A look at Japanese Fanuc (TYO: 6954), a world leader in CNC and industrial robots~

Mount Fuji (with Fanuc)
Finally got to see Mount Fuji when I was leaving the area on the last day~

Recently I went to Japan for a week for travel, in particular to Tokyo and the Mount Fuji area (Hakone – Gora and Fuji-kawaguchiko).

The first thing that stood out to me when I touched down on Tokyo Narita airport was that I saw Fanuc advertisements everywhere on the trolleys at the airport. Lol. Fanuc is a great company which I have analysed two months ago in August 2018, after a friend of mine brought my attention to it.

And the interesting thing that happened was that when I was in Japan, due to probably escalated concerns over US-China trade war and rate hikes, Fanuc’s share price came down even more, despite already crashing ~30% from the peak this year, which got me more interested.

So, here’s a brief write-up on Fanuc. And do visit my friend’s post on Fanuc too if you are interested.


Fanuc is the world leader in CNC (computer numerical control, i.e. the brains to control machines) and industrial robots. A Japanese company established in 1972 as a spin-off from Fujitsu, it is currently run by the son of the founder. It has commanded more than 50% (up to around 60%) global market share in CNC for decades and around 25% of global market share in industrial robot arms.

Let’s start with two videos that give an overview of Fanuc and its products/services, first one in 2016 and second one in 2018.

Fanuc is one of the Big 4 of industrial robots (together with Switzerland-based ABB, Japan-based Yaskawa, and German-based Kuka). It’s prowess and leadership in industrial robots are both shown in the demand side (largest in CNC, largest in terms of number of robots installed, top 3 in various segments of robots, good branding and reception by customers due to good quality, reliability and service (it stocks much more inventory than the competitors, and it replaces a faulty part in the customer’s factory instead of repairing there, to reduce down time); and the supply side (it’s fabulous production model of producing standardized parts (including rejecting customers’ highly customized orders), building on proven past technology (instead of drastically new ones), to leverage on existing knowledge curve and reduce the number of parts involved, issues with reliability and changes to production lines.

These are shown in its operating margins north of 30%-40% (comparable or even higher than Apple even though it is asset heavy!), significantly higher than the other Big 3 that has between 4%-12% operating margins. What’s more is that Fanuc achieved this on slightly lower selling price of its products than its competitors. So Fanuc’s products, although not using the most innovative technology, are cheaper, proven, reliable, and come with good service (lifetime management and at least 25 years of spare parts available, even for parts for machines no longer produced). And reliability and good and fast services are very important in production plants, where downtimes can cost a bomb (can be tens of thousands of dollars per minute for some customers).

Fanuc has achieved what GM and GE set up to achieve many years ago, to automate the factories worldwide, but failed terribly (after spending lots of money and high-performance management resources), and are now partnering with and helping Fanuc to sell its products (and using them too). Fanuc’s production plants are mainly in Japan (mainly around Mount Fuji – where Fuji eruption is quite a significant risk that can wipe out its factories) and some of them are lights-out factory, i.e. no lights and air-con are turned on because there is no one inside the factories (it’s just lots of robots producing lots of robots, to the extent that the mother robot has to be tied with clear markers so people know which robot is producing which, given the fast speed of movement of robots).

Industrial robots market is picking up now, projected to grow at ~15% for the next few years (so there is sufficient tailwind for the leaders, with increased pie shared by them), given improvements in technology and increase in labour costs in leading manufacturing countries (especially in China, where robot density per production worker is still extremely low). And deep learning, AI and IoT are picking up, and Fanuc has a head start in 2016 (with Cisco, Rockwell Automation, etc), in terms of linking all the robots and machines in its customers’ factories to collect and process all the data (to predict when a robot is going to go down, and thus scheduling maintenance promptly, reducing downtime), and improving the yield of the robots (by using AI to make the robots learn how to do things better and coordinate with other robots).It’s FIELD system is an open platform, akin to the App Store on your smartphone, where developers can develop app for different use of the robots or machines linked. And its ZDT (Zero Down Time) application has already been adopted by its customers and saved them millions of dollars of cost savings.

Albeit having a ROIC of 25%-40% (excluding its massive cash of ~JPY 800b (no debt), which is more than half of book value equity), and having just spent massive amounts of capex for factory and production lines expansion in the past 3 years (of ~JPY 100b per year, dwarfing the ~JPY 30b of capex per year in the previous 7 years), in view of the strong current backlogs of orders and future orders, the market has priced Fanuc lower, sending its price down >40% from the peak early this year, and back to 2015 level, due to concerns of slowing down of smartphone sales (of which the robots that help to make smartphone components, including Apple’s metal casings, are about 1/3 of Fanuc’s total revenues) (and probably due to concerns over US-China trade war). This part of Fanuc’s business is tied to the cyclical smartphone cycles, but its order books for other products are still going strong, and in the long term the cycle would go up and down regardless, with an overall structural uptrend.

I see Fanuc still growing (and leading together with the other 3 of Big 4) in the next 5-10 years, riding on this structural uptrend in industrial robots and automation happening around the world (even SE Asia countries, with relatively lower labour costs) are also adopting them now).

At the current market cap of ~JPY 3.7 trillion, this implies an EV of ~JPY 2.9 trillion, so a EV/NOPAT of about 14x FY2015 (ended Mar) NOPAT (its good year), 23x FY2017, 16x FY2018, or 20x FY2019 (management forecast as at Jun 2018, which is lower than previous years due to slowdown in IT-related industry this year. However, its forecasts tend to be conservative, with it outperforming in the end).

Which can be attractive, from a long-term investor’s perspective, for a high ROIC market leader (3x-10x greater operating margins than largest leading peers based on their firm-wide overall margins (instead of specifically on comparable business segments) with sufficient runway in a market with strong tailwind run by a focused founder-family-management with more than five decades of experience (during the financial crisis in 2009, it shut down its communications with investors, because it wanted to focus on the operations of the business, which some might deem not good).

I personally think Fanuc could reasonably be worth around JPY 3.9-4.5 trillion, or JPY 20-23k per share, and could compound its value at 17-20% a year for the next 5-10 years, based on the reasonable and optimistic scenarios in my valuation below.

Fanuc - Valuation (as at 20 October 2018)
My valuation of Fanuc (as at October 2018)

Another interesting development is the acquisition of German-based Kuka by Chinese Midea Group in 2016/2017, after Midea failed to get its hands on Japan-based Yaskawa. After that event, the German auto manufacturers have been gradually switching out Kuka’s robots which are dominant in the German market, to other players including Fanuc, due to concerns of the Chinese obtaining all the data and know-how of German auto production processes (the robots and machines are now collecting almost all info, so if one gets its hand on the robots, it has a lot of data). So even though Fanuc might face tougher competition from Kuka in the Chinese market (which is growly rapidly and has more than enough pie for everyone I believe), it actually benefited a lot from the German market (and it is expanding its European operations there now aggressively), a market with the 2nd or 3rd highest robot density per manufacturing worker in the world (after Korea).

Mount Fuji - Observing
Admiring Mount Fuji, and contemplating the future of Fanuc~ (Mount Fuji please don’t erupt lol)

Hope you have enjoyed the post and Mount Fuji. Do let me know if you have any comments or insights on Fanuc or this industry 🙂

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Is There Value in Best Pacific International (HKG: 2111)?

Company name: Best Pacific International Holdings Ltd (“Best Pacific”)

Stock code: HKG: 2111

Market cap (as at 14 July 2018): HKD 2.4 billion

Average daily traded value: HKD 0.9 million

1. Executive summary

 

Best Pacific is a China-based textile manufacturer of high-performance lingerie and sportswear materials, with a focus on elastic fabric, elastic webbings and lace. It is the world largest lingerie materials manufacturer, supplying to renowned lingerie brands (e.g. Victoria’s Secret, Triumph, Wacoal, Maniform, Aimer, and Spanx) since 2003, and is increasingly expanding its sales to global sportswear brands (e.g. Under Armour, Lululemon, Adidas, Puma, 2XU and Sweaty Betty) since 2013.

Best Pacific fits my investment criteria – a good company with strong lasting moat (Criteria 1), high returns on capital (Criteria 2) and sufficient reinvestment opportunities (or growth runway) (Criteria 3); run by decent/good management (Criteria 4); and available at reasonable/attractive prices (Criteria 5) – and therefore constitutes one of my key holdings which I intend to hold for long (five years or more, as long as the fundamentals and my thesis remain intact).

The following sections set out:

  • an introduction of the company;
  • details and my views of the company, in terms of:
    1. its moat (criteria 1);
    2. its return on capital (criteria 2);
    3. its reinvestment opportunities (criteria 3);
    4. its management (criteria 4);
    5. the risks associated; and
    6. its valuation (criteria 5);
  • some concluding thoughts.

2. Introduction

Overview

Best Pacific was founded in 2003 by two textile veteran, Mr Lu Yuguang 盧煜光 (current executive chairman) and Mr Kane Zhang Haitao 張海濤 (current CEO), and was listed on HKSE on 23 May 2014, raising around HKD 530m.

In 2004, it began its operations in Dongguan, China, manufacturing and selling elastic fabric products to lingerie players. Subsequently, it progressively expanded its operations, and six years later it started launching more product categories – elastic webbing products (2010) and lace products (2012), becoming a one-stop supplier of the major material components of a typical bra.

In 2013, leveraging on its expertise and knowledge in elastic materials (elastic fabric and webbing), it expanded into a new high-growth market – the sportswear materials market, and the management intends to grow this business segment to a size larger than that of lingerie.

History and development of Best Pacific

02 - History and development of Best Pacific
Source: CICC 2016 report.

Business model

Best Pacific mainly engages in the manufacture and sales of elastic fabrics, elastic webbing and laces.

Unlike an ordinary OEM (original equipment manufacturer), it works in close partnerships with (i) the lingerie/ sportswear brand owners, (ii) the mid‑/ down-stream garment manufacturers and (iii) the raw material (fibre/ yarn) manufacturers, to apply the market intelligence it gains from them and its own R&D activities in designing its products. This R&D activity, innovation capability and close partnership with other stakeholders in the value chain differentiates Best Pacific from a normal OEM/ ODM (original design manufacturer).

Best Pacific’s value chain and business model

03 - Best Pacific's value chain and business model
Source: IPO prospectus.

In addition, Best Pacific specialises in producing fabrics using synthetic fibres, in its case nylon and spandex (or also known as elastane globally outside of the U.S., or associated with Lycra which is a common type of spandex invented by DuPont), instead of natural fibres (e.g. cotton and wool). Synthetic fibres have certain advantages over natural fibres, for e.g. cheaper, lighter, more durable, have more strength, and offer more colours, textures and other properties (water resistant, quick to dry, super elastic, anti-bacteria, etc), and there has been increasing use of synthetic fibres (which have a shorter history) in the market. However, compared to natural fibres, they are much more difficult to dye, which is a key process in the production, and therefore requires a certain level of know-how and skills. Thus, contrary to the general impression of commodity-like textile manufacturers, Best Pacific competes not just on price, but also on technology, know-how, innovation and quality in the synthetic materials field.

Properties of different fibres

04 - Properties of different fibres
Source: Oriental Patron 2015 report.

On the lingerie segment, a unique point about Best Pacific is that it is not only the largest lingerie materials provider in the world (more on market and competitors later), but also one of the few players that provide one‑stop solution for the three (of four) major components of a typical bra, in terms of cost – elastic fabric (29%), elastic webbing (21%) and lace (16%). It does not deal with molded foam (22%), but there has been increasing popularity of bralettes which do without molded cups, so for those products Best Pacific is able to supply almost all the components required.

Components of a typical bra

05 - Components of a typical bra

In terms of pricing, Best Pacific generally adopts a cost plus pricing model, which according to the company has enabled it to maintain a relatively stable gross profit margin.

So, in short, Best Pacific’s business model (which allows it to extract economic rents) is that:

  • it procures textile raw materials and converts them into fabrics which it sells to garment manufacturers or brands, pricing them on a cost-plus basis (where possible) and therefore isolating itself from any changes in raw material costs;
  • it adds value in the process of converting the materials into fabrics, where it utilises and leverages on its PPE base, know-how/skills/technology to understand the market requirements/trends and produce good quality fabrics and innovations (in terms of raw material innovation and end product innovation) that it has developed over years of R&D, market research and close partnership/relationship with its customers and suppliers. It also adds value on the lingerie segment in terms of being a one-stop supplier of the major components of materials, allowing for easier procurement, quality control and consistency and shorter lead time. These are the main value-adding aspects of Best Pacific, which allow it to earn decent/superior gross profits (ressulting in economic rents); and
  • it imposes (financial and operational) discipline on itself to control/ minimise the operating costs of the business, for e.g. by controlling labour costs, adopting automation both in terms of production and warehousing inventory control, strategically locating its production facilities close to customers to reduce logistics cost and lead time, etc. In my view, this is a hygiene factor that Best Pacific has to achieve, which does not allow it to extract additional economic rent (since peers would do the same, and in fact can probably do better due to their larger sizes and greater customer concentration (resulting in less distribution costs) and earn above-average return on capital.

Operations

Best Pacific has the following visions and missions (based on its 2017 annual report):

  • Vision: “Build on innovation and technology” has always been the Group’s vision in developing new products to meet the market demand. Through its dedication in research and development, the Group has developed a diversified portfolio of high-performance lingerie, sportswear and apparel materials, which are blended with quality, comfort and functionalities.
  • Mission: While Best Pacific is expanding and diversifying the customer portfolio with its innovative products across the sectors, we also focus on delivering our social responsibilities and the Group has always aimed at creating a green, healthy and safe working environment, while at the same time educating and equipping our staff with the relevant skills and knowledge to manufacture safe and quality products. Best Pacific not only sees the mission as part of our high corporate governance and social responsibilities, but also considers it a crucial element for the long term sustainable development of the Group.

In terms of operations, Best Pacific has been based in Dongguan, China all the time, until it expanded into Vietnam (2016) and Sri Lanka (May 2018). As at the end of 2017, it has 6,409 full time employees – 91% (5,859) in China and 9% (550) mainly in Vietnam.

In terms of products, Best Pacific produces three product categories – elastic fabric, elastic webbing and lace.

Best Pacific’s products

Customers

Since its operations in 2004, Best Pacific has gradually secured several global renowned lingerie and sportswear brands and developed close relationships with them (which in my view goes to showing its quality products and strong capabilities).

Some examples of customer sign-ups include Triumph (2004), Marks & Spencer (2005), Victoria’s Secret (2007), Wacoal (2008), Under Armour (2012), LuluLemon (2013), Adidas (2013), 2XU (2016), Sweaty Betty (2016) and Uniqlo (2018 – tentative, as I have not been able to confirm this yet).

Currently, it has a broad customer base of over 300 customers (according to a 2017 report by Huatai Financial).

Best Pacific’s customers

However, Best Pacific has a few key customers that constituted a major portion of its sales, in particular Victoria’s Secret (around 25% for both lingerie (12%) and sportswear (12%)), Under Armour (4%), Calvin Klein, Marks & Spencers, Wacoal and Triumph; and is therefore exposed to the sales performance of those customers. This level of customer concentration, however, is low relative to a few of the other strong competitors/peers (e.g. Shenzhou International and Pacific Textile – more on competitors later) which can have ~70%-80% of sales concentrated in top 5 customers.

Details of Best Pacific’s customers

The images below provide a better idea of the type of end products sold by Best Pacific’s customers.

Products sold by Best Pacific’s customers

As seen in the figure below (based on 2014 financials), the sportswear brands that Best Pacific works with has relatively high gross profit margins (>45%), which are potential indicators of powerful brands with a certain level of pricing power.

GPM of sportswear brands (2014)

10 - GPM of sportswear brands
Source: Oriental Patron 2015 report.

Assets & production

As at end 2017, Best Pacific had total assets of HKD 4,215 million (based on book value), with the majority being:

  • PPE – HKD 2,277m (54%);
  • Inventories – HKD 694m (16%);
  • Receivables – HKD 648m (15%); and
  • Cash and bank deposits – HKD 243m (6%).

The majority of its PPE (HKD 2,277m) was:

  • machinery (HKD 1,309m or 58%);
  • buildings (HKD 551m or 24%); and
  • construction in progress (HKD 357m or 16%).

As seen in its asset base, Best Pacific is operating in a capital intensive environment, with more than half of its assets in PPE, of which around 60% of it is machinery. According to a Daiwa 2014 report, “Since the majority of the machines used by Best Pacific are state-of-the-art ones and are imported from Europe (Karl Mayer machines for elastic fabric and lace, Miller machines for lace), we expect machinery purchases to continue to take up the bulk of the Best Pacific’s capex budget.” The costs of these textile-producing machineries are not cheap (especially for lace). Based on data in the 2014 IPO prospectus, the (approximate) cost of one machine for:

  • elastic fabric was HKD 0.39m;
  • elastic webbing was HKD 0.23m; and
  • lace was HKD 5.32m.

In terms of production, the production process is capital intensive as it is highly mechanised, where the company processes nylon and spande into elastic fabrics, elastic webbing and lace (as shown in the diagram below). The production time from raw material to finished elastic fabrics and lace is ~2-3 weeks and ~1 week for elastic webbing, while raw materials are generally prepared three months ahead.

Production process

11 - Production process
Source: 2014 IPO prospectus.

In terms of production facilities, the company has been increasing its capacity for all three product categories greatly over the last few years, more than doubling the capacity from 2013 to 2017 (i.e. a CAGR of 18% or more), partly due to increased capital from its IPO in 2014.

Best Pacific’s production capacity

International production footprint of Best Pacific

13 - International production footprint of Best Pacific
Source: Company 2017 results presentation dated 21 Mar 2018.

