Description

Introduction

Allan International ("Allan", HK: 0684) is an OEM and ODM that manufactures and sells a wide range of household electrical appliances. The company is headquartered in Hong Kong and its sole manufacturing facility is in Lilin, Huizhou. Allan is quite small; it is currently trading at around HK$500 million in market capitalization.

It apparently does not operate in an attractive industry. The space is highly fragmented and competitive. Moreover, the products and services provided in this space are relatively commoditized. Therefore, Allan and its competitors have virtually no pricing power. In a good year, Allan earns a return on invested capital of ~7%; more recently, it has been earning low single-digit or even negative returns.

Naturally, investors are not interested in the stock, which has led to an extremely interesting situation: the company is currently trading at a market capitalization below its total cash balance. Because Allan also has minimal debt and other liabilities, it's trading at negative enterprise value. You can essentially buy the company for its current cash balance and get the rest of the business for free.

For instance, Allan owns a couple of attractive real estate properties: the ninth floor of a major commercial property in Wan Chai, Hong Kong (and two associated parking spaces), and a lot in Hui Nan Hi-Tech Industrial Park in Guangdong with three manufacturing facilities.

In Allan's financial report, the office space is valued at HK$270 million, the car parking spaces valued at HK$5 million, and the manufacturing plants in Guangdong are valued at $219 million.

The company also holds $49 million in financial assets, consisting of:

• $26 million in listed debt instruments with a fixed interest rate from 1.6 to 4.3%
• $11 million in unit-linked funds, representing equity and debt securities in "various markets"
• $11 million in debt instruments

Ultimately, what all of this analysis is trying to say is that you are essentially getting these assets for free at today's market valuation.

Risks

However, Allan is cheap for multiple reasons.

• The company's revenues have been shrinking. Past 5-year sales CAGR has been -13%.
• The company has virtually no pricing power and operates in a vicious industry. It would be lucky to earn gross margins over 15%.
• Its five largest customers account for nearly 90% of sales. The largest customer accounts for almost a third of sales.
• Its sales to the US (32% of sales) and Europe (47% of sales) may at higher risk due to trade tensions.
• The company is controlled by the founding family: The Cheung family owns 61% of the share register.

Nevertheless, I believe the company's shares are still compelling despite the issues.

Firstly, while the company's sales have been shrinking, its costs have been shrinking too. Whereas previously, the company operated two manufacturing facilities in Huizhou and Guangdong, the company recently consolidated its production footprint under one roof in Huizhou. This not only lowers the cost of ongoing operations, but also frees up their production facilities in Guangdong for rent. One facility has been leased out in April 2019; whether the other two can be leased out remains to be seen but is unlikely.

Secondly, there has been little evidence of the Cheung family using the company as its "piggy bank." The only concern I have is that the executive directors are likely getting slightly above-market pay - their annual salaries range between $1.7 to $2.7 million. Although there are also some related-party transactions, the transactions seem reasonable. For instance, the company rents out its investment property at Capital Centre and rents a smaller office in Chai Wan from a related party at a reasonable rent. Independent directors only get a modest annual fee of HK$120,000.

Finally, the company is a consistent dividend payer, and has also paid special dividends when the cash balance is large.

Margin of Safety

Assuming the company liquidates itself today, conservative assumptions suggest around a 50% return. Note that I've discounted Allan's receivables and inventory to ~50% of their face value, its investment properties by 50%, and the rest of the company's fixed assets by 60-100% while maintaining the full face value of its liabilities. Less conservative assumptions suggest 80%+ returns.

Of course, management might not liquidate today. Management has certainly not shown any signs of liquidating or selling the business. It may not even liquidate two or three years down the line.

Nevertheless, the stock will still likely offer a satisfactory rate of return from regular and special dividends. While Allan's underlying OEM and ODM business is a melting ice cube, it should still continue to be, at least, a break-even business. Historically, core operations have earned slightly positive EBIT margins, and with management's efforts to slim its footprint, costs should be even more manageable. After factoring in rental and investment income, the business earns low single-digit margins. Today, the company's shares offer a dividend yield of 6.4%, which I believe is sustainable going forward.

In a bear case scenario, I model out the company burning through ~HK$75 million in free cash flow each year (over the last five years, Allan earned an average of HK$40 million per year) and still continuing to pay out HK$20 million of dividends each year (average over last five years is HK$44 million per year). I assume that the terminal value in FY2026E is the leftover cash after dividends and free cash flows, and $450 million in investment properties and other assets (essentially flat from today's valuation). This results in a 6% IRR.

Pre-Mortem

If I permanently lose capital from this investment, it will be most likely be either from:

• The business' core operations deteriorating at a faster rate than I imagine. For instance, one of the company's customers could go bankrupt or switch suppliers. Given the operating leverage in OEM and ODM production, this may result in a greater than expected cash burn.
• The Cheung family begins raiding the company for cash, through related-party transactions, egregiously high pay, or other means.

It will be important to monitor the development of the company to manage the risk of these outcomes. Nevertheless, I believe the company's shares still offer a compelling expected return even when factoring in the probability of these two outcomes.

I think on balance, this company offers an expected annual return of 8 - 12%.

Catalyst

• Sale of company
• Liquidation of company
• Share repurchases
• Dividends