Tag Archives: Quality Value

WEEKLY COMMENTARY 2/27/17 – 3/5/17

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

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news this week.

 

 

INTERESTING LINKS

 

 

The Fervent Loyalty of a Costco Member (Scuttlebutt Investor)

 

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

 

 

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

 

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

 

 

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

 

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

 

 

3G Purchases and Their Profit Margins (Economist)

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

WEEKLY COMMENTARY 2/20/17 – 2/26/17

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

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news.

 

 

INTERESTING LINKS

 

 

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

 

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

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

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

Shareowner’s Rights Across the Markets (CFA Institute)

 

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

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.

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 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

 

 

2015 Reperio Model Portfolio Review 1/4/2016

2015 Reperio Model Portfolio Review 1/4/2016

 

 

2015 Portfolio Review 1 4 2016 Returns

 

Our primary concern is avoiding permanent loss of capital. Our secondary concern is absolute returns with a goal of 15% per annum for each investment.  Our final concern is beating our benchmark ensuring active management adds value.  In 2015, Reperio Capital’s Model Portfolio ended the year up 14.3% while the iShares MSCI Emerging Market Small Cap ETF declined by 9.1%.  We successfully avoided any permanent loss of capital and beat our benchmark by 23.4% but missed our target return of 15.0% as we are building our portfolio and our average cash position 67.5% in 2015.  At the end of 2015, our cash position is at 38.1% but is expected to increase by 15.6%, assuming no price changes as we are reducing our position in Peak Sport Products and Honworld Group.  We are attempting to find one idea per month, which will make us closer to fully invested.  Cash is a residual of opportunities but fully invested assumes a cash position between 10-30%.

 

 

PC Jeweller

 

PC Jeweller’s (PCJL:IN) share price appreciated by 80.1% with a 1.5% dividend yield, while the Indian Rupee depreciated by 4.5% against the dollar.  PC Jeweller grew its operating income by 25.8% over the past year with the remainder of the share price appreciation coming from multiple expansion with EV/ttm EBIT increasing from 8.5 at the end of 2014 to 10.5 times at the end of 2015.

 

2015 Portfolio Review 1 4 2016 PC Jeweller

 

PC Jeweller opened its first franchise in the previous quarter. Franchising requires little or no capital.  Franchises will be set up in locations where the company has no operations.  In addition, the company is going to open smaller locations to tap the middle/lower class markets, which the company does not serve.

 

The unorganized segment accounts for 80% of the market and in seven to ten years management believes the organized sector will reach 80% of the market with only 15-20 organized players. The company is targeting opening 15 showrooms in FY2016 and plans to add an average 100,000 sq ft per year over the next 5 years.  Assuming PC Jeweller reaches half of its expansion targets over the next five years, with similar profitability per square foot, the company will be trading on a 6.3 times EV/EBIT multiple. This is very conservative as it is half the company’s expansion target, assumes no improvement to profitability, and no franchises.  PC Jeweller is extremely profitable with an average ROIC of 38% since 2008 with stability during an industry downturn.  The company has a very strong financial position with net debt to EBIT of 0.55 times. The company’s management is strong operationally with no capital allocation missteps and there are no corporate governance issues. Despite, the company’s financial health, profitability, growth outlook and management, PC Jeweller is only valued at an EV/EBIT of 10.3 times.  We have sold more than our original investment but continue to hold our current 5.0% position given the company’s profitability, growth outlook, and valuation.

 

 

Zensar Technologies

 

Zensar Technologies’ (ZENT:IN) share price appreciated by 80.6% in Indian Rupee terms. The company paid a 1.8% dividend yield and the rupee depreciated by 4.5% against the US Dollar. Zensar’s FQ2 2016 trailing twelve month sales have increased by 15.9% and trailing month operating income has increased by 26.8%. While the company is growing its intrinsic value, there has also been multiple expansion with the company’s EV/ttm EBIT increasing from 8.4 times at the end of 2015 to 12.7 times at the end of 2016.

 

Zensar continues to execute well with the number of million dollar contracts continuing to increase.  At the end of FY2015, the company’s digital revenues accounted for 13% of revenues up from 5% in at the end of FY2014.  The company expects revenues to reach 20% at the end of FY2016.  The company also continues to increase the number of employees, revenue per employee, and profitability per employee. Since 2011, the company’s employee count grew by 6% per annum, revenue per employee grew by 10% per annum, and operating income per employee grew by 20% per annum.

 

2015 Portfolio Review 1 4 2016 Zensar employees

 

In December 2015, Zensar appointed Sandeep Kishore as the next CEO & MD. He comes from HCL where he is vice president and global head for the life sciences and health care and the public services businesses. He has over 25 years experience in the Indian IT Outsourcing industry and has a very impressive resume.

 

Zensar has one of the highest percentages of digital revenues among the Indian IT Services companies, and has aspirations to be a Tier 1 IT services provider. It continues to generates strong profitability with an average ROIC of 25% since 2005 with little variability.  The company believes it can continue to grow at mid to high teen rates for the foreseeable future.  The company has proven it ability growth with an average revenue growth rate of 23% since 2005. Despite, the company’s strong financial health, profitability, growth outlook, Zensar Technologies is only valued at an EV/EBIT of 12.7 times.

 

 

Peak Sport Products

 

Since our initial purchase in March 2015, Peak Sport Products’ (1968:HK) share price appreciated by 4.2%, paid a 7.7% dividend with no change to the Hong Kong Dollar US Dollar exchange rate.  Peak was initially a 9.1% cost base position. At the time, the company was trading just above its net current asset value and an EV/EBIT of 3.1 times. With the exception of a large cash position on the balance sheet, the company had not made any significant capital allocation mistakes. In July 2015, Peak issued 280 million shares or 11.72% dilution to existing shareholders. Insiders did not sell any of their shares.  The company sold the shares at net price of HKD2.43 representing an EV/EBIT of 4.8 times.  After the placement and during a period of significant stress in the Chinese markets, Peak’s share price fell to a low of HKD1.55 well below the company’s net current asset value of HKD2.15. Our initial position fell from 9.1% to 6.1%.  Given the discount to its net current asset value, we increased our position size by 5.6% to a 15.0% cost position.

 

The company continues to generate consistent profitability with a leading position in the niche segment of the basketball performance market. The company has growth opportunities in both the international and in new segments, tennis and running, where it is bringing its focus on performance and functionality. Despite the company’s strong balance sheet, three year average ROIC of 17%, and mid to high single digit growth, the company is no longer trading at a significant discount to its net current asset value but right above its net current asset value. We are adjusting our position to 5.0% as management credibility and capital allocation skills are in question making the investment a deep value investment rather than a quality value investment.  Our max deep value position is a 5.0% cost position given the inherent weaknesses of deeper value businesses.

 

 

Honworld Group

 

We started purchasing Honworld Group (2226:HK) after our initial recommendation in June 2015. The company’s share price has appreciated by 28.6% from our weighted average purchase price with no dividends and no significant change to the Hong Kong Dollar relative to the US Dollar.  Honworld is the largest cooking wine producer in China. The company is very regional with 88% of its revenues coming from the company’s key regions, which account for roughly 26% of China’s population. The company is still expanding its distribution channel within its key regions.  The combination of the company’s size and ability to garner premium pricing as it is the only one of the top four producers that uses an all natural brewing process for its condiment products gives the company a large gross profit advantage over its closest competitors. Honworld’s gross profit is 2.86 times its largest competitor, 4.81 times is second largest competitor, 8.89 times its third largest competitor, and 16.00 times its fourth largest competitor. This size advantage allows Honworld to significantly outspend competitors on acquiring new customers via marketing and building out its distribution channel and improving the company’s products through research and development. The company has pricing power given the company’s product quality and the low cost of the product.  Unit economics are fantastic with the four year average ROIC per liter is 79%. The company is also growing at 20% rate despite the concerns over the Chinese economy.  Management is passionate, owner operators with integrity although there are some question marks over capital allocation related to building inventories.  Management stated in its H1 2015 interim report that inventory is now sufficient for growth requirements so this may point to decreasing inventory levels. In November 2015, the primary owner charged his shares to receive a loan for his holding company.  Management honesty is evidenced by the donation of the primary shareholder’s cooking wine inventory, valued at RMB7.0 million to the company before its IPO.  Additionally, the primary shareholder sold his family’s cooking wine secret recipe to the company for RMB1.  His family also owned Honworld’s main brand before the communist revolution.  We believe the main shareholder sees the asset as his family’s heritage that he would not put at risk.  Despite the business quality and cheap valuation, EV/EBIT of 9.8 times, the charging of shares for a loan, the lack of few cash flow due to the misallocation of capital, and management unwillingness to have discuss the company all lead to lowering our position to a 5.0% position in our model portfolio.

 

 

Miko International

 

Miko International’s (1247:HK) share price has fallen by 27.4% since our initial purchase. The original investment thesis was buying a very profitable, rapidly growing business with a healthy balance sheet run by owner operators. The vast majority of the investment thesis still holds with the exception of the strong growth.  In the first half of 2015, Miko saw negative top line and operating profit growth.  The company put this down to a slowing economy as well as closing of many stores for refurbishment.  The favorable sign of the weaker growth in H1 2015 was Miko’s ability to maintain strong profitability.  Typically, when a retailer is hit by slowing growth working capital balloons and fixed costs become more prominent driving down profitability.  While Miko’s profitability took a slight hit in H1 2015, with ROIC falling to 26%, it was still well above the company’s cost of capital.  Miko is in the process of acquiring distributors and running the retail operations themselves as Miko has been selling products to distributors at 35% of final ASP.  Miko had full control of retail operations but this makes it more formal, allows for better contact with customers and brings the distributors margins in house.  As illustrated in our initiation report, the IRR on taking the retail activity in house is well above the cost of capital.  Despite continued strong returns, management are owner operators with no material corporate governance issues, Miko is trading at 78% of its net cash position and 58% of its net current asset value. It will remain at its current position size given its lack of liquidity.

 

 

Company 9/18/15

 

Company 9/18/15’s share price appreciated by 14.6% from our weighted average purchase price. The company is very strong at acquiring companies very cheaply without taking on debt, and improving their operations.  In all its business segments, the company has shown consistent success generating ROIC well above its peer group average.  The company has multiple unique activities with a tailored value chain that is not easily replicable.  The company’s latest results show it growing at 20% without any acquisitions and over the past five years the company has grow by 50% per annum. Finally, the company’s executives are very strong operators, capital allocators, owner operators, and are increasing their stake in the company. In 2015, the company’s chairman and main shareholder increased his stake from 45.14% to 51.66%.   Despite all the strengths of the company, it trades on an EV/EBIT of 4.9 times.  It is currently our largest and highest conviction position at a 14.5% cost position.

 

 

Company 11/19/15

 

Company 11/19/15 is down 7.0% in US Dollar terms since our purchase in November 2015. The company built multiple competitive advantages in the domestic market and the company is trying to replicate these advantages in the export market.  Within the domestic market, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements.  It produces a low priced experienced good that is purchased infrequently combined with heavy spending on advertising the company has built a strong brand allowing for pricing power. In the export market, the company is at the low end of the cost curve ensuring the company stays competitive and profitable.

 

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

 

Despite the company’s strengths, there is upside to the bear case scenario of no growth and trough margins with the company trading on a 10.5% NOPAT yield and an 8.8% FCF yield. Using conservative assumptions, estimated annualized return over the next five years is 15-17.5%.  It will remain a 5.0% cost base position.

Honworld Group H1 2015 Results Review 9/1/2015

Honworld Group H1 2015 Results Review 9/1/2015

 

Honworld Group                                                                                             

Recommendation: Buy                                   

Ticker: 2226:HKG

Closing Price (9/1/2015): HKD4.02

6 Month Avg. Daily Vol. (USD): 1,190,945

Estimated Annualized Return: 20.3%

 

 

Honworld Group reported first half of 2015 results on August 31, 2015. The company’s key value drivers are illustrated below.

 

Key Value Drivers Table H1 2015

 

In the first half of 2015, Honworld’s revenue grew by 19.9% and its operating profit grew by 23.7%. The macro concerns surrounding China are not affecting Honworld.  The company continues to introduce new products to its distribution channel and it is aggressively building its distribution channel.

 

The company’s gross margin is stable averaging 58.0% over the past three years after two years of an increasing gross margin associated with improving product mix. The stability in gross margin and the company’s premium pricing with a significant market share advantage over peers illustrates the company’s pricing power.  The company is the first to sell naturally brewed cooking wine and other naturally brewed condiments giving its brand a healthy position in the consumer mind allowing for premium pricing.  Its largest competitors produce their cooking wine with a chemically based product.

