One of the most frequent questions we are asked as Fund managers is from where we get our investment ideas. While most of us will use a screening tool to filter down companies from the investable universe (up to 17,000 stocks across the globe from which to choose!) we also use other sources: direct observation, forums, webinars, and other fund manager’s portfolios, to name a few. My latest investment idea came to me after remembering a recent exchange I had with a close group of friends.
For a number of years now, my friends and I make an effort and force ourselves to meet up for dinner every Thursday. No matter the occasion, we use it as an excuse to stay in touch with one and other at least once every week. A couple of months ago, it was one of the couple’s turn to host and; as always, we found ourselves hearing about their latest holiday to yet another exotic location. They travel quite extensively and are never short of a story having visited Angel’s Fall in Venezuela, Indonesia and its Komodo Dragons, Bora Bora’s remote beaches in French Polynesia and the Gobi desert with a short stay in St Petersburg beforehand. Their stories are generally told through videos. This is not always by everyone’s choice but we can hardly say no to them once they begin playing them! On this occasion, they were telling us about Singapore, the Marina Bay Sands Skypark, its botanical gardens and the city’s iconic Ferris wheel, the Singapore Flyer. I then began wondering who owned and managed such a unique tourist attraction and much like the iconic London Eye, Mickey’s Fun Wheel in the U.S., the Riesenrad in Vienna and the Zhengzhou Ferris wheel in China… were the companies behind them good investment opportunities? A week later and after some additional research in the industry, I landed upon Straco Corporation.
Investment Idea- STRACO CORPORATION (STCO)
Straco Corp. is a leading leisure listed company that develops and manages tourism-related assets mainly in Singapore and China. Their businesses include: the Singapore Flyer (SF), Shanghai Ocean Aquarium (SOA), Underwater World Xiamen (UWX), The Lixing Cable Service (LLC) in China, among others. Straco was founded in 2002 and was listed in the Singapore stock exchange from February 2004. The company’s market capitalization is EUR 453m, a share price of around SGD 0.86 and a total turnover close to SGD 130m (EUR 80m).
What sets Straco Corporation apart and why does this company fall into Global Quality Edge Fund’s investment philosophy?
Straight-forward and easy-to-understand business – Almost all its revenue comes from ticket sales to their tourist attractions, while their costs are mainly those associated to upkeep and maintenance of their assets and their employee’s salary (35% of total costs)
Operating Leverage – Managing tourist-related assets will involve up to 80% of fixed costs of total costs, which translates into a high operating leverage and in turn, high margins and profitability.
Pricing power – Straco is able to increase prices to their tourist’s attractions by 10 to 15% every 2 to 3 years without having an impact on final demand. From Chart 1, we can how the operating gross margin has grown over the past few years (93% correlation), proving the company’s pricing power advantage.
Barriers to entry – The strategic geographic sites in Singapore and China plus the difficulty in obtaining licensing permissions to build and run tourist attractions at a very high cost are all good indicators of high entry barriers for would-be competitors.
Assets shielded from competition – Straco has built a lot of goodwill and strong relationships with the local authorities and governments in China and Singapore that have helped and advised the leisure company locate the ideal sites for its tourist attractions. Straco’s business is highly regulated and any new ventures would be hard to deliver without these.
Strong experience and knowledge in the business – Mr. Wu Hsioh Kwang is the current CEO of Straco since March 2003 and has worked in the business in China since 1980, allowing him to leverage all his experience, knowledge and relationships to successfully run the day to day business.
Mr. Wu is also is chairman of the culture, education and community affairs committee at the Singapore Chinese Chamber of Commerce and vice-chairman of tourism and leisure for the Chinese business group at the Singapore Business Federation. As a philanthropist, he donated $2m to University of California, Berkeley to aide overseas Chinese students.
Interest alignment between company management and stockholders – About 55% of Straco stock is owned between Mr. Wu and his wife, proving a clear interest alignment between investors and senior management. This investment is structured through Straco Holding PTE.
Efficient capital management – Due to the nature of the business, Straco has been generating enough cash flow allowing the company to steadily increase dividends across the years, as well as repurchase shares whenever senior management perceives its stock is being undervalued.
Strong solvency – Total gross debt is only SGD 103m, including all off-balance sheet operating leases which add up to about SGD 50m. If we take the company’s SGD 185m in cash, Straco’s net cash flow totals SGD 86m. It was only in the first few years that the company had debt on its balance sheet to finance the initial constructions of its tourist attractions.
