Tag Archives: Sell

Grendene Q1 2017 Results Review May 8 2017

Grendene Q1 2017 Results Review May 8 2017

Grendene recently reported its Q1 2017 results.  Net revenue grew by 7.2% as domestic revenue grew 23.6%, export revenue declined by 19.1%, and sales taxes and deductions increased by 22%. With regard to pricing, net ASP fell by 1.1% and volume increased by 8.5%. Within Brazil, domestic ASP increased by 7.0% and volume increased by 13.0%. In export markets, ASP declined by 19.8% in BRL terms and 0.3% in USD.  In Q1 2017 Brazil was clearly much stronger than export markets.

 

The table above illustrates total volume, ASP, domestic market volume, domestic ASP, export volume, export ASP in BRL, and export ASP in USD. The company seems to have significant seasonality.

 

In volume terms, Q1 is typically an average quarter overall but it is a weak quarter in the domestic market and a stronger quarter in the export markets. Q1 2017 volume was weak overall relative to the average Q1 volume with domestic volume slightly above the average Q1 volume and export volume well below the typical Q1 volume.

 

The chart above illustrates volume over the trailing twelve months (TTM) for the domestic, export, and a combination of the two (overall). TTM volumes peaked for Grendene in Q4 2013 and fell by 7.7% per annum overall with both domestic and export markets declining by the roughly the same amount.

 

In ASP terms, there is a lot less seasonality with prices consistently increasing in both domestic and export markets at a rate of 2.9% in the domestic market and 3.8% in USD terms in export markets. The ability to raise prices in both domestic and export markets despite a falling volumes and a weak overall macro environment may be a good sign of the company’s pricing power. The company may also be stretching its ability to raise prices as the company sells lower cost shoes that may not provide as much value to customers at higher prices.

 

Grendene’s gross profit grew by 11.0% in Q1 2017 with its gross margin expanding by 59 basis points (bps) over Q1 2016 and 37 bps over Q4 2016. The gross margin expansion over Q1 2016 was driven primarily by a decrease in cost of goods sold per pair as the ASP decreased from BRL13.63 to BRL13.47. Cost of goods sold per pair decreased from BRL7.25 in Q1 2016 to BRL6.95 in Q1 2017. The driver was a decrease in personnel expense.

 

 

Along with higher prices during periods of weak demand, the company’s ability to increase consistently its gross margin points to pricing power.

 

Selling expenses increased by 2.2% year on year, while administrative expenses decreased by 11.7% leading to an increase in operating profit by 28.9%. The company’s continues to maintain a focus on operational efficiency.

 

The company’s increased volume and decreased costs led to a 28.9% increase in operating profit. Grendene’s working capital increased by 2.9% year on year, while PP&E increased by 4.3%.

 

Our initial investment thesis for Grendene was a company that built multiple competitive advantages in the domestic market. Within the domestic market, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements. It produces a low priced experienced good and has built a strong brand allowing for pricing power. Grendene’s exports are at the low end of the cost curve ensuring the company stays competitive in export markets. The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect. It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.
We believe the quality of the business remains but the valuation is no longer as cheap as it once was. At the time of our initial recommendation, valuations were attractive with the company trading on a NOPAT yield of 10.1%, a FCF yield of 8.5%, an EV/IC of 1.6 times. Grendene is now trading at a NOPAT yield of 6.7%, a FCF yield of 6.7% and an EV/IC of 5.0 times at a time of elevated profitability.  If we were to normalize margins, Grendene would be trading at a NOPAT yield of 5.3% and a FCF yield of 5.5% making a 5% growth rate into perpetuity necessary for a double-digit return.

 

The company‘s margin of safety has been eliminated leading us to sell our position and no longer cover Grendene. We will continue to follow its developments, in case valuation become more attractive.

 

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

Universal Health May 9, 2016 Overpaying for an Acquisition + Share Issuance = Enough is Enough?

 

On May 9, 2016, Universal Health agreed to purchase 36.38% of Jilin Wenhui Capsules Limited for RMB270.3 million placing an enterprise value on Jilin Wenhui of RMB743.0 million.  The company is a new high-tech enterprise that conducts research and development, manufactures, and sells hollow capsules, and is a leading capsule manufacturing enterprise in terms of scale in northeastern China. Jilin Wenhui Capsules current annual output of medical hollow capsule was approximately 15.0 billion, with plant capsule capacity of approximately 6.0 billion and plant gelatin (modified starch) capacity of approximately 5,000 tonnes. To complete the transaction, Universal Health issued 400,000 shares at a price of HKD0.725.

