EXECUTIVE SUMMARY

Trading Metrics and Multiples

Business Overview

Established more than 40 years ago by the Cheung family, Allan International ("Allan") is an original design manufacturer (ODM) of a variety of small kitchen appliances - e.g. blenders, food processors, deep fryers, blenders, kettles - and the low-cost producer within the industry.  Allan is headquartered in Hong Kong with manufacturing facilities in Huizhou, Guangdong.  The Company's top customers, accounting for 95% of revenue, are Philips Electronics, DeLonghi, and SEB SA.  The Company's end markets are divided between Europe (54% of sales), Asia (27%) and the Americas (14%).

Summary Investment Thesis

Allan has (1) a long track record of capital-efficient financial performance that (2) is sustainable as the low-cost provider; (3) is run by an honest and highly aligned ownership/management team; (4) has attractive growth prospects but (5) is trading at a valuation that implies long-term decline.

1.      Excellent operational track record.  Since 2001, Allan has recorded average ROE of 16% while maintaining a very conservative balance sheet with an average of 40% of book value tied up in excess cash, financial investments and investment properties.  Adjusting for these financial assets, Allan's long-term average ROE is over 26%.

2.      Sustainable performance.  While Allan operates in a highly competitive industry, it takes advantage of its structural advantages to be a low-cost provider in the industry and should be able to sustain its operating margins as long as it executes well.

3.      Aligned ownership/management team.  Independent experts have vouched for the integrity and stability of the management team.  Company insiders have bought the stock heavily and have increased their ownership position for over time.  The last time the company issued a single share was more than a decade ago.

4.      Solid growth prospects.  Allan's addressable market is growing, driven by the long-term secular shift of small appliance manufacturing to China.  In addition, while Europe is Allan's largest end market, the Asia region has grown at a 25%+ CAGR over the last five years and now accounts for 27% of its revenue.  The commencement of operations of a new factory that will double the Company's manufacturing capacity is validation of management's views on the company's future growth prospects.

5.      Attractive valuation.  Adjusting out cash and investments (which is equal to about 40% of the book equity) Allan is currently trading at 2.2x LTM EBIT.  Overall, the stock is trading at 4.4x LTM P/E and 0.9x tangible book value.  At these levels, Allan is trading more like a liquidation play even though it is clearly a quality business with solid growth prospects.

Situation

The Company recently released its FY2011 results.  Reasons why the stock is under-valued may include (i) valuation discount as a small-cap that attracts no equity research coverage (ii) lack of liquidity and float is a major obstacle for institutional investors (iii) Eurozone exposure and (iv) headline P/E multiple penalizes the Company for carrying a large cash balance.

The Company declared a 15 HK cent final dividend with the ex-dividend date of August 11, 2011.  The cash impact of the dividend has been adjusted out of the enterprise value calculation and cash balances in this report.

Recommendation

Buy at the current price levels as a long-term holding.  I cannot offer any specific catalysts other than the earnings reports which are released every six months - the 1H FY2012 report will be released near the end of 2011.  The company has historically paid out between 40-45% of its net profits in the form of dividends.

INVESTMENT THESIS

1)         Operational Track Record

Review of the Company's long-term operational track record is important due to the highly competitive nature of the ODM and export manufacturing industry.  As shown in the table below, Allan has made steady progress, resulting in superior returns on capital, especially when compared with other manufacturers.  The headwinds that Allan currently faces - rising input costs and adverse FX movement - have existed for the last decade and Allan has been able to expand its footprint by becoming more efficient.  Based on analysis of the MD&A and discussion with experts, Allan has achieved greater efficiency through semi-automation, utilization of six-sigma best practices and increased scale.  For example, management first discussed earnestly pursuing semi-automation in the FY2005 annual report.  Since then, revenue per employee has more than doubled.  Management began implementing six-sigma best practices in early 2008 and since then the inventory turnover rate has more than doubled. 

* Excludes Construction-in-Progress

** Proxy for return on incremental invested capital.  Adj. Net Income calculated as EBIT * (1 - 20% tax rate).  Capital Employed calculated as normalized working capital (11% of revenue) + fixed assets excl. construction in progress 

2)         Margin Sustainability

While the ODM business model is highly competitive, Allan has certain structural advantages which should allow it to maintain its margins over time.

Margin Analysis.  Allan's gross margins are volatile on a year-to-year basis but revert to a long-term trendline.  Allan prices its products on a one-year forward basis in US dollar terms, with margins narrowing in times of input cost inflation and widening in times of input cost deflation.  While input costs have risen significantly over the past decade, Allan has generally been able to pass through some of this in the form of price increases so that the long-term trend of gross margin erosion has been gradual.  As the company has scaled, it has kept SG&A in check and as a result seen its EBIT margins increase.

FY2008 - when gross margin reached its nadir at 13% - was not only impacted by sharply rising input costs, but also by one-time policy changes affecting the Chinese export industry, including a reduction in VAT refund for a wide range of export product categories and restrictions on certain commodities for use in the export business.  Thus, in the future, even in a high inflation environment such as this year, margins should not fall to such low levels.  Easing commodity price and inflation pressures should translate into stabilization of gross margins in FY2012.

Structural Cost Advantages.  Allan's main input costs are electric motors, electricity & energy costs, copper, sheet metal and labor.  Allan can only have a structural cost disadvantage with regard to electricity and labor since the rest are global commodities.  In this case, Allan would be vulnerable to competition based in areas with lower electricity and labor costs, such as inland PRC. 

