Eratat Lifestyle - Forward PE 1.5X

Hi Ethan999, (Just to let you know that I am going to take a no nonsense tone of reply, because I have seen these questions asked before in the forums, and it's about time to put an end to bad logic)

I agree with you totally on P/E being a simplistic measure, and it's extremely true. However, the relationship between P/E and value becomes incredibly correlated once the measure comes really close to 1.

Just to illustrate, if a company had earned $2 per share in a year (and we make the very reasonable assume that there's no hanky panky going on), then the value of the company can be said to increase by $2, ceteris paribus.

As such, a company that has made $2 for the last two years can be said to be valued at $4 (a simple but strong argument).

Unless there is strong suspect that there is fraud or that mangement in inept, the value of the company would be $4 given 2 years of historical earnings of $2 each.

For forward P/E, the first year (or in Eratat's case, the 8 cents it's expected to earn this year should be incorporated into the price unless you believe that management is fraudulant - which I am not ready to proclaim, lest I get a suit for defamation).

Take into account the earnings made over the last 2 years - and that kind of set a base of valuation. Please note that when I did my rationalization, P/E was but one aspect mentioned... and to be honest, I didn't even include a full analysis.

What I wrote was but what was on my head at that moment in time. I typically use a modular approach with a strong base, and modules which will give me systematic gains based on fundamental reasoning (e.g. psychology - and I don't mean opinions... I'm talking about scientifically supported cognitive, emotive and behavioral constructs; transaction cost economics with the full fundametals involving assumptions based on opportunistic behavior and asset specificity,institutional theory from both a economic and a sociological perspective - based on TCE, mimicry and isomorphism, network theory focusing on node and strength of ties analysis, agency theory based on the principal-agent relationship, and signalling theory - from a strategic perspective).

From those fundamental perspective, I've made an anlysis that (like I said) are my 2 cents worth. You can choose to reject my points... but I'm just showing support.

Besides, your points are quite superficial, to be honest. 1. Your point on competitive market with low entry barriers, including global fashion brands, etc... well. I have to let you know that I teach strategic managemnt as a living, and my training is in this area... and to use just barriers of entry to gauge industry attractiveness is well... wrongfuly applied.

You have done your analysis without even clearly identifying the industry. Have you considered strategic groups (you know... giodarno and versace do not compete for the same clients - as an example). If you do not identify the industry well... How can you make a statement like "As the Chinese middle class grows..." I find your causal relationship explanation ... deficient. (Support - Industry analysis tools, including strategic groups analysis and basic market positioning, mainly based on the resource based view and industrial-organizational economics)

2. You talk about working capital again - a management concept used to identify industry attractiveness. Yet, I must mention that without identifying the industry (You should at least try to identify it based on a 4 digit SIC or NAICS code... if not, a 6 digit SIC or NAICS code will work), how can I trust your analysis?

You won't be able to come up with a meaningful result. You also throw in confounding factors that are weak from a causal perspective. If you were a distributor, would you buy things you believe will not sell? If you can honestly say YES you would, then it supports my point that your cause-effect is lacking.

If you say NO, then it supports the fact that your statement is meaningless. (Ahhh - the benefits of doing a Ph.D.... that one can come to strong conclusions based on philosophy 101 logic links) (Support - similar to point 1, and philosopy 101 - basic logic to determine fallacies... I believe the arts program has a basic year 1 course in NUS that covers this)

3. Your point in 3 is again moot because the success of Eratat is not dependent on some distributors not being able to sell their products. It's based on having enough distributors being able to sell the products... and this has been shown to be true from Erata's public announcements.

Please do your homework and not confound the situation based on too many "I think" statements that are made in a fallacy state. You can use Darwinian theory of survival of the fittest. Some distributors might fail for whatever reason, and it will not matter as long as there are enough that can succeed well. Eratat had specifically addressed this point themself. (Support - Philosophy 101, Darwinian theory, network theory)

4. I agree with you. Receivables is a huge portion of NAV. Now, do this. Pretend that their receivables is 0. That every single dollar of receivable is bad debts. Eratat would still have 500 million RMB of assets (less receivables and goodwill) over 120 million RMB of liabilities. Hmmm, pretty good, I think.

