Home-grown furnishings company Koda Ltd is expanding and growing its original brand, Commune. We take a deeper look at the history and track record of the company in order to tease out an investment thesis.
January 14, 2020
Koda Ltd (SGX: BJZ) was established in Singapore and founded in 1972. The group was founded by chairman Koh Teng Kwee and now has three generations of the Koh family working within the same business. Koda is a premier furniture company and is recognised as a leading original design manufacturer (ODM) in the world.
The group is known for its strength in design and caters to upscale customers worldwide with its aesthetically pleasing and functional furniture. The group also established its own brand, Commune, back in 2011 as an in-house brand focusing on retail products, and has a presence in Singapore, Malaysia, China and Vietnam.
As of 30 June 2019 (the fiscal year 2019), the group has a total of 67 Commune outlets;
- four owner-operated in Singapore
- four distributor-retail (DR) stores in Malaysia
- 56 DR-stores in China
- one DR store each in the Philippines and Hong Kong,
- and one brand-in-store presence in Australia.
The group has managed to turn its business around after 8 years of hard work and by tweaking many aspects of the business. Below, we analyse the transformation of the business over the last five years and also look at the growth potential of the Commune brand moving forward.
Koda’s revenue has grown from USD 47.3 million in FY 2015 to USD 57.9 million in FY 2019, no mean feat when you consider that the group is in an intensely competitive industry.
There was a steep drop in revenue from FY 2015 to FY 2016 (-21.5% year-on-year) due to the divestment of subsidiaries Metrolink (China) and Rossano (Vietnam) as these were loss-making entities.
Following this drop, Koda focused on increasing the number of DR stores and drove sales of Commune products to the USA and China (export sales), resulting in consistent revenue growth during the next three fiscal years.
Gross margin also demonstrated impressive growth from FY 2015 through to FY 2018, up from 23.9% to 35.5%. The first jump from 23.9% to 27.7% in FY 2016 was due to the divestment of loss-making entities Rossano and Metrolink that had been a drag on margins, plus the growth of Koda’s retail and distribution business.
Subsequently, gross margins improved even further with improved manufacturing and supply chain efficiencies, surpassing the 30% mark. Higher capacity utilisation, along with higher revenue and pricing power from Commune, helped to propel margins to a 4-year high of 35.8%. For FY 2019, gross margin eased slightly due to a change in sales mix as well as research and development costs incurred for a new range of products.
As a result of business process redesign, net margins for the group jumped from a low of 0.9% in FY 2015 to around 9% to 10% for FY 2018 and FY 2019.
In FY 2017, the group built a dedicated hub in Malaysia to facilitate logistic flows, leading to reduced transportation costs and better production efficiencies. Higher distribution, logistics and staff costs for FY 2019 brought down net margins a little, but the group’s transformation from a low margin to a higher margin business was now in structural place.
Note: I added in a line that explains the evolution of Koda’s issued share capital base. The company did a 5-for-1 share consolidation in FY 2016 due to the minimum trading price criteria set by SGX, whereby the share price needs to be at least S$0.20 for the company to remain listed. Subsequently, in FY 2017 and FY 2018, the company issued a 1-for-2 bonus issue and a 1-for-1 bonus issue respectively, increasing the number of issued shares.
Strong Balance Sheet
Koda has demonstrated a remarkable ability to pay down debt and fill their coffers with cash, which is always a very good thing for investors. Even for FY 2015, the group had already started out on a net cash position, with manageable gross debt levels at USD 910,000. Net cash then stood at USD 2.2 million.
Fast forward to FY 2019 and cash balance has jumped to USD 13.4 million, while gross debt has more than halved to just USD 403,000. Management has reiterated prudence time and again in its Annual Report and this is evidenced by the numbers over the years.
Free cash flow
The group has a track record of consistent free cash flow (FCF) generation. The graph above shows this clearly, and for FY 2016, Koda continued to generate decent levels of FCF despite selling off the Metrolink and Rossano businesses. Operating cash flow remains very healthy and though the group has to spend on capital expenditures to improve production processes and streamline supply chains, the group still manages to churn out good levels of FCF.
Business segment highlights
Moving on to Koda’s business segment highlights, its ODM business is parked under the “Manufacturing” division, while the Commune business is classified under “Retail and Distribution”. From the breakdown above, we can note that the growth in overall revenue was broad-based and saw both segments showing year-on-year growth from FY 2016 through to FY 2019.
Improvements made to the production process and investments made to boost the Commune brand have helped the segment to report increasing segment profits since FY 2017, with a profit margin of around 8%. Manufacturing’s segment profit has grown in line with the increase in overseas exports, and segment margins have held steady within the 9% to 10% region.
