Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Exactly 22 years ago a certain “Michael99” pitched a growing Mexican poultry producer at 3.5x earnings and sitting on a cash pile.  Since then, generations of value investors have been reminiscing about the good old days when opportunities like this existed.

Dream International is not a poultry producer.  Instead, it is a glorified sweatshop ^TM * headquartered in Hong Kong and run by a Korean family who had such great corporate controls that someone stole their bank token and with it $5M.

So why write up this idea and why should you care?

In the last decade the company grew top line LDD and EPS by 20% annually.  Competing against smaller family shops, it benefits from scale / quality advantages, which helped the company generate 18% ROE in the last 15 years (even though ROE was penalized by the cash pile it carried).  It trades for 4x earnings and has a cash pile equal to 30% of the market cap (note I didn’t adjust the PE for the cash on the balance sheet).  Its EV/EBIT is 2x.  

What if it is a perpetual value trap you ask?  

Well, Dream sports a well-covered 12% dividend yield, so the investor gets paid above market returns just to wait.  In addition to management being competent in their trade, they’re also fair.  Their compensation is far from excessive at 3% of EBIT for the top-10 paid employees (in the aggregate).  This is important because they control 68% of shares and consequently, can take whatever they want (and many HK controlling shareholders do exactly that as we’ll discuss later on).

The company was written up on this website by gvinvesting in 2018.  While the future panned out pretty much exactly like the author predicted, the IRR since 2018 was a mere 9% (including dividends).  This happened because the PE went from 7.7x at the time of writing to 4x presently. Had the multiple stayed the same, the IRR would have been >20%.  We’ll discuss later possible IRR end results, including in a scenario where the stock goes back from 4x to 7-8x earnings + earnings growth + a juicy dividend yield.

Introduction:

The company is a contract manufacturer of plush and plastic toys (with a small tarp business).  The plush part is highly manual (hence the “sweatshop” part), while the plastic toys business is getting more and more automated.  

The company does not own any IP and is simply manufacturing toys for its customers, which include Disney parks, Funko, Hasbro, Spin Master, Bandai, Sega, OLC Group and DreamWorks.  The company has scale advantages, as it competes with much smaller competitors.  As a result, while gross margins have been stable (ex. COVID):

EBIT margins expanded:

This is thanks to scale benefits (overhead / sales trending down over time):

In my view this is evidence of management keeping overhead low.

As a result of signing new customers, expanding share with existing customers and opening new factories, I expect the company to continue growing top line and even more bottom line.

Trade wars:

It almost seems like the company was designed for trade wars.  12 years ago, it had 7 factories, all in China.  Since then, it has been redeploying its capital almost exclusively outside of China.  As a result, it now has 27 factories, out of which 20 are in Vietnam.  Dream is in the process of building its first Indonesia factory to further diversify locations.  According to management, Vietnam capacity is so in demand that it’s getting harder to get employees and so there’s significant demand and preorders in the Indonesian factory.  One can only assume that if the Indonesian expansion will be successful, Dream will build additional factories there.

In its recent investor call, management indicated that the company is increasing its share at the expense of Chinese manufacturers.

Valuation:

Here’s a basic framework to estimate future value:

1. Revenue hits HK$6.5B in 2026 thanks to organic growth (new factories).

2. 16% operating margins (lower than 1H 2024 TTM which was 18%) even though should improve from here.

3. Applying 20% tax rate and 677M shares gets us to an EPS of HK$1.23.

4. 7x multiple is HK$8.6.

I’d argue that this is conservative because margins should further expand (as explained earlier), it ignores the HK$3-HK$3.5 in net cash PS the company will have, and I’d argue that the multiple can be higher.  Almost every year the company got a PE of 8x or higher:

While we wait for the stock to ~double from current stock price, investors get a 12% dividend yield.  

The following table details the expected IRR based on how long it takes to get to the target price of 7x earnings:

To summarize, even this investment becomes a stubborn value trap that takes a full decade to hit merely a PE of 7x and even if there’s no growth after the current factories ramp up, and even if we won’t give credit to the cash pile, which should be over HK$7 per share at that point, the expected IRR is still over 18%.

