A reader asked me about my views on Huabao International which is listed on HKSE (Hong Kong Market), it appears that the company has strong fundamentals (9 years of good results).
Ok, before I start, would like to say that I spend a lot of time reading up on Singapore listed companies, or investing books / news in general. This is probably due to my familiarity with companies / environment here. At the same time, I always feel that one must always have a list of good companies and war-chest ready (for market crashes). Compiling a list of good companies is fun, building up a war chest is the hard part (as I am just a normal employee with regular pay, and selling stocks is always difficult).
OK so back to the list, so far I have a list of ‘good’ companies listed on the HKSE (the list is arguable cause I did not really spend a lot of time tracking or reading up on them. Like I said before, I spend time reading on Singapore-listed companies, but not Hong Kong-listed companies) – see below. I probably would read more about these companies when Hong Kong market crashes big time.
- Hosa International Ltd2200:HKG
- Luk Fook Holdings (Intl) Ltd.
- Man Wah Holdings (1999)
- Real Nutriceutical Group Ltd
- Tencent Holdings Ltd (0700)
- Vtech Holdings Ltd. (VTKLY)
So back to Huabao International. The company researches and develops, produces, distributes, imports, and exports flavors, reconstituted tobacco leaves, new materials, and fragrances in China. It provides flavors and fragrances for tobacco, food, and personal care products. The company is also involved in the production and sale of natural extracts; filter materials; and fine chemicals.
Huabao Group has over 40 subsidiaries throughout 5 countries and 19 cities. The Group is one of the top 10 flavors and fragrances companies in the world, with a leading market capitalization among listed flavors and fragrances companies in Asia.The Group takes leadership in China’s flavors and fragrances industry and has been the leading producer in terms of sales revenue among competitors.
I have spent some time reading its Annual Report (AR) – not a friendly version I might venture to say. Find it interesting that the Chairwoman is relatively young (Chu Lam Yiu, 45 is one of the youngest self-made billionaires in the world). Ms Chu is the single largest shareholder of the Company (as stated in the AR) – a report in 2012 states that she owns about 38% of Huabao. However rising to the top is not without perils (read here).
Refreshing take from what I normally see from other Annual Reports – chairperson tend to be more elderly.
Let’s think about its business narrative first.
The Group has organized its operations into four main operating segments (figures behind each segment is the respective turnover for the six months ended 30 September 2014):
- Flavours; (HKD1,590,276,000 – 74%)
- Fragrances; (HKD41,942,000- 2%)
- Reconstituted tobacco leaves; (HKD483,178,000 – 22%)
- New materials (HKD43,868,000 – 2%)
*Turnover for the six months ended 30 September 2014. (Total: HKD2,159,264,000)
So technically, Flavours contribute the most turnover (followed by Reconstituted tobacco leaves). Will focus on Flavours. But what exactly is it? Keywords found in the AR about Flavours segment:
- Food additive trading business within the food and beverage business (which is with lower profit margins),
- Tobacco business (cigarette & tobacco flavors).
Hmm.. ‘Sin’ industry.
To paraphrase what is written in the AR:
Flavours business has realized relatively speedy growth while benefitting from the further improvement in product structure of China’s tobacco industry, realizing results from the Group’s “Big Customers, Big Brands” strategy implemented in the food and beverage business, and recovery in the demand of overseas business. Sales revenue of the business reached HKD1,584,179,000, representing an increase of approximately 11.2% over the corresponding period last year.
Let’s think in terms of macro context (not particularly bright according to what I have read in the AR):
- Cigarette industry in China according to the AR – Given the overall industry sales volume growth has been slowing down during the past few years, it is clear that the industry revenue and the profitability have been boosted more and more by the improvement in product structure.
- F&B Market in China according to the AR: The entire food and beverage consumer market remained relatively weak. In terms of food safety, non-compliance incidents relating to food safety in recent years have caused substantial impact on food flavours and food additives industries.
I am quite apprehensive of the tobacco business esp. in an environment I am not familiar in. Would the government impose rules as stringent as in Singapore (eg. smoke only in certain areas, impose manufacturers to display unpleasant photos of cancerous growth in cigarette packaging, high tax duty etc)? This is a powerful and unknown force which could impact the industry as a whole. And reading about the outlook doesn’t help either.
