Huabao International Holdings Limited (My Take)

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.

1. Hosa International Ltd2200:HKG
2. Luk Fook Holdings (Intl) Ltd.
3. Man Wah Holdings (1999)
4. Real Nutriceutical Group Ltd
5. Tencent Holdings Ltd (0700)
6. Nagacorp
7. 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):

1. Flavours; (HKD1,590,276,000 – 74%)
2. Fragrances; (HKD41,942,000- 2%)
3. Reconstituted tobacco leaves; (HKD483,178,000 – 22%)
4. 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:

1. Food additive trading business within the food and beverage business  (which is with lower profit margins), 
2. 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:

1. P/E ratio is a low 5.94 (as per POEMS 2.0)
2. EV/EBITDA is a low 3.54 (As a rule of thumb, any EV/EBITDA below 10 is the sign of a good value).
3. Profit margin is high at 45.92% (but need to see the historical track record)
4. Operating margin is high at 52.99%.
5. It lots of cash, HKD 3 Billion after omitting total debt.
6. Total Debt / Equity is a low 7.98
7. Current Ratio ( total assets of a company (both liquid and illiquid) relative to that company’s total liabilities) is a high 4.13.
8. 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=EPSxPE

• 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

Intrinsic Value

P=F/(1+R)N

• 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.