Dear ANTA sports, You Should Have Resisted the Temptation of that Convertible Debt

This post is in response to the headline earlier in the week (14th January, 2020) that Hong Kong-listed Chinese sportswear company Anta sports (2020 HK) is issuing Eur1bn (US$1.1bn) convertible bond in order to refinance its existing debt.

You Shouldn't have done it

You do not need the money 

According to your latest published financials, you were a net cash company. As of  six months ending June 2019, you had a net cash balance of 928 million RMB. According to the same financial statements, you generated an operating cashflow of over 4bn RMB and a free cashflow of over 2.7bn RMB in just the first six months of 2019!

That is an enviable situation for any company, especially given that in your case, you managed to remain in a net cash position even after completing the acquisition of Amer Sports, in which you invested slightly over EUR1.5billion (Note 12 of 1H2019 report). According to some sell-side analysts, you incurred a debt of 850 mm Euros for the acquisition. We failed to find this specific information in any of your publicly disclosed documents, including 1H2019 financial report. However, our own quick calculation from reading of Note 18 of your financial statements suggests a slightly lower debt incurrence. 

The deluge of cash that you generated from your businesses in 1H2019 is not a one-off phenomenon. In the year 2018 and 2017 also, you generated a free cashflow of 3.45bn RMB and 2.67bn RMB respectively, as highlighted on page 10 of your 2018 annual report.

If we assume business 'as usual,' (and there is no reason not to), then your should be in a position to completely pay down the existing debt from your operating cashflow in less than two years.

Your 'disclosed' list of reasons for the issuance do not make sense 

In the release issued by you to the Hong Kong stock exchange announcing the bond, you list the following as the reasons for issuing the bond:

"provide the Company with additional funding at lower cost to repay its existing debts and optimize its financing structure, to further strengthen the working capital for the Company, as well as potentially enhance the equity base of the Company."

There is no doubt that as net cash company, your financing structure was far from optimum. However, anyone who's taken Corporate Finance 101 in the university or business school would be able to argue that taking on additional convertible debt would make your financing structure even less optimum.

An 'optimum' capital structure, according to corporate finance theory, would involve a combination of debt and equity, with a reasonable gearing that would result in optimum 'cost of capital.' Taking this additional convertible debt would only increase your 'gross' cash balance, therefore making your capital structure even more sub-optimal than it currently is.  

Working capital, by its very nature, is a short-term liquidity need of the company and it is best met by short-term sources of fund such as a cash-credit facility or a working capital loan from a bank. Convertible debt, because of the potential equity conversion, is the longest term source of financing (ranking only behind plain vanilla equity fund raising).

Finally, I do not know what you even mean by 'potentially enhancing the equity base.'

If these were the reasons provided to you by your bankers, then I lament the quality of young chaps going into (or the old chaps still staying in) investment banking these days. I'm surprised that none of the sell-side analysts have questioned your reasons, but then, given how dependent the brokers have become on investment banking revenue after their commission pool was massacred by MIFID II, I shouldn't be so surprised.

Why would you throw away 3% of your equity forever?

I am curious about your choice of the financial instrument. The headline talks about it being a zero coupon bond maturing in 2025, issued at a premium of 40% over the last close. There is no fault with the timing of the fund raise (given the interest rates are so low), as well as the pricing (especially given the stellar performance of your stock price).

Let me illustrate that simplistically without going into too much of the underlying math, which I am sure your bankers have shown you. A convertible bond is a composite instrument, having an underlying 'strait bond' portion and an 'equity option' portion. A zero coupon bond offers no interest, therefore in this case the value is accruing to the investor only from the equity option. The pricing of equity option depends on the conversion premium, duration, and volatility in the stock price (as measured by standard deviation). Higher the volatility, higher the valuation. Given the relatively low volatility in your stock price in the past year (assuming this lower volatility continues in near future), the option is quite attractive for the issuer, in this case you.

However cheaper the funding source might be, I question your judgement: the conversion does result in over 3% dilution. You are potentially giving away 3% economic interest in the company forever, for raising the money that you do not really need? I really wonder why your existing investors should be fine with it.
   

This will only give an additional issue to your detractors to talk about

You have had your share of detractors, having been a target of a number of short-seller reports, the latest one by Muddy Waters Research, here, here, and here. Agreed that these reports have at best, created only a blip on your stellar stock price performance, but we believe that it has nonetheless created a skepticism among the investors about the veracity of your accounts, including your cash balance and the strength of your operating cashflow. 

This is very evident from your shareholder base. For a company of your size, operating track record, your institutional shareholders base in our opinion is, at best, 'thin.' Four of the top ten funds that own your shares are exchange traded funds or ETFs, who have invested in your shares, let's say, not because they love you, but because you are part of an index that they track. Not a single investor owns more than 1% of your stock, which in Hong Kong market, for a company of your size and track record, is unusual.

...for instance, what are you doing with such high cash balance?

Resorting to irrational financing decisions such as the issuance of this convertible bond is only going to alienate potential investors further, who could question if the company indeed has the interests of its investors at heart.

