Kingmaker – a Sustainable Earnings Case Study
We look at hundreds of companies experiencing falling earnings (as Kingmaker was when we bought in 2008) but invest only in a select few (2-3 per year) where we can gain conviction on the long-term sustainability of the company. Kingmaker was one such company: a small ($100m), HK listed shoe manufacturer.
The opportunity: In 2004, Kingmaker walked away from a large American client as US anti-dumping laws eroded margins. This was a rational management decision, aimed at optimising long-term performance over short-term revenue streams. With falling revenue and earnings, the market reacted and the share price fell over 70%.
Detailed Research – finding conviction in Sustainable Earnings: We took the time to assess whether Kingmaker had Sustainable Earnings by challenging the consensus, looking at all the fundamentals driving and surrounding the company. We found that the market had overlooked a number of key points in Kingmaker’s business, including:
- Concrete competitive advantages
- Established relationships. Kingmaker served top-tier clients (including Clarks, Stride Rite, Skechers and New Balance) who relied on its products
- Operational flexibility. Production capabilities in China, Vietnam and Cambodia enabled Kingmaker to shift production to lower cost facilities and improve margins
- Financial flexibility. Kingmaker’s balance sheet was rock solid (lots of cash and no debt) ensuring it could survive a protracted period of lower earnings
- Cash flow. Our analysis revealed prudent management of working capital and capital expenditure, showing that Kingmaker was able to support and maintain cash flow above profits in each of the difficult years (2006 – 2010)
Having established the quality of the company, we used undemanding margins and revenue assumptions (both significantly discounted from peaks) to set a conservative level for Sustainable Earnings: $75m through the cycle. This equated to a valuation of 8x SE – well below our maximum entry level of 12x SE.
Able to achieve conviction in our Sustainable Earnings, we initiated our first buy in March 2008.
The outcome: As long-term investors, patience is key. Confident in our view of Sustainable Earnings, we were willing to wait for Kingmaker to make the necessary adjustments to its business, anticipating a recovery of earnings and a subsequent reflection in the share price. With time earnings improved, rising significantly above our Sustainable Earnings assessment, and the share price responded accordingly.
As is typical of a Kennox stock, we saw price fluctuations on short-term earnings movements during the course of our holding period. These provided us with opportunities to add (at prices below 10x SE), trim (at 15x SE) and exit when the price reached our upper valuations threshold of 20x SE.
Our return on Kingmaker was +570%.