Dairy Farm logo

Dairy Farm – Asian food giant

Dairy Farm

+ Exposure to Asian region with rapid middle class growth.

+ Franchise taker of world-renowned brands in selected markets (IKEA, 7-Eleven, Starbucks).

+ Joint Ventures with highly successful companies (Maxim’s, Yonghui).

+ Strong and majority owner in Jardine Group, with newly appointed CEO for Dairy Farm.

+ Counter cyclical to property market, lower rent means higher margins.

– Competition severe in grocery and health, now online is also a new threat.

– Revenue increased rapidly in several segments 2006-2012, but margins started to deteriorate the years after. Turn-around still unsure.

– In the hands of property companies who can sometimes aggressively raise rents.

Dairy Farm stock chart

 

When I took a 4% position in the company I wrote a brief summary of the company: (Portfolio changes Dairy-farm & Ramirent). Dairy Farm operates supermarkets, hypermarkets, convenience stores, health and beauty stores and home furnishings stores in Asia. Below is a overview of how profits were distributed in 2016 and the main brands contributing to that profit:

DF Profit and brands

For people familiar with the Asian region many of these brands represent daily life of grocery, food, snacks and health purchases.

Operating Countries

Dairy Farm countries

As can be seen in the table above, there is a heavy tilt towards Hong Kong and Mainland China. It’s not fully clear from the annual reports, but Dairy Farm has struggled somewhat with it’s operations in some South East Asian nations so far. This is also reflected in the Net closures in some of these markets.

Ownership structure

Many of the brands are fully owned by Dairy Farm (Welcome, Market Place, Mannings etc.). Some are also run on a franchise basis for certain countries (IKEA, 7-Eleven and Starbucks). The third category are investments where a majority stake has been taken but they are not fully owned by Dairy Farm (Not fully owned Subsidiaries). The fourth category is where minority stakes are held (Associates or sometimes called Joint Ventures). The below picture gives some clarity on the two last categories:

Fairy Farm Subs and assoc

Dairy Farm recently agreed to acquire the remaining stake in Rustan and hence forth own 100% of Rustan.

Of the above Subsidiaries and Associates Yonghui Superstores and Maxim’s are the two major holdings. Yonghui is listed in China and PT Hero is listed in Indonesia.

Context and background

Although listed in Singapore, Dairy Farm is mainly a Hong Kong based company and naturally it’s business has a larger portion of sales in Hong Kong. For a overview of the history I suggest reading the timeline on the homepage (Dairy Farm Company History). Dairy Farm belongs to the Jardine group, which holds a 78% majority shareholding in the company. The Jardine group also has its base in Hong Kong and has been around almost as long as Hong Kong. With the growth of Hong Kong they have expanded together with the city. The Jardine Group spans a wide number of sectors. It’s relevant to have some basic understanding of the other companies in the Jardine group, because they will often work in co-operation. For example the Jardine Group owns a lot of property. The grocery stores, restaurants and other businesses of Dairy Farm is often found in buildings owned by the Jardine Group. This below picture gives an overview of the main entities within the Jardine Group.

Jardine Group and leadership

Jardine Matheson structure

The cross holding structure of the two main entities in blue, dates back to the 1980s. At the time Jardine Matheson and Hongkong Land bought shareholdings in each other as protection from hostile acquirers. The main threat was Li Ka-Shing and his C.K Hutchison Holdings which acquired A.S. Watson Group, which is one of the main competitors to Dairy Farm. As can also be seen the Keswick family holds position in Jardine Matheson and effectively controls the Board of Jardine and by that also Dairy Farm. Ben Keswick is the Chairman of Dairy Farm’s board of directors. In total four members of the Keswick family is on the Dairy Farm board.

Graham Allan who led the company for five years stepped down in August this year. Looking at the operations of Dairy Farm, Graham has not really done an outstanding job, I think that is the main reason he is being replaced. Ian McLeod another veteran is replacing him, one can just speculate if he will be able to “turn things around”. But I see it as a positive that someone new comes in after lackluster performance for the last 4-5 years.

Duopoly and free markets?

I think its worth to mention, that Asia is not like the US or Europe when establishing a business.  Hong Kong for example could probably for an outside investor seem like a very free economy, with low barriers to entry. This is very far from the reality. For example the grocery stores Welcome and ParkNShop has reigned in a fairly undisturbed duopoly in Hong Kong for many years now. Back in the 1990’s the giant Carrefour tried to establish itself in Hong Kong seeing that margins where very healthy in the city. A few years later they gave up (Carrefour Bails Out). They could neither secure a fully working supply chain or locations to expand their operations. Why? Because the property are often controlled by Jardine Group or Hutchison, which are the ultimate owners of Welcome and ParkNShop. In the same way they control much of the food distribution. In a city like Hong Kong there are many examples of businesses that are protected due to vested interests from business owners, who are allowed to influence politics. The same goes for many other markets in Asia, where without local market “knowledge” it will be very hard to succeed.  For the interested reader who wants to understand more of the company dynamics in Asia I highly recommend the book Asian Godfathers.

For Dairy Farm this means that the company in some markets are partially protected from the market forces and could potentially enjoy higher margins than otherwise would be possible. But how these profits are split between Property owners, distributors and other parts of the organisation is of course not fully clear. For example Jardine Group could slightly skew the rental paid from Dairy Farms shops & restaurants and dramatically affect the groups profitability. But I don’t see any major concern on this point, rather it is a positive to be on good terms with your landlord. This duopoly situation in the case of Hong Kong is highly unlikely to change in any foreseeable future (to the detriment of consumers). But as we will see from the financials later, Dairy Farm has struggled to uphold previously very strong margins.