More importantly, the skeptics could again raise questions about your extremely high and ballooning gross cash balance, or about your strong cashflow. You see, as of 1H19, you had a 'gross' cash balance of 8.2bn RMB, which will only go higher following this Convertible Bond.

Even the non-skeptics may perhaps be right in asking: Anta dear, what are you doing with a gross cash balance that is as high as 45% of your equity capital base? Are there things you'd like to explain about your operating cashflow?

Unless you have some readily available answers, I'd say good luck to you....and your existing investors!

(Note: This article is purely an exercise in extra-curricular academic interest. Neither I nor do the funds managed by my firm have any long or short interest in Anta sports. This article does not constitute any recommendation on the stock.)  

Hong Kong's Property Affordability Crisis

This September I completed 20 years in Hong Kong. Not only have I spent almost entire of my working life in Hong Kong, but also my children were born here; it is the place I call home.

My adopted home is going through troubled times in the last six months. The current situation  started as protests against the extradition bill proposed by the government, but has morphed into something larger. While the possible reasons behind Hong Kong's discontent cover an entire gamut of political, economic and financial issues, in this post I want to analyse a very narrow topic which in my opinion is one of the reasons of discontent among Hong Kong people: housing affordability in the city. 

Hong Kong has the lowest housing affordability in the World

Everyone who knows Hong Kong understands how big a role the property sector plays in the economy. An apartment or a house anywhere in the world would generally form the biggest asset any middle class individual could dream to own, even though this wish would generally tie up the largest proportion of their net worth. But in Hong Kong, soaring property prices is increasingly turning this wish into a pipe dream.  According to the 2019 Demographia Housing Affordability Survey, Hong Kong is facing a housing affordability crisis. The survey defines affordability in terms of price to income ratio (PIR), calculated as the average home price divided by average income. For Hong Kong, that ratio is 21 years. In other words, it would take an average Hong Kong person 21 years to save enough money to buy a home.  The same multiple for Singapore, for instance, is 4.6.

As much as 50% of expenses for an average Hong-Konger could be linked to property prices... 

Housing forms 34% of Hong Kong's composite CPI (as against 23% in Singapore), or about a third of average consumer's expenditure (Source: Census and Statistics Department, Hong Kong SAR). This is only the direct housing costs, but the high housing prices in Hong Kong have indirect impact as well. For instance, most commercial establishments have to pay rental on their premises, and for most shops in Hong Kong, this works out to anywhere between fifteen to twenty five percent of their revenue. This impacts the cost of a host of services ranging from schooling to a haircut. If we add the indirect cost of property prices to the CPI, property would form about 50% of a household expenditure. (In doing so, we have assumed that 20% of the costs of all food and services bought by a household has an imputed property rental component.)

...and affordability over the last 10 years has only gone down

Hong Kong's housing affordability has progressively worsened since 2003. In 2011, which was the first time Demographia included Hong Kong in its survey, the PIR for Hong Kong was already the worst in the world, at 11.4 and has since then almost doubled. The reason being, that property prices have outpaced wage growth. Chart 1 below plots average Hong Kong wages in the last ten years versus property prices, both data re-based to 100 in November 2009.

                                                  Source: Datastream

Over the last 10 years, wages in Hong Kong are up 50%, only slightly outpacing inflation, where as property prices in Hong Kong are up 178%, thus making housing in the city ever more unaffordable.

Singapore in contrast has done a better job at containing property prices

The city state of Singapore has done a much better job in controlling its property prices. Over the last 10 years in Singapore, the property prices are up only 25%, as shown in chart 2 below. In fact, current property prices in Singapore are below where they were in 2013! That was the year when transaction restrictions were introduced in Singapore as well as Hong Kong and while these measures were successful in Singapore, they have been completely ineffective in Hong Kong.

                                                  Source: Datastream

Singapore's unique property ownership model has served its citizens better

Singapore is an example worth emulating. Property ownership in Singapore is as high as 88%, among the highest in the world. This compares with less than 50% property ownership for Hong Kong. Singapore market is dominated by government-sponsored housing program, called Housing Development Board (HDB) scheme. Over 81% of Singapore's population lives in HDB flats, which are subsidized by the government. If one includes the subsidies and other grants provided by the government to encourage home ownership, the property PIR in Singapore drops to as low as 3.2 according to Demographia report, making Singapore among the most affordable large urban markets in the world.

Hong Kong government's over-reliance on land premium as a source of revenue is a problem

Hong Kong in the past has followed a free market approach to everything. Yet, it's land supply policy is among the most restrictive in the world. Almost all of the land in Hong Kong is owned or controlled by the government, and is released to property developers through land auctions. The government generates about 20% of the revenue from land premium and another 15% from stamp duties on property transactions. Hong Kong government is very much aware of its reliance on property land premium. In fact, the 2019 budget document talks about the narrow base of government revenue as an issue and looks for steps to diversify these.