The fact that we can use a worst case scenario for receivables kind of dilute the first part of your point in 4. With respect to the second part, subsidies... well. I agree on you again - but you're thinking of it like Eratat and their distributors are enemies playing in a situation of a zero sum game.

If you use game theory and network analysis, you will realize that Eratat is a social entity and have to interact with their key suppliers and distributors, and that the success of one actually promotes the success of the others. This relationship type of business should be very familar to us, Asians.

The Kieretsu and Chaebols and good examples of such a phenomenon at work. While an over-reliance of such an approach can lead to a lot of issues, I do not believe that's the case with Eratat because there are many signals sent by them to suggest that it is not the case (e.g. that the distributors are governed on a year by year basis, to determine continuity).

As such, there is NO real "contradicting strategies", as you might have suggested. Saying that, it might not be the best strategy for them. All I'm saying is that there is logic to ground their choice of subsidies, and it DOES NOT contradict the other strategic elements which I've observed.

Coming to YOUR OWN conclusions of "endless concessions to distributors?" is nothing more than fear mongering, without a basis for that statement. (Support - Network analysis with focus on nodes and strength of ties, basic bookkeeping/accounting, transaction cost economics, resource based view)

<continued in posting below>

Hi tactitican,
I am not an academia in investment, but i do have some questions and doubts about Eratat. I agree that Eratat is undervalued, I sold all my holding based on my analysis (my own logicial thinking, might not be scientific, but i welcome your comments, so that to learn more about investments) that is it losing its competitive edge, and hence the undervaluation will get lesser.
I must first confess that i do not have all data and information, I gather my judgement based on whatever is available.
First, from another forummer, the CFO when quizzzed  about maintaining an EPS of 8 cents or achieve 10% growth, they say they would do their best. I believe its rather an tall order. As calculated, they an margin of 49% for apparel to do that for an order book of 380 million, and it most probably would be higher than 49% as i make generous assumption about costs. Yes, if their earning fall by 10-15% in 1H, are they still attractive, well yes, as the PE and assets ratio you mentioned will still be very undemanding, but why do i still sell??
When I cannot understand a business logic, I sell, i might be terrible ignorant (I welcome you to point them out), but there is something inherent incoherence. WHy do business move up the value chain? To have better margins, so as to translate to higher profits! Sales might fall, but profits still increase due to margins. The order book consists of both the prenium and classic products, the increase in prenium orders instead of leading to a stronger order book, result in a weaker 20% fall in order book, then what value-addness are there in rushing into the prenium orders?
The margins for apparels is already quite high, close to 40 %. As pointed out in my earlier posts, their ASP has been raising significantly but their margins is still flat for apparels, it is explained as due to the outsourcing of their production of apparels, well i am not convinced. Why is lesser pieces (lower costs) and higher ASP costing margin to fall, abeit marginally. Even if there is no funky business with regards to their margins, wouldn't they be at the mercy of their suppliers then??? Higher ASP are being offsets by costs, what valueaddness is there, where is the competitive advantage?
Next, from my conversation with friends in China and articles i read from the Ctei website, China is now flooded with local brands that are selling at prenium prices, which is not actually very different from Eratat ASP now. The problem is, there are many established overseas brand that are selling at comparable price. When I am aware of this, I become very worried about the competitiveness of Eratat. Are they able to gain any market share at all? The order book confirmed that they are not able to, and hence i decide to bail out. I was lucky to be out of the counter at the highest price for the day and make a small profit, otherwise i would be stuck with paper loss now.
 I have no issue with insider selling out or a stagnant order book, but the significant fall in order book and the uncomprehensible margins and the highly competitive sector makes me feel that its no longer worth the risk
 

