Dear Investors and Friends,

 

In our inaugural letter in October 2023, we introduced the Variis Stakeholder Investing approach as a cornerstone of our investment philosophy. Building on this foundation, our quality analysis incorporates two additional pillars: moat analysis and management assessment. Together, these three pillars support our investment architecture, and help us to curate a selection of high quality investment opportunities—our Focus List. In this letter we focus on the second pillar: moat analysis.

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The concept of moats, while long-standing and extensively explored, remains complex. The complexity around moat assessment is heightened in the dynamic environment of emerging markets. The main challenge is that accurate information about what is happening is harder to come by in EM investing. Furthermore, faster economic growth, evolving consumer preferences, and changing regulations may more aggressively reshape the competitive landscape and challenge existing moats.

 

Rather than theorizing about moat analysis, we use this letter to illustrate our approach in practice through a holding in the strategy: E Ink.      

 

E Ink moat analysis case study

Founded in 1997 and with a market capitalization of approximately US$10bn, E Ink is a provider of ePaper solutions headquartered in Taiwan. E Ink has an intellectual property (IP) rights moat protecting its Electronic Paper Display (EPD) technology (think Kindle screens). This moat is protected not only by patents, but also by know-how and increasingly by scale, which drives lower unit costs. E Ink holds a market share in the high 90s across e-readers, electronic shelf labels, and signage applications—so dominant that the brand name "E Ink" is synonymous with the product itself.

 

Our continued research on E Ink’s moat focuses on whether new entrants can breach E Ink’s defences and compete at scale with a product that the market demands. It’s clear that a breach would be highly disruptive: E Ink enjoys gross margins of roughly 50% and returns on capital employed (ROCE) of 60–100%. If the technology were commoditized, gross margins could drop significantly, and this could well impair the value of our investment.

 

The history of E Ink is important in understanding the IP moat. The technology was originally invented and commercialized by a group of researchers at MIT. Professor Joseph Jacobson and his co-inventors were inducted into the US National Inventors Hall of Fame for discovering the microencapsulated electrophoretic display technology behind E Ink. Electrophoresis is the motion of charged particles. In layman’s terms, they figured out how to move black and white particles around inside tiny capsules using an external electric field. What is special about the technology, as anyone who owns a Kindle knows, is that it uses no backlight but rather reflects ambient light, like ordinary paper, and therefore eliminates eye strain and reduces battery usage. It took about a decade from the basic scientific discovery at MIT to mass commercialization with the Kindle. 

 

Professor Jacobson and his co-inventors patented their discovery in the late 1990s. This initial patent expired in 2018. Given this, the core idea of microencapsulated electrophoretic display technology can be, and has been, duplicated by ambitious competitors. But in the six years from the expiry of the core patent, E Ink’s virtual monopoly has been maintained. 

 

Prime View, a listed, Ho-family controlled Taiwanese LCD display manufacturer acquired E Ink in 2009. Despite the core patent expiry, the Ho family have so far been able to maintain and even expand the moat even while growing revenue almost 20x. We attribute E Ink’s continued moat expansion to three factors:

1. Heavy R&D investment: E Ink has heavily invested in R&D, generating additional patents covering the evolution of the technology to full colour, greater contrast, faster refresh rates and longer useful lives. E Ink spends a mid-teens percentage of revenue on R&D, or about USD150m annually, which for an electronics manufacturing business is exceptionally high.

2. Strategic pricing: E ink has wisely pushed pricing lower, and instead focused on expanding the TAM (Total Addressable Market) and driving volumes. E Ink’s low unit pricing, just a dollar or two per unit for the E Ink film, makes it difficult for new entrants to achieve profitability. By not maximizing short run profits, E Ink keeps the pricing umbrella at a level where the incentive for new entrants is weak, and the customer surplus is large.

3. Efficient scale: E Ink addresses a market of limited size, and this limits the incentive of large new entrants to pursue the TAM. This set-up is often referred to as “efficient scale”. Given E Ink’s near monopoly, their revenue is essentially the TAM and that is currently about USD1bn. If, to pick a farfetched example, Apple partnered with Foxconn to attempt to disrupt E Ink’s franchise, the result wouldn’t materially benefit either Apple or Foxconn. 

 

As we continue to pressure test E Ink’s moat width and how that is trending, we’ve focused our research in several areas:

• Competing producers of E Ink film: There are several display electronics businesses in China that aim to compete with E Ink using the same core technology. They haven’t achieved volume commercial production and don’t have meaningful scale. The products also just look worse. This is something we recheck regularly.

• Downstream module makers: For a large part of their business, E Ink sells only the film, and these downstream module makers, particularly China’s BOE Technology, do the low-value-add assembly of electronic shelf labels. The sourcing decisions of the leading module makers indicate a lot about E Ink’s moat, so it’s also something we monitor.

• System integrators: Electronic shelf label (ESL) buyers, such as Walmart, purchase from system integrators. The leading system integrator is a French listed company called Vusion. As Walmart rolls out ESLs across 2,300 stores by 2026, they are partnering with Vusion. The modules Vusion provides to Walmart all contain E Ink’s film.

• LCD displays for electronic shop labels: LCD screens are an older emissive display technology that is potentially a substitute for E Ink modules in an ESL and digital signage context. We monitor how decision makers compare these options because LCD devices require a constant power source, and installation and maintenance is cumbersome.

 

We have conviction that E Ink’s moat is robust. That said, we consciously and constantly question that conviction and search for disconfirming evidence. We believe that the TAM across a variety of applications for E Ink continues to expand. If, as we expect, E Ink’s management continues to progress the technology—better colour, sharper contrast, faster refresh rates and longer useful lives—and manages pricing to disincentivize competition, then the moat can likely be maintained or even widened. The increased TAM can then be effectively captured. If the moat shows signs of narrowing or being breached, we aim to detect that early, re-evaluate the investment case, and potentially sell the investment.

