Quarterly Letter, VIP SEA

Quarterly Letter from CIO, VIP Southeast Asia Chapter, Q4 2023

Dear Sponsors, Board of Advisors, Members and Readers,

I'm You Gin, one of the co-CIOs for VIP SEA, alongside Javier. I'm excited to be writing this quarter's letter and updating you on the happenings of VIP SEA this quarter.

Our new batch of 5 analysts have finished writing their initial memos with the guidance of the senior members. Several of them have pitched their ideas at the monthly IC meetings and the team is currently discussing if capital should be deployed in these companies. This Q4 letter will mainly focus on reviewing our current portfolio as we finalise the companies to redeploy our existing capital.

Z Club Academy, a new monthly meet-the-investor initiative, has also begun in Feb 2024 as we invited Pulak Prasad, founder of Nalanda Capital to share their investment philosophies and interact with our club members. We have many more distinguished investors lined up for the upcoming months, notably Allen Xiao from Amundi Asset Management US, Daniel Phua from Foord Asset Management, and Raymond Goh from New Silk Road Investment for this quarter.

Portfolio Update

BYD

BYD was a stock that we invested in as a vehicle to provide us with high quality exposure to the Chinese market. The company’s decades-worth of investments to vertically integrate their supply chain, create proprietary battery technology, as well as amass a gargantuan production scale, has allowed them to manufacture vehicles at a much lower unit cost than peers. These costs have been readily passed on to consumers, which has continuously strengthened BYD cars’ value proposition as the go-to entry-level vehicle.

BYD forgoes pricing to pursue volume, and volume is exactly what they have achieved. In 2023, BYD successfully hit their 3 million delivery target, delivering 3.02mn pure electric and plug-in hybrid vehicles to customers at home and abroad. This is an astounding growth of 62.3% from 2022. The company now targets 4mn in deliveries for 2024.

In 2023, BYD generated RMB 602bn of revenues, a 42% YoY growth. EBITDA margin was at 12.9%, a 320bps expansion from the year prior. Net income grew a whopping 81% YoY, with net margin hitting 14.2%, up from 9.8% a year earlier. Despite seemingly phenomenal headline numbers, net earnings actually slightly missed consensus estimates with RMB 30.04bn vs RMB 30.94bn estimate. This can be attributed to the EV price war in China and generally weakening global demand.

Despite the business remaining fundamentally robust, the stock is still down qoq by -15%, mainly driven by a market wide correction in China equity markets. This move came in response to weakness in broader macro, and a dwindling trust towards the Chinese government with regards to policy management. Despite some efforts to reinvigorate the property market and some adjustments to monetary policy, the supposed effects have not yet been felt by the broader economy. This correction that we rode downwards may have been an oversight, as we did not expect market technicals to deteriorate this much and this quickly, with China seeing huge troughs of fund outflows last year, regardless of any company-level fundamentals. However, in Feb’24, China snapped a six-month streak of outflows after China officials signalled fresh support to prop up the stock market. A short beta rally helped BYD stock to rebound meaningfully, with its A shares rallying 8.2% YTD and H shares down -3.7% in the same period. The Hang Seng was up 0.9% YTD.

From a portfolio perspective, we continue to be bullish on BYD as a great business, but perhaps no longer as a great stock. While business fundamentals are sound and valuations look insanely cheap, we find it meaningless to hold the stock if sentiment towards Chinese stocks in general remains weak, and foreign investors do not have the confidence to inject liquidity into the market. From industry chatter, we are aware that many large funds (i.e. hedge funds, pensions, long-onlies) are still staying far away from China. That said, we do not see any clear catalysts for the stock in the next few quarters - be it from a macro perspective or at the company level, that would compel large volumes of buying. Furthermore, BYD is also facing tough comps, with an objectively strong 2023. This makes the future probability of outperformance more uncertain. This is a stock that has (fortunately) not moved the needle too much in our portfolio; we are currently looking to sell off the stock/trim a significant portion of our position. We will likely replace the Asia exposure in our portfolio with some Japanese names, as Japan is going through major reforms that should serve as structural tailwinds for the entire market (i.e. TSE reforms, wage hikes, moderate inflation). More on Japan will be addressed in the next quarterly note. We may also capture China exposure through a non-Chinese company with main operations in another market but with a sizeable segment in China. These stocks should have a more win-win narrative, (i.e. without China the rest of the business is still strong / if China rebounds, buy on China recovery story).

An example of a business with such a profile would be Apple, but more work will have to be done here to find the best fit for our portfolio.

