Towards the end of my trip a couple of weeks ago, I was in a shopping centre in Hong Kong. I was between meetings and badly in need of a quick snack. I fancied some toast with kaya (coconut jam) and when I saw the familiar sign of a caf chain known for this, I headed straight towards it.
I was highly disappointed. Not by the kaya toast but because I never got to taste it. The caf was so busy there wasn't a seat free anywhere. Business was clearly booming.
I dropped in on this chain several times in several cities along the way. And it was usually a similar story. Not quite as hectic most times I got served. But it was clear sales were very healthy.
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Now, this is a company I've had my eye on for a while. But I've never been convinced that it could spread far enough and get big enough to be worth our while. This time, though, seeing how many new outlets it had and how well they seemed to be doing, I decided it was time to take a closer look.
Why food stocks dominate Asia Investor
By now you'll have noticed that quite a number of stocks in the Asia Investor portfolio so far are food and beverage groups. Companies like snack maker Hsu Fu Chi, soft drinks group Vitasoy and chocolate specialist Petra Foods.
But that's a very much a deliberate decision. Firms like this are very well-placed to tap in to rising consumer spending in the years and decades ahead. As people become richer, they diversify their eating habits, buy more packaged and processed food and are willing to pay a bit extra for top brands.
In my view, this kind of firm has an almost unequalled ability to earn consistent long-term returns from the growing spending power of Asia's middle class.
This week's recommendation is related to the same story, but comes at it from a slightly different angle. It's a little riskier than the stocks above but its near-term growth potential is even greater. If all goes to plan, I think we could be looking at a gain of around 100-140% over the next three years.
Before I get into the details of this, I want to remind all investors in First Reit about the company's rights issue. At the end of this issue, there's a bit of background that should cover what you need to know about. If you've invested in First, I recommend that you read this carefully.
But first, the next Asia Investor stock
Let me start by explaining how radical changes in Asian eating habits are playing into the hands of this rapidly expanding franchise.
Cashing in on Asia's hungry shoppers
There are two main stories to get to grips with here. First, as you may well have seen if you've visited wealthy Asian countries like Singapore, Hong Kong and Japan, consumers there have a real appetite for baked goods. There seem to be almost as many bakeries as there are on the streets on Paris, although some of the recipes would leave a French boulanger in shock.
Take the pork floss bun: a sweet bun, filled with something that tastes slightly like mayonnaise and topped with meat that's been stewed and then dried until all the fibres come apart and it becomes fluffy. It actually tastes better than it may sound I really like them. But even if you don't fancy sampling one, pop into any Asian bakery and you'll quickly see how popular they are.
Still while fresh-baked buns aren't exactly luxury goods, they're the kind of thing you can only really sell on to urban consumers with a bit of disposable income. In fact, they're well suited to busy urban lives as a way to grab a quick snack on the go.
So unsurprisingly, bread consumption is much higher in developed Asia countries than in markets like China. But the emerging urban middle class in poorer countries is showing strong signs of developing the same tastes: the Chinese baking industry has been growing at an average 20% pace in recent years, according to data from JP Morgan analysts, citing the local trade body.
So that's the first part of this story. The second is understanding mall culture' and eating out in Asia. In Britain, most of us don't like to hang around shopping centres that much. Get in, buy what you want, get out. But in much of Asia, high-end shopping malls can be much more of a leisure destination.
And that applies to the food as well. I don't think anyone in their right mind has ever gone to a British shopping centre for a decent meal. But in a modern Asian mall, the food court often offers pretty good, freshly-cooked food in a wide range of different styles.
Perhaps even more surprisingly to British eyes, mall eating is not just stalls and canteen-style tables. Many expensive malls are also home to upmarket restaurant chains, sometimes even ones with a Michelin star.
Again, this is also a likely to be a good growth market in years ahead. Growing urban populations with more spending power will shop more and spend more time in malls. That will include eating in the food courts and dining out in the restaurants.
So these are the two themes that my recommendation this week taps into.
Sales are growing 27% a year
Breadtalk is a Singaporean firm that runs bakeries, restaurants and food courts in shopping malls. Founded in 2000 by husband and wife team George Quek Meng Tong and Katherine Lee Lih Leng, both experienced catering management executives, the firm has expanded rapidly over the past decade.
It's their strategy for expansion that appeals to me franchising a very popular brand across Asia's shopping malls and food courts. We've seen before how a powerful a top brand can be in powering growth. Hsu Fu Chi, Petra and Vitasoy have been able to establish a dominant position in their home territory, then use the expertise, networks and cashflow from that to roll out their key brand out to new consumers elsewhere.
