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When a group of the very best leaders were asked by the Wall Street Journal in 1999 to pick the most influential invention of the millennium, the late Mr. Lee Kuan Yew alone shunned the printing press, electricity, the internal combustion engine and the internet and chose something odd: the air-conditioner. He explained that, before air-con, people living in the tropics were at a disadvantage because the heat and humidity damaged the quality of their work. Now, they “need no longer lag behind”. LKY was obsessed with productivity and driven to do his best in crafting his own greatest invention in Singapore.

More than 25 years ago, there was an Asian company who was producing and selling air-conditioner with a productivity level that would have made LKY proud. And they were so good that the Japanese manufacturers got worried and tried lobbying to impose anti-dumping duties on the company’s imports into Japan. That didn’t work. Then the Japanese got clever, really clever. They drastically restricted the number of the most important Component X in the air-conditioner shipped to the company’s country. Overnight, the company’s impressive productivity machinery grinds to a halt.

In the words of Mr. C, the chairman of the company: “That was when we realized deeply that if we lack the heart of the aircon, the X, the heart of technology, having sales orders is pointless since production cannot take place. That was when we decided to undertake the task of having control over the technological know-how in X and the new spinoff company was established with the vision of technical independence. Only with technical independence can you build for the long-term.”

Our latest monthly Moat Report Asia for April 2015 examines an Asian company that is the world’s #4 air-conditioner X manufacturer with 10% market share, up from 3.5% in 2000. Regionally, the company is #1 in its domestic market with 39% share, 30% in North America, 12% in Europe, 9% in Japan, 13% in South America. The company also has niche dominance in X for the recreational vehicle (RV) market in North America with 60% market share and over 90% market share in a new application in X (“Y”) for a niche household appliance in Europe in partnership with Bosch. The company’s annual X capacity is 15m units and has plans to expand by 6m units to 21m units in 2H15. The company has a diversified customer base that include Carrier-United Technologies, Goodman-Daikin, Bosch, Electrolux, Miele, Haier, TCL, Midea, Sharp, Sanyo,. The company’s strategic shareholders include a Japanese electronics giant with equity stake of 4.86%.

What makes It a wide-moat business? We are impressed with its advanced production and technological know-how: (1) Grinding: The company has developed deep intangible know-how in grinding technology for X, in which metals need to be ground to micrometer-level precision, thinner than a human hair. The company is able to achieve exceptional production efficiency of 68 ppm i.e. out of every 1 million units, only 68 are rejected, possibly the best quality standard in the industry. (2) Inverter controller: It is not possible to create an energy-saving air conditioner with satisfactory performance by attaching an inverter procured from an electronics parts maker to a conventional air conditioner. Making an energy-saving air conditioner requires knowledge that cannot be easily imitated, such as the ideal number of motor revolutions under certain operating conditions. Sophisticated control technologies are required to optimally control the temperature in multiple rooms with multi-split air conditioners.

Above all, the company has superior R&D capabilities to leverage upon technology and know-how to enter into new higher-margin business, including adopting the open innovation business model to co-develop new products with external strategic partners. As a result, the company’s gross margin has risen from 12.97% in 2010 to 16.5% in 2013. These new businesses have promising market potential and scalability, including (1) higher-spec air-conditioner X for recreational vehicles (RV) in which the company has 60% market share in North America; (2) “Y” co-developed with Germany’s Bosch in which the company has >90% market share in Europe, and potential new customers in dish-dryer; (3) “Y” for commercial and residential applications; (4) breaking the Japanese dominance in high efficiency Brushless Direct Current (BLDC) motor product, (5) air-purifier in partnership with Sharp, (6) mini-X in portable fire extinguisher, mini-dehumidifier, portable aircon. Management shared that they have mid-to-long-term plans to develop BLDC motors for vehicles, DC inverter controller and high-end X for medical applications.

