The “SWFF” guide for value investors to identify Asian wide-moat compounders: Making available to the masses products and services that used to be affordable by only the rich – Bamboo Innovator Monthly Riddle

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BAMBOO LETTER UPDATE | August 31, 2015
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Dear Friends,

Can You Guess This Asian Wide-Moat Company?

The “SWFF” guide for value investors to identify Asian wide-moat compounders: Making available to the masses products and services that used to be affordable by only the rich

What do you care enough about to risk time, energy, and money to try to make happen?

What if you are operating in an emerging Asian country where the electricity cost is the highest in the region, even ahead of developed Japan and Singapore, due to complex political and regulatory capture reasons, and the high electricity rates have resulted in one of the most under-penetrated markets in household appliances such as air-conditioners and refrigerators as consumers are wary of their energy bills that may comprise as much as one-third of their income? It would be foolhardy and risky to have a business to sell air-conditioners in such a country, isn’t it?

In his thought-provoking book “Taking Smart Risks: How Sharp Leaders Win When Stakes Are High”, Doug Sundheim explains that at the heart of the capacity to take smart risks is genuine passion, or what is called SWFF (“Something Worth Fighting For”). A SWFF must be simple, stir emotions, lend itself to a narrative or story, and inspire action. The idea is simple and powerful: Can the value investor sense, observe and measure the SWFF in the companies and entrepreneurs they invest in, as opposed to pretenders who take short-cuts, using complex financial engineering schemes and accounting tunneling manipulations to opportunistically generate short-term “wow” results that would eventually unwind in massive impairment losses?

In the month of September, we investigate a listed Asian family business that has persevered for over fifty years since 1962 in this high-electricity-rates emerging country to sell something that seems risky – air-conditioners and refrigerators to consumers and commercial clients. Mr. C, the third generation business leader of this family business, commented:

“I’m very proud of the fact that [Company’s name], at its core, is a homegrown business that is dedicated to helping [our countrymen] live, work and play in cool comfort. I am proud that our products are energy efficient, thus helping them save on electricity expenses. But even as more.. are able to purchase high-end air-conditioners, we are still looking to provide energy-saving cooling solutions that the typical [local] can afford and enjoy. After all, we believe that air-conditioning is a necessity, not a luxury—especially in a tropical country such as ours.”

Led by the capable, down-to-earth third generation leader Mr. C who believe in making available to his countrymen products and services that used to be affordable by only the rich as his family and personal SWFF, [Company’s name] is now the #1 market leader in air-conditioner (36.7% market share) and refrigeration (25.6% market share) which are under-penetrated appliances in the country, with household penetration rates at 6% and 35% respectively, amongst the lowest in Asia where its neighbours have at least twice the penetration rate, representing significant untapped market potential.

Amongst the white good appliances that are disrupted by ecommerce, the sale of aircon and refrigerator remain resilient because they require installation and aftermarket service support. [Company’s name] provides unmatched end-to-end solutions from production to distribution to aftersales services network that spreads across the logistically-challenged country. [Company’s name] has over 90% appliance store coverage nationwide and its unrivalled aftersales service business is supported by over 170 accredited installer companies; over 130 accredited service centers; over 2,000 technicians; rapid sales facilitation and service turnaround from over 1,000 merchandisers deployed at the point of sale; and 8 dedicated parts stores; and a centralized in-house call center, distribution, parts availability/support as well as regional field personnel. Its robust logistics network ensure speedy delivery and fast service response.

The company has an impressive track record of continuous product innovations adapted to local market conditions supported by 8 self-owned labs, complemented by an engineering and design team of more than 30 engineers who focus on designing and developing solutions for the consumer suitable for the local market, including patented energy-saving fan-plug technology and corrosion-resistant coating, adding value to the consumer experience.

In its commercial business, the company is working with architects and building consultants at design stage to provide customized solutions and creates a sticky partnership. [Company’s name] develop solutions for commercial clients that cover the entire lifecycle of the air-conditioning and refrigeration products, beginning with the design stage and moving through equipment scoping and selection, supply, installation and testing and commissioning and aftermarket services. As a result of providing end-to-end solutions from direct sales relationship with its sticky commercial clients, [Company’s name] has created a resilient recurring income stream in an otherwise cyclical project-based business in which players are competing on prices, discounts and bribes.

