A lot of companies have announced their full year earnings in the last few months. I have been updating my own models but never got to actually publishing updates on the companies I have written up before.
In the meantime, I have been thinking a lot about how to deal with the effect of the Corona-virus on valuation. On the one hand, one could argue that the effects will most likely be transitory and we should normalize earnings for this. On the other hand, some companies have been so heavily impacted that they look completely different from 5 months ago. Since I weigh stocks in my portfolio on a relative basis and every company has been impacted differently, I can’t exclude the Corona-virus impact.
Today, we start with Dream International (1126 HK). I had the privilege of meeting a fellow value investor who contacted me through the blog. He was very knowledgeable about Dream’s business. Some of his insights and comments have definitely influenced my valuation. Let’s start with the report.
Revenues grew by 12.9% to HK$3,991.8M. Gross Profit margin recovered from last year to 23.6%. Profit attributable to equity shareholders soared by 43.6% to $HK432.2M. This implies a net profit margin of 12.0%. I have updated the historical data and this is how the valuation drivers look.
As you can see in the charts above, Dream has been very successful in increasing revenues, while investing in operating assets at attractive ROICs. Growing revenues has brought a very nice operating leverage. As you can see in the third chart , the operating expenses as a percentage of revenue went from 17% in 2010 to less than 10% in 2019. The question is, how will this look going forward? Dream has stated in their 2019 Interim report that they are targeting US$700M (HK$5,425M) of revenue in 2021. To be honest, I am a little afraid now that Dream is focussing too much on the revenue number by itself. Investing for growth is only valuable if done at an attractive ROIC. There are some indications that my fear might be warranted. Dream is about to close a connected transaction where it buys two companies for a total consideration of HK$125.3M. These companies produce tarpaulin, which seems to be a commodity product. Total 2018 Profit after tax for those two companies was HK$14.2M, which implies an 11% ROI. (The circular also mentions though that profit was quite a bit higher for 1 of the companies for the first six months of 2019.) Buying these two companies for the revenue growth does not look valuable.
Then about the annual report itself. The prospects section of the MD&A, is very upbeat considering the circumstances. I do understand the longer term picture of consolidation in the sector, but I can not imagine current circumstances don’t warrant at least some caution. The only thing they do mention regarding the Corona-virus is that the Tarpaulin will do well because of the disruption of Chinese manufacturers. Analysts are predicting revenue declines for 2020 for two of its major customers (Funko and Spin Master). Also Disneyland (Oriental Land) will not be selling merchandise when the parks are closed. But they don’t really mention any of this.
So in short, I do not have a good indication of how revenues and profits will be in 2020. I tried to come up with a scenarios that I thought could be realistic.
This valuation needs some explanation. I have modeled that Dream will more or less meet its target of US$700M in revenue in 2022 instead of 2021. 2020 revenues went down by 15% to account for the impact of the corona-virus. GPM is on a downward path towards 19% reflecting the concerns that I pointed out earlier. The operating expenses are going up with a fixed increment of HK$30M per year.
This results in a value of around HK$7.5 per share or a 28% expected return at the current price. That’s less bullish than my first write up but certainly still very attractive.
