Activation Group (9919 HK)
A cheap pick-and-shovel play on Chinese luxury consumption
Executive Summary
Activation Group is a leading event planning and organizing agency in China, with a focus on international luxury brands. The business was heavily impacted by COVID related lockdowns in China in both 2020 and 2022, but was still profitable in the second half of 2022 during the peak of Covid infections in China. We expect a normalized operating environment in 2023 and beyond for the company where physical events can be held without any restrictions. It is also likely to benefit from the increasing marketing focus by international luxury brands in China. At the price of HKD1.32 per share (as of market close on 17 Mar 2023, inclusive of the announced regular and special dividends), we estimate an IRR of 19%+ over the coming 3 years.
Business Description
Brief History
Activation Group was founded in 2013 by Mr Steve Lau, the current CEO and Mr Johnny Ng, the current COO, together with a group of marketing professionals in Hong Kong, and subsequently relocated to Shanghai, China. Its major client initially was LVMH, and it gradually built its track record and reputation in the industry, broadening its client base. As of today, they organize large scale events such as major fashion shows, product launch events, and exhibitions for most major brands including LVMH, Hermes, Cartier and Gucci in China. Within China's 'Experiential Marketing' segment, the company has the highest market share at 10%.
The company was first listed on China’s NEEQ from 2016 to 2018 and then delisted. It was later relisted on the HKEX in 2019. It was soon hit by COVID in 2020. The business had a great year in 2021 due to the successful containment of COVID in China, but as COVID began to spread in China and it went into a more radical mode of lockdowns in 2022, Activation was heavily impacted because most physical events were canceled or delayed.
Clients of Activation. Source: Company Presentation
Segments
Activation has 3 segments:
Experiential Marketing (74% of revenue in 2022): they organize physical events and provide creative ideas to their clients. Given the industries their clients are in, the events are mostly luxury fashion related events (fashion shows, jewelry exhibitions), car shows and some tech events.
Digital Marketing (22.2% of revenue in 2022): these are add-on services that Activation sells to their existing clients. For example, Activation manages the live streaming of the physical events. In some cases, it arranges KOLs to promote their clients’ brands and products via digital channels.
IP Development (3.8% of revenue in 2022): Activation signed deals with 3 partners, namely Tour de France, LaLiga Club, Shanghai Design Week to organize events and have exclusive use of their IPs in China. Major revenue sources in this segment are namely event ticketing, sponsorships and souvenirs.
Our base case does not expect a material change in business mix, although management has spoken about ambitions to grow the digital marketing segment, which is a higher gross margin business but of similar profit margin compared to Experiential Marketing due to more expensive creative talents, and IP Development segment, which is a higher profit margin segment.
Some recent events organized by Activation
Competition
Experiential marketing is a fragmented industry in China. Activation has the highest market share at 10%. There are smaller private players, namely K2 and Apex. Relationships with luxury brands, creativity and execution capability are key in the industry. Track records are important to demonstrate creativity and execution capability. Clients tend to stick with the same agency if they execute well. Unlike auto brands, luxury brands generally do not run a bidding process to pick an agency.
The overall advertising industry in China is highly competitive, taking into account the extremely competitive but fast growing digital advertising segment. Activation has however positioned itself in a niche and it has been expanding its client base and growing its market share for years.
Margin Structure
The projects are all run on a cost-plus basis. Clients will pay for all costs for the events while Activation charges a markup, depending on the client segment. Historically the gross profit margin has been kept at around 30%, due to the mix of higher margin luxury clients.
Depending on the revenue, around 10-15% of the revenue is staff cost and then there is another 5-6% of overhead and depreciation and amortization. Normalizing the revenue and earnings, the net profit margin is around 10% and we expect it to maintain if not improve, as management has been quite careful with adding headcounts and controlling fixed costs.
It is worth noting that this business has high operating leverage with low capital needs. Both the staff cost and other overhead do not grow inline with the revenue. The number of team members in a project is 10 to 15, even in a large one. They have little need to add extra headcount for larger projects. This means there is operating leverage when revenue increases. The capex has historically been lower than 0.5% of total revenue and we expect this to continue.
Thesis
The thesis for Activation is business recovery and tailwinds in marketing spending in China by luxury brands, with the former having a much higher weight in our thesis.
Earnings Recovery
China lifted all COVID restrictions in late 2022. As such, we expect the company can operate in a normal environment going forward. Referencing their revenue and margins in 2021 (a COVID year), the performance in 2023 will very likely be better than that of 2021. Despite all the difficulties, the Experiential Marketing segment performed better in the second half of 2022 than the previous year. Also, as events were canceled in 2022, we understand brands have unused marketing budgets that could be reallocated to 2023.
The business’s operating costs are quite scalable as it is mostly staff cost and some overhead. With revenue and gross profit recovered to RMB 900M+ and RMB 270M+ respectively, the business will very likely be able to show its true economics, which we estimated to be around 10% net profit margin.
Increasing Luxury Marketing Spending in China
Chinese nationals occupied a significant share (33%) of global personal luxury goods consumption before COVID. The sales to Chinese nationals in 2022 were just 69% of the 2019’s total according to Bain. It is quite likely the sales to Chinese nationals will increase in 2023 as there will no longer be lockdowns and traffic restrictions on Chinese citizens.
