AI #16: How you could make 150% in the Chinese Noodle Wars

Do you remember the British Cola Wars? During the 1990s, Coca-Cola and Pepsi Cola suddenly found themselves under attack from two upstarts: Virgin Cola and Sainsbury’s Classic Cola.For a while, the battle was fierce. But today, it’s as if it never happened.

Do you remember the British Cola Wars? During the 1990s, Coca-Cola and Pepsi Cola suddenly found themselves under attack from two upstarts: Virgin Cola and Sainsbury's Classic Cola.

For a while, the battle was fierce. But today, it's as if it never happened. When did you last actually notice the label on a bottle that wasn't Coke or Pepsi?

That's the strength of a top consumer brand. Once established, it's almost impossible to depose them. A deep-pocketed rival might make an impression for a while with heavy advertising and novelty but it's very hard to make it last.

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That's why spotting the great investments from the Asian consumer boom will be about identifying early on which brands are set to endure. Eventually, most consumer sectors seem to settle down into a near-oligopoly of a few firms with a huge stable of brands. If you think about soft drinks in the US, it's Coca-Cola, Pepsi and Dr Pepper Snapple. If you look at chocolate in the UK, it's Cadbury's, Mars and Nestl. The major players vary between markets, but the pattern is typically three-four heavyweights.

As we saw with the Cola Wars, this process is well advanced in the developed world. But there's a lot more to play for in developing markets such as China, where many industries haven't fully consolidated.

And that means that success in these markets can't simply be measured in terms of one year's earnings. It's more important to build and defend market share, and ensure that you're one of the long-term winners in a market that has decades of growth ahead of it.

That's what the stock I'll be looking at this week is doing right now. It's trying to fix some mistakes it made in the past to be certain of being one of the big players in the future.

But that's hurting profits and the market isn't keen on that. Its shares are down more than 25% over the last year.

But I think that's a very short-sighted way to look at it. This looks like a very good buying opportunity one that I think could double your money over the next two years.

The history of an expensive mistake

This recommendation begins with a failure. When Taiwanese companies were moving into China in the late 1980s and early 1990s, one firm looked well placed to dominate the enormous market for instant noodles. Uni-President was the leading food company in Taiwan and with its expertise and deep pockets, it should have had little trouble transferring that to the mainland.

But management miscalculated. They decided to run the China business from the Taiwan headquarters and didn't pay enough attention to local conditions. So when they tried to launch shrimp-flavoured noodles on the mainland at a slightly lower price than in Taiwan, for example, they made a big mistake. Neither the flavour nor the price was right.

This left an opportunity for rivals and in particular, a small Taiwanese cooking-oil company called Ting Hsin. Unable to beat Uni-President in Taiwan, Ting Hsin's owners, the Wei brothers, bet heavily on the mainland. Three of the brothers moved there and began developing their products based on what they encountered on the ground.

The gamble paid off. Today, Ting Hsin's China division Tingyi is the dominant player in instant noodles in China with a market share of around 56%, far ahead of rivals such as Uni-President, Hualong and Baixing. It's also a heavyweight in soft drinks. And as one of the few sizeable independent China consumer businesses, it's an investor favourite, trading on a 2009 price/earnings ratio of 36.

Tingyi has done extremely well it's undoubtedly a fine company. But it's not the subject of this week's recommendation. While it may sound surprising giving the history I've relayed above, I'm inclined to think Uni-President's China division (UPC) represents the better opportunity at the moment

UPC won't stay cheap for long

It took Uni-President a while to understand what it was doing wrong. And by that point, there was no chance of overtaking Tingyi. But it's still managed to build a sizeable business in China.

The firm is number three in instant noodles behind Tingyi and Hualong with a market share of around 9% at the end of 2009. That business is currently loss-making as it tries to gain further share, but the beverages divisions is earning healthy profits. UPC is number two behind Coca-Cola in diluted fruit juice and number two behind Tingyi in ready-to-drink tea.

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And while the firm's track record isn't as impressive as Tingyi or Want Want, another high-profile Taiwanese-owned food and beverage firm, it's still seen some good profit growth. Over the last five years, earnings have grown at an average of 29% per year.

So why then is UPC so much cheaper than Tingyi and Want Want? The stock trades on a p/e of 18.6 times 2009 earnings, against 36.7 for Tingyi and 38.4 for Want Want.

