Dream International (Dream) is a HK-listed producer of plush and plastic toys with factories in Vietnam and China. Dream has grown its revenues from 1 billion HKD in 2009 to 3.5 Billion in 2018 (13.3% 10y CAGR, 21% 5y CAGR) while maintaining Gross Margins of around 25%. Return on Net Operating Assets has fluctuated between 20 and 35%. I believe the ROIC is more likely around 30% once a new factory is up and running. (Rapid growth means a lot of new factories are still ramping up output.) The Plastics segment was the main growth driver. In 2014 the plastic toys were responsible for 200m in revenues, now it is good for 1.7B. Dream has recently started a new business segment, plastic dolls.
The toy manufacturing industry overall has the characteristics of a commodity business. There seems little pricing power and costs are mainly determined by labor and material costs (oil). However Dream has profited from a tremendous consolidation in the sector. In the annual report of 2008, Dream mentions that the number of toy exporting companies in China went down from 8,610 to 4,388. It has cultivated good relationships with some big customers (Disney, Oriental Land, Funko, Spin Master, …) It gets big volume orders which helps boost their gross margins. It also seems these customers are quite sticky. In December 2018, Dream signed a long-term sourcing agreement with a big existing customer. Dream has been quick in realizing the labor cost advantage in China would gradually disappear. They were pioneers in expanding almost all of the new capacity in Vietnam. Although a recession would be a headwind for Dream, the current trade war might prove a blessing. It produces most of the toys in Vietnam and prolonged tariffs might force the sector to consolidate even faster in Mainland China.
Risks
- Not sure it can pass on rising labor & material costs.
- High customer concentration: 4 biggest customers are 75% of revenues.
- The executive directors are getting old, so Dreams long-term relationships might be in danger. (The chairman, who is 70 years old, owns 67.5% of the business so might be willing to continue business development)
- Excess Capital allocation decisions. So far the company has a bad track record in allocating excess cash. In 2009, Dream lost money playing with derivatives. More recently Dream spent 200m HKD on real estate for their headquarters. The implied cap rate is around 2.5%, hardly a productive use of capital. They explicitly mention capital appreciation as one of the reasons for buying. So far Dream has reinvested most of the cash in the business but once growth comes down, cash needs to be returned to the shareholders.
- Corporate governance: There were some accounting issues. In 2011 they recognized some revenue which was subsequently delayed.
Valuation (see models below)
- Base Case
Dream had a hiccup during 2018 in terms of Gross margin (GM). They explained that they needed to redesign some new products which led to some delays. Also they offered special pricing in order to cement some long term relationships with clients. So I will assume that the GM will return to 27.5%. Operating expenses are clearly subject to economies of scale but let’s hold them steady at 11%. After 16.5% taxes, this makes for a 13.8% Profit Margin (PM), which seems very reasonable. Asset turnover (ATO) is historically quite steady around 2.5. In 2018, this has been influenced by the purchase of the headquarters. However I do believe that Dreams business might become a bit more capital expensive and so this will lead to a slightly lower turnover of 2.25. Dream has doubled its revenue in the last three years, so this might be a bit too conservative but I will go for an increase of 2B HKD in five years (10% CAGR) and then 3% in perpetuity. This results in a value of 9.16 HKD per share. (Technically it should be a little bit more because the historical ATO of 2.5 suggests less reinvestment needed in the first period.) Current price is around 4.3 HKD per share, which means there is 113% upside. This market price implies a 22.5% required return.
- Downside Case
There are few scenarios that I could think of in which Dream would not perform as well as in the base case scenario. The biggest risk is Gross Margin compression either due to material or wage inflation or due to pressure from customers to lower prices. In case Gross Margin drops to 20%, the Profit Margin would be around 7.5%. In this scenario, they might also lose a big client, which I simulated with a drop of 30% in volumes. Some of the operating assets will be worthless at that point so I wrote down 200m against the cash-flow that got released in T+1. This scenario leads to a valuation of 2.96 HKD per share. This is very close to Dreams book value.
- Bullish Case
A bullish case would cover all bullish scenarios at once. (Improving Gross Margin slightly, operating costs exhibiting economies of scale and Asset turnover increasing.) Let’s assume the GM to be 30% and operating expenses coming down 3 percentage points from 11% to 8% during the 5 years projection. This means we will start with a PM of 15.8% increasing to 18.4%. In terms of revenue, I choose to double the revenues over the period, this might prove to be conservative if they can find two more product lines or two more big clients. This would result in a valuation of 14.42 HKD.
Just to be clear. The Bullish case is an unlikely scenario, the same is true for the downside case. There will be plenty of new information points in the future which will guide into a more narrow distribution of outcomes as the company matures. If the bullish case is priced tomorrow, i do not want to keep any position. If the business is priced at 3 – 3.5 HKD, I will definitely buy more.