And by choosing to franchise just as McDonald's or Burger King expanded Breadtalk can earn far higher margins as they grow. The advantage of franchising for growth in the catering industry is that it limits your risks: if a new outlet doesn't take off, it's the franchisee that takes most of the loss. That makes it a good way of expanding quickly into new markets and testing the waters. What's more, the firm can grow its network substantially with limited need for new investment and scalable, capital-light businesses are exactly what I like to see as an investor.
When it listed on the stockmarket in 2003, Breadtalk had just 22 bakeries in Singapore and a single franchise in Jakarta. This has since grown to over 400 outlets today, through a mix of direct ownership and franchises. It now operates in 13 countries across Asia and the Middle East, with the core markets being Singapore and China.
Incidentally, the rest of the world is more important to profits than its 7% slice of revenue suggests, because the majority of this is revenue from franchises. But Breadtalk doesn't break profits down by geography in the same way.
The firm has managed to combine that rapid expansion with a history of profitability, which isn't always the case when trying to grow quickly. It's made money every year since it was formed, except in 2004. From 2005 to 2009, revenues grew at 27%/year and net income by 81%/year.
Let's take a quick look at the firm's three main divisions and what they do.
Division 1 The successful bakery franchise
The eponymous Breadtalk bakeries and the Toastbox cafes attached to many of them are the heart of the group. In the first nine months of this year, they accounted for 45% of revenue and 35% of operating profit.
Having built a successful concept and brand in Singapore, the company is now mostly relying on franchising to grow the number of outlets and spread across the region, although it uses direct ownership in certain key foreign markets that it knows well, such as Shanghai and Beijing. As of end September, there were 354 bakeries, of which 142 were directly owned and 212 were franchises.
Division 2 A very profitable restaurant chain
Breadtalk's second division is restaurants, where there are three brands within the group at present, operating somewhat different strategies. First, it has the Singapore franchise for Din Tai Fung, an award-winning chain originally from Taiwan but now expanding across Asia. There are 8 restaurants in Singapore and the firm is also expanding into Thailand, with a first outlet now opening in Bangkok.
The company also has the master franchise for US burger chain Carl's Jr. in China and is currently opening its first three outlets there. Meanwhile, the third brand is its own label, a Japanese-style noodle chain called RamenPlay, which Breadtalk has developed in a joint venture with Japanese restaurant group Sanpou. This will initially be rolled out in Singapore and China and currently has six open outlets. Din Tai Fung is currently profitable, while the Carl's Junior and RamenPlay lines are still incurring start-up losses.
Restaurants are a higher margin business than bakeries, so as this division grows, so should Breadtalk's profitability. They're also more strongly exposed to the newly affluent, who are likely to dine out in premium restaurants such as Din Tai Fung more as their incomes rise. On the downside, higher-end restaurants are typically more cyclical: people cut down on restaurant spending when the economy slows much more than they do for snacks and fastfood.
Division 3 Chinese food courts
Lastly, the food court business which operates under the Food Republic brand began in China (it was an earlier business founded by the CEO which was merged into Breadtalk in 2004). The majority of its 30 courts are based in China, but it also operates five in each of Singapore and Hong Kong and one in Malaysia.
Under this business model, the company operates the overall food court and leases space to the individual stalls that prepare and sell the food. Rental income is part fixed rate and part based on a stall's sales. Breadtalk focuses mostly on higher-end malls in prime locations and appears to put a lot more effort into dcor and ambience than many other food court operators.
That's the business today what of the future?
1,000 bakeries in the next 4 years
Breadtalk has grown strongly from the outset, but the management have ambitious plans to expand, involving more than doubling the number of outlets in each division. First, it hopes to have 1,000 bakeries in the next 3-4 years, with most of that growth coming from the franchise model.
Second, it plans to have around 80 food courts over the same period. Most of this expansion is likely to be in China. And third, it hopes to have around 200 restaurants, probably over a slightly longer period. This should include rolling out Carl's Junior across a number of Chinese cities and franchising its own RamenPlay brand widely, especially in Singapore and China.
These are ambitious plans and there is no certainty of success. I would be inclined to regard the restaurant expansion as the most likely to fall short, since much of this is less tested than the Breadtalk and Food Republic businesses: Carl's Junior is late to China compared to other major American burger chains, while the RamenPlay brand has yet to be established anywhere.