The diagram above depicts Best Pacific’s international production layout. Up until 2016, all of its production facilities were located in Donguan city in Guangdong province (and Jiangxi province) in China. On the Dongguan plant, China Securities International indicates in its January 2017 report that [emphasis mine]:

  • Dongguan plant is running at 24 hours a day, with high labour retention rate. There are a total of 3,000 workers in the Dongguan plant, with production running 24 hours a day on 3 shifts of around 8 hours each. The average monthly wage rate is c. RMB 4,000, which is higher than the industry average. Also, a dormitory is provided in Dongguan’s city centre. As such, the worker’s retention rate after the previous Chinese New Year holidays was over 90%”;
  • We are impressed by its high automation production process, making it nimble on capacity adjustment and least vulnerable to wage hike in China, which we believe will be one of its major competitive edges over a shortening order cycle”; and
  • At present, its warehouse is operated manually. BP is planning to upgrade it to full automation in 2017. This is expected to enhance its production efficiency and the estimated cost is RMB 100mn.

In 2016/2017, the company started constructing its first plant in Vietnam, in the VSIP (Vietnam Singapore Industrial Park) in Hai Duong, with a total investment of around HKD 600m, increasing the production capacity for elastic fabric and webbing by ~25%-30% (compared to end 2015). The plant was completed in mid 2017, with the trial production started in July 2017 and the first batch of production conducted in 2017Q3. As at March 2018, there was over 500 staff (~9% of total workforce) employed in Vietnam and the company expected to hire up to 1,200 local workforce in the near future.

According to the company, the reasons for the expansion of production in Vietnam include to leverage on the beneficial tax incentives and the cost savings from lower labour costs and logistic costs, and to be located nearer to its customers (e.g. Regina Miracle (IDM for Victoria’s Secret) and many other brands/garment manufacturers which have been moving their production from China to other countries like Vietnam since early 2010s (mainly in the wake of relatively higher labour costs in China).

Details of Best Pacific’s Vietnam plant

According to a CSI 2017 report, “BP is expected to derive cost savings from logistics (it no longer needs to ship its products to its customers in Vietnam), and lower labour and operating costs (which is 40% lower than PRC).”

Recently, in May 2018, Best Pacific also started a joint venture with Brandix (Sri Lanka’s largest end-to-end apparel solutions provider (with 55k employees vs Shenzhou’s 75k) and an existing long-term major customer of Best Pacific (with overlapping customer base, e.g. Victoria’s Secret and M&S, and other customers like GAP and A&F)) in Sri Lanka, Best Pacific Textiles Lanka (“BPTL”), to manufacture and sell synthetic textiles and textile related products.

The total capital contribution into BPTL would be USD 70m (or, less likely, USD 50m, based on a different source) from Best Pacific (75%) and Brandix (25%), with some in-kind asset contribution (including main factory building structure and store building structure) of USD 1.5m from Brandix. The JV will be managed primarily by Best Pacific and will produce fabrics (with a specific focus on warp knit synthetic fabric) and supply to Brandix, and Best Pacific would become the most preferred supplier.

According to a DBS June 2018 report, the joint venture would require a new plant and construction should finish by the end of FY18F, which would form a substantial part of Best Pacific’s capex for the year.

Details on Best Pacific’s joint venture with Brandix

15 - Details on Best Pacific's joint venture with Brandix
Source: Company 2017 results presentation dated 21 March 2018.

A bit more about Brandix – It also has partnership with Pacific Textile (Best Pacific’s competitor) for a very long time since 2004, through a joint venture called Teejay Lankan Plc, which was listed in 2011 on the Colombo Stock Exchange and focuses on knitted fabrics for the intimate apparel and sportswear industries, with its largest clients being Victoria’s Secret, Marks & Spencer and Intimissimi. This joint venture was more of a cotton fabric producer, instead of synthetic, but has entered into the synthetic fiber segment (due to good growth and demand, and to be a comprehensive one-stop supplier) in 2017 (with acquisitions of companies with such manufacturing facility). However, the focus of the synthetic category is polyamite, different from Best Pacific’s nylon and spandex, so I see it as a different and indirect competition. In my opinion, it might be that Brandix does not have the experience/ capability to manufacture the right type of synthetic fiber, including in this JV with Pacific Textile (allthough I am not entirely sure now). Thus, it had to, or it chose to, partner with Best Pacific recently to go into the synthetic nylon and spandex categories. The fact that it chose Best Pacific, and not Pacific Textile or others, was a positive point to me.

In addition, on 4 December 2017, Best Pacific also entered into a joint venture agreement with MAS Capital (a direct wholly-owned subsidiary of MAS, which is a current major customer of Best Pacific with long-term business relationships, and a reputable leader in the industry of apparel and textile manufacturing with mature international operation systems) in relation to the acquisition of 51% of the total issued share capital of Trischel Fabric (Private) Limited from MAS Capital.

According to the 2017 annual report, “Pursuant to the MAS JV Agreement, the consideration for the acquisition shall equal to 51% of the net asset value of Trischel as at the completion date and, in any event, shall be no more than US$50,000,000. Pursuant to the MAS JV Agreement, the completion of the acquisition shall take place on or before 1 August 2018 or any other date as BPSL (Thulhiriya) and MAS Capital may agree in writing. After completion, Trischel will continue its existing businesses including, among others, the manufacture of warp and weft knitted fabric, and the importation of yarn and greige fabric and complementary accessories for dyeing and finishing for export. Up to the date of this annual report [around 20 March 2018], completion has not yet taken place and Trischel is still owned as to 100% by MAS Capital.”

Details on Best Pacific’s joint venture with MAS

16 - Details on Best Pacific's joint venture with MAS
Source: Company 2017 results presentation dated 21 March 2018.

According to a DBS June 2018 report, “BP should takeover the MAS JV in 2H17, which is an existing operating plant. BP has already deployed staff for this operation and minor profit contribution is likely within FY18F. The Brandix JV requires a new plant and construction should finish by the end of FY18F. The majority of BP’s capital expenditure in FY18F would be associated with this expansion.

A bit more about MAS – It also owns (unclear ownership %) Stretchline Holdings, the largest lingerie elastic webbing maker (5.1% market share in global elastic webbing in 2012, versus Best Pacific’s 3.9%) based on a Frost & Sullivan research. Based on Stretchline’s website, it is the world largest and only branded narrow fabric manufacturer, with many (patented) innovations (LockSafe, Fit-J, BondeLast, Stay4Sure and Fortitube technologies, which are lock-knit, narrow fabric, silicone coating, or puncture resistant fabric wirecasing technologies).

Materials & suppliers

The primary raw materials that Best Pacific uses in its production are nylon and spandex (around 70% of all raw materials based on a Daiwa 2014 report). The company also sources dyes from the suppliers. The cost of raw materials form a large part of the company’s cost of sales, at around 50%-60% in the past five years (2013-2017). It purchases these raw materials mainly from suppliers in China, Taiwan, Hong Kong and other overseas countries, which are manufacturers and sourcing agents of nylon and spandex.

Based on the 2014 IPO prospectus, the company has had business relationships with its five largest suppliers (which constituted around half of its total purchases, which has seen come down to 36% in 2017) for long periods, ranging from four to 10 years. Based on a Daiwa 2014 report, the company’s main suppliers include:

  • Korea-based Hyosung (004800 KS) – Best Pacific partnered with Hyosung to launch a new range of fabrics with MIPAN Aqua X and creora Fresh (with moisture management, UV protection, comfort, fit and freshness from odour neutralising technologies) at ISPO Munich in February 2017;
  • Japan-based Asahi Kasei (3407 JP); and
  • Japan-based Toray Industries (3402 JP) – which has become a substantial shareholder of Pacific Textile in early 2018, the closest competitor of Best Pacific.

Based on my own research, I have also identified working relationships between Best Pacific and other suppliers, i.e.:

  • US-based Eastman Chemical Company (NYSE: EMN) – Best Pacific produces Naia-based fabrics which are hypoallergenic, breathable, have a silky luxurious drape and hand-feel, and have good printing properties; and
  • US-based Invista – Best Pacific has worked with Invista since its mill’s inception in 2003 and launched one of the first lines of commercially available Lycra Sport Power-Comfort-Energy (PCE) index-certified fabrics in mid 2017.

The prices of Best Pacific’s raw materials are affected by the prices of spandex and nylon, which are in turn affected by fluctuations in crude oil prices and the supply-demand economics in the market (e.g. economic crisis leading to lower demand and therefore lower prices, and oversupply in certain markets at certain times leading to lower prices). The chart below provides some idea of the prices of nylon and spandex in China, albeit for an outdated period.

Average price of nylon and spandex in China, 2008-2013

17 - Average price of nylon and spandex in China, 2008-2013
Source: IPO prospectus dated 13 May 2014.

In my view, Best Pacific is exposed to the fluctuations of raw material prices to a minimal extent only, because:

  • it sets its product prices on a cost-plus basis, so as long as it is value-adding (from its R&D and innovation and the quality of its products) and as long as the brands (of which most of them have quite high gross margins and branding/pricing power) or garment manufacturers are not facing tremendous headwinds, it should be able to pass on most (if not all) of the increase in raw material prices; and
  • according to a CICC 2016 report, “Prices of raw materials (spandex and nylon) are influenced by oil prices, while yarn providers hedge the fluctuations. The ASP has been less volatile vs. raw material prices in the past. Judging from historical financial results, the company’s sales have shown steady growth and do not fluctuate together with raw-material prices.”

This, in my view, is supported or evidenced by the company’s relatively stable and high gross margins in the past few years (2017 GPM was affected by other factors – more on the financials later), although these are historical records which do not guarantee that Best Pacific can continue to produce innovative and quality products to justify the price premium of its products.

Best Pacific’s gross profit margins

18 - Best Pacific's gross profit margins
Source: Annual reports.

R&D & innovations

R&D is a big part of Best Pacific, in line with its core value of “Build on innovation and technology”. Historically, it has been spending around 2%-3% of its revenue, or HKD 38m (in 2013) to HKD 80m (2017) a year , on R&D activities.

For example, the 2017 annual report states “The Group is dedicated to catering to the changing market preferences by introducing innovative lingerie, apparel and sportswear materials. For the years ended 31 December 2016 and 2017, the Group’s research and development costs represented approximately 2.2% and 3.0% of its total revenue, respectively.

In terms of R&D, the 2014 IPO prospectus states that “Apart from maintaining close relationships with lingerie brand owners to develop new lingerie materials, we also work closely with out major raw material suppliers, who are leading players in the nylon and spandex industries, to jointly develop new fabrics or materials in response to the evolving market demands. When a new material is jointly developed by us and the supplier, we may request the supplier to enter into exclusively arrangements with us for the supply of the jointly developed material, allowing us to capture the market demands for such new material on an exclusive basis and increase our market share in the global lingerie materials market. The costs associated with our collaborations with our suppliers on research and development are generally shared between us and the suppliers.” [emphasis mine] The company also has a design studio in Qingdao City in order to capture local talents and innovation since 2012.

As at the end of 2013, the R&D team consisted of 91 personnel who are led by Mr. Shi Jiangzhi 石蒋志, a member of the senior management team who has been an employee of the company for ~10 years then, and the company had registered for 30 patents in China which are material in relation to its business.

Three years later, as at the end of 2016, the R&D team has grown slightly to more than 100 personnel (based on a CICC December 2016 report) and the number of patents has at least doubled to more than 60, being a mix of design patents and fabric patents (as at December 2015, based on a Oriental Patron 2015 report). The R&D team is split into two teams, one working closely with the major raw material suppliers, who are leading players in the nylon and spandex (Elastane) industries to develop new fabrics and material, and another team focusing on other research and lingerie product designs. In terms of design, I have only come across data for 2013, where the company generated about a substantial 200 new designs in 2013.

Best Pacific’s R&D facilties

In addition, the company:

  • works closely with a French fashion consulting firm (since May 2012) to assist in design and advise on trends, colors, and choice of threads and materials for elastic fabrics, elastic webbing and lace products;
  • has also opened a School of Management and Administration in June 2016, “which aims to provide generic management training to employees of different managerial level, the first leadership and management training programme was launched during the year and external consultants have been engaged to give lectures to the relevant employees once a month since August 2016”; and
  • has also established a Institute of Technology and Research in June 2016, and during the year, “the Institute engaged external professionals in the textile sector to provide a series of lectures to employees of different positions. The lectures aimed to introduce updated garment design concepts, manufacturing techniques and other industry specific knowledge to the relevant employees, so as to strengthen their knowledge of textile technology and to provide them with updates on the innovation and trends of the textile and garment industry. There were a total of 60 employees from the design team, research and development team, sales team and production department attending the lectures.”

The company’s R&D activities has resulted in a few key innovations, as follows:

  • April 2011, Lingerie material for Victoria’s Secret: In April 2011, Best Pacific’s R&D team developed a material for bras that was granted a patent, and was ultimately selected by Victoria’s Secret for its Body by Victoria’s product line. By developing the material, Best Pacific was able to enter into an exclusivity agreement with Victoria’s Secret to supply the material to its designated OEMs from 2012 to 2014, which laid the foundation for more business.On a separate note, on Best Pacific’s relationship with Victoria’s Secret, according to a CICC December 2016 report, “Best Pacific International became a supplier of the brand [Victoria’s Secret] following a 3-year evaluation of the company’s R&D capabilities, and it now accounts for 50%, 60% and 25% of lingerie material, sportswear material and elastic webbing orders from Victoria’s Secret.” [emphasis mine] This, to some extent, shows the vigour of Victoria’s Secret’s evaluation process and the R&D capability of Best Pacific;
  • Mid 2013, Under Armour SpeedForm: In mid 2013, Under Armour launched its star SpeedForm running shoes (featuring flexibility, comfort, lightness and seamlessness) with the slogan “a bra for your feet,” signaling that core manufacturing technology could be shared between intimate wear and high- tier functional sportswear products. Best Pacific (together with Regina Miracle) was selected as the supplier of the cutting-edge materials for those shoes (the same materials that Best Pacific has developed for bras are now also being used in running shoes).A Daiwa 2014 report states that “To draw a parallel, we would compare Under Armour’s SpeedForm to Nike’s Flyknit footwear product, both of which are considered by the market as potential game changers in the footwear industry and as being highly innovative. The fact that Best Pacific beat other much larger and more experienced shoe makers like Yue Yuen to supply the SpeedForm running shoes is a testament to the company’s technological know-how, in our view. While SpeedForm was launched in mid-2013, Best Pacific was still the only supplier of SpeedForm to Under Armour at end-June 2014.” [emphasis mine]A quote from the 2015 Investor Day of Under Armour says it all: “We made shoes in a bra factory because it enabled us to do things that’s never been done before, by the level of fit and comfort that was unmatched and unobtainable in traditional footwear manufacturing facilities.” Best Pacific, joining hands with Regina Miracle, is part of this breakthrough; and
    20-under-armours-speedform-shoes.jpg
  • June 2017, Invista’s Lycra sport PCE (Power-Comfort-Energy) index: It was announced in June 2017 that Best Pacific, and another textile makers (Taiwan-based Eclat Textile), started integrating Lycra Sport’s Power-Comfort-Energy index criteria in their products.“In today’s global-competitive marketplace, innovation alone isn’t enough,” said Huw Williams, Invista’s global segment director, activewear and outdoor. “You also have to be able to clearly and concisely communicate to customers the advantages of fabrics employing a technology like Lycra Sport. That’s what the Power, Comfort and Energy index enables mills to do.”The new fabrics by Best Pacific leverage the recovery performance of Lycra Sport technology and Best Pacific’s high-gauge, double-knit construction to deliver a high stretch modulus that’s well suited for the high-growth active sportswear sectors. Kevin Zan, general manager of Best Pacific’s sports division, said Lycra Sport PCE, launched last year, has been a game changer when it comes to designing, producing, differentiating and selling performance fabrics.One year later, in July 2018, Best Pacific launched a new consumer-centric LYCRA® Bra Fabric Finder™ (BFF) at the Paris Mode City Show to help consumers pick the perfect casual bra. The new “BFF” consumer initiative builds on the original LYCRA® Bra Fabric Finder™ B2B program launched in 2017, which was created by INVISTA to help designers easily identify the best fabric construction and add functionality to any casual bra collection. While the list of participating mills is global, Best Pacific has built the most comprehensive collection of qualified fabrics.

Market & competitors

Lingerie (materials) market

According to a research by Frost & Sullivan, the global lingerie materials market was worth around USD 8.9 billion in 2015, and had been growing at around 5%-6% in the five years leading to that (2011-2015). Meanwhile, the output of China’s lingerie materials market was around RMB 15 billion (or ~USD 2.4b) in 2015, so around 25% of the global market.

Lingerie materials market size

The global lingerie materials market is highly fragmented, with a large number of Chinese and overseas players. The top five lingerie materials maker took up around 9% of the market (as at 2012). Best Pacific is the largest player overall (2.3%) and in elastic fabric (5.3%), and second largest in elastic webbing (3.9%).

Market share of lingerie materials makers, 2012

22 - Market share of lingerie materials makers, 2012
Source: Daiwa 2014 report.

The lingerie materials industry presents high barrier of entry to new entrants, mainly due to:

  • its capital and labour intensive nature, where large-scale investments in fixed assets, raw materials, technology, human resources and cash flow are required to achieve economies of scale. These investments include the capital investments required for setting up a factory and purchasing machineries with new technology, employing and fostering professional, technical and management personnel;
  • the high environmental compliance standards – with local and foreign countries attaching high importance to environmental issues, the production process involving emission of wastewater is regulated by government constraints and green barriers set by international purchasers. As a result, significant investments required for facilities to control emission of wastewater and compliance with green standards are also likely to pose difficulties for new entrants; and
  • the need to establish operating track record and trust with the customers, where client expansion is difficult for new entrants because it takes time to build trust with customers that demand stringent product quality and such customers have a tendency to purchase from established, qualified and authorised suppliers.

