This week's casual valuation is Jerash Holdings, a company with a market cap of $52m and a terrible share price performance (down over 50% since its IPO less than 5 years ago).
Disclaimer: Two weeks ago, I bought 100 shares (at $4/share)
This post, as all others before, focuses on sharing my analysis that is focused on the fundamentals and ends with a valuation.
Introduction
Jerash Holdings is a clothing manufacturing company, that sells 67% of its products to VF corporation (that owns The North Face, Timberland, Vans), 24% to New Balance, and the remaining 9% to other customers. This is already a risk that we need to take into account. If they lose one of the major customers, that will have a significant impact on the company's profitability.
They provide a split of their products to show that they are diversified between:
– Pants and shorts (41%)
– Jacket (35%)
– Crew necks and other (17%)
– Polo (7%)
This, to me, is completely irrelevant as there's a high correlation between the demand for each segment. If the demand decreases, it decreases for all products, almost equally.
Therefore, I find this equally relevant as if a shoe manufacturing company shares that they're diversified and manufacture 50% left and 50% right shoes.
So far, I am not providing any info on why I opened a position, but plenty why one shouldn't.
The balance sheet
I'd like to start here, as the company has $23m in cash, which is quite significant for a company with a $52m of market cap. What about debt? If we take the leases into account and the unearned revenue, that's roughly $2m. Obviously, they have a great financial position.
Their book value/share is $5.67 (vs. the current market price of $4.21).
No, the goodwill isn't significant to boost the book value significantly (it's only $0.5m).
The book value (other than the cash mentioned above) is consisting of their PPE (carrying amount of $22m) and inventory ($36m).
It is important to mention, the PPE increased significantly over the last 5 years, as they expanded their manufacturing capacity (both through capex, but also by acquiring companies that have manufacturing facilities).
The enterprise value is around $30m (market cap adjusted for cash/debt).
The profitability
In general, this is a very low-margin industry. The revenue of the company increased by roughly 60% since 2019, but its margins have decreased:
Gross margin (22% –> 18%)
Operating margin (7.5% –> 5.4%)
Operating profit is up from $6.4m to $7.5m
So, a company with an enterprise value of $30m, is generating around $7.5m in operating profit in times when their margins have compressed.
Do they have a moat? Absolutely no. The only advantage that the company has is its access to cheaper labor. Wait, did I not mention that their manufacturing facilities are in Jordan? Ah, that brings me to my list of all the risks.
The main risks
- Losing a key customer (VF Corp / New Balance)
- 84% of the assets are in Jordan, while 95% of the revenue comes from the US), which brings supply chain risk, currency fluctuation risk, political, social, and economical instability risk of Jordan and the Middle East (but also the US).
Low liquidity
Before I move into assumptions about the future and valuation, I'd like to point out that this is a company with fairly low liquidity. On an average day (in the last year), 19k shares changed ownership.
In fact, when I bought my 100 shares, I moved the price up and created an additional $1.5m market cap. Never felt so powerful before.
Analysts' expectations
The analysts are quite optimistic about the future of Jerash, expecting the revenue to grow 35% in 3 years' time. All that while improving the operating margin from the current 5.5% to almost 8%.
Me? I am not that optimistic.
My key assumptions
Revenue growth: 39% over the next 10 years
Operating margin: to increase from the current 5.5% to 6% over time.
Because they expanded quite fast, their SG&A expenses as % of revenue increased. As a company, they focused on increasing volume, while sacrificing margin. Overall, they increased the operating profit (in absolute terms), but I do expect them to decrease the SG&A as they figure out ways to optimize this segment of the business. This could lead to 2% margin expansion, but as they haven't proven that yet, well, I am not going to include it in my forecasts (unlike the analysts)
Discount rate: 12.7% (WACC-based)
I'm adjusting for the risks in 2 ways:
- Using assumptions that I believe have a high probability to come true
- Using a higher discount rate
Lastly, the ratio between the book value and the market price gives me confidence that I won't lose money, even if the risks are to become true.
On the other side, if it continues generating $4-5m in FCF, I think that's quite a good yield on $30m EV.
Outcome: $4.98/share (current market price $4.21)
Based on my assumptions, the IRR is around 16.5%.
What if I am wrong?
I could be wrong in many ways, but let's take a look at how the valuation changes if I use different assumptions regarding revenue / operating margins in 10 years' time.
| Revenue / Op. margin | 5% | 6% | 7% | 8% |
|---|---|---|---|---|
| 30% ($181m) | $4.2 | $4.9 | $5.4 | $6.0 |
| 39% ($193m) | $4.2 | $5.0 | $5.5 | $6.1 |
| 50% ($209m) | $4.2 | $5.0 | $5.6 | $6.2 |
| 75% ($243m) | $4.2 | $5.1 | $5.7 | $6.5 |
Now, looking at this table, it might seem as if it doesn't make sense. How is it possible that with a 5% margin, the valuation is the same, regardless if the company's revenue is $181m or $243m?
In order for Jerash to increase revenue significantly, they need to make huge investments. I am not only referring to new manufacturing facilities but also to capital tied in working capital (especially inventory). When that is the case and they earn 5% operating profit, that doesn't add value. Therefore, to significantly increase the value of the company, the management has to focus on improving margins (especially decreasing the SG&A costs).
Could I be wrong? Absolutely!
Thank you for reading the post until the end, I'd love to hear your feedback.
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