If you want your country to keep getting richer, education matters. Otherwise you're doomed to stay a low-cost source of labour. China understands this and it's investing heavily in the sector. It's written in law that government education spending must grow faster than tax revenue.
But individuals know this too and they're dipping into their own pockets. Enrolment into mostly private vocational training courses is growing at 5% a year, even as demographics top out and entrance to state universities declines.
So it's no surprise that Chinese education is already a popular idea with investors. US-listed New Oriental Education is the long-time darling of the sector, trading on a price/earnings ratio of 48 times.
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And right now this sector appeals to me as well. I like its combination of solid growth and defensive trends. People rarely cut back on it during downturns because it's an investment in their or their children's future. Indeed, in the West, adult education spending often goes up when the economy turns down, because people believe that new skills will help them find a better job.
But you don't have to pay 48 times play this sector. In fact I've found an emerging publishing powerhouse that looks deeply undervalued one that I think could treble your return over the next five years.
How to avoid the lunatics in this cut throat industry
I've been an English language teacher and I know from experience that this is a highly competitive business with low barriers to entry. Worse, it seems to attract a striking number of lunatics who lack the business sense to realise that constantly undercutting each other on price is not the way to make money in the long run.
I would be happy to add a schools network to the portfolio but it has to be at a low, low price. I'm currently doing research on one elsewhere in Asia. I met the chairman a couple of weeks ago and was impressed by their operation and plans. The only disadvantage is that it's tiny it would be by a long way the smallest firm to feature in Asia Investor. I'll report back to you on that when I've finished my review.
But in the meantime, my China education play is going to go in a slightly different direction. As you'll probably know if you had to buy educational books or teaching materials recently, they can be pretty expensive. And while they're certainly not free to make specialist authors need to be paid successful book series can deliver pretty good margins.
This is a business that can reward scale. Big education, training and publishing groups like Pearson have strong market positions, defensive earnings and limited capital reinvestment needs, meaning sizeable dividend payments to shareholders.
That strikes me as much more attractive prospect that New Oriental Education on 48 times earnings. So I went looking for a potential future Pearson of China. And I think I've found one, thanks to some very helpful policies from the Chinese government.
The gold underneath all the cryptic Chinese jargon
Sichuan Xinhua Winshare Chainstore isn't good at explaining to outsiders exactly what it does. The annual report seems to have been written by career bureaucrats and translated with crushing literalness.
A quick skim will tell you that it has four main businesses, named in full "Product", "Retailing", "Subscription" and "Zhongpan". Delve into the management discussion and you'll be brought up short by enlightening sentences like "the overall strength of the publishing industry was further enhanced by the publishing system reform entering into a new stage of open diversification and intense vertical dissemination".
So it's no surprise that investors haven't paid that much attention to this firm. It took me two days of research to get a solid grip on exactly what it does. And I'll admit that the only reason why I was prepared to put in the time was because I noticed that three very different but independent-minded and credible groups of investors hold or have held shares in it, so I knew there must be something interesting underneath it all.
So what does Winshare (as I'll call it from now on) do? In a nutshell, it publishes, distributes and sells books, with a particular focus on the education market in its home province of Sichuan. But in the long run, it stands a good chance of becoming a lot more than that. To understand why, we need to look at what these cryptically named divisions do.
"Product" refers to its publishing division. Technically speaking, the firm doesn't have full rights to be a publisher so it does this through "co-operative" agreements with other firms that have the necessary permissions. This is why the division is so vaguely named but this restriction should be changing soon.
"Retailing" refers to its chain of 191 bookstores through Sichuan under the Xinhua Bookstore, Wen Xuan and Times Xinhua brands, plus one in the city of Xi'an and one in Chongqing municipality.
This is the least attractive major division to me, partly because there are better retail stories in China I'm doing some research on the food and convenience store sector at the moment and hope to have a recommendation for you there. But more importantly, the management of this division is (or was) pretty poor at their job. Historically, the division has been breaking even at best and is currently loss-making when all overheads are factored in.
"Subscription" refers to the distribution of educational materials. And this is where the lights really start to come on, since the core of this is a cosy monopoly. Winshare has the exclusive distribution rights for textbooks for primary and lower secondary schools in its home province of Sichuan, which are almost entirely subsidised and paid for by the government, meaning a very dependable income stream.
