Long: Cuckoo Electronics (192400)


Share price: 198,000 won
Market cap: 1.85 trillion won
Shares outstanding: 9.8 million
Daily volume: 150,000 shares (30 billion won)


Summary: Strong Korean brand tapping into a growing Chinese middle class market, special situation creating a temporary selling pressure, analyst estimates stale / too low

The Business

Cuckoo Electronics is Korea's top manufacturer of rice cookers. With a stable 70 percent domestic market share, Cuckoo rice cookers have also become very popular in China. Cuckoo also operates a water purifier rental business and is expanding into other appliance rentals. Cuckoo's sales grew 65% in 2013 and are estimated to grow by 15% in 2014, with operating profits growing 102% in 2013 and 26% in 2014E. 2014 estimates are likely too low.

Rice cooker purchases are decided on a combination of brand and technology. The value of brand in rice cookers is similar to brand value in home appliances in general, but with one key improvement: in Cuckoo's key markets, rice is a staple food eaten with every meal. Users become accustomed to the particular flavor and texture of rice generated by their chosen brand of rice cooker. While this taste difference is highly subjective, like Coke vs. Pepsi, users are reluctant to switch brands. I asked a few Koreans about their preference and they all insisted that Cuckoo cooks much better than the Japanese brands. Cuckoo has been the market leader in Korea, in both sales and customer satisfaction, since it entered the business 15 years ago.

The leading-edge rice cooking technology is induction heating (IH). IH works by passing a current through coils, creating an electromagnetic field that generates heat directly in the magnetic cooking pan that is inserted into the coils. IH improves rice cooking in two primary ways. First, temperature sensing and adjustment can be more accurate and instantaneous, allowing for more precise cooking algorithms. Secondly, the heat distribution is more uniform across the pan (rather than just heating the pan from below), which results in more consistent rice.

These technological advancements have driven increases in ASP over the years. Domestic ASP of IH cookers is 253,000 won, about twice the ASP of the previous generation (pressure cookers) and over four times that of thermal cookers. Interestingly, ASPs have risen within each category as well, reflecting improving technology, materials quality, and brand equity. IH cookers are only about half of domestic sales currently, a figure that should continue to rise well into the future.
 
China represents about 10% of Cuckoo's sales, but growing rapidly. The Chinese love Korean duty free shops, where Cuckoo's sales have doubled over the previous year and where 90% of sales are to Chinese. This investment reminds me of Amorepacific, another investment of mine which has done very well this year off of DFS sales. Korean DFS and Korean products in general have become very popular in China with the influence of Korean soap operas and K-pop, and the use of Korean stars in advertising. The number of Chinese tourists visiting Korea has quadrupled since 2010 from 1 million to 4 million, and Chinese now spend more money in Korean DFS than Koreans do. Here are a few articles on the topic:

http://www.moodiereport.com/document.php?doc_id=37171
http://asia.nikkei.com/print/article/19799

In addition to DFS sales, Cuckoo also maintains a significant retail presence of 800 shops in China, and has customized its branding for China. Cuckoo is positioning itself to be the leader in high-end rice cookers in the Chinese market. IH cookers currently have only 5% market share in China, but as that figure grows, Cuckoo will do extremely well. China addressable market is estimated to be 2 trillion won.

I don't have much to say about the water purifier rental business. It's a decent quality business and growing very fast, from nothing in 2012 to 80 billion won in 2013 and likely to grow another 50% in 2014. They have a very small percentage of market share domestically, and market penetration of water purifiers in Korea is about half of the average of other developed countries. Cuckoo outsources production to an OEM; this business can be considered a brand extension strategy to capitalize on their trust with consumers. This business will be about 25% of sales in 2014. The market leader, Coway, trades at 23x P/E.