On the plus side, my perception is that Breadtalk has generally met or exceeded its targets in the past. And the intelligent use of franchising should mitigate some of the risks that come with rapid expansion.
Most importantly, the firm has an experienced management team with a track record of success. Let's take a closer look at the owners.
A smart and prudent family-run business
The founders continue to own the majority of shares in the business, as the table below shows. Chen Kuo Hua, who holds a smaller stake, is a non-executive director who formerly worked in management in the food courts division and with the founders in Taiwan before Breadtalk was set up.
As I always note, there are risks and advantages to investing in a family- or founder- controlled business. On the plus side, management's personal wealth is likely to be tied up in the business, which should encourage them to take a prudent, long-term view. On the downside, the presence of a controlling shareholder can lead to corporate governance abuses that damage the interests of minority investors.
Ideally, I like to see a significant holding from an activist fund as evidence that there's someone on the roster to watch out for outside shareholders' interests: there are a handful of names that I look out for particularly in Asian small caps. Unfortunately, I don't know a great deal about Keywise Capital Management, but I am aware that it's a Hong Kong-based small cap specialist that runs several Asia and China focused funds, so I think it's likely that it's this kind of investor.
There are smaller holdings by a number of institutions, including Wasatch, a US-based small cap specialist. The independent directors include a lawyer at a leading Singaporean firm and a member of parliament. And from reviewing the company's history, I don't see any obvious red flags, so I am reasonably comfortable with the governance situation here.
Average daily volume in Breadtalk is around 500,000 over the past year, although I think that includes a number of block trades: a more representative average would probably be around 200,000. This should be plenty of liquidity for the average private investor. Judging by Bloomberg data, the free float is around 25%.
A few risks to keep an eye on
In addition to the usual risks of investing in the shares recommended in Asia Investor, I'd stress the following for Breadtalk:
First, the company's ambitious expansion plans create a clear risk of execution problems. Management's track record and franchising strategy mitigate this somewhat. But there are always risks that the firm could overstretch in some ways.
For example, earlier this month, the firm disclosed an apparent staff fraud in a Malaysian subsidiary. Such problems can crop up from time to time in any firm but could conceivably indicate inadequate internal controls as a result of rapid expansion.
Second, as with all our food and beverage plays, Breadtalk is exposed to changes in the cost of raw materials such as flour and cooking oil. The firm is also vulnerable to rising labour costs and indeed reports pressure on wages in the China operations at present.
When input price increase, its margins will be hurt unless it's able to pass on higher costs through prices rises or bring down costs through other means such as bulk purchasing or efficiency gains.
On the plus side, Breadtalk has kept gross margins in a relatively stable range (54%-56%) in the past five years. This suggests that it operates good cost control strategies and is well placed to deal with such price pressures.
Third, Breadtalk operates in an industry that is highly fragmented, with many small players and a few larger peers in most of its markets. Competition is tough. Barriers to entry are low, especially in bakeries, although slightly higher in food courts by virtue of limited locations and higher-end restaurants. And in China in particular, a number of other domestic and international chains are also expanding quickly as they try to establish a leading position in this potentially enormous market.
Successful firms will need to establish strong brands, keep refreshing what it offers so that customers don't become bored and maintain high quality standards. Breadtalk's management have shown vision in finding ways to make their business stand out: notably the use of glass-fronted kitchens at its bakeries that lets customers view the baking process, which both helps attracting interest from passersby and reassuring shoppers about food hygiene (which I believe is a particularly strong selling point in China).
Fourth, there is economic risk. A prolonged slump in its markets especially China at a time when the firm is expanding quickly could be very damaging. The expansion plans into the more cyclical restaurant sector increase this risk. That said, its established Singaporean operations should provide some protection against the risks in its fast-growth markets.
On the basis of my valuation, we will also be getting that growth at a very reasonable price
Why there's potential for 140% gains
The table below shows recent results and my estimates for Breadtalk. As you can see, this year's profit will be depressed on account of the start-up losses at Carl's Junior and RamenPlay, write-downs on closing two loss-making food courts in China, and a provision for loss on the fraud in Malaysia. Generally, while Breadtalk has shown strong long-run growth, this growth has been volatile on account of the timing of expansions and associated costs.
Income should recover sharply in 2011, although the size of the rebound will depend somewhat on the timing of new outlet opening and how long the Carl's Junior and RamenPlay start-ups take to break even. (The fact that EPS for this year is likely to be lower than in 2008 while net income is projected to be higher is because the firm did a bonus issue of shares to existing shareholders earlier this year to increase the number of shares in issue and hopefully boost liquidity.)
