LG H&H is a South Korean consumer goods conglomerate. The company started as a supplier of laundry detergents, home cleaning products, shampoos, toothpaste and other branded household goods. Most of these are well-known brands within South Korea. A few products like Physiogel and Dr. Groot are also sold internationally with some success, although none are blockbusters. Later, LG H&H also became a bottling company for Coca-Cola beverages. In addition, it distributes a few of its own beverages throughout South Korea. As its third division, LG H&H runs a portfolio of branded beauty products selling worldwide at different price points. This cosmetics business has been going down lately, taking the LG H&H share price with it.
What went wrong? Over the last decade, cosmetics became LG H&H's most profitable division. This was mostly due to the success of the luxury brand The History of Whoo in China. This brand benefitted from the K-Beauty (Korean beauty) trend. It was successfully sold within Mainland China and through Korean duty-free shops to Chinese tourists and daigou traders.
The Chinese market accounted for 16 percent of LG H&H's total sales. If the company adds revenue created by Chinese duty-free customers, the ratio increases to 38 percent. This has worried many industry watchers, who argued that LG H&H should cut its heavy reliance on the Chinese market.
With the Covid lockdowns, the travel-related part of the cosmetics business disappeared overnight. The local sales within China were also poor. Nobody needs luxury cosmetics when staying at home in lockdown. However, post-Covid, neither the travel business nor the local sales within the mainland recovered. Investors noticed, and the share collapsed.
I will attempt to map out LG H&H's prospects. Is it a lost case, or can we expect a turnaround? I will structure my analysis around four questions.
- Could the Chinese interest in The History of Whoo return?
- Can LG H&H develop into a global cosmetics company?
- Do the non-cosmetics activities, i.e. beverages and household goods, justify the current share price?
- Is the preferred share more attractive than the common share?
Let's first check the latest financials from the LG H&H 4Q2023 report
An 12.3% revenue drop in the beauty segment may not seem disastrous. However, 2022 was still a Covid lockdown year in Asia. For 2023, we would expect a post-Covid rebound, but there is a revenue drop instead. For a luxury product like The History of Whoo, such a drop could indicate trend-setters and early-adaptors abandoning the brand. This means a larger group of trend-followers may leave the brand later.
HDB = Home Care & Daily Beauty. This segment includes cleaning products and daily personal care brands like Physiogel, Dr. Groot, and Euthymol toothpaste. Revenues dropped somewhat. Operating Profits dropped a lot more. This seems primarily due to price inflation of ingredients and transport costs. I am not worried about this segment.
Refreshment = Domestic Coca-Cola bottling operations plus distribution of LG H&H's own beverage brands. There are no big worries here, either.
The sales increase in North America looks promising, but let's note that LG H&H took a controlling stake in The Crème Shop in 2022. The Crème Shop sales counted for the first time for a full financial year in 2023.
The segmentation by region clearly shows the decline in sales in China. Let's address this issue first.
1. Could the Chinese interest in The History of Whoo return?
I broke the answer into four sections.
- a. Limits to the daigou trade
- b. Changing consumer tastes within China. K-Beauty wave is fading. China's own brands are increasingly doing well.
- c. Anti-Korean sentiment within Mainland China
- d. The Chinese consumer is facing budget constraints due to economic recession. Luxury products are cyclical.
1.a. Limits to the daigou trade.
Daigou are Chinese professional shoppers who travel to Hong Kong and other countries to buy foreign consumption goods. They bring those back into China for re-selling. You might think this is a marginal business, but there were 1 million daigou traders until the borders closed in 2020 to fight Covid.
The daigou trade started because many foreign products were initially unavailable in China. Even when available, those were cheaper abroad because of lower sales taxes in those countries. It seems the Chinese authorities are now fed up with this type of tax 'arbitrage', or call it tax evasion. When post-Covid travel resumed, returning daigou traders were stopped at the Chinese border and held to luggage restrictions.
A large part of The History of Whoo sales took place via daigou traders visiting duty-free shops in Seoul, Korea. In addition, Chinese tourists who buy cosmetics for personal use are not returning yet. The decline in Chinese outbound tourism may be related to economic recession. I will address this below in the 1.d. section.
1.b. Changing consumer tastes within China. K-Beauty wave is fading. China's own brands are increasingly doing well.
The History of Whoo sales numbers within China are also poor. In the regional segment table above, we can see that Mainland China sales are down 19.6%. Does it indicate that The History of Whoo brand is history? There are mixed reports about the state of the brand.
I found several reports in which The History of Whoo scores well, such as this one about the Kuaishou 618 Shopping Festival. Admittedly, the value of these anecdotal reports from isolated events are hard to assess. It could be that a popular live-streamer promoted The History of Whoo during a peak broadcast hour. At the same 618 Shopping Festival, but on another platform (TMall), The History of Whoo and other Korean brands sold poorly. A news article concluded...
