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.

Fairway Group Holdings

I’ve been following Fairway (FWM) since their IPO in 2013 and boy has it been a wild ride. The company, founded by the Glickberg family, is a retailer of natural and organic groceries in the greater NY area and has been in existence since the 1930s. In 2007 a PE fund by the name of Sterling Partners acquired 80% of the company for $150m and in 2013 took it public.

The company IPOd with much fanfare and expectations at $13/share, reaching highs of $28, then falling all the way down to the $2s towards the end of last year. The reason for that: seriously high growth expectations that turned out to be too ambitious. When filing the S-1 the company had 11 stores (currently 15) and the plans of growing the store count by 3-4 annually. The stores were a mix between urban and suburban, naturally with a different set of economics. The urban stores are around 40,000 sq. ft. (gross), while the suburbans are 60,000 sq. ft. (gross). Growth plans (backed by consultants) saw the possibility of growing to 90 stores in the Northeast states and 300 nationwide.

These expectations were taken down to 2-3 stores annually, then to 1-2 and then they stopped giving guidance, all in the space of a year. In addition, the C-level suite was a bit of a revolving door with the board having gone through two CEOs until they hired the current CEO, Jack Murphy. In short, as far as the IPO itself is concerned it was a very successful one (for the original shareholders / backers) less so for the poor souls who bought in the following months.

Below is a snapshot of FWM vs some its competitors.

Source: Fairway Group

The new CEO has an impressive background in building grocery businesses, such as Earth Fare or Fresh Fields, amongst other businesses within a PE platform. He came out of retirement to take on the challenge of turning Fairway around. He is going back to basics – “Supermarket 101” (increasing SSS, better merchandising, inventory management etc) on the operations side and slowing down store expansion. The bleeding seems to have stopped but the turnaround will take some time for sure. I’d urge you to read the transcripts or listen to the conference calls pre and post his appointment. The tone is markedly different (for the better that is).

In terms of numbers, in the last full year (ended March 2014) the company generated $776m of sales and EBITDA of -$7m, and in the TTM sales of $800m and $3m EBITDA. While over the last five years (through 2014) sales have almost doubled, SSS was practically negative across all years and it hasn’t been better since 2014 either. This massive expansion in sales came from an almost 3x growth in sq. footage but at a cost of lower sales per square foot. Gross margins have bobbed around the 33% mark over the last five years, generally in line with comps. It’s also worth noting that given the losses over the last few years the company generated NOLs of $150m (per the last 10-K), with a 20 year life so they’ll not be paying taxes for a while.

If you dig through the financials, you’ll find that the company likes to report adjusted EBITDA, basically adding back every item they can think of as “one off”. Adj. EBITDA for the last full year was $49m, so as you can see there is quite bit of tweaking that goes on here (store opening and advertising costs, equity compensation etc). Some of it is fair, but for instance equity comp shouldn’t be adjusted for. For the last twelve months adj. EBITDA is around $40m with a 5% margin.

Looking at valuation, FWM’s current market cap is $260m and with net debt of $220m, you get to EV of $480m. There isn’t a long enough historical multiple trading range yet for FWM so triangulating valuation by using various comps is fair. On the high end you’ve the likes of Whole Foods or The Fresh Market with multiples of 10-14x (EBITDA margins of 8-9%) and on the lower end companies such as Safeway or Kroger with lower margins (4-5%) that traded historically at 6-8x. 

Based on an 8x multiple, the market is currently pricing $60m EBITDA for FWM (most likely adjusted basis), so one could argue that the shares are fair to overvalued based on near term results. FWM could be generating $70m EBITDA (on my estimates) in the near to mid-term due to improving margins (expanding private label sales, cost cutting, improving productivity etc), which is of course subject to the effectiveness of the turnaround. If this is the case multiple expansion is likely to follow. Using the $70m EBITDA and a multiple of 8-10x (high end of the low margin comps and low end of the high margin comps) you get to share price between $8-11 vs the current $6.

I’ve seen other research on FWM, which assume more generous earnings. You could argue that the new CEO has a great track record and has done these sorts of things before so my numbers could be on the conservative side. I’m OK with that, there are many things can go wrong and normally turnarounds turn slower than expected. I’d throw in here that (while I’m less familiar with the geography where FWM operates) it could be an interesting opportunity for Whole Foods to consider M&A with Fairway. It could be worth more to them considering that they could take out a large part of the costs.

There are considerations around corporate governance that's also worth flagging. FWM is a controlled company with a dual share class and the PE fund holds 92% of the super voting class B, while Howard Glickberg holds the remaining. Furthermore, the fund owns 28% of the class A shares as well. All in, they control 80% of the votes. Additionally, there are related party transactions that I don’t like such as FWM leasing properties from companies where Howard Glickberg has an interest. He is also the director of development and reports solely to the board of directors.

One word on the share price. Since the lows of October the price is up almost 3x so the shares had very good momentum behind them so far. Any pullback from here would be welcomed though.