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Dukang Distillers: High Spirits or Deep Sorrow?

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Dukang Distillers (DKNG.SP) is a Singapore-listed producer of the the national alcohol of China and it could be a good stock pick for the contrarian.

Positive Factors

1) Sheer Market Size and Potential

The Chinese baijiu (spirits) market is projected to grow to CNY581b by 2015, versus CNY437b in 2013, according to estimates by EuroMonitor. Much of the growth is likely to be in the mass-market to mid-tier baijiu segments, which is where Dukang plays and is well-placed to take advantage.

2) Compelling valuations

Dukang is trading at just 3.5 times Price/Earnings (trailing 12 months), which compares very favourably to fellow mid-tier baijiu companies such as Luzhou Laojiao (7.1 times) and Anhui Gu Jing (9.1 times), just to name a few. Based on profitability in the most recent quarter, forward P/E ratio could deteriorate to about 6 times, which would still provide a comfortable buffer for investors at current prices.

3) M&A target

Western beverage companies appear to have slowly come to realise that rather than encouraging beer consumption in China, it would be much easier to sell baijiu to Chinese consumers. For instance, Diageo has recently increased its stake in a distillery (Sichuan Sweenfun) that produces the Shuijingfang baijiu. This is a significant event in that it marks the first time that the Chinese government has granted approval to the taking over of a well-known baijiu brand and sets the precedent for future takeovers. It is not difficult to see that Dukang would make a good strategic fit within the portfolio of a beverage giant such as Anheuser Busch Inbev or even Thai Beverage.

4) New substantial shareholders

Fidelity is a substantial shareholder with just over 7% of shares bought at an average price of about S$0.45/share, while 2 entities (Kaifeng Tian Feng Mills Co and Treasure Winner Holdings) bought out Dukang's former chairman's 43.8% stake at S$0.474/share. These stakes were acquired fairly recently (only within the last 6 months at the time of writing) and at prices significantly above current share price, which implies that these cornerstone shareholders do see the long term value of the company, notwithstanding the temporary setback in the industry.

 

Downside Factors

1) Government curbs on entertainment expenses by officials

The baijiu industry is undergoing a trying period, due to a government  drive to crack down on lavish spending by officials on gifts and entertainment. As a result, the sales at Kweichow Moutai (the bellwether of the baijiu industry) slowed to just 10.0% for 9M 2013, compared with 43.8% growth in 2012 over the previous year. Dukang has been similarly affected, with revenue for the quarter ended Sep 2013 slipping 4%, while profit decreased 52.4%. It has to be highlighted though that profit slumped due to an increase in advertising expenses (average selling prices have been remarkably stable, as is gross profit at nearly 40%). Nonetheless, Dukang's share price has corresponding slipped 50% from its peak of 65c (in Jun 2013) to 32.5c as of Dec 2013.

2) Stigma of an S-chip

While China is an enormous market, past cases of cooked books of companies based in China have also been of epic proportions. While the truth is most Chinese companies are untainted and the increased scrutiny has weeded out many culprits, investors still view overseas-listed China companies such as Dukang with distrust. If not for this reason, Dukang is unlikely to have been valued by the market at such attractive levels currently.

3) Lack of dividends

The perception problem is not helped by the fact that Dukang has not paid a dividend in the 5 years since it was first listed in Singapore. A quick examination of Dukang's balance sheet (>CNY600m cash on hand) and cash flow statement (>CNY200m free cash flow in the last 12 months) shows that the company is is fully able to fund at least CNY100m of dividends per year (or about 2.5 Singapore cents per share) and still hoard CNY100m of cash. That it has not done so does foster some doubt that the company is really doing as well as what its financial reports say.

4) Privatisation could be on the cheap

Given the long term prospects of consumer goods in China, it looks all but certain that in the next few years Dukang would be privatised by its substantial shareholders or by a major beverage group. However, judging from past exit offers for s-chips, the exit valuation could be very low. For instance, in the most recent example of a privatisation of an s-chip, Synear shareholders were offered an exit price of just 0.38 times Net Asset Value. (Incidentally, the new largest effective shareholder of Dukang is Synear's present CEO Wang Peng who controls the 29.5% Dukang stake held by Treasure Winner Holdings)


History

  • Sep 2008: Listed in Singapore as Trump Dragon Distillers at IPO price of S$0.31
  • Jan 2010: Acquired Luoyang Dukang Holdings (which owns the Ruyang Dukang brand)
  • May 2010: Renamed Dukang Distillers
  • Mar 2011: Issued 130m Taiwan Depository Receipts (TDR) at a price equivalent to about S$0.81 per share
  • Apr 2013: Dukang baijiu placed on China Ministry of Foreign Affairs' official list of beverages that can be served to foreign dignitaries
  • Dec 2013: Ex-Chairman Gao Feng sold all shares (43.8% of outstanding shares) to 2 parties

 

Fair Value

Valuing an S-chip is always a tricky business, but even if zero growth is assumed, at an annual free cash flow of CNY200m and a discount rate of 7%, Dukang would still be conservatively worth some S$0.71 per share, which is 118% above the current price of $0.325. Given that 3 major investors have only recently taken substantial stakes in Dukang (and they would have done their due diligence on the company), the greater risk though is not one of cooked books at Dukang, but that the company could be taken private before its potential value could be realised.

 

Conclusion

Dukang Disillers looks to be undervalued, whether by the historic price paid by its current major shareholders, or against its peers in the industry. Although Dukang may see profits dip going forward, it is still an immensely profitable company and has been less affected by the weak demand at the premium end of the baijiu market. At the current price of 32.5c per share, all negative factors appear to have already been priced in and Dukang could surprise on the upside. BUY.


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Last Updated ( Wednesday, 11 December 2013 02:00 )  
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