GOBI Cashmere EQUITY RESEARCH BUY. Old brand, new fashion

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1 EQUITY RESEARCH BUY Stock Information (MNT) Stock Code GOV Price 5000 Target Price 7000 Upside Potential 40% Market Cap 39 billion Key Financials P/E 23 ROE 5% ROA 3% Net Profit Margin 5% EV/EBITDA 9 Dividend per share 0.16% Debt 19,966 Cash 1, Analyst Dotno Dashdorj dotno@micc.mn GOBI Cashmere Old brand, new fashion Due to analyst departure, we are re-initiating our coverage of Gobi JSC with a BUY rating and a target price of MNT 7000 upon reviewing the company s performance and management plans. As the structure and operations of the company have not changed, our report focuses on the performance and future plans. Comprehensive strategy in quality improvement, marketing and product reinvention. Gobi s management has invested significant capital on improving competitiveness in both domestic and international markets. As the oldest and most prestigious cashmere brand name in Mongolia, Gobi s management seems committed to maintaining, if not increasing its domestic and export market share. Substantial equipment upgrades for improved quality and efficiency. Gobi spent over MNT 20 billion between 2007 and 2011 on new equipment purchases for its factory, and 2012 marks the end of this upgrading process with a new Italian spinning machine by Gaudino. Brand-building efforts to establish products as luxury goods. A new collection by Italian designer Salvatore Palatella best embodies this change. Gobi is adopting newer and more fashionable designs to target a younger and higher-income demographic group. Adjustment of product types to increase value-adding processes to achieve higher export and revenues. Gobi invested in machines to create higher quality finished products, and thus will decrease its production of half-finished knit products (such as cashmere and wool fabric) and processed cashmere fibre, which fetch lower prices. The new machines will allow Gobi to create thinner and lighter products more suited to warmer climates such as Europe, East Asia and North America. Preferential treatment from the Government of Mongolia. Gobi is able to obtain long-term loans from the government at a discount. It also received a 5-year MNT 10 billion loan from the European Bank of Reconstruction and Development (EBRD) at a discount. This low cost of debt is beneficial for the company s expansion and dividend paying ability. Regular dividends, big increase in As major investment activities for expansion are completing, we expect sales and profits to rise, which will raise the dividend.

2 Changes Capital Investments Gobi JSC has spent over MNT 15.5 billion (USD 12 million) between 2007 and 2010 on equipment and technology upgrades for product quality and efficiency improvements. Of these, over 8.8 billion or 59% were spent to upgrade the knitting factory. Knitting is the highest value adding process, thus the products fetch higher prices. The types of machines purchased perform functions including fibre sorting, de-hairing, dyeing, mixing, spinning, knitting, weaving, finishing, soft-sewing. The capital expenditure includes other equipment for improving ventilation, mechanics, plumbing, printing and factory floor efficiency. In 2011, the dividends increased drastically, and the salaries to cash flow from sales ratio decreased, indicating the increase in efficiency. The following table shows the capital expenditures between 2007 and The company is making the last of the major purchases in Without further major cap-ex, the retained earnings will likely decrease, boosting dividends. We believe the profits are poised to increase in the next few years. Year Capital Expenditures (MNT) ,262, ,432,397, ,705,209, ,638,532, ,007,849, ,000,000 Total 15,481,250,974 Source: Company Product Type Until now, Gobi s export products included large amounts of raw and semi-processed cashmere, wool and semi-finished products such as weaved cloths. Producing these require less value adding, thus they generate lower revenues. The recent large factory purchases will allow Gobi to focus on the high-priced cashmere and woollen knit garments, add more value, and generate higher revenues. The management plans to decrease or stop the sales of the abovementioned semi-finished products. Marketing The Mongolian producers are improving their product quality in order to compete in the international cashmere garments market, where cashmere is considered a luxury good. Gobi is at the forefront of this effort, and has developed its products to have more modern, fashionable design. One of the key signs is its new collection featuring the Italian designer Saverio Palatella. 2

3 Figure 1. The designer collection boutique for Saverio Palatella Aside from Palatella, Gobi is shifting its design to lighter, thinner garments to suit the demand from the warmer regions in Europe and East Asia, while working to increase its exports simultaneously. The majority of the sales (65%) are in Mongolia now, thus the export market may have significant potentials. In addition, the company is working to diversify its export client base. Key Risks Cashmere prices Raw cashmere prices have been rising in the recent years, and Gobi s raw material costs have followed accordingly. High cashmere prices cuts into the profits, but there are no ways to hedge against price fluctuations in Mongolia currently. Therefore, if the price of cashmere rises in the global market, the prices in Mongolia will follow suit, and decrease Gobi s profits. Figure 2. Raw cashmere prices (MNT) * Gobi JSC average purchase price Export prices from China Average white raw cashmere price in UB *Forecast Source: Bloomberg 3

