Description

Investment Thesis
The case for Kweichow Moutai Co Ltd (China SH:600519) is simple. It is a wonderful business selling at discount to intrinsic value due to concerns over Chinese government’s crackdown on corruption and a slowdown in the Chinese economy. The selloff is likely caused by overreaction from unsophisticated Chinese retail investors, who make up a large portion of investor base in China’s A-share market. As of the close of Feb 15th, 2016, Kweichow Moutai traded at around RMB 200, or less than 14 times NTM P/E and 4.3x P/B. Moutai will comfortably growth topline at MSD to HSD and grow EPS at HSD to LDD for years to come, a classic compounder. The overly negative sentiment among investors both in mainland China and overseas (investors through the Shanghai-Hong Kong Stock Connect) has given long-term value investors a chance to own an incredible business at a reasonable valuation. With fear over Chinese currency devaluation and dwindling foreign reserves hitting the daily headlines in the media, market participants fail to consider company fundamentals in making investment decisions. Sometimes we have to go against the crowd and be contrarian. Of course you need to be contrarian and correct, not contrarian for the sake of being contrarian. For value investors, one variable will always ensure long-term success – human nature.

Business Description and History
Kweichow Moutai Co., Ltd. is principally engaged in the manufacture and distribution of Moutai liquor series products. The Company’s main products portfolio consists of Kweichow Moutai liquors and other liquor series, including millesimes liquor series products, gift liquor series products, common liquor series products, Han Jiang liquors, Ren liquors, Moutai Prince liquors, Moutai Yingbin Chiew, Elite General, Great China and others. It distributes its products in domestic and overseas markets.

Kweichow Moutai’s main product is the Moutai alcoholic beverage. Moutai is the No.1 ranked premium baijiu (traditional Chinese liquor) in China. Moutai traces its roots back 2000 years ago to the Han Dynasty (206 BC – 220 AD). From inception, it has gone through thousands of years of perfection and improvements. During the Qing Dynasty (1644–1911), Moutai became the first Chinese liquor to be produced on a large-scale with an annual output of 170 tons. Today, Kweichow Moutai is one of the most recognized premium brands in China, with annual sales of over 30 billion RMB and net income of over 15 billion RMB. 

Business Model
Moutai has a very efficient and profitable business model characterized by high margin, high ROE, and an efficient distribution network. Baijiu, especially premium baijiu, is a high margin business. Raw materials costs are often minimal compared to the selling price. As the recipes of premium baijiu often require combinations of special grains that only grown in certain geographical regions or unique climates, top baijiu brands often enjoy a natural moat that is impossible to replicate. This characteristic of the high-end baijiu market allows premium baijiu producers to have strong pricing power, leading to high margins. Furthermore, Moutai’s distribution system keeps its bottom line one level removed from the vast price fluctuation of retail Moutai prices by selling directly to authorized retailers and direct sale stores at a high margin. The distributors or specialty stores then add a certain percentage to this so-called “out-of-factory” price and bear the risk of retail price fluctuations. This system incentivizes the distributors to sell more Moutai at higher prices. 

Moutai is very selective about its distributors, making it a privilege to be selected as a Moutai authorized reseller. The scarcity of authorized resellers in turn helps Moutai keep the incentives of distributors aligned with its own. Distributors are incentivized to perform well as to keep the lucrative license to distribute Moutai. Moutai also reduces the concentration of sales risk by limiting the percentage of total sales any one distributor can obtain by controlling the product amount supplied to each reseller. This act of control is both on a geographical level and one a distributor level. No single distributer of Moutai accounts for more than 5% of its total annual sales.

For the last 10 years, Moutai has maintained:
• gross margins of 80% and above
• EBITDA margins of 58% and above
• Net income margins of 33% and above
• ROA of 15% and above
• ROE of 24% and above
• ROIC of 22% and above
• Traded between low of 8.8x P/E to high of 76.7x P/E
• Traded between low of 3.1x P/B to high of 26.4x P/B

Comparison between Moutai and Leading Western Spirits Makers
Moutai has better margins and better return on equity than western spirit makers yet is trading at a much lower multiple to earnings. Although the dynamics in the Chinese A-share market are vastly different from those in the US and European equity market, in the long term, fundamentals will drive the valuation.