 

The company continues to spend heavily on distribution and on administrative expenses (primarily R&D) with both expenses amounting to 16.5% of sales in the first half of 2015.  Given the company is the largest cooking wine producers in the country continued investment in the distribution channel, advertising, new products, and new processes is strategically the right thing to do to take advantage of its economies of scale. According to its IPO prospectus, Honworld market share is two times is largest competitor and equal to the market share of the four closest competitors.  Given Honworld sells a premium product, its gross profit advantage over peers is even greater.  Honworld’s size advantage over its closest peer increases from 2.15 times using sales to 2.86 times using gross profit.  The four closest competitors’ cumulative share is 104% of Honworld’s market share but is only 75% of Honworld’s gross profit share.

 

Despite heavy investment is base wine inventory, Honworld still generated an annualized ROIC of 17.6% in H1 2015. Heavy investment in inventory is the main concern associated with an investment in Honworld.  Management seems determined to continue to investment in base wine despite raw materials being commodity products available from many producers. If there are increases in raw material costs the whole industry will feel the pain.  Given the company’s premium position in the consumer’s mind, Honworld is the most likely competitor to be able to pass on prices increases. Holding inventory and ageing it allows the company to sell a premium product. Unfortunately, the gross margin associated with the higher price does not compensate for the inventory investment required leading to depressed ROIC with higher inventory.

 

Inv Req per Liter of Base Wine

 

The table above shows Honworld’s investment in base wine.  Fixed capital is primarily facilities associated with storing base wine so it is should be included in calculations for cost of base wine.  Other working capital requirements are minimal and therefore are used to add conservatism.  According to the company’s balance sheet in 2014, each liter of base wine cost RMB9.2.

 

Inventory Used and Sold

 

Each bottle of cooking wine is a mixture of spices, base wine, and water meaning each liter of base wine translates to multiple liters of what is actually sold. Lower quality product uses lower amounts of base wine. Vinegar uses cooking wine while Soy Sauce products do not.  2014 is estimated as the company did not provide this information.  In 2013, each liter of base wine translated to 2.8 liters of output. At 2.5 liters of output for each base wine of input, the 225 million liters of base wine the company is targeting for 2015 translates to 562.50 million liters of sales volume or 5.64 years of 2015 sales volume assuming a 20% growth rate in 2015.

 

Economics Per Litre

 

The table above shows the economics of the business on a per unit basis.  2013 is data from the IPO prospectus while 2014 is estimated.  Even with heavy investment in fixed costs the company generates an ROIC on a per liter basis close to 90%.  The contribution margin per liter is above 100%.  The company should spend heavily on acquiring customers through increased distribution and new products. The heavy spending on fixed costs also allows the company to cement its competitive position by taking advantage of its size. Inventory build on the other hand drags down 2014 ROIC from 86% on a per liter basis to the company ROIC of 18.1%.

 

Gross Margin by product

 

The table above illustrates gross margin by product.  Premium cooking wine products generate a gross margin close to 75% while medium-range cooking wine products generate a gross margin of 45%.  Medium-range products generate a lower gross margin compared to mass market due to packaging.

 

Base Wine by Product Category

 

The table above shows the amount of base wine for each product and the number of years it needs to be aged.  Assuming the company can sells all it products at premium cooking wine gross margins and inventory is 10 years current year sales equal to the average age of vintage wine in premium cooking wine.

 

Economics All Premium Products

 

As illustrated ageing inventory and selling 100% premium products leads to a per liter ROIC averaging 135% but holding inventory for 10 years increases investment requirements leading to an overall company ROIC average of 13.5% half the current average of 27.2% and well below the per liter ROIC average of 78.3%.  The main problem is management views EBITDA margin as the key indicator of profitability rather than ROIC.  The heavy investment in inventory shifts it from a consumer product company to something similar to a car dealership where profitability is tied up in inventory.

The company is financially strong with H1 2015 net debt to operating profit of 0.89.

 

Overall, Honworld has a potential to build a strong competitive advantage given its brand positioning among consumers and its economies of scale.  The company is generating strong returns on invested capital despite heavy investments in fixed costs to cement its competitive position and poor investments in inventory.

 

The company is growing its top line and profitability at 20% despite macro-concerns in China.

 

It has a very passionate management team with integrity. The founder transferred his family’s secret recipes to the company for RMB1 and donated his personal stock of cooking wine valued at RMB7.0 million. He built his personal cooking wine inventory since 1990 when he first entered the industry but well before he founded Honworld and purchased its cooking wine subsidiary. His family also owned Honworld’s key brand before the communist revolution.

 

At the close of business on September 1, 2015, Honworld is valued at 6.8 times EV/ttm EBIT offering a conservatively estimated return of 20.3% for the foreseeable future.  If the management is able to eliminate inventory build it could generate a much higher return as the franchise value used in the calculation assumes 15% ROIC indefinitely.  Given heavy investments in fixed costs and inventory this figure should eventually be higher. It’s growth, potential competitive advantage, strong returns, and passionate management with integrity makes it our current top pick.

Estimated Returns 9 1 2015

 

Honworld Initial Position Size June 7, 2015

Honworld Initial Position Size June 7, 2015

We are initiating a 7.5% position in Honworld.  The company ticks many of the boxes for a great investment including a regional brand moving to a national brand. The existence of economies of scale with customer captivity.  The company is extremely profitable when stripping out growth investments that are depressing profitability and the company has a very strong management team.  The current expected return is roughly 17% using conservative assumptions.  If there is any pullback, we will add to our position.

Honworld Group 2226:HKG Initiation Report

Honworld Group – The Undervalued, Well-Run Leading Chinese Cooking Wine Producer Building a Moat and a National Brand

 

Honworld Group

Recommendation: Buy

Ticker: 2226:HKG

Closing Price (6/5/2015): HK$6.33

6 Month Avg. Daily Vol. (USD): $1,325,015

Est. 5 Year Annualized Return: ~17%

June 7, 2015

 

 

FACTOR RATINGS

Factor Ratings 

 

 


 

KEY STATISTICS

Key Statistics

 

 


 

INVESTMENT THESIS

 

Honworld is the largest Chinese cooking wine producer with a 13.8% market share in 2012. The company is the only top four cooking wine producer using a naturally brewed, traditional production process allowing the company to garner premium pricing. This premium pricing amplifies the company’s size advantage over its top four competitors, as 95% of cost of goods sold is raw materials in the form of agricultural commodities. As illustrated below in 2012 (latest available data), Honworld’s sales are 2.16 times and its gross profit is 2.86 times its largest competitor. Sales are 3.21 times and gross profit is 4.21 times its second largest competitor.

 

Top 5 Sales Multiple and Gross Profit Multiple

 

Honworld’s size advantage is important as fixed expenses account for a large portion of sales. Over the past two years, the company has spent 13.1% of sales and 22.7% of gross profit on fixed expenses. Only the two largest peers can match Honworld’s spending on fixed costs and remain profitable. The company is spending on fixed costs accounts for 64.7% of the largest competitor’s gross profit and 95.4% of the second largest competitor’s gross profit.

 

Top 5 Fixed Costs Sales and Gross Profit

 

The market’s growth, the convergence of tastes within China and the nature of the product all make economies of scale particularly important. In a rapidly growing market, Honworld can outspend competitors on reaching more customers through its distribution channel and building a stronger brand through advertising and R&D. Consumer tastes are converging in China is shifting the market from many regional markets to a national market. Larger companies will be the biggest beneficiaries as fixed costs can be spread over one market rather than customizing fixed costs for each regional market. Regional markets fragments the industry as smaller companies can survive with market share only in the regional market. In a national market, the presence of fixed costs leads to a higher minimum efficient scale driving out smaller competition. Cooking wine is a low priced experience good and a strong brand lowers search costs creating customer captivity via habit. The strength of Honworld’s brand is evidenced by premium pricing with a high market share and pricing power with gross margins remaining constant over the past few years.

 

The Chairman, founder, and CEO, Mr. Chen Weizhong is a passionate owner operator with integrity, a long-term vision, and the ability to execute the company’s vision. Mr. Chen holds 53.62% of Honworld aligning his interests with minority shareholders. Mr. Chen’s passion is illustrated by building a personal base wine inventory from early 1990s when he entered the condiment industry. This inventory build started before he founded his first condiment company in 1995, where base wine was not used in the production process, and well before he purchased the Lao Heng He cooking wine brand in 2005. Mr. Chen then donated the 11.3 million liters of base wine inventory valued at RMB7.0 million. He also transferred his secret recipes to the company for RMB1. Over the past five years, the five highest paid employees received 0.51% of operating income compared to an industry average of 1.57%, further illustrating the integrity and the view minority shareholders are partners. Mr. Chen takes a long-term view as illustrated by the short pain associated with building inventory to support growth and spending heavily on fixed costs. These cement the company’s competitive position despite depressing current profitability. The management team is also relatively young with the average age of 40 years old meaning they have the energy and desire to build a national brand.

 

The company’s economies of scale, premium pricing, and pricing power allow the company to generate returns on invested capital above the cost of capital. From 2010 to 2014, assuming one year of base wine inventory and associated capital requirements, the company averaged a ROIC of 25.4%.

 

The company’s ability to generate ROIC greater than its cost of capital allows growth to add value. Between 2012 and 2017, the Chinese condiment market is expected to grow at 12.4% per year and the Chinese cooking wine industry is expected to grow at 20.3% per year. Honworld is expected to outpace the overall Chinese cooking wine industry growth as the company’s naturally brewed products sold at a premium price cater to an increasing wealthy, health conscious Chinese consumer. The company’s current key region account for roughly 90% of sales only accounts for 26% of the population, so the company has long runway for growth.

 

The company is building a multi-faceted competitive advantage, has a strong management team, is very profitability, and has a long runway for growth yet is only trading on an EV/EBIT of 10.7 times. The market is pricing in 5% growth over the next five years fading to a terminal growth rate of 0% and 40% operating margins, which seems conservative given the market is growing at 20% and the company is depressing current profitability due to high spending on fixed costs.

 

The expected return for the Honworld assuming a constant ROIC is 17.3%.

 

Expected Return Calculation

 

The base case earnings valuation assumes 10% forecast period growth and 0% terminal growth with current margins. This scenario offers 14% upside to 2015 intrinsic value and 116% to 2020 intrinsic value.

 

 

KEY METRICS TO WATCH

 

  • Economies of scale = market share relative to peers, gross profit share relative to peers, and spending on fixed costs
  • Brand strength = premium pricing while maintaining market share advantage over peers
  • Pricing power = gross margin consistency or expansion
  • Competitive rivalry = market growth and consolidation
  • Capital efficiency = capital turnover ratios and the level of base wine inventory are key drivers of profitability

 

 


 

HISTORY

 

The Lao Heng He brand, Honworld’s main brand, can be traced back to Lao Yuan Da Jiang Yuan, a brewing enterprise focused on the manufacturing and sale of condiment products, established during the reign of Chinese Emperor Xianfeng (1851 A.D.–1861 A.D.). Lao Yuan Da Jiang Yuan had a number of fermentation starter recipes used to produce soy sauce, fermented bean curd, pickled vegetables, and other fermented products.

 

Lao Heng He won the Gold Award at the Panama – Pacific International Exposition, a world fair hosted by San Francisco, California in 1915 for its sauces and pickled vegetables. It also won the Gold Award at the West Lake Exposition, a world fair hosted by Hangzhou City in 1929 for its rose fermented bean curd. In 1930, the company changed its name to Lao Heng He Brewing Enterprise.

 

In the early days of Lao Heng He, the current majority shareholder’s (Mr. Chen Weizhong) ancestors, including Mr. Chen Guofu and Mr. Chen Lifu, were major shareholders. In 1951, two years after the founding of the PRC, Lao Heng He Brewing Enterprise was registered with the Huzhou City government as a private partnership and renamed into Lao Heng He Xing Ji Brewing Factory. In 1957, it became a joint state-private operative enterprise under the name of Joint State-Private Operative Hu Zhou Lao Heng He Brewing Factory. In 1966, the company was restructured into a state-owned enterprise named Huzhou Brewing Factory. In 1988, Huzhou Brewing Factory was renamed to Huzhou Lao Heng He Brewing Factory restoring Lao Heng He to the company name. In 2000, the Huzhou Government approved the restructuring of Huzhou Lao Heng He Brewing Factory into a joint-stock cooperative enterprise. After of the restructuring, the shareholders of Huzhou Lao Heng He Brewing Factory consisted of 110 employee-shareholders and Huzhou Commercial Group Corporation, a state-owned enterprise.

 

 

Controlling Shareholder

 

In 1995, Mr. Chen Weizhong established Huzhou Zhong Wei Brewing Factory, a manufacturer of pickled vegetables, soy sauce, and other fermented condiment products. In 2006, the company changed its name to Zhejiang Zhong Wei Brewing Co., Ltd (Zhong Wei). Zhong Wei and its products received a number of awards under Mr. Chen’s management.

