Description

Thesis

Wonderful Sky Financial Group is the dominant financial PR firm in Hong Kong, with a 35% market share among companies filing for an IPO and a 70% market share by amount of funds raised. Since 2009, the company has compounded revenues and net income at 25%+ per year while generating enormous ROEs. It currently sells for 6.5x earnings excluding its cash and investments. The chairman owns >60% of the company while Value Partners is the second largest shareholder with a 6% stake.

Wonderful Sky history & management

Wonderful Sky was founded in 1996 by Chairman Liu Tianni after he moved from Beijing to HK and realized that companies from the Mainland would soon flock to list in HK. Wonderful Sky carved its niche as a Mandarin-speaking PR firm catering to Chinese corporates – in contrast to the Cantonese HK PR firms that worked with local HK corporates. In 1995, 17 Mainland enterprises were listed in HK; today, there are more than 1,000. In 2012, Wonderful Sky itself went public on the HK Stock Exchange. Mr. Liu is 53 years old, has never sold a share (including in the IPO), and has purchased shares for his personal account on numerous occasions. He has a great track record of increasing the company’s intrinsic value per share while paying high dividends and occasionally repurchasing shares.

Market background

Over the past decade, HK has been the leading IPO market by amount of capital raised.

                                                          Ranking: capital raised in IPOs

More than 2,000 companies are listed in HK. Each year, an average of 100+ new companies go public. In doing so, they enlist a wide number of third parties to assist them: banks, legal advisors, accountants, property valuers, translators, printers, industry experts, registrars, and PR firms.

                                                           Number of IPOs in Hong Kong

* These are uplistings from an exchange with lower requirements

In 2016, the top 10 IPOs raised HK$129 billion, or 16.6 billion USD. In the process, they worked with nearly 50 banks, 30 law firms, five auditors, and nine compliance advisors. Yet, with one minor exception, they all worked with only 1 PR firm:

Since 2012, Wonderful Sky has had a 35% market share in terms of IPOs but a 70% market share in terms of funds raised. In 2016, the company had a 90% market share in terms of funds raised. The company’s two main competitors are Porda Havas and Strategic Public Relations Group. Each of them has fewer than 1/3 the clients of Wonderful Sky and is rarely involved in the top Chinese H-Share IPOs.

Business model

To prepare a company for its IPO, Wonderful Sky creates corporate presentation materials, translates financial documents, issues press releases, organizes press conferences, liaises with bankers and lawyers, and coordinates investor roadshows. The company will typically charge a client HK$ 3-4 million for a small IPO and double digit millions for a large one, with the blended average around HK$ 8 million, or 1 million USD. More than 90% of the IPO clients will in turn become long-term retainer clients. They pay a base monthly fee of HK$50-80,000 (6,500 – 10,500 USD) for media monitoring and press releases, and they pay extra for events such as earnings announcement presentations – of which there are typically 2 each year in HK (semi-annual and annual results). Overall, just over 1/3 of Wonderful Sky’s revenues are related to IPO listings, while nearly 2/3 of revenues are recurring with nearly 100% customer retention. Typically, the churned customers tend to be companies that go bankrupt or are no longer able to afford PR.

Competitive advantage

Wonderful Sky has strong customer captivity primarily for the following reasons:

1)      An IPO happens once. It is similar to an expensive photographer at your wedding – you would rather cringe at the price than the result. The PR in the IPO can have a large effect on how much capital a company raises or its image with investors – and there is no second chance.

2)      The PR service is suggested by knowledgeable middlemen. The banks working on the deal will coordinate the tender for various firms. Given that Wonderful Sky is the most dominant firm, bankers tend to suggest Wonderful Sky to their clients, who have had little prior exposure to the capital markets. This is somewhat similar to the trusted optometrist that suggests Essilor glasses or the trusted plumber that suggests Geberit toilets (an example from AKO Capital’s “Quality Investing”).

