 4G.

 

The company also has better 3G coverage.

 

The evidence points to size is a crucial competitive variable and barrier to entry among mobile operators.

 

The other barrier to entry is regulatory. In the latest 4G spectrum auction, only companies that are majority owned by a Thai could participate. Telecom companies outside of Thailand have the capital and desire to enter the market but the inability to find a suitable local partner to meet the spectrum auction requirements of being a local firm.

 

There was a threat of a new entrant when Jasmine International won a spectrum auction in December 2015. Fortunately for the industry, Jasmine was unable to raise the necessary capital illustrating the difficulty in entering the industry.

 

 

Other Four Forces

 

The industry is in a period of intense rivalry as competitors invested heavily in upfront fixed costs of acquiring spectrum and building out 3G and 4G networks. In a quest to generate as much profit as possible on their upfront investment, competitors are marketing aggressively through handset subsidies and marketing expenses to gain subscribers on their networks. Since 2010, AIS invested THB43.205 billion in spectrum, DTAC invested THB13.615 billion, and True invested THB48.602 billion.

 

In October 2012, Thailand auctioned 3G spectrum with AIS, DTAC and True all winning 15MHz of 2100MHz spectrum. AIS paid THB14.63 billion for its spectrum, while DTAC and True both paid THB13.50 billion for their spectrum. Thailand then auctioned 1800MHz spectrum in November 2015 with AIS and True winning 15MHz of spectrum. AIS paid THB41.00 billion while True paid THB39.80 billion. In December 2015, Thailand auctioned 20MHz of 900MHz spectrum. Initially, True and a new entrant Jasmine International won the spectrum. True paid THB76.30bn for its 10MHz allocation but Jasmine was unable to pay for the spectrum it won so the spectrum was re-auctioned in July 2016 with AIS winning the spectrum auction by bidding THB75.70 billion. Cumulatively, DTAC has paid for its entire spectrum. AIS paid THB43.205 billion of its THB131.33 billion spectrum obligations so the company has THB88.125 of spectrum payments that still need to be made. True paid THB48.602 of its THB129.60 billion spectrum obligations meaning the company has roughly THB81.00 billion in spectrum payments to be made. DTAC’s has 45MHz (3x15MHz) of spectrum with a license expiring in September 2018. This spectrum will be auctioned in July 2018 with a reserve price of THB3 billion per MHz or THB45 billion per 15MHz block of spectrum.

 

The investment in spectrum is followed by the need to build out an infrastructure to allow the company to sell the spectrum to customers. The more capex spent building infrastructure creates greater supply as well as a greater desire to get a return on the upfront investment in spectrum and infrastructure leading to more aggressive marketing campaign to acquire customers.

 

AIS has guided capex of THB40 billion in 2016 to build out its 3G and 4G networks with half going to 4G. The company had already spent THB14bn in 2015 on 4G network spend bringing the total capex to THB54 billion to build a 4G network will cover 80% of the country. According to the Bangkok Post, AIS will spend a total of THB60 billion to build out is 4G network. True estimates it will cost THB56 billion to provide 4G LTE to 97% of the country.

 

The chart above shows capex since 2010 with Q1 2016, Q2 2016, and Q3 2016 capex annualized. Combined capex increased from THB 14 billion in 2010 to roughly THB100 billion on an annualized basis in Q1 2016, Q2 2016, and Q3 2016. The increase in capex should continue for at least the next year as competitors continue to build out their 4G networks.

 

To recoup the investment in spectrum and infrastructure build, Thai telcos are aggressively marketing. Handset gross margins are a good indicator of the current level of marketing aggressiveness. Recently, AIS has been heavily subsidizing handsets to migrate from 2G to 3G as it license for its 2G spectrum expired near the end of 2015, while DTAC is subsidizing handsets to slow market share losses as it has gotten a reputation for having a low quality network due to underinvestment. All competitors are subsidizing handsets to acquire 4G customers as companies roll out their 4G network. Companies are also subsidizing smart phones for postpaid subscribers as postpaid subscribers use much more data and voice leading to an ARPU over 3 times the ARPU of prepaid subscribers. AIS’s guidance is for continued subsidies and negative handset gross margins in 2016. The industry handset gross margin declined from 5.1% in Q1 2013 to -18.9% in Q3 2016, making Q3 2016 handset gross margin the lowest since 2013.

