Mass Consumption Part 6B – How do you build the FedEx of China?

Last week, we discussed the economics of China’s express delivery industry. This week, we review their balance sheet to gauge who is likely to become the next UPS/FedEx of China.


Last week we discussed China’s rising express delivery market and how it has grown together with China’s massive online retailers. As a quick recap, in 2016, online retail sales made up 14.30% of China’s overall retail sales and for the express delivery industry, it delivered 27.9bn parcels and generated overall revenues of US$59.8bn.  chart (29)

With China’s express delivery market expected to double in the next five years, everyone is vying to become the UPS or FedEx of China.

chart (30)

When we reviewed the economics of China’s top express delivery companies and compared their margins and profitability to the top US operators like UPS and FedEx, we came away with mixed feelings (see full discussion here). While we were very positive about the express delivery market’s overall growth, we are concerned that competition from new operators vying for market share would compress margins.

Crunching the balance sheet

Embed from Getty Images

After having some time to digest our initial thoughts, we are still scratching our heads. Something is missing. Why is there such a big divergence in valuation?

chart (39)

One could argue that the high PE ratio of SF Express and Best (net loss) was because of companies sacrificing near-term earnings for long-term market share. But in order to emerge from this fight, you need to either have (1) strong underlying cash flow or (2) a strong balance sheet to sustain you for the long haul.

A look at another conventional valuation metric, price-to-book, shows an even greater divergence. To me, the 3.1x-7.0x price-to-book ratio that ZTO, FedEx, STO and YTO are trading at would be within my range of expectations. But what about UPS at 81.6x and SF Express at 11.3x PB?

chart (40)

Although labour costs is a major component of the express business but there are also a lot of hard assets as well. What about the trucks, the planes, the computer systems, the conveyor belts, not to mention the drones?

Embed from Getty Images

PPE make up 50% of US express company assets and only 13-28% for China

This is where we see one of the big differences between the US and China express companies. For UPS and FedEx, property, plant and equipment (PPE) was the largest component of their assets. Even after accumulated deprecation, PPE still made up around 50% of UPS and FedEx’s total assets. For the Chinese express companies, SF, ZTO and YTO have PPE around 26-28%. Best and STO’s PPE are only 13-15% of assets.

chart (41)

Since some companies sometimes classify their software as intangible assets, we further consider intangible assets and goodwill. Again, we see that UPS and FedEx are fairly close with intangible and goodwill making up around 14% of assets. Grouping PPE and intangibles together, we see that these make up around 65% of the US express companies’ asset base.

Need to buy more trucks and build more sorting facilities

For the China express companies, SF, ZTO and YTO are hovering around 39-45% but STO and Best are only around 20-22%. This suggest to me that if these companies want to institutionalize their business and expand their market share, more investments and capex is needed. They must buy more trucks, more planes, build more sorting facilities and build out their logistics network.

Embed from Getty Images

On this basis, it is no surprise that SF Express and YTO have higher PPE and intangible assets. Their revenues have already started to scale.

chart (33)

Capital structures reflect the early stages of investment

For the China express sector, one silver lining is that they appear to have anticipated this need and have already tapped the capital markets. As of June 2017, four of the five China express companies are sitting on net cash. Although SF Express had US$73mn net debt, its 2% net-debt-to-equity ratio suggest there is lots of scope for it to borrow.chart (42)

In comparison, given the relative maturity of FedEx and UPS business, their capital structure is optimised to boost ROEs.

Incumbents best positioned to become China’s UPS/FedEx

If we apply the filter of (1) normalised margins and (2) high PPE-intangibles, this would suggest that the two largest incumbent operators, SF Express and YTO, best resemble FedEx and UPS. That said, one would still have to decide whether the current PE ratios of 52.8x and 37.2x is too high a price to pay for that potential future.

Embed from Getty Images



Mass Consumption Part 6 – Getting your online purchases from Point A to Point B

Embed from Getty Images

Online shopping. This is the trend behind massive internet companies like Alibaba and Amazon. The picture above is from last year’s “Singles’ Day” sales event where Alibaba pulled in Rmb120.7bn of online sales just within 24 hours on November 11, 2016.

But behind the glamour of online shopping, there is a less glamorous but equally important service that drives this mega trend – express delivery. I have often wondered how the heck do they manage to ship goods so quickly. Didn’t I just click confirm payment yesterday and bam the goods are already at my home.

Here is a picture of how it happens.