 

2010

  • National Flagship Enterprise in Agricultural Industrialization
  • China’s Best Ten Condiment Producer

 

2011

  • Famous Brand in Zhejiang Province

 

 

Purchase of Lao Heng He

 

On June 1, 2005, to expand Zhong Wei’s condiment business and to return the Lao Heng He business to his family, Mr. Chen purchased Huzhou Lao Heng He Brewing Factory for just under RMB4.2 million.

 

Mr. Chen did not have sufficient capital to purchase Huzhou Lao Heng He Brewing Factory so Ms. Ho Ping Tanya, a longtime business acquaintance of Mr. Chen, extended a loan of RMB2.6 million for a 25.41% equity interest in Huzhou Lao Heng He Brewing Factory in June 2005. Mr. Chen paid the remaining amount. In 2012, Ms. Ho’s percentage ownership was adjusted to 25.8214%, to take into account approximately RMB0.9 million of uncollected trade receivables.

 

Mr. Chen kept Zhong Wei and Huzhou Lao Heng He Brewing Factory as separate entities, due to the distinct production processes and food safety risk profiles. Zhong Wei manufactured its products based on the pickled and preservation process, while Huzhou Lao Heng He Brewing Factory used a natural fermentation process to manufacture its products.

 

Since acquiring the Lao Heng He brand in 2005, Mr. Chen sought to rebuild the century-old brand and expand the cooking wine business by capitalizing on Zhong Wei’s established condiment business, procurement capabilities, and distribution network. Given its dependence on Zhong Wei’s procurement capabilities and distribution network, a large portion of Huzhou Lao Heng He Brewing Factory’s raw material procurement and sales were from and to Zhong Wei. Zhong Wei represented 29.9%, 41.4%, 8.5%, and 3.8% of total raw material purchases in 2010, 2011, 2012, and for the eight months ended August 31, 2013, respectively. The percentage of sales to Zhong Wei by product is listed below.

 

Sales to Zhong Wei

 

Zhong Wei resold the company’s products to distributors leading to a lower margin on products sold to Zhong Wei relative to other distribution channels. As Huzhou Lao Heng He Brewing Factory built its own distribution and procurement capabilities, Zhong Wei significance diminished in importance and gross margin increased from 36.9% in 2010 to 57.2% in 2012. Along with the improvement in distribution channels, improving product mix and increased ASPs drove gross margin improvements.

 

In 2010, Mr. Chen contemplated listing Zhong Wei, including the Lao Heng He business, in China. At the time, there was a significant backlog of applications for listing on the A-share markets and the vetting and approval process for any listing of Zhong Wei was expected to be lengthy and uncertain.

 

In 2012, Mr. Chen decided to list the Lao Heng He business in Hong Kong and dispose of Zhong Wei. In June 2012, Zhong Wei transferred to Mr. Chen and Ms. Xing Liyu 95% and 5% of the equity interests in Lao Heng He, for a consideration of RMB9.5 million and RMB0.5 million, respectively. In addition, Zhong Wei granted Lao Heng He exclusive licenses to use the trademarks that were previously transferred by Lao Heng He, for nominal consideration.

 

On December 25, 2012, Mr. Chen and Ms. Xing transferred all of their ownership in Zhong Wei to an independent third party for just under RMB9.0 million and just over RMB1.0 million, respectively. The third party purchaser of Zhong Wei had been an investor in construction materials and condiment products distribution businesses.

 

In December 2012, Honworld was incorporated in the Cayman Islands and Lao Heng He Group Limited was incorporated in Hong Kong. Honworld went public on January 28, 2014 at HK$7.15 selling 25% of the company, in the form of new shares, to the public for HK$1,028 million. The post-IPO organizational structure is listed below.

 

Corporate Structure Post IPO

 

On September 2, 2014, Honworld issued warrants offering the right to purchase 100,000,000 new shares at HK$8.00 per share for gross proceeds of HK$10,000,000. The subscriber was Mr. Chan, the Chairman and director of CCH Group Co., Limited. CCH Group is engaged in organizing promotional events, movie production, operating a talent agency, and distribution of art works and commercial decorative products. The warrants are exercisable in the twelve months following September 2, 2014. The subscription price represented a 24.8% premium to the closing price on the last trading day before the announcement.

 

On May 14, 2015, Ms. Ho sold 14% (72.625 million shares) of the company to Hwabao Overseas Markets Investment No. 2 QDII Single Unit Trust Plan 32-8 for HK$405.25 million or $5.58 per share, a 17% discount to the May 14, 2015 closing price of $6.70. Hwabao Overseas Market Investment QDII No. 2 is an investment vehicle owned by Baosteel. Through Foremost Star Holdings, Ms. Ho continues to hold 4.67% of Honworld.

 

Today, Honworld is a producer of Chinese cooking wine, soy sauce, vinegar, and other condiment products. Cooking wine is the primary product accounting for 71% of revenues and an estimated 69% of gross profit in 2014.

 

Revenue and Gross Profit breakdown by product

 


 

INDUSTRY

 

 

Chinese Condiment Industry

 

Condiment products are used in food preparation to add a particular flavor and aroma. Key condiment products include cooking wine, soy sauce, vinegar, and MSG.

 

According to a 2013 Euromonitor Report, the total value of the Chinese condiment market grew at a compound annual growth rate (CAGR) of 14.4% from 2008 to 2012. This growth is expected to continue with the condiment market expected to grow at a CAGR of 12.4% between 2012 and 2017.

 

 

The Chinese Cooking Wine Industry

 

Chinese cooking wine has been around for centuries and is an essential ingredient in food preparation to deliver richer flavors and dissolve meat and fish odors. It is also used as a dipping sauce for popular snacks.

 

According to the 2013 Euromonitor Report, from 2008 to 2012, the Chinese cooking wine retail sales grew at a CAGR of 23.4%. From 2012 to 2017, the Chinese cooking wine retail sales is expected to grow at a CAGR of 20.3% reaching RMB10.6 billion in 2017. From 2008 to 2012, retail volume in the Chinese cooking wine market grew at a CAGR of 15.6%. From 2012 to 2017, retail volume is expected to grow at a CAGR of 12.7%, reaching 1.5 million tonnes in 2017. From 2008 to 2012, retail prices increased by 6.7% per year. From 2012 to 2017, retail prices are expected to increase by 6.7%.

 

The key drivers of growth within the Chinese cooking wine industry is increasing urbanization and purchasing power, increasing health and safety awareness, and growing convergence of regional tastes.

 

Chinese cooking wine is primarily distributed 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.

 

 

Chinese Cooking Wine Production

 

Chinese cooking wine can be produced using one of three methods.

 

  1. Naturally Brewed Rice Wine as a base
  2. Alcohol as a base (chemically produced)
  3. Mixture of the first two methods

 

Cooking wine using naturally brewed rice wine is higher quality and healthier as it contains many nutrients, such as vitamins and amino acids. Chemically produced cooking wine that uses alcohol as a base contains preservatives, plasticizer, glacial acetic acid, and other artificial flavors.

 

China’s population is more and more health consciousness leading to naturally brewed cooking wine increasing in popularity and growing faster than the overall market. Honworld is the only top four cooking wine producer using the naturally brewed production method.

 

The Chinese cooking wine production process illustrated below takes between 30-35 days before the aging process.

 

Cooking Wine Production Process 

 

Fermentation usually takes place between October and May as the cold weather aides the process.

Cooking Wine Production Process part 2

 

 

Industry Activities

 

Profitability is tied to individual activities rather than the value chain as a whole; therefore, it is crucial to analyze each basic activity. The key activities in the Chinese Cooking Wine Value Chain are listed below.

 

Chinese Cooking Wine Value Chain

 

Raw Materials

 

Raw materials averaged 95% of Honworld’s cost of goods sold between 2010 to the IPO prospectus date. The key raw materials are listed below along with their percentage of total raw material costs.

 

Raw Material costs

 

The vast majority of raw materials are pure commodities with many sellers. Excess profitability from the production of pure commodities occurs from either short-term supply and demand mismatches or being a low cost producer.

 

In the case of short-term supply and demand mismatches allows for short-term excess profits or losses for producers. Supply and demand mismatches are unpredictable and the ability to bring on new supply will determine the length of excess profits or losses. Given farmers can shift the crops they plant on an annual basis, supply and demand mismatches should not persist for more than a year or two and will affect the price for the consumer of raw materials. Excess profitability from being a low cost producer may exist for a prolonged period but does not affect the prices to the next step in the value chain.

 

Raw material sellers have very little bargaining power, as their product is a commodity in the truest sense; products are standardized making pricing the only thing that matters. There a large amount of sellers so these commodities can be purchased from many different sellers. No cooking wine producer participates in the production of raw materials.

 

Raw material production is very political in China as food security is crucial. Rice prices on the domestic market are much higher than the import market due to Beijing’s price support for domestically produced rice to incentivize domestic production. Many Chinese mills import lower cost international rice. Raw material production and regulation must be watched due to the political nature and potential for regulatory changes in China. The chart below illustrates international raw material prices indexed to 100 at the beginning of 1990.

 

Raw Material Price Index

 

 

Cooking Wine Production

 

At the end of 2012, there were over 1,000 Chinese cooking wine producers. The large number of players points to low barriers to entry, regional tastes, or a combination of both. Producing cooking wine takes little capital, little equipment, and little time (30-35 days) so it is probably a combination of both.

 

In 2012, the top five producers in the cooking wine industry account for 28.1% market share in terms of value and 14.0% in terms of volume.

 

Top 5 Market Share Value Volume

 

Although barriers to entry in production may be minimal, the ability to differentiate during the production process (naturally brewed vs. alcohol based vs. mixture) is growing in importance as customers grow increasingly health conscious allowing naturally brewed cooking wine to continue to take share and command a premium price.

 

With various contamination and food safety scandals in recent years, customers are becoming more concerned with the quality of the product shifting competition away from pure price, favoring larger well-known brands. There is also increased regulatory scrutiny, which brings increased fixed costs associated with compliance of regulations also favoring larger brands.

 

 

Ageing

 

There are various categories of cooking wine classified by the percentage of base wine per liter of cooking wine, the percentage of vintage base wine per liter of cooking wine (aged based wine), the alcohol by volume (ABV), and the average age of the vintage base wine.

 

Honworld Products by category

 

The longer base wine is aged the greater the scarcity and the more difficult it is for peers to replicate the product, as it requires patience, discipline, and capital. The capital probably is the most abundant, patience and discipline in a short-term oriented world is very scarce.

 

Honworld’s gross margins illustrate either scarcity of aged vintage wine or lack of competition. For the periods reported in the IPO prospectus, premium cooking wine generated gross margins of 70-80%, high-end cooking wine generates gross margin of 65-70%, medium-range cooking wine generates gross margin between 45-50%, and mass-market cooking wine generates gross margin of 50-55%.

 

Smaller to medium size competitors selling commodity, alcohol based products will have a difficult time competing on age of inventory with larger companies that have greater profitability from selling premium products and access capital market.

 

 

Seasoning and Blending

 

Seasoning and blending is the mixing of the base wine and the flavoring of the cooking wine. The amount of base wine used, the amount vintage of the base wine, and the age of vintage base wine determine the product quality. Honworld adds vintage base wine with regular base wine and spices. Given cooking wine is a key flavor in Chinese cooking and is ingested, the ability to create a product meeting customer tastes is crucial and could potentially lead to customer captivity as customer get used to a specific flavor of cooking wine.

 

 

Fixed Costs

 

Fixed costs consist of distribution expense and research and development. Distribution expense consists of advertising expenses, marketing expenses, promotion expenses, travelling expenses, and remuneration of sales employees. Fixed costs not associated with selling products favors larger companies as larger companies can spend more reaching more customers through higher advertising expenses and larger distribution networks. This is particularly advantageous as the market shifts from many regional markets to a national market as advertising can reach all customers within the national market rather than being fragmented by local tastes and languages. The shift from regional markets to one national market aides the bigger players as relative size in the local market is what matters. If the local market becomes a national market, the largest companies are the biggest beneficiaries as the minimum efficient scale increases.

 

The large distribution network and a consistent brand means the same product can be found in any part of the national market with similar consistency easing a customer’s purchasing decision lowering search costs leading to habit and customer captivity. If a customer travels from one part of the country to another part of the country, a national brand gives the customer comfort as cooking wine is an experience good whose quality is only determined through use. The brand represents a known product and as long the customer experienced consistency with the brand the customer will be more likely to choose the brand over an untested regional brand. With a low priced, experience good that forms such an important part of a dish, purchasing an untested brand is a risk.

 

Research and development includes spending on new products, existing products and improving the production process. As long as research and development is efficient it benefits larger companies as larger companies can spend more than smaller companies to improve the existing business and introduce new products. As Chinese economy grows and people migrate, regional tastes converge leading to homogeneous national tastes. Larger cooking wine producers have the ability to spend more research to find the national taste through the distribution of new products.