Business Outlook and segments

Dairy Farm gives exposure to the rising Asian middle and upper-middle class. This surely is a tailwind for the business as a whole since this segment is more or less destined to grow. That said, some parts of Dairy Farm’s business face especially severe competition from online options. Especially the Health and Beauty segment seems to be suffering from this. There has also been strong competition in the grocery segment, many large operators like Tesco and Carrefour has also believed in the rise of the Asian middle-class and done large investments in the region. Other areas like Maxim’s restaurants are doing very well, it’s a general trend to eat less at home and thanks to take-away services like Deliveroo, restuarants can increase sales volumes even further. So some disruption is positive, others are negative. Unfortunately Dairy Farm does not fully break down Revenue and Profits both in the segment and country dimension, but we can at least understand the different business segments.

Supermarkets/hypermarkets

DF_superhyperstores

This segment is by far the largest, measured by Revenue for Dairy Farm. But being such a low margin business it does not drive Operating Profit to the same degree. Although my discussion about duopoly above, this segment has really struggled to uphold its margins. I made a small peer analysis, to see what Operating Margins are for other grocery store operators around the world. Although every market and country is different, it gives an overview of what can be expected in this segment.

DF Supermarket Op Margin vs Peers

Looking at large developed markets like the USA and France, what we expect in a good year is slightly above 3% Op Margins. Whereas more niche markets like South Africa and even Australia is showing signs of margins above 5%. It’s quite extraordinary that the difference is so large. The closest comparison to Dairy Farm would Sun Art. If Sun Art is a measure of structural changes there has been some margin deterioration in Asia, but not nearly as much as Dairy Farm experiences. Dairy Farm used to be best in class 2009, now its rather “worst in class” and margins has deteriorated down to returns in line with more mature markets. I believe this is partly structural, but also to some degree mis-management from Dairy Farm’s side. Perhaps the new CEO would be able to lift margins back up to 4% over the coming years. It’s not easy to call a turn-around in margins, but I do feel there is a skewed probability to the upside, since margins are already at lows, compared to peers. One could also argue that less developed markets should have higher margins on grocery business, why? It is seen more as a luxury and status product to buy groceries in a nice store compared to a busy wet-market. Given the status component, consumers should in theory be less price sensitive, which would lift margins, as is the case for Shoprite in South Africa.

Some markets, like Hong Kong is fairly saturated in terms of growth potential, whereas countries like the Philippines where Rustan only operates about 60 stores, there is still a lot of potential to grow. The competition varies across the region and the success of Dairy Farm’s subsidiaries. Indonesia and Malaysia with large populations are really markets where one could hope for future growth. But these markets are also where significant competition has been seen and operations are struggling. Overall one can say this segment has been the problem area for Dairy Farm for some time now and is the main reason why we are trading far below historical highs share price wise. One particular company has been doing very well though and that is Yonghui Superstores.

DF_supermarrket_salesinc

Yonghui Superstores

This Chinese supermarket chain was not included in the Operating Margin comparison above. Yonghui which Dairy Farm owns 19.99% of deserves a section of it’s own. This has been a very successful investment for Dairy Farm. The initial holding was bought below 4 CNY per share in 2014. In 2015 JD.com wanted a 10% stake and to protect its ownership share Dairy Farm added to it’s investment.  After very strong performance Yonghui is today trading above 10 CNY per share and the MCAP of Yonghui Superstores is about 14.5 bn USD.  With Dairy Farm’s MCAP slightly below 11 bn USD, this has become a very significant holding for Dairy Farm. Yonghui is trading at pretty aggressive multiple, recently Tencent announced they are also taking a 5% stake in Yonghui and the stock surged further. So now we have two Chinese internet giants who wants to co-operate with Yonghui, probably with the same thoughts as Amazon has with its Whole Foods purchase. I think this also shows some of the unlocked values for the future in other parts of Dairy Farm’s supermarket holdings. So for grocery stores online is not just a threat, there is also a potential buy-out from the Tech industry, who can’t handle the delivery chain of fresh food products without the established companies.

yonghui stock chart

Yonghui has transformed somewhat over the last years. From running massive 5000 m^2 hypermarkets, the company launched smaller 500-1000 m^2 Super Species stores. The company has grown very impressively and one can say with benefit of hindsight that the China stock market crash in 2015 created a very nice buying opportunity below 4 CNY per share. Read more about the companies change in profile in this article: Yonghui Superstores dishes up new brands to satisfy customers.

yonghui_rev_opinc

Although Revenue and Operating Income has climbed impressively, the stock is now trading at very stretched multiples, trading more like a Tech company than a grocery retailer, with a P/E above 50. This might not be sustainable valuation short term, but Yonghui gives Dairy Farm a strong foothold in the quickly expanding Chinese market. As we also will see later, the Dairy Farm share price is probably not fully discounting the current market valuation of Yonghui.

Convenience Stores

HONG KONG - CIRCA NOVEMBER, 2016: a 7-Eleven store in Hong Kong. 7-Eleven is an international chain

Dairy Farm operates convenience stores in Hong Kong, Macau, Singapore and Guangdong Province under license from 7-Eleven Inc., with a 65% interest in the business in Guangdong Province. Many (in HK roughly half) of the 7-Eleven outlets are run as franchises. The ultimate owner of 7-Eleven Inc is Japanese listed  Seven & I Holdings Co.

The 7-eleven business has also struggled with margins for a few years, but the latest half year figures has shown early signs of a turn-around. Dairy Farm contributes some of the profit increases to a change in stores to more ready to eat food. In the annual report they state: “Ready-to-Eat (RTE) food offerings continued to improve with over 10% year-on-year sales growth across the Group, which was double the rate of overall growth in the convenience store business.” Another source of growth is in mainland China, where the number of 7-eleven stores has grown from 550 to about 900 in 5 years.