 

In addition to handset subsidies, competitors are aggressively on pricing and marketing. Marketing expenses among all players are on an increasing trend as illustrated by the chart below, Q1, Q2, & Q3 2016 marketing expenses are annualized. In 2010, industry marketing expenses totaled THB9.5 billion. In Q3 2016, annualized marketing expenses reached THB55.2 billion.

 

Despite lower regulatory costs, higher marketing expenses led AIS to guide for a 2016 EBITDA margin of 37%-38% in 2016 down from 45.6% in 2015. The regulatory costs for 2G were the highest in the world at 20-30% of revenue. The 3G and 4G regulatory costs are much more lenient with up to 5.25% of revenue going to regulatory costs. DTAC also expects its EBITDA margin to decrease to 27%-30% in 2016 from 31.8% in 2015. Industry regulatory costs decreased from 26.5% of industry sales in Q1 2013 to 8.8% of industry sales in Q2 2016.

 

Further fueling the rivalry is TRUE’s market share gains (+9.1%) since Q1 2013 at the expense of DTAC (-5.2%) and AIS (-3.8%). Given the importance of economies of scale, it makes sense for firms to increase the rivalry to maintain market share.

 

True’s also recent recently raised capital. In December 2013, True spun off its infrastructure assets through an IPO raising THB58.1 billion or USD1.8 billion. The infrastructure fund allows investors to benefit from the revenues generated by telecom towers, a core fibre-optic network and related transmission equipment, and a broadband access system located in provincial areas of Thailand. In January 2015, True sold 350 towers and 8,000km of fiber to its infrastructure fund for THB14 billion or USD424 million. In September 2014, China Mobile purchased 18% of True for THB28.6 billion or USD880 million in a private share placement. Despite the fund raising, True’s net debt to ttm operating profit is still at 6.05 as the company has generated cumulative free cash flows of THB-113.81 billion since the beginning of 2011. The continuous fund raising fueled by negative cash flows points to the competitive advantage held by AIS.

 

As illustrated above from 2010 to the end of 2015, True’s operating cash before any investments just covered investment in working capital and investment in spectrum. With external capital needed for almost all of the company’s investment in network. AIS’s generated the highest operating cash flow before any investment and free cash flow. DTAC generated a strong operating cash flow before any investments but spent significantly less than its peers on its network and spectrum. If DTAC spent a similar amount on spectrum and network build its free cash flow as AIS and True, its free cash flow would have been slightly negative. The lack of investment in its network and spectrum has hurt DTAC brand leading to market share losses to True.

 

Weak economic growth in Thailand and continued decline in voice revenues also add to the intensity of the rivalry in the industry.

 

 

Threat of Substitutes

 

The threat of substitutes for voice revenue is high as users are shifting away from voice to text, messaging apps or cheap voice services like Whatsapp or Skype leading to a continual decline in voice revenues.

 

The decline in voice revenue is a trend among more mature mobile markets as illustrated by the chart/table above.

 

The threat of substitutes for data revenue is low as mobile phones are a necessity and the trend continues to shift towards an increasing reliance on mobile phones for many aspects of daily life. The shift away from voice revenue is to substitutes that generate data revenue for mobile operators.

 

The overall threat of substitution to mobile operators’ products is low as the mobile phone is now such an important part of everyday life.

 

 

Bargaining Power of Suppliers

 

The bargaining power of suppliers is low. The main supplier are handset providers and SIM card producers as AIS creates its own infrastructure. SIM card manufacturers make a commodity product and the industry is much more fragmented than the mobile operator industry. The handset industry is also more fragmented than the mobile operator industry giving operators bargaining power when discussing handset purchases. The only supplier with any bargaining power is probably Apple given the brand associated with its product.

 

 

Bargaining Power of Customers

 

Customers have some bargaining power as they can freely switch providers particularly when so many subscribers are pre-paid meaning there are no contracts and there is number portability. Additionally, the information of all operators offering are readily available allowing customers to easily compare competitors increasing the bargaining power of customers. The ease of comparing competitors’ offerings along with the increasing cost of mobile services makes customers very focused on pricing.

