Saturday, 26 July 2014

Weekend links

Fortune: The secretive billionaire who built Silicon Valley

John Burbank interview snippet on mispricings

Greenlight Capital Q2 letter

Jeremy Grantham Q2 letters

Jim Chanos interview with Charlie Rose

A great CNBC profile on Leon Cooperman

Wednesday, 23 July 2014

Briefly on Symphony International

I’ve a problem that I’d like to share, some might even consider it an addiction. It’s to do with holding companies. You see, every time I find one I have obsessive needs to research it, a sort of occupational hazard. The right thing to do would be to say no outright but…I get weak in my knees, can’t help it.

These creatures were a big hit back in the days and worked as a sort of internal capital market – i.e. cash generated from unit A was used to invest in unit B or to buy a whole new unit. There are magicians who made this structure work like a well-oiled machine such as Warren Buffett or Li Ka-shing but of course there are many other failed attempts as well. Holding companies are still alive and well in emerging markets (to effect family control etc) but these structures are often opaque and nowadays people tend to prefer cleaner and focused companies, which can be better valued as well – hence the term “conglomerate discount”.

Moving on from the theoretical overview to Symphony (SIHL:LN). Listed in 2007 and based in Singapore, the company operates as a permanent capital vehicle (i.e. similar to a closed end fund) investing mostly in Asian public equities. The graph gives an overview of the NAV. I’ll not go into detail into the workings of the NAV, you can find more info on the company’s website. Suffice to say that SIHL owns companies operating in health care, hospitality, real estate and lifestyle (consumer brands), essentially a play on the rise of affluence in Asia.

Source: Annual Report 2013

The largest investment is Minor International (around 1/3 of the NAV) and this is the reason I got interested. For a while I’ve been searching for ways to invest in Minor (MINT:TB), which is a Thai listed hospitality, restaurant and lifestyle co controlled by Bill Heinecke on whom I posted a Bloomberg article a few weeks back. I’ve a ton of respect for the guy and he has a tremendous track record. Ideally I would have wanted to invest during the fall off in MINT’s share price earlier this year but as luck would have it I found SIHL only recently when the valuation is less attractive.

I compiled a very brief NAV model on SIHL, of which the key items are below. Currently the share is trading at a 35% discount to NAV (vs 43% average historically). A better way to look at the holding discount is by taking into account a conglomerate discount/tax consideration that would be required to be paid if the company would be required to sell its investments to be wound up. Assuming 25% (you can pick your own number but it looks reasonable considering capital gains tax on foreign investments), the holding discount narrows to 14% (vs 24% average historically). While you are still getting SIHL at a discount it is not as substantial as historically, so we are kind of in uncharted territory here, and the majority of underlying assets are fairly valued as well.

Source: Company filings

Few things I like: to try and close this glaring discount the company initiated a few shareholder friendly moves such as (i) distributing 80% of the NAV if by 2017 September the discount exceeds 35% in the preceding 3 months (ii) shareholder approval for further share issuance under certain circumstances (how nice…) (iii) a proposed buyback programme for max 15% of total shares.

Few things I like a lot less: our discussion wouldn’t be complete without a discussion on comp. The investment manager charges 2.25% on NAV ($15m last year; fees are capped between $8m to $15m), which is fairly expensive given that you could buy most of the holdings via a discount broker or another equity fund that would likely charge you less. In addition, there are a lot of options and management shares that lead to dilution (arguably though these are performance based to a certain extent, but still dilutive).

If any of my loyal readers (all 2 of them) have any views on SIHL or management do drop me a line would be interested in hearing your thoughts. Thank you!

Sunday, 20 July 2014

Knowles, no not that one

One good thing about the return of animal spirits is the increased corporate activity resulting in restructurings, spin-offs and so on to “unlock and/or create substantial value for shareholders” (or whatever presentations say nowadays). Sarcasm apart, there are often gems that surface into public ownership, which are part of larger conglomerates, operating in different segments, making them non-core from the company’s/shareholders’ perspective. Thus when shares of the new entity are distributed to existing shareholders, the shareholder base is oftentimes not “natural” and it takes some time before shares move to investors who can better value such situations. I believe that this is the case at hand with Knowles (KN).

Up until 2014 February KN was part of Dover Corp, an industrial conglomerate, when it was spun-off. Rationale given at the time was that while it’s a high growth business the capex requirement for Knowles was too much for Dover as it would have starved it’s other businesses. They wanted to focus on their slower growth albeit more predictable businesses hence the separation was pursued. Dover market cap now around $15bn ($13bn around the spin) while Knowles is $2.5bn. Furthermore, Dover pays a dividend while Knowles not (and not likely in the next few years due to reinvestment). So the above gives a flavour of why there is a difference in shareholder base. The two companies have very different business models and the implied “higher volatility” of the tech segment is clearly something industrials investors wouldn’t consider.