 

In 2015, Jilin Wenhui had a net asset value of RMB26 million, profit before tax of RMB6.99 million, and profit after tax of RMB5.34 million.  Universal Health purchased price places a valuation on Jilin Wenhui at 28.4 times book value and 139.1 times earnings.  These are astronomical figures in the absence of further information to analyze Jilin Wenhui. It seems the company is just throwing money away and paying anything to main growth something that is often seen with serial acquirers.  Universal Health is all over the place with its capital allocation.  We will be exiting our position in Universal Health as soon as possible.

 

While it is unfortunate we made mistakes on Universal Health and Miko International, the best teacher is pain and these mistakes will strengthen our investment process. There are a number of lessons that we have taken from the Universal Health and Miko International mistakes.

 

  1. Entry positions should be less aggressive allowing us to gain a better understanding of the company over time. This strategy would have prevented the gains we saw in PC Jeweller but downside protection is just as important if not more important than upside potential.   Less aggressive position sizes also pay respect to our ignorance and the limits of our knowledge.  We still believe in concentrated portfolios but small cap investing particularly in Emerging Markets bring additional risks and additional diversification is needed.  We still believe in concentrated portfolios 20-30 companies but oversized positions that investors can take in larger, well established companies may not be as prudent in smaller companies.
  2. We need to put more emphasis on why a stock is cheap. If it has tremendous operating history and good current earnings yet is extremely cheap, it may be a value trap, particularly in China.
  3. Focus needs to be on companies with long history of operations and being publicly traded. Both Miko International and Universal Health IPO’d over the past few years and they had not been operating for decades.
  4. Capital allocation is crucial and missteps should be viewed with extreme caution. Miko International issued shares at extremely cheap valuations with significant net cash balance.  A major red flag, which we overlooked.
  5. Along these lines, while strong financial health is crucial to any investment case, very large net cash positions is a potential sign of poor capital allocation at best and fraud at worst.
  6. When management starts selling your should probably start selling too as they have much more information about the company than you.
  7. Stay away from serial acquirers particularly in industries where there is n strategic logic for acquisitions.
  8. Chinese companies seem to be a different breed where financial statements cannot always be trusted. As outside investors, the primary evidence is financial statements of the company and competitors.  We look for additional evidence from independent sources to corroborate financial statements but it is not always there.  If financial statements cannot be trusted, you cannot invest.  Given the risk, we will be requiring additional evidence with Chinese companies and holding them at lower weights.

Peak Sport and Universal Health Position Sizes May 3 2016

Peak Sport Products and Universal Health Position Sizes May 3 2016

We have reduced our position in Peak Sport Products by USD4.64 million slightly above our target sales of USD4.5 million at an average sale of HKD2.1098 or inital blended cost on Peak Sport positions is HKD2.0826 so we are able to reduce our positions without a loss.   We are reducing our position size by a further USD3.0 million.  The company reported weaker than expected operational data in China, and after the Miko International fiasco, the share issuance in June 2015 with a significant amount of net cash on the balance sheet raises concerns about the cash.  Given we view Peak Sport as a deep value position, a 2.0% position size is a more appropriate given the concerns over management credibility and slowing growth.

 

Universal Health is another Hong Kong listed Chinese company that we described as Company 9/18/15 in the past. This is another deep value holding where we put too much faith in financial statements.  Management pledged shares without notifying the stock exchange and subsequently were forced sellers causing the share price to fall by just under 60% on one day. The company also sold 20% of the company to a financial buyer who subsequently sold almost half its position the following.  It seems as if the shares were pledged to the financial buyer who promptly sold the shares. The company followed this by reporting poor 2015 results.  Loss aversion stopped us from selling earlier.  It probably is the culprit in why we held Miko as long as we did.  We are decreasing our position size in Universal Health by USD2.0 million to roughly a 2.0% position size.

