Beauty China (Bloomberg ticker BCH SP) possesses one of the top 10 cosmetics brands in China. The company currently trades at 11.4x 2008 earnings and 8.2x 2009 earnings (excluding excess cash on the balance sheet) and has a long-term growth rate of 25-35% per year. We believe this company is worth S$ 2.26-2.84, significantly more than the current price of S$ 1.33. (Prices are in Singapore dollars.)

 

The company is benefiting from enormous secular tailwinds. Economic history has shown that as countries develop and become more wealthy, people begin to spend a larger and larger portion of their incomes on cosmetics. This is currently taking place in China. The Chinese cosmetics industry is growing rapidly (estimated at 10-20%), and Beauty China will be a prime beneficiary.

 

Beauty China possesses very attractive financial characteristics. Over the last 5 years, revenue and operating income have grown 38% and 27% on average annually (CAGR). Operating margins are approximately 30%, and ROE is over 100% (will come down).

 

The primary reason the stock is cheap is because operating profit growth will slow over the next 2-4 quarters due to startup costs as the company ramps up production at its new cosmetics production plant in Zhuhai. During the first half of 2007, revenue grew at 33% and operating income grew at 30%, in line with historical levels. Over the coming several quarters, revenue growth should continue to be around 30%. As the company starts up the new factory, operating income growth will slow. However, once the factory is up and running, Beauty China will experience several quarters of above trend operating income growth as the company recaptures lost margin and experiences margin expansion from the factory. In other words, operating income growth over the coming quarters may look something like 1%, 5%, 5%, 9%, 53%, 73%, instead of 30%, 30%, 30%, . . . . Over the next 2-3 years in totality, operating income should grow 25-35% annualized, but the growth just will not be in a straight line because of costs from bringing the new factory online.

 

This slowdown in profit growth is completely known and has been discussed by management for the last 7 months. We believe the temporary slowdown in earnings growth presents an opportunity to buy a long term 25-35% grower at 11.4x earnings in an extremely attractive business.

 

In addition to this writeup, the reports put out by Merrill Lynch and the company’s investor presentation (available at  http://www.beautychinaholdings.com/IR_slides.asp) are useful sources of information. The stock trades approximately $600,000 (USD) per day on the Singapore exchange and so is liquid enough for institutional investors to buy.

 

 

 

Over the last several years, we have been watching the tremendous economic growth taking place in China and India and wondering how to participate. As long-term value investors, our hope has been to invest now in great businesses with long runways of growth ahead that we hope to own for a long time. If we can find businesses in China of the same quality as Starbuck’s, Moody’s, or See’s Candy in the US, we should be able to compound money at high rates of return for a long period of time.

 

Unfortunately, finding companies like these has been easier said than done. Most of the Chinese businesses that we are pitched have narrow economic moats, questionable business models, or are in commodity industries. And the Chinese companies with significant competitive moats tend to already be trading at nosebleed valuations. Beauty China is one of the few Chinese companies we have looked at in an attractive business that trades at a cheap valuation. Cosmetics companies with strong brands are truly great businesses. They typically have ability to raise prices from year to year, grow over the long-term, have high margins, generate strong cash flow, possess high return on capital, and are stable businesses as long as brand identity is maintained.

 

 

 

Beauty China sells two main brands of cosmetics. Colour Zone is the company’s flagship brand responsible for approximately 90% of sales. The company is developing a second brand called Charming Lady which is currently in its startup phase.

 

The Chinese cosmetics market can be divided into 3 tiers. At the very high end are brands like Lancome. High end brands sell products which are nearly identical in quality and price point to the products those companies sell in the West and Japan. The mass market (middle level) is made up of branded products made by both Chinese companies and international cosmetics giants. Price points in this market typically range from 40-150 RMB ($5-20). Below the mass market, the cosmetics market is mainly made up of unbranded, low price products. Product quality at the low end can be highly inconsistent.

 

The mass market is currently affordable for a fraction of people in China. Accurate data is hard to obtain, but published estimates suggest that perhaps 150 million of China’s 1.3 billion people can afford mass market cosmetics. As the country becomes increasingly wealthy more and more people are beginning to be able to afford cosmetics. Currently, annual per capita spending on cosmetics averages $4 compared to $60 in the West. However, annual per capita cosmetics spending in the most developed Chinese cities (where wages and incomes are higher) is already up to $20. Based on this data, one might anticipate that the cosmetics market will have a long road of growth ahead. The market is currently estimated to be growing at 10-20% annually.

