Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 1 Vitasoy International Profitability w orsen by C ovid - 19 , g rowth p otential r emains after r ehabilitation The unexpected worldwide recent events are certainly going to reduce Vitasoy’s profitability in 2020 and 2021. We therefore estimate losses for Vitasoy, at least in 2020, at most until 2022. Vitasoy remains a well - established company in Chinese and Hong Ko ngese beverage market which will allow strong Free Cash Flows back in a few years. Accordingly, a stock up - jump is to be forecasted in the next weeks considering the actual 22 - months record low stock price. The company and its B usiness Strategies Vitasoy International Holdings Limited is a well - known Hong Kong beverage company producing a wider variety of beverages such as high - protein soy milk, tea and fruit juice. It was founded in 1940 and specialized originally in the operation of tuck shops in secondary school canteens and public recreation facilities. A series of juice drinks packed in paper cartons, plastic bottles and cans were later developed and introduced to the beverage market starting from the 1970 ’ s. To be consistent with its vision wh ich is to provide high quality and nutritious products to the general public, Vitasoy tends to sell at the most affordable price in a market. This shows an effort to attract customers from its closest competitor to gain market share. Under the cost leadership strategy, Vitasoy’s value creation was mainly driven by its growth in sales volume. Facing a mature beverage market in Hong Kong whose consumer annual intaking of 12 kilograms of soy milk per person, the current capacity of production plants has reached 100%. Vitasoy thus decided to expand its production capacity building 20 new production lines in Dongguan. Although this expansion brings huge initial investment cost, the enlarged production capacity is expected to bring future cash flows producing batches of high quality products once going into operation in 2021. Only 30% of the total sales are from Hong Kong operation s . In fact, the Ma inland China operation, which comprises 62% of its total sales revenue is the major driver of Vitasoy’s operating performance. Experiencing rapid revenue of Vitasoy China up to 33% in 2018, the company is seeking category extension and growing brand influe nce and introducing premium high nutrition Health Plus range targeting high - end customers in the Mainland market. On the other hand, due to increasing raw material price and keen competition in the Mainland, the Company’s sales growth in 2019 deteriorated to 9.2%. To drive long term sustainable growth in the value creation process and maintain its competitive power in the existing market, Vitasoy also tried to keep its production costs at a level below the industry average. It is hence a common practice fo r Vitasoy to upgrade the machinery every year to improve production efficiency, as well as engage in quality control. Vitasoy is then able to build up reputation as its brand name lasting for over fifty years . This is to maintain consumer satisfaction as w ell as offering an aggressive selling price by lowering its unit direct manufacturing cost. In conclusion, Vitasoy is not able to set its product at a high level to earn a huge profit margin selling each unit of product due to easy entrance in the bevera ge market. Dominant players in the market try to cut their prices to seize power from the market, which may result in a price war in the market. Facing this hard situation, Vitasoy chooses to price its product at a much affordable level than its competitor s and is mainly engaged in price leadership strategy. This implies that the value of the firm is mainly driven by its growing sales volume and improving product quality. Equity Research Vitasoy International (0345.HK) Beverage Industry Current price (6 - April - 2020) HKD 24.40 Target price (3 1 - March - 2021) HKD 3 6 55 12 - month Recommendation BUY 52 - wk Range HKD 4 2 00 – 31 11 Market Cap (billions) HKD 25,878 Forecasted 2020 EPS HKD 0. 23 – (0.77) Forecasted 2020 ROCE 6.8 % – ( 24.3 )% 5 - years daily Beta 0.593 Current P/E 34.61 Current P/B 7.45 Stock performance vs Hang Seng Index: 42.00 36.55 3 1.11 24.40 Optimistic scenario Target Price Pessimistic scenario Current price Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 2 Valuation Optimistic Pro - forma Vitasoy's forecasted financial statements in thousands of HKD 2018A 2019A 2020E 2021E 2022E 2023E 2024E Sales growth rate 20% 16% - 20% 10% 10% 15% 15% Sales 6 464 525 7 526 495 6 021 196 6 623 316 7 285 647 8 378 494 9 635 268 Cost of sales 3 044 767 3 484 665 2 696 563 2 980 492 3 278 541 3 770 322 4 335 871 Gross Margin rate 53% 54% 55% 55% 55% 55% 55% Gross Margin 3 419 758 4 041 830 3 324 633 3 642 824 4 007 106 4 608 172 5 299 398 Expense ratio 41% 41% 50% 45% 45% 40% 40% Expenses 2 625 339 3 104 814 3 010 598 2 980 492 3 278 541 3 351 398 3 854 107 Operating income from sales