Embed from Getty Images

China’s e-commerce expected to rise from US$2.8trn in 2016 to US$5.9trn in 2021

According to iResearch, the gross merchandise value (GMV) of China’s e-commerce market has increased 3x from US$988bn in 2011 to US$2,825bn in 2016. In the next five years, it expects the GMV of China’s e-commerce market to double to US$5,785bn by 2021.

chart (28)

Source: iResearch.

In terms of online penetration, online retail sales now account for 14.3% of China’s overall retail sales, a higher penetration rate than the 11.7% in the US.

chart (27)

Logistics and shipping are the new landlords

Intuitively, we know the draw of online shopping, namely, cheaper goods and greater convenience. But why are goods cheaper? One big reason is the removal of rental costs from the retail equation.

A while back, I came across an interesting illustration in the WSJ. Using a pair of US$150 jeans as example, the offline “bricks-and-mortar” retail sales would net US$24 after the various operating expenses, a net margin of 16%. By comparison, through the online sales channel, the residual profit is almost double that at US$45, or a 30% margin

Screen Shot 2017-09-29 at 1.04.56 pm.png

What was interesting in the illustration was where the two channels differ. As you can see from the above, there is no difference in Cost of Goods Sold and there is also no difference in Marketing expenses. Although there is no “Store Payroll” in the online sales channel, one could argue that the software maintenance operating costs is almost the same. Similarly, freight to retail store has been replaced by warehouse/fulfilment.

The key difference is Rent and other retail operating costs being replaced by free standards shipping and return. In the traditional model, rent accounted for 15% of sales and other retail operating costs made up 8%. In the online model, free shipping and return make up 7%.

What this cost comparison suggest to me is that in the new online environment, the shipping and logistics companies are the new landlords in the virtual distribution channel.

China Express Delivery Market – 27.9bn parcels and US$59.8bn

While China’s e-commerce has tripled in size over the past five years, its express delivery market has grown even faster. The number of parcels delivered has increased 7.5x from 3.7bn in 2011 to 27.9bn in 2016.chart (29)

In dollar value, China’s express delivery market has quintupled from US$12bn to US$59.8bn in 2016. According to iResearch, in the next five years, the number of parcels are expected to double, reaching 60bn parcels and US$124.5bn by 2020. Although these numbers may seem big, they are actually quite conservative if one were to consider that FedEx and UPS each generated revenues in excess of US$60bn last year.

chart (30)

Business model – Network Partner Vs. Direct Model

Unlike the US where express delivery is dominated by two players (FedEx and UPS), China’s express delivery market is more fragmented.

China’s express delivery companies tend to follow one of two business models, namely the network partner model or the direct model.

  • Under the direct model, the likes of SF Express and EMS (related to China post) manage the entire delivery channel from parcel collection to sorting to transportation to delivery.
  • Under the network partner model, companies like ZTO, YTO, STO and Yuanda only manage the centralise sorting and transportation. The last mile pick-up and delivery is left to smaller local network partners to handle.

chart (31)

Growing pie but profitability being squeezed by rising competition

Looking at the financials released by five express delivery operators, the pie is clearly growing. Among the likes of SF Express, YTO, ZTO, STO and Best, their collective revenue increased by 29.7% in 2016 to Rmb103bn and in the 1H of 2017, their revenues has grown another 30.6% to Rmb60bn.

chart (33)

Among these five operators, SF Express is the clear leader. In 1H 2017, SF Express earned Rmb32.2bn revenue, giving it a 54% market share among these five operators. YTO Express was the second largest revenue earner at Rmb8.2bn with Best Inc a close number three at Rmb8.1bn.

chart (34)

As with most things in China, if there is money to be made, competition will sniff it out. When we compare 1H 2017 revenue growth with 2016, only SF Express and Best Inc were able to accelerate sales growth. It is clear that Best Inc’s market share gain is coming at the expense of the other operators.

chart (35)

More worrying is the manner by which Best Inc is going after market share. In 2016, Best Inc’s gross margin was -6%, some 25pp lower than SF Express’s 19% gross margin.

chart (32)

With competition aggressively going after top line growth, profitability has suffered with four of the five operators showing a decline in 1H 2017 gross and net profit margins.

chart (36)

The other key notable from the above gross and net margin chart is the dispersion among operators. Gross margins range from ZTO’s 33% to Best’s -0.6%.

