Bamboo Innovator

Can You Guess This Asian Wide-Moat Company?

“Honor the Past, have Discipline and Hard Work for the Present, have Vision with Passion for the Future”

“I believe in three things: Past, present and future. Honor the past, which means honor your parents, for the values they give to you, the experiences they pass down. For the present, you have discipline, hard work, using the talent you have been given. Last, the future, which is vision with passion.”

– Madam Y

Which Asian superbrand is so strong that Italian chocolate and confectionary giant Ferrero SpA and Unilever are compelled to bundle their products to better reach out to win the hearts and wallets of the local consumers? And these giants bear the cost of the superbrand’s product in the co-marketing campaign.

This month in December/January 2017, we investigate the owner behind this Asian superbrand who commands a dominant 90% of the domestic mass market share with its brand. Yet, there is a still a visible long runway to compound growth as the company operates in the segment which contributes to 20% market share of the overall highly fragmented industry with room for growth to consolidate the home/small producers making up 68% of the overall market and boutique producers accounting for 12% of the market. [Company’s name] operates 10 factories that is supported by a vast and efficient distribution network of 61,000 point of sales via modern trade channels and traditional trade channels. Established in 1996 by Madam Y and her father, together with two Japanese giants who later became strategic shareholders and technological and trade partners, [Company’s name] has become one of the country’s most recognizable household brands. [Company’s name] is also far-sighted in cultivating children as long-term consumers as they grow up, just like McDonald’s, by conducting factory visits for school children and opening their brand house at Kidzania, the edutainment centers allowing children to work in adult jobs and earn currency and receiving more than 31 million visitors since its opening, making it one of the fastest growing global edutainment brands in the world.

Due to its strong brand equity and efficient supply chain management, [Company’s name] generates a growing ROE of 34.3% and enjoys low to negative cash conversion cycle, a rare quality for manufacturers. This allows the company to repay its bank loans quickly using idle cash as it expands to grow. This efficiency is enabled by its adoption of the ERP system to integrate all systems and procedures starting from raw material purchase to product distribution. The program can also integrate the real-time conditions of the factories, which is a useful feature considering the different locations of the factories. In addition, [Company’s name] laid foundations for advanced distribution network and market penetration in 2012 with its own program which uses state of the art technology to monitor selling patterns, manage product and drop mix; remapping distribution areas built over the last 20 years and expanding its network of agents and distributors. The development of state-of-the-art tracking systems enabled the company to have a growing distribution network and deeper and wider market coverage. This technology allows the company to not only go to areas with potential demand but it enables them to support their distribution agents to increase sales of its branded products.

There are several listed iconic fast-moving consumer food brands in Asia and we think one of the closest comparables is Thailand’s Taokaenoi. Taokaenoi is Thailand’s market leader in processed seaweed snack products with dominant market share of around 62%. Noteworthy is that while [Company’s name] and Taokaenoi both enjoyed market dominance in their respective categories with comparable EBIT margin at 19-20%, [Company’s name] absolute level of sales and operating profit is around 40% higher than Taokaenoi’s US$127m and US$25.3m respectively and [Company’s name] enjoys a superior cash conversion cycle advantage of only 2 days as compared to Taokaenoi’s 30 days, yet [Company’s name] has a market value that is 44% smaller than Taokaenoi’s US$1bn market cap due to the huge disparity in valuations. [Company’s name] trades at EV/EBIT 17.6x and EV/EBITDA 14.1x, a 56-62% discount to Taokaenoi. We think the valuation gap between [Company’s name] and its comparables should closed over time as it continues to execute with performance. Since FY2012, [Company’s name] sales have grown 105% while operating profit grew faster at 133% and we believe the company can build on the momentum to generate over 50% growth in operating profits in the next 3-5 years, and spur an upward valuation re-rating towards a potential doubling in market cap.

We are impressed by [Company’s name] co-founder & CEO Madam Y for her tenacity in transforming the company to become Asia-ex-Japan’s manufacturer in its product category through making far-sighted and consistent continuous investments in production know-how, brand building, distribution network and IT system to scale up. We like the company’s strong management team and corporate culture to foster the win-together mindset and we think [Company’s name] deserves a valuation premium as it continues to consolidate the fragmented industry and expands its presence in a new market in which operations will commence in 3Q2017.

Below are excerpts of her unique insights on succession to the family business which reflected her strong desire and values to scale the business to greater heights by being grounded in discipline, hard work and a vision with passion:

Q: “You were designated at an early age as the successor to take over and lead the family business. What are your plans for your children in the family business?”

Madam Y: “Looking back, I would not do that to my children [Madam Y has three]. I don’t think bloodline qualifies—it’s got to be based on other things as well. To separate ownership and management is not easy for a parent, especially family companies, coming from the Asian families, because they always want it to be whole, it has to be “my son” or “my daughter” who continues the business. But it’s not necessarily good. My father always said, as an insider, you will guard your family assets, you will run the company very well. To me, both insiders and outsiders can ruin the company. As long as my children carry the vision and have the passion for what I do with the family business, they qualify to start the race, but I will not put them as a leader in that position. I will use professionals. I believe in three things: Past, present and future. Honor the past, which means honor your parents, for the values they give to you, the experiences they pass down. For the present, you have discipline, hard work, using the talent you have been given. Last, the future, which is vision with passion.”

Who is Madam Y and this Asian wide-moat innovator?

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/

Can You Guess This Asian Wide-Moat Company?

The Five Principles of Success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’

MUNGER: I think Warren and I can match anybody’s failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed… 

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That’s true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail…a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done. 

What is the investment Achilles heel of Warren Buffett and Charlie Munger?

It appears to be in the “tough, tough” retail industry, from the above CNBC interview in 2014, given that it is “hard to establish a permanent moat that your competitors can’t cross”. Also, their biggest error of omission, as Buffett admitted during Berkshire Hathaway 2004 AGM, had been his “thumb-sucking” reluctance in investing more in Wal-Mart in the 1990s because of one-eighth of a point uptick in the stock price. One of the best investment deals that Warren Buffett considered he has made was ironically in a retailer, a furniture store called Nebraska Furniture Mart (NFM). NFM was founded in 1937 by the late Rose Blumkin, fondly known as “Mrs. B”, a Russian immigrant to America, with $500 she had saved for 16 years selling used clothes. NFM was set up in Omaha with no locational or product advantage and goes up against rich, long-entrenched competition – and grew to become one of the top furniture retailers in the country. Buffett had also tried to assemble a furniture empire since with the purchase of Utah-based RC Wiley in May 1995, Star Furniture in Jun 1997, Jordan’s Furniture in Oct 1999, and rental furniture provider CORT Business Services Corporation in Jan 2000. But none came close to matching NFM’s success. In Jun 2004, Berkshire also invested 9% In home furnishing retailer Pier 1 Imports (NYSE: PIR), an investment that did not work out. In Aug 2007, according to Bloomberg news, Buffett even mentioned about the Swedish-controlled flat-packed furniture retail innovator IKEA as a possible investment target, though the trust foundation setup at IKEA made the acquisition impossible.

Make no mistake: NFM and IKEA are the rare exceptions. Furniture retailers face critical economic hurdles and problems in building a wide moat and scaling up the business. Furniture is a category of product that is difficult for a retailer to handle, because (1) inventory turnover rates are low for durable goods, thus few furniture retailers manufacture their own products because of low purchase frequency and distribution efficiency, (2) unlike consumer electronics, it is rare for a furniture manufacturer to have a well-known brand, and it is hard to alter product features notably over a short period, making it difficult to promote replacement demand, (3) furniture sales usually require direct customer contact and explanations in-store, as well as delivery, which adds to the SG&A cost burden. Those rare few innovators who can overcome these formidable business dynamics like IKEA will enjoy increasing returns to scale and the business gets easier as it gets bigger.

In this month of September/October, we investigate another IKEA-like innovator who is the undisputed dominant specialty chain in furniture and home furnishing in its domestic market with rarity value as the only listed Asian company with a unique integrated manufacturing-logistics-retail business model in the industry with an 90% self-developed private label product ratio to sell low- to mid-priced high-quality functional merchandise to the masses. Whereas most furniture retailers simply sell furniture, [Company’s name] has put effort into offering a complete lineup of “home fashion” products which contribute to 60% of its sales. “Home fashion” products are purchased frequently, and by devoting effort to the development of such products, [Company’s name] has achieved the kind of customer-drawing power that other specialty furniture retailers lack. [Company’s name] develops these products itself for over 80% of its offerings.

[Company’s name] has achieved an astounding 29 consecutive years of growth in sales and profit, converting macroeconomic adversities ranging from consumption tax hike to currency volatility into opportunities to grow further. Despite [Company’s name] market leadership, it is still operating in a fragmented domestic market with around 10% market share in the home and garden market and has a long runway ahead to extend its market leadership, particularly in the urban areas. [Company’s name] has expanded its market share in the low-end category, but it has also been releasing mid-priced products that offer additional value in terms of quality and function since 2012, and this has led to the expansion of its customer base. [Company’s name] currently has a network of domestic stores and 37 overseas stores and targets 1,000 stores by 2022, 3,000 stores by 2032. [Company’s name] was established in in 1967 by founder Mr N.

Furniture and home furnishing business has low inventory turnover and loading efficiency is poor. As a result, controlling procurement and distribution costs is critical to achieving low-cost operations and to coordinate store openings and expansion. [Company’s name] manages the whole process of product planning, materials procurement, production, distribution and sales in order to reduce its intermediary costs, which enables it to offer highly functional quality products at low prices. This source of [Company’s name] wide-moat competitive strength is very much under-appreciated until the value investor understands the business economics of the furniture and home furnishing business. [Company’s name] “returns” benefits gained from lower COGS (on raw material changes, design revisions, and improved production yields at overseas plants) to customers through lower pricing. This policy has generated a virtuous circle of sales expansion from increasing economies of scale, and high customer loyalty is captured.

