GOME Electrical Appliances (OTCPK:GMELY) has been called China's Best Buy (BBY) in the past, even though the comparison can get a bit stretched at times. Where Best Buy is estimated to hold about 30% share of the U.S. electronics and appliance retailing market, GOME is #1 in China in consumer electronics with about 10% share. Even so, both companies had a period of serious turmoil as "growth for the sake of growth" created an inefficient store base and online competition made serious inroads into their businesses.
Whether you believe Best Buy's turnaround plan is working and will continue to work is a story for another day. What I want to focus on today is the strategic shift at GOME that has led to improved same-store sales and the way in which management views the evolution of competition and retailing in China. I believe that GOME is correct in its view that success will ultimately come down to a battle of logistics, and I think the company is ahead of its rivals in building for that reality. I do not believe that GOME will ever generate sizable FCF margins, but I do believe that modest improvement, coupled with supply chain investments that will help the company maintain its competitiveness, support a fair value almost 50% above today's level.
As a quick aside, I would encourage investors who are considering GOME shares to buy the Hong Kong-listed shares if possible (0493.HK). I realize that it can be more expensive to do so, but the liquidity on the ADRs is not very good at all.
What It Is, And What It Will Be
As I said, GOME is already a very large retailer in China, and the largest consumer electronics retailer (while rival Suning is larger overall, particularly in appliances), with more than 1,000 stores in more than 250 Chinese cities. About two-thirds of the company's store base is in the Tier 1 cities, with just under half of company sales coming from Beijing, Guangzhou, Shanghai, and Shenzhen.
Much as companies like Best Buy may try to excuse their poor execution in China by claiming the market is much different, there's nothing too unusual about GOME's business. The fact that air conditioners represent about 14% of sales may seem a little odd to Americans, but getting 25% of sales from AV (DVDs, etc.), 20% from large white goods like refrigerators and washing machines, 15% from telecom, and 13% from small appliances seems pretty typical for a consumer electronics retailer.
Until fairly recently, GOME was struggling in the face of competition (particularly online retailers like 360Buy.com), scandals involving the company chairman, and a store base that was built more to chase growth than generate profits. Things have already started turning around in a meaningful way - although the company still believes about 20% of its stores are loss-making (and as many as 100 could be closed relatively soon), sales per square foot are up 50% since the first quarter of 2012.
Simply closing bad stores has helped, and so has rationalizing pricing and assortments between offline/online and Tier 1 and non-Tier 1 cities (selling cheaper, more standardized products in rural areas). At the same time, though, management has been working on its assortment and store presentation and also increasing its private label mix - with a target of 25% of sales in 2015.
Management has also gotten smarter about its online strategy. GOME has moved away from aggressive price promotions and instead focused on making online sales a viable profitable business. This isn't easy with competition from 360Buy.com, Tmall (owned by Alibaba), Tencent, Suning, and Amazon's (AMZN) Chinese operations. Even so, GOME management has found that they only need to be aggressive on a relatively small percentage of online SKUs (20% to 30%) that really overlap, while being able to price less standardized and more exclusive merchandise more profitably.
Logistics Will Be Where GOME Wins Or Loses
One of the things that makes GOME stand out to me as an investment opportunity is its different viewpoint on the evolving Chinese retailing environment. GOME doesn't believe that it's really going to be possible for anybody to stand apart just on assortments or pricing and competition is going to keep relentless pressure on pricing.
If nobody can win on price or assortment, GOME reasons, win on cost. At its recent corporate day, management said that it now regards itself as a "supply chain company" and is putting significant efforts and attention into refining its supply and logistics operations, leaning on Bain Capital (which owns nearly 10% of the stock) for advice and assistance. This is a multi-stage, multi-year plan, but GOME is looking to streamline product ordering (taking advantage of making fewer, larger orders) and planning cycles, and also streamline its inventory management and supply chain - in essence, cutting the cost of getting merchandise into and through its stores. Then there is the aforementioned private label offerings - a good way to match online rivals that want to try to undercut on prices.
This has worked well for others - a big part of the competitive advantage for Wal-Mart (WMT) and Amazon in the U.S. centers around their incredible logistics and distribution systems, and their ability to efficiently order and distribute its merchandise. It also gives new retailing options to GOME - management has talked about using this improved system to move less popular merchandise to rural stores (where they can sell it with less markdown) instead of letting it moulder on the shelves in the big city stores.
Leveraging Demand Into Cash Flow
While third quarter sales at GOME were up just 4% due to store closures and declines in online sales (due to the shift from growth to profitability), same-store sales were up more than 12% after climbing about 8% in the second quarter. Gross margins were also better by more than two full points, and the company has reversed year-ago operating losses and is generating solid free cash flow again.
Over the next decade, I'm looking for GOME to grow its top line at a rate of around 7% to 8%. Certainly there are risks that Suning, Amazon, 360Buy.Com, and/or others find a way to undercut GOME on price and grab share from them, but I think GOME's ability to offer private label merchandise and differentiated online/offline assortments will work in its favor. Moreover, I think GOME is building a real edge with its focus on logistics and supply chain costs - if GOME ultimately has to accept that they have no pricing power in the market, they can still profit from having below-average COGS and operating costs.
To that end, I'm looking for improvements in the free cash flow margin, but not windfall profits by any means. I expect GOME to bump along generating FCF margins of 2% to 2.5% for the next five years, with a gradual improvement over time to around 3%. I don't want to call GOME "the next Wal-Mart," but Wal-Mart's historical performance suggests those targets are not unreasonable, particularly as GOME doesn't need to go nuts on new store additions.
The Bottom Line
My revenue and cash flow assumptions ultimately produce a DCF-based target just under HKD 2.00 - roughly 50% above today's price. These shares have already recovered significantly over the past year (up more than 60%) but still only trade about 2.25x tangible book (against a sector average of around 3x), about 0.35x sales, and at 3x to 5x forward EBITDA (different services provide different average analyst EBITDA estimates).
With China showing signs of economic recovery, and the government periodically subsidizing the purchase of more energy-efficient appliances, I believe the underlying demand fundamentals for GOME are sound. I also believe that the company's strategy of building a strategic edge in its supply chain is a wise one, and a good way to compete with rivals, both online and offline, in the coming years. Coupled with an attractive valuation, I believe GOME shares still have meaningful room to the upside from here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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