HL Global Enterprises (AVX.SI) - Cloud of Uncertainty Removed

In my previous post here, we discussed about HL Global Enterprises' relatively complicated disposal of LKN Investment International Pte Ltd (LKNII) and some salient features about why the shares of the company were worth a bet. Looks like most (if not all) of the points covered went through nicely and things are indeed looking very well for them.

In Summary:

1. Disposal of LKNII and CHQ is completed and the >S$100M proceeds are already received.

2. Part of the proceeds are used to pay off the Venture Lewis loan in full.

3. HL Global Enterprises' future earnings will be relieved of the heavy interest expense as a result of payment of the loan and we should reasonably expect positive earnings going forward.

4. The free cash flows of the group remains positive as usual.

5. The group has applied for removal from the SGX-ST watchlist and they had undertaken to provide a reasonable exit offer for minority shareholders should SGX-ST somehow rejects the application (in my opinion, this scenario is unlikely).

6. A 3-cents dividend is declared, giving a yield of 6.4% on current price of 46.5-cents. This is the first dividend declared since probably >10 years ago.

7. The group is reviewing the proposed development of their Melaka property as well as sourcing for sustainable and viable businesses with the huge excess cash that remains even after the payment of the 3-cents dividend.

8. There are some changes to the Board.

HL Global Enterprises has essentially gone from net debt to net cash of about 60-cents per share. Book value also went from negative to about +84-cents per share (higher than my previous estimate of 75-cents per share). As mentioned previously, even after this disposal the group still have various profitable operations, investments and properties. At just 46.5-cents today and considering that much of the uncertainty related to the disposal removed, HL Global Enterprises is still significantly undervalued and definitely worth a bet.

Disclosure:
Long HL Global Enterprises (AVX.SI) since Jul '17

HL Global Enterprises (AVX.SI) - Potential exit from SGX-ST Watchlist

A few interesting facts from the completion of the complex disposal of  HL Global Enterprises' (AVX.SI) share capital of LKN Investment International  Pte Ltd (LKNII), which consists of 100% interest in Hutai that owns the 106-unit serviced apartment building Elite Residences located near Shanghai's central district as well as the 60% interest in loss-making CHQ that consists of  the 455-unit Copthorne Hotel in Qingdao, located near Qingdao's central business district. More information can be gleaned here:

Elite Residences in Shanghai, the PRC

1. The company will receive net proceeds in excess of S$100M from both deals, the bulk of it already received.

2. HL Global will become a net cash company VS a net debt company before the disposal.

3. HL Global should report positive book value VS a negative book value previously.

4. The now positive book value should also be very much more than the current market cap (I estimate it to be around S$72M or S$0.75/share vs market cap of about S$44M or S$0.455/share).

5. The company will report a significant gain in earnings this year due to this disposal.

6. Main investments and properties of the group after completion still consists of:
a. 100% interest in Augustland Hotel Sdn Bhd which owns and operates the profitable Copthorne Hotel Cameron Highlands;
b. 49% interest in a management services company to Equatorial Hotel Shanghai;
c.100% interest in Victory Heights which owns a land located in Tengah Malaysia and finally;
d. 2 other pieces of land of approximately 8,400 sqm in Cameron Highlands, Malaysia.

As guided by management in earlier reports, I believe HL Global will use part of the huge cash proceeds for the repayment of the unsecured loan which has been one of the main causes of its losses the past few years via interest expense. Coupled with loss-making CHQ already out of the picture, HL Global should be able to report reasonable earnings going forward, fulfill the financial exit criteria and be removed from the SGX-ST Watchlist that is probably causing disinterest in the shares of this company. The company has also been reporting positive free cash flows.

Lastly, the substantial cash that remains even after paying the unsecured loan in full may be used to fund suitable acquisitions of new businesses and possibly, the payment of a dividend.

Management has been trying various ways to get HL Global out of the SGX-ST watchlist for some time now and I think this is one of the more favorable (if not most favorable) outcomes that potentially will lead to the exit of SGX watchlist.

Disclosure:
Long HL Global Enterprises (AVX.SI) since Jul '17

SMRT Corporation Buyout Offer: An Alternative Viewpoint

Temasek is buying out the 'troubled' transport firm SMRT at S$1.68 - valuing the company at about S$2.56B. Because Temasek owns 54.1%, they have to pay about S$1.18B for the remaining stake.

Readers of my blog would have known I bought SMRT back in 2014 at an average cost of about $1.02 and sold the same year at $1.49. I left a comment and highlighted that the non-fare segment of the company seemed attractive as follows:

Comment: Quite lucky here as a short while from my initial purchase, the price spiked up due to government's announcement about the new model. Nevertheless, the price at S$1.02 was clearly undervalued. The non-fare segment of the company was rather attractive too. Considering the nature and moat of the business, I probably run the risk that I've sold too low at S$1.49. Price now is S$1.58.

