Description

Chuk Kin “C.K.” Lau generated 23% annual returns for his shareholders over the past 13 years in his role as controlling shareholder and Chairman/CEO of Cinderella Media (formerly Recruit Holdings).  Even more remarkable is that these exceptional returns were made possible not only by a successful turnaround of the existing loss-making business but by the creation of two unrelated businesses from scratch, followed by highly accretive M&A and generous returns of capital to shareholders.

Despite C.K.’s Hall of Fame stats, he still operates in relative obscurity in what might be the least sexy industry in the Hong Kong small cap space: book printing.  Thanks to the apocalyptic visions that come to mind when these two words are spoken roughly forty years into the digital age, investors can invest alongside C.K. today at 5x P/E with a net cash balance sheet through 1010 Printing, which was created within Cinderella Media in 2006, separately listed in 2011 and spun out to shareholders in 2014.  We think C.K. will be able to continue his run of great performance for shareholders over the next several years, with 60% upside to immediate fair value and potential for further growth.

Background

C.K. started his professional career in the printing industry and co-founded Midas Printing in 1990.  Midas was listed in 1996, and the founding group sold their controlling stake, held through ERI Holdings, in 2000.  C.K., who oversaw five profitable years as Managing Director, left Midas and signed a non-compete agreement shortly after the change in control.

With the windfall from the Midas sale, C.K. formed ER2 Holdings, which through subsidiary City Apex acquired a 34% stake in publicly listed Recruit Holdings from Publicitas and JC Decaux in October 2002.  The Company, which primarily operated a job information magazine and online portal in Hong Kong, was hemorrhaging cash at the time, and City Apex injected capital following the stake acquisition.  C.K. took the reins as Chairman of Recruit Holdings on November 1, 2002.  Within the first year of C.K.’s leadership, the Company turned a HK$28.9m operating loss into a $2.6m operating profit on HK$50m of revenue.

In March 2004, the Company secured an exclusive agreement for advertising and production of China Eastern Airlines’ monthly in-flight magazine.  The business grew to include contracts with Air China, China Southern, and Taiwan-based China Airlines, and proved to be a nice way to profit from growth in luxury goods sales in China during the boom years, peaking at HK$730m revenue and HK$150m operating profit in 2012.  However, airlines took notice as the business became more profitable, and Air China became the first to take in-flight advertising sales back in-house when their contract came up for renewal in December 2012.

In 2005, following the expiry of C.K.’s non-compete agreement with Midas, the Company launched a printing business, 1010 Printing.  1010 Printing was profitable from the first year of operations, focusing on cookbooks, full-color coffee table and children’s books, and primary textbooks which were less susceptible to secular decline than novels or secondary textbooks.  1010 Printing was separately listed in 2011 and Cinderella Media’s 60% stake in the Company was distributed to shareholders in April 2014.

Following the loss of the Air China contract in 2012, C.K. began to focus most of his efforts on 1010 Printing as he saw the writing on the wall for the remaining in-flight advertising contracts.  In August 2015, ER2 Holdings sold its controlling stake in Cinderella Media for HK$2.04 per share, triggering a mandatory takeover offer for all remaining shares at that price (was not fully subscribed as shares have traded above that price since). 

Investors who followed C.K. into Recruit Holdings at an equivalent of HK$0.52 per share in 2002 ultimately received HK$1.88 per share of regular and special dividends, at least HK$2.04 for their remaining stake in Cinderella Media, and the equivalent of HK$1.45 per share of 1010 Printing shares, based on today’s trading price.  As excess capital was distributed, shareholders had a number of opportunities to reinvest dividends at attractive IRRs as well.

1010 Printing

We expect that not many VIC members on the long side would claim to be familiar with the printing industry, as the capital intensive and increasingly commoditized nature and secular decline of the industry would prevent most printers from popping up on quality-focused stock screens.  Most of what we think we know about the printing business, we know from following 1010 Printing, and we would welcome comments from any members who have spent time researching the industry on the short side.

1010’s business model is predicated on the assumption that the market for print will decline substantially over time.  Global print penetration for novels could fall to 30% by 2020, and the textbook market may be as low as 20% print in 5-10 years.  This trend actually reversed somewhat in 2015, suggesting that print may not decline as fast as initially predicted:

http://www.nytimes.com/2015/09/23/business/media/the-plot-twist-e-book-sales-slip-and-print-is-far-from-dead.html?_r=0

As such, 1010’s business is primarily focused on more resilient end markets where digital penetration is low and staying low.  Digital penetration of coffee table and cookbooks is only 5% and growing at a single digit rate, and the print market for these books is actually still growing.  The same goes for children’s picture books.  Fiction has been avoided entirely.

Paper inventory management is a key focus for the Company, as it makes up about 40% of a printer’s costs.  1010 sources the majority of its paper from Japan, where fierce competition and oversupply due to low financing costs have driven prices down to the point that it is cheaper than locally produced Chinese paper after transportation costs are included.  The Company buys in bulk in advance and sells at spot at an attractive margin and can predict the type and amount of paper needed by maintaining good relationships with their top customers, as about 50% of revenue is from reprint.  Lower paper costs have given the Company a significant edge over local competitors Midas and Hung Hing in gross and operating margins.  As 1010 wins or acquires more business, its bargaining power for supplies should continue to improve.

