Value Investors Club / Surya Pertiwi (SPTO)

Description

Investment Summary

Surya Pertiwi (SPTO) is the leading distributor of sanitary wares (55.1% market share), bathroom fittings (49.8% market share) and other bathroom related products in Indonesia by both volume and value
Company is the exclusive agent for TOTO (over 90% of sales) and also carry products from brands such as Villeroy & Boch, Kaldewei, Geberit, Stiebel Eltron and Franke. Since inception in 1987, it has been distributing TOTO products that its sister company, Surya Toto Indonesia (STI), manufactures. From mid-2018 onward, SPTO has been manufacturing some sanitary wares through a JV with STI where they own 51% and STI holds 49% which would allow them to capture some of the manufacturer margins
Growth has been flat from for the past 3 years due to poor property sales since 2016 due to oversupply of property (2010-2015 was the boom cycle) and tax reform. This looks to be normalizing as the 2 largest real estate developers have been reducing inventory levels = have to start building more soon. Other drivers would be: i) shift from squatting toilets to sitting toilets as the country becomes more developed, ii) higher disposable income leads to lower population per household fewer people per toilet
SPTO has been able to sustain their market share due to having the most extensive distribution network in the country and the widest product offering in their catalogue - 11 sole distributors that cover 14 major cities ex-Jakarta and Surabaya and 100+ dealers in Jakarta and Surabaya. In total, they have ~3,000 shops that carry TOTO products and having a functional logistics/distribution network in a country with over 15,000 islands is hard to replicate
Key Risks: i) Related party transactions: The same families that collectively own 60% of SPTO also own 54.5% of STI. SPTO buys 90% of its products from STI at a fixed discount of 56% to the catalogue price for over 40 years but no fixed contract to prevent STI from reducing this discount after 2026. ii) Deal with TOTO Japan: STI and TOTO Japan have been signing 10-year contracts to use the TOTO brand since 1978 with the last contract being signed in 2016. While Japanese firms are typically known to have strong working relationships, there is no guarantee that TOTO will extend the contract after 2026.

Prologue - How did the company get to where they are today?

1968: The founding families (Alim and Gojali) established the company (SPTO) by contacting TOTO to become the exclusive distributor. They imported TOTO products directly from Japan
1978: After Indonesia government raised import tax by 200%, founders went to Japan and convinced TOTO (TSE: 5332) to set up their first JV outside of Japan. This was the birth of Surya Toto (STI)
2017: TOTO received a contract to supply 700k pieces annually to China from 2019-2023 which they outsourced it to STI (this would absorb 25% of their existing capacity of 2.8m)
2018: STI had been running at 90%+ capacity, to make up for the shortfall, SPTO and STI created a JV (51/49) for US$50m in Surabaya called Surya Pertiwi Nusantara (SPN) which an initial capacity of 500k pieces annually with 1 production line. The entire factory has space to fit 10 lines (potential capacity of 5m) if required, thus bulk of the expansionary capex on land + building has been incurred. Company IPO'ed in May 2018 for capex, reduce debt (currently net cash) and lower tax rate (25% to 20% if free float is 40%)

Business Model

Traditional boring business - Distributing toilet products

SPTO's business model is, like most distributors, to buy from the manufacturer at a discount to retail price and sell it to their customers (dealers, distributors and projects) at a smaller discount to retail prices. As 90% of their sales are TOTO branded products, my ch@ine will focus on the terms with TOTO

SPTO buys from STI at a 56% discount to the retail price (which is determined by STI) and sell its to their customers at varying discounts - refer to my well-drawn diagram above for an approximate illustration :)
After receiving the sanitary wares and fittings from STI, SPTO distributes 45% to dealers in Jakarta and Surabaya (who sell directly to customers), 25% to 11 sole distributors that cover 14 cities excluding Jakarta and Surabaya (who then sell it to other dealers in those cities) and 30% to projects (developers who want Toto products in their shopping malls / hotels / homes)
In the ecosystem, the NPM that each player makes are:

