Building a Core China Portfolio – Part 4, Let’s Start Digging!

5 Sep

In my previous blog entry (https://ravendragon.wordpress.com/2010/09/02/building-a-core-china-portfolio-%E2%80%93-part-3-assessing-quality/) we discussed the notion that a lot can be understood about a company by its numbers, before we even know the details of its business model and drivers, let alone speak to the company’s representatives. We are using VTech Holdings as our first example based on the 100 companies delineated in my shortlist to be found at the following URL: https://ravendragon.wordpress.com/2010/08/25/building-a-core-china-portfolio-%E2%80%93-part-2-the-shortlist/

To reach a deeper understanding we will compare the ROE of VTech with its main competitors, as well as the components of said ROE with that of main competitors.  But that leads us to the following question: who are VTech’s main competitors?

The company reports 3 main segments:

  • Manufacture and supply of corded phones (TEL)
  • Electronic Learning Products (ELP)
  • Contract Manufacturing Services (CMS)

Over the past 5 years the TEL segment has contributed to about 45% of the company’s top-line, and the ELP segment to just shy of 40%. As such, I consider 2 peer groups to be useful:

  • Phone manufacturers
  • (Electronic) toy manufacturers
  • [One could potentially look at VTech in the context of Hong Kong exporters as about 55% of revenues come from the US, and 35% from the EU]

Before we start digging into the toy manufacturers, let me just remind you of the components of ROE so you can understand why I am performing the decomposition below, ans see the influence each component has over the final return figure:

ROE = [EBIT%]  x [Asset Turnover] x [1-Tax Rate] x [Leverage]


Toy Manufacturer Data

Figure 1 – Historical ROE vs. Toy Peers

Figure 2 – Historical EBIT Margin vs. Toy Peers


Figure 3 – Historical Asset Turnover vs. Toy Peers

Figure 4 – Historical Leverage vs. Toy Peers

Now let’s move onto the phone manufacturers:

Figure 5 – Historical ROE vs. Phone Peers

Figure 6 – Historical EBIT Margin vs. Phone Peers

Figure 7 – Historical Asset Turnover vs. Phone Peers

Figure 8 – Historical Leverage vs. Phone Peers

Interpretations

For most of the past 2 decades VTech has been the best in class performer in terms of ROE in both peer groups. This is evident from figures 1 and 5. That’s no simple accomplishment. Let me assure you, that this is a live investigation – I’d not seen this data up until this point. Let me also remind you that consistency and sustainability of strong results are they key element we are looking for.

Figures 3 and 7 show that the asset turnover (sales/total assets) at VTech is simply world class, and has contributed heavily over 20 years to the company’s impressive returns. In a coming blog, if we decide to stick with VTech we will want to break this down and see what is contributing to the strong asset turnover (e.g. is it heavily influenced by fixed asset turnover, net working capital turnover, and are there any weak links).

Normally one finds that companies with high asset turnover have lower EBIT margins, and vice-versa.  It’s normally a reflection of whether the company’s strategy is more focused on volumes (i.e. high asset turnover) or high pricing (i.e. high EBIT%). With that in mind we can perhaps understand why VTech’s margins have been historically lower than its toy peer group (see figures 2 and 6).

In fact looking at these figures we see that it was a negative EBIT margin in 2001 that significantly contributed to the poor ROE in that year (it was exacerbated by a slightly lower leverage in 2000-2002).  If we continue beyond today’s blog entry with VTech, we will want to understand what happened that year and ask questions such as the following: Is the company more prone to cyclical risks than its competitors in both peer groups? If so why? Has this changed? How? Is it simply more operationally leveraged? Again why? Etc… Was this a one off?

Despite this weaker long-term margin history, I am very encouraged to see that EBIT margins performed very strongly in both absolute terms and relatively compared with both peer groups (see figures 2 and 6) since 2006. Is this sustainable, and if so how? What changed? Was it simply mix? Geography? Etc… We will want to find this out.

Conclusions

This is a quality company. It is worth understanding the business model, drivers, and future sustainability.

  • Strong sustainable ROE (both relatively and on an absolute basis) of about 40%
  • driven mainly by very high asset turnover
  • and good EBIT margins in recent years.
  • Leverage is within the peer group ranges and at very acceptable level historically.

Next I will be asking questions to dig into qualitative elements of the firm in order to judge its sustainable profit levels, provide an upside / downside valuation range.

With such a value range we will be able to understand a good entry point for VTech and judge whether the current risk reward posits a buying opportunity.

Caveat

One point at this stage – I notice that the company does not report product segments below the revenue line. I do not like this as I am unable to ascertain the strengths, returns, and sustainability of each part of the business, and to know whether one is dragging the other up or down. I will look more at this.

Zai Jian

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