4 General Economic Slowdown If the Mongolian economy continues to grow with the current momentum, the improved purchasing capacity of the domestic market will help Gobi s sales. However, between 2012, the risk of a disorderly resolution of the Greek/European debt crisis still exists, which will plunge the global markets in to a slowdown, from which Mongolia will not be spared. In this case, all exports from Mongolia will slow down. Although Mongolian cashmere has a small market share abroad, it has lots of rooms for improving competitiveness in terms of desirability and price. Valuation Changes We have adjusted our prior target share price to MNT This update is based on new information and forecast of financials and raw cashmere prices. We also changed our forecasts based on the new plans announced by the company. We valued this stock using a DCF method on Free Cash Flow to Equity, and we used a Cost of Equity of 15% based on our assumptions about Mongolian risk premium and Gobi s risks. We assumed a straight-line depreciation for the equipment over 20 years with a salvage value of 20%. The projected maintenance cap-ex is worth 30% of the book value of equipment spent every other year starting The following table shows a sensitivity analysis on the share price based on the cost of equity. Cost of Equity Target Price per Share 10% 12,718 11% 11,134 12% 9,858 13% 8,806 14% 7,925 15% 7,175 16% 6,530 17% 5,970 18% 5,478 19% 5,043 20% 4,657 Financials Balance sheet As the following table shows, Gobi s debt has increased due to the new long term loans acquired from the EBRD and the Government of Mongolia. However, the current ration shows that the company s ability to cover its short term debts has improved. Also, since the 4

5 P/B ratio has decreased while total equity increased, the price may rise in the near future. The two-fold increase in cash and debt is in-line with the new longterm loans we mentioned before. However, as there will be no further large cap-ex after 2012, we believe the profit margins will increase. millions MNT Cash 1, ,529 Debt 8,609 9,834 9,214 19,966 Debt/Equity (market) P/B EV 52,175 37,061 53,601 60,386 Current Ratio Income Statement The company indicated that the decrease in net income was due to a sudden rise in cashmere prices in However, the increased operating margin to the levels of 2009 given the rise in sales also indicates a gain in efficiency. In 2011, the profit margin was down to 5%. However, we believe this will increase after 2012 as no more cap-ex will be made. The relatively high P/E ratio speaks more about the low earnings in 2011 than the share price. millions MNT Sales 19,586 20,247 28,895 35,365 EBITDA 630 3,093 5,013 4,259 EBIT 569 3,017 4,895 4,034 Net Income (327) 1,502 3,361 1,700 Operating Margin 3% 17% 14% 17% Net Profit Margin -2% 7% 12% 5% EBIT/Interest Expenses ROE -1% 6% 12% 5% ROA -1% 4% 10% 3% P/E (136.39) Cash Flow The following table shows the dramatic rise in dividends. We expect the dividends to rise further as the company has no reason to retain as much earnings after 2012 due to the end of the heavy cap-ex phase. Also, the new loans have longer term, and relatively low interest rates, thus we do not believe the debt repayment ratio will increase much from the current levels. Gobi obtained the loan from EBRD at 6-7% interest, which is much lower than the average 12-13% interest that Mongolian firms generally pay. We believe the decrease in the proportion of cash outflow on salaries indicate an increase in efficiency. As we explained in the Risks section, the cost of raw materials and fuel increased in 2011, and similar risks will continue to exist. 5

6 millions MNT Dividend per share Debt repayment / Cash 32% flow from sales 34% 71% Salaries / Cash flow from sales 18% 15% 14% Raw material purchases/ Cash flow from 27% 38% 45% sales Transportation expenses / Cash flow from sales 21% 9% 13% 6

7 ABOUT MICC Mongolia International Capital Corporation (MICC) was established in 2005 as the first investmentbanking firm in Mongolia. Mongolia s rapid economic development and favorable financial environment present unique prospects for investment opportunities and growth potential for companies. In order to enable our clients and investors to take full advantage of these opportunities, MICC offers investment banking, asset management, securities underwriting and brokerage services. In addition, we conduct periodic macroeconomic research, develop analyses of domestic industries and review equities listed on the Mongolian Stock Exchange. MICC continues to make history in the Mongolian financial sector. We serve leading companies in the mining, manufacturing, financial, retail trade, airline and construction sectors, and prize our close and long-standing working relationships with our clients. Our goal is to assist both local and international companies realize their strategic goals by offering innovative and efficient financing solutions. Contact Information: Central Tower, Suite 912 Mail Box 42 2 Sukhbaatar Square, SBD-8 Ulaanbaatar a, Mongolia Tel: Fax: info@micc.mn DISCLOSURE This material was prepared independently of the Company by the research analyst(s) named at the beginning of this document, for informational purposes only, and is not intended to address the needs of any specific person or entity. Any forecasts or recommendations made in this report are certified to accurately reflect the exclusive views of the aforementioned research analyst(s), based on all available information, as of the date of publication. The research analyst(s) will not be held responsible for the accuracy or completeness of the information provided in this document. The opinions expressed herein are not intended to be the sole basis upon which investment decisions are made, and neither Mongolia International Capital Corporation nor the Company will assume liability for any losses that may arise from investment activity relating to securities profiled in this report. While no part of the compensation of the research analyst(s) is dependent upon the contents of this report, Mongolia International Capital Corporation is not prohibited from transacting with companies profiled in research reports, and may at the present time or at any time subsequent to the writing of this report be involved in conducting business with the Company. 7