The bull case can obviously be much better.  If earnings grow 15% / year from here and stock trades for 8x earnings in 5 years, the IRR (including dividends) would be over 40%.  This earnings growth would still be lower than the last 10 years and assumes no dividend growth and no value for the $6 ps in cash the company will have in this scenario. 

Investing in HK:

I’ll admit that in the past I only made a handful of HK investments.  As a HK stock picking tourist, a typical response I got when talking to Asia focused funds was “yeah, 1126 is cheap, just like every other stock in HK”.  However, I could not find a single example of a company that trades for such a low multiple with:

1. A non-shrinking business (forget about a growing one like Dream’s). 

2. Management not plundering the company.  Sure, you can find company trading for 3x earnings, with management taking 60% of EBIT as “compensation”.  Dream’s top 10 employees combined are paid <3% of EBIT.

3. A great balance sheet.

The margin of safety appears large enough to allow nontraditional HK investors to dip their tows (hence the analogy to Michael99’s 2002 chicken processor pitch).

Side note: if anyone knows of a HK company that trades for sub 4x earnings with faster growth, a better balance sheet and a good management team, would love to learn about it in the comments section.

Management, Controls and the lost token ordeal:

Let’s start with the lost token.  Obviously demonstrates lacking controls, but to management’s credit:

1. The theft was discovered on February 22, 2022.  A police complaint was filed on the same day.

2. It was reported to the market on February 23, 2022.

3. The head of accounting was removed from the board on March 25, 2022.

The CFO, who’s the founder’s son in law is still there though…

Seems extremely amateurish for a public company, but for better or worse, it’s clear that management treats the company as a family business.  It has been mostly a good thing so far, but this is definitely not something that should have happened.  With Management owning most of the company, it was mostly stolen from them personally, so I’d hope that the lesson was learned.

A way to frame it is to assume mishaps and haircut earnings or the “fair” multiple (even though it was an unprecedented event for Dream in its 22 years as a public company).  Still, this is a company that in spite of everything that happened in the world, grew EPS by 20% a year for a decade with no debt and a big cash pile.  So even if we factor in an occasional mishap (which I hope won’t happen), and consequently value the cash at a 10% discount to face value, I don’t think it dramatically impacts the value (remember we gave 0 value to cash in all of the above valuation frameworks).

As discussed above, management has been fair in compensation and when doing deals with the company.  This is important because:

a. They can do pretty much whatever they want.

b. Often, that’s exactly what HK companies’ management teams will do.

The tarp business I mentioned earlier was purchased from the controlling family for HKD120M in 2019.  Over the last 5 years it generated over HKD250M of EBITDA, which puts the multiple at 2.5x EBITDA (no segment level EBIT data available, but EBIT tends to be 80-90% of EBITDA, so assuming it generated an EBIT of HKD200M in 5 years, implies ~3x EBIT).  Doesn’t seem like they robbed minority shareholders to say the least.

Management also refers to the ROE matric in all their presentations, which is probably why they got high teens ROE in the last 15 years.

Risks:

1. Did you read the part where the bank token was stolen?  Corporate controls may not be as good as one hopes.

2. Customer concentration.  Their scale advantages allow for better margins and more quality control at a given product’s price point.  This is supposed to help with the risks of losing customers.  

3. Demographics.  People are having less kids, but the expenditure per kid is increasing and can offset.  

4. China / Cold War II.  Thanks to the manufacturing footprint, this could be an advantage to a degree, but obviously it depends how bad CWII gets.

5. Temporary issues from post COVID destocking and cost inflation.  I don’t view this as a serious long-term threat and in any case at 4x earnings it’s more of an opportunity as we wait for inventories and buying patterns to normalize. 

6. Forex risks.  HK$ is pegged to USD, but most expenses are in Vietnam / China while 45% of sales are to North America, 26% to Japan and 17% to China, so some mismatch.  Does not really change the thesis because should probably not be material either way.

*Stole the glorified sweatshop from a friend, so the trademark is his not mine.

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

You don’t need one, because you get paid 12% / year to wait.