Comparison to FedEx and UPS

In order to gauge what longer term sustainable margins may be like, we turn to the US operators. As we alluded to earlier, FedEx and UPS generated revenues of US$60.3bn and US$60.9bn in their last financial year. This is roughly 7x larger than SF Express’ US$8.6bn 2016 revenues. From a market capitalisation perspective, UPS is nearly 72% larger than FedEx and 2.86x the size of SF Express.  chart (37)

From a profitability perspective, in their last financial year, UPS and FedEx recorded operating margin around 8.3%-9.0% and net margin around 5.0-5.6%. Among the Chinese operators, SF Express and YTO Express’ margins most resemble the US operators. SF Express had operating margin of 6.8% and net margin of 7.2% (it had some non-operating gains) while YTO Express generated operating and net margin of 10% and 8.1% respectively.

chart (38)

China express sector – Strong sales growth but margins likely to compress further

Based on the, we would come away with the following initial impressions:

  • (1) Strong top line growth for China’s express operator – China’s top express delivery operator, SF Express, currently only generate sales that is one-seventh that of UPS and FedEx. Given the expected rise of China’s overall economy and e-commerce, there should be ample runaway before China’s express delivery sector’s growth peaks.
  • (2) Margins likely to come down – Normally, in a fragmented market, one would expect strong competition and low margins to be the norm. However, in this case, China’s express delivery sector margins are much higher than the US duopoly. As new operators vie for a piece of the express action, margins are likely to come down. Among China’s express operators, only the two larger operators of SF Express and YTO Express have margins that resemble those of the mature US operators.



How to boost your memory?

Ten years ago, the first iPhone was launched. It had 16GB of storage and 128MB of Ram. Last year, when the iPhone 7 Plus was released, it offered 256GB of storage and 3GB of Ram. In the past 10 years, storage has increased by 16x while memory has risen 23x. In this post, we look into the memory trends from the perspective of one of the top 3 operators. Here’s a quick takeaway: (1) Volumes up 53-64% p.a., (2) prices down 23-29% p.a., and (3) manufacturing costs down 22-23% p.a. While the long term demand trend is up, with current margins more than double the long-run average, jumping in now is like buying the iPhone 7 just before the iPhone 8 is launched. You’ll get some enjoyment out of it but you may regret paying full price later on.

Ten years ago, Apple release the first iPhone and completely revolutionised the smartphone industry. But did you remember that when the first iPhone was released it only came with either 4GB, 8GB or 16GB of storage and its memory was only 128MB.

Embed from Getty Images

Fast forward to the present day. I don’t know what the spec of the iPhone 8 is but if you consider the iPhone 7 Plus, that had up to 256GB of storage and its memory was 3 GB. Its storage increased by 16x while its memory increased by 23x.

Here’s a safe bet, demand for memory and storage will rise

I’m not a tech expert but I think a pretty safe bet is that the demand for memory will only increase as our various gadgets become increasingly connected. Furthermore, as more and more computing and applications gets stored in the cloud, although the memory in your computer or smartphone may not rise, the storage in the cloud is being added.

According to the DRAMeXchange, the top three players in DRAM are Samsung (61.5% market share), SK Hynix (21.7%) and Micron (14.9%). In terms of NAND Flash, Samsung is also the leader with 35.6% market share, followed by Toshiba and Western Digital at 17.5% each. Micron holds a 12.9% market share in NAND Flash.

Although Samsung is the leader in both DRAM and NAND Flash, since its business also encompass mobile devices, consumer electronics and a bunch of other stuff, it is hard to dig out details on how the memory market has evolved over the past years.

For that, we turn to the #3 operator. Digging through the past 10 years annual reports, we learned a couple of interesting bits.

Volumes have risen by 53%-64% p.a over the past five years

The good news is that demand for memory has been strong. Over the past five years, the sales volume for DRAM and NAND memory have risen an average of 53% and 64% p.a.

chart (19)

Prices have fallen 23-29% p.a.

The bad news for memory makers (but good news for consumers) is that the average selling price for memory has been declining steadily. Over the past 10 years, the ASP per gigabit of DRAM and NAND have fallen by 23% and 29% p.a.

Put another way, if 1 gigabit of DRAM costs $100 in 2006, it now cost only $4.3 in 2016. Similarly, for 1 gigabit of NAND that costs $100 in 2006, it would now only costs $1.5. This is a cumulative decline of 96% and 98.5% for DRAM and NAND respectively.

chart (20)

Given how quickly prices have fallen, it’s good that demand/volumes have risen so fast, otherwise, it would have been hard for top line revenues to increase.

Costs to manufacture have also fallen steadily, down 22-23% p.a.

The good news for memory makers is that the cost to manufacture have also come down gradually. Going back the last seven years (as far as the data goes), we can see that the cost to manufacture one gigabit of memory has fallen an average of 23% and 22% for DRAM and NAND respectively.