STI (manufacturer): 16% (margins will increase as exports to China grows because exports are usually higher value-added products)
SPTO: 10% (this figure has been quite stable for the past 3 years even though there were poor sales growth) - Terms of payment for SPTO are 90 days
Customers:

Dealers: 4% - Only available in Jakarta and Surabaya where they have 100+ dealers
Sole distributors: 6% (they have to further sell to regional dealers who must be able to make some margin). Have 11 distributors who only sell Toto products that cover 14 major cities except Jakarta and Surabaya
Projects: Not applicable because they are large developers who buy products directly from SPTO for apartments, hotels and malls

But wait, why do their customers allow SPTO to earn such high margins compared to them? There are a few reasons:

Toto is the most sought after brand in the country (with 50%+ market share) - if you don't carry their products you will not draw customers. Anecdotally, from a conversation with a small developer in Indo, he said - "Toto are pretty good with lobbying the interior designers and architects + they're synonymous with quality"
Low bargaining power: The top 10 dealers account for only 13.5% of total sales while Toto products account for the lion's share of their sales
Long working relationships: Management said most of their 11 sole distributors and over 50% of their 100 dealers have been with them for over 30 years, living very comfortable lives. Thus, unless there's a big "push factor", most will be reluctant to change the status quo.
Furthermore, SPTO is willing to spend to ensure that top performers are happy, giving them incentives like trips to US, Europe or Japan based on sales targets (seems to be a recurrent thing among Indonesian companies I've met, I suspect many of them have not had the opportunity to travel long distance)

Toto has the largest production capacity in Indonesia with 8 production lines while their main competitors American Standard and INAX only have 1 line. Currently, Kohler is in the process of building 1 line but they do not compete in the same price point
According to CLSA, all stores they polled agreed that Toto has superior after-sales service compared to all other brands due to 3 factor - i) readily available spare parts at dealers, ii) easy access to Toto technicians who can identify product problems, and iii) easy replacement of defective product

What are sources of competitive advantages in this business?

According to a Third Bridge transcript on bathroom products in Australia (transcript attached), the expert said that in the past, competitive advantages were limited to product and it was all about innovation in product or price.
Unfortunately, that is no longer sustainable so the new competitive advantage is the supply chain and just-in-time delivery (which SPTO has the best in Indonesia, hence they have been able to maintain at 50%+ market share for years)
Having the right logistics, good working capital (especially inventory) and maintaining overall customer satisfaction has become the new sustainable competitive advantage - hence Toto's focus on superior after-sales service
The small players don't have that insight, infrastructure and understanding to deliver that compared to large players who have coverage across the country
Secondly, the ability to give retailers just-in-time delivery, the stock burden is moved from them to the manufacturer (which partially explains SPTO's increased of inventory days from 60 to 80 days)
Finally, size is also quite important (but not impossible to replicate) as the larger you are, the more you can enjoy scale on production, transportation, and A&P costs. Toto has 8x larger production capacity than their closest competitor in Indonesia

New business since 2018: Manufacturing is starting to be shifted from STI to SPTO through SPN - Currently 25% of products, expected to increase to 30-40% in 2 years

After STI received a contract from TOTO Japan to supply 700k pieces per annum to China from 2019-2023. As STI's factory in Jakarta is at maximum capacity of 2.8m pieces and have no surrounding land for expansion, the family thought it would be best to set up another factory and gradually shift domestic demand to it (illustrated by another picturesque drawing by yours truly)

As SPTO handles the distribution of Toto domestically, the family thought it would be most logical to allow SPTO to own the factory while STI transitioned into manufacture + export of higher value products. However, TOTO Japan felt that manufacturing was very profitable and still wanted exposure, hence they settled on a 51/49 JV
The cost of land and building = US$50m, of which SPTO paid $25.5m. The total area of 35 hectares has enough space for 10 production lines, but to ensure no excess capacity, SPN currently only has 1 line that as of March 2019, is running at 100% capacity and its on track to produce 500k units this year which will satisfy ~25% of SPTO's products.
STI also posted 30 of their experienced staff to help run SPN and ensure there will be minimal teething issues.
In the medium-long term, SPTO does not rule out the possibility of using SPN's production (as they increase from 1 to 10 lines) for export of higher margin products and the company is targeting 30-40% of products coming from SPN in 2020

All this sounds fine, but what does this mean for SPTO?