Hi Tactician,
Thanks for your very elaborate reply.
First of all let me clarify that I have not even read your initial posting, and my posting on P/E as a measurement of value was not meant as a response to your posting at all. My posting was rather long and I notice that your response is even longer; even now I have not read it in its entirety. Honestly, I doubt that many people would, even mine.
At the end of the day this is essentially a forum, not an academic conference, and considering the length of my initial posting I did not already expect many people to fully read it, I just wanted to put it out there. Because this is not an academic conference where we exchange dissertations, for practical considerations not every point can be elaborated to the fullest because the longer the post, the less likely people will read it in its entirety, just like how I have only managed to skim through your posting. Practical considerations have to be balanced with the need to be elaborate.  Or perhaps as an academic on school holidays you may have more time than I Because of time constraints, here are my brief responses to your points. I will try to write you a more elaborate response when I have the time.
Why draw the line at 2 years of earnings then? Why not take the entire history of earnings? But then there are many stocks out there that for many years now have been priced at less than the accumulated sum of all historical earnings. Are they all therefore undervalued?
Maybe we could say hypothethically that a stock which got listed for 2 years, earned $4 in the 2 years, and paid out the $4 earnings in its entirety as dividends over the 2 years to investors and then closed down all operations, it would be safe to say it was worth roughly $4 (actually less when you discount the time value of money but let’s keep this for simplicity’s sake).  
But that's a hypothetical case. In reality, how much of those earnings can the company pay out to investors? This depends on the company’s cash flow and working capital requirements. If much of these earnings have not been collected in the form of receivables (which in Eratat’s case have been lengthening) and even if and when collected, these earnings have to be primarily used as working capital due to large working capital requirements, and this cycles continues with no sign of shortening receivables and decreasing working capital requirements, how much can they spare to pay in the form of dividends?
Considering Eratat’s management felt they needed the placement in order to fund working capital, if they had not done the placement they may not even have paid any dividends or maybe much lesser dividends. So my question then is how much of these $4 of earnings can flow to investors? If it can’t flow to investors how much value is in there? This is especially so if value hinges on the sum of all future cash flows, not necessarily the company’s own cash flows but direct cash flows to investors in the form of dividends. Will investors ever see that value?  
The future component of earnings also surely cannot be omitted. If a company that made $4 over the last 2 years is projected by an investor to make $4 losses in each of the next 5 years, can it still be said to be worth the $4 that it made over the last 2 years?  
Regarding the point about the 7 examples I gave they were meant to be questions over the certainty or sustainability of future cash flows with respect to what they achieved in 2011. The crux of my point here was that you can never wait till you’re 100% sure about the positives or negatives of a stock because by that time the stock would either be too expensive or too cheap. For example, we’re all 100% sure now that Enron was a fraud, what is it worth now? What are China Gaoxian or China Hongwei worth now, now that everyone knows for certain they were cooking the books?
My point is that you got to go by probability based on the available ‘clues’. The information we have about Eratat will not tell us with 100% certainty whether it’s a good or bad investment, because there are always a lot of unknowns, you just got to go by the probabilities based on your own judgment.  Therefore these 7 points I raised were meant as potential points to consider when looking at the potential negatives of Eratat with regards to future cash flows, hardly meant as statements with 100% absolutes on why Eratat is a bad investment and will fail for sure. Neither you nor I can know with 100% certainty based on the information we have, we merely go by probability, therefore if there is avenue for doubt about its sustainability, these points must be raised. Therefore to knock these points off as superficial based on the fact that they do not show with 100% certainty that Eratat will fail is like trying to knock a scarecrow dead – you would be hardly getting the gist of my point.  
A couple more points  
1.       Eratat is a fashion apparel company. I don’t think anyone would seriously doubt the logic that fashion apparel companies in China are targeting the growing wealth of its populace and consumption growth in China. I find it pointless to elaborate on such an obvious point. There is also no doubt that global fashion companies like Zara, H&M, Gap, Uniqlo, upon entering into China, are also in direct competition for market share in this growing middle class consumption. Or are you implying that Eratat is merely targeting a niche market? No one who buys Eratat in China would be interested in buying Zara or Gap?
2.       Of course distributors would only buy if they could they will be able to make profits selling Eratat products. Well apparently quite a few distributors discontinued, were their Eratat products not selling well enough? Again we can’t know with 100% certainty, but once again this falls under the ‘doubt’ segment of the probability argument. What we do know is that overall orders have decreased from 517 million rmb (1h 2011) to 380 million rmb (1h 2012). On the whole, distributors were less bullish about selling Eratat products this year than they were last year.  
A few points I would like to address but I’ll do so  when I have more time. Also, I don’t want to my post to be any longer than it already is because it’s doubtful how many people on a forum would want to read such long essay-like postings. Thank you for the interesting discussion.    