This has resulted in poor housing situation for average Hong Kong citizens 

A result of this has been a perverse incentive for the government to keep land and housing in a short supply, so that they can keep charging ever higher land premium. Home ownership in Hong Kong is only 49%, and the ownership among low income families is much lower. About 45% of Hong Kong's households live in public housing estates,  but over two-thirds of these are rented. Also, the quality of Hong Kong's public housing apartments leaves much to be desired. Over 83% the public housing rental flats are less than 40sqm in size, resulting in a per-capita living space  of only 13.3sqm. Over 25% of the public housing units are over 35 years old. Construction of new flats is also woefully inadequate: only 25,000 new housing units were created in 2018, and this number has remained more or less stagnant over the last decade.

The current waiting list for a public housing flat is 5.5 years, but that severely understates the number of households that require assistance for housing. For FY19/20, the eligibility income limit and asset limit for a 4-person household are HK$29,240 and HK$530,000.

Eligibility threshold for public housing in Hong Kong needs to be increased

Below I highlight why the current eligibility threshold for availing public housing could be inadequate. The table below shows the average price per saleable area for apartments less than 70sqm in 2018. This is based on the aggregate of actual transaction prices in 2018.

Average price of flats <70 m2 for 2018
	HK$ / sqm
Hong Kong Island	177,928
Kowloon	147,625
New Territories	123,261

Source: Housing Bureau, HKSAR government

Based on above, an apartment in New Territories with 40sqm usable area (assuming a generous efficiency ratio of 80%, that would require buying an apartment with 50sqm saleable area) would cost about HK$5million. Assuming a 80% mortgage ratio, the buyer will have to come up with a down payment of HK$1million.

I used the online mortgage calculator available on HSBC's website to calculate the eligibility for a HK$4million mortgage. Assuming the highest available repayment period of 30 years and a default interest rate of 2.8%, that family would need a household income of HK$36,550, which is 25% above the current eligibility income threshold.

Now let's see how long will a family with that income take to save enough money for the down-payment. HSBC, in calculating the mortgage capacity, allows for 45% of the household income to be used in repaying the mortgage. If we are being slightly generous and consider that the household saves 50% of its income for the down-payment, it would mean monthly savings of HK$18,250. We have to assume that while they are waiting, the household would have to stay in a rented flat. Average rent in New territories were HK$268/sqm for 2018. If they skimp and stay in a 30sqm flat, they could end up saving approximately HK$10,000 per month after paying the rent, implying that it would take them over eight years to save the million dollars required for the down payment. If the housing prices continue to increase the way they have done, then after eight years of saving and collecting money for the down-payment, they might indeed find themselves short, with their dream of owning their home only so much more distant!

I would argue that increasing the public housing eligibility limit by even 25% to HK$36,550 would not be adequate. Firstly, in the above calculation, we have not left any slack for contingent liabilities such as any personal or medical emergencies that a family might incur and consume at least a part of their savings. Secondly, the data we have used is from last year. According to the most current information available on property prices, the Centa-City Leading Index, suggests that property prices in Hong Kong are already up 9.9% YTD.

Increasing the eligibility threshold for public housing would only increase the number of applicants and further lengthen the waiting period from the current 5.5 years. Therefore, the supply of public housing also has to be increased substantially.

Conclusion

Hong Kong's soaring property prices have made it the most unaffordable city in the world. Supply of private as well as public housing has to be increased for effective control of property prices. Public Housing in Hong Kong, majority of which is rented, is inadequate, with per-capita living space of only 13.3sqm and over a quarter of the stock more than 35 years old. The current eligibility threshold for public housing needs to be increased. Following the Singapore model of widening the property ownership could go a long way in resolving the current strife. It could even have an added benefit of creating a wider stakeholder-ship of Hong Kong citizens in their city.


Sources:

1. 2019 Demographia housing affordability survey (http://demographia.com/dhi.pdf)
2. "Monthly report on the consumer price index, September 2019." Census and Statistics department, HKSAR government. (https://www.statistics.gov.hk/pub/B10600012019MM09B0100.pdf)
3. Information paper on prices statistics, Singapore department of statistics (https://www.statistics.gov.hk/pub/B10600012019MM09B0100.pdf)
4. "Major Sources of Government Revenue." Research Office, Legislative Council Secretariat, HKSAR (https://www.legco.gov.hk/research-publications/english/1718issf03-major-sources-of-government-revenue-20180530-e.pdf)
5. "2019-2020 Budget." Research Office, Legislative Council Secretariat, HKSAR (https://www.legco.gov.hk/research-publications/english/1819rb01-the-2019-2020-budget-20190416-e.pdf)
6. "Housing in Figures 2019." Transport and Housing Bureau, HKSAR Government. (https://www.thb.gov.hk/eng/psp/publications/housing/HIF2019.pdf)
7. The Mortgage Calculator, HSBC Hong Kong. (https://www.hsbc.com.hk/personal/mortgages/home-mortgage-loans/calculator.html)
8. "Centa-City Leading Index" (www1.centadata.com/cci/cci_e.htm)

Indonesian Financials Offer Significant Value

Why do we like Indonesia?

We are bullish on Indonesia.  

