Haier Electronics Group Company Limited (Haier) is the leading manufacturer of washing machines and water heaters in China. Its market share in terms of sales value for both products continues to rank first in China. It holds a market share of 26.9% in washing machines and 18.2% in water heaters. Since 2009, Haier has been transforming from being a home-appliance manufacturer to being an Integrated Channel Services (ICS) business. ICS encompasses distribution, logistics, after-sales services and e-commerce and other businesses.
Source: Haier’s Annual Report FY15
To date, ICS contributes nearly 75% of the total revenue, but due to its low margin, it contributes only 39% of the profit.
Source: Haier’s Annual Report FY15
To avoid confusion, Haier Electronics (listed in HK with stock code 1169) is a subsidiary of Qingdao Haier (listed in Shanghai with stock code SHA: 600690), which is the leading manufacturer of many other home appliances: air conditioners, washing machines, dishwashers, water heaters, TV, vacuum cleaners, rice cookers, etc. Qingdao Haier owns 56.17% of Haier Electronics. This post is focusing on Haier Electronics only.
Drop in Market Expectation
In 2014, several banks initiated coverage of Haier. Credit Suisse issued a 37-page report with target price of 30. UBS issued a 28-page report with target price of 25. Haier’s share price at that time as around 19-22. The target price indicates lots of upside to the share price. A report with 28 to 37 pages takes some time to read and digest. This post will not study Haier in such detail. It will mainly focus on a few important items.
From the start of 2014 until now, the company was doing ok. Revenue peaked at 67bn in 2014 and fell to 62.8bn in 2015, which was same level as 2013. Net profit actually grew from 2bn in 2013 to 2.7bn in 2015. But its share price fell from the range of 18-24 at the start of 2014 to 11-14 now. That’s a huge 40% drop!
Again, like many other stocks that I studied, there wasn’t anything wrong with the company. It’s the market expectation that is the real problem. In 2013 when Haier was growing well (net profit grew 20%), the market expectation was equally high (or even higher). Haier was priced at 25 P/E in 2013. As Haier maintained net profit growth of 20% in 2014, its share price fell from 22 to around 19 and the P/E was 17.9x. In 2015, when the market realized that Haier couldn’t grow its revenue and net profit as fast as previously expected, the share price dived down 20% to 15, and P/E dropped to 14.1x. In 2016 first half, the falling momentum continued and the price dropped to 11-14 range with latest P/E at 11.6x.
In 2 years 10 months, the market expectation changed from P/E of 25x to 12x. That largely explains why the share price fell 40% during the period.
To understand and value Haier, we have to understand each business segment.
1. Washing Machine
Haier’s washing machines continues to rank 1st in terms of sales value and sales volume in China. Its market share is relatively stable at around 26%. From 2010 to 2015, revenue grew at CAGR of 5.4% while profit before tax at 9.1%. The growth driver comes increasing penetration rate of washing machines in both rural and urban areas. The penetration rate is close to 100% in urban areas, but as urbanization is still taking place, more people are moving to cities, and that increases the demand for washing machines.
2. Water Heaters
Like its washing machines, Haier’s water heaters remains number one in terms of sales value in China with market share of around 18%. From 2010 to 2015, revenue grew at CAGR of 8.1% while profit before tax at 12%. The growth driver is similar to Washing Machine’s, mainly from rising penetration rate and urbanization.
3. Integrated Channel Services (ICS)
This business segment can be further divided into 4 sub-segment:
- Distribution and Services: distribute Haier branded products (washing machines, water heaters, air con, refrigerators, brown goods, etc) and other third-party (non-Haier branded) products.
- E-commerce: sell the products through e-commerce: e-Haier, Taobao, Tmall and JD.com.
- Logistics: delivery the products from merchants, factories, franchise stores to customers. The products include home appliances and furniture. The logistics company is called Goodaymart, which can deliver big items on the same day or next day.
- After-sales services
All these sub-segments are integrated as one business segment. Basically, they work together as a supply chain to sell the products to customers through online or offline, with or without middleman.
Just for ICS itself, you can write several pages of report on the details. You can find banks’ research report online for that or read up the Company’s annual report for clearer understanding. We will not go into the details.