Nevertheless, the food sector has some conflicting views – good & bad. The relatively good part -> (read here – Huabao International gained about 1.5% market share in 2014 over 2013 and here – The flavours (food and beverages) industry is largely consolidated with top five players – Huabao being one of them).
However, being an outsider, and the lack of analysts’ reports on Huabao (found online – perhaps they have more articles about Huabao in the Chinese articles), I am not particularly sure what its business moat is. Simply say what is it that prevents consumers from switching to other companies, what are Huabao’s strong points (besides its own laboratories – constructed a State-recognised technical centre and a post-doctorate scientific research workstation in Shanghai, and has established joint laboratories with several major tobacco enterprises; a designated RTL production and R&D base in Shantou, Guangdong province authorised by the STMA and overseas R&D centres in Germany and the U.S, its relatively big size…). The previous report attached earlier in this post (can read it here again) dated April 2012, seems to suggest that Huabao has made efforts to conceal its operations by using such tactics as substantially reducing its public disclosures in financial reporting and using Photoshop to hide the location of one its facilities. Seem to find a number of other posts that are skeptical about this company also (read here and here).
Hmm.. China firm + Not transparent operation + too good to believe figures —> Alarm bells ringing. Check out why I didn’t buy Sino Grandness shares (read my earlier post here – item 6).
Let’s take a look at its financial (see below):
There are a lot of good points here:
- P/E ratio is a low 5.94 (as per POEMS 2.0)
- EV/EBITDA is a low 3.54 (As a rule of thumb, any EV/EBITDA below 10 is the sign of a good value).
- Profit margin is high at 45.92% (but need to see the historical track record)
- Operating margin is high at 52.99%.
- It lots of cash, HKD 3 Billion after omitting total debt.
- Total Debt / Equity is a low 7.98
- Current Ratio ( total assets of a company (both liquid and illiquid) relative to that company’s total liabilities) is a high 4.13.
- Dividend Yield(%) is ok at 2.5%
Let’s look at its historical track record.
Another impressive sets of results.
- Revenue, operating income, net income, earning per share, book value per share and free cash flow all show a upward trend (even during the 2008/09 financial crisis).
- Gross margin, Operating margin and payout ratio all show a consistently high level.
Finally, there’s return on invested capital (ROIC), which combines the best of both worlds. It measures the return on all capital in- vested in the firm, regardless of whether it is equity or debt. So, it incorporates debt—unlike ROA—but removes the distortion that can make highly leveraged companies look very profitable using ROE.
(Pg 124, The Little Book That Builds Wealth)
ROA, ROE and ROIC all show a slight downward trend, but overall they are still relatively high at around 20%.
Let’s do a quick study on the trailing PEG and intrinsic value of Huabao International Holdings Limited .
1) Trailing PEG
- P/E: 5.94
- Dividend Yield (%): 2.5
- EPS compound growth rate: 4.65% (base on 5 years EPS CAGR – using a starting EPS of 0.51 and ending EPS of 0.64 over a 5 years period)
The trailing PEG will be 5.94/(2.5+4.65) = 0.83. Which is good (< 1).
2) Intrinsic Value
First let’s look at the estimated 5 years earning growth. We are going to use a time-frame of 5 years from now for this purpose. Given EPS and a PE ratio, stock price can easily be calculated for any company. Using the below formula.
F = P(1+R)N where:
- F = the future EPS
- P = the starting (present) EPS (HKD 0.64)
- R = compound growth rate (4.65%. However let’s take a 20% discount, and use 3.72% as I am not really sure if growth can be maintained)
- N = number of years in the future (5)
Estimated future EPS: 0.77
I will be estimating the future PE of Huabao International Holdings Limited to be 17.5875 (See data from Morningstar) – average of the PEs from 2007 to 2014.
Future Stock Price
- P = future stock price
- EPS = future EPS
- PE = future PE
Hence future stock price of Huabao International Holdings Limited is 17.5875 x 0.77 = 13.542375
- P = present (intrinsic) value
- F = future stock price (13.542375)
- R = MARR (15% or 0.15)
- N = Number of years (5)
Hence, the intrinsic value of Huabao International Holdings Limited is 6.73.
Stock price of Huabao International Holdings Limited on 13 Aug 2015 is 3.82. There is a margin of safety and percentage difference between the intrinsic value and current stock price is 43%.