With 263 Million people, Indonesia is the fourth most populated country in the world. Demographics are positive, with median age at 28 years and fertility rate of 2.5 (This compares with China, with median age at 37 years and a fertility rate of 1.5).

A commodity slump in 2014 and 2015 led to the closure of thousands of small mines. The GDP growth fell down to 4.8% in 2015, from a high of 6.2% in 2011. Financial markets wobbled and Rupiah depreciated by 10% against US$ in 2015. It was a quick reminder to the investors of what has been all along the classic vulnerability of the country: its reliance on external capital. Any external shock results in this capital being withdrawn. Weakness of its institutions and related policy effectiveness has been another related concern.

However, the response in the face of 2015 crisis enhanced our confidence in the country: despite weakness in commodity prices affecting the government revenue, they were persistent in reining in costs, and maintaining a fiscal discipline. Measures include a cut in Jokowi's pet infrastructure spending plans, continued roll back of fuel subsidies, revision in electricity prices despite economic weakness, and a resistance to cut gas prices for the industries. Stability in the currency took priority over focus on growth. The fiscal and monetary policy worked in sync. Current account deficit fell from 3.2% of GDP in 2013 to 1.8% of GDP in 2016, and likely to be even lower in 2017. Rating agencies have rewarded that fiscal discipline with an upgrade. Moody's, which already had an investment grade rating for Indonesia, upgraded its outlook to positive in February this year, and S&P upgraded the rating to investment grade in May.

We have progressively increased our holdings in Indonesia all of 2016, when it replaced Thailand as our biggest ASEAN market. By May 2017, Indonesia formed 22% of our portfolio, surpassing Hong Kong/China, and our weighing there continues to increase. I am a bottom-up stock-picker. Macro, for me, plays a second fiddle at best over compelling company fundamentals - therefore, the fact that we have 22% of our fund in Indonesia is a mere outcome of the ideas we find there versus other markets.

What do we like in Indonesia? 

We believe that the financials sector in Indonesia is a bargain.

Outside the big four banks, the rest of the sector trades at or below book. The Non-Performing Loans (NPLs) are elevated, but we believe they peaked in Q1 2017 and are on the way to a mend. Banks in Indonesia are well-capitalized, NIMs are better than most other places in the world, and relatively sticky. Our holding includes one such smaller cap bank stock.

Even the insurance companies there trade at book. We have to admit that some of this low multiple could be because of smaller size and lower liquidity of the stocks, but that does not bother us. Penetration levels in insurance are among the lowest in the world, and we like the long runway that presents for growth. We own one insurance stock.

However, the best value we find is in the non-bank financial companies. These companies are mainly in the consumer financing, where the yields are high. Consumer lending in Indonesia went out of control in the post-GFC boom periods in 2011 and 2012. NPLs spiked, the regulator stepped in with control measures, and the loan growth suffered. But the sector has been on mend since the last three years. NPLs are under control now, and loan growth has returned. This sector will be one of the biggest beneficiaries of a sovereign ratings upgrade, due to its reliance on wholesale funding. Funding costs are coming down, and yields are lagging that, so NIMs and profitability are expanding. If we think that the banks are well-capitalized, then the finance companies are super well-capitalized. For our two holdings this sub-sector, capital adequacy runs in the mid-20% range, and yet their ROEs are over 20%. They trade close to book, at single digit PEs, and offer dividend yields reaching 10%.

Shui On Land (272 HK) has still not started working for the shareholders.

No cause for celebration for the shareholders

This year, Shui On Land (stock code: 272.HK) will finish 10 years as a listed company on the stock exchange in Hong Kong and instead of celebrating, its shareholders (until recently, we were one of them) will be in mourning.

Since listing in late 2006, Shui On Land has lost 48% in value (total return - including dividends), producing an annualized return of -6%. Over the same timeframe, Hang Seng Index has generated a Positive return of 75%, or 5.8% annualized. In other words, if you had invested in Shui On Land at its IPO in 2006, your HK$100 invested would have been worth only HK$55. The same amount, invested in Hang Seng Index ETF, would have been worth HK$183.

If you were a fund manager with such a track record, underperforming your index by over 11% annually, you would have got fired long time ago, and your fund would have gone into extinction as investors would have pulled out all their money.

How has the company managed such an extraordinary feat?

World-class projects do not translate to shareholder returns

Shui On Land is a great name in property development, being credited with perhaps the most famous urban redevelopment project globally, Shanghai Xintiandi. In 1997, the company negotiated an urban redevelopment scheme in the Taipingqiao area of Shanghai. In the deal, Shui On took the responsibility of redeveloping an area covering 30,000 sqm of land, committing an investment of US$3bn over a fifteen year period. The construction displaced 3,500 households. The area was redeveloped into a cultural, retail, entertainment and commercial hub, in a mix of low and high-rise development. Most of the features of the old "Shikumen" architecture were retained, and so were some historical landmarks. The project was a huge success, winning global accolades and resulting in significant property price appreciation in the project and for the surrounding areas. It lifted company's profile and following the success of Xintiandi, Shui On received many such redevelopment projects across the country.  

