Hai Di Lao 海底捞 from a Cook's perspective

Hai Di lao

It is a stock that make up more than half of my portfolio, I’ll discuss why I’m interested in it. I will break them down to few points. Most of the information in this article is from the IPO prospectus. For the info that is not from the prospectus I would normally start the statements with the words like “In my opinion” or “I think”.

Business Moat

As mentioned in their prospectus, their advantage versus other hot pot restaurant would be their unique management structure. What it does is to connect the incentives among all the employees effectively and doing it in a scalable way(prospectus can explain better with charts) To do this effectively you will need a good brand power in order to ramp up customer fast in newly open restaurant, experience management, and good supply chain. They had countless copy cats for many years but none of them causes a threat.

Good service comes only with good pay check.
A good “culture” without good economic compensation and career opportunity is just brainwashing and employees knows that. It is the best incentives that maintain the professionalism. On the other hand, It is the need of promotions of the developed talents that pushes Hai Di Lao to expand so rapidly these two years. They together could create a competitive working environment. Other smaller competitors with lower table turnover simply can’t afford to pay their workers the same salary and the they don’t have the same career that many advancement opportunities available as well. As a result, they get the best people with critical mass effect. It is not possible in my opinion to have another restaurant that could rival its service quality. On the other hand, people will notice that service in Singapore’s Haidilaos are actually not up to the standard with China’s ones. From what I heard from Haidilao’s managers it is because the worker in China are usually more obedient compare to people here.

When I started my career in Shangri-la hotel Singapore and I heard the general manager said that It is the people who serve that matter the most, the warmth will stay in guests hearts longer than any other quality.
Why service is more reliable than taste? I know how much different people’s taste in different areas vary. You will be surprise how much different a Singaporean and a Malaysian judging the taste of a food even though they live quite close. However, good service is good service, it is commonly accepted around the globe, it is hard to imagine ten years later people will prefer bad service. And of course service affects the taste of food along with smells and presentation more than people realise.

Their biggest competitor would be BaNu(巴奴）They are having a fierce competition in Zheng Zhou for last few years and the loser is not one of them as they both survive with good profit. The losers are the small individual hot pot restaurants, many of them became unprofitable and closed their shops.

The hidden advantage would be their established supply chain Shu Hai and Yi Hai. The reason they were spun off from the restaurant’s group is because they want to turn the central kitchen from a cost center to a profit center. Management intended to make them more sensitive to market competitions and cost.(Yi Hai is not the exclusive supplier of the soup base like many people think it is, Shu Hai supply them as well) Their expansion would also get extra help by selling their product to third party(In that sense third party “helped” them to expand) as they are more assets heavy compare to restaurant group. In my opinion, the cost of central kitchen is already in that “food ingredients” expense, it would make sense since 40% of COGS is actually high in industrial standard. The idea behind this structure is Kazuo Inamori’s amoeba management. Please learn more about it if you are really interested in learning more about business instead of just “stocks”.

One of their advantage is reflected in their rental of property which is only 3 to 4 percent of their revenue which is extraordinary among restaurants. This is because they have the strong brand power to negotiate the rental(Malls need them to attract guest traffic for them). They do not need to rely on prime location to maintain high traffic. However, as they try to expand and create brand recognition oversea, outside China they will mainly open their restaurant in prime location first. Therefore, we will see the rental percentage slowly increase with the oversea expansion start to speed up.

One of the thing i like about Hai Di Lao is that the restaurant hasn't receive any outside money, they expand by selling hot pot one by one. (their supply chains however did receive money from funds, but they are outside of the equity)

Hot pot in China isn’t really like hot pot in Singapore. It is almost their national food. The brand power of Hai Di Lao is vastly different between a person who lives in Singapore and a person who lives in China.

I think the Biggest moat is Mr. Zhang Yong. He and Wang Zheng of Pinduoduo are the most intelligent CEOs in China in my opinion.

Expansion

They have an unique management model by combining the best features of both the traditional franchise model and the self-owned and operated model. They have continually refined their management system to find the optimal balance between standardisation and flexibility, and between control and autonomy, to allow restaurant managers to have sufficient freedom and flexibility while maintaining control over critical aspects of restaurant management.

After they reorganised their internal management structure in mid-2016 to implemented a bottom-up driven project identification process, It is obvious that it made the new restaurants opening more rapidly. The reason for the accelerate expansion is because they need to train people in their restaurants in order to develop a manager. As the number of restaurants increase, naturally the number of “training ground” also increase thus more and more manager will be produced in a compounding rate. Therefore, they won’t expand at a static rate like 100 restaurants every year but more likely to 1.5x or even 2x every year until they reach highest possible density in all the cities (to the management it means 10% of restaurants in that city reach a certain low level of table turnover or even lose making, it will then stop expansion in that city and compensate the affected managers) and they are deliberately making it as their expansion strategy.