The company’s manufacturing facilities in aircon and refrigerators are the largest of their kind in the country. Interestingly, it has an innovative lean manufacturing strategy with entrepreneurial local partners who are former employees. due to its effective cost management and resilient business model integrating distribution reach, logistics and aftersales to produce scale advantages in efficiencies, [Company’s name] has amongst the lowest operating expense (OPEX) as % sales in the industry at 16.7% vs 25-30% for local and global peers.

The company’s strong top-of-mind brand equity has also attracted long-term strategic partners to add value to the customer experience. New businesses include acquiring a 51% effective interest in the local affiliate of a leading American MNC elevator-escalator company in Mar 2014 and forming a 40:60 JV with an Asian MNC giant in Nov 2013.

In terms of business nature, margins and profitability, [Company’s name] is comparable to India’s Voltas (NSI: VOLTAS), India’s #1 aircon company who is an affiliate of the Tata Group with a 20% market share. [Company’s name] has a much higher and more stable market share than Voltas and generates higher ROE at 23.1% as compared to Voltas’ 18.1%. Yet, [Company’s name] trades at a 140% valuation discount in terms of EV/EBIT and EV/EBITDA at 9x as compared with 21x for Voltas. We think [Company’s name] deserves to command a higher valuation premium for its market leadership in an under-penetrated domestic market, its strong portfolio of synergistic businesses, and its visible long run way to reinvest its profits back into the core business to extend its market leadership and widen the moat. The company has a healthy balance sheet with net cash comprising 26% of book equity due to its integrated business model that has enabled the generation of steady, resilient and growing margins, profits and cashflow and the efficient employment of capital with a 23.1% ROE.

[Company’s name] may surprise on the upside with its long-term plans to expand beyond the core into businesses that leverage upon its core competencies and core business infrastructure with potential new strategic partners into kitchen solutions and building management solutions (fire & security, generators, building maintenance, remote monitoring, energy performance contracting). Sales have increased 64% in the past four years and EBIT and EBITDA growth is faster at 85% due to effective cost management. We believe [Company’s name] can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential tripling in market cap based on EV/EBITDA 15x.

During the recent volatility in the emerging markets, [Company’s name] is down 20% since August, more than the 10% decline in the local composite stock Index. [Company’s name] interim result is also decent, with 1H15 sales +11.2%, driven by new business revenue which more than doubled yoy, and operating profit +10.1% on effective cost management (OPEX +2.2% yoy). After the fall, [Company’s name] is now trading at an attractive EV/EBIT 9x and EV/EBITDA 8.6x and we think this is an opportunity to accumulate.

We like how Mr. C has forged a unique entrepreneurial culture and strong corporate governance at [Company’s name]. The dedication and passion in finding ways to better serve customers has opened up [Company’s name] to a future of great possibilities and [Company name]’s next 50 years will be about providing innovative value-added cooling, energy-saving and building management solutions.

Finding SWFF (Something Worth Fighting For) is the process of identifying and clarifying why risk taking and sacrifice is important to you in the first place. From the below conversation, we can also understand a little more about the SWFF factor in the company and Mr. C:

Q: “[Company’s name] has an illustrious business history of over 50 years, having celebrated your jubilee year 3 years ago in 2012. Can you share with us how the success journey of the company started, and importantly, how you got started working at the family business? What are the business and personal challenges that you faced as a third-generation business leader and how did you adjust along the way?”

Mr. C: “[Company’s name] was founded by my grandfather… in 1962.., while my father… developed it into a leading appliance manufacturer… We attribute our growth and success to our unique integrated manufacturing-distribution-aftersales services-solutions model focused on customer satisfaction.

At a young tender age of 7, I spent my extra waking hours working hours working for the family business… But the harsh reality of working in a ‘real office’ struck me hard at the age of 11 as I was sent to the company’s factory to finally get my hands dirty, working alongside plant employees in a hot room with no air-conditioning where we assembled parts, even though our business was making air-conditioners. I had to work with two conditions under my father’s explicit orders: one, I cannot work in an air-conditioned room and second, I cannot eat in the executive floor so I can truly mingle with the factory workers. I think that built my character. That’s when I realized the value of hard work and the humility of hard work. It was there I also realized the value in earning the respect of employees, no matter their pay grade. I also learned to see the perspective of other people, that you see things from the ground level – and I think that gives our organization an advantage. In hindsight, the lesson my father wanted us to learn was the dignity and respect for hard work.