Sportswear market

Sportswear is a large and fast growing market in recent years, due to the trend to be more healthy and exercise more, and the ‘athleisure’ trend. Best Pacific’s 2016 annual report states that “global sportswear market was a supernova in 2016. According to Euromonitor International’s research report, the retail sales value is estimated to show a 7% compound annual growth rate (“CAGR”) from 2016 to 2020, as compared to about a 3.4% CAGR recorded between 2010 and 2015. “One in every six dollars we spend globally on apparel and footwear, we spend on sportswear”, quoted from a Euromonitor International’s research report, which implies the huge potential in the sportswear market and has reaffirmed Best Pacific’s intention to further expand our sportswear business.

Overall textile market

The overall textile industry has undergone at least two major changes in the 2010s, i.e.:

  • manufacturers, both textile and garment, shifting their production bases out from China to other developing countries (e.g. Vietnam and Cambodia), in view of the rising and relatively higher labour costs in China – average monthly wage of USD 700-800 in China vs USD 250-300 in Vietnam (based on a Maybank 2017 report); and
  • industry consolidations, due to challenges in the industry, in terms of cost control and more stringent demands for shorter lead time (to cater to the fast changing trends) and better quality of production and materials (higher performance materials with various features), where the companies that are smaller or less efficient that could not adapt got squeezed out.

According to a Huatai June 2017 report, “Since 2010, many smaller OEMs have shut down operations due to industry consolidation, caused by the rise in labor cost and stringent requirements from brand owners in areas such as environment protection, child labor and work overtime rules. As of March, there are 19,740 enterprises in the textile industry in China, down 40% from the peak level of 33,218 in 2010. We believe the downward trend will likely persist as OEM manufacturers continue to shift to other locations with cheaper labor costs such as Vietnam and Cambodia. We understand that labor costs in some Southeast Asian countries are 50% lower than in China. Companies that can afford to relocate and those who can survive the industry consolidation are deemed survivors with strong potential to increase capacity and win orders from brand owners.

China textile industry details

23 - China textile industry details
Source: Huatai 2017 report.

Competitors/market players

There are many players in the textile industry, with different characteristics, for e.g.:

  • upstream (yarns) vs mid-stream (fabric) vs down-stream (garment);
  • different focus/specialisation in terms of raw materials – natural vs synthetic fibres;
  • different production layout (in terms of the geographical bases); and
  • different business strategy, for e.g. in terms of customer concentration.

The diagram below provides a good overview of the textile value chain, and where Best Pacific sits in that chain.

Sportswear brands supply chain

24 - Sportswear brands supply chain
Source: Oriental Patron 2015 report.

Within this textile value chain, I have a preference for the mid-stream players, as I see it as an area with potentially more companies with moats/ competitive advantages, instead of just a commodity player. Oriental Patron puts it nicely in its 2015 report, stating that “Fabric makers have the edge – We believe the fabric makers are more preferable as they are 1) less labour intensive, 2) more technological know-how is involved, especially in the dyeing process, and 3) less violable to any sudden changes in raw material prices, as they have greater bargaining power to pass on the costs. In fact, we can tell from the gross and net margins from the listed peers. The fabric makers’s average net margins outperformed at 11.8%.

Textile and manufacturing chain

25 - Textile and manufacturing chain
Source: Oriental Patron 2015 report.

As seen in the chart below, the mid-stream players, or the vertically integrated players (from up- to down-stream) generally have higher gross margins, which are indicative of higher pricing power (and potential ability to extract economic rent).

Gross profit margins of textile makers

26 - Gross profit margins of textile makers
Source: Oriental Patron 2015 report.

In terms of Best Pacific’s competitors, each of the players (including the mid-stream ones) has different charateristics and business dynamics than Best Pacific.

The closest competitor is probably Pacific Textiles, where they both deal with synthetic materials and have quite similar customer segments (both lingerie and sportswear) and production bases. However, Pacific Textile has lower gross margins, high customer concentration (Uniqlo and Victoria’s Secret) and low reinvestment activities (its dividend payout for past few years was 100% or more). More importantly, its annual filings have very limited information which basically make it difficult for me to understand the business and its developments, and I don’t want to own businesses that I can’t understand. However, it would be worthwhile tracking Pacific Textiles since it has some overlapping customers with Best Pacific, a different financial year end (March) and a JV with Brandix which is partnering with Best Pacific currently.

The diagrams below provide more information about the different players and their focus/ strength and customer base.

Details and comparison of textile players

27 - Details and comparison of textile players (1)
Source: CSI 2017 report.
27 - Details and comparison of textile players (2)
Source: Huatai 2017 report.
27 - Details and comparison of textile players (3)
Source: Oriental Patron 2015 report.

Regina Miracle is in more of the downstream side (albeit an IDM, innovative design manufacturer, which has some high value-adding activities too) and is a close customer of Best Pacific, producing the garments for Victoria’s Secret, Under Armour and other customers (Adidas, Reebok, Calvin Klein, Maniform, Champion, Bali and Warners). It has lower gross profit margins than Best Pacific, even though it is larger (should be the largest bra manufacturer with a ~1% global market share) and also spends more % (~4%)of revenue on R&D, probably due to its lower-margins downstream garment production activities. Even though this company appeals less to me, it is worth monitoring it given that it is a major customer of Best Pacific and shares similar situations with Best Pacific (similar customers and the expansion of production bases in Vietnam at an earlier time than Best Pacific).

Shenzhou International is another interesting player, where it is a very large (around 10x Best Pacific’s size) vertically integrated player with production bases in various locations (China, Vietnam and Cambodia). It has high gross and net profit margins too (comparable gross margins but higher net margins than Best Pacific due to lower operating costs due to a greater customer concentration (90% for Uniqlo, Adidas, Nike and Puma)), with high return on capital. Without having delved deep into Shenzhou International, I am sticking with Best Pacific for now (which I am satisfied with), partly due to its niche position in lingerie market which gives it a very strong hold in that market (Shenzhou does more of sportswear and general apparel, so less innovation involved, but has great advantage due to its vertically integrated model and fast lead time) and smaller size (thus benefiting from a smaller base effect). However, it’s a company worth exploring more in my opinion, as it would most likely benefit a lot from the industry consolidation.

Overall, I don’t see these big, renowned, or quality players as competing strongly with each other, as the industry is highly fragmented. The very weak or weak players would get squeezed out, which provide rooms for growth for the strong players that remain, and given that it takes time to expand and scale up production in this capital- (and for some, labour-) intensive business, there are still room for the strong players to grow in the next few years without having to compete heads-on with each other strongly. Thus, I don’t need to choose the best player, only a good enough player for my standards (this is not a winner-take-all market), that is available for purchase at a good price.

Financials

This sub-section sets out some summary financials of Best Pacific (more are covered later at the relevant places).

As seen in the table below, over the past four years, from 2013 to 2017:

  • revenue has grown relatively consistently at a CAGR of 14%, from HKD 1.7b in 2013 to HKD 2.8b in 2017;
  • gross profit has grown at a lower CAGR of 10% and profits at a mediocre CAGR of around 5% – This is mainly due to the underperformance in 2017 in terms of profits, which I consider is an one-off depression in margins due to the start-up phase of expansion in production facilities and operations in Vietnam. The first half of the year saw assets (machineries and plants, amounting to additional ~25% production capacity) and personnel (around 500 people, or 10% increase in total workforce) being built up with no revenues at all (and additional expenses due to hiring and training of personnel and other professional expenses), until the trial production in trial production in July 2017 and official first batch production in 2017Q3;
  • GPM and NPM have remained relatively high at ~30% (28%-34%) and ~15% (11%-19%) or more respectively, with lace products commanding the highest GPM (45%-50%), followed by elastic webbing (30%-35%) and elastic fabric (26%-31%); and
  • the mix of different product categories has remained relatively stable, with elastic fabric at around two‑third, elastic fabric one-third, and lace minimally at 3%-4%.

Best Pacific’s revenue, profits, profitability and growth

28 - Best Pacific's revenue, profits, profitability and growth
Source: Annual reports.

Meanwhile, production capacities have grown faster, at around 20% or more per year during the same period, while number of employees have grown by around 19%, but some of the new capacities and personnel have not been fully utilised yet.

Best Pacific’s operating data

29 - Best Pacific's operating data
Source: Annual reports.

In terms of geographical location of the direct customers (not the location where the end garments are sold to), the top three based on revenues are Hong Kong (declining to 34%), China (stable at ~25%) and Sri Lanka (slight downtrend to 15%).

Best Pacific’s revenue by geography (based on direct customer)

30 - Best Pacific's revenue by geography
Source: Annual reports.

In terms of costs, total costs have been revolving around 80%-90% of revenue in 2013 to 2017, with cost of sales being 67% to 72% and operating costs being 15%-19%. There are some operating leverage for the company to tap on now at this point of time (with production capacities not being fully utilised, especially the new capacities, therefore rendering manufacturing overheads to be more of a semi-fixed nature), because as at 2017:

  • variable costs were around 55% of revenue; and
  • semi-variable costs were around 34% of revenue (with manufacturing overheads being 26%) (I have not treated any costs as fixed costs, even though they might be, to be conservative in thinking about operating leverage in a growing business context).

Best Pacific’s costs

32 - Best Pacific's costs
Source: Annual reports.

In terms of balance sheet items, from 2014 to 2017 (2013 is not that meaningful as it was before equity raising via IPO and paydown of debt in 2014):

  • share base has increased only slightly (due to issuance of some share options) at a CAGR of <1%;
  • total equity and net book value has increased at a CAGR of 12%;
  • total assets and PPE have increased at a CAGR of 14% and (a much higher) 27% respectively, which shows the substantial expansion in production base; and
  • leverage has greatly increased from net cash position in 2014 to 43% net-debt-to-equity in 2017, due to the use of cash and take-up of debt to expand production facilities.

Best Pacific’s summary balance sheet

31 - Best Pacific's summary balance sheet
Source: Annual reports.

In terms of working capital, the cash conversion cycle has generally been stable, but was squeezed in 2017, due to increase in inventory days (due to brand customers demanding faster lead time, and stock up of inventory due to increased production layout in more locations) and reduction in payable days (to secure better pricing from the suppliers).

Best Pacific’s working capital cycle

33 - Best Pacific's working capital cycle
Source: Annual reports.

In terms of cash flows:

  • quality of earnings have been pretty good, with net cash from operating activities being 130% to 175% of PAT in 2013 to 2015, although this measure dropped to below 100% in 2016 and 2017 due to greater increase in working capital requirements;
  • the company has been reinvesting its operating cash flows a lot into capex to expand the business and production facilities, with capex exceeding depreciation by a significant margin (sowing the seeds now and reaping the rewards in a few years time, when capex slows down and goes back to a more reasonable sustainable manner, although not happening in 2018 due to the capex scheduled for Sri Lanka expansion); and
  • the company distributes out about half or less of the remaining free cash flows as dividends, at around 25%-35% of PAT (in line with the indicated dividend policy of at least 20% payout), and uses the remaining amounts to build up cash and pay down debt (especially in 2013 to 2015).

Best Pacific’s key cash flows

34 - Best Pacific's key cash flows
Source: Annual reports.

3. Moat

Overall

A company with high return on capital is unlikely to be able to sustain that high level of return over a long time without a strong and lasting moat, and that is not the type of company that I want to own, hence my focus on moat.

In my view, Best Pacific has two types of moat – (i) a strong moat in terms of intangibles, and (ii) a weak (or less strong) moat in terms of efficient scale.

Intangibles

Best Pacific has the following intangibles which allow it to secure existing and new customers and orders, and extract economic rent or high return on capital:

  • close partnership and relationship with both the customers (lingerie and sportswear brands or downstream players (e.g. Regina Miracle)) and the suppliers (synthetic fibre producers) in gathering market intelligence and developing new (innovative) products, e.g. working with:
    • Invista since 2003, and launching Lycra Sport PCE index-certified fabrics in mid 2017, and launching a new consumer-centric LYCRA Bra Fabric Finder (BFF) for the designers in July 2018;
    • Victoria’s Secret since 2007, and developing a new bra material in April 2011, of which it entered into an exclusive supply arrangement with Victoria’s Secret for three years from 2012 to 2014; and
    • Under Armour since 2012, and (together with Regina Miracle) developing and supplying the materials for Under Armour’s star SpeedForm running shoes;
  • strong production and R&D capabilities, including track record:
    • evidenced by Victoria’s Secret’s selection of it as one of its main supplier (in fact, the largest) after a 3-year evaluation of its R&D capabilities and presumably its quality products, becoming the largest global lingerie materials maker in a short period of 10 years (it was already the largest when it IPO‑ed in 2014), and securing of major global brands including in sportswear despite its new entry; and
    • supported by its continuous large spending on modern machineries from European companies (of approximately HKD 0.2m-5.3m per machine, from Karl Mayer and Miller) (with the total PPE now worth HKD 2.3b at end 2017), and substantial spending on R&D (HKD 84m in 2017, or 2%-3% of revenue in the past few years, among the highest in the industry compared with other leading players) with a substantial team (>100 employees, or around 2% of total workforce);
  • a pool of innovation and design inventions and patents developed over the years – more than 60, in terms of both design and fabric patents, as at end 2016 (which doubled from the 30 three years ago in end 2013), and substantial amount of new designs every year (200 new designs in 2013); and
  • a certain level of branding within the industry, for its quality (and pricier) products – according a Daiwa 2015 report, its “market research with multiple players along the lingerie value chain shows that Best Pacific is known among its peers, suppliers and customers for its high-quality but often pricier fabrics [emphasis mine].

These intangibles (relationship, R&D, product quality, innovations and branding) have allowed Best Pacific to secure existing/new customers and orders, and charged a premium on its products, evidenced by its high gross margin (the highest in 2015 compared to some leading peers), as shown in the figure below.

Leading textile players’ R&D expenses and profit margins

35 - Leading textile players' R&amp;D expenses and profit margins
Source: CICC 2016 report.

Although Best Pacific has a strong moat in terms of intangibles currently, which is good, it is also important to figure out the moat trend for this moat, i.e. whether it would become stronger, remain the same, or become weaker in the future, say in the next 5 to 10 years.

In my opinion, Best Pacific is still up-ing its game in R&D and innovations, given:

  • its active decision to increase R&D spending (a higher 3.0% of a higher revenue in 2017, vs. the previous low 2.2%-2.3%, although this increase was partly driven by demands from the brands side);
  • its recent launch of Invista Lycra Sport PCE index-certified fabrics last year (mid 2017) and LYCRA Bra Fabric Finder (BFF) for the designers recently (July 2018) of which it has the most comprehensive collection of qualified fabrics among the participating mills; and
  • its recent strategic collaborations with leading downstream players in Sri Lanka (Brandix and MAS) to produce synthetic fabrics;

and therefore I think that this strong intangibles moat of Best Pacific should remain at least as strong, with optionality for an upward improvement.

Efficient scale

Best Pacific has a weak (or less strong) moat in terms of efficient scale in the lingerie segment, where the niche lingerie segment (with a much smaller total addressable market) has not been a focus of the larger textile players which focus more on the general apparel and/ or sportswear segment (with higher growth).

Best Pacific’s focus on this niche lingerie segment in the first decade of its founding has allowed it to become the leading players in the lingerie field, being the world largest lingerie materials maker (albeit still a small 2% to 3% overall market share).

As a result, as of now, Best Pacific is more established than the other players, both in terms of breadth (where it deals with all three major components of a lingerie – elastic fabric, elastic webbings and lace) and depth (know‑how, R&D, capital and PPE investments, and human capital required to run this business well). This presents a strong edge (and opportunities) for Best Pacific, because:

  • the new/less established textile players would have to fork out substantial capital and time to grow the lingerie business and build track record and relationship with the lingerie brands, which presents inertia and more challenges to them (as compared to Best Pacific); and
  • this allows Best Pacific to leverage its leading position in this lingerie segment, in terms of both breadth and depth/quality, to entrench itself further, secure more orders from existing/new customers and grow its market share, for example by cross-selling its different product categories to existing customers, and offering the solution of a one-stop shop of the major bra components which is valuable in an industry where shorter lead time, consistency in quality and specification (e.g. colour), and ease of procurement (to ensure smooth production/supply chain process) are important.

Market share of lingerie materials makers, 2012

36 - Market share of lingerie materials makers, 2012
Source: Daiwa 2014 report.

This moat in efficient scale, which led to Best Pacific gaining strong trust and relationship with its lingerie customers, has partly contributed to Best Pacific’s progress in cross-selling its products in the past few years (both within lingerie product categories, and across market segments (lingerie and sportswear)), as discussed in its annual reports:

  • 2015: “Benefiting from its strong design capabilities and the strategy to cross sell to existing customers, the Group has started the lace transactions with the majority of its core customers, fully demonstrating the wide recognition and further consolidating the Group’s unique position as a one-stop solutions provider”;
  • 2016: “Our one-stop solutions strategy will further benefit the Group from such trend as some of our major lingerie customers are also expanding their businesses into sportswear, creating further cross-selling opportunities for the Group”; and
  • 2017: “With the effort of cross-selling of our team and our dedication in expanding our market share, the revenue of elastic webbing also reported an increase by approximately 13.1% to approximately HK$941.6 million during the year under review”.

In my view, given the (i) barriers of entry into the lingerie textile industry, (ii) lack of interest from the larger textile players to participate/compete in this niche segment, and (iii) potential consolidation of the industry due to challenges in terms of cost pressures and stricter lead time requirement from the brands, this efficient scale moat of Best Pacific should also remain at least as strong, with optionality for an upward improvement.

