Echostar, climbing high mountains

Note 1: If you don´t know anything about communication satellites, I would recommend to read this link communication-satellites-101 before you go ahead.

Overview

With a fleet of 9 Ku-FSS, Ka-FSS and S-MSS, EchoStar (SATS) provides video distribution, data communications, and backhaul services to meet the needs of media and broadcast organizations, enterprise customers, and US government service providers.

Headquartered in Englewood, Colo., and conducting business around the globe, EchoStar operates two business segments: Hughes Network Systems and EchoStar Satellite Services (ESS).

According to the last Q3 of 2019, dated at Sep 30th, EchoStar had $1,841.1m of revenues, $-1.6m of EBIT and total assets for $7,037.8m.

As of Nov 21th, 2019, EchoStar´s market capitalization was $3.9B with 97.4 million shares outstanding at a value of $40.68 each.

History

EchoStar was founded in 1980 by Charles Ergen with $500k in savings, as a distributor of C band TV systems.

In 1995, the firm launched its first satellite, EchoStar I. In 1996, it established the DISH Network business to market its home satellite TV system.

In 2008 DISH Network was spun-off, so EchoStar and DISH Network operate as separate public companies. However, a substantial majority of the voting power of the shares of both companies is owned beneficially by Charles Ergen.

As of Nov 21th, 2019, DISH Network and EchoStar, had a market capitalization of $20B and Charlie has a net worth of ~$10B

Business Segments

EchoStar has two important businesses, adding a third “Corporate&Other” not classified in the other two.

1.Hughes Segment

Hughes is the global leader in satellite broadband for home and office, delivering solutions and a comprehensive suite of managed services for enterprises and governments worldwide. Two kinds of customers, two businesses within Hughes, ie: Consumer and Enterprise.

Hughes is supported by a fleet of 5 Ka-band satellites: Jupiter1, Jupiter2, Eutelsat 65, Telesat T19V and SPACEWAY 3.

2.EchoStar Satellite Service

ESS consists of 2 Ku/Ka satellites which provide video distribution, data communications and backhaul services to meet the needs of media and broadcast organizations, enterprise customers and government service providers.

Hughes Segment Business and Jupiter Satellites

This segment is supported by two fundamental satellites: Jupiter1 and Jupiter2. What are Jupiter Satellites? and what can we expect from them?

Over the past several years, a technology shift has occurred within the satellite industry; as an example: Ka-Band EchoStar XIX/Jupiter2, launched in 2016, offer 200x capacity compared to legacy Ku-Band satellites, with in-orbit cost per Gigabyte per Second (Gbps) only a fraction of older satellites and confirming Moore´s Law.

The number of satellites that can offer this sort of service is also limited by the number of orbital slots available and the IP is very hard to recreate. In fact, only two companies fit: EchoStar and Viasat (VSAT), leaving us with a duopoly market.

Hughes Consumer Business

Consumer Business sells broadband service to consumers in very rural/underserved areas.

In the last years, Hughes Satellites has increased its capacity (Gbps) and the Hughes Consumer Business has increased its number of subscribers, going from 626,000 subscribers and 10Gbps in 2011 to 1,437,000 subscribers and 370Gbps in 30Sep2019. In the next table you can see this significance evolution.

The cost to build out infrastructure to underserved households in US is very expensive for cable, DSL or fiber companies. The Federal Communications Commission (FCC) estimated the cost to deliver broadband to the 10-20m households in extremely remote areas at approximately $8-10k per home. A cable company receiving $65/month in broadband revenue ($780/year) on a average life of four years for a customer and a 18% EBIT margin, spending $8-10k to receive a total present value of $8,229k in cash flows over the life of a subscriber, do not seems a good business.

On the other hand, if EchoStar spends $450m to build a satellite that can service 1m susbcribers who are willing to pay for higher speeds (25mbps) vs dial-up/DSL (1-5mbps), their cost to build out to a home is about $500 (including some cost of the modem at the customer´s home), constituting favorable economics.