Alibaba

We have been holding Alibaba since it was pitched by analyst, Olivia. Below we have an overview of how the different parts of Alibaba are doing and key highlights. We believe the company is extremely undervalued, trading at 13x PE but remain cautious due to poor sentiment on Chinese stocks as a whole.

Taotian Group: The revenue in Q4 2023 increased by 2% year-on-year to 129.1 billion yuan with retail businesses in China reaching 123.8 billion yuan (YoY +1%) and wholesale business revenue in China reaching 5.3 billion yuan (YoY +23%), mainly due to the increase in value-added service revenue from premium members.

Alibaba International Digital Business Group: The revenue in Q4 2023 increased by 44% year-on-year to 28.5 billion yuan. Cross-border and global retail businesses achieved revenue of 23.3 billion yuan (YoY +56%), mainly driven by the strong growth in overall retail orders under the robust performance of major retail platforms, as well as revenue contribution from AliExpress Choice and the improvement in realization rate. Cross-border and global wholesale businesses achieved revenue of 5.3 billion yuan (YoY +8%), with growth mainly coming from the increase in value-added service revenue related to cross-border business.

Cloud Intelligence Group: The revenue in Q4 2023 increased by 3% year-on-year to 28.1 billion yuan, with an adjusted EBITA margin of 8%. The continuous improvement in adjusted EBITDA reflects the group's focus on public cloud business and efficiency improvement, leading to an improvement in product structure and the continuous enhancement of cloud business profitability.

Cainiao Group: The revenue in Q4 2023 increased by 24% year-on-year to 28.5 billion yuan, mainly driven by the revenue from cross-border logistics fulfilment solutions. The order volume of high-quality logistics services with 5-day delivery worldwide achieved triple-digit growth compared to the previous quarter.

Local Services Group: The revenue in Q4 2023 increased by 13% year-on-year to 15.2 billion yuan, with the overall order volume increasing by over 20% year-on-year. As of December 31, 2023, the group had over 390 million annual active consumers.

Alibaba's international platform also launched the AI+ image design tool PicCopilot. On the day of its launch, it secured the second position on the weekly leaderboard of the authoritative AI new product discovery platform ProductHunt. PicCopilot has the greatest advantages in "multilingual" and "understanding e-commerce," enabling rapid generation of marketing point images adapted to different country markets and languages, thereby increasing product click-through rates. The click-through rate of product point images generated by PicCopilot has increased by an average of over 7%, significantly outperforming traditional advertisement images.

On March 26, Alibaba announced its decision to withdraw the listing application for Cainiao and to make a tender offer for the shares owned by minority shareholders of Cainiao and those owned by employees, involving an amount of up to $3.75 billion. From a strategic perspective, Alibaba's primary goal is to win in the e-commerce field, necessitating the restoration of market share and driving business growth. Cainiao will continue to serve as a core part of Alibaba's business and an important infrastructure for e-commerce, facilitating closer integration with Alibaba's e-commerce business. Additionally, Alibaba will continue to increase its strategic investment in the logistics field to support Cainiao's global expansion. Another reason for the decision is mainly due to the current downturn in the capital market, resulting in Cainiao's valuation being lower than expected. The performance of the Hong Kong capital market is not optimistic, especially in 2023, which was rather dismal.

From a portfolio perspective, considering that it comprises 67% of China stocks, there will be a need to trim our positions due to the reasons mentioned above.

Costco

You Gin, Co-CIO of VIP SEA pitched Costco in the previous quarter and it has performed extremely well. This is likely driven by the crackdown in membership sharing and expectations of a membership fee hike which could give a boost to the company's revenue. According to Costco’s CFO, the hike is a matter of when and not if. This decision is likely to be affected by macro conditions and the timing of the interest rate cuts by the Fed.

In Q2 2024, Costco’s net sales for the company were $57.33 billion, an increase of 5.6% year over year. Net income is $1.74 billion, up 18.3% year on year. Traffic increased 5.3% across the globe. This quarter, Costco also opened four new clubs, including three in the U.S. and one in Shenzhen, China, its sixth club to open in China. Costco is expected to continue expanding with plans to open 30 stores in 2024, two of which will be relocations. In Q3 and Q4, Costco plans to open 15 new locations — 11 in the U.S., two in Japan, and one each in China and South Korea. This is in line with expectations.

Costco ended its Q2 with 73.4 million paid household members, a 7.8% year-over-year growth. This is above its past 5-year age of 6.2%. It also had 33.9 million paid executive members in Q2, 2% higher than Q2 2023. Executive members represent slightly more than 46% of paid members and 73% of worldwide sales.