 

Honworld’s scale advantage is illustrated by Honworld market share. In 2012, Honworld was the largest producer of cooking wine with 13.8% market share of total value. Honworld’s market share is 2.16 times its largest competitor, 3.21 times its second largest competitor, 6.00 times its third largest competitor, and 10.62 times its fourth largest competitor. In 2013 and 2014, Honworld spent and 5.5% of sales on selling and distribution expenses and 7.6% of sales on research and development leading to a total of 13.1% of sales spent on fixed costs. Assuming the top five companies had similar growth, for competitors to spend an equivalent amount on fixed cost the largest competitor would spend 28.3% of sales, the second largest competitor would spend 42.2% of sales, the third largest competitor would spend 78.8% of sales, and the fourth largest competitor would spend 139.5% of sales.

 

Top 5 Honworld fixed costs to sales

 

Honworld’s value market share to volume market share ratio illustrates higher profitability than peers creating even greater scale advantage. In 2012, Honworld’s value market share to volume market share ratio is 2.38 times a 39% premium to its peer group average value market share to volume market share ratio of 1.71 times, meaning Honworld ASP is 39% higher than its peer group. Given 95% of cost of goods sold is raw materials where no player has a purchasing edge, the cost of goods sold per unit should be roughly equivalent amplifying Honworld’s top line edge.

 

Top 5 Honworld fixed costs to gross profit

 

In 2012, Honworld’s gross profit was 2.86 times its largest competitor, 4.21 times its second largest competitor, 8.89 times its third largest competitor, and 16.00 times its fourth largest competitor. In 2013 and 2014, Honworld spent 9.2% of gross profit on selling and distribution expenses and 13.2% of sales on research and development leading to a total 22.7% of gross profit spent on fixed costs. Assuming the top five companies had similar growth, for competitors to spend an equivalent amount on fixed cost the largest competitor would spend 64.7% of sales, the second largest competitor would spend 95.4% of sales, the third largest competitor would spend 201.4% of sales, and the fourth largest competitor would spend 362.6% of sales.

 

Honworld has the potential to build a national brand. It is currently the only top four producers using the healthier naturally brewed base wine. As illustrated, the company can outspend peers on advertising to build its brand, educating consumer on the benefits of naturally brewed cooking wine, growing its distribution channel to reach new customers, spending on creating new products to meet customers’ needs.

 

Cooking wine is also a low priced, experience good meaning the quality of the product can be determined through use. With cooking wine being an important part of many dishes including being used as a marinade, buying a lower quality cooking wine could ruin a dish. Given the marinating process takes significant amount of time, it would be a huge source of frustration if a dish is ruined and spending slightly more for a good cooking wine that is a known entity makes a lot of sense.

 

Honworld brand strength is illustrated through its premium pricing and pricing power. Honworld’s market share in value is 2.38 times its market share in volume compared to peers average market share in value to market share in volume ratio of 1.71 times illustrating Honworld’s ability to generate higher ASP than peers. As illustrated by the market share in value to market share in volume ratio, Honworld prices its products at a 39% premium to its largest competitors while maintain a significant market share advantage over peers. In 2012, the overall industry average price per liter is RMB4.4 compared to Honworld’s RMB5.4 per liter. Regarding pricing power, in 2014, Honworld increased prices on its mid-range products by 25%. The average price of the cooking wine is very low at RMB4.4 per liter but it is vital component in many Chinese dishes giving it significant potential for price increases. The graphic below shows the cost of various Chinese cooking wines. Lao Heng He Scallion and Ginger is one of Honworld’s medium-range products and are priced at a premium to peer group products. Products packaged in a pouch can be assumed to be mass-market products while bottled products can be assumed to be medium-range products similar to Honworld’s product.

 

Online Product Comparison

 

The table below illustrates the price of Honworld’s product relative to other grocery products.

 

Honworld Products relative to other groceries

 

As illustrated above a liter of Honworld’s mass-market cooking wine is less than half the price of a loaf of white bread, while a liter of Honworld’s premium product is slightly more expensive than a liter of milk.

 

The table below shows a few recipes that use Chinese cooking wine also known as Shaoxing wine. The cost of the cooking wine is compared to only the cost of the meat in the dish. Using Honworld’s premium cooking wine price, cooking wine accounts for 6.8%, 25.9%, and 15.5% of the cost of the meat in General Tso’s Chicken, Chinese Hoisin Chicken, and Shaoxing Drunken Chicken, respectively. A 5% increase would be barely noticeable to the consumer particularly when food inflation is about 2.7% in China.

 

Recipes with cooking wine

 

Honworld’s premium prices inform customers of the quality of the product, as individuals perceive higher price products to be better quality. The naturally brewed products inform customers of the healthiness and quality of the product.

 

Fixed costs separate from volume allows for economies of scale and higher profitability for larger players. The economies of scale will grow in importance as the market consolidates from many regional markets to one national market and the national fixed costs can be spread over a large amount of volume. Any player wanting to maintain profitability advantages from economies of scale needs to maintain its size advantage over competitors.

 

 

Distribution

 

Within the Chinese cooking wine industry, distribution is outsourced to regional distributors with well-established local distribution networks primarily involved in the distribution of food and condiment products. If something is outsourced, every competitor can gain access to it and therefore there are no opportunities to gain excess profits. Although, distributors have limited resources and smaller producers may find it difficult to gain access to the same distribution channels as larger players further adding to the size advantage in the industry. Among the larger players, there will be probably little difference in the ability to access distribution networks.

 

Well-established distribution networks take time to replicate. Furthermore, as an owner of a product you want to partner with the largest distribution networks to get your product in the most outlets at the lowest possible cost giving large distributors bargaining power over their suppliers.

 

Cooking wine distribution will most likely continue to be outsourced as the time and cost of replicating the distribution network internally is prohibitive. Distributors will likely consolidate as the food and condiment industry shifts from regional markets to a national market. The increased bargaining power that comes with consolidation will be dependent on the speed of consolidation of distributors relative to the consolidation of cooking wine producers.

 

Although there are over 1,000 cooking wine manufacturers, there are potential barriers to entry within activities in the Chinese cooking wine industry. These activities with the greatest potential for barriers to entry are ageing of base wine, blending and seasoning, fixed costs (distribution expense and R&D), and distribution.

 

As regional markets become a national market with more homogenous tastes, the industry should consolidate as the minimum efficient scale increases making economies of scale become more important.

 

 

Other Competitive Forces

 

The competitive rivalry among participants is low as the market is growing at 15-20% annually. In addition, some players have been able to differentiate their product by naturally brewing the base wine, increased percentage of base wine, increased percentage of vintage base wine, and age of vintage base wine leading to competition on product characteristics rather than price. The price of the product is low priced potentially allowing for price increases decreasing competitive rivalry. There are no exit barriers.

 

The risk of substitution is low. High quality Sherry wine can be used as a substitute but is foreign and a person cooking a Chinese dish in China is more likely to have Chinese cooking wine on hand than Sherry. If that person goes to the store to purchase Chinese cooking wine, it is likely to be more available than Sherry. Chinese cooking wine has been used for the recipe for generations and is much more likely to be on the front of the mind than Sherry. The customer probably does not even think of Sherry as a substitute.

 

 


 

COMPANY DESCRIPTION

 

Honworld is a producer of Chinese cooking wine, soy sauce, vinegar, and other condiments. Cooking wine is the primary source of both revenues and gross profit accounting for 71% of revenues and an estimated 69% of gross profit in 2014.

 

Revenue and Gross Profit breakdown by product

 

Value Proposition

 

Honworld provides healthy, high quality condiment products. It uses a naturally brewed, traditional production process for its cooking wine and other condiments. It is the only top four cooking wine producer using a naturally brewed production process. The company’s goal is to be one of the largest Chinese condiment producers.

 

Given its focus on naturally brewed products manufactured with traditional production methods, it aims to serve the premium, high-end and medium-range end of the market. Honworld sells very little in the mass-market segment. The company is trying to build a premium brand image to maintain consistency the company primarily selling medium-range products and above.

 

The company sells its products at a premium to the market and its main competitors, yet, maintains a large market share lead illustrating the strength of the company’s brand. Honworld’s premium prices inform the customer of the quality of the product, as individuals perceive higher price products to be better quality. The naturally brewed production process informs the customer of the product’s health attributes.

 

 

Cooking Wine

 

Cooking wine products

 

Cooking wine accounts for 71% of sales and an estimated 69% of gross profit in 2014. Honworld’s cooking wine is naturally brewed. Its three largest cooking wine competitors use alcohol as a base, also known as chemically produced, in their cooking wine. Naturally brewed cooking wine is healthier, due to higher level of nutrients. With the increasing health consciousness in China, the company’s growth is outpacing the market. Honworld’s naturally brewed production is one of the reasons it is the largest cooking wine producers in China with a 13.8% value market share and a 5.8% volume market share in 2012.

 

Top 5 Market Share Value Volume

 

Honworld’s naturally brewed cooking wine allows it to position itself as a premium producer and receive a higher ASP for its products. As illustrated by the value market share to volume market share ratio, in 2012, Honworld was able to receive a 39% higher ASP relative to the top five players in the market and a 16.6 percentage point gross margin advantage over its peers. The average ASP in 2013 across all cooking wine producers was estimated at RMB4.67 per liter while Honworld’s ASP was an estimated RMB8.02 per liter.

 

Honworld produces four categories of cooking wine premium, high-end, medium-range and mass-market. Each category is classified by the amount of base wine used, the amount of vintage age base wine, the age of the vintage age base wine, and the amount of alcohol by volume.

 

Honworld Products by category

 

The suggested retail prices, average selling prices, 2014 revenues, 2013 estimated gross margins, and packaging material used for each product category are illustrated below.

 

Honworld product by category asp gross margin packaging

 

In 2014, premium cooking wine accounted for 14.8% of total sales, 20.9% of cooking wine sales, and an estimated 18.8% of total gross profit. High-end cooking wine accounted for 16.6% of total sales, 23.4% of cooking wine sales, and an estimated 18.6% of total gross profit. Medium-range cooking wine accounted for 36.8% of total sales, 52.0% of cooking wine sales, and an estimated 28.6% of total gross profit. Mass-market cooking wine accounted for 2.7% of total sales, 3.8% of total sales, and an estimated 3.8% of total gross profit. The overall cooking wine segment grew by 136.5% per year from 2010 to 2014, with all cooking wine segments recording strong growth.

 

Revenue breakdown

 

As shown above, in 2010 Honworld primarily produced mass-market and medium-range cooking wine. In December 2011, the company started producing naturally brewed cooking wine. The shift to naturally brewed products allowed the company to differentiate its products and position them as a higher quality, healthier option increasing the customer’s willingness to pay. As illustrated below, post-2011, there was a big shift from mass-market products to higher-end and premium products.

 

Sales by category chart

 

The shift to higher quality cooking wine and increased ASP within each category has lead to an increase in the cooking wine blended ASP.

 

ASP by cooking wine category

 

Overall, Honworld’s blended cooking wine ASP has increased from RMB2.48 per liter in 2010 to RMB8.02 per liter at the time of the IPO prospectus. The growth in ASP is a combination of both product mix and rising ASPs within each category, with the change in product mix accounting for the majority of the growth as mass-market went from 58% of sales in 2010 to 4% of sales in 2014.

 

ASP change cooking wine

 

Above the mass-market segment, annual cooking wine ASP changes saw barely any increase. The company mentioned it was able to raise prices by 25% on some medium-range products in the second half of 2014.

 

From 2010 to 2014, mass-market cooking wine volume declined slightly, while medium-range volume accounted for 71% of total volume growth, high-end accounted for 19% of total volume growth, and premium volume accounted for 11% of total volume growth.

 

 

Cooking Wine Volume by product

The table below shows gross margin each cooking wine category. 2013 and 2014 gross margins are estimated, as the company have not reported gross margin post-IPO prospectus.

 

cooking wine gross margin by category

 

Gross margin for the premium and high-end segment are extremely high as it takes significant amount of patience, discipline, and capital, due to inventory requirements, to create a premium and high-end products leading to lower competition in these segments. Medium-range products face more competition. Prices are RMB1.90 per liter above mass-market but the cost of production is RMB1.85 per liter is higher due to the requirements to differentiate from mass-market products. In 2013, medium-range products had 21% more base wine per liter than mass-market products and required bottle packaging vs. pouches for mass-market. These two characteristics drove the cost of goods sold per liter up from RMB1.70 on mass-market products to RMB3.35 on medium-range products.

 

ASP COGS Gross Profit per liter cooking wine by category

 

In 2014, estimated gross profit per liter was RMB12.32 per liter for the premium segment, RMB7.13 per liter for the high-end segment, RMB2.79 per liter for the medium-range segment, and RMB2.60 per liter for the mass-market segment. While premium and high-end gross profit per liter remained relatively stable, medium-range and mass-market gross profit have respectively grown 28.9% and 26.2% per year from 2010 to 2014.