EchoStar and competitors Viasat´s combined 4 satellites can serve 4m customers while the Federal Communications Commission (FCC) estimates that market size is about 20m unserved/underserved households in the US alone.

Finally, two more potential areas that will be satisfied by Ka-Band Jupiter Satellites are: 5G Wireless and Inflight Broadband Speeds.

5G Wireless is an ultrafast wireless standard that requires a densified network – ie more wireless towers along with small cell wireless towers attached to lampposts and in buildings. 5G is also all about backhaul –when we densify wireless networks with so many more radios, we need to “trunk” that data back through to the data centers. Trunking is accomplished through fiber/cable in large cities and satellite in rural areas. Given their cost per bit advantage in Ka-Band, we could envision an entire fleet of Echostar satellites across the world trunking capacity in rural areas.

In-flight broadband speeds using Ka-Band are much faster than substitute products that use Ku-Band. This is a large and growing market as new satellites are built across regions with aircraft traffic.

What can I expect from this business in the next years? We can start by the last data of susbcribers reported which is 1.437 millions, and I have estimated an average annual revenue per user $780, this give me a revenue of $1,121 millions in Hughes Consumer Business.

I will assume an expected growth equal the current expected inflation of 1.54% (nominal interest rate minus TIPS) for revenues per subscriber. Moreover, I will expect 2.735 millions subscribers around year 3 according capacity of satellites, and stay at this level forever.

I should advise that I have not consider any other satellite in the next years, but this is wrong as Echostar plans to launch Jupiter3 in 2020 adding more capacity and revenues.

Hughes Enterprise Business

Echostar provides of managed network services for large blue chip and medium/small enterprises across a range of industries (Lottery, Retail, Hospitallity, Restaurant, Finance/banking, Oil&gas, Airbone broadband, etc).

Enterprise Business offer connectivity to business in remote areas (ie all Getty stations outside cable/DSL footprint for transaction connectivity) utilizing Hughes´s aforementioned satellite constellations. Similar to the Consumer Business, with customers in rural areas, this business has little completion and 99% customer renewal.

In addition, the Enterprise Business supplies of satellite ground infrastructure and terminals to operators (Telefonica, Vodacom, IntelSat, EutelSat, GlobalStar, YahSat, BSNL, SES, OneWeb, etc).

Same question again as consumer business: what future for enterprise business? We know that Total Hughes Revenues has been $1,806 millions and resting the amount of $1,121 millions of Hughes Consumer Revenues, give us $685 millions for Hughes Enterprise Revenues. 

I will be very conservative with the future of these revenues and I will assume a growth in perpetuity of 1.69% (Risk Free Rate in usd = 10Yr bond usd).

Valuing Operating Assets of Hughes Business

Following in the next table I summarize a probable future for the Hughes Segment and operating income in the next 10 yrs.

I have estimated a current EBIT of $88.15 millions (previously adjusted to R&D expenses and operating leses, and after allocated corporate expenses) giving a margin of 4.88%, which I will scale up to the global industry average of 14.96% plus a 5% premium (19.96%) in year 5 and stay forever at that level assuming Echostar will share the duopoly with Viasat thanks to its economy of scale.

Tax rate will scale up to the Marginal Tax Rate in year 10.

I will assume a high capital investment model with low S/C Ratio. Although current S/C ratio is 0.49, I will assume that the company will improve progressively up to the global industry average of 0.99 in year 10.

The company had $797 in NOLs at 30dic18, and that amount must be taken in account in valuation.

Current cost of capital is 9.32%, and will move towards the global industry average of 6.38% in year 10.

Finally I obtain a value operating assets about $4,589 millions.

The European Spectrum Business, two probable scenarios

Echostar acquired Solaris in 2013 for $21.8 millions.

Solaris is a satellite company with 30MHZ of S-band spectrum in Europe and a satellite orbital slot. Echostar could lease the spectrum to wireless carrier and sell satellite service (machine to machine for logistics management, satellite radio service.. etc).

