After close to 10 years of lacklustre performance, Koda is on the cusp of a multi-year growth trajectory mainly driven by the 3rd-generation of the Koh family who turned the company around by streamlining operations and divesting non-core assets.
At S$0.70, Koda is valued at S$57.6m. With a trailing P/E of 8x, I believe this company is undervalued given its robust balance sheet and clear growth catalysts.
Koda was founded in 1972 by Koh Teng Kwee and was listed in 2002. The group specializes in household furniture as an original equipment manufacturer (OEM) and original design manufacturer (ODM), exporting its products to more than 50 countries (including US, Europe, China, Japan) currently. It has factories in Malaysia and Vietnam.
In 2011, Koda launched its in-house retail furniture brand Commune as part of its diversification downstream. Commune commands higher profit margins compared to the manufacturing business. The brand’s unique selling point is its strong design focus and high quality at a good/premium price point. As at 30 Apr’ 18, Commune has 45 stores in China, 4 in Singapore, 3 in Malaysia, and 1 in Australia. Commune plans to have 100 stores in China by 2020.
- Manufacturing currently accounts for 84% of the group’s revenues while Commune contributes 16%.
- The manufacturing business supplies the products that Commune sells.
- Gross margin for the manufacturing business is around 30% while Commune commands higher gross margins of about 50%.
- The group’s gross margins are expected to trend higher as Commune contributes more revenues on the back of increased store roll-outs and changes made to boost efficiency (discussed under Investment Thesis #3).
- Koda currently derives most of its revenues from the USA (39%), followed by Singapore (11%), China (9%), Korea (9%), Australia (9%), and Japan (7%).
- Koh Teng Kwee, Founder & Non-Exec Chairman, 11.48% stake
- James Koh Jyh Gang, Deputy Chairman & Managing Director,16.47% stake
- Ernie Koh Jyh Eng, Executive Director (Sales & Marketing), 10.88% stake
- Koh Shwu Lee, Executive Director (Finance & Administration), 10.09% stake
- Joshua Koh Zhu Xian, Commune CEO, 2.67% stake
- Julian Koh Zhu Lian, Head of Design, 2.56% stake
- Total = 54.15%
Koda is a family business with management holding a majority (54.15%) stake in the group. James, Ernie, and Swu Lee are children of Koh Teng Kwee. Joshua and Julian are the sons of James Koh. The majority ownership held by management aligns the interests of minority shareholders. Management has also been declaring dividends annually since 2015 after turning the company around.
Dividend History Table
Dividend payout ratio for FY16 and FY17 was 12%. Hence, there is much room to increase payout given the company’s improving profitability and increasing cash pile.
Investment Thesis #1 – In the East: China and Beyond
To recap, Commune opened its first outlet in China in 2014 and expeditiously grew its number of stores through a dealership model. Dealers will set up shop under the Commune brand and are sold the Commune products at wholesale prices. There is no consignment so the unsold products cannot be returned to Commune. In addition, the dealers cannot carry other brands.
In order to reduce lead time from order to delivery to weeks instead of the usual 1-3months like other industry players, Commune will carry more inventory which will require more working capital.
The dealership model offers 2 key advantages:
- It enables Commune to scale quickly without incurring CAPEX.
- Non-consignment eliminates the risk of unsold inventory being returned
To meet its goal of 100 stores by 2020, Commune has to open 5 stores per quarter. This is highly possible given that there is strong demand from dealers who would like to carry Commune’s products (this is in part due to the above average dealer margin provided by Commune, this margin is expected to decrease over time). The only problem now is that Commune is currently facing supply constraints for space from mall operators, which would place a lid on how fast it can grow. Regardless, management seems confident in achieving its growth target; in its latest 3Q18 results press release, James Koh said, “…Our China expansion plans have also exceeded my expectations.” while Joshua Koh said, “Our plan to have 100 stores in China by 2020 is well on track“.