 

 

Soy Sauce

 

Honworld’s soy sauce products mainly consist of Fish Soy Sauce and Premium Flavored Soy Sauce. Fish Soy Sauce is produced using fish and soy beans in the fermentation process, a production technique that is patented by Honworld in China. Fish Soy Sauce is primarily used as a dipping sauce. At the time of the IPO, it came in 200 ml bottles with a suggested retail price of RMB28.0. Premium Flavored Soy Sauce products come in 150 ml to 1.28 liter bottles with suggested retail prices ranging from RMB4.9 to RMB26.8, can be used both as a dipping sauce and as flavoring agent in cooking and food preparation. The company is also increasingly focused on the production of higher end soy sauce leading to higher ASPs.

 

Soy Sauce key stats

 

In 2014, soy sauce accounted for 16% of revenues and 19% of gross profit. ASP has steadily increased in 2011 and 2012 then saw a dramatic increase in 2013. The dramatic increase in revenues, ASP, and profitability was due to a new distribution agreement with a leading soy sauce distributor. The company is able to generate very strong profitability in the soy sauce business.

 

In January 2015, the company launched two new soy sauce products, Stewed Mushroom Dark Soy Sauce and Zero-additive Premium Flavored Soy Sauce. Both are healthy products using traditional brewing methods consistent with the premium, natural, healthy brand Honworld is trying to project.

 

The company is a much smaller player in the soy sauce and may struggle against larger players due to similar competitive advantages the company is trying to build in the cooking wine market. Despite the potential competitive struggles, it makes sense for the company to create healthy products using traditional brewing methods consistent with its brand image that the company can push through existing distribution channels with very little additional investment required.

 

 

Vinegar

 

Honworld’s vinegar is rice vinegar. The company’s key vinegar products are Rose Rice Vinegar, Premium Zhejiang Vinegar, and Crab Vinegar. All of Honworld’s vinegar is naturally brewed and can be used either as a flavor agent or a dipping sauce. At the time of the IPO, vinegar products came in 200 ml to 750 ml bottles or 400 ml bags, with suggested retail prices ranging from RMB4.3 to RMB38.0.

 

Vinegar Key Stats

 

Vinegar has been a very strong product category for Honworld. It has consistently grown at a rapid pace and the company’s Premium Zhejiang Vinegar is well known in China. The naturally brewed production process fits well with the company’s brand and positioning. The company has consistently increased ASPs, volumes, and gross margins in the vinegar business.

 

Like soy sauce, the company is a smaller player but the company’s products are consistent with the overall brand image and with an expanding distribution network, there is very little cost of pushing additional products through the distribution channels. The product seems to be catching on with consumers as illustrated by the 382% growth in 2014.

 

 

Others

 

Other products include Zhong Wei branded paste and pickled vegetables procured from Zhong Wei, such as Gold Chili Paste. The company also produces Lao Heng He branded bean curd products, such as Rose Fermented Bean Curd, which was granted the gold award at the 1929 Westlake Exposition. Other products sales have not grown since 2012. Honworld’s focus is on higher margin, faster growing products. Other products only accounted for 3.1% of sales and an estimated 1.6% of gross profit in 2014. Other products also have much weaker gross margin as these products are a combination of own brand and Zhong Wei branded products.

 

Other Products Key Stats 

 

Distribution

 

Currently, Honworld’s sales are primarily in the regional markets of Zhejiang Province, Shanghai, Guangdong Province, Liaoning Province, Shandong Province, and Beijing. Sales to these regions accounted for 73%, 62%, 85%, and 88% of sales in 2010, 2011, 2012, and in the eight months ending August 2013, respectively.

 

Sales by Region

 

Honworld’s key regions account for 26% of China’s population and 35% of its GDP meaning there is a large runway for growth if the company is able to move from a regional player to a national player.

 

Distribution Map

 

The graphic above shows Honworld’s distribution network at the time of its IPO with its key regions outlined.

 

Since the IPO, Honworld has added a number of new distribution partners in new and existing markets. Since December 2014, the company has announced distribution agreements via the Hong Kong Stock Exchange.

 

On December 14, 2014, Honworld announced Lao Heng He brand Cooking wine would be sold in Hong Kong’s major supermarkets, including but not limited to Wellcome and PARKnSHOP, by January 2015 at the earliest. On February 11, 2015, the company announced 750ml Chef’s Huadiao and 500ml Chinese Cooking Wine (were available in 138 Wellcome stores and 5 Megasuper Market stores and will be available in 200 PARKnSHOP stores and 89 China Resources Vanguard stores within the next two to three months. This is the company’s first entrance into the Hong Kong market.

 

On January 12, 2015, the company announced its premium, high-end, and medium-range cooking wine products were for sale on the Heike Flagship Store, and the company’s other range of products will be launched for sale shortly after. Shenzhen Shunfeng Heike is the online shopping service community store under that services the O2O (online to offline) market. This is a new market.

 

On January 20, 2015, Honworld announced it expanded its direct sales efforts in the Eastern China market by signing a cooperation agreement with Zhejiang Zhongyi Trading Company Limited (Zhongyi).  Zhongyi owns 45 supermarkets in Zhejiang Province and has access to other distribution channels, including 120 highway service stations in Eastern China.  11 of Honworld’s products, including cooking wines, vinegar, soy sauce and other products will be sold through these channels. This is Honworld’s strongest market and illustrates there is still growth potential within its strongest markets.

 

On January 26, 2015, Honworld launched a flagship store on JD.com.  All of the company’s products will be available on this e-commerce platform. This is a new market.

 

On February 24, 2015, the company announced a distribution agreement with Taiyuan Honghan Food Co. Ltd, one of the major cooking oil distributors in Taiyuan.  A number of Honworld’s cooking wines are available for sale in hypermarkets and wholesale markets in the Taiyuan region. Taiyuan is the capital and largest city of North China’s Shanxi province. This is one of Honworld’s least penetrated regions.

 

On March 12, 2015, the company announced a distribution agreement in the Guangzhou region with Guangzhou Guangshenglin, a major cooking oil distributor in the region.  Honworld’s products will be available in 396 supermarkets in the region. Guangzhou is the capital and largest city of Guangdong province. This is one of Honworld’s strongest regions. The agreement illustrates even in its strongest regions, it still can increase its presence.

 

On March 31, 2015, Honworld announced distribution agreements with Yanchen Funing Dinghao Trading Co Ltd and Yancheng Binhai Dontuo Food Trading Company for the Jiangsu region. Both are well known condiment distributors and Honworld’s products will be available in community stores, agricultural trade markets, and wholesale markets in the Jiangsu region.  At the time of the IPO, Jiangsu Province has the second most distributors at 35.

 

On April 9, 2015, the company announced it opened a flagship store on Yihaodian, a Chinese online grocery business, with 20 of the company’s products available. This is a new market.

 

On April 21, 2015, the company entered into a distribution agreement with Anhui Linquan Jiawangshangmao Co., Ltd.  The company’s products will be in supermarket, community stores, agricultural trade markets, and wholesale markets in Linquan County areas distributed by Jiawangshangmao. Jiawangshangmao is the county-level chief distributor of famous cooking oil and pickle brand in Linquan County with extensive distribution channels in the county. Linquan County is a county of Anhui Province, China. With 24 distributors at the time of the IPO, Anhui Province is one of the most penetrated provinces.

 

On April 24, 2015, Honworld entered into cooperation agreements with Jiangsu Jianhu Xiangtianjie Trading Co., Ltd. and Jintan City Chengxi Binhui Seasoning Operation Department. Xiangtianjie Trading and Chengxi Binhui are a county-level master distributor and a distributor of condiment brands in their county, respectively. The company’s products will be sold through the sales channels of Xiangtianjie Trading and Chengxi Binhui and are now widely available in local community stores, small-scale supermarkets, agricultural trade markets, and wholesale markets. .  At the time of the IPO, Jiangsu Province has the second most distributors at 35

 

In 2013 and 2014, Honworld spent an average of 7.3% of sales on distribution expense.  Due to its scale advantage, the company should continue to spend heavily on distribution expenses.

 

 

Research and Development

 

In 2013 and 2014, the company spent a combined RMB91.5 million or 7.6% of sales on research and development. Honworld’s research and development effort goes to improving the production process, improving existing products, and creating new products. Given the company’s market share lead in cooking wine, additional fixed cost creates a competitive advantage over peers.

 

In the first half of 2014, Honworld introduced two new products including lees cooking wine and Shrimp Paste Soy Sauce.

 

In February 2015, the company announced new soy sauce products, Stewed Mushroom Dark Soy Sauce and Zero-additive Premium Flavored Soy Sauce. These products use traditional brewing methods while still being product innovations. Stewed Mushroom Dark Soy Sauce does not use caramel additives and Zero-additive Premium Flavored Soy Sauce also has no additives. Naturally brewed products using traditionally production methods, or healthy products all position the company as a high quality, premium producer reinforcing its existing brand.

 

 

Operating Margin

 

Breakdown margins and investment to sales

 

Honworld’s gross margin increased from 36.9% to 57.8% from 2010 to 2014.  An improving product mix and decreased reliance on Zhong Wei’s distribution lead to the increase in gross margin.  Honworld’s reliance on Zhong Wei’s distribution is now insignificant so margin expansion due to higher margin distribution will be not drive margin expansion in the future. Gross margin improvements will have to come from continued product mix improvement and pricing power.

 

As the Chinese consumer grows richer, the company’s product mix should continue improve as sales shift from medium-range products (GM~45%) to high-end (GM~65%) and premium products (GM~75%). As mentioned under the industry section, pricing power will come from the low price of the product and the brand the company is creating by spending more on fixed costs (distribution expense and R&D) given the company’s market share advantage over its cooking wine competitors. In 2012, Honworld had 2.16 times the market share of its largest competitor, 3.21 times the market share of its second competitor, 6.00 times the market share of its third largest competitor, and 10.62 times the market share of its fourth largest competitor.  When looking at gross profit advantage, Honworld’s premium price amplifies the scale advantage.  In 2012, Honworld’s gross profit was 2.86 times its largest competitor, 4.21 times its second largest competitor, 8.89 times its third largest competitor, and 16.00 times its fourth largest competitor.

 

Distribution expenses have increased as Honworld aggressively builds its distribution network and advertises. It is a fixed cost that will eventually decrease as a percentage of sales, but over the next five to ten years as the distribution network shifts from regional to national it will remain elevated. The company should spend as much as possible to increase its distribution network as the presence of fixed costs lead to economies of scale. The presence of economies of scale means market share and gross profit market share are the key factors in profitability within the industry.

 

Research and development expenses are the majority of administrative expenses averaging 57% of administrative expenses over the past three years.   The other administrative expenses are not disclosed but the company has done a good job of keeping the number of management and administrative employees to a minimum at 11 and the expense of the five highest paid employees has not increased dramatically.

 

Employee and employee expense

 

The company is also building inventory and production facilities for future growth so there may be a case that the additional administrative expenses are infrastructure for future growth. At the time of the company’s IPO, Honworld only utilized 41.3% of bottling capacity in the first eight months of 2013 and 59.9% in 2012.

 

To get an idea of the potential for distribution expenses and administrative expenses, other Chinese condiment companies are listed below.

 

Peer Group Condiments key metrics to sales

 

Over the past four years, the average gross margin of Chinese condiment producers is 30.9% compared to Honworld’s 54.1%. Honworld’s higher gross margin is evidence that its message of naturally brewed products using traditional production processes are getting through to customers and their products are increasing the customers willingness to pay.  This premium pricing is further illustrated by the company’s higher ASP than top five cooking wine peers with significant market share lead.

 

For Chinese condiment producers listed in China, we were unable to get a breakdown of SG&A between distribution expenses and administrative expenses.  Overall,  from 2011 to 2014 Chinese condiment producers average SG&A was 18.5% of sales compared to Honworld’s 16.7% of sales.  For those condiment producers listed in Hong Kong, the average distribution expense was 7.5% of sales so Honworld’s distribution expenses at 8.2% of sales was roughly the same. The average administrative expense of Hong Kong listed Chinese condiment producers was 3.3% while Honworld’s was 8.5%. In 2013 and 2014, Honworld’s average administrative expense was 13.0% of sales. The differential in administrative expense is Honworld’s research and development expense, which averaged 7.6% of sales in 2013 and 2014. Given the company’s market share advantage in the cooking wine segment, creating additional fixed costs required to compete increases the minimum efficient scale within the industry consolidating the market. Other than research and development, Honworld seems to be building its infrastructure for future growth in the form of production, storage, and bottling capacity.

 

Management and administrative employees are kept low at 11 and personnel expenses are not ballooning so the additional administrative expenses do not seem to be due to inefficiencies.