Users of smartphones are consuming more bandwidth each year, straining the medium by which the bandwidth is transmitted, spectrum. As wireless operators scramble to offer higher speeds to consumers, the value of spectrum will continue to increase.

Echostar is in discussions with regulators across the EU to repurpose this spectrum for terrestrial use.

Thus, it is probable one of these scenarios:

Scenario1

Let´s suppose that Echostar receive full approval from all EU regulators to run a Wholesale LTE Network.

I will consider this scenario as an option to expand an investment in new markets, to take advantage of favorable conditions.

Above I detail the inputs to estimate the value of the option ($1,599 millions) using a Black-Schole model.

Scenario2

If Echostar does not receive full approval from all EU regulator, the company could launch some combination of a satellite radio network with a wireless network.

Using the same method as the Scenario1, I value the option in $913 millions.

Investment in Dish Mexico

Echostar owns 49% of Dish Mexico, an entity that provides direct-to-home satellite services in Mexico. While financials are undisclosed, Dish Mexico has grown its subscriber base at 40%+/year and is estimated to have about 5m subs, currently.

While DBS providers in the US and in other developed nations trade at about $400-600/ subscriber, ARPUs are about 50% lower in Mexico, thus we value the investment in Dish Mexico at $613 millions.

Tying the pieces that I understand

Probably there are more hidden value in Echostar, for example: what about other minority investments, or what future could we expect in the ESS segment,.. there are other examples, but my capacity to discover other value is limited and I have decided to concentrate my efforts in what I know: Hughes Segment with subscribers in consumer front, Hughes Segment in enterprise front, the investment in Dish Mexico and the two options/scenarios of the spectrum in Europe.

Attaching all these three values, I finally arrive at $69.80 value/share for scenario.1 and $62.77 value/share for a worst scenario.2

Communication Satellites 101

What are Electromagnetic Waves?

Mechanical waves and electromagnetic waves are two important ways that energy is transported in the world around us.

Waves in water and sound waves in air are two examples of mechanical waves. These mechanical waves travel through a medium by causing the molecules to bump into each other, like falling dominoes transferring energy from one to the next.

Electromagnetic waves differ from mechanical waves in that they do not require a medium to propagate. This means that they can travel not only through air and solid materials, but also through the vacuum of space.

Electromagnetic waves have crests and troughs similar to those of ocean waves. The distance between crests is the wavelength. The shortest wavelengths are just fractions of the size of an atom, while the longest wavelengths scientists currently study can be larger than the diameter of our planet!

The number of crests that pass a given point within one second is described as the frequency of the wave. One wave—or cycle—per second is called a Hertz (Hz). A wave with two cycles that pass a point in one second has a frequency of 2 Hz.

An electromagnetic wave can also be described in terms of its energy—in units of measure called electron volts (eV). An electron volt is the amount of kinetic energy needed to move an electron through one volt potential. Moving along the spectrum from long to short wavelengths, energy increases as the wavelength shortens.

Consider a jump rope with its ends being pulled up and down. More energy is needed to make the rope have more waves.

Depending on which range of frequencies Electromagnetic Waves are moving, there are several types: Radio, Microwaves, Infrared, Visible Light, Ultraviolet, X-ray and Gamma Ray.

What is a Communication Satellite?

A communication satellite is a device used to receive, amplifies and transmit radio & micro waves in space. The satellite has communications equipment including receive and transmit antennas, power, and electronic components which enable to receive a radio signal from a terminal, and then transmit that same radio signal to another terminal.

The radio waves used for telecommunications links travel by “line of sight” and so are obstructed by the curve of the Earth. The purpose of satellites is to relay the signal around the curve of the Earth allowing communication between widely separated geographical points.