Having first hand experience from these stores I think this is one area which is not threatened by the onset of online. This is actually the perfect complement to buying staple products online. It’s also caters to the modern big city life, where you don’t have time to queue up to buy a bottle of water or some snacks. So you are willing to pay up perhaps up to double to price compared grocery stores for the same goods, thanks to its convenience. It is also an area which benefits from tourism, since tourist are even less price sensitive when visiting a city. Everyone who travels to Hong Kong / Macau / Singapore and walks around the city, might take a quick stop into the 7-eleven to buy some tissue paper and dry away some sweat or something to drink. Especially in Hong Kong it is also a very popular venue for buying chilled alcoholic drinks, it’s become somewhat of a phenomenon in party district Lang Kwai Fong to go to “Club 7” and hang out on the street drinking cheap beer from the 7-eleven store (to the frustration of bar owners next by).

7eleven_salesinc

Health and Beauty Stores

Mannings Plus_L

Consist of the brands Mannings (Hong Kong & Macau), Guardian (Cambodia, Indonesia, Malaysia, Singapore & Vietnam), Rose Pharmacy (Philippines) and GNC (Hong Kong).

Although I visited the Mannings stores many times, it’s still a bit hard to describe what the customer offering actually is. A regular Mannings store is like a Pharmacy in other countries, but without the prescription medicines. Meaning they focus on selling food supplements, creams and pills for smaller health problems, skin-care products, as well as beauty products like hair coloring, cosmetics etc. They also operate Mannings Plus, which also has the pharmacy part where you can pick-up subscription medicines. As is the case with grocery stores again Li Ka-Shing’s empire is the main competitor also in this field, with their Watson stores. For Groceries Dairy Farm has the lead on Li Ka-Shing’s group, but for these types of stores Watson is the clear dominant player, with 4 times as many stores in the region.

For store sales in Hong Kong visiting Mainland Chinese tourist have also been an important customer group and when tourist numbers started to dwindle during 2014 sales suffered at the same time as rents continued to surge.

Mannings/Guardian is the area I’m most worried about in terms of future online disruption. It’s very easy to order toothpaste, shampoo, sun-screen or food supplements online instead of visiting a Mannings store. Especially mainland Chinese are today used to ordering more or less anything on Taobao. On the other hand, I have myself been an early adopter on buying items online, started with electronics and now buying clothes, shoes etc online. Judging just by my own behavior I have not started to order my multi-vitamin pills online, it’s not really worth the hassle, although I could save a few USD. But for these types of shops female shoppers are more important and a lot of the products they would buy in Mannings are cheaper online.

Looking at store numbers, with a net closure of 100 stores, this also speaks of a challenging market. But this cost control closing loss-making stores has also improved the bottom line, which saw a turn-around in the latest semi-annual report. All this being said, Operating Margins in this segment is still much higher than for grocery and 7-eleven stores.

df_healtsalesinc

Home Furnishing – IKEA

IKEA operates in Hong Kong, Taiwan through Dairy Farm and in Indonesia through 84% owned listed PT Hero. This has been a fantastic franchise for Dairy Farm. Starting off in small scale in Hong Kong, it did not really tip the scale on Dairy Farm’s bottom line. But with time and opening of stores both in Hong Kong and later Taiwan and Indonesia it is now making a significant contribution to Dairy Farm’s total Net Income. And judging by IKEA’s success in other markets I think this is something that just will keep growing with Asia’s middle class. The IKEA concept is actually even nicer in Asia than in many western countries. In the western world IKEA is located in the outskirts of the suburbs with huge parking lot where people desperately try to squeeze these brown flat packages in the back of their cars. Arriving home then comes the daunting challenges of following the instructions to assemble all of the products. In Asia the concept is much neater. The stores are smaller and located more centrally, you can walk around and look and feel on the products. With the cheap labor costs in Asia you can then order home delivery for free and by adding 10% on the price they will even assemble the products for you (and they are very efficient doing it). It’s so practical and price wise unbeatable for what you get, so its hard to find a single home without IKEA products.

I think this a gem to have in the portfolio of products and I expect it to over the long term keep increasing Revenue and profits steadily, the biggest risk if the franchise would be renegotiated for some reason.

IKEA_salesinc

Maxim’s

Is a family run restaurant business from Hong Kong owned 50/50 by the family and Dairy Farm. More recently they have also expanded their restaurant operations to Mainland China and a few outlets in Macau. Except running many of the most popular local restaurants, Maxim’s group has also managed to sign several important license agreements for brands like Starbucks Coffee, The Cheesecake Factory, Genki Sushi and IPPUDO Ramen. The most recent such agreement is the launch of Shake Shack in Hong Kong during 2018.

Starbucks has become somewhat of a status symbol in Asia, a place to see and be seen. In Hong Kong Maxim’s run the Starbucks brand, but unfortunately Starbucks in China is owned by Starbucks themselves. But there are other untapped markets in terms of coffee consumption. Maxim’s is now opening Starbucks stores in Vietnam and Cambodia.

Knowing Hong Kong very well I can myself in somewhat Peter Lynch fashion say that many of Maxim’s restaurants are among the most popular in the city, with long long lines around lunch and dinner time. The explanation is pretty simple, they provide good tasting food at a price point that most other restaurants who don’t belong to a big group like Maxim’s struggle to match. The track-record is pretty amazing for the group, providing Dairy Farm with Net Income CAGR of 11% over a 10 year period. I see several reasons why growth will continue on this trajectory. Firstly the in-roads in China has been successful, for example opening a Cheescake Factory at Shanghai Disneyland. The other being home food delivery growing strongly in the region, which will benefit restaurants in general. Obviously tourist numbers entering Hong Kong will also greatly affect Maxim’s future.

maxims_netinc

Other

One should mention that Dairy Farm experienced accounting issues in 2012 in it’s Giant operations in Malayisa. Whistleblower reveals accounting blip in Dairy Farm’s 2H12 results. One might argue that an added risk premium is warranted for these type of things, which probably are more common in emerging markets where Dairy Farm operates. From what I have seen Dairy Farm takes this seriously and has their own internal auditors assessing their different companies. I’m not particularly worried about this happening again.

