Is Haidilao a good stock to own?

Haidilao has been one of the top-performing stocks in Hong Kong this year. The premium hot pot restaurant brand's share price has climbed 79.4 per cent this year, compared to a 10.8 per cent gain for the Hang Seng Index.

But historical share price performance is not necessarily an indicator of future success. With that said, I decided to do a quick analysis of Haidilao's business. I will use Ser Jing's six-criteria investment framework to determine if the company is indeed worth buying.

1. IS ITS REVENUE SMALL IN RELATION TO A LARGE AND/OR GROWING MARKET, OR IS ITS REVENUE LARGE IN A FAST GROWING MARKET? 

This criterion is important because Ser Jing and I want to invest in companies that have the ability to grow. The size of the company's addressable market, and the speed of the market's growth, are important determinants of the company's growth potential.

I think Haidilao ticks this box easily. The hotpot king's revenues are still tiny compared to its overall addressable market size. 

Haidilao, as of 30 June 2019, had a network of 593 restaurants around the world. On the surface that seems like plenty but if you dig deeper a different picture emerges.

First, Haidilao has room to grow in China. The company has 550 restaurants in mainland China. Given that China's middle-class population (defined by the Chinese government as having an annual income of RMB 60,000 (S$11,600) to RMB 500,000) numbers around 420 million people, that translates to just one restaurant for every 763,300 middle-income person in the country. 

Comparatively, the largest casual dining chains in the US restaurant industry serve around 200,000 to 500,000 people (including the low-income population) per restaurant.

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If we assume Haidilao can penetrate the market at the low end of that range, it can increase its store count by more than 30 per cent just based on the current middle-income population.

On top of that, the middle income population in China is growing - and fast. Mckinsey estimates that the upper-middle-class population (defined by McKinsey as having an annual income of RMB 106,000 RMB to RMB 229,000) will account for 54 per cent of urban households by 2022, up from just 14 per cent in 2012.

That loosely translates to a population of 750 million people. The new generation of upper-middle-class is more sophisticated, has more picky taste, and is more loyal to brands.

All of which is good news for Haidilao, which already has an established reputation for good food and impeccable service.

The Mainland China market is not the company's only avenue for growth. Haidilao has successfully broken into other International markets such as Taiwan, Singapore, Japan, South Korea, Malaysia, Australia, the United Kingdom, Canada, and Vietnam.

And it has barely scratched the surface of the International market scene. It only operates 43 restaurants outside of China, leaving it plenty of room for growth. The average spending per guest outside of China is also much higher at RMB 185 per customer, compared to its overall average spend of RMB 104.4 per customer. 

The company's recent financial results also point to its ability to grow. In the 12 months ending 30 June 2019, Haidilao increased its store count by 73.9 per cent, or 252 stores. More importantly, the increase in store numbers had little impact on existing stores, signaling limited cannibalisation.

Same-store sales increased by around 4.7 per cent and the average same-store table turnover increased to 5.2 from 5.0.

2. DOES HAIDILAO HAVE A STRONG BALANCE SHEET WITH MINIMAL OR A REASONABLE AMOUNT OF DEBT?

[[nid:426411]] Haidilao is in a great position financially. As of 30 June 2019, the group reported a positive net cash balance of around RMB 2.57 billion. It also had another RMB 1.7 billion in deposits placed with financial institutions.

The company generated RMB 1.9 billion in cash from operations in the first six months of 2019; it was more than sufficient to fund capital expenditures for the opening of new restaurants which amounted to RMB 1.7 billion.

It is good to see that Haidilao is using internally-generated cash to expand rather than tapping into its reserves.

3. DOES HAIDILAO'S MANAGEMENT TEAM HAVE INTEGRITY, CAPABILITY, AND AN INNOVATIVE MINDSET? 

Haidilao has not had a long history as a listed company, but its management seems to be treating existing shareholders fairly for now.

Even though 38 per cent of Haidilao's suppliers are linked to CEO Zhang Yong and his family, the cost of goods has not increased unreasonably since Haidilao was listed. This is a sign that Zhang Yong is committed to treating Haidilao and its minority shareholders fairly. On top of that, Haidilao has also started to reward shareholders by paying a small dividend for 2018.

Zhang Yong has also proven himself to be a capable leader. Now Singapore's richest man, Zhang Yong has maintained his commitment to improving the customer experience in his restaurants.

He has also overseen the company's adaptation numerous times, including its expansion into delivery, Haidilao-branded food products and the adoption of artificial intelligence in restaurant operations.

Haidilao is also one of the more innovative businesses in the traditional F&B industry: 

• The company was one of the first to provide unique manicure and free snack services for customers waiting for a seat.
• This year, it deployed intelligent robotic arms and intelligent soup base preparation machines in 3 restaurants. It also introduced AI robot waiters in 179 restaurants.
• It has expanded its offering and now offers milk tea under the Haidilao brand. In 2019 alone it introduced 187 new dishes.
• It encourages restaurant-level managers to maintain customer service by sending at least 15 mystery diners each year to each restaurant to rate their experience. Their feedback is a key performance indicator for managers.
• Restaurant managers are also compensated based on the profitability of the restaurants under their care.
• Restaurant managers are encouraged to train mentees and they are then compensated based on the profitability of the restaurants that their mentees manage. 