In gist, I have my doubts regarding the business moat of this company. I would need time to be familiar with this company – big size, unfamiliar product, lack of articles about it, foreign regulatory systems (if I have a filing tray like Warren, I probably put this in the ‘Too difficult to understand’ tray).
However, the calculated trailing PEG and calculated Intrinsic Value of this stock suggest that it is undervalued. With the wide margin of safety, it might be worth a second look (esp. when the Hong Kong market crashes). Personally, I feel that the Hong Kong market is still volatile.
Nevertheless, interesting take by the reader on this one.
Thanks for your analysis!
I share your concerns regarding the “too good to be true” figures. But there is one aspect which might allay this concern, which is the increasing dividends payout each year for the past 9 years (amount which is still below the respective year’s FCF). The payout ratio (wrt to Net Income) is 40% below except last year which was 80%. I think this shows that there is real cash generated by the business.
And at current price, dividend yield is about 8%. So I think it is worth trying to understand this company more.
Hmm..upon reading the Anonymous Analytics report, it did raised several red flags. Think it is wise not to allocate too much capital should one decide to invest. All the analysis would be useless if everything is setup as a sham.
When I think about foreign companies, I tend to study the narrative first then the financial fundamentals. This is the opposite of what I normally do for Singapore companies. Perhaps in most cases for local firms, I normally see the brands, products, news more – so I have a feel of how the company has grown (or how they operate). However for foreign companies, if it is readily transparent and understand, it would be worth studying further – into the figures. I am quite apprehensive about ‘creative’ accounting. Singapore is a small but stringent market, as compared to China (although cases of fraud can still be found here). Sometimes, without being aware, we tend to take this (stringent standard) for granted.
For instance, I basically know what most of the companies in my portfolio are doing or what their services / products are. Even for fundamentally weak firms like SIA, SMRT, Golden Agri, etc.
To even stretch it further, there are a lot of beaten down companies now, some may have historical good fundamentals – like Boustead, Super Group, OSIM, Japan Foods, Neo Group, SIA Engineering, Penguin Intl (or firms not doing well financially but share price still not down like Breadtalk…). And in the case for Warren Buffett, so are Precision Castparts / IBM whose financials do not look pretty (this is the same person who went up to the owner of Nebraska Furniture and ask her point blank how much she wants for her business and brought a cheque once she offered a price which was $65 million- and given that it is not even a listed company so the financial records are not known. Subsequently the firm was valued at $85 mil). So the ques, is would you feel more comfortable holding these type of companies or fundamentally good foreign firms which you are not sure what they are doing, selling, etc – in the event that stock prices crash violently.
The idea of investing in ‘What you know’ may be a double edge sword (you end up owning local companies stocks only, and miss out on the wonderful opportunities out there)…but when you invest in companies operating in unfamiliar territory, you really need a wide margin of safety. The good thing about Huabao is that it is China’s largest flavour & fragrance (F&F) company. But so was Noble and Olam in the commodity world (before a few bloggers crashed their growth stories). I see some similarities between Iceberg report on Noble and Anonymous Analytics report on Huabao (paying exorbitant amount for an entity, reselling it to its own subsidiary etc).
Unfortunately, for me the downside risk seems to out weight the potential upside at the moment. So one would really need to read up more on this company (provided the company is open about it first). The lack of news and articles about this company is a concern for me. And I had a hard time understanding their annual report which I feel is really too wordy without getting to the facts (and the firm is also not exactly small… which add to the complexity).
In the Anonymous Analytics report, there is a portion about the possibility of the chair person, Ms Chu using the profits from the sale of her shares to fund the dividend payout. Even with the 5% interest gain by putting the money in the bank, base on the past proportion of shares owned by the public , it is possible to fund the dividend while keeping most of the principle amount (she has) intact.
The issue may only be apparent from now to the future, given her ownership of shares has dwindled from 90 plus percent to less than 38 percent- dividend payout to public becomes more due to their higher percentage alone, and increasing earning resulting in increasing dividend just to keep up with the yield.
When the dividend falls short of public expectation – share prices will react.
Thanks for sharing your thoughts. There is much I can learn from you. Went to check the if the chairwoman did indeed increase her shareholdings like what she promised after the Anonymous Analytics attack. Her holdings increased very slightly from 38+% to 39+%, 3 years on.
Huabao also just realised a profit warning regarding for their Net Income.