That said, although costs have gradually fallen, prices have dropped faster. Over the past six years, if one were to compare the change in ASP versus the change in costs, there have only been two years when the change in ASP-change in costs have been favourable. chart (24)

So is it a good business? Average gross margins at 18%

Let’s weigh the pros and cons.

On the plus side, demand is strong. Demand has risen by more than 50% p.a. over the past 10 years. However, this demand does seem to be partly price elastic. As price falls, demand rise to mitigate the effect of the price fall. From an overall top down basis, we can see that net sales have grown 13% p.a. over the past 12 years. chart (22)

The key does seem to be gross margin levels. Given the volatile pricing environment, gross margins have oscillated from +33% to -9%. With an average gross margin of 18% over the past 12 years, one could make a case for reversion to the mean over time.

chart (21)

However, given the market is forward-looking, this would mean that perhaps the best time to look into the sector is when reported margins are below trend (18%) and the worst time to look into the sector is when reported margins are above trend. At the moment, margins are at historical highs with gross margins around 48% in 3Q 2017. Although it is always tempting to argue that “this time it’s different” and there are structural changes to the margins, those four words have historically proven to be very costly.

chart (26)

That said, if we consider that  over the past 12 years, the difference between year highs and year lows are 132%, and for 2017 to date, this memory maker has only increased by 43%, perhaps there is room for the current enthusiasm to run a bit hotter. I just hope it doesn’t melt the floppy disk.

Embed from Getty Images


Note: Source for all charts: Company data

Mass Consumption Part 5 – The Six Million Dollar Man

Do you remember the show “The Six Million Dollar Man”? His right arm, both legs and left eye were replaced with bionic parts. While there is still some ways to go until “parts” can get to those levels, knee, hips and other replacements are now becoming more commonplace. In this post, we look at where the two powerful themes of ageing population and robotics intersect.

China has an ageing population. Japan has an ageing population. Hong Kong has an ageing population. It seems like everywhere you look, the population is ageing. In absolute terms, China had 131mn people above 65 years old in 2015, some 9.6% of the overall population.

Screen Shot 2017-08-24 at 6.18.10 pm

Source: World Bank

Bringing this issue closer to home, as I get older and my parents’ generation gets older, I’m starting to hear a lot more about knee and hip replacements. A few years back, when my mother had back surgery, one thing that I was very impressed by was the speed of her recovery and how non-invasive the procedure was. I did not think much about it but I remembered the company behind the device they installed in her back to relieve the pressure on her spine.

Ageing population and robotics – How can you not love this theme?

Recently, this idea of medically-assisted robotics came back to me. When I think about robotics-related medicine, the first image that comes to mind is something like the following. It involves a shrink ray, a space ship and cancer cells being zapped by brave adventurers.


Source: Google images

The reality is actually quite different.

Embed from Getty Images

While fundamentals and valuations are important for investment decisions, you have to get people interested first. And as far as hooks go, I would suggest that the twin themes of “Ageing Population” and “Robotics” are tough to beat.

With that in mind, we begin our voyage to survey this landscape.

Who are the players?

The following is not a comprehensive list but they were some names that I consistently came across as I was going through the various annual reports. The one name that is omitted here is Johnson and Johnson. Since it is such a large conglomerate, to include it here would probably distort the picture somewhat.

chart (7)

In terms of market cap and net sales, Medtronic and Stryker are the two big guys. Medtronics has a market cap of around US$111bn and generates net sales around US$30bn. Stryker has a market cap around US$52bn and generates net sales around US$11bn. Intuitive Surgical and Zimmer Biomet are smaller niche players but their market cap of US$37bn and US$23bn is actually not that small at all.

chart (8)

What do they do? Robots, drills, scopes, knees, hips and dental implants

Among the four players above, Medtronics and Stryker have broader business interest. For Medtronics, it classifies its business into four segments (1) Cardiac and Vascular, (2) Minimally Invasive Therapies, (3) Restorative Therapies and (4) Diabetes. For Stryker, its three segments are Orthopedics, MedSurg and Neurotechnology and Spine.

For Intuitive Surgical, its business is mainly in selling and maintaining the da Vinci surgical system (pictured above). Notably, it makes 52% of its revenues from the sale of instrument and accessories while system sales only make up 29%. As for Zimmer Biomet, it specialises in musculoskeletal healthcare. They design and manufacture orthopaedics reconstructive products, dental implants and other related surgical products.

Basically, if you need any “parts” for your knees, hips, spine, jaw, skull, these are the guys that you turn to.

