Detecting mis-pricing in China Lilang

When it comes to formal menswear brands, which ones appear in your mind? Hugo Boss? Ermenegildo Zegna? Alfred Dunhill? Armani? Brooks Brothers? Ralph Lauren? There are many out there, and I’m sure you have not heard of LILANZ.

Lilang - Pictures 1Lilang - Pictures 2

China Lilang (stock ticker 1234.HK – easy to remember) is a China-based menswear company. It designs, sources, manufactures high-quality business and casual apparel for men and wholesales under its core brand “LILANZ” and “L2”. It has 2,575 stores across China, out of which 2,108 are freestanding retail stores, while the balance are shops-in-shops in Department stores. At its peak in 2013-2014, Lilang had more than 3400 stores. For comparison, Hugo Boss has only 442 freestanding retail stores in 2016.

Lilang - Stores across Region

Lilang - Stores breakdown
Source: Company’s Annual Report 2016

Business Model

Looking at the number of stores above, this should catch your attention. Lilang has only 2 self-operated stores. The rest, 2398 stores, are operated by distributors or sub-distributors. That means Lilang is a wholesaler, not a retailer. This is like being a franchisor, such as McDonald’s Corp, while the distributors are the franchisee.

For business expansion, retailers have a higher capital requirement to open new stores, which involve paying several months of rental in advance, renovating the stores, stocking up on the inventory, holding promotion and advertising. Retailers also have higher fixed operating costs, mainly from the rental and labor cost. Wholesalers, on the other hand, just have to focus on stocking up on the inventory and have lower fixed costs. With lower capital requirement and high net profit margin of 20-24%, Lilang achieved an impressive ROIC of around 50-70% for the period 2011-2016.

First Trade

I first discovered Lilang when I was looking for undervalued stocks at my previous hedge fund in 2014. Lilang was trading at ~9x P/E while holding a large amount of cash (30% of market cap) and had a relatively stable free cash flow. Only 1-2 sell-side analyst covered the stock, and they projected declining margin. My fund manager had a look at the Company and did not like its declining margin (projected by sell-side analysts). For its low P/E, he cautioned that it could be a value trap too. Therefore, the fund did not invest. But I did.

I bought it at 5.03 in June 2014 and sold out at 5.50 in August 2014. That’s around 8.5% net return in 2 months.

I bought after Lilang announced its decent winter trade fair result, which had high single-digit increase in order value.

I sold after Lilang announced its interim first half financial result for FY14, which beat the market expectation with +2.5% yoy earnings growth (market expectation was really low after a bad 2013 year).

Lilang - Share price - 2014 YTD-Sep
Source: Google Finance

As you will see in the Trade Fair discussion later, trade fair result is the preview for the financial performance. A strong growth in trade fair order value tells you that next interim financial result will be good. A decline in trade fair order value gives you a warning on next interim financial result. If you see the share price moves in opposite direction to trade fair result, it’s a good indicator of market mis-pricing.

Trade Fair

Lilang has three trade fairs in a year to sell their products to distributors. Winter and Fall/Autumn trade fair are two main shows, while Spring/Summer trade fair is a small one.

Lilang - Result Dates

Lilang - Trade Fair Results - 20170607
Source: Company reports

Trade fair result is a preview to financial reports as seen from the table above.

From 2008 to 2011, the trade fair order value averaged 20-40% yoy growth. Not surprisingly, the revenue achieved 30-37% yoy growth during the same period.

2012 winter trade fair order valued started to decline. This lead to falling revenue in second half of the same year.

2013 was a bad year with declining trade fair order value in all seasons. This showed up in 17.7% fall in full year revenue.

2014 was the recovery year from the bad 2013. The two major trade fairs in Fall and Winter saw a mid single-digit growth. Its full year revenue was also up by mid single-digit (+5.8% yoy).

2015 continued the growth story in trade fair and financial result.

2016 was just like 2013 with declining trade fair order value in all seasons. This is reflected in 10.3% drop in full year revenue.

Second Trade

In late 2016, I had lunch with my ex fund manager and I brought up Lilang again. I thought it’s cheap at around 4.50 (market cap HKD 5.4bn) while holding net cash of CNY 2.1bn and generating free cash flow of at least CNY 400-600m over the past 4 years. It reported bad trade fair results (decline) over the year, but seemed to slowly recovered from the worst. Its recent spring/summer trade fair saw some recovery despite still being a decline. He cautioned me that it’s a bit like gambling if we were to buy the company based on its trade fair result. We have no clue whether next trade fair result will be good, bad or turnaround. I listened to him, so I did not buy. I wanted to wait for clearer signals.

