Description

Introduction

This is an illiquid small/microcap stock listed on the Hong Kong stock exchange.  It trades around $80K of USD value per day, so even small funds and PAs will probably need to scale in or out slowly.  The company is registered in the Cayman Islands and headquartered in Hong Kong, while most of its operations are in mainland China.  There's only one sell-side analyst who covers the stock, from KGI Securities, and she currently rates it a "Buy" with a target price of HKD$1.37.

If you’re ok with all the above and are still reading, then I think Tang Palace (1181-HK) is worth a closer look. At the current price of HKD$1.18/share, the Hong Kong stock market is giving you the opportunity to buy a multi-brand restaurant business with revenues growing at a CAGR of 11.0% over the past 5 years, and 14.5% over the past 10 years, at a 2019E EV/EBIT multiple of 4.1x and a 2019E dividend yield of 9.7%. Note that these are my own forward earnings and dividend estimates which I derive below, not those of the KGI Securities analyst, and that my estimates are actually more conservative than hers. I don't have access to the KGI research report, so I don't know how she came up with the HKD$1.37 target price, but suffice it to say I think that's way too low.  Even if the multiple never re-rates to a more rational level, dividends and fundamental growth alone should generate 20%+ annual returns (9.7% + 11.0%) for many years to come.  

The company IPO’d on 4/18/2011 at HKD$0.66/share (split adjusted) and closed at HKD$0.92/share on its first day of trading.  So, you can buy shares today at about a 28% premium from where the stock closed on its first day, but the company’s revenue and net earnings are now more than double what they were then, the expected annual dividend has more than tripled, and an additional HKD$0.14/share of net cash has built up on the balance sheet despite funding all that growth and despite the dividend payout ratio growing from 60% initially to its current level of 100%.  Well I don’t know about you, but I don’t see investment opportunities like this one very often in the US stock market. 

Background

After reading mpk391’s write-up on Texhong Textile, I started to wonder how many other really cheap HK-listed Chinese stocks might be available.  I was also drawn to these because Mohnish Pabrai, whom I respect a lot, now has "zero percent" in the US and is mostly invested in India and China where he believes there are vastly better opportunities to find significantly mispriced stocks.  So, I ran a few screens on FactSet and came up with several possibilities, and the one that really stood out to me was Tang Palace (1181-HK).

Tang Palace opened its first traditional Chinese restaurant in Shenzhen, PRC in the year 1997.  They expanded to Beijing in 2002, and by the end of 2002 they operated a total of 3 restaurants. By the end of 2008 they'd expanded to 13 restaurants located in 4 cities: Beijing, Shanghai, Shenzhen and Dongguan.  In 2010 they opened their first casual dining restaurant as a franchisee under the brand name "Pepper Lunch".  When they IPO'd in April 2011, they planned to use the raised funds to quickly expand this casual dining business.  They later licensed another casual dining franchise called "PappaRich" and by the end of 2013 operated a total of 50 restaurants, 24 of which were the new Pepper Lunch and PappaRich casual dining brands.  In 2014 they introduced a new self-developed casual dining brand called "Social Place" and operated a total of 58 restaurants, 30 of which were casual dining.   

In 2015 they introduced another self-developed casual dining brand "Canton Tea Room", and moved the PappaRich restaurants into a JV partnership structure with the franchiser.  The PappaRich brand hadn't performed as well as expected, so they restructured that business and got the franchiser more involved.  The PappaRich business is no longer included in consolidated revenue or operating restaurant count, but it remains on the balance sheet as an investment asset.  They also shut down some under-performing Pepper Lunch restaurants in 2015 and ended the year with 57 operated restaurants, 23 of which were casual dining.  In 2016 they closed 7 more under-performing Pepper Lunch outlets, but continued to expand the very successful Social Place brand, and ended the year with 49 restaurants (19 casual dining).  By year-end 2017 they were back up to 56 restaurants (25 casual dining), and as of June 30, 2018 they have 58 restaurants (26 casual dining).