greenrockie, the only probable reason to explain the gross margin of the PREMIUM is that the cost price of the PREMIUM rise as equal fast as the selling price. Compared to fuxing, Eratat is in a much better shape. If cost goes up, they have the branding to raise their ASP to maintain the margins. But look at fuxing, they hv to lower their gross margins so badly to get the sales. another reason is the individual premium apparel order is not large enough, so their suppliers charge them a higher cost. Imagine same piece apparel- 10,000 vs 100,000 order- the unit cost definitely differs greatly, even if it is same material costs. As more premium shop opens and premium orders increase, i believe we shld be able to see the margin coming in.
 
"First, from another forummer, the CFO when quizzzed  about maintaining an EPS of 8 cents or achieve 10% growth, they say they would do their best" - well, the CFO has to answer in a diplomatic manner. If he says gurantee can get that growth, i would be even worried... esp rite now, there's too much economic uncertainty. But CFO Ken did say they would remain focus on their business, do their best to achieve results and hopefully, when the bull resumes, their stock could be one of those that will experience the run.
 
yes. apparel is not a tech company and it can never have monopoly rights like microsoft. there will always be competition and global brands coming in. Same for F&B or other service or most product companies. But what will differentiate will be branding. The best way is to go to shanghai and observe the shops there, and judge for yrself. tat's why Eratat hires a very famous italian fashion designer. H&M, Zara all gt a lot of competitors, but they have survived well all these years with good branding.
 
Actually, the drop in the order book is mostly due to drop in footwear. The premium order stays comparable to autumn/winter 2011 because i think the existing distributors have already exhausted a huge capital in opening more than over 50 premium shops in 2011. Need some time to breakeven, and then consolidate their cash first.
 
while 1H2012 book order drops, i believe 2H2012 book order shld be able to exceed 500 RMB and be comparable to 2H2012 at least. if shanghai premium is successful, if they are lucky, new distributors may come in in 2H2012 or early 2013 and then we shld see another explosive book order growth.
 
i agree there are uncertainties. The strategy direction seems to be right but when will it give investors the outcome that we hope to see, time will tell. but of course, if one thinks that the risk appetite doesn't fit u or there are better rewarding stock, then exiting of Eratat may be a good option for u. For now, i'll maintain my hold in Eratat. At least, in the midst of rising labour costs everywhere, I can't find any better stocks with businesses I like in sgx...
My view.
 
[hr]
[greenrookie 16-11-2011]:

Hi tactitican,
I am not an academia in investment, but i do have some questions and doubts about Eratat. I agree that Eratat is undervalued, I sold all my holding based on my analysis (my own logicial thinking, might not be scientific, but i welcome your comments, so that to learn more about investments) that is it losing its competitive edge, and hence the undervaluation will get lesser.
I must first confess that i do not have all data and information, I gather my judgement based on whatever is available.
First, from another forummer, the CFO when quizzzed  about maintaining an EPS of 8 cents or achieve 10% growth, they say they would do their best. I believe its rather an tall order. As calculated, they an margin of 49% for apparel to do that for an order book of 380 million, and it most probably would be higher than 49% as i make generous assumption about costs. Yes, if their earning fall by 10-15% in 1H, are they still attractive, well yes, as the PE and assets ratio you mentioned will still be very undemanding, but why do i still sell??
When I cannot understand a business logic, I sell, i might be terrible ignorant (I welcome you to point them out), but there is something inherent incoherence. WHy do business move up the value chain? To have better margins, so as to translate to higher profits! Sales might fall, but profits still increase due to margins. The order book consists of both the prenium and classic products, the increase in prenium orders instead of leading to a stronger order book, result in a weaker 20% fall in order book, then what value-addness are there in rushing into the prenium orders?
The margins for apparels is already quite high, close to 40 %. As pointed out in my earlier posts, their ASP has been raising significantly but their margins is still flat for apparels, it is explained as due to the outsourcing of their production of apparels, well i am not convinced. Why is lesser pieces (lower costs) and higher ASP costing margin to fall, abeit marginally. Even if there is no funky business with regards to their margins, wouldn't they be at the mercy of their suppliers then??? Higher ASP are being offsets by costs, what valueaddness is there, where is the competitive advantage?
Next, from my conversation with friends in China and articles i read from the Ctei website, China is now flooded with local brands that are selling at prenium prices, which is not actually very different from Eratat ASP now. The problem is, there are many established overseas brand that are selling at comparable price. When I am aware of this, I become very worried about the competitiveness of Eratat. Are they able to gain any market share at all? The order book confirmed that they are not able to, and hence i decide to bail out. I was lucky to be out of the counter at the highest price for the day and make a small profit, otherwise i would be stuck with paper loss now.
 I have no issue with insider selling out or a stagnant order book, but the significant fall in order book and the uncomprehensible margins and the highly competitive sector makes me feel that its no longer worth the risk
 