The company pursued a vertical integration strategy and has the capability and know-how to make everything in-house at present, resulting in one of the most efficient working capital cycle in the industry. As the global #4 X manufacturer making 15m units, or one out of ten X in the world, the company has built formidable competitive advantages in scale and product quality, and it has bold plans to expand capacity to 21m units. Profit margin is likely to climb further as it extends its dominant market leadership in the higher-margin niche segments of North American recreational vehicle (RV) market with 60% market share, European “Y” market with over 90% market share and break into new applications and market segments and new applications in air purifiers in China in partnership with Sharp. The company’s short-term downside is protected by an attractive 6.37% dividend yield.

The company has a visible long runway as it broke the long-time dominance of the Japanese in the multi-billion energy-efficient Brushless DC (BLDC) motor market with initial output of 1.5m units (ASP $10-11/unit) in Jan 2015 and a new plant with initial output of 3-5m units in 2H15 with potential to scale up capacity to a total of 24m units. Valuation is also decent and reasonably cheap for a world-class company with PE 12.6x, EV/EBIT 10.6x and EV/EBITDA 7.1x. Net profit and EBITDA could potentially double to $70m and $150m respectively in the next 5 years in FY2020, pointing towards a 280% growth in market value to $1.8bn based on a modest EV/EBITDA 12x.

Despite being not profitable for as long as the first ten years since it was established in 1989 due to the lack of production scale, the company persisted in pursuing the aspiration of achieving technical independence in the heart of the air-conditioner technology – the X – under the leadership of its chairman Mr. C. Led by Chairman C and CEO L, the company showed grit and determination in breaking past the milestone of an accumulative 100m units in 2014 and has plans to produce and sell another 100m units by 2020/21. We think the perseverance and focus is rare in Asian firms and the company deserves a valuation premium.

Q: “Chairman C, we admire your persistence and determination that resulted in [company’s name]’s success as the global #4 air-conditioner X company. What kept you going all these years? And how do you pass on your values to the corporate culture and your employees at [company’s name]?”

Mr. C: “In life, we must have dreams and aspirations. With dreams, our life becomes beautiful. An enterprise must pursue its dreams too. Our initial dream was to have technical independence and to produce world-class products. We are now #4 in the world and aiming at overtaking #3 in the next five years. Above all, [company’s name] aims to pursue the dream of creating infinite possibilities in smart, innovative energy-saving and environmentally-friendly future with ‘[Company’s name] Inside’, like ‘Intel Inside’, for multiple products and applications because of our superior quality and innovation.

The corporate culture is that all of us at [company’s name] must adjust rapidly to the changing world. Attitudes, morals and thinking are the starting point of thoughts. Only by allowing our attitude to change our habits, habit to change character and character to change life and maintain a positive outlook on life can the ‘responsibility, integrity, innovation’ values fill employees and grow with the company. Anyone with responsibility, motivation and ambition can help [Company’s name] to create a new chapter in history and keep rewriting it.”

Who is Mr. C and this wide-moat Bamboo Innovator?

PS: In remembrance of the late Mr. Lee Kuan Yew, modern Singapore’s founding father, we like to share an article series that we wrote five years ago about Berkshire Hathaway and Singapore, both wide-moat compounders created and built by visionary leaders.

Part 1: The power of vision

The success of Berkshire Hathaway and Singapore can be traced to their visionary leaders who work with winning teams

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/LHZB_20100809_2.pdf

Part 2: Lion Infrastructure and value investing

Both of them are an ongoing team process that demands sacrifice, hard work and soberness to scale new heights

http://www.businesstimes.com.sg/?dlink=/sub/views/story/0,4574,389848,00.html

Part 3: Lion Infrastructure is the way to go

To reach a US$2 trillion GDP in 2065, Singapore must create and build commercial assets with a special quality

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/BT_20101230_1.pdf

The Trilogy in One Document:

http://www.slideshare.net/KeeKoonBoon/lion-trilogy-lion-entrepreneurs-and-lion-infrastructure-media-articles

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

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