Hengan International (1044-HK)

Hengan is a turnaround / restructuring story. Just like with any turnaround, it’s a risky play. But I’m making the bet risk/reward is favorable.

Hengan is a large manufacturer of paper products in China. It mostly makes sanitary napkins, tissues, and diapers. Sanitary napkins are the key franchise, where it has leading share and generates huge margins. Diapers are the big trouble spot. They’ve really screwed up this franchise, and are losing massive share to Japanese players and Kimberly Clark. They’ve lost a small amount of share in the other two key markets over the last 2 years, but things have been relatively stable there.

End markets are okay – generally growing mid single digits. Due to screw-ups internally, Hengan has grown slower than end markets over the last few years. The stock is trading near multi-year lows. Valuation is 17x NTM PE, making it pretty cheap for a large EM staples company. There is also a large dividend yield.

Problems at Hengan

Where to start…..

There are “structural problems” and “execution problems” which are somewhat entangled.

Structural problems are largely in the diapers space:

• ·       They are pretty much all in low-mid tier diapers, when the market has shifted to premium imported diapers
• ·       They are really weak in the specialty baby store channel (think BuyBuy Baby in the US), which has grown massively in importance for baby products in recent years
• ·       They are really weak online

Execution problems of course have made it very difficult to address these structural problems. From the work that I’ve done, Hengan is a paternal, inefficient, rather lazy organization. In the commercial / sales teams for example, there are 11 layers of bureaucracy, and the smallest decisions take weeks to make. Employees are underpaid and unmotivated. As one person told me (paraphrasing): “Hengan is a place where lazy people go to relax. We often play cards in the office until the late afternoon, and then do a few sales calls”.

So, they are losing a lot of sales opportunities. Internal communication is poor and silo’ed. Brand managers and R&D are not receiving enough feedback from the field.

It’s actually a wonder that the firm hasn’t completely imploded already.

This is a testament to their moat – powerful distribution particularly in lower tier cities, pretty good brands, manufacturing scale, etc.

Restructuring

The plan is extremely ambitious.

The first step is a huge SAP implementation (which has been completed), allowing managers to get day to day visibility on KPIs across the company.

The second step is a radical restructuring of the sales team – instead of 11 layers of bureaucracy, they are breaking the entire organization into self sufficient “amoeba teams” of 8-15 people, each responsible for a particular territory or channel. The amoeba teams will be comped on sales and profitability, and will have complete accountability for their actions.

I suggest pulling up their investor slides, which has some useful charts and explains what they are doing.

This process took nearly a year and was completed in April 2017. Benefits are:

• ·       Decisions (below a certain $ limit) will be made by amoeba team leaders. For example, if they want to do a joint promotion with a retailer, the team leader can authorize instead of someone much higher on the chain
  
  
• ·       Alignment of incentives. Amoeba teams will be accountable for results.
  
  
• ·       More motivated sales force. Fixed comp will decrease. Incentive comp will dramatically increase. High performers will make 2-3x previous salary.
  
  
• ·       Better mix / gross profit – as teams are incentivized accordingly|
  
  
• ·       Cost savings – for example, there was very significant attrition in middle management ranks. These jobs were essentially made obsolete. Some were made into amoeba team heads. Also, theoretically, amoeba teams will generate additional cost saving ideas over time.
  
  
• ·       Shorter lines of communication between sales, production, branding, and R&D. Theoretically allowing more market responsiveness by Hengan.
  
  
• ·       Less possibility of channel stuffing which was a problem historically. The distribution function is not controlled by sales. Distribution will be expected to keep track of channel inventory. Also, there is a 3 year earnout formula to dissuade stuffing.

Obviously anything this radical is risky. There are a million ways to screw up. But so far, the tentative feedback I’ve gotten from distributors and employees have been positive (though most people express uncertainty, as you might expect). I detect a nascent but distinct change in attitude. People are working harder. The “lazy person” syndrome is on its way out. This was a chaotic process, particularly in H2 2016. But I detect things have calmed down a bit more recently.

At the end of the day, this is a bet that proper incentives will win the day. (Paraphrasing Munger).

Other Notes

Several companies in China have converted to some form of “amoeba management” in recent years. The idea was originally copied from Kyocera (Japan). Other Chinese examples include: Huawei, Haier, Yonghui. The Yonghui example was instructive. They finished the reform by YE2015 – essentially they created amoeba teams for each department in the store and comped them accordingly. The result was accelerating revenue and 100bps of margin improvement. The stock is up 75% since.

Hengan is probably in the worst shape culturally of these companies, so we’ll see if the reform works. Management is showing a lot of confidence. The controlling shareholders have bought HKD$1.4bn of stock (nearly $200M) in the open market since Dec 2016 at near today’s prices.

Investors don’t seem to be giving Hengan a lot of credit. I don’t blame them. This is a show me story. I’m betting that at worst, the firm won’t implode and there won’t be enormous downside. If it works, it could be pretty darn good.