Moutai, trading at 14.1x NTM P/E, has grown revenue in the last 10 years at 28.2% CAGR, EPS at 34.1% CAGR, with current operating margins of 74.6%, net income margins of 50.0%, and ROE of 29.6%. Brown-Forman, trading at 27.1x NTM P/E, has grown revenue in the last 10 years at 5.6% CAGR, EPS at 9.1% CAGR, with current operating margins of 32.4%, net income margins of 22.0%, and ROE of 39.2%. Diageo, trading at 19.6x NTM P/E, has grown revenue in the last 10 years at 4.9% CAGR, EPS at 8.0% CAGR, with current operating margins of 26.2%, net income margins of 19.9%, and ROE of 32.2%.

China’s Drinking Culture
To understand Moutai’s business and its wide moat, it is essential to understand China’s drinking culture, which has been cultivated for thousands of years and can be seen and felt in many areas of the Chinese business/social life. China’s alcoholic drink industry is dominated by the big four categories, which combine to make up of more than 95% of the market share. The big four categories are:
• Baijiu (Chinese Spirits, domestic only)
• Red Wine (both domestic and imported)
• Beer (both domestic and imported)
• Yellow Wine (domestic only)

Baijiu dominates the market share due to a number of factors 
1. It is the traditional Chinese liquor and represents the Chinese drinking culture. 
2. Baijiu’s fragrant and aromatic flavor goes well with Chinese’s cuisine.
3. Chinese business and get-together dinners can be a few hours long. Drinking beers during these long dinner sessions can be quite filling in a short period of time so that you cannot fully appreciate the food. Therefore, baijiu is often the preferred liquor. 
4. Premium baijiu, such as Moutai will prevent hangovers the next day. 
5. Baijiu is the ultimate form of showing respect and sincerity to the elders and business clients/partners. 

Let’s take a look at one company in each category: Kweichow Moutai (SH600519) in baijiu, Yantai Changyu (SZ000869) in red wine, Tsingtao Brewery (SH600600) in beer, and Zhejiang Shaoxing Wine (SH600059) in yellow wine. Moutai has grown revenue in the last 10 years at 28.2% CAGR, EPS at 34.1% CAGR, with current net income margins of 50.0%, and ROE of 29.6%. In comparison, Changyu has grown revenue in the last 10 years at 12.8% CAGR, EPS at 9.0% CAGR, with current net income margins of 23.4%, and ROE of 15.1%. Tsingtao has grown revenue in the last 10 years at 13.3% CAGR, EPS at 18.5% CAGR, with current net income margins of 6.6%, and ROE of 10.6%. Shaoxing Wine has grown revenue in the last 10 years at 9.3% CAGR, EPS at 11.2% CAGR, with current net income margins of 14.6%, and ROE of 5.4%.
Moutai also has the widest moat in the baijiu market. Let’s compare Moutai’s results to three other baijiu companies: Luzhou Lao Jiao (SZ000568), Wuliangye Yibin (SZ000858), and Anhui Gujing Distillery (SZ000596). Lao Jiao has grown revenue in the last 10 years at 30.1% CAGR, EPS at 55.4% CAGR, with current net income margins of 17.9%, and ROE of 14.9%. Wuliangye has grown revenue in the last 10 years at 20.0% CAGR, EPS at 25.3% CAGR, with current net income margins of 28.3%, and ROE of 14.3%. Gujing has grown revenue in the last 10 years at 22.8% CAGR, EPS at 61.0% CAGR, with current net income margins of 13.3%, and ROE of 14.8%.

Out of the three bands mentioned above, Wuliangye is the closest competitor to Moutai, in terms of pricing and customer base. Moutai’s premium series is selling at a large premium to Wuliangye’s premium series, which is considered as the equivalent to Moutai’s premium series in terms of alcohol content and quality. The price differentials have usually been around 20-50%. This superior pricing power is very likely to be sustainable over a very long period of time. Aside from the mere association effect from Moutai’s cultural and historical status, geographical conditions and Moutai’s unique brewing technique ensure the longevity of Moutai’s pricing power.

Unique Geographical Condition
The town of Moutai is located near longitude of 105° and latitude of 27 °in the Valley of Red Water River. It has an annual mean temperature of 18.5 Celsius, an annual average relative humidity of 78%, and an average annual rainfall of about 1088mm. Located in a valley, the town of Moutai experiences mild wind speeds thereby creating an environment very accommodative to the reproduction of microbial needed to brew Moutai. Additionally, a special type of grain, sorghum, is used to brew Moutai. Sorghum can only be grown in Guizhou and Sichuan province due to the special climate and geographic conditions.

