Description

Want Want China is a high quality, branded consumer Food and Beverage business, demonstrated by consistent 20% operating margins and 25%+ unlevered returns on equity, run by an aligned founder.  The current valuation, though not super-cheap at 14x post-tax, enjoys balance sheet safety, is historically unusual, and I think underestimates the prospects for a company with a long track-record of growth.

Business description and business quality

The company manufactures, distributes and sells a wide variety of branded Food and Beverages.  Sales are almost entirely in China.  Starting with rice crackers in the 1980’s, it has expanded into a variety of snacks such as popsicles and jellies, candies, rice ball cakes, nuts and beans.  In the 1990’s they launched beverages such as flavored milk.  

Unlevered returns on equity over the past decade have been consistently above 25%.  Market share estimates for its range of established products vary from 30%-75%.   Brand recognition is high despite relatively low advertising and promotional expense (3.7% of sales).  Consumer loyalty is strong.  Tetra Pak – which sells more of its 125 ml drink cartons to Want Want than to any other customer worldwide - recently conducted research that reported a low degree of price sensitivity from Hot Kid consumers, which allowed the company to maintain 40%+ gross margins even during recent weakness. 

Many Chinese businesses reported huge growth 2005-2013.  Investors rightly fear that many could go all the way down the hill again.  This company should not be one of them.

History – how did we get here?

Chairman Tsai Eng-Meng (aged 59) joined his father’s company aged 18 in 1976.  He listed the company first in Singapore in May 1996, before taking it private in September 2007.  Demonstrating that he cares about market valuation and acts when the stock trades cheaply, he subsequently stripped out the non-core unprofitable operations before relisting in Hong Kong as a pure China Food and Beverage company in March 2008.

The 60% drop in the stock from HKD 13 in April 2014 to HKD 5 today has been due to both macro and company-specific factors.  Chinese macro factors should be familiar.  The main company news has been that sales of the company’s flagship product, Hot Kid Milk, stopped growing during the past two years, partly due to increased competition from alternative, healthier beverages.  Despite the significant change in the sales growth rate, the product remains very popular and generated about $1.75 billion in sales, or 47% of group total in 2015.

Investment thesis

Periods of sales slowdowns after many years of growth can present investing opportunities, if the valuation underestimates business quality and future growth prospects.

Specifically:

1.     Hot Kid Milk, after years of hot growth and representing almost half of total sales, dramatically turned cold starting in 2014.  So it became easy to sell the stock.

2.     But the broader portfolio of brands is still intact. 

3.     And the track record of growing a high quality portfolio of Food and Beverage brands is strong.

4.     This is not a typical commodity-like Chinese business.  Therefore mean reversion / recession economics should be kinder. 

5.  Product innovation continues.  Manufacturing and distribution capacity permit low-cost roll out of new products that might prove marginal for smaller competitors.  7% of sales come from products introduced within the last 3 years; 1.5% within the last 12 months.  So a return to growth should not be ruled out.

6.     There are over one billion Chinese!  Urbanization!  Growing consumption!  CHINA!!   N.B.  This argument has been retired due to exhaustion.  We apologize in advance for any disappointment.

Capital allocation and Alignment of interests

Since the 2008 re-listing, capital allocation has been impressive:

1.     Investment capital gets allocated to the segment generating the highest returns on capital.  Rice Crackers and Snack Foods have produced respectable returns, so capex has exceeded D&A, but the extraordinary returns enjoyed by Dairy Products, typically running at double the levels of the other two segments, has been rewarded with commensurately more (5-8x) capex.  This looks like rational capital allocation to me, not the result of nepotism or family fiefdoms occasionally found in such family dominated companies.

2.     Cash gets returned to shareholders by a truly dynamic dividend policy.  When the stock gets cheap, the dividend gets cut, and replaced with buybacks.  As the stock became historically cheap in H1 2015, the dividend was halved, and replaced by stock repurchases.  Refreshingly rare.