At the headline level, net sales growth have been impressive for these four players. But upon closer examination, much of this was driven by M&A.

chart (18)

If one were to look at Goodwill as a percentage of total assets, we can note that with the exception of ISRG (3.1%), the other three all carry goodwill that is around 30-40% of their total assets (Accounting note: Goodwill arises when you pay for more than the tangible value of assets).

chart (13)

The US make up 56-73% of net sales

From a geographic angle, the US make up the lion’s share of business. For ISRG and SYK, US sales make up nearly three-quarter of overall sales. Medtronic probably has the most global presence with the US only making up around 56% of overall sales.

chart (12)

Operating margins around 18-19%

For the two larger and more comprehensive players, Medtronics and Stryker, their operating margins have hovered around 18-19%. Zimmer Biomet appears lower at first glance but its operating margin is partly depressed by some merger related expenses. Adjusting for this, their operating margin would have also been around 18% as well. ISRG is the clear outlier here with its operating margin close to 35%. We suppose this may be due to its higher recurrent income as instrument and accessories sales and service for its da Vinci system make up nearly 70% of net sales.

chart (9)

SG&A as important as COGS

While cost of goods sold is obviously an important factor behind operating margin, the effort to sell and market these products are just as important. As the following chart shows, selling, general and administrative expenses (SG&A) account for nearly 33-38% of sales. Again, ISRG is an outlier as its instrument and accessories sales is recurrent in nature and hence needs less “push” out to their customers.

From a outsider and layman perspective, while the various products do a lot of good to improve quality of life and prolong general health among the ageing population, the medical technology and solutions business appears very competitive.

chart (11)

Research and development – around 5-8% of total sales

In order to stay ahead, one would either have to continue to innovate by investing some 5-8% of net sales into research and development or conversely, acquire smaller players and their innovative products.

chart (10)

Now, let’s see who can come up with the shrink ray first. I’m sure Gundam will come in handy when its time to battle cancer cells or to create some separation between L3 and L4.

Embed from Getty Images

Love-hate relationships – Airlines

I have a love-hate relationship with my local airline, Cathay Pacific. I used to be a big fan but my loyalty has waned. I still want to support my local airline but I don’t like how they changed the frequent flyer programme and how we are now all packed in likes sardines. As a traveller, that’s how I feel but if I were a shareholder, would my hate turn to love as the cost cutting effort start to pay off? With CX’s market cap at only a fraction that of its global peers, how much of the challenges from budget airlines, fuel costs are already factored into the price?

Embed from Getty Images

I have a love-hate relationship with my local airline. In the past, I was a big fan of Cathay Pacific. They were slightly more expensive but the service and amenities were much better than the competition.

But over the past few years, the relationship has changed. Firstly, they changed their loyalty programme, making it much harder to achieve any frequent flyer status unless you are a corporate traveller willing to pay full fare economy/business. Secondly, even when I have flown with them, I find that they have pared back their services so much that I wonder if they are worth it. Now, I am packed in like the sardines above and the food offering leaves a lot to be desired. It reminds me a lot of when I used to fly on US domestic flights. The flights were always full and people brought their own food on board.

But here is where the love-hate part comes in. Just because I don’t like the service, does it mean I should also dislike the stock? After all, if the airline is now cutting costs and becoming more efficient, is that not good for shareholders? It is a fine line because if consumers have other choices, then top line revenue may fall faster than cost savings.

How the greats have fallen – CX market cap

If one were to look at how far the likes of Cathay Pacific and Singapore Airlines have fallen you only have to consider their market caps. At US$6bn, Cathay Pacific’s market capitalisation is now less than a quarter that of the three big American airlines. Its market cap is also less than half of the three Chinese airlines, 30% smaller than Singapore Airlines and 25% smaller than Qantas.

chart (1)

Challenges – Competition, fuel and small markets

Now, there are real challenges facing CX which help to explain why it has fallen so far behind its peers. There is the rising competition from the budget airlines. There is the fuel hedge that has gone horribly wrong and there is also the fact that it serves a much smaller market.

Fleet size and average age – CX at 9.0, SQ and CA at 6.4 yrs old

One stat where this shows up is fleet size. At the end of 2016, CX had a fleet size of 189 airplanes. SQ is slightly smaller at 178 planes but just to CX’s North, the three Chinese airlines have an average of 640 planes. The three US airlines is more than double that at 1,356 planes.