They only got like 2.2% of the market share of Hot Pot market that has 13.7% of the 4 trillion yuan market. In addition, according to Frost and Sullivan, the market revenue for Hot pot is estimated to have CAGR of 11% in the mid-to-high price range restaurant.

Cash Flow

One of the good thing about lousy restaurant industry is that they receive cash upfront from customers and only pay their suppliers at later date thus generating positive cash flow as they expand. The trade receivables turnover days were 3.5 days in the six months ended June 30,2018, whereas trade payables were generally settle within 30 to 60 days. The result good liquidity is beneficial for rapid expansions. Furthermore, they historically are able to achieve breakeven in a relatively short period.

They could easily have open over thousands of restaurants by accepting outside investment since they are famous and popular for many years(the restaurant rose to fame around 2008) but chose not to do so. It is because they need time to build their own talent pool instead by hiring outsiders and they also need time to build their own supply chain.

Earning

For bottom line, you need to consider there are actually some items that impair the profit in their income statement.

New restaurants opened will not contribute revenue on the first six months. Revenue will only start to flow in six months after its opening and they need time to increase their table turnover rate.

the majority of their newly-opened restaurants generally incurred pre-opening expenses ranging from approximately RMB1 million to RMB2 million. These pre-opening costs are typically incurred around and within the three months leading up to a restaurant’s opening, while the restaurant has not begun to generate revenue. For instance, they incurred significant pre-opening costs for the 71 new restaurants they opened in the first half of 2018, as well as for 53 of the new restaurants scheduled to be opened in the second half of 2018 which had a material effect in their profit margin for the six months ended June 30, 2018. You need to understand that these are not COGS but rather a lot of the “cost” is actually more like “investment”-an investment that have cash investment payback period of six to thirteen months. To put it into a way you could imagine, a company that could buy 100+% yield bond with room to grow. I’m not sure those people who said that the stock is expansive actually notice it or not because I do not yet find a single person who mention about it in internet(They mostly consider the stock is extremely expensive without further explain what made the expense and revenue)

The restaurant level operating profit margin(not including cost of running the group) would be 19.7% versus 8.8% of the group profit for the six months ended June 30,2018.

They generally enter into long-term leases ranging from five to 15 years with an option to renew for their restaurants. Rent under a substantial majority of their leases is fixed amounts and subject to incremental increases every two to three years as stipulated in the lease agreement. Their leases typically include a rent-free period of at least three months to facilitate the decoration and renovation of the premises. However, they start to recognize rent expenses immediately on a straight-line basis over the term of the lease (including the initial rent-free period). This difference means that their property rent and related expenses is typically higher than their actual rent payment in cash in the initial period of their lease, and typically lower than their actual rent payment in cash from the middle to the end of the lease period. On the other hand, due to accounting policy change to IFRS, in the year 2019 instead of excluding the long-term leases from balance sheet they will sum up total leases into a right-of-use assets and create liability of payment obligation. So you would see the liability increase by around double next year that makes the business looks not so “asset light”.

Capital expenditure primarily represented the capital expenditure for group’s newly-opened restaurants according to the prospectus. Of course it will include a little of technology investment but I would think that it is also a value adding investment that will differentiate themselves from not only hot pot restaurants but all other restaurants. However, there are actually a little of it was used for renovating existing restaurants. Nevertheless, it might be useful to use see what’s the earning would be like if they stop expending and renovating for year 2018.

Start with earning of six months ended June 30 2018

Capex: 984.8m
Profit before tax after Capex deduction: 1885.7m

Normally the second half of the year is more profitable than first half but just assume that the earning stays the same as the first half’s for conservatism. It would be:

Profit before tax after Capex deduction for full year 2018: 3771.4m
If we give it a tax rate of 30% : 2639.98m

So we have PE of 31.25 if we take out the expansion cost. But of course in reality the expansion cost has a compounding effect to profit that is too good to take out. Important to note that above numbers are imaginary. It exist only in my imagination and only for me to see how much the expansions affects the valuation of the shares.

Risk

Food safety of course, it doesn’t need much explanation. When you are at the top, everyone is trying to shot you down.
The dilution of company’s culture due to rapid expansion.
After the business in China reach maturity they might failed to enter oversea market with the same success they enjoyed. There is no guarantee that people outside China will accept the restaurants as much as Chinese’s nation.
If the queue and table turnover rate decrease due to rapid expansion the margin will continue to shrink. It will also impact the brand power.
Labour continue to get more expansive, It will decrease the profit margin.
The price might be too expensive and in the future the stock might not enjoy much appreciation.

Conclusion 

How far can they go? they are in a trillion dollar market which have high CAGR for years to come. Where is the rooftop is beyond my circle of competence, what I think might likely to happen is that they could easily open at least 1000 stores in China. It is a strongest hot pot brand in a lousy business, that require the excellent management, structure and culture to keep it going. I think they are just getting started after 20 years of preparation and I could buy it with reasonable price. 

However, never listen to me as I'm not your financial fiduciary and do your due diligence in investing. The only way to become a better investor is to become a better business thinker.