Valuation

My valuation will start of in the current state and I will try to model the different segments from a revenue generation and operating profit margin point of view. Taking into account the backdrop of a rising consumer base, competition, previous track-record and general operating margins. These are the projections I will draw for the coming 10 years:

DF_opmargins_projection

DF_salesgrowth_projection

DF_OpInc_projection

Looking closely at the graphs above, I’m expressing a fairly bearish view on the Health and Beauty segment going forward. The Supermarket and 7-eleven stores I believe will show a slight recovery in margins and otherwise grow with the regions fairly high growth rates. The ones that will really play catch up in terms of generating bottom line profit is Maxim’s and IKEA which I project has a very positive future within the group.

Other assumptions:

Tax-rate: 15.5%

WACC: 7.5%

This gives me a fair value of these Dairy Farm operations of 8.78 USD per share, versus latest share price at 7.91 USD. But that is excluding Yonghui holding, which is currently worth 2.23 USD per share, giving it a total value of 11 USD per share.

For the first six months of 2017 Yonghui produced for the first time meaningful Net Income to Dairy Farm, at 31.1 MUSD, putting it in-line with IKEA in terms of profit generation. But the market is valuing Yonghui to extreme multiples currently. Dairy Farm’s share of Yonghui is currently worth about 3bn USD, which translates to 2.23 USD per Dairy Farm share. So adding that to the value of the rest of operations 8.78+2.23=11.01 USD per share. I’m not sure if I want to fully discount the quite aggressive current Yonghui valuation, but that is how the market currently values it. So from that perspective Dairy Farm is worth 11 USD per share.  I find this valuation gap to my fairly conservative projections attractive.

Another way to look at it is buying Dairy Farms core business, which I get at fair price with Yonghui Superstores, which is a major holding, for free.

Summary

As the population in the Asian nations becomes more affluent, the habits to acquire food will change. From more simple groceries shopping in out-door wet-markets, to clean air-con centers with a wider variate of products, especially offering imported products. This is something the western world take for granted, we usually don’t even have local out-door markets easily available anymore. But for a up and coming Asian family this is a big deal and also related to status. We afford to buy our food at the luxurious food store with high quality products. Same goes for Maxim’s restaurants in Hong Kong and China, where when you become richer can afford to eat out more, instead of cooking at home. Deliveroo and other food delivery services are also important explanations to why restaurants now can serve and reach a much wider base of customers from a small well located restaurant. IKEA in the same way upgrade peoples homes with good looking new furniture for very reasonable prices.

I also have hopes that the newly appointed CEO will be able to significantly lift margins in the grocery segment over the coming years.

This is a slow and steady stock, very defensive, with a lot of high quality businesses. Something I’m ready to own for the very long-term. As of today I increase my current exposure from about 4% of NAV to a total 7% position.

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Portfolio changes – Criteo In, Sony out

Adding Criteo 6% weight

For the second time I buy back into a stock I previously held. First time it was NetEase, this time it is Criteo (Criteo – Growth Case). To also revisit the reason I sold it was uncertainty on their revenue model and competitors crying wolf (Criteo – lawsuit scares me). Like all previous holdings of mine, I have kept this on my watch-list. With time I have understood their core model better. Although one has to mention that they keep innovating and coming up with new revenue sources that again are hard to understand.

But to summarize, the investment case is not very different from Catena Media, which is the affiliate for betting i have in my portfolio. Both companies are just trying to in the most clever way route customers to companies homepages and generate sales. The more I think about it this a very natural next step, we do not browse as much as we once did, we go to known pages through apps, but companies still want to reach us with their message. It’s a new and changing field and it might be that there is no room in the future for this players and Google/Apple takes it all. But that’s not my view, I think these players will mature and be a more accepted part of the business for anyone wanting to generate online sales. In the current circumstance for Criteo I feel the market has taken a way to negative view of the possibilities that Apple will limit their business model in the future. Meanwhile since I sold, the company has kept delivering very well and building up its cash-pile. I think the company is still misunderstood and negativity has again taken over and the stock is oversold. I find the stock attractively priced with a nice risk reward.

The biggest negative I can find is how they keep increasing the Equity awards compensation, although the stock price is not moving up. Clearly their metrics for Equity awards is not aligned with share holder returns.

Sell Sony – full holding

After a very decent run its time to part ways with Sony. I bought the stock believing the VR gear could become a big hit. It has done decently well but has not at all been any main reason why Sony has had solid results in general or good results in the games business. A bigger reason for the recent profit upgrade is the image sensor business, which goes into smartphones. An area I did not foresee at all would drive profits, sometimes you are just lucky too.

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A lot of work for nothing..

I noticed over the past months that a lot of my initial holdings, from when I started the blog has been performing extremely well. I always try to evaluate if what I have been doing make sense, or if I should change my investment strategy. So I decided to check, how well has my starting portfolio done in comparison to my real portfolio? In my real portfolio (as you know) holdings have been sold, trimmed and a lot of new holdings have come into the portfolio. Has all the work of throwing out old investment cases and adding new ones added significant amounts of alpha, or has it even been destructive?

My assumption is that I just hold the starting portfolio from March 18th, 2016. Since one of my holdings, SAFT was bought by Total, that holding is just placed in cash. Because of this cash levels will be high and on average at similar levels to my real portfolio.

Starting Portfolio

Starting_portfolio2016

So how will this starting portfolio hold up against all my “clever” moves where I took profits in some holdings, cut my losses in others and found new good investment cases?