Powered by its unique integrated manufacturing-logistics-retail business model that is perhaps rivalled by only the unlisted giant IKEA, [Company’s name] is able to enjoy a lasting wide-moat competitive advantage that grows stronger with time with the virtuous cycle of customer returns that generate one of the highest ROE at 23.3% and profit margin relative to all its industry peers. Notably, [Company’s name] present operating profit margin at 16.3% is the highest in the industry, which is a steady structural progress over the years from 6% in 2001 to 13% to 2009, and looks set to improve further with a higher sales mix of higher-margin mid-priced quality functional products that expand its customer base. [Company’s name] has a healthy balance sheet with a 13.3% net cash-to-equity ratio to generate an impressive ROE of 23.3% and it currently trades at EV/EBIT 16.3x. [Company’s name] suffered a short-term 23% correction in share price from its recent high in July due to overall market uncertainty and without any major negative firm-specific news. We believe that once its upcoming earnings are announced on Sep 27, 2016 delivering another record-high results, the share price will rebound strongly.

From Wal-Mart to IKEA, companies with a greater sense of Purpose and insurgency in making available to the masses once expensive products and services that used to be affordable by only the rich, the “10X price disruptors”, are powerful super-compounders delivering superior shareholders’ returns for a long period of time. Motivated by this grand purpose to bring true life affluence to customers following his learning trip to US in 1972, Mr. N resolved to cut the middlemen and dedicated his life mission to building a unique integrated manufacturing-logistics-retail business model to offer quality merchandise at low affordable prices. [Company’s name] grew from 2 stores into a nationwide chain with dominant market leadership. We are highly impressed by the unique business model that gets stronger and easier over time and [Company’s name] still has a long runway to grow its store network in the fragmented furniture and home furnishing market in both domestic and overseas markets. [Company’s name] has also developed a powerful human capital strategy which has been a powerful enabler in supporting store expansion to achieve growth in sales and profit for 30 consecutive years. We think this is very rare for an Asian company and [Company’s name] deserves a valuation premium for its staying power and genuine potential to be one of the rare Asian company to reach the $100bn market cap milestone.

Below are some excerpts with the CEO Mr. N on his entrepreneurial journey to scale up his business into a formidable world-class innovator:

Q: “Chairman, [Company’s name] has achieved phenomenal success since it was established in 1967 to command domestic market share leadership in furniture and home fashion & furnishings. Can you share with us how the wonderful story of [Company’s name] started, including your own journey, especially the tipping point and challenges along the way? What is your personal driving force?”

Mr N: “It all began 49 years ago. The year was 1967 when I opened a small furniture store. My tiny 1,000 square foot store served the local community. Then I married and opened another store of about maybe three times that size. We finally managed to earn a decent living with the stores’ sales. However, a year later, another company opened a store of five times that size which made us go almost bankrupt. These were busy days and uncertain times but I continued to look forward and search for ways to grow my new venture.

In 1972, I was then 27, one study tour organized by an industry association to the United States was all it took to change the course of my struggling furniture store. During a week in California, I witnessed how differently Americans shopped and lived. Obviously, that I was deeply shocked. I was truly astonished, moved and struck. In the US there was no stand-alone furniture. Everything was built on the building, like walk-in closets. Compared to our country’s crowded living spaces, California homes were spacious with separate areas for entertaining and dining where guests would be welcomed, and the further back there would be a family-room. American consumers went to convenient retail stores to buy color-coordinated furniture and accessories to enhance their beautiful homes. In contrast, we had only mismatched offerings to choose from. They even had one bathroom on each floor! Most shocking to me was how inexpensive the high-quality merchandise in the US was compared to similar products back home. American furniture was designed to make life easier for consumers, not simply to pad manufacturers’ bottom lines. I recalled that I was so astonished by the difference in furniture and interior decor products in terms of price, selection, and quality.

It was like a dream world, I was so excited I could barely get any sleep. I wanted to bring the affluence of the US to my country. It was at this moment that I decided to bring back to my country what I had learned in the US. At first, I was pursuing my own sales and profit. Then I realized I was wrong. Ever since I visited the US, I changed my life philosophy, setting up an aim to enrich everyday life of people. I made my mind to develop and provide affordable and full-featured products for people. Furniture had occupied an important position in the lifestyle of the people. I would use my company to help people live as prosperously and comfortably as Americans. That wish and determination have never switched since [Company’s name] was founded, and remains there during every moment of its development. Setting and realizing this goal is our greatest pleasure.

Tracing back to the time when we advanced nationwide, we heard customers that they were surprised to see the numerous choices and the low prices in [Company’s name]. We can’t help but imagine the house we like and the room we desire, after what we saw in [Company’s name]. Not to mention it is the first time that we realize our imagination may come true. Every time we hear this, we are reminded once again, that our unremitting efforts have come to a result. We promise to keep an ear out for our customers as always, to step onto the arena of the whole world, to realize our dream deep inside, and to achieve so, we will do our utmost. We continue to chant the strong and simple words ‘to enrich the people’s life’ and to spread a dream to the customers, build a fire of motivation in the employees, stakeholders and business partners.

My personal driving force has been this ‘romance’ and purpose to help people around the world achieve the richness of living in the true sense by providing products with the appropriate quality and functionality for the customers at affordable price. Pursuing higher goals over a long period of time is critical because otherwise improvement will be superficial.

Looking back and our scale of our company is like a dream. [Company’s name] has been able to create value and grow successfully with tenacity and staying power because there was ‘romance’ and a long-term vision. That’s right, I have repeatedly told employees that to work at [Company’s name], it is important to have this five principles of success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’. ‘Romance’ is a feeling in one to contribute for the people and for the sake of the world over one’s life. Without such a Purpose, life is nothing. Humans were originally born for the people, for the sake of the world. Life is aspiring to become a person useful to the world. This is an ideal to get right from young, and even when one is 50 years old, 60 years old.”

Who is Mr. N and this Asian wide-moat innovator?

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/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company?

Tooling Up the World With Mastery

Do you have the right tools to succeed in your work?

The Scottish historian Thomas Carlyle, who coined the term “the dismal science” for economics, once said famously that “Man is a tool-using animal. Without tools he is nothing, with tools he is all.”

In this month of January 2016, we investigate 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. Yet this world-class innovator trades at PE 7.5x and EV/EBIT 10.8x.

Its 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. Technology ownership of key components raised quality and lower cost at a structural level, with production yield raised to 95% and costs reduced by 15%. Due to its mastery of critical end-to-end know-how, the company also utilize its magnesium alloy die casting technology in 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.

This is possible because of the leadership by Mr. L and his brother who have demonstrated grit and foresight in a series of critical business decisions, ranging from (1) building  a vertically integrated ODM business model to invest in developing innovative new products, (2) insisting on 100% ownership of the ODM design and manufacturing know-how by continuously building up its capabilities in tool technology from die-casting, coasting, painting, firing pin heat treatment, mold production, and plastics injection; the know-how accumulated over the years is not easily replicated, thus giving rise to our long-term profitability and a win-win partnership with our customers who stayed loyal; (3) resisting the institutional imperative to focus on designing and producing higher-end products while its peers rushed into China, (4) expanding during the 2007-08 Global Financial Crisis to (5) grooming its own group of talents in design and operations who are able to point out from a systems perspective the detailed continuous improvements needed in each production process.

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.

We like how the L brothers have cultivated a decentralized culture of mastery, empowerment and growth at the company to keep winning loyal customers and innovating new products. On its culture, below are some excerpts of the conversation shared by Mr. L:

Q: “What is the culture like at [Company’s name] and what is your management philosophy and style to guide your leadership?”

Mr. L: “Although [Company’s name] is globally number one in its field, I am the company’s driver. Whenever there are clients coming by to visit us, either my brother or myself will drive the company car to receive them. Our culture is such that everyone at [Company’s name] are familiar with my slogan of exceeding targets, challenge the limits, and stay grounded and pragmatic in executing. Our culture is that we treat our products as important as our lives. 

If the real estate industry has its maxim in ‘it’s all about the location, location, location’, our golden maxim to guide us is ‘it’s all about the product quality, product quality, product quality.’ This is why in our 32 years of establishment, we have not been afraid of losing customers and we have quality customers continuously coming in.

Our culture is aligned to our blue ocean strategy which is simple: to focus on innovation and quality in product and R&D. This strategy has been my unshakeable belief all these years. In order to pursue excellence in quality, as long as it can be changed and improved, I will constantly remind and demand my staff to seek breakthroughs and mastery. Do you know why the word ‘quality’ in the written Chinese 品 is formed by three ‘kous’ 口? The reason is because with two kous as the foundation, there is always a higher kou on top or mastery waiting to be reached.

Our management philosophy is ‘Integrity, responsibility, and steadiness in innovating. Constantly demand improvement in product quality, stay focused and loyal to the core business, and never stray and mal-invest.’

As shared, I was in the legal arena for 25 years. When I retired, I was the Chief Judge of…. I have gone past the age of striving for fame and fortune. The most important thing in the jump from the legal scene into entrepreneurship is to recognize oneself, to be self-aware of my role and responsibilities. To operate and manage a business is really tough work. Most of us who pressed on are using our hearts, our entire lives to operate.

Although I am [Company’s name]’s Chairman, I believe very much in empowerment and authorized decision rights to my team, in accordance to the Taoist philosophy of ‘managing with wuwei’ 无为而治 or governing by doing nothing that goes against nature.”

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

PS1: 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:

http://www.asx.com.au/asxpdf/20151102/pdf/432nk9r3hhw4nf.pdf (pg 10-14)

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will issue an additional Monthly Moat Report Asia in 1Q16.