The decreasing popularity of Korean brands can be attributed to polarization between the dominance of high-end European brands and more affordable Chinese local brands, coupled with increasingly patriotic consumption among China's young generation.
This patriotic consumption trend is known as the guochao movement. The article suggests that LG H&H itself has already identified this trend and is moving its focus towards other markets, such as North America and Vietnam.
1.c. Anti-Korean sentiment within Mainland China.
During 2017, political tensions arose between South Korea and China, known as the THAAD crisis. South Korea’s decision to cooperate with the US to build the THAAD missile defence system in 2017 resulted in China banning Korean imports for two years. Naturally, this had an immediate impact on the beauty industry, from local e-commerce sites discontinuing sales to fewer Chinese tourists in Korea.
But it’s arguably the lingering effects, namely the anti-Korean sentiment and surging nationalism, that are proving more troubling.
Is K-Beauty’s Reign Coming To A Close? Jing Daily 5 April 2021
If you read only one article linked from this blog, make it this one. It is a mini-history of the rise and fall of Korean cosmetics brands in China and already identifies the guochao wave. The article is from April 2022, a few months before I bought my LG H&H shares. Unfortunately, I did not encounter this article at the time. It would likely have influenced my conclusion about LG H&H and would perhaps have stopped me from buying the share.
1.d. The Chinese consumer is facing budget constraints due to economic recession. Luxury products are cyclical.
Recently, there have been many news reports of an economic recession within the PRC of China. Other reports and opinions debate this perception. I don't have the specific macroeconomic insights to decide who is right, but it seems like Chinese consumers face personal budget constraints.
Cosmetics are usually filed under consumer staples, which suggests the sales figures are relatively non-cyclical. This might be the wrong category because cosmetics sales are sensitive to customer budgets, especially in the luxury cosmetics category, where we find The History of Whoo. Premium beauty products are better filed under consumer discretionary, a market category where consumer spending correlates with the economic cycle.
I am not sure whether an economic recession has started in China, but it would explain the decreasing sales revenues of History of Whoo. It is a more straightforward explanation than the three more case-specific reasons 1.a. , 1.b. and 1.c. The recession argument also gives some hope for LG H&H to return to former sales successes because recessions do not last forever.
2. Can LG H&H develop into a global beauty company?
Let's assume for a minute that the lost Chinese market share will not be recaptured by LG H&H. Will the worldwide expansion of the LG H&H business compensate for the losses in the Chinese market? Over the last few years, LG H&H has started building its worldwide presence with the US market as its focus.
To become a truly global beauty company, we must continue to expand our business in North America, the world’s largest trendy market.
Cha Suk-yong, former CEO of LG H&H, The Korea Times, 3 February 2022.
I will evaluate the success of LG H&H's globalization efforts in two parts.
- 2.a. Online mindshare review of the brands
- 2.b. My Avon rant
2.a. Online mindshare review of the brands
I wanted to get an impression of the current global mindshare of LG H&H brands, using the online presence of these brands as a rough and non-scientific measurement of success. I show the Google Trends direction of the brand name and its Instagram follower count. This survey is informal and flawed. I will address the limitations in footnote 1 beneath this blog posting.
From this data, I am not optimistic about the LG H&H brands. The company does not look like a global beauty powerhouse at all. As a comparison, I also displayed the eight L'Occitane brands. The L'Occitane portfolio looks much more promising.
When visiting The History of Whoo Instagram pages, you may initially agree that their pictures and video clips look gorgeous. LG H&H got the right creative people together. However, I do wonder whether this aesthetics-focused approach stops working at some point. The products are not explained in any way. There is not much content to appeal emotionally to potential customers. The whole styling feels aloof. The same goes for the O Hui and SU:M37 visuals. Is the marketing department going somewhere with these brands, or are they just showing pretty pictures?
2.b. My Avon rant
In April 2019, LG H&H bought Avon North America (US and Canada), which calls itself the leading social-selling beauty company in North America. It is an old brand that depends on its consumers joining as independent representatives and, after some training, selling cosmetics to friends, acquaintances, and their local community.
I don't like direct-selling schemes, as I explained last year in my blog about Beshom / HAI-O. There are often controversies surrounding these networks. Admittedly, Avon is relatively non-controversial and has no MLM elements. There are no schemes for representatives to recruit other representatives into a pyramid scheme. Avon only accommodates direct selling, allowing representatives to sell cosmetics within their social circles. I still consider it unethical to exploit friends and acquaintances like that.