Some SMRT Non-Rail Results

Let's have a look at the results of 3 of the largest Non-Rail segments, namely: the Taxi, Rental and Advertising Segment -

As can be seen, all 3 segments have shown marked and consistent increase in both the topline and operating results (total in 2016: S$123M) over the past 6 years. The total operating profit for the Rail & Non-Rail Segments is S$142.6M. That means the 3 biggest Non-Rail segment is >85% of the total Non-Rail and Rail operating results. I think it is not unreasonable to expect that the Non-Rail segments will do quite well in the foreseeable future. These 3 very profitable, inherently stable and growing segments combined could probably be worth about S$1.7B (this is only a quick and dirty estimate of 13X - 15X operating profit). Also take note that there are other Non-Rail segments that may be of some value as well (classified as Engineering Services, Other Services and Investment Holding and Support Services).

I'm not so sure why the focus out there concerns so much about the Rail segment and why the management has not expressed any thoughts on the striving Non-Rail segment with regards to the buyout offer. But from the standpoint of the investor and those who are supposed have a duty to look after shareholders' interest, it is unwise to focus solely on the Rail segment and keep harping about the Rail's corresponding risk.

There seems to be much confusion whether SMRT Rails should be more concerned with the investors' interest or the public's. Also, Chief Executive Desmond Kuek (former army general) said that "significant risks remain and many factors are outside the control of SMRT such as uncertainty over future fare increases and ridership numbers." I'm not so sure how 'significant' the risk for the rail segment is in the future despite being relieved of their heavy operating assets under the new Rail Financing Framework. I would hazard a guess that both fare and ridership numbers will at least remain stable and it is likely that operations will be less risky compared to before the implementation of the framework.

Proposed Solution

1. Since the focus of the buyout seemed to be on the Rail segment: spin out the Non-Rail segments so that their proper value can be realized by the market. Existing shareholders should be more than happy to then sell off the operations of the Rail and Bus segments not owned by Temasek for a lesser, say S$500M (this values the Rail & Bus segments to be about S$1.1B. Assuming the above valuation of $1.7B for the 3 Non-Rail segments are correct, SMRT could potentially be worth in excess of S$2.8B which corresponds to a price of about S$1.84 per share). 
2. Offer a (higher) price that truly reflects the value of both the Rail & Non-Rail segments. (I read in the news that in the past 10 odd years, SMRT's price averaged about S$1.64. Offered price is S$1.68. Obviously some shareholders might be unhappy with the current offer).

Advantages are Two-Fold:

1. Rail and Bus assets out of the way and privatized - the role of a public transport operator can be better fulfilled in the long term without taking the pressure of short-term market expectations.
2. With the Rail segment out, the market can more easily discern the true value of the remaining Non-Rail entities. Not only can shareholders receive some cash from the disposal, they would probably be very pleased to have their hands on a growing and very profitable Non-Rail segment.

Some Things to Work Out

Now, the Advertising and Rental businesses are obviously highly intertwined with the Rail business. Therefore, the question to ask is if the above solution is possible at all? I'll leave these to the shareholders and management to answer for themselves. It's tough, but a fair and equitable solution should be created for all parties involved.

Disclosure:
No position in SMRT (S53.SI) as of 21 July 2016

Koyo International (5OC.SI) - Is It Worth The Risk?

Koyo International (Company Website) is listed in the SGX Catalist since 2009 and its principal activities broadly consists of four core segments, namely:

1. Mechanical and Electrical engineering services
2. Supply of renewable energy and green products for building services
3. Property development and construction
4. Supply of construction materials and ancillary services

The company has been operating since the 1980s. As of 1H2015, it has S$42.2M (VS S$20M Revenue for 2014) worth of contracts on hand with completion dates between 2015 to 2021. I'm not going to talk much here - readers can understand more and judge for themselves in the annual reports or company website.

As mentioned in my previous post, I would prefer to keep my articles brief in the future. I'll keep this analysis simple without delving too much into the specifics. Some basic metrics are as follows:

Price = S$0.061

P/E (ttm) = 7.8x

EV/EBIT = 3.7x (est $6M excess cash VS $14.9M net cash)

P/B (mrq) = 0.66x

ROE (TTM) = 8.4%

The Story

Over the past 1-2 years, for largely unknown reasons, the share price skyrocketed from around S$0.05 all the way to a high of S$0.40. Readers of my blog would have known that I bought into its shares a couple of years back and sold it for a decent profit. More details here.

