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.

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.

RexLot and the Chinese Lottery Market

I always had a fascination with lottery. Not that I ever played it but this type of gaming sits at the intersection of gambling and the state/government i.e. essentially promoted gambling. Which brings me to China. The only way to gamble (legally) in China is via lottery that is sponsored by the state while any other method is forbidden (though that doesn’t seem to stop people, more on this later). Of course you have Macau but technically speaking that’s outside of the country. Furthermore, judging by the effectiveness of the clamp down on corruption and indications of going after some junkets this might be under pressure going forward.

In the below I’ll talk a bit about the Chinese lottery market and a HK listed company called RexLot that I think is pretty interesting in this space.

Chinese lottery market

There are two types of lotteries in the country: welfare and sport lottery, which have been operational since 1987 and 1994, respectively. It is an important fundraising method for the government as 20-25% of gross lottery sales are used to fund welfare and sport activities. Under the current set-up the Ministry of Finance operates as the regulatory authority.

Source: China LotSynergy

The Chinese lottery market has grown 20%+ p.a. over the last decade and current sales are RMB 309bn (c. $50bn). On a relative basis, lottery spending per capita in China is US$27 vs Hong Kong and Japan of $125 and $93 and USA of $185. Given that legal gaming (ex-casinos) is far below other Asian countries (either per capita or % of GDP: China is less than 0.5% vs c. 1% in the region on avg) the government has an incentive to support growth of lottery for welfare and sports development funding.

Source: China lottery sales since 2009 (RMB bn). Ministry of Finance

Various estimates point to the fact that the “not so legal” gaming market in China is worth around RMB 1tn (c. $160bn) i.e. the majority of gaming is kept off books currently. To illustrate the magnitude, assuming that 5% of this moves to the legal side of things that’s 16% growth yoy. The government is spearheading efforts by going after these operators, enhancing the choice of games and increasing official payout ratios to attract more players.

In terms of the big picture, 57% of the lottery sales is related to welfare and 43% to sports lottery. The most popular game is computer ticket game (CTG, or the traditional lottery tickets) both in welfare and sports. These make up 68% of the total sales. The remaining consists of video lottery, single match sports games (SMG) and scratch cards.

CTG is the bread and butter and sales grew 20% p.a., most notably due to the introduction of high frequency games (i.e. draws happening daily or intra-daily). Scratch card sales declined since 2012 partly due to capacity constrained card printers and lack of new games. Capacity is expected to be limited through 2014, however this segment, while the most flexible, is still facing challenges vs CTG and online based games. SMG grew 50% p.a. since 2009 mostly supported by the introduction of new games and sports gambling will be one of the key driving force going forward. VLT is perhaps the closest to casino gaming (i.e. similar to a slot machine, potential for addiction etc), thus has the highest potential for regulatory changes. Indeed between 2008-2009 the MoF ceased operations to strengthen regulation

Source: 2013 Chinese lottery sales breakdown. Ministry of Finance

Looking at the distribution of economics in the sector (depending of different games) 50-69% of the sales are paid out to the players, 18-35% paid to the domestic lottery funds, 3-5% to cover costs of operating the lottery centres. The remaining 6-10% is allocated to lottery game and other service providers. The majority of service agreements between the government and lottery operators are for a 5-year period on average and based on an element of revenue sharing.

Internet lottery

Perhaps, the most important catalyst of the Chinese lottery market is moving online and to mobile as internet penetration increases and e-shopping becomes more widely accepted. In 2013, online sales made up around 5% of total lottery sales in China.

There are many specialised sites that operate online lottery such as 500.com (listed on the NASDAQ, currently the target of Muddy Waters) or Okooo (60% owned by RexLot). Besides the specialised sites, portals such as Taobao and Baidu also started offering games due to the increasing popularity. The key benefit for the specialised site operators is that they already have existing relationships with the government authorities and customers whereas the platforms do not have the operations set up with the lottery stores/government (they currently use RexLot’s or other competitors' systems on which the companies charge commission – the beauty of being a toll road owner…).

Now, the online lottery market is currently in a nascent stage and as such regulation is key. Operators have to meet certain regulations (registered capital, risk management etc) before they can be granted approval. The MoF is currently developing the regulation for the market. There is pilot regulation in place for sports lottery and of the private operators only 500.com has one.

The ministry is expected to issue licenses going forward to move online sales from this grey area, however this will take time (most have expected this to occur before the World Cup). The MoF is expected to give licenses to 2-3 operators per province.

For now to circumvent the fact that there are no licenses operators are moving to mobile, where regulation is relatively more lax. Furthermore, while online lottery sales do exist the back-end is linked to traditional paper-based lottery in co-operation with the provincial lottery centres but the aim is to move fully online.

I’ll not hammer on about the increase in Chinese consumer spending and how the government is pushing for this rebalancing (it’s all over the news). Growth in disposable income has slowed recently and while certainly there will be bumps in the road, in the long-term there is a positive tailwind from the structural change in the economy. It is worth noting that lottery sales are highly correlated with disposable income. Historically, the minimum face value lottery bets were RMB 2, thus geared towards the blue-collar market. With the increase in the sophistications of the games and platforms (mobile and internet gaming) the addressable market will certainly be growing.

