Target price: $15
Down the rabbit hole it goes
Last week, during Venture Corp’s first quarter results briefing, an intrepid reporter stood up to ask a simple question that everyone seemed to be avoiding. Quoting our report (link here), she wanted to know what Venture’s customer base was made of.
Instead of addressing the query and coming clean with the numbers, Wong not only dismissed the reporter’s questions, he remained evasive and even called us cowards.
"Do these people have the guts to show their face? Don't listen to rumours,” Wong was reported to have said, according to the Business Times.
We agree with at least one part of his comments – don’t listen to rumours. Instead pay attention to the facts. And in this report, we intend to lay the facts out straight.
30% of a lie is still a lie
The key to unlocking the truth behind Venture’s valuation is figuring out just exactly how much of Venture’s business is related to Philip Morris International’s IQOS products.
Venture has steadfastly refused to say the exact percentage, citing confidentiality agreements. What little Venture has let on is that no one customer makes up more than between 5 per cent and 10 per cent of their total sales. Market estimates range from as low as 3 per cent, to as high as 11 per cent.
No one except Venture knows the real answer but every knows this is critical to Venture’s share price.
To find out how much of Venture’s revenue is related to IQOS, we have to find out two things. One, how many of these units did Venture sell to IQOS. Second, at what price did the sale take place?
Establishing these two data points requires a process of complicated reverse engineering since Venture has refused to shed light on the process. Fortunately, the data and information is freely available in the public.
Modern contract manufacturing is as much as business about logistics than it is about actual production. In Venture’s IQOS production case, it relies on a range of suppliers to make the product.
One key plastic supplier for Venture is a Chinese manufacturer called Xiamen Intretech (002925). In its IPO prospectus, Venture is listed as the largest customer of the company (see snapshot below), contributing 52.73 per cent, or about RMB 690 million/S$144 million in revenues alone. (The Chinese count in 10,000s. So, 69,702.54 in the report below is really 69,702.54 multiplied by 10,000.)
What is more interesting is how Intretech describes the products that it sells to Venture. It calls them “electronic smoke precision plastics parts”, which are most likely parts that are related to IQOS.
Figure 1 Table showing contribution of Venture's sales to Intretech
According to Intretech’s Initial Public Offer prospectus, the Chinese manufacturer said they sold about 7.95 million units of “Innovative Consumer Electronics Products” in the first half of 2017. This is most likely where sales of plastic components for IQOS are parked under. (See table below)
Figure 2 Table showing how Intertech's revenue is broken down to its various products
But we cannot assume that all 7.95 million units of these innovative electronic products are IQOS-related. We have to go back to 2014, before Venture became a customer of Intretech.
Figure 3 A breakdown of Intretech revenues for 2014 shows that Provo Craft accounted for RMB 136.7 million of the company’s sales.
Here we see that Provo Craft contributed 21.32 per cent of total Intretech’s revenues, or RMB 136.7MM, back in 2014.
To find out how many units this equates to, we cross reference this number to the same category of “Innovative Consumer Electronics Product” in Figure 2. In 2014, some 193,500 units were sold (Figure 4). It’s safe to say that this sales volume can be almost 100 per cent attributable to Provo Craft’s sales.
Figure 4 Intretech sold 193,500 units to Provo Craft
The next step is simple math: We divide the Provo Craft sales by the number of units to find out the per unit revenue for Intretech.
RMB 136.7MM / 193,500 units = 706 RMB per unit
It is possible that the 193,500 units of “Innovative Consumer Electronics Product” sold by Intretech included customers other than Provo Craft back in 2014. But given the large importance of Provo Craft’s business to Intretech in 2014 – more than 20 per cent - this is unlikely.
Armed with the per unit cost of Provo Craft’s products made by Intretech, we can now untangle that figure from Venture’s IQOS products.
We go back to Intretech’s IPO prospectus on page 1-1-241.
Figure 5 Provo Craft accounts for RMB 198.9m of Intretech's revenues
Intretech sold a total of RMB 198.9 million worth of products to Provo Craft, accounting for 15.14 per cent of its total sales in the first half of 2017. If we assume the cost per unit of Provo Craft’s products from Intretech did not change, we just need to divide the revenue by the per cost unit.