On 15 Jan 2016, SGX released a statement and urged caution when dealing with Koyo International's share as >30% of the trading was done by the same group buying and selling among themselves.

When the market reopened the next trading day (18 Jan 2016), the share price crashed >80% to about S$0.05 and subsequently recovered to between S$0.055-S$0.065 range.

Summary of Investment Thesis

1. There's currently no evidence or indications from SGX that the management or insiders themselves are manipulating the share price.
2. On 18 Jan 2016, the company bought back 6,300,000 shares @ about S$0.099 for a total of $630K. That's about 3.3% of outstanding shares.
3. On 19 Jan 2016, independent director Serena Lee purchased 800,000 shares and raised her stake from zero to about 0.42% of outstanding.
4. On 20 Jan 2016, Serena Lee again bought another 700,000 shares, raising her stake from 0.42% to 0.78%. A quick check shows that if Serena does not sell any shares from this point on, she should be one of the top 20 largest shareholders of the company. To my knowledge, Serena did not own any shares of the company since at least 2011.
5. Current price is one of the lowest since 15 months back and my valuation work shows that the company would be worth at minimum S$0.07 and its intrinsic value should be closer to S$0.10.
6. Some brokerages have instituted trading restrictions on the company after the "Trade with Caution Alert" by SGX, causing the share price to remain depressed even after crashing significantly.
7. The company has a relatively long operating history, is in sound financial condition and I can reasonably expect it to continue turning in respectable results in the next 5-10 years.

Key Risks

The 2 main risks I observe were: 1. Accounting issues with financial statements and/or 2. Certain parties are in fact the ones manipulating the share price (its not hard to find out who stands to gain most when the share price of the company is up). If an analyst bought it even at such low prices, any one of these materializing may mean a disastrous investment result. No amount of margin of safety can save an analyst from a fraudulent financial statement and a management that lacks integrity.

So far, there's no indication or evidence of such risks materializing (yet). Also, the share buybacks from the company and an independent director provide some level of comfort.

Conclusion and Some Thoughts

At S$0.40, Koyo International is clearly expensive and a purchase at that point would certainly prove reckless. At the same time, a price of S$0.056 clearly undervalues the company and absent the 2 key risks coming true, a purchase should turn out profitable.

Does being slapped with a "Trade with Caution" alert by SGX warrant a significant sell-down to huge undervaluation territory? It really depends. Security selection requires a skillful balance between the facts of the past and possibilities of the future. The future is uncertain and as investors, we always have to take and manage risk. The risks mentioned above are very real but the fact is that there are currently little evidence that it will happen. An investor always have to deal with probabilities and as of now, my own judgement (I may be dead wrong) tells me that the risk to reward ratio is largely skewed to my advantage.

To be sure, if any of the risks mentioned turn out to be true, it is sensible to sell the stock (even at a loss). Before that, one can only control his/her risk by first understanding them and then diversifying adequately as well as sizing such positions appropriately so that it will not inflict mortal damage to the portfolio as a whole.

Interestingly, this situation bears some resemblance to that of Avi-Tech Electronics which is listed in the SGX Watchlist due to 3 consecutive years of pre-tax losses. The share price got hammered so badly that a purchase (do refer to my write-up here) made just last year would have reaped respectable results and dividends for the aggressive investor.

Let me know what are your thoughts.

Disclosure:

Long Koyo International (5OC.SI)

Note: Disclaimer applies. Not a recommendation to buy or sell.

Avi-Tech Electronics Update - 30% Unrealized Gain in 2-3 Months & Half-year Earnings Report

In my analysis on Avi Tech Electronics (See Avi-Tech Electronics - Is Quick Profit Possible?), I highlighted the reasons both quantitatively and qualitatively, why I feel the company is undervalued and that the various ongoing corporate actions may serve as a catalyst to drive up the price towards its true value. Since my initial post about it on 30 December, the price has risen from S$0.074 to S$0.091 - a reasonable gain of >22% in about one and a half months. My own average price of S$0.699 would mean a 30% gain since around 2-3 months back at November. With the release of the half-yearly results yesterday, this post is just an update about how the story unfolds so far and my intended actions.

Much Improved Continuing Operations - Industry or Management Actions?

Table 1: Avi Tech Electronics 1H15 Financial Summary (Continuing Operations)

As seen clearly from the Table 1 above, revenue, gross profit and net income show marked improvements. Similar growth may be observed in its operating cash flows (you can find out more from the company's latest earnings release).

