Pembridgecap

A Wealth Creation Journal

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Live Streaming My Investment Portfolio

I am not sure if there is much benefit to broadcast my portfolio online. But it certainly sounds FUN! I was born in a small village with a very auspicious sounding name which loosely translates to mean a hundred victories. I really love that name and in honour of the village, I am calling my portfolio – Invictus. I hope it also brings me many victories in the years ahead.

I have included here is a breakdown of my portfolio as of 31 Dec 2019 and Invictus’s performance since inception in 2016.

  • Invictus Gross Return is the return after trading cost, admin fees and so on…
  • Invictus Net Return is the return after I applied an artificial fee structure of 0% fixed charge + 20% of the profit above 5% return. Unfortunately, nobody is paying me any fees now but I am determined to change this!
  • While I could not care less about what the index does in any month, quarter, and year, it is the best yardstick to measure performance over the long term

Here is how I will update my portfolio on this blog:

  • Every investment action will be updated here with at most 2-3 days of delay
  • I will try to explain all of my investment decisions as much as possible but no promises here
  • Every 6 months, I will provide a comprehensive portfolio update with performance and detail portfolio breakdown as seen above
  • Every 6 months, I will write a letter to explain my thinkings in more detail

Please feel free to share any feedback/comments with me! Even better if you share an investment idea with me!

Disclaimer: All information and material presented here are based on a virtual portfolio where there might or might not be actual trading activities behind it. The information contained herein is not intended to be a source of investment advice, credit analysis and trading recommendation. The sole purpose of this document is to document general investment thoughts and reflections on different businesses.

 

Games Workshop – 1H 2020 Results Update – The Best Is Yet To Be

07:57

1H 2020 (6 months ending 1st Dec 2019) results were excellent! What a privilege to be a partner in this spectacular business! Especially the kind of hardworking partner where all I have to do is just sit and watch.

The most exciting part of the earnings release was the doubling of the licensing income from GBP 5.5m to GBP 10.7m due to the launch of a new video game. A big part of my investment thesis on GW relies on the increased monetisation of its Warhammer IP beyond just miniatures. While this is a step in the right direction, I fully expect the licensing income to be lumpy and would take years to materialise fully.

In the meantime, the core miniature business is firing on all cylinders….

The revenue grew 18.5% to GBP 148.4m which is above my long term expectation of 10-15%. New games and miniatures release schedule will impact the growth in a specific period. My long term expectation remains unchanged in this regard.

A more detailed study of the revenue growth reveals some encouraging signs. GW breaks down revenue into three channels – Trade, Retail and Online.

Trade channel is 52.6% of the total revenue and growing the fastest at 27.2%. Trade is mostly made up of local mom and pop hobby stores which stocks a variety of trading card and board games such as Magic the Gathering & Catan. These hobby stores are usually the centre of local hobby community which is very similar to GW’s own retail stores. There are 4900 distributors at the end of 1H 2020. The distributor count grew 11.4% and the annual revenue per distributor grew 14.2% to GBP 31.9k. The annual revenue per store for GW’s own retail store is GBP 173k. So there is a 5x gap. Over time, distributors should increase retail sales productivity to close this gap.

Retail channel is 31% of the total revenue and growing at a slower rate of 7.5%. Retail consists of Warhammers stores owned by Games Workshop. The store counted increased by 2.5% while the revenue per store increased by 5% on a YoY basis. Finally, the online channel grew 15.6% and makes up for 16.5% of the total revenue base.

Opening retail stores will help to build brand awareness and seed the initial Warhammer community in a new locality. However, the independent hobby stores is likely to remain the most important driver for revenue growth for the next few years. Because it is uneconomical for GW to open stores everywhere. Online will remain a complementary channel to help fans acquire miniatures that are not stocked in the local hobby store.

Due to the completion of the new factory and optimisation of operational controls, the gross margin has expanded by 2.5% to 69.5%. Different revenue mix of newer vs older miniatures in any one period lead to fluctuating gross margin. Gross margin of an older miniature is higher as the fixed cost of building a plastic mould is amortised over a larger volume. I would expect the gross margin to fluctuate between 67-70%. The core operating profit was GBP 48.5m which was up 37.8% due to the beautiful effect of operating leverage. Core operating profit margin stood at 32.7%.

Investment consideration – at ~GBP 67 per share, GW is valued at roughly 25-28x 2020E earnings. While it is not cheap on a headline basis, I am holding onto my positions due to 1) healthy top-line growth + operating leverage and 2) a very positive prospect on IP monetisation.

