Pembridgecap

A Wealth Creation Journal

Category: Investment Updates (page 2 of 2)

Baoye Group – a mistake & a lesson

I recently sold my ownership in Baoye and ended the 4-year partnership with the business. I registered a 5% loss, but the real economic loss is much higher after accounting for the opportunity cost of having the capital tied up in an unproductive venue.

This experience changed my view on what constitutes a truly conservative investment. I used to consider securities, such as Baoye, trading below its net asset value as a conservative investment. However, for such an investment to be profitable, the discount to intrinsic value needs to narrow over a reasonable time period. Unless there are clear paths such as activist involvement to value realisation, time may not be your friend in these situations. On the other hand, time is the friend of a great business that can grow its intrinsic value. Mr Market may at any point misprice a great business, but the market value will generally grow alongside intrinsic value. Hence a truly conservative investment is a great business selling at cheap to fair valuation. The lesson is not about avoiding average businesses with dirt-cheap valuations; instead, it is about a better calibration of the relative attractiveness of investment opportunities.

Phil Fisher believed that there are only three reasons to sell the ownership of businesses: 1) “a mistake has been made with the original purchase”, 2) the company’s business quality starts to deteriorate with the passage of time, and 3) a more attractive investment opportunity that is more deserving of the capital. In this case, Baoye was sold because of the first reason as I committed a mistake in my original investment analysis. The most unfortunate part is that it took me four years to recognise and correct this mistake. I promise to learn faster next time!

As a reminder, Baoye Group is a Chinese company that is vertically integrated with construction, residential real estate development and building materials. We became a partner in the business because Baoye offered 1) very attractive valuation, 2) good and well-aligned management team, and 3) potential growth prospect from prefabricated buildings. My biggest analytical mistake was with Baoye‘s growth prospects. I believed that prefabricated buildings would drive growth at Baoye’s building material business. While Baoye did build numerous prefabrication factories, they only contributed 2% to operating profit. Most of the business’s profit is still in residential development.

This is evidenced in the capital allocation decision as well. Over the last four years, management allocated capital in the following manner:

  1. ~RMB 5.7bn in land purchases for residential property development
  2. ~RMB 1bn in capex (mostly for building housing industrialisation related factories)
  3. ~RMB 0.2bn in share buybacks

The vast majority of capital was recycled in residential development. On its balance sheet, Baoye has a book value of RMB 8.7bn as of June 2019. It carries a cost value of ~RMB 9bn land and properties for residential development. While the founder of Baoye, Mr Peng, has been talking about the revolution in construction through prefabrication for many years now, he has not allocated capital according to his vision. Without growth from the prefabricated construction business, Baoye is just a regional residential property developer in China with undifferentiated product offering in an increasingly consolidated sector. I do believe that housing industrialisation will one day revolutionise the construction sector, but I am not sure Baoye will be the main beneficiary of it.

I have misjudged the management team’s desire to profit from the cheap market valuation as it is trading at 0.3x P/B with 50% of its market capitalisation in net cash. Given Hong Kong Stock Exchange’s listing rules, the company is only allowed to buy back 1-2% of total share base each year. So, sizable share buyback is impossible. There is a lot of social status attached with owning a listed company in China that I suspect Baoye management enjoys. I believe they are fully capable of taking advantage of the cheap valuation. But they chose not to because they have other capital allocation priorities.

TC comments

I haven’t sold and have learned at least a few things.

As your partner blogger, I reject the “great biz at fair” vs “fair biz at cheap” argument. This seems only correct in hindsight. As you say, the lesson is not to never do fair biz at cheap, it’s the calibration of correctly trading off these two that needs to be good.

I still believe this is a very “fair” (neither great nor bad, but high conviction of being “average”) business at a *very*  cheap valuation (high conviction of cheapness). So in terms of this calibration it seems fine to me. Rather, if this was a stock listed on US (it isn’t & not saying this is somehow “unfair”), this might have worked in the same ’16-’19 time-frame.

Maybe the already large management ownership together with the steady share buyback is working against minority shareholders, as the stock becomes more illiquid and the market starts discounting a future where a squeeze-out becomes a possibility. A calibration takeaway here might be to prefer management owning 20-40% versus more than 50% from the thesis outset.

