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It’s my 200th post – I’ve been saving up! These are a few of my favourite things

i) Emerging Markets:   No surprise there, I recently posted a detailed write-up of my emerging (& frontier) markets investment thesis. They enjoy some key advantages – younger/faster growing populations (with far lower entitlements), labour costs that are a fraction of developed market costs, control of a major portion of the world’s natural resources, low/stable debt ratios, a 50% share of world GDP, and GDP growth expected to be twice that of developed markets. And all this is offered at a discount!?

However, all investors see is a slowdown in emerging market growth (a legacy of the financial crisis) vs. developed markets which are bouncing back (fueled on the crack of QE) – emerging markets have been punished accordingly. But you can’t escape the fact these markets will probably generate far superior GDP growth for years to come… As an investor, that kind of growth (& value) is exactly where you want to be. Unfortunately, emerging market stock-picking can be a daunting task! A short-cut is to seek out Western listed/managed companies with a majority of their revenues & profits in emerging markets – presuming they’re on sale at the right price, that is…

ii) Luxury Goods:   I’ve an enduring faith in human vanity & insecurity – luxury goods companies have long existed to satisfy those traits. By selling dreams, status, taste, style, heritage, exclusivity…basically wants, not needs. But needs can usually be satisfied at a fair price, while wants are often infinite & indifferent to price. Of course, this creates a v desirable opportunity for companies – high-margin annuity revenue streams.

Luxury was originally an elite privilege, but increasing democratization has opened up middle class aspiration as a huge new market. We’ve also seen wealthy emerging market consumers indulge in an orgy of conspicuous consumption, which shows no signs of abating – it’s even trickling down to the burgeoning middle classes in those markets. Noting the demographics, and slower developed market growth, an increasing emphasis on domestic consumption can be expected in emerging markets – luxury goods will be an obvious (& probably unintended) beneficiary. And it’s already happening, the Chinese are now the world’s top luxury goods spenders!

Obviously, luxury goods companies are now a great play on my emerging markets investment thesis. Unfortunately, their high margins & attractive long-term growth profile are usually priced accordingly! Seems like the only time to buy these companies is when they’re really suffering, or margins are non-existent – and that’s a bloody tough purchase to make! Probably my biggest mistake in the past few years was almost buying Mulberry Group (MUL:LN) at sub-100p back in 2009. At least it’s encouraged me to patiently watch & wait for another opportunity ever since…

iii) Auction Houses:   Auctioneering is probably the most attractive agency business you could invest in. Their commission rates are high, they get to charge both buyers & sellers, they require limited capital, and the business model usually has some inherent flexibilities to deal with the economic cycle. After all, it’s a people business – presuming you staff appropriately, you should enjoy a decent margin in most circumstances. But if volumes & prices escalate, you enjoy relatively fixed costs & increasing economies of scale – for example, it’s just as easy to sell a $100 million painting as a $50 mio one. Which means 25-30%+ operating margins are v achievable. [I’m reminded of another favourite of mine – asset managers!]

The internet’s proved to be an opportunity – enabling brand-new online models like eBay (EBAY:US), but mostly providing support & broadening the reach of existing auction models. Which reminds me of another compelling auction attribute – the network effect (online & offline). Rising volumes, coupled with greater utility & expertise, attracts increasing numbers of sellers as they gravitate to the largest pool of (likely) buyers. And vice versa, of course (specialization obviously enhances the effect). All in all, auction houses are scaleable, low-risk & high-margin businesses – but rather frustratingly, they’re almost inevitably too pricey for me. Again, it’s been a long wait for a bargain…

OK, let’s be greedy – what are the chances of a threefer here? Yes, a stock which offers all of the above, and is a bargain to boot. [And no, I don’t mean Sotheby’s (BID:US)! Though I think it qualifies – but perhaps the price is too steep, even if Dan Loeb’s getting involved]. So…let’s introduce:

Saga Furs (SAGCV:FH)

Saga Chart

Ugh, feel like throwing up on your shoes at the thought of buying into that price rally? You might want to stop reading now. Ditto, if fur provokes the same visceral response. Otherwise, keep reading – could Saga Furs possibly still be a cheap stock..?

