Tsit Wing's 2Q 2008 results - a worrying disappointment

At first glance

While sales improved by 8.1%, or HKD 7.3m, this is more then offset by:

• a huge jump in cost of sales: -10.8m
• other operating income (loss): -2.7m
• distribution costs: 2.0m
  

This resulted in Q2's profit to plunge by 7.9m or 83.7% to 1.5m from 9.4m a year ago.

Worrying signs

Poor performance in China

While sales in first half of 2008 rose by 77%, operating profit dropped by 50%, a result of high material and operating costs. Looks like the expansion into China is far from successful yet. Ever since Tsit Wing ventured into China, the segment had been loss making and they had successful narrowed their loss year after year. This segment finally posted a marginal gain in 2007. But now, the marginal gain could easily be eroded and a segmental loss could be posted this year.

Closing down of small independent tea bistros

With high inflation, rising cost in both materials, labour, rental etc, small bistros are struggling to survive. Tsit Wing anticipated many to close down and hence impacting their sales even further.

Piling inventory

Inventories shot up significantly from 74.9m from 55.5m in 1Q 2008. Thus there is a sudden built up of 19.4m. This stockpiling could be management's answer to the rising cost of raw materials. Like any other commodities, the prices of tea and coffee had been very volatile lately. Such stock piling (locking-in at current prices) could back fire if the cost of commodities are to plunge in near future.

To manage the cost of raw materials, the management reported that they had engaged in hedging and trading activities. While rising demand due to growing global economies and population in the long term could lead to increase prices, however, commodity prices could be subjected to short term irrational, unpredictable forces depicted by Mr Market. The following tables illustrated how volatile the prices can be:

• Monthly coffee prices from 1998 to 2008
• Daily prices in August 2008

Thus, in my opinion, such hedging and trading actions is very dangerous. Indeed, Tsit Wing had incurred a marked-to-market loss of 2.2m since 30th June 2008. Fortunately, 1.7m is unrealized and are reversed in July.

Encouraging developments

Strengthening USD

Raw material cost is not a one way street. Commodity prices are ultimately subjected to supply and demand changes. With rising cost, demand will have to go down ultimately, resulted in over supply and a resultant drop in prices. The cycle repeats.

Part of the reason of the rising inflation and cost had to do with the weakening HKD. Hong Kong dollar is pegged to USD, about 7.75-7.85 HKD to a USD and the recent depreciating USD takes a toll on the inflation of Hong Kong in general where most items are imported.

I had already highlighted the reversal in fundamental for USD in my earlier post in May 2008 that the strengthening of USD is expected in the horizon, just that I don't know when. Thus the recent jump in USD against major currencies is not surprising.

A strengthening USD, and hence HKD, will bring a much needed respite to the inflation problem to HKD. Hopefully for Tsit Wing, the 20% increase in cost of sales (mainly due to raw materials) in the past quarters could be reduced in the coming quarters.

Strong balance sheet

They had little or no debt and huge cash horde of about 71m HKD. While the road ahead is challenging, at least they are in good financial shape to tackle the storm. Given the past boom in the Chinese markets in almost every sector, many companies had over expanded on increase leverage. During crunch times with falling demand, tight liquidity and rising interest, their eventual exit from the market should bode well for conservative and sound companies like Tsit Wing. However, until then, there is no foreseeable recovery for Tsit Wing in sight.

Going forward

The near future is dismal. Sales will definitely be hit and falling profits ahead is no longer surprising. Fortunately, they are in a strong financial shape to weather the storm ahead and hopefully, they can emerge stronger.