On 13 Feb’ 18, it was announced that Commune has partnered up with IE Singapore to execute its growth strategies. Here are some interesting points from the announcement:
- China contributed S$7m in sales or 64% of Commune’s total revenue in 2017, delivering 40% revenue growth year-on-year.
- In a short span of 3 years, Commune opened over 42 physical stores across tier one and tier two cities in China.
- The Chinese demographic is changing, with consumers developing a preference for modern, designer furniture.
- IE Singapore is working with Commune to expand to Indonesia, Taiwan and Thailand by connecting it to mall owners and dealers.
Using back of the envelope calculation, each Commune store in China is raking in on average S$0.17m in sales per year. 100 stores would translate to S$17m in sales, implying a CAGR of 34.4% in sales growth for the period 2017-20. Applying a gross margin of 50%, we have a gross profit of S$8.5m coming in from China alone. To put things in perspective, Koda’s FY17 gross profit was US$15.9m (S$21.3m). The potential upside to gross profit would be same-store sales growth and gross margin improvements.
One interesting empirical trend going on with the Chinese consumer is the perception that higher priced goods are better in quality. Hence, Commune is sitting at a sweet spot in terms of product and pricing.
Zooming out to a more macro view, we can see that Commune is operating in a fast-growing (albeit decelerating) Chinese market. According to Marketline (Jan’ 18 Industry Profile Report), the Chinese furniture and floor coverings market is forecasted to have a value of US$251.9b, an increase of 73.1% since 2017. This represents a CAGR of 11.6% for the period 2017-22. The report also mentioned that “consumers’ increasing purchasing power has driven the furniture market in recent years and with over 630 million households nationwide, the scope for further expansion is huge, particularly as the middle class continues to grow.”
BMI Research (Industry Forecast – Consumer Spending – China – Q2 2018) mentioned that Chinese households are predicted to be one of the fastest-growing in the world in the next 5 years, averaging 10.3% annually in local currency terms. This will be underpinned by a burgeoning middle class, rapid urbanization, and heightened retail competition. BMI Research forecasts total household spending will grow from CNY32.5t in 2018 to CNY47.2t by 2022, making it one of the most attractive markets in the world.
More importantly, BMI Research expects furniture and furnishing spending to grow 78.8% from CNY619.65b in 2017 to CNY1,108.01b in 2022. This represents a CAGR of 12.3% for the period 2017-22. This will be underpinned by population growth, higher disposable incomes, and a growing middle class that is keen on acquiring big-name brands as a testament to their financial success.
Investment Thesis #2 – In the West: Positive US Housing & Funiture Outlook
According to Marketline (Jan’ 18 Industry Profile Report), the US furniture and floor coverings market is expected to accelerate, with a CAGR of 3% for the period 2017-22, which is anticipated to expand the market to a value of US$141.9b by end’ 22. Marketline also mentions in pg 8 of the report:
“In August 2017, President Trump signed a new executive order to streamline the construction approval process. As a former real estate developer himself, President Trump is likely to put much emphasis on construction in the near future. The mayor of San Francisco, Ed Lee also hopes to speed up permits and approvals. This should kick-start building. This inturn creates a need for furniture and floor coverings.”
As the US is the largest export market (39% of FY17 revenues) for Koda’s manufacturing business, the positive outlook on the market bodes well for the company.
Note: In Paper, Power, Taiga, published earlier this month, I wrote about the US housing construction market and its outlook which serves as a leading indicator for the furniture market in the US.
Investment Thesis #3 – Improving Financials & Free Cash Flow
Quarterly revenues started to turn around in 3Q16 (Mar ’16) on the back of increased contribution from both the manufacturing and Commune business.
Quarterly gross profit bottomed out in 3Q15 (Mar ’15) and has grown 159% to US$4.89m in 3Q18 (Mar ’18) in 3 years.