Knowles is essentially a technology company that sells (a) microphones, speakers and other audio equipment that go into mobile phones, tablets etc (c. 60% of sales; Mobile Consumer Electronics segment) and (b) components for hearing aid, defence and telecom use (c. 40% of sales; Specialty Components segment). Dover built this business by acquiring competitors along the way.

In 2013 KN generated $1.2bn sales (64%/36% split) and $274m EBITDA (70%/30% split, before overhead). Overall, it’s 8.7% increase in revenue year on year driven by a 16% revenue increase in MCE from higher volumes mostly in smartphones but drop of 2% in SC due to drop off in government spending and lower demand for specialty equipment in hearing aid. It’s worth highlighting that the SC segment is prone to fluctuations in government spending, telecom industry capex, which impact results.

There are almost two different businesses within KN. The SC segment is not terribly exciting from growth perspective, however KN does command the market in the supply of hearing aids and related solutions (65-70% share) with one meaningful competitor in Sonion (Danish private co, which just got taken out by Novo A/S). Aging, albeit more affluent and technology savvy population bodes well for the use of the currently under-penetrated hearing aid market. KN is developing new technology in this area and sees possibilities to use technology from it’s other segment (MCE) in hearing aids, which could make the end product less expensive by reducing high labour costs in the manufacturing process via automation.

MCE will grow more rapidly (and has grown - 52% since 2011) as handheld devices are becoming more sophisticated acoustically. KN’s focus is on microphones and according to third-party/company estimates the company has a 60-70% share of the market (total market of c. $0.7-0.8bn). In terms of the speakers, it has an estimated 15% share (behind AAC – 50% share and Goertek with 25%). Overall, KN is no. 5 in the entire MEMS market (micro-electromechanical systems, essentially the miniature equipment that goes into devices; don’t worry I had to get my dictionary as well) behind the likes of Bosch, HP and so on.

The key to the story is higher quantity and quality audio equipment that goes into handheld devices. The current average audio content of a smartphone (such as speakers, microphone etc) is between $2-3, which is expected to grow to $3-5 over the next few years. As the below chart shows prices of new products that go into smartphones are clearly following the trend of falling off after a while (indeed Knowles has cut pricing historically, though this is likely on the older equipment; if you look at product pricing of phones or tablets they follow a similar fashion) but coming in at higher levels vs before. Simply put, users want better sound quality in phones, whether its microphones for talking or recording HD videos or speakers for listening, voice control is just coming into life as well as wearable devices.

Source: Knowles presentation

Barriers to entry are high and KN’s moat comes from the fact that the product life is very short (just look at a release of a new iPhone/iPad every year) and getting new products that are more complex to scale would be tough for a new comer and not to mention the ongoing R&D (around 7% of KN’s sales). What’s interesting is that Nokia and Blackberry were both customers of Knowles emanating from a previous acquisition. As these companies all but blew up KN’s sales grew through as its products are practically in every OEM and the impact should be eliminated later this year so fundamentals would be improving.

A few years ago, KN began an internal restructuring process which management pegged at $40-50m annualised cost saving of which around half has been completed by end 2013. The company is reducing its manufacturing facilities from 18 to 11 and moving them to lower cost locations. On a recent earnings call they noted the possibility to bring these cost savings a bit forward in timing, which will help margins improve faster. Management guides operating margin expansion to 22% from the historical 17-18% partly generated from the above (on a non-GAAP basis mind you).

So what’s it worth? The listing took place at $30 per share and despite a lot of trading activity the price has gone…nowhere ($29 now). At current prices the company is trading at TTM EV/EBITDA 10x and forward around 9x. This is roughly in line with the historical multiples of Dover. The two closest peers are AAC Technologies (2018:HK) and Goertek (2241:CH). AAC traded at 14-15x historically and Goertek now trades at 14x forward.  While getting to AAC multiples would probably be a stretch as it generates EBITDA margins in the mid 30s, I think 10-11x is not out of the question. Interestingly, Goertek generates KN like margins and still trades at a premium. It is noteworthy that both AAC and Goertek are essentially manufacturers for OEMs using third party technology while KN has in-house research and design.

Let’s take a conservative approach: sales growing at 5% through 2015 (about half of historical), margins getting up to 25%, 11x multiple (20% discount to AAC) gets you to a share price of $40 (vs $29 current). Assuming flat margins and 10x multiple (more or less status quo) will get you to $30. Assuming, 25% margins and only a 10% discount to the multiple will get you to $46 per share.

So: increasing unit sales x increasing unit prices x expanding margins = $$$

Add a potential multiple rerating and we have an interesting situation on our hand.