4. Return on capital

Historical return on capital

Best Pacific’s historical return on capital has been generally satisfactory and above my requirement (ROE of at least 15%), albeit it has only a short history of four years in terms of periods post-IPO (in 2014).

As seen in the table below, during the period 2014 to 2017:

  • ROA has been around 7% – 14%;
  • ROE has been around 13% – 24%, with:
    • equity multiplier of 167% – 183%, levered up mainly due to debt and payables (54% and 28% respectively in 2017);
    • asset turnover of 66% – 78%, where asset base is mainly PPE, inventories, receivables and cash (54%, 16%, 15% and 6% respectively in 2017);
    • net profit margin of 11% – 19% (GPM, EBIT margin and NPM of 28%, 14% and 11% respectively in 2017);
  • ROIC has been around 10% – 23%, with:
    • invested capital turnover of 80% – 130%; and
    • NOPAT margin of 12% to 20%.

Best Pacific’s returns on capital

37 - Best Pacific's returns on capital
Source: Annual reports.

In terms of returns on new capital, from 2013 to 2016 (i.e. excluding 2017 where major expansions were going on, of which the results were not fully shown yet – and depending on the success of execution of those expansions, the returns would be affected accordingly), the CAGR of of the different measures of returns on new capital was very satisfactory, where the CAGR of:

  • RONA was 21%;
  • RONE was 20%; and
  • RONIC was 35%.

Sustainable return on capital

Going forward, I expect that Best Pacific should be able to achieve overall ROE of between 15% to 20% or more. In terms of Du Pont components, I expect:

  • equity multiplier to come down to around 160% to 170%, due to paydown of debt and potentially reduction in payables % (if suppliers require shorter payment terms for better prices for Best Pacific);
  • asset turnover to recover from the 2017 level of 66% to 71% (average for 2014-2016), as the utilisation for new capacities ramp up; and
  • net profit margin to recover from the 2017 level of 11% to at least 16% (average for 2014-2016, which is lower than that for 2015 and 2016 of 17% and 18% respectively), as the depreciation and other manufacturing overheads (included in cost of sales) get spread over a larger volume/ revenue base as new capacities ramp up, and distribution expenses and administrative expenses come down as a % of revenue due to lower transport costs (to customers in Vietnam as there are plants now in Vietnam) and the semi‑fixed nature of administrative expenses coupled with growing revenue.

Based on the above, the ROE would be at least 18% to 19%, with further upside if NPM is greater than 16%.

This ROE of 18%-19% is reasonable compared to that achieved by other leading peers (see screenshots below):

  • Pacific Textile: 27% in 2014, and 30% in 2017 (estimated); and
  • Shenzhou International: 18% in 2014, and 22% in 2017 (estimated).

Details of Best Pacific’s peers

38 - Details of Best Pacific's peers (1)
Source: Daiwa Nov 2014 report.
38 - Details of Best Pacific's peers (2)
Source: Maybank Jul 2017 report.

5. Reinvestment opportunities

In my opinion, there are sufficient opportunities for Best Pacific to reinvest its earnings to grow its business, moderately in the mid to high single digit growth rate for the lingerie business, and low to mid teens for the sportswear business.

As indicated earlier:

  • according to research by Frost & Sullivan, in 2015, the global and China lingerie materials market was worth around USD 8.9 billion (and had been growing at around 5%-6% in the five years leading to that (2011-2015)) and USD 2.4b respectively, with around 66% of them being the three components that Best Pacific sells (elastic fabric, elastic webbing and lace), so around USD 5.9b and USD 1.6b respectively; and
  • according to a Euromonitor International’s research report in 2016, the retail sales value of global sportswear market was estimated to show a 7% CAGR from 2016 to 2020.

To grow, Best Pacific can grow with the whole market which is growing at mid single digits, and take over some market share (including from makers using natural fibres, instead of synthetic fibres) in this consolidating industry (which is possible given Best Pacific’s good or leading position, especially when compared with those inefficient players without much competitive advantages or niche focus that get slowly squeezed out).

Best Pacific’s dividend policy is a minimum of 20% payout ratio and it has been paying out around 15%-35% in the past five years, averaging 27%.

I estimate that Best Pacific would be able to reinvest around 70% or more of its earnings every year for the next five years, and achieve a minimum ROE of 18%, and therefore a growth in net profit of around 13% (= 70% * 18%). Doing some calculations to see what this means:

  • Best Pacific earned around HKD 300m (2017) to HKD 450m (2016) in net profits, and I expect a profit level normalised for the start-up activities (on the manufacturing overheads costs) in 2017 to be around HKD 400m (see table below);
  • My adjustment of Best Pacific’s 2017 costs and profits

    39 - My adjustment of Best Pacific's 2017 costs and profits
    Source: Annual reports.
  • a reinvestment of 70% resulting in 13% growth means an reinvestment amount of HKD 280m (= HKD 400m * 70%) and increase in net profit of HKD 52m (= HKD 400m * 13%);
  • assuming a minimum net profit margin of 15%, the implied increase in revenue is maximum HKD 350m a year (i.e. similar to the increase in sportswear sales alone in 2017 of HKD 340m, or USD 45m); and
  • this USD 45m is minimal compared with the USD 6b of total addressable market on the lingerie side (i.e. < 0.1%) and a much larger market for the sportswear side (which uses more length of fabric per garment piece), so this increase in size seems possible and reasonable to me.

6. Management

Details

Best Pacific is mainly run by founder-owner-operators and two family members, as follows:

  • Lu Yuguang (盧煜光) (52), the co-founder (in 2003) and current executive chairman, who formulates overall management plans and oversees the strategic business development;
  • Zhang Haitao (張海濤) (48), the co-founder and current CEO, who formulates and executes overall corporate directions and business strategies;
  • Wu Shaolun (吳少倫) (53), Mr. Lu’s brother in-law and the current GM, who is principally responsible for the company’s infrastructure and the general management of Dongguan BPT and Dongguan NHE. Mr. Wu has been with Best Pacific since founding and was given a 5% shareholding in the company by Mr. Lu from his own shares for nil consideration in 2006 in recognition of his contribution to the growth in business; and
  • Zheng Tingting (鄭婷婷) (43), Mr. Zhang’s spouse and the current COO and vice-president of marketing, who is responsible for the overall operations, manufacturing and developing and implementing the sales and marketing strategies.

Photo of management team

39b - Photo of management team
Source: AlphaLab by Fifth Person.

The screenshots below set out the details of some board members and management team, mainly extracted from company filings (there are not much other publicly available information on them). A few notable points are:

  • there are seven board members, i.e. the four executive directors listed above and three independent non-executive directors – Mr. Cheung Yat Ming 張一鳴, Mr. Ding Baoshan 丁寶山, and Mr. Sai Chun Yu 佘振宇;
  • the three executive director gentlemen (Mr. Lu, Mr. Zhang and Mr. Wu) have been with the company since founding in 2003, are all textile veteran (even before the founding of the company) with 20+ years of industry experience (starting with either elastic webbing (Mr. Lu, chairman) or elastic fabric (Mr. Zhang, CEO)), and are still at a decent age of around 50 years old;
  • Zheng (current VP of marketing) joined the company a few years later in 2006 as a sales manager, and then vice president of marketing and also COO for a certain period, and before that she was a sourcing specialist with a stationery company (Parker Pen (Shanghai) Limited) in 2004-2006;
  • the CFO (and company secretary), Mr. Chan Yiu Sing (陳耀星) (39), is a relatively young guy (as compared to the other executives) and is responsible for ensuring and maintaining the standards of corporate governance of the company (note: capital allocation and other strategic financial decision makings are not mentioned in the company filings). He has 12 years of experience in au audit, investment, accounting and finance, and presumably no industry experience;
  • the vice-president of R&D, Mr. Shi Jiangzhi (石蒋志) (36), is responsible for leading the efforts to develop innovative technologies in support of the company’s strategic R&D plans. Although he is young, he has been in the textile industry for 17 years, since 2001. He has joined the company since founding, working in various departments and then supervisor and manager of various departments (including planning department), before being promoted to VP of R&D in April 2011. His academic studies (mainly certificate level) were in computer application and then textile engineering (Hunan College of Textile), and electrical maintenance (Labor Bureau in Xiangan City); and
  • the executive directors are also involved in and hold positions in various local/regional associations (mainly in Dongguan, where the company is based), as follows:
    • Mr. Lu: Since July 2017 and April 2017, Mr. Lu has been appointed as the president of Dongguan City MaChong Association of Enterprises with Foreign Investment (東莞市外商投資企業協會麻涌分會) and as an executive director of World Dongguan Entrepreneurs (世界莞商聯合會) respectively;
    • Mr. Zhang: Mr. Zhang has been a director of the Guangdong Textiles Association (廣東省紡織協會) since November 2009 and an individual life member of the Hong Kong General Chamber of Textiles Limited (香港紡織商會) since September 2013; and
    • Mr. Wu: Mr. Wu has been a member of the High-tech Enterprises Association in Dongguan City (東莞市高新技術企業協會) since July 2009 and a director of the Dongguan City Association of Enterprises with Foreign Investment (東莞市外商投資企業協會) since November 2013.

Details of board members and management team

Alignment of interest & shareholder friendliness

On ownership, the management owns a very large portion of the company of around 73%, with Mr. Lu (the chairman) owning 62% of the company. Thus, the management is aligned with the shareholders as they themselves are large shareholders.

Best Pacific’s management ownership

41 - Best Pacific's management ownership
Source: Annual reports.

However, in such cases where the management has very large ownership (of above 50%), the minority shareholders have to be cautious as to whether the management are thinking of and taking care of the minorities well, or are taking advantage of them (due to their executive roles and large control of the company).

In my view, the management is fine in this aspect based on their past behaviour and actions (or at least no red flag stands out to me), and in terms of the use of cash, has been either using the free cash to pay down debt or distributing the excess free cash back to shareholders, in line with the stated dividend policy of minimum 20% payout ratio (and increasing the dividends per share from HKD 8.5 cents in 2014 to HKD 16.8 cents in 2016, albeit dropping to HKD 5.9 cents in 2017 due to the challenging situation that year).

Besides that, in terms of remuneration:

  • the management has been paying themselves reasonable amounts of salaries with large performance-based components. For example, in 2014 to 2017, Mr. Lu (the chairman) received total compensation of around HKD 4m to HKD 7m per year, which was 3% to 2.5% of profit after tax for the year, and the performance-based component was around 37% to 56%;
  • for the three gentlemen (i.e. excluding Ms. Zheng), the dividends that they received for the year were at most times greater than their remunerations for their executive roles, and especially so for Mr. Lu, where his dividends were 9x to 16x his executive remuneration. This, to me, is a very good point from the perspective of the minority shareholders, because this basically puts Mr. Lu on the same boat with the minority shareholders. If the company does not perform, even though he can still try to pay himself similar levels of executive remuneration, the reduction in the amount of dividends that the company can distribute to him sustainably in the long term would be much larger than what he gets from the executive remuneration;
  • in 2017 when the company were hit on gross and net profits, all of the four executive directors were not paid any performance related payments, which effectively reduced their remuneration by around HKD 1m-4m (or around 40% pay cut compared to the previous year for a few of them); and
  • Zheng received a very substantial sum of HKD 13m of performance related incentive payments, which was almost 7x her fixed salaries. However, I have not been able to identify what those payments relate to, why they were paid and whether they were reasonable, which may be a cause of concern (especially if this happens again in the future).

Best Pacific’s management’s remuneration

42 - Best Pacific's management's remuneration
Source: Annual reports.

Overall, I feel that the management is aligned with shareholders, mainly due to their large stakes in the company, and have been paying themselves reasonable amount of compensation (and not taking advantage of the minorities).

Capital allocation

In my opinion, the management’s capital allocation behaviour has been decent thus far (albeit only a short operating history of more than four years since IPO), due to the following points:

  • the company has indicated and kept the same dividend policy over the years, i.e. minimum 20% payout, and has done so generally (except for 2014) – 25%, 14%, 31%, 34% and 32% in 2013 to 2017 respectively;
  • the company has been using its operating cash flows reasonably over the past five years – by first paying down its massive debt accumulated pre-IPO and building up some cash position at the same time in 2013 to 2015, and then gradually increasing its investments in assets (PPE or production facilities, and working capital) to grow the business to cater to increasing demand and opportunities in the market (especially sportswear) and taking up debt where necessary to a reasonable amount in 2016 and 2017; and
  • in November 2015, the company made an acquisition of 40% of Charming Elastic (and its subsidiary, Jiangxi Charming Elastic Fabric Wearing Company Limited) that was involved in the manufacturing of elastic webbing in China, and was then slightly loss-making (according to a Oriental Patron 2015 report), from Top Form (a listed underwear garment and a leading brassiere maker, and a top 10 clients of Best Pacific),to increase its production capacities to grow. The company paid HKD 9m-10m for 40% then, and then, in 2017 a further HKD 13m to increase its stakes to 51% upon Charming Elastic meeting the financial performance target.Best Pacific’s share of the post-acquisition profit of Charming Elastic was HKD 5m and HKD 4m in 2016 and 2017 respectively. This translated to an annual ROI of 54% based on the first tranch of investment (= HKD 5m / HKD 9m), and at least 21% based on the total of the two tranches of investment (= (HKD 5m + HKD 4m) / 2 / (HKD 9m + HKD 13m)). The ROI of more than 20% on this investment is, in my opinion, good, and provides some indications of good capital allocation skills of the management (at least in this one case).

One minor whine that I have is that the CFO appears to have less experience (both in terms of years, and in terms of industry experience) than the executive directors and therefore may not be contributing to the capital allocation activities of the company much (although I could be wrong). This probably leaves the executive directors to have to take on this very important task more heavily, although they might not have the relevant financial skills (at least based on their academics) to deal with them well.

7. Risks

Main risks

In my view, the main risks facing Best Pacific include:

  • its dependence on its customers’ sales performances, which are subject to changes in trends/fashion that are not easy to predict at times.In Best Pacific’s case, this risk is partly mitigated by its diverse customer base of >300 customers, and lower level of customer concentration of 36% (in terms of revenue) for top 5 customers (as compared to some other leading peers which can have up to 80% or more concentrated on their top 5 customers), which has come down from ~40% in 2014 and 2015 as it acquires more customers.However, its sales to its largest customer, i.e. Victoria’s Secret, still constituted a large portion of total revenue, at around 25% (12% lingerie and 12% sportswear as of 2016), where Victoria’s Secret sourced around half of its supplies (excluding lace materials, which it sourced from others) from Best Pacific. Thus, Best Pacific is subject to some extent to Victoria’s Secret’s sales performance, which has not been good in the past few years, with its same-store comparable sales declining, with it losing market share to others especially to players with more natural-oriented (instead of bombshell-oriented) type of bras (e.g. bralettes) like Aerie (by American Eagle Outfitters, which has been performing very well in the past few years), and with it discontinuing its swimmear product line. Victoria’s Secret’s overall sales growth has turned positive in June 2018 at 1%, although its same store comparable sales (for retail stores) growth are still in the negative 1%-2% region, but its online sales growth has been quite positive (albeit still a small segment).Hopefully, Victoria’s Secret’s sales would start to stabilise more (and recover), and Best Pacific would be able to secure more customers to reduce its exposure to Victoria’s Secret’s sales performance;
  • expansion execution risks, where Best Pacific used to operate only in China, but is now expanding to Vietnam and Sri Lanka, locations with different operating environments and where the management might have less operating experiences. Any delay or disruption in production would affect the revenue and profits of the company.For example, Pacific Textile, a competitor of Best Pacific, faced a special unforeseen circumstance for its Vietnam plant, where the operations were interrupted due to the gateway being blocked by villagers for around 9 months, from April 2017 until January 2018, which adversely affected its financial performance for that period.Meanwhile, Regina Miracle, an IDM and a major customer of Best Pacific which built its first Vietnam plant in March 2016 in VSIP (i.e. the same location as Best Pacific), took around two years of smooth operations for its Vietnam production line to start contributing profits. Going with the same timeline, it might take another year for Best Pacific’s Vietnam plant, which started official production in 2017Q3, to start turning in profits (although Best Pacific has higher margins than Regina Miracle, so it might be able to turn in profits earlier).This expansion execution risk is a risk that would affect Best Pacific continuously, even after it manages to run the Vietnam and Sri Lanka plants smoothly in the future. This is because for Best Pacific to grow (which is still the management’s intention right now, unlike Pacific Textile that just distributes out all free cash flows), it would have to continously expand its production facilities and capacities to be able to manufacture and sell more volumes;
  • foreign exchange movement risks, where Best Pacific mainly sells in USD and HKD, and incurs costs in RMB, so any appreciation of RMB would have some adverse effects on its profitability. To mitigate this risk, Best Pacific “entered into certain foreign-exchange contracts to pay U.S. dollars and receive RMB” (based on IPO prospectus) and “manages its foreign exchange risk by performing regular reviews and monitoring its foreign exchange exposure. Our finance department will monitor our foreign exchange risk on a continuous basis by analysing our domestic and overseas sales order on hand, expected domestic and overseas orders from customers and estimated foreign currency payment for our purchases. We intend to manage our foreign exchange risks by (i) managing our sales, purchases and expenses denominated in Hong Kong dollars and U.S. dollars through our Hong Kong subsidiaries and managing our sales, purchases and expenses denominated in RMB through our PRC subsidiaries; and (ii) holding cash and bank deposits denominated in RMB primarily by our PRC subsidiaries and cash and bank deposits denominated in Hong Kong and U.S. dollars primarily by our Company and Hong Kong subsidiaries” (based on 2014 report). With the expansion of international production layout in Vietnam and Sri Lanka, this risk should reduce; and
  • increasing challenges in the textile industry in general, where the customers (brands) are having greater demands in terms of (shorter) lead time (to cater to the fast fashion trend cycle, and for just-in-time production), lower costs for their raw materials, greater product innovations, etc. This risk should affect more adversely the players that are smaller and do not have any niche, and players that do not have much competitive advantages or moat, and in turn result in industry consolidation with the stronger players (which I think Best Pacific is) staying in the game or emerging stronger. Even then, Best Pacific would have to continuously innovate and produce good quality products to continue to get orders from the customers.