What's causing the difference? Well, earnings this year are going to be disappointing: analysts' consensus is for a fall of 16%, against a rise of 13% for Tingyi (and I think that could be optimistic). Unsurprisingly, the market isn't very happy about that.

But if we dig into the details, I think this may be a good thing. Let me explain why.

UPC goes on the offensive

If we look at recent results, we can see that UPC has delivered some solid profit growth, but has lagged on revenue. That average five-year compound annual growth rate of 29% for net income is in line with Tingyi and Want Want, but its average revenue growth of 9% is way behind (see chart below).

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The implication is that UPC hasn't been focused enough on chasing market share against rivals and is ceding ground. Yes, it's still getting good profit growth out of greater efficiencies and underlying market growth, but at this stage it's even more important to strengthen its position in preparation for the point when the industry consolidates. Obviously you still want to be profitable, but the goal is not to maximise short-term profits at this stage.

The good news is that management realises that they've been slipping up here. So over the past year or two, UPC has begun competing more aggressively on market share, especially in specific niches where it believes it can build a leading position. And the numbers suggest that they're doing well. Interim results showed revenues up 36% on the same period in 2009, with noodle sales up 53.5% and drink sales up 30.1%. That's substantially faster than the firm has managed at any other point in the last few years.

The downside to this is that it's pushed up promotional and marketing costs, and with this coming on top of higher raw materials costs, profitability took a big hit. Interim profits were down 30%, while profit for the first nine months which is not directly reported by the company, but has to be divulged by its parent under Taiwanese reporting rules seems to have been down 24%. Having been on a steadily improving trend, net income margin has fallen back to 4.8% from 7.75% the previous year.

The good news is that this should be short-term pain for long-term gain, strengthening UPC's market position. Obviously, rivals such as Tingyi and Coca-Cola may fight back with price wars and promotional drives of their own. But this trend should favour the biggest players in the long run, forcing out the smaller suppliers and accelerating sector consolidation around three or four top brands with UPC likely to be one of them.

While this is ultimately good for all the potential oligopolists, UPC probably has the most to gain from it in the shorter term. The company has already brought down its profit margins to gain share, putting the stock out of favour with investors. If it succeeds in this and net margins begin to pick up back towards the 7% area in the next couple of years, it will be doing pretty well against low expectations. On the other hand, if Tingyi wants to fight it all the way on market share, it will probably have to sacrifice some of its much fatter margins to do so.

And so UPC seems to me to have much more potential upside right now than more in-favour plays like Tingyi and Want Want. As we'll see below, if it gets things right I think the stock could double over the next one-to-two years.

But first let's take a close look at who owns the company

Why you can trust this Taiwanese titan

Uni-President China is a Hong Kong-listed company, having first floated in 2007. It's a spin-off from its Taipei-listed parent Uni-President, which remains the controlling shareholder. Management is headed by Alex Lo Chih-Hsien, the son of Uni-President founder Kao Chin-Yen, who is also a non-executive director.

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The second-largest shareholder is US investment manager T Rowe Price, followed by a large number of other institutions with small stakes. I know that Arisaig Partners, who are shareholders in our existing portfolio stocks Hsu Fu Chi and Vitasoy, also hold a stake; this is an encouraging sign from a governance point of view, since this fund seems to be closely engaged with what goes on at its investments.

I also regard UPC's Taiwanese background and the parent's long history as a positive for outside investors. As I've mentioned before, I prefer companies run by Taiwanese or Hong Kong management teams when it comes to investing in China, since corporate governance standards tend to be higher than in mainland companies.

Obviously this isn't universally true. There are perfectly legitimate mainland companies and plenty of extremely dubious ones from Taiwan. But there's little doubt in my mind that the overall standard is significantly better, thanks to a longer history of capitalism, better rule of law and different attitudes towards outside investors.

Clearly, with a single shareholder holding almost three-quarters of the company, the free float isn't enormous on a percentage basis, at under 10%. But this is a large stock by Asia Investor standards, with a market cap of HK$15.5bn and average daily volume of around almost 3.6 million over the past year. So by our standards, this is highly liquid and there won't be any limits on the size of the position you'd be able to take.

A few risks to remember

In addition to the usual risks with Asia Investor recommendations, I'd like to flag up the following:

First, like all food and beverage plays, Uni-President is subject to cost pressures from raw materials and wages and the more that it's focusing on market share, the less able it will be to pass these on to consumers. We saw this in the latest interim results, where gross margin dropped to 34%, from 42% in the same period last year.