Unique Brewing Technique
The production of Moutai is extremely seasonal. Moutai ferments at a higher temperature than all other baijiu brands, taking place at 63 Celsius (10-15 Celsius higher than other baijiu). Moutai’s distilling process also requires a 10-20 Celsius higher temperature than other baijiu brands. Additionally, it takes a year to produce the alcoholic base of Moutai whereas for other baijiu brands, it only takes a few weeks to a few months. Furthermore, the production of Moutai requires special yeast that requires a 6-month special storage before entering the production stage. This is 3-4 months longer than other baijiu brands. Lastly, it takes 3 years before the blending process can take place for Moutai. This puts the whole production cycle at around 5 years total. 

Management
Kweichow Moutai has a very experienced and conservative management team, with a track record of compounding both revenues and net income at a rate that outpaces the avearge business. Senior management’s total compensation during 2013 totaled 4.8 million RMB, which is only 3 basis points of Moutai’s net income, a level that is more than reasonable. Current management team has also navigated Kweichow Moutai through the difficult times of 1998-2002. During the current industry wide setback, Kweichow Moutai actually achieved revenue and profit growth while other leading premium baijiu producers, such as Wuliangye Yibin sufferred from double digit revenue and profit drop. Renguo Yuan, Chairman of the Board, is from Renhui City, Guizhou Province. He joined Kweichow Moutai when he was 18 years old and never left. He has held numerous positions within the Company, working his way through the ranks to become Chairman of the Board. He is very well respected in the baijiu industry. Kweichow Moutai also has very little debt and strong cash position. Management has increased dividends from 16 cents per share in 2002 to 5.77 RMB per share, currenlty reaching about a 40% annual payout ratio and a dividend yield of 3%.

Capital Allocation
From a capital allocation perspective, Moutai’s management has the following options:
• Acquire other companies – Moutai rarely acquires other companies 
• Pay dividends - Moutai has been paying dividend every year
• Repurchase shares - This is rare in China
• Leave it in the bank - Where most of Moutai’s cash is
• Pay down debt - Moutai doesn’t have much debt
• Invest the capital back into the business - Moutai has done this a lot

Historically, Moutai’s supply has been lagging demand by a considerable margin. For this reason, Moutai has spent most of its retained earnings in the past on expansion. Moutai’s capex planning, like other baijiu producers, follows a 5-year plan. Moutai has been pretty successful in capex planning. Tenth “5-Year Plan” 2001-2005: Moutai spent RMB 2 billion on capex and reaped RMB 18.5 billion incremental net income in the next 5 years. Eleventh “5-Year Plan” 2006-2010: Moutai spent RMB 5.6 billion on capex and even without considering 2014 and 2015, Moutai has earned almost RMB 40 billion incremental net income compared to the prior 5 year period. It seems to be appropriate to conclude that while capex spending does seem high, it is due to the need of expansion. The high capex spending in 2013 has seen a reversal in 2014 and the LTM. The 2014 capital expenditure decreased from RMB 5.406 billion to RMB 4.431 billion, further decreasing to RMB 2.492 billion LTM. The big picture is whether Moutai can earn a high return on capital investment. Moutai’s management has a track record of doing just that. Yes, the return on investment will likely be lower than what it has been in the past but it is the best use of cash.

Ownership Structure
Kweichow Moutai Co Ltd is 62% owned by Kweichow Moutai Group, which is 100% owned by the Government of Guizhou Province. This ownership structure is a double-edged sword. Kweichow Moutai will have the support from the government but at the same time is subject to government’s pressure in terms of policies that will benefit the government while at the same time destroy values for shareholders. 

Why is the Stock Cheap?
The China A-share market, especially the Shanghai market, is trading at the lower range of historical multiples due to a variety of factors. Through general observation and extensive discussions with both fund managers and baijiu industry experts, on top of the general negative view on the Chinese stock market, the perception on the baijiu industry in China is even more negative at the moment.

The No.1 cited reason for the negative outlook is concern over government’s crackdown on corruption and its potential effect on premium brands such as Moutai and Wuliangye. Furthermore, recent price drops in Moutai’s premium products have caused many consumers and potential authorized resellers to stand on the sideline in expectation of further price drops. As unsophisticated retail investors make up a large portion of China’s A-share market, Moutai’s solid fundamentals and superb model are likely ignored by investors who are pre-occupied with short-term volatilities and negativities. One thing widely misunderstood is that the retail price drop mainly affected Moutai’s authorized retailers as opposed to Moutai itself. As explained before, Kweichow Moutai sells directly to authorize resellers at what is called the “out-of-factory” price. Any fluctuation outside this “out-of-factory” price will directly affect the resellers’ margins, Kweichow Moutai’s bottom line is unaffected. 