 

Peak Sport Products Position Size April 15, 2016

Peak Sport Products Position Size April 15, 2016

We have completed the sale of just under USD3.639 million of Peak Sport Products or 13,716,110 shares at an average price of HKD2.058 bring our position size to just under USD9.858 million or a 9.2% cost position.

We are going to sell another USD4.5 million to bring Peak Sport Products more inline with our new position sizing philosophy.  We will only sell if the price remains above HKD1.90. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. The company is somewhere between a deep value and high quality investment therefore the position size probably should be closer to 5.0%.

 

Company 9/8/15 Position Size April 13, 2016

Company 9/8/15 Position Size April 13, 2016

We have completed the sale of just over USD3.3 million of Company 9/8/15.  Its current position size of 4.7% better reflects the deep value nature of the position as the risk associated with the position.

Peak Sport Products Position Size April 7, 2016

Peak Sport Products Position Size April 7, 2016

We are decreasing Peak Sports Products position size by USD3.5 million assuming the share price remains above HKD1.75 per share. The company is performing well operationally with 9.4% revenue growth, 11.4% gross profit growth, and 34.6% operating profit growth with a 28% ROIC.  The stock is also cheap at just under is net current asset value with a dividend yield of 7.7% and an expected growth rate of mid to high single digits leads to an expected return around 15%.  Unfortunately, the company’s capital allocation decision to issue new shares while holding such a large net cash position eliminates roughly one year of expected return due to the issuance. It also puts in question the cash on the balance sheet and management’s capital allocation ability. A smaller position size is warranted.

 

Company 9/8/15 Position Size and Results April 6, 2016

Company 9/8/15 Position Size and Results April 6, 2016

 

We have sold just under USD5.4 million of our position in Company 9/8/15 just over the USD5 million stated on March 24, 2016.  The company is now a 7.6% position.

 

On March 31, 2016, Company 9/8/15 reported annual results.  Revenue increased by 10% for the full year with a 120 basis point decline in gross margin from 29.10% to 27.90% due to weakness in high gross margin products. The big concern was the 96% increase in selling expenses and the 92% increase in administrative expenses. Selling expenses increased by RMB484 million and administrative expense increased by RMB71 million.  The largest increase in selling expenses was advertising and other marketing expenses, which increased by RMB395 million or 366.4% as the company injected more resources in TV, network and vehicle advertisement for the purpose of promoting the Yushi brand and held large membership promotion activities and brand promotion activities. The next largest increase was employee benefit expense, which increased by RMB103 million or 44.6%. The increase was mainly due to the one-off payment of share incentives..  Other expenses such as transportation and related charges increased by RMB12 million or 15%.  Rental expenses also increased by RMB19 million or 21.9%.  These expenses account for the vast majority of increases in operational expenses.   Additionally, Company 9/8/15 took a RMB109 million impairment charge related to previous acquisitions within its retail business.

 

Overall, the company’s operating income decreased by 70% from RMB688 million in 2014 to RMB206 million in 2015.  Working capital increased by RMB183 million driven by a RMB86 million increase in prepayments and other receivables as well as a RMB75 million decrease in accounts payable.  Fixed capital decreased from RMB125 million to RMB107 million. Despite the increase in expenses, Company 9/8/15 was able to generate a ROIC of 16%.

In the second half of 2015 revenue decreased by 3% compared to H2 2014. The company’s gross margin declined by 154 basis points from 28.59% in H2 2014 to 27.05% in H2 2015. The company generated an operating loss of RMB125 million in H2 2015 as the increase in operating expenses mentioned above only started in the second half of the year.

 

Within the retail business, the pharmacy count increased by 1 from 953 to 954 while sales grew by 16.3%. Retail gross margin declined by 199 basis points from 39.7% in 2014 to 37.7% in 2015. Operating margin also declined 1200 basis points from 21.9% in 2014 to 9.9% in 2015 as operating expenses ballooned to from 17.8% of sales in 2014 to 27.8% in 2015. Asset turnover increased from 1.31 to 1.43 illustrating assets are still being used efficiently and the increased in operating expenses are the main driver of weakness in the retail segment.

 

Within the retail segment, Company 9/8/15 started reported two sub segments Retail I and Retail II. Retails I segment are retail business with higher future development potential and strategic focus, while Retails II segment are retail business located in the areas without strategic importance and high growth potential.  The RMB108.9 million impairment charge came in the Retail II segment.  Retail I segment accounts for 91% of assets, 85% of revenues, 85% of gross profit and 93% of adjusted EBITDA.