The stock currently trades on around 13 times my estimated earnings for next year, which doesn't seem excessive given its track record and prospects. Although you don't look towards a growth story like this for income, it has been paying a small dividend since 2007; last year's was S$0.01, amounting to a trailing yield of around 1.6%.
The balance sheet looks in reasonable shape to support growth. The total debt to equity ratio was 27% as at end September and the company has held it in a 25-30% range since 2007. Interest coverage (the ratio of earnings before interest and taxes to interest expense) in the first nine months of the year was a very comfortable 19. Operating cash flow is consistently positive and the company had a cash balance of S$55m as at end September.
One thing that might stand out though is that Breadtalk has a current ratio (current assets to current liabilities) of 0.89. A current ratio of under one is often a warning sign that the firm is struggling to pay its bills, piling up unpaid liabilities at its suppliers. While it varies between industries, a ratio in the range of 1.2 to two is usually considered desirable.
So is this a sign of financing issues? No. For cash businesses such as restaurants and retail, it's not uncommon when they're expanding quickly: because their customers pay upfront, they will have received cash for the goods they sell before they've even paid their suppliers.
MacDonald's' current ratio was never above 0.8 from 1987 (the earliest results I can get) until 2005. Tesco notorious for its ability to squeeze suppliers for longer payment terms has never had a current ratio above 0.75 in the 23 years of results I have, and ran one below 0.4 for much of the 1990s. So given that Breadtalk's balance sheet looks fine in other respects, this does not look like a red flag to me.
So what about my valuation of this firm? Initially, I'm going to value Breadtalk on a p/e of 15 times my base case for FY2011 so a buy limit of S$0.72.
This may look a little low given the kind of growth potential that I've suggested the firm has. And it's a marked discount to Hong Kong-listed stocks such as Caf de Coral. This firm is perhaps its closest peer, running fast-food restaurants and bakeries across Asia, with a particular focus on Hong Kong and China. It trades on a forward p/e of 19-20 times.
But even though Breadtalk's track record so far is good, there is clear execution risk in its expansion plans. So it makes no sense to pay this kind of valuation: Caf de Coral is a significantly larger firm, with slower but steadier growth. A multiple of 15 times is quite enough for Breadtalk at this stage.
But if the business grows as hoped, I think earnings could be around 6.5-7.5 Singapore cents per share in FY2013. The company would be around twice the size it is today and in my view would likely trade on a higher multiple of 20 or so if its growth prospects continued to look strong.
So on a price of around S$1.30-S$1.50 then, representing a potential three-year price return of around 100-140%, looks quite achievable although I need to stress again that this comes with slightly greater risk than usual for Asia Investor.
Recommendation
Buy: Breadtalk Group
Ticker: BREAD (Bloomberg), BRET (Reuters), 5DA (SGX and many brokers)
Exchange: Singapore (main board)
Market cap: S$178m
Bid/mid/offer prices: S$0.62/S$0.63/S$0.63
Buy limit: S$0.72
52-week low/high: S$0.43/S$0.72
Breadtalk is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.
First Reit rights issue: important information
Before I finish this week, I want to go over some of the details of the announced rights issue in First Reit. If you've invested in this stock and you're not familiar with dealing with rights issues in foreign shares, please read this following carefully.
As I mentioned in my last email, First Reit has agreed to acquire two new facilities in Indonesia from its sponsor Lippo Group: a general purpose hospital and a specialist cancer centre. We already knew about this deal it's been in the pipeline for a while (please check my original report for the full background on the properties).
The deal looks to be slightly more favourably priced than I anticipated. The total cost should be around S$210m, marking a combined discount of around 15% to the properties' assessed value. This should ensure a solid boost to First's yield.
According to the company's figures, had the acquisition and rights issue taken place at the start of last year, the FY2009 payout would have been equivalent to a yield of 8.83% compared with an actual yield of 8.02% (based on the unit price as at the start of November). So I view this as an attractively priced deal. As discussed in my original report, I hope First should continue to profit from similar yield accretive deals with its sponsor in future.
