“Lion Rock Group Limited (Lion Rock) is engaged in providing quality printing services to international book publishers, trade, professional and educational conglomerates, print media companies and government departments.” (From the website) The group was founded in 2005 by the Recruit Group as a way of diversifying its business and spun off and separately listed in 2011. Had you invested in the company when it was listed and reinvested the dividends, you would be sitting on a 320% total return (19% CAGR) versus 58% for the Hang Seng Index. From the end of 2011 until the end of 2018, revenues have increased from 640M to 1665M HKD (15% CAGR), while core operating income increased from 60M to 176M (17% CAGR). Gross profit margins look steady at around 27-28% while net profit margins average around 9-10%. Returns on net operating assets have been above 20% for 5 out of the last 6 years.
The printing services industry does face headwinds:
- Weak demand: Internet and electronic format books have increasingly become more popular. This weak demand and low margins have created an incentive for consolidation between publishers. This lowered the pricing power of the printing services industry compared to the publishing industry.
- Commodity industry: With the advance in technology, book printing is increasingly a “commodity industry”.
- Increase in labor costs: Increases in Chinese labor costs are hard to pass on to the customer due to limited pricing power.
- Raw material costs: The price of paper is by far the biggest cost driver for printers. China has had an overcapacity in paper production. This was a big plus for China/Asia based printers. This overcapacity has been slowly absorbed by extra demand and the price of paper has been going up.
These headwinds notwithstanding, I believe Lion Rock has a few characteristics which could make it cope better and even profit from these headwinds:
- Lion Rock believes the printing sector is due for consolidation. There are too many small Chinese family-led companies in the printing sector. Consolidation of the sector is taking longer than expected due to low interest rates and higher real estate prices which are bailing out printers with financial difficulties. But longer term, the above mentioned headwinds are favorable for a financially very strong Lion Rock (positive net cash position after debt and operating leases) as it will weed out the smaller competitors and give some pricing power back to the printers. As Lion Rock grows larger it will become more efficient due to better pricing for larger orders of paper.
- Execution: Lion Rock is known for quality at competitive prices and fast turnaround times. Two major factors contribute to this. Thanks to their size and expertise, they have a large inventory of paper which they procure at advantageous prices. Not needing to order paper, gives them a big headstart for production once an order is received. Secondly, they use an in-house built ERP system to streamline the whole production process and to optimize utilization capacity. Small to medium size publishers like doing business with Lion Rock because of the technical support they receive during the whole process.
- Capital allocation and strategy: Management is continuously on the lookout for consolidation and gaining scale with vertical and horizontal mergers. Since 2012, it has acquired (stakes in) 4 different companies. Each of those were bought at opportunistic times when those companies had business or balance sheet issues. In each of these acquisitions, management went in and turned around the business by cutting costs, exploiting synergies and growing the top line. It is very hard to exactly evaluate the return on incremental invested capital of those acquired businesses as management does not provide net profits per business segment but return on net operating assets has been around 20% since 2013. Quarto Group, the latest acquisition (2018), is being delevered and turned around and is expected to start contributing to Lion Rocks results in 2020.
Risks
- Key man risk: Mr. Lau Chuk Kin is a major shareholder (43%) and the director responsible for the overall strategic formulation and management of the group. He has been responsible for the acquisitions that made Lion rock grow so fast. Mr. Lau is 66 years old now, so he might be up for retirement. On the other hand, he just started his latest project at Quarto Group as CEO. This indicates that he is still very ambitious. Even if he would retire as executive, his 43% share in the company will make sure that he keeps an eye on the business. His right-hand, Ms. Lam, the current CFO has been involved in all the deals also and is only 52 years old.
- Small/Medium publishers might face credit problems. The printers generally extend generous payment terms. Lion Rock has shown in the past to be selective in accepting clients. If orders are borderline economically viable or the customer is not very creditworthy, they prefer to forego the business and take the short term revenue hit. This has been one of the reasons why the topline has not been growing much in the last few years.