It also has the exclusive rights to distribute the non-subsidised textbooks for upper secondary and vocational schools. And on the back of this relationship with schools, it has a very strong (but non-exclusive) position in the market for supplementary educational materials.
Finally, "Zhongpan" is the distribution business for its own products and increasingly for those of other publishers. The company is aiming to build a nationwide distribution network to act as the middleman between China's hundreds of publishers and retail outlets and other customers.
The charts below breaks down revenue and profit by division. Revenue allocation in this kind of vertical business is probably rather arbitrary - and in this case, I suspect driven by tax breaks on some divisions. But you can see clearly that education supplies is the dominant part of the company.
This should continue to be a very solid cash-generating core business. However, it's those smaller publishing and distribution businesses that make the firm's growth prospects so interesting.
But to understand why, you need to understand the Chinese government's stated goal of revitalising and reforming the "cultural sector". Contrary to what you might think, this does not mean liberalising publishing rules and trying to increase competition. In fact, it's quite the reverse.
Winshare could become China's Pearson
Publishing and distribution is obviously a politically sensitive area in a country that has extensive censorship and thus China wants its national interests to be protected. So while policymakers are forcing state bodies to become commercially orientated and encouraging private investment, the goal is not to end up with lots of small competing firms. Indeed the industry is already very fragmented. Rather, the aim is to establish a handful of larger, more powerful firms that have the clout to protect Chinese cultural interests.
Conceptually, it's perhaps a little like continental European governments' efforts to protect their local cultural industries from a perceived glut of English-language output. Except this is on a much bigger scale. The Chinese publishing industry is already estimated to be the largest in the world, and growing affluence (and literacy) should see it continue to grow.
So, Chinese publishing and distribution businesses are being pushed to merge into a handful of much larger integrated publishing groups that span different areas of the industry, and go across province borders. Within the next five years, China hopes to have a handful of firms with sales of at least Rmb10bn each. That's around three times current sales at Winshare, which is in turn already one of the largest of the publishing groups.
Given its current size and clear plans for expansion, Winshare stands a good chance of being one of the winners from this process and evolving into a major nationwide publishing and media firm. There are three main parts to its strategy:
First, it's going to become a full publishing business. It recently announced a long-in-the-offing deal to acquire a group of 15 publishing companies from a company owned by the provincial government (which is also ultimately Winshare's controlling shareholder). This will bring the right to publish in-house and remove the need for co-operative deals. The price tag for this business is RMB1.255m, which amounts to 11 times 2009 earnings. That looks a pretty favourable price.
Second, it's expanding the Zhongpan network nationwide, acting as a middleman distributor between China's hundreds of small and medium-sized publishers and retail chains and other buyers around the country. With the industry still relatively fragmented, I think it's clear that a firm that builds a nationwide distribution chain could end up in a very powerful position, given the economies of scale that it could offer publishers and retailers.
Winshare doesn't divulge much about the growth size of its network in company filings, but I gather that it now has regional offices in 24 provinces, covering 397 cities (60% of its target) and serving around 2,000 bookstores (for context, I believe there are something in the region of 10,000 bookstores in China). However, it breaks out investment in each division and it's clearly investing seriously in this; last year, capex for Zhongpan amounted to RMB165m or 70% of total capex.
Third, it intends to sell its supplementary education materials outside Sichuan. It can't market textbooks in other provinces because the exclusive rights for that are held by other provincial firms. But there are no such restrictions on other materials. As I understand it, the company goal is to become the leading publisher and distributor of these types of products nationwide. In principle, this goal should combine well with its new in-house publishing division and the development of the nationwide distribution network.
Importantly, expanding the unsuccessful retail business is not part of the plan. Originally, it planned to use some of the proceeds raised in its IPO to expand outside Sichuan. But the continuing poor performance of the chain has meant that this plan has seems to have been quietly dropped in favour of a much more sensible focus on publishing and distribution.
So to recap briefly, what I like about Winshare is the fact that it has a lucrative local education monopoly with nationwide growth potential in both education and other publishing thanks to government policy. It seems quite possible to me that within five years or so, it could be three times larger than it is today.
Crucially, I think the nature of this "cultural reform" is not a concept yet really grasped by the market. Once the outcome becomes clear i.e. bigger profits for a select few Winshare could see more investor interest and a higher valuation. So this makes it an interesting long-term play, both on education and the wider publishing business.