Strong organic growth and potential for inorganic growth – During the last 5 to 10 years, total sales have grown at an annual compound rate above 20% with only 1 inorganic growth element after the company acquired the Singapore Flyer in deal worth up to SGD 117m for a 90% stake in 2014, using cash and debt. Straco’s strong cash position would allow it to purchase other tourist assets to take on debt up to 2x EBITDA (SGD 160m) without compromising its balance sheet. Mr. Wu (CEO) recently said in their 2016 annual report that “We [Straco] remain on the lookout for good projects to build or acquire, and continue to assess potential tourism investments, but until we come across the rare opportunity that is a true step forward in terms of quality, scale and potential returns, we will remain prudent in matters of cash management”
Reinvesting profits and high ROIC – Pay-out dividend rate is below 50%, allowing the company to have a strong cash position to invest in new assets or repurchase shares. Straco is therefore not capital intensive with a low CAPEX (Capital Expenditure) and null strain on cash. The company is able to maintain high-levels of return on invested capital (ROIC) at a sustained rate above 30%.
Management compensation – Approximately 45% of the CEO’s salary is made up of variable compensation in the shape of bonus and stock options, tied to long term business performance.
Neutral or negative cash-cycle – Straco does not need to finance its cash flow needs, as most of its ticket sales are paid in cash and suppliers are paid off within 85 days.
Low analyst coverage – The leisure company is covered only by 4 local broker analysts which is the best way to obtain information about the company is by speaking directly to its management.
Low percentage of institutional investors – We like the fact that institutional investors only represent less than 10% ownership in the company, currently hovering around 6%. This directly translates Straco into a not-so-well-known company and increases the chances of it trading at a discount due to the limited information that can be found on the company.
Strong and sustainable competitive advantages – Straco’s competitive advantage exists in the form of a unique and regulated (intangible) asset and the strategic sites where they were built. As mentioned previously, the company faces very few if not no challenging competitors, as a result of the company’s exclusive and iconic assets that are difficult to replicate. The initial investment for a new tourist attraction would be incredibly high and pre-approval from local authorities and the government would be needed in order to operate a new project under the appropriate licenses.
The sites where the tourist attractions are located are also exclusive, offering unparalleled views of Singapore and Chinese cities in central locations making them the perfect place for first-time sightseers to visit. This naturally protects and guarantees the company’s on-going ticket sales.
If a new site were to open, like Disneyland Shanghai did in June 2016, we do see this being a matter of concern and direct competition for Straco’s Shanghai Ocean Aquarium, as it would present itself as an opportunity to bring even more tourists to the city.
Share repurchasing announcement – On 28th April 2017, Straco announced a new share repurchase programme, authorizing a share buyback worth up to a maximum of 86.03m shares, equivalent to 10% of all shares outstanding. Until 14th December 2017, the company had had only repurchased 0.1% of the total amount, leading us to believe that share repurchasing is a strong support for the company’s equity listing.
How do we value Straco Corporation?
The main business drivers of this leisure company can be narrowed down to 2: 1) Strong tourist traffic and 2) High consumer spending. Stats from the China National Tourist office reveal that local tourism has been growing at 10% in the last five years accounting for almost 70% of
China’s total tourism. This industry makes up for 10% of China’s GDP while consumer spending is 65%, when measured for the first nine months of 2017.
A study called “Discover China’s Emerging Middle class” claims the sprawling urban middle class in China is set to reach 365m people by 2020 which widely supports the local positive trend seen in domestic tourism. The China National Tourist office also sees a rise from international visitors that would reach 137.1million travelers by 2020 if current growth rates remain high. In Singapore, the Singapore Tourism Board foresees a 1-3% growth in tourists coming from abroad to not only visit the island city-state but also from tourism drawn in by Indonesia and China that continue to register double digit rise in the number of visits.
Straco’s annual report breaks down the number of tourists they register each year at all their attractions:
In Chart 2, we can see how stable the business is and how almost every year it’s been able to increase the number of visitors to their sites. Even during the last financial crisis, Straco maintained a net influx of tourists and its compound annual growth rate for the last 10 years has been above 10%.
