Introduction:
Hai Di Lao is the most popular hotpot restaurant in China and most of Asia. It's known for the extraordinary customer service and extremely cordial atmosphere. However, it may be tough to continue achieving the impressive Y/Y growth that HDL is used to due to a few reasons such as lack of clear management guidance, tough margins and the nature of the business.
Investment Thesis 1:
Lack of Clear Management Guidance
Due to Covid-19, HDL's management had to strategically close down stores. Management recognizes the need to be more conservative and has laid out the “Woodpecker” plan. The plan is to close business that (1) have low customer traffic due to a lack of established business district, (2) Unsatisfactory performance (3) Areas with high HDL density.
But beyond this plan, management did not lay out any other plans going forward. This opacity makes it hard to maintain confidence in management and whether they are steering the ship in the right direction or into an ice berg. With their earnings report usually laying out very vague plans on using technology to enhance the experience for customers or describing R&D with very low barriers to entry.
Investment Thesis 2:
Tough Margins
The Unique Selling Point (USP) for HDL may turn out to be a double edged sword. With very strong economic incentive to motivate employees, the margins for HDL may be significantly lower than other restaurants. This problem is temporarily buoyed by the weak housing market in China that allows HDL to buff their margins with very cheap rent. However, the areas for HDL to shave margins are low. This means that HDL's only other way of improving margins is to improve revenue through charging an even larger premium. However, I'm skeptical of whether HDL is able to do that or not as HDL is still a restaurant chain it is not an established restaurant that can command a very high premium.
Investment Thesis 3:
Nature of the Business
HDL's business model is that they would have a very interactive waiting areas e.g. Customers can fold paper cranes while waiting for their table to reduce their final bill. The longer the customers wait, the hungrier they get and the more food they will order. However, this also means that opening up restaurant has negative within firm externality. Customers could choose to simply head to another nearby outlet which is less crowded, which means that opening new restaurants may yield declining ROIC overtime. With the strong 996 culture in China, it may also mean that the restaurant business becomes less viable as customers have lesser time and patience for Hot Pot.
The room for innovation in the hot pot restaurant isn't a lot and this lack of innovation may severely limit the potential margins for HDL.
Revenue:
I've assumed that HDL will carry out its Woodpecker plan for 2 years before proceeding back into growth mode for 5 years before slowing its pace of growth. Revenue/Restaurant will also increase as I assume that due to HDL closing down less effective stores and gaining even more brand goodwill the prices it can charge will increase as well.
Forecasting number of restaurants to be opened, I followed historic Y/Y trends and overall had a CAGR of restaurants opened at 3%.
Forecasting Revenue/Restaurant, given that less effective restaurants are shuttered I’d assume that revenue/restaurant increases back to 2021 level by the end of the woodpecker plan before decreasing in the expansion years. And in perpetuity holding at higher than pre covid levels.
Delivery pegged as a %restaurants, rationale being that as the business performs well the goodwill of HDL will carry, improving customer loyalty. Even though more restaurants may mean more convenience to just eat at the restaurant, due to China’s 996 culture it may not be a feasible option, so I purely consider this under the rationale of HDL’s goodwill improving.
Same with the sale of condiments, the main reason for condiments to be sold is because of the strong goodwill for HDL and consumer’s trust in the quality of HDL so I’ve opted for less granularity. (You don’t see HDL advertising their condiments, and mainly sell in their own HDL stores, not supermarkets.)
Revenue Model: [INSERT]
COST:
RENT EXPENSE
Rent is significantly cheaper now than 2018 levels because of a myriad of reasons (1) During the property craze before China's 3 red lines was established there was a large influx of funds for property (SOURCE) leading to supply of properties to increase drastically. (2) The collapse of Evergrande led to demand for property investment cooling off.
I’d argue that this depressed rent cannot last forever, given that Rent Expense as a % of revenue went from 4% in 2018 to 0.9% in 2022. I’d assume that amount will bounce back to about 2.5%. However, that timing may take a very long while as defaulted property developers have to finish their development and it takes time to rebuild confidence. So I’d assume it takes about 10 years to bounce back to 2.5%.
STAFF COST & RAW MATERIAL
From 2019 – 2021, as HDL was aggressively growing they did not manage their variable cost effectively so their Staff Cost & Raw Material as a % of Revenue started ballooning. I believe at the end of the “woodpecker” plan these costs as a % of Revenue will drop back down to 2018 levels as HDL more effectively manages these costs. During the expansion plan, these costs will balloon back up to 2021 levels before dropping back down to even lower than 2018 as HDL now enjoys a significant amount of Economies of Scale.
OTHERS
Assumed to be a %revenue and opted for less granularity, forecasting it based on historical trends.
Cost Model: [INSERT]
WACC:
Cost of Equity
10Y China T-Bond (1M Avg) = 2.69%
A+ Risk Spread (1M Avg) = 1.07%
RFR = 1.62%
ERP = Unable to find any reliable analyst’s forecast for ERP, the next best alternative is to take US stable market ERP + Adding in china’s currency default risk.
ERP = 6.48% + 1.07% = 7.55%
Beta (SOURCE) = 0.73
COE = 7.13%
Cost of Debt
A+ Bond Yield (1M Avg) = 5.47%
Tax Rate = 25%
COD = 4.10%
Weightage
Shares Outstanding = 5415M
Market Value of Equity (1M Avg) = 122 921M
Weighted Average Life of Liability = 3 Years [INSERT]
Interest Expense = 473.879M
Market Value of Liability = 8850M
%Liability = 0.07%
%Equity = 99.3%
WACC = 7.37%
ASSUMPTIONS:
- Tax Rate at 25% for my entire forecast.
- There is no Cannibalistic Externality for opening up new restaurants.
- “Woodpecker” Plan lasts for 2 Years and HDL will expand for 5 Years.
- Change in NWC will follow historic trend. NWC schedule [INSERT]
SANITY CHECK:
(SOURCE)
CONCLUSION:
Ultimately, I value HDL at RMB$12.55. I believe that my valuation differing from market's valuation could potentially be due to the opacity in Management's future plans. The Market may be more optimistic in how long they believe “Woodpecker” plan will last for and how high the growth of HDL can be. The optimism could also stem from the belief that Hot Pot will become more popular in other parts of the world, this international expansion was one aspect which I did not consider in my DCF.
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