Other minor risks

There are also a few other risks which I deem more minor, as follows:

  • fluctuation (or increase) in raw material prices – In my opinion, this affects the upstream players more. Given its cost-plus pricing model, as long as Best Pacific can continue to produce quality and innovative products (through its R&D activities), Best Pacific should be able to pass on most (if not all) of the increase in raw material costs to the customers;
  • short operating track record as a public company post-IPO – Best Pacific has only operated for around four years as a public company since its IPO in May 2014, and running a public company well could be slightly different from running a private one well, for e.g. the company is now a larger company, more focused on growth and expansion, and has more financing options to consider;
  • interest rate risk – As the company stated in its 2017 report, “With our current reliance on debt financing, the Group expects the overall borrowing costs to increase in 2018. Our management will continue to closely monitor the interest rate exposure and will consider hedging strategies should the need arise”; and
  • greater volatility of lace selling price – According to a Daiwa 2014 report, “ASPs and order flow for lace tend to be more volatile than for elastic fabrics and webbing, as demand for lace is more dependent on trends in fashion and design.” This is seen in 2017, where Best Pacific’s lace revenue declined by 22%, due to the market demand for simpler and thinner lace, which commanded a lower unit selling price. However, lace is still a very small segment in terms of revenue (3% in 2017), so this is less of a concern now.

8. Valuation

My valuation

To value Best Pacific (or rather, to estimate a value that I am willing to pay for), I use a simple P/E and EV/NOPAT multiple approach, and consider three main scenarios – conservative, reasonable and optimistic.

I make the following assumptions for my inputs, for the conservative, reasonable and optimistic scenarios respectively:

  • PAT: HKD 300m (based on 2017 figure), HKD 400m (based on my estimate as explained earlier to normalise for costs associated with the start-up phase of Vietnam expansion in 2017), and HKD 450m (assuming further improvement in margins from improved operations efficiency and utilisation in Vietnam and improved operating leverage, and the HKD 450m is slightly lower than that achieved in 2016 of HKD 456m);
  • NOPAT: HKD 330m (based on 2017 figure), HKD 440m and HKD 490m, of which the latter two are scaled up using the ratios for PAT;
  • Expected growth: As explained earlier, ROE of 18% and reinvestment rate of 70%, resulting in expected growth of 13%;
  • Multiple: 10x (equivalent to 10% earnings yield and close to 10% FCF yield – Best Pacific’s free cash flow conversion is good, although it may get pressure from working capital side), 13x (i.e. same as expected growth level, going by the logic of Peter Lynch’s PEG, which I firmly believe in) and 16x (if ROE or reinvestment is higher than what I assumed for my main case);
  • Net debt (where applicable): HKD 1.0b (based on 2017 figure) for all scenarios; and
  • Shares outstanding: 1.0 bilion shares (based on end 2017 figure) for all scenarios.

My valuation of Best Pacific

43 - My valuation of Best Pacific
Source: My own analysis and annual reports.

Based on the above, I consider Best Pacific to be worth around HKD 4.50 to HKD 5.00 (based on my reasonable scenarios), with upside to HKD 6.60 to HKD 7.00 if things turn out better. These imply a margin of safety of at least 50% based on the share price of HKD 2.34 as at 14 July 2018.

In the conservative scenarios (which do not incorporate any recovery in financial performance from the start-up phase of Vietnam expansion in 2017, which I consider highly unlikely), Best Pacific is still worth around HKD 2.20 to HKD 2.90, translating to a maximum loss of 5% based on the current price.

This situation can be summed up nicely as a “Heads I win, tails I don’t lose up” type of situation, one favoured by Mohnish Pabrai (a Dhando investor with a concentrated portfolio and impressive track record).

On a separate note, my assumed P/E level is in line with Best Pacific’s historical levels, and lower than its peers’ historical levels (although the peers are larger and have longer histories as public companies).

Best Pacific’s historical P/E levels

Best Pacific’s peers’ historical P/E levels

45 - Best Pacific's peers' historical PE levels
Source: Maybank Oct 2016 report.

Floor value

There is also an interesting phenomenon which I have observed for Best Pacific. In my opinion, the market sees Best Pacific as a growth or dividend stock, more so the former, and in such cases the market tends to focus on earnings and forget about assets.

The market capitalisation of Best Pacific has dropped to HKD 2,426m (as at 14 July 2018), which is close to its net book value of HKD 2,301m (constituting HKD 4,215m of assets and HKD 1,914m of liabilities). The HKD 4,215m of assets are made up of:

  • HKD 2,277m of PPE (of which around HKD 1.0b was new additions in 2017);
  • HKD 694m of inventories;
  • HKD 648m of trade receivables;
  • HKD 243m of cash and cash equivalents; and
  • HKD 352m of other assets (HKD 105m of deposits, HKD 103m of prepaid lease payments, HKD 81m of other receivables, deposits and prepayments, and others).

In my opinion, it’s hard to see how a leading textile player (world largest lingerie material maker to top brands, and growing sportswear material maker that has been securing new renowned brands for the past few years), which has spent around HKD 267m on R&D activities (which are not capitalised) in the past five years and produced innovations used by top brands, with more than 15 years of operating history and more than 60 patents (not recognised on is balance sheet), could be worth only its net book value (comprising decent/good quality assets with ROA of above 10%).

Thus, I consider Best Pacific’s net book value of HKD 2,301m or HKD 2.24 per share to form its absolute floor value, which is slightly lower than the current price of HKD 2.34.

As Mike Zapata, a former US Navy SEAL (development group, or more commonly known as the SEAL team 6) member turned fund manager said, “buy on balance sheet, sell on earnings” – in my case, it’s “buy on balance sheet, extract value (as a business owner) from earnings”.

What has the market gotten wrong?

One question worth pondering about (for every investment) is that why I am right, or why the market is wrong. No one knows what the market is pricing in, but my guess is that the market is over-concerned with the expansion activities in Vietnam (and Sri Lanka soon) and the resulting decline in profits in 2017, and potentially any trade wars and economic uncertainties with hot or big money flowing out of Asia back to the U.S. (or elsewhere).

In my view, the market in general tends to not distinguish between uncertainty and risk (which to me is permanent loss of capital), equate the both as same, and discount for them in the security price. This sometimes can present good opportunities for investors who are willing to stomach the uncertainties, especially if those uncertainties do not really pose the same level of risks.

In Best Pacific’s case, I do agree that there are uncertainties, and a certain lower level of risks, involved with the expansions in Vietnam, in the sense that it is not easy to estimate reliably what level of orders, utilisation and improved operating performances can the Vietnam operations achieve, and when. However, I consider all such uncertainties (which do not translate fully into risks) have been priced in, and when all bad things are priced in, the only situation that can unfold is the future is either the same, or positive developments.

9. Concluding thoughts

Overall, I see myself as buying into a good quality business (high ROE and ROIC) with non-excessive leverage (43% net-debt-to-equity now, which should come down in the future) that is swimming with the tide (moderate tailwind in lingerie, and strong tailwind in sportswear) and run by good decent-aged founder-owner-operators who has built this company for more than 15 years (and to the world largest lingerie materials maker (with revenue of HKD 1.7b in 2013) in less than 10 years since founding in 2003, which is an impressive feat to me) with large stakes at play (73% ownership, with dividend payments exceeding the executive remuneration (around 10x or more for Mr. Lu) with substantial performance‑based components) and are still actively thinking about and growing the company for the long term (by going IPO in 2014 and strategically expanding into Vietnam (2017) and Sri Lanka (this and next year), which are long-term initiatives and not short-term goals.

In terms of where I see the business in 5 to 10 years, I see Best Pacific as doubling its overall business in 5-6 years (to revenue of about HKD 6b), with its international production layout maturing and situated close to its customers (lead time is very important) and its R&D team churning out new innovations and sales/marketing team securing new customers for growth and reduction of reliance on Victoria’s Secret, and its sportswear business overtaking its lingerie business (29% vs 71% now) in line with the management’s plans.

In terms of what moves the needles (and hence to monitor), I consider two main things for the long term – first, the ability of Best Pacific to continue to secure more orders from existing and new customers, especially from sportswear, without sacrificing its gross margins; and second, the willingness of the company to continue investing in R&D and its ability to produce new innovations/designs/patents – and one main thing for the short term, i.e. the smooth operations of the Vietnam plant and improvement of its efficiency to levels similar to the China plants.

 

Note: This is not a recommendation to buy or sell. As with all (value) investments, it’s of utmost importance to do your own due diligence. And as Peter Lynch puts it, “know what you own, and know why you own it”.

Disclosure: The author has long position in Best Pacific as at the time of writing.

Riverstone 2017 AGM – 8 Key Takeaways

Riverstone 2017 AGM
Riverstone 2017 AGM at Raffles City Convention Center

Recently, I attended Riverstone’s 2017 AGM on 23 April 2018 at Raffles City Convention Center. I have been a shareholder of the company since September 2016 but this is my first time attending its AGM (finally got to meet the good management in person). It’s held in a relatively small room, with about 60-70 shareholders attending I think.

Riverstone is one of the good companies in my portfolio that I feel very comfortable about holding long-term (and accumulating if the prices are fair), due to various reasons  – high ROE, very conservative capital structure, good industry tailwind, good management with high stakes in the company, reasonably solid moat, well paved expansion plans for the next few years, etc.

Aloysius from the Little Snowball did a very good job covering the company, so I would recommend reading it here (although I have slightly more conservative assumptions than his), especially if you are not familiar with this company.

Before I attended the AGM, I have already intended to hold it for at least another two-three years, unless the fundamentals, the industry dynamics or operating environment changes. After the AGM, I felt even more comfortable with my shareholdings in it, as I feel that the management is honest and down-to-earth and will be there working diligently and smartly to protect the business and our money in it (I was a little bit surprised at how soft spoken and humble Mr Wong Teek Son, the executive chairman and CEO, is, which is quite different from what I expected).

Here are 8 things I took away from the AGM!

1. Riverstone has strong moats in certain cleanroom gloves (especially Class 100)

Cleanroom segment has performed well and better than healthcare last year, and will continue to be the focus for the next few years, given the higher margins and strong demand. Overall market demand for cleanroom gloves is expected to grow at 10% per year, but as the market continue to switch from natural rubber to nitrile rubber gloves (which Riverstone is in), the expected market growth would be higher than 10%. Riverstone’s plan is to grow cleanroom volume by 20% per year steadily, which means taking some market share from both natural and nitrile rubber players. Although the sales volume side should not face much pressure, Mr Wong expects there would be some pressure on both pricing squeeze (2%-3% per year) and costs.

According to management, Riverstone among the few strongest players in cleanroom, with the biggest competitor being Ansell and Kimberly Clark (but one of them focus more on the U.S. and the other on Europe, and less on SE Asia). Within cleanroom, there are many sub-categories, in terms of material (latex, nitrile, PVC coated) and class. Riverstone is especially strong, or probably the best, in Class 100 gloves, with about 50% market share worldwide in terms of volume. These Class 100 cleanroom gloves made up about 20% of total revenue last year. According to Mr Wong, within Class 100, Riverstone has the best technology in the world, where its gloves emit only a certain low amount of electrostatic particles (something like that), and the next best competitor is still very far behind in technology in terms of that measurement. In terms of competition in Malaysia, there are very limited players in Malaysia in cleanroom. Besides that, a barrier of entry for new competitors is that the process to become a cleanroom vendor is longer than healthcare gloves, as the criteria is much stricter.

Riverstone’s cleanroom gloves are also highly customised. We can’t really put a % to how much of its gloves are actually customised for certain customers, and how much % are non-customised standard gloves/ solutions. This is because almost the entire solution/process/product is sort of customised, where Riverstone’s team engages with and work closely with the customers’ engineers in their production sites, for long periods, figuring out the specifications/ solutions that best fit the customers’ situation/demands. Some of their customers have been with them for decades, and they are always constantly working together to continue customising the best solution. Every customer is different, for e.g. each requires gloves that can withstand certain chemicals differently, and therefore it is not a simple standard process. These are the reasons why its customers are very sticky, according to Mr Wong. Furthermore, Riverstone deals directly with most of these customers (instead of going through distributors), which is time and energy intensive, but resulting in a very close relationship with the customers, which Mr Wong sees is one of the competitive advantages Riverstone has over its competitors in the cleanroom segment.

Overall, Mr Wong thinks that the key issue that decides whether Riverstone can perform well in cleanroom in the long run is whether it can constantly catch up in terms of technology, and not capacity/demand issues, as technology is really important in this field.

A side point on cleanroom expansion plan is that Riverstone has set up new service centers in Shenzhen and will set up centers too in Vietnam soon.

2. Healthcare overall demand is still strong

Overall demand for healthcare gloves is now 270 billion units and is expected to be 8% per annum (i.e. about 20 billion units per year). Riverstone is expanding 1.0-1.5 billion units every year, so it’s only a small portion of the total market increase.

According to Mr Wong, it is not easy to develop good and cheap healthcare gloves. The management running the company are very important, and training to personnel is very important too. Given that Riverstone has executed well and is now well recognised by the customers, Mr Wong is confident that this business segment will be consistent, as long as he and the team manage it well.

In terms of distribution strategy, Riverstone relies on distributors for big orders for large companies, which comprise a large portion of its sales. At the same time, Riverstone also specifically allocate some of its sales to small customers, in which it deals with them directly to establish a direct relationship (like its cleanroom segment) and performs some customisation solutions to build the business together with the customers. In short, Riverstone is trying to use its advantage of being a relatively smaller company and craft out some niche and competitive advantage here, instead of just mainly competing on costs and quality.

On issue of potential over-supply and excess capacities in the market, Mr Wong said that he is not concerned. He said that what you hear in the market is only companies/people telling you how much new capacities are coming in, but what you don’t hear is that how much of the existing capacities are old capacities that have to be retired or not being used.

On the recent problems faced by Chinese healthcare glove players due to pollution issues, the extra demand provided to non-Chinese players were taken up by Riverstone competitors, which is why we see Top Glove, etc doing very well in the last quarter. However, given that Riverstone has always been operating at almost full capacity (~90%), it does not have excess capacity to benefit from this situation.

And on R&D, the 20-strong R&D team used to be all doing R&D on cleanroom gloves, but now some of them are working on healthcare gloves to work on innovative products and some upgrading of existing products.

3. Continued efforts in automation will help to drive operating costs down

Mr Wong shared that although they have been implementing automation in the production processes for a few years, there are still much more room for automation. This is because the technology is always changing, and there are always new and better machines/technology that they can adopt. For e.g. two main areas with automation opportunities are stripping and packing, where the expected financial benefits of those automation are to drive the unit costs of that activity (per glove) down by almost 50%.

4. The current expansion plans will last until 2019

The current expansion plans entail building dipping lines (which are interchangeable between cleanroom and healthcare) of 1-1.2b units per year. The expansion plans are until 2019 only, because after that, the company will run out of land and has to find new land.

5. China sales are still doing well

The company has been getting more sales from China, but are not reflected as such in the annual report. This is because when the China orders become big, they would ship the orders from Malaysia instead of from China for various reasons (e.g. tax). Thus, they would be captured under Malaysia’s sales.

6. Mr Wong thinks that the greatest risks/concerns are not on the demand/revenue side, but on the cost side

Mr Wong mentioned that the next few years should be stable growing business, but the key risks (including for the long-term) would not be on the demand/revenue side, but on the cost side. In particular, two points, i.e.:

  • the supply of latex raw material, where the suppliers (like companies XX and XX – I forgot the name, but I mentioned Synthomer which Mr Wong acknowledged too) may not be able to supply sufficient volume (which will also result in increasing prices); and
  •  the supply of resources, in particular water (and electric), as the gloves production processes consume massive amounts of water, and any shortage/disruption of water supply can be quite detrimental to the operations.

7. Other points

  • The recent take-up of borrowing is for Ecomedical Gloves for expansion into Vietnam (which is easier in terms of cash management across different geographies).
  • Receivable days for cleanroom are generally longer, at around 90 days, versus 0-60 days for healthcare.
  • Lim Sing Poew, who joined Riverstone as Group general manager in 2017, is actually the company’s ex-CFO last time. He went to work for a competitor Top Glove for 1.5 years, but came back in the end. (Note: I personally think that this shows something).
  • The company hedges 50% of its sales revenue every month (by selling forwards), and won’t change this hedging strategy because it’s hard to predict the changes. It prefers to focus on the business side, instead of the FX side.
  • The company’s remuneration is highly performance based, both for management and also for all employees to some extent. The staff costs in FY2017 increased by 20%, from RM80m to RM97m, due partly to increase in base salary (which happens every year) and partly to higher incentives for the year (all the employees, including general workers, got a 1-week incentive as the company achieved 10% growth in terms of profit over the previous year). Besides that, the management’s remuneration has a large portion based on performance too, where there is a minimum hurdle in terms of net profit to cross to start getting the profit sharing component, which increases as it crosses higher tier hurdles.

8. Last but not least, Mr Wong will still be here to run the business for the foreseeable future

Mr Wong thinks that the overall outlook for the company is still looking good. When asked whether he would sell out if approached by interested parties (e.g. the bigger glove companies which can benefit from its strong cleanroom segment), his answer for now is no. He said that his health conditions are still okay (although it’s very energy-intensive to run a glove company, due to the high level of focus needed – a disruption or an issue in operations for a few hours can lose a lot of production volumes), he is not in need of those finances too, and he is still passionate about the business, and therefore he wants to continue to run it as long as health conditions permit.