These unique initiatives have helped to create a culture of providing good service and have enabled the company to retain talent more effectively.

4. ARE ITS REVENUE STREAMS RECURRING IN NATURE? 

A recurring revenue stream is an underrated but beautiful thing to have. It means the company does not have to spend time and money to remake a past sale. This can be achieved through repetitive customer behaviour or long contracts with clients.

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In Haidilao's case, its strong brand and loyal customers make its revenue streams recurring and predictable. 

Needless to say, more brand-conscious consumers are loyal to brands that they trust. Haidilao has a strong brand and sticky following with consumers. The long queues in its Singapore outlets are a testament to that.

The number of customers Haidilao serves is also obviously large. In 2018, it served more than 160 million customers! That means it has no customer concentration risk at all.

5. DOES HAIDILAO HAVE A PROVEN ABILITY TO GROW? 

Haidilao was listed only in 2018, and so far, it has shown the ability to grow based on its financials released in its initial public offering prospectus and subsequent earnings updates.

Revenue has compounded by 43 per cent per year from 2015 to 2018 and the growth rate accelerated to 59 per cent in the first half of 2019. Profit has grown at an even faster pace, at a compounded rate of 82 per cent per year from 2015 to 2018. In the first half of 2019, profit increased by 41 per cent.

6. DOES HAIDILAO HAVE A HIGH LIKELIHOOD OF GENERATING A STRONG AND GROWING STREAM OF FREE CASH FLOW IN THE FUTURE? 

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The true value of a company is not based on its profits but on all the cash that it can generate in the future. That is why the sixth criteria of the investment framework is so important.

Based on Haidilao's recognisable brand, strong customer loyalty, and the management's determination to keep customer-satisfaction high, I can see customers continuing to frequent the company's restaurants well into the future.

Haidilao is not only well-positioned to grow its store count, but same-store sales are also growing at mid-single-digits.

Although capital expenditures remain high, likely due to the opening of stores, I foresee that Haidilao could start to generate copious amounts of free cash flow in the future.

RISKS

A discussion of a company will not be complete without addressing the potential risks.

Keyman risk is an important concern I have with Haidilao. Zhang Yong is a visionary leader who reinvented the hotpot dining space, through innovative initiatives. He continues to adopt new technologies and has constantly implemented plans to improve his customers' dining experience.

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He is the key reason for the brand's huge success so far. Zhang Yong is 45 now and I don't foresee him stepping down anytime soon. Nevertheless, investors should watch this space.

Another risk is that Haidilao continues to source supplies from entities with related-party ownership. Even though these related-party suppliers have so far been fair to Haidilao, there remains a risk that things could change. 

Lastly, execution risk is another concern. The company's growth is dependent on it expanding the number of stores without affecting its existing business. Store-location choice is an important determinant of whether new restaurants succeed.

On top of that, while size improves economies of scale, it can also become increasingly difficult to maintain food quality, food safety, and the quality of the customer experience. 

VALUATION 

What is a good price to pay for Haidilao? As with any company, I think this requires a reasonable amount of judgment and estimation. 

The company recorded revenue of RMB 10.6 billion in China in the first half of 2019. Based on the addressable market size, I think the mainland Chinese market can easily absorb 1,500 Haidilao restaurants. That's a three-fold increase.

The international market is a bit harder to estimate. But I do think Haidilao can easily increase its store count in geographies with large Chinese populations such as Taiwan, Singapore, Malaysia, Australia, United States, and Hong Kong. For simplicity's sake, let's assume it can increase its current international store count of 43 by three times to 129.

We will also leave out the growth in delivery sales for now. 

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Based on these assumptions, Haidilao can achieve an annual profit (assuming net profit margin remains the same) to shareholders of around RMB5.5 billion.

If we attach a multiple of 30 times to that figure, we can estimate a reasonable future market capitalisation. Based on this rough estimation, the company's future market capitalisation should be around RMB 164 billion.

I think that Haidilao, at the current rate it is expanding its network, can realistically hit that level of profit in eight to 10 years.

If I want to achieve an annualised return of 10 per cent, the most I would pay for the company would be RMB 76.5 billion.

At its current share price, it has a market capitalisation of RMB 154.8 billion, which is around 74 times trailing earnings. The company's current market cap is twice the amount I would be willing to pay based on my calculations.

Although the numbers I used for my estimation may be conservative, the current market cap seems inflated and leaves investors exposed to huge risk should the company fail to achieve the anticipated growth.

THE GOOD INVESTORS' CONCLUSION 

Haidilao ticks all six criteria of Ser Jing's investment framework and is certainly a good business with great prospects. I think my estimates of the potential addressable market are fairly conservative, and the company could easily grow faster and bigger than I predicted. The addressable market could also grow much more as the Haidilao brand could penetrate the International market more deeply.

But despite all that, from a valuation perspective, the company's share price is a little too expensive for my liking. It leaves very little room for execution error. Should Haidilao fail to deliver my projected growth, its stock might also risk valuation-compression.

As such, even though Haidilao is a solid growth company, it is only on my watchlist.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.