3.     Value-based stock repurchases.

This sensible capital allocation is the fruit of a management that is both talented, and aligned with minority shareholders.  Chairman Tsai Eng-Meng owns 47.8% of shares outstanding.  Combined with his four children, one of whom (aged 31) is COO, with another son and nephew as non-executives, the family owns 54.5%. 

Obviously the significant share repurchases of 2015 suggest that the chairman believes the stock currently underestimates his business’ future prospects.  He might be wrong.  An insider’s business insight might be worthless during major macro dislocations.  But at least by increasing his own equity stake in this way his opinion is honest.

Why is it cheap?

No doubt some shareholders bought Want-Want during the boom years because of that supposedly-compelling investing theme: china, China, CHINA!  With a viewpoint currently turned through 180 degrees, the three reasons CHINA! China, china… now explain why those deserting the stock leave it cheap:

1.  The rule of law in China, and its enforcement, operates differently than Western norms.  At times when this becomes obvious, like now, few investors care about risk-adjusted valuations.

·      High profile Chinese businessmen have disappeared recently, apparently to assist Chinese police with various investigations, resulting in significant investor uncertainty and suspended stocks:

·      Fosun International’s stock was suspended on the Hong Kong stock exchange on December 11, 2015, after its co-founder and chairman Guo Guangchang, with personal wealth of $5.7bn disappeared, and was subsequently released four days later.  Neither he nor the company has explained the nature of the investigation; apparently he has not been formally charged with any crime.

·      Metersbonwe, one of China’s best-known fashion brands, suspended its shares on the Shezhen stock exchange January 7, 2016 after its founder and chairman Zhou Chengjian, with personal wealth of $4bn, was apparently pulled in by the police.

·       A real estate billionaire, Vantone’s Feng Lun recently wrote: “A private tycoon once said, ‘In the eyes of a government official, we are nothing but cockroaches. If he wants to kill you, he kills you. If he wants to let you live, he lets you live.”

·      Much less wealthy, but contributing to general investor unease, a small Hong Kong publisher of books critical of China’s political leaders, has seen four connected individuals disappear in recent months, and a fifth, Lee Bo apparently kidnapped from the business’s warehouse in Hong Kong on December 30, 2015 by mainland Chinese police.  If credible sources prove accurate, Chinese police acted contrary to Hong Kong’s theoretically independent legal system under the “one country, two system,” by physically removing Bo, a British citizen, to the mainland to assist them with their investigations.

·      What does all this mean for the Taiwanese-born Tsai, whose pro-Beijing public comments are hard to discern from his clear economic incentives?  “Wealth comes with health warning in China,” writes the Financial Times’ Patti Waldmeir in Shanghai, in one of her several good recent articles on the subject.  My conclusion is that this is a macro risk that can be underwritten at a sufficient margin of safety.  It should not disqualify investment, but I realize that it will for many, therefore the risk premium can widen significantly.

2.  China goes ex-growth.

·      As dependable as a Chinese government statistician’s numbers, Want Want’s sales consistently grew double digit until two years ago.  They then abruptly declined in 2014 and probably again in 2015.  Even these small 1% YoY declines can cruelly dash dreams of trees growing to the sky.   

·      A leveraged $1.5 billion short USDCNY speculative position sits on the company’s balance sheet.  This is obvious stupidity.  But unless compounded in the future, it should prove a non-fatal wound, which we can only hope leaves a permanent scar.

3.  Valuation declines in Chinese competitors.  These were nosebleed high; are now somewhat lower; but are unlikely to tempt new Want Want investors for some time yet.

Bottom line: there are some clearly understandable reasons currently depressing the stock’s valuation below the probable course of future cash flows.  Their existence increase the chances of getting a bargain.

Disclaimer:   This is not investment advice and is not intended to be distributed in any jurisdiction where it would contravene local laws. The author or affiliated parties might buy or sell this or related securities without further notification. 

Catalyst

Resilience into economic weakness

100% of FCF gets allocated to stock repurchases at depressed prices, already demonstrated in H2 2015 

or insiders take private again