Another calibration for me is to lighten up on a similar company when management *that already has high ownership percentage* stops the dividend. If I recall correctly, we could have trimmed our positions at roughly the same price when this happened years ago. In hindsight, the reasoning management gave “housing industrialisation capex” was only a half-truth, as the company still has plenty of cash. The company has only done buybacks since.

Another interesting thing is that we learned (or indeed both have the illusion of having learned) different things.

Maybe it is not as important to the thesis, but the following is an insight for which I have the highest conviction that it is actually a correct insight from this situation:

A few years ago, I became a dogmatic believer in tax-efficient buybacks, always preferring buybacks to dividends because of taxes. Indeed, from a theoretical point of view, when keeping future stock “% discount to NAV” valuations *constant* to the current % NAV discount, buybacks are exactly as accretive as dividends (only difference is taxes).

However, as I outlined above, in situations were minorities might get nervous because liquidity decreases disproportionally (buying 1% of outstanding if float is 30% outstanding is 3% of float, vs buying 1% of 99% of outstanding only 1%) and a squeeze out is getting discounted, this is where practice starts disagreeing with my theory. In other words, % discount to NAV does not remain constant (i.e. “value + return of capital in bb/divi is its own catalyst” argument) but widens. I believe the devil’s advocate argument here is to say that 1 pp buybacks of a very small float should also have a very big boosting effect to the share price when they are carried out.

That is a long-winded way of the hindsight gut feeling “bird in the hand is worth two in the bush” that really teached me the virtue of a dividend. Tax efficiency is NOT the only difference with buybacks in practice.

My last take-away is that I am reinforcing my belief that countries with stock markets that are going sideways or down do *not* tend to become more efficient in the cross-section. In other words, in a rising Chinese stock market, this stock might have gotten discovered by more sophisticated international stock pickers. Instead we got increasing international scepticism vs China / HK, even from the “low base” when we invested in 2016.

A thought I wrestle with: is this truly a safe stock because of its large cash position? Or does it tank when the global economy sinks, as geopolitics typically becomes more muddy (or at least the perception) and international investors lose faith in (1) enforcing property rights in the future (2) values denominated in a currency that has capital controls etc. This is what I will call “cyclicality thru geopolitics”. Is Baoye similar to owning a cash-rich “safe” net net in Georgia or Taiwan (with invasion of neighboring country becoming more probable to please populace when the economy sinks)? That would make its fundamental *conditional* beta higher in black swan situations higher than we might think (i.e. low beta until things really go awry). But yes, I am probably overthinking this, and maybe this is already under-owned by the international investor community.

Dart Group Memo – Dec 2019

One of my major contributor my profit this year is Dart Group. Since my initial purchase of Dart Group’s business ownership in Oct 2016, it has both doubled its revenue and net profit while the share price has increased by 4.3x from GBP 3.7 per share to GBP 17 per share due to the most wonderful combination of earnings growth and multiple rerating. I am proud to report that with more than 14m of annual passenger traffic, Dart has overtaken Tui to become the largest package holiday operator in the UK. Better yet, it is also more profitable than its main competitors. Dart enjoys 10-11% operating profit margin while Tui’s margins are half of that.

The initial investment thesis in Dart Group was anchored on 1) demand for package holiday will remain resilient after Brexit, and 2) Dart Group is a good quality business that is misunderstood. I underestimated both factors. UK’s demand for package holiday was more than resilient; it grew at an annualised rate of 5% for the last three years. Dart’s management team did a first-rate job successfully launching a new base in London Stansted, launching new products and constantly improving customer value propositions. I did not foresee the exit of two large competitors in a relatively short period of time. Hence, the timing of purchasing more Dart shares in the first half of 2019 was incredibly lucky. The third-largest package holiday operator, Thomas Cook, declared bankruptcy in September 2019 and since then Dart Group share price soared more than 100%. Thomas Cook roughly represented 20% of total market volume and have ~30% volume overlap with Dart Group. I fully expect Dart Group to capture 20-25% of Thomas Cook’s customer base and enjoy some temporary price increase. Net profit margin in FY2020 could rise above the usual 4-5% range and reach 6-7%. However, the profit boost will be short term in nature. Just like the bankruptcy of Monarch in 2017, the market will respond to supply shortage swiftly which will lead to normalisation of prices and compressing Dart’s profit margin.