ICS business grew rapidly since its start in 2009, coincide with the rapid rise of e-commerce (Alibaba’s TMall). Haier started its ICS business in 2009. That’s why we see exploding revenue growth from 2009 to now. But ICS is a very low margin business, hence the blended gross margin fell from 28% before ICS to around 14-16% now. Past performances became less relevant as the Company is transforming from a white-goods player to an ICS player (distribution + e-commerce + logistics).
Looking at its profitability over the past 3 years, Haier managed to grow increase its operating margin from low 4% to 5+%. ROE declines from 30+% to 20%. One thing that you can note is that gross margin is around 15% only now and operating margin is 4-5%. This is a low margin business, but quiet decent return on capital ROE of 20%). With such low margin, a small percentage point change can shift the profit substantially. For example, if margin of 4% increases to 5%, that’s 20% rise in profit, everything else equal. On the reverse, if the margin of 5% drops to 4%, that’s 25% fall in profit, everything else equal.
We can’t just take the blended financial data to do valuation as it has different businesses. We can combine washing machines and water heaters, but certainly can’t combine any of them with ICS.
Let’s breakdown the revenue and profits into segment:
Profit margins in aggregate rose in the past 5 years. Profit margin for washing machines rose from 7.3% in FY10 to 8.4% in FY15. Water heater also saw its margin rising from 10.0% to 11.6%. ICS margin rose was flat. The return on capital for each segment is high.
The ROA and ROE per segment look very high. I’m not sure how Haier segregate the assets and liabilities per segment. If we compare the aggregate ROA of 12.1% in FY15 with the blended average ROA ex-cash of 13.7% from reported numbers, it’s not too far off. ROA of 13% is very good for home appliance business. This is higher than the cost of business and should create value in long run.
Investing for Growth
Haier is investing aggressively in the past few years, especially in ICS business. The capex is for construction of additional logistics warehouses, purchase of plant and equipment for capacity expansion. We will study whether the capex has created value for the Company by increasing the profit. This will be done by comparing the capex and the incremental profit increase from the prior year. For example, Haier spent capex of 252m in FY12 for washing machine, and its FY12 profit (before tax) increased by 209m from FY11.
For Washing Machines, capex increased multi-folds after FY11. Total capex from FY12 to FY15 was 1bn. From FY11 to FY15, revenue increased by 22.4%, while profit increased by 52%. Total incremental profit generated (before tax) from FY12 to FY15 was 1.45bn (or 1.09bn after tax of 25%). This incremental profit is calculated by taking the profit in each year from FY12 to FY15 and deducting the profit in FY11.
For Water Heaters, capex rose sharply after FY10. Total capex from FY11 to FY15 was 495m. From FY10 to FY15, revenue increased by 47%, while profit increased by 76%. Total incremental profit generated (before tax) from FY11 to FY15 was 809m (or 607m after tax of 25%). This incremental profit is calculated by taking the profit in each year from FY11 to FY15 and deducting the profit in FY10.
ICS was started in FY09. Total capex from FY10 to FY15 was 2.1bn. During this period, revenue doubled and profit nearly doubled. Total profit before tax generated (including elimination of intersegment sales) was 4.58bn (or 3.43bn after tax of 25%).
In each of the three businesses, total capex in the past 6 years have generated total incremental profit that is higher than the capex itself. The benefits from construction of logistics warehouse or increased capacity can last longer than just 3-4 years. Therefore, we know that the capex is creating value to the shareholders.
Capex in FY15 was the record highest due to 975m capex for ICS. Much of this is spent on constructing new logistics warehouses. Currently, Goodaymart Logistics’ average daily delivery volume is 0.25 million, and maximum daily delivery volume reach to 0.90 million, representing the leading capacity in the large item transportation industry. The aggressive investment is to anticipate the continued robust growth of e-commerce sector. Goodaymart Logistics aims to become No. 1 large-scale goods logistics service provider in terms of domestic market share and customer satisfaction.
Haier is investing in Internet of Things (IoT) for its home appliances business. The potential of IoT is huge and it’s still at an infant stage at the moment. These “smart” home appliances may trigger a higher replacement rate for the appliances, thus increasing the demand. But, I can’t quantify the impact of IoT. For now, I assume neutrality to IoT.