3)      The cost of PR is a trivial fraction of total IPO costs. For instance, the largest IPO in 2016 was the Postal Savings Bank of China, which raised HK$57 billion. Its total IPO fees were just over HK$1 billion, of which their PR fees to Wonderful Sky were just over 1% of the total.

4)      The cost of ongoing PR following the IPO is a fraction of the cost of IPO PR. After spending an average of HK$8 million, the monthly fee of HK$50-80,000 is low both on an absolute and relative basis.

5)      There is a switching cost to changing PR firms as well as a loyalty effect. The Chairman has relationships with these companies over a very long period of time. In addition, it would take time for a new PR to learn about the business and management teams of the clients they represent.

Wonderful Sky also has an economies of scale advantage compared to its competitors in HK. Given that it does PR for over 30 IPOs each year as well as 300 retainer clients, the company spends a significant sum on newspaper advertising, hotels and conference rooms, and travel. In total, these costs make up more than 75% of the cost of sales; over time, the company’s purchase volumes have resulted in increasing discounts over time.

Track record & opportunity

Wonderful Sky went public in 2012 and provides historical financials since 2009. Since then, both revenue and profit have increased nearly 5.5x. The company introduced its roadshow business a few years ago which has higher pass-through costs and lower margins.

                                                Wonderful Sky financials

                                      (Figures in million HK$ for the year ended March 31)*

*2017 figures will soon be released.

Wonderful Sky will continue to generate new clients via IPOs in HK and the majority of these clients will become recurring customers. In addition, each year the company wins a dozen or so clients from competitors. It is now also expanding into Mainland China and Singapore, where it has already done PR for a small number of IPOs. The majority of the profits are returned to shareholders via dividends.

Valuation

The share price is HK$2.09 with just under 1.2 billion shares outstanding, for a market cap of HK$2.5 billion. Net cash and investments today are around HK$1.2 billion, leaving an enterprise value of HK$1.3 billion compared to earnings of HK$200 million. The P/E ex-cash is 6.5x (15% yield), with a dividend yield >6% on a 60% payout ratio. Of course, when we invest in a company with so much underutilized cash (4% return or so) we are effectively buying cash and generating a high return from the operation and a lower return from the cash. In the future, the company will likely pay more dividends as the cash balance continues to increase.

Risks

There are several risks to an investment in Wonderful Sky.

1)      HK may lose its position as a financial center. Ten years from now, Chinese corporates may see no value to listing in HK. Historically they have listed in HK because it was a developed capital market with a stable IPO regime. Wonderful Sky has a foothold in the Mainland China IPO market, but the market is less developed and pricing for PR is far lower than in HK. Over time, if HK loses its position, Wonderful Sky’s business could be at risk. In the short run, earnings would decline if the number of IPOs decreases, but the recurring revenues would cushion the decline.

2)      The quality of the chairman’s relationships may decline. The corporates are loyal to Wonderful Sky in part due to their relationship with the Chairman.

3)      The quality of the capital allocation may decline. Since its IPO, Wonderful Sky has done one stock issuance at a time when the share price doubled in short order. The company viewed this as an opportunity to increase the institutional ownership of the company while raising funds at a good price. Despite the increase in stock price, I believe the company was and continues to be worth a lot more and thus consider the issuance to have been dilutive. Aside from this instance, the capital allocation has been prudent with high dividend payout ratios and one spurt of share repurchases at large discounts to intrinsic value. There is a risk of a bad acquisition, but the company understands that it is often cheaper to hire away than to acquire and also realizes the low P/E of its own shares.

4)      Employees could launch competing firms. There are no factories or large capital requirements necessary for this business. It is a human capital business and employees could leave and take the relationships with them.

5)      The management has a family style approach. There are several family members involved in the company. Some investors view this as a negative. However, I believe we are aligned with the Chairman and his family. His stake is very large and the dividend he receives each year is 25x his salary.

6)      The HKD may depreciate against the USD.

Catalyst

Continued cash generation

Increased dividends or repurchases