Summary:

All of Malaysia’s publicly listed branded retail jewelry companies – Tomei, Degem, and Poh Kong – look silly cheap right now.  Their combined market cap, MYR 422 million (or USD 132 million), represents a 36% discount to their combined “net net current asset value” (i.e. current assets less total liabilities) of MYR 657 million.  They trade at just 0.25x combined sales (FY2012), 5.9x combined net income (FY2012), and 0.53x combined book value (1Q2013), and have paid consistent dividends (double-digit payout ratios) over the last decade.  The above valuations are not only silly cheap, they’re unbelievable when you realize that Malaysia is a country of 29 million Malays (Muslims), Chinese, and Indians – ethnicities that regularly need jewelry, especially gold jewelry, to celebrate their numerous rituals and holidays (i.e. 49 different public holidays will be observed this year alone publicholidays.com.my)!

If I was a less picky armchair investor, I might be happy closing my eyes to buy all three companies at current prices and going on vacation.  But since I’m picky, insecure in my armchair judgment, and never made money with my eyes closed, I visited Malaysia three times (once with my wife, a GIA diamond graduate) to see these companies/stores in person.  Though my visits confirmed that these are all real, recognizable jewelry brands (ask any Malaysian if they’ve heard of Tomei/Poh Kong/Degem), I also learned some other things (more on this later) that narrowed my investment decision to just one company: Tomei Consolidated (Bloomberg ticker: TOME MK). 

Tomei is a leading mid/high-end Malaysian jewelry retailer owned/managed by upstanding people.  How upstanding?  Upstanding enough that LVMH recently granted Tomei the exclusive franchise rights of De Beers Diamond Jewellers http://www.debeers.com/ in Malaysia (i.e. De Beers’ retail arm is 50/50  owned by LVMH and Anglo American but LVMH manages it, see http://www.lvmh.com/uploads/assets/Com-fi/Documents/en/RA_LVMH_Complet_GB_2012.pdf), with further options for Singapore, Vietnam, Thailand, and Indonesia http://www.bursamalaysia.com/market/listed-companies/company-announcements/1155641.  As the saying goes, “options always have positive value” – so while it’s still too early to tell what develops with De Beers, Tomei’s right to sell the world’s best diamond jewelry in the wealthiest ASEAN countries is something worth keeping in mind, too. 

Tomei has never lost money (average ROE from 2007-2012: 13%) or omitted a dividend but sells for just 6.8x FY2012 net profits, 0.51x 1Q2013 book value, and a 44% discount to 1Q2013 net current assets minus total liabilities.  At this price, I think buyers of Tomei are well rewarded for accepting the two major risks facing the company: 1) they owe some bank debt against unhedged gold inventory, and 2) Malaysia might impose consumption taxes for the first time ever.

(Helpful information sources, no longer on the web or Bloomberg):

-          2006 IPO prospectus https://www.dropbox.com/s/v70lgsha6xpro10/IPO.pdf

-          1Q2013 investor presentation https://www.dropbox.com/s/vp947326zxsdhvj/Tomei_1Q13_Presentation.pdf

-          2011 DBS Vickers report https://www.dropbox.com/s/ez6ns7ezss8m7h9/20110405%20dbs%20initiate.pdf

-          Detailed summary of De Beers franchise contract https://www.dropbox.com/s/slt5snzdstutkhr/De%20Beers-Tomei%20notes.pdf

-          Detailed financial projections for the first De Beers franchise store in Malaysia https://www.dropbox.com/s/nnajl6ivras3ehi/Tomei%20Business%20Plan%20Highlights.pdf

Tomei background:

Short history: Tomei initially started in 1968 as a 3^rd party manufacturer of jewelry.  When the Asian Crisis triggered steep retail rent discounts in Kuala Lumpur during the mid-late 1990s, however, Tomei decided to shift focus towards retailing jewelry under their own “Tomei” brand.  By early 2006 Tomei had 39 stores, revenue approaching MYR 200 million, and a nice profit margin – but more ambition than capital.  So Tomei IPO’d in 2006 at MYR 0.95 per share, opened more stores, and achieved the below track record through the end of 2012.  Though Tomei didn’t execute their expansion perfectly (more on this later), they did manage to grow their footprint at a fast clip while earning respectable profit margins. 