Graph_20171105_RealvsStart

Somewhat crushing results, where I’m exactly neck and neck with my starting portfolio. Looking at risk adjusted returns I’m slightly slightly ahead. My real portfolio had a standard deviation of 12.4% versus the starting portfolios 13.6%.

How the result was achieved for the Starting Portfolio

StartingPortfolio_Performance

What happened?

Basically the explanation is that I made the mistake of selling two holdings that did extremely well after I sold. Zhengtong Auto and Highpower International. I didn’t have the staying power and bought into other holdings that did well, but not nearly as well as these two. Other than that, I made the right decisions, exiting many of my other holdings like SAS Preference shares, Criteo, Ctrip and MQ holding, all four under-performing quite a lot.

But how ironic to end up in the same place after 1.5 year of struggling to beat the benchmark. Hopefully I at least learned a thing or three, that’s the main point of all the hard work..

 

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Dairy Farm logo

Portfolio changes – Dairy Farm & Ramirent

Ramirent out

I continue to rotate my portfolio away from cyclical companies to safer quality havens. Ramirent has been riding the cyclical construction boom in the Nordics. I believe we are seeing the very last legs of that. Especially in Sweden construction could very soon come to a halt with daily articles commenting on the property market. This is something I have analyzed closely myself and I have seen the signs for quite some time. So I’m a bit disappointed that I didn’t manage to exit Ramirent when the stock was trading at least one EUR higher, but here we are. I kept this holding since I started the blog, to avoid the risk of follow this cyclical company all the way down again, it’s time to sell. So as of today’s close I sell my full holding in Ramirent.

Dairy Farm

I actually started to research this investment thanks to a comment I got from on of you readers. The question was if I have looked at Jardine Matheson Group. My answer at the time is that its a very complex conglomerate to research, because it contains so many different types of exposure. One of the core holdings of the Jardine Group is called Dairy Farm and as many of Jardine’s holdings it is separately listed. It’s name might lead you to the wrong conclusions, it’s not a milk company of any kind, but a diversified company of Asian retail stores, mainly focused on food. It might come as a surprise for some people living in Asia that this company is the owner of so many famous retail stores for the Asian region. Dairy Farm operates supermarkets, hypermarkets, convenience stores, health and beauty stores and home furnishings stores under all these well-known brands:

DairyFarm_companies

I have been trying the last few weeks to enter this stock at a more attractive level, but failed to find/time any weakness. Therefore I took an initially smaller position of 4% in this company at today’s close, with the possibility to add in-case I see any short-term share weakness. This is not a cheap stock, but a quality company that I intend to hold for the very long term. It has good exposure to the growing middle-class in Asia. A full analysis will follow at a later date.

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Portfolio Review Q3

The third quarter of the year has passed and the bull market is still roaring pretty strong. My guess a few years ago would have been that we should have seen a larger setback by now. On this particular point I feel pretty humbled by being wrong for so long. Performance wise I do not feel as humble. I have done quite a number of things wrong during this year, mainly selling stocks too early. But in general I did more things right than wrong and that’s what counts. Let’s go through the performance and some high- and lowlights.

Performance

Graph_20171006

Year to date the Global Stock Picking portfolio is up +24.5%, that compares favorably to MSCI World (Total Return) which is up +17.4%, but lagging Hang Seng (Total Return) which is up an incredible +29.3%. Looking at risk adjusted returns, I’m not faring that well though. Although I have run a large cash position (which lowers volatility) the volatility YTD is at 10.5%, compared to MSCI World at 5.5% and Hang Seng at 11%. So risk adjusted I come out with the worst Sharpe ratio of 2.33 vs 2.66 for Hang Seng and 3.17 for MSCI World. I guess that also says something about the state of things in the markets when a Global Index portfolio is returning a Sharpe >3.

I probably sound like a broken record soon, but this to me is a very late stage bull market and one should plan accordingly. I did make an attempt to discuss the topic recently (Where to hide – a factor approach).

Compare with Hang Seng?

That I have added Hang Seng as a comparison might be somewhat misleading, since my intention is to run a Global portfolio. The reason why I added Hang Seng was due to my heavy China tilt when I started the blog. I would argue that is not a constant tilt that I will have over time. It was an allocation call I made at the time. It is a call I’m obviously happy about, since it has given me free Beta out-performance against MSCI World, which is my true benchmark.

Lately I worry about the Chinese economy and the valuations has got more stretched also for Chinese stocks. As you know from previous posts I actively rotated away from China. Currently my portfolio has 16.5% of its cash invested in companies with most of its earnings from China (Coslight, XTEP and NetEase). I will keep the Hang Seng comparison for sometime, but I might remove it at some point.

Highlights

Buying Gilead became a very well timed investment. The market really liked the new product line their are buying themselves into through their acquisition of Kite Pharma. I honestly don’t have the knowledge to know if this will actually be so fruitful as the market seems to think. My impression is that (the market thinks) Gilead has a strong acquisition track record.

Nagacorp which we discussed extensively in the comments and I choose to double up on has come back to something closer to fair value. The company continues to execute well on attracting more VIP players and the Naga2 complex is about to open in full scale. Next Chinese New Year will be very very interesting, I’m optimistic about further share appreciation. As long as the majority holder does not decide to do something stupid (again).

LG Chem which is my long long term holding for the EV-theme (being a leader in battery technology) has performed very well lately (although not as well as the pure-play Samsung SDI). Unfortunately the battery part of LG Chem is still fairly small. I expect it to grow substantially over the coming 5 years.

Lowlights

I made a bet that XTEP, the Chinese shoe company was lagging it’s competitors who have all had great runs in the stock market and would do some catch-up after it’s semi-annual was released. It turned out being the opposite and I doubled up before the stock collapsed. I feel a bit beaten up, picking the only Chinese shoe company that is down performance wise. Still haven’t given up though, although less about my position than before.