Long read on US shale gas backdrop

How America’s most reckless billionaire created the fracking boom [Guardian] –  Bethany McLean on the shale industry & Chesapeake (CHK) founder

    • in 2008, conventional wisdom was that 8$ was a natural gas price floor (it cratered to 2.5$)
    • there was a real scare of US running out of gas before the shale revolution, with even Greenspan comments

“Landmen were always the stepchild of the industry,” he later told Rolling Stone. “Geologists and engineers were the important guys – but it dawned on me pretty early that all their fancy ideas aren’t worth very much if we don’t have a lease. If you’ve got the lease and I don’t, you win.” – McClendon, Chesapeake Energy founder

In my opinion, the US natural gas industry has become an interesting pond to fish in.

That other shale phenomenon, shale oil is actually the biggest risk factor for the price of US natural gas (i.e. cheapest fossil fuel globally, and cleaner than oil & coal). US Shale oil producers make their decisions based on the oil price. As a “side effect”, they also produce associated gas. This “free” natural gas competes with cheap shale gas producers in the US.  Interestingly, the US natural gas price is becoming counter-cyclical via the worldwide oil price. As the oil price suffers from an important demand shock in a recession, and shale oil producers are swing producers of oil, this growing competition of “free” associated gas is turned off (hence local nat gas supply shrinks).

In other words, while US shale gas producers are amongst the cheapest fossil fuel producers in the world, most US shale oil producers are almost the opposite (the marginal producers that turn off if oil demand retreats). As “associated gas” production of oil producers is turned off, this is very positive for US natural gas producers.

As credit markets are already shutting for natural gas producers (have a look at breathtaking multi-year plummeting share prices of AR, RR, CNX), a recession will probably put a damper on shale gas drilling (i.e. capex) growth as well. Lastly, demand growth remains underpinned by being the cheapest fossil fuel in the world. Meanwhile, US natural gas equities are very cheap compared to their prospective maintenance cash flows (20-50% yields) and SEC PV-10 reserves.  Both valuation measures give 0$ credit to the huge dormant assets convexity/optionality (no costs if US nat gas prices go down, but extra profits if nat gas starts rising). Of course these are commodity businesses with the usual disadvantages, except one! This idiosyncratic group of commodity businesses can’t be criticized as “cyclical” anymore. That is a game changer. More later.

“Simply put, low prices cure low prices as consumers are motivated to consume more and producers are compelled to produce less” – McClendon

Games Workshop – An Investment Fantasy

Games Workshop (GW) is the largest investment (20%) within my portfolio as it is the cheapest and simplest idea that I can find. When GW ownership was first acquired in April 2018, I only committed 5% of total investment funds because I did not fully appreciate GW’s outstanding business quality. Despite the share price increasing from GBP 22.75 to GBP 61 since then, I further increased the investment in GW as my understanding and conviction in the business developed positively. I may be a slow learner, but it is better to be late than never.

GW is the UK-based creator of Warhammer Hobby which makes fantasy miniatures set in endless, imaginary worlds called Warhammer Universe. The Warhammer Hobby involves painting and collecting Warhammer miniatures with rich backstories developed over 500+ Warhammer novels in the last two decades. Fans can form armies with the miniatures to participate in the tabletop wargaming with the rules developed by GW. All miniatures are designed and manufactured in the company’s headquarter in Nottingham. The story writers collaborate with miniature designers and game makers to weave new characters, games and stories seamlessly together. GW generates revenue through the sales of miniature and the royalty income from licensing its intellectual properties (IP) for PC and mobile games.

I think of Warhammer fan base in three categories – Collectors, Gamers and IP fans. The Collectors preoccupy themselves with collecting and painting miniatures because of their design and beauty. The Gamers are passionate about the wargames and strategically acquire miniatures based on their roles and powers in the game. IP fans, fascinated by the Warhammer Universe, mostly enjoy the Warhammer novels. In reality, the fans have one main preference but also participate in other aspects of the hobby in varying degrees. Interestingly, the Collectors make up for 30-40% of GW’s revenue.

While not everyone is a natural fan of the Warhammer, those who carry the Hobby Gene have an innate tendency to become a fan. This love affair between fans and GW was under trial during the period from 2010 to 2015. Under the leadership of previous Games Workshop management, the company had minimal communication with the fan community, shun social medial (because they did not want to deal with criticism from the fans), closed down popular product lines and increased prices excessively to offset a shrinking fan base. During this 5-year period from 2010 to 2015, the revenue shrunk from GBP 126.5m to GBP 119.1m while the net profit declined from GBP 15.1m to GBP 12.3m.