In March, Lilang announced its Fall trade fair result, which saw a recovery to high single-digit growth. Unfortunately, the share price already ran ahead of the result. It recovered from its low of 4.40s at end of 2016 to 4.70s in early February. Then, it spiked to 5.70s in one week before settling down at 5.30s in March. I simply missed out while watching at sideline.

Lilang - Share price - 2016-2017 Jun
Source: Google Finance

As luck would have it, the share price fell to 4.70s in May in the usual period of market fluctuation. This was the opportunity to buy.

I bought Lilang at 4.78 in May in anticipation of improving Winter Trade Fair results in June. It did not disappoint. Winter Trade Fair reported low double-digit growth in order value (beat my expectation), and its share price rose to 5.13 on the day of announcement.

With the recovery in both major trade fair (Fall and Winter), we can reasonably expect the interim and full year financial result to be good. The share price has since risen to 5.30s.

Why did I think the Winter Trade Fair result would be good? 

1. FY16 was a bad year but first half of FY17 already saw some recovery. Fall trade fair value even achieved mid single-digit growth.

2. Lilang discontinued its L2 casual brand in Fall and started Lilanz casual wear. Before this, Lilanz is a pure formal wear with a premium price. Lilanz has a higher brand value than L2 and is priced higher too. The management remarked that the new Lilanz casual wear was well received by the market, thus they are likely to focus on growing this casual wear brand. This should increase the order value in winter trade fair.

The losses from discontinuation of L2 brand were already (partly or mostly) charged to FY16 financial result. The recorded loss was CNY 50m for L2 in FY16. That means there are two positives for FY17: 1) improving margin after discontinuation of L2 brand, and 2) recovery in trade fairs.

If the trade fair result turns out to be flat, I still have the improving margin to support FY17’s earnings.

Market Mis-pricing

My first and second trades on Lilang are really based on some market mis-pricing. For the first trade, the good winter trade fair result was followed by a small decline in share price. That gave an opportunity to buy before the predictable better-than-expected interim result was released. For the second trade, the share price rose to reflect the good Fall trade fair correctly but dropped prior to Winter trade fair result. Again, that drop gave an opportunity to buy before the anticipated continued recovery in Winter trade fair result. For each trade, we could get around 10% return in 2-3 months while holding a relatively low risk.

Super 100% Rally?

What if luck is on your side? That happened in mid 2015 when the share price rose from 4.80s at start of 2015 to 10 in June, giving you over 100% return in 6 months.

But, you don’t rationalize that spike with any company specific information or your skill, prediction, judgment, foresight. You look at the broader stock market movement. Shanghai Composite Index was having an irrational rally of 60% during the same period. From June to December, everything came crashing down, back to the same level at the start of the year. It will be impossible for you to time your buy near the low and sell near the high.

Lilang - Share price - 2015
Source: Google Finance

Throughout 2015, Lilang did continue its recovery in trade fairs and sales, but the share price’s behavior was carried away by the broader stock market movement. When you invest in stock market, you have to be prepared that business performance and share price performance can be detached for a considerable time. Professionals (analysts and fund managers) will look for all sorts of signals or catalysts to time the purchase at bottom or just before the spike, but very often, the effort is not able to yield consistent result.

High Reward but Higher Risk

If I did not listen to my ex-fund manager in late 2016 and bought the shares at 4.40s, I would be sitting on 20% return by now instead of 10%. But that higher return tells only one side of story. The other side of story not told is the higher risk taken. If I had bought at 4.40s in late 2016, I would have taken bigger risk because I had no clue or whatsoever whether Lilang was experiencing a recovery. The buy would have been based on *feel* than analysis.

Bigger Picture

The above trades were executed based on company operational data that was not priced in correctly by the market. It’s only worthwhile doing if Lilang is fairly valued or undervalued. If Lilang is overvalued from the start, then it’s not worth doing it. Therefore, we’ll have to do valuation of the overall company.

We can talk long story about the quality of the company, about its strategy, history, performance throughout the time, competition, etc. That will be a long post to write and we are not doing that. We focus more on the quantitative stuff this time.