Table 2: Avi-Tech Results Including & Excluding Disposal Group

I've extracted Table 2 from my previous post on Avi Tech. Here, you'll notice that the company has been loss making for many years. Also, despite cleaning up the effects of the subsidaries (they are contributing the bulk of losses for the past few years) that are in the midst of being discontinued, the core operations still show slight negative results from 2012 to 2014. Since 1Q2015, it is clear that not only did the disposal of subsidiaries help stem further losses, the improvements in core business have contributed to profitability as well. All in all, the results in 1H2015 represents a significant turnaround transition from loss-making to profitability.

Table 3: Avi Tech Quarter-Quarter & Half Year Results (Continuing Operations)

I believe it is important to pinpoint whether the improvements in core operations are the result of improvement in trends of the industry or due to specific actions undertaken by the management. From the announcement, the management mentioned that the semi-conductor industry as a whole appears to be in an uptrend recovery and they 'remain optimistic of continued improving performance if this uptrend continues'. With improved results seen across all business segments, it is pretty clear that the industry recovery did play a large part in the increase in revenue for the past few quarters.

However, I argue that the management played a significant role in retaining these revenues especially since the company's inclusion into the SGX watchlist in 4Q14. The gross profit margin has grown from 11.3% in 4Q14 to 22.6% in 2Q15 and this is, to quote the management, 'partly the result of  effectiveness of the ongoing cost control measures and the enhancement in productivity across all business segments'. This is made clearer if we observe the drop of COGS as a percentage of revenue from 88.7% in 4Q14 to 77.4% in 2Q15. Another factor that plays a part is the significant decline of its operating expenses as a percentage of revenue from 18.9% to 9.9%. Although we do not have much information about the specifics of operating expenses, in the typical case such expenses should not provide future economic benefits to the company and thus such cost-cutting measures usually will not have serious undesirable consequences.

To sum it all up, an investor of the company should be heartened to see that the better set of results are not solely due to general improvements in the semi-conductor industry but also due to active steps taken by the management to ensure that more money flows into the bottom line.

Bonus: Cash from Discontinued Operations

I just want to highlight the fact that the discontinued operations did contribute a decent amount to the bottom line in the past 2 quarters. Although non-recurring in nature, its always good to know that its disposal will continue to throw in some amounts of cash for the company. The net asset value of this group under disposal currently stands at about $966,000.

Interim Dividends - 1st Time Since 2011

Another positive note is the resumption of dividend payments after a hiatus of more than 3 years. Coupled with the purchase of shares by directors in the past 6 months, the interim dividends declared is a clear show of confidence from management that they believe that the company has indeed turned around. The interim dividends of $0.3 cents per share represents about 3.3% dividend yield at current market prices (4.3% based on my own purchase price).

Valuation

In my previous article about Avi-Tech, I estimated that the liquidation value to be about S$0.094 per share. Using the same method alluded in that post, the new liquidation value should be S$0.099. I continue to believe that this is the minimum valuation that should be afforded to the company, especially considering that the continued improvement of business operations should provide further support to its intrinsic worth. This new valuation excludes the proceeds that Avi-Tech could have received in the future from the disposal of its subsidiaries.

Table 4: Avi Tech Electronics Pro-Forma Financial Results

Another reasonable way of checking the valuation would be the use of pro-forma statements as shown above. The main assumption here is that management is able to continue to keep Cost of Sales and Operating Expenses at 79.9% and 10.7% of revenue, as per 1H15 results. Finance costs and Operating income have been pretty stable over the years and should not venture too far away from $0.100M and $1M respectively.

From Scenario 1, if we were to assume that revenue reverts back to its worst level seen so far in 2014 (for eg, if semi-conductor industry as a whole declines and affect sales badly), the implied P/E ratio at current price of S$0.091 is 12.7x. Do note that 2014 net earnings is negative. This difference is mainly due to management's cost cutting and productivity measures that I had highlighted above - which further shows the importance of such management actions. If we were to annualize the 1H15 results such that the revenue will at least maintain current levels (as in Scenario 2), the implied P/E becomes 11.0x. These valuations ain't that demanding at all. Of course, the P/E based on my purchase price would have been much lower at 9.8x and 8.4x respectively. (I did not include Scenario 3, which is for those who feel the improvement in the industry as a whole will contribute further to sales growth. If this does happen, valuations will obviously be more attractive.)

Conclusion

It seems that Avi-Tech Electronics has finally turned around. Although we can't be sure if these very much improved results can be sustained, we can take comfort that:

1. The discontinued subsidiaries will not contribute any more losses to the company.
2. Share purchase from directors in the past months and the resumption of dividends after >3 years indicate management's confidence about the prospects of the company.
3. Management seems to be actively taking targeted measures to ensure profitability since the company was placed in the SGX Watchlist.
4. The current market price of the company is not too excessive, both on a liquidation and earnings basis.