In Nov 2017 (link to the 2017 memo), I wrote that “Jet2 will run at around 11-12m pax capacity with 91% load factor” and have “GBP 2.4bn revenue in 2019”. Oh, boy, was I wrong! In 2019, Jet2 actually have 14m passengers and a GBP 3.5bn revenue. Again I credit this excellent growth to Jet2 management team and more specifically Steve Heapy.

Dart Group grew its package holiday business at an annualised rate of 22.8% for the last 11 years. Dart is now ~20% of the total European holiday market in the UK in terms of holiday visits. Narrowing down to the European package holiday segment, Dart’s market share is even higher at 30%. The European holiday market is growing at 5% and the European package holiday market is growing at 8%. I believe Dart can continue to gain market share but at a much slower pace. Or said in another way, there are no more new airports in the UK that Dart could enter to change its growth trajectory materially. For the next 10 years, Dart is extremely likely to grow at a much slower pace versus the previous 10 years. My best guess is that 10% would be very respectable. Again I could be wrong here again….

On the profit margin side, I expect the profit margin to slowly deteriorate due to general cost inflation and limited pricing power. Dart’s value proposition is to provide good value for money holidays to its customers. There is also limited operating leverage in the business without pricing power. One potential source of operating leverage comes from higher Winter revenue. Typically, Dart makes all its money in Summer and must endure losses in the Winter because the Winter volume is not high enough to cover the fixed cost. If Dart could grow its Winter business materially, then there could be some operating leverage. However, the overall UK winter holiday is roughly 2-2.5m visits per year. This pales when compared to the Summer market of 20-30m. The size of Dart’s fixed cost is determined by the peak capacity of 2m passenger per month during the Summer months. Considering the overall Winter holiday market size, it is very unlikely for Dart’s Winter revenue to ever become large enough relative to the fixed cost base that is determined is peak volume during Summer months.

Another possibility for the profit margin to expand is to increase penetration of package holiday relative to the flight-only seats. The cost to serve a flight-only customer and a package holiday customer is roughly the same. Hence if Dart can convert more flight-only customer into a package holiday customer, its profit margin should improve. Currently, 52.8% of total customer choose the package holiday product. I believe that for mature airports such as Leeds, it is not possible to increase the package holiday penetration materially in the future. For newer airports such as Stansted and Birmingham, the package holiday penetration is still quite low. Over the next 5 years, one could see package holiday penetration increasing further to 55% at best.

Combining the slowing revenue growth outlook and compressing profit margin together, earnings likely to grow at less than 10% over the next 5 years. For a company with no pricing power and confined long term grow runway, I am comfortable underwriting a 10-12x terminal multiple on net profit. Correspondingly, the position size has been trimmed back from a 13% position to a 5% position.

Dart Group Memo – 25th Nov 2017

Dart Group (DTG) released its latest 1H FY18 results on 16th Nov 2017. Operating results were very satisfactory. The total number of passenger sector flown for the period between Mar-Sep 2017 increased by 41% while the ticket yield decreased by 17% from GBP 92 to GBP 76. With the competitive pricing, load factor remained at an impressive 93.2%. Consequently, leisure travel revenue grew 36%. Operating profit grew 22% which led to a continued margin compression of 12.3% as compared to 13.5% in 1H FY17.

Advanced sales grew by 38% from GBP 519m to GBP 713m which is indicating a strong growth for the Winter of 2017/2018. The growth in Winter programme corresponds to Jet2’s capacity expansion as the company grows its aircraft fleet. Strong free cash flow generation with impact from working capital is largely neutral. Capex spend is expected to be much higher in 2H 17 with aircraft delivery.

All things considered, this is a very impressive operation performance by the Dart Group management. The share price rallied strongly upon the release of the set of performance. The market seemed to value DTG very differently over a 5-month period. However, the intrinsic value of DTG most definitely did not change as much as that implied by the share price. I added to my position after Mr Market taking a dim view of the company’s prospect after results release in July 2017. I am glad that Mr Market has changed his view since then.

Post the recent share price rally, DTG is the biggest position in my portfolio by far (~30%). Naturally, I am re-evaluating the appropriate sizing for DTG. To arrive at what is the optimal position size, one would need to understand 1) the expected upside and 2) the downside risks.