However, Shui On's model of 'integrated' development resulted in projects with long gestation period that are heavy in upfront capex, with returns that accrue only at the tail end of the development cycle. Majority of the projects involve years of resettlement and rehabilitation of existing residents, for which the compensation has to be paid upfront.

Over the years, Shui On has amassed an investment property portfolio valued at RMB56bn (inclusive of RMB12bn of investment properties under development). Over 80% of the rental income is derived from high quality assets in Shanghai. Annualized gross rental yield (calculated using the actual gross rental income in 1H16) based on the current market value of investment property is only 3.9%.

Working for the bondholders

A combination of above factors has caused Shui On's RoE to steadily decline from a peak of 16.5% in 2007 to just over 2% in 2015. Longer gestation on its construction projects, and a reluctance to monetize fully valued investment portfolio has kept Shui On's  asset turn consistently low. All this resulted in very high debt burden on the company. Company's debt peaked in 2015 at RMB48bn, with a net gearing of 81%. More than a third of this debt is through USD denominated bonds, on which Shui On pays on average 9%+ coupon. Shui On's average cost on its debt is >6%.

We saw this and concluded that Shui On Land's management was working for its lenders and bondholders: it pays over 6% average in  interest, while on an investment property portfolio of even bigger value, it takes home only 3.9% in gross rentals (net of maintenance and management costs, this would be even lower). And indeed, our association with Shui On started with its bonds, in 2013 when its 10.125% coupon perpetual bonds started trading below par. With the company's background as a successful reputed developer and quality of its investment property portfolio, we got comfortable that company is unlikely to default: even in a situation of complete distress, it could easily unlock significant value by selling its investment properties.

As a holder in Shui On's bonds, we used to meet its Investor Relations personnel and attended the analyst briefings after each results. However, our conclusion remained that the company was working for its bondholders and not shareholders, and we paid scant attention to its stock.

The Chairman, Mr. Lo, intervenes

That changed towards end-2014. In early 2015, Mr. Vincent Lo, the controlling shareholder of Shui On Land who owns 57% of Shui On's shares, started looking at the operations of the company on active basis. During an analyst briefing we attended for its 2014 results, Mr. Lo was forceful in articulating its strategy. Its multi-pronged plan was to start selling low-yielding assets, stay away from long gestation projects requiring a lot of upfront capex; instead, look for JVs with local partners. The strategy called for increasing the asset turnover and reducing the debt levels. We liked what we heard, and we thought that the company was finally beginning to work for its shareholders. That's when we bought the shares (sometime in early 2015).

True to his word, Mr. Lo began to deliver. When the spin-off plan for Shanghai Xintiandi failed (due to valuation expectations), the company started selling assets piecemeal. The old CEO and CFO left the company. Even the development property sales began to accelerate (to be fair, that has more to do with the life cycle stage of the projects). Bond market has liked these actions and bond spreads have narrowed since. From yielding over 10%, the perpetuals now yield slightly over 5%.  For a bond offering announced last month, Shui On managed to raise USD250mm of 3 yr maturity funding for a coupon of only 4.375%. As bond investor, we have made money in Shui On's bonds. But alas, as a stock investor, we are yet to see any redemption.

But not enough

We held Shui On's shares for over eighteen months. During that time period, property prices in Shanghai, where bulk of Shui On's land bank and investment properties are located, are up 60%! As a stock investor, we are getting cautious about the stage of the cycle the property market in China. Several Tier 1 & 2 cities in China have announced tightening measures after seeing almost two years of strong property markets that have fueled significant property price hikes and we think Shanghai could be next.

Even more worrying signs for us as stock investor were Mr. Lo's statements at the 1H2016 analyst briefing we attended in August. When asked about the general outlook of China, Mr. Lo said he was 'worried.' That's the reason he gave for his preference for conserving cash, rather than spending it on share buybacks. But then he also said that he would like to shore up Shui On's land bank, given that more of its projects are reaching 'mature' stage. He lamented the 'aggressiveness' with which the local property companies were bidding for projects in Shanghai, which he claimed was pricing Shui On out.

At that meeting, we reached a conclusion. Mr. Lo, unfortunately, has still not started working for the shareholders. If he did, you would cancel all the plans for your company to buy additional land bank in this overheated market and divert that cash to aggressively buyback his company's shares. He is a smart businessman, so I hope he doesn't needed reminding that  at 0.38x Price to Book, he would need to spend only 38cents to a dollar to acquire more of his company. Even that book value is hugely understated according to his own presentation, since 74% of the company's land bank is stated at cost and not at market value.

At that presentation Mr. Lo proved that he, like many of your industry peers, have formed a habit of working for his bondholders, and his decision not to buyback his stock helped us to make ours. Last month, we sold our shares in Shui On Land. Including the dividends, we made an annualized 5% return on our investment. That is well below the average return of our fund, but that's better than RoE of Shui On Land. It is also vastly better than what the investors have done since the IPO. Against this, on Shui On's bonds, we have made annualized 12%+ returns. We are still holding on to the bonds, but the yield on them has fallen to only slightly above 5%, so they have already gone out of value territory.