The moniker really given to people like myself is we are COO [children of the owner]. But in my father’s case, you have to earn the title, for you to be a CEO. We all had to work hard and know the company from the bottom up. This was why all my free time in the mornings were spent in the office to learn. It was an unforgettable and enriching experience—my father was firmly against special treatment of the COO, so I really learned what it was like being one of the factory workers. I mingled with them, and ate with them in the cafeteria. Actually, I wasn’t allowed inside the executive rooms at all.

I prefer to work in a manufacturing environment. My father was a huge influence. But even on my own, I was attracted to the idea of people designing and building things that help improve lives, and help make the world a comfortable place. Understanding how things work just fascinates me. And in terms of running a business, that is in my genes, so I had a very strong inclination towards running and growing an enterprise.”

Q: “How about the personal pressures that you face in taking over the reins of the family business?”

Mr. C: “When you join a company and you’re the owner, am I there because of my name or am I there because of what I can do? I think that challenge was more to myself than to the employees. Proving that you know we were worth the position that we carry. That, I tell you, is the biggest challenge faced by companies like ourselves where you have a family corporation, where you tend to tangle up family affairs and business affairs—that’s very critical. I have proven my naysayers and detractors dead wrong.

Being heir to my family’s empire has put a lot of weight on my shoulders. My name is on every product we carry. If you criticize our product, you criticize me. This is one challenge we face every day – proving that we are worth the position we carry. We are so passionate in building solutions worth staking our name on. They say that the third generation will destroy the business that the first generation established, but I think I was able to prove that wrong. Of course, I am proud that we… are able to carry on the legacy of my father and grandfather, and that we were able to make the business flourish even more… We are now a local company with international clout, backed by solid infrastructure and research & development ties that attune the firm to the needs of consumers.

The way I look at it is that I have a goal, that goal is clear, achieving those goals. Working every day to achieve those goals and moving to the next goals. I often tell our people in the plant – we have very big plants – and I ask them, ‘How do you eat an elephant? Piece by piece.’ And that’s what we do with our expectations. It’s not about, ‘hey, I want to be this great guy up here,’ it’s about taking that step at a time. I think humility is very important in that as a person, you are thankful with what you have accomplished. I think being humble as possible is good for this business.

Despite the success of the company, I remain hands-on in the business as I believe in the importance of team work in running the company. And I don’t micro manage. I believe in my team, from the factory workers to the corporate employees, and I trust them to do their tasks well. There is a lot of communication, constituting some 80% of my time, bringing groups together, sharing the vision, helping solve problems. You have to know your staff. If I don’t understand what they are doing, how will I motivate this organization? I’m very easy to relate with. That’s the advantage – people can easily come to me, talk to me and we discuss. But I challenge them and bring out the best in them. Every time, I try to raise the bar, motivate and challenge people to do their best and help them develop their potential.”

Q: “Can you share with us what you believe is [Company name] economic moat and unique competitive edge in garnering a market leadership position..?”

Mr. C: “[Company’s name] market leadership has been built through in-depth knowledge of the end-user and the industry as well as a proven track record which enabled us to build a strong reputation and a solid customer base. We have and continue to offer the widest range of products and the best end-to-end customized cooling solutions and backing this with excellent after sales services to meet the needs of local consumers and businesses… These cooling solutions are defined by individual customer needs and are adapted to [the local] weather conditions and use. We understand the [local] consumer by heart. The company has established its track record by introducing automatic timers into air conditioning units and our patented fan-plug technology, knowing that families switch between air conditioning and fans throughout the night to save on electricity. We also launched refrigerators with larger freezer compartments as many families use them for business. Such intimate knowledge of its target consumers has driven [Company’s name] phenomenal growth.”

Q: “Where do you see [Company’s name] in 2020 and in the next 50 years?”

Mr C: “We see a future of great possibilities… Our next 50 years will be about providing solutions – solutions that will enhance our environment – whether at home, at work, in the place of business or in areas of recreation and leisure. We are not a perfect company, but we have always strived and dedicated all our efforts and are very passionate in finding ways to better serve our customers.“

Who is Mr. C and his wide-moat family business innovator?

PS: We also like to share with you an article “Scouring Accounting Footnotes to Prevent Tunneling” which we penned for our local newspaper Business Times Singapore that was published on 19 Aug 2015:

https://www.smu.edu.sg/BT_20150819_1.pdf

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

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