Asia’s Wide-Moat Winners in China’s Yuan and “Quality Fade” Meltdown – Bamboo Innovator Weekly Insight
January 18, 2016 Leave a comment
|“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”|
|BAMBOO LETTER UPDATE | Jaunary 18, 2016|
|Bamboo Innovator Insight (Issue 116)
Asia’s Wide-Moat Winners in China’s Yuan and “Quality Fade” Meltdown
“福兮祸所伏 祸兮福所倚” – 《老子》第五十八章
“Good fortune lies within bad, and bad fortune lurks within good.” – Lao Tzu
“At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it’s going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.”
– Warren Buffett
Should the devaluation risk of the Chinese Yuan becoming the next Ringgit materializes, and capital flight outflow accelerates into a flood that overwhelms the forex reserves and triggers non-performing loans (NPLs), how can value investors position their portfolio in stock picks that are long-term winners in this trend?
While the weaker yuan appears to temporarily benefit Chinese exporters of commodities, such as steel, which are facing an overproduction and overcapacity situation contributing to a glut in inventories and artificially propping up employment for social purposes, we think that a weak yuan has negative overall impact on Chinese companies who are reliant on USD-denominated debt and are dependent on importing specialty materials and high-tech components to “manufacture” the products. The typical Chinese companies do not possess these know-how and technologies since they are opportunistic traders-dealers-distributors and have been indulging in non-core business activities to generate non-operating and investment income from riding the yield curve impact of a strengthening yuan since 2007.
On the ground conversations with local Chinese companies have indicated that core profit margins have compressed severely. According to the official data before the devaluation in August and December 2015/January 2016, 97% of the increase in profits earned by Chinese manufacturers came from securities investment income. A recent report by Financial Times on Jan 11, 2016 pointed that China banks could require up to US$7.7 trillion of new capital and funding over the next three years with the rise in NPLs which have been doubling annually since 2012 to become a “neutron bomb”. “China Merchants Bank, China Everbright and ICBC are seen as among the most troubled,” and “State bailouts could send the government debt to GDP ratio spiralling from 22% to 122%.”
This well-hidden messy situation has also exacerbated and accelerated the problem of “quality fade”, the deliberate and secretive habit of widening profit margins through cutting corners and a reduction in the quality of materials.
We think an underappreciated opportunity lies in this “quality fade” problem which has reached a tipping point in triggering Chinese middle-class consumers to switch and flock to using quality products in their daily lives by Japan, Korea and Australia/New Zealand.
In Japan, the hunger of Chinese consumers for quality led to the phenomenon of “bakugai”, or “explosive buying” by Chinese tourists of Japanese goods from rice cookers, electronic toilet seats, air purifiers, watches, infant milk, baby shoes, biscuits, high-end apparels and shoes, diapers, cosmetics, perfumes, spirits, cigarettes, bicycle parts, and condoms to toothbrushes. In the China online marketplaces Taobao, Tmall, JDmall, Japanese goods dominate. For instance, the disposable diapers of Unicharm, Lion Corp, Kao and Daio Paper have become smashing hits. Lion’s high-end Systema toothbrushes, sold for about $1.60-$2.40 in China, two to three times more than a typical local brand, made its online debut in China in 2011 on Alibaba’s Taobao and by the year ended December 2014, sales had rocketed fifteen-fold, and Lion became No. 1 in China’s e-commerce market for toothbrushes within just three years. Ryohin Keikaku, operator of Muji stores, has seen increasing popularity and sales of its “no-brand” quality products amongst Chinese consumers despite the apparent overall economic slowdown and has opened its largest Muji apparel and household goods store in downtown Shanghai in December last year.
While there are reasonable concerns that the weaker yuan would result in Chinese consumers to cut back on their spending on such foreign goods, we think that the “quality fade” problem would provide a rising floor for such purchases, especially when the perceived and actual value for money had become part of the lifestyle habit of the Chinese over the past few years.
As highlighted in last week’s article “Bending Adversity with Low-Volatility Wide-Moat Innovators”, we are positive on overlooked and undervalued Hidden Champions in Asia with market leadership and unique business models. One of them, whom we have highlighted last week, is a winner in this hunger for quality by Chinese consumers, a Japanese-listed consumer healthcare/lifestyle innovator who enjoys a dominant 50% domestic market share leadership to provide healthy recurring cashflow.