The Recent Price Drop and Historical Price Drops
As discussed earlier, Chinese government’s crackdown on corruption has caused the price of Moutai’s premium series Moutai 53 degree to drop almost 60% from the 2012 highs (see charts in the previous section). Moutai’s premium series 38 degree suffered similar magnitude of price drop. History doesn’t repeat itself, but there are similarities. By looking at the history of Chinese baijiu industry, we can glean information that could help us assess the current situation. Prior to the recent round of price drop, the baijiu industry experienced two similar price drops. 

The first time was from March 1989 to the second half of 1990. Moutai’s premium series dropped from RMB 208 per bottle to RMB 95 per bottle (55% drop). This round of price drops resulted in an industry repositioning. Lower-end baijiu brands prospered after the industry consolidation as consumers’ preferences shifted toward lower-end value brands. 

The second industry-wide price drop occurred during 1998. This time Moutai’s premium series dropped more than 30%. Similar to current price drop, the 1998 price drop was caused by a government crackdown on corruption. Government issued regulations prohibiting the consumption of baijiu during official dinners and also limited the amount of advertising baijiu producers could post. The industry-wide price drop and limitation on advertising forced many small low-end producers into bankruptcy (these were the same producers that had prospered after the first industry-wide price drop). Major premium baijiu brands such as Moutai went through another round of restructuring. This round of price drop laid the foundation for the rise of premium baijiu brand. 

The current industry price drop has only affected the high-end brands such as Moutai and Wuliangye. For Moutai’s case, however, the retailers and resellers have born most of damage from the price drop. In fact, Moutai’s gross margin has expanded a little bit from the 2011 and 2012 levels, counterintuitive given the current market conditions and people’s perception on high-end baijiu brands. If history rhymes, there are 3 possible scenarios:

• The Chinese consumers move to lower-end baijiu brands like they did in the late 1980s. 
• The baijiu industry goes through a prolonged period of recession. 
• The baijiu industry is suffering from a temporary setback and come back stronger.

I think the likelihood of the first scenario is very low as the income level in China has improved dramatically from the late 1980s. Even a bottle of premium Moutai is very affordable to a typical mid-class Chinese family at these price levels. As income level improves, the Chinese people’s demand for quality moves in lockstep. 

The second scenario is more likely than the first scenario but the likelihood is also low. This is mainly because as the Chinese economy is going through the transition from investment driven growth to consumption driven growth, which bodes well for increased liquor consumption in the medium to long term. Furthermore, there are political reasons why this scenario is unlikely, especially in the case of Moutai. Moutai is the most important corporation in Guizhou Province and the town of Moutai is heavily dependent on Moutai’s profitability. The government has every incentive to prevent a prolonged period of baijiu recession in order to avoid social unrest. 

The third scenario is the most likely one in my opinion. The tailwind of China’s economic growth and the still expanding mid-class will continue to expand the demand for premium baijiu as they become more affordable. In Moutai’s case, limited supply caused by aforementioned unique climate and brewing techniques will also serve to limit the downside of Moutai’s prices. After a three year adjustment, the sector headwind is already less of a drag now with signs of stabilization in both volume and price.

Key Drivers to Consider
• Moutai is one of the most recognized brands in China with the widest moat in the spirits market. 
• Moutai’s business model is characterized by high margin, high return on capital, and high return on equity. It has been a compounding machine for many years. 
• Moutai has a low debt cash rich balance sheet, which is a reflection of the conservativeness of management. 
• Tailwind from China’s growing income level and growing number of middle-class consumers is likely to vastly overweigh the headwind from Chinese government’s anti-corruption effort. 
• Moutai’s supply has historically been limited and demand has far exceeded supply. Management is determined to expand the production capacity. 
• China’s baijiu industry is going through a consolidation phase, which is likely to result in improved industry conditions and solidify Moutai’s position as the No.1 brand.
• Moutai is transitioning from a predominantly high-end brand to a more mass-market consumer product by coming out with middle-end and lower-end products.
• Potential international expansion can further solidify Moutai’s brand value

Key Risks to Consider
• Hard landing of Chinese economy caused by either burst of credit bubble and real estate bubble or large-scale social unrest.
• Concern over government’s anti-corruption efforts and its effect on premium baijiu producers.
• Prolonged negative reaction from Chinese consumers with regards to the whole baijiu industry, which will put extra pressure on pricing.
• The younger generation (30 and below) is less prone to consume Moutai than the older generation.
• Disruption to Moutai’s raw material supply chain due to weather related factors.
• Moutai’s capex exploded since 2002. There is a risk that this rapid expansion in capex will lead to lower return on capital in the future. Furthermore, it is likely that this capex explosion is directed by the Guizhou government, which has incentive to funnel some of money out of Moutai.
• As Moutai keeps expanding its production capacity, labor cost has risen as well. Since it usually takes a few years for the labor cost to be fully reflected in the bottom line, we won’t be able to see the full effect until a few years later. The likely effect is margin contraction.
• Baijiu may lose share to wine in the alcoholic drinks market.
• No articulated strategy for use of cash on the balance sheet.