Overall, the numbers show a healthy and increasing trend as Koda opens more DR stores for Commune in other countries while boosting its manufacturing division to handle increased exports to countries such as the USA.
Koda has always been generous with dividends, as can be seen in the table above. For FY 2017, the year where net profit jumped significantly, the group also rewarded investors with significantly higher dividends, including a special 2 cent dividend. FY 2018 dividends were comparable to that of FY 2017 (adjusted for the 1-for-1 bonus issue), and dividends continued their upward climb in FY 2019, with the group introducing an interim special dividend for the first time.
Total dividends for FY 2019 came up to 2.5 cents, which provides a generous dividend yield of around 4.3% at the last traded share price of S$0.58.
Growth Strategies and Catalysts
One strong point about Koda is its willingness to communicate with shareholders on its business plans and strategies through commentary in its Annual Reports, as well as releasing periodic updates on the business through presentations and press releases. Investors should appreciate management’s candour in sharing information on the group’s plans and charting the strategic, long-term direction of the company. This generous sharing allows investors to assess the group’s transformation and growth over the years, and also helps to provide visibility with regards to what the future holds.
Koda’s Strategic Review
In July 2017, Koda released a corporate and business update whereby it outlined what it had achieved and set a course for the future. A major strategic review was concluded and management concluded that measures needed to be taken to address various aspects, such as the need to match shorter delivery lead times for key export clients, as well as changing order patterns arising from smaller minimum order quantities and wider product mix.
As a result, the group devised a 4-pillar forward strategy that will help to grow Commune’s footprint and ensure margins are maintained or even improved.
4-Pillar Forward Strategy
The four pillars for Koda’s new strategy are:
- improving manufacturing efficiency,
- strengthening supply chain management,
- building up and expanding the Commune brand,
- and enhancing shareholder value.
The aim of improving production efficiency is to ensure margins remain high, the output can be easily expanded and utilisation rates remain at optimal levels (85% to 90%). Supply chain management improvement entails selecting the right sub-contractors, process improvements for procurement and manufacturing, and establishing a 60,000 square foot storage and distribution hub.
For the Commune brand’s expansion, I feel this was the most important pillar and sets the stage for the sustained and continued growth of the brand over the last few years. Commune boasts its own in-house design team and releases one collection every year. Back in July 2017, Commune had a total of 43 stores, with four operating in Singapore, three DR ones in Malaysia and 35 in China (along with one brand-in-store presence in Australia). Fast forward to end-June 2019 and China now has 56 DR stores, while a new DR store each has been set up in Hong Kong and the Philippines. This shows the steady brand expansion for Commune as management grows its regional footprint.
Future growth for Commune
Management has reiterated (in FY 2019’s press release) that the planned rollout of 100 Commune stores by 2020 remains on track, with product development efforts in place to target different consumer segments. Mr Joshua Koh, CEO of Commune, reaffirmed the brand’s plans to invest in digitalisation in order to differentiate themselves from other furniture brands. One of these was the launch of the Commune in-motion consumer experience which provides customers with a seamless omni-channel experience.
A new brand called Alt.O by Commune, conceived via a strategic collaboration with established European brands such as Bolia and Hubsch was also launched in FY 2019. Alt.O caters to larger format homes and targets a more affluent customer base, and its first concept store was opened in Millenia Walk, Singapore recently.
This is part of Commune’s ongoing efforts to reach out to different consumer segments in order to diversify and enhance its revenue streams.
The Furniture Industry: Importance of Quality and Branding
The furniture market has always been closely tied to new home developments, as well as consumer affluence. The former drives demand for furniture as people shift into new homes, while the latter accounts for the drive to either upgrade furniture or replace worn-out pieces. The barriers to entry are low for furniture and there are many players in a crowded industry, catering to differing needs and price points. The global furniture market is expected to grow at a compound annual growth rate (CAGR) of around 3.5% from 2018 through to 2025, according to Allied Market Research.
Some drivers include higher disposable incomes, overall growth in real estate and demand for luxury and premium furniture. These long-term trends will benefit all furniture manufacturers and retailers, but it will also make the market more crowded as such growth will attract many new entrants.
This is where the importance of branding and quality come into play.
Furniture brands such as Commune and IKEA command strong mind share in consumers and target specific consumer segments in order to generate continued brand loyalty.
Compare this to a generic shop-house furniture manufacturer that are a dime a dozen – it’s almost impossible to price your products at a premium and command high gross margins unless you offer a compelling brand proposition.