More importantly, this type of sales is gradually becoming obsolete. Nowadays, people have neither the time nor the desire to meet with acquaintances and talk about consumer products. Shopping and comparison websites now offer all the information you need about these products. We can compare information and prices from different websites and get a less biased product overview than talking to just one person.
Don't take my word for it. This is the Google Trends graph for the avon.com domain as visited from within the US.
The interest in Avon is clearly diminishing. As a side note, there was an increasing interest in Avon.com in 2008 and 2009, which were years of economic crisis in the US. I think this extra interest was not in buying cosmetics from Avon but more likely in becoming an Avon representative and earning some extra money during financially challenging times.
Despite the declining interest in Avon North America, former LG H&H CEO Cha Suk-yong decided to buy this company. He likely saw Avon as a distribution network for the existing LG H&H brand portfolio. When we visit Avon.com now, we find affordable LG H&H brands such as Belif, Dr. Groot and Isa Knox in the Avon online shop. However, these K-Beauty brands seem a poor match for the typical Avon customer in the US.
In the 4Q2023 report, current LG H&H management listed 'Aim for Avon business turnaround' among its action points. Although Avon is in decline, it still has over 500,000 independent representatives. Turning this business around seems like a huge task to me.
3. Do the non-cosmetics activities, i.e. the beverages and household goods, alone justify the current share price?
I have a quantitative and a qualitative answer.
- 3.a. P/E calculation
- 3.b. Koo family drama
3.a. P/E calculation
Refer to the latest financials from the LG H&H 4Q2023 report in the second picture of this blog. Net Profit for 2023 is 164 bn KRW. When comparing this figure with other financial years, it does not seem particularly distorted by some one-off gain or loss. So, let's use this and assume that the beauty division, currently 30% of operating profit, will collapse further to 0% of total earnings next year. So, I am not assuming that the beauty division will not turn into a loss. Hence, 164 -/- 30% = 114.8 bn KRW earnings will remain. There are 17,717,894 shares (Common + Preferred). In this scenario, earnings will drop to 6,479 KRW per share.
Common share price = 336,000 (15 Feb 2024), P/E = 51.8
Pref share price = 150,600 (15 Feb 2024), P/E = 23.2
This theoretical P/E valuation seems high, considering the HDB and Refreshing divisions seem stagnant.
Next, let's assume that Beauty continues contributing 30% of profit in the future. In that case, the P/E will be 36.3 and 16.3, respectively. Still, it's not particularly cheap. It looks like investors are pricing in a recovery of the LG H&H beauty segment at the current share price of around 150,000 KRW.
3.b. Koo family drama
Who will drive this anticipated recovery of the beauty business? A listed holding company called LG Corp (KRX:003550) is the largest shareholder of LG H&H, with 34.03% of the Company’s ordinary shares. LG Corp, in turn, has been founded and run by the Koo family for over three generations. In general, I prefer to invest in family-owned companies for various reasons. However, in this case, I hesitate to label LG Corp and LG H&H as typical family companies. Both are part of a chaebol construction.
A chaebol is a South Korean conglomerate run by a family. Politicians traditionally favour chaebols as a way to advance South Korea's economy. It is a complex arrangement. While writing this blog, CNBC released a clip explaining the chaebols in more detail. Against this background, we can question whether the LG businesses were grown by the entrepreneurial talent of the Koo family or more through government support. In this light, LG H&H may not have all the typical advantages of a family company over a professionally run corporation.
Another question is whether the current LG Chairman and CEO of LG Corp, Koo Kwang-mo, has been entirely focused on his job lately. His predecessor, former LG chairman Koo Bon-moo, had only two daughters as biological children. However, women are not considered suitable heirs within South Korean business culture. Anticipating this 'problem', Koo Bon-moo adopted his brother's son, setting him up as his successor. When Koo Bon-moo died in 2018, the adopted son, Koo Kwang-mo, took the reigns as planned. However, he was relatively young (40) and had limited experience as a manager. Recently, affairs took a dark turn when the widow of Koo Bon-moo and the two daughters filed a lawsuit accusing Koo Kwang-mo of misleading them about the will and the inheritance of the former chairman. The New York Times has an article about the case, which sits somewhere between a K-drama and Shakespeare's King Lear.
Back to LG H&H, where Lee Jung-ae succeeded long-time CEO Cha Suk-yong at the end of 2022. News articles suggest that Cha Suk-yong himself did not want to leave LG H&H. In light of the Koo family drama, we could speculate that Koo Kwang-mo is placing his people in LG's companies to solidify his position. In any case, the replacement of Cha Suk-yong does not seem to improve the LG H&H management.