Retail segment: Today over 95% of Tomei’s retail sales are generated in Malaysian indoor shopping malls, but a small portion also comes from department store kiosks in China (11 total) and Vietnam (7 total) inside various “Parkson” outlets (note: Parkson is Malaysia’s leading department store operator with a large presence in China/Vietnam, too). 

In 2006, 55% of Tomei’s sales were more commoditized gold products (low double digit gross margin, 3-4 month inventory turn) and 45% of sales were more intricate gem-set products (high gross margin, 1+ year inventory turn).  Thanks to the bull market in gold prices since that time, today 70% of sales are gold products and 30% of sales are gem-set products.  As of 2012 December, half of Tomei’s inventory was gold related and half was non-gold related.  

Tomei’s management would prefer to sell a lot less gold and a lot more gem set jewelry, but the income levels (i.e. USD 10,000 GDP per capita) and consumption habits of their traditional Muslim/Chinese/Indian clients are still skewed towards gold for now.  If the experience of Hong Kong’s leading jewelers (i.e. Chow Tai Fook) is any guide, it’s going to take a long time for a local brand like Tomei to even get 50% of sales from non-gold products.  This is why the De Beers franchise is so important to Tomei’s development: it’s a way to get paid to learn how to become a first class gem-set jeweler.

Manufacturing/wholesale segment: this legacy manufacturing business serving small local jewelers is completely removed from Tomei’s retail side, which produces 100% of its products in-house.  All the manufacturing done here is for third parties on a “made to order” basis, so there’s very little capex or inventory involved.  Tomei’s management indicates that as long as this business remains profitable (and as far as we can see it’s never posted a loss), they’ll keep it as a cash cow as it doesn’t require any additional funding, gives them insight into customers/competitors, and provides a good source of raw materials bartering (especially when there’s a bottleneck in physical gold supply).  A good comparable for this segment would be Thailand’s Pranda Jewelry (Bloomberg ticker: PRANDA TB), one of Asia’s leading third party jewelry manufacturers/wholesalers.

Ownership/management: The Chairman/Founder, Ng Teck Fong, is a 75-year old Malaysian Chinese that runs the company with his four adult children (two serve on the board only, while two work day-to-day) and one daughter-in-law (in charge of manufacturing/wholesaling).  The Ng family now owns 61% of the total shares outstanding.  The Chairman has as a BS in Chemistry from Taiwan’s National Cheng Kung University, while his four children and daughter-in-law each have BA’s and/or MBA’s from Iowa State University.  I’ve chatted with the Chairman, his children involved in the retail business day-to-day, and their CFO on multiple occasions and they all seem like low-key, upstanding, and candid people that genuinely care about doing a good job. 

What I could observe with my own eyes confirmed as much: they’re the only company I’ve ever visited in Malaysia that 1) doesn’t have any company signage on their office exteriors, 2) has 100% of their directors/employees walking around in their socks to keep the floor clean, and 3) has the 75 year-old Chairman still working alone well past 6pm in a small windowless office adjoining the sole conference room ready to burst through a hidden door to greet visitors unannounced.  I also attended a private VIP sales event Tomei hosted in a suite at the Grand Hyatt Kuala Lumpur for a handful of elite De Beers Malaysia customers – the Chairman, his daughter in charge of the De Beers Malaysia franchise, and CFO all arrived early and stayed late to mingle with customers even though the event’s potential sales would not have amounted to much overall.  

