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.

Sunday, 26 April 2015

Weekend reading

A recent series of articles from the Economist on family businesses (Economist)

FT interview with Li Keqiang (FT)

Recent article from the FT on the fortunes of Macau (FT)

The mess around VW is seemingly coming to an end after the chairman was ousted (NYTimes)

James Altucher's interview with Mark Ford, founder of Early to Rise (Part 1 and Part 2)

Interview with Harris Kupperman, CEO of Mongolia Growth Group and author of Adventures in Capitalism, on Mongolia (Emerging Frontiers)

Very interesting talk with Stan Druckenmiller (Value Walk)

Brian Rose interviews Ivana Chubbuck, an acting coach to the legends (London Real)

Seymour Schulich on Deals, Business, Decisions and Life (Farnam Street)

Why do we have allergies (Farnam Street)

Sunday, 12 April 2015

Weekend reading

Dozen things I've learned from (i) Lou Simpson and (ii) Stanley Druckenmiller (25iq)

Henry Paulson's 8 rules for dealing with a rising China (ChinaRT)

Can Hong Kong catch up to Shanghai? (Barron's Asia). This is incredible:

"Much of the Shanghai rally has been driven by liquidity from retail investors. China’s securities regulator said on average, over 100,000 new stock accounts were opened every working day this year. In the last two weeks of March, over 1 million new accounts were opened – a record. By comparison, Hong Kong is a population of only 7 million.

CBS 60 minutes documentary on Wikipedia (60 minutes)

The messy minds of creative people (Scientific American)

The noise in our head (and artificial intelligence) (Seth Godin). Very succinctly put:

"One reason we easily dismiss the astonishing things computers can do is that we know that they don't carry around a narrative, a play by play, the noise in their head that's actually (in our view) 'intelligence.'

It turns out, though, that the narrative is a bug, not a feature. That narrative doesn't help us perform better, it actually makes us less intelligent. Any athlete or world-class performer (in debate, dance or dungeonmastering) will tell you that they do their best work when they are so engaged that the narrative disappears."

Saturday, 11 April 2015

Tsui Wah Holdings

We’ve all been there. You mysteriously find yourself in Hong Kong’s Lan Kwai Fong area, 3am on a midweek morning wondering home when you stumble upon an open Tsui Wah restaurant on Wellington Street with a great sigh of relief (swear it only happened once to me, okay maybe twice…). Tsui Wah is an institution in Hong Kong with its history dating back to the 1960s. It is a restaurant type that’s locally known as a Cha Chaan Teng (loose translation is tea canteen), mostly found in the Southern part of greater China (HK, Macau, Guandong etc), combining the elements of Cantonese, Western and other Asian cuisines in a casual setting. Highly recommend a look at their Top 10 dishes (of the 170+). The Cha Chaan Teng market is highly fragmented with a lot of mom and pop shops in HK but TW is the largest with a 3.2% share.

The company went public in late 2012 to raise funds for expansion. At the end of 2012 it had 22 stores, generating sales of HK$760m. TW currently has 47 restaurants across HK (29), China (17) and Macau (1). In the last financial year it generated sales of HK$1.5bn and EBITDA of HK$260m ($190 and $33m respectively; inc. JVs). The operations are extremely efficient with standardised and scalable chain of restaurants, central kitchens, speedy service and 8 restaurants with round the clock opening times. To illustrate, the average revenue per store is $4.5m (closer to $5m in HK and $4m China) vs $2-3m for global peers and $1-1.5m for the avg chain Cha Chaan Teng in HK; avg. sales of around $1,100/Sq. Ft.; 11-12 customer/seat turnover; ROIC on invested capital in high double digits etc, you get the idea.

TW has a very ambitious expansion plan for which they raised capital at the IPO (c. HK$795m or $100m). Mgmt. plans to increase restaurant count to over 80 by 2017. By 2015 they target to have 52 stores, implying 14 stores p.a. through 2017 (which could prove to be aggressive) mostly in China. Each store costs around $1.15m to build (with minimal maintenance capex), with average 1-2 months to breakeven and 18 months payback. I’m modelling 4 and 7 store openings for HK and China respectively p.a. by 2017 for a total count of 74 (39 in HK and 34 in China). Currently, HK represents the bulk of the business, but China has been gaining share and makes up c. 30% of sales.

The economics between HK and China are somewhat different. HK has longer avg. opening hours (19 vs 14 hours), higher turnover (11-12x vs 6x), which is compensated by higher avg. check size in China (RMB180 vs HK$90 in HK) given higher menu prices and targeting of higher income population, and higher square footage (7-10,000 Sq. Ft. vs 3,000 Sq. Ft in HK on avg.). Two points to add here on the prices and square footage: (i) TW increased avg. menu prices virtually every year and its prices even in HK are at a premium to other similar type restaurants and (ii) on the square footage mgmt. indicated that they plan on introducing smaller stores in China as a new operating model.