before tax 794 419 937 016 314 035 662 332 728 565 1 256 774 1 445 290 Tax on sales (22.72%) 180 492 212 890 71 349 150 482 165 530 285 539 328 370 Core operating income 613 927 724 126 242 686 511 850 563 035 971 235 1 116 920 Core EPS 0.58 0.68 0.23 0.48 0.53 0.92 1.05 Core DPS 0.35 0.41 0.00 0.29 0.32 0.55 0.63 ATO 2.43 2.42 2.05 2.10 2.20 2.30 2.30 NOA 2 657 174 3 104 707 2 937 169 3 153 960 3 311 658 3 642 824 4 189 247 Free Cash Flow 355 703 276 593 410 224 295 059 405 337 640 069 570 497 Core RNOA 23.1% 23.3% 8.3% 16.2% 17.0% 26.7% 26.7% - Profit margin 9.5% 9.6% 4.0% 7.7% 7.7% 11.6% 11.6% - Asset turnover 2.43 2.42 2.05 2.10 2.20 2.30 2.30 Growth in NOA 16.8% - 5.4% 7.4% 5.0% 10.0% 15.0% Residual OI 512 212 611 462 111 047 387 314 429 307 830 821 962 465 CSE 3 280 167 3 538 941 3 637 169 3 653 960 3 911 658 4 342 824 4 889 247 ROCE 21.2% 6.8% 14.0% 14.9% 23.5% 24.2% Optimistic Discounted Cash Flow Valuation in thousands of HKD, except Share Value 2019A 2020E 2021E 2022E 2023E 2024E Free Cash Flow 276 593 410 224 295 059 405 337 640 069 570 497 Discount rate 4.24% Perpetual growth rate 3.00% Discount period 1 2 3 4 5 Present Value of FCF 393 538 271 544 357 860 542 112 463 534 Continuing Value 47 958 535 Present Value of Continuing Value 38 966 724 Total Present Value 40 995 312 Number of shares outstanding (03 - 2019) 1 060 585 Share Value (03 - 2019) 38.65 Target Price (03 - 2021) 42.00 Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 3 Pessimistic Pro - forma Vitasoy's forecasted financial statements in thousands of HKD 2018A 2019A 2020E 2021E 2022E 2023E 2024E Sales growth rate 20% 16% - 30% 5% 10% 15% 15% Sales 6 464 525 7 526 495 5 268 547 5 531 974 6 085 171 6 997 947 8 047 639 Cost of sales 3 044 767 3 484 665 2 634 273 2 655 347 2 799 179 3 149 076 3 621 438 Gross Margin rate 53% 54% 50% 52% 54% 55% 55% Gross Margin 3 419 758 4 041 830 2 634 273 2 876 626 3 285 992 3 848 871 4 426 201 Expense ratio 41% 41% 70% 65% 55% 50% 40% Expenses 2 625 339 3 104 814 3 687 983 3 595 783 3 346 844 3 498 973 3 219 056 Operating income from sales before tax 794 419 937 016 - 1 053 709 - 719 157 - 60 852 349 897 1 207 146 Tax on sales (22.72%) 180 492 212 890 - 239 403 - 163 392 - 13 826 79 497 274 264 Core operating income 613 927 724 126 - 814 307 - 555 764 - 47 026 270 401 932 882 Core EPS 0.58 0.68 - 0.77 - 0.52 - 0.04 0.25 0.88 Core DPS 0.35 0.41 0.00 0.00 0.00 0.15 0.53 ATO 2.43 2.42 1.90 2.00 2.10 2.20 2.20 NOA 2 657 174 3 104 707 2 772 919 2 765 987 2 897 701 3 180 885 3 658 018 Free Cash Flow 355 703 276 593 - 482 519 - 548 832 - 178 740 - 12 784 455 750 Core RNOA 23.1% 23.3% - 29.4% - 20.1% - 1.6% 8.5% 25.5% - Profit margin 9.5% 9.6% - 15.5% - 10.0% - 0.8% 3.9% 11.6% - Asset turnover 2.43 2.42 1.90 2.00 2.10 2.20 2.20 Growth in NOA 16.8% - 10.7% - 0.3% 4.8% 9.8% 15.0% Residual OI 512 212 611 462 - 945 946 - 673 336 - 164 304 147 538 798 013 CSE 3 280 167 3 538 941 3 172 919 3 265 987 3 497 701 3 880 885 4 358 018 ROCE 21.2% - 24.3% - 17.3% - 1.4% 7.3% 22.6% Pessimistic Discounted Cash Flow Valuation in thousands of HKD, except Share Value 2019A 2020E 2021E 2022E 2023E 2024E Free Cash Flow 276 593 - 482 519 - 548 832 - 178 740 - 12 784 455 750 Discount rate 4.24% Perpetual growth rate 3.00% Discount period 1 2 3 4 5 Present Value of FCF - 462 892 - 505 092 - 157 804 - 10 827 370 300 Continuing Value 38 312 366 Present Value of Continuing Value 31 129 129 Total Present Value 30 362 813 Number of shares outstanding (03 - 2019) 1 060 585 Share Value (03 - 2019) 28.63 Target Price (03 - 2021) 31.11 Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 4 Reformulate d Financial Statements Reformulated Comprehensive Income Statement in thousands o f HKD 2016 2017 2018 2019 Operating revenues 5 551 898 5 406 090 6 464 525 7 526 495 Cost of sales - 2 726 117 - 2 532 704 - 3 044 767 - 3 484 665 Gross margin 2 825 781 2 873 386 3 419 758 4 041 830 Marketing, selling and distribution expenses 1 496 807 1 491 517 1 729 371 2 104 514 Administration expenses 468 279 487 795 559 096 635 281 Other operating expenses 289 393 270 273 336 872 365 019 Operating income from sales before tax 571 302 623 801 794 419 937 016 Taxes reported - 34 064 - 190 383 - 160 679 - 208 143 Tax effect of financial income 488 44 210 2 687 3 553 Tax on other operating income 5 875 5 746 - 798 724 Operating income from sales after tax 543 601 483 374 635 629 733 149 Government grants on PP&E 8 283 7 917 3 570 8 692 Scrap sales 8 611 1 637 1 019 4 382 Reversal of long outstanding other payables 1 720 1 970 2 441 1 679 Sundry income 7 243 14 394 7 273 7 668 Share of losses of joint venture 0 - 627 - 17 814 - 19 236 Tax on other operating income 5 875 5 746 - 798 724 Remeasurement of employee retirement benefit liabilities - 11 457 8 579 6 095 - 5 141 Exchange differences on translation - 41 943 - 87 588 145 272 - 122 804 Cash flow hedge - 217 - 888 5 685 - 4 088 Operating income after tax 509 966 423 022 789 968 603 578 Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 