De Beers franchise: the single December 2012 stock exchange announcement Tomei made about the De Beers franchise http://www.bursamalaysia.com/market/listed-companies/company-announcements/1155641 was so short and easy to miss that I only found out about it in January 2013 when the Chairman came through his adjoining office brandishing a “De Beers” business card.  I was also surprised to learn that entire De Beers franchise contract – including financial projects for the first De Beers store in Malaysia – was made available to the public, albeit only “offline” (read-only hard copy version, no Xeroxing allowed) for just three months.  Tomei’s CFO graciously made arrangements for me to access the franchise contract and financial projections for note-taking (see https://www.dropbox.com/s/slt5snzdstutkhr/De%20Beers-Tomei%20notes.pdf and https://www.dropbox.com/s/nnajl6ivras3ehi/Tomei%20Business%20Plan%20Highlights.pdf).  

The franchise contract is full of details, but the key point is that it sets up a traditional wholesale/retail relationship between De Beers and Tomei whereby Tomei promises to buy and maintain a certain level of inventory (USD 2 million) from De Beers at a fixed wholesale price and re-sell it to walk-in clients at a fixed retail price.  De Beers will provide a certain level of technical/marketing support (i.e. they flew over a charming 60-year old diamond expert with a black suit and soothing British accent to entertain customers at Tomei’s VIP event), but doesn’t charge any royalties or fees.  Tomei’s risk is no different from operating their own stores: inventory turnover, rental expenses, staff costs/commissions, consumer sentiment, etc.  De Beers’ risk is 1) that Tomei ruins De Beers’ brand equity in Southeast Asia, and 2) that Tomei defaults on payments for inventory.

Although the financial impact to Tomei from the De Beers deal will be small in the beginning, I view the franchise agreement as a big stamp of approval of Tomei’s capability as a luxury retailer.  Assuming LVMH knows what they’re doing (and their track record certainly suggests that they do), if after careful consideration and vetting they still felt that granting Tomei exclusive franchise rights to De Beers in five ASEAN countries with a combined population of 434 mllion was their best course of action, then that should speak volumes about Tomei’s reputation in their country and industry.  That we can buy still Tomei shares at a 44% discount to net current assets less total liabilities despite the above is very surprising.    

Major risks:

Bank borrowings and unhedged gold inventory:  for the last several years, borrowing unsecured credit cheaply to buy unhedged physical gold that you could mark-up for a double digit gross profit margin and sell quickly worked like a charm – until 2013, that is.  Tomei didn’t expect gold prices to rise forever but was still caught off-guard by the swift collapse in gold prices this April.  While the gold rout didn’t push Tomei into loss-making territory, it did squeeze their gross margins a lot: we saw this in 1Q2013 results already, so we should expect an even uglier 2Q2013 report card.*   

To be fair, Tomei’s management wasn’t 100% oblivious to gold price risk.  Rather, their philosophy for the last few decades has been to say “we’re jewelers in the real world with a gross margin cushion building a brand, not commodities traders making directional bets on a virtual screen, so we don’t want to hedge – our inventory is marked at historical cost, and the stocks we sell are replenished immediately, so if gold prices drop, we’ll average down our cost-basis and eventually benefit from that, too… and, anyway, only half of our inventory is gold-related.” 

If Tomei had little/no debt, this philosophy would make more sense.  The problem is Tomei does have debt, and their net debt to equity ratio increased a lot – from 0.51 to 0.95 – since they IPO’d in 2006 to fund their furious store expansion program.  The good news is their debt is unsecured, twice-covered by liquid/semi-liquid inventory, and not onerously expensive.  The bad news is it comes with a bunch of covenants that can make their bankers nervous when gold prices drop like a rock.  These covenants don’t permit A) a debt to equity ratio over 1.2x, B) bank borrowings in excess of 1.5x net tangible assets, C) net debt to equity in excess of 1x, D) dividends greater than net income, and E) debt service coverage ratio to fall below 2.5x.  Though Tomei is not currently in violation of any of the above covenants, given how close they are to hitting their 1x net debt to equity ceiling I would not be surprised if there was a sudden attempt to raise new equity in a discounted rights issue (benefits all shareholders but slower to execute) or a third-party placement (dilutes all shareholders, directors/family can’t participate, but faster to execute).

