Merchant House International: a cheap shoe manufacturer listed in Australia

To start off this post, a quote from Berkshire’s annual letter for 2000:

“Most of our manufacturing, retailing and service businesses did at least reasonably well last year.

The exception was shoes, particularly at Dexter. In our shoe businesses generally, our attempt to keep the bulk of our production in domestic factories has cost us dearly. We face another very tough year in 2001 also, as we make significant changes in how we do business.

I clearly made a mistake in paying what I did for Dexter in 1993. Furthermore, I compounded that mistake in a huge way by using Berkshire shares in payment. Last year, to recognize my error, we charged off all the remaining accounting goodwill that was attributable to the Dexter transaction. We may regain some economic goodwill at Dexter in the future, but we clearly have none at present.”
Warren Buffett – Annual letter to shareholders of Berkshire Hathaway for the year 2000

(Emphasis mine)

Merchant House International (MHI.AX) is a producer of footwear and home textiles. The footwear business accounts for 62% of the FY 2014 sales and home textiles 38%. The company is listed in Australia, but has its headquarters in Hong Kong and their factories are mainly located in China.

The company was founded by Ms Loretta Lee in 1978 and the footwear division has been active since 1980. Loretta Lee owns 53.5% of the outstanding shares. Merchant House International’s customers are primarily located in the US. The company’s main customers are major discount retail chains like Wal-Mart, Kmart and Sears. There is strong customer concentration: the company’s 4 largest customers accounted for 64% of the sales in FY 2014.

At the current share price of A$0.19, MHI is trading at 90% of NCAV and 45% of book value. A brief overview of the results for the last 5 years is presented in the annual report:

It should be noted that the results for 2014 were dictated by two significant events: the sale of the company’s headquarters in Hong Kong, which accounted for A$9.3m of the profit and a loss of A$1.2m for deregistering one of its discontinued operations. So results for FY 2014 are a lot worse than they look at first glance, but there were some problems in their textiles plant that should not re-occur next year:

The Group’s operating profit, excluding an extraordinary gain from disposal of the Hong Kong office, declined approximately 53%, from $3.7 million a year ago to $1.7 million. Our profitability was negatively impacted due to management and cost control problems in our wholly-owned textiles manufacturing plant in China. Management expect this to be a one-time incidence and appropriate measures were taken to rectify the problems.

Earnings have been in the A$3m-4m range since 2007. Given this record and the company’s book value, a market cap of A$18m looks pretty cheap. Merchant House has consistently paid dividends. After the sale of their headquarters they paid a little more than usual and total payouts were A$0.025 for FY 2014. In the three years preceding, the company paid out A$0.015. If we assume a future dividend of A$0.015 per year then that means a yield of 7.9% at the current share price.

The reason for the quote from Berkshire is that a company like MHI is probably one small player that Berkshire’s shoe businesses have had to compete with over the years. Merchant House’s low labor costs in China can not be matched in the US. It is interesting that in recent years the trend of moving production to China seems to be reversing to some extent. As minimum wages have been increased in many Chinese regions the gap between the US and China in production costs has narrowed.

MHI is a great example of a possible trend among companies to bring manufacturing operations back to the US from overseas. In 2013 the company established a new manufacturing plant in Knoxville called Footwear Industries of Tennessee. The official opening ceremony was on May 22, 2014. MHI plans to invest $5m in this new factory (in FY 2014 total capex was A$3.6m) and thinks it will invest another $5m over the next two years. The goal is to have 25% of MHI’s shoes manufactured in the US in two years. There’s a very interesting article from July 13 in the Wall Street Journal about MHI’s subsidiary in the US that describes Ms Lee’s plans in more detail: Shoemaking Gets a Foot in the Door in the U.S. – Hong Kong-based Producer of Work Boots Opens Factory in Tennessee.

These investments in the US could of course fail. It is not a certainty that the company can operate profitably in the US. I understand their reasoning: since such a large percentage of their business comes from US retailers it makes sense to establish yourself close to your customers. That does not mean it will actually work.

That being said, MHI will still produce most of its products in China for the foreseeable future. Given their long history of profitable operations, positive free cash flow and the large discount to book value, I think Merchant House International is a nice addition to a diversified portfolio of net-nets. The shares are pretty illiquid as so often with companies profiled on this blog.

Disclosure: long Merchant House International