What's more, the publishing acquisition is using cash from its IPO in 2007 that's currently just earning a very low rate of interest in the bank. As we'll see later, adding this into the business on favourable terms should lead to a substantial jump in earnings next year, which I don't believe the market is yet pricing in. So we could be looking at a potential gain of around 40% within the next year, regardless of the longer term.
A complex history with many stakeholders
The history of Winshare is almost as complicated as its business. The firm is part of China's extensive Xinhua Bookstore network, which you can see all over the country. In case you're wondering, this has nothing to do with China's well-known Xinhua News Agency. In fact, the term Xinhua is present in quite a few unrelated business names it's rarely that anyone bothers to translate it but it means "new China", which refers to communist China.
The first Xinhua Bookstore was set up by Mao in 1937 and was ultimately expanded into a nationwide network that controlled most of the distribution and retail of printed materials in China. At one point, the entire network was controlled by a head office in Beijing, but after Deng Xiaoping took power in 1978, control of each province's network was delegated to the provincial government. However, all regions continued using the same national brand.
So Winshare controls the network for Sichuan. Its controlling shareholder is Sichuan Xinhua Publishing Group, which is ultimately owned by the State-owned Assets and Supervision Commission of Sichuan, part of the Sichuan provincial government. Thus it is a state-owned firm, which carries risks that I'll discuss below.
The company floated on the Hong Kong stock exchange in 2007, listing around 39% of its total capital as H shares. (If you're not familiar with different types of Chinese shares, H shares are the Hong Kong listed shares of companies incorporated in the mainland.) The remainder is held as non-tradeable shares by various state shareholders and by Chengdu Hua Sheng, a company controlled by one of Winshare's directors.
Notable major H share investors include the National Council Social Security Fund, one of China's state pension funds, and Atlantis Investment Management. The latter is an Asia-specialist fund group whose China funds are managed by the highly regarded Yang Liu, who I know scrutinises companies in great detail before investing. These two account for 9.09% and 4.84% of the H share float respectively.
Ideally, I like to see a well-known independent director or representative of a major investor on the board when investing in little-known companies. We don't really have that comfort here, but one of the independent directors is an experienced Hong Kong accountant who serves on a number of boards, including BYD Electronic and cement maker Anhui Conch.
The freefloat is around 30% per day, while liquidity is good at an average of 2.2 million shares traded per day over the last year.
Some risks to consider
In addition to the usual Asia Investor risks, I'd emphasise the following:
Winshare is a state-owned firm. As always with any company that has a controlling shareholder, the interests of minority investors may divulge from those of the one that can call the shots. In particular with state firms, national or provincial interests may take precedence over making a profit. My feeling is that this is unlikely in this case since the national interest is to create large, profitable publishing groups, but it's not impossible.
Even if the interests of investors and the firm are aligned, there is an increased risk of poor execution with a state-controlled firm. Many of the staff and management will have spent all of their careers in a state-directed business environment and may not be good at dealing with more market-orientated strategy.
That said, in Winshare's case, some senior executives were reshuffled in 2008 and the director responsible for the underperforming retail division turfed out. I regard this as a promising sign that the state-owned parent company will push management to deliver commercial results (as many of the better state-owned enterprises are now doing in China).
There are also political risks. We're investing in a story that's ultimately driven by China's desire to have a handful of large publishing groups. It's possible that this objective will change and it's also possible that even if it doesn't, policymakers might want the eventual winners in this process to be firms other than Winshare. However, at present, there is no sign of this.
On the political front, you should also be aware that were Winshare to lose its exclusive distribution rights within Sichuan, it would have a very serious impact on its prospects, since this monopoly is at the heart of its business encouraging. This is possible, although I consider it unlikely.
I understand that the Xinhua Bookstore chains have always had this role in each province due to their wide distribution networks and have no obvious rivals. In addition, the fact that Winshare is backed by the same provincial government that grants this contract argues against local politicians undermining what could become a flagship local company.
Winshare benefits from tax breaks granted to key companies in the cultural sector and consequently pays little VAT or corporate tax. The VAT break has been extended every year so far, while the corporate tax breaks are supposedly assured until at least 2013. It seems very likely to me that the government will continue to offer these tax advantages as it tries to push cultural sector reform. However, were these to be withdrawn there would certainly be a substantial impact on Winshare's profits.
Finally, there are higher-than-usual information risks when it comes to shareholders being certain what is going on. Winshare is Hong Kong listed and subject to the usual disclosure rules for companies on this exchange. The consolidated accounts are audited by Ernst & Young.