I didn't spend too much time investigating online reviews, but I did check out some that were written in English.  They seemed to be mostly 4 or 5 stars, with a few 3 stars, but I didn't see anything that surprised or alarmed me.

Financials

The above operational time line and associated financial statement information are summarized below.  The company reports financial results semi-annually in Chinese RMB currency.  All data shown below are fiscal year values, other than the gray column corresponding to the most recently reported semi-annual period ending 6/30/2018.  

Here's how I calculated the FY2018 and FY2019 estimates, shown above in the two left-most columns. For FY2018, I assumed the 12.2% revenue growth rate reported in H1 2018 would continue through the rest of this year.  For FY2019, I assumed revenue growth would decelerate to the 5-yr historical CAGR of 11.0%.  Note: that's significantly more conservative than their longer term CAGR of 14.5%.  For EBITDA margins, I again assumed reported H1 2018 EBITDA margins of 13.8% would continue through the rest of the year.  For FY2019, I assumed EBITDA margins would improve to the 10-Yr average of 14.2%.  Similar logic applies to EBIT margin.  Note that Pretax Income is larger than EBIT because of the net cash position.

It's worth noting something unusual about the company's income tax rate.  They pay a 25% flat PRC income tax, but there's an additional 10% PRC "dividend withholding tax" they have to pay when their PRC subsidiaries distribute dividends to headquarters in Hong Kong.  So their tax rate is highly dependent upon their dividend policy, and I believe the dividend distribution and associated tax occurs in the following fiscal year, not the current fiscal year.  Also, note that I use the term "Dividend Proposed" in the table above because dividends have to be approved by shareholders at the annual meeting which occurs the following year.

Once the PRC subsidiaries distribute dividends to Hong Kong headquarters, there's no additional tax charged when those dividends are in turn distributed to shareholders who reside in Hong Kong.  However, for US residents and other foreign investors, there may be an additional 10% Hong Kong withholding tax charged.  I'm not sure about that part yet, but I do know that even if the additional 10% tax is withheld by Hong Kong, it can be effectively refunded by the US government through a foreign tax credit as long as the stock is held in a taxable account.  If the stock is held in a tax deferred account, it may be impossible to recover that 10% Hong Kong withholding tax.  I've run into this problem before with Canadian dividend paying stocks in an IRA account.

Anyway, I assumed a 32.0% effective tax rate for 2019, which is close to but a little smaller than the 32.3% reported in H1 2018 since I'm assuming the dividends distributed in 2019 will be lower than those distributed in 2018 (because those were based on 2017 earnings which had higher than usual EBITDA margins).

The company's revenue has grown both through same-store sales growth and by opening more new restaurants than they shut down over time.  Unfortunately, their disclosure of same-store sales leaves something to be desired.  For some reason they don't seem to report it consistently, but they have been reporting it in more recent periods.  The recent same-store sales deceleration to 1.1% reported in H1 2018 might be a red flag, but there wasn't any discussion of it in the interim report.  It is something to keep an eye on though.

Cash Flows, Dividend/Buyback Restrictions, Prepaid Membership Cards

Examination of the financial information above should make it clear that cash keeps building up on their balance sheet despite the consistently high dividend payout ratio.  That's a nice problem to have, but if this were a US company the shareholders would probably be pressuring management to distribute more cash or buy back stock given how under-levered the balance sheet is.  I'm certainly no expert on this matter, but one thing I did notice when reading through the public filings is this statement in their IPO prospectus.

"As regards our PRC-incorporated subsidiaries, the PRC laws require that dividends be paid only out of the net profit calculated according to the PRC accounting principles, which differ from generally accepted accounting principles in other jurisdictions, including HKFRS. The PRC laws also require foreign-invested enterprises, such as our subsidiaries in China, to set aside part of their net profit as statutory reserves. These statutory reserves are not available for distribution as cash dividends."

Therefore, I'm not counting on the company to ever distribute that excess cash to shareholders as a special dividend or buyback, but if the dividend payout ratio remains at 100% and capex exceeds D&A, the excess cash can be worked off that way.