 

Mobile operators compete on network quality as much as price. The difference in network quality creates a cost of switching from a good network to a bad network. Hindering bargaining power is the presence of only three mobile operators creating a significant amount of concentration at the mobile operator level while customers lack concentration. Overall, customers seem to have a fair bit of bargaining power due to number portability and the ease of comparing competitors’ offerings.

 

 

Industry Growth

 

In Thailand, mobile penetration reached 126% in 2015 meaning there is relatively little growth potential from an increase in subscribers. Since Q1 2013, subscribers grew at a CAGR of 1.9%. At the end of Q3 2016, smartphone penetration reached 70% while 4G handsets penetration reached 19% meaning future growth will not come from subscriber growth or even increased smartphone penetration but from increase in 4G penetration, which comes with increased data usage. In Q3 2016, AIS data subscribers accounted for 57% of total subscribers averaging 2,960 MB of data used per month up from 34% and 240 MB in Q1 2013 representing 17% CAGR in data subscribers and a 95% CAGR in data usage. Over the same period, the estimated price per MB has declined from THB0.2046 in Q1 2013 to THB0.0201 in Q3 2016.

 

The growth of data usage now makes non-voice revenue a larger portion of revenues than voice revenue with non-voice accounting for 56.5% of service revenue in Q3 2016 up from 27.3% in Q1 2013. Since the Q1 2013, non-voice revenue grew at a CAGR of 23.0% compared to voice revenue declining at 11.7% per year.

 

 

MANAGEMENT

 

All director and executives of Intouch Holdings have very small share ownership and therefore are hired hands rather than owner operators. Neither Intouch’s management nor AIS’s management do not extract too much value with the remuneration of directors and executives only 0.18% of operating income at Intouch Holdings and 0.25% of operating income at AIS.

 

 

Capital Allocation

 

Despite Intouch’s goal of achieving 25% of value from non-AIS businesses, AIS currently accounts for over 95% of Intouch’s market value therefore the focus will primarily be on AIS’s capital allocation decision.

 

To determine the strength of capital allocation decisions, we will attempt to determine a return on investment. The majority of AIS’s business is 3G but the company is building out its 4G network. For conservatism, we assume no change in the current competitive environment and no growth in AIS business to get a perpetuity cash flow figure. AIS spent THB131.33 billion on 3G and 4G spectrum. Additionally, the high end of the company’s 3G network build is THB90 billion. The company also estimates 4G network build will cost THB60 billion. The total investment in spectrum and network build THB281.33 billion.

 

Assuming a 15 year useful life on the investment, no change in subscribers, no growth in ARPU, an operating margin of 25%, a tax rate of 25%, and no salvage value; the overall investment in 3G and 4G generates a return on investment of 14.3%. It is not the returns that the company is used to generating, as the investment cost in 4G spectrum was expensive, but it still creates value for the company. The investment is a necessity for the company to stay competitive.

 

Looking at the assumptions, AIS currently has 39.8734 million subscribers so there is no change to the number of subscribers in the market or to market share. Depreciation is assumed to have a 15 year useful life, in-line with the license period leading to an annual depreciation expense of THB18.755 billion. Depreciation is 16.3% of sales well above the average rate of 12.5% over the past five years. ARPU is expected to remain stable at THB240 per month as the increased data usage is offset by cheap data prices. AIS’s ARPU has averaged THB240 per month since Q1 2013 with no particular trend. The 25% tax rate equals the company’s historical tax rate. The operating margin of 25% is well below historical rates. It is assumed that competition continues into perpetuity with negative handset margins and elevated marketing expenses with lower regulatory expenses from 3G and 4G networks as Q3 2016 saw operating margin at 24.3% with gross margin at 44.0%, selling expense at 10.3% of revenue, administrative expenses at 9.3% of sales, and depreciation and amortization at 16.9% of revenue. The table below illustrates the sensitivity of the investment in 3G & 4G to various assumptions.

 

Other than mobile, AIS is investing in fixed broadband with a goal of full coverage of Bangkok by end of 2016 and having significant market share in three years. The investment is insignificant relative to the investment in mobile.

 

Both Intouch and AIS are very shareholder friendly with an 100% dividend payout policy.

