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Wednesday 19 June 2013

Do we want Want Want? Not Just Yet

Recently Bloomberg put up a video clip of Asia's most profitable food companies.  Amongst them was Want Want China a constituent of the Hang Seng Index.  I have been tracking the stock for awhile but have not done anything about because I had a feeling that it was 'fully priced'.  So with all the excitement I am allocating some 'kick-the-tyre' time to analyze if the price is right.  Want Want (旺旺) is a well known brand name in rice crackers, snack foods, beverage and dairy products in China.  If you walk to the snack foods and beverage section in China's supermarkets, you will see it prominently displayed.

The Company started in 1962 in Taiwan as a manufacture of canned agriculture products for export.  In 1982, the Company entered the Taiwan rice crackers (Westerners would not understand!) market under the Want Want (旺旺) brand name and in 1992, the China market.  In the following years, the Company diversified from a pure rice cracker manufacturer into snack foods, beverages and dairy products. 

In 1996 the Company listed on the Singapore Stock Exchange.  The Company delisted from SGX-ST in December 2007 and restructured the business by separating its hospital, hotels and property businesses to go back to its food and beverage roots.  Shortly thereafter, in March 2008, the Company became a publicly listed company on the Hong Kong Stock Exchange.

Tabled below is a summary of the financials of the Company since its Hong Kong listing.

The Company trades at an eye-watering PE of 32.  Is it a good buy? 

The Company have compounded revenues at 25% per annum over the past five years but revenue growth in 2012 dropped sharply to 14% compared to an average rise of 29% over the past 7 years to 2011.  Management did acknowledge the fall was mainly attributable to the rice crackers segment due the timing of the lunar new year sales and expects growth to resume historical trends.

Similarly earnings compounded at 25.7% over a five year period but earnings increased 32% compared to an average of 28% for the five years to 2011. 

The higher growth in earnings is directly attributable to the Company's gross profit increase of 30% compared to 21% in 2011.  Gross margin also rose 4.7% to 39.5% in 2012.  The rise in margin was due to a combination of price rises, lower input prices and improved costs management.

Over 90% of the Company's revenue is from China.  It sells its products through a network of 8,000 distributors and 356 sales offices throughout China.  In 2007, there were 15,000 distributors and 308 sales offices.  We cannot say categorically if the Company have substantially culled the number of distributors or due to outside factors such as consolidation in the distribution sector. 

Regardless, the emergence of large supermarket chains (Carrefour, Tesco, Walmart, 好又多, 华人万家, 大润发, 欧尚, Park 'n' Save etc.) and group buying franchise groceries shops (美佳, 天福) with substantially larger bargaining power over past few years have not dented margins. 

We conclude that Want Want over the past 20 years has successfully built strong brand recognition and therefore we can infer its brand has significant franchise value.  But does it warrant the price tag?

The numbers.

Ideally to get some reasonable comfort from the past, we want to look at a 10 year trading history, but we only have available figures going back to 2007 so we will have to make do.  We also have some scant revenue, earnings figures going back to 2004.

Want Want earns a very high rate of return on its equity (ROE).  ROE in 2012 is 37.9%, its 3 and 5 year average ROE is 35.9% and 38.2% respectively.  Assuming it continues to compound at a similar rate of say 37% over the next five years (baring any disaster), its per share earnings would grow from US$4.19cents to US$20cents.  The share price's PE had been as high as 38 (2013) and as low as 15 (2009) with an average of 27.  At a PE of 15, the share price five years from now would be HK$23.50 (US$20cents x 7.75* x 15) and at 27, it would be HK$42.30 (US$20cents x 7.75* x 27). 

*Exchange rate: US$1 : HK$7.75

If you purchased the stock today at HK$10.36 and sold it five years later at a PE of 15, you would enjoy a compound rate of return of 17.8% or 32.5% at a PE of 27.  This compares to current Fixed Deposit rates of 1.75% (HK deposit rates) and inflation at 4%+.  Are the returns reasonable?  In the past five years the share price have increased from HK$3.10 to HK$10.40 producing a compound rate of return of 27.5%.  On this basis and based on how confident you are that historical trends are likely to continue into the future, you can safely lock this one away for the next five years.

However one should not ignore over-confidence nor the potential for tail events - both on the macro front and company specific. 

Over-confidence is when the writer here is not applying sufficient critical thinking or doing enough homework.  Past results cannot be linearly applied to future prospects; for one thing, 10 years ago, Want Want probably did not have the distribution reach it now has.  If the market is well covered it could mean future growth prospects might slow.  Should that be the case, it might not justify current market rating.  On this we can gain some comfort that increasing market share/penetration would come from new products to its network.  Want Want has a successful track record of introducing new flavours and products such as dairy products.
On the macro front, problems abound that China would soon face a financial crisis of its own making.  I shall not go into details, suffice to say there has been increasing stress in the banking (including shadow banking) system and outlook remains foggy.  You can pick up the story if you like from this link.

On specific company issues, it is instructive to revisit history.  Warren Buffet purchased Coca-Cola at US$5.22 at a PE of 14.5 (EPS US$0.36) in 1988, it was a low point for Coca-Cola because of strategic missteps in the previous years.  A similar incident might happen in the form of a food safety scare which is so prevalent now in China and big corporations have not been immune, case in point KFC and Megniu Dairy.  However, because of their strong brand value, they have not mortally damaged their franchise value.  Nevertheless, assuming some temporary disruption and earnings dropped 20% immediately after purchase to HK$3.34cents; compounding at 37% over the next five years gives EPS of US$16.17cents.  At a PE of 15 this would translate to a share price of HK$18.80 giving a net compound growth of 12.7% versus the 17.8% above.  Still respectable but your margin of safety increasingly is becoming vulnerable.

So how good is management at utilizing retained earnings?  Well, EPS increased from US$2cents in 2008 to US$4.19cents in 2012 giving a net increase of US$2.19cents.  Cumulative EPS between 2008 and 2012 is US$14.44cents and cumulative dividends per share over the same period is US$11.14cents producing a net cumulative earnings retained of US$3.3cents.  Therefore return in 2012 from net earnings retained between 2008 and 2012 is 66%.  

Want Want trades in line with EPS growth historically, it already trades at intrinsic value and so there is little room for disappointment.  Events beyond our control suggest a higher level of skepticsm and diligence required for the enterprising investor.  For now, your writer cannot recommend an investment in Want Want.

For a passive investor looking for surety in cash distribution with the benefit of capital appreciation (in the form of purchasing power preservation) over a longer term horizon, Want Want is a good Company to allocate some money to.

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