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/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

In a Pit with a Lion on a Snowy Day: Lessons for Value Investors

As the year-end Christmas season approaches, we are reminded of of an obscure passage in the Old Testament book and its relevance to value investors in their search for wide-moat compounders in an increasingly uncertain environment following the supposedly “expected” symbolic decision to hike US interest rate for the first time in nearly a decade.

Buried in the Old Testament of 2 Samuel, the 23rd chapter and the 20-21 verses, is the story of Benaiah who chased a lion down into a pit on a snowy day. Encountering a lion in the wild is bad luck. Finding yourself in a pit with a lion on a snowy day qualifies as a horrible, terrible day. The instinct and the prudent thing to do is to run away. Most people would have seen the lion as a five-hundred-pound problem, but not Benaiah, who did not let fear dictate his choices. The Scripture doesn’t describe Benaiah as being prudent. It uses the adjective valiant. He chose to face and fight the lion, and killed it, defying the impossible odds. Fast forward two verses, Benaiah won a place in a bodyguard position in the administration of David, the King of Israel. Benaiah went on to have a brilliant military career, climbing all the way up the chain of command to become commander in chief of Israel’s army. His genealogy of success can be traced all the way back to a life-or-death encounter with a man-eating lion.

In a sense, Benaiah’s heroic acts of courage were unplanned. But don’t think that Benaiah was unprepared. He couldn’t predict when, how, or where the lion encounter would happen, but he had been preparing for it since he was a boy, wrestling with his poor pet cat that doubled as an imaginary lion, practicing his swordsmanship in front of a mirror until it became second nature, staging faux battles with his brothers. So when the lion crossed his path, he didn’t see it as bad luck. He saw it as an stewardship opportunity. Success equals stewardship. Stewardship of how we manage our time, talent, energy, including opportunity.

The story of Benaiah resembles that of companies facing disruptive changes and their response that would determine their destiny. Over the decade plus, we have encountered a number of entrepreneurs who faced disruptive changes and chose to chase the lions in building and deepening the wide moat in their business model.

Shanghai M&G Stationary (Shanghai: 603899) – Stock Price Performance, 2014-2015

One of them include Shanghai M&G Stationary 晨光文具 (603899 CH), which was facing the disruptive digitization and smartphone threat to writing instruments and stationary. When M&G was established in the 1990s by the brothers Chen Huwen and Chen Huxiong and their sister Chen Xueling, they also faced a powerful and bigger incumbent lion TrueColor Stationery (真彩文具) who was the pioneer in introducing gel ink pen in China. In other words, M&G was in a pit with a lion on a snowy day, just like Benaiah.

The Chens responded with designing a unique and extensive win-win distribution partnership and launching a wide-range of high-quality, user-friendly, stylish, and value-for-money products. M&G is also the trend creator for the stationery industry with continuous new product and marketing innovations that include “Confucius Blesses Your Scholarly Success” writing pens designed for exams for the 200-million student population, also a popular gift set during this festive year-end season for school-going children before they start school in the New Year ahead.

M&G now corners the stationery market for students and it is said that three out of every ten stationery shops around the 600,000 schools in China belong to M&G. In addition to its own brand M&G, the company has also established partnerships with Auchan, Disney, Tesco and Walmart. M&G products are also available in over 40 countries and regions, with network covering Asia, Europe and Middle East, and it has sole agent in Malaysia, Singapore, Thailand and Vietnam. All three of the Chen siblings started working in the retail industry as teenagers and endured difficulties. Because they started from the bottom, they understand the difficulties and always will want to help sales people on the ground to do well. The brothers both own about 28% of M&G, now China’s largest stationary maker with a market cap of US$2.72 billion, generating $550m in sales and $64m in operating profits and 19.6% ROE.

The Chen siblings emphasized the need to focus on quality in order to win respect. Like Benaiah who had been preparing himself since young, Chen started running around as a 17 year-old salesman and encountered the stationery industry. Chen chose to focus his time and entrepreneurial energy in the stationery industry as they believe it relates to the child’s growth, learning, and thinking.

They also noticed the opportunity that comes from common misunderstanding that the business of pen has a very low threshold. Because people’s traditional impression stationery industry threshold is low, the industry manufacturing equipment and technology lags behind. Interestingly, China’s Premier Li Keqiang complained at a seminar with a question “Why can’t China make a good ballpoint pen?”, commenting that Chinese pens felt “rough” compared to pens made in Japan, Germany, and Switzerland. Li said China’s manufacturers at the lowest levels should focus on innovating their technology.

The business of pen is an advanced production industry requiring know-how in precision equipment that include precision lathes, the manufacturing equipment of the same level to manufacture luxury watches, with some requiring even higher precision than watch-making. Thus, the core technology of each pen — the stainless steel ball and its casing — is imported as China does not have a machine with the precision required to make the best ballpoint pens. Because the tip is hollow, the intrinsic quality of tolerance cannot be measured with a measuring tool, as compared to watch parts that are solid. A sophisticated infrared microscope is needed to monitor the quality. As Chen explains, “You are now writing with the nib, ball diameter 0.5 mm. If the writing length reaches 1,000 meters, the ball must withstand more than 200,000 times the rotational friction. Keeping the written precision has extremely high requirements as the ball must achieve micron-level precision. The key is the quality of the pen is demanding, but the unit price is very low, which means large-scale production is required to maintain product quality and stability.”

Better quality goods and services ultimately rely on quality and process management in both production and distribution- marketing. While M&G product quality standard is world-class reaching only 15 defects per million, Chen emphasized that this meant that their one-day output yield would mean 1,500 complaints from the customers and from the propagation angle, one negative defect would spread to 7 people and this meant that the problem might spread to 10,000 unhappy customers in one day. Thus, Chen emphasized that “Mass production while controlling a certain quality at the same time is very difficult. A lot of factories are cottage-style with no brand, no quality, and we are up against counterfeit and copycats. The pursuit of excellence, the pursuit of 100% quality, is always our goal, not just that simple goal of achieving few defects per millionth.” Chen added that their company name M&G “adds a layer of deeper meaning: exceed customer expectations to provide products and services to win customer respect and trust – a pursuit of excellence for quality”.

M&G has established a network of provincial distribution centers, with more than 3,000 channel partners, 100,000 retail outlets, and 100% coverage key account stores that include Carrefour , Wal-Mart , Tesco, Rosen, and all other major supermarkets, convenience stores. M&G’s deep and strong marketing network ensures its stationery products can arrive in 3 days in every city in China. M&G also built an informational analytics network to carry out product real-time monitoring to have an accurate understanding of market needs.

Its unique decentralized marketing system resembles Berkshire Hathaway, with the M&G’s HQ having only 50 people who focus on cultivating primary market dealers cultivate into single-brand dealers with dealer training guidance, planning and team building. The primary market dealers foster the secondary market dealers, who in turn build the rural market towns.

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The goal of life is not the elimination of fear and risk; the goal is to muster the moral courage to chase lions, the opportunities which often look like insurmountable obstacles. The lion-chaser Benaiah devoted himself to being watchful and thankful. The word watchful is a throwback to the Old Testament watchmen whose job was to sit on the city wall, scan the horizon, and keep watch. They were the first ones to see an attacking army or traveling traders. They see further than others see. They see things before others see them. And they see things that people don’t see.

Chen is watchful of M&G’s progress: “Every year I took our team to study abroad from excellent high-level dealers to help them improve their respective areas and to explore new ideas. In Japan we learned a lot; they are meticulous in their management and in the manufacturing, which should be worth learning. Their cost control, quality assurance, and their pursuit of excellence is worthy of study.” Above all, Chen commented that “An enterprise should always maintain a sense of crisis, to be able to progress; an entrepreneur must maintain a sense of balance and not overestimate oneself and lose control. All the world’s successful brands are not accidental. They have decades, centuries of history. There is no shortcut.”

With the story of Benaiah and M&G, we like to wish our readers a Merry Christmas and a Blessed New Year 2016. Thank you for your support all this while.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS1: 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:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

PS2: We will be back in the week of 4th January in the New Year 2016.

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

Access the in-depth idea presentation:

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

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

The Swordless Samurai: Lessons for Value Investors from Japan’s Wide-Moat Innovator Cookpad

“Gratitude sparked in me a burning desire to better myself and help others. Contrary to what many think, the essence of leadership lies in serving, not in being served. Those who aspire to motivate followers need to learn the Secret of Gratitude: Leaders must be grateful.”

– From the book “The Swordless Samurai: Leadership Wisdom of Japan’s Sixteenth Century Legend Toyotomi Hideyoshi” by Kitami Masao

“Because I want a happy society. Happiness starts at the family table.”

– Cookpad’s founder Akimitsu Sano

How did a seemingly unknown company surpass illustrious giants such as Yahoo, Ajinomoto, Rakuten, Kikkoman to command an unheard of 90% domestic market share in a lucrative and growing service craved by over 56 million monthly users to generate over $30m in operating profit that is growing with new innovative services?

The rise of Cookpad (Tokyo: 2193), which has compounded 800% since 2009 to a market value of $2.26bn, and its newly-minted low-profile 42-year-old billionaire founder Akimitsu Sano who owns 44% in the company reminded me of the leadership story of Hideyoshi Toyotom (1536-1598), one of the most remarkable – and the most unlikely – leaders in Japan’s history.

Cookpad (Tokyo: 7956) – Stock Price Performance, 2009-2015

Despite his lack of strength and size, clumsiness at martial arts, and unglamorous peasant lineage, the “swordless samurai” Hideyohsi learned to outthink and outmanuever every pedigreed foe to become one of the greatest military and civc leaders Japan has every known, unifying a nation torn apart by more than a hundred years of civil strife, earning his position through hard work and innovation rather than birthright, becoming the ultimate underdog hero.

One of the most interesting and important leadership lessons Hideyoshi teaches us is that the essence of leadership lies in serving others, not in being served, an ethic that seemed increasingly rare these days. Hideyoshi goes on to explain that gratitude is the key esntiment that inspires true leaders to devote themselves to serving others.