Riverstone 2017 AGM - With Mr Wong
With Mr Wong Teek Son, Executive Chairman and CEO, who doesn’t pay himself any Director’s fees.

I personally am very reassured by this, by his passion/energy for the company (while adopting a conservative approach to grow the business – which protects the downside), which makes me feel comfortable handing my money to these diligent, honest and down-to-earth management for them to take care of it and compound it well (together with the growth of the business).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 3]

In the previous post, we talked about the five reasons why I think Capilano is worth looking at. Today, we will discuss what are the risks and how much I think Capilano is worth.

What are the risks?

Now that we have looked at all the positive points about Capilano, let’s consider the risks that Capilano faces:

  • Honey production risks: The amount of honey crop is highly exposed to weather factors that are uncontrollable by the beekeepers. Bad weather conditions – too cold (the honey bees might die, or they need to consume more of their own honey to generate heat during cold winter), little rain or dry conditions (means less amount of nectar around for the pollinators), strong winds/cyclone (flowers and buds would be knocked off plants, resulting in less nectar available), El Nino, and warm winter (this is cited by an analyst report, to which I don’t understand why) – and pest/diseases can seriously jeopardise the honey crop for that year, and affect both the amount of honey stock (an important ingredient to ensure a smooth business operations) and the level of sales and profits.In my opinion, this is the biggest risk that Capilano, and all other honey packers/producers, face. However, I see this risk as affecting more of the short term business performance (which does not concern me with a long-term view that much), and less of the long term. This is because the stronger players with better cash flows and balance sheets would be able to hold out until the honey season turns better, and still perform reasonably well on average in the long run, unless the bad weather is prolonged over many many years. In fact, the big players might actually end up benefiting in some form. For example, in FY2015, where honey crop was really bad, Capilano took advantage of the situation of lack of honey supply in the market to procure honey and push its market share from 50% to 70% in the Australian market. Overall, I would monitor this risk by keeping an eye on the weather developments and the honey stakeholders’ (Capilano’s, its competitors’ and bee associations’) commentaries on honey production and seasons over time;
  • Strong competition and expansion risks in overseas markets: Although Capilano is very strong in the Australian market, it is less so in the other markets, which it intends to expand its activities. For example, China, a strategic market which Capilano chooses to focus on, has already seen the New Zealand players, for example Comvita, developing and solidifying their bases there for some time, setting out distribution channels and partnerships with local firms. Although the overseas markets are still big enough, I would expect strong competition and retaliation/activities by the competitors, and therefore Capilano would have to plan and execute well in order to establish itself well and expand in those markets;
  • Pricing power in Australia: Beekeeping and honey farming are very labour-intensive activities, especially for Manuka honey, and increasing labour costs would exert pressure on Capilano’s profitability. If Capilano is not able to pass on all the costs increase down to the distributor/retailer that sells to the end consumers, Capilano’s margins would suffer. In this regard, Capilano mainly sells to the big supermarkets in Australia (e.g. Coles and Woolworths) that have great bargaining power, so Capilano would face some pressure from this side too. Earlier, we have already seen Capilano’s gross profit margin declining from 46.3% in FY2013 to 41.5% in FY2016, although it started to stabilise and recover to 42.3% in FY2017. I think that this ties in to some extent with the first risk (honey production risk) too, as a bad season would see the beekeepers producing less honey and therefore demanding higher prices for them (which means higher costs to Capilano) to stay in business, which is probably what’s in play to a certain extent on Capilano’s declining GPM in the past few years (despite its switches in product mixes to higher margin products);
  • Other risks, which include stronger competition in the Australian domestic market (which I think the risk is relatively lower given its stronghold), economic slowdown impacting honey demand, in Australia and/or the export markets (honey, especially Manuka honey, is more of a premium product, which people might consume less during economic downturns), acquisition risks (Capilano’s inability to manage and integrate its future acquisitions, including beekeeping operations, well) and overall development of the Australian Manuka honey industry (for e.g. the Kiwis are currently trying to trademark the use of the word “Manuka” to restrict to only honey produced in New Zealand, which of course, the Aussies stood up to fight against, and challenges on the scientific evidence of the superiority of health benefits of Australian and Manuka honey).

How much is Capilano worth?

And finally, the golden question – How much is Capilano worth? Or rather, how much am I comfortable with considering a position in Capilano (as valuation is an art, and there is no single right answer), as a good company can make a bad investment given the wrong price, and a bad company can make a good investment given the right price. Thus, value investing (value vs price).

Given that Capilano’s debt is minimal (considering its past capital structure) and I expect that its maintenance capex should be close to its existing D&A, to keep things simple, I would value Capilano using a multiples approach (which I commonly use), and in particular just a simple P/E ratio, instead of a EV/operating profit ratio.

Before I discuss my valuation, let’s recap some of the important items that would affect the valuation:

  • in terms of growth, the CAGR from FY2013-2017 for honey sales volume, revenue, gross profit and PAT is 12.6%, 16.5%, 13.9% and 31.6% respectively;
  • In terms of return on capital, the ROE in the past two years (FY2016 and FY2017) is around 17%, with the most recent 16.6% of ROE in FY2017 achieved with the lowest equity multiplier (of 155%) compared with the past few years. The incremental return on capital, based on the CAGR from FY2013-2017, is between 17% to 24% (16.5% for RONA, 19.5% for RONE, and 23.6% for RONIC (remember RONE is, in my view slightly depressed, and lower than this RONIC due to the pare-down of debt)) during a period in which it deleveraged its balance sheet (i.e. reducing the equity multiplier) and building up its inventory (which increases asset base, thereby reducing asset turnover), which means that there is room for potential improvements for its incremental returns on capital;
  • in terms of capital allocation, its past dividend payout ratio has been around 35% – 40% since IPO;
  • in terms of balance sheet, as at the end of FY2017, it had a net debt of AUD 7.8m (AUD 9.0m of debt and AUD 1.2m of cash), receivables (AUD 24m) that were greater than its payables (AUD 21m), and an inventory of AUD 44m.

And here’s how I value Capilano:

  • I value Capilano under three scenarios, which is normally what I do, being a conservative scenario, a reasonable scenario, and an optimistic scenario;
  • I start off with Capilano’s latest PAT in FY2017, of AUD 10.3m;
    1. This FY2017 PAT, based on just accounting numbers, was overstated by one-off net gain of AUD 0.74m (gain on sale of beekeepers assets of AUD 2.07m, minus the downward revaluation of honey stock due to low honeyprice of AUD 1.33m);
    2. However, in my opinion, there are a few other factors that suppressed the FY2017 PAT – (i) losses from its two JVs totalling AUD 0.37m (loss of AUD 0.12m and AUD 0.25m for WA and Medibee respectively) due to start-up phase and bad honey season for WA, (ii) temporary issues for overseas sales, with FY2017 overseas sales declining by AUD 5.2m compared to the previous year, mainly due to tough international market (which is recovering now) and exiting of less profitable markets and products (which is more of one-off nature, and that the company can focus instead on sales of its honey stock in more profitable markets), and (iii) the increased spending of marketing costs for new products (Beeotic) of AUD 2.2m, of which either the costs would taper down after a few years (the company currently still wants to push this product a lot), or these marketing activities, if successful, would result in higher revenue which pulls up the PAT; and
    3. Therefore, I choose to make a net uplift to the FY2017 PAT of between 0% to 10% for the three scenarios, to arrive at a sustainable/normalised level of PAT going forward, for me to apply my assumed P/E on. I consider this 10% max net uplift (of around AUD 1m) to be reasonable, given the substantial decline in overseas sales of AUD 5m which could potentially recover (either soon or in one or two years’ time). This would be something that I would monitor in Capilano’s FY2018 H1 and full year report, to see whether my assumption is reasonable and whether any adjustment is needed;
  • For P/E multiple, I use a range of 15x to 18x for my three scenarios, with the mid-point of 16.5x for my reasonable case.
    1. For my conservative scenario, I see it as a worst case scenario where Capilano does not garner any substantial growth in the future, and merely keeping up with inflation or rise in costs. In this case, given Capilano’s strong ability to convert profits into cash flows and low capex needs, I deem a 15x P/E, or 6.7% earnings yield, to be sufficient for my appetite, since it can almost distribute all of the 6.7% earnings yield as dividends, although this scenario is highly unlikely given the short term growth opportunities still available to Capilano;
    2. For my aggressive scenario, I choose a P/E of 18x, which is lower than its CAGR (FY2013-2017) for profits of 31.6% (which is artificially boosted by enlarged equity base) and closer to its CAGR for revenue of 16.5%.Now, let’s try to put the returns on capital into the equation. I would say I would expect Capilano to be able to achieve incremental return on capital of between 19.5% (based on its past RONE) and 23.6% (based on its past RONIC). To be conservative, I would use a lower number of 20% for my valuation. This means that my assumed P/E of 18x is still reasonable as it is lower than the 20% incremental return on capital (which, in most cases, sets the upper limit of the level of earnings growth). This also means that if I want a PEG of 1x, my assumed P/E of 18x would entail the company reinvesting about 90% of its earnings, which is possible, but unlikely.As a side point, if Capilano takes on slightly more leverage (than its current net-debt-to-equity of 13%) and can manage its working capital, especially inventory, better, there are still rooms for improvements for its incremental returns on capital;
    3. For my reasonable scenario, I take the mid-point of the two P/Es above, resulting in an assumed P/E of 16.5x, which I consider quite reasonable. If not for the high exposure risk of honey production to weather conditions, I would be more comfortable with paying a higher P/E.In addition, to achieve a PEG of 1x, or earnings growth rate of 16.5x, this means that the company has to either reinvest 83% of its earnings, which is unlikely (but still possible if there are sufficient reinvestment opportunities) as it is higher than its past reinvestment rates of 60% – 65%, or take on more leverage to boost its equity returns, or achieve an incremental return on capital of 25.5% (assuming 65% reinvestment rate), which is slightly higher than its past RONIC of 23.6%, and is possible.At a reinvestment rate of 65%, the growth in earnings of Capilano would be around 13% (= 20% * 65%). Also, at a P/E of 16.5x and an assumed dividend payout of 35%, this would mean that my dividend yield would be around 2% (= 1 / 0.165 * 0.35).
  • I deduct a net debt of AUD 7.8m from my valuation, to be conservative (although this is theoretically wrong given that I have used P/E, instead of EV/operating earnings, in the first place). I would say this is quite conservative, given that if we look at Capilano’s last working capital position, its receivables is higher than its payables (by a few millions) and it had a closing inventory of AUD 44m, which it had paid in cash for and could use to generate revenues and profits without incurring any cash costs (although acknowledging that it would require a reasonable level to inventory to run its operations, which in FY2014 and FY2015, it was surviving at about half of the current inventory (AUD 14m and AUD 23m respectively, although it has a much larger operations now with more JVs and acquired companies).

Based on these assumptions, I value Capilano (see table below), in today’s terms, at around AUD 170m to AUD 200m, or around AUD 18 to AUD 21 per share, based on my reasonable and optimistic scenarios. In my conservative scenario, which I consider to be a very unlikely worst scenario, Capilano would still be worth around AUD 150m (or AUD 15.50 per share) as a floor.

Capilano - Valuation (Jan 2018)

Going with my reasonable valuation scenario, I would expect my returns from being a partial owner in Capilano, based on a 35% dividend payout, to come from a 2% annual dividend yield and the capital appreciation of Capilano arising from an increase of its operating earnings by around 13% per annum, giving me a total return of approximately 15% per year. This 15% total return is purely a guide, and of course, would be affected by both positive and negative fundamental developments over the years, and the lack of adequacy of my analysis. Hopefully, I would see more positive developments (e.g. a recovery to a higher level of normalised/sustainable earnings, and/or higher RONIC, arising from either better pricing power, better asset turnover, switch to higher-margin products, more efficient operations, good honey seasons, etc).

On the last point, Charlie Munger always likes to say that “all I want to know is where I’m going to die so I’ll never go there”. Putting myself in this shoes and thinking what could kill my investment in Capilano, I see the worst worst case scenario as one where there are:

  1. prolonged bad honey seasons (due to bad weather/diseases/crazy human acts resulting in bad crops and/or death of honey bees);
  2. worsening of Capilano’s performances in its export markets (due to increasingly stronger competition) and probably its local market too (declining gross profit margins, or if competitors decide to scale up or undertake price cuts in good honey seasons);
  3. strong retaliation from competitors in the China market (in which it intends to strategically invest in (which requires capital)), resulting in prolonged price wars;
  4. cock-ups in its two JVs (maybe due to inexperience in bee farming);
  5. sabotage of Capilano’s branding in Australia (we have seen one in 2016, in which Victorian apiarist Simon Mulvany waged a social media campaign against Capilano, accusing it of selling “toxic”, imported honey and of using misleading labelling);
  6. departures of key senior management, including Ben McKee who has been appointed as CEO in 2012 and MD in 2013; and
  7. New Zealand winning its bid to trademark “Manuka” honey, which would create a mess for the worldwide Manuka honey market.

In a simulated quite awful and unfortunate case, with probably up to four of the factors above happening at the same time, I see Capilano’s profits dropping to around AUD 7.5m (about 73% of its FY2017 profits), and at a P/E of 15x, it would be worth around AUD 110m, i.e. ~35% less than my reasonable valuation of AUD 170m. Hopefully, I won’t get to validate the accuracy of such a valuation. In any way, forcing myself to think about these disasters, or where I would die, would make me more alert to which are the most important factors to monitor and stop me from going there (hopefully, in time).

 

Note: This is not a recommendation to buy or sell. As with all (value) investments, it’s of utmost importance to do your own due diligence. And as Peter Lynch puts it, “know what you own, and know why you own it”.

Disclosure: The author has long position in Capilano as at the time of writing.

P.S. If you want to receive updates on my future posts, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 2]

In an earlier post, I wrote that, in my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Today, we will visit these points in turn.

Why I think Capilano is worth looking at?

1. Good business economics of Capilano’s honey packing business

Capilano’s honey packing business has good business economics, reflected by its strong financials. When it comes to business economics and financials, the most important thing that I look for is strong returns on capital (ROA, ROE and ROIC).

Capilano has excelled in this area, for a packing/distributor business model, with strong ROA (around 9%-11%), ROE (16%-23%) and ROIC (12%-18%), and crazy ROPPE (24%-49%) in FY2014-17, while not employing moderate leverage (net-debt-to-equity of 13%-27%) during the same period.

Capilano - Returns on capitalCapilano - Leverage

To understand why Capilano is able to achieve such strong returns of capital, it is important to understand its business model and the assets that drive its returns and growth first.

In terms of business model, a honey packer, like Capilano, basically just purchase raw honey from the beekeepers families/enterprises at a reasonable price, filter them, pack them into nice containers or glass jars in its high-tech factories with a high level of automation (it has just over 120 employees who oversee the honey packing process in its head office, implying almost AUD 1m of annual revenue per packing employee), give them some branding labels and pushes the products into domestic retail channels (supermarkets/ pharmacies/ health food stores and grocery stores) and overseas markets (either as retail or industrial products).

In simple terms, it means Capilano is almost just a middleman who consolidate the honey and sell them. Therefore, Capilano’s most important asset is not its fixed assets (to be more specific, its PPE), but its inventory, i.e. raw honey stock.

A quick look at its balance sheet explain this. As at the end of FY2017, its total assets of AUD 96m is mainly made up of inventories (46% or AUD 44m), followed by receivables (25% or AUD 24m) and PPE (22% or AUD 21m).

Capilano - Assets

This makes logical sense, because to pack and sell honey to increase sales, you need honey in the first place. Since Capilano mainly sources its honey from others, it doesn’t require as much PPE (or biological assets, aka bees) to generate those honey. Therefore, inventory, and the ability to purchase and stock up sufficient inventory, is crucial for Capilano’s business. Fortunately, Capilano is good in this – it has a very strong access to honey supply, which is one of the factors I think Capilano is worth looking at, which I will touch on shortly.

Now that we understand Capilano’s business model and asset components, let’s go back to revisit its returns on capital and understand its components. To keep things simple and focused, let’s focus on just ROE.

Capilano - Returns on capital (short)As seen in the table above, Capilano’s ROE started at 16% in FY2014, went up to 23% in FY2015, before coming down to 17% in FY2017. Although the ROE in FY2017 sort of went back to its original level three years ago, its individual Du Pont components have changed quite some extent:

  • Equity multiplier has come down from 174% to 155%, which to me is a good thing, since the current returns are achieved on a less leveraged capital base (which also mean that future ROE can increase if the company can take on and manage more liabilities carefully – a large part of its liabilities is mainly payables (61%), followed by debt (26%));
  • Asset turnover has come down from 173% to 138%, which is not a positive thing to me, but the comforting part is it has started to stabilise and hopefully it would go up in the future. My take on the declining asset turnover is probably that the company has been acquiring many different companies/assets (which I will touch on later) which disrupts/changes the mix of the asset turnover, coupled with quite bad honey production seasons in the past few years (which I will also touch on later);
  • NPM has gone up by 45%, from 5.4% of revenue to 7.8% of revenue, which is a very positive thing. This indicates improving operating efficiency (even on the back of declining GPM) and Capilano’s ability to compete with competitors successful and still increases its profitability (by spending much marketing expenses in terms of % of revenue), which I attribute partly to Capilano’s strong brand (which is one of its moats, which I will touch on later).

The good part is that it is not just its existing returns on capital that are strong. Its incremental returns on capital are solid too, at north of 16% up to 24% depending on which returns on capital we look at (see table below – focus on the CAGR and not the yearly incremental returns which are quite volatile). One point to note is that Capilano’s RONE is lower than its RONIC, and is in my view slightly depressed, mainly due to the use of its retained earnings to pare down long-term debt during that period (resulting in a greater increase in the equity base than the invested capital base).