There are many functions and services which satellites are designed and used for: telephone communications, internet, video and TV distribution, etc

A vast array of satellites exist with various Frequencies (C Band, Ku Band, L Band, etc), Altitudes (LEO, MEO, GEO) and Orbital Planes (Equatorial, Circular, Inclined, Polar, etc)

Frequencies Used for Satellite Communications

Life of a Staellite

The design life of geostationary satellites is approximatly 10-15 years.

Orbital Location and Footprint

The location of a satellite is referred to its orbital position. All Geostationary Satellites are located in a single ring above the equator. The requirement to space these satellites apart means that there are a limited number “slots” available, thus only limited number of satellites can be placed in geostationary orbit.

The location of a satellite is normally measured in terms of longitudinal degrees East or West from the prime Meridian of 0 degrees.

The area of Earth’s surface for coverage of transmit to or receive from is called the footprint which can be tailored for different frequencies and power levels.

Uplink and Downlink

Signals transmitted from Earth to Satellite are referred to as uplink signals, and signals received from the Satellite are downlink signals.

The satellite, through the transponder, converts the signal before it retransmits back to earth.

The signals going up to the satellite are at one frequency range (band of frequencies) and the satellite changes them to a different frequency range coming down so they won´t interfere with the signals going up.

As an example: “C Band” uplinks at 6 GHz and downlinks at 4 GHz and “Ku Band” uplinks at 14 GHz and downlinks at 12 GHz.

Throughput rates (Mbps) say us how much data actually is sent/received to/from a Satellite. Of course, throughput rates depends on “Uplink/Downlink” signals and the frequencies assigned.

Satellites and Orbits

Geosynchronous Orbit (GEO) are located 35,786 km above Earth. A single satellite can view approximately 1/3 of Earth´s surface. They travel in the same direction and speed as Earths´s rotation so they appear “stationary” and Earth station do not need to track the satellite.

Medium Earth Orbit (MEO) are located 8,000-20,000 Km above Earth. Typically, they have an elliptical (oval-shaped) orbit, but some travel in near perfect circles. The orbital period is anywhere from 2 to 12 hours. The most common use for satellites in this region is for navigation, communication, and geodetic/space environment science. They are used by GPS satellites. Communications satellites that cover the North and South Pole use MEO satellites.

Low Earth Orbit (LEO) are located 500-2,000 Km above Earth. LEOs are much closer to earth and travel at high speed to avoid being pulled out of orbit by Earth’s gravity. They orbit Earth about every 90 minutes. The international space station is a LEO.

What is Installed on the Ground?

All communications with a geostationary satellite requires the use of Earth stations. They may be fixed or mobile, from small to very large antennas.

The Earth station typically consists of an antenna, RF (radio frequency) equipment to Transmit&Receive, indoor unit and the final communications devices. Final communications devices could be local or off site via terrestrial network.

A teleport or super hub is essentially a large version of a typical Earth station. Teleports have similar equipment to a remotes but the equipment will be hub centric since it is looking at many remotes, rather than the remote just looking at the hub.

As well teleports will also have extra reliability by means of backup power, redundancy of equipment, and sometimes the ability to counteract the effects of fading (uplink power control).

Types of Satellite Services

There are several defined types of satellite service.

Fixed Satellites Services (FSS), so-called because the terminals on the ground are in fixed locations

Mobile Satellite Services (MSS) , where the terminals can be fixed, or in motion such as on a vehicle, a ship or even an airplane.

The worldwide market for fixed satellite services (FSS) is now over $10 billion annually and is significantly larger than the worldwide market for mobile satellite services (MSS).

Historically, Fixed systems have higher throughput and lower operating costs than Mobile systems as a rule. But Fixed Satellite Services (FSS) hardware is more expensive and features larger antennas. They are often susceptible to damage from sand, snow or rain.

Mobile systems have smaller antennas, lower hardware costs and broader coverage. But the cost per minute of use is much higher than Fixed systems, and the throughput rates are far lower than those for Fixed systems.