5 Reformulated Balance Sheet in thousands o f HKD 2016 2017 2018 2019 Operating assets 3 909 559 3 887 261 4 530 998 5 399 467 Working cash 221 088 258 387 338 602 529 918 Trade and other receivables 827 627 900 003 954 944 984 008 Inventories 528 264 582 446 709 312 748 284 Other property, plant and equipment 2 114 264 1 986 480 2 277 653 2 759 250 Goodwill 36 547 35 293 18 983 18 375 Deferred tax assets 101 290 56 451 103 362 81 169 Interests in leasehold land held for own use 67 568 62 182 67 134 176 428 Deposists for the acquisition of PPE 309 1 125 1 586 1 601 Intangible assets (brand name) 4 530 4 010 3 922 3 417 Interest in joint venture 0 148 45 291 59 290 Current tax recoverable 8 072 736 10 209 37 727 Operating liabilities 1 133 705 1 269 974 1 614 435 1 990 612 Trade creditors and bills payable 416 294 497 239 574 402 660 898 Receipts in advance from customers 0 0 363 442 489 225 Accrued expenses and other payables 607 628 652 197 555 337 689 749 Current tax payable 16 675 37 781 31 265 29 135 Employee retirement benefit liabilities 28 033 22 065 16 066 22 624 Deferred tax liabilities 65 075 60 692 73 923 98 981 Net operating assets 2 775 854 2 617 287 2 916 563 3 408 855 Financial assets 275 267 599 346 651 180 478 742 Investment properties 5 140 4 614 4 088 3 628 Bank deposits 1 406 0 0 0 Assets of disposal group classified for sale 218 078 0 0 0 Cash and bank deposits 50 643 594 732 647 092 475 114 Financial liabilities 378 491 210 077 28 187 44 508 Derivative financial instruments 2 190 618 181 0 Current bank loans 139 652 7 329 27 085 44 508 Non current bank loans 207 341 200 000 0 0 Liabilities of disposal group classified for sale 26 039 0 0 0 Non current obligations under finance leases 2 134 909 0 0 Current obligations under finance leases 1 135 1 221 921 0 Net financial assets - 103 224 389 269 622 993 434 234 Minority interest 212 128 218 337 259 389 304 148 Common Shareholders' Equity 2 460 502 2 788 219 3 280 167 3 538 941 Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 6 Reformulated Statement of Changes in Shareholders' equity in thousands o f HKD 2 016 2017 2018 2019 Beginning book value of common equity 2 124 672 2 411 863 2 689 706 3 169 146 - Non controlling interest 205 587 212 128 218 337 259 389 + Dividends payables 208 504 260 612 316 850 370 410 Real balance 2 127 589 2 460 347 2 788 219 3 280 167 + Capital contributions 60 894 46 269 77 877 48 347 - Share repurchase 0 0 0 0 - Dividends - 208 504 - 260 612 - 316 850 - 370 410 Transactions with shareholders - 147 610 - 214 343 - 238 973 - 322 063 + Net icome 530 616 618 372 585 774 695 907 + Other comprehensive income - 50 093 - 74 649 145 028 - 115 084 - Preferred dividends 0 0 0 0 Comprehensive income available 480 523 543 723 730 802 580 823 Closing book value of common equity 2 460 502 2 789 727 3 280 048 3 538 927 Profitability Analysis Return on C ommon E quity (ROCE), which is a commonly used indicator for the firm’s profitability, can be decomposed into drivers over three levels of analysis, namely analysis of operating profitability, financial leverage and oper ating spread. Each level of change in profitability can be explained by its indicators. Return on operating assets (RNOA), financial leverage (FLEV) and operating spread (SPREAD ) are regarded as indicators of operating profitability, financial leverage and operating spread respectively. Therefore, it can be said that ROCE is a weighted return to operating and financial activities. As the firm has negative N et F inancial O bligation s (NFO) , which implies that the firm has more financial assets than financial obligations, FLEV is expressed by Net Fin ancial Assets (NFA) divided by C ommon Share holders’ E quity (CSE). Also, for SPREAD , RNOA is deducted by the R eturn on Net F inancial A ssets (RNFA) instead of N et B orrowing C osts (NBC) when the company handl es financial assets instead of being a borrower For RNOA, it can be further decomposed into two drivers which are P rofit M argin (PM) and A sset T urnover (ATO), given an equation suggests that RNOA is the product of the firm’s PM and ATO. PM is driven by I ncome S tatement items such as gross margin and general administrative expenses, while ATO is mainly driven by B alance S heet items such as the firm ’s receivables and payables. The main drivers for FLEV are NFA and CSE , given an equation suggests that FLEV equals to NFA divided by CSE. Finally, RNFA is determined by the earned N et F inancial I ncome (NFI ) proportion to the firm’s NFA. Then, the effec t of the above - mentioned drivers on the firm’s profitability would be analyzed : At the first level of analysis, the main indicator of the firm’s profitability, ROCE , is calculated. ROCE increase d to 24% from 2017 to 2018, then dropped significantly to 17% in 2019. To explain the changes, drivers of ROCE, RNOA, FLEV and SPREAD should be analyzed. Vitasoy’s weighted return to operating activities can be explained by RNOA. 