Short Notes on Petra

Article from The Edge (Singapore) Dec 26th. Short points:

• Petra accounts for 11% of worlds cocoa grinding capacity, fourth after ADM and Cargill (14% each) and Barry Callebaut (12%)
• In Petra's Indonseia market, they sold cheap chocolates. The Top Wafer bar comntains 12% cocoa powder, while normal chocolate contains 30% chocolate butter. They used wafer instead, and did everything possible to bring the price to IDR500 (7c).
• Worldwide, chocolate companies are vertically de-segregating. Nestle focuses on consumer brands. Barry Callebaut is the largest chocolate maker in the world - has economies of scale.
• Analysts (on cocoa grinding): Petra is a small player in Europe, may lack necessary economies of scale. Claudia Lenz, who covers barry Callebaut for Bank Vontobel: In Asia, the demand for compounds and fillings [cocoa powder based products] is much higher than for 'real' chocolate [cocoa butter]. In Europe, the market consists more of real chocolate and I'm not sure whether Petra foods has fully adapted to that.
• John Chuang (CEO): Petra's board has debated on whether to seperate the consumer and ingredients business, but a decision has yet to be made.
  

Short Notes on Eu Yan Sang

Article from The Edge (Singapore), Dec 26 2011.

Eu Yan Sang

Interview with Richard Eu:

• As of Sept 11, EYS has 189 stores in SG, M'sia, HK, Macau and China. Also sells products to supermarkets and convenience stores. 23 TCM clinics in SG/M'sia, and 2 integrative clinics in HK.
• Growth can no longer be dependent on further expansion in the TCM space alone, will hit saturation at some point. In the company's early years, growth was 20%... "Now our growth rate is slowing down...How do get into another phase of growth where you can look at 15 to 20% growth? Thats why we have to go beyond TCM."
  
• Plans to acquire a stable of brands to move into the natural wellness space (eg: detox, organic)
• EYS stores already carry a range of natural foods, health supplements such as honey mart honey, zing spa products, ProNature oatmeal.
• Want to separate TCM brand from company. Mentions Nestle: They have their own brand, but also a portfolio of other brands (e.g.: Maggi, Nespresso). EYS must own and develop other brands. "Its going to take years, probably beyond my time."
  
• Article mentions past failures: "Red, White & Pure" restaurant launched in 2006 which combined TCM based cuisine with spa treatment...failed and was disposed of in 2009. "It was the wrong time and wrong location" In Aug 10, EYS paid A$3.56m for Healthzone, esp. for its retail franchise in China. Healthzone collapsed last month, probably has to be written off.

My opinion:

I think this is a slippery slope. From medical, tested and proven treatments, to things which may be beneficial, to things that are rubbish:

• Some of EYS current business is equivalent to (the western idea of) selling medicine or pharmaceuticals (whether prescribed e.g.: antibiotics, or over-the-counter e.g.: panadol). The items sold are backed by (some) scientific research, or 5000 years of TCM tradition, so do generally work.
• Other products are like health supplements (e.g.: birds nest), may be the equivalent of buying vitamins or fiber supplements. Don't know if they work, but it may.
  
• At the bottom, we have practically any cosmetic, weight loss, anti-aging product. These are marketing driven fads....bust cream, slim-10, anti-oxidants, ginko, whatever else....

There are more and more competitors as you move down the slope, with fewer barriers to entry and chances for brand building. It is a riskier business. EYS is good at their core business, but it will be hard to move beyond that, especially if they want to move into a crowded, fickle and marketing driven industry.

Should EYS be valued as a value stock (PE 5-10), rather than as a growth stock (PE 15)?

Stocks I don't like

As a value investor, looking to buy solid, undervalued stocks when the markets go into a tailspin, these are the things I avoid.

Technology

Building a sustainable competitive advantage is meaningless in the tech sector, where industries quickly change to become unrecognizable. So I would not buy technology stocks based on low valuations or high market share (e.g.: Microsoft and Cisco today, Nokia several years ago). If I was to buy tech, it would be as part of a growth strategy: in a bull market, with a stock at all times high, with growing sales and their new products that are changing the world....just remember to leave once the party is over: today's hot product is tomorrow's junk....

I also like the idea of avoiding any product/service whose input and output is information (See 'Software eats part of the world'). e.g.: credit cards, newspapers, TV, bookstores.

Change is bad for value investing.


Banking and Finance

Banks are a black box. They make money by lending it out and hoping people can pay back. There is no way to judge the quality of earnings from their cashflow statements. In addition, banking crises occur regularly enough that we can consider them a part of human nature.