1. Washing Machine
In FY15, it generated revenue of 15bn and profit before tax of 1.25bn. It has maintained its number 1 market share position for many years and increased the profit margin slightly over the years. However, as the penetration rate of washing machines has reached a high level, the growth rate is also slowing. To be conservative, I assume growth rate of only 2.5%.
I estimate that the Free Cash Flow to Firm (FCFF) for washing machine business is around CNY 864m. With 10% WACC and 2.5% terminal growth, washing machine business can be worth 11.5bn. That’s P/E of 12.3x.
2. Water Heaters
In FY15, it generated revenue of 4.6bn and profit before tax of 536m. Like Washing machine, Water Heaters has maintained its number 1 market share position for many years with rising profit margin. But, due to the already high penetration rate of water heaters, to be conservative, I assume growth rate of only 2.5%.
I estimate the FCFF for water heaters business to be around 341m. With 10% WACC and 2.5% terminal growth, water heater business can be worth 4.5bn. That’s P/E of 11.3x.
In FY15, it generated revenue of 57.9bn (or 43.2bn if we eliminate intersegment sales) and profit before tax of 843bn. Haier exited from third-party home appliance distribution business as it was making losses overall. This caused the revenue to decline, but profit to rise as margin improved.
This is the tougher business to value as it contains many moving parts. Haier is investing very aggressively in its logistics. Its offline distribution business is currently suffering from soft market demand and price war. Its e-commerce business, partnering with Alibaba’s Tmall, is growing rapidly. Current revenue and profit figures can change quite drastically in the next few years, and I can’t predict it.
To be conservative (I hope), I estimate the FCFF for ICS to be around 478m (vs PBT of 843m in FY15). With 12% WACC and 3% terminal growth, ICS business can be worth 5.3bn. That’s P/E of only 8.4x.
There’s average 70m of corporate and unallocated expenses in the past 6 years. There are also other incomes from government subsidies, compensation from suppliers and others that are harder to predict but can be meaningful and recurring. These other incomes range from 120m to 240m in the past 3 years. We assume these other income to average 120m. After deducting the corporate and unallocated expenses of 70m, the balance is 50m additional income. We apply current P/E of 12x and value this additional income at 600m (or 0.6bn)
Sum of the Parts
Estimated Total Enterprise Value (EV) for Haier is 11.5 + 4.5 + 5.3 + 0.6 = 21.9bn (CNY).
Adding net cash of 11.5bn (as at June 2016), the estimated Equity Value is 33.4bn (CNY).
At current CNYHKD exchange rate of 1.15, the estimated equity value in HKD is HKD 38.4bn or HKD 13.5 per share. Based on FY15 reported diluted EPS of 0.951, the P/E is 14x.
At today’s share price of HKD 12.92, my estimated valuation price of 13.5 has just 4.5% upside. In other words, current share price is quite fair.
I think the key in my valuation is on the ICS. I don’t really understand the strength and weakness of this business and how competitive this business is. E-commerce is booming now, but as happen to many things related to tech, things can change very quickly. Haier is growing its logistics aggressively and could make mistake in the expansion. For example, over-building the logistics warehouse, which leads to over-capacity and under-utilization.
Growth not factored in (yet)
In my valuation, I have assumed a slow growth rate of just 2.5 – 3.0% going forward. From FY10 to FY15m, Haier’s total revenue actually grew at CAGR of 11.3% and operating profit at CAGR of 13.7%. Therefore, I could be too conservative in my assumption of growth rate.
The aggressive capital spending in washing machines and water heaters in recent years could generate substantial profit growth for next few years. The large capex in ICS coupled with strong growth in e-commerce should see rising revenue and profits in medium term. If executed well, Haier could increase the capacity utilization of its logistics warehouses, thus improving the margins.
If we factor in a stronger growth potential from all recent large capex and assume Haier executes its plan well, then my estimated value would increase to around 15, which has 16% upside from the current share price of 12.92.
Conclusion: HOLD. Current share price of 12.92 is quite fair.