DTG can generate further upside by 1) growing its free cash flow; 2) pay down of debt 3) expansion of valuation of multiple. While I do believe that the current multiple on DTG is on the conservative side, I typically do not count on multiple expansion for value creation. As such I would focus on future earnings growth and value creation to equity holder through debt repayment. DTG can generate further earnings growth by:

  1. Volume growth – this can be achieved either through 1) expanding to new airport and 2) adding new routes to existing airports

  1. Pricing growth – this can be achieved either through 1) increasing prices and 2) improving revenue mix by getting customers to purchase higher valued products

  1. Cost efficiency – given that the mix of aircraft is skewing towards new planes, one would expect some degree of operational efficiencies

  1. Operating leverage – as DTG continue to grow in its bases, it should be able to spread fixed cost over larger revenue and achieve some margin expansion. This is especially true at newer bases

DTG might be able to expand to new bases to generate further growth, but it would not be prudent to anchor an investment on such an aggressive assumption. I am happy to be wrong here. So in this analysis, I assume that future volume growth is only coming from adding new routes to existing bases. In the short term, DTG is likely to enjoy high single-digit volume growth due to the collapse of Monarch. In the longer term, DTG is unlikely to grow its volume above the market as competition in the airline/holiday industry is intense. Similarly, on the pricing side, I suspect pricing growth is very limited due to competition. But DTG does get some insulation from pure price competition because they are focused on holiday destinations and are currently very profitable while being very price competitive. Putting the two together, DTG’s organic revenue growth over the next five years is unlikely to exceed 10% while the risk of a cyclical downturn is more severe at current valuation.

By replacing older aircrafts with modern aircrafts, DTG should be able to realise cost savings through fuel efficiency and lower maintenance cost. But the impact of this should be fully incorporated by 2019. It is difficult to estimate this precisely, but I am not expecting a more than 1% of EBIT margin improvement. On the other hand, the risk of a higher fuel price weighs down on the cost savings from the new planes. Operational leverage might kick in with further growth, but this is difficult to quantify.

Putting the above together, I estimate that Jet2 will run at around 11-12m pax capacity with 91% load factor. Assuming a conservative pricing environment, I get GBP 2.4bn revenue in 2019. With an 11.5% EBITDA margin and no working capital benefit, I get ~ GBP 200m operating cash flow. The question of what is the right maintenance capex is a difficult one. I assume that with newer aircrafts in the fleet, the run-rate maintenance capex is close to GBP 60m. Deducting the maintenance capex, the FCF would be ~GBP 150m; implying a close to 15% free cash flow yield on GBP 1bn market cap. Assume that all FCF is used for debt repayment, equity value should increase while the FCF yield would decrease assuming that FCF doesn’t increase too much over time. In today’s world, 15% FCF is still a very attractive rate. Nonetheless, the upside on DTG is probably around 30-50% without any multiple expansion. Given that, I have investment opportunities with similar downside risk but 100% upside. It no longer makes sense to allocate such a large size to DTG.

However, Jet2 is still the best-valued package holiday business where it strikes a great balance between customer service, experience and price. The company is managed by an excellent management team and a well-aligned owner operator. Jet2’s position as value for money package holiday operator should prove to be most robust in a recessionary environment.

At this point, I believe 15% position size is probably the right one for DTG. I am retaining a large position size because I am very keen to partner alongside a competent and well-align management at a reasonable if not cheap valuation. However, I will be selling down more DTG shares.

MC

Dart Group – Memo post FY17 results

Thomas’s enthusiasm on religiously updating this blog has put me to shame and as such I will share my latest thoughts on Dart post the latest results release last week.

While many investors counsel against sharing investment ideas because it exposes one to commitment bias. Despite the commitment bias risk, I want to document my thoughts ex-ante so that I can remove any hindsight bias should my judgement prove to be wealth destructive. So here we go:

Post the results, DTG share price went on free fall – a whooping 20% drop in 2 days. Just like TC, DTG makes up ~25% of my portfolio. So this was emotionally hard to bear despite all the lessons of rationality that we keep reading about in books.

The market reacted violently because:

  • Operating profit probably did not meet market expectations given the run-up in share price before the results release
  • Huge uncertainty associated with the non-UK ownership issue

I suspect the issue surrounding non-UK ownership was the more important driver is pushing the share price down. As we all know, market hates and punishes uncertainty very punitively.