Serving others to bring joy to the dinner table has been the philosophical foundation underlying Cookpad’s success. Cookpad was founded in the midst of the Asian Financial Crisis in Oct 1997 by Sano-san immediately after he graduated from Keio University. While at university, Sano worked as a produce retailer together with local farmers. Sano continued pursuing socially-involved entrepreneurship and joined an NGO. Participation in a UN meeting proved fateful. Touched by the smiles of delegates from some of the poorer Caribbean nations, Sano realized that economic prosperity was not necessarily a driver of genuine happiness. That nascent desire to pursue projects which might touch the hearts of those around him brought him to the idea of cooking for pleasure, a concept underpinned by his experience as a reseller of high-quality, appetizing fresh produce from the farm and the desire to bring joy to the dinner table.

It has not been an easy journey for Sano: “I tried to monetize Cookpad from day 1, but it took me 6 years. What did my wife and I eat during those 6 years? My wife’s family are farmers, so they gave us food and our living cost was so damn low.” Kitchen@coin, the predecessor of Cookpad, was launched in 1998 as a recipe site that allowed users to search and comment on recipe submissions. The name Cookpad was adopted in 1999, with the site allowing users to revel in pictures of their culinary creations and helpful feedback from other users about their experience with the recipe. Cookpad began accepting advertising in 2002, including accepting recipes specifically utilizing advertisers’ products as well as holding tie-up promotions like contests designed to feature a specific advertiser’s products. The success of these ads brought substantial benefits for advertisers with increased demand, re-evaluation of existing products, increased recognition of new products, which in turn supported the successful maturation of Cookpad’s business model.

Every day at around 4 p.m., as schoolchildren make their way home, hordes of people across Japan — predominantly female, predominantly in their 30s — start furiously typing on their PCs and smartphones. They all have one burning question on their minds: “What should I cook for dinner?” Cookpad has penetrated into the daily lifestyle of Japanese housewives and other shoppers purchasing food and dinner ingredients who can often be found clutching smartphones accessing Cookpad as they peruse supermarket aisles. Today, more than 56 million users use Cookpad to share and find 2.1 million recipes to prepare at home. Cookpad has expanded its user base twelve fold in the past seven years, making it the 55th-most-viewed website in Japan; more than half of all Japanese women in their 20s and 30s visit it. Cookpad earns half of its revenue from premium services (1.6m subscription users in Japan), 34% from advertising, and 16% from ecommerce.

The “Tsukurepo” platform is perhaps the most underappreciated wide-moat competitive advantage and intangible asset of Cookpad, as this platform…

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Read more about the business model of Cookpad at the Moat Report Asia: http://www.moatreport.com/updates/

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Like Hideyoshi who has attracted talented leaders and created a brain trust dedicated to the mission such as warfare strategist Hanbei, former monk and organizational leader Mitsunari, etc, Sano has Yoshiteru Akita, the current CEO since May 2012. Akita was the former CEO of Kakaku.com from 2003-2010 during which share price jumped from ¥187 to ¥486 during his tenure. Akita owns 14.76% of Cookpad and is regarded as an internet management pioneer. Like Hideyoshi who looks for passionate and dedicated talents, Sano commented that “We look to see if the candidate codes at home or outside the work place. We look for someone who looks like they cannot help but code at any occasion.”

Above all, Hideyoshi’s clarity and power of the vision in reuniting Japan and ending the Age of Wars connected followers, allies and partners, inspiring them with the force of his vision to fight alongside the cause, empowering them to overcome seemingly impossible odds, sustaining his rise to ultimate leadership.

Sano has ambition to make Cookpad a household name around the world with various overseas acquisitions that include Cucumbertown, a U.S. food-blogging platform. Sano believes the way to increase visitor traffic is to offer more high-quality recipes that can make people happy and for the site to offer such attractive, useful services that all users are willing to pay for them. Sano’s clarity and power of vision that connects follower and allies is that he believes cooking helps keep families united and that happiness starts at the family table:

“Probably, the most important thing for an entrepreneur is to find a problem you’re passionate about. It’s not the size of capital that matter, but whether you’re really solving real customer problem or not. Create something! Create your own category! We wanted to offer free recipes as a contribution to the society. It’s essential to know what you are doing because the market is full of competitors. Do you think my vision is to create recipe site only? No, my vision is diversity in your food! Harmony in Japanese families begins in their table at home; by having diversity in your food, you’re not controlled by only one food resource, which means stability of price. Because I want a happy society. Happiness starts at the family table.”

The word “samurai” originally meant “one who serves”. Hideyoshi would have called Cookpad’s Sano-san the “Cooking Samurai”. Hideyoshi sums up the leadership precepts underlying his success:

“You may be surprised to learn that my successful quest to achieve the epitome of leadership was built on the commonplace notions of devotion, gratitude, hard work, and bold action. These principles appear so simple that you might not consider them “secrets”. But few people comprehend their true power, and still fewer understand that they form the cornerstone of the samurai code, an honoured protocol of conduct handed down for hundreds of years. The samurai code covers far more than the mere use of weapons, which is fortunate for me, since I have a reputation as the worst fighter in Japan’s history! But mu most formidable weapon has always been my mind: You might call me the swordless samurai.”

In essence, value investors could do well when they invest in leaders who focus on the values of devotion, gratitude, hard work, and bold action.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: 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:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

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

Access the in-depth idea presentation:

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

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

The Essence of Pricing Power of Asian Wide-Moat Compounders

Having taught cost accounting at the university, I always find that the topic on “pricing” to create, communicate and retain value has been sorely neglected. Management tend to have fear of prices, especially when they need to increase them. The fear has one legitimate source: one can never know with absolute certainty how customers will react to a price change. If we raise prices, will customers remain loyal or will they run in droves to the competition? Will they really buy more, if we cut prices? As a result, managers invariably keep their hands off the pricing lever if they have doubt, turning their attention to something more tangible and more certain: cost management. But what is the underlying business model scalability, wide-moat competitive advantages, cost structure dynamics, and organizational system to support the pricing decision and pricing strategy?

The importance of pricing in investment fundamental analysis cannot be emphasized more. In fact, Warren Buffett once described “pricing power” as the most important factor in evaluating a business: “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business,” he said in 2011. In case of either inflation or deflation, value investors want to own companies that have pricing power — it will protect their earnings. Those companies will be able to pass higher costs to their customers during a time of inflation and maintain their prices during deflation without fear of volume decline or loss of market share.

Charlie Munger, the influential partner to Buffett’s success, also commented on the valuation effect of “untapped pricing power” for wide-moat compounders like Disney and See’s Candy:

“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. You will get a few opportunities to profit from finding underpricing. There are actually people out there who don’t price everything as high as the market will easily stand. And once you figure that out, it’s like finding in the street—if you have the courage of your convictions.”

For instance, Disney’s Magic Kingdom actually saw an increase in attendance in all of the last five years except 2010 despite the fact that the price of admission also went up, even hiking to a 3 figure price tag of $105 for a one-day ticket to Magic Kingdom at Walt Disney World in Orlando. While tourism spending is a consumer discretionary item, consumers are increasingly more interested in spending money on unique and innovative “experiences” rather than on things.

At Costco, one of Munger’s favorite companies, member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. By selling several staples as loss leaders – fresh food and gas -Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon. Becoming “Amazon-proof” is an enviable position for any retailer, as the company’s online dominance has most major retailers such as Target and Walmart playing catchup.

The more conscientious students with intellectual curiosity in my accounting class find the various cases shared to be useful. Some of these cases include how JC Penney, once considered America’s most venerated department store chain, plunged over 80% in market value since Feb 2012 when then-CEO Ron Johnson radically altered its pricing strategy from frequent sales promotions at deep discounts off its higher list prices to an everyday low pricing model that eschewed sales and clearance discounting, dubbed “Fair and Square”. Launched without any consumer testing, the new pricing strategy failed dramatically. Customers voted with their feet, leaving the retailer in droves when they could not get products at the discounted price they had come to expect.

Parker Hannifin, the #1 motion & control company, rose 240% since 2001, outperforming the 55% rise in the S&P 500 index, when Donald Washkewicz introduced “winnovation” in integrating pricing into its innovation process, aiming to pinpoint and develop products that offer the most potential for price premiums. Parker Hannifin build upon basic “cost” information to think deeper about the pricing decision of its over 800,000 seemingly “homogenous” widgets, differentiating them and determining their prices by what its over 470,000 customers are willing to pay rather than what a product costs to make and using the straightforward cost-plus pricing.

Or the case of how Apple changed its pricing structure for songs sold through iTunes from a flat fee of $0.99 to a 3-tier price of $0.69, $0.99 and $1.29. The top 200 songs in any given week which make up more than one-sixth of digital music sales – songs by artists like Adele – are charged at the highest price of $1.29. Six months after Apple implemented the new pricing model, downloads of the top 200 tracks were down by 6%. However, because Apple’s iTunes costs – wholesale song costs, network and transaction fees and other operating costs – do not vary based on the price of each download, the profits from the 30% price increase more than made up for the losses from the 6% decrease in volume. Apple has also applied this new pricing structure to movies available through iTunes, which range from $14.99 for new releases to $9.99 for most other films.