Ability to capture some manufacturing margins - GPM has increased by 80bps from 23.9% in FY17 to 24.7% in FY18 from half a year of production. This figure will increase as production continues to be shifted from STI to SPN (management said GPM could reach 30% in 3 years but that may be too optimistic)
Lower logistics cost - Jakarta and Surabaya are on the opposite ends of Java (775km away to be exact). A facility that produces Toto products will reduce logistics cost for SPTO, especially in a country with poor infrastructure
Higher D&A and lower ROCE - SPTO is going from asset-light to asset-heavy (PP&E grew from Rp 276bn in FY16 to Rp 769bn in FY17). While I don't fully agree with their plans as it'll lower ROCE from 80% to 20%+, I do see the merits, especially since the family is adopting a longer term view when they have more production lines
In summary, GPM and EBITDA margin will increase while EBIT margin will be lowered for the next 1-2 years (until increase in GPM > increase in D&A expense)

In addition, SPN might have a higher EBIT margin than STI because: i) Lower labor cost in Surabaya compared to Jakarta - labor cost is 20% of SPN's COGS vs 36% of STI's COGS in FY17, ii) As it's majority owned by a Toto distributor, SPN is not required to pay any royalty fees to TOTO Japan, while STI does (~2% of sales). Since manufacturing is wholly owned by Toto Japan, there are no other comparables
What about raw materials and logistics?

The company sources clay and kiln regionally from Vietnam and Korea while it gets its glaze from UK
Raw materials are usually imported by sea and third-party logistics will transport them from the habour to the factory on trucks
Once the finished goods are made, the same third-party trucks will transport them from the factory to their customers

Growth Drivers - 3 reasons why I think the company will be able to accelerate growth

i) Indonesia compared to other EMs

Major overarching factor is over 50% of the country is using squatting toilets or just holes in the ground compared to 5% in Thailand and 2% in Singapore. With urbanization and rising middle class in Indonesia, these squatting toilets are making way for more upmarket versions

From 2005-2010: The sales CAGR of squatting was 12.3% vs sitting's 9.2%
From 2012-2016: The CAGR for squatting was 12.9% vs sitting's 13.5%, overtaking squatting for the first time (admittedly this was during the property boom)

Based on data from WHO/UNICEF (thanks to NB), we can see that there is an inverse correlation between no. of people per toilet and GDP per capita. My very basic hypothesis is that as the country continues to develop, the number of toilets should increase + replacing existing squatting toilets with sitting toilets

ii) Property recovery

From 2008-2018 to company has grown revenue at 11.6% CAGR (~1.5x GDP growth of 7.6%). To be clear, the business is highly correlated to the property cycle so I believe a good proxy to monitor is the property price in Indonesia.
As a data point, during the "boom" period from 2010 to 2015, revenues grew from ~Rp 900bn to Rp 2171bn (18% CAGR). So what caused the boom in 2010?

The main driver was the coal demand from China which drove prices to over US$100/ton (currently $80/ton). The massive economy had a trickle down effect in other sectors, with property being a large beneficiary
As the market hadn't recovered from 1998's Asian Financial Crisis, property supply was limited
However, speculators were flipping properties for a 30-40% capital gain within a year, and when Jokowi assumed power in 2014, he implemented certain regulations which led to a cooling off in demand
Unfortunately developers continued to be "greedy" and continued to build inventory without realizing demand had tapered downwards, leading to an oversupply for the past 3 years