Now I noted above that the growth plan might be aggressive. TW’s key expansion target is China and within that Shanghai, which is one of the most competitive food and restaurant markets as you can imagine. TW has gone from having one store in 2010 to 17 currently however this came to the detriment of sales per store. Casual dining is exploding in China, however competition especially from chains such as Xinwang or Charme is heating up (no pun intended), which is impacting performance. The company is committed to not compete on price (it has the highest avg. check size amongst the chains) but on core values and expected to have a tough time with further expansion Shanghai. There is also an element of difference in customer preference and taste between the Shanghai/Sichuan cuisine vs the more tamed Cantonese. But Shanghai is not the only place in China with growth potential. TW operates in Shenzhen or Wuhan, which it could tap for further expansion. In addition to store count growth management is experimenting with other source of growth such as deliveries in HK, though there would naturally be some cannibalisation.

So this is all wonderful but let’s see if it’s cheap. The current share price following the HK market’s run up last week is HK$2.78, market cap of HK$4bn ($515m) and EV of HK$3.4bn ($440m), trading at 13x EBITDA. I’m estimating that by 2017, TW will have 74 stores (below guidance) with 39 in HK and 34 in China. I’m using two methods to estimate revenues: (i) avg. Sq. Ft. x avg. sales/Sq. Ft and (ii) avg. store count x revenue/restaurant. In the first instance the key assumptions are: (a) 3,000 Sq. Ft. in HK and 8,500 Sq. Ft. in China (declining to 6,500 Sq. Ft. by 2017 to account for mgmt.’s plan to introduce smaller restaurants); (b) avg. sales/Sq. Ft. HK$13k and c. HK$4k, for HK and China respectively. In the second method I’m assuming HK$36m and HK$32m revenue per restaurant for HK and China respectively. Both methods get me to HK$2.3-2.4bn revenue by 2017 and assuming a ramp-up to 17% EBITDA margins (below historical average) I get to HK$400m EBITDA. This implies a multiple of around 8.5x, which I believe is quite low. Based on TW’s and peers historical EBITDA range of at least 12x, the implied share price is HK$3.7 for a conservative 35% upside.  My estimates are fairly conservative: (i) below guidance and consensus restaurant count growth, (ii) below historical overall average sales/Sq. Ft. ($900 in my model vs $1,100 historically) and (iii) below historical EBITDA margins. In addition to the cheap valuation, the company has a dividend payout policy of no less than 30%, however this averaged 50% since the IPO. The forward yield is around 3%.

It would be remiss not to mention the massive share price decline during 2014. The company went public in 2012 at around HK$2.5 per share, eventually increasing to HK$5.6 by late 2013, dropping all the way down to HK$2.3 in mid March 2015. This was due to a combination of events: (i) secondary share sale of controlling shareholders to “increase liquidity in the market” at HK$5; (ii) resignation and then appointment of a CEO (one of the co-founders); (iii) slower Chinese expansion; (iv) slower SSSG in China and (v) increase in costs (especially rent in HK), impacting margins. As noted above the Chinese competitive environment is tougher, in addition growth can hurt margins in the early years as new stores are not up to the scale of the existing ones. There is no short term remedy for this but TW’s actions, such as increasing the number and efficiency of the central kitchens will eventually help, as well as the ramp up of the new restaurants.

On the governance issues, the secondary share sale caught investors by surprise. TW is a controlled company with 5 key shareholders (also co-founders and directors) owning 65% of the company currently, and they sold down 8% in January 2014 at HK$5.  The reason given was the standard “increasing liquidity in the market” but it’s certainly not positive when core shareholders are selling. The shares certainly ran ahead of themselves (over 2x from the IPO price) so the shareholders probably saw it as an attractive time to sell down. Then to compensate for the sale to a small extent in April 2014 as the price started to drop, core shareholders acquired 7m shares (0.5% of total) at around HK$4. In addition, there are related party transactions to consider where the company buys or leases properties from the directors.

The potential risks with the investment are: (i) slowing growth and store opening guidance; (ii) food safety issues – this has been increasing in China; (iii) increasing costs – labour, raw materials or property related.

In closing, I believe that TW is a high quality business, with a very unique brand, growth story and capable management, whose share price got beaten up bad. I think it’s worth taking a closer look at.

Friday, 3 April 2015

Weekend reading

Just had a chance to read Skagen's (European value investors) annual report for 2014. Must read every year (Skagen)

Two oldie but goodie interviews with Doug Barnett of Quest Management, a Thailand based value investor with a phenomenal track record (Opalesque TV and Agora Talk)

Great posts from Farnam Street: (i) A few lessons, (ii) Five techniques to improve your luck and (iii) Mental models

Daily Journal 2015 meeting notes (ValueWalk)

Value investors suffer during steady QE rally (FT)

The footsy index: how sneakers became very big business (FT)

Brian Rose interviews Anita Moorjani, who tells a fascinating story about her survival of cancer (LondonReal)