Having said all these and with the new estimated minimum liquidation value of $0.099 as a guide, I'll probably continue to hold on to my shareholdings until price exceeds above this or if there's any serious deterioration of fundamentals in the company that warrants my attention. Did any of you bought into Avi-Tech? Let me know your opinions!

Related Articles:
Avi Tech Electronics (CT1.SI) - Is Quick Profit Possible?
My SG Porfolio (Top Realized Gains & Losses) and Some Recent Picks

Disclosure:
Long Avi-Tech Electronics (CT1.SI)

Q&A: Insights Gained from Interesting Comments

I mentioned previously in the post on Our Stock Investment Philosophy that one of the reasons for writing in this blog is to subject our investment thoughts to scrutiny and feedback so as to gain new insights in our investment journey. In the past 2 months, there are multiple comments from fellow bloggers and readers about my writings that I feel adds so much value to this blog. I couldn't ask for more. I'll like to take this opportunity to thank readers for their insightful comments and also republish some of these for the benefit of those who had have missed these comments despite reading the article.

I've tried my best to be selective and also to summarize these questions and answers so that readers can get the gist of it. Also, to save time, I've organized in such a way that you can go to the relevant heading and/or question that interests you. Of course, there are more comments which are very insightful and definitely worth a look if you have time. If you want more details, you can click on the headings to go to the relevant article (the comments section is below these articles, scroll down all the way if you want to read only those).

Sembcorp Industries - Is It Worth the Buy Now?

The one thing analysts and all investors (and myself) have been saying is the low PER their utilities segment is currently valued in. We think it's cheap if we compare it against fellow peers. But the question is, it has been for many years they are trading under PER of 10x, so I'm not quite sure what would propel the shares to be trading at 15x. We may be too optimistic in that sense. We may be wrong of course but the market has proven us wrong again and again. Will we see a day where it is trading at PER of 15x? Maybe yes one day, and we can only hope. 

Reply: I suspect that many investors or potential ones are still deeply fixated about Sembcorp’s Marine business and has not been aware of the success and growth of the utilities business, thereby undervaluing it. Like you, I’m also not sure what would propel the shares of the Utilities segment to 15x. But assuming we are not comparing with its peer businesses or the market's valuation, and only basing strictly on a discounted cash flow perspective, I think this valuation is fair considering the economic characteristics of Utilities segment (leading position, stability and predictability of cash flows etc). Basically on a zero-growth basis we are putting a discount rate of 6.7% for a respectable business.

Also, my hunch is that my valuation for the Marine segment is probably a tad too low (Earnings power of S285M vs TTM earnings of S$345M plus PER of 12-13X) and I have considered the Urban Development business to be worth zero which is definitely not true.

Lastly, some final considerations which I did not include in the post is that – the Marine segment is probably the one providing the cash for Utilities expansion traditionally. If Marine is unable to do well under current circumstances, the Utilities might be affected. Sembcorp claims that the small Urban Development business may be a springboard for further involvement in opportunities for Utilities side but so far I haven’t really seen any synergies in this aspect (anyone, please correct me if I’m wrong). I guess these business relations wasn’t completely factored into my analysis. The valuation might be higher or lower because of these but I must really thank the margin of safety for providing some comfort here.

As an investor of SCI too, I feel pretty confident. Yet, looking at the price curve, I noted that in Oct 2011, there is a dip of prices below 3.5? And that was already way beyond post crisis low period below 2.5. I had not followed SCI then and was curious why did that happen? Just pondering will a repeat happen?

Reply: Great questions posed there regarding the price chart. I think your guess is as good as mine whether a repeat of price below S$3.50 or even S$2.50 will happen. Personally, I feel there’s always a chance something like that will happen again though.

However, looking at this situation on a value standpoint may be a source of vindication. The ~S$3.40 price occurred in 2011Q4. In terms of available information then and for simplicity, we can use 2010’s financial data for reference. With earnings of S$793M (you may want to refer to the table in my post), the PER turns out to be about 7.7x which is also very attractive. Perhaps that is why over such a short period of time 3-6 months, the stock price recovered.

Alternatively, if you follow my post and using the same technique, (Here, I assume that my view of the fundamentals/stability for both Marine & Utilities is the same at that point in time as it is now (this is quite likely) & I also used latest results for Utilities but 7-years average for Marine instead of 10 years), the valuation becomes S$6650M or about $3.70/share. I ignored the other segments in both cases. It turns out that this is decidedly less attractive at that point of time compared to now on a price to value basis (Value VS Price – 2011 is S$3.70 VS S$3.40 & 2014 is S$5.15 VS S$4.15). Thus we can say that even though the price is lower at ~$3.40 in 2011, it is not necessarily more attractive when it is priced at S$4.15 in 2014. Of course there may be bias (hindsight) etc but I’ve tried to minimize them using the same method when looking at the company for both periods.