One reason they've been generating cash so efficiently is the growing non-cash net Working Capital (WC) deficit.  That seems to be common in the restaurant business since retail customers pay immediately while suppliers and employees are paid with a delay.  As the business grows so does the WC deficit, which then becomes a consistent source of operating cash flow.  However, in this case the WC deficit is larger than average and has grown as a percentage of revenue.  I believe that's due to a growing prepaid membership/loyalty card program the company began several years ago.  Their prepaid customers effectively give them free float to invest, but they don't seem to do anything with that cash other than put it into CDs.

Corporate Governance

Given that I'm a US-based investor with admittedly limited experience in buying individual stocks from emerging market countries like China, the issue of corporate governance and the risk of fraudulent financial reporting is one of my top concerns here.  That's one reason I set up my screen to look for companies with a high dividend yield and a long history of paying dividends.  That's obviously not a foolproof way to guard against fraud, but it's certainly easier to fake a financial statement than it is to fake a long history of cash dividends paid out to shareholders.  I'm also comforted by the fact that Ernst & Young is their auditor, not a foreign accounting firm I've never heard of.  

Judging from the publicly available financials, it certainly appears that Tang Palace is a company with a long history of being run for the benefit of its owners/shareholders.  Even before it was a publicly listed company it was paying large dividends to its private owners, at least during the three prior years shown in the IPO prospectus.  The company appears to be run very conservatively and prudently, without a lot of the empire building behavior that seems to be so common among US executive teams. Management seems very willing to scale back growth plans that aren't working out as well as expected (see the discussion above on "Pepper Lunch" and "PappaRich"), while pursuing more aggressively the ideas that are working ("Social Place" brand, prepaid membership cards, expansion of their traditional Chinese restaurant brands).

It's comforting to see that the company remains solidly profitable, and continues to pay dividends, even when there's a significant amount of business restructuring taking place as there was in 2015 and 2016.  I'd also note that management doesn't use "one-time restructuring costs" and "adjusted earnings" in their MD&A to make the profits sound better than they really are.  Stock-based compensation to executives and other employees has been reasonable; total shares outstanding has grown at a rate of ~0.45% per year over the ~7 years it's been a publicly listed company.  Overall, I find the management behavior and discussion to be straightforward and less promotional than what I'm used to as a US-based investor. 

The original three co-founders still collectively own 66.9% of the company.  Mr. Yip Shu Ming (62 years old) is chairman of the board and owns 23.2%.  He's still actively involved with the company and earns an annual salary of ~$160K (USD) plus $69K BoD fees.  Mr. Chan Man Wai (63) is vice chairman of the board, owns 33.8% of the shares and gets ~$65K/yr in BoD fees, but earns no other salary at the company.  Finally, Mr. Ku Hok Chiue (72) owns 9.9% and is on the BoD ($69K/yr in BoD fees), but earns no other salary at the company.  These three co-founders had a long prior history in the restaurant business before founding Tang Palace.   

The CEO is Ms. Weng Peihe (47) who is also on the BoD.  She started off as a manager when the company opened its first restaurant in 1997 and became CEO in the year 2000. She currently owns 2.2% of the shares and her ownership stake has been gradually rising through stock-based comp, which I consider a positive since she seems to be running the company very well and is much younger than the three co-founders.

One potential red flag is in the area of related-party transactions, or as it's called in the public filings "CCT" (Continuing Connected Transactions).  The three co-founders own real-estate entities that rent 5 properties to Tang Palace: 4 of them are restaurant properties and 1 is a training center. While this is non-ideal, I'm not terribly concerned for a few reasons.  First of all, the company now operates 58 restaurants so the percentage of rent being paid to the co-founders is quite small.  Second, these same 5 properties have been rented to the company since before it went public, and the rental amounts are all disclosed and don't appear to be out of line compared to their third-party rental costs.  Third, the co-founders receive far more compensation from the company's dividend payments than from this rental income.  Overall, I think the alignment of interests between management and shareholders is very good despite these related-party transactions.