Demand for both FSS and MSS is growing rapidly and the distinction between the two is becoming blurred as fixed antennas get smaller and mobile terminals accommodate higher throughput speeds.

A third class is “broadcast satellite service” (BSS). Signals are transmitted or retransmitted by space stations are intented for direct reception by the general public. Subscribers receive signals directly from geostationary satellites. Signals are broadcast in digital format at microwave frequencies.

A subscriber needs an installation of a dish antenna, a conventional TV set, a signal converter placed next to the TV set, and a length of coaxial cable between the dish and the converter.

The dish intercepts microwave signals directly from the satellite. The converter produces output that can be viewed on the TV receiver.

What is a Backhaul?

A backhaul (or local loop) is the intermediate link between a core network (teleport or hub) to smaller networks or devices at the edge of the network. It is the physical link or circuit that connects the customers premises to an Earth station.

A backhaul is usually more cost-effective than a customer having their own hub or teleport.

Fading

Satellite Services are subject to fading.

The higher the frequency the more the signal may be affected. C Band is less affected than Ku. Ku is less affected than Ka.

Fading can severely affect service when heavy rain or snow is present.

Tolerances are built into the power levels of the transmitted services to minimize the effect. These tolerances are referred to as fade margins.

That means we transmit more power than what is needed during clear sky conditions and the amount of this power is determined by the link budget analysis.

System design will include a margin to accommodate some signal reduction by precipitation. How much fade margin is used will be determined by the customer’s service availability requirements.

Even with fade margin there still will be some instances where the density of clouds and rain reduces the signal enough that it affects data with errors, or a voice call gets noisy, or it affects a TV channel.

HONMA Golf, Governance and Corporate Finance

In this post I will try to give the big picture of HONMA Golf, that is to say, an analysis of Corporate Governance and Corporate Finance and what this analysis would recommend to the management which could be sound arrogance, but this is a part of the analysis exercise, no more, no less.

It could be said that this post should have been posted before valuation, but I have two reasons why I didn’t it, the first one is that Corporate Finance is a tedious work and sometimes could distract from the main story of the company, and the second reason is simple: link stories and numbers are much more fun.

Let´s start...

Corporate Governance (Ownership & Board)

At March 30th, 2019, HONMA had 609.05 millions of outstanding shares and the significant investors in HONMA are:

• Kouun Holding Ltd (53.2%): Private holding controlled by the founder Mr. Jian Guo Liu, (Individual Large Hdg)
• Charoen Pokphand Group Company Ltd (15%): Thai private company controlled by “Chearavanont” family, (Individual Large Hdg)
• Itochu Corp (6.29%): Japanese public company trading in Tokyo Stock Exchange, (Individual Large Hdg)
• Fosun International Ltd (5.85%): Chinese public company trading in Shangai Stock Exchange and controlled by Mr. Guo Guangchang (Institutional Large Hdg)

These four major investors represent 80.2% of the company, leaving a free float of around 20% available to other holders (private investors, institutional investors and banks with less than 5% of the outstanding shares).

The firm has significant individual holdings and small institutional holding, therefore the marginal investor is “Kouunn Holding Ltd” controlled by Mr. Jian Guo Liu, and I will assume that “Kounn” is diversified.

The board is composed of the 8 members described as follow:

Some conclusions of the table above:

• Majority of directors are insiders
• President and Chairman are the same person
• Not all committees are entirely of outsiders

With all these conclusions above I can´t consider that the board of HONMA is effective in acting as a counterweight to a powerful Chairman/President, Mr Liu Jianguo. Consequently I would recommend to revert these 3 points.

Risk (Cost of equity, Cost of debt & Cost of capital)

As a risk free rate, I used the 10 year Japan government bond rate of -0.157% less Default Spread for Japan of 0.68%, resulting -0.84%.

The average global unlevered beta is 0.83 for Recreation business, as HONMA operates in only one business, I will take an unlevered beta for HONMA  of 0.83. Taking into account debt/equity ratio -lease commitments adjustments- gives me the levered beta of 0.87.