It is frustrating to see this Chinese property agency business so cheap: Hopefluent (733.HK)

Hopefluent (733.HK), Among the largest property agencies in the country

One of the most frustrating value investments in Hong Kong for us has been Hopefluent (733.HK). 

Hopefluent is the dominant property agent in Guangzhou, the largest city in Southern China, with a population of 12 Million residents. To give you an idea of scale, that's more than the population of Belgium.

Like any other property agency business, Hopefluent generates revenue through sales commission. In China however, secondary property market is still nascent and primary market dominates the transactions nationwide. For Hopefluent, primary agency business is three times as large as secondary business. In 2015, primary agency business generated a turnover of HK$1.8bn, from arranging property sales worth HK$215bn. Against this, the country's largest property company, China Overseas Land (688.HK) had primary property sales of HK$135bn in 2015. Hopefluent managed sales for over 900 projects in over 150 cities in China, with over 60% of its primary segment revenue coming from outside Guangzhou.

In addition, the company also has a sizable property management business. Hopefluent managed over 300 properties generating a revenue of HK$350mm in 2015.

It is frustrating to see this Chinese property agent trading so cheap

We own the stock in our portfolio and here are the reasons why we think it is frustratingly cheap. 

1. The company has a net cash of HK$1bn (vs a market cap of HK$1.3bn, or US$175mm, at the stock price of HK$2.03) - net cash forms 77% of the company's current market cap. It has short-term debt of only HK$39mm and no long-term debt. Its 2015 annual report, which will get you this data, can be found here.

2. In 2015, the company earned profits of HK$223bn. Excluding a disposal gain of HK$61mm, the core earnings were HK$177mm. That translates to a trailing core P/E of 7.3x, with trailing 3.9% dividend yield. Do you even want me to talk about ex-cash P/E?

3. The trailing book value is HK$2.23bn, translating to trailing P/B of only 0.6x, at trailing 10% RoE. And again, I'm not even talking about ex-cash P/B.

4. It's not that the stock is going cheap because its earnings are too volatile. Since listing in 2004, company has always been profitable, except one year: 2008. Average profit in the last ten years was HK$131mm; the stock is trading at 10x trailing ten years' average earnings. 

5. Soufun holdings (SFUN.US) acquired about 112mm shares in Hopefluent in 2014 at HK$3.00 per share. The controlling shareholder, Mr. Fu also bought 42mm shares at HK$3.00 per share, since he did not want to get diluted. While the earnings have grown in 2015, stock has languished, trading now at 31% discount to where Soufun and the controlling shareholder bought. 

We are hopeful for Hopefluent

As a small cap value investor, our journey with Hopefluent has been frustrating. The stock price has been virtually flat since 2012. It is down 10% YTD, and 15% since the inception of our fund, when we bought the stock.

Yet, we are hopeful about the company's earnings prospects.

Outlook for 2016 seems rosy. Property sales in China are up. Guangzhou, Hopefluent's key market where property transactions and prices had trailed last year, is seeing revival in transactions as well as pricing this year. The company has made foray into several property related segments late last year, which we believe should start yielding results this year.


The controlling shareholder has been acquiring shares in the open market. Since the beginning of the year, the Chairman Mr. Fu has bought 4.87mm shares in the company, a bit under 1%. Creeping acquisition rules in Hong Kong market allow him to buy 2% per year at most without triggering a general offer. 1H16 results may or may not act as a catalyst, but for a stock that is trading at <2x trailing ex-cash earnings and 0.6x trailing book, we see little downside. As a value investor, we are patiently waiting.

As Uber and Ola fight it out, Indian consumer is the real winner

My recent visit to India earlier this month was full of pleasant surprises, one of which is the topic of this post. I was visiting my parents in Vadodara, Gujarat. For those unfamiliar with India, Vadodara is a tier-3 city in the state of Gujarat, with a population of 1.8 million. 

Indian taxis - the past, and the present

Upon reaching Vadodara airport, I wanted to take a taxi. Those familiar with the local travel scene in small-town India would probably know that taxi service as we know it -- in the form of sedan cars -- is non-existent in India outside the metros. What we have instead is its small-town avatar, a motorized tricycle, called auto rikshaw. They seat three people and have little room for a suitcase or any bulky item. As a result for the travelers with luggage, car taxis are available at the airport and railway stations in most cities, including Vadodara. 

No patience for haggling

A rental car booth was in the baggage collection area of the airport. I casually inquired, and was told that the charge for a drop anywhere in the city was five hundred rupees. Reckoning that the price was too steep, I decided to try my luck outside. As soon as I came out, a swarm of drivers surrounded me; twelve, fifteen of them. It was seven am and mid-summer sun was out, morning was already warm. The offers started at five hundred rupees. I could have haggled and brought the price down, but I was too tired, having spent the previous night at Mumbai airport. I was willing to take one, anyone, but it was impossible for me to talk to a single person without creating a scene. One man was trying to snatch my suitcase, another tugged at my backpack, a third pulled my sleeve. I braced myself, ran back into the arrival hall, and booked a taxi from the travel counter. 