1010’s physical plant in Guangdong is 100% utilized, and at this point at least 60% of their revenue is outsourced.  The Company has no plans to expand physical capacity, C.K. likens their asset-light print management strategy to the “Li & Fung of printing.”  Margins are lower, but obviously capital requirements are much lower. 

Most of 1010’s competitors in China are operating asset-heavy business models; in many cases they own their own factories.  As the secular decline of the industry has pressured revenues and margins, some operators are closing up shop and selling the factory buildings, which tend to be worth far more than the operating businesses themselves.

APOL Acquisition

In December 2012, 1010 Printing announced the acquisition of Asia Pacific Offset Limited, an asset-light print management company with a largely complementary customer base of international book publishers.  APOL was already outsourcing all of its business to printing subcontractors in China, so the integration of APOL’s print brokerage business into 1010 Printing was relatively seamless.

http://www.1010printing.com/pdf/investor/20130113/e1127_130114_cir.pdf

APOL’s net income in 2010, 2011, and 2012 was HK$22m, HK$40m, and HK$40m respectively, and the purchase price was HK$160m, only 4x P/E.  In conjunction with the acquisition, the Company raised HK$100m through a fully subscribed rights issue at HK$0.50 per share.

http://www.1010printing.com/pdf/investor/20130314/e1127_prospectus.pdf

As the rights issue was fully subscribed by all shareholders, it was not dilutive to existing shareholders, and the shares have not traded below the offering price since.  In 2013, EPS grew 51% yoy due in part to the addition of APOL financial results.

Given the valuation paid and compatibility with the existing business, the APOL acquisition was highly value accretive for 1010 Printing shareholders.

Opus Group Turnaround

In July 2014, 1010 Printing purchased the bank debt of Opus Group, a diversified Australian printer on the verge of bankruptcy, from Commonwealth Bank of Australia for HK$150m, with a face value of HK$339m.  In October 2014, a recapitalization plan was announced in which the entirety of the debt would be converted to equity:

http://www.1010printing.com/pdf/investor/20141023/e1127_141024_cir.pdf

Following the recapitalization, 1010 Printing owns 61.8% of Opus Group equity and options that will increase its stake to 67.6% when exercised in full.  The purchase price of the CBA debt and subsequent conversion implied a market cap of about A$34m. 

In the year ended June 2014, Opus recorded a net loss of A$47.1 due to a goodwill writedown of A$38.1m and net interest expense of A$7.3m.  EBIT was A$3.3m and EBITDA was A$10.4m on A$116.9m of revenue.  Net debt before conversion stood at A$50.6m.

In addition to eliminating debt and thus interest expenses, Opus Group has undergone sweeping organizational change under 1010’s ownership and C.K.’s leadership.  C.K. parachuted in his CFO who has worked with him since the Midas days, Idy Lam, to help oversee the transition, saving A$350k in professional fees per annum that would otherwise go to an interim CFO.  A good amount of fat has been cut out at the top, as 11 senior staff earning A$200k per annum each have left.  5 of these staff members were in the finance department, and judging by previous results they were likely doing more harm than good. 

Aside from a workforce readjustment, C.K. and Idy also looked for low hanging fruit on the expense side, for instance saving nearly A$400k from a change in the Company’s insurance policy.  They have also realized some synergy with 1010 by sharing buying power and equipment.  As one can imagine, there was initially some strong pushback from the management team in Australia, but as the results are starting to show, the pushback has subsided.

In the 6 months ended June 2015, Opus reported A$55.5m revenue, A$6.1m EBITDA, A$4.2m EBIT, and A$4.7m net income helped by a A$0.7m extraordinary gain.  Net cash stood at A$6.7m.  Based on these initial numbers, the implied forward valuation of 1010’s investment was about 2.8x EV/EBITDA, 4.0x EV/EBIT.  There could be more good news to come, as C.K. is now working to introduce Australian-based business to Opus and has mentioned that the Company could benefit from very nice operating leverage if utilization rises above 60%.  We believe that Opus could ultimately generate A$10m of annual net income.

http://opusgroup.com.au/media/docs/pdf-20150825.pdf

Furthermore, there are a range of corporate actions which could take place in the near future which would be very beneficial to Opus and 1010 shareholders.  The Company resumed dividend payments following the June 2015 results, but there is considerable room to increase the payout ratio if they remain listed which could ultimately result in a high teens dividend yield on the current share price.  The Company recently disposed of its New Zealand-based Outdoor Media business, which could be a sign of what’s to come with the Australian-based Outdoor Media business, which management sees as non-core but has been well run and consistently profitable.  Finally, the Company has established a share sale facility for holders of Unmarketable Parcels, meaning parcels with a market value under A$500, which will reduce the number of shareholders from 3,823 to 383.  This could be preparation for a privatization proposal, which would generate further professional fee savings for 1010 shareholders.

http://opusgroup.com.au/media/docs/pdf-20151030.pdf

http://opusgroup.com.au/media/docs/pdf-20150904.pdf

Opus Group’s results contributed HK$17m to 1010 Printing’s H1 2015 net income.  For now, the Opus net income is compensating for a setback in the core business caused by currency headwinds.  A strengthening USD and RMB in the first half hurt business in Europe and Latin America.  Historically, a strengthening RMB against the AUD has also hurt 1010’s business, but having Opus to refer Australian business to and vice versa may soften the AUD/RMB currency exchange rate effects going forward.  The cost to print in Australia has been as much as twice the cost to print in China in recent years, but a weakening AUD makes local Australian printers more economically viable.