0.0% 10.0% 20.0% 30.0% 2 0 1 6 2 0 1 7 2 0 1 8 2 0 1 9 R O C E 0.0% 10.0% 20.0% 30.0% 40.0% 2 0 1 6 2 0 1 7 2 0 1 8 2 0 1 9 R N O A Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 7 The firm’s RNOA exp anded to 29% from 2017 to 2018, then dropped significantly to 19% in 2019. This fluctuation can be explained by its two drivers PM and ATO. PM grew from 7% to 11% in 2018, mainly driven by other income earned from exchange gain on translation which is on a trad ing basis. From the firm’s consolidated income statement, we can see that for 2017, Vitasoy experienced an exchange loss in 2017 but then earned a massive gain in 2018 This difference leads to the rise of PM . In the next year, PM decrease d to 8%, mainly driven by the absence of other income. It can be concluded that the exchange difference can be an unusual item which can make Vitasoy’s profitability fluctuates as it sells products all over the world. The ATO rose from 2.18 times to 2.56 times from 2017 to 2018. The increase is mainly driven by the firm’s return on investment on PP & E. The firm spen t a huge amount of investment on the improvement of existing plants to ensure good quality control and efficiency of it s production. The investment in new plants also retrieves the firm’s bottleneck from the existing fully utilized production capacity. More units of the product can be sold to the market and this brings to more sales revenue generated. In the following year , ATO slightly increased from 2.56 times to 2.61 times due to further investment in PP & E. However, the growth in ATO slowed down due to keen competition in mainland China. Under the co - effect of worsening the Chinese economy by the Sino - US trade war, the d ownside risks of the firm’s sales revenue have increased. For 2018, both PM and ATO rose lead to an increase in RNOA. Even though PM and ATO go in the opposite direction in 2019, RNOA decreases in 2019 as a percentage increase in ATO is much lower than the percentage decrease in PM. Apart from PM and ATO, there are furthermore three drivers for RNOA, namely R eturn on O perating A ssets (ROOA), O perating Liabilities L everage (OLLEV) and O perating L everage S pread (OLSPREAD). 2017 2018 2019 ROOA 11.16% 19.04% 12.92% OLLEV 48.39% 57.00% 62.57% OLSPREAD 9.68% 16.66% 10.91% All three indicators increased from 2017 to 2018. Specifically, ROOA surged from 11% to 19%, while OLLEV increased from 48% and 57%, and OLSPREAD from 10% to 17 % . These significant upsurge s imply that Vitasoy tends to rely more on support from suppliers as the short - term borrowing rate is low in 2018. According to the statistics from the HKMA, the closing short - term borrowing rate in 2018 is about 2.0%, which is typically very low for the firm to engage in credit purchases. The firm hence benefited from credit support and enjoy an upward movement of its profitability. On the other hand, the economic situation for firms became more difficult due to the Sino - US trade war. Suppliers tend to charge a higher rate of short - term borrowing when the firm engages in credit purchases. Also, operating income decreased in 2019 due to weakened R MB which leads to a n exchange loss suffered from trading during the year. As a result, Both ROOA and OLSPREAD dropped in 2019. As the slight increase in OLLEV cannot cover the downward effect caused by shrinking ROOA and OLSPREAD, the overall RNOA decrease d in 2019. This can show how suppliers' credit support is important to the firm’s profitability. Vitasoy’s weighted return to financing activities can be explained by FLEV and SPREAD 2017 2018 2019 FLEV - 5.45% - 16.68% - 15.50% RNOA 15.85% 28.54% 19.74% RNFA 105.14% 1.81% 2.29% SPREAD - 89.29% 26.73% 17.45% 0.0% 5.0% 10.0% 15.0% 2 0 1 6 2 0 1 7 2 0 1 8 2 0 1 9 P R O F I T M A R G I N 2.00 2.10 2.20 2.30 2.40 2.50 2 0 1 6 2 0 1 7 2 0 1 8 2 0 1 9 A S S E T T U R N O V E R Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 8 For the FLEV , it decreases from - 5% to - 17% in 2018, mainly because the company repaid its bank loan in full amounted to HK$20 million. Such a huge drop in financial obligation will push down the firm’s net financial leverage. In 2019, FLEV showed a slight rise from - 17% to - 16%. Given that this change is immaterial comparing with the fluctuation of the other drivers of profitability, we can leave this insignificant drop when doing the analysis. The SPREAD , which is computed by deducting RNOA by RNFA, increase d significantly from - 89% to 27%. The 2017 financial performance of Vitasoy showed a negative operating spread as there was a huge financial income for the year. In 2017, the company earned an unusual financial income from the disposal of assets and liabilities for sale amounted to HK$18.9 million. This is regarded as a sudden rise in financial income obviously, but this increase will not be persistent as the firm may not dispose financial assets freque ntly. As the disposal gain is absent in 2018, the overall RNFA dropped significantly. As a result, SPREAD increase d to a large extent in 2018. In the following fiscal year ended 2019, operating spread dropped slightly from 27% to 17% mainly driven by the a bsence of other income which is exchange gain on translation as mentioned in the above discussion on RNOA. Finally, the effect of the changes in the drivers on the firm’s profitability can be concluded. Provided that ROCE can be decomposed into the above three main drivers, the changes in profitability can be explained by their fluctuations. The table below sum marized changes in the drivers. 