Digital growth continues to be an important driver in Costco’s sales. Its e-commerce sales grew 18.4% in the quarter compared with the year earlier. There were significant upgrades to Costco’s app which is critical as 60% of its e-commerce business is done through its mobile app and mobile browser. App downloads were up 2.8 million in the quarter and currently total about 33 million. This represents 1.5% of US total sales but will continue to make up a bigger proportion with growth finally back on track.

Costco is currently trading at 47x PE which is 43% higher than its historical average of 33x. Close competitors, Walmart is trading at 31x PE whilst BJ’s Wholesale Club is trading at 19x PE, both of which are near their historical averages. From a valuation perspective, Costco is expensive and trading at a premium compared to its peers. Fundamentally, Costco is sound and is poised to grow sustainably in the future. However, given that Costco has already hit its price target as set out initially, the team is considering closing the position and redeploying the capital to another stock which is trading at a more attractive valuation. This is also supported by the idea of “buying the rumour and selling the news” where the membership hike is priced into the stock given its huge run-up from Nov 2023 and we can potentially see a massive retracement in stock price when the hike is eventually announced. Costco remains an attractive company to hold for the long term but its stock remains overvalued as we expect it to undergo a major retracement in the near future. It might be wise to reenter a position in Costco once valuations become more attractive.

Spotify

Javier, Co-CIO of VIP SEA presents his updated analysis on Spotify, one of our holdings which has also outperformed expectations this quarter.

Spotify (NYSE: SPOT) has continued to outperform within the VIP SEA portfolio, generating 19.7% of returns in excess of the benchmark index, S&P500 since Q3 2023 (23.7% stock returns vs 4% index returns).

Spotify is the largest music streaming platform globally, with an estimated 32% market share as of 2023. Summarizing our thesis, we believed that Spotify’s ability to achieve profitability was being severely underestimated by the market. A mere 8% CAGR in Monthly Active Users (MAUs) over the next 3 years would have resulted in SPOT hitting profitability about a year earlier than the market was expecting.

From a portfolio construction lens, Spotify was a stock that we added to the portfolio as it had historically shown signs of resiliency against recessionary pressures, thus serving as a solid bottom-up stock pick that would help us to go against any potential sluggishness in the broader market as we saw many idiosyncratic opportunities for upside. Furthermore, this company had a solid balance sheet – a net cash balance with positive operating cash flows served as a safety net as they pursued sustainable growth. This gave us a sense of assurance during a time of elevated rates. Our fundamental view on Spotify still holds, and we believe it to be a great exposure to retain in our portfolio.

In Q4 2023, all of Spotify’s KPIs met or exceeded guidance. MAU net additions of 28mn surpassed guidance by 1mn, representing the second largest Q4 net addition performance in history, contributing to record full-year net additions of 113mn, and growing 23% YoY to 602mn. Premium Subscribers grew 15% YoY to 236mn, 1mn above guidance. Q4 net additions of 10mn contributed to record full-year net additions of 31mn. Subscriber net additions of 10mn were also ahead by 1mn.

Revenue grew 20% Y/Y on a constant currency basis, reflecting another ~300 bps of sequential acceleration vs. Q3 2023. Gross Margin of 26.7% was also ahead and up 140 bps YoY, while an Operating Loss of (€75) million was better due to lower marketing and personnel and related costs. Excluding €143 million in charges associated with efficiency actions taken late in the quarter (which were incorporated into guidance), Spotify generated €68mn in Adjusted Operating Income, more than double the Operating Income achieved in the previous quarter. Free Cash Flow was €396 million in the quarter, up from -€75mn in the same period last year, and €210mn in the previous quarter. With revenue and profitability trends both inflecting favourably heading into 2024, we view the business as well positioned to deliver improving growth and profitability as they progress towards delivering against their Investor Day goals.

With regards to valuations, SPOT is now trading around its 10Y average forward EV/Sales multiple (2.8x). While SPOT continues to be a stock that we wish to hold in our portfolio, we are starting to shift our thinking towards finding a potential exit zone. For now, valuations do not seem overly extended.

With rate cuts likely coming in June/July, tech should be a sector to see sustained tailwinds in overall spends and general investor sentiment towards risk-on assets. Enterprise advertising spends is also seeing a recovery, and Spotify stands to ride this rebound with their audio advertising business. Overall, we think that the stock still has some juice, but likely not for long. For now, we will continue to monitor the stock closely for another quarter.

Overall it has been an exciting quarter and I look forward to the changes in the portfolio soon.

With Best Wishes,

Cheng You Gin

on behalf of the Value Investing Program’s Southeast Asia Chapter