 

Peer Group HK FB key metrics to sales

 

Hong Kong listed Chinese food and beverage companies’ distribution and administrative expenses are in the table above to get an idea of what companies with the largest distribution networks pay to maintain and grow their networks.  There is a wide disparity in spending on distribution expense between different players with Want Want spending 11.9% of sales on the low end and Tenfu spending 28.7% with an average distribution expense at 22.2% of sales. On the administrative side, there is also a wide disparity with Tingyi on the low end at 2.9% of sales and Tenfu on the high end at 11.4% of sales with an average administrative expense at 6.4% of sales.

 

Given Honworld’s market share advantage and the potential for fixed costs in the form of distribution expenses, including advertising, and research and development, spending as much as possible on these fixed costs in an efficient manner will improve the company, increase its reach, educate more customers, and consolidate the market by increasing the minimum efficient scale to compete. These economies of scale are magnified by potential customer captivity in the form of a brand as cooking wine is a low priced, experience good and consistency of brand will lower search costs for consumers and potentially lead to habit forming behavior creating customer captivity.

 

 

Taxes

 

On March 7, 2014 Honworld received approval of new and advanced technology enterprise status allowing the company to pay a 15% tax rate for three years ending 2015 including the retroactive tax rate for 2013. From 2016 onwards, the company’s tax rate will revert to the 25% statutory tax rate.

 

 

Investment Requirements

 

Historical investment requirements

 

The table above shows investment requirements as a percentage of total sales. Working capital is Honworld’s largest investment requirement.  Within working capital, inventory is the largest investment requirement.

 

Working Capital Investments CCC

 

It is a bit concerning that days sales outstanding, other current assets days (100% prepaid expenses), payables days, and other non-interest bearing current liabilities days increased in 2014, potentially pointing to inventory being pushed through the channel,  increasing bad debt from distributors, or growth of assets tied to the company’s inventory build.

 

Inventory cost per liter of base wine

 

Honworld is building its inventory to support future growth, to create sufficient supply of base wine to create a buffer against raw material costs, and to allow for ageing of vintage base wine. The higher the concentration of vintage wine  and the older the vintage wine, the higher the premium that can be charged so in this case the building of inventory either supports growth or leads to the ability to charge a premium due to more and older vintage base wine. In the near term, cash flow is hurt, but like with R&D and distribution expenses, short term pain leads to long-term gain.  There is a risk that the company is just decreasing capital efficiency and compensation in the form of higher prices will not come to fruition and profitability will suffering.

 

In 2015, the company’s target is to build its base wine inventory to 225 million liters.  Over the past two years, the cost of each liter of base wine, as measured by base wine inventory divided by total inventory, has equaled roughly RMB5.5. At this rate, it will cost RMB366 million to build inventory to the 2015 target.

 

In addition, to go from 55 million liters of base wine to 158 million liters of base wine additional capex of RMB133 million was needed for production and storage facilities or an additional RMB1.29 million in capex was needed for each additional million liters of base wine inventory.  Using the RMB1.29 million in capex, to increase the base wine inventory from the current 158 million liters to 225 million liters, an additional RMB86 million in capex for new production facilities will be needed bringing the total investment required for both inventory and production facilities to RMB452.2 million or RMB6.79 per liter.

 

Honworld’s capital expenditures are growth oriented.  From 2010 to 2014, the company spent on average 22.6% of sales or 62.4 times depreciation expense over the same period. The company should continue to spend a significant amount of sales on capex as the company moves from a regional condiment producer to a national condiment producer.

 

 

ROIC

 

Profitability Key Stats

 

Honworld has performed very well over the past few years with ROIC well above the company’s cost of capital averaging 20.7% from 2010 to 2014. In 2014, there was a decline in ROIC due to the influx of capital from the IPO, investments in inventory, investment in productive assets that have not been fully utilized, investment in distribution network and investment in research and development. In the short to medium term, profitability will probably in the form of ROIC will remain depressed but longer term, Honworld profitability will be determined on the ability to capture value through economies of scale and customer captivity.

 

Since shifting to a naturally brewed production process, Honworld has been able to differentiate its products to command a premium price and grow its operations rapidly. The company has started to build a brand in its key regions where the vast majority of its sales come from. Over the longer term, there is potential for the company to build a national brand and customer captivity allowing it to take advantage of its size and the opportunity to outspend competitors.

 

 

Business Economics

 

The table below illustrates the business economics on a per liter of sales volume basis. The total volume is the sum of volume disclosed by the company or estimated (2013 & 2014) and includes all cooking wine volume, soy sauce volume, and vinegar volume.  In 2013 & 2014, ASP and gross margin were estimated for each product. ASP remained flat from the last reported figure in the eight months ending August 2014.

 

Business economics per liter of sales volume

 

Total volume continues to grow quickly. ASP looks to have declined in 2014 due to the estimated volume growth of Vinegar, which is a lower ASP product (estimated RMB5.50 per liter). Vinegar’s gains are more likely to be a combination of volume and ASP as volume would have grown by 382% to account for the growth in Vinegar revenues.  The lower ASP of vinegar drives everything on the income statement lower on a per liter basis.

 

The balance sheet accounts continue to grow on a sales volume basis as the company builds inventory for future growth. Other working capital (with exception of accounts receivables) and fixed capital are a function of inventory build.  The growth in invested capital per liter sold drives down capital efficiency and the return on invested capital of the business.

 

The table below illustrates inventory, other working capital, and fixed capital per liter of base wine inventory. On a per liter basis, balance sheet accounts are more appropriately analyzed on the base wine inventory volume rather than sales volume.

 

Economics per liter of base wine

 

Over the past two years, the investment in inventory averaged RMB5.57 per liter of base wine in inventory. Net investment in other working capital is volatile and less significant averaging RMB1.02 per liter of base wine. Over the past four years, fixed capital investment has averaged RMB3.23 per liter of base wine.

 

COGS per liter sold to the cost of inventory per liter of base wine inventory has fluctuated over the past four years with an averaged 78.88%. A liter of base wine inventory produces greater than a liter of cooking wine as it is mixed with water.  The percentage of base wine used in the production of a liter of cooking wine is one of the key determinants of the grade of cooking wine. For example in 2013, the company’s premium products contained only 93% base wine per liter of cooking wine, high-end products contained 87% base wine, medium-range contained 85% base wine, and mass-market contained 68% base wine per liter of cooking wine. This allows us to connect the level of investment required to the income statement.

 

Given the growth of the company and the capital requirements to support the growth, it is best to eliminate capital expenditures on growth to identify the true profitability of the business. Using volume sold as a denominator in the per liter calculation gives an accurate representation of the income statement but not the balance sheet as investments are made to support base wine inventory, which is growing much faster than sales volume. To get an accurate representation of investment requirements, it is best to use base wine inventory volume as the denominator in the per liter calculation and then link the investments on a per liter of base wine to the income statement through the cost of goods sold to cost of inventory ratio. The tax rate is normalized to the statutory rate for 2013 and 2014. This methodology leads to a ROIC of 36.1% in 2013 and 32.3% in 2014 and a 2010 to 2014 average ROIC of 22.7%.

 

Another way of illustrating the same calculation is to assume one year of base wine inventory is sufficient to run the business in a steady state. Assets above this level are investments for growth and assets below this level assumes underinvestment on the part of the company. This method of determining profitability allows for scenario analysis, in case, capital efficiency continues to deteriorate.

 

Inventory levels are the key driver of the level of Honworld’s assets as fixed capital in the form of production and storage facilities are determined by the level of base wine inventory. Non-interest bearing liabilities and pre-paid expenses are primarily to purchase raw materials or other assets related to base wine inventory. Accounts receivables are probably the only working capital item not directly tied to base wine inventory. Given the relationship of operating assets and liabilities to base wine inventory, it is the key driver of capital requirements. The tax level is also normalized to the statutory tax rate of 25% rather than the current temporary rate of 15%.

 

Two base wine inventory scenarios are used to determine the underlying profitability of the company. One scenario is close to the historical average of capital efficiency for the company and another scenario is near trough capital efficiency for the company.

 

Investment requirements 1 year and 2 year of base wine

 

In 2011 and 2012, the company held too little inventory, other working capital, and fixed capital therefore growth investment was negative and maintenance capital requirements were above total invested capital leading to an artificially elevated ROIC.

 

In 2013, the company invested capital was close to the capital required for one year of base wine inventory but the tax rate was at the temporary 15% rate.  After adjusting the tax rate to the statutory tax rate of 25%, the company’s ROIC was 37.4%.

 

In 2014, assuming one year of base wine inventory, the company’s true ROIC was 32.3%. Assuming two years of base wine inventory the true ROIC was 16.1%. Using the NOPAT margin of the last three years and five year turnover measures, the average ROIC for one year of base wine inventory is 25.4% and 12.7% for two years of base wine inventory.

 

If the company is efficient enough to maintain base wine inventory of one year while maintaining premium pricing, pricing power, and the heavy spend on fixed costs, it can generate a ROIC twice its cost of capital. If the company continues to build base wine inventory and is unable to turn the inventory build into a higher portion of high-end and premium products, which use higher levels of vintage base wine and garner higher prices and gross profits per liter, the company’s profitability will revert to its cost of capital.

 

At two years of base wine inventory, the lower capital efficiency associated with the higher asset level requires operating margin to increase from the current 40% to 75% to compensate for the lower turnover levels, which will be very difficult to do given only the gross margins on premium products are anywhere near that level.

 

In the short to medium term, profitability will probably in the form of ROIC will remain depressed due to the inventory and related asset build to support future growth and high levels of fixed costs to build out the distribution network and create new products. Over the longer term, assuming the company does not over build inventory, Honworld should reap the rewards of current investments given the ability to capture value through economies of scale and customer captivity.

 

 

Growth Outlook

 

Given ROIC is consistently greater than the company’s cost of capital and there is a potential competitive advantage, growth adds value and is worthy of review.

 

The cooking wine market is expected to grow at roughly 20% per year between 2012 and 2017. Honworld should outperform the market as its healthier, naturally brewed product using traditional production methods resonates with a more health conscious and increasingly wealthier consumer.  The company can also outspend peers on distribution to reach consumers, advertising to educate consumers, and research and development to improving existing products and processes and to create new products.

 

Honworld’s key markets only accounts for 26% of the total population of China and 36% of China’s GDP so the company has a long run way for growth, if it is successful at transitioning from a regional player to a national player.

 

Sales by Region 

 

Financing growth

 

Financing Requirements 

 

The ability to use capital efficiently driven by capital turnover will Honworld’s ability to finance growth internally. Working capital turnover decreased to 0.7 times in 2014 from 1.8 times in 2013, as the company increased its stock of base wine. Working capital turnover may continue to decline until the company is able to sell more premium and high-end products, which require aged vintage base wine. In 2015, the company plans to increase its base wine stock to 225 million liters from 158 million liters in 2014.  For inventory turnover to remain the same revenues would have to grow by 42%.

 

Given the expected inventory build, capital efficiency ratios should decline.  With the assumptions below post-2015, the company can grow at roughly 15% without needing external financing.

 

  • Working capital turnover declines to 0.5
  • Fixed capital declines to 1.0, historically half as much fixed capital is required to support working capital.
  • Overall invested capital turnover declines to 0.33
  • Turnover ratios level after 2015
  • Operating margin remains flat at 40%
  • ROIC declines to 10%

 

Assuming no change in turnover ratios from 2014 and operating margin remains flat, Honworld can grow at roughly 20% without any external financing.

 

 

Unique Activities

 

Only unique activities that competitors cannot replicate can create sustained excess profitability. If competitors can replicate an activity, excess profitability will lead to replication eliminating excess profits. What does Honworld do that is unique?  First, the company is the only competitor within the top four cooking wine producers naturally brewing its product. Honworld was able to switch near the end of the 2011 and growth as taken off so this can easily be replicated.  Honworld was able to be the first, which resonates with customers from a positioning stand point but positioning is not a competitive advantage.

 

The taste of the product is not easily replicated and could potentially lead to customer captivity.  Distinct tastes in foods are often difficult to replicate leading to habit when purchasing particularly on low costs, experience goods where a strong, consistent brand lowers search costs.

 

The amount the company can spend on fixed costs such as distribution expense and research and development is very difficult to replicate. Honworld’s sales are 2.16 times larger than its closest competitor, 3.21 time larger than its second largest competitor, 6.00 times larger its third largest competitor, and 10.62 time larger than its fourth largest competitor and closest naturally brewed competitor.

 

Top 5 Market Share Value Volume

 

The size affect of higher sales is amplified by the company’s premium pricing and higher gross margins than peers. The company is able to spend that much more on distribution, advertising, and research and development than its closest competitors. This is important particularly in a growing market as the Honworld can reach that many more customers than its peers through its distribution network and advertising allowing it to acquire a disproportionate amount of new customer. Capturing new customers is particularly important in a market with customer captivity and economies of scale. This size advantage matters in the local market.  In a market that is moving from many regional markets with many tastes to a homogenous national market, the local market is the national market increasing the importance of size on a national level rather than at a regional level.