Capilano - Incremental returns on capital

These strong RONIC (and RONE) would ensure that our shareholder money is well spent and generate good returns when the company grows (which I call good growth – not all growth are good and value-accretive for shareholders).

These are all positive indicators, but remember, as we have just discussed, no matter how good the returns on capital are, the most important capital/asset that the company needs to grow is not the fixed assets which the company can build easily, but a strong and sustainable (and even better, increasing) supply of good raw honey at reasonable prices, which I will touch on next.

At this point of time, some of you might be also thinking if the ROIC and RONIC are so good, why aren’t other players coming in and taking a piece of the cake? The answer is it is difficult, as Capilano is protected partly by the difficult nature of beekeeping (it is much more difficult compared to other primary agricultural industries) and partly by its strong moats (intangible assets and efficient scale), which I will touch on shortly.

2. Strong access to honey supply

Capilano has very strong access to one of the most important ingredient to be successful in this honey packing business, i.e. good honey supply (at reasonable prices).

The first question to answer is what’s so difficult about procuring honey supplies, especially the Manuka honeys? The answer is that rearing bees and farming honey (especially Manuka honey, which requires beekeepers ensuring that the bees only pollinate from the Manuka plants) are not easy. I think OTC Adventures explains this very well, so I will just quote him.

I think Capilano is somewhat sheltered from competition by barriers to entry that honey suppliers face. First, adding honey-making capacity is a lot more complicated than, say, increasing corn or wheat acreage. A field can be planted with whatever crop offers the best prospective return at the moment, but increasing honey output requires building infrastructure that can only be used to produce honey. For bee-keepers to justify adding capacity, they must be confident that higher prices will last. Essentially, the honey price cycle moves much more slowly than those of easier to produce agricultural products.

Therefore, due to the difficult nature of beekeeping business, the supply of raw honey in Australia is limited and if we talk about Manuka honey, there is a strong under-supply due to strong and growing demand for this health product, especially increasingly from emerging markets (think China).

Based on Australian Honey Bee Industry Council (AHBIC), as of August 2017, there were around 21k beekeepers and 647k bee hives in the whole of Australia, with 85% of the total bee hives owned by 8% of the beekeepers (the larger producers with more 50 hives or more), and most of the bee hives located in New South Wales, followed by Queensland, Victoria, SA and WA (Capilano sources from all these five territories/states).

Capilano - No of beekeepers

So how does Capilano manage to get this strong access to honey supply in Australia? Capilano got a strong and lucky hand, due to its origin as a bee-keeper cooperative in 1953, which allows it to develop strong and lasting relationships with many beekeepers for many decades (it currently sources from more than 600 beekeepers, on top of its wholly-owned beekeeping enterprises). Furthermore, in the past, the bee-keepers are required to own a certain number of shares in Capilano for each bee hive in operation (this has been discontinued), which gave them incentive to supply their honey to Capilano but not others.

Besides this natural advantage, Capilano has also been making it a priority to take good care of the beekeepers and paying them good prices for their raw honey, so that the bee-keepers will choose to sell their honey to Capilano and have confidence that Capilano would continue to procure from them at good prices even in difficult market conditions, as it knows that it needs these beekeepers to stay in business so that it would continue to get sufficient honey supply.

Capilano is able to do so (i.e. pay the bee-keepers good prices) as it is able to pass on some of the price increase to the end consumers due to its strong branding, with a >70% market share (which is one of its moats, falling under the intangibles category) and it has lower fixed costs per product unit due to its large business size.

Besides that, Capilano also spent a great deal of efforts to help the beekeepers. For example, Capilano undertook two initiatives in FY2015 – producing a Pest Management Pack for Varroa, a potentially serious pest of bees if or when it arrives in Australia, and a Manuka Information Pack, for the beekeepers.

The outcome of Capilano’s efforts in developing good relationships with a large network of bee-keepers (currently more than 600 bee-keepers) is the development of a strong moat, i.e. intangibles, relating to its strong and long-lasting relationship with bee-keepers, that allows it to gain access to sustainable supply of honey and protect its high returns on capital.

This limited supply market of honey also creates another moat (efficient scale) for Capilano, as the market is not large enough, from the supply side, to support more new entrants (which have to incur large capital costs that can be spread over less scale at the beginning), thus setting up high barriers of entry to new entrants.

Despite having a strong supply network of bee-keepers to source its honey from, getting sufficient honey supply (to ensure an efficient packing process and sufficient stock for sales) is still a difficult feat for Capilano, as the honey production season is highly affected by weather conditions. A bad season, like very cold weather or little rain (the plants grow less and flowers bloom less), can result in bad honey crops.

These bad honey seasons happened in the past few years, in FY2014 and FY2015, with some improvements seen in FY2016 and FY2017, as seen in the chart below (sourced from Capilano’s FY2017 AGM presentation).

Capilano - Honey supply security

To further ensure supply security of honey, Capilano has recently gone upstream into the bee-keeping business, which to me is a positive development since honey supply is such crucial in this business. In particular, Capilano invested in three entities (Kirksbee Honey in July 2015, Medibee Apiaries in July 2016, and Western Honey Supplies, also in July 2016):

  • Kirksbee Honey: On 30 July 2015, Capilano acquired 100% of the share capital in Kirksbees Honey Pty Ltd, a beekeeping enterprise, for AUD 5.3m (made up of AUD 3.2m of plant and equipment + AUD 0.13m of biological assets + AUD 2m of intangibles). Capilano also purchased the land and buildings associated with the business for AUD 0.75m, therefore paying a total of AUD 6m for the deal.This beekeeping enterprise is one of Australia’s largest active Manuka honey producers, which is located in Evans Head, New South Wales. The acquisition included the assets required to operate the business including bee hives, apiary sites, vehicles, related property, sheds and honey extraction equipment. In FY 2015, the beekeeping enterprise produced over AUD 2m worth of bee products, which implied that Capilano paid a P/S of around 3.0x for the deal (= AUD 6m/ AUD 2m). According to the company, Kirskbee was attractive to Capilano as a consequence of:
    – the notable Manuka floral apiary sites the business has access to;
    – the provision of future assurances in its supply chain with regard to high value Manuka honey supply;
    – the potential to grow production over time; and
    – the ability to train and foster new industry entrants to the beekeeping industry.A news article in March 2016 states that “[l]ast year Capilano bought the country’s largest Manuka beekeeping operation at Evans Heads in NSW for $6 million, in the hope it would cash in on the China-Australia free-trade agreement. Health-conscious Chinese are interested in the purported medicinal benefits of Manuka honey, which is produced by bees that feed on the flowers of the scrub-type tree species of the same name, native to Australia and New Zealand, well known for its antibacterial qualities. With China’s demand for Manuka honey increasing, Capilano Honey is ready to reap the FTA’s rewards, aiming to get ahead of its New Zealand competitors. Under the agreement between China and Australia, the 15 per cent tariff on natural honey and the up to 25 per cent tariff on honey-related products will be removed for Australian honey exports to China”.

    Given that the acquisition price was around AUD 6m (although the most part was for PPE and intangibles), which was about 77% of Capilano’s profits of AUD 7.8m in FY2015, and that Kirksbee seems to be one of the then largest Manuka operation in Australia, I would expect Capilano’s honey supplies to grow significantly after its acquisition. However, Capilano’s domestic honey receival in FY 2016 was only 11%, or 1,235 tonnes greater than the previous year (see table below), although I have limited information on these data and there may be other factors affecting the honey crop that year too. Overall, with Kirskbee, Capilano should have stronger and better access to Manuka honey supplies, although all these should have been reflected in the financials in the past two years (FY2016 and FY2017).
    Capilano - Honey stock

  • Medibee Apiaries: In July 2016, Capilano and New Zealand based Manuka specialist Comvita (CVT.NZ) formed a 50:50 JV, called Medibee Apiaries, to secure greater manuka honey volumes in Australia and to develop medical and natural health products. On 29 July 2016, Capilano sold its manuka beekeeping assets into the JV for AUD 9.225m. AUD 2m of these proceeds were redeployed as a loan to the JV to fund its growth.The FY2016 annual report describes this as “[i]n a significant departure from our previous dependence on the purchase of honey and bee products from other beekeeping enterprises, Capilano has begun to vertically integrate by investing in selected beekeeping enterprises, primarily in the production of high value Leptospermum honey used in our premium range of medical and natural health products. These operations will be managed by Medibee, a 50/50 Joint Venture with Comvita who are a New Zealand company that have extensive production and marketing expertise from their own operations in New Zealand and who currently operate in Australia in a sales and marketing capacity. We expect this new joint venture to assist our business by increasing the security of supply and by expanding our involvement in the international value chain for Leptospermum or Manuka honeys”.In FY2017 H1, Medibee has been focusing on growing the number of bee hives organically first, before focusing on the honey production. As stated in the FY2017 H1 report, “[t]his financial year we started two primary production joint-ventures, one a Manuka focussed operation in northern New South Wales and the other based in highly productive regions of Western Australia. In both cases we have organically grown beehive numbers to minimise disease risk, which requires splitting existing hives and initially reducing honey production. This work has increased hive numbers that will improve our production performance in coming seasons”.

    And in FY2017 overall, Medibee is still in the midst of developing the beekeepers’ skills and acquiring additional flora resources, and at the same time, increasing hive numbers to fully utilise current floral resources. In FY2017, after a full year of operations, Medibee incurred a net loss of AUD 246k (with a revenue of AUD 1.58m and total expenses of AUD 1.83m). Even though Medibee is still loss-making and is still building up its foundation, the honey production has already been quite promising. In particular, the management states that “[o]ur two primary production joint ventures have now completed a full year of operations and while the focus has been on expanding the hive numbers to allow them to fully utilize the resources they have access to, they have also produced a reasonable crop of honey. Most pleasingly, they have been able to match and in some cases exceed the production of other similar businesses that operate in the same geographic regions in a below average season” and “[d]espite a low production season this year that impacted profitability we remain confident of the future positive earnings potential of this venture, in addition to the benefits of improved supply security”.

    Overall, I am very positive about this development for a few reasons.

    First, this joint venture and move to upstream activities would allow Capilano to have more control and management over its honey supply base, on top of providing it with more honey supply to fulfil the market demand (over the years, Capilano has been importing honey from overseas (especially Argentina), which it blends with its Australian honey and sells under its Allowrie brand, to fulfil market demand. To get an idea of how big this issue is, in FY2015, Capilano bought 9,265 tonnes of domestic honey and 6,000 tonnes of imported honey, although I suspect the amount of imports has decreased since as the domestic honey production improves).

    Second, this is a joint venture with Comvita, the world and New Zealand largest Manuka player, with its more than double Capilano’s size in terms of market capitalisation, and has extensive experiences and skills in producing Manuka honey in New Zealand, and therefore Capilano would be able to leverage off Comvita’s experiences while Comvita benefits from Capilano’s Australian base. I suspect that Comvita wanted to come into Australia for honey production,because of the more difficult and volatile operating environment for honey production in New Zealand, compared to Australia (Watson & Son New Zealand, a popular Manuka honey brand, was put into liquidation in September 2016, due to the worst honey season in 35 years which affected Watson & Son’s cash flows).

    Third, this joint venture is already showing some results. In FY2017, Medibee was the single largest supplier of Manuka honey to Capilano, providing it with AUD 1.2m worth of honey, and it has around 3,600 hives as at October 2017 (according to Comvita’s data; Comvita had around 30,000 bee hives in New Zealand in June 2016). As Capilano gets from Medibee more and more Manuka honey, which commands higher margins, to sell them, I expect that Capilano’s gross margins would go up, in line with its strategic focus to switch to more premium high-margin products.

    Last, an analyst report states that “[i]n addition to the JV earnings, CZZ will also earn revenue from packing and supplying Comvita’s products in Australia”. This arrangement seems positive to me, but I have been unable to get more information on this.

  • Western Honey Supplies: Unlike Medibee, this is a joint venture that focuses on the supply of normal honey (and not Manuka honey). On 7 July 2016, Capilano Honey Limited acquired 50% of the share capital in Western Honey Supplies Pty Ltd for a cash consideration of AUD 2.5 million and established a 50/50 Joint Venture with Western Australia honey producer, Spurge Apiaries, to provide geographic diversity, secure supply and grow production. On 26 August 2016, Capilano Honey Limited sold 77 apiary site licenses to Western Honey Supplies Pty Ltd for AUD 363,116.Based on the FY2016 and FY2017 reports, “Capilano has entered a joint venture with an existing contracted honey supplier in Western Australia to assist the expansion of this already large honey producing enterprise. While these enterprises will help to secure Capilano’s supply base they will also give us a platform to train and assist potential new entrants into honey production either as employees or ultimately in their own right. We will endeavour to use them to assist rather than compete with our existing contracted supplier base who are mostly very efficient family based businesses” and “Western Honey Supplies is a Joint Venture with a large existing supplier based in Western Australia (WA). Its main focus is increasing supply security of premium floral and organic honey from WA. This venture has also made strategic acquisitions to increase floral resources and invested in increasing hive numbers. One of WA’s worst production seasons last year also impacted profitability, but enabled efforts to focus on hive number expansion and beekeeper skills development for the future betterment of the business. Western Honey Supplies was the single largest supplier of WA honey to Capilano this financial year and is one of our top five suppliers nationally”.
    Although Western Honey Supplies also made a net loss of AUD 122k (with a revenue of AUD 1.0m and total expenses of AUD 1.1m) in FY2017, I see it as a long-term strategic investment which is incurring start-up phase costs, where it was increasing the number of bee hives and floral resources. As with Medibee, the management said that “We are confident of the future positive earnings potential of these ventures, in addition to the benefits of improved supply security. A low production season over FY17 impacted profitability in both ventures”. Overall, I see this development as positive and crucial for Capilano’s strategic plan for its procurement of honey supplies in the future.

At the same time, besides focusing on the bees for its future sustainable access to honey supplies, Capilano has also been focusing on the long-run development of beekeepers and the apicultural industry. It instigated a “Keeping Futures Program” to provide the next generation of beekeepers with career paths and training, whilst protecting the world’s healthiest population of honey bees found in Australia. In addition, in collaboration with Medibee Apiaries, it has also implemented a traineeship program that has just employed three new enthusiastic beekeepers that will be educated with a sponsored practical and theory component. These activities show that the company and management are willing to take the long-view, to ensure its long-term success, instead of just focusing on its short term performance, which to me is good because it is in line with my investing style of holding a good company for long (of course, assuming it is still good over time).

Now that we have looked at Capilano’s strong and sustainable access to honey supplies, the next question I would like to answer is is now a good time to look at Capilano? Which business development cycle is it in now?

3. Reaping rewards after a period of investing and consolidation phases

Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history.

The table below, on Capilano’s generation and use of cash over the past few years, explains everything.

Capilano - Past use of cash

In FY2014 to FY2017:

  • Capilano generated profits of AUD 32m and operating cash flows before WC changes of AUD 39m;
  • Capilano spent those AUD 39m of OCF before WC and its existing cash balances on building up its WC (AUD 25m, of which AUD 26m relates to build-up of inventory) and investments in capex (AUD 19m for investments in PPE and associates, and acquisitions); and
  • in terms of financing, Capilano got AUD 17m of cash from share issuances (mainly in FY2016 which it said would be used to retire debt, fund acquisitions, new product development and capital equipment), which it used to retire AUD 7m of debt and pay out AUD 10m of dividends.

This means that, despite the enlarged share capital base (but with a more solid balance sheet due to retirement of debt), Capilano basically reinvested all of its operating cash flows (before WC of AUD 39m) in the past four years in either:

  • building up its honey stock, by a whopping AUD 26m to AUD 44m (an amount >4x its PAT in FY2017 of AUD 10m); or
  • investing in PPE (AUD 14m, mainly for upgrade of its second major packing line in FY2014; and production efficiency upgrades, installation of several new packing lines at its Maryborough site, replacement of temporary hotrooms at Richlands (QLD) and acquisitions of more beekeeping assets in FY2016) and entities (AUD 2.7m for acquisition of Kirksbee’s intangibles in FY2016, and AUD 2.5m for Western Honey in FY2017).

In my view, Capilano’s investing and consolidating activities have been established, and these investments are now ready to put Capilano in a good position to secure more honey supplies and grow its operations, sales and margins over the next few years.

First, with a better honey stock of almost 6k tonnes (and more beekeeping assets and enterprises) now, Capilano can run its operations in a smoother and more efficient manner, compared to few years ago in FY2015 where it had only a honey stock of 2.9k tonnes and it had to pack about 1k tonne of honey per month, which would put a strain on operation and distribution management. With a stronger honey stock now, Capilano is also in a better position to plan for and fulfil more sales both overseas and domestic, therefore improving its chances of increasing sales in the future.

Second, Capilano’s investments in the two JVs in FY2017, Medibee and Western Honey, are ready to bear fruit. Both the JVs made losses of AUD 0.25m and AUD 0.12m respectively, due to their investments in the foundations (securing more floral resources, developing beekeepers’ skills, and building more bee hives, instead of focusing on the actual honey production) and a moderate/bad honey season (especially in WA). The management is positive over the future positive earnings potential of these two JVs and expect production performance to improve soon. Given that these two JVs form large portions of Capilano’s existing honey supply, where they are the largest Manuka honey and WA honey individual supplier respectively, when their honey production improves over the long run, I expect them to contribute positively to both Capilano’s honey supply (which can improve its sales) and earnings (through switches in product mix to higher-margin Manuka honey, and more operating efficiency and operating leverage).