Hi Green Rookie, I had actually typed a nice and long response, but lost it while trying to post. I’ll do a summarized version here.

Overall, I agree with your points. You should not invest in a company you do not understand. However, no one really can claim to understand a company so well (like at 100%), unless they are an insider.

For myself, I feel I understand Eratat comfortably enough to make my previous posts.

The points you bring up are very good, and valid, but they do not change my perspective because I had already taken them into consideration.

I already had expected Eratat’s next year’s EPS to fall (in my previous post, I had given up to 25% drop in expected EPS in 2012, compared to the expected EPS of 8 cents in 2011).

Competition and other industrial factors will definitely influence Eratat. However, there are many other factors that can help them too. A lot of these companies are trying to move into white space (or blue ocean), and you will see some of them fail too.

I believe Eratat has shown me (but their routines and articulation of strategy, and I can sense-make it) enough to bet on them winning.

You asked me why you exited. Well, I can think of 4 reasons. (although I seemed to have forgotten

1) – hahaha – that’s the issue with being overly process oriented. It’s more about thinking than memorizing... so sorry for my less than perfect memory. 1. You exited because you believed in the semi-strong market hypothesis – and believed that the market has priced in Eratat at 12 cents accurately (this would be a weak subconscious reason that would affect your later cognitive processes when you come to a decision)

2. Because of (1), you reacted to the less than stellar news when Eratat announced their 3Q results. They failed to meet with your expectations (Expectation Theory) and you felt that share price should fall as a result (Thus, point 1 plays a part in benchmarking for you).

3. You might have this because your time horizon does not match the expected payoff for Eratat, which you believe deep down, is undervalued. As such, it might have made sense for you to take out your money to invest elsewhere where you believe will give you better returns over your time horizon (Hence, you are not really a value investor, even if you try to find value stocks. This is because value investors tend to be highly disciplined and analyse the situation without any real emotions involved).

Churning your money is a legitimate strategy and if you can time it right, a very lucrative one... but don’t miss the boat on stocks you might believe in but stay un-invested because you think they will not move.

Cognitive dissonance theory will also support explanations to support your decision (which might explain why you tend to stand up for Eratat when invested, and push Eratat aside when out of the investment. To prevent Cognitive Dissonance, one should be very aware of it, and discount its effects when investing. I’m trying to do that all the time).

4. Hmm, I had 4 reasons the last time I wrote this (before losing it online) – well. I need to run, so I will leave this part blank for now Either way, I had incorporated your points even before to make my assessment. Saying that. It is good to have good points brought up as a reminder, to remain vigilant. Thanks.

Hi Green Rookie, I was about to leave but then remembered the 4th reason. 4. You might have exited because of indirect/subtle emotive pressures. With all the bad news and fear surrounding S Chips, the general economic issues all voer the world, etc... It created an environment that is very conducive to the emotive construct of fear. As such, you might have decided to stay away until you can get a better read on things. Together with your concerns on Eratat, this emotive response is logical. Cheers