 

 


 

MANAGEMENT

 

 

Background

 

The Chairman, founder and Chief Executive Officer is Mr. Chen Weizhong. Mr. Chen is 43 and holds a 53.62% stake in Honworld, aligning his incentives with minority shareholders. His ancestors were shareholders in a predecessor company, prior to the communist revolution. Given his family history with the business and the Lao Heng He brand, Mr. Chen may see Honworld as a family legacy.

 

It seems the business is his passion. In December 2008, Mr. Chen contributed 5.3 million liters of base wine with 10 to 20 Wine Years and approximately 6.0 million liters of base wine with over 20 Wine Years. He started accumulating the base wine when he entered the condiment business in 1990. The accumulation of base wine started well before Mr. Chen founded his first condiment company (Zhong Wei) in 1995, which did not require base wine for its products, and well before purchasing the Lao Heng He brand in June 2005.

 

His integrity is evidenced by the donation of the 11.3 million liters to the company, which had an estimated fair value of RMB7.0 million, and his transfer of his secret recipe to the company for RMB1. Using a low end of recent inventory costs (RMB5.0 per liter), this base wine now costs RMB56.5 million to reproduce.

 

 

Strategy

 

Mr. Chen seems to have a strong understanding of strategy. The company stated any acquisition should create economic value for the company. The use of the term economic value is rarely seen in any company never mind an Asian company with a market capitalization under HK$5 billion.

 

Honworld pioneered naturally brewed cooking wine using traditional production methods. The company is executing its differentiation strategy and telling the appropriate marketing story allowing the company to garner a premium price and maintain pricing power. In addition, given the company’s size advantage, the high expenditure on fixed costs in the form of distribution expense and research and development are keys to cementing Honworld’s competitive position and consolidating the market. The size advantage and expenditures on fixed costs are particularly important as the company speaks of converging tastes within China leading to a national market with one taste rather than a regional market with diverse tastes. With economies of scale relative size in a market matters, the shift from local market to national market relative size on a national level becomes much more important than relative size in local markets. A national market with fixed costs increases the minimum efficient scale increasing the market share on a national level required to compete.

 

As the market shifts from regional to national and consolidation occurs, it will be very difficult for smaller players to get into distributors networks as distributors only have limited resources leading to an inability to get shelf space at retailers creating another advantage for larger players. There is also potential for customer captivity making size more important as a strong brand on a low priced, experience good lowers the search cost for customers and leads to habit-forming behavior.

 

The key strategic measures for Honworld is market share and gross profitability relative to peers to ensure its scale advantage is intact.  To make sure the company is fully taking advantage of its scale, expenditures on strategic fixed costs such as distribution expense and research and development should be maximized while remaining efficient. Customer captivity and strength of product is illustrated by premium pricing coupled with a high market share and gross margin.

 

The large expenditures on distribution expenses and research and development hurt current profitability, but the ability to withstand short-term pain in favor of greater profitability in the long-term points to a long-term vision, which is crucial to continued strong performance in the company.

 

 

Execution

 

Operationally, the company is also executing very well. The company’s products are being received very well as illustrated by the company’s growth, ability to increase prices, and premium prices combined with the largest market share. The company is effectively building out its distribution network. It is also positioning its products in the right segments and not allowing its premium brand image to deteriorate by selling mass-market products. The company is also spending heavily on fixed costs leveraging its size advantage over competitors. The best measure of operational efficiency is ROIC. Honworld has performed very well over the past few years with ROIC well above the company’s cost of capital averaging 20.7% from 2010 to 2014. In 2014, there was a decline in ROIC due to the influx of capital from the IPO, investments in inventory, investment in productive assets that have not been utilized, investment in distribution network and investment in research and development.

 

Profitability Key Stats

 

Given the growth of the company and the capital requirements to support the growth, it is best to eliminate capital expenditures on growth to identify the true underlying profitability of the business, which is accomplished by creating an income statement on a per liter sold, creating a balance sheet on a per liter of base wine, and linking the two.

 

Investments per liter of base wine and ROIC per liter of base wine

 

After eliminating the affect on profitability from distortions from growth investments, the company was able to maintain a ROIC over 30% for the past two years and averaged 22.7% since 2010.

 

In the short to medium term, profitability will probably in the form of ROIC will remain depressed due to the inventory and related asset build to support future growth and high levels of fixed costs to build out the distribution network and create new products. Over the longer term, assuming the company does not over build inventory, Honworld should reap the rewards of current investments given the ability to capture value through economies of scale and customer captivity.

 

 

Capital Allocation

 

There are no current capital allocation issues. The company is focused on its premium products, all of which have profitability above the cost of capital. There is a potential issue if the company continues to build inventory levels. The current levels support growth in the business, but if the inventory levels and associated assets increase too much and the company is unable to increase its gross margin through high prices from aged vintage base wine, the profitability derived from the brand and economies of scale are eliminated by poor capital efficiency.

 

Capital allocation

 

As illustrated above, the company is allocating a significant amount of cash flow to inventory to buffer against raw materials prices and to support future growth. Building inventory to account for future growth makes sense as long as there is a plan to increase capital efficiency as growth slows. Building inventory to account for raw material costs makes little sense as the company is essentially taking a view on commodity prices. Very few people are able to make a macroeconomic assessment and be accurate.

 

The company’s allocation of capital (18.5% of sales in 2013 & 2014) to distribution expense and research and development are moat enhancing given the presence of economies of scale, the company’s current size advantage, and potential customer captivity.

 

In 2015, the company is paying its first dividend of RMB0.10 per share roughly a 25% payout ratio, or RMB51.875 million. At the time of the IPO, the owners did not sell shares but offered new shares so a dividend to release capital to the owners make some sense, but in the context of the financing requirements of future growth and the excess profits the company currently earns in reinvestment opportunities, it would be wiser to keep the capital for reinvestment.

 

 

Salaries

 

Five highest paid historical

 

Management’s salaries are not excessive. Overall, the five highest paid employees received RMB1.16 million or 0.44% of operating income in 2014. From 2010 to 2014, the five highest paid employees received 0.51% of operating income. This does not seem to be excessive value extraction for the strength of the company’s performance and a peer group average of 1.57%.

 

Highest paid vs peers

 

Accounting

 

Accounting vs peers

 

The company’s accounting policies are in-line with peers and do not seem to be overly aggressive. Commercialized research and development amortized over 5-7 years may appear aggressive but it is in-line with the business’ economics.

 

 

Related Party Transactions/Corporate Governance

 

Auditors are Ernst and Young so Honworld is unlikely to have any influence over the auditors. There are no related party transactions or other corporate governance issues.

 

 

Reporting

 

Management does not report key business metrics needed to do a proper business analysis. Each year the company reports revenues from each product category but nothing more. Much more transparency is needed, at a minimum, volume of each product category, ASP of each product category, gross margin for each product category, inventory by age, number of distributors, and market share should be reported.

 

With the exception of not reporting key business metrics, management is passionate about the business, treats minority shareholders as partners, understands strategy, and executes its strategy efficiently. Management is allocating capital appropriately for now but inventory levels needs to be watched. Finally, management is young enough to build an organization to a national condiment business in the next twenty to thirty years.

 

 

Director’s Biographies

 

Mr. Chen Weizhong, aged 43, is the Chairman of the Board, founder, and chief executive officer of Honworld. He is primarily responsible for overall strategic planning, recipes use and control, distribution network expansion, and overall business operations. He has over 20 years of experience in the Chinese condiment industry. He possesses unique information about the research, development and intellectual property related to the company’s products, including the trade-secret recipes of fermentation starter and cooking wine spices.

 

Mr. Chen started his career in the condiment industry as early as 1990 and accumulated extensive experience in the condiment industry, especially in production, research and development, and sales and marketing.

 

Before founding Honworld in 2005, he was Chairman and general manager of Zhejiang Zhong Wei Brewing Co., Ltd. from 1995 to 2012. Mr. Chen completed a business administration advance class at Zhejiang University in 2008. Mr. Chen has been a member of the China Condiment Industrial Association since 2008. He is also Chairman of the Huzhou Rice Wine Industrial Association since 2012.

 

Zhong Wei and its brand have received a number of awards in recent years.

 

2010

  • National Flagship Enterprise in Agricultural Industrialization
  • China’s Best Ten Condiment Producer

 

2011

  • Famous Brand in Zhejiang Province

 

Mr. Sheng Mingjian, aged 40, is the vice general manager and executive Director. Mr. Sheng is primarily responsible for the management of the company’s financing activities and assisting Mr. Chen with the management of overall business operations. He has more than 10 years of experience in the condiment industry with extensive management experience in capital and business operations. Before joining Honworld in 2006, he was the general manager of Zhong Wei from 2001 to 2006.

 

Mr. Wang Chao, aged 37, is the managing director of sales and marketing and an executive Director. Mr. Wang is primarily responsible for the company’s sales and marketing. He has 15 years of experience in the condiment industry. Mr. Wang joined Huzhou Lao Heng He Brewing Factory in 1998 where he worked in various departments, including business operation department and finance department. Since 2006, Mr. Wang worked in management positions in Huzhou Lao Heng He’s customer service center and sales and marketing department. Mr. Wang graduated from Zhejiang Electronic Polytechnic School in 1998.

 

Mr. Zhang Bihong, aged 39, is a non-executive Director. Mr. Zhang has more than 18 years of experience in the areas of auditing, tax, asset valuation, and financial management. He is currently a certified tax agent in China (issued by China Certified Tax Agents Association on June 2, 2000). Mr. Zhang is primarily responsible for the company’s investor relation work.

 

Prior to joining Honworld in 2012, Mr. Zhang served as the director and chief financial officer of Tianli Agritech, Inc., a company listed on NASDAQ (Stock Code: OINK), from 2010 to 2011. He was a partner of Beijing Zhong Cheng Xin An Rui Accounting Firm from 2008 to 2009. Mr. Zhang was the senior manager at BDO Reanda Xin Public Accountants from 2005 to 2008 and served as a senior manager at Inner Mongolia Zhong Tian Hua Zheng Accounting Firm from 1995 to 2005. Mr. Zhang graduated from Inner Mongolia Agricultural College in 1995 with a diploma in economics (accounting).

 

Mr. Shen Zhenchang, aged 68, is an independent non-executive Director. Mr. Shen has more than 40 years of experience in the cooking wine industry. From 1971 to 2006, Mr. Shen worked with China Shaoxing Rice Wine Group (previously known as Shaoxing City Rice Wine Corporation). Before his retirement from the China Shaoxing Rice Wine Group in 2006, Mr. Shen was the director of its office of general affairs. Mr. Shen is a member of the China Brewing Industry Association (rice wine branch), where he has been the deputy council director and secretary general since 2000.

 

Additionally, Mr. Shen currently serves as a member of National Wine Brewing Standard Technology Committee, a judge at the reviewing committee of China Alcoholic Drinks Association Science Technology Award, and the deputy director of the editorial board of China Rice Wine magazine.

 

Mr. Ma Chaosong, aged 42, is an independent non-executive Director. Mr. Ma is a senior accountant (issued by the Beijing Senior Specialized Technique Qualification Evaluation Committee on January 6, 2006), certified public accountant (issued by the Chinese Institute of Certified Public Accountants on September 28, 1999), certified tax agent (issued by China Certified Tax Agents Association on May 11, 2012), and certified public valuer (issued by China’s Ministry of Finance on April 24, 2012) in China. Since 2000, Mr. Ma has been the Chairman of Beijing Xin Li Heng Tax Agency Co., Ltd. He has more than 11 years of experience in auditing, accounting, and taxation. In May 2011, Mr. Ma was appointed as an independent director of China National Complete Plant Import & Export Corp. Ltd. From 1997 to 1999, Mr. Ma was a project manager at Zhong Ce Accounting Firm.

 

In 1997, Mr. Ma graduated from the Research Institute of Fiscal Science, Ministry of Finance of the PRC, with a master’s degree in accounting. He graduated from Renmin University of China in 1994 with a bachelor’s degree in accounting.

 

Mr. Lei Jiasu, aged 59, is an independent non-executive Director. Currently, Mr. Lei is the director of the Research Centre of Chinese Enterprise Growth and Economic Security in Beijing Tsinghua University. Since 1996, he has been a lecturer in the School of Economics and Management of Beijing Tsinghua University. Between 1994 and 1996, he worked as a post-doctoral researcher in Beijing Tsinghua University. From 1983 to 1989, Mr. Lei taught as a lecturer in Xi’an Electronic and Technology University.

 

In 2001, Mr. Lei was awarded the title of professor by Beijing Tsinghua University. He graduated as a doctoral research fellow from the School of Economics and Management of Beijing Tsinghua University in 1993.