So for a long term investor, don't buy when times are good, as the next crisis will hit and drive down the share price of your bank. And don't buy when times are bad, as they can go to zero. Bill Miller beat the S&P for 15 straight years, then in 2009 he "bought ‘cheap’ financials after the credit crunch, but later they got even cheaper". Like Bear Stearns and AIG. He resigned a few years later.

Investment banks are worse, some seem deliberately designed to store risky assets until they blow up.

How do you know which banks are good and which are bad? If Bill Miller and GIC cannot get it right, what makes you think you can?

REITS

I've two main objections to REITS:

• First, Singapore Reits must payout 90% of their income as dividends. So they are in perpetual debt. Meaning that you are taking for granted low interest rates and access to finance....forever. Ironically, I think they would be better long term investments if they could use their income to payoff their debt.
  
• Second, how many REITS bought property at low, low prices during the 08/09 market crash? I cant think of any. A-REIT even made a rights issue at the bottom of the downturn. Some people may even get the impression that REITS are not run to benefit their shareholders.
  

Stocks I'm interested in

Still waiting for a recession, and drawing up a list of stocks that I want to buy. And others that I still have to look in to (*).

Dominators: Buffet-like companies, with large market share and only a handful of competitors, these companies have a sustainable competitive advantage in their industries. These stocks will never go to zero, and could rise 50-100% from bear market trough to bull. Might be possible to hold these stocks forever:

• Coca Cola: Buffet's largest holding. Strong distribution network gives it a moat.
  
• UPS: Only a 2 or 3 competitors worldwide, and one in the US. Buffet also holds some.
  
• Diageo: Largest spirits producer in the world , and a cashcow; sales nearly double its closest competitor.

Local Blue chips: Big players in Singapore or the region: Also will probably never go to zero, though they do not have a sustainable competitive advantage. Usually rise 50-150% from bear market trough to bull:

• Diary Farm: Large player in Asia supermarkets & convenience stores. Low debt, generates cash.
  
• SIA Engineering (*). Or maybe STE (*).
• Raffles Medical Group (*), or possible its overseas competitors (eg: The hospital in Thailand...).
• A property development company (freehold property only): Wheelock, SC Global (*), or CDL (*). Wheelock has historically been the most astute in its timing, but has been doing nothing for the past few years. Check the others, esp. their debt, and how their properties are values on their balance sheet.
• Eu Yang Sang: Low debt, and a long history of being profitable and generating free cashflow.
• Goodpack (*): Large share of natural rubber shipments, and gaining share in artificial rubber. Has it started generating free cashflow yet?

Small fry. Risky, but I try to target those with few competitors and good balance sheets, to avoid the ones that go to zero. These are also very illiquid. May rise 2-4 times from bear to bull.

• Petra: Love their branded consumer distribution, as a producer and distributor of Chocolates in Indonesia. Not so keen on their cocoa processing.
• Silverlake Axis (*): Handles a large proportion of banking transactions in SEA. Clients have long term (3-5 year) maintenance contracts, giving a stream of future profits.
• HDD industry: There is a small company which makes a large percentage (worldwide) of the HD actuator arms - forget its name (*). Alternatively, Seagate may be worth looking at. Always a large risk of obsolescence when buying tech: this is a bet that HDDs will still be around to hold information in the cloud.
• 2nd Chance Properties (*): Plans to change to the property business, by buying commercial property in a downturn. Interesting idea, though I have not looked at the company yet.
  

Punting:

• China Mingzong. Currently selling at 5X earnings, (as far as I can make out) in a non-cyclical industry. They don't have pricing power, but their industry should grow. Largest competitor may be a fraud, no guarantees about this one either. May buy a little with money I can afford to lose in the hope it goes up 5-10X in the long term.
• AirAsia: Don't know where to classify this one, they are in a new industry...in fact they are the industry - no one seems to be able to replicate them profitably after years of trying. But they have fuckloads of debt and unimaginable future capital commitments.
  

Lets see if 2012 brings a chance to buy....

Diageo (DGE:LSE)

World's largest spirits maker. They make Johnnie Walker, Smirnoff, Guinness, Baileys among others. Most of their products are number 1 or number 2 in their markets:

Competitive Advantage

Diageo's worldwide sales are twice that of their nearest competitor, Pernod Ricard. The third (or forth) largest producer, Barcardi, is privately owned and does not disclose sales. Next come 'Brown & Foreman', and Beam (formerly Fortune Brands), which have 1/3rd or 1/4th of Diageo's sales.
Notes:

• Diageo reports in Pounds, currency conversion values above from here and here.
• Diageo owns 1/3rd of Moet Hennessey.