First will be funding this through a five-for-four rights issue, priced at S$0.5/unit. That's a discount of 48.5% to the current unit price. The theoretical ex-rights price or TERP (the price at which units should trade when the issue is completed and the new units issued) is just under S$0.71 (based on the current unit price)
How a rights issue works
In a rights issue, existing shareholders are granted nil paid' rights. Nil paid means that the right to subscribe for the new shares is being sold without the necessary payment for the shares being made: in other words, on exercising the rights, they will need to pay the issue price (S$0.5 per new share, in this case).
Shareholders can choose to take up their rights and pay for the new shares. Alternatively they can instruct their broker to sell the nil paid rights on their behalf at any point during the nil paid rights trading period (which will be 8 th December 16 th December in this case). If they do neither, the rights will be sold on their behalf and they will receive the proceeds of this sale, less costs.
The value of the nil-paid rights depends on how much demand there is for the rights issue. But assuming it's fully subscribed, it should be roughly equal to the theoretical ex-rights price, less the issue price.
A shareholder's financial position immediately after the issue is approximately the same whatever they do. If they take up the rights, they own an increased number of shares at a lower average price, which should be close to the TERP of S$0.71, assuming nothing happens to move the share price does not much in the meantime.
If they don't take up the rights issue, the value of the existing shares is obviously diluted: they will drop from S$0.97 to around S$0.71 (in theory) after the rights issue is completed. But shareholders should receive a payment that works out to roughly S$0.26 per share (before costs) for the nil-paid rights, which of course is equal to the difference between S$0.97 and S$0.71.
There is also technically an option to renounce the rights. In this case, the holder receives no new shares and no payment for the nil paid rights. So their existing shareholding is diluted, the price of the shares falls to around S$0.71 after the rights issue is completed and they receive no compensating payment. Clearly, this is almost never a good idea.
I continue to rate First as a Buy at present. For portfolio purposes, the formal recommendation is to take up the rights issue was taken up and the purchase will be adjusted on the basis that this is done.
Whether the best option for those of you who are invested in First is to take up the rights or sell them depends on individual considerations such as how much of your portfolio should be allocated to First. I'm not permitted to provide individual advice on that and if you have any doubts as to what you should do, I can only recommend that you consult an independent financial advisor.
Make sure your broker knows what they're doing
However, a couple of readers have mentioned to me that their broker seems to be struggling to deal with a rights issue in a foreign stock. In particular, this section in the announcement seems to be causing some confusion:
The Rights Units will be issued to eligible Unitholders, being Unitholders with Units standing to the credit of their Securities Account and whose registered addresses with The Central Depository (Pte) Limited (" CDP ") are in Singapore as at the Rights Issue Books Closure Date or who have, at least three Market Days10 prior to the Rights Issue Books Closure Date, provided CDP with addresses in Singapore for the service of notices and documents and such Unitholders who the Manager, on behalf of First REIT, and in consultation with Oversea-Chinese Banking Corporation Limited and Credit Suisse (Singapore) Limited, as the joint lead managers and underwriters for the Rights Issue (the " Joint Lead Managers and Underwriters "), in its sole discretion determine, may be offered Rights Units without breaching applicable securities laws ("Eligible Unitholder")
This doesn't mean that the rights issue is only available to Singapore residents. The condition is that the CDP (Singapore's securities depositary, which keeps records of who owns which shares) needs to have been provided with an address in Singapore to which relevant documents can be sent at least three trading days before the closure date (which is 5pm on December 3 rd).
Having a local service address is a standard condition with rights issues in Singapore and many other markets. Usually, the announcement makes it clear that this is to make dealing with paperwork practical, but for some reason First left out this explanation. Your broker's local office or partner's office in Singapore is perfectly suitable for this purpose.
In my view, any broker who deals foreign shares should be familiar with this process and know what to do to ensure that you're on the books. But since it sounds like some UK brokers aren't as efficient with this as they might be and I can't speak for which of them will handle it flawlessly and which won't.
So it's worth making sure everything goes smoothly. If you have shares in First and wish to take up the rights, I recommend that you call up your broker to check exactly what you need to do and how they'll handle it.
The obvious question now is: What happens if the CDP doesn't have a service address for you? In that case, you won't be allocated rights. But you shouldn't lose out financially.
Rights that would otherwise be allocated to foreign shareholders who don't provide a service address and so can't be allocated them will be sold nil paid' on the market. The proceeds from this - less costs - will be paid to the foreign shareholders. So they will be in the same position as someone who gets their rights entitlement allocated but chooses to sell the rights or allow them to be sold on their behalf.
I hope this clarifies the background. But if you are uncertain about what your broker will do, I recommend you contact them to check.