I guess the point here is that due to business developments over the years, we have better clarity in forming a rough intrinsic value estimate of the business itself which in 2014, we estimate it to be close to S$5.15 wherein we ‘wrongly’ estimate it to be at S$3.70 based on the available data in 2011. Without any doubts, we may yet again be proved wrong as the future unfolds. That's why we can't depend only on this counter in our entire portfolio.

Not satisfied with the dividend yield.

Reply: The dividend yield for Sembcorp Industries is not the best among many of the blue chip stocks around. However, I suggest that dividend yield is part of the overall analysis. 

If after analysis, we like a stock like Sembcorp but we feel the yield is too low, I think there's 2 ways to handle this: 

1. If you feel that dividends will remain constant, wait for the price to drop further to get a higher dividend yield; or

2. Ensure the current price is low enough such that there's good upside for capital appreciation. Buy at this low enough price and hope that based on the fundamentals & potential growth of the company, the earnings will increase in the long-term and maybe future dividends will increase as a result.

For me, since the current dividend yield is already good enough for me and the company has been paying dividends yearly for >10 years now, I opt for the latter point 2 which is obviously the less wiser way.

Avi-Tech Electronics - Is Quick Profit Possible?

Seems this company has trouble finding ways to make money? It's longer term prospect doesn't sound exciting. Be careful of considering liquidation value based on its current cash. Check how much it burns as well. Can disappear quickly due to operating expenses if it isn't generating profitable sales. That margin of safety may not exist.

Reply: Thanks so much for visiting my blog. I think you’ve raised a valid point here. The longer term prospect doesn’t sound exciting at all. However, I believe the beaten-down price coupled with the various corporate actions that act as some sort of catalyst have made the stock a potentially attractive investment.

With regards to liquidation value, I’ve used it as one of the indicators of the company’s value. Like I mentioned in this post, between 2011-2013, the bulk of negative earnings are attributed to the subsidiaries (they contributed –S$12.8M while core ops contributed +S$1.7M). These loss-making subsidiaries are the exact same ones that management will discontinue and this will help stem much of the losses. Core operations endured comparatively minor losses which was worst at -S$1.61M in 2013 (VS subsidiaries –S$7.6M in 2012). 1Q2015 shows core business operating profitably signalling a potential turnaround. 

With these, I believe the company is unlikely to burn as much cash as the past 3-4 years and correspondingly, the liquidation value can be used as a reasonable guide to its valuation at this point in time. Of course, the future is unpredictable and management can still burn cash in the future, especially through similar unsuccessful acquisitions. What I can say is that I did not place any positive prospects of the future in my valuation while the negative prospects are still guarded by some indication of margin of safety.

All in all, if I can find a few companies in this investment situation and at this price level for my even-type portfolio, I think the probability of profiting should be high overall. If you read my previous post on My SG Portfolio 2014 and Some recent picks,you will notice some companies in my event-type situations aren’t doing very well operationally and doesn’t seem to have bright prospects (one of them is facing a lawsuit too). I guess the point here for me is that because of these past losses, the price of Avi-Tech had been beaten down by investors/speculators to a point so low that they have essentially assumed these losses are very likely to continue far into the future.

How to Get Rich - The Beauty of Compounding to Investors & Companies

Have you tried using simulation which is the most important factor out of the three? Time, starting capital or return factor?

I think you’ve posed a very valid case here about finding out which is the most important factor. Honestly, I'm not very good at such simulations. But if you've noticed, I've used a factor of 1.5 for rate of return, r and starting capital, P in the case study (i.e $100K x 1.5 = $150K, 10% x 1.5 = 15%). For time period, t, if we use a starting capital of $100K and 30 years (20years x 1.5), the final amount would be about S$1.75M. From this single but likely inconclusive datapoint, it appears that time period and rate of return are the most important factors to consider.

Unfortunately the rate of return probably is one of the least predictable of the 3 factors since there's no way we can be sure we can achieve 10% or 15% return over the long haul. Because of this unpredictability, I thought it is not so useful to state which factor is the most important in the practical sense. However, very fortunately for us, the time period is quite within our control and easily ‘applied’ if and only if we are young enough to start. Then again, achieving a 2-3% return over the long haul is probably easier than say, compounding it for 50 years due to the limitations of being a human. A balanced effort in working on all factors should be the better way to handle the compound equation.