A favorite Asian example is Japan’s Kyocera, the advanced ceramics company, working with the same material used to produce rice bowls.  If a company sells one truckload of rice bowls for ¥1.5m, the profit is about ¥0.1m. However, if that company sells one truckload of IC packs, which are made of the same ceramic material, it can charge ¥50bn, making a profit of ¥15bn. The products are based on the same material, but the difference in profit is obvious. The secret of Kyocera’s success was in its ongoing commitment to resolving any problems of customers while overcoming technical challenges. It also experienced constant price pressure, with customers in effect saying, “If you don’t lower your prices, we won’t place any more orders.” In that situation, the company made all-out efforts to reduce costs, opening up the market for a fierce cost-cutting struggle. The basic requirements for a technology-oriented company to exploit its uniqueness are: (1) Choose a core technology and then improve and then upgrade it; (2) Exchange technical information while positively fostering human relations; and (3) When an obstacle is encountered, start to adopt an attitude of making every attempt cause a positive splash in the market and with customers. The inventions of Kyocera’s founder Dr. Kazuo Inamori, who was the first person in Japan to synthesize Forsterite, a kind of ceramic that played a pivotal role in electronic circuitry for TV sets, helped supported Japan’s global revolution in TV manufacturing in 1950s after WWII. Kyocera’s advanced ceramic materials also fostered the development of the semiconductor industry.

Pigeon Corp (Tokyo: 7956) – Stock Price Performance, 1988-2015

For Japan’s Pigeon Corp…

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Read more about the pricing power strategy of Pigeon Corp and 3 other Asian wide-moat companies at the Moat Report Asia: http://www.moatreport.com/updates/

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Pricing also intrigued the late managmenet guru Peter Druckerfrom an economics and also from an ethical perspective. He understood profit to be the “cost of survival” and sufficiently high prices to be a “means for survival”. Above all, he warned against the abuses of market power. He commented on price transparency and advocated fair behavior. The pricing abuse of pharmaceutical drug companies from Michael Person’s Valeant to Martin Shkreli’s Turing Pharmaceuticals has sparked public furore and threathened the going concern of their business. Pricing power to maximize profits become an inflmmatory phrase and lighting rod.

Hedge fund manager Bill Ackman compared “platform stock” Valeant to early-stage Berkshire Hathaway in early 2015; William Thorndike, author of The Outsiders, compared Valeant’s CEO Michael Person to Liberty’s cable billionaire John Malone. When Valeant’s share price collapsed in Oct 2015, many sophisticated institutional investors were hurt. Charlie Munger commented in March 2015 that companies like ITT Corp., made money back in the 1960s in an “evil way” by buying businesses with low-quality earnings then playing accounting games to push valuations higher. “Valeant, the pharmaceutical company, is ITT come back to life,” Munger said. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.” Valeant relied on “gamesmanship” to run up its value and created a “phony growth record.” We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant: Valeant CEO Michael Pearson is known as an aggressive cost cutter. Valeant’s corporate culture is that it does not want to spend money on science and sees no wrong in substantially jacking up prices of drugs after acquiring them, violating the Drucker’s ethical principle on pricing power.

Value investors analysing the pricing power of business need to understand that a sustainable fair game between the seller and consumer in pricing lies in one word: value. Ultimately, the customer is only willing to pay for the value he or she gets. The challenge for any seller is to find out what this perceived value is and then price the product or service accordingly. It leaves the seller or manager/ entrepreneur three tasks which the value investor must know in order to understand the effect of pricing power on value creation: (1) Create value: The quality of materials, performance, and design all drive the perceived value of customers. This is also where innovation comes into play; (2) Communicate value: This is how you influence customers’ perception. It includes how you describe the product, your selling proposition, and the brand. Value communication also covers packaging, product performance, and shelf or online placement; (3) Retain value: What happens post-purchase is decisive in shaping a lasting, positive perception. Expectations about how the value lasts will have a decisive influence on a customers’ willingness to pay. The customer stays loyal only if the exchange with the seller cultivates a lasting sense of fairness. Customer satisfaction and loyalty is the only way to build and deepen wide-moats and compound long-term value.

An ancient Chinese business philosophy sums up best the essence of pricing power and sustainable value creation for value investors:

斯商，不以见利为利，以诚为利；

斯业，不以富贵为贵，以和为贵；

斯买，不以压价为价，以衡为价；

斯卖，不以赚赢为赢，以信为赢；

斯货，不以奇货为货，以需为货；

斯财，不以敛财为财，以均为财；

斯诺，不以应答为答，以真为答；

斯贷，不以牟取为贷，以义为贷；

斯典，不以值念为念，以正为念。

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: 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:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.pdf

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

Access the in-depth idea presentation:

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

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Investor Day Presentation – Our Investment Strategy: Investing with Conviction to Outperform in Times of Volatility and Uncertainty

This week, 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:

http://www.asx.com.au/asxpdf/20151201/pdf/433hdp24p2twyj.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/

Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company?

The Asian Innovator’s DNA Powering Robots, Drones, Automobiles, Medical Equipment, Smart Grid and Green Energy

Amazon’s mobile army of KIVA cargo-carrying robots cruising in the complex automated warehouses need this product inside them in order to function. So too for Amazon’s hordes of unmanned aerial vehicle (UAV) or drones to deliver packages – without this product, airplanes, spaceships cannot fly, the best electronic device cannot function.

This month of November/December, we investigate an Asian-listed wide-moat innovator who is the leading designer and maker of this product that is critical for Amazon’s robots and drones, and wide-range of high-value-add end-applications, from medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things, to function properly.

Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier.

Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba. The company was founded in 1989 by Mr. W who was a former math teacher and had honed his skills as a sales manager for the American MNC who is the world’s largest maker of this product.

The company offers a one-stop solution for R&D, design, vertically-integrated manufacturing capabilities in molding, in-house tooling, component sourcing and assembly of finished goods, similar to giant Hon Hai’s famous eCMMS model. It is capable of taking orders for customized products, turnkey projects and a total solution from international brand-name clients and its flexible production facilities and know-how offer customers high-mix & low-volume services.

The company’s industrial business has received notable orders and long-term contracts from a major US client for FY2016-17 for power-saving equipment and will start shipping smart-grid monitoring module application orders in FY2016. [Company’s name]’s smart-grid devices enable distribution feeder voltage regulation control and power-saving mode, detecting user’s utilization of electronic energy, and help them save about 20% of electricity use per year, taking power from low-use clients and supplying more to higher users. The system saves on power waste for the end-users too; for example, in a shopping mall, the equipment detects where there are fewer people and can adjust air-conditioner temperatures automatically. Overall, the electronic power-saving system saves energy for both the power company and the end-user, and also provides electronic data for analysis, part of the Internet-of-Things (IoT) concept. As the systems will be installed outdoors, devices are deigned to prevent water and dust ingress and offering erosion protection, allowing operation in harsh environments.  This client has signed contracts with power companies in the US, India, Saudi Arabia, and the Philippines, and is looking for new companies to break into, boosting strong prospects for long-term business development due to the need for growing energy-efficiency.

The company plans to enter the supply chain of aerospace electronic components in the Asia-Pacific region with an joint investment in Aug 2015 with a European firm with Boeing, Airbus and GE Aviation being its major customers. It has received the AS 9100 certification for its manufacturing facilities in China for aerospace applications and the construction of the factory started in 2H15 and is scheduled for production in 2016.

For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.

Led by founder and chairman Mr. W and his team of 500 R&D talent out of around 5,000 employees, the company has transformed its business model three times successfully. Mr. W attributed the success of the company’s continued renewal and transformation to the “Innovator’s DNA” and his role as the “teacher, not the boss” in cultivating a corporate culture that fosters innovation. Below are some excerpts of the conversation with Mr. W:

Q: “Chairman W, you mention about that having an ‘Innovator’s DNA’ is the key factor that determine whether the business model transformation succeeds or fails. Can you elaborate more on how you cultivates and develops this ‘Innovator’s DNA’ and corporate culture in [Company’s name]? What personal role do you play in fostering the innovative corporate culture?”

Mr. W: “[Company’s name] has actively nurtured and cultivated organizational innovation, decentralizing the central HQ power and cascading the decision rights throughout the organization in groups. We are not stingy at all in putting down ‘power’, coordinating a performance-based way of approaching and doing things, giving every talent the platform to perform to their best potential.

Every business unit have the autonomy and power to pursue and choose their own customers, to possess the ultimate decision right to develop new markets or carry out R&D. Because [Company’s name] is willing to share, because [Company’s name] treasures talents, our small but closely-knitted team of talents are able to fully make good use of their decision rights, authority and power entrusted upon them, accelerating the speed of development in [Company’s name]’s ‘nervous system’ in intelligence to react and respond to market challenges and opportunities with speed. With the friendly internal competition, [Company’s name] is forever renewing itself and keeping itself dynamic, youthful, vibrant and energetic.

With the ‘Innovator’s DNA’ flowing through [Company’s name], we are able to make a third business model transformation in 2012 onwards, entering into the higher-margin, higher value-add product applications.. In this Industrial Age 4.0, our integrated design-manufacturing-integrated service business model ensures that we are able to innovate new products that include robotic applications for Amazon’s automatic warehouses and win the trust of our customers to foster long-term customer loyalty.

We know that our wide-moat competitive strength does not lie in mass production of standardized items. We need to be more sensitive, we need to be faster. Our focus in the higher value-add niche markets enable us to maintain and grow profit margins and growth. We believe that choosing and deepening our roots in the right niche markets and having the right strategy and risk management will result in [Company’s name] to grow steadily one-step at a time.

Tech business guru Geoffrey Moore commented: ‘The biggest trap that successful enterprises face is that they were kidnapped by their past success. Maturing companies face their stall point in growth from their core business.’

The ‘Innovator’s DNA’ enabled [Company’s name] to be courageous and meticulous in doing the right things right at the right time, to combine innovative strategy with product lifecycle management, rapidly locking in the market and ensuring customer stickiness, continuously and consistently improving the solution to ensure steady and resilient growth, making prudent capital allocation in R&D investments in new fields to seek a new trajectory growth path to strive for the best profitability and efficient use of capital resources.

Notably, by successfully transforming our business model three times over our lifecycle, this has created an intangible advantage and quality in our organizational culture and united our team towards a sense of purpose and common objective.