Now...Taxis in majority of Indian cities, or the "auto rikshaw," look like this 

The future of taxis?

That evening I was recounting the incident to my friend who has settled in Vadodara after a stint overseas. "Next time, try Olacab," he said. And thus I was introduced to India's latest online revolution. 

The next day when I had to go out, I tried Olacab. I called the Olacab hotline number my friend had given to me. I was surprised when the operator told me that I can book a taxi only through their smartphone App. It was a minor irritant, but I managed to download the app and book a cab without much trouble. The driver called me half an hour before the time I needed the taxi, and he was at our gate in time. His car was brand new; like any new car owner in Vadodara, he had not even taken the plastic wrapping off the seats. The aircon worked even in the blazing heat of Vadodara summer, where outside temperature was 43 degrees. When I reached my destination, the bill was about a hundred rupees. An auto rikshaw would have charged only slightly less, and that too after minutes of haggling. I was so overjoyed I wanted to hug the driver. 

I had about one hour's work and after this amazing experience, I didn't want to go back home in a rikshaw, so I decided to pay one rupee a minute waiting charge and hold my Olacab. 

But... do the economics make sense?

The Future of taxis in India? (Bhavish Aggarwal, CEO and co-founder of Ola in front of an Olacab)

On the way back, what I learned from the driver really amazed me. 

In the last six months, three taxi calling services have launched in Vadodara, and Uber is expected to launch soon. When Olacabs launched their services in the city, they had one hundred and fifty cabs on contract. For the first six months, they gave one thousand rupees per day to each driver as a handout, irrespective of the fares they got. For the first six months, in Vadodara alone, they burned twenty seven million rupees. Later, they changed that to four hundred rupees after every ten rides and seventy drivers from the original of one fifty . My driver told me he usually gets more than ten rides in a day. So as I write, the company is still burning close to one million rupees a month in Vadodara alone. 

In addition, the company also spent money on promotion to the consumers: a bonus of rupees fifty to hundred upon downloading the app, fifty rupees off on the first ride, etc. I learned through online articles and blog posts that in bigger cities, their handouts to drivers are even larger and could be as high as two thousand rupees per day. 

So, how much money could they have burned to date? Probably only the insiders and existing investors are privy to this figure, but given that they have launched services in eighty eight cities now, a simplistic back-of-the envelope calculation would suggest about three billion rupees (US$46 million) only in handouts to drivers, taking Vadodara as the average! If anything, this figure is likely to be an underestimate, since their payments to the drivers are higher in the metros and bigger cities. 

Small change

That might look like a staggering sum to spend before even realizing any revenue from the cabs. However, it is only a small change considering the amount that the company has raised from the investors and the US$2.4billion valuation that it fetched from its latest round of funding. I have my own views on this valuation; I think it could be significantly overvalued, but exploring that should be the topic for a separate post. (Meanwhile, people interested on this topic should take a look at Prof. Aswath Damodaran's excellent blog post on valuation of Uber.) 

Why is Olacabs in such a tearing hurry to expand, one may ask? The only answer could be that they are in a land-grab mode, and want to preempt the rivals, especially the bigger and better funded Uber. I believe with its current expansion spree, it could be years before Olacabs makes money. And I do wish them luck and hope that they succeed, because I love what they are doing to the taxi scene in India.

In the mean time, consumer is the real winner. As long as I was in India, I gave auto rikshaws a break, and traveled everywhere by Olacabs. I also took an Olacab on the way back to the airport. It cost me only a hundred and forty rupees.  

Before leaving India, I did two things. One, I bought my father a smartphone. I ordered it on flipkart; it cost me twenty percent cheaper than buying from the local phone dealer. Two, I downloaded Olacabs app on his new smartphone. 

BILT Paper perpetuals with 12.3% yield offers good investment opportunity

INTRODUCTION
Disclosure: We own this instrument in our portfolio.

BILT Paper, the subsidiary of Ballarpur Industries, India's largest manufacturer of paper, has a US$ denominated perpetual bond that offers 12.3% yield based on Bloomberg offers (coupon: 9.75%, Price: 92.5 cents. Bloomberg ticker: BILTIN 9 3/4 08/28/49 Corp, ISIN: USN08328AA95).

The discussion below summarizes the events that led to a distress in the bonds and argues that the situation is now on a mend, resulting in a potential investment opportunity for buy-and-hold investors looking for yield. 

BACKGROUND
Largest Paper Company in India and Malaysia...
Member of the Gautam Thapar led Avantha Group, Ballarpur Industries is the manufacturer of writing & printing paper in India and Malaysia, with a market share of 25% and 30% respectively. BILT Paper BV is the subsidiary of Ballarpur Industries that owns the pulp and paper manufacturing and forestry assets (where as rest of the more 'consumer' businesses such as specialty paper, branded stationery and hygiene business are owned directly by Ballarpur Industries). The group is the only vertically integrated manufacturer in India, controlling the entire chain from plantations to pulp to paper. It also has captive power plants at all its locations.