“This masked weak demand from Chinese consumers, whose purchases of luxury goods are still well below prepandemic levels. Bain estimates that sales to Chinese nationals in 2022 were just 69% of 2019’s total. This is partly because of lockdowns, but China’s shoppers also prefer to buy luxury goods overseas, where prices are cheaper. The same handbag bought in Paris can cost 40% less than one bought at home, so demand has been subdued with international travel off limits.”
(Source: WSJ)
The sheer size of sales to Chinese nationals is too large for luxury brands to ignore. The share of personal luxury goods consumption by Chinese nationals is forecasted to be 40-45%, above the level in 2019.
Executives of luxury brands have recently made some positive comments on luxury consumption in China. For example, LVMH's Bernard Arnault said at the 2022 results presentation
"If that is indeed the case -- and it began in the month of January -- we have every reason to be confident, even optimistic about the Chinese market”.
According to our conversation with company’s executives, major luxury brands allocate their marketing budgets based on where their end customers reside, not where the end customers purchase their products.
Marketing spending of major luxury brands has always been tracking their revenues as a percentage of total revenue. Therefore if luxury brands continue to grow their revenues and Chinese accounts for a large share of their revenues, regardless of whether they buy in China or outside, we should expect luxury brands’ brand building expenses in China to remain at a decent level, if not increase, benefiting Activation.
Capital Allocation
The business of Activation requires very little capital expenditure to run and grow because it is a people business, where the biggest cost item is staff cost. In our communication with the management team, they also said that they are not pursuing any M&As and are more interested in growing the business organically. Given the nature of the business, we do not expect much capital need going forward.
The official dividend policy is a payout ratio of at least 30%. It has however been far more generous than that as it has paid out more than its net earnings since its IPO on an aggregated basis. It has also been buying back shares at low prices ($0.53 to $1.41) and paid a special dividend in 2022. A total of 6.9% of its total shares have been bought back since Mar 2020. While we do not expect another special dividend this year, we believe the management is quite generous when it comes to dividend, instead of holding cash idle on their balance sheet. As we will elaborate below, it helps that senior staff have high ownership in the company, and dividends are akin to a bonus for the senior staff and are key to staff retention. In fact, the special dividend recently announced was precisely a reward to the senior staff for their hard work during the pandemic. Credit to the management for declaring a special dividend over cash bonus as they want shareholders to benefit equally. Therefore we are confident that they will pay out significantly more than 30% of their earnings over time.
Insider Ownership
As of 30 June 2022, Mr Lau and Mr Ng together own 36.47% of the shares. Partners, which are key management, own another 26.98% of the shares, including unallocated shares held in a special vehicle ACT Partners. We believe there is high shareholder alignment. Key partner turnover has been low due to their material ownership in the company.
Valuation
We expect the business to achieve RMB 1B of revenue in 2023 with a 10% net profit margin, implying a 7.86x 2023 forward earnings at the share price of HKD 1.32.. Assuming a 70% dividend payout ratio going forward, it is trading at 8.9% forward dividend yield. We estimated the revenue growth from 2024 to 2026 to be 10% for 1 year and then 5% for the remaining two years. Assuming an 8% exit dividend yield, the IRR is estimated to be 19.3% at the price of HKD1.32 per share.
If revenues, profits and payout ratio can be sustained at our expected 2023 level, investors can yield 8.9% dividends every year, and higher if the business can grow. While we have covered the tailwind of ongoing growth in luxury consumption and marketing budget in China, we believe investors do not need to pay much for the growth at this price. Margin expansion, which is likely given the operating leverage, is also not taken into account in our IRR analysis.
Risks
Currency Risk
The company’s revenue and costs are mostly in RMB while it pays its dividend in HKD due to its listing location. A weaker RMB will translate into a lower dividend in HKD. Given China's monetary policy this year, it's not hard to imagine a scenario in which the RMB depreciates.[Link 1][Link 2]
Chinese Luxury Consumption
There are reports that the Chinese economy is recovering slower than expected. While the luxury sector remains resilient, a deep recession in China could drag it down, and with it the marketing dollars.
“Common Prosperity” has so far not shown much impact on Chinese consumption in the luxury sector. However, it has remained a theme in the Chinese regime and is constantly being stressed.
It is also worth noting that luxury items such as Rolex watches and Hermes handbags are used by some to move capital out of China. There are practical incentives for the Chinese government to affect luxury spending beyond ideological reasons.
We cannot imagine what a massive crackdown on the luxury sector in China would look like. It may however be worse than complete lockdowns for Activation if it happens due to its impact on the terminal value of the company.
Disclosure
The author of this article owns shares in Activation Group (9919 HK).
This article is for informational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities mentioned herein. Readers should conduct their own research and due diligence before making any investment decisions. Investing in stocks involves risks, and past performance is no guarantee of future results. The author assumes no responsibility for any losses incurred as a result of using this information.
The views and opinions expressed in this article are purely those of the author and do not reflect the official position of any organization they may be affiliated with. The author has not been compensated in any way by any of the companies mentioned in this article. Please note that the author may buy or sell shares of any of the companies mentioned in this article at any time without further disclosure.
Very well written and organized. Thank you!