What’s interesting is the average age of the fleet. I kind of guessed that SQ’s fleet would be very young at 6.4 years old. With China’s strong growth and acquisitive nature, it was also not a surprised that their fleet was only 6.1 years old. But I was quite surprised to see that Cathay’s fleet is now 9.0 years old. By comparison, although the American airlines have much larger fleets, they are much older with an average age between 10.3 and 17.0 years.

chart (2)

As consumers, we would of course prefer the newer plane. From a business perspective, although the newer planes offer better fuel efficiency, they cost money, lots of money.

Here I would suggest that one reason why the US airlines have higher market cap and higher valuation is partly due to their older fleets. First, the lower depreciation charge help to boost operating margins. Second, on a cash flow level, the more conservative replacement strategy has meant that Operating Cash Flows tended to exceeded capital expenditure. In other words, they are earning more cash than they are spending on new planes. Notably, Air China and China Southern, despite building up a very young fleet have also managed to keep Operating CF above capex.

chart (5)

On the flipside, we see that SQ and CX have operating CF that are 0.64x and 0.41x that of capex. As we alluded to earlier, part of CX’s problem is due to a fuel hedge gone wrong. This cost CX approximately HK$8.5bn in 2016 and if one were to exclude this loss, CX’s operating CF to capex ratio would be around 0.98x but still below 1.0x.

What about competition from budget airlines?

Relative to the US, budget airlines have had a much shorter history in Asia. So, in order to gauge their potential impact, we look to the US to see how they may have affected revenue growth and margin.

At a glance, we can see that in 2016, the three US airlines saw revenues declining by 2.68% on average. While revenues declined, the US airlines enjoyed the highest operating margin of 14.2%. This is even higher than the Chinese airline’s average operating margin of 13.0%. So while competition from budget airlines could lead to an overall decline in top line revenue, this suggest that profitability could still be maintained with greater efficiency.

chart (4)

Load factors and costs management

In order to dissect the efficiency issue further, we consider load factors. Is CX’s problem tied to too many empty seats or is it because its running costs are too high?

Load factor not the problem, CX packing them in like sardines

As the following chart shows, CX actually fills their flight as tightly as the US airlines do. In 2016, CX’s load factor (kind of like an occupancy rate) of 84.5% is only a little bit below Delta’s 84.6%. It is in fact higher than AA’s 81.7%, UA’s 82.9% and much higher than the Chinese airline’s 80.8% load factor.

chart (3)

If CX’s problem is not too many empty seats, are the budget airlines causing it to sell its seats too cheaply? This might be the case. When we divide total revenues by total passengers kilometres flown, we see that CX earned an average of 9.7 US cents per kilometre. Interestingly, despite the competition from budget airlines, the US airlines commanded an average of 11.2 cents per kilometre. The Chinese airlines are clearly competing on lower price with an average charge of 8.8 cents per kilometre. But if we were to compare CX to Air China, the price differential is not that big now at 9.7 cents to 9.2 cents, so the worst may already be behind it.

chart (6)

Operating costs are the key culprit

Where CX has lots of work to do is in cost cutting. If one were to look at operating expense per available seat kilometres flown, CX has got the second highest costs at 8.2 cents (SQ highest at 8.9 cents). Even if we were to exclude the HK$8.5bn fuel hedging loss in 2016, CX’s operating expense per kilometre flown would still be around 7.5 cents. This is lower than the US airlines but still much higher than the Chinese airline’s average operating costs of 6.2 cents.

You might not love it as a consumer…

Granted the Chinese airlines’ lower cost may be due to cheaper labour or landing fees but if CX is to compete against them as well as the budget airlines, they will have to continue to focus on reducing costs.

Unfortunately for the consumer, this means the cheap pastry meals are here to stay and may even be extended beyond the short haul flights. My guess is that CX will increasingly resemble an US airline. There will be more more ancilliary charges, limited inflight entertainment and older planes. Considering that the average fleet age for American, United and Delta is between 10 and 17 years old, beyond the planes currently on order, the average age for CX’s fleet appears likely to rise.

Embed from Getty Images

For employees, this is also bad news. Staff costs represents 21% of CX’s revenues and if the company is to try to restore profitability this is the one area that it can control. There is nothing that CX can do about its fuel hedge. Short term capex commitments are also already set. For CX to boost cash flow, it must turn to wages.

…but shareholders may hate it less

The only good news will be to shareholders. After suffering through a 50% correction in share price over the past two years, if CX is successful in restoring its profitability, its valuation gap should narrow with those of its peers.

Embed from Getty Images

As a CX frequent flyer, I don’t like the the changes that are coming my way. But as the saying goes, if you can’t beat them, you might as well join them.