4. Is the preferred share more attractive than the common share?
I hold the LG H&H Preferred share (KRX:051905) rather than the common share (KRX:051900). The preferred share was, and still is, much cheaper than the common share. However, the preferred share does not allow you to vote at any AGM or EGM of the company. To compensate for this limitation, the holder gets 50 KRW (about 0.04 USD) more dividend per preferred share. Otherwise, the common share and preferred share are equal.
Talking about dividends, LG H&H has been cutting payouts in 2022, both in absolute numbers and as a percentage of the profit. The pay-out rate dropped to 16.6%, to be exact. The company is not doing well, so it seems prudent to retain earnings. However, the payout ratio was already low when business was booming, at about 20% on average. This is a general complaint about Korean companies. They prefer to hoard cash on the balance sheet rather than pay out dividends. As a result, Korean corporate balance sheets are often strong. Following this tradition, LG H&H has no net debt either. Suppose management will eventually hike the dividends back to the 2021 level of 12,050 KRW per preferred share. The dividend yield on today's share price would be about 7.5% in that case. That would be an attractive yield for a consumer staples company.
Jonathan Pines of the investment firm Federated Hermes Limited published an essay aptly called enough is enough (link directly to the PDF), condemning the poor corporate governance within many South Korean companies. Most of his objections apply to LG H&H, too.
Finally, we could wonder whether the preferred share could one day be cancelled and exchanged for a common share, considering the minuscule differences between the two shares. This would reduce the voting power of LG Corp, so it seems an unlikely event for the moment. However, if the Korean government is serious about reducing the influence of the chaebols, it could be a consequence of regulation change. The preferred share trades with a relatively consistent discount of about 50% to the common share, which would mean an instant doubling in the value of the preferred share. However, I am not holding my breath while waiting for a simplification of the share class structure. I am not aware of any Korean company that already initiated such a simplification.
Final thoughts
My investment in LG H&H Pref. shares was the worst ever in my investing history, both in absolute numbers and as a percentage of the investment (-57%). While analysing this loss, I became aware of two psychological biases.
1. Loss aversion
If the Chinese sales of The History of Whoo products recover, the share will likely recover, too. My decision to sell off the share now would be a big mistake. The same goes when LG H&H manages, against my expectations, to evolve into a globally successful cosmetics company. However, both events would qualify as turnarounds. Let's remember that Warren Buffett wrote that turnarounds seldom turn.
2. Rationalizing selling
I was compelled to quickly sell the stock and move on from this bad investment. The -57% loss would disappear from my current portfolio overview, and my time and attention would be free to focus on other holdings. I tried to counter-act this urge by first writing this rather long evaluation of LG H&H.
Conclusion
The LG H&H state of affairs is not clear-cut. There is not one big red flag, such as in the case of Mega Lifesciences PCL, where I got uncomfortable with the Myanmar activities. Instead, it is more of a string of orange flags, such as the Chinese business, the brand's global mindshare, the valuation and the ownership. None of these factors seem disastrous on its own. Hence, I was forced to weigh these factors in conjunction. Ultimately, I decided the picture did not look bright, so I sold the share.
Some lessons from the case
- From the newspaper article mentioned earlier, I could have known this was a turn-around situation before even buying the share. In the future, I should search harder for information that contradicts my bull thesis before buying the share. Perhaps I should have avoided LG H&H altogether because I do not speak the Korean language. I would have picked up on negative sentiment within the local news coverage much earlier if I knew the language.
- A company that is technically a family company may not have the advantages of a typical family company.
- Luxury and premium cosmetics are more fashion-sensitive than I realized. Fashion fads come and go, even more so in China.
- Different complexities came together in one case: a difficult key country (China), irregular sales channels (daigou buying, duty-free selling, Avon direct selling), and leadership changes at the top (LG Corp and LG H&H). Charlie Munger fans might call it a negative lolapalooza effect. This defies the boring-consumer-staples-for-the-long-run and sleep-well-at-night principles behind the coffee can portfolio.
Disclosure: Sold LG H&H Pref. shares. Long L'Occitane, InNature (Bodyshop Malaysia/Vietnam), Creighton's (Emma Hardie)
Footnote 1: Objections to measuring brand mindshare through their social media presence. 1. Instagram users might not unfollow a brand even when they lose all interest in it; they just ignore its postings. 2. The Face Shop and The Creme Shop target young women who use Instagram more actively. 3. Chinese internet users do not use Instagram and Google; the interest in The History of Whoo is underreported. There are other linguistical, technical and cultural objections to using Google Trends and Instagram here. 4. A potential customer for an expensive brand such as The History of Whoo has a much higher value than followers for cheaper cosmetics and day-to-day personal care brands. Still, I am confident we are capturing the brand preference trends over time.
No comments:
Post a Comment