Quarterly net profit has consistently surpassed US$1m over the last 4 quarters. Prior to that, Koda was averaging below US$0.5m per quarter.
Both gross and net margins have improved from 24.5% and 2.9% to 36.4% and 8.7% respectively. This was driven by the investments made to improve operational efficiency as well as stronger contribution from Commune which commands higher gross margins of about 50%.
Management believes gross margin have room to improve given the following reasons:
- The utilization rate for its manufacturing facilities currently stands around 80%. However, this rate is only based on one shift. By increasing the number of shifts (e.g. 1.5 or 2), Koda can easily increase capacity without incurring significant CAPEX.
- Management has been investing in automation (CNC Machines and Finishing Machines) to boost efficiency. These machines reduce the number of workers required at a station from 6 to only 1. The forecasted CAPEX for these machines is US$1m per year.
- Bulk buying of raw materials. While this will decrease the cost of raw materials, it also means Koda will carry more inventory which would require more working capital.
- Increase sub-contracting in Vietnam for manufacturing of components at lower costs.
- Production differentiation with a wider mix of materials including metal, glass, leather as well as exotic materials such as shagreen. This will enable Koda to price its products at a higher premium.
As a result of its positive cash flow from operations and limited CAPEX, Koda’s cash has been increasing consistently while borrowings have been decreasing, resulting in a strengthening net cash position.
At S$0.70, 16.4% of Koda’s market cap is in net cash. The recent 2 quarter decline in net cash was due to increases in working capital to support increasing business activities.
I have used both DCF and P/E to value the company.
For my DCF Model (Refer to Appendix A for entire model), my key assumptions are:
- 2-stage DCF with 5-year topline growth and zero growth thereafter.
- Declining revenue growth from 4% in 2018 to 2% in 2022.
- Improving gross margin from 36% in 2018 to 40% in 2022.
- Increasing S&D expenses as a % of revenues from 8.3% in 2017 to 11% thereafter.
- Annual CAPEX of US$1.5m.
- A discount rate of 10%.
What we get is a target price of S$0.99, an upside of 42% based on current price of S$0.70. This implies an FY18 P/E of 11.3x and a 5-year 10% CAGR in net profit.
Based on an unrated report by CGS-CIMB, average furniture manufacturers/distributors are trading at 6.3x forward P/E while furniture retailers are trading at 12.4x forward P/E. One key reason for the large gap in valuations is due to the better growth rates and profitability of the latter as seen by their superior 3-year EPS CAGR and ROE. In addition, gross margins for furniture retailers are higher than furniture manufacturers.
My DCF implied P/E of 11.3x is above average furniture manufacturers but below average furniture retailers. Given that Commune, a furniture retailer is poised to be a key growth driver of Koda over the next few years, its P/E should trade closer towards furniture retailers than manufacturers.
Target price of S$0.99 is 9.6% below its 52-week high of S$1.095 achieved on 31 Oct ’17.
One possible way for Koda to quickly unlock value for its shareholders would be to spin-off its fast-growing Commune on either the SGX or HKEX since furniture retailers command higher valuations.
There is currently no analyst coverage on this counter. Any initiation coverage by the local brokerage houses should enable the company to rerate upwards.
Recent Company Buybacks
The weighted average price of the recent share buyback was $0.64. This could be seen as a form of price support (or downside) where management deems the company to be undervalued. Based on current price of $0.70, it is trading at a 9.6% premium.
- Family-owned and managed business with the majority stake
- Positive industry tailwinds in major markets (US & China)
- Improving profitability and margins with free cash flow
- Clear growth catalysts with low CAPEX requirements
- Robust net cash balance sheet
- DCF-derived and P/E backed valuation of S$0.99 per share, a 41% upside and implied FY18 P/E of 11.3x.
- Trade tensions between US and China
- Cyclical business
- Changes in consumer taste and preferences hard to predict
- Execution risks in aggressive Commune expansion
- Highly illiquid stock