Beauty China @ 96.5 cents ( Cosmetics / China ) 3 comments

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Main issues

1.High valuation of 18X PE and 6X P/NTA

2.Intensifying competition from more highly-desired Western brands as China opens up post-WTO

3.Main shareholder selling

Beauty China's main shareholder has sold 14% of his original 54%, or about a quarter, of his post-IPO stake in the last year from late 2004 to recently. This should be interesting to any observer who might be interested in following the institutional investors into buying this stock.

Beauty China enjoyed a strong price surge during early 2005 when it jumped from about 60 cents to nearly a dollar after the chairman sold off about 6% of his stakes to institutional shareholders. The move triggered revaluation of the stock, mainly due to greater broker coverage, in particular Merrill Lynch who gave it an amazing price target of $1.40 or so. This always happens when big players move in; the brokers will support their clients.

Of course, Beauty China is itself a quality company, having shown consecutive years of 30-40% topline and bottomline growth, which is why several institutional funds have followed on in buying into it, such as Lloyd George and Fidelity recently. However, my view is that for investors looking to buy in now to try and catch further price surges arising from further placements by the chairman are facing more risk than potential returns.

A look at the valuation gives some cause for concern. It is trading at 18 times its trailing PE. Its NTA is low at $0.15, primarily because it is a brand management company which outsources manufacturing. Its high return on equity is partly due to this; however it is likely that the price surge has already factored this in while largely ignoring risks of low asset backing and potential earnings disappointments (because the high historical PE suggests that the price is factoring in high earnings growth of say, 30-40% in the next 2-3 years).

I have to admit that I know nothing much about cosmetics, and am not about to do any scuttlebutt on that. Probably Beauty China has a strong brand name in the China cosmetic market. However, how strong can it be when the company was only established in 1997? One thing I do know is that China opened up its retail and distribution sectors fully to foreign companies at the end of 2004, in accordance with WTO requirements. Surely the big Western companies like Revlon and L'Oreal are going to expand in a big way, given the importance of the Chinese market? It is my observation that China consumer patterns will favour Western products. I have friends who work in China, and often are asked by their China colleagues to help purchase Western and Japanese cosmetics for them on their trips back to Singapore (apparently they're cheaper in Singapore than China!). That is why I am wary of buying into China product brand companies, especially when they price in future earnings optimistically. How "sticky" is the Color Zone brand managed by Beauty China? The next year (ie. FY05) or two will be crucial, in assessing the degree to which uncumbered competition from foreign players in the retail market and distribution channels will undercut top and bottomlines of the brand. Until then, unless the investor has a clear conviction, perhaps based on personal experience or industry knowlege, that the brand is able to withstand foreign competition, he should not invest too much hopes in the brand.

Perhaps that is why the chairman has been managing his risk by converting part of his shares into cash. Meanwhile, fund managers have nothing to lose by buying into the stock since apparently the "risk" of Beauty China has been reduced by broker recommendations and by other fund managers buying. After all, if they lose money everybody loses together and no-one will be censured for buying unknown/uncovered stocks. To me, the valuation is just plain wrong.