Absolute Valuation

As shown in the table below, I conservatively estimate Tang Palace's per-share intrinsic value to be within the range HKD$1.27-$3.34.  Given the current stock price of HKD$1.18, and the excess cash+investment value of HKD$0.39 per share sitting on the balance sheet (explained in more detail below), the stock market is valuing the operating business at a 1-yr forward P/E of 6.1x using my base-case earnings estimate for 2019.  Given the historical growth rate of this business, and the very shareholder-friendly manner in which it's been run so far, it should be clear this business is being offered to stock market investors at a bargain price. 

The base-case NOPAT margin was derived as described previously, where NOPAT = EBIT * (1 - effective tax rate) - Minority Interest, and where I used 32.0% as the effective tax rate.  The low/base/high forward NOPAT multiples of 10/15/20 were chosen arbitrarily, but given the sort of average growth rate and ROIC indicated in the financials I think they're quite conservative. 

Another area where I've been conservative is in the calculation of "Excess Cash".  Note that Net Cash = Cash - Total Debt is 518.8M RMB as of 6/30/18, whereas "Excess Cash" is 335.7M RMB in the table above.  The difference comes from two places: (1) There was a 93.3M RMB dividend payable as of 6/30/18 which has now been paid, and (2) I subtracted an additional 89.8M RMB from Net Cash to account for the company's larger than average non-cash WC deficit of 13.0% of revenue.  As alluded to earlier, I think that's caused by their growing prepaid membership card program, in which case that's a very real source of float which perhaps shouldn't be adjusted downwards as I've done here, but I wanted to be conservative in my valuation.  As shown below, I found that company-owned restaurant businesses in the US have an average non-cash WC deficit of 7.1% of revenue, so I adjusted Tang Palace's actual net cash balance downwards to account for that 5.9% difference. 

Relative Valuation

The table below compares Tang Palace to a set of similar companies I selected.  These are all restaurant companies located in either Hong Kong, Mainland China or Taiwan.  Forward sell-side estimates weren't available for most of these, so the comparisons use trailing reported data.  Only companies with positive TTM net earnings were included in the comp set.  Market Cap and Enterprise Value are in US dollars. Note that the averages shown for the P/E and EV/EBIT multiples are actually "harmonic averages" (i.e., 1/average(E/P)) since that statistic is more robust to the presence of outliers.

Even though I tried to filter out very low quality companies, requiring positive TTM net earnings for instance, as you can see by viewing their price charts or by looking at the right-most "5-Yr Total Return" column many of these stocks have been disastrous investments over the past several years.  So I think it's fair to say this is a tough, cut-throat industry, and having good management and strong brands is very important.  For the reasons described above I think Tang Palace's management has proven itself, and the above-average operating metrics and attractive 5-yr total return on the stock indicate that as well.  Despite all those positives, for reasons I frankly don't understand the stock is still very attractively priced relative to the comps based on standard metrics like dividend yield, P/E and EV/EBIT.

I thought it would also be relevant to compare Tang Palace against some US-based restaurant companies, as shown in the table below. I only included companies that primarily own and operate the restaurants themselves, as opposed to those that primarily sell franchise licenses to the actual operators. Sell-side forward estimates were available for these companies, so I included those valuation ratios as well as the trailing ones.

The disparity between Tang Palace's valuation and the US-based comps is even more stark than it was versus the Hong Kong/China comps.  Frankly I don't know why anybody would buy these US restaurant stocks when they could buy Tang Palace instead.

One last thing I wanted to mention before I post this: I'm 99% sure the data is incorrect, but according to FactSet's Ownership database all of the insiders have sold all of their stock some time after the 6/30/2018 as-of date for the most recent semi-annual filing.  I couldn't find any filing showing this to be the case, and the person I spoke to at FactSet couldn't find anything either, but in the spirit of full disclosure I just wanted to mention this unresolved issue I'm having.  FactSet is looking into it and will get back to me.  

Catalyst

None.  Don't really need one though.  Dividend + fundamental growth should give 20%+ returns for many years to come.