2017 - 2018 2018 - 2019 ∆ RNOA Increase Decrease ∆ FLEV Decrease Increase ∆ SPREAD Increase Decrease In 2018, Vitasoy’s FLEV decrease and SPREAD increase would lead to the amount in the blanket decrease. Under the co - effect of the rise in RNOA, the firm’s ROCE increase as a result. This analysis matches the changes in ROCE calculated at the first level of changes in profitability. The increase in ROCE also implies improved profitability in 2018. In contrast , SPREAD has been reduced in 2019. Under the co - effect of drop in RNOA, the firm’s ROCE cutback gradually. This result match with the calculation of ROCE in the first level of changes in profita bility. The dec line in ROCE also implies slightly worsening profitability in 2019. Earnings Sustainability and Questionable Accounting Practices • Watch for deferred revenue Vitasoy is not so transparent about this matter. Among the past financial sta tements, it only explicitly reported unearned revenue in 2018 and 2019. For other years, unearned revenue is merged with accrued expenses and other payables so that we cannot distinguish it. in thousands o f HKD 2 019 Balance (31 - March - 2018) 363 442 Exchange adjustment - 23 370 Recognition of unearned revenue - 338 310 Increase in unearned revenue related to sales deposit 4 535 518 Recognition of unearned revenues related to sales deposit - 4 048 055 Balance (31 - March - 2019) 489 225 During 2018 - 2019 , after being adjusted for exchange difference, the unearned revenue from the last period was $340 072, among which 99.48% ($338 310) was recognized as sales. Over the year , the company received forward sales deposits amount to $4 535 518 and most of them have been recognized within the year, carrying $489 225 unearned revenue for the next period. Since this part was settled within the year, only the amount of $338 310 is from the “cookie jar”, which is insignificant compared to the core operating revenue of $7 526 495 in 2019 (around 4.5%). Therefor e, we should conclude that Vitasoy s upposedly is not manipulating unearned revenue to create fake sales. Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 9 • Watch for marketing expenditures Vitasoy does not disclose exact amount of cash spent on marketing, we can only observe the amount spent on marketing, selling and distribution as a whole has an increasing trend over the last for years. When measured as a proportion of sales, they appear to be stable and have no effect on exaggerating future earnings. in thousands o f HKD 2 016 2017 2018 2019 Operating revenues 5 551 898 5 406 090 6 464 525 7 526 495 Cost of sales - 2 726 117 - 2 532 704 - 3 044 767 - 3 484 665 Gross margin 2 825 781 2 873 386 3 419 758 4 041 830 Marketing, selling and distribution expenses 1 496 807 1 491 517 1 729 371 2 104 514 Expense ratio 27.0% 27.6% 26.8% 28.0% Although we do not have the exact statistics for 2020, we can infer that since Vitasoy’s marketing expenses for the 2020 Q4 had already been put in place, if we consider the effect of Covid - 19, these expenses did not achieve their expected effect, which might hurt the sustainability of future earnings. • Watch for the pension costs in thousands o f HKD 2 016 2017 2018 2019 Current service sot 3 749 3 824 3 351 3 197 Administrative expenses 193 91 119 88 Net interet on net defined benefit liability 94 244 264 212 Total amonunt recognized in profit or loss 4 036 4 159 3 734 3 497 Actuarial losses 5 441 - 5 356 3 169 3 463 Return on plan assets 5 641 - 4 235 - 7 892 2 097 Total amount recognized in other comprehensive income 11 082 - 9 591 - 4 723 5 560 Total defined benefit expense 15 118 - 5 432 - 989 9 057 In Vitasoy’s case, expected return on plan assets is only a tiny and neglig ible proportion of earnings and is not likely to be used to exaggerate earnings. • Reformulate income statement to identify core and unusual items Reformulated Income Statement to identify Core and Unusual items in thousands o f HKD 2016 2017 2018 2019 Core Operating revenues 5 551 898 5 406 090 6 464 525 7 526 495 Core Cost of sales - 2 726 117 - 2 532 704 - 3 044 767 - 3 484 665 Core Gross margin 2 825 781 2 873 386 3 419 758 4 041 830 Core Marketing, selling and distribution expenses 1 496 807 1 491 517 1 729 371 2 104 514 Core Administration expenses 468 279 487 795 559 096 635 281 Other core operating expenses 289 393 270 273 336 872 365 019 Core Operating income from sales before tax 571 302 623 