 

Beauty China’s products address the mass market segment. Colour Zone products participate in the middle-to-low price points of the mass market, and Charming Lady (in development) addresses the high end of the mass market. Colour Zone’s target demographic is young women ages 18-28. Charming Lady is targeted to a slightly older age group with more conservative color choices and the ability to add on a high margin skin care segment similar to Avon and Olay. Competing products in the middle market include local Chinese brands and Western brands such as Maybelline, Avon, Revlon, Cover Girl, etc.

 

Beauty China was started in 1996 by Wong Hon Wai (Chairman). In the beginning, the company had only 50 products. Access to capital was limited at the time so the company developed a low capital, low-risk business model. The company does not manufacture and distribute product using the standard wholesale model. Instead it buys raw materials, arranges for shipment to third-party manufacturers, and then has the finished product shipped to its distributors. Distributors are third-parties and are not company owned. Throughout this process inventories are largely carried by distributors, not the company. Furthermore, distributors have no rights to return products so inventory risk for Beauty China is low. Moreover, Beauty China’s customers pay for most of the retail capex needed for distribution. (Beauty China pays for some of the retail racks and displays but does not pay for any capex for store construction.) The result has been that the company has been able to sustain very high ROEs and generate large amounts of free cash while growing. ROEs (excluding excess cash) have been more than 100%, and the company has converted about 70% of net income into free cash flow (after paying the capex needed for 30%+ annual revenue growth).

 

 

 

The key to the company’s success so far has been focus on product quality and branding. Uneven product quality has been a major problem in China’s cosmetics market. Even well-known international cosmetics players have been hurt by incidents of toxic chemicals being discovered in their products. Beauty China is very focused on production quality, and this is one of the main reasons the company has recently decided to take ownership of its own production. Its new plant in Zhuhai will be one of the first GMP certified cosmetics factories in China, and thus should give the company a leg up in terms of product quality. We have visited this factory, and the place looks very impressive.

 

The company has also been successful in building brand strength. Beauty China has been focused for many years on branding through TV, print, promotional events, and media sponsorships. We have confirmed that Colour Zone is a well recognized brand by visiting malls in China and talking with young women who are the company’s core demographic. In 2004, Beauty China hired pop group “The Twins” to serve as brand ambassadors for Colour Zone. This move has given the company a boost in terms of brand recognition.

 

Accurate market share data is difficult to come by, but Beauty China is estimated to control approximately 4-5% of the Chinese cosmetics market and rank somewhere in the range of #3-8 in terms of market share. Maybelline is the market leader with estimated 15% share. After that, several brands such as Avon, Revlon, Yue-Sai (now owned by L’Oreal), and Cover Girl each control 3-8% of the market. The market is fragmented, and there are many small players. It is expected that many of these players will lose share to larger companies like Beauty China going forward due to the Chinese government’s ongoing push to improve cosmetics safety and quality.

 

Beauty China’s growth has been driven by expansion of its distribution network. The company started with only one distribution point (POS) for Colour Zone in 1996, and this has since grown to 1,345 POS for Colour Zone and 214 POS for Charming Lady. Points of distribution have recently been growing at 30% annually. Over time, Beauty China experiences same store sales growth from existing POS, however, new POS that are opened each year start at a lower sales per POS so the average sales per POS stays flat over time. This is equivalent to US retailers (like Bed Bath and Beyond in its high growth days) with high comps where sales per store is flat over time because new stores added into the store base each year start off at lower sales levels muting growth in average sales per store.

 

Beauty China’s still has the potential to add many more POS, and over time its distribution network should be multiples of its current size. Maybelline already has over 10,000 POS in China, and Avon has over 5,000.

