Zungui Haixi

Recently I have been looking to the TSX Venture exchange to find mispriced assets. That’s not to say the TSX is expensive (or cheap), but there is a little too much optimism for me. I have begun to scour the Venture exchange in hopes of finding a gem.

Recently, there has been fear of the growing number of Chinese companies that are turning out to be frauds. To be honest, it doesn’t surprise me. Whenever money flows into “hot” sectors, there are bound to be a few rotten apples. It happened during the dot-com bubble, it happened during the housing bubble, it’s happening right now it the junior gold sector, and it is happening in some interlisted companies from China. I have to admit, I am quite curious how there could be such things hiding in plain sight given the amount of information available. I remember reading Fooling Some of the People All of the Time, by David Einhorn, and being amazed at what still slips through the cracks.

When the news about RINO International came out, here, I thought it would be a good chance to pick up some quicker growing companies from China at a discount. I wanted to stick with Canadian listed stocks as they seem to be better monitored. I also wanted to stick with a company who is being audited by a major accounting firm.

Enter Zungui Haixi (ZUN on TSX venture). Shares didn’t sell off like I had hoped, but the company appears to be extremely cheap.

Zungui manufactures and sells athletic footwear, apparel and accessories (Sportswear) and casual footwear (Casual) in the PRC (People’s Republic of China).

Overview

The industry has seen tremendous growth in the last 5 years, averaging a CAGR of over 30%. It looks like the trend is likely to continue as long as China’s economy continues to grow at a decent rate. Despite global competition, domestic sportswear makes up 50% of sportswear revenue (vs. about 40% 5 years ago). Meaning that major global firms (Nike, Adidas, etc.) haven’t had an easy time penetrating the Chinese market. With middle class income rising at around 10% per year in China, ZUN is poised to benefit. As with most retailers, there is stiff competition within their borders.

ZUN has over 112 corporate retail stores and is about to has just hit 2,000 retail distributors. ZUN is placed 8th in size of market share within China, with a mere 1.2%. The company targets the middle class with prices of $15-35 sportswear and $25-50 for casual. The big push is into Tier 2 and Tier 3 cities. Not major cities (by China standards) but these still have a population of under 5 million. There are 174 Tier 2 cities and 735 Tier 3 cities in which the company sells its goods. Canada has only 5 cities with a population over 1 million (if you include surrounding areas).

The company is planning a huge production expansion, although they already rely on 50% of manufacturing to be outsourced for sports footwear and 100% for sports apparel. The expansion will bring the company’ s current production up from 4.4 million pairs to over 6 million pairs, even with the expansion the company will have to rely heavily on subcontractors for production as they are selling around 12 million pairs. The subcontractor’s leave the company with lower gross margins. The company manufactures 100% of their casual footwear. The company uses around 15 companies for outsourcing, so there is no heavy concentration.

There has been a big expansion in the number of stores. The corporate stores (now over 100), mostly in Shishi City, are used to test layouts and new product introductions. The retail distributors (now over 2,000) are were the majority of product is moved. The company gives incentives to distributors to open, there is an initial subsidy given to each store. The size of the subsidy depends on the store. This means there are higher initial costs to expansion, but increased future revenue. Given the rapid expansion of store locations there has been an increase in total selling costs, from under 5 million top almost 8 million. Though this cost is likely to increase as the company continues to open more stores, the cost will be spread out over more stores. There is a 6 month break even target for each store opening. Once open, the stores are closely monitored. ZUN hasn’t been afraid to close underperforming stores in the past.

The majority of workers (+80%) are on the production line, and there has been upward pressure on wages. There is always the risk of higher wages and social obligations on behalf of the employees.

Insider ownership is substantial at 60%. The Cai family owns 35 million of the 62 million outstanding. There is some other insider ownership, including the lead of board of over 1 million shares. There is over 2 million options exercisable at $3.25. So that could provide some resistance if the share price gets there.

Margins have remained stable even during the expansion of stores and the recession. ROIC is high by GAAP standards, but it might be over stated. ROE is still north of 20%, no debt and high cash balance.

Valuation

  • P/E under 7, using operating earnings.
  • EV/EBITDA around 2.5.
  • Priced at 66% of my EPV (around $4.25 fair value), which is a no growth stable margins scenario.
  • DCF yields a fair price over $7.50 with 12% growth, and $5.5o with inflation level growth. I am using owner earnings for the input number.
  • Under 2X book value.
  • The company has around $1.44/share in cash, and plans to use it for the expansion.

Risks

  • There may always be a “China discount” on shares of ZUN.
  • Wages for workers could rise dramatically.
  • Prices for outsourcing can rise.
  • Did I mention fashion.
  • The usual fears over currency, political and nuclear headline risk.
  • Delays in production expansion.
  • General execution risk that’s accompanied by such a rapid expansion.
  • Potential real estate bubble in China.

Summary

You are paying well under 10x earnings for a company that should grow earnings by at least 15%/year. Giving us a PEG ratio under 1. I’m not going to try to predict a fair value as there are many variables, but I know it is much higher that today’s share price.

Margins should remain stable or improve as the company scales into more stores. The recently opened stores will start generating revenue that will show up on the income statement in the coming quarters. The expansion will also help keep gross margins within their target range.

The large insider ownership puts management on my side. Compensation is not excessive. The team seems to have plenty of experience from an execution standpoint, as well as dealing with Canadian listed stocks in China.

Potential Catalysts

  • Share buyback.
  • Possible dividend in 2011.
  • completion of production expansion.
  • Strong revenue growth in the coming years.
  • Removal of the “China discount”.
  • Somebody pours water on Mr. Market (to wake him up).

I will buy a half position here and wait for share price movement or company news to help give me a more concrete fair value. Happy investing everyone.

Dean

The author is long shares of ZUN at time of writing.

Company Website

2 Comments

Filed under Company Analysis

2 responses to “Zungui Haixi

  1. Andrew Choi

    What about retail channel stuffing as a potential risk? IMO, there are more than enough ways for them to fake earnings without raising a red flag on the accounting side….

    • Andrew,

      You are right about channel stuffing being a risk; I should have put that in the original post. Even though channel stuffing is illegal, it still happens.

      The expansion of stores has pushed up accounts receivables. We will have to wait a few quarters (or more) to see if these go down as revenue picks up in the new stores. They have been relatively steady for the last year when compared to revenue despite the increased number of stores. There will still be quite a bit of store openings throughout the rest of the year, so there might still be elevated level of receivables.

      This is one of the reasons I will limit my position size.
      Thanks for the comment. Feel free to reply.
      Dean

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