To estimate the equity risk premium of HONMA, I looked at HONMA's revenues by regions and applied the equity risk premiums for each of these countries. This results in a weighted ERP for HONMA of 6.67%. 

Based on the above risk free rate, beta and ERP, HONMA´s cost of equity in JPY is 4.99%.

The company provides with information about its pre-tax cost of debt between 0.33% and 0.51%, averaging  0.42%.

The market value of debt outstanding is Ұ4,986 million and the market value of equity is Ұ61,581 million.

Based on a cost of equity of  4.99% and a cost of debt of 0.42%, the cost of capital of HONMA is 4.64% and HONMA should only undertake investments that return at least 4.64%, the minimum acceptable hurdle rate.

Capital Structure

HONMA´s debt to capital ratio is 9.11%, lower than average global industry (23.12%) and probably underlevered.

All debt is short-term debt with maturity less than one year. The debt is mainly in USD (62%) and JPY (23%), the rest of debt (14%) is distributed in HKD, TWD, RMB and others. All HONMA debt has a floating rate between 0.33%-0.51%.

A certain level of debt for HONMA has the following advantages and disadvantages:

Optimal Capital Structure & Financing Changes

HONMA´s current debt-capital ratio is 9.19%.

Simulating across various debt-to-capital ratios, and taking to account changes in the levered beta, cost of equity, interest payments, interest coverage ratios, cost of equity, etc, the following is revealed:

Optimal debt-capital ratio (60.00%) is greater than current, and it seems that HONMA is underlevered.

Given its shareholder structure (Mr. Liu Guo hold 53.2% of common shares) and its market capitalization (over HK$4.2 billion), HONMA seems an unlikely target for a takeover.

An EVA to equity and EVA to capital positives (see previous post), could indicate that HONMA has good projects and I would recommend to the company, take additional suitable projects with returns above its hurdle rate, and finances them with additional debt.

I would advise HONMA to align the debt maturities with the durations of those projects (and the respective assets generating cash flows).

For all projects, I would assume lifecycles around 3 years, and thus recommend financing them with longer-term debt and with a mix of currencies related to the project costs and expected revenues.

The more uncertainty HONMA sees in the future and in its newly started projects, the more it should use floating-rate debt. 

By raising its debt-to-capital ratio up to around 60%, HONMA could increase its firm value from Ұ52,475 million to Ұ53,053 million, and its stock price from Ұ99.43 to Ұ100.37 (+1%). By doing this, HONMA’s cost of capital would drop to 4.48%, really not too much. Thus I don´t see any significant reduction in the cost of capital to justify any increment on debt.

Dividend Policy

HONMA has returned Ұ6,874 million to stockholders in the last three fiscal years (analyzed from 2016/2017 to 2018/2019) having generated Ұ3,250 million of FCFE in that period.

The reduction of debt and the big increment in working capital in period 2016/2017 explain a negative FCFEE for that fiscal year and the reduction of the aggregate. There isn’t any indication that HONMA plans to stop its dividends, therefore the dividend policy in fiscal year 2016/2017 should not occur again.

HONMA Golf, expanding premium niches in the market

Overview

HONMA Golf Ltd –incorporated in Cayman Islands, listed on Hong Kong Stock Exchange with ticker 6858 and headquartered in Tokyo– is a prestigious and iconic brand in the golf industry.

The company utilizes innovative technologies and traditional Japanese craftsmanship to provide golfers across the globe with premium, high tech and the best performing golf clubs, balls and accessories.

The Group’s sales and distribution network consists of HONMA-branded self-operated stores as well as distributors, and develops and manages its sales and distribution network on a country-by-country basis to cater for the specific retail landscape and consumer demographics.

As the only vertically integrated golf company with in-house design, development and manufacturing capabilities, a strong retail footprint in Asia and diverse range of golf clubs and golf related products, HONMA is positioned to grow its business in Asia and beyond, benefitting from the return of golfers in mature golf markets such as US and Japan and from increased participation in golf´s new markets such as Korea and China.