When our team is familiar with the footsteps of transformation, we can always keep a proactive mindset to coordinate with the market strategy, the IT system, and continuously renew our ‘Innovator’s DNA’ through the process, refine our operating model and adapt to the ever-changing environment.

Importantly, we have to change and innovate before crisis arrives, having the determination to open up new paths of growth. [Company’s name] is like a sponge, constantly sucking in various information from the external business environment, transforming them into new product innovation and new business model breakthrough, and the footsteps to our business renewal and transformation will never cease.

My personal role in [Company’s name] with regards to fostering an innovative corporate culture would be that of a teacher.

As shared, I was formerly a math teacher and the soul of a teacher never diminishes. I am the teacher at [Company’s name], not the boss. A good teacher has to teach according to the different aptitude of the student to unleash their greatest potential. It is the same principle when treating our employees. Everyone has different views on doing things. A leader has to keep an open mind and must listen to the views and feedback of our team and to encourage the team to develop their strengths and perform their best.

We [Company’s name]-ites are not afraid of setbacks and mistakes and also possess the courage to take responsibility and accountability in their work. Even during the difficult periods throughout our corporate history when we were having intense cost pressure, we never retrench any workers and we kept the M plant. We started off our business in M and we will never forsake our root and foundation.”

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

PS1: We will be doing a double issue of the Monthly Moat Report Asia in the week of 4^th January. Thank you for your kind understanding and support. We will be back with the weekly on 1 December with presentation slides of our Investor Day – we will be sharing insights on our investment strategy of our listed Asian equities portfolio.

PS2: 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: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the Monetary Authority of Singapore (MAS) about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.

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/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

What the Best Do Better Than Everyone Else – Asian Wide-Moat Innovators Surpassing Stall Points in Scaling New Heights

Can a small guy with a big heart succeed against all odds?

In the masterful book “Training Camp: What the Best Do Better Than Everyone Else” that was based on interviews with top professionals from a wide variety of fields, author Jon Gordon tells about the tale of Martin Jones, an undrafted rookie trying to make it in the NFL. After spraining his ankle in the preseason, Martin thinks his dream is lost, until he meets a very special coach who shares life-changing lessons that keep his dream alive as he strives for excellence and brings out the best in others every day.

The story of Martin bears some resemblance to the hidden fear and doubt that blighted many SME business owners whom we have interacted over the years. Despite attaining a certain level of success and personal wealth, their hearts are ever more unsettled as time passes, because they have hit a stall point in their core business model and they are unable to unlock the valuation potential of their business. In other words, they failed the acid test that value investors should employ to gain conviction in sizing up the investment bet to outperform in times of volatility and uncertainty, a seemingly simple but profound question: “Does the business get easier as it gets bigger?”

We like to share an article “Surpassing Stall Points in Scaling New Heights” below that we wrote in May 2011 in which we kicked ourselves and asked the tough question: “Is there a “natural limit” or “stall point” in the size of the business by industry and country as the entrepreneur attempts to scale up before he or she faces the challenge of their corporate lives to overcome the start of a secular reversal in fortune?” We had used the story of Ray Kroc to highlight how he and his team scaled McDonald’s with tenacity amidst the thicket of resource-rich incumbents, aggressive competitors under the wings of corporate giants, and copycats.

It has been four years since the article was written and we like to update the question for value investors to address the power of disruption lashing SME business owners and even giants who had hit the stall point in the growth of their core business model. Even seemingly stable wide-moat companies are not spared: McDonald’s is upended by fast casual disruptors such as Chipotle Mexican Grill; big beer firms are forced to merge with consumers switching to craft beer with innovative styles; Coca-Cola challenged by the secular decline of soda consumption as consumer taste change toward healthy and natural beverages. The decay in valuation once accorded to these incumbents and the narrowing of the economic moat had accelerated, posing an incredible dilemma for value investors:

“Should value investors hunt for what seemed to be “bargains” in disrupted business models hitting stall points? Or should they pivot and switch to buying the richly-valued disruptors instead?”

The icon of disruption is epitomized by Travis Kalanick, Uber’s co-founder, who entered and thrived in city after city, despite the opposition of giant taxi companies, lawsuits, strikes, consumer privacy woes, and other controversies from some of its drivers, who are private contractors rather than full-time employees. The question on the minds of value investors is undoubtedly: how do you value a company like Uber, as was asked and updated in Oct 2015 by NYU’s finance professor Aswath Damodaran. Uber was last valued at over $50bn from its last bond term sheet in Jun 2015 revealing $470m in operating losses on $415m in revenue. Even the disruptor Uber was not spared from being disrupted itself – by Google, who could end up undercutting Uber’s revenue by offering a service for free in a free app called “Free Ride” using its Google autonomous cars. Some venture capitalists have called the disruption risk of Google’s Free Ride to be overblown because Google was only trying a carpooling service internally for employees.

Asian Wide-Moat Innovator (Red) vs S&P 500 Index – Stock Price Performance, 1997-2015

The business of carpooling reminded us of an Asian wide-moat innovator in our Index who is the largest developer and operator of time-rental parking spaces. This innovator had updated the antiquated parking lot business and pioneered 24-hour automated time-rental parking services and became the most well-known brand of unmanned pay-by-the-hour parking lots, pulling itself ahead of its competitors who range from large real estate operators to sole proprietors. In terms of vehicle units managed, this innovator is over twice the size of rivals. The company disrupted itself by starting a car sharing business in June 2009, which was unprofitable for quite due to heavy up-front investment, but it turned profitable in FY14 and becomes an earnings driver to generate ROE of over 18% and this highly profitable world-class innovator is trading at EV/EBITDA 9x. Contrasting with Uber’s $470m in operating losses, this Asian innovator has created possibly the only profitable car-sharing business in the world, owning 60% of all vehicles used for car sharing services in its country.

The second generation leader of this family business has also introduced an innovative system that made it possible for the parking lot operator to…

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Importantly, as a result of striving for excellence every day, the low-profile family leaders are able to surpass its stall points in its business model to scale new heights. It is the task of value investors to dive through the rumpus and bustle of cabal in poignantly troubled times in a vigilant watch for Bamboo Innovators devoted in their intensive task of building a wide-moat business.

Surpassing Stall Points in Scaling New Heights

BY KEE Koon Boon, 9 May 2011

2011 marks the 50^th “anniversary” since Ray Kroc, 59 years old then, bought out McDonald’s for US$2.7 million from the McDonald brothers who were the original pioneers of the fast food restaurant “system”– an expensive valuation then and with no secret recipe for hamburgers, no patents, and no technological breakthroughs. Since fully taking charge of McDonald’s destiny, Kroc, the visionary leader, enlisted the help of a team with Fred Turner as the execution extraordinaire, June Martino as the human resource specialist, and Harry Sonnenborne as the numbers guy who advised him that real estate was the key to a franchise’s financial success.

By 1965, the year when McDonald’s was listed – interestingly, at the same time as Singapore’s independence – the team had scaled the business nationwide with tenacity to more than 700 restaurants amidst the thicket of resource-rich incumbents, aggressive competitors under the wings of corporate giants, and copycats. McDonald’s now has more than 32,000 restaurants worldwide in 117 countries and two-thirds of its sales are now contributed from outside of America. More than 75 percent of McDonald’s restaurants worldwide are owned and operated by independent local men and women. McDonald’s is also one of the largest property companies with US$17.6 billion in self-owned “McProperty” real estate retail assets. The company’s market capitalization has since multiplied 140 times in 45 years to US$88 billion currently.

Why McDonald’s, easily one of the most recognizable brand name in the world, is not a core buy-and-hold stock in the portfolio of Warren Buffett, the world’s greatest value investor, is probably one of the greatest underexplored enigmas in value investing. The non-investment by Buffett’s Berkshire Hathaway is all the more ironic given that McDonald’s is the biggest buyer of Coke – and the Golden Arches was also listed in the same year as Berkshire. Having multiplied his returns by 10-folds after investing in Coca-Cola in a big way in 1988, the ubiquitous beverage brand is arguably the business model that most define Buffett’s philosophy in value investing.

When asked whether he would buy McDonald’s and go away for twenty years, Buffett gave an intriguing reply in a lecture at the Florida School of Business back in October 1998. “It is a tougher business over time“, Buffett said, “People don’t want to be eating – exception to the kids when they are giving away Beanie Babies or something – at McDonald’s every day. If people drink five Cokes a day, they probably will drink five of them tomorrow… I like the products that stand alone absent price promotions or appeals although you can build a very good business based on that.”

Buffett’s Berkshire Hathaway did purchase McDonald’s in 1995/6 when it was probably around US$17 to 20 billion, but he exited in 1997/8 at around US$26 to 30 billion. Although McDonald’s grew to US$50 billion around a year later, it started its precipitous trend to fall to US$13 billion by February 2002 as it posts its first ever quarterly loss. Singapore’s dynamic entrepreneur Robert Kwan, who had a small wholesale toy store, was earlier than Buffett, opening with sharp foresight the first McDonald’s in Singapore in 1979 at Liat Towers, although he sold off his share in the business in 2003. Mr. Kwan carried his experience and insights to rejuvenate the Singapore Zoo, Bird Park and Night Safari, bringing them back into the black in his role as the executive chairman of Wildlife Reserves Singapore in 2003, later stepping down in 2007.

“A tougher business over time”, an all-important axiom for entrepreneurs and value investors.

Coca-Cola itself hit its peak at around US$200 billion in market cap in Jul 1998 before dwindling to US$90 billion by 2005 and recovering to US$165 billion presently. Starbucks, in its 40^th “anniversary” this year, poured its heart to scale one cup at a time after Howard Schultz bought over the six Starbucks shops for US$4 million in 1987 to reach US$28 billion in 2006 before hitting the roadblock to tumble to US$7 billion by end 2008 and is now back up again to US$38 billion.