In my move to rotate away from China (Time to rotate away from China) I have sold a number of holdings lately. Two which I sold after very strong returns were YY and BYD. It has been a bit hard to see the shares continue to surge another 30-40% after I sold, but such is life. As I wrote at the time for YY, I got scared of the Chinese Gov clampdown on streaming services, but these things often go away and so it did. And the upside I saw very shortly after came true.

Catena Media which I just bought into also had a negative event right after I bought. The CEO was fired with immediate effect. This gives me some worry that something might surface in the Q3 report. I have considering to reduce my initially fairly ballsy position. The only positive keeping me from doing it is the interim CEO which I have very high hopes about.

I bought two bricks and mortar stocks, XXL and Tokmanni, I reversed my decision with a smaller loss for XXL and kept Tokmanni. So far I should have done the opposite, since XXL has rebounded nicely whereas Tokmanni is treading water.

Current Portfolio

Holdings_20171006

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New holding Essity

As of yesterday’s close I entered a 6% position in Essity, the newly formed personal care and tissue products company. Essity was the Hygien part of SCA and was spun out of SCA earlier this year. That left SCA with forest ownership and pulp production in SCA.

I have kept SCA on the radar for a long time and it has always been the Hygien part of the company that I found attractive. After the spin-off the Essity share has traded down whereas the SCA part has continued up. I like Essity for the quality of their products and I believe there is room for Essity to increase margins to similar levels like competitors. I think they have especially strong products for growth in Asia, for example through their majority holding of Hong Kong listed Vinda. I have considered investing in Vinda instead, but I see more room for multiple expansion in Essity and also a more diversified holding (less concentrated on China).

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New holding – Catena Media

After listening to interviews with both the CEO and the largest owner of Casino and betting affiliate Catena Media, I started to understand this niche market a bit better. I decided to take a position in this gaming industry niche. Gaming affiliates has been a pretty murky business, with a high number of very small companies (more or less one guy sitting at home creating a homepage). But it has also been an insanely fast growing and lucrative business. Catena Media is organically and by acquisitions building up to be a large dominant player in this market. They recently took a step to invest in the Japanese market. It probably won’t be easy to break through in the Asian markets, but the Swedish gambling companies are very much at the forefront in general. So this can be a first step towards new growth for Catena.

This is a high risk position, but I feel I have space to take risk in my portfolio right now, cash-levels are very high and I lowered my Beta my taking less bets on China and buying more quality companies. So I initiate this at a 6% position, since I believe it is a good entry point, where the market has oversold this holding on scares of majority owners exiting the company. Which was in a pretty clear way denied, by the majority owner in a recent interview. Also the company looks cheap valuation-wise. A full analysis might come at a later date, but right now I’m focusing on finding more new investment cases.

 

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Sell BYD and EV mania

Sell full BYD holding

A quick post to state that as of today’s close I sold my full remaining position in BYD.

EV mania

When I started this blog 1.5 year ago the first EV mania wave had passed, Tesla had been treading water in the 200 USD range for a few years. But I was convinced that this rally still had more steam, the wide public had not yet caught this massive change that was upon us. Now I would say everyone is on the “EV-train”, in the sense that everyone now believes EVs will take over the world in the coming 5 years. I have no idea how far this EV-mania can go, perhaps are we still in early stages and valuations will double from these levels. But I feel the easy money has now been made. I was right, EVs are taking over, now the whole world agrees and anything touching EVs is rallying like no tomorrow. Look at the Global X Lithium & Battery Tech ETF share price and traded volumes.

LIT_ETF_perf

So for me this it the time to start being cautious, be thankful that the investment thesis worked and stop being so heavily tilted towards this theme. Outside of this “blog fund” I also been invested in this ETF, which I now also sold.

Portfolio wise I still have 2 holdings geared towards EV exposure, LG Chem and Coslight. For the long-term I keep LG Chem, will I believe will be one of the big battery providers to the western car makers. I also keep Coslight which as a small cap is still at a low valuation, and I think there is a potential for a multiple expansion if this mania continues. It has lately also sold parts of its battery factory for laptops, to gear itself more towards batteries for the Chinese EV market, which I don’t think the market really picked up on (yet).

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The Perfect Storm – Teva – Part 2

Recent development

This is the continuation of my post (Teva – Part 1) more than a month ago on Teva Pharmaceutical Industries. At the time the ADR was trading at about 18.5 USD per share. The share price would continue to deteriorate over the coming month down towards a low of 15 USD per share. But a week ago the stock made a huge jump upwards after the new CEO was announced. So before we dive into the valuation, let’s look at recent development.

The 3 billion CEO

As was mentioned Teva has been in a long (and desperate) search for a new CEO. When it finally was announced that Kåre Schultz, the danish drugmaker Lundbeck’s CEO has taken up the position, the Teva share rallied about 20% and increased Teva’s marked cap with about 3bn USD. At the same time Lundbeck saw it’s share drop with -13%, so the value of a CEO can apparently be very big. I suspected a pop the day the CEO was announced, but this was way out of proportion in my oppinion. Showing Teva’s desperate state is the size of Schultz sign on bonus, which all-in amounts to about 44 million USD, with 20m in cash. Nicely done for some who earned the equivalent of $6.1 million in salary and bonus last year!

Looking at what Schultz has accomplished. Schultz comes with a strong track record at Novo Nordisk and lately as Lundbeck CEO where he navigated the company through a difficult period that saw patents expiring for its biggest drugs. He cut about 17 percent of the workforce and oversaw a $480 million restructuring and brought a number of new medicines to the market. Lundbeck is now on track to report record sales and earnings this year and its stock price has almost tripled since Schultz’s appointment.