 

Other than the investment in AIS, Intouch also has smaller investments in Thaicom and a number of private equity investments related to media and telecommunications. The company’s stated goal is for non-AIS investments to reach 25% of the value of the portfolio. Many of the private equity investments are for to aid AIS of strategy of providing more content and digital applications. Intouch’s largest investment outside of AIS and Thaicom is a home shopping network in Thailand called High Shopping Co. Ltd. It is 51% owned by Intouch and 49% owned by Hyundai Home Shopping and has total capital THB500 million. The TV home shopping market in Thailand is expected to double in market value to 20 billion baht by 2020. Intouch forecasts it share of the market will reach THB4.5 billion in 2020, or of 20% of the TV home shopping market in Thailand.

 

 

VALUATION

 

Currently, AIS is overvalued as the market has yet to factor in decreased capital efficiency from the size of the recent investment.  The total investment will reach 282 billion while estimated revenues are less than half of that. In order to get the market’s current valuation for AIS, assuming an alleviation of competitive pressures leading to average historical margins and no growth, invested capital turnover needs to remain near historical levels. Even with these assumptions, there is 10% downside.  Assuming no growth, a persistence of competitive pressures along with a decline in invested capital turnover to 1.1 times, half of the historical average of 2.2 times, AIS intrinsic value is closer to THB70.00.

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

 

Company News

 position-summary-table

PC Jeweller

PC Jeweller’s share price fell by 15.1% during the week bringing the total decline to 31.7% this month as the Indian government demonetized INR500 and INR1,000 notes in an attempt to fight “black money”. On the back of the regulation, the market is speculated that gems and jewelry companies would be one of the most impacted industries as gold and jewelry is thought to be a favorite “black money” asset. The Indian jewelry industry participants speculate a potential import ban on gold is also coming.

 

After the fall in share price, PC Jeweller is now offers a 9.1% NOPAT yield causing us to increase our position to 4.0%. While the company is in an industry with no barriers to entry evident by the thousands of competitors, PC Jeweller and Titan are far more operationally efficient than competitors creating excess profits through strong management. Our initial theory on PC Jeweller’s and Titan’s excess profits was associated with weaker competition from the unorganized sector, but the continued outperformance of PC Jeweller and Titan while listed peers continue to struggle points to operational advantage over organized peers.

indian-jewelry-value-driver-comps

 

The table shows the key value drivers within the industry as well as the financial health of peers. From 2012 to 2016, PC Jeweller has the third highest gross margin with the highest operating margin. Gross margin points directly to the customers’ willingness to pay while the difference between gross margin and operating margin point to the efficiency of management in running operations. In addition to the highest operating margin, PC Jeweller also has the fastest growth in the industry. PC Jeweller has the second highest ROIC leading to the second highest value creation in the form of excess profits. PC Jeweller and Titan are the only competitors that generated any significant excess profits over the period examined. The ability to continually generate excess profits in a period of raw material constraints and weak demand points to the strength of the management teams at PC Jeweller and Titan and an ability for sustained excess profits.

 

To get to an annualized return of 15%, PC Jeweller would have to fight margin pressures through stable operating margin and capital efficiency, while growing at 10% during the forecast period fading to a 0% growth rate in perpetuity. These assumptions do not seem too aggressive given, management ability to continue to create value despite points to sustained excess profits. New store openings and franchising should provide the 10% growth with the fade to 0% growth in year ten potentially being conservative. Our big concern with the above assumptions is competitive pressures lead to ROIC contraction rather than growth. If we change our profitability assumption to marginal excess profits from superior management (ROIC = 15%, Economic Spread = 2.5%), the five year would be 10%. This profitability assumption seems much more conservative and gives us sufficient comfort that if profitability declines there is still ample upside. It seems the risk reward is balanced sufficiently to increase our position size in PC Jeweller to 4.0%. We will be increasing our position size at a price below INR375.

 

