Month: August 2014

The Value Edge

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The Hour Glass

C1 Est. in 1979, THG is one of Asia’s reputable luxury retail groups with 30 boutiques in nine key cities throughout the Asia Pacific Region. THG prides itself as world’s leading cultural retail enterprise. They have been recognised by notable international publications such as Monocle and Vanity Fair as one of the most influential specialty retailers in the world. Furthermore, THG has been accorded the ‘Best Watch Retail’ honours by Singapore Tatler in 2014.

Fundamental Analysis

(I) Earnings: C2

Business Operations

THG operates across several countries – Singapore, Malaysia, Hong Kong, Australia, Thailand and Japan. The bulk of their profits, about 72%, come from their South East Asia and Australia operations. It may seem that THG has minimal reliance on the Chinese spending power, however, their exposure to Chinese mainlanders actually account for about 20% of THG’s sales. We would argue that this key clientele is responsible for THG’s historical performance and it is evident that the past few years have boded well for THG – profit attributable to shareholders increased at a 4-year CAGR of 13.9% while gross margins remained consistently above 20%. Similarly, net profit margins have been very consistent in the last 4 years. This reflects the management success in margin control by keeping operating expenses below 14% of sales.

Driven by Same-Store Growth

From FY2010 to FY2014, overall store count remained unchanged at 32 which indicate that growth has been due to same-store sales growth. We can attribute this to the spending power of Chinese tourists, with Hong Kong, Thailand and Singapore ranking among their top 5 travel destinations. While the THG’s Chinese story has weakened in the past year, exacerbated by the political situation in Thailand, it was offset by the effects of Abenomics, allowing THG to eke out a slight growth in FY2014. Moving forward, recovery in Thailand is a source of growth; THG plans to open another 2 boutiques in Bangkok and 2 Laduree points of sales. Looking at 1Q2015 results, recovery in Thailand has definitely begun, with results from Thailand increasing by 95% quarter on quarter. Unsurprisingly, the primary risk would be a China slowdown.

(II) Balance Sheet & Cash Flows: C3

Efficient Inventory Management

THG has a very high current ratio of 4.9 and cash ratio of approximately 2.9x (more on this later). Some might frown upon such abnormally high current and cash ratios as inefficient cash management. However in the case of THG, we view this as a necessity given the relatively high 3-year average inventory turnover days of 192. This is typical of the luxury watch industry; in fact, companies like Sincere Watches and Cortina have even higher inventory turnover days at 313 and 258 days respectively.

Cash Hoard and Lumpy Cash Flows

We note the lumpy cash flows under Free Cash Flow (2) if we were to consider working capital changes and it is indeed a stark contrast to the FCF before working capital changes. We had 2 primary thoughts on this – one, why is this so? And two, is it a concern? To address the first issue, the disparity is due to large increases in inventory levels from same-store sales growth, as mentioned above. Also, Trade Payables/Trade Receivables has sharply increased from FY2010 to FY2014. What this means is that THG is able to get more favourable credit terms with its suppliers. Now, as per our second concern, is this a serious issue? In some sense, this can   essentially be perceived as a snowballing of liabilities. However, given that this is accompanied by increasing cash reserves, we see little risk in any liability implosion. As growth slows, the disparity between the two FCFs will also decrease. As such, we deem it appropriate to use FCF before working capital changes for our cash flow analysis.

Undervalued Associates

From an asset perspective, there is upside in the valuation of their Thai associates held at SGD8.4m. For FY2014, it had ownership-adjusted profits of SGD2.9m, in spite of the political unrest in Thailand, and based on their recent FY2015 Q1 results, we expect profits to be maintained at this level at the very least. This gives us an ROE of about 34.5%. It is quite likely that their fair value is upwards of SGD8.4m, but of course there is always a question of unlocking value and it is highly improbably that management will be cashing out their stake anytime soon. Therefore, we do not account for any re-valuation but merely view it as a subtle positive note.

(III) Financial Ratios: C4

As a regional company, there is no escaping comparison with its regional competitors, of which only Cortina is Singapore-listed.  The figures above are based on the latest annual reports except for the calculation of FCF-yield which is normalized on a 5-year average. To put it simply, there is no competition – THG triumphs the others by a fair margin. However, readers should be aware that this is a mere face value judgement; more detailed analysis on the other companies might yield new findings.

Qualitative Analysis

(I) Competitive Advantage/Moat:

If we were to be owners of THG, one key question would be ‘How does THG compete?’ What makes THG stand out from the rest? Inventory management aside, the core purpose of a luxury retailer, or any retailer at that, is to attract customers. We opine the following factors in evaluating a retailer’s ability to attract customers:

1) Pricing & Profitability Pricing is typically a key factor in differentiating retailers. However, for luxury goods, this is not so much an issue. In fact, THG increased their average unit retail sale price by 8% and was still able to grow their revenue and NPAT. This is does not mean that profitability is expected to be similar across the board – this is where efficient inventory management comes in in lowering costs. THG stands out in this aspect, as evident by its superior net profit margins. However, higher profitability does not translate to consumer utility when price is relatively inelastic and therefore does not help to attract customers.