Ballarpur Industries is listed in India (TIcker: BILT IN) and BILT Paper also intends to get listed in an overseas stock exchange (likely Singapore).

...with ambitious expansion plans...
Malaysian operations were acquired in 2007. Following the financial crisis, BILT Paper went on a massive expansion spree. It increased the paper capacity from 780,000 tons to 1million tons and expanded the pulp capacity from 462,00 tons to 752,000 tons. The expansion aimed to increase vertical integration and reduce costs.

...but poor execution...
However, the execution was bad. The expansions were delayed, there were cost overruns, Indian rupee tanked and the cost (and value) of its US$ debt sky-rocketed. Its balance sheet took further toll when it bought two captive power plant units from Avantha Power for US$103mm. With economic slowdown India in 2013, paper prices also suffered, affecting the profitability. Plans to list BILT Paper were indefinitely postponed.

...resulting in stretched balance sheet...
Though BILT Paper is not listed, it has published its annual report for 2013 (presumably because it is preparing for an IPO). The following analysis is based on its June 2013 Annual Report. (FY14 annual report is not available yet. My guess is that FY14 balance sheet is slightly worse)

BILT Paper had FY13 revenues of US$722mm and EBITDA of US$98mm. Interest payment, including the distribution on perpetuals, was US$68mm. That results in interest coverage of 1.44.

Unlike the company's auditors, I do not see perpetuals as an equity (it requires servicing and though coupon deferrals are possible, it is construed almost like an event of default). Assuming that perpetuals is a debt, the company has total equity (Book Value) of US$509mm and net debt of US$870mm. That translates to a gearing (net debt to equity) of 1.7x and Debt to EBITDA of 8.7x. These are highly stretched debt levels - Debt to EBITDA of 3-4x are considered more 'normal.'

...and rumors of a likely default
In 2H 2013, when the rumors were rife that BILT Paper is going to default on the coupon payments, the bonds hit a low of 60cents to a dollar. Later, the rating agency Fitch downgraded the perpetuals to B+.   

INVESTMENT RATIONALE
Though the bonds have since recovered and now at 92.5 cents, are well above their distressed levels, but we believe they still offer an attractive risk-reward. 

1. Capex has peaked: Between 2010 to 2013, BILT Paper embarked upon a massive capex of over US$400mm. With the pulp mill in Sabah commissioned in FY13 and in India earlier this year, the last leg of capex is finally over, and the the Chairman Mr. Thapar declared so in his address to shareholders in FY13 annual report. Going forward, I expect only the maintenance capex of about US$20-30mm per year. BILT Paper should generate positive cashflow, which should go towards reducing the debt and improving the balance sheet.

2. Profitability to improve going forward: With the new pulp mills stabilized and operating optimally, BILT Paper would be totally self-reliant on pulp. Vertical integration should reduce pulp costs and improve the profitability going forward, which will be further enhanced as its plantation in Sabah is also expanded.

3. Investment by IFC improves the balance sheet and credit profile: Last month, IFC announced plans to invest US$100million in equity and provide up to US$150mm in loans to BILT Paper. The equity investment has already come through giving IFC a 14.3% stake, according to the announcement on 4th November (IFC's investment puts the equity value of BILT Paper  at US$600mm). BILT's press release earlier mentioned that IFC loan would be used to refinance some of the highest cost debt. The effect is to increase the equity, reduce the debt and gearing and the finance costs. Having IFC as an equity and debt investor in the company provides comfort for other investors. This could improve chances of BILT Paper's successful IPO and also open up other sources of funds.

4. Yield pick-up if the bonds are called: There is a likelihood that the perpetuals will be called at the next call date. Perpetuals come with a step-up clause in the coupons. At the next call date in 2016, the coupon steps up to 5yr US Treasury note + 8.57%. For instance, the current yield on 5yr US Treasury note of 1.63% would put the new coupon at 10.3% (and will fluctuate according to yield on Treasury note at each coupon date). Between now and 2016, the Treasury yield is likely to only increase, resulting in even higher coupons and creating even more incentive for the company to call the bonds. If the bonds are called, the yield to next call works out to 14.75%

If they are not called in 2016, the next call date after 2016 is in 2021, when the coupon steps up by another 1%.

RISKS
1. Interest rates: Almost all of BILT Paper's debt is floating. Inability to quickly deleverage before the rates start rising could stress the cashflow .

2. Macro slowdown: Paper prices are highly susceptible to economic slowdown, as witnessed in India last year. Declining paper prices could put pressure on profitability.

3. Corporate Governance: Decision to acquire captive power plant from Avantha Group when BILT Paper's balance sheet was already stretched, was untimely and creates corporate governance red flags in my opinion. Similar transactions in future may create unexpected capex outlay and jeopardize the balance sheet.

CONCLUSION
We own BILT Paper perpetuals in our portfolio. With improving macro conditions in India, increased access to funding by the company and a lack of capex, I believe that with 12.3% yield, the bonds offer excellent investment opportunity for buy-and-hold investors seeking yield (Minimum ticket for the bonds is US$200,000 in face value).