IPO dynamics

From what I understand, the IPO was motivated by the founder's brother's desire for liquidity. The brother sold half of his shares (15% of shares outstanding) in the IPO, which was run by Woori Investment Securities. The IPO pricing at 104,000 won appears to have been a generous gift to clients of Woori. It's difficult for me to speculate why the brother would sell at this price beyond the usual reasons, but it's important to note that neither the founder, his son (the CEO), nor the company sold shares in the IPO. Also, Cuckoo employees bought 20% of the IPO, while the IPO itself was oversubscribed by 600x (not a typo). The stock opened at 180,000 won and closed "limit up" at 207,000 on the first day of trading. The shares went as high as 255,000 before dropping back to the 200,000 range. Woori clients, as I understand it, agreed to a one month lockup in order to be allocated IPO shares. Sitting on a quick double, it's likely that many of them began selling at the beginning of September when the lockup expired.

 

Furthermore, Korean law allows newly public companies to decline to file quarterly earnings in the quarter in which an IPO is filed. While most companies customarily file the quarter anyway, Cuckoo for some reason did not. Some investors took this as a negative signal and sold the shares off, however, it is unlikely that it signals anything. There is no reason to believe that the business is weak, if anything, it is stronger than expected. Mobile searches on Naver for Cuckoo have been rising rapidly and are now 50% higher than they were in the first half of 2014. Some of this interest may be related to the IPO-- BUT, search traffic remains strong well after IPO, and at worst, the IPO was free marketing for the company. The China market and DFS also seem strong, based on Baidu search volume and on DFS data. Shilla, a public company which gets 90% of revenue from DFS and 76% from Chinese customers, showed a Y/Y revenue increase of 30% in Q2 (the quarter for which Cuckoo has not filed). These two data -- search traffic and DFS data -- are not factored into sell side estimates, which appear to be based on guidance from the company which is most likely sandbagged and was provided before the IPO.

Financials

    2014E (sell side)    2014Q1    2013    2012
Sales    585    142.2    508.7    306.7
Cost of sales        79.4    301.6    242.7
Gross Profit        62.8    207.1    63.9
SG&A        37.6    137.9    30.4
OP    87    25.1    69.2    33.5
Pretax Profit    90    25.5    74.0    36.3
Net profit    70    19.2    57.4    28.8

Valuation

The sell side is likely far too low on 2014E, at a 2014 net profit of 80, the stock would be valued at 25x 2014 earnings, and at a net profit of 85, the valuation would be 23.5x 2014 earnings. But we are only a few months from 2015, so a more appropriate valuation metric would be 2015 P/E, which is probably at 20x or lower. These numbers are cheap for a company growing this quickly and with such a large addressable market. Comps: LiHom-Cuchen trades at 27x trailing P/E and Coway at 23x trailing P/E.

Risks

Competition. Japanese companies Zojirushi and Tiger make technically capable rice cookers, but they are not as well positioned for the China market and have no chance to compete with Cuckoo's brand in Korea. Samsung and LG were previously in the rice cooker market, but exited ~8 years ago for various reasons. It's possible that they re-enter the market, but I believe that they won't try because of Cuckoo's  brand, technology, distribution and service networks, but I could be wrong.
 
Technology. Cuckoo has been the technology leader historically, with the Japanese following them, but this could change if a new generation of cooking technology is invented. This would not be totally negative as a new technology will also likely spur new purchases.

North Korea. 20% of Cuckoo's production is located in Gaeseong Industrial Region, the special economic collaboration between North and South Korea. However, this is not Cuckoo's IH production, or even their pressure cooker production, it is only their thermal cookers. So the economic impact to Cuckoo of a production shutdown would be much lower than 20%. The South Korean government also maintains an insurance fund to compensate manufacturers in the event of a shutdown.

China macro. There are big problems in China construction and real estate. Depending on how you trade this stock, there are two ways to look at it. As a trade on the IPO dynamics, it's unlikely that these macro risks will materialize within the time frame of the trade. As a long term investment, it's an issue but Chinese purchases of rice and rice cookers will probably be okay. If concerned, short some overpriced property companies in HK.

IPO dynamics end
Files next quarter beating estimates
Chinese middle class keeps growing