Tuesday, August 6, 2013

Fosun - The Case for BRK.CN

I. Thesis: 

Fosun is a privately owned Chinese conglomerate headquartered in Shanghai. It was founded in 1992 by four Fudan University (a top-five university in China) graduates. Fosun moved into pharmaceutical, steel, mining, real estate and most recently and perhaps more importantly to Fosun’s future, insurance and asset management. Fosun is striving to transform itself into an insurance-oriented investment group and effectively implementing its philosophy of value investing, thereby enabling Fosun to make strides towards its vision of becoming a “premium investment group with a focus on China’s growth momentum.” Investing in Fosun also will benefit from the long term trend of RMB appreciation against the dollar (The RMB has been appreciating against the USD at about 2.8% per year compounded annually for the past 10 years). 

II. Segments 

(i) The pharmaceuticals and health care segment comprises the business of Fosun Pharma and its subsidiaries. Fosun Pharma, established in 1994, and its subsidiaries are mainly engaged in the research and development, manufacture, sale and trading of pharmaceutical and healthcare products. The Pharmaceutical segment generated revenue of RMB 7.3 billion (about $1.16 billion), profit before taxes of RMB 2.1 billion (about $337.4 million) and spent RMB 962 (about 152.7) million on capital expenditures. From 2007 (the year Fosun went public in Hong Kong and started presenting annual reports) to 2012, this segment generated a total revenues of RMB 33.3 billion (about $5.3 billion), profit before taxes of RMB 6.7 billion (about $1.06 billion) and spent RMB 3.84 billion (about $610 million) on capital expenditures. 

(ii) Property segment comprises the business of Shanghai Forte Land Co. Ltd. (Forte) and its subsidiaries, excluding its investment in the insurance business. Forte, established in 1998, and its subsidiaries mainly engage in the development and sale of properties in China. Forte operates property business mainly in tier 1 and tier 2 cities including Shanghai, Beijing, Tianjin, Nanjing, Chongqing, Chengdu, Xi’an, Wuhan, Datong, Wuxi, Hangzhou, Taiyuan, Changsha and Changchun. During 2012, the Property segment generated revenue of RMB 10.5 billion (about $1.67 billion), profit before taxes of RMB 2.61 billion ($412 million) and spent RMB 39 million (about $6.2 million) on capital expenditures. From 2007 to 2012, this segment generated a total revenues of RMB 44.4 billion (about $7 billion), profit before taxes of RMB 13.5 billion (about $2.1 billion) and spent RMB 455 million (about $72 million) on capital expenditures. 

(iii) The steel segment comprises the business of Nanjing Iron & Steel United (Nanjing Nangang) and its subsidiaries. Nanjing Nangang and its subsidiaries mainly engage in the manufacture, sale and trading of iron and steel products. Fosun first invested in Nanjing Nangang in 2003 for RMB 1.65 billion. During 2012, the Steel segment generated revenue of RMB 32 billion (about $5 billion), losses before taxes of RMB 862.4 million ($137 million) and spent RMB 3 billion (about $476 million) on capital expenditures. From 2007 to 2012, this segment generated a total revenues of RMB 196.8 billion (about $ 31.2 billion), profit before taxes of RMB 7.4 billion (about $1.2 billion) and spent RMB 17.5 billion (about $2.78 billion) on capital expenditures. 

(iv) The mining segment comprises the business of Hainan Mining Co. Ltd. (Hainan Mining) and its subsidiaries. Hainan Mining and its subsidiaries mainly engages in the mining and ore processing of various metals. Founded in August 2007, with a registered capital of RMB1.5 billion, Hainan Mining is jointly established by Fosun and Hainan Iron and Steel Company, owning 60% and 40% interest, respectively. Hainan Mining owns a zonochlorite mine with polymetallic and nonmetallic ore. The mine has rich reserves of high-grade iron-rich ore, and is known as “China’s largest iron-rich ore producer.” Hainan Mining’s open-pit mining system is highly mechanized. It is capable of mining, beneficiating, tailings recovery, nickel and copper smelting and equipment maintenance. The mine has an annual overburden removal capacity of 16 million tons, raw iron ore mining capacity of 4.6 million tons and final iron ore products capacity of 3.3 million tons. Main products include blast furnace lump, fine ore, iron ore concentrate, electro deposited copper, cobaltous oxide, etc. Its customers include a number of domestic iron and steel enterprises such as Wuhan Iron & Steel, Shao Gang, Nanjing Iron & Steel and Anhui Iron & Steel and so forth. During 2012, the Mining segment generated revenue of RMB 1.95 billion (about $310 million), profits before taxes of RMB 1.1 billion ($172 million) and spent RMB 529.7 million (about $84.1 million) on capital expenditures.