801 794 419 937 016 Taxes reported - 34 064 - 190 383 - 160 679 - 208 143 Tax effect of financial income 488 44 210 2 687 3 553 Tax on other operating income 5 875 5 746 - 798 724 Tax allocated to unusual items 0 0 0 0 Operating income from sales after tax 543 601 483 374 635 629 733 149 Government grants on PP&E 8 283 7 917 3 570 8 692 Scrap sales 8 611 1 637 1 019 4 382 Reversal of long outstanding other payables 1 720 1 970 2 441 1 679 Sundry income 7 243 14 394 7 273 7 668 Share of losses of joint venture 0 - 627 - 17 814 - 19 236 Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 10 Tax on other operating income 5 875 5 746 - 798 724 Core operating income 563 583 502 919 632 916 735 610 Unusual items after tax * 0 0 0 0 Remeasurement of employee retirement benefit liabilities - 11 457 8 579 6 095 - 5 141 Exchange differences on translation - 41 943 - 87 588 145 272 - 122 804 Cash flow hedge - 217 - 888 5 685 - 4 088 Unusual income - 53 617 - 79 897 157 052 - 132 033 Comprehensive operating income ** 509 966 423 022 789 968 603 578 * Expected pension return is listed under other comprehensive income (or unusual items equivalently) and is after tax ** Net Comprehensive Income is included in comprehensive operating income • Analysis of change in ROCE in thousands o f HKD 2016 2017 2018 2019 NOA 2 563 726 2 400 458 2 657 055 3 104 693 NFA - 103 224 389 269 622 993 434 234 CSE 2 460 502 2 789 727 3 280 048 3 538 927 ROCE 20.71% 24.08% 17.04% RNOA 15.85% 28.54% 19.74% NBC 5.45% 16.68% 15.50% RNFA 105.14% 1.81% 2.29% SPREAD - 89.29% 26.73% 17.46% Core sales PM 8.94% 9.83% 9.74% ATO 2.178 2.556 2.613 Core other income/ NOA 0.79% - 0.11% 0.09% Unusual items/ NOA - 3.22% 6.21% - 4.58% NCI / NOA 1.20% 2.70% 1.21% • Analyze the change of ROCE between 2017 and 2018 ∆ ROCE ∆ RNOA ∆ Spread*FLEV ∆ FLEX*Spread 3.37% 12.69% - 6.32% - 3.00% Δ ROCE is mainly driven by Δ RNOA, though the effect of change in the SPREAD and FLEV is non - negligible. The change in the SPREAD is significant because 2017 is a critical year for Vitasoy to turn NFO to NFA. RNFA of 105.14% is based on the average NFA, thus leads to the negative SPREAD in 2017 and large effect of change in SPREAD and FLEV. Later we can see the effect of these two terms become normal in the next period. ∆ RNOA can be explained by three parts: the effect due to ∆ PM , the effect due to ∆ ATO , and effect due to other items (including core other income, unusual incomes and the effect of NCI). Food products industry typically has a PM of 4.4 and an ATO of 2.74. Compared to the industry figures, Vitasoy has a higher PM and lower ATO. So we first place the effect due to change in PM over the effect due to change in ATO, to get a more accurate effect of change in PM. ∆ RNOA ∆ Core PM*ATO ∆ ATO*Core PM ∆ Core other income/ NOA ∆ Unusual income/ NOA ∆ NCI/ NOA 12.69% 1.94% 3.72% - 0.89% 9.43% 1.51% During this year, Vitasoy has achieved a notable improvement in terms of effectiveness. Its ability to generate more profits for given sales increased. Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 11 • Analyze the change of ROCE between 2018 and 2019 ∆ ROCE ∆ RNOA ∆ Spread*FLEV ∆ FLEX*Spread - 7.04% - 8.80% 1.55% 0.20% In that year, t he effect of change in SPREAD and FLEV are all positive and they help to mask the drop of RNOA. For the same reason, we place the effect due to change in PM over the effect due to change in ATO. ∆ RNOA ∆ Core PM*ATO ∆ ATO*Core PM ∆ Core other income/ NOA ∆ Unusual income/ NOA ∆ NCI/ NOA - 8.80% - 0.23% 0.55% 0.19% - 10.79% - 1.49% We observe that the change in RNOA is mainly driven by the change in unusual items, where exchange differences on translation account for the major part. PM slightly declined and led to a negative effect. We consider this change a minor issue. From t hat analysis, we conclude that Vitasoy’s earnings are reasonable , if not considering unusual items, and are likely to be theoretically sustainable in the future. Actually, the company announced a profit warning in late March this year , following Covid - 19 outbr eak and increasing shrinkage in Hong - Kong’s and China’s consumptions P/E, P/B and Market’s Expectation of Future Earnings Growth P/E ratio Year end Open High Low Average 31 - Mar - 19 57.968 30.662 58.73 30.662 44.696 31 - Mar - 18 36.511 28.052 39.675 27.04 33.357 31 - Mar - 17 26.259 24.592 28.218 22.858 26.038 31 - Mar - 16 28.574 23.68 32.56 21.391 26.975 Required return 2 016 2017 2018 2019 Average Hong Kong 8.56% 8.04% 7.70% 8.83% 8.28% Mainland China 7.70% 8.60% 9.67% 9.21% 8.80% P/B ratio Year end Open High Low Average 31 - Mar - 19 11.627 6.15 11.78 6.15 8.965 31 - Mar - 18 6.749 5.185 7.333 4.998 6.166 31 - Mar - 17 6.037 5.654 6.717 5.255 5.986 31 - Mar - 16 6.286 5.21 7.163 4.706 5.935 The market gave Vitasoy an average 2019 P/E ratio of 44.7 and P/B ratio of 8.97 , both high relative to the normal ratios , of 12 and 1 respectively. From the high P/B ratio, we can infer that the market is expecting future