Just when it seems like GW is set on an inevitable slow decline, Kevin Roundtree took over as the new CEO of Games Workshop in 2016. The first thing he did was to reconnect with the Warhammer fan base through the Internet. Then, he reintroduced the popular Warhammer games that fans loved. Most importantly, he makes it easier for fans to get into the hobby by offering lower price point starter sets and simplified the game rules. The fans are elated and came back into the hobby in droves. One fan even commented that “it is like Games Workshop was taken over by someone who actually knows about sales and marketing in the twenty-first century.” Its revenue doubled to GBP 256.6m while its net profit jumped five-fold from GBP 12.3m in 2015 to GBP 65.8m in 2019. This is a testament of the fans’ loyalty towards Warhammer. Few companies can not only keep their customers after years of mistreatment but also win them back with one big gesture.

So why are fans so loyal to Warhammer? Warhammer has a differentiated customer experience that few can match – beautifully designed miniatures with great details, a strong physical network of players, and cleverly crafted fantasy worlds that fans can immerse themselves into. Even as fans complained about GW during 2010 – 2015, they acknowledged GW’s miniature as best in the industry. GW has the unique competence to mass-produce high-quality miniatures in a cost-effective manner because it has years of accumulated manufacturing know-how and the scale to internalise its entire manufacturing process. As the largest fantasy miniature producer, they can cover the fixed cost of investing in customised tools and mouldings. The design team can work closely together with the manufacturing team to push the limits on manufacturing the next best miniatures.

Gamers are going to play the games that have a decent chance of finding another Gamer to play against in the local community; thus it is critical to have a minimum player population size locally. Hence, GW uses its fleet of 500+ physical retail stores to provide physical space for local fans to meet and recruit new blood into local Warhammer communities. Local Warhammer clubs are formed as the fan base grew. It took GW over 30 years to build this physical network of Gamers globally which new competitors will find it hard to replicate.

Put in another way, GW’s moat lies in its physical social network of Gamers. Warhammer – the game – is the equivalent of Facebook – the digital platform – that binds these players together. Each new player joining Warhammer strengthens the social network because it increases the existing players’ probability of finding a good game quickly. Physical social networks are of course inferior to virtual social networks because 1) Gamers cannot have a game whenever and wherever they want, 2) Gamers’ social relationships are not digitalised and hence not accessible to GW, and 3) Gamers’ interactions cannot be stored in a useful format. Nonetheless, the physical social network is still a powerful moat for the business.

Finally, GW’s IP elevates Warhammer above other board games and tabletop games. Most board / tabletop games are hit-driven businesses where new gameplays are easily copied by competitors. Unlike most board / tabletop games, Warhammer fans immerse themselves in the narratives as they collect and play the miniatures. It is a common scene to see Warhammers fans tries re-enact plots from the narratives through the games. Ask any Warhammer fan what they like most about their favourite miniatures, and the reasons usually are the characters’ personalities and their struggles and victories in the narratives. The progress in the narratives will introduce new characters which then is made into new miniatures. The stories give meanings to the lifeless miniatures and emotional bonds are formed when fans project themselves into the characters. This emotional bond with Warhammer drives repeat purchase. Or in the modern business parlance, Warhammer fans have high lifetime value. This strategy is common among other successful media franchises such as Pokémon and Star Wars.

I believe GW’s moat is likely to grow stronger with its unique corporate culture and first-rate management team. GW’s culture is formed by employees who are themselves biggest fans of Warhammer and they come to work here because they love what they do. GW also has a very strong creative culture where people have the creative freedom to try new things. After spending two decades at GW, Kevin, the CEO, is the right steward of company culture. I have come to know him better over the last year. He cares deeply about Games Workshop and he understands the full potential of Warhammer IP. Kevin set up a new media business unit to bring the Warhammer IP into mainstream media. If this is done successfully, the acquisition cost of new fans is going to decrease significantly. One of the biggest investment risks is Kevin’s departure due to some unforeseen reasons.

I value GW in two parts – core earnings from the sale of miniatures and royalty income from IP licensing. Through acquiring new fans and growing spend by existing fans, GW can grow its core earnings by 10-15% annually. I do not need to know precisely the size of the total market to believe that GW has a very long growth runway ahead. Another popular card game called Magic the Gathering has ~ USD 500m in revenue double that of Games Workshop’s revenue. GW has a sizable fan base in China but negligible revenue. I think China can be at least as big as the US which is GBP 100+m (50% of total revenue). On the royalty income side, GW is significantly underearning relative to the strength of its Warhammer IP. It is currently generating GBP 11.4m which is only 5% of its miniature sales. The top media franchises, such as Pokemon and Dragon Ball, make the majority of their income from licensing rather than merchandise sales. Despite paying a hefty multiple of 24x 2020 earnings, I believe we are getting a fantastic bargain because this is a very high-quality franchise with strong growth prospects, under-appreciated IP monetisation potential and strong corporate culture that reinforces its moat with time.

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.

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