I already mentioned in my previous post that it was my intention to sell the remainder of my Allan International position soon, and that’s exactly what I did today. Including dividends the stock returned 17.5% in a bit more than one and a half years. Not bad, but not good either compared to the overall market or my own performance. But you can’t get it right every single time, and making mistakes is part of the learning process. But luckily making mistakes in investing doesn’t have to be costly. Not just because you can do something stupid and get lucky, but mainly because the market is often approximately right about the fair value of a company. Buying something that you think is undervalued but is actually reasonably priced isn’t going to cost you in the long run.

Disclosure

No position in Allan International anymore.

Investigating an unknown company is a lot more exciting than reviewing an existing position, but the latter is probably more important since it’s about something you actually own. I have been a  shareholder of Allan International Holdings (0684.HK) for a bit more than a year, and the company and it’s intrinsic value haven’t remained static in this time. My own knowledge about valuing companies is also growing and changing. If you checkout my original write-up on the company you’ll see that it’s a bit superficial. So a good time to start fresh and see how I think about Allan International today.

Historical performance

Allan International makes household electric appliances like kettles, mixers and blenders. The company is based in Hong Kong and has it’s manufacturing facilities in China. They are in a competitive business and produce a true commodity product: there is no competitive advantage here, the only thing that matters is efficiency. Let’s take a look at the data first:

As is visible in the table above the historical performance of the company has been excellent on average, but revenue growth has stalled since 2011 while gross margins also show a downward trajectory since 2010. Despite the fact that revenue has been flat the company has invested heavily in new manufacturing capacity: the amount of PP&E on the balance sheet is up roughly 67% since 2011. Another noteworthy development on the balance sheet is the investment property the company bought last year and the bank debt related to this purchase. Despite the use of debt the liquidity position of Allen International remains extremely healthy with a net cash position of HK$207M.

Valuation

The Allen International valuation puzzle has three pieces: the value of the investment property, the net cash balance and the value of the operating business. The first two pieces are straightforward to value: the cash and the investment property can both be valued at book value. Maybe a haircut for the investment property is appropriate. The value is appraised for every financial report, but you never know what the true value is until it’s sold again, and I’m always a bit distrustful when I see valuations adjusted upwards.

Simply taking the TTM Adjusted EBIT figure from the table above as a normalize pretax earnings figure seems a reasonable shortcut (it’s between the 5 year and 10 year average). The effective corporate tax rate in Hong Kong is a bit below 20% (based on the reported income tax expense), so this would give us an earnings figure of ~HK$100M. Throw a 8.5x no-growth multiple on that and we would get the following valuation:

• Cash: HK$207M
• Investment property: HK$220M
• Operating business: HK$850M
• Total: HK$1277M

The current market cap of Allan International is HK$711M, so it still seems that the company is cheap. If you deduct the value of the cash and the investment property from the market cap the effective P/E ratio is less than 3x.

This was more or less the valuation approach I used in my original write-up, but it does have a flaw. Net book value for the operating business is HK$532M and this is significantly less than the valuation based on the earnings potential. Given the fact that Allen International is active in a competitive commodity business it doesn’t make much sense to value the company above book value, and since a lot of PP&E is fairly new there is probably also not a big difference between accounting value and economic value.

While I don’t think Allan International deserves to trade at a significant premium to book value I also doubt that a large discount is appropriate. The current return on equity is still a respectable 14%, and the company pays out roughly 40 percent of it’s net income as a dividend to shareholders (tax free: there is no dividend withholding tax in Hong Kong).

Conclusion

I still think Allan International is undervalued, but I don’t think it’s such a great deal as I originally thought one year ago. A valuation around book value seems more reasonable to me. Based on current and historical earnings the business is a steal at today’s prices, but don’t think you can justify a big premium above book value. This means that my estimate of intrinsic value is around HK$2.86/share, or 34% above the latest share price.

Combine this with, what looks to me, good corporate governance, high insider ownership and a big dividend and you still have pretty decent investment. But at the same time the company is not as cheap as I would like. If I didn’t already own it today I doubt that I would buy it today, so this means that Allan is moving up on the list of things to sell if I need cash.