Most businesses are not so fortunate to be able to recover. In 1962, the year IBM turned 50, Tom Watson Jr. – IBM’s chairman and the son of its founder – commented that of the top 25 industrial corporations in the United States in 1900, only two remained on that list by 1961. This year in 2011, as IBM celebrated its centennial, its current CEO Sam Palmisano carried on Watson’s insight and said that of the top 25 companies on the Fortune 500 at the time of Watson’s lecture, only four remained in 2010.

Is there a “natural limit” or “stall point” in the size of the business by industry and country as the entrepreneur attempts to scale up before he or she faces the challenge of their corporate lives to overcome the start of a secular reversal in fortune? After all, if an elephant were larger by a mere 15 percent, its body weight would require such bone and muscle strength in its legs that its weight would make it simply too heavy for the muscles to lift, and the beast, unable to move, would starve.

Yet, elephants can dance, as what Lou Gertsner said in describing how he led IBM to overcome a near-death experience in the early 1990s when he took over as CEO in April 1993. IBM then was at US$10 billion after falling from its 1987 peak at US$50 billion. By reducing the Big Blue’s dependency in mainframe manufacturing, which was supplanted by personal computers and servers, and building the global platform for services to provide higher value to customers, a core business which today accounts for over 40 percent of its overall profits, Lou had multiplied the market cap 10-folds to US$100 billion by the time he passed over the leadership baton in 2002 to Sam Palmisano. Palmisano quadrupled earnings and created another US$120 billion in shareholders’ value in 10 years as he positioned IBM in software and analytics, an area which now contribute more profits than services do.

Understanding the dynamics of this stall point can illuminate important lessons for both the Asian entrepreneur trying to scale his or her enterprise to a greater height and the diligent value investor wanting to generate sustainable compounding returns. In other words, value investing is about investing in the outstanding entrepreneur building the durable economic moat which means the business gets easier, not harder, as it gets bigger.

One key to McDonald’s success is what…

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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/

In the month of October, we investigate a listed Asian family business founded in 1975 that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer. The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.

We believe that the outstanding leadership provided by the inspiring visionary founder and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Capital Allocation in Asian Wide-Moat Innovators: The Story of the Jin and Hui Merchants

“…the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve. The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

– Warren Buffett

Intelligent capital allocation is possibly the most important skill that entrepreneurs need to master to cross the chasm to “Stage 2” to become a true wide-moat compounder. It requires understanding the long-term value of an array of opportunities to reinvest back into widening the economic moat of the business; sourcing and using money prudently and sagaciously in capital expenditures, R&D, M&As; having a sharp analytical framework and independence of mind to avoid “institutional imperative” and the illusory comfort of equating “busyness” in embarking different projects and multiple activities as “productive”.

Having recently visited the facilities and interacted with the top management team of one of Singapore’s most beloved consumer brands last week, we are confident that with the right capital allocation capabilities, selected Asian entrepreneurial companies can build upon their strong foundation, brand heritage and brand equity to scale to greater heights and create and compound value in a sustainable way.

Michael Mauboussin and his colleagues have written a great guide to capital allocation for investors: Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance. The authors shared a Checklist for Assessing Capital Allocation Skills, reproduced below:

Past Spending Patterns

• Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
• How has the company funded its investments?
• Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
• Have there been shifts in the pattern of spending?
• If there is new management, has spending changed?
• Who makes which capital allocation decision?
• How does the company conduct its budgeting process?

 Calculate ROIC and ROIIC

• Have you calculated ROIC over time and observed a trend?
• Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
• Have you compared the company’s results to those of its peers?
• Have you calculated ROIIC for one year and rolling three- and five-year periods?

Incentives and Governance

• How is the company’s incentive compensation structured?
• How much stock does senior management own?
• Is total shareholder return calculated on a relative basis?
• Have you examined the company’s incentive score?
• Are the measures in place to encourage management to think for the long term?

 Five Principles of Capital Allocation

• Does the company use zero-based capital allocation or is it dominated by spending inertia?
• Is the company focused on funding strategies or projects?
• Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
• Does the company prune businesses with poor prospects for creating value?
• Does the company know how to calculate the value of its assets and does it act accordingly?

We like to share a story that we had written back in February 2011 about Hengan (1044 HK) to illustrate thoughtful capital allocation during 2004-2009; Hengan invested heavily to move up the value chain in higher-end products and to distinguish itself from the hundreds of low-end producers, becoming the largest producer of personal hygiene products such as tissue paper, sanitary napkins, pantiliners and baby diapers and compounding its market cap from a billion to $12 billion in the process.

Importantly, to complement the checklist approach, we explore why the once-powerful Jin and Hui merchant groups in China did not manage to cross the chasm to “Stage 2” to become true wide-moat compounders and blew up because they did not understand thoughtful capital allocation; while the Ningbo entrepreneurs “were more far-sighted, reinvesting their profits into building sustainable industrial businesses rather than making speculative asset transactions that yield transient profits, making the successful transition to Stage 2.”

We hope the story of the eclipse of the Jin and Hui merchants will provide positive and uplifting lessons for entrepreneurs and value investors: the compounding power of capital allocation when mastered properly.

Eclipse of the Jin and Hui Merchants: Lessons for Entrepreneurs and Value Investors

By KEE Koon Boon, 20 Feb 2011

Pinnacle to pits. Such is the tragic and thought-provoking path of the powerful Shanxi-based “Jin Merchants” (晋商) and Anhui-based “Hui Merchants” (徽商) during China’s Ming Dynasty till their demise in the late-Qing Dynasty as they could not cross the chasm to “Stage 2”.

They were richer than the emperor and their business empires stretched as far as to Asia, Russia and Europe. The powerful Shanxi “banks” (piaohao 票号) offered a full array of financial services, establishing the remote inland Shanxi province’s Pingyao and the nearby Qixian and Taigu counties as the premier financial centers or China’s Wall Street then; the first and largest of them, Sunrise Provident (Rishengchang 日升昌), was the modern equivalent of JPMorgan.

They were extremely hardworking; the Hui Merchants were also called “Hui Camels” as camels symbolize their propensity to tolerate hardwork and overcome adversity in harsh conditions. They were highly educated and cultured; the Hui Merchants were also called “Confucius merchants” and one in five imperial scholars came from the Anhui province then. They worked in “teams”; family groups and clan members collaborate to dominate geographies and industries ranging from tea, timber to textile.

So why and how did these two powerful business empires went into oblivion?

Both the Jin and Hui Merchants, for all their vast accumulated wealth, did not invest for growth in building an economic moat, a unique durable business model.

Take the case of Dashengkui (大盛魁), one of the largest business empires established by three “Jin Merchants” then. It had 20,000 camels, dominating the logistics business in China, particularly in the transport of tea to Mongolia, Xinjiang and Russia. Its assets were said to be so vast that they can be converted into enough 50-liang tael to lay a road that stretches from Ulan Bator (the capital and largest city of Mongolia) to Beijing.

Despite the advent of steamship as a low-cost and efficient transportation means, Dashengkui failed to invest any of its profits or reserves in upgrading its logistics assets. Also, the Jin Merchants who dominated the tea trade and became very rich, used the profits and cashflow from the businesses to fund their lavish lifestyles and indulge in asset speculation, purchase land and rebuilt their houses.

In 1866, without the burden of tariffs, the Russians started to transport tea from China via the sea route and subsequently exported the tea to Europe and Middle-East. They established modern processing and manufacturing facilities in places such as Hankou, Jiujiang, Fuzhou, making use of coal-based steam turbine technology and machines rather than the manually-driven turbines and labor-intensive manufacturing methods used by the Chinese Jin Merchants.

The Russians produced high quality and low-cost tea bricks in huge quantities and had the added advantage of transporting via the cheaper sea route instead of the conventional land-based path dominated by Dashengkui. The fortunes of the Jin Merchants started to take a sharp deterioration. They were contented to rely on their core business of piaohao and pawnshops for the cashflow to speculate in property and to fund their lavish lifestyles. As a result, they missed the opportunity to convert their piaohao into banks, including declining the invitation to invest in the current HSBC.

Hu Xueyan胡雪岩 (1823-1885), dubbed the richest-ever Chinese entrepreneur and known as the “Red-Topped Merchant” (hongding shangren 红顶商人) after the scarlet tasselled hat which reflected his position as a first-grade imperial official and awarded the “yellow mandarin jacket”, was probably the most celebrated Hui Merchant.

Despite the realities of the Industrial Revolution exposing the weaknesses of the labor-intensive manufacturing methods employed by most of the Chinese merchants as compared with the modern machines which western companies invested heavily in, Hu, a veteran in the silk business, insisted on using labor to process raw silk. At that time, the western companies had the upper hand and deliberately depressed the price of raw silk in China.

In May 1882, Hu purchased raw silk in bulk, hoping to monopolize the supply in order to force the cartel of western companies to buy at higher prices. Hu was an accomplished opportunistic trader all his life and he was highly confident that his Fukang “Bank” was “rock-solid” in providing the financing to fight the battle with the western companies.

Unfortunately, after two consecutive years of drought in Europe prior to Hu’s purchase, Italy had a good silk crop harvest. Raw silk prices plummet and Hu’s unsold inventory depressed the silk market further. A French navy fleet also arrived at Shanghai, threatening to attack China.

With the prospects of a Sino-French war breaking out, cash became king and banks withdrew their short-term loans. Trade halted and there were massive property and asset disposals in Shanghai. Bank runs erupted, impacting Hu’s “rock-solid” Fukang Bank. By December 1883, Hu was bankrupt. Hu died in 1885 in the same year as did General Zuo Zongtang 左宗棠, who provided Hu protection and patronage, enabling Hu to get and stay rich.

Their neighbors, the Ningbo Entrepreneurs, were more far-sighted, reinvesting their profits into building sustainable industrial businesses rather than making speculative asset transactions that yield transient profits, making the successful transition to Stage 2.