From an operational perspective, I was very happy with the progress that DTG is making for couple of reasons:

  • The capex numbers confirmed a previous assumption that DTG has ~50% discount on the listing price of the new Boeing 737-800s
  • Revenue growth in winter season continued which is critical as the newer fleet would have to be justified by better utilization rate all year round
  • Advanced revenue jumped 40% YoY which is STRONG indicator of the success of the new bases – Stansted and Birmingham
  • Net debt was very much under control helped by the cash flow generated by negative working capital with growth

The main reason for softer EBIT margin was due to one-off costs and cost ramp up in new airports (Stansted and Birmingham) i.e. the cost was incurred before the revenue came in.

When we decided to invest in DTG in Oct 2016, the biggest risk was that Brexit would lead to a sharp drop in demand for oversea package holidays which would be disastrous for DTG as it was taking on debt to purchase new aircraft. Increasing capacity through debt when demand is about to decline is a recipe for massive value destruction as witnessed in many of the commodity companies.

However the strong advanced sales and the revenue growth in FY17 indicated that the demand for package holiday in the UK has not been affected by the weaker Sterling post Brexit. This corroborates the UK holiday data released by ONS in May 2017. The strong growth in advanced sales is an important signal because it implies that people are booking their summer holidays as usual. In fact the strong demand for FY 2017 summer is particularly encouraging because Britons would have fully digested the impacts of Brexit and still decided to spend on holiday in the subsequent year.

The implication of the above point is that our worst-case scenario is increasingly unlikely to happen and as such the downside risk of an investment in DTG is diminishing. Operationally, the range of outcomes for DTG in the next 2 years is heavily skewed to the base and bull case. (Base case assumed growth associated opening 2 new bases and no growth afterwards and bull case assumes that there is still 5% organic growth in topline after the new bases are up and running at steady state)

Going forward, I think the value of DTG is driven by the following factors:

  1. Normalized run-rate FCF in base case in GBP 120 – 140m which implies an FCF yield of 17% based on the share price today
  2. Pay down of debt will lead to appreciation of equity value
  3. Given a mix of old and new aircraft in the fleet today, DTG can choose to retire old planes more quickly depending on the demand conditions. Full credit to TC for his insight on this point
  4. Multiple expansion as the company proves its success with the new bases and lower leverage in the steady state environment

As such I have added and will continue to add to my DTG position if the price goes down further in the absence of new information.

On the non-UK ownership point, the context is such that both EU and UK requires their airlines to be majority owned by EU or UK nationals. Before Brexit, UK airlines just have to comply with the EU regulations. Post Brexit, UK airlines have to ensure that the company is majority UK owned to maintain its operating license. DTG is proposing to add a new clause to the article of association to force any non-UK shareholders to sell his/her shares. Ryanair and Easyjet already have this clause in their article of association. The worst case is that we are forced to sell when the share price is very low as we are not UK nationals.

Firstly, DTG noted in its announcement that they believe currently non-UK shareholders make up less than 35% of the shareholder base. DTG is 40% owned by its founder, Philip Meeson who is a UK national. Secondly, the company will try its best to avoid activating such clause unless absolutely required. Thirdly, we still dont know how the Brexit negotiation will play out on this issue – maybe it is favorable maybe it is not.

So there is a good chance that this clause is not required. But the important question is if the company decided to trigger this clause how are they going to decide which shareholders to force sell. I.e. if there are 40% non-UK shareholders and DTG wants to bring that down to 35%. How do they choose which 5% of the non-UK shareholder base to force sell?

The company did not comment on this. But we decided to look at Ryanair and Easyjet for inspiration. It turns out that it depends on the chronological order at which non-UK shareholders register their shares with the company. For example, if you are the first non-UK shareholder to register with the company then you are the last one to be forced to sell. And they will first force sell the shareholders who have not registered with the company. So this gave me great comfort that as long as I register my shares with DTG asap, I should be okay.

So I am comfortable with the two issues and continue to hold the DTG shares. Of course I change my mind when the facts change to quote John Maynard Keynes.

MC

Newer posts »

© 2020 Pembridgecap

Theme by Anders NorenUp ↑