According to the company, sanitaryware and fitting sales typically lag property sales by 6-9 months. After 3 years of weak sales (2016-2018), since the start of 2019, the property players have been reporting better than expected sales + many slowed building new developments and preferred to sell existing inventory = need for replacement coming. Brief results for the 3 largest players:

Pakuwon (PWON IJ): FY18 sales +23%, Inventory -29%
Summarecon (SMRA IJ): FY18 sales +0%, Inventory -25% (1Q19 pre-sales +148% yoy)
Bumi Serpong (BSDE IJ): FY18 sales -36% (very high base in FY17 due to landbank sales to Chinese developer)

Simultaneously, bank loan growth has started to rise meaningfully after a long cyclical downturn, but we're still long way from the peak of 2011-2014
While i doubt Indonesia will return to its heydays of 30% property price increase per year, the government introduced 4 stimulus measures in July 2018 to improve residential ownership:

i) Accelerating mortgage disbursements to developers on landed properties to 30% upfront from 40% after completion of foundation,
ii) Raising maximum number of properties for mortgages from 2 to 5,
iii) Relaxation of LTV requirements for first mortgage,
iv) Reduction of luxury tax (will benefit SPTO more than others because while competition is fiercer in the low-end segments, they're dominant in the high-end sanitary ware & fittings which tend to have higher margins

iii) Company-specific

As mentioned earlier, because of its market dominance, most of the growth from sanitary ware & fittings will come from growing the pie
However, the company is not resting on its laurels and waiting for the property cycle to recover. They have started focusing on kitchen and other complementary products (mostly imported for now until they reach critical mass) to become an "all-in-one" solution provider. SPTO believes that their market share and data give them access + insights into the market's acceptance of other complementary products. For reference, GPM of Kitchen products is ~40% vs 22-24% for bathroom products
In the medium-long term, they could benefit from China's booming demand for Toto products + dwindling supply due to environmental reasons once STI's capacity is fully utilized for export

Toto has 3 factories in China (Beijing, Shanghai and Xiamen) which combine to produce 6-8m units each year (total number of toilets sold 86m+ in China) - To reduce pollution, the government has mandated that the factories turn off their kiln once a month. This has led to huge cost inflation and inefficiencies (takes one day to heat up the kiln and a lot of heat). As such, company shared that TOTO Japan was probably going to shut down the Beijing factory which currently supplies ~1.5m pieces p.a
Toto sales grew 17% in China in FY18 due a number of factors (from Third Bridge transcript on Chinese bathroom sector) - i) Greater proportion of houses are sold to clients fully furnished, ii) Toto products are seen as "high-end" thus new shopping malls would like to use their products and it doesn't add much to the overall cost, iii) Chinese like Toto's intelligent and innovative products as they invest heavily in R&D

Valuation

Outside view - Manufacturers, distributors and Surya Pertiwi

How does Surya Pertiwi measure?

Most notably, topline growth has been severely lacking, even compared to fellow Indonesian distributors which has led to share price under-performance as seen below. From my understanding, because toilets and fittings are usually big ticket purchases, Indonesians tend to only buy a new one when they upgrade their home. In comparison, Catur and Arwana both primarily distribute tiles which are used in most forms of renovations (kitchen, bathroom, living room etc). Nevertheless, since they seem less cyclical, it makes sense for them to trade at a premium to SPTO
Margins seems to be broadly in-line, therefore I don't see a huge risk of margin shrinking. EBIT margin might be higher than the typical distributor but we have to consider the fact that none of the other 4 distributors have such a strong market share
Why do they have higher margins than TOTO Japan? i) TOTO spends almost 4% of sales on R&D because it wants to be seen as the "intelligent toilet", ii) Japan has higher labor costs (10% of sales) vs SPTO's staff cost of 4% and iii) High A&P spend to benefit their operations globally (14% of sales)
Admittedly, SPTO's CCC is much lower than both manufacturers and distributors, while Surya Toto (STI) has the highest among all peers. There is a risk that the families that control both companies have allowed SPTO to report better figures and there is a chance that this could reverse in the future. However, a mitigating factor is STI is increasing its exports, which would lead to higher receivable days in exchange for higher margins. Also, STI has higher inventory days because they have to keep raw materials and WIP whereas SPTO only keeps finished goods
On all 3 multiplies, SPTO is vastly undervalued and even if we attribute a discount for cyclicality or future unfavorable related party transactions, I believe we have a sufficient margin of safety in the price