All the 3 factors are highly intertwined and complementary to one another. For example, compounding $100K at 15% for 18, 19 and 20 years will give $1.24M, $1.42M ($180K more from 18th year), $1.64M ($220K more from 19th year) respectively. A good compound rate is important but the effect will be more pronounced if the length of time is extended due to the exponential effect of the formula. Similar relation applies for the other factors.

In conclusion, due to the varying ease of application and unpredictable nature of some factors, it is quite hard to conclude decisively which factor will do most for us in our lifetime. Consequently, I believe the best way to reconcile this is to focus on all 3 factors based on my proposed method to tackle each factor in my post (under The Real Trick – Combining all 3 Inputs).

THE BEAUTY OF COMPOUNDING COMPANIES & ITS IMPLICATIONS

Good post again to show the different scenarios amongst the 4. It's interesting though that you actually used the book value as a measurement of growth. I thought book value growth is much harder to achieve than earnings growth as it covers a wider spectrum. It is like earnings is the subset of that.

Reply: I used book value in this case because it's easier for me to explain the compounding effect. Also, unlike earnings and cashflows, book value is less subject to fluctuations with time and thus more predictable for use. Besides these, book value is highly related to earnings - A consistently growing book value usually indicates healthy earnings over the period since whatever is left in net income after deducting dividends goes to the book. Lastly, we can also view book value as a rough gauge to the company's intrinsic value if it is to be a liquidated. This means that using book value is not wrong although it may not be the best choice in the end.

Other Articles:
My SG Portfolio 2014 (Top Realized Gains & Losses) and Some Recent Picks
AP Oil - A Neglected but Cheap Stock in Singapore
Our Stocks Investment Philosophy

Avi-Tech Electronics (CT1.SI) – Is Quick Profit Possible?

In my post on My SG Portfolio 2014 and Some Recent Picks, I’ve mentioned that one of my event-driven picks for 2015 is Avi-Tech Electronics. I think price then was about S$0.074 and I’ve accumulated since November at an average price including costs of S$0.699. There are some interesting comments in the post (you should read it here) and I thought that probably it’s good to write a short article about my analysis.

Avi-Tech Electronics is listed on the SGX and is a provider for Burn-in, engineering and manufacturing services in the semi-conductor & electronics industry. In 2011, It ventured into the Imaging Equipment and Energy Efficient Products by starting 2 subsidiaries to ‘diversify and substantiate long-term growth’ for the company. Guess what happened in the end: since 2011, the company began incurring losses largely due to these same subsidiaries and management has finally decided to discontinue these operations just a couple of months back. Originally, the classification of this type of purchase in my portfolio (see post for more details about this) do not require intensive analysis – so I’ll try to keep things simple here. The following data are based on my 30 Dec 2014 post:

Price = S$0.074
Shares outstanding = 342,422,096
Market Cap = S$25.34M
P/E = NA (losses)
EV/EBIT = NA (losses)

P/NTA = 0.63

Investment Thesis

The results in this classification of stocks depend a lot on corporate events which in some sense serve as a catalyst to close up the price-value gap, hopefully in a fairly short period of time. My investment decision is premised on the following: 

1. The management has destroyed huge value over the years from the 2 loss-making subsidiaries. Many shareholders could have loss confidence with management's ability and decided to sell / cut losses.
2. The poorer fundamentals and financial results combined with the inclusion onto the SGX watch-list due to 3 consecutive years of pre-tax losses has led to a stock price decline that is likely over-exaggerated.
3. This exaggeration led to a fair degree of undervaluation which also means a potential investment opportunity to the shrewd analyst.
4. Directors have been mopping up shares recently with their own money and to that extent, agreeing with my view that the stock price might be undervalued.
5. The disposal of subsidiaries which are main contributors of past years' losses may improve future earnings at least in the short term and this may prop up the market price.

Key Risks / Uncertainty

Management indicated that they will “continue with its plans to seek new areas of growth whether through mergers and acquisitions, or any structured transaction or business, which will add value to shareholders.” Has management really learnt their lesson from previous experiences? Are they capable enough to continue ‘adding value’ through acquisitions? Personally, I feel its foolish for them to do that considering their core business ain’t doing as well as before too (more details below).

Also, we can’t deny the fact that they are in a difficult semi-conductor industry which presents a challenge to the management (that is perhaps why they insist on growing through acquisitions etc) and a risk that the investor need to be wary of.

Safeguards and Checks – In case things do not turn out well

Like I say, the need for intensive analysis is not really required for the event-type part of my portfolio and I hope to realize some profits in a reasonably short period of time. However, as a safeguard, I better ensure there’s some sort of margin of safety if things don’t work out and I might have to hold on to it for a longer than expected timeframe. Since this will be a minor position in my portfolio, a brief analysis should be sufficient.