 

Within the distribution segment, revenue grew by 5.2%, gross profit decreased by 2.3%, and operating profit decreased by 85.2% due to the increased advertising and promotional expenses.

 

The company is in a strong financial position with a net cash position of RMB1,299 million yet has not decided to pay a dividend.  The company also mentioned it was about to raise cash through a share issuance putting in question the cash on the balance sheet.

 

Company 9/8/15’s problems are not industry related as the largest Chinese pharmaceutical retailer and distributor Sinopharm grew its revenue by 13% and operating profit by 17% in 2015.  Zhongzhi Pharmaceutical also saw revenue growth of 19% and gross profit growth of 12%.

 

The results are disappointing. Revenue increased, a slight decrease in gross margin, and working capital not increasing significantly, operational momentum seems to be continuing but at a cost as increased advertising costs drastically reduced profitability.  The company did not disclosure a share pledge and then sold shares to a financial institution that was immediately forced to sell.  Overall management credibility and integrity is highly questionable and the business quality is in question.  The results in the first half of 2016 will be crucial to determining whether the elevated expenses were a one off or normalized earnings are significantly lower. The company is trading just above net cash. We will decrease our position by another USD3.0 million to bring the position size down to 5.0% closer to the risk associated with the position as it is now a deep value position with management with questionable integrity and capital allocation skills.

Peak Sports Product Annual Results Review March 23, 2016

Peak Sport Products Annual Results Review March 23, 2016

 

On March 15, 2016, Peak Sport Products (1968:HK) reported its annual results. It then released its annual report on March 21, 2016.  Peak was able to increase its revenues by 9.4%, operating income by 34.6%, and net income by 22.3%.  The company closed five stores over the year so efficiency of stores drove the increase.  The efficiency came as the company introduced new products in new categories (tennis and running). Selling expenses decreased by 8.0% while administrative expenses increased by 1.0%. Both expenses lagging sales growth lead to the increase in operating income of 34.6%.

 

Peak Profitability 2015 Result Review

 

Compared to 2014, the company’s gross margin increased by 70 basis points in 2015.  It is also well above the average of 2012 to 2015 and 2006 to 2015.  Gross margin increase points to the industry being past the sharp downturn seen in 2012 and 2013.

 

Peak’s operating margin increased by 340 basis points in 2015 as the company decreased spending on selling and distribution and administrative expenses barely increased. Overall, the company’s return on invested capital increased from 19.6% in 2014 to 27.8% in 2015.

 

During the industry’s consolidation, gross margin and operating margins decline slightly and have since recovered, but invested capital turnover declined drastically and has not recovered.

 

Peak Capital Efficiency 2015 Result Review

 

As illustrated above, both working capital turnover and fixed capital turnover declined significantly from peaks and have recovered slightly but not fully as the industry continues to cope with working capital and capacity issues.

 

In June 2015, the company raised capital increasing its share count by 290.761 million shares or 13.86% of the previous share count.  The company mentioned the share raising was for international marketing expenses and to avoid Chinese withholding tax by moving cash in China overseas.  The company decreased marketing expenses this year despite the share issuance.  Despite the cost of raising capital being lower than the withholding tax the company would have paid for shipping money overseas, the share issuance was perplexing as the company has so much cash on the balance sheet.  At the end of 2015, the company net cash position is equal to 92.6% of the company’s market capitalization and 5.9 times 2015 operating income.  The question becomes does the company actually have the cash reported on the balance sheet.  The company has been paying steady dividends pointing to having the cash. The main shareholders have maintained their shareholding without any share sales illustrating their confidence in the company.

 

Peak Shareholder Structure 2015 Result Review

 

Brand building through advertising is a key value driver within the sportswear industry so hopefully we will see a significant increase decreasing the cash on the balance sheet.  Regardless, the share issuance was confusing and at best a very, very poor capital allocation decisions.

 

Overall, the sportswear industry is recovering after a period of significant contraction.  Peak is insulated from competition within the industry from fast fashion players as the company’s focus is performance products rather than fashion allowing it to retain the leading market share in basketball for six straight years.  The company is increasing its focus on international markets and other sports (tennis and running) giving it further growth opportunities.