For your calculation on intrinsic value, I can see that you choose to use the average however P/E has been on a downward movement since 2007 from 41 to 9.5. The range seems a little huge and I am wondering if this will affect the overall calculation of intrinsic value. Would like to know why you choose to take the average instead of medium or TTM.
Basically the calculation of Intrinsic value is an estimate (it will never be accurate), which is why we have a margin of safety (buffer).
Well you may be right, a more accurate / conservative intrinsic value maybe to use the lower P/E (2014 P/E of 9.5) in this case as there is a downward trend. (if we use a lower P/E, the future stock price will be lower, and consequently the intrinsic value).
If we use P/E as 9.5, future stock price will be 7.315, intrinsic value will be 3.64. Stock price of Huabao on 17 Aug 2015 is 3.18, so there is some margin of safety (~12%).
To quote the book Buffettology by Mary Buffett and David Clark, pg 281:
Please note: When you are choosing a price-to-earnings ratio— P/E—to multiply your projected future per share earnings by, you get the best perspective by running your calculations with the average annual P/E ratio for the last ten years. You should also run your equations with the high and the low P/E ratio for the last ten years, just to give you a better perspective of how well you might or might not do. But be warned, stocks don’t always trade at their historically high P/E. To be overly optimistic in using a historically high P/E ratio can create projections that lead to disaster. Stick with the average annual P/E ratio for the last ten years, especially if there has been a huge spread between the high and the low P/E ratio within the last ten years. When in doubt, choose the middle road.
Thank you for your insightful response. I will take note of that in my own valuation. Just curious why use EPS valuation method instead of FCF valuation method?
I don’t really have a good answer to that, both are estimates. Initially I started using DCF (Discounted Cash Flow) to try to work out the Intrinsic value, but I found it troublesome to calculate free cash flow (until I found Morningstar).
Was reading up the difference – found this website.
To quote: The author provides evidence that supports the idea that stock prices follow earnings than other forms of cash flow measurements because of the noise in cash flows. Things like accounting accruals, cash related transactions, changes in working capital and the ever changing needs of capex.
Hi, may I know which service did you subscribe to obtain the 10 years data for analysis?
I go to Morningstar. If you are looking for 10 yrs data for free cash flow or earnings per share, look under Key Ratios.
However, sometimes they do not provide all the years.
Thank you for sharing! I have been following your blog as a new investor, and it’s really eye opening for me. 😄
Thank you for your insightful analysis on the company. I noticed that when calculating PEG, you had used P/E / (dividend yield + EPS CAGR). Please pardon my ignorance but can you share why dividend yield is used in the calculation? In other instances, I saw that PEG is simply P/E / EPS CAGR.
Perhaps you can check out this website and this website.
Thank you for sharing. Love reading your blog. As A newbie, I have much to learn.
What do you think of the Market now? Are you feeling greedy? I hope you have bullets.
I’m feeling greedy but I don’t have bullets now. I was caught off guard. I’m thinking to realize loss on my so-so counters to deploy to some great companies on a sale right now. Any advice?
My war-chest has always been too low for my liking (creating a huge warchest is never easy).
I think the market now presents a fair bit of opportunities, and I have been dipping a little into it very slowly. There is really no hurry. The near term outlook appears gloomy (rising interest rates, China slowdown, market plunges, Euro – Greece mess, commodity plunge etc), of course the longer term outlook will always be good.
A lot of companies seem to facing troubles in their earnings (even for great companies) – and it is common to read about management citing slowdown in local and overseas markets as a factor. Well, to rotate your holdings from fundamentally poor companies to those with better prospects seem like a good move. I think you must really have to gauge of what the values of these so-so counters are (vs the current share price). Also the narratives and outlook of the companies. But if the so-so counters fundamentals have not deteriorated badly, I don’t think it is wise to sell. Typically people should hold stocks for 3 years or more to know the fundamentals of company.
For me personally, selling is always difficult (and I hate to realise loss) – my weakness. I always felt that patience is very important. Also in the long term I am a net buyer of stocks, so if I keep loading up on better performing and fundamentally strong companies, my portfolio overall will be better (it is impossible to get all your picks correct). In addition, some of my weaker performing stocks are in commodities and cyclical in nature, so fundamentally and operational wise, they are not really bad. They just move in cycles, waiting for the up cycle is the tough part. The ques is: is it wise to sell when the cycle is at the low portion?
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