From 50/50 to 59/41 – Return of the animal spirits

The Hang Seng Index has risen 25% in 2017 and is now within 3.7% of the 2015 peak. The market had been strong but how much of an outlier is it? When we look at daily performance, we find the HSI had risen 59% of the time with an average gain/loss ratio of 1.29x, putting it in similar outlier territory as 2015 and 2007.

Until very recently, Hong Kong’s 2017 stock market rally had been one of the most stealthy bull market in recent memory. As of  1 August, the Hang Seng Index had risen 25% and at 27,540, the HSI is only 3.7% below the 2015 peak of 28,588 and 13.8% below the all-time high of 31,958 that was reached on 30 October 2007.

Screen Shot 2017-08-03 at 12.42.26 am

3.7% away from 2015 peak, will the good times last?

As we approach the 2015 大時代 peak, we get the inevitable question about bubbles and whether we are due for a correction.

From a historical perspective, we can certainly appreciate where the concern is coming. In 2015, the Hang Seng Index had a blazing start, rising 21% by 28 April. Had the pace continued for the full year, it would have annualised to 63%. But the good times did not last. After peaking on April 28, the market corrected 23% the rest of the year and reversed the previous gains to a full year loss of 7.4%. Ouch.

Screen Shot 2017-08-03 at 9.37.58 am.png

So, what are we to make of this year’s (2017) strong performance? Is it a repeat of 2015’s roller coaster ride or is the current rally likely to prove more sustainable?

Until today, my gut feel was that it may have more room to run. Why? First, I think the market’s animal spirits feeds on recent peaks. Until 2015’s 28,588 peak is surpassed, I suspect Mr. and Mrs Wong are still sceptical. From a behavioural perspective, others have commented that one sign of bubble is when taxi drivers start to give out stock tips and people quit their day jobs to day-trade.

I read somewhere that in the US market, the number of days that the market goes up and the times that the market goes down is roughly 50/50. Although the odds are roughly even, the reason why the markets have tended to go up is because average gains have outweigh average losses and the compound effect leads to long-term cumulative gains.

3,922 up days and 3,633 down days since 1986

I wanted to see if the same held true for the local stock market. Looking at the Hang Seng Index’s performance since 1986, although the market had risen 9.7x, the number of up days versus the number of down days is almost 50/50. Specifically, there were 3,922 up days and 3,633 down days. This is a ratio of 51.9%/48.1%. If one were to consider the average daily movements, the average up day gain was 1.09% while the average down day loss was 1.08%, so again very  close to 50/50.

Screen Shot 2017-08-03 at 9.34.03 am.png

2017 has been an outlier – 59.4% Up Days and Gain/Loss ratio of 1.29

What about 2017? Well, in the 143 trading days this year, there has been 85 up days and 58 down days. This is a ratio of 59.4/40.6. Furthermore, when we consider the average daily movement, although the average gain on up days is only 0.57%, when this is compared against an average loss of 0.44% on down days, the gain/loss ratio of 1.29 is much higher the past five year’s average of 1.01.

Screen Shot 2017-08-03 at 1.05.08 am

Current rally as much of an outlier as 2015 and 2007

Clearly, the 2017 rally had been strong but how does it compare to the previous “bubbles”. In the more recent memory, there was the 2015 大時代 rally. Through the first 78 trading days of 2015, the index rose 21%. Over those 78 trading days, there were 49 up days and only 29 down days. While 2015’s up days ratio of 63% is 4pp higher than 2017’s 59%, the average gain/loss ratio was milder at 1.19x (0.77% average gain versus -0.64% average loss).

Screen Shot 2017-08-03 at 1.06.24 am

If one were to look further back, we saw an even more euphoric rally in 2007. Driven by hopes of a “through-train’ of China domestic investments, the Hang Seng Index had rallied by 60.7% through 30 October 2007 and reached an all-time intra-day high of 31,958. During this period, over the 204 trading days, the Hang Seng Index rose on 115 days and fell on 89 days. The Up days to Down days ratio was 56/44. Although this was milder than 2015’s 63/37 up/down days ratio, the longer duration of the cycle couple with an average gain/loss ratio of 1.20x helped to push the market up by 60%.

2017 less hot than 2005 and 2007

So if one were to consider the current market condition, we can see that 2017’s up days ratio of 59.4% is higher than 2007’s 56% but lower than 2015’s 63%. But from a daily percentage change ratio, 2017’s 1.29x ratio is higher than 2015’s 1.19x ad 2007’s 1.20x.