2) Number of Stores and Store Locations C7

Prima facie, THG has the third highest number of stores at 32. However, it is always important for us to understand the intricacies behind the numbers as numbers alone can be misleading. For example, 21 of Sincere’s 39 stores are exclusive Franck Muller boutiques which in my opinion, restricts its appeal to a very niche group of customers. And even though Hengdeli has the second largest network of stores, it has an uncomfortably high exposure to the Chinese market. We can see that Sincere, THG and Cortina are equally diverse in terms of geographical market exposure, with all of them highly concentrated in the South-east Asian region. I would say that Sincere actually has the best network of stores but THG and Cortina come a very close second and third respectively. However, if we were to consider the fact that most of Sincere’s stores are Franck Muller boutiques and that it is more exposed to the Chinese market, THG would take the crown in terms of overall store network quality. To conclude, THG does not fair any worse to its competitors in terms of its ability to attract customers. We cannot conclude that THG is superior – firstly, because all of them are very close in terms of store networks and secondly, because higher profitability does not translate to consumer utility when price is relatively inelastic. It would not be wrong to say that THG has no economic moat; they have little capability in retaining customers. In terms of branding, I do not think that Cortina and Sincere are any less reputable than THG. When it comes to luxury watch retailers, the purpose of branding, in my opinion, is to provide a degree of assurance to customers that they will not be buying any fake products. Past that level, there is little marginal benefit to the retailers; ultimately, it is the brands and reputations of watches that count rather than that of the store front. On the flip side, while there is little to differentiate the companies to consumers and there is little moat, we can take comfort in knowing that THG is the one that gets the most out of every dollar in sales.

(II) Industry Outlook According to the WorldWatchReport report released on 26 March 2014:

“Despite a slowdown in sales in Asia, global consumer demand for luxury watches grew by +5.7%. Global demand was fuelled once again by BRIC markets with the highest year-to-year increases in China (+59.4%), Russia (+20.4%) and India (+12.0%) The Chinese luxury market is not dead: Interest in all luxury watch categories continues to escalate, led by Omega, Cartier and Rolex. Though sales at home may have declined, Chinese thirst for luxury watches is not showing any signs of slowdown, according to exclusive data shared for the first time by Baidu, China’s leading search engine, for Digital Luxury Group.”

This is definitely positive news and with 2 new stores in Thailand in the pipeline, THG is well-positioned to leverage on this trend. Nevertheless, the prospect of a Chinese crash is an ever-present overhang which is beyond our expertise to analyse. As such, we adopt a conservative stance and assume zero sales growth moving forward. This assumption will also guide our valuation.


If we were to look at relative valuation, THG would be an easy call to make. However as far as possible, we refrain from relative valuation for if one were to compare less-rotten apples with even more-rotted apples, the less-rotten apples would always seem fresh. In a simpler sense, it could mean that THG is undervalued, or that the rest are overvalued, and we can never be certain of either. Once again, there is no right or wrong and if relative valuation is your cup of tea, by all means stick with it. As a form of absolute valuation, we value THG based on FCF yield which currently stands at 10.7% at a price of SGD1.80. We think that anything above 10% is adequate compensation for the risk of a luxury retailer. Based on a FCF yield of 10%, we will have a target price of SGD1.93.


THG is a solid company with consistent cash flow and a neck above its peers considering its share price. While our target price does not seem to indicate much upside or margin of safety, it was arrived at under conservative assumptions to accommodate for possible downsides in industry outlook.  In fact, anything above 8% FCF yield will not be considered expensive for Mr. Market. THG may not be the blockbuster counter that we all seek, but if you are looking to make your cash work in the meantime, THG will be a suitable candidate.

Disclosure: The authors are long E5P.SI

Using A Net-Net Strategy

Over the years of investing, my partner and I have experimented with various valuation models. From the simplest of just investing based on dividend yields to one of the most complex models by Colombia Business School. The purpose of my article today is not about sharing all the various models we have used but just one – the NCAV strategy.

NCAV – Net Current Asset Value is argued by Graham to be approximately the company’s liquidation value. The strategy is just screening for all companies trading below their NCAV and investing in the best 20 companies. With so many more complex valuation models out there, many may be skeptical about such a simple strategy. However, I would like to point out that success with investing is not based on the complexity of your valuation model but rather how strong your logic is.

Of course, words are all meaningless without results to back it up.

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Over the period of 3 years, it can be seen that the NCAV portfolio not only outperformed the S&P500 but by did so by a huge margin of approximately 5x.

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Over the next 3 years, it can be seen that the NCAV portfolio under performed the S&P500. However, the important thing to note would be the underperformance is very marginal.

Screen Shot 2014-08-05 at 4.43.21 pm

On the last period, it can be seen that the NCAV portfolio once again outperformed the S&P500. Interestingly to note, while the NCAV portfolio was affected much more than the S&P500 during the Global Financial Crisis, it recovered at a much faster pace as compared to the S&P500. Whether this is an one-off incident or a trait for a NCAV portfolio, I do not have sufficient results to prove it.

Over these 3 periods, it can be seen that whilst the NCAV portfolio does under perform the benchmark 33.3% of the time, the cumulative results still outstrips it.

Credits are given to Jae Jun of Old School Value for conducting the backtesting of a NCAV strategy.