Tuesday, September 2, 2014

Analysis of Biostime International (HKG:1112)

Please read the disclaimer here:http://greedydragoninvestment.blogspot.com/p/about-greedy-dragon.html. Enjoy the article, bitches!

Today I will be analyzing Biostime International. Biostime is a premium pediatric nutrition and baby care products provider in China. For the 6 months ended June 30, 2014, infant formulas contributed 84.9% of the company’s revenue. According to Biostime’s 2013 annual report, the majority of its products and raw materials are imported from Europe and the USA. I recently took a small position in the stock at Hong Kong Dollar (HKD) 33.85 per share when the stock was down around 10% during the day. The stock then proceeded to drop by about another 10% the next day. The stock currently trades at HKD 28 and, according to Google Finance, has a reasonable P/E ratio of 16.33. While it sucks that I missed out on a better deal by just a day, I understand that I can’t possibly time the market. I should be satisfied that I got a piece of a good business at what I think is a reasonable price. I can’t fathom how some people believe they can predict whether a stock will go up one day, one month or even one year from now. I mean I don’t even know who I’m going to have masturbatory fantasies about tonight, let alone what hundreds or thousands of people think the price of a stock should be next week.    

I really like Biostime’s asset-light business model and its strong brand that gives it pricing power. Property, plant and equipment made up only 5.89% of the company’s total assets as at June 30, 2014. For the 6 months ended June 30, 2014, Biostime generated 61.6% of its total infant formulas revenue from the high-tier segment. According to a survey conducted by Nielsen, BIOSTIME gained the No.1 position in the supreme-tier infant formula market in China in 2013, with a market-share of 27.7% in terms of retail sales (source: Biostime’s website).  These factors helped the company generate healthy annualized return on average equity and return on average assets of 24.70% and 11.28% respectively for the 6 months ended June 30, 2014. It is important to note that since the end of 2013, the company issued a large amount of zero-coupon convertible bonds. The carrying value of the convertible bonds was Renminbi 2.446 billion or around 38% of the size of the company's balance sheet as at June 30, 2014. Needless to say, the company’s ROA would have been significantly higher had it not issued the convertible bonds. According to this article on FinanceAsia, the convertible bonds were priced at a yield of 2.875% (mmmmm cheap financing, delicious!). If Biostime can reinvest the proceeds from the convertible bonds at returns on capital that it enjoys right now, then I believe it will create a ton of long-term value for shareholders.  The convertible bonds have an initial conversion price of HKD 90.84 per share.

 But it ain't all rainbows and sunshine (or donuts and ice-cream, as I would like to say). The company’s gross profit margin of 61.47% for the 6 months ended June 30, 2014 was below its 66.44% gross profit margin for the same period last year. I assume that this decline was a result of the company cutting the prices of its infant formula products to comply with China’s anti-monopoly law. For more information on the price cuts, you can view this Bloomberg article which was published on July last year. The price cuts would also explain why sales volume growth outpaced revenue growth for the infant formula division. The sales volume for the high-tier and supreme-tier infant formulas grew by 18.7% and 15.3% year-on-year respectively. However, revenue for the high-tier and supreme-tier infant formulas grew by only 14.7% and 4.3% respectively. Revenue from the infant formula division as a whole grew by 10.5% from the same period last year (which is still pretty good). Selling and distribution costs increased to 36.6% of revenue for the 6 months ended June 30, 2014 from 32.4% in the same period last year. According to Biostime’s 2014 interim report, “the increase was primarily as a result of (i) increased advertising and brand building costs for the promotion of Adimil, the Group’s new infant formula brand; and (ii) increased expenditure on the recruitment, training and other related costs as a result of the Group’s business unit restructuring”.

However, there are good things going on for Biostime as well. Even with the price cuts and higher cost structure, the company still generates good returns on capital. The company is still growing its sales volume of infant formulas at a healthy rate and the prospects for the industry seem decent enough. According to Nielsen, the China infant formula market will grow at a CARG of 14% in the next three years, reaching a market size of RMB100 billion by 2016 (source: Biostime’s 2014 interim report). I personally believe that people in China will become richer in the long-term and more parents with newborns will upgrade to better infant formulas. If this is indeed the case, Biostime will be attractively positioned as it’s already well-established as a quality infant formula producer.

 There is also the possibility of the ECB fucking up the Euro with their negative interest rates. A weaker Euro could result in Biostime enjoying a lower cost of goods and higher margins. I don’t count on the Euro dropping to make this investment work. But I understand that a weaker Euro could be a positive catalyst for Biostime.

As I mentioned earlier, I have a small position in Biostime. I might take a few more nibbles at the stock since it’s declined pretty significantly since I first bought it. But I don’t think I will build up a significant position until maybe the end of 2015 (assuming the stock is still reasonably valued). I want to wait for more financial reports to get a clearer picture on whether this company still has the potential to be a value creating behemoth.  I know it has been quite a while since I last posted an article. As usual, my time has been occupied playing video games (Fire Emblem: Awakening is my latest addiction). Well, I guess this concludes the article. I will now go back to training and marrying my characters in the game so that they will give birth to badass children. Thank you for reading. Take care and stay rational.  

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