(v) The asset management segment engages in the asset management business through the platform such as corporation funds, partnership funds and trusts. Fosun established its asset management practice in 2010 with the launch of Fosun-Carlyle Shanghai Equity Investment Enterprise (Carlyle-Fosun), Prameria-Fosun China Opportunity Fund L.P., Shanghai Fosun Capital Equity Investment Fund L.P. and Shanghai Star Equity Investment L.P. (Star Capital), etc. The asset management segment is still in the early stage. As of Dec. 31, 2012, the asset management of the group raised funds amounting to RMB 16,658.1 million, the revenue from the management fee of the asset management business amounted to RMB 159.74 million . In 2012, the asset management business of the group invested in a total of 28 additional new projects and increased investments in five existing projects with an accumulated investment of RMB 4,435.2 million. Fosun also prepares to launch a new RMB-denominated Weishi Fund and a new fund denominated in USD in 2012, which it claims may eventually start operation during 2013. 

(vi) The insurance segment engages in the operation of and investment in the insurance business. Fosun’s insurance segment mainly includes Yong’an P&C Insurance, which is a property and casualty insurance company headquartered in Xi’an with a nationwide presence, Pramerica Fosun Life Insurance, which commenced its operations in October 2012 and focused on providing life insurance, health insurance, casualty insurance and all other kinds of personal insurance products approved by China Insurance Regulatory Commission and related services, and Peak Reinsurance, which obtained its certificate of authorization in respect of reinsurance business from the Office of the Commissioner of Insurance in Hong Kong in December 2012 and focused on providing reinsurance services and investing its investable assets. 

(vii) The investment segment comprises, principally, the investments in strategic associates, private equity investments, secondary market investments, limited partner investments and other investments. Fosun’s investments in strategic associates include Yuyuan, Jianlong Group and Shanjiaowulin. Yuyuan is mainly engaged in commercial retail and gold and jewellery wholesale and retail; Jianlong is a steel manufacturer in North China and Northeast China and Shanjiaowulin is a joint venture between Fosun and Shanxi Coking Coal Group Co. Ltd. It is a new coal mine with raw coal reserves such as prime coking coal. After years of construction, Shanjiaowulin has initially formed a complete industrial chain covering from coal production to coke processing, further to the deep processing of methanol and other coal chemical industrial chains. Fosun’s investments in the P/E include enterprises such as Zhaojin Mining, a large conglomerate with exploration, mining, processing and smelting operations focusing on the gold production business. Fosun’s investments in the secondary market include Focus Media (culture and media industry), Club Med (luxury resort), Folli Follie (fashion resort) and Minsheng Bank (commercial banking), etc. Fosun’s Investment Segment has generated profit before taxes of approximately RMB 7 billion (about $1.1 billion) from 2007 to 2012. 

Fosun adheres to the value investing philosophy in making investment with very solid investment track record. For example, Fosun’s investment in Minsheng Bank totals 2.19% of ownership as of Dec. 31, 2012. Fosun bought one-third of the volume at HK$5.729 per share when Minsheng reached low of HKD 5.39 on Sept. 5, 2012. Total Investment in Minsheng Bank totaled 2.965 billion RMB since 2011 with realized profit of 876 million RMB, and dividends income of 182 million RMB. 

III. Management Team: 

Fosun was founded by a team of four Fudan University graduates led by Guo Guangchang. Mr. Guo, who is considered to be the “Warren Buffett of China," graduated from Fudan University with a degree in philosophy in 1989 and later obtained his MBA degree from Fudan University as well. Fosun’s management quartet possesses the rare combination of superior intellectual capability, extremely imperturbable temperament and outstanding foresight. The track record speaks for the high caliber of the management team. Fosun captured opportunities arising from consumption and services upgrade, urbanization and industrial upgrade brought by the restructuring of China’s economy towards domestic demand. At the same time, Fosun seeks to capitalize on structural changes in the global economy, implementing its unique investment model of "combining China's growth momentum with global resources" and reinforcing its position as a China expert with global capacity, with a view to constantly creating value for the society and its shareholders. 

