Elegant ladies in high heels, water at $1000 per liter and Huabao, an interesting stock on the Hong Kong Stock Exchange

A couple of years ago my wife and my business partner's wife turned up at our office in Bondi Junction and then went shopping in the mega-mall below.

This is the sort of thing that gives a tight-wad like me nightmares.

A couple of hours later they returned with their bags. My wife was wearing a new perfume which I kind of liked.

I would have told her I liked it even if I was completely indifferent (she is my beloved wife) but I could say it honestly. It was Chanel Gardenia.

This was about a month before our tenth wedding anniversary so I had solved the gift problem – or so I thought. Later I popped down to DJs (think Nordstrom for Australia) and Myer (the also-ran department store) looking for Gardenia. No chance. Eventually a customer took pity on me and told me you could only find this at the Chanel shop.

I could see the bill going up.

I found the Chanel shop in a part of the mall I never visit and the shopkeeper (an elegant woman in high-heels who looked straight through me) eventually showed me the perfume which came only in sizable and expensive bottles. Three minutes later and $230 lighter I had my gift.

Mission accomplished.

Australian labeling laws require that Chanel specify some of the ingredients. Here is the label (now somewhat decayed):

It is a pretentious label. They call water “Aqua”. Guess they can't bring themselves to admit they sell water at almost $1000 per litre. Alcohol is the main ingredient – probably a good proportion of the total. Most the rest I had never heard of.

Being an inquisitive type I looked them up – I even looked on Alibaba for the cost (per tonne) of these chemicals so I could get some idea of how much I was being ripped off by the fancy box and the elegant lady in high-heels. It spoiled the romance but was educational. According to Wikipedia, Citral is a 3,7-dimethyl-2,6-octadienal or lemonal, is either of, or a mixture of, a pair of terpenoids. The E-isomer is known as geraniol (also an ingredient of the perfume). It is pheremonal in insects (and in the hope – probably vain - of the perfume manufacturer pheremonal in humans too). There are lots of suppliers on Alibaba – mostly by the barrel. Most of these are distributors for Givaudan – a Swiss flavors and fragrances business.

Linalool is a major fragrance chemical used – according to Wikipedia – in 60-80 percent of “perfumed hygene products” and also by pest-professionals as an insecticide. (Note what this perfume does – drives insects wild with pheremones and kills them. Think what it can do for you!) Again most the distributors on Alibaba are distributors for Givaudan. You can buy it here for $5 a kilogram and they will sell you 1000 tonnes per month. It is kosher (and Halal) too!

From there I went looking at Givaudan – the company that probably manufactured this fragrant “Aqua”. It is an interesting company with an enormous website containing technical specifications (instructions, FDA approvals etc) for the thousands of flavors and fragrances it manufactures. When you see apple-pie and cheesecake flavored yogurt what you are seeing is their fine Swiss technology. There are - if you do a Google count - about 11 thousand pages on this website. This is a sophisticated and wide-reaching business.

Givaudan is an interesting stock (we think about it as a long) and it is currently trading fairly low relative to sales vis its history. It is the technological leader in flavors and fragrances.

Here is its P&L in Swiss Francs for the past two years...

This company does CHF336 million (almost 400 million dollars) a year in research and development. That is what your cheesecake flavored yogurt and Britany perfume cost to develop. This R&D is a pretty solid barrier to entry. After quite considerable distribution costs (you have to interest the food manufacturer in the bizarre terpanoid you have developed) and considerable R&D Givaudan winds up with operating income of 13.1 percent of sales.

There is another flavors and fragrances company – International Flavors and Fragrances – that used to be the leader and is still the leader in tobacco flavoring (a declining business I would guess). IFF is well known to people who have read the investment classic “Common Stocks and Uncommon Profits”. IFF had a tech leadership for generations and was a fantastic stock - it is still not a bad one. Somehow (I don't know how as I do not have the history) it ceded much of that leadership to Givaudan.

All very interesting and grist for the memory bank.