In terms of reporting, Straco divides up its business in 3 segments: 1) Aquariums, 2) Giant Observation Wheels 3) others. The aquariums represent approximately 70% of Total Sales and 82% of their Operating Income, while the Observation Wheels account for 29% and 16%, respectively.
Shanghai Ocean Aquarium and Underwater World Xiamen are among the Aquarium assets of the company. Even though food and drink are sold at the parks, these do not make up as much of the Total Sales compared to the entry ticket sales. This average at CNY 160 (EUR 20) for the Shanghai aquarium, CNY 130 (EUR 17) for Xiamen and CNY 200 (EUR 25) for the Singapore Flyer.
To breakdown Straco total turnover worth SGD 130m, we assume an average ticket price of CNY 170 which will incorporate already a 25% discount rate (for either children, pensioners, disabled visitors, etc.) and multiply the average price by the number of visitors that were recorded until September last year: 5.05 visits. The slight drop in 2016 which is then maintained and carried over to 2017 was owed to the lower number of tourists at Underwater World Xiamen (UWX) due to newly imposed tourism restrictions by local authorities. We do not see this as a threat to the aquarium’s business as the company recently announced it was planning to off-set the drop in numbers by extending the hours in which the park remained open.
By now, you may know that Global Quality Edge Fund does not rely on consensus estimates as part of the investment decision process. What we do is calculate a normalized operating margin with sufficient enough history that encompasses a full economic cycle. In Straco’s case, we arrived at a 45% normalized operating margin, under our conservative view, which contrasts from the 52.2% actual reported by the company. If we apply a 30% fiscal rate, our NOPAT (Net Operating Profit After Tax would result in SGD 40m over the last twelve month sales of SGD 127m. We then move on to the Free Cash Flow and remind ourselves that the cash position of the company is neutral or negative, investments represent around 2.5% of Total Sales and the company allocates around 1.5% of Total Sales to stock option payments. From our view point, it’s an expense and therefore we subtract it. This leaves us with a final normalized Free Cash Flow of SGD 52m, meaning the cash conversion rate is greater than 100%. Remarkable!
If we continue with our assumptions and calculate Straco’s Total Net Cash at SGD 86m, the total number of shares outstanding is SGD 865m (4m convertible shares due to stock options) and applying a last twelve month price to earnings multiple (PE) of 15x, our intrinsic value for Straco’s share price is SGD 0.96/share, 12% higher than its current price. It is important to note that this intrinsic value of SGD 0.96 does not assume any future growth, nor does it take into account price increases or a premium on top of its multiple due to the high quality business they run. If we were to adjust our calculation and incorporate our previous observations on growth, pricing power and premium, our theoretical value would be of SGD 126, with a safety margin of almost 50% of today’s current price of SGD 0.86. Our floor value in the event of an economic recession (unlikely under the current conditions in the far east but still possible) is of SGD 0.65, in other words, a 25% drop from current levels, at which point we would increase our stake and allocation in our fund.
Which are Straco’s main risks?
A more relaxed stance in their pricing power in future years, exposure to terror attacks, competing companies building more tourist attractions in surrounding areas, unexpected maintenance costs that could lead to disruptions in service or technical faults that could put guests at risk.
Are there any red flags?
We have not found any relevant accounting red flag. We only have to bear in mind that tourist attractions have a strong seasonal component to them, especially around the 3rd quarter of the year where more than half of Total Sales are booked.
How was the company’s last quarterly result 3Q17?
Mr Wu told investors in his last earnings call for the 3rd quarter of 2017, “We are satisfied with the overall performance for the year-to-date as our attractions, other than UWX, registered positive growth. UWX’s performance had been impacted by falling visitor numbers, which dropped more than 30% in 3Q due to the further restriction on visitor 2 numbers to Gulangyu by the local authorities, as well as tight traffic control in Xiamen city in view of the 2017 BRICS Summit held in September”.
In conclusion, we see Straco Corporation as an extraordinary company with clear and sustainable competitive advantages, a unique set of assets, sound capital management, experienced Senior management, committed to their investors and trading at a discount 15x below profits or 8x EBITDA.
Column by Quim Abril, founder and portfolio manager of Global Quality Edge Fund
PORTFOLIO MANAGER’S NOTE: I wrote this report by myself and expressed only my opinion. This report is not a recommendation to buy or sell. Directly or indirectly, the portfolio manager has a position in the assets mentioned here.