Due to exceptionally strong demand from selling its consumer healthcare/lifestyle high-end products on online platforms to Chinese middle-class consumers over the past few years, especially in its innovative super-premium product that was launched in April 2015 and is priced double that of the premium product of its UK-listed global rival, this innovator has stepped out of its comfort zone to build its first plant in China for the past eight decades in Guangzhou which will be operational by March 2016. Now the second-largest brand in the China market with a 14% market share, this Japanese innovator is set to close the gap with the UK-listed leader whose product quality and innovation lagged behind. This Japanese innovator will be converting an existing factory to focus production of its innovative super-premium product which has doubled its overall interim results profits (year end March to 1st half September) since it was launched only in April 2015. It has also leveraged its material science technology and know-how to build a 90% market share in its industrial business niche.
This low-profile family business innovator was established in 1934 under the motto of using science to enrich everyday lives and has avidly pursued high product quality and sought to build its brand. It has made consistent dividend payout and share buyback over the last ten years. The company has also issued a positive profit alert on Nov 5, 2015.
This innovator trades at a decent EV/EBIT 13.7x and a EV/Sales of 1x and has a healthy net-cash balance sheet with a long runway to compound value.
This innovator reminds us of two Japanese ancient proverbs that we find particularly relevant for value investors in this challenging times. The first proverb is “雨降って地固まる” (Ame futte ji katamaru), which means that “after the rain, the earth hardens”. In other words, adversity builds character and opportunities.
The second is “能ある鷹は爪を隠す” (No aru taka-wa tsume-wo kakusu), which means a skilled falcon hides its talons. Now, after hiding its talons for the past decades, and when most manufacturers are retreating from China due to the erosion of their cost competitiveness in largely commoditized goods, this Japanese innovator is using them to its advantage when no one expects it after building strong demand for its innovative high-end consumer lifestyle products using the China online marketplaces and it is carrying out low-risk capex investments to cater to Chinese consumers who are hungry for quality.
We will reveal the names of some of these Hidden Champions in the 5th Annual Value Investing Summit (VIS) on 23-24 January 2016 in Singapore. Do stay tune as we bend adversity together by investing in Asia’s wide-moat winners that are beneficiaries of China’s “quality fade” meltdown.
PS1: We will be back on 26 January with the slides in the 5th Value Investing Summit (VIS).
PS2: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:
PS3: We will issue an additional Monthly Moat Report Asia in 1Q16.
The Moat Report Asia
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
Our latest monthly Moat Report Asia for January 2016 investigates an Asian-listed wide-moat innovator who is the world’s largest ODM producer of an important tool with multiple applications for automobiles, aerospace and homes with a global market share of 20-25%. Its 18.9% operating profit margin and 18.5% ROE is higher than that of its branded clients because of its negotiating and pricing power, technological prowess and vertically-integrated business model from upstream tooling design/ manufacturing to downstream final assembly.
This deep vertical integration allows the company to achieve high precision standards in each part of the production process, and enhances its design ability to innovate lighter but stronger tool products. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in pneumatic tools to produce aluminium-magnesium alloy bicycle frames for all top 7 global bicycle manufacturers. In 4Q15, the company also penetrated into the supply chain of possibly the most important American customer in a game-changing private label partnership that provides a long visible runway for the company. The company started shipping industrial-level tools to this American MNC in 4Q15. This private label order yields a higher gross margin of 50-60% as compared to the typical 10-40%. The company was co-founded in 1983 by Mr. L after his retirement as Chief Judge in his local region and the L family controls 30-35% of the company.
Since the 2007/08 Global Financial Crisis, we like how the company has emerged stronger with major positive transformations to its business model resiliency: (1) Shifting to higher-margin industrial-level tools; (2) Successful new growth in auto tools which grew from 6% of total sales in 2006 to 37% in FY14; (3) Penetration into Europe, which contributed from 11% of total sales in 2006 to 33% in 1H15; (4) Client concentration risk reduced: its top 2 clients used to contribute 64% of revenue in 2006 and that proportion was down to <20% in 1H15.
The company has been prudent and shareholder-friendly in its capital allocation decisions. In particular, the company announced a capital reduction plan in Aug 2015 and shares outstanding will decline 10% to return excess cash to shareholders and improve its ROE. As at Sep 2015, the company has a healthy balance sheet with net cash at 54% of book equity (21% of market cap), which could provide some short-term downside protection when coupled with its 5.3% dividend yield.
Sales has increased 32% in the past four years and EBIT and EBITDA growth is faster at 41-74% due to effective cost management in its vertically integrated strategy and higher weightage of higher-margin products in product mix. We believe the company can build on the momentum to at least double its profits in the next 4-5 years, pointing towards a potential doubling in market cap.