Screen Shot 2017-08-03 at 1.08.35 am

In the long run, reversion to the mean is likely but timing is anyone’s guess

In the long run, a reversion to the man is probably inevitable and the up day to down day ratio should probably trend back towards 50/50. But as one can see in the table above, that up days ratio remained elevated in 2006 (59%) and 2007 (56%) and only reverted back to 47% in 2008.

Be that as it may, given the combination of higher than expect win streak and higher than normal win ratio, it might be better to simply ride the current wave than to initiate new buy positions at this stage. Caveat emptor.




Mass Consumption Part 4 – Whassssup? Watching the game, having a beer

Whassup? During the summer, when it is scorching outside, there are few things better than an ice-cold beer. In Part 4 of our Mass Consumption series we review the state of the beer industry. But unlike the previous post, the Chinese beer industry outlook is not “whassup”. In fact, after peaking in 2013, Chinese beer consumption has fallen for three straight years and operating margins are less than half of global peers.



For those unfamiliar with the term, Whassup was an iconic beer commercial from the late 1990s. The commercial was so successful that for quite a while, everyone went around saying “Whassup?”. To truly appreciate the fad at the time, you have to go back and watch the commercial. (Youtube link here). It may appear silly now, but admit it, you said your fair share of “Whassup” back then.

As promised from my “Fried Chicken and Coffee” post, I was planning to do some work on the Beer industry but I did some initial reading, I I really did not feel a sense of urgency, hence the lateness of this post. To put it simply, the beer industry is not “Whassup?”

China beer production peaked in 2013

chart (9)

According to data from the National Bureau of Statistics, in 2016, China’s beer production was 450.6mn hectolitres. Beer production had peaked in 2013 at 506.2mn hl and has now fallen for three straight years and are now down 11% from the peak. This is very different from the other mass consumption themes that we had been talking about (i.e. ageing population, travel and fast food).

Volumes down across most major breweries

Looking into the numbers, this is not just a China phenomenon. Across the major international breweries, Heineken was the only one to report a growth in beer sales in 2016 (up 6.3%). The largest brewery, AB InBev (owner of Budweiser, Stella Artois and Corona) saw sales volume drop by 0.4% in 2016. Carlsberg’s sales volume fell by 2.8% while Tsing Tao’s declined by 6.6%.

Screen Shot 2017-07-19 at 3.24.21 pm

Craft beers and premium-ization

With overall beer consumption flat, in order to grow revenues, breweries have turned to craft and premium beers to try to boost overall ASPs. Next time when you order a Leffe or Camden Town, you are in fact ordering a cousin of Budweiser (so to speak). Here’s a table of the family of beers.

Screen Shot 2017-07-19 at 3.27.21 pm

For instance, did you know that Budweiser, Corona, Hoegarden, Boddington’s and Pure Blond are from the same family. Similarly, the Carlsberg family of beers include Grimbergen and Brooklyn Lager. And in the Heineken family, this includes Moretti, Sol, Anchor and Tiger.

Alcohol-Free and Ciders

In addition to premium craft  beers, another focus area for the breweries is the “low and no-alcohol” beer segment. AB InBev has set a goal to have low-and-no alcohol beers represent 20% of its global beer volumes by 2025. For Carlsberg, although Craft and Non-alcoholic beer only represent 5% of its beer volume, they make up 10% of net revenues. As for Heineken, the low-and no-alcohol segment represented 12mn hectolitres in 2016.

Margins are all over the place

While the beer industry’s growth profile is very different from the other mass consumption industries that we have reviewed, there is one aspect that is similar: Low China margins.

At 29%, AB InBev has the highest EBIT margin among the breweries. Heineken and Carlsberg are at 17% and 13% respectively. By comparison, the two Chinese breweries’ operating profit margin of 6% is less than half of their international peers.

chart (13)

Looking at the international breweries’ segmental results, China’s lower margin is not obvious. For AB InBev, although its Asia Pacific profit margin of 16% is well below those of Latin America, North America and EMEA, it is still more than double that of Tsingtao and CR Beer.

chart (12)

Interestingly, for Heineken and Carlsberg, their Asian operating margins are actually higher than those of Europe and the America. Of the three, Heineken’s 32% operating margin in Asia is the highest among our comparison group.

chart (10)chart (11)

Need to diet before I have a pint

Although overall volume growth has been anaemic, the sector has not done too poorly over the past 12 months. On a blended basis, the five beer stocks above are up 27% against their 52 weeks lows. But with current price only 8% below their 52 week highs, I feel that similar to my own situation, the stocks may need to go on a diet before they become attractive again.

chart (15)