Allan claims that direct labor accounts for less than 10% of total costs (this is supported by calculations using Allan's reported headcount).  Moreover, being located in the well-developed Pearl River Delta manufacturing nexus gives Allan other advantages, such as closer access to component suppliers and transportation, which allows Allan to lower inventory and logistics costs and provide customers with more reliable service.  It is this combination of labor costs and infrastructure that mean that Allan will not to be at a structural disadvantage by continuing to base its manufacturing operations in Guangdong for the medium-term.

Note that Allan had previously considered moving production inland before but decided against it due to the above mentioned factors.  Other export manufacturers such as Simatelex, which Allan considers its closest competitor, and public appliance export manufacturers such as Ya Horng, Airlux, Kenford, and Alco, have all decided to keep production in Guangdong currently.  Finally, I note that nothing precludes Allan from expanding to lower-cost inland areas in the future.

Allan is also vulnerable to appreciation of the RMB and weakening of USD (orders are invoiced in USD).  This would put them at a disadvantage to perceived competition from Southeast Asia but I believe this threat to be theoretical at this point.

I believe that over the next five years, gross margin should remain at or above the 16% range.

3)         Ownership/Management Team

The founding Cheung family holds a 60% controlling stake in the Company and occupies most senior management positions.  Trust in this team is critical to getting comfortable investing in Allan.

Third-Party Confirmation.  A personal contact who formerly worked in Deloitte's Hong Kong office, which has audited Allan for 12 years, has vouched for the Company.  He describes the Company as "very clean, very stable" and its management team as "exceptionally organized" and of "very high integrity".  Among the Big 4 accounting firms, Deloitte is known for covering many HK-based Chinese manufacturers.

In addition, David Webb (http://webb-site.com/), a long-time Hong Kong-based small-cap investor, corporate governance advocate, and whistleblower (former independent director of Hong Kong Exchanges and Clearing), has been the largest non-family investor in Allan since 2003 and currently holds a 10% stake.  Mr. Webb is a significant shareholder in a number of small-cap Hong Kong-listed manufacturers and Allan is one of his largest positions.

Recent Insider Buying.  Between April 2010 and March 2011, Mr. Webb increased his stake from 7% to 10% of the Company.  Filings show that his shareholding reached 10% in March 2011 with purchases made at HK3.48 per share.

The Cheung family has consistently been purchasing shares for many years, increasing its shareholding from 56% in 2003 to the current 60% level.  The most recent purchase was in July 2011 at HK3.03 per share.

4)         Future Growth

Even though the small kitchen appliance market in Europe, Allan's largest end market, is mature and overall consumer spending is expected to be stagnant over the next several years, Allan still benefits from several secular growth trends.

Continuation of Outsourcing Trend.  The secular movement of manufacturing from high-cost to low-cost areas is not complete and is taking place primarily through third-party outsourcing.  For example, France-based SEB, the largest pure small kitchen appliance company and Allan's third-largest customer, still has 48% of its production in the Eurozone, down from 72% in 2001.  The main beneficiary of this is third-party outsourcing, which has grown from 9% in 2001 to 37%.  Both SEB and Philips have stated that they plan to continue increasing their share of revenue coming from outsourcing in the future, noting that they are a way to reduce assets while increasing earnings.

While Allan's customer concentration and exposure to slow-growing European and North American are not ideal, the Company has shown that it can still successfully grow by expanding share of wallet of existing customers and by increasing sales in Asia and other emerging markets such as Africa.  Asia (largely driven by China) has grown at a 29% CAGR over the past 5 years and now accounts for 27% of sales.

New Facilities Double Manufacturing Capacity.  Between 2006 and 2009, the Company invested in and completed construction of two new factory blocks on a newly purchased parcel of land in Huizhou.  Due to the economic downturn, the Company decided to delay activation of this facility.  With its current facilities operating at near full capacity, Management has decided to commence operation of the new plant.  After a delay, the plant commenced operations last month (August 2011).  Management has stated that this new factory will effectively double manufacturing capacity.

Allan has seen elevated capex over the past year as they have been building and outfitting the new manufacturing facilities.  Given Allan's track record of superior returns on capital, this investment is likely to result in significant revenue growth and increased earnings power in the long run.

KEY INVESTMENT RISKS

Customer Concentration.  Allan's revenue is highly concentrated, with the top 3 customers - Philips, DeLonghi, and SEB SA account for 94% of revenue.  Philips alone accounts for 45% of revenue.  All three are leaders in the small kitchen appliance industry so the main risk is lack of bargaining power as opposed to counterparty risk.

Cost Inflation/Appreciation of RMB. As discussed earlier, this will lead to margin pressure but the threat is not a competitive one because Allan is not at a structural cost disadvantage and other manufacturers will face similar cost increases.  The larger worry is what effect inflation will have on end consumer demand (as well as near/medium term concerns about European demand).

Competitive Industry.  As discussed above, ODM manufacturing is a highly competitive business requiring continuous operational improvement to stay ahead of competitors.

Potential Competition from Domestic Appliance Industry.  There are number of mainland Chinese appliance manufacturers, including Midea, Joyoung, and Zhejiang Aishida, and Supor (a subsidiary of Groupe SEB), that are significantly larger than Allan (though perhaps not larger in Allan's specific product categories).  These companies are currently focused mainly on the domestic market and their products are generally considered to be of lower quality than Allan's products which are meant for the international market.  Theoretically, these companies could enjoy scale benefits if they were to compete direct with Allan.

VALUATION

I value the Company using at 7x FY2011 EBIT, which I believe appropriately balances the company's growth prospects with the risks described above.  This multiple implies a share price of $4.79, a 125% premium to the current trading price.