So this is obviously a big positive for Teva and it increases the probability for a successful execution of their very crucial strategy going forward.

Asset sell-offs

Teva needs to sell assets to meet debt covenants. I have been trying to build an model of future cash-flows over the last few weeks. One of my starting assumptions was around the anticipated asset sell-offs. I spent some time trying to estimate how much Teva would be able to get for it’s “non-core” units. This exercise became less meaningful now, since half of the asset sales already been announced.

Women’s health unit

What has been announced so far, in 2 tranches, is Paragard and the rest of the Global Women’s health portfolio, for a total sales value of 2.48bn USD. Here I have to say that Teva surprised on the upside. In my estimates I had a range for potential sales value of about 3-6x Sales, with me leaning closer to the 3x Sales valuation. But here they got paid close to the 6x range for the whole unit. It seems the Paragard unit which sold for 1.1bn USD with sales of only 168m USD, was worth a lot more than I anticipated. Well done Teva!

Future asset sales

I previously assumed that Teva would want to sell it’s Respiratory business to bring in enough cash, but it seems they got paid enough for the Women’s health unit, to be able to keep it. Which brightens my analysis of the future somewhat. The other unit up for sale is the European Oncology and Pain unit. Again it’s hard to guess on multiples, but sales 2016 was 285m USD and high estimates of valuations has been in the 1bn USD range. So I will assume 1bn and with that sell, in total shaving off a total of 3.5bn on a 35bn USD debt burden.

Valuation discussion

It has not been an easy task to come up with detailed estimate of Teva’s future cash flows. The Generics business is at an infliction point, where margins have been expanding for a number of years for all companies. As with most businesses, when margins gets more attractive, competition moves in. As we will see from my analysis, the million dollar question for Teva’s future is how will margins for Generics products develop over the coming years.

Teva has two main business units

The two main business units are: Generics and Specialty Pharma (meaning mostly pharma under patents). The two units are further split into the following and also a “other” unit:

  • Generics (Sales 11,990m)
    • US (4,556m)
    • Europe (3,563)
    • Rest of the World (3,871)
  • Specialty Pharma (Sales 8,674m)
    • Copaxone (4,223m)
    • Other CNS (1,060m)
    • Respiratory (1,274m)
    • Oncology and Pain (1,139m)
    • Women’s Health (458m, now sold)
    • Other Specialty (520m)
  • Other Revenues (1,239m)

Although Generics Sales is higher, the total Operating Income is slightly higher for Specialty Pharma, given its a higher margin business. In my analysis I try to forecast at least partly on this sub-level.

Assumptions – Future Generics market is the key

I quite quickly realized that valuing Teva is about understanding how the Generics market will look like in the future. Up until now Teva has managed to substantially increase its margins on Generics, so has also other companies, like Actavis that Teva bought. With margins now decreasing, both due to pricing power of major buyers (See link) in the US, as well as increased competition from Indian and Chinese players, the investment case might look very different. One the other hand, the sales volumes of generics seems to have a continuously bright future. Generics sales have exploded over the last decade, but with more big drugs falling out of the patent cliff as well as countries pushing for usage of generic alternatives to lower costs, it seems plausible that growth continue at an above market rate.

The more I read about Generics, it looks like any other maturing market with limited barriers to entry. Volumes go up, margins come down and left are the largest most skillful players who can use its scale to out-compete smaller players. So what is left to find out is if Teva is one of those players, has the market in its panic priced Teva way too low, even if what is left is a lower margin business but with good volume growth over the coming 10 years.

Assumption Details

Given that Teva is such a huge company, it’s very hard to accurately model each units future cash-flows but hitting the right assumptions for revenue and margin. I have focused on the broad picture and spent most of the time trying to get the figures right for Generics and Copaxone. It would be too lengthy to go into all the assumptions on margin deterioration and sales.

  • For both business units when calculating margins, R&D, Selling & Marketing and General & Admin expenses has been added into the cost structure. For a bull case, more synergy effects from the merger have been assumed than in the bear case.
  • Discount rate in Bear Case 10%, Base Case 9% and Bull Case 8%. 1% change in discount rate, changes valuation by about 2-3 USD per share.
  • 31.5bn USD debt assumed

Copaxone and other Specialty Pharma

Copaxone is a case about it’s patent expiring on it’s 40 mg drug. It’s not so much a question if the patent will expire, but just how soon, and how quickly generics will take over the market. Here are my assumptions on Specialty Pharma:

copaxone

otherspecialty_Teva

Generics Markets

Teva does not specify how much of the recent margin deterioration in Generics is affecting the different regions. But since Teva still produces Actavis Sales numbers separately, together with total sales numbers, one can back out, at least an approximate Sales deterioration per region. The Sales deterioration is not due to less sold drugs in volume, but due to margins shrinking so quick that top line decreases. What is not really mentioned by Teva is that “Rest of the World” margins and revenue is suffering even worse than the US market, while Europe is seeing more of a mild margin deterioration. I therefore make different revenue decrease assumptions for the different regions. Unfortunately Teva does not produce Generics margins for the regions, so only Sales numbers are modeled with such detail. I have used what I can find in terms of short term and long term forecasts for the generics market.

generics_revenue_teva

generics_grossmargin_teva

generics_operatingmarg_teva

Total

The Total becomes mainly a combined effect of Copaxone income falling off a cliff and the future for the Generics market:

Teva_totaloperatingInc

Other costs

Teva is very good to hide costs and show PowerPoint presentations with very hyped up figures, showing figures excluding for example Legal settlement costs, which is more or less a re-occurring item every year. So on top of the business units Operating Income above I have afterwards deducted legal and settlement fees of 500m USD per year.