First, let’s tackle the elephant mink in the room. Fur’s an emotive subject, courtesy of PETA et al. In addition to being offensive (& oddly sexist), their campaigns wilfully misrepresent the fur trade. For decades, they’ve focused on trapping & Chinese fur farms – which are worlds apart from regulated & certified European/N American fur farming. More galling is the utterly absurd irrelevance of this focus on fur: The industry produces 55-60 million pelts a year – a rounding error vs. the billion animals that produce leather each year, and the tens of billions (seriously, check it) of animals slaughtered each year for food. I suspect the old stereotype of plutocrats in fur coats is at play here – an Hermes handbag goes unnoticed, but there’s nothing like fur to enrage a class warrior!

Since we’re on the subject of food & animals, PETA might want to re-prioritize: a) The US food supply produces 3,900 calories per person per day. Where’s it all going?! Why not take a bite of a cupcake, then stomp it into the dirt in front of a hungry third world child? And b) The US pet industry’s now worth $56 billion – yes, every single US household spends nearly $500 a year on pets. How much food, vaccinations & education would that buy for the same neglected child? How about a PETA campaign highlighting these obscenities?

Personally, I’m all for improved regulation & certification – but I also recognize humanity’s used meat, fur & leather for thousands of years. We’re not changing now… There is no right or wrong here, and only one obvious compromise (as with so many things in life) – feel free to abstain, but don’t dictate your choice to others. Anyway, PETA’s decades-long campaign has failed miserably – nobody cares! The new millennial generation’s simply too busy Instagramming their damn food. And I read somewhere, all but one of the original naked models has worn fur since.

Because fur’s back, baby!

Let’s rewind – the fur trade endured the anti-luxury/fashion 60s & 70s, only to run slap bang into PETA’s anti-fur campaign in the 80s & 90s. That just left rich old ladies wearing fur…while a new generation forgot all about it. Then the 2000s arrived & fur was rediscovered. And its exile bestowed an unusual legacy – the latter part of the 20th century’s forgotten, fur now echoes the glamour of Hollywood’s golden age, while also managing to be a slightly daring & ultra-modern fashion material & accessory. And that mix of classic & contemporary is exactly what all luxury goods strive to evoke…

Now celebs & models have embraced fur again, while rappers add an extra touch of bling (and Macklemore adds his own fun/retro touch). Major designers have re-incorporated fur into their collections, and an upcoming generation of designers has been successfully courted. [Older designers tend to trim/accessorize with fur, while younger designers learn new technologies & techniques to produce lighter all year-round apparel. In Asia & Eurasia, the market’s still more oriented to fur coats & jackets]. Global retail sales reached a record $15.6 billion in the 2011/12 season – a 70% sales increase in the past dozen years. Growth’s driven by Asia (esp. China), with sales tripling in the past decade. The region now represents 35% of the global market, well in excess of European (at 28%). Eurasia (primarily Russia) is fast gaining on Europe though, with a 27.5% share, while N & S America are woefully under-represented at just 7% of the market.

About 85% of supply now comes from fur farms, with Denmark the global leader (at 28%). Overall, N Europe accounts for almost two-thirds of global supply, followed by China (around 25%), and then N America (10%) – mink’s by far the predominant fur, then fox. Farmers sell via auction houses – most are allied with/owned by fur breeder associations (only Saga is public, but the Finnish Fur Breeders’ Association is still a large share/vote-holder), and actively grade, market & promote fur. Kopenhagen Fur is the largest house, with an apparent 35-40% global market share, while Saga Furs has perhaps a 15-20% market share (NB: My rough estimates). Other houses include North American Fur Auctions, American Legend Cooperative & Fur Harvesters Auction. Now, let’s take a look at Saga’s financials – we’ll go back to 2006 to also include their pre-financial crisis sales peak:

Saga Furs I

Saga II

[And here’s my file, for reference: Saga Furs].