Lottery market summary

To summarise (i) lottery will continue to be an important driver of raising money for welfare/sports spending, (ii) with the deeper penetration of mobile/internet the distribution channels are increasing as well as the number of games, (iii) government is clamping down on casinos/junket operators. While Macau is certainly more exciting than buying a lottery ticket, we can expect some migration of gaming RMBs to the legalised market, especially in sports betting. While growth rates historically have been 20-25%+ p.a., I’m expecting it to slow to around 10% p.a. in the mid to long-term (simply law of large numbers and penetration).

RexLot

The company is listed in Hong Kong and established a good track record in the Chinese lottery business mostly via M&A. RexLot has developed a vertically integrated lottery operation, with a very strong presence in the country and relations with the government. It is the clear market leader in a number of segments (e.g. welfare lottery) and well positioned to be a beneficiary of the currently nascent internet lottery market.

RexLot has the ability to distribute its games via their partners’ POS, lottery stores and increasingly mobile/internet. It is currently the largest lottery company in China. Barriers to entry are quite high, as operations require approval from the government (e.g. as noted above for internet operations), not to mention the existing customer base.

From 2009 sales grew from HK$1.2bn to HK$2.2bn in 2013 while net income grew from HK$0.4bn to HK$0.9bn. The company operates in two segments (i) System & Games Development and (ii) Distribution & Marketing. SGDB (essentially upstream) contributed 45% of revenue while DMB (downstream) makes up 65% in 2013.

Source: Key milestones. Company

Source: RexLot sales breakdown (2013). Company

Looking at the economics for the key segments: Welfare CTG, POS distribution, Internet and Mobile.

RexLot provides Welfare CTG systems (machines, system connections etc) to lottery centres in 17 provinces in China for a share of the revenue based on a 5-year contract on avg. This share has been as high as 1.8% back in 2010 but was lowered to 1% recently. The government is pushing down these rates and recently one of RexLot’s competitors agreed a rate at 0.65%. This is a huge drop in economics. In 2013, this market was worth c. HK$165bn, of which RexLot captured around 50%. Assuming a 1% rate on it gets you to HK$826m in sales, while lowering it to 0.65% results in a loss of c. HK$290m. This segment’s avg. EBITDA margin is between 70-75%.

RexLot’s POS distribution has an estimated market share of 30-35% with about 80k POS nationwide. On average the company has a 2.5% share of revenue with EBITDA margins of 70-75%. Retail channels include PetroChina, China Post etc as well as supermarkets and grocery stores.

RexLot owns 60% of Okooo.com, which it bought for c. HK$0.7bn (amongst other assets in a package deal) in 2011 and plans to buy the remaining portion as well (more on this below). This segment is about 20% of sales.

Lastly, mobile makes up 15% of revenues. Historically, SMS (text message) was the key driver, however as smartphones are becoming the norm this is migrating to the electronic lottery platform. EBITDA margin in this segment is between 60-70% and the company has c. 20m subscribers currently.

The company is controlled by Victor Chan (CEO of the company; finance and M&A background) who owns c. 14% and there are a few funds that own 5-10% positions.

Financials and valuation

The current share price is HK$0.8 market cap is HK$9.3bn while EV HK$8.7bn (company has been net cash since 2011). The company trades at 8x PE and 5x EBITDA, historically the multiples are 8.5x and 5.5x, respectively, which is quite modest for a company with leading market share.

As noted above the margins are high given the nature of the business. Net margin averaged 40% over the last five years. RexLot pays a dividend with a payout ratio of around 30% in 2013, which the company expects to raise to 50% in the mid-term.

The company runs a relatively conservative balance sheet, however to fund growth instead of raising debt they issue equity. In 2011/2012 the company diluted equity holders by about 25% by raising c. HK$1.4bn convertible bonds (maturing in 2016). Despite communication of more favourable shareholder treatment it issued another $1.9bn worth of convertibles in April 2014 (4.5% interest; maturing in 2019). Conversion price is HK$1.41 (vs current price of $HK0.8) resulting in an issuance of 1.3bn shares, assuming full conversion. In the company’s defence both capital raising rounds were for M&A, the most recent for the prospective acquisition of the remaining 40% of Okooo.com that they do not own. Mgmt communicates transaction close in late 2014.

I ran a DCF as I was curious how the market looks at the stock. Via some reverse engineering I think the market is valuing the stock excluding the internet business, which is fair to an extent. An internet business does exist (with the backend tied to the lottery centres), however no official licenses have been granted yet to move fully online. 

My key assumptions are 10% CAGR in Chinese lottery sales growth, reduction of the welfare CTG royalties from the current 1% to 0.5% over time and modest growth in internet and mobile platforms. Based on my assumptions (c. 7% p.a. EBIT/bottom line growth, which I think are pretty conservative) I get to a DCF value of HK$1.2-1.3 per share, excluding the internet business it’s HK$0.8-0.9 per share. There seems to be decent upside, subject to the official license, and even assuming no internet there is some protection on the downside.

Risks

• Absolutely the key risk is changes in policy: e.g. change in the payout structure of contracts, revenue share percentages, regulation around introduction new games etc
• The online licenses have not been granted, while RexLot operates its internet business as an extension of its SMG business (backend still based on traditional printed paper system). If the company doesn’t get a proper internet license and the government shuts this operation down this could have a substantial impact
• In terms of macro, lottery spending is correlated with consumer spending and decline in a single year or years can impact revenues
• Slower penetration of internet and mobile can slow down the rollout of the new games
• On the company side, mgmt. has a good track record in M&A and growing the business but further potential dilution scares me

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