Third, with the stronger (and more normal) level of honey stock now, after the worst honey seasons few years ago, an improving honey season would fare well for Capilano’s business. The company is expecting a better season in FY2018. In the FY2017 annual report released on 7 August 2017, TR Morgan (the chairman) said that “[h]oney production has improved this season and with reasonable prospects for next season in most regions we hope to be able to take advantage of this additional honey to further expand sales into profitable overseas opportunities”, and Ben Mckee (the MD) said that “[t]he improved rain patterns in key production areas has led to a notable increase in honey supply in recent months, with our largest ever winter honey supply for many, many, years. Weather permitting, we remain very optimistic of the potential for increased honey production in the coming season from spring 2017”. During the AGM presentation on 17 November 2017, the company reiterated that “FY18 crop prospects are looking promising, with an above average crop forecast”. Therefore, it seems that Capilano is on track to secure a decent, if not a good, supply of honey and performance in FY2018.

Last, Capilano has been using its cash from operations to significantly “repair” and de-leverage its balance sheet, paring down its debt-to-equity (and its net-debt-to-equity) from 61% (and 60%) in FY2013 to 14% (and 13%) in FY2017, with strong interest cover too. This puts Capilano in a strong balance sheet and cash flows position (recall the big New Zealand player, Watson & Son that was put into liquidation in 2016, due to cash flow problems arising from bad honey seasons) to take up any future opportunities for expansions or acquisitions. I guess the management has learned from their lessons of not using excessive leverage, which dragged down the company’s profits and cash flows, during the years leading to FY2010 (with a debt-to-equity and net-debt-to-equity of 101% and 43%), and is now more careful of the capital management of the company, and has finally de-leveraged to a comfortable level after many years of efforts.

Capilano - Leverage

4. Strong sustainable cash flows to fund dividends and growth

Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).

As Capilano is not a capital-intensive business (in terms of PPE), its earnings power has been strong. As seen in the table below, its OCF before WC changes has been consistently above 100% of PAT, except for FY2017 at 90% (but that was depressed due to some one-off non-cash gain).

Capilano - Cash flows

Capilano’s WC changes have exerted a large drag on its free cash flow generation capability, but that’s due to the need and intention to rebuild its inventory base over the past few years, which I think would not happen at the same magnitude again going into the future. Its latest capex on PPE in FY2017 was lower than previous years (which saw more capex due to the investments in new packing lines and replacement of temporary hotrooms due to the fire at Richlands in 2012), at about AUD 1.4m (as it pursued a disciplined approach to capital investment and capital was deployed for select production efficiency upgrades and expense improvement projects), slightly lower than its D&A of AUD 1.6m, and I expect that its maintenance (plus a bit of growth) capex going forward would not deviate much from its D&A, and would in the region of AUD 1.5m – AUD 2m.

In my opinion, Capilano is able to achieve such strong and steady (profits and) cash flows due to its strong branding and strong base in Australia, where it commands an impressive 70% (and still growing) market share since FY2015, which it increased from slightly less than 50% in FY2014 (by smartly exploiting the lack of supply to its advantage in FY2015 – a whopping 20% market share jump (based on the information that I am aware of)). A large market share conveys Capilano with much benefits – for e.g. with its products occupying more shelf spaces in more supermarkets in more locations, consumers become more and more exposed to and familiar with its brand over time, and is more likely to choose its products on average. Bigger size also means that Capilano can spread its marketing costs over a much larger base, thus having an edge on profitability and pricing power than its competitors. As at FY2017, Capilano also commands about 30% of repeat customers. In addition, Capilano’s new products (for e.g. Beeotic) would also help it to gain more customers in the future, by either attracting new consumers to the honey category (who would be exposed to its existing honey products too), or by attracting existing honey consumers to switch to its brand in trying out its new products.

This stronghold of cash flows in its domestic base is an important point which makes me prefer to look at Capilano more than its New Zealand competitors, as the strong market share leadership really entrenches Capilano’s ability to continue to extract significant amounts of cash flows, with less uncertainty, from its domestic business, which made up of a large chunk (83% in terms of revenue) of its business.

With these strong sustainable cash flows from its domestic business, Capilano would be able to return some value to shareholders by distributing some of them as dividends (the company doesn’t appear to have any fixed dividend policy, but its dividend payout has been stable at around 35%-40% since IPO), and use the remaining funds to reinvest in its business at high returns on capital (as we have previously examined, its CAGR from FY2013-17 of return on incremental capital ranges between 17%-24%, depending on which asset base you consider).

The near-term growth areas/opportunities that Capilano can/is reinvesting its capital in includes:

  • Expansion of the sales of its new products, in particular its new innovative healthy prebiotic honey, Beeotic®, which was launched in late September 2016 in Australia (and launched in Singapore in around November 2017 with free sampling events). Beeotic is the world’s first clinically-tested prebiotic honey, and is 100% Australian honey. This product has been developed on the back of extensive industry research over several years, has been listed with the Therapeutic Goods Administration (TGA) and is exclusive to Capilano. It sells for more than double the price of normal honey. In Singapore, its Beeotic honey (500gm) is selling for SGD 22, i.e. about 265% of the price of its normal honey (SGD 8.25) (see pictures below, taken on 6 January 2018).

    The company states that “[m]ore advertising, product development and strategic marketing is planned to support the product and further educate consumers. Beeotic has brought new honey consumers to the honey category and the product is awaiting regulatory approvals in a range of key export markets, noting we are currently selling into China as a priority establishment market”.

    According to an analyst report, “[p]ositively, Beeotic is attracting new, health-conscious consumers, upgrading CZZ’s existing customers and growing the overall honey category. The product has good distribution in Australia”. Another article states that “[i]mportantly, for the first time in many years, CZZ will actively market this new product”. Indeed, Capilano’s spent a significant AUD 2.2m in FY2017 on the marketing of new products (which should largely be attributable to the Beeotic product), which took up about 14% of its total marketing and promotion expenses (of AUD 15.3m in FY2017). If this product takes off well and gets sold in more markets after the relevant regulatory approvals, it should contribute much to Capilano’s revenues and, more importantly, its earnings given the better margins for the Beeotic product;

  • Expansion of overseas market, focusing on high returns market, especially China. China is a lucrative market for natural honey, especially Manuka honey, given its people’s strong demand for natural and overseas high quality food. According to an article by Alizila (the news hub for Alibaba Group that runs TaoaBao and TMall), “[the majority of Tmall’s customers’] spending habits are reflected in types of products that sell on Tmall Global. The platform’s best-sellers include Victoria’s Secret lingerie, Swisse cranberry capsule (health supplements) from Australia, Manuka honey from New Zealand, skincare products sold by Japan’s Matsumoto Kiyoshi, milk sold by German supermarket chain Metro, olive oil sold by British retailer Sainsbury’s and other name-brand items from abroad”. The China market has been buying a lot of Manuka honey from New Zealand, with Comvita’s honey being a very popular brand in the China market.Although Capilano is not as strong as its New Zealand competitors in the China market, with wide distributions and local partners there, Capilano has expressed much intention in proactively investing in this market (see its FY2017 AGM slide below). Historical revenue data on its exports to China has been limited, but what I can gather indicates that Capilano’s sales to the China market has grown by 57% and 39% in FY2016 and FY2017 respectively, albeit from a smaller revenue base.According to an analyst report in August 2017, “[c]entral to the company’s target of growing its premium and higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar) is increasing export sales, with China identified as a key market. CZZ has tripled its export department to achieve its export led growth strategy. The company currently sells into China through pharmacy and grocery channels. It is in about 2,000 Chinese pharmacies and is hoping to increase this to 3,000 in the short term. The company is looking to increase its brand awareness in China by training staff and increasing online marketing. CZZ launched its China TMall e-commerce site earlier this year. CZZ will also look to expand into additional export markets in the future”.
    Capilano - China expansion
    In addition to the China market, there are also bright sides to the other export markets in the near future. In FY2017, Capilano’s total revenue decreased slightly by 0.4% from AUD 134m to AUD 133m, mainly due to a significant decrease in export revenue of AUD 5.2m (from AUD 27.7m to AUD 22.5m). This was because of lower international honey prices and greater competition, mostly notably in lower margin industrial segments, and that its export sales that year were impacted by a now resolved trade restriction to one of our biggest markets in the Middle East.

    In relation to this underperformance, the company said that the “[i]nternational bulk honey markets have been relatively stable following the softening in price we saw last year, with competition remaining strong in most overseas markets. Capilano has reluctantly ceased supply to some international industrial segments due to unsustainable prices and insufficient margin”. In November 2017, during the AGM, the company stated that “[i]nternational prices for Manuka have been rising and the market is changing”, implying a potentially brighter FY2018 for export sales.

  • Ramp up of the two joint ventures. As discussed earlier, Capilano is still investing in its two joint ventures (Medibee and Western Honey), which it started at the beginning of FY2017. As these two joint ventures stabilise and increase honey production, they should drive Capilano’s sales and profits.
  • Driving of more sales volume. As and when the honey production season turns better, Capilano would get to procure more raw honey (both normal and Manuka), which it can spend efforts on driving the packing, sales and distribution of more honey sales.

5. Strong and growing moats, with runways for growth opportunities

Last but probably most importantly, I see Capilano as being able to grow and deepen its moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

Ultimately, high returns on capital would eventually attract returns-seeking capitalists, which eventually push down the returns on capital to moderate rates, which is why it’s of utmost importance for a wonderful company to have strong moats to protect itself against any impending competition. I see Capilano as having two strong moats that help reduce the attacks by its enemies, i.e. intangible assets (strong branding and relationship with a network of beekeeper suppliers) and efficient scale, which we have discussed earlier.

What I think is even more powerful is that I see Capilano as having a positive moat trend (a concept devised and used by Morningstar) too. This means that I see Capilano as being able to deepen its moat more and more over time. The reasoning goes like this:

  • Capilano has strong moats now and currently has the largest market share and size in Australia;
  • This allows Capilano to spread its fixed costs (packing machines and factories overheads, distribution costs, and marketing costs) more, thus commanding lower fixed costs per unit, and has stronger balance sheets;
  • This in turn allows Capilano to achieve better profitability than the competitors, and thus more able to pay more competitive prices, if necessary (especially during bad times), to the beekeepers in Australia for their raw honey, and continue to source continuously from them even during tough times;
  • This begets trust and confidence from the beekeeper suppliers, resulting in stronger relationships between Capilano and the beekeepers;
  • This results in Capilano having better and more sustainable access to more honey supplies, which in turn allows it to achieve higher sales and grow bigger in size; and
  • The whole cycle continues again and again, strengthening Capilano’s moats over time, and at the same time setting up stronger barriers for impending competition.

In addition, I also see Capilano as having sufficient runways for it to reinvest its capital for the long term, in areas like:

  • new product development (which the company has listed as one of the few key strategic priorities for its 2020 strategy), ideally on products that incorporate more value-add (and thus higher margins) than raw honey, for example the recent Beeotic product;
  • expansion of honey production, either through increasing activities in its two joint ventures, or new ventures including M&A activities;
  • additional marketing and sales activities, especially for higher margin products (Manuka, Jarrah, Beeotic and Apple Cider Vinegar), enhancing its branding more and making more advances in the various distribution channels (supermarkets, pharmacies, groceries and health food channels);
  • expansion into overseas markets, especially Asian markets where Manuka demand would still exceed supply for some time

Warren Buffett says in his 1992 letter that “[l]eaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”. Hopefully, Capilano would have sufficiently long enough period and opportunities for it to reinvest its capital at high returns (supported by its moats and pricing power), and produce considerable value for its shareholders.

Now that we have looked at all the positive things about Capilano, we shall discuss the risks that Capilano faces in my next post, so stay tuned.

Disclosure: The author has long position in Capilano as at the time of writing.

P.S. If you want to receive updates on my future post, do subscribe to my blog by using the subscribe function (on either the right or the bottom of the page).

Is There Money in Capilano Honey (ASX: CZZ)? [Part 1]

Executive summary

Capilano Honey logo

Capilano Honey (ASX: CZZ) is Australia’s largest honey packer that sells honey products (both normal honey and premium Manuka honey) in both Australia and overseas markets, with a market capitalisation (in January 2018) of around AUD 175m. It was listed on ASX in July 2012, and thereafter from FY2013 (ending June 2013) to FY2017, it has almost doubled its revenue (AUD 73m to AUD 133m), tripled its net profits (AUD 3.4m to AUD 10.3m), while increasing its honey sales volume by more than 40% (from 9,800 tonnes in FY2013 to 14,000 tonnes in FY2016) and expanding its number of outstanding shares by 11% only. In my opinion, Capilano is a strong company with strong (and growing) moats with high returns on capital, and it’s worth looking at for the following reasons:

  1. Capilano’s honey packing business has good business economics, reflected by its strong financials.
  2. Capilano has very strong access to one of the most important ingredient to be successful in this business, i.e. good honey supply.
  3. Capilano has been investing and consolidating its businesses in the past few years, investing in additional resources, repairing its inventory and strengthening its balance sheet, and is ready to reap the rewards, with an improving honey production season to come after its worst few years in history;
  4. Capilano’s stronghold in Australian market (of >70% market share) provides it with strong and sustainable cash flows, which are partly returned to shareholders as dividends and partly reinvested for future growth in markets with high growth potential (e.g. China).
  5. Last but probably most importantly, I see Capilano as being able to grow and deepen its strong moat as time passes and has long runways for growth opportunities (from new markets, new products, greater sales volumes and potentially more M&A activities to expand its asset base).

This will be a long post and therefore I am splitting it into three parts:

  1. Introduction to Capilano Honey;
  2. Why I think Capilano is worth looking at; and
  3. What are the risks, and how much is Capilano worth?

Introduction to Capilano Honey

Capilano Honey was founded in 1953 as the co-operative Honey Corporation of Australia to help protect the interests of beekeepers, by purchasing honey from them and helping them to be price-setters instead of price-takers.

It was initially listed on the Bendigo Stock Exchange in 2004 following legislative changes that deemed Capilano ineligible to operate an internal market for trading shares between beekeepers in the co-operative (the beekeepers have to hold a certain number of shares per hive owned). It was subsequently forced to move to ASX in 2012, because BSX was changing the nature of its exchange to make it a clean energy exchange.

Capilano - Product range

It currently sells mainly (about 95%) honey products (both normal honey and premium Manuka honey (Manuka honey is produced from the Leptospermum species of plants that are native to Australia and New Zealand, and this honey is recognised for its scarcity and unique clinically proven antibacterial qualities and consequential premium price) and some (about 5%) non-honey products (apple cider vinegar and beeswax). It is a very popular brand in Australia with a market share of more than 70%. The Australian market contributes to 83% of its revenue in FY2016, with the remainder coming from more than 30 countries (as of 2016) in Asia, Middle East, America, Europe and other countries.

The video below provides a good introduction into Capilano Honey and the beekeeping and honey packing businesses.

In terms of operations:

  • its head office and main packing plant are in Brisbane, with two other packing plants in Perth and Maryborough;
  • it has just over 120 employees who oversee the honey packing process in its head office;
  • it carries a few honey brands that target different market segments, i.e. Capilano Honey, Allowrie, Barnes Natural Brand, Wescobee and Beevital Manuka honey;
  • it has a honey market share of >70% in Australia, and Manuka honey market share of around 11% worldwide;
  • it sources its honey mainly from more than 600 beekeepers in Australia, and has also gone upstream into its beekeeping businesses since mid-2015. In terms of Capilano’s honey suppliers, they vary greatly in size, including “hobbyist/amateur” beekeepers with 100 hives, medium producers with 600-700 hives, and large producers with more than 5,000 hives, where the big commercial guys would produce 100 tonnes of honey a season for Capilano;
  • it purchases, subject to the amount of available supply, around 10k-11k tonnes of honey from beekeepers annually (in FY2016 and FY2017), and imports honey from other countries (e.g. Argentina) to make up the shortfall;
  • it packs more than 1,200 tonnes of honey per month (with a total of 15k tonnes packed in FY2017);
  • it sold about 14k tonnes of honey in FY2016 (no data on FY2017); and
  • it had a honey stock of around 6k tonnes at the end of FY2017 (Jun 2017).

As seen in the figure below, Capilano sources its honey from various areas in Australia, with some of them being more premium honey.

Capilano - Honey sourcing regions

Capilano’s competitors include other honey brands in Australia, New Zealand and other countries. In terms of Manuka honey, which is produced only in Australia and New Zealand, Capilano faces competition mainly from the popular New Zealand brands, which include Comvita, Watson & Son, Nature’s Way, Pure Honey New Zealand, Ora Honey, Streamland, and Arataki Honey.

In terms of financials, let’s have a look at its revenue and profitability over the past few years. As seen in the tables below, from FY2013 to FY2017:

  • revenue has been growing at (0.4)% to 40.5% per year, with a CAGR of 16.5%. These growths are mainly driven by mainly increase in average selling price (ASP), followed by sales volume (CAGR of 12.6% from FY2013-16); and
  • gross profit has been growing at a CAGR of 13.9%, driven mainly by revenue growth, offset by a decline in GPM from 46% to 42%. The decline in GPM was due to increasing costs of raw honey supply due to lack of honey supply (with Capilano passing on some of these costs hike to the consumers, but not fully), offset to an extent by Capilano’s switch to higher-margin products to help improve GPM, although the end result was still a decline in GPM; and
  • net profit has been growing significantly at a CAGR of 31.6%, driven mainly by revenue growth and improvements in operating margins as the business scales up in size (with NPM increasing from 4.8% to 7.8%). The increase in NPM was driven mainly by declining marketing expenses (from 16.0% to 11.5%), declining depreciation expenses (from 2.5% to 1.2%) and declining interest expense (from 1.5% to 0.3%).

Capilano - Revenue and profitsCapilano - Costs

In the next post, I will talk about why I think Capilano Honey is worth looking at for a value investor. Do subscribe to my blog to make sure that you receive the updates.