 

 

 

The chart below gives the company’s historical financials:

 

	2001A	2002A	2003A	2004A	2005A	2006A	2007E	2008E	2009E
Revenue (Hong Kong $)	93,500	138,100	188,055	262,335	346,586	466,601	615,913	800,687	1,040,894
CGS			-63,822	-95,360	-126,876	-174,045
Gross Profit			124,233	166,975	219,710	292,556
Other Operating Inc.			312	1,347	3,141	8,815
Distribution			-35,602	-57,143	-92,904	-138,931
Administrative			-8,738	-12,665	-14,052	-16,923
Other Operating Exp.			-407	-870	-5,743	-10,333
Operating Income	40,600	58,400	79,798	97,644	110,152	135,184	155,210	208,179	291,450
Finance Cost				-362	-536	-444	-810	-1,000	-1,000
Pretax Profit			79,798	97,282	109,616	134,740	154,400	207,179	290,450
Taxes			-13,667	-9,097
Profit After Taxes			66,131	88,185	109,616	134,740	154,400	207,179	290,450
Diluted Shares			342,360	342,360	343,991	343,991	345,000	359,000	359,000
EPS (HK$)			0.19	0.26	0.32	0.39	0.45	0.58	0.81
EPS (Singapore $)			0.04	0.05	0.06	0.08	0.09	0.11	0.16
Operating Stats
Operating Margin	43.4%	42.3%	42.4%	37.2%	31.8%	29.0%	25.2%	26.0%	28.0%
Revenue Growth		47.7%	36.2%	39.5%	32.1%	34.6%	32.0%	30.0%	30.0%
Operating Income Growth		43.8%	36.6%	22.4%	12.8%	22.7%	14.8%	34.1%	40.0%
ROE (Ex. Cash)			251%	168%	133%	109%
Valuation
Share Price (Singapore $)								1.33	1.33
Cash								(0.06)	(0.06)
Adjusted Price								1.27	1.27
P/E								11.4	8.2

 

 

As shown the company has a phenomenal record of financial success. Revenue has grown at 30%+ in every year of the company’s history, and operating income CAGR over the last 5 years has been 27%. The company’s ROE has been historically over 100% due to the company’s asset light model. This will come down in the future (but still remain healthy) due to the capital the company has invested into its new production plant.

 

One of the questions that often comes up regarding the company is: Why have margins come down? Margins have fallen by approximately 13% over the last 5 years, mainly as the result of the company increasing A&P (advertising and promotion) spending from less than 10% of sales to more than 20% of sales (21% projected for 2007). We view this as a healthy and natural evolution of the company’s business over time and an important part of building brand strength. International cosmetics players with strong brands typically spend 20-30% of sales of on A&P. Beauty China has said that it expects A&P spending to stabilize around 20% over the long term, but we think it is more likely that spending will continue to rise as a percentage of sales, albeit more slowly than in the recent past.

 

Another common question that often comes up is: Why does the company pay no taxes? Beauty China has set up a subsidiary in Macau which is exempt from taxes as part of its tax planning strategy. This subsidiary sources the company’s products and sells them to its distributors. As a result, the company’s income is booked in Macau, and Beauty China does not pay taxes on it. There is no move underway currently to start requiring Macau companies to pay taxes, and the Chinese government has a disincentive to do this in the medium term given the importance of Macau as an engine of economic growth. However, at some point it is possible that Beauty China will have to start paying taxes. In our DCF models, we assume that the company pays no taxes for 5 years and after that begins paying the uniform Chinese rate of 25%. We take comfort in the fact that if earnings are fully taxed, the company’s 2008 EPS multiple only rises from 11.4x to 15.3x which is still cheap for a business of this quality.

 

 

 

There are several reasons why Beauty China’s stock is currently cheap. The most important of these has to do investor unwillingness to hold the stock in the short term because earnings growth will slow over the next several quarters due to startup costs from the company’s new factory. The factory has been in trial production since March of 2007 and is just now starting commercial production. Initially, Beauty China’s own production will use roughly 35-40% of the plant’s capacity, and over time the company’s growth will mean that more and more production is taken up by the company’s own products. The company has plans to fill unused production by signing OEM manufacturing contracts with other cosmetics companies. Since the factory is one of the most modern in the country, the company has already seen interest from other companies in filling capacity. The plant is expected to break even at roughly 60% capacity and eventually produce a 30% operating margin once it is fully operational. However, during the startup phase, the factory is expected to dampen earnings growth. Because the exact timing of the new plant’s startup is difficult to predict, exact forecasts are tough but the coming quarters may look something like:

 

 

	Q1 07	Q2 07	Q3 07E	Q4 07E	Q1 08E	Q2 08E	Q3 08E	Q4 08E
Revenue (Millions HK$)	114.7	118.7	182.1	196.0	149.1	154.3	236.8	254.9
Net Income	35.4	34.6	41.9	41.2	37.3	37.8	63.9	71.4
Earnings Growth YOY			0.7%	4.8%	5.3%	9.3%	52.6%	73.3%
Net Income Margin	31%	29%	23%	21%	25%	25%	27%	28%