Weekend links

Great article from Bill Gates on his favourite business book. It also contains a chapter excerpt, which can be downloaded free

Telling story of a loss of family fortune. Growing too fast and leverage can literally kill

Great collection of investment books. They are going on my reading list

Fascinating article from the FT on the ever increasing threat of water scarcity

Sunday, 6 July 2014

Luk Fook, or will the conspicuous consumption ever make a comeback

I’d like to put a disclaimer up front by saying that when I started the research the stock was around HK$19 (from here on $ refers to HK$, unless otherwise stated), consecutively reaching $24, which was close to my near-term target price. It’s always a great outcome when things work out faster than expected (very fast in this case) but building a substantial position can be made fairly challenging.

So, if I’d want to be completely blunt about this idea the following is what I’d say. Luk Fook (590:HK) is a HK listed jewellery manufacturer and distributor focusing mostly on middle aged Mainland Chinese customers via stores in HK, Macau, Mainland China and a few other in the US, Singapore etc. The stock got a bit hammered recently on tough SSSG comps and of course the clampdown on Chinese style excessive consumption (think baiju out of golden cups) which got me interested in the sector and the company. Now, Luk Fook (“LF”) generated double digit returns on capital over the last five years (20%+), grew sales and earnings by c. 4x, store count to 1,268 yet it trades at 7.5x TTM PE and 8.5x forward PE and pays a 5.5% TTM dividend.

I like the stock as (i) the sentiment around Luk Fook and it’s comps are improving, (ii) fundamentals remain solid (just returned from a long-trip to Asia and saw first hand the level of consumption…) (iii) expansion plans remain intact (iv) HK IVS (essentially the individual travel permit for Mainland Chinese) is not expected to change materially thus this overhang is removing (v) valuation is very attractive (both absolute and relative vs peers).

Key concerns from the Street are (i) tough SSSG comps for this FY (ii) IVS scheme changes (iii) China macro but to a most extent are mitigated or priced in (clearly no one company can solve the China macro picture). My target price is around $25 for the near term, which is roughly where the stock trades now but for the longer term, it could be a very interesting story.

Now let’s get to the details.

A very enterprising HK businessman founded Luk Fook by the name of Wong Wai Sheung. He practically grew up in the jewellery business as his father run a small store in HK but eventually realised that you needed scale. In 1991 he set up LF with one store in North Point and to cut a long story short it grew to 1,268 stores in the ensuing years. Company has been listed since 1997 and he maintains a majority stake in the company.

The business is structured in three segments: retailing, wholesaling and licensing by operations and to HK/Macau/Overseas and China by geography:
  • Retail segment represents the majority of sales and EBIT mostly coming from HK/Macau/Overseas. Margins are the lowest across the segments due to substantial opex (rent, staff etc) to operate company owned stores
  • Wholesale consists of two parts: (1) sales of merchandise mostly to licensees in China/corporate clients to a smaller extent and (2) sales of scrap gold and platinum to merchants (from traded-in products)
  • The licensing business is the smallest (but one could salivate over the margins) also made up of two parts: (1) royalty fees LF earns from jewellery sales to licensees and (2) consultancy fees inc. joining fees per outlet and other training fees etc
The below chart shows an overview of consolidated results over the last five years:

Source: Luk Fook public filings

Additionally, LF closed the 50% acquisition of 3D Gold in FY2014, which is a Chinese retailer and licensor of jewellery, from HK Resources for c. $245m consideration, $57m convertible debt and a $100m loan for working capital. The company will provide consultancy services to the company and help grow the company using its track record.

In terms of products, the breakdown is roughly 65%/35% gold and gem-set, with average gross margins of 8-15% and 35%, respectively.

Source: Luk Fook public filings

The company has 1,268 stores across its network. The stores in HK/Macau/Overseas are self-operated (total of 60 at end of 2014) while in China LF has 83 self-operated stores and 1,125 on a license basis. In terms of location and format the majority of stores in HK are in prime locations and mostly street-side vs malls whereas in China malls are preferred. In China, self-operated stores are based in higher tier cities to basically show good example for the licensees on how they should operate, which are mostly in China’s lower tier cities. In terms of growth the company guided for stores to grow 15% in the next few years, mainly in the Mainland. Additionally, the company has one manufacturing facility in China and gem lab for certification.

Source: Luk Fook public filings

Location of one of LF’s stores in TST in Hong Kong with a 3D Gold store right next door. Primary research.

Despite China providing around 60% of self-operated stores, it only makes up 10% of retail sales. On a per store basis, one store in China generates $20m while the others around $240m. This is due to higher traffic and average ticket price. Indeed, as the chart below shows avg ticket size in HK is around 2x vs Mainland China, however flat vs HK/Macau stores where customers pay with UnionPay (favoured payment method of Mainland Chinese customers when abroad).