The management team also sticks to Graham and Buffett’s philosophy when making investment decisions. The most famous investment made by Fosun is the purchase of Minsheng Bank, a well-fun non-government-owned commercial bank. Fosun was greedy when others were fearful. As noted earlier, Fosun bought one-third of the volume at HK$5.729 per share when Minsheng reached low of HKD 5.39 on Sept 5, 2012. Investment in Minsheng Bank totaled 2.965 billion RMB since 2011 with realized profit of 876 million RMB, and dividends income of 182 million RMB.

IV. Value Gap
The market is undervaluing Fosun mainly because of the following reasons: 

1. Under-appreciation of the transformation that is currently undertaken by Fosun’s management team. The transformation is very likely to create long term value for Fosun’s shareholders. See the next section for a detailed discussion. 

2. The prevalent pessimism against China’s stock markets in general (Heng Seng Composite is closely related to the Shanghai and Shengzhen Composites). Although the concerns over China’s overheating real estate market and burgeoning local government debt may be valid, it is likely that the market has priced in those concerns. 

3. Concern over Fosun’s exposure to the real estate bubble, and the slowdown of mining and steel industries in China. Forte’s operation is concentrated mostly in tier 1 cities such as Beijing, Shanghai and Chongqing, where demand for real estate still outweighs supply. The “ghost cities” portrayed by Western media are all tier 2 and tier 3 cities such as Ordos, where supply vastly outpaced demand. Furthermore, Forte’s exposure to residential real estate is mitigated by its diversified revenue stream. It also develops urban complexes which are intended for use by non-state-owned enterprises, commercial and tourism properties, senior housing properties and Industrial parks with the support of local government. Fosun is also determined to cut its exposure to the mining and steel industry through the aforementioned transformation. 

4. As Fosun’s business portfolio spans across many different industries and each industry has unique operational characteristics, it is difficult to value the whole business. While the last three reasons contribute to Fosun’s under-valuation based on current business conditions, the first reason may very well prove to be creating the largest value gap as the market has not properly priced in the potential value creation unlocked by Fosun’s transformation. 

V. Business Transformation and Potential Massive Value Creation 

Inspired by Berkshire Hathaway’s business model, Fosun is making strides towards its vision of becoming “a premium insurance-oriented investment group with a focus on China’s growth momentum.” Previously, Fosun’s business operation was concentrated in capital-intensive businesses such as mining and steel. The steel segment accounted for more than 75% of Fosun’s revenue in 2007 and only 61.3% of the company’s total revenue in 2012. The steel segment is very capital intensive with low profit margin. From 2007 to 2012, Fosun had to spend more than the profit before taxes on capital expenditure on the steel segment. By shifting from industrial operations to Insurance and Asset Management, Fosun can better utilize its strength, which lies in the management’s unusual discipline and ability to generate superior returns on investments. 

Asset Management:
Fosun has also tapped into the asset management business recently. It retains in the asset management business through the platform such as corporation funds, partnership funds and trusts. For the fiscal year ended December 2012, the Asset management segment reported revenue of RMB 159.74 million, reflecting an increase of 184.46% over the revenue of 2011. The segment only accounted for 0.3% of the company’s total revenue in 2012. Fosun engages in asset management business through raising and managing funds from third parties and collects management fee revenue and shares investment gains. Fosun acts as a general partner of the funds Fosun manages. Fosun manages the following funds as of Dec. 31, 2012: 

• Pramerica-Fosun China Opportunity Fund (USD denominated)
• QFLP Fund (Carlyle-Fosun) 
• RMB Private Equity Fund 
• Star Capital, and 
• Real estate series funds of Forte. 

Fosun has an enviable investment track record with ROI averaged 38%. As Fosun’s investment capability has been well recognized both in China and in foreign market, Fosun should be able to expand the asset management rapidly during the next few years with AUM well over RMB 100 billion and management fees and incentive fees in the billions of RMB. 

Fosun had contemplated entering the insurance business a long time ago but the management did not know enough about the insurance business. They kept learning about the business everyday and made the investment in Yong’an Insurance in 2007. Yong’An is an established business with proven success in China’s property and casualty market. Fosun’s investment in Yong’An insurance gives Fosun almost 20% ownership. Fosun is very likely to increase its ownership percentage or even acquire the whole insurance business in the future. 