Total sales are total auction sales, which suffered a 39% (post-financial crisis) decline, but still managed a 71% increase over the last six years. Saga’s turnover (i.e. commission) averages out around 10.4% of auction sales – and is inversely correlated, reflecting flexible & sliding scale fees. Not surprisingly, its operating margin turned negative in 2009, but rapidly expanded to 28.6% last year on record sales. We should also note financial income consists of interest & penalties charged on buyer & breeder receivables. Considering total auction sales & presuming stiff terms, 2012 financial income of EUR 6.4 mio isn’t extraordinary. Since this income is integral to the business model, we’ll include it to calculate a (more appropriate) adjusted operating profit: So the 2009 adjusted operating margin of (1.4)% barely entered negative territory, despite a substantial sales decline. And Saga enjoyed an average 24.2% operating margin over the past 7 yrs, culminating in a 2012 margin of 39.2%.

These margins highlight another key strength – Saga’s also a luxury goods company! Yes, Saga Furs is actually a decades old brand – perhaps the most famous luxury fur brand in the world. Ironically, the company only acquired the brand recently (Saga Furs changed its name from Finnish Fur Sales (FFS) after the purchase). But for many years, FFS was already a key contributor (EUR 4 m+ pa) to the brand & its development. This led to an agreement to sell all Saga furs through FFS, which culminated in the 2011 acquisition of the brand & the Saga Furs Design Centre.

This strategy’s obviously defensive & offensive. A key objective is to promote fur – in association with the International Fur Trade Federation (IFTF) & its Origin Assured initiative. But the primary objective, of course, was to create & promote a luxury fur brand. With Saga Furs responsible for 100% of the sourcing, sorting, grading & promotion of its branded fur, it now controls buyers & sellers’ access to (predominantly certified) high quality premium furs (inc. mutation pelts & about half the global fox fur market). This luxury branding also serves to differentiate its European-sourced fur, in terms of quality & price, from inferior & less regulated fur produced in China. This is a compelling proposition for fur farmers, but also for buyers: They recognize new money/emerging market consumers know real luxury comes from Europe!

Moving on – Saga also looks good from a risk perspective. Financial expense has been a minor P&L component for the past couple of years. The balance sheet also looks clean – though at first glance, receivables look alarming at 116% of turnover. But remember, these are buyer & breeder receivables – they amount to just 9.5% of total auction sales. Saga did suffer some fairly minor financial crisis-related losses, but these were later recovered. [If I recall, Saga also retains title ’til it receives payment]. As sales scale up, it’s important to remember how well the company survived that worst case scenario. The company has EUR 40.5 mio on hand, and net debt’s only EUR 1.9 m. Inventories of EUR 1.5 m nicely illustrate the auction model – Saga isn’t taking principal risk. I should also note global fur prices are set in dollars, so Saga’s turnover is essentially dollar-based (vs. a EUR expense base). This could produce a significant P&L impact – but with the EUR/USD trading ’round 1.3500, I’m fairly relaxed about the exposure. I suspect a weak dollar and/or strong emerging market currencies would encourage incremental demand anyway.

So…what’s Saga Furs worth?!

First, we need to get an idea of Saga Furs current run-rate. To date, the company’s reported Q1-Q3 (for FY 2013) – so we can calculate LTM EPS is now EUR 4.93 (and likely to improve with record Jun & Sep auctions reported since). Adjusted operating margin, at 37.0%, is similar to 2012. Turnover’s more complicated – after the Sep auction, Saga’s reported almost a cool billion in total auction sales! But that’s over a 14 mth period, as Saga’s shifting to an Oct year-end to better match the fur sales season. But total sales for the last 4 auctions (Dec, Mar, Jun, Sep) gives us an annual run-rate of EUR 891 mio. We don’t have turnover from the last 2 auctions, but if we apply recent commission rates, we can arrive at a current EUR 73.0 m pa run-rate.

