When I bought Biostime in 2015, it was an infant formula producer in China which had highly enviable growth, margins and return on invested capital (>20%) since their IPO (in 2010) to 2014. Its stock price went up from about HKD 10 in 2010 to HKD 70 in 2014.
Biostime paid out some of their earnings as dividends, but also had a fast growing cash pile partly due to their explosive growth and partly due to their business model, which is to outsource production of their infant formula to a high quality producer in Europe. As a result of the OEM model, there is little need for capital expenditure for business expansion.
When a company exhibits a combination of high growth, high margins and a growing cash balance, history tells us to be mindful of the possibility that the company could be fraudulent.
Despite being flush with cash, Biostime raised RMB 2.4b in 2014 by issuing zero coupon convertible bonds, at a underlying strike price of around HKD 90. This raised my suspicions further. The only plausible reason to raise this much capital when there was sufficient cash for the business was that it was very cheap to do so. A strike price of HKD 90 implied a P/E of around 30-40x. This meant that the interest free bonds were unlikely to get converted into equity unless the business continues to do well in the next few years and/or the valuation on a P/E basis continues to be very high.
In 2014/2015, there was heavy competition in the infant formula market in China. Biostime’s growth stalled and margins were squeezed. In the first half of 2015, Biostime’s revenues fell 10% and net profits fell 34% (to RMB 204m) from the year before. Its stock price fell from a high of HKD 70 in early 2014 to its low teens in late 2015.
In Sep 2015, Biostime announced the acquisition of a 83% stake in Swisse, an eponymous producer of vitamins and other health supplements in Australia, for RMB 6b. This acquisition was funded by cash on hand, USD debt, and issuance of Biostime shares. Given that most of the existing cash was used up, it proves the authenticity of Biostime’s results since their IPO.
Swisse’s earnings for FY Jun 2015 was AUD 73m, equivalent to around RMB 330m. Earnings attributable to Biostime were 83% of 330m = RMB 273m = HKD 327m. If we just take Biostime’s FY 15’s interim earnings as a simple estimate of its full year earnings, it would imply full year earnings of RMB 204m*2 = RMB 408m = HKD 489m. Adding that to Swisse’s earnings would give us full year earnings of HKD 816m.
Total outstanding shares of 620m and a share price of around HKD 13 implied a market valuation of HKD 8b for Biostime. Given that I thought that Swisse’s business was likely to grow rapidly and that the troubles in the infant formula market were likely to be temporary (for reasons outlined below), paying a P/E of 10x for such a company was a bargain. Hence I put a significant portion of my portfolio in Biostime.
Due to cultural reasons and also the one child policy, parents in China typically spare no expense in obtaining the best money can get for their kids. Infant formula is no exception, as it is highly important for infant development. Because Biostime’s products are produced by a quality manufacturer in France, this partly explained their explosive growth in sales from 2010-2014.
However, super normal profits in an industry inevitably attracts competition, which may lead to an oversupply in the market. This leads to competitive pricing pressure, and poor results for all the players in the industry. This was the reason given by Biostime’s management for poor results in 2015. As we learn in Economics 101, such an oversupply is temporary. Sellers lower their prices to clear stock, and supply gets rationalised in the future.
A similar thing happened in the sportswear market in China in 2013. Up until then, sales and profits were growing for all of the listed sportswear manufacturers, and they got a bit overzealous in opening new stores. At the time, I recall seeing every other store being a sportswear store in certain popular shopping areas in Shenzhen. This resulted in a temporary oversupply, which then corrected itself after about one year. All of the listed sportswear manufacturers including leading China brand Anta 2020.HK took a hit in 2013, but then almost all of them later recovered to varying degrees.
Given that infant formula typically has a shelf life of one year, buyers cannot stock up on the product for future use. This meant that good results in the past were an indication of the demand in that particular year. Assuming that the market players were rational, I thought that the situation in the infant formula market were most likely going to play out as it did in the sportswear market. Hence, the most likely scenario was that Biostime’s results will improve in about 1-2 years. The other possibility is that sellers do not behave rationally and continue to oversupply the market for a prolonged period, as we see this happening in other markets such as in aluminium and the car rental market. This will lead to poor results for industry players.
Generally speaking, the reputation for quality of food sold in China is not good. There were several food safety incidents such as the melamine tainted infant formula scandal in 2008, fake foods such as eggs and meat being passed off as the real deal, and more recently in 2014, Ting Hsin (parent company of Tingyi 0322.HK) being found using recycled oil in their food products.
Increasingly, because of the distrust towards locally sold infant formula, many parents went to the extent of sourcing the product from overseas to ensure their quality. Hong Kong, which borders the south eastern China city of Shenzhen, was a popular place for parents and traders to buy infant formula. The demand from China was so great that people in Hong Kong started to complain about a shortage of infant formula and in 2013, Hong Kong passed a law which limited the number of cans of infant formula allowed out of Hong Kong to 2 cans per traveler.