Lilang - Financials 10Y - 2016
Source: Morningstar.com
Lilang - Profitability 10Y - 2016
Source: Morningstar.com

Back in mid 2014 when I was studying Lilang, the Company was holding CNY 1.5bn of net cash (or HKD 1.87bn based on CNY-HKD exchange rate of 1.25) while having a market cap of CNY 4.8bn (or HKD 6bn). That gives Enterprise Value (EV) of CNY 3.3bn. So, the cash was 30% of market cap.

Total net profit and free cash flow over the past 4 years were CNY 2.2bn and 1.6bn. Latest year net profit and free cash flow were CNY 516m and 634m, implying P/E ex-cash of 6.4x. Excluding the excess cash, Lilang achieved impressive ROIC of 50%, ROA of 25% and ROE of 50%.

The company was experiencing falling sales and profit in 2013, but that’s largely been priced in. Lilang still generated a very healthy and strong free cash flow, and gave out dividend yield of 5-6%. Conservatively, I valued the company to be worth at least HKD 5.5-6.0. All these considerations and the improving trade fairs were the reasons I bought it at HKD 5.03.

Now, back to May 2017, Lilang was holding CNY 2.2bn of cash (increased by 700m from CNY 1.5bn in 2014 after paying dividends, telling you that it’s really generating lots of free cash) against market cap of CNY 5.1bn (CNY-HKD exchange rate is now ~1.14). The cash represents 43% of market cap, and the EV is CNY 2.9bn.

Over the past 3 years (since start of 2014), total net profit and free cash flow were CNY 1.72bn and 1.49bn. Trailing twelve months P/E ex-cash is 5.4x. Excluding the excess cash, return on capital remains impressive, ROIC of 56%, ROA of 26% and ROE of 65%. After all these years, the company continues to generate lots of free cash flow at high rate of return on capital. My conservative estimate of the fair value remains the same as 3 years ago at HKD 5.5-6.0.

Sometimes I wonder if such good reported numbers are real or made up, especially when the companies are unknown. I can’t verify if the numbers are real or not. I hope its auditor, KPMG, is doing a proper job. For my own due diligence, at least I verify that over the past 4 years, it has paid out a total of CNY 1.6bn dividends and 680m corporate tax in cash. That’s a combined cash payout of 2.28bn in 4 years. During the same period, the company’s share price is actually going nowhere. So, the founders/largest shareholders don’t benefit anything except from the dividend distribution. For a cash holding of 2.18bn, the company received interest income of nearly 70m in FY16 (97m in FY15). That implies effective interest rate of around 3.2%, which is not far from China banks’ current time deposit rate.

The only problem Lilang faces is sustainable growth. With the rise of e-commerce, nearly all brick-and-mortar retailers (especially in fashion apparel business) suffer from intense competition. Online retailers often compete on price, which is the worst thing to compete. Despite all the tough competition, Lilang still managed to perform reasonably well, maintaining its high operating margin and high return on capital. To be conservative, I assume its revenue to decline for next 2 years and use zero for terminal growth rate.

In the end, I arrive at fair value estimate of HKD 5.5-6.0. That gives me confidence to buy when the price was below 5.0 with the added knowledge that trade fair result should continue its recovery. This catalyst helps to time the purchase.

Will I hold this company for long term?

Lilang’s high return on capital may suggest that the management is doing a superb job at running it. Its business model of being a wholesaler also has lower fixed costs and provides lower volatility to its earnings. However, looking at its business performance and share price performance over the past 4-5 years, it’s easy to see that it’s going nowhere. Growth is the missing key.

It’s operating without any competitive advantage in a perfectly competitive market (many producers and consumers, no barriers to entry or exit, perfect information, homogeneous goods). It becomes even more challenging to grow revenue in future as shoppers move to online shopping with unlimited choices for comparison. I don’t have any special insight on how it’s going to perform differently in future compared to the past, but I expect the competition to get even tougher in future.

Therefore, Lilang is not a company that I will hold for long term.

Suggestion to Management

If I can give one suggestion to the management (the founders and also the largest shareholders), it’s to use the excess cash to buy back the shares as its current share price is undervalued. The excess cash is also earning a low return of around 3%, which penalizes the overall performance of the company. Some investors will also take a discount on the excess cash when valuing the company. Shareholders stand to benefit more from the share buy-back at current share price.

Lilang - Share price - 2013 to 2017 Jun
Source: Google Finance

 

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