 

We made the initial investment in E Ink at a time when the company was struggling with ESL inventory digestion and revenue was temporarily in decline. Given the massive potential TAM for ESL given low penetration, the integrator channel had aggressively stocked up, driving E Ink’s ESL revenue up 1.3x in 2022. When it became clear that end market demand growth was more like 30-40%, a period of retrenchment ensued. Our work on E Ink’s moat durability, and the factors underpinning that, gave us the conviction to invest when revenue and earnings were falling. As the period of inventory digestion has ended and growth has resumed, E Ink shares have risen over 60%. If, as we expect, the TAM continues to expand with E Ink large signage, upside from here is still significant.

 

Yifeng Pharmacy moat analysis

To further illustrate our process around moat analysis, we think it’s also helpful to share an example where we haven’t been able to build sufficient conviction around the durability of a moat in a high-return business. The example we’re sharing is Yifeng Pharmacy Chain. Founded in 2001 and headquartered in Changsha, China, Yifeng is one of the largest retail pharmacy chains in China. 

 

Yifeng has been a favourite of foreign funds. Investors are attracted to Yifeng because they are the highest quality operator—judged on management alignment, growth and margins—in China’s fragmented but rapidly consolidating retail pharmacy sector. Also, retail pharmacy ostensibly appears a socially-positive, non-political business that potentially alleviates pressure on China’s overburdened hospitals. Yifeng, in theory, should be a supply-side cost driven competitive moat from scale-driven purchasing power and procurement cost control. Basically, they are big and can buy drugs and other healthcare products from suppliers cheaper, and pass those savings on to consumers driving a virtuous flywheel effect with higher sales density. The set-up for Yifeng’s development matches a successful template investors have seen before and like. Yifeng also likely has a secondary contributor to the moat from brand recognition and trust.  When considering their health care needs, consumers tend to select branded chains with reliable standards over less predictable “Mom & Pop” style outlets.  

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Yifeng has for years earned a roughly 40% gross profit margin (GPM). That’s a very high margin level in the global pharmacy context, and one might assume a reflection of exceptional competitive advantages. Accord, the leading state-owned pharmacy in China, has a 25% GPM. CVS pharmacies in the US earn low 20s GPMs. If we shift our perspective to operating margins, Yifeng’s 10% operating margins are almost twice those of CVS’ pharmacy segment despite the latter’s much larger relative scale. Even Brazil’s Raia Drogasil, which is held in the portfolio, is a 5-6% margin business. Yifeng’s high profitability is an attraction only if it is sustainable. We haven’t been able to get comfort around that sustainability for a couple reasons. 

 

First, online to offline (O2O) platforms in China such as Meituan are increasingly delivering items from retail pharmacies to consumers as part of their quick commerce offering. Yifeng and its peers have little choice but to participate in the O2O business given competitive pressures—if they boycott the platforms, competitors will simply fill the demand. Given the market power of the O2O platforms, the GPM for Yifeng from these sales is low at only 10%. For Yifeng, O2O is a bad business, significantly outgrowing the direct retail business, and likely to become ever more material. Even worse, it is sapping in-store footfall and therefore the opportunity to upsell visitors on higher margin items. Sales densities for Yifeng’s stores are falling. The O2O platforms are essentially breaching Yifeng’s moat. 

 

Second, the Chinese government has started to address the high channel mark-ups of drugs. While mark-ups of prescription drugs are legally capped at 15%, with purchase discounts and rebates private pharmacies have historically been able to squeeze out higher profits. Linked to the government health scheme reimbursement, the government has created price comparison tools and limits on relative price differences by channel. It seems that Yifeng’s high gross margins are under direct threat from government actions to ensure consumers get value for money. Yifeng cited increased government oversight on insurance spending as a headwind in their 2Q24 results. There’s little reason to expect this headwind to abate as the Chinese government has a strong record of action to suppress healthcare costs. We see these government pricing actions as a regulatory threat to Yifeng’s moat.

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Yifeng’s unlevered return on capital employed has historically been very high at around 50%. Unfortunately, it seems this relates more to the relatively high prices customers are paying, and less to do with the sort of moat characteristics you’d hope for—the flywheel effect of strong customer traffic driven by great deals. As the government pressures pricing, especially where there is in-scheme reimbursement, and the O2O platforms divert instore traffic, we worry that Yifeng’s returns will fade reflecting a narrower moat. If Yifeng ends up being a 5% operating margin business, and asset turns decline due to lower sales density, the fair value of this business might be substantially lower.

 

Conclusion

Our investment philosophy at Variis combines a rigorous analysis of moats, management quality (which we will expand on in a future letter) and a stakeholder investing (VSI) approach to navigate emerging markets. Through this comprehensive framework, we sift through the vast expanse of opportunities, distilling our Focus List to around 100 of the highest quality companies. At any time, the strategy is invested in the most compelling 20-30 Focus List companies. By adhering to our approach, which combines quality assessment with valuation discipline, we strive to identify winners and deliver exceptional returns for our investors over the long term.

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Thank you for your ongoing interest and support!

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FOR PROFESSIONAL INVESTORS AND ADVISORS ONLY

The contents of this document are communicated by, and the property of, Variis Partners LLP. The information and opinions contained in this document are subject to updating and verification and may be subject to amendment. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by Variis Partners LLP or its directors. No liability is accepted by such persons for the accuracy or completeness of any information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document. The information contained in this document is strictly confidential. The value of investments and any income generated may go down as well as up and is not guaranteed.

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