Australia is also a popular destination for Chinese people to buy infant formula. In particular, the Bellamy (ASX: BAL) brand of infant formula is most popular among Chinese parents. Another product that is popular among Chinese people in Australia are vitamins and health supplements, of which Swisse and Blackmores (ASX: BKL) are the market leaders. A list of products sold can be found on here. Such products are in such high demand that when Chinese people travel to Australia, they typically buy the product and bring it back home to China. For Chinese living in Australia, they buy the product and send it to their families in China by post.
Biostime has an existing distribution network in China, so acquiring Swisse allowed them to distribute their products in China, saving the need for Chinese people to buy the product from Australia and bringing or shipping it back. It also opens up the potential of serving a much bigger domestic market in China. This led to my optimism on Swisse’s business post acquisition.
However, there are some downsides. Firstly, the bulk of Swisse’s product range is neither patented nor proprietary. Swisse’s mouth watering 25% net profit margin means that new entrants can easily under price Swisse on similar products. Indeed, during my visits to Australia over the years, I noticed an increasing number of new competitors to Swisse. Branding may play some part in consumers’ buying decision, but we know very well that increased supply and price competition will mostly lead to reduced sales/prices for the incumbents.
It is interesting to study consumers’ attitudes towards brands in different industries. In certain markets that sell a commodity, the brand can mean everything. A shiny stone packed in their signature blue box can command a hefty premium compared to the same stone sold elsewhere. I am of course talking about Tiffany and Co’s (NYSE: TIF) diamond rings. On the other hand, for a product with different technical specifications such as television sets, its brand does not generally mean much. As a result, it is well known that TV manufacturers such as Sony and Panasonic do not have great results in this market.
Even though Biostime and Blackmores are the current market leaders, due to the relatively short amount of time in which the brands became established, and that the bulk of their products can be easily replicated, I am taking the view that it will be more susceptible to pricing pressures.
Secondly, although it is generally accepted that vitamins and health supplements are good for your health, except for certain supplements which target specific ailments such as high cholesterol, its effects are not easily measurable. This is because your general health and general well being is affected by a number of different factors, such as diet, genetics, mood, exercise and so on. As a result, the consumption of vitamins and supplements may help in achieving good health, but it may not be directly attributable to it. In the long run, there is some doubt as to whether consumers will continue to believe that taking such products are essential for good health.
Fast forward to today. A couple of developments led me to rethink my thesis and decide to pare down my bet significantly. Biostime’s infant formula results were still weak in 2016 and Swisse sales did not grow as much as expected. In the nine months to Sep 2016, infant formula revenues were down marginally from the previous year. Margins also did not improve. Management suggested that sustained price competition due to tighter regulations to be introduced in 2017, leading producers to produce more before new regulations kick in (preventing those without a quality certificate issued by the government from selling), were to blame for the poor results. I am somewhat skeptical of this reason, as I can see that publicly listed competitor Bellamy’s achieved much better results over the same period. This suggests that there may be a shift in consumers’ preferences to overseas produced brands that are also foreign owned. Although Biostime is still able to maintain its market share of 5-6% since its peak in 2014, I am erring on side of caution.
China also relaxed its decades-long one child policy on 1 Jan 2016, allowing couples to have two children. This is positive news for the infant formula market, but recent numbers suggest that the policy was not as effective as intended, as live births only increased by 1.4m to 17.6m in 2016 as compared to 2015. This is an increase of less than 10%.
Most worrying are management’s capital allocation decisions, which resulted in Biostime taking on more debt and foreign currency risk than I am comfortable with. As of 30 Jun 2016, Biostime has convertible bonds due 2019 totalling RMB 1.1b, and bank loans and senior notes of around RMB 5.6b, of which around RMB 3.9b is denominated in USD. This is a total debt of RMB 6.7b against total equity of RMB 4.1b. Annual interest payments will total around RMB 500m, against estimated operating profit before interest and taxes of around RMB 1.5b. Biostime’s revenues are mainly in AUD and RMB, while majority of the debt is in USD. Any adverse movements in currency and/or negative market developments may make it difficult for Biostime to service their interest payments.
Also, approximately USD 250m (RMB 1.6b) of the senior notes (7.25% coupon) was issued to fund the repurchase some of the convertible bonds that were issued in 2014. The bonds are interest free and in my opinion unlikely to be converted into equity in 2019 due to the high strike price of HKD 90. Exchanging interest free debt for high yielding foreign currency debt does not seem like a good idea to me.
On 24 Jan 2017, Biostime issued another USD 200m in senior notes at 7.25% to fund the acquisition of the remainig 17% stake in Swisse. CEO of Swisse Radek Sali also resigned to pursue personal interests. Both are not encouraging developments. Biostime’s debt will now increase by another RMB 1.5b, and will add on more currency risk and leverage to an already high leveraged company.
After revisiting the pros and cons of the thesis, at the current share price of around HKD 27, which represents a P/E of around 18x, I do not like the odds I am being given to take on the risk. Hence, I am significantly reducing my stake and quite possibly exiting the position.
C is for Compounding 