Source: Luk Fook public filings

Brand positioning of LF is geared for mass-market in China proudly showcasing its HK origin, which can provide reassurance to customers of better quality vs Mainland brands.

In terms of positioning vs other brands in the domestic market, customers view Western brands such as Tiffany’s, Cartier etc as high-end while HK brands like Chow Tai Fook, Chow Sang Sang and LF as mid-high end with differing avg. ticket prices, product mix etc. This positioning essentially gave LF the flexibility to rapidly expand presence in China, which say a higher-end brand would have probably done slower. However, this also gives the company weaker channel checks and potential for weaker brand positioning due to fragmented operations, which it tries to mitigate via using self-operated stores to set examples of operations and additional security measures.

A few words on the recent annual results and consecutive update. FY2014 was a banner year for LF partly due to lower gold prices, which resulted in a gold rush accompanied by higher gem-set sales. The company increased sales 43%, EBIT by 54% and net profit increased to c. $1.9bn from $1.2bn yoy. Same store sales growth for the year was 25% (7.4% in 2013) of which 22% in HK/Macau and 46% in China respectively (7% for both yoy). On the call the company tempered expectations and noted that April and May 2014 SSSG was -56% (vs +93% yoy) thus this FY is up against a tough comp and 2012 will be a better comp, but some weakening can be expected. Indeed, overall May HK retail sales are down by 4.1% yoy mostly driven by jewellery/luxury segment downturn. Q1 trading update from LF is expected in July, so we will have more clarity then.

Let's look at valuation. So, you get all of the above for $13bn at current prices and the question is what it’s really worth. To note the company has generally been debt free but added $568m on a short-term basis for RMB cash needs. It doesn’t really worry me and net cash remains at roughly the same $1.2bn level as last year. I prefer debt over dilution, however it's worth highlighting that LF raised equity capital twice in the last few years so this could potentially be an issue.

Historically, the company traded on a PE of between 7-9x, the lowest amongst peers, due to perceived more “mass-market” approach vs peers, lowest gold hedging etc. If we compare to peers, Chow Tai Fook (“CTF”) normally trades mid double digits of 13-15x, it is the largest of the peers, best brand recognition, highest gold hedge-ration (LF only hedges 20-25%) and Chow Sang Sang (“CSS”) is somewhere between the two and has a full-retail model (vs element of licensing for the others).

A key item to the thesis is the spending habit of Mainland Chinese in HK, who are ever increasing in presence and contribute more and more to HK retail spending. While initially visitors arrived in groups, under the Individual Visit Scheme (IVS) mainlanders from select cities could travel to HK and Macau on an individual basis since 2003. The government aimed to rein this in which made retailers and investors jittery, however what seems to be transpiring is a limitation of individual travel to a maximum of 52 times a year, which honestly shouldn’t cause a material change to status quo. I mean really, how much jewellery you can buy in a week but just in case you'd need more golden ornaments I'm sure you have contacts who haven't maxed out their travel limit.

I estimate that earnings in the next year will be down vs FY 2014’s $3.17 per share and will be more comparable to FY2013 vs FY2014. Based on my calculations the company will be earning somewhere between $2.5-3 per share in FY 2015 and $3-3.5 per share the year after. Now depending on how bullish you want to be the question remains the multiples. As the SSSG decline for FY 2015 is likely getting priced into the stock (there was some decline over the last few days when May HK retail sales were released) and the IVS overhang is getting removed (which was key to the bear thesis) the stock could be up for a re-rating. If we assume an 8-9x multiple (so avg of 8.5x) for FY 2015 and 2016 this would imply a share price of $25 (blended for the two years) conservatively with a 4.5-5% dividend yield to boot. Any weakness in the share price will be a good reason to add to a position.

So the above was my thinking when I first looked at the stock initially at $19, however it since came up, essentially hitting my target price. I’d say that based on what we know for the near-term it’s a fair price for this stock. I actually prefer LF over the peers due to least challenging valuation and largest contributor of HK to EBIT which is positive regarding the developments around the IVS.

But something tells me that it could be a very interesting story for the long-term. I can give you the usual story about how emerging Chinese consumer will be buying more and in a society where jewellery, especially gold, plays such a huge role this is the case more so. I do think this story is valid but probably China will go through a few contractions, which will impact spending but companies like LF with increasing presence in the Mainland, acting as consolidators are sure to do well in the long-term.

Source: publically available filings found on Luk Fook investor relations site

Weekend Links

Carol Loomis of Fortune to retire

Interesting article on the game of golf in China

My continuing education of Jirka Rysavy

Always enjoy reading Farnam Street, this one is on the role of the critic

Charlie Rose interview with the founder of York Capital

From one of my favourite blog - Adventures in Capitalism by Harris Kupperman - on the evolution of  short selling research