Osim @ 1.77 ( Health products / Singapore ) 11 comments

Final Poll Results: 9:3

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1. Brookstone operations showing evidence of decline

2. Core operations showing evidence of deterioration

Given that two out of the three quarters of FY06 had not exactly been satisfactory for the high standards priced into Osim's valuation, it is surprising that the market has not punished it more severely. It is now back at 1.77, about 50% higher than its year-starting market cap (after adjusting for its mid-year 1:5 split) and just 15% off its peak. Yet things are not exactly rosy, looking at the trends indicated in the financials.

First-off, the big acquisition of 2005, Brookstone. It is clear now that its equity-accounted results are having a big impact, albeit of the negative flavour, on Osim's quarterly financials. Below is a listing of the quarterly results for Brookstone alone starting from 1Q05:

Period: 3Q06, 2Q06, 1Q06, 4Q05, 3Q05, 2Q05, 1Q05
Net profit/loss (US$M): -10.3, -11.0, -11.3, +17.0, -14.5, -5.7, -6.8

Considering that in FY04, Brookstone’s sales rose 15% over the previous year to US$500 million while earning a net profit of US$21 million, it has severely underperformed in FY05 and FY06 so far, looking at the quarterly trends. Summing up the quarters, Brookstone incurred ~US$10M losses in FY05 and looks like incurring another big loss in FY06; stagnant sales growth year-on-year exhibited so far in FY06 suggests there is unlikely to be any miracle in 4Q06 (although it will be a profit). Frankly, it looks like the Osim consortium bought a dud --- as a number of Singapore companies making major acquisitions overseas have experienced (eg. Yeo Hiap Seng), in an attempt to secure an instant North American sales and distribution network. There is no free lunch in the world, and much work would have to be done to get a declining company back on track. Even worse, Osim has tacked heavy debts onto itself to finance the acquisition, from a cash-rich position before the acquisition to a high gearing of debt-equity about equal to parity now.

So far up to 2Q06, the counterweight to Brookstone's poor performance had been Osim's core massage chair business, which had hitherto been having impressive growth rates. A popular figure used to check the popularity of retail outlets is the use of same-store sales, since sales growth could be due to new outlets rather than any growth in product or brand popularity; growth due to new outlet growth is less desirable because they add to fixed overhead burden. In 3Q06 my estimates for this figure have exhibited a sharp decline in both the North Asia and South Asia markets: in North Asia, number of outlets are 17% more than in 3Q05, while sales growth in this region has declined 5%; in South Asia, number of outlets are 24% more than in 3Q05, while sales growth in this region has only been 17%. It is a dramatic decline from the previous quarters where sales had grown 30-60% year-on-year despite low store unit growth. And to add to it, profit margins have declined, leading to a drop in profit even before associate (Brookstone) impact. The more cynical can claim that Brookstone losses were used to disguise the extent of the core business deterioration, when in fact Brookstone losses in 3Q06 had actually been less than that in 3Q05 (-US$14M).

It may not be advisable, of course, to cut things too fine by analysing results quarter by quarter if we consider company strategy and budgeting (eg. marketing) tends to be drawn out over an entire year; however, Osim themselves have identified the systematic reason: the North Asia market, especially in China, is plagued by imitations that have eroded revenue and margins. Could this trend continue?

The buyer of Osim now will be betting on two things: firstly, that Brookstone eventually works out fine in the fourth quarter and that Osim can piggy-back on its sales network in the US to expand sales in the North-American market; and secondly, that Osim's brand equity is something worth buying into despite all the teething acquisition problems. Would one be willing to place this bet? I wouldn't, for a stock trading at 20X FY05 PE looking at a reduced FY06 net profit. It is true that it has had a strong track record, yet the 3Q06 results exhibiting a slowdown in core operations gives ample evidence to suggest reconsideration. Ron Sim purchased more stock after the 3Q06 results to show his confidence; of course he would, since he started the company and holds >50% of its stock on whose share price his wealth depends.

Poll(please vote)
I agree that Osim is a hot-stock-not: Yes/No