RMB 198.9 million / RMB 706 per unit = 281,500 units
Intretech sold 281,500 units to Provo Craft in 1H 2017. Total volumes of “Innovative Consumer Electronics Product” was about 7.9 million. To get IQOS volume we subtract Provo Craft units from total units produced by Intertech.
7.9 million units – 281,500 units = 7.65 million units.
We know that Venture accounted for RMB 692 million of sales for Intretch (See Figure 5). To get the per unit cost, we divide RMB 692 million by 7.65 million units. The final figure is 91 RMB per plastic component sold to Venture, or about S$19.
We did a few more checks to get the estimate for the full year of 2017. We believe that the number of plastic component units sold to Venture was about 16 million. This means that over the whole year Venture accounted for RMB 1.45 billion, or about S$300 million, of Intretech’s revenues.
This number checks out when crossed against Intretech’s latest annual report figures (Figure 6) (http://www.cninfo.com.cn/finalpage/2018-03-30/1204546628.PDF). They stated that their top customer is responsible for RMB 1.48 billion of revenues. They do not disclose the name of this customer but it is clear that the top customer for Intretech is Venture.
Figure 6 Intretch's top 5 largest customers
Run, not hide
After all of the math, some wonder if all this serves only to confuse.
The best way to address this is to hear it is from Intretech itself.
During their IPO presentation, the company’s own spokesman said that at least RMB 1.5 billion in revenues is from IQOS alone. That’s right, they said upfront that they are producing for IQOS, through Venture.
But we know that the plastic component is likely to be just a small part of the entire product.
Here, we had to rely on the ground research and interviews to establish a few more facts.
1) The plastic component accounts for between 20 per cent and 25 per cent of the entire IQOS product cost.
2) This means that Venture should be selling the fully assembled product to PMI for between US$75 to US$80. PMI retails IQOS for about US$150.
If we assume that Venture sold about 85 per cent of its products produced to PMI, we can safely arrive at the conclusion that Venture produced about 13.5 million IQOS units in 2017.
This equates to about S$1.2 billion in IQOS sales to PMI – or about 30 per cent of its $4 billion revenue. The actual figure is likely to vary between 25 per cent and 35 per cent, largely because we can’t be sure how many plastic components are required for each IQOS unit.
But it is most definitely likely to be more than 10 per cent, as stated by Venture.
The market has started to cast doubt over Venture’s numbers. What’s rattling investors is their dogged refusal to address these pressing questions. Over the past week since the Q1 results, Venture’s share price has continued to fall. Investors are bailing out and it is easy to see why.
The question is, how deep does the rabbit hole go?
With the dismal Q1 earnings, which fell 8 per cent, one can be sure that full year earnings would be down by at least 8 per cent, if not more. That would equate to full year earnings estimate of S$419 million.
This means they are trading at roughly 13.5 times forward earnings. This is much too high.
Taiwanese Foxconn and Hon Hai trade at about 10 times forward earnings. Their clients include blue chip clients such as Acer, Cisco, Dell and Google, just to name a few. Also, Hon Hai’s is not to be mistaken for being just a contract manufacturer. They have spent tens of billions of dollars into research and development globally and has a total of 49,599 granted patents and 56,098 patent applications distributed into 60,691 patent families.
Venture has been called Singapore’s Foxconn. Perhaps, to a certain extent. But they are trading much higher than Foxconn, which does not make sense.
Secondly, Venture’s sales and earnings have clearly peaked. We expect a major slowdown in earnings and margins in Q2 and potentially even a decline going into 2019.
We believe that Venture should be trading at best 10x forward earnings. This means they should be trading at no more than $15. If this sounds low, it is not. Remember, Venture was trading at just $10 in early 2017.
The only way to be sure whether we are cowards or truth seekers is for Venture to own up on their numbers.
In the meantime, we will see you at halfway down the hole, on level 15.
 91 RMB x 16 million units = RMB 1.45 billion
 16 million units x 85% = 13.5 million units