Disclosure

For now still long Allan International Holdings

Another of my favorite idea’s is Allan International Holdings Ltd (0684.HK). The group is engaged in the design and manufacturing of a wide range of household electrical appliances such as blenders, mixers, deep fryers and kettles.

Some key statistics about the company:

Last Price: 2.21
Shares outstanding: 335.43M
Market Cap: 737.95M
Trailing P/E (ttm): 4.53
Price/Book (mrq): 0.9
EV/EBIT: 2.2

All amounts in this write-up are in HK$, so it’s actually a pretty small company with a market cap just under 100M USD. The company is controlled by the Cheung family that owns 60%, and has been a net buyer of shares over the past years. I don’t have any special insight on the workings of the company, growth prospects, and the small appliance industry, so I thought it is best to just look at past performance. For some insights on the competitive advantages of the company and margin sustainability I recommend you to read the write-up on VIC.

The company has been very profitable the past 10 years, and seems to be growing at a healthy rate: not what you would expect with a 4.5x PE ratio. On average 50 percent of the income goes directly towards shareholders, giving it currently a dividend yield of 9.5 percent, already a nice return. With investing in companies in a far away country seeing a healthy dividend stream is especially a good sign because it basically means that the cash flows reported by the company have to be real, and we are not looking at a fraud.

When we look at the assets on the balance sheet the company appears even cheaper. It currently has 316M in cash on the balance sheet: almost 43 percent of the total market cap (small part of that has been used to pay the latest dividend). If we would subtract this from the market cap and adjust the PE ratio for the cash on the balance sheet we would get a PE of just 2.6x. The business looks to be priced as if it’s heading towards extinction, while the numbers show a growing and profitable business.

There are of course some risks to the investment, but I have been unable to find anything on the company that would warrant such a low valuation. The company has not reported anything material since the release of the latest annual report (7 June 2011), and on Google, Yahoo Finance and Reuters there is no news worth mentioning. There are some risks though that do warrant some discount:

• The customers of the company are very concentrated. The largest five customers account for 94% of all sales while the biggest customer is good for 45% of all sales.
• The Cheung family controls the company, and the other share holders don’t have a strong position.
• The products the company produces are commodity products: competition is intense, and competitors might emerge that are able to produce the same products at a lower cost.
• The macro-economic outlook, especially for Europe, has worsened throughout this year, and consumer demand and thus sales, will probably fall if we enter another recession. Europe accounts for 54% of sales, Asia 27% and America for 14%.

A positive note is that David Webb is a big share holder owning 10% of the company. He is a well-known activist for shareholder rights in Hong Kong, and the wikipedia article about him also notes that he seems to be a capable investor:

From 1999 to 2008, Webb made an annual Christmas share tip where he recommends a single undervalued but well-run company. His picks are believed to have strongly influenced the price of selected stocks. However, The Standard criticised Webb after reporting that he himself owned holdings in his own Christmas share tip (which he has always disclosed), in one case giving himself almost a 40% unrealised profit on his holdings the following day after the tip was published. In December 2009, he announced an end to the “Christmas Pick” after a 10-year run in which they returned a cumulative 1118%, compared with an 87% return in the Hang Seng Index over that period., saying that the success of the picks “has become something of a distraction” to the main goal of raising the standards of Hong Kong’s corporate and economic governance.

Conclusion

Allan International seems to be a hugely undervalued company, and to be honest; the biggest risk I see is that I’m missing something. Sure it’s small and not followed by any analyst, but is that enough to explain the current valuation? The balance sheet and income statement of the company are pretty straight forward and easy to understand.

That said: I do have to put some faith in my own analysis and Google skills. If we would be conservative, and apply a 10x multiple on the average earnings from the past 5 years (basically giving no value to potential growth, and discounting the growth in the past two years) we get a share price of 3.53. If we add the cash on the books to this value, we end up with a share price of 4.41: a double from current levels and if the company continues to grow it should actually be a lot higher.

A slight negative is that the company only reports results twice a year, but next month the Interim Report for 2011/2012 should be released. That should confirm if we missed anything, or not.

On a scale from 1 to 10 I give the stock a 8.5; there are some risks and uncertainties, but it’s ridiculously under priced giving it a wide margin of error and I really like that a large part of the income goes towards paying the shareholders a dividend.

Disclosure

Author is long 0684.HK.