residual earnings to be larger than zero, and the book value is expected to grow at a r ate that is higher than the equity cost of capital. From the high P/E ratio, we can infer that future residual earnings are expected to be larger than the current residual earnings of $ 284.2 million, and book value is expected to grow at a rate higher than the current growth rate and the required return. Future earnings are expected to grow with sustainability. Vitasoy’s P/ E and P/ B ratios are faithful representations of investor psychology. Vitasoy is addressed as “Kweichow Moutai among Hong Kong stocks” ( 港股小茅台 ) by investors. In the past decade, it maintained a gross margin ratio of around 50% and a net profit rate of around 10%. With its brand name accumulated over years, Vitasoy has a loyal customer base in Hong Kong, Guangdong, Guangxi, and other regions. Its products are simple so it can easily maintain its market share without too much investment in R&D. At the same time, Vita soy is generous with respect to its dividend policy. It pays out around 50% of its earnings every year as dividends. So long - term investors can receive steady cash inflows every year and use them for reinvestment. Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 12 2 016 2017 2018 2019 Standard dividend payout ratio 63.75% 43.56% 47.96% 43.65% The increasing P/ E and P/ B ratios over the last four years imply investors were satisfied with the company’s performance in terms of profitability, earnings growth, and value distribution overall, and they had higher expectations every year over the last four years. Is this high P /E ratio justified for growth? Based on the required return, the benchmark we used for PEG is 1.43. Even if we use 25% as growth rate, PEG Ratio = !! # $% = 1 788 > 1 43 . Due to the current economic situation and Vitasoy’s performance in the first half of 2020, we could assume th at its growth rate is not likely to be higher and 1.788 would be the lowest possible PEG ratio, indicating that investors are over - optimistic and they are paying too much for imaginary growth. Factors beyond the financial reports • Brand name Be accused of financial fraud As a company with a long history in Hong Kong, its brand value is non - negligible. Vitasoy attached high importance to marketing and spends an increasing amount of money on marketing and distribution every year to maintain its strong brand name. Under the cost leadership strategy, the brand name is definitely a key factor to increase ATO and thus sales. Any damage to the brand name will affect valuation to a great extent. Vitasoy has grabbed a large market share in M ainland Chi na in recent years, attracting investors’ attention. Its share price soared from $ 3.5 in 2009 to $ 42.05 in 2019, representing a 13 - fold increase in market value. However, according to Valiant Varriors, there is a lot of “water” in it. Earlier this year, Valiant Varriors issued a report alleging "financial fraud" of Vitasoy. The report said the company had overstated its profit and capital expenditure in its Chinese and Australian operations, underestimated the impact of rising costs to maintain a high gross margin as well as covering its poor cash flow. The report also mentioned that Vitasoy’s financia l statistics in its financial reports diverge significantly from those submitted to China Trade and Industry Bureau. And it pointed out that Vitasoy is only worth $ 10 per share, having a potential decline of 63.9%. In response to the short - selling report, Vitasoy issued an urgent statement on January 16 , 2020 saying that the management strongly denies the allegations contained in the report and considers them inaccurate and misleading. Put aside the faithfulness of these allegations, being targeted by shor t sellers always brings suspicion to investors and affects the company's positive brand image. Products repeatedly appear on the blacklist In recent years, Vitasoy’s products appear on the blacklist many times which seriously affected its product reputa tion. On October 30, 2017, the General Administration of Customs of China (GACC) published on its website the information of food products that were not allowed to enter the country, and 55 batches of Vitasoy’s products were listed on the blacklist. In Oc tober 2018, Vitasoy’s soymilk drinks had been denied entry because of the excessive use of calcium pantothenate. In April 2019, Vitasoy’s 8100 kg milk drinks were denied due to unqualified labels. In December 2019, five batches of Vitasoy's milk products w ere refused due to filth and corruption. • Operating environment under Covid - 19 The financial report for Vitasoy in 2019 indicates the company launched subsidiaries in China for operating business. The revenue earned by two of the subsidiaries, Shenzhen Vitasoy and Vitasoy Foshan, reached near $ 2,000 million in 2019, around 25.8% of total revenue. It reveals Vitasoy heavily relied on its operating business in China. Besides Guangdong province, Vitasoy