Recently I came by Huabao – a Chinese flavors and fragrances company listed on the Hong Kong stock exchange. Market cap is about 20 billion Hong Kong dollars - about 2.5 billion USD.

The web site clearly is not as sophisticated as Givaudan. Counted pages on the site in Google total 49.

Huabao has a market cap of a bit over a third of Givaudan, and is a strange beast. Like IFF it claims to be primarily a tobacco flavorant. Here is the P&L.

Huabao it seems is a truly miraculous business. Gross profit is over 70 percent. Marketing and distribution expense is 80 million Hong Kong dollars – roughly a twentieth of Givaudan. Research and development expenses are 73 million HKD – a little over 10 million or about a fortieth of Givaudan's expense.

Profit before tax is 1871 million Hong Kong dollars on total sales of 2852 million HK dollars. That is 65 percent of sales and it compares (very) favorably with 13 percent at Givaudan of sales.

Huabao gets superior margins – nay vastly superior margins – whilst doing much less R&D and having much less selling expense. Truly miraculous. Givaudan – the putative technical leader – should watch out.

I wanted to work out what Huabao actually sold – what R&D they had – what technology they had that justified their superior returns. Alas this was difficult. You see HBGlobal.com is not a very informative website.

Here – in pictures – is the page (yes one page) that describes their product set.

Compare this page to the very detailed  specification at Givaudan. HBGlobal does not even allow its product specifications to be indexed on Google. (Go on – look at the page – it is pictures of text, not text, and hence not indexed.)

I went looking for all the chemicals in my wife's perfume on Alibaba. I could not find Huabao as a supplier. Nor could I find HBGlobal.

I googled “+Huabao. +citral” and the core reference I found was to Jishui Huabao Natural Medicated Oil Factory being a buyer of citral. Similar results were obtained for other chemicals.

I did this with lots of combinations of chemicals and the brand names they operated under (at least the brand names they operated under according to the HBGlobal website).

The website states that Kongque is a long established food additives brand in China. Kongque turns up in one index as one of literally 40 pages of suppliers for food flavor additives. Here is their entry which tells you nothing about them but gives a limited range of products (Lecithin, Foodstuff Essence, Flavor, Collagen Protein, Stuff Additives, Trichloromethyl Sucrose, Crystalline Fruit Sugar, Phosphate, Water-retaining). I have no idea what "stuff additives" are - and Trichloromethyl Sucrose is also a strange product - according to some links a sweetener 8000 times as sweet as sugar - but I can't find any non-Chinese references to it. Moreover this claim is likely false: saccharine is usually thought to 300-500 times as sweet as sugar and that is sweeter than most of the other standard sugar substitutes.

This tiny list of lightly specified products does not compare favorably to the sophisticated list at Givaudan.

For the life of me I can't work out what Huabao does that makes it so profitable – I can't work out what chemicals it makes, what  products it sells and why it manages to do so with much less research and development than Givaudan (or International Flavors and Fragrances).

Still Huabao must be real. You see it is audited by Price Waterhouse Coopers, it is not a reverse merger and it is listed on the Hong Kong Stock exchange – and we know that the HKSE is far more honest than the reverse mergers in the US. Mr Charles Li, the CEO of the HKSE told us.

So – if any of my readers know more about the flavors and fragrances business than you can get from reading Wikipedia and a perfume label and looking at Alibaba will you let me know.

Please.

Meanwhile – on the basis I can't understand any of this I am short on behalf of my clients. Super-fat margins in a chemical company almost devoid of research and development does not sound very sustainable to me.

My readers are a clever lot – so if you can help me, or talk me out of this position I would be thrilled.

Thanks in advance.



John

Post scripts: Some commentators have suggested that this company is a reverse merger - going public via the back door in 2006. I have not checked.

Also some commentators have suggested that Trichloromethyl Sucrose is the sweetener known in the US under the brand name "splenda". The 8000 times as sweet as sugar statistic sort of matches - and splenda has three chlorine atoms in the structure so cold be "trichloro" as per the name. But I am not sure where the methyls (ie CH3s) come in. There is a structure illustrated here.