High-quality, or rather, quality at a good price point, is also important in establishing a loyal customer base.
Rather than being a general ODM manufacturer, furniture companies that can carve out a niche for themselves will survive economic cycles, while others without such attributes will disappear in due course.
For competitive analysis, I chose two other Singapore-listed furniture companies — LY Corporation (SGX: 1H8) and Sitra Holdings (SGX: 5LE), as well as one Hong Kong-listed sofa manufacturer Man Wah Holdings (SEHK: 1999).
It can clearly be seen that the smaller players LY and Sitra report gross margins under 10%, while net margin is either dismal (1%) or at a loss. Established companies such as Man Wah command high gross and net margins (35% and 13%, respectively), which demonstrates the importance of branding and scale.
Of the four players, Koda has the highest dividend yield at 4%+, while it is also trading at the cheapest valuation of under 10x price-earnings. However, investors should note that liquidity is fairly low for Koda compared to Man Wah, so it may take time to accumulate a sizeable position.
Risks to the business
Key risks for Koda include intense competition in the furniture space, but this should be mitigated by its strong branding (Commune) and high price points (Alt.O). These attributes help it to stand out among the rest and differentiates the company from the crowd.
Another pertinent risk is that of an economic downturn. As Koda sells mainly high-end furniture in their DR stores, and Commune and Alt.O are positioned as such, it would be more susceptible to a recession where people cut back on non-essential spending. Thus far, Commune’s expansion has taken place at a time of economic expansion (FY 2017-2019), so we do not know how the group will fare should it encounter a protracted downturn. It may have to write off inventory amid slower sales, and this could ultimately hit profits badly and even push the group into losses.
The mitigating factor here is that the group has an ODM division that exports to other markets such as the USA and Europe. This can help to buffer the impact of a recession as such furniture is more affordably-priced, leading to more resilient demand.
Valuation and conclusion
In summary, Koda is trading at cheap valuations, offers an enticing dividend yield (paid twice a year) and also has clearly laid-out plans for expansion. Low liquidity is an issue, though, so investors may wish to take a small position and then increase this over time, all the while monitoring corporate developments.
We have here what seems like a solid stock. Having said that, I’m ok sitting this one out. There are a two main reasons why.
- Risk-Reward Ratio is Unattractive (I’m biased, please note)
- Company has no downside protection in a recession
I’ve talked about risk-reward ratios previously and I think one of the important facts to establish is that you should always buy cheap. Koda is by no means cheap. It’s business has been growing, management owns 30% of the business and the market has rightly marked it up at a premium. That means if you invest in this company, you need to be certain about growth prospects. I could always be wrong but I think we’re nearing the end of the bull run cycle with multiple IPOs hitting the market last year and this year. When IPOS hit the market en masse, it’s because the price of listing is just too damn attractive to insiders and market participants are frothing at the mouth looking for the next hot thing. This type of behaviour typically precedes a crash or at least a correction. Some of the questions I’m left wondering to myself are as such;
- Can Koda compete with Chinese brands?
- Can Koda surpass Chinese nationalism in consumer spending? When Korea allowed US to plant missile defence systems, Chinese consumers boycotted Lotte, forcing it out of business and costing it millions of dollars. Sure Singapore won’t take a public stand but will we beat Chinese local furniture stocks when China consumers opt to support local?
- Koda has established a luxury brand that in and of itself typically affords some level of cycle protection. Luxury buyers who are ultra rich are typically not affected by stock market movements. Remember, a majority of the people in the world are not involved in the markets at all – they’re just everyday folks going about their lives with very little exposure. But does Koda have a budget brand that can help it survive a downturn? A sort of extreme value for money play on good furniture that can see growth during a recession? If it can’t, and if its at risk of dying DURING a recession, what’s the point of investing in it?
That’s my thought process so far. I like that they have grown so quickly and I like that they have a presence in China. Management is open and honest and they hold significant shares as well so they’re unlikely to screw shareholders over. Having said that, their growth story depends on the economy playing out well and their retail stores in China to do well. It’s also quite clear that the increase in number of stores have not been commensurate with a similar increase in revenue. Each store added on seems to only have fractionally added to the revenue stream which means profits are being somewhat suppressed. Not a good sign for a business hoping to become a franchise. I’m giving this one a pass in lieu of the fact that they will likely take a beating during an economic downturn and don’t seem to be rapidly accelerating as much as they should be with the increase in number of stores. I could be wrong, and stores do have a lag time before they start adding to the balance sheet, but it doesn’t bode well.