Second, it might be useful to approach valuation in a somewhat round-about way – beginning with an uber-bull scenario. Well, we really don’t need a scenario, let’s just revisit the auction house & luxury goods sectors I discussed earlier. There are really just four auctioneers to consider:

Auction House

And here’s a half-dozen of the leading luxury goods companies:

Luxury Goods

Like I said, these valuations are a little rich for my blood! But you’ll note Saga basically equals/exceeds both sectors’ average operating margin & earnings growth rate (as implied by the PEG ratio). So let’s award auction house multiples to Saga – i.e. an average of a 30.7 P/E & a 4.0 Price/Sales ratio. Which actually equates to EUR 151.46 on a P/E basis & EUR 80.10 on a P/S basis! There’s little reason not to believe Saga deserves a EUR 115.78 price target, which offers 184% Upside Potential

But let’s now consider an uber-bear scenario. Don’t forget, in most scenarios, greater regulatory intervention might simply prompt Saga to change sourcing, or even domicile. It might also drive up European fur quality, demand & prices – potentially benefiting Saga. Instead, let’s picture a total European fur ban – if you’re invested in Saga, surely that represents catastrophe?!

Well, probably not… [And have a little faith in Saga – after all, they’ve been around for 75 yrs now!]

When the rubber hits the road, governments tend to shirk from destroying livelihoods, jobs, exports etc. And we’re pretty much talking about the EU here – major regulatory change is glacial in speed & impact, and sure to include grandfather clauses and/or substantial compensation payments. Now consider Saga’s latest NAV of EUR 23.34 & its current 8.3 P/E ratio: Tot up a few more years of earnings (probably accompanied by rising prices), a sale or liquidation of the company (I believe current NAV is achievable), substantial compensation payment(s), and a sale of the valuable Saga Furs brand (to a Chinese owner, for example), and it’s hard to argue there’s significant downside risk here…

OK, now let’s home in on a more realistic valuation. I usually avoid them, but I think a decent P/E multiple is perfectly justified by Saga’s earnings history & prospects. But we’ll also balance it with a more conservative Price/Sales approach:

– Saga’s long-term earnings growth has been 14.1% pa, while average earnings growth for the past two years was 47%. Mix those up any way you want, and I think Saga’s overall growth rate & quality of earnings certainly deserves a sector multiple. But let’s observe my usual earnings rule/phobia, and limit Saga to a max. 20 P/E. That’s a discount of about a third vs. the auction house sector – perhaps a little unfair, but also prudent.

– Saga’s average adjusted operating margin (in the past 7 yrs) was 24.2%. However, operating free cash flow’s averaged 134% of operating profit over the same period – add financial income, and average adjusted operating free cash flow was 28.0%. I’d also note the company could easily distribute the majority of its EUR 40.5 mio of cash, without imposing a material financial risk. Putting all this together, I believe a 3.0 Price/Sales multiple’s well deserved.

We therefore arrive at [NB: Saga has 0.9 m A shares & 2.7 m C shares. Only the C shares are publicly traded]:

(EUR 4.93 * 20 P/E + EUR 73.0 mio * 3.0 P/S / 3.6 m shares) / 2 =       EUR 79.70 Fair Value per share

This price target still offers an Upside Potential of 95%.

Um, I suspect you’re thinking about that price graph again… Saga’s up 32%, 113% & 198% in the past month, year & 2 yrs, respectively – how on earth can it still be cheap?! Well, perhaps the correct question is: Why was it so damn cheap to begin with? I really can’t answer it anyway – except to say I’m no longer surprised how inefficient the market can sometimes be. Two years ago, the company wasn’t even called Saga Furs, and it was just another (sub-50 mio) European micro-cap – I guess it was flying below just about everybody’s radar… Clearly, judging by the share price, that’s now changing – rapidly!