Most Recent Update on Moutai
I believe the worst impact from anti-corruption measure is over as conversations with Moutai’s distributors reinforce this point. They highlighted Moutai’s sales exposure to corporate segment (a substantial portion of which may be linked to gifting) has significantly decreased from 80-90% in 2011 to ~40% in 2015. Specifically, Moutai saw significant YoY increase in customer advances in 3Q15, suggesting that distributors are turning more positive for 2016 (usually a big jump before the Lunar New Year). The distributors also noted that despite some high-end brands being under pressure to cut prices to push sales, Moutai’s moves to discipline supply in early Jan 2016 have well sustained Feitian Moutai’s market prices at above RMB 850 level.

Moutai currently has very little debt (RMB 6.37 billion) and strong cash position (RMB 30.54 billion, 12% of market cap). Top line will mostly growth MSD to HSD for the next couple years for the following reasons. 1) continued distribution network expansion such as duty-free and supermarkets; 2) new product launches and the introduction of smaller-sized packaging; 3) accelerating growth in secondary brands; 4) general growth in end-market consumption, with the transition to more mass-market facing. 

Logistics of Buying China A-shares
The details of the Shanghai-Hong Kong Stock Connect can be found in the link below.
http://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Documents/Investor_Book_En.pdf

A list of the companies that can be purchased through the Shanghai-Hong Kong Stock Connect can be found in the link below.
http://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Documents/List%20of%20Eligible%20Stocks%20for%20Northbound%20Trading%20(Eng).pdf

Catalyst

1. Secular tailwinds – There are a few secular tailwinds that are still in Moutai’s favor. First of all, continuing inflationary pressure will make it easier for Moutai to raise prices at a higher rate than the inflation rate due to the value of the brand. Secondly, China’s population is still growing, which means the market for Moutai is growing. Thirdly, rising income levels and number of middle-class families will increase the demand for Moutai, which will help Moutai achieve both sustainable pricing power and volume growth. Lastly, the aging of the Chinese population will drive an increased demand for hard liquor and quality liquor.

2. International expansion – Kweichow Moutai’s Chairman of the Board, Renguo Yuan, said the following in a recent press release: “Our goal is to build Moutai into an international brand and expand our international revenue to 30% of total revenues. We are aiming to establish 5 foreign branches this year. We just established presence in France and we will expand to Australia, United States, Russia, Japan or South Korea in the future.” According to Kweichow Moutai’s most recent annual report, international sales only accounted for 3.5% of total revenue. Even if Moutai doesn’t achieve the 30% target, any improvement from the current 3.5% level will boast revenue and earnings. Moutai may not fit well with Western consumers’ tastes but there are plenty of Chinese overseas, who are all very aware of the Moutai brand. As the number of Chinese immigrants, who are usually wealthier than domestic Chinese, increases in countries such as Australia and United States, Moutai’s international market will become bigger in the future. 

3. New distribution channels combined with an improving Chinese domestic economy– Kweichow Moutai recently announced that it would expand its distribution channels to regions where historically no authorized Moutai distributors existed. This effort is coupled with introducing smaller-sized packaging and accelerating growth in secondary brands. The premium branding with unique products and fragmented distribution model leads to strong bargaining power for Moutai. Moutai also has the resources to spend on advertising both through traditional media channels and social media. The goal is to make Moutai available to ordinary Chinese people and turn mass-consumption into a larger portion of total revenues. Although the results of this new strategy are yet to be determined, the rising Chinese income level and the rising number of middle-class consumers bode well for Moutai’s new strategy.

4. Institutionalization of the China A-share market – Over the past the Chinese government has been undertaking many market reforms, such as the Shanghai-Hong Kong Stock Connect, to allow institutional capital to make up a greater portion of the stock market shareholder base. With the planned Shenzhen-Hong Kong Stock Connect on the horizon, the goal is to invite more long-term shareholders to take ownership in Chinese companies. This will be garner a greater sense of corporate governance/transparency and better capital allocation. These reforms, despite being slow to come to fruition, will be long-term drivers of opening up the China A-share market to global investors.