Fosun’s investment in the insurance business remained almost “dormant” until late 2011 when it announced to partner with Prudential to establish a life insurance joint venture in China called Pramerica Fosun Life Insurance with registered capital of RMB 500 million. Pramerica Fosun Life Insurance commenced its operation in October 2012. If Pramerica is successful in the long run, Fosun should be able to create substantial value for shareholders. Although 2012 was a difficult year for China’s life insurance industry, long-term industry prospects remain bright due to: 
• An aging population that will spark stronger demand for health and retirement income products. 
• Continued increase in the size and wealth of middle class that will transform into higher demand for life insurance market. 
• The continued loosening up of constrains on investments allowed by life insurance companies that will offer more flexibility and availability of the products offered and thus better meet customer demands. 
• The potential implementation of a taxed-deferred pension program that will likely boost the demand for savings and retirement-related products in China. According to GlobalTimes, “under the program, the insured are allowed to buy 1,000 yuan ($157.35) of commercial pension insurance, a certain sum of which can be deducted from the amount the income tax is levied on, and pay income tax after they begin to draw their pensions.” The program has been postponed multiple times because implementing the program means lowering the fiscal income of local governments, but it is expected to be rolled out eventually. 

Fosun also teamed up with International Finance Corporation and established Peak Reinsurance Company Ltd., which started its underwriting operations on Dec. 28, 2012, with an initial capital of US$550 million in Hong Kong. With an initial focus on property and casualty treaty reinsurance solutions, Peak Re is specialized in developing modernized risk management solutions for the Asia-Pacific community. According to Peak Re’s website, “Peak Re believes that Asia Pacific has been underinsured in general. For instance, in the aftermath of a series of natural catastrophes in Asia Pacific in 2011, including Thai flood, Tohoku earthquake and tsunami, New Zealand earthquake and Australian floods, less than 22%; of the total economic loss registered was insured, significantly below the ratio of insured loss to economic loss seen in the US and Europe in the same period, which stood at approximately 63% and 50%, respectively. In 2010 China suffered its most devastating floods in a decade causing around US$50 billion economic loss, of which only US$1 billion was covered by insurance5 – another example illustrating the low insurance penetration in Asia. In view of the situation, beyond providing general reinsurance solutions, Peak Re also invests significantly in the research and development of risk management solutions tailored for demand by households and business in the region. In cooperation with IFC and Fosun, Peak Re aims to enter into emerging Asian markets including China, India, and Indonesia in the next five years.” The future of Peak Re is much harder to evaluate than Pramerica Fosun. 

Fosun’s management is actively trying to arrange a meeting with Warren Buffett. It is very likely that Fosun’s management team will ask him a lot of questions regarding running the reinsurance business. Buffett’s letters to shareholders have discussed the reinsurance business extensively. Berkshire's competitive advantage in the business includes its unmatched financial strength, its ability to supply a quote faster than anyone in the businessand the ability to issue policies with limits larger than most competitors can be prepared to write. With Fosun’s strong financial position and given the discipline and intelligence of the management team, Fosun’s investment in the business may very well prove to be value-added. 

VI. Risks: 

1. The macroeconomic situation gets much worse in China, which will have a wide effect across Foson’s segments, especially steel and mining. It is likely that this is partially priced in. 

2. The insurance transformation is not successful. This is a risk that can either have a minimum impact on the valuation or create huge value for Fosun going forward. If the transformation is not successful, Fosun can simply drop the insurance business. 

3. The transformation and continued diversification of business may create too much distraction for management. Although historically this has not been a problem, the expansion of asset management and insurance business requires a significant amount of management’s time and effort. 

VII. Valuation and Conclusion: 

Fosun is in the process of its multi-year transformation geared towards focusing more on asset management and insurance. The company’s goal, to quote Wang Qunbin, executive director and present of Fosun, is to “become more and more like Berkshire Hathaway.” The company has the capacity to suffer from short-term operating losses resulting from the newly launched insurance businesses (insurance businesses can take many years to show operating profits). Fosun has also been deviating from its capital intensive steel and mining business, which will free up more capital for investment opportunities. Fosun is trading between 1.1 and 1.2 times book value, at 11 times earnings and is yielding 2% currently.

Even if the transformation is not successful, a premium business like Fosun should be trading at least 1.5 times book value. Fosun’s book value per share as of Dec. 31, 2012, is RMB 5.48 and growing at 12% per year since 2007. In five years, Fosun’s book value will be grown to approximately RMB 9.7 per share or HKD 12.3 per share. Applying a P/B ratio of 1.5, Fosun’s per share price should be worth about HKD 18.5 per share, or almost 200% higher than what Mr. Market is offering now. 

If the transformation is successful, the value created by Fosun is hard to measure at this point. Learning from Warren Buffett, we’ll leave it as between zero and a lot. As discussed in the above, even at zero, Fosun seems to be very undervalued. 

Disclosure: No position in Fosun.