As of Jun 17th, 2019, HONMA´s market capitalization was HK$4,263 million with 609 million shares outstanding at a value of HK$7.00 each.

Back and Current Story

Founded in 1959, HONMA fell on hard times with the collapse of Japan´s bubble economy in the 1990s. It had overinvested in golf courses and made other missteps. In 2005, it filed for bankruptcy protection, and in 2010 – in what many Japanese viewed as a painful indignity – it was bought by a Chinese fund run by businessman Liu Jianguo who also operates a Shanghai company that makes hair dryers and rice cookers. Yet Liu Jianguo became Chairman and President of HONMA since then.

In October 2016, the company went public at HK$10 without fanfare and Liu Jianguo turned HONMA around by revamping its sales strategy since then –Ұ18,525 millions revenues in period 2014-2015 and Ұ27,770 millions revenues in period 2018-2019, so a CAGR 4 Years of 10%–.

Although revenues has been decelerated from 21% in 2016 down to 6% in 2019, EBIT margin has maintained around 20% which makes sense, as I will describe later, with the strategy of the company.

The charts below set forth the breakdown by region and product of the total sales in 30mar19.

As we see HONMA have a strong presence in its home markets of Japan, Korea and China (including Hong Kong and Macau), while clubs represents by product the most important source of revenues.

Global Golf Products Industry Overview and where fit HONMA

Golf is a sport which boasts worldwide popularity and is enjoyed by millions globally. The sport involves players using various types of clubs to hit balls into a series of holes with the aim of minimizing the number of strokes required. To play golf, a golfer needs a set of clubs of various lengths and sizes, a set of golf balls and related accessories such as gloves and bags. These products make up the core of the global golf products market. Golf apparel includes clothing and shoes targeted at the golf lifestyle market and forms another important segment of the golf products market.

Key market players supporting the market expansion significantly include Callaway Golf Company, Amer Sports Corporation, MIZUNO Corporation, TaylorMade Golf Company, Inc., Acushnet Holdings Corp., Roger Cleveland Golf Company, Inc., Parsons Xtreme Golf, LLC, Bridgestone Sports Co., Ltd., Honma Golf Co., Ltd., and Epon Golf.

Although global retail sales has been stagnated since 2014 (US$13.4B), HONMA has been able to increase its market share from 1.5% at 2015/2016 to 1.9% at 2018/2019.

The following factors are expected to be key drivers of growth for the golf products industry over the next several years:

• New Markets and Demographics. Golf has traditionally been under-penetrated in emerging markets. In recent years, more people in emerging markets, especially in Asia, have started to play the sport, driven by increasing disposable income, higher standards of living and greater emphasis on leisure activities. Meanwhile, golf has also gained greater popularity among women and the younger generation worldwide, as a result of the increasing perception of golf as a “lifestyle sport”, a new generation of young golfers coming to prominence on the professional circuit, and additional marketing efforts by golf brands towards these demographics.
• “Lifestyle Sport” Proposition. Positioned as a “lifestyle sport” with an element of prestige that accommodates competition, entertainment and physical exercise, golf appeals to modern consumers who pursue a higher quality lifestyle with an increasing awareness for health and wellness.
• Golf ’s Return to the Olympic Games. The reinstatement of golf at the 2016 Olympic Games significantly raised the profile of the sport worldwide. As we edge closer to the 2020 Tokyo Olympic Games, global attention is slowly starting to focus on Olympic qualification. With Japan hosting the 2020 Olympics, the golf markets in Japan and other parts of Asia are expected to receive a significant boost in the build-up to the Olympics.
• Digitalization of Retail Channels. Digital retail channels such as e-commerce, mobile commerce and social commerce now address consumers’ purchase preferences, which were predominantly restricted to brick and mortar stores in the past. These emerging channels play vital roles in penetrating different consumer segments.
• Technological Innovation. Golf products development has always been driven by technological innovations over the years. Further developments in clubs, balls and related products are expected to make the game more accessible, enjoyable and exciting, while continuing to attract new players.