And I think that’s perfectly justified – because I think there’s a dawning realization Saga might just present a (pretty) unique situation. You may have noticed the number of pelts sold annually has barely changed in the past 6 yrs – from 8.8 m to 9.3 mio. Therefore, the majority of the company’s increase in turnover (& margins) comes from rising pelt prices. Which suggests the main risk shareholders face is probably not company risk, it’s external risk – that is, fur market supply/demand & price fundamentals. A sudden increase in supply, or an unexpected fall in consumer demand, could potentially torpedo prices & Saga’s turnover. But let’s read the tea leaves here – why hasn’t supply already expanded significantly in response to higher prices? [We should ask, is Saga simply losing share in a growing market? But there’s no evidence of that – quite the reverse, I suspect].

In reality, it’s not that simple – for obvious reasons, the fur industry is not a normal market. Fur farming’s an increasingly specialized (& unsubsidized) activity, the number of fur farms has been in decline for the past 3 decades (only stabilizing in the last couple of years), and farmers continue to face an uncertain & potentially expensive future of regulation (& animal rights activism). They also face the threat of cheap & fast-growing Chinese competition. The vast majority of fur farmers are members of a national breeders association – they rely on these associations, the auction houses & the IFTF to promote fur. By necessity, or agreement, most farmers often rely on a single auction house to sell their pelts. I believe this creates a situation in Europe (& N America) where new fur farms are rare, supply can be easily & tightly managed, and there’s an overwhelming emphasis on certification & quality (rather than quantity).

But at the same time (in the past 5-10 years), there’s been a secular shift in demand – primarily from the emerging markets. And I think current Chinese (& Russian) demand to date may be the tip of the iceberg – potentially, there’s huge unfulfilled demand in those countries & elsewhere. [It’s worth pointing out 55-60 million pelts is only the equivalent of about 1.2 mio fur coats a year! Of course, not everybody wants fur coats – or even bikinis – but lighter furs & new design techniques now mean fur is accessible & desirable even in the hottest of emerging markets]. And this growing demand has collided with a relatively fixed supply…so, naturally, the market’s experienced a pretty abrupt & substantial step-up in prices – possibly on a (semi) permanent basis. [Let’s add some valuable context here – current mink prices don’t appear any more expensive, in real terms, than prices 35 years ago!]. As long as fur farmers are organized on a co-operative basis, and their incomes are rising nicely, why would they even bother to embark on uncertain & expensive expansion?

Obviously, this situation may well change over time – almost inevitably, excess demand must attract new supply. But in the near/medium-term, I’m far more comfortable betting on continued excess demand for premium fur, rather than a sudden supply surplus. And Saga Furs is positioned in exactly the right place to be a primary beneficiary… And let’s not forget this recent announcement – it’s a huge endorsement of the growing network effect that Saga commands. I don’t yet know the economics of this collaboration, or whether it will lead to a more permanent arrangement, but it certainly seems to promise another record year for Saga…

In summary: Despite the rally in Saga’s share price, it only trades on a 2.0 P/S ratio (vs. an adjusted operating margin of 37.0%) & an 8.3 P/E ratio. Things look even better from a cash flow perspective – exc. the cost of the Saga acquisition, the company: i) has a rather stunning 3 year average adjusted operating free cash flow margin of 50.3%, and ii) trades at just 7.1 times its 3 year average free cash flow. Looking ahead, my price target would be equivalent to a 16.2 P/E & a 3.9 P/S multiple. Considering the recent share price momentum, Saga comes with a health warningSometimes you play ’em as you find ’em, sometimes you don’t…

If you’re keen on investing, I can’t tell you if the current price is a good place to buy, or if it’s better to hold off for a retracement. All I can tell you is that I obviously believe the company’s intrinsic value is substantially higher, it appears to have excellent growth prospects, and I now have a 7.8% portfolio holding in Saga Furs.

  • Tgt Mkt Cap:   EUR 286.9 mio
  • Tgt P/E:  16.2
  • Tgt Price/Sales:  3.9
  • Tgt Fair Value:   EUR 79.70
  • Upside Potential:   95%