Diageo's margins seem slightly lower than their competitors:
Notes:

• All exclude excise and corporate taxes, except possibly for MH.
• All include discontinued ops except Beam - the difference is negligible
  

MorningStar believes that Diageo has a strong distribution and sales network in North America (33% of sales, 44% profit in 2011), "resulting in operating margins in North America in excess of 35%, well above the firm's consolidated margin in the high 20s, and higher than most of its competitors."

Cyclical

From the above graph, operating Margins of all companies were affected by the 08/09 recession.

Sales did not fall however (Organic sales growth of zero in 08 and 2% in 09). Organic sales generally rise by high single digits (5-8%) during good times.

Business Model

The company is a cashcow, regularly generating profits and free cashflow year in year out:

How much of their costs are fixed, and how much variable?

From the above graph, many of their costs seem seem to be variable, not fixed:

• I'm not sure how staff costs can be variable.
• For marketing: I guess when times are bad, advertising is cheaper.
• Cannot tell what their 'Others' cost is. 2009's dip can be partially explained by a 1bn loss from the Pension scheme.

This an asset light business. There's very little depreciation or operating leases, and most of asset are brands (intangibles).

High inventories:

• Morningstar notes that: "About one third of Diageo's volume ... is derived from maturing products, which can sit in inventory and age for up to 30 years. ... Diageo expenses these input costs on an actual usage basis, meaning that it could be 10-30 years before today's cost inflation affects the income statement. Therefore, we suggest investors look closely at cash flow in addition to earnings when valuing Diageo."
• They have about 2.7bn of Maturing Inventories, over 80% of it intended to be held more than one year.
  

Beyond future 0-8% organic growth, acquisitions are required. Diageo looks for companies with "strong local routes to market":

• Worldwide: MH is most desirable, but not for sale. Diageo is currently negotiating to buy Jose Curevo.
• Diageo is restricted from entering into Tequila, Cognac and Chapagne, due to their agreements with HM and Jose Curevo. There may also be anti-trust restrictions if it ends up owning to many popular brands in the same category.
• Recently bought a 23.6% stake in Halico, Vietnam's leading spirits maker for £33m. Bought Mey Icki, which controls 80% of the market for Raki, at £1.3bn, at 9.9 times 2010 EBITA.

Balance Sheet

£6.7bn long term debt. Slightly over 3 years profit (before-tax).

Pensions liability underfunded by £838m as of June 2011:

• Their actuarial assumptions (p130. eg: salary increase, inflation) look OK.
• Discount rates are 4.9 to 5.7%. About 40% of the fund is in equities, with an expected return of 8.3%. Probably OK.
• The group expects to make 163m contributions in 2012.

Negligible operating leases: 368m over the next 5 years.

Cashflows

Net Cashflow from Operations (basically CFO minus tax and interest) is usually higher than their reported profit. Outlays on Cash Flow from investment are usually quire small:

Conclusion

I would buy in a recession.

SG Property Development Rules

New (and existing) rules applying to property developers (BT Fri 9th Dec, front page, Kalpana Rashiwala).

Old rules:

• Any developer buying a Government Land Sale (GLS) residential site had to complete development in 5 years (no time limit on sales).
• When buying a private sector residential site, foreign developers have to obtain a Qualifying Certificate, which requires 5 year limit for the TOP (development) and another 2 year limit on sales. Any developer with even a single foreign shareholder is considered 'foreign', hence CDL, Capitaland & Wheelock face these limits. Only local, privately owned developers (Far East, Hoi Hup) were except.

New rules:

• For any site bought after Dec 8th, must develop and sell all units within 5 years. Otherwise they must pay a 10% additional buyer's stamp duty (ABSD) at the end of the 5 year period (with interest).

My thoughts:

• Levels the playing field between private and publicly owned property developers.
• Forcing developers to sell during a downturn may exacerbate it. Every last unit must be sold within the timeframe. Would these measures be removed? Retroactively?
  
• I used to like Wheelock due to their astute market timing. As they have no undeveloped property in its landbank: they are now restricted to developing and selling any new land withing 5 years (previously it was 7).
• SC Global may benefit, as they have a large bank of prime freehold land bought before the restrictions came into force.
  

LVMH

Worlds largest luxury goods seller. 2010 revenue/profit breakdown:

• Fashion & leather goods (38%/62%)
• Wine & Spirits (16%/22%)
• Perfume + cosmetics (15%/8%)
• retailing (27%/5%)
• watches + jewelry (4%/3%)

First we look at the first 2 segments separately.