According to HONMA Golf, consumer preferences for golf clubs can be classified under two key dimensions:

• the willingness to spend, or acceptable price of clubs; and
• the degree of enthusiasm for golf. The degree of enthusiasm can be measured by the consumer’s skill and participation level, which is score for playing one round of golf, as well as number of rounds played within a particular time period.

Based on the two key dimensions described above, the golf clubs market can be segmented into the 9 Key Segments, each consisting of a unique type of golf club consumer.

HONMA currently offers golf clubs mainly under three major product families, namely BERES, TOUR WORLD and BeZeal, each targeting specific consumer segments:

• BERES golf clubs target consumers in Segment 2, which is the Group’s traditional customer base and comprises affluent consumers willing to pay a premium price for golf clubs
• TOUR WORLD golf clubs target consumers in Segment 6, which comprises golf enthusiasts who place a higher emphasis on performance
• Be ZEAL golf clubs target consumers in Segment 5, which comprises beginner golfers who are looking to improve their performance.

Segments 5 and 6 are experiencing faster growth rates compared to the overall growth rates of major golf markets.

How good are the existing investments

On March 30th, 2019, HONMA presented its results for the last fiscal year. The company earned  ¥4,732.0 million as after‐tax operating income on a book value of capital invested of ¥16,357.6 million, while the net income was ¥4,127.5 million on a book value of equity of ¥28,050.0 million.

The after‐tax return on capital based upon these numbers is 29% and the return on equity is 15%.

With after tax return on capital of 29% and relative to the cost of capital of 4.64%, HONMA seems to be earning an excess return of 24.29%. With a return on equity of 15% and relative to the cost of equity of 4.99%, HONMA earns an excess return of 9.72%.

Therefore  HONMA has a positive amount Economic Value Added both to capital and equity:

Since IPO in 2016, HONMA has focused in targeting niches of golf market which are willing to pay a premium for golf clubs. In order to increase sales in these segments, the company has launched several golf clubs families in the last 3 years to align with its target consumer´s preferences. This growth strategy can explain both high ROC and ROE.

Valuation

A plausible story for the future of HONMA could be an exclusive golf company, with low production and medium/high prices. The benefits of this strategy are high operating margins partly because of the high prices, and partly because the company does not have to spend much more on expensive ad campaigns or selling than it is doing now (currently 11% of revenues). It also will keep reinvestment needs to a minimum, since capacity expansion will not be necessary, though the company will continue spending on R&D to preserve its edge (currently 1% of revenues). In addition, by focusing on people with more purchasing power around the world, HONMA may be less affected by macroeconomic forces than other golf companies.

The inputs into my valuation reflect the story, with low revenue growth, high margins and low reinvestment, driving value:

1. Revenues growth of 5% a year for next 5 years, scaling down to the current risk free rate -0.84% in year 10
2. HONMA´s EBIT Margin stays at 20%, the current margin in last year
3. Sales/Invested Capital stays at 1.52 reflecting the little need for capacity expansion
4. Cost of capital of 4.67%, scaling down to global industry average

Other relevant inputs to be assumed:

1. Many growth companies fail, especially if they have trouble raising cash. In case of HONMA, I will give a 10% probability of failure with a distress proceeds of 0% if assets are worth nothing in case the firm would fail.
2. HONMA will earn a ROC equal to 15%, greater than its Cost of Capital. I am assuming that the firm will maintain its alleged competitive advantage (given by its incremental market share and high ROC & ROE) in the long run.

With all these inputs and others not described on this post, the resulting value is shown below:

The value for equity give us Ұ91,856 million which dividing to number of shares 613.26 million, give us Ұ149.78 per share (or HK$10.34) well above the stock price of HK$6.78.