This is principally a short-term risk rather than a long-term one. It can cause swings in earnings from time to time that may disappoint the market and lead to short term share price volatility. But over time, companies in this type of business have generally been able to pass on costs and maintain good margins.

The bigger strategic risk is whether Uni-President's current strategy succeeds in strengthening its market share and positioning it as one of the major players as its markets consolidate over the years and decades ahead. To be clear, I don't believe that the firm is going to overtake Tingyi or Coca-Cola for market leadership. But to be a well-placed number two or three in these long-term growth markets is still a very attractive proposition - and I think Uni-President has a good chance of doing that.

However, there is no guarantee of this. It might be that Uni-President continues to lose market share and is overtaken by other smaller players, until it lacks the critical mass and economies of scale to compete effectively. I think this is unlikely, but clearly not impossible. We'll have more visibility on this over the next year or so, when we see if the group has succeeded in regaining market share which is what its sales growth suggests.

Third, with a dominant majority shareholder such as UPC's parent, there's always a risk that it will act in ways that benefit it, but not minority shareholders. I don't see any history of this or any reason to suspect that it will be the case. UPC is a fairly straightforward, well-focused business. But obviously there is always a slight risk of this.

A potential 90-150% gain in the next couple of years

The table below shows recent results and my estimates for Uni-President China. FY2010 is now over, but we don't yet have the results for it, hence it's still an estimate.

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On a current price of HK$4.3, Uni-President China is trading on around 25 times my FY2010E (based on the current RMB/HKD exchange rate) but only around 13 times my FY2011E. We only have two years of dividend payouts to go by, but the firm seems to be targeting a payout ratio of around 50%, which would point to a prospective yield of 2% for next year and 3.8% the year after.

The balance sheet looks in very solid shape. UPC has no bank borrowings and cash on hand was RMB2.45bn as at end June. The current ratio (short-term assets to short-term liabilities) was two, above what would usually be considered necessary. Cashflow from operations has been consistently positive, as you'd expect in a business like this. That puts it in a good position to absorb the cost of its promotional push and still maintain dividends.

What's the potential for UPC if it recovers as I believe it can? In the past, the stock has at times traded on a p/e of 30 or over, like its peers. I think that if it shows the short-term sacrifice of margins for sales is paying off next year, it will rerate back towards that area. (As I showed in the last issue, history suggests that p/es of 30 or even 40 aren't insane for dominant consumer staples companies, although I confess I find it hard to buy a share on a multiple like that.)

Putting a multiple of 25 times earnings on my estimate for FY2011 would point to a potential price of about HK$8, or around 90% upside from here in a year or so. If we assume that margins can then improve a bit further to around 7-7.5% (in line with the 2009 results ) and put it on a similar p/e to Tingyi and Want Want (ie around 30), that suggests a more bullish case of up to HK$11, or about 150% potential upside over a couple of years.

That said, there is some uncertainty about this outlook. I think we already have some evidence that UPC can regain market share from its sales figures but it's less obvious how quickly and how far it will be able to bring up margins. So I'm going to set an initial buy limit of HK$5.70, which is equivalent to a p/e of 17.5 on my FY2011 estimates, and shouldn't be too much of a stretch even if margins remain much lower than I expect. I'll consider raising this when we have the results for the second half and can see what the trend in margins is.


Buy: Uni-President China Holdings

Ticker: 220

Exchange: Hong Kong (main board)

Market cap: HK$15.5bn

Bid/mid/offer prices: HK$4.31/HK$4.31/HK$4.32

Buy limit: HK$5.70

52-week low/high: HK$3.81/HK$6.00

UPC is listed on the main board of the Hong Kong stock exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. The standard lot size is 1,000 and most brokers will refuse orders that are not an exact multiple of this amount.

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Other updates

Before I go, one brief change to the portfolio stocks. Vitasoy has had a strong couple of weeks since the start of the new year, which has taken it through my buy limit. Consequently, it moves to a HOLD.

Thanks to all of you who completed the Asia Investor reader survey last week - if you didn't and you'd like to, there's still time to do so. The feedback was extremely helpful and I'll answer some of the main questions and suggestions that came up in the next issue.

There are also some recent updates from portfolio stocks to bring you. And if I have space, I plan to expand on the recent issue where I talked about the power of top consumer brands to look at some of the best-placed companies in Asia.