Tag Archives: Position Sizing

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

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

 

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

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

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

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

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

 

 

 

New Research Report October 19, 2017

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

GMA Holdings Position Size 10/2/17

GMA Holdings Position Size 10/2/17

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

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

PC Jeweller & Anscor Position Size 10/2/17

PC Jeweller & Anscor Position Size 10/2/17

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

 

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

 

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

 

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

PC Jeweller FY2017 Results 6/1/17

PC Jeweller FY2017 Results Review June 1, 2017

 

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

 

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


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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Stalexport Autostrady Q1 2017 Results May 14, 2017

Stalexport Autostrady Q1 2017 Results May 14, 2017

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

 

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

 

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

Turk Tuborg 2016 Full Year Results May 11, 2017

Turk Tuborg 2016 Full Year Results May 11, 2017

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Honworld 2016 Full Year Results Review 5/7/2017

Honworld 2016 Full Year Results Review

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

A. Soriano Corporation 2/23/17

A. Soriano Corporation

Bloomberg Ticker:                              ANS:PM

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

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

Market Cap (USD mn):           156

Estimated Annualized Return:            18.0%

February 23, 2017

 

A_Soriano_Corp_Feb_23_2017_Final

 

INVESTMENT THESIS

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

 

 

COMPANY DESCRIPTION

 

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

 

 

Phelps Dodge International Philippines

 

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

 

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

 

 

Seven Seas Resorts and Leisure

 

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

 

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

 

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

 

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

 

 

Cirrus Medical Staffing, Inc.

 

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

 

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

 

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

 

 

KSA Realty Corporation

 

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

 

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

 

 

Enderun Colleges, Inc.

 

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

 

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

 

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

 

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

 

 

Prople Limited

 

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

 

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

 

 

AGP International Holdings Ltd.

 

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

 

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

 

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

 

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

 

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

 

 

VALUATION

 

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

 

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

 

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

 

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

 

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

 

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

 

 

RISKS

 

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

 

Our goal with assessing macro risk is not to forecast the path of macroeconomic indicators but to eliminate risks from a poor macroeconomic position. Anscor’s business is primarily in the Philippines, a country that seems to be in very good financial health. In 2015, the country’s current account was 2.6% of GDP and its structural balance was 0.18% of GDP allowing the country to self-finance all the domestic initiatives as well as decrease the country’s debt load. The country does not have too much credit in the system with domestic credit provided by the financial sector at 59.1% at the end of 2015, which is well below the Emerging Markets average of 97.5% and the High Income countries average of 205%. Gross government debt as a percentage of GDP stood just under 35% with External Debt to GDP at 36%. The one concerning macroeconomic indicator is the level of growth in credit in the Philippines. Over the past five years, the amount of domestic credit provided by the financial sector has increased at a rate 12% per annum. When a country is growing its banking assets at this pace, there is a high probability of an increase in non-performing loans. The country’s banking system has a healthy capital balance with capital to assets at 10.6%.

 

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

 

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

 

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

 

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

 

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

 

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

 

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