Nonetheless, this is a mainland company as distinct from one run by a Hong Kong or Taiwanese entrepreneur. As a rule of thumb, this increases the risk of hidden fraud or incompetence, since mainland China does not have such long-standing capital markets or culture of corporate governance.
In particular, mainland firms both state-owned and private tend to have a weakness for speculating in property or the stock market or making unfocused investments. In this case, there are a couple of non-core holdings one equity and one real estate - that I'll look at below. These date from 2007, should both ultimately be profitable investments and there seems to be no indication that management is going further in this direction.
Winshare's status under provincial government control and relatively high profile actually makes me more comfortable than I might be with a business set up by an entrepreneur. Close state oversight can have some benefits in keeping managers honest if the state wants a good quality flagship listed company. And there is a clear long-term strategy with obvious provincial government support, which reduces the risk of management going off the rails strategically.
However, you should be fully aware of the distinctions between this firm and our other China investments so far such as Vitasoy and Hsu Fu Chi. Although I see no evidence so far, I am obliged to stress that the potential for hidden mismanagement is greater. However, I believe that given the company's potential, the current valuation compensates us for these risks.
The five year outlook says earnings could double or better
The last three years' results and my estimates are shown in the table below. Note that the 2007 profit was inflated by the timing of tax rebates - due to a change in the tax rules, effectively the company got two years' worth of VAT concessions within the same year.
So the firm currently trades on a p/e of around 11.7 times last years earnings and around 10.7 times my estimate for the current year (based on the current Hong Kong dollar/renminbi exchange rate of 1.14).
Last year it paid a final dividend of RMB0.08 and a special dividend of RMB0.2, putting it on a trailing yield of 7.5%. The firm also paid a special dividend of RMB0.21 in 2007 and RMB0.12 in 2008 on top of the regular dividend. There's no guarantee, but healthy cashflow and large cash reserves suggest that large payouts should continue for now.
The firm had RMB2.5bn in cash and term deposits as at end December. After completing the publishing purchase and allowing for other small commitments, I'd estimate that it has around RMB1.1bn on hand, giving it plenty of scope for further investments. Key balance sheet measures look solid; as at end December, it had no long-term debt, while the current ratio - liquid assets divided by short-term liabilities - stood at 2.22.
In addition to its core business, the firm has a number of other assets. The first is the remaining cash mentioned. This should hopefully be channelled into other earnings-boosting investments in the near future, including a planned RMB420bn investment in new logistics centre. In the meantime, based on my estimate of remaining cash, it amounts to around RMB0.97/share (HK$1.10).
There are also a few non-operating assets. Winshare owns a 6.85% stake in another large publishing and distribution firm, Anhui Xinhua Media, which listed on the Shanghai stock exchange in January this year. On current valuations, that's worth around RMB0.73 (HK$0.84) per share although to me the stock looks overvalued and I might estimate a fundamental value at half that.
Anhui Xinhua makes sense as a strategic investment, but there's less rationale behind a 2.46% stake in the unlisted Bank of Chengdu one of the two non-core holdings I mentioned earlier. This was purchased for RMB240m in 2007 when the bank was raising capital; other investors include Malaysia's Hong Leong Bank and a large Chinese private equity group. It's not clear when this bank might float, but I'd estimate that Winshare's stake might be worth twice or more what it paid for it perhaps about HK$0.5 per share.
Finally, when the company was prepared for listing, its parent injected a 62.5% stake in a prime patch of land in the centre of Chengdu into the business. This is quite common with Chinese privatisations and the land should be worth far more than it's currently carried at on the books. Winshare plans to work with its parent (which holds the remaining 37.5%) to develop this into a large commercial, retail and residential complex.
Frankly, I prefer to see my publishers stick to publishing rather than getting involved in real estate, but it's rare to find a firm in mainland China that has no real estate assets. And in this case, given the way that the site was handed to Winshare, it should be profitable regardless of the state of the property market. I'm not in any position to value this, but I've seen estimates (from 2008) of HK$1-2/share, depending on how it's developed.
However, I'm not factoring any of these assets into my valuation, because I regard looking for hidden value as a risky game unless there's a real prospect of activist investor getting control of the firm to unlock it which isn't possible here due to Winshare's state-owned parent. In theory, these assets could give considerable further upside, but we don't know if management will handle these in way that delivers real benefits to shareholders. So I'm focusing purely on the operating, dividend-paying business and regarding anything else as a bonus.