 

 

Management Biographies

 

Mr. Chen Weizhong, aged 43, is the Chairman of the Board, founder, CEO, and executive Director. His biography is listed above.

 

Mr. Sheng Mingjian, aged 40, is the vice general manager and an executive Director. His biography is listed above.

 

Mr. Wang Chao, aged 37, is the managing director of sales and marketing and an executive Director. His biography is listed above.

 

Mr. Wan Peiyao, aged 43, is the director of production. He is primarily responsible for Honworld’s production management. He has more than 11 years of experience in the condiment and cooking wine industry. Mr. Wan joined Honworld in 2005, and has worked in various departments, including workshop operation department, cooking wine production department, and plant operation department. Prior to joining the company, Mr. Wan was the plant manager and executive assistant to the general manager of Huzhou Ganchang Wine Company from 2000 to 2005. Mr. Wan passed the test for first-class sommelier of China in December 2012.

 

Mr. Wan graduated from Zhejiang University of Technology with a bachelor’s degree in Industrial Engineering (Biochemistry) in 1995.

 

Ms. Zhao Yaqin, aged 37, is the financial controller, responsible for the company’s financing, account and tax matters. She has more than 11 years of experience in the areas of financial management, accounting practices, and tax arrangements. She joined Honworld in 2005 as manager of the finance department and became the financial controller in 2012. Prior to Honworld, Ms. Zhao was the manager of finance department of Zhong Wei from 2003 to 2005.

 

Ms. Zhao received a diploma in accounting from the Central Radio and Television University in 2006.

 

 


 

VALUATION

 

 

Asset Valuation

 

To value Honworld based on the company’s assets two valuations are used, a liquidation valuation and an asset reproduction valuation. Liquidation value is the net current asset value, which equates to current assets minus total liabilities. Net current asset value is an extremely conservative measure of the company’s value.  If the industry is not viable then the liquidation value is the appropriate valuation methodology.

 

Reproduction value is the cost to replicate the company’s assets to reach an equivalent competitive position. Honworld’s reproduction value replicates book value, as the majority of assets are either current assets or recently added longer term assets, both of which are assumed to be fairly valued on the balance sheet.  In addition, distribution expense and R&D expense is depreciated on a straight line basis  over five years.  The non-depreciated fixed cost asset is added to the book value of the company as these expenses need to be replicated to build a competitive position similar to Honworld’s current position.  Reproduction value is appropriate if no competitive advantage exists in the industry, as all excess profits will be competed away.

 

Asset Valuations 

 

As illustrated above, Honworld is trading well above its liquidation value (HK$1.74 per share) and reproduction value (HK$3.26). Given Honworld’s profitability, potential to sustain excess profits and growth in the market asset valuations are probably no as useful as earnings based valuations.  Reproduction value does provide a useful benchmark in case the company is not able to build a competitive advantage and profitability reverts to the cost of capital intrinsic value will revert to reproduction value.

 

 

Earnings Valuations

 

The expected return calculation eliminates the need for any forecasting but assumes current earnings are normalized earnings and the return on invested capital remains stable. The expected return for Honworld is calculated using NOPAT, dividend yield, reinvested earnings, return on invested capital, franchise value, and organic growth.  Honworld has an expected return of 17.3% per year. The company is current trading on an EBIT Yield of 9.1%.  Using a normalized tax rate of 25% the NOPAT yield is 7.0%. The company is paying out 25% in dividends leading to a dividend yield of 1.8% with the remaining 5.3% of the NOPAT yield reinvested at 20%, roughly the historical average, leads to a value of reinvested earnings of 7.9%.  The company should be able to grow organically at 5% leading to an overall expected return of 17.3%.

 

Expected Return Calculation

 

If you assume a return on invested capital of 15%, the expected return is 14.7%. The table below shows the expected return sensitivity to changes in the return on invested capital and organic growth.

 

Expected Return Sensitivity Table

 

When valuing Honworld based on its earnings, three valuation methods are used a residual income valuation, a DCF valuation, and an earnings power valuation. Intrinsic value is determined by averaging the three valuations. Three different models are used to corroborate the valuation of other methodologies. All models have a five-year forecast period with a four-year fade to the terminal assumptions in year ten. The key assumptions used in the all earnings based valuations are listed below.

 

Key Value Driver Assumptions

 

A discount rate of 10% is used in all valuations. The tax rate used is 25% as it is the regulatory tax rate.  On March 7, 2014, Honworld received approval of new and advanced technology enterprise status allowing the company to pay a 15% tax rate for three years ending 2015 including the retroactive tax rate for 2013. From 2016 onwards, the company’s tax rate will revert to the statutory 25%. Given only one future year has a 15% tax rate, it has minimal effect on intrinsic value therefore, the statutory tax rate is more appropriate.

 

Honworld is currently building its inventory along with the other working capital and fixed capital needed to support its inventory build. The company increased its base wine inventory from 55 million liters in 2013 to 158 million liters in 2014.  It plans a further increase to 225 million liters in 2015.  The inventory build is to support future growth and to provide a buffer against raw material prices.  The first table shows fixed capital turnover, working capital turnover and invested capital turnover under different scenarios.

 

Historical Capital Efficiency various scenarios

 

The table below shows a time series of working capital turnover, fixed capital turnover and total invested capital turnover under three scenarios; historic turnover, turnover assuming base wine inventory equivalent to one year of sales or a per liter basis, and turnover assuming two years of base wine inventory. Assuming an inventory at a specific level relative to sales eliminates the effect of investment for growth.

 

Historical Capital Efficiency

 

Given the growth in assets to accommodate future growth, capital efficiency is expected to decline to the average turnover assuming two years of base wine inventory over the next five years and then fade to a terminal rate of one year of base wine inventory as growth slows. The tables below show 2015 upside sensitivity to various fixed capital turnover and working capital turnover rates, assuming 0% growth and 40% operating margins into perpetuity. The first table below shows 2015 intrinsic value upside sensitivity to changes in the fixed capital turnover rate and working capital turnover rate during the first five years of the forecast period.

 

Forecasted Capital Turnover Scenario

 

There is 10% downside to 2015 intrinsic value using current fixed capital turnover of 1.17 and working capital turnover of 0.67. If the company is able to improve capital efficiency to average efficiency with one year of base wine inventory (fixed capital turnover = 2.33, working capital turnover = 1.34), there is 14% upside.

 

The second table shows upside to 2015 intrinsic value sensitivity to changes in the fixed capital turnover rate and working capital turnover terminal assumptions in year 10.

 

Terminal Capital Turnover Scenario

 

If Honworld is unable to improve capital efficiency over its capital efficiency with two years of base wine inventory, there is 26% downside from current prices as ROIC will be slightly above the cost of capital therefore valuation should not be that much different from the reproduction value.

 

The table below shows Honworld’s intrinsic value under various sales growth and operating margin scenarios. Historical average operating margins are 36%, which is probably a little conservative. Before 2012, the company did not naturally brew its cooking wine therefore it could not command a premium price on its products, and the company distributed its products primarily through Zhong Wei leading to a lower gross margin. Although the historical average may not be an accurate reflection of current profitability, it is useful to illustrate incase the company’s pricing power erodes leading to lower operating margins and an ROIC closer to the cost of capital.

 

Current margins are 40% and the most accurate reflection of current profitability.  The company has averaged roughly 40% operating margins since producing naturally brewed cooking wine and decreasing Zhong Wei’s significance in distribution. If the company is able to build a competitive advantage and take advantage of scale, fixed costs as a percentage of sales will shrink leading to expanding operating margins in the future. The company is in the process of building its moat therefore fixed expenses should be as high as possible while still be efficient to make the minimum efficient scale as high as possible to limit the number of competitors able to compete in the market.

 

Peak margins are the highest margins the company achieved, 43.3% in 2012.  This margin represents the potential of the business if the company is able to leverage fixed costs into higher profitability.

 

Earnings Based Valuations Scenarios

 

As illustrated, the market is pricing in roughly 5% growth over the next five years fading to 0% terminal rate at current margins. In the short term, margins may contract as Honworld spends on growing the business, but in the longer run margins should be close to the current level if not higher if the company is successful in achieving the competitive advantages discussed in the report and take advantage of the operating leverage associated with fixed costs. If no competitive advantage exists, there is likely to be many years of market growth decreasing the competitive rivalry within the market leading to excess profitability for 5-10 years, maybe more.  5% growth fading to 0% terminal growth with current margins offers 80% upside over the next 5 years.

 

The base case is 10% during the forecast period fading to 0% growth into perpetuity with current margins, offers 14% upside to 2015 intrinsic value and 116% upside to 2020 intrinsic value. The 10% growth over the next few years is conservative enough to provide a sufficient margin of safety as it is half the current growth rate of the overall market. 0% growth into perpetuity does account for any pricing power or growth into a national player so it seems conservative enough to provide a sufficient margin of safety. This valuation is meant to be very conservative to ensure a sufficient margin of safety. The market is growing at twice the forecast period growth rate used and the company may be in the early stages of moving from a regional company to a national company as the company’s key regions account for roughly 90% of the company’s sales but only account for 26% of the country’s population and 35% of its GDP.

 

Sales by Region

 

In addition, the company has a very strong brand image as illustrated by premium pricing and high market share.  The company also has pricing power as illustrated by recent price increases, stable gross margins, and a product that is a low priced experience good, which may lead to growth well past the first ten years.

 

 


 

RISKS

 

Honworld lacks a long operating history with financial statements only going back to 2010. In addition, the company has only been trading as a public company since January 2014.

 

Honworld has a significant customer concentration. In 2014, the largest customer accounted for 21.7% of total revenue and the five largest customers accounted for 71.3% of total revenue.

 

Honworld has a significant supplier concentration. In 2014, the largest supplier accounted for 21.2% of the Group’s total purchases and the five largest suppliers accounted for 66.8% of total purchases.

 

Honworld is growing at a rapid pace with significant capital requirements. If the company decreases capital efficiency or grows too fast, outside capital may be needed leading to dilution. Capital efficiency is a key driver of profitability. If it were to remain weak, valuations would suffer.

 

Honworld’s profitability could be hurt by expansion outside of its key markets. The company generates a significant portion of its revenues from a few key markets. As the company expands its distribution network, its products may not be as well known and may not command the premium received in its key markets leading to weaker profitability.

 

If Honworld is not able to build a competitive advantage, the company may not be able to recoup the investment in distribution and research and development through premium prices leading to these investments destroying value.

 

If economies of scale are present in the market and the company is unable to maintain its size advantage over peers, its competitive position may weaken, competitive rivalry may intensify, and profitability will deteriorate.

 

If regional tastes do not become national tastes, markets will remain fragmented eliminating the company size advantage and increasing investment requirements as advertising must be done locally rather than nationally.

 

The current valuation is pricing in continuation of current margins. If the company‘s competitive position weakens and its pricing power diminishes the market may devalue to company.

 

The company raw materials are agricultural products, which may increase in value. If raw materials increase in value and the company is not able to pass on those raw material cost increases profitability will suffer.

 

The rapid growth of the company may outpace the growth of the necessary internal controls and infrastructure for management to handle the growth leading to potential bad debts, or deterioration of the company’s brand.

 

The company sells naturally brewed products. If the main cooking wine competition shifts its production from chemically produced to naturally brewed, the company’s premium pricing may disappear and its position within the market may weaken.

 

The company outsources distribution. If distributors sell the company’s products at a lower price than the company desires, it may hurt the company’s premium brand.

 

If the company’s products were contaminated, it would destroy the company’s brand.

 

An economic slowdown in China leads to weaker than expected demand and an inability to raise prices.

 

 


 

FINANCIAL STATEMENTS

Financial Statements

 

 

 

 


 

Reperio Capital Model Portfolio Q4 & 2014 Results Review

Reperio Capital Model Portfolio Q4 & 2014 Results Review

In the fourth quarter of 2014, the Reperio Capital Model Portfolio fell by 0.76%. PC Jeweller fell 8.1%, Zensar fell 2.5% and the Indian Rupee fell 2.9%. In the quarter, the Reperio Model Portfolio outperformed EEM by 5.5% and EEMS by 6.6%.

 

For 2014 (inception date May 25, 2014), the Reperio Capital Model Portfolio increased by 12.67% in absolute terms.

2014 Absolute Performance Chart

The model portfolio outperformed EEM by 20.9% and EEMS by 21.3%.

2014 Relative Performance Chart

During the quarter, we decreased our position in PC Jeweller after the share price exceeded the no growth target price for PC Jeweller. At the end of 2014, the Reperio Model Portfolio consists of PC Jeweller at 6.4%, Zensar Technologies at 4.8% and cash at 89.8%. Cash is not an asset allocation decision but a residual. We are highly selective and are constantly searching for new ideas.