Zensar Technologies

On November 17, 2016, Zensar Technologies reported FQ2 2017 results. Revenue grew by 2.7% and operating profit declined by 9.3%. FQ2 2017 was the third straight quarter where operating profit declined as the lack of growth on the top combined with continued growth in employee benefit expense leading to margin compression. The margin compression comes with an increasing average deal size and an increasing number of customers above 1 million, Zensar are unable to grow its top line as rapidly as its employee benefit expense leading to margin contraction. The weak top line growth may be temporary as the company’s backlog is strong at USD700 million up from USD500 million in the last quarter. Zensar is now offering a NOPAT yield of 6.5% despite being a business with no competitive advantage. With very aggressive assumption of a 12.5% discount rate, stable margins and capital efficiency, 10% forecast period growth, and 5% growth into perpetuity, Zensar offers 85% upside over the next five years. Growth in perpetuity is usually only assumed for companies with sustainable competitive advantages, which seems not to be the case for Zensar. Assuming a perpetuity growth rate of 0% decreases the potential upside over the next five years to 47%. Changing the growth assumptions to a 5% growth rate over the next five years, and a 0% terminal growth rate, there is only 19% upside over the next five years. Given the lack of upside, and lack of competitive advantages, we will be selling our Zensar position at prices above INR900.

 

Other Links

 

Why Moats are Essential for Profitability (Restaurant Edition) (25iq)

A fantastic essay at 25iq discussing the importance of moats. It also discusses the amount of research needed to understand the economics of a business. (link)

 

A Narrative Narrative (Polemic’s Pains)

A good blog post discussing how the current narrative on many topics is nothing more than speculation and subject to rapid change (link)

 

Expected Return (Research Affiliates)

Research Affiliates maintains expected real returns of different asset classes including Emerging Market Equities. (link) Given our view that the discount rate is an opportunity cost it may be more appropriate to view expected returns as the discount rate rather than historical returns. The appropriate discount rate for Emerging Markets would be 7.3% expect real return. Adding an additional 2.5% for expected inflation gets to roughly 10% discount rate. Adding an additional 2.5% as a margin of error gets us to 12.5%, our current discount rate. The idea that the discount rate should be tied to expected returns needs to be flushed out, but it seems interesting.

 

Predicting the Long Term is Easier than Predicting the Short Term (Intrinsic Investing)

An interesting article discussing how it is easier to predict the long term than the short term due and why this is one of the reason investing for the long term investing outperforms short term investing. (link)

 

Value Stocks vs. Value Traps (Old School Value)

Old School Value wrote an interesting article by discussing the characteristics of Value Stock and Value Traps. (link)

 

Chris Mayers on 100-Baggers (MicroCapClub)

Chris Mayers wrote 100-Baggers, an update on Thomas Phelps 1972 book 100 to 1 in the Stock Market. In this video, he discusses the key characteristic of 100-Baggers. (link) Below are the summary points.

 

  • Start small
  • Hold for a long time
  • Prefer a low multiple
  • High returns on capital
  • Owner operators

 

Fake News (Stratechery)

A good article by Stratechery on the subject of “fake” news, Facebook’s role in the delivering the news, and the dangers of who decides what news is deemed fake. (link) The discussion of fake news is interesting with the potential to leading us down a scary path. We must not forget the masses still receive their news from a small number of news outlets creating gatekeepers who deem some information to be newsworthy and other information less newsworthy. The existing gatekeepers already create narratives and form opinions among the population.

 

How the Brain Decides Without You (Nautilus)

It may not matter what the facts are, as the brain seems to decide how the world appears based on your existing views. (link) The best way to ensure, you are not missing anything due to pre-existing biases is to seek out the other side of the argument and understand it as well as you understand your side of the argument.

 

How Headlines Change the Way We Think (New Yorker)

Tied to the previous two articles, is an older article from the New Yorker discussing how headlines change the way we think about a story (link)

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

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

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

 

Company News

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

 

Random Thoughts

 

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

importance-of-terminal-value-ft

 

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

 

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

1-yr-treasury-rate

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

 

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

 

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

 

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

 

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

1-scenario-terminal-value-total-value

 

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

 

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

3-scenario-terminal-value-total-value

 

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

 

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

nyse-lse-holding-period

other-exchange-holding-periods

 

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

 

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

residual-income-terminal-value

 

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

 

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

 

 

Other Interesting Links

 

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

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

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

 

Apple Should Buy Netflix (link)

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

 

Competitive Advantage of Owner Operators (link)

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

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

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

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

 

Honworld recently released its H1 2016 report.  In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.

 

Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.

 

The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.

h1-2016-chinese-condiment-producers-growth

 

Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.

 

The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else.  It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.

 

Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.

 

We are moving to a new approach for position sizing.  There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base.  Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.

 

Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.

 

Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.

 

High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation.  Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.

 

The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies.   Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential  bad investments while still offer enough concentration to take advantage of upside from good investments.