In my view, the enlarged Winshare group should trade on a p/e of around 12 times estimated earnings by mid 2011 as effect of the publishing deal becomes obvious. On my estimates for FY2011E, that points to a price of around HK$5.7. Including a likely dividend payout of around 7.5%, this suggests a potential one-year return of around 40% on the current price, which is attractive. I'm setting the buy limit as HK$5, based on my usual 15% a year minimum target return on the share price.
I'm taking an unusually short-term view on this firm, because I want to see evidence that its strategy is developing beyond the immediate earnings boost from the publishing deal. But in terms of long-term potential if industry consolidation goes well, I think earnings could double or triple over five years and the stock would be likely to get a sizeable rerating to p/e of 15 or better in that situation. So a five-year target of HK$10-15 looks very possible.
Buy: Sichuan Xinhua Winshare Chainstore
Exchange: Hong Kong (mainboard)
Market cap: HK$4,825m
Bid/mid/offer prices: HK$4.25/HK$4.25/HK$4.28
Buy limit: HK$5.00
52-week low/high: HK$2.61/HK$4.84
Yearly change: 2007 (part year) -11%; 2008 -64%; 2009 +94%; 2010 (to date) +40%. Sichuan Xinhua Winshare Chainstore was listed in May 2007.
For UK readers, Winshare is listed on the main board of the Hong Kong exchange and so will be eligible for an ISA if your provider allows foreign shares to be held in one.
That's it from me this week. Winshare is the eighth addition to the Asia Investor portfolio, so for the next issue I'll be taking a break from recommendations to carry out a quick review of the portfolio to date. I'll be catching up on recent results and news from a number of stocks, and also talking about the structure of the portfolio so far and how I plan to develop it over the next few months.
Until then, as always you can reach me on firstname.lastname@example.org.
Cris Sholto Heaton
|ASIA Investor Portfolio|
|Status||Stock||Ticker||Exchange||AI Date||AI Issue No.||Offer Price Then||Bid Price Now||Change %||Buy Limit|
|Buy||Silverlake Axis||SILV, SLVX, 5CP||Singapore||26/05/10||Report||S$0.29||S$0.345||18.97%||S$0.4|
|Buy||Hsu Fu Chi International||HFCI, HSFU, AS5||Singapore||08/06/10||#1||S$2.32||S$2.55||9.91%||S$2.85|
|Buy||Vitasoy International Holdings||345||Hong Kong||22/06/10||#2||HK$6.00||HK$6.20||3.33%||HK$7.00|
|Buy||ARA Asset Management||ARA, ARAM, D1R||Singapore||06/07/10||#3||S$1.09||S$1.15||5.5%||S$1.35|
|Buy||ICICI Bank||IBN||New York||20/07/10||#4||US$ 37.97||US$41.21||11.69%||US$44.4|
|Buy||Petra Foods||PETRA, PEFO, P34||Singapore||03/08/10||#5||S$1.44||S$1.46||1.39%||S$1.60|
|Buy||Sichuan Xinhua Winshare Chainstore||811||Hong Kong||20/08/2010||#6||HK$4.28||HK$4.25||-0.7%||HK$5.00|
(Singapore tickers vary between brokers. The three common ones are listed for each stock.)
Sources used in preparing this report: Sichuan Xinhua Winshare Chainstore - IPO prospectus 2007, annual reports 2007-2009, interim reports 2007-2009, regulatory announcements 30/07/08, 08/06/09, 29/12/09, 01/04/10, 24/04/10, 18/05/10, 22/06/10 & 28/06/10
Research note on company - OSK 29/09/08
Research note on company - OSK 11/06/09
Research note on company - Guoco Capital 12/06/09
Research note on company - Guoco Capital 23/06/10
Publishing's Shrinking Page - Caixin.com 11/01/10
Private education, changing needs - FT China Confidential 15/07/10
(loosely "Xinhua Winshare's skillful restructuring increases value by several hundred million renminbi in six months") - People's Daily Online 03/02/10 (Chinese language only)
Scholar calls for tough action to boost investment in Chinese education to 4% of GDP - People's Daily Online 21/02/10
Bank of Chengdu Logs H1 Net Profit of RMB 770 mln - Business China 17/08/10
Stock prices and data from Bloomberg
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