 

 

As shown, the initial startup costs will depress margins leading to below trend earnings growth for a few quarters. (Trend growth is roughly 25-35%.) As the plant continues to ramp and margin is recaptured, earnings growth will then be above trend for a few quarters. Over the long term, the effect of the plant should be to improve margins as Beauty China captures incremental profits from in house production. In totality, when viewed with a 2-3 year perspective, earnings should grow at trend (or better) over that entire time, but the pattern will be several below trend quarters followed by above trend quarters. Revenue should continue to grow steadily at 25-35% during this time. We believe the slowdown in reported earnings over the coming quarters (although fully disclosed by the company since the beginning of this year) has held the stock price down. For long-term investors this presents an opportunity.

 

There are two other factors that are likely contributing to the company’s cheap valuation. First, the company is underfollowed in the investment community. While management does talk to investors, they do not spend much time on the investor relations circuit and do not have a charismatic spokesperson to interact with shareholders. Beauty China is definitely not the in vogue China play that makes the rounds at every China conference. We would suggest that investors who are interested set up a call or meeting with the company’s CFO Joe Wong. We have met with Joe twice in Hong Kong and also toured the company’s new factory with him. Joe is not a polished spokesperson, but he knows the business, is good with the numbers, and speaks English. The best way to get a call set up is to work through Merrill Lynch or UOB Kay Hian (regional broker).

 

The final factor contributing to the stock being cheap is that Singapore listed companies are often not given the same multiples as companies traded in Hong Kong. Despite the fact that corporate governance is generally considered better in Singapore, Asian investors perceive companies listed in Hong Kong as being more prestigious than those listed in Singapore.

 

 

 

The main risk of investing in Beauty China revolves around how the company will deal with competition from international cosmetics houses. International cosmetics companies view developing their cosmetics businesses in China as a top priority. In many cases, they have employed a “land grab” mentality to the Chinese market, trying to grab as much market share as quickly as possible often without regard to long term economics. A good example of this is Maybelline (owned by L’Oreal). Maybelline has achieved #1 market share in China, but to do so the company has spent so much on marketing that the business has lost money. Moreover, in its drive to expand, the company has aggressively built out its distribution network to over 10,000 POS. However, industry sources indicate that in doing this Maybelline opened many unprofitable POS with low sales volume and has had to restructure portions of its distribution network.

 

Throughout its history, Beauty China has faced international cosmetics companies intent on capturing market share with the ability to spend money supplied by profitable operations in other parts of the world. So far, Beauty China has been able to thrive against this competition due to its local market knowledge and sound business execution. It has grown market share consistently and built a very profitable business. If history is any guide, this is likely to continue, and so far there is no indication that competitive pressures are seriously hampering the company’s growth or profitability. However, there is a risk that at some point Beauty China will struggle to compete against the money, marketing, and R&D infrastructure of the major international cosmetics houses.

 

A secondary risk of investing in the company revolves around its new production facility. Beauty China has invested significant capital into the Zhuhai plant. It is important that the operation of the plant goes as planned, that the plant’s economics are as expected, and that the company is able to secure OEM contracts to fill excess capacity. All of this should be achievable, but until the plant is up and running, there is some risk that things do not go as planned.

 

 

 

The stock currently trades at S$ 1.33 (Singapore dollars) per share. After making all payments for the new plant, Beauty China will have S$ 0.06 of net cash per share. Subtracting this from the stock price gives an adjusted price of S$ 1.27. Beauty China should earn S$ 0.11 and S$ 0.16 in 2008, and 2009 respectively. So the company is trading at 11.4x 2008 EPS and 8.2x 2009 EPS.

 

Given the company’s 25-35% growth, high ROE, prodigious cash generation, attractive end market, and strong business model, we believe Beauty China should trade at 20-25x 2008 earnings (plus excess cash). This would imply a value of S$ 2.26-2.84 per share. International cosmetics companies L’Oreal and Estee Lauder trade at 22x and 18x earnings respectively and should grow earnings around 10% long term. Beauty China’s much faster growth rate would argue for a significantly higher multiple than these companies, but it also makes sense to factor in a “China discount.” A company with Beauty China’s growth, returns, and cash flow characteristics in the US would probably receive a 30-35x EPS multiple, but given the China factor, we think 20-25x is reasonable.