Monday, 27 April 2015

Tingyi, or how to be successful if you ever find yourself in the middle of a noodle war

I don’t often write about compounders. It takes a different set of skills to correctly identify and conceptualise all the moving pieces that would make a company a real compounder vs simply buying cheap stocks. Having said all of that, there is a company I’ve been following for a while that could turn about to be an interesting situation.

Tingyi was founded in the early 1990s, listed in HK and is a large China based food and beverage company that is going through some changes. It is the largest producers of instant noodles in the world (e.g. 56% market share in China in value terms as of 2014, which is the largest market by far). It has a majority ownership in a beverage JV with its ParentCo, Pepsi and Asahi. This JV is the largest in China and has market share of 55% in ready to drink tea, 26% in juices and 19% in bottled water. 

Tingyi owns the Master Kong brand, which is probably the most well-known and valued instant noodle brands in the country. Its current market share is about 56%, with plans on reaching 60% in the coming years. In terms of size, noodle business revenues are about 3x of the next competitor in China, which gives it financial firepower and scale. This proved to be very important in what can be best described as the noodle wars or sausage wars in China. Starting in 2009, one of Tingyi’s competitors, Uni-President began promoting new noodle products by giving away free sausages and offering price discounts. Tingyi retorted and given its scale and firepower it was gradually able to put an end to this nonsense. While both peers suffered a decrease in operating margins, for Uni-President these new, aggressively marketed products represented a large % of overall revenues while for Tingyi they were (i) much smaller – c.15% of noodle sales and (ii) it could cover promotional costs much easier from profits from other product lines. As a result Uni-President was bleeding more and eventually conceded. It was very interesting to follow this live, essentially textbook economics 101. It will be a good lesson for competitors – whom are hurting from margin and share loss – to consider carefully any such moves again. Incidentally, a similar battle went down in milk teas as well.

Interestingly, while the Master Kong brand is very famous in China it doesn’t “travel" well (but who cares if you own the largest market). Having conducted a non-representative survey in HK, customers there prefer different brands to Master Kong (due to food safety issues amongst others) but when in China it’s the No.1 brand they seek out. There you go, fun fact for the day.

Tingyi got into the drinks business in 1996 and slowly expanded its brand portfolio and geographical coverage. Later it sold a stake in the beverage business to Asahi and Itochu and in a faithful turn of events this business was merged into Pepsi’s China unit in 2012 (more on this below). The drinks business consists of four major types of products: tea, water, juice and CSD and Tingyi has top market share across these segments (est. 30% in the overall non-alcoholic drinks market in China). In addition, with the Pepsi brand portfolio Tingyi has an exposure to faster growing products such as sports drinks, spring water etc though these are out of reach for most consumers yet in terms of prices. In 2012 Pepsi came knocking on Tingyi’s door after years of losses in their China beverage business. In Q1 that year the parties announced that Pepsi will inject its bottling plants into Tingyi’s beverage business and take a 5% stake (!) with an option to increase it to 20% by 2015. In it’s current shape this JV is 47.5% owned by Tingyi, 30.4% Asahi, 17.1% Ting Hsin (Tingyi’s ParentCo) and 5% Pepsi. What did Tingyi get in exchange: an inefficient business with a drag on margins in the last few years (EBIT margins dropped from 9% in 2010 to 3-4% in 2012/13). No seriously, the portfolio expanded as well as revenues and given hard synergies Tingyi was able to stop the bleeding in 2013 (promotional and raw material cost reduced, increased sharing of beverage distribution and production between the two companies etc). Moreover, on the HR side Tingyi is restructuring the sales and distribution units to make the Pepsi business as efficient as their own.

Finally, as noted above Tingyi has a substantial distribution network in China, e.g. about 37,000 wholesalers, 118,000 directly serviced retailers and 130 production facilities. This platform serves also as a springboard to distribute other F&B brands and to that end Tingyi started JVs with foreign companies (such as Calbee of Japan or most recently with Starbucks). In addition, mgmt. is considering domestic M&A such as in instant foods (ex noodles) to grow this segment.