 

The company is currently trading just above its net cash position, just below its liquidation value, and 38% below its reproduction value.

 

Peak Valuation 2015 Result Review

 

On an earnings basis, we used key value drivers during the recent industry downturn assuming it is the new normal and the industry boom of 2006 to 2011 will not be replicated.  Assuming no growth, trough margins, and trough capital efficiency, the company has 89% upside to its estimated 2021 fair value.  Assuming 5% growth and average margins the company has 215% upside to an estimated 2021 fair value.

 

Despite, the extremely poor capital allocation, the company is very cheap and growing. It is now trading just above its net cash position, just below net current asset value, and just below book value despite generating an average return on invested capital of 20% during an industry slump.   We will maintain our current position size.

Peak Sport Products Position Size Decrease 12 24 2015

Peak Sport Products Position Size Decrease 12 24 2015

 

We are decreasing our position size in Peak Sport Products to 5.0% cost base.  We increased our position from roughly 9.0% initial position size to a 15.0% cost base when the company’s share price got down around HKD1.60 well below its NCAV.  The share price has since rallied by 40% returning to roughly our initial entry point, but the company also issued shares in the interim. Management may have had good reasons for the share issuance but with the amount of cash on the balance sheet the credibility of management, the company’s management, and the capital allocation abilities are severely in doubt. It is now considered nothing more than a deep value holding.  Logic states given the added issues with management the new position size should be lower than the original positions size.

 

Deep value holdings will now be between 2.5% to 5.0% cost base positions. Higher quality stocks will remain between 5.0% and 15.0% cost base position.  The lower position size for deep value reflects the fact that deep value stocks cannot be held for the long term and offers only a one time gain.  Deep value stocks often come with issues that create a bit more nervousness around the stock and lead to more comfort with a lower position size.

Honworld Group Shares Pledged by Chairman and Largest Shareholder 11/20/2015

Honworld Group Shares Pledged by Chairman and Largest Shareholder

 

Honworld Group                                                                                              

Ticker: 2226:HK

Closing Price (11/20/2015): HKD5.33

1 Year Avg. Daily Vol. (USD mn): 0.97

Estimated Annualized Return: 18.0%

 

In a November 20, 2015 announcement, Honworld Group announced on November 16, 2015, its chairman and largest shareholder “charged” 100.3 million shares representing just over 36% of his shareholding in Honworld and just under 20% of the total shares outstanding to a financial institution as security for its subscription of a note issued by Key Shine Global Holdings Limited. Key Shine is the chairman’s investment vehicle and the entity that hold his 278,169,750 shares in Honworld.

 

While the company used the word “charged”, this represents nothing more than a pledge of shares for a loan.  Honworld stated it did not fall under Hong Kong Listing Rule 13.17, which would have required greater discloser. In the announcement, the company made no disclosure about the size of the debt or the reason for the debt.

 

This is a major corporate governance red flag.  The company has not returned any communications regarding this or our continued requests for discussion about the company misallocation of capital to inventory.  The company could have been more transparent with this transaction by disclosing the amount and the reasoning for pledging shares.

 

The pledging of shares by an owner is something that we look at during the research process into any new investment and if shares are pledged, particularly of this magnitude, we tend not to invest in the company.  Pledging of shares greatly increase the risk of forced selling, which we would prefer not to be on the selling side, potential change of control, and potential conflict of interest between minority shareholders and the largest shareholder.

 

Every day the market provides a price for every listed company.  The question we constantly ask is will we buy this company today?  It takes into account a number of things such as current portfolio position, business quality, management strength, and valuations. Given this new event of shares being pledged, would we invest in this company? The answer is no.  The company seems to have a very strong competitive position but this event, the poor allocation of capital to inventory leading to poor free cash flow generation, and the lack of communication greatly decreases our confidence in management.  While the company has a strong competitive position and meets our requirement for expected return, there is no reason to risk capital if there are questions about management quality or corporate governance.

 

Given the company’s lack of communications, increased corporate governance risk, its misallocation of capital to inventory, and the lack of cash flow in the business, we are decreasing our stake in the company to 5% of our model portfolio.  The shares are illiquid so it may take some time to get to 5% but once there more likely than not we will be selling all our shares.