has set manufacturing plants in Shanghai and Wuhan fo r production. The spread of Covid - 19 inevitably impedes the efficiency of production within these factories. Since the outbreak, Vitasoy’s route - to - market planning and supply chain operations throughout M ainland China have been severely affected, especiall y the operations in Wuhan. As most of Vitasoy’s business in mainland China comes from general channels, the closure of small retail stores and supermarkets has a huge impact on the business. Region governments around China ordered the closure of factories and blocked the control point for entering the region in late January 2020 . Many industries are forced to shut down the production line. Even the region government approved for industries to continue in operating, they will find difficulties in maintainin g the efficiency of operation since the labour outside cannot enter the blocked regions. Insufficient demand also restricts the company's capacity utilization, resulting in a significant increase in unit production costs. Since March, as China's strict pr evention measures achieved its initial success, offline retail channels have begun to recover gradually. Now Wuhan has reopened and most regions in China are back to normal production. However, the company needs to clear the backlog first, but Arnaud SEITE arnaud.seite@link. cuhk.edu.hk 13 its shipments were not optimistic. Transportation costs have notably increased. At the same time, they still face the risks of Covid - 19 rebound as 10 provincial - level regions have reported local new cases during the last two weeks. Hong Kong market has a lso been affected by the outbreak of Covid - 19 even though its number of cases and deaths are one of the lowest worldwide . Customers switch to daily necessities therefore the overall take - home sales will decline. Sales come from convenience stores will decl ine because more customers prefer to stay away from crowded areas and keep a social distance. Sales from canteens and tuck shops in schools will also decline due to the suspension of school. These are the culprits for restriction of production, increase of unit cost and decline of earnings in Q4 2020. As a result, the company is expected to record a substantial decrease in profit attributable to shareholders for the 2020 by approximately 25% to 35% as compared to 2019 according to the management’s profit warning report. • Management for internal control Companies require internal control to ensure the effectiveness and efficiency for operations. As an international company , Vitasoy develops various operation lines in producing different kinds of beverag es all around the world. These operation lines involve different processes, such as beverage concentrating, bottling and packaging, to cooperate. These processes are linked together in chains. Errors incur in one of the processes undoubtedly will impede th e following process to operate. Minor errors in operation already ruin the efficiency for production to a high extent, and because it can incur anywhere o n the operation, detailed monitoring is necessary in each production process to confirm the operation is in control, to be effective. This is the reason why internal control is important for companies. There are five components of internal control: Risk assessment, control activities, information and communication, and monitoring, to create the most suita ble control environment for the company. Designing an effective internal control is important for companies. This is not only to maintain the efficiency and effectiveness of operations, but also help the company to comply with laws and regulations, and mak e their financial reporting be reliable. Valuation of the company undoubtedly will increase if they reach goals in these three perspectives. We will analyze the internal control for Vitasoy to determine whether Vitasoy achieves these objectives. The Corpo rate Governance Policy clearly demonstrates Vitasoy has a good control environment in management. For the risk assessment, it will be carried out by both internal audit departments and external auditors. Internal audit committee will regularly analyze any factors that may increase risk of the company (such as economic recession), assessing the likelihood of the risk occurring and determining any actions necessary to manage the risk. Assessment of risk performed internally will be reported to the board of di rectors and external auditors. Both three parties will appoint a general meeting regularly (usually 3 - 4 months a time), to review the company’s financial statement and confirm integrity and honesty for all reporting. Vitasoy also performed lots of work in control activities. Duties of directors, internal auditors and the remaining employees are separated adequately to make sure their workings will not be interfered. Directors focus on the overall strategic planning and general management, while the other e mployees aim at specific manageme