• Maintain BUY with higher Target Price of SGD2.95 from SGD2.13, 15% upside and 3% FY19F yield.
• BEST WORLD INTERNATIONAL LTD (SGX:CGN)’s 4Q18 results beat our as well as consensus’ estimate. For the full year, core PATMI grew 15% y-o-y to SGD63.9m.
• Over-exuberance in the market resulted in Best World’s share price soaring 24% in the first two weeks of February over no apparent news, before collapsing on concerns raised in the Business Times article. We note that Best World has issued a statement to clarify the issues raised. It is also looking to engage an independent review to address the relevant concerns. We believe the move towards greater transparency will build greater confidence among the investment community.

Understand the Business Before Investing

Uncovering the secret.

• Best World’s share price took a plunge on 18 Feb on concerns highlighted by the Business Times article, Sales of DR's Secret in China: Best World's best-kept secret? Some of the key contentions raised include:
  1. The business model in China;
  2. Best World’s limited direct selling licence in China;
  3. Ability to track sales;
  4. Reconciliation of sales figures to underlying consumer demand.

Greater confidence instilled after Business Times article.

• We believe management has adequately addressed the confusion with regards to change in its business model in China in its clarification announcement dated 23 Feb. We would also like to reiterate that while the company has limited direct selling licence in China, it was selling into the China market via import agents prior to 2Q18 and is selling into China through its franchisee after 2Q18. Its franchise licence applies to the whole of China and encompasses the sale of skincare products.
• We came out more confident of Best World’s corporate governance after this saga. In order to assure the investment community, the group is willing to incur additional professional costs to engage an independent reviewer to address concerns raised with regards to its business validity. With regards to the inability to locate franchisees in China mentioned in the article, the group now maintains an updated list of its franchisees on its website.
• During the analysts’ briefing, management also mentioned that Best World is working with its franchisees to collate its end-consumer numbers in China. Once compiled and verified, the group would publish these figures quarterly, similar to the direct selling membership numbers it provides. We believe this increase in transparency would bode well for investor confidence in the long run.

However, some innate risks are unavoidable...

• Nonetheless, we agree with the Business Times article that tracking sales and the underlying consumer demand for this company remain challenging. However, this is the innate risk of the business model. As previously highlighted in our initiation report, unlike traditional retailers, Best World’s distributors and franchisees sell largely through the sharing of product usage experiences. There is therefore limited visibility on sales growth and the inventory floating on trade.
• Best World also has limited control over sales efforts and purchases made by its distributors and franchisees. Inventory build-up by distributors or franchisees could occur without the group or investment community being aware of it, posing risks to sudden earnings decline.

… but relatively lower risk in the new franchise model.

• The change from export model to franchise model in China, however, would mitigate this risk to a certain extent.
• As opposed to the export model where import agents get credit terms from the group, the group operates on cash-before-delivery terms with its franchisees. There is therefore a lower risk of inventory build-up by the franchisees as they have to pay cash up front before purchasing and there is no return policy for unsold goods. As such, moving forward, we believe there would be better correlation between sales figures recorded by the group and the underlying demand of end-consumers.

4Q18 Results Were Above Expectations

• Sales from all markets came in above our expectations, while the franchise business model in China achieved stronger margins. During the briefing, management said it still expects 50% y-o-y growth in end-consumer demand for the China market. As such, we remain confident of its growth prospects in the near term.
• We raise our FY19F-21F earnings by 8-14% on the back of higher revenue and margin assumptions.

Going Back to Fundamentals

• Since Best World’s share price has now retraced to a more reasonable level, we see value emerging, given the strong growth prospects in its China franchise business.
• We raised our Target Price to SGD2.95 on the back of stronger earnings growth as well as a higher target P/E multiple of 18x in our blended valuation methodology (refer to attached PDF report) to reflect increased clarity in the franchise business’ margins.

Stay Safe, Stick to Fundamentals

• While we are confident of the near-term earnings prospects, we caveat investors to avoid chasing Best World’s share price when valuation runs way too high. Unlike a usual retail business, Best World’s direct selling model and franchise model operate largely by “social selling”. This business model itself innately has limited visibility in end-consumer demand.
• Key risks include overstocking of inventories by franchisees and inability to track the sudden drop in end-consumer demand.

Valuation

We raised our Target Price to SGD2.95 based on our blended valuation methodology.

• As highlighted in our initiation report - Best World - RHB Invest 2018-10-23: Put Your Skin In The Best Game; Initiate BUY, we think Best World’s share price is likely to re-rate upon more clarity about its earnings prowess in China following 3Q18 and 4Q18 results. Our Target Price is now based on the average of 18x target P/E and DCF valuation.
• Our 18x target P/E is based on peer average and is also in line with Best World’s 5-year average P/E.
• Our WACC assumption for DCF valuation also includes additional country risk premium to account for its exposure to the China market.
• Our new Target Price implies 15% upside from current levels.

Source: RHB Invest Research - 28 Feb 2019