General observations / comments:

As expected, manufacturers tended to have higher GPM and EBIT margins than distributors (Geberit seems to do extremely well in this regard, but looks to be rewarded by its valuation). Its sister company, Surya Toto, had ~1.5x EBIT margin even though it had similar GPM because it exported its higher-end products which have better margins than those sold in Indonesia
Interestingly, both traded at similar EV/EBIT multiples but distributors had higher P/E (could be a function of fewer listed distributors in the sector). My view is that most the distributors on my list were smaller and more localized, thus have been able to grow sales quicker. On the other hand, many of the manufacturers are huge MNCs that might be in the "mature" stage of their lifecycle
There were much fewer listed pure-play sanitaryware distributors, with the only true comps being Reece and RAK Ceramics while Catur (tiles, paints, glass and wood) and Arwana (tiles) distributed other building materials

Inside view

I think normative state SPTO can generate 7%+ FCFy if it decides to stop expansionary capex - Why? A good proxy is STI which is generating 8-10% FCFy once it decided to stop expanding its factory.
I forecast a 7% topline growth for the next 5 years (company guided 9-10%) and a dip in EBIT margin from 12.9% in FY18 which gradually recovers in 2022 (from 11.5% in FY19 to 13% in FY22) due to higher D&A from SPN factory. On the other hand, management thinks margin will benefit strongly from bringing some manufacturing in-house.
Looking at the manufacturer margins, the average EBIT is 12.7%, so I don't feel comfortable assuming a large increase from its current 12.9% but perhaps SPTO will be able to do it because of their commanding market share of 50%+
Finally, from 2019 onwards, they will have 20% tax rate because of an incentive for companies to increase free float (having 40% free float would lower ETR from 25% to 20%)

Risks

The same 2 families control both STI and SPTO - In our view, this is the biggest risk to the thesis. Based on our channel checks the families do not have a bad name nor could we find any adverse news on them. Is there a risk that STI decides to raise prices? Definitely, but it has not done so for the past 40+ years, keeping the discount at 56% (plus there's a real 10-yr contract that is renewable in 2026). A positive is that the families own 60% of SPTO but only 54.5% of STI, thus if they were to "cheat", it would benefit them more to make SPTO the beneficiary
Reliance on TOTO brand - 90% of SPTO's sales are TOTO (and almost 100% of STI) so if they lose rights it could be disastrous. Similar to the above, STI has been signing 10-year contracts with TOTO for the right to manufacture their products (expires in 2026 as well). From what I gather, Japanese firms term to be quite loyal and would not flippantly change their contracts, especially after working with these 2 families since the 1960s. However, this is a big risk that must be highlighted and cannot really be mitigated
Exposure to property cycle - Honestly, I'm not a property expert, so I won't predict where the bottom of the cycle is. What I can say that I believe the price we are being given to be owners of SPTO is cheap enough to give us a sufficient margin of safety. The company is net cash, and based on STI's history since its listing in 1991, the company has only had a net loss in 2 years, 1998 and 2000, which were probably the 2 worst years in Indonesia (Asian Financial Crisis).

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

5% reduction in corporate tax rate will be a boost to EPS from FY19

Recovery of property developer

show sort by

			2019	2020
Price:	980.00	EPS	82.5	88.4
Shares Out. (in M):	3	P/E	11.9	11.1
Market Cap (in $M):	186	P/FCF	35	19
Net Debt (in $M):	54	EBIT	26	29
TEV (in $M):	240	TEV/EBIT	9.3	8.2