- The US imposed a 15% duty on printed books from China. This might increase further. Lion Rock has already a lot capacity outside of China and is even considering moving all of the existing capacity to Malaysia, where labour is much cheaper. All in all, this might be even a tailwind if it reduces the Chinese printing capacity.
- The market for printed books declines further. Lion Rock Group is mainly active in illustrated leisure and lifestyle books, text books, learning materials and children’s books. This specific segment is more resilient to the trend towards digital. Also, it does look like e-book sales are losing momentum or even falling recently.
Valuation
Lion Rock is currently trading around 1.2 HKD. This implies an Enterprise Value of around 900M HKD after adjusting for cash, minority interest, debt and operating leases. Net Income including minority interests is around 180M HKD. (I have included the minority interest part of net income because it is also included in the EV calculation. Numbers excluding minorities would be 800M HKD and 165M HKD. Either way it does not change the story much.) Depreciation is probably overstating maintenance CapEx but let’s ignore that. So assuming no growth, we get an earnings yield of around 20%.
However, this scenario is too conservative. Mr. Lau has been acquiring new businesses at great prices and turned them around. Also, Lion Rock will profit from any downturn in the printing sector as this would push out a lot of small competitors. I believe Lion Rock has a large runway ahead of itself and could keep growing its earnings and free cash flow for the foreseeable future. So if I model 10% growth for coming five years after which growth declines to 2% perpetually and I use a discount rate of 12.5% for those free cash flows (after reinvesting for growth at around 20% ROIC), I arrive at a value of 2.35 HKD. A double from here.
While we wait for Mr. Lau to continue to do his magic we are getting paid a growing 8.5% dividend.
Hi,
This is an interesting review of Lion Rock group. I have a few questions and hope that you can shed some light for my learning journey.
1) Which part of the financial report shows the “depreciation is overstating maintenance CapEx”?
2) How do you derived at an earnings yield of around 20%? Using EPS (2018)/Share Price = 0.22/1.22 = 18.33%
3) “if I model 10% growth for coming five years after which growth declines to 2% perpetually and I use a discount rate of 12.5% for those free cash flows (after reinvesting for growth at around 20% ROIC), I arrive at a value of 2.35 HKD”
How do you derive at 20% ROIC?
Hi,
First of all, thank you for reading and commenting. One of my aims, besides structuring my investment process, is to get feedback and to get challenged on my thought process.
1) In the end, the value of a company are its future discounted cash flows. Generally, cash flows are lower than net income due to depreciation being lower than maintenance and growth capex. Here, I took net income as a proxy for cash flows because I reasoned that depreciation was equal to maintenance capex if not higher. Now to see how depreciation relates to the maintenance capex, you would have to determine which part of the capex is for growth and which part is for maintenance. Lion rock does not provide those. But if we take a look at the Cash Flow statement eg. from 2012 until the end of 2018, we can see total depreciation charges of 299M while acquisition of Fixed and Intangibles was 200M. There were acquisitions of subsidiaries, but most of these were asset light (so not a lot of depreciation stemming from those). Also the 200M includes new printers bought in 2018 (70M), so this indicates less capex going forward. And the last indication is that PPE has been dropping over the years while revenues were growing. This means more depreciation than new investments. This is proof from their aim towards a more asset-light business.
2) I probably used earnings yield in a fast and loose way. I was looking at EV and Net income. Still quite close to 20% 🙂
3)Here I assumed that Lion Rock could invest in growth at a ROIC of 20%. This is based on its historical Return on Net Operating assets. Here is a table of the historical operating metrics. (RNOA = Return on net operating assets, PM = Profit Margin, ATO = Asset Turnover)
FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 FY 2015 FY 2016 FY 2017 FY 2018
RNOA 16.9% 14.1% 13.9% 20.8% 18.1% 23.8% 22.8% 23.0% 21.3%
PM 12.5% 9.3% 9.6% 10.1% 9.5% 10.3% 9.4% 9.3% 10.5%
ATO 1.5 1.5 1.4 2.1 1.9 2.3 2.4 2.5 2.0