Gold prices have shifted up again recently, so it’s possible that Tomei can just “ride it out” for a while as they build up their equity base and cash level.  Longer-term, however, it would not be crazy for Tomei to start copying the hedging programs at leading Hong Kong jewelers like Chow Tai Fook (see details here on PDF page 17   http://corporate.chowtaifook.com/attachment/2012120716011017_en.pdf). 

*The (small) silver lining in all this is that Tomei’s foot traffic increased a lot (probably 2-3x) since April 2013, and sales have gone through the roof as customers that needed gold jewelry anyway for upcoming weddings, births, etc. rushed to buy at discounted prices.  All that extra gold-driven foot traffic brought more people into the stores and in contact with Tomei’s higher margin gem-set products – a very good thing even if it didn’t result in immediate sales.

Malaysian consumption taxes:  this is really a political risk, and since I’m not an expert in Malaysian politics I can’t comment much except to highlight that the consensus view (see http://www.cnbc.com/id/100437948) is that sooner or later goods and services taxes will be imposed for the first time ever on all goods, including jewelry (currently, jewelry sales in Malaysia are tax free just like in Hong Kong).  Tomei’s management said they studied this issue, and according to their research (based largely on the experience of other countries), consumption taxes do negatively affect jewelry sales for a little while, but they can also spur some pre-deadline “rush” demand upfront.

Expansion teething problems: Tomei is still losing a small amount of money in China/Vietnam, but management has no intentions pulling out any time soon so losses could balloon if they aren’t careful.  Likewise, in Malaysia Tomei closed five stores and opened 12 stores during 2012, which inflated operating expenses somewhat for that year.  Most of those 12 new stores opened in 2012 are still not profitable in 2013 – while management is hopeful that these loss-making stores will turnaround soon (i.e. normal time to profitability for new stores historically has been 0.5-1 year), it is possible that these stores were big location mistakes to begin with.  Fortunately, Tomei’s management realizes that aggressive expansion is not in the company’s best interests this year; maximizing cashflow and paying back debt will be the focus instead.

Why not own the competitors, too?

Poh Kong: Maybe I’m old fashioned, but I believe in owning stocks that allow me to sleep well.  While I can confirm Poh Kong is a real brand with real products (most of their stores are still positioned as the traditional pawn-shop style neighborhood jeweler selling gold to grandmothers), owning Poh Kong would definitely not allow me to sleep well.  

Why?  First, every annual report they have published since their IPO was audited by GEP Associates, a no-name auditor with almost no other listed company clients (see all the auditors of Malaysian listed companies here: https://www.dropbox.com/s/dcp8tp0dz2tknhx/auditor%20list%20malaysia.pdf).  A few months ago they fired GEP Associates and upgraded their auditor to Baker Tilly, but that will only affect the 2013 financials and beyond. 

Second, I felt very uneasy visiting the Chairman’s palatial gold-filled office; let’s just say the milieu was the polar opposite of Tomei’s (i.e. the Chairman’s business card, attached here https://www.dropbox.com/s/pxfcpjpxsw3fqgu/chairman%20card.pdf, was made to look like a replica of an Amex gold credit card!).  

Third, the Chairman and his finance guys were not really able to answer questions in the same level of detail as their counterparts at Tomei – maybe they just didn’t feel comfortable describing their business to a new visitor like me, but their terseness certainly didn’t inspire any confidence from me.

Degem: I don’t have much to say about this company since they have repeatedly rejected my broker’s requests for a meeting or phone call.  Of all the companies in this industry, they have the fanciest stores (they’re positioned above Tomei with a higher percentage of gem-set jewlery), the most expensive auditor (KPMG), and the cleanest balance sheet.  Degem frankly looks like a decent company at a silly cheap price, but life is short – if there’s no chance for corporate access then I can’t sleep well no matter what.