While investing for growth is critical, it is important for value investors to note that making capital investments without allocating them to build a team and an economic moat is likely to be an inefficient and value-destroying exercise. They will fall into the general category of firms described by finance researchers Sheridan Titman, John Wei and Xie Feixue in their 2004 JFQA paper. These firms that increase capital investments substantially destroy future firm value in the long-run because investors consistently fail to appreciate managerial motivations to put the best possible spin on their new “growth opportunities” when raising capital to fund their “expenditures”.

In addition, value investors need to be discerning in understanding that investing to build an economic moat to build up the intangibles and core competencies for sustainable and scalable growth could depress short-term cashflow. Thus, the financial numbers may not look appealing from a historical snapshot perspective.

Established by Mr. Sze Man Bok and Mr. Hui Chit Lin in 1985, Hengan grew over 20-fold from US$480 million to US$11 billion since its HK listing in 1998 to become the largest producer of personal hygiene products such as tissue paper, sanitary napkins, pantiliners and baby diapers.

Interestingly, Hengan was below a billion market cap post listing until 2004. From 1998 to 2003, Hengan invested a total of around S$140 million in capital expenditures and conserved cash. The capex figure scaled six-folds to a total of S$830 million from 2004 to 2009 as Hengan invested heavily to move up the value chain in higher-end products and to distinguish itself from the hundreds of low-end producers. Annual profits grew six-folds from a size of S$57 million in 2003 to S$400 million in 2009, creating S$12 billion in firm value in the process.

Long-term entrepreneurs need to appreciate that generating profits via collecting transactions will not lead to sustained compounding returns. Hu Xueyan, the consummate trader in accruing multiple profitable transactions all his life, witnessed the horror of not building a durable economic moat when he opened his warehouses that were stockpiled with unsold silkworm pupae. The silkworms had metamorphosed into moths and Hu literally watched his fortunes flutter away.

Profits need to emanate from, housed and reinvested in an economic moat to be rejuvenated, propelling the enterprise to scale new heights and generate sustained compounding returns. Without doing so, they risk blowing up in Stage 1 like the Jin and Hui Merchants.

It is the task of value investors to dive through the rumpus and bustle of cabal in poignantly troubled times in a vigilant watch for outstanding entrepreneurs devoted in their intensive task of building an economic moat.

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: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the regulatory authorities in Singapore about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.

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/

In the month of October, we investigate a listed Asian family business founded in 1975 that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer. The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.

We believe that the outstanding leadership provided by the inspiring visionary founder and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.

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Living the Life That Is Upright and Executing Day By Day to Scale Asia’s Wide-Moat Foodservice Company 

Can You Guess This Asian Wide-Moat Company?

“Work hard. Deal with people honestly. Always look to improve yourself. Celebrate if we outdo ourselves, not when we outdo others. Enjoy what you are doing. This will help you to deliver the best products and services to your customers. It will also help you to strive to improve until you achieve excellence. Be ready to innovate. And never be afraid to dream big! The advice and motivation comes from one source – my mother. She is steadfast in counselling us, on how to live the life that is upright.”

This is the message that the inspiring Mr. C has for like-minded entrepreneurs and the next generation of leaders.

In the month of October, we investigate a listed Asian family business founded in 1975 by Mr. C and his wife that is now a leader in the foodservice industry with multiple brand format across several categories to capture a bigger chunk of the dining-out market where >12% of its local domestic population dine at one of their outlets every week, led by their flagship brand which dominates the market with a share of 57% which is 3x the value share of its next largest peer.

The under-penetrated domestic market, where foodservice spending per capita is one of the lowest in Asia, paves the way for acceleration and long-term structural growth in outlet expansion, especially in the provincial areas where margins are potentially higher, as urbanization rise. Such market dominance and brand equity in generating consistent cashflow is underappreciated and deserves valuation premium.

The company’s flagship brand, which contributed 52% of systemwide sales, has powerful store economics driven by high margin, low cash investment cost per outlet, resulting in cash-on-cash return of 43%, which is significantly higher than the 24% return for the average US peers. Its other domestic brands are leaders in their own categories with market share ranging from 35-91%.

Its international brands in China have broken even in 3Q14 after its initial entry more than 10 years ago; all along, the operations are profitable at the store level, but lack enough scale to cover the corporate and infrastructure overheads in which the management has committed to long-term investments in central kitchens to support the scaling up of the network expansion. In Jan 2015, management also inked a 60:40 JV and master franchise agreement with famous US snack chain in China and commented that they are exploring the opportunity to acquire a US brand with a $1bn market capitalization.

Being born into a poor family, Mr. C has demonstrated far-sightedness, discipline and values to build and scale the company into Asia’s leading foodservice company by “giving our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends.” Below is an excerpt shedding more insights into the inspiring entrepreneurial story of Mr. C:

********

Q: “…Can you share with us the story of how the company started? What are the business and personal challenges that you face along the way? How did you overcome them and what are the lessons that you have learnt?”

Mr. C: “…That was the first lesson – and it is something that [Company’s name] espouses to this day. I believe that we should give our fellow men more than they expect, whether they be customers, co-workers, suppliers, family and friends. I think that comes from the view that we don’t have to be greedy in our daily lives or business. If we strike the right balance, we share the benefits with whomever we’re dealing…

Saving every dollar we could was our mindset during the early days of [Company’s name] when we had a lone store… We had to do everything by ourselves in the beginning.. My wife and I even cleaned the toilet. When there’s no cashier, you do the cashier.. if there’s no janitor, you clean the toilet. It’s like your neighborhood mom-and-pop store. We also served the customers as waiter and waitress, and then at night, we do the accounting by ourselves. As my wife said wisely, ‘There’s a Chinese saying that says it’s easier for you to save than to earn’. So if you have something and you can save it. Don’t waste it because to earn money, it takes a lot of hard work. We worked hands-on but as the business propels, we noticed they could not do it all so we started to set up an organization hired store managers, and trained people.

During those challenges I continued to have high hopes and optimism that anything is possible. I think I pick up this belief from my mom. Our role is to do what we can as best we can and don’t worry about the outcome. The outcome will take care of itself. This belief has allowed me to sleep well at night. It gives me new hope everyday.

The third lesson is that innovation starts in our minds. Our mindsets determine what we’re able to accomplish. The story of [Company’s name] is a story of finding opportunity amidst difficult times. The main thing is to dream, dream big and not be afraid of it. Dreams are free. Why limit what you are aspiring for? But dreaming is not enough. One must be willing to put in the needed action and hard work to make these dreams come true. If you dream big and put your dreams into action you will indefinitely make mistakes. But don’t be scared to make mistakes. Just be quick to recognize them and learn from them as fast as you can. Learn from each mistake and it will not be a waste of time. If we place no restrictions on ourselves, then we’re capable of doing anything. If we are not greedy, then more things will return to us. If we give more to our fellowmen and to our customers, more than what they expect, they’ll return over and over again…

…The food business is still very basic. It’s still about taste. It’s still about How did you serve me? Is your place nice? Am I treated well? Do I get value? If you think about it, if we’re going out to eat, these are the basic things we look out for, but the execution is the difficult part. It’s not like other businesses where it’s the concept or the knowledge that’s difficult. Here, there’s no secret; it’s very easy, but it’s the execution that’s hard. If you ask a lot of restaurant, they know all these things. Executing day by day is what’s hard.”

********

Historical precedents in Chipotle and Yum Brands show that EBITDA/store growth drives valuation multiple expansion; EBITDA/store and EV/store is not just a linear combination but an exponential one. Thus, companies that successfully increase store profitability in a sustainable manner will see valuation increase by an even greater degree. Market has rewarded the company in the past for productivity improvements but has punished the company lately for the weaker-than-expected FY2014 and 1H15 results. Enterprise Value/store for is now back to 2013 valuation multiple despite expanding store count by 8.6% and sales/store growth increasing 1.5% in the trailing 12 months. If EBITDA/store improves 5% back to 2013 level and the company is able to sustain the improvement as it expands the store count to the target level in the next 3 years, EV/store could rebound and EV could jump, indicating a 36-56% upside potential.

The company’s store economics and return metrics is more like “fast casual” that include Chipotle, Starbucks, Shake Shack, which have higher returns and tend to trade at higher valuation multiples. In terms of EV/EBITDA to the fast casual companies, the company trades at a 37% discount. The Price/Sales ratio of fast casual companies is >5x, as compared to the company’s 2.16x, indicating room for profitability improvement, especially with its China business breaking even in 3Q14, and therefore providing the foundation for further valuation gains. Thus, the company’s business model which is more fast-casual in its superior store economics, is underappreciated and undervalued by 37% to >100%.

We believe that the outstanding leadership provided by the inspiring visionary Mr. C, and his management esprit de corps team which has out-trumped the foreign and local rivals to dominate its domestic market, deserves a valuation premium. Most would have been contented to rest on their laurels but Mr. C has international ambitions, the “Maker’s” mentality to create value, by taking calculated risks to expand smartly with its own brands in selected countries and to acquire already-popular brands and work to improve their strength. The management has also fostered a powerful performance-based empowerment corporate culture and positive work environment where everyone has a sense of pride and emotional commitment in sustainably growing the company, which we believe is rare for an Asian company and is the underappreciated source of its wide-moat it enjoys in executing the scaling of the multi-brands, the product innovation, the support for franchise partners and identifying and integrating synergistic M&A targets. In essence, the company provides resilient growth with visible long run-way and upside surprise from outstanding execution track record in M&As.

Can you guess who is Mr. C and his wide-moat family business?

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: PDF article link on SMU website. We are honoured to be able to have the opportunity to present to the top management of the regulatory authorities in Singapore about implementing the fact-based forward-looking fraud detection framework in a world’s first for Singapore.

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/

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. 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.

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.