Leather and Fashion

I never imagined that I would ever, in my entire life, see a line of people queuing to shop for thousand dollar handbags.

It is difficult to convey how luxury goods are a part of everyday life here. The car you drive, the watch or clothes you wear, do really mean something. Women can instinctively identify a myriad of branded handbags, jewelery and watches at a glance.


The book "The Cult of the Luxury Brand", believes that Asian countries follow a model in their adoption of Luxury goods; the final stage is where Japan is now, where it is a 'way of life'. They write about the ubiquitous LV in Japan: "It is well past the stage of a trend, it has become an enduring requirement - like sushi or green tea - essential to the Japanese way of life...the company has taken the trend to conform to its logical end: To be Japanese means to have a Louis Vuitton bag. The brown bag with the original monogram pattern and pale leather trimmings has come to define the Japanese national identity."

In short, luxury goods are not a luxury. They are a part of everyday life. From junior office ladies to tai-tais, many people here must have them to function in society. This bodes well for the continuing consumption of luxury goods, which can be supercharged by an emerging China and India.

Comparing sales and profit margins of other brands with LVMH is hard, because LVMH does not break down sales for the many brands they own (LV, Fendi, Donna Karan, Loewe, Marc Jacobs, Celine, Kenzo, Giovenchy, Thomas Pink, Pucci, Belutti, Rossimoda). The chart below show show the total amounts for 'fashion and leather' for LVMH, compared with individual brands for other companies (so not really an apples-to-apples comparison):

From the above, their flagship LV brand, has, at most, twice the sales of the nearest competitor.

[For Coach, converted to Euros at a rate of 1 USD = 0.7394 Eur]

LVMH's margins are among the highest in the industry, only occasionally surpassed only by coach. The LV brand itself would probably have even higher margins, as they are lumping in all brands together.

LVMH's 'leather and fashion' revenue did not fall during the 2008 crisis. It may have been due to China, LV did not break down the figures.

Wine & Spirits

2010 revenue and profits are split evenly between "Wine/Champagne" and Spirits.

The champagne market is highly fragmented, with many producers. This article (free here) puts MH at an 18% global market share. It also discusses how MH is trying to tie up supplies in the (govt mandated) champagne growing regions. I would put MH as the largest player in a fragmented field, but with no real dominance or pricing power.

The champagne/wine market is highly cyclical, as with any commodity that has a fluctuating price and takes time to grow. e.g.: champagne grape glut in 2009, wine grapes in 2003.

For spirits:

• MH trails the largest playes in the spirits market (2010 revenue: 3.3 bn Euros). The largest player is Diaego (revenue: 15 bn Euro) and Pernod-Ricard (June 09 revenue: 7 bn Euros).
• MH's products do not appear in the top lists for spirits.
• HM has a 44% share of the cognac market. Cognac went out of fashion in the early 90's, but is now revived due to rappers and China.
  

HM is not a leader in this market. The Champagne market is highly cyclical. And the spirits market is subject to changing fads and fashions.

Business Model and Risks

For the company as a whole, about 10% of their revenue is spent on advertising.

In the luxury goods business, the main aim is to develop a 'buzz'. Usually done by having celebrities and A-list people wear your products, appear at your parties, etc. This creates a fashion, which people talk about and want to imitate. This 'buzz' is the heart of the luxury goods business - it feeds it and is fed by it. I'm not sure exactly what creates it, but its more than throwing millions of dollars at advertising.

LVMH's income statement is quite sketchy: cannot tell how much of their costs are variable and how much are fixed. The financial statements are short: LV does not even break up their sales/margins by brand; contrast to Coach for example, which provides same store sales.

The chairman, Bernard Arnault, owns 47% of the company and has direct control. Two of his five children currently work there: Antoine Arnault has a management role and is on the board of directors, Delphine Arnault is a director, and nephew Harry Seaman may be involved as well.

LVMH owns many unrelated businesses. Ranging from a stake in Hermes (designer bags costing 50K), to cosmetics retailer Sephora (similar to 'Watsons', but for cosmetics), to Charles & Keith ($30-$40 women's shoes). Does not seem to have any focus. Combined with their sketchy financial information, makes it hard to track.

To conclude:

• LVMH's main business is Fashion and Leather goods. The others are just sidelines or distractions. And are in more competitive markets, so unlikely to make the same margins as leather goods.
  
• This is the only area they have have a competitive advantage in. The LV brand probably sells twice as much as its closest rival, and has the industry's highest operating margins.
  
• This market has the potential to boom, thanks to China/India.

I'm not sure if I'd be comfortable buying this stock.