The issue with leverage

Naturally with leverage the company becomes more risky, how much more risky is really shown in a DCF of the above cash-flows. I value the company including it’s assumed remaining debt of 31.5bn USD, meaning NPV of Cashflows has to be larger than the debt, to give a positive value to equity. This is of-course does not become a realistic case close to zero equity value. Since an option value kicks in, the option that the companies future cash flows will improve.

But this leverage also makes it more easy to understand why some analyst has a buy recommendation with a target price 100% above current market price and others come to the conclusion it’s still a sell. The difference in assumptions is actually not that large.

Valuation results

Bear Case

The bear case gives a negative equity value of about -2 USD per share, accounting for option value and dilution, the value per share is set 3 USD.

The meaning of this result would be there is only option value left (as described above). It also gives an indication of how hard it will be for Teva to service it’s debt, especially if funding costs goes up for the company (which it will, when cash flow deteriorates). If funding cost reaches 10% as the WACC in my DCF, then the company really can’t service it’s debt anymore on the cash flow it generates. There is really a non negligible probability for the company defaulting, then one can argue that the Israeli state would never allow that, and that it probably true. The bear case anyhow, indicates a share price with possible future share dilution in the low single digits.

I would give this cash-flow scenario a probability of about 20%

Base Case

The Base case gives a share price of 14 USD per share.

I have done my best to try to estimate a realistic base case scenario for Teva, short-term and long-term. Against the Base case Teva currently is slightly over-valued and before the CEO announcement was fairly valued. The panic pricing I had anticipated before my analysis rather came out as being in-line with my base case.

I would give this cash-flow scenario a probability of about 60%

Bull Case

The bull case gives a share price of 43 USD per share.

Here the company manages to execute on all it promises and also very optimistically margins of its Generics business improves again in 2018 and onwards. On a gross margin level, they will still slightly decrease from the best levels seen, but thanks to synergy effects, the operating margins come out very good. Also Copaxone generics versions will be delayed by a couple of years. I have found only one example of a generics company that lately managed to keep its margins fairly stable and that is Perrigo, but they still state they expect weakening going forward (Perrigo surprises). So the expectation of a quick turn-around in margins is very optimistic and rather a blue sky scenario in that sense, rather than a very realistic bull case

I would give this cash-flow scenario a probability of about 20%. I think the CEO hire has taken this probability from 10% to 20%.

Summary

Weighted valuation: 20% * 3 USD + 60% * 14 USD + 20% * 43 USD = 17.6 USD, which is 10 cents from where it is trading at this moment.

To be able to buy the stock, either the stock price needs to go lower, or the probability for the bull case needs to go higher. As soon as the market sees that generic margins are not turning as bad as expected, the stock has as we can see great potential. This explosive share price potential is of course due to Teva’s very heavy leverage. But this kind of leveraged bet on the generics market is not anything I’m willing to do without a serious margin of safety. I would not be comfortable to buy the Teva stock before we see almost a single digit stock price. Therefor my recommendation right now is wait and see. Most likely they will deliver another larger good-will write-down during next year, since the cash-flow the Actavis division is generating is nowhere near what they paid for it (they need to shave off probably another 8-10bn USD). Since Teva is such a large and complex company, this analysis has taken a lot of time from researching other interesting stocks, so somewhat frustrating to come to the this conclusion, which was somewhat surprising to me.

As always, any comments are highly appreciated.

 

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Another Portfolio change

Defensive is my new offensive

So I continue my quest of reducing China exposure and finding good defensive plays. My portfolio changes are the following as of market closings today (Tuesday):

  • Buy 6% of my NAV into Gilead Sciences
  • Add 50% to my current holding in Xtep International
  • Sell 40% of my current holding in BYD
  • Sell my full holding in CRRC

All in all this slightly reduces my very large cash position. Some quick comments on the changes:

Gilead Sciences

As I have mentioned in several posts, I have been circling the Pharma sector for quite some time now. Since it is, at best, a murky area to try to estimate the value of a big companies research pipeline, I have struggled to come to an investment decision. It’s easier with companies where current cash-flow motives more of the value. I tend to end up a bit too much on Seeking alpha, trying to find people who do understand the intricate details of this industry and especially the pipeline. Someone that I do trust though on the topic is Martin Shkreli, who freely shares on his thoughts in his Youtube streams. He is a fan of Gilead lately (when the valuation has come down). That gave me some comfort to keep looking at the stock. After seeing this (WertArt Capital on Gilead) very in-depth review of Gilead, I realized I might be a bit late to the party. But nevertheless, I want exposure to the sector which I feel have come down valuation wise and is defensive. Giliead is the best I have been able to come up with after a long search. I feel confident enough to take a position at what I believe is still a decent entry point, with some confirmation that the down-trend is broken.

XTEP International

The case is simple, if this company is not a fraud, it is undervalued. All other Chinese shoe companies have continued to perform fairly well and outperformed XTEP. This might be the ugly duckling, but I don’t believe it is THAT ugly. We will also get a very quick answer on my bet, since the earning report is released tomorrow, I’m hoping for a +10% pop upwards in the stock-price.

BYD

The countries outside of China keep disappointing me in how much they dare to commit to electric buses, it’s already proven to work fine in China. This is where BYD is very strong and have a top product. On top of that I still don’t see BYD releasing a car anything near to Tesla Model 3 or Chevy Bolt, so my thesis from over a year ago, that I’m unsure of BYD’s success in the car market, stays the same. I haven’t given up on BYD, but I could see this one visit the high 30’s again and choose to reduce my position.

CRRC

This was my Belt and Road play, perhaps somewhat sloppily implemented. I decided to not invest in the theme before I understand it much better than I do right now. It has a holding I don’t have a strong view on and selling it reduces my China exposure, so out it goes.

My next post..

..will be about Teva. I have been very occupied lately and I still need some time to dive into the details. So stay tuned for Part 2 and let’s see if it becomes a new investment or not.

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