Source: Tingyi. Distribution and production facilities across China

After reading about this fabulous company you’ll probably think that the share price hasn’t seen a down day since the listing. Well, not quite. The share price has gone exactly…nowhere for the better part of the last six years. In fact, it’s at the same price it was in late 2009. While sales have increased from $5bn to the current $10bn, operating and net margins have declined from around 12% and 8% to 7% and 4%, respectively. Essentially, revenues doubled but profitability stagnated partly due to integrating the beverage business, noodle wars etc that took a toll on margins. However, forward multiples remained relatively flat over the last five years: EV/EBITDA 13x, EV/EBIT 18x and P/E 29x (rarely below 25x) on average, which is quite generous considering all of the above. It is worth noting that Tingyi trades at a premium to its China peers due to large market share, strong scale advantage and expected growth trajectory.

In terms of revenues, noodles represent 40%, beverage just shy of 60% and instant food, others etc the rest. In terms of EBIT noodles make up over 60% (essentially the cash cow of the group). In 2014 Tingyi generated revenues of $10.2bn and EBIT of $685m. Overall, net income and EBITDA reached $400m and $1.1bn during the year. Results are moderately down from 2013 given a decline in noodles sales due some food safety issues and scandals. Food safety, as I’m sure you aware if you travel there, is a huge issue in China. Over the last year or so Tingyi’s ecosystem was hit with a number of scandals for products being found in food that were not exactly meant for human consumption. While not all of them impacted Tingyi’s products specifically, some implicated companies owned by its ParentCo. Either way it’s not a pleasant issue to deal with and certainly affects sentiment.

Looking at valuation and earning power. These last few years have been challenging for Tingyi given all the operational issues, however the future is looking brighter. What could this business generate over the next couple of years? Assuming 7.5% p.a. revenue growth between 2014-17 (below historical rates), element of margin recovery (though below peaks) for both EBIT and net income to around 8.5% and 5.5% respectively (also below guidance) and historical average trading multiples, I get to a share price of around HK$26 (vs HK$16.6 currently) for 18% CAGR. My numbers are below guidance and probably on the conservative end of things. While I acknowledge Tingyi’s scale and capabilities many things will have to go right in the process (Pepsi integration to mention one). But that is OK; this is an idea with a long runway ahead of itself and not a quick turnaround. Tingyi maintains a 50% dividend payout with a current yield of 1.7%. It’s worth noting that there is debt on the balance sheet ($1.5bn net, mostly to pay for new HQs and other facilities) but Tingyi generates strong free cash flow and capex will be declining in the next couple of years (mgmt. guides $600-800m p.a.).

Tingyi reminds me of situations I’ve seen before in many emerging market branded businesses. Large, well-capitalised, foreign company ABC decides to enter XYZ emerging market (naturally after sitting through hours worth of eloquent consultant presentations) only to have their head handed to them by an incumbent local producer, either with a brand so ingrained in the culture that no amount of advertising could change or such scale that replicating it would take a lifetime. For instance Ulker, a Turkish biscuit company comes to mind.

Governance wise Tingyi, like many in Asia, is a controlled company. The founding family (originally from Taiwan) owns 1/3 of the company via Ting Hsin, Sanyo Foods another 1/3 (Japanese food co, stake acquired in 1999) with the rest in free float in HK. There is a very good profile on the founding family from a 2011 Forbes article if you care to read further.

Risks worth keeping in mind: (i) competitive landscape – while competitors are probably licking their wounds, another round of noodle wars could hurt profitability, though Tingyi would probably come out victorious, (ii) food safety issues – it can kill a brand and Tingyi had it’s fair share of bad news recently (while not all related to it), (iii) increase in commodity / input prices – it’s a food business after all and (iv) delay in integrating the Pepsi business, M&A execution etc.