Investment Property Sale and Leaseback

If you are still not fully convinced that a Hong Kong company could be a great capital allocator, we have one more piece of evidence for you.  In September 2014, 1010 announced that it would sell its investment property, a floor in a Hong Kong office building primarily held for its own use but partially rented out to independent third parties, to Cinderella Media.  In a market where the majority of listed companies own some kind of investment property, it feels like 1010 is making a bold statement:

“The 1010 PGL Board is of the view that as property investment is not the core business of 1010 PGL, the disposal of EOIL will enable the 1010 PGL Group to focus on its core business of provision of printing services and improve its management and operation efficiency.”

http://www.1010printing.com/pdf/investor/20140901/EW_Ann_EOIL_1Sep2014.pdf

Shareholders

Following the Cinderella Media stake sale, 1010 Printing is C.K.’s only substantial public holding.  In addition to the 34.6% stake held by ER2 Holdings, C.K. increased his personal stake to 4.6% in late 2013. 

The second largest shareholder is Hong Kong-based activist investor David Webb, who declared a stake over 5% in 2014 and has been gradually increasing his stake to 8% today.  Webb is vocal at the Company’s AGMs, and his input on corporate governance has been welcomed by the Board.  Given Webb’s excellent investment track record (https://webb-site.com/articles/pick2009.asp) and dedication to strengthening corporate governance in Hong Kong, we think we find ourselves in good company.

The third largest shareholder is JobStreet Corporation Berhad, which owns a 7% stake received through its holding in Cinderella Media.  JobStreet is a listed holding company that historically held online job classified properties in Asia.  The Company originally made an investment in Cinderella Media for Recruit, but they likely stayed for C.K.  In 2014, JobStreet sold its 100%-owned Southeast Asian properties to its largest shareholder, Australian online job classified Seek Limited, and paid a special dividend to shareholders.  In 2015, JobStreet disposed of its remaining stake in Cinderella Media through the mandatory takeover offer.  1010 Printing does not seem to fit with the Company’s current investment strategy, and in fact they seem reluctant to include the stake when they list their holdings on their corporate website: http://jcbnext.com/.  We think it is likely that JobStreet would be looking to sell their 1010 Printing stake, either back to the Company or to C.K.

Valuation

Our historical financials may look a bit different from those in financial databases, as we are pulling the numbers from the annual reports.  In Capital IQ, “Other Income” is not included in EBIT, although the majority of this income is from sales of scrapped paper and by-products, which we think would be correctly accounting for as revenue and thus included in EBIT.  The item is recurring, and in Capital IQ the result is that net income is higher than EBIT in every year since 2008.  This doesn’t make sense for investors who prefer to use EV/EBIT as a valuation tool.

2015 and 2016 estimates are our own, and we admit that it is very difficult to predict results with a high degree of accuracy given wide swings in the currency markets of late and the potential for more M&A.  2015 estimates are based on a continuation of H1 2015, and 2016 estimates assume 5% organic growth.  2015 Annual Results will be announced this Monday, February 29.

Our view is that the business should be able to continue to win share in a shrinking market for the foreseeable future both organically and through accretive M&A with C.K. at the helm, and any excess capital that cannot be deployed at an attractive rate of return will be returned to shareholders sooner rather than later.  We think current fair value is closer to HK$1.60 per share, which would still give investors a 12% earnings yield which will either be distributed or reinvested in growth.  However, if undervaluation persists, we think the stock still has a good chance of reaching this price within two years as cash comes in.

Key Risks

Key man risk – Shareholders have raised the issue of a succession plan at past AGMs, and it is something that management has had time to consider and prepare.  If something happened to C.K., we do not believe that the business would subsequently fall apart but the growth potential would likely diminish considerably.    We believe that it is more likely that the management team would focus their efforts on maintaining the existing business and that the shareholder base would consider strategic options, potentially an outright sale.

Currency risk –The Company’s end markets, production base, and paper supply are all denominated in different currencies, adding a layer of complexity to financial operations that management has thus far handled well.  From our understanding, it appears that the business could weaken further if the USD continues to strengthen along with the RMB.  At the same time, many market observers are calling for a weaker RMB or a weaker USD or both, which would help our cause. 

Rising paper costs – as the largest single component in the cost structure, a turn in the paper market would hurt 1010 and the wider printed book market.

Rising labor costs – A demographic-led labor shortage is driving up wages in China, which will hurt Chinese printers’ global competitiveness.

Accelerated decline in printed book market

Fierce price competition from players fighting for survival

Catalyst

Accretive acquisitions

Increased return of capital

Low valuation