Financial Position

The balance sheet is generally cash rich with net cash equivalents of about S$23.5M which compares favorably to the market cap at S$25.3M. Book value is about S$40M. If the company is liquidated now, I believe we can get back more than what we pay now. Of course, if management continues eroding value by doing foolish expansions, the intrinsic value on a liquidating basis may drop below our price paid in light of such later developments in the business. 

Earnings

Avi-Tech Electronics Financial Summary

I’ve cleaned up the effects of the loss-making subsidiaries in the above table and it is clear that these subsidiaries have indeed eroded earnings between 2011 and 2013, before management decide to discontinue operations in 2014. The core operations haven’t been doing well too considering that they also have registered some losses between 2012 to 2014. Core business revenue has declined drastically from S$70M to S$23M over 7 years.  However, keep in mind that the bulk of the negative earnings is attributed to the subsidiaries (contribution by subsidiaries is -S$12.8M compared to +S$1.7M for core business from 2011 to 2013). 

Valuation

Not surprisingly, thanks to these loss-making subsidiaries, share price has declined more than 60% since 2011. The discontinuation of the subsidiaries has stemmed losses greatly and results in 1Q2015 shows a positive profit. Could there be turnaround which can lift share price higher? No one can say this for sure.

Avi-Tech Electronics 5 Year Stock Chart

Let's use 2010 and 2015 results for comparison since in both years, the loss-making subsidiaries are non-existent. A back-of-the envelope calculation shows PER of 2010 is about 15.6X while forward PER of 2015 appears to be about 9.1X (I annualized 1Q15 earnings per share of S$0.002 here as an approximation). Assuming all else remains the same, this could be another indication that share price decline has been exaggerated and the market probably has not factored in the positive effects from the disposal. If valuation in 2010 is any guide, the market price should be priced around S$0.12! Of course, I’m not saying these assumptions are reasonable but at least it gives me some level of comfort here knowing that I'm not buying at a ridiculously high price.

Because the earnings has been quite unstable, probably the balance sheet can give better insights about its intrinsic value. Taking a haircut of 50% to PPE (NB: this part of the balance sheet is throwing in some S$500K-S$700K rental income annually), 25% to inventory and 10% to receivables, we get a liquidation value of S$0.094 per share as compared to the price of S$0.074. (Potential Bonus 1: I did not include the proceeds that the company may receive from the disposal of subsidiary in this valuation).

Conclusion

A high price can turn stocks of good quality businesses into a speculative purchase and likewise, a low price can turn a speculative stock into an attractive investment. My opinion is that Avi-Tech belongs to the latter. Considering the pros and cons, I think the low price coupled with the existence of potential catalysts make the purchase of Avi-tech too attractive to be denied by the security analyst. However, the risks mentioned above also means that the sizing of the position in the portfolio should be kept relatively small - just in case management screw things up again. (Potential Bonus 2: we already ensured there's some margin of safety to absorb unfavourable future developments but what if by some freak nature, the future acquisitions are so successful that future earnings improve dramatically? This is definitely not accounted for yet).

Some Final Thoughts

Due to it’s classification in my portfolio & unless there’s any clear-cut change in circumstances, my guess is that I will take most of my profits (if any) within the next 12 months. I mentioned that my average price purchased including costs since November ‘14 is S$0.0699. Price now at S$0.078 would mean that my current returns is about 12% in slightly less than 2 months. Obviously this is not the best business in the best industry and I have the urge to take my profits initially when it was at S$0.08. After some deliberation, I figured that my estimate of S$0.094 is really a minimum valuation which is so conservative to the extent that it is a reasonably dependable guide. Moreover, one of the directors bought back shares a couple of days back at about S$0.078. Maybe somewhere around S$0.09 I can consider trimming my stakes. I would be more than happy to get some opinions about this.

PS: I’m surprised that I took about an hour of analysis before my decision to purchase Avi-Tech but it took me more than 3-4 hours to write it in this blog!

Disclosure:

Long Avi-Tech Electronics  (CT1.SI)

SEMBCORP INDUSTRIES (U96.SI): Is It Worth The Buy Now?

The recent oil price rout has beaten down many stocks of oil-related companies and probably its good to have a look to see if valuations are compelling enough. Now, I usually like to buy clear-cut bargain type stocks and consequently most of my portfolio consists of small to mid cap businesses like AP Oil (see post here for full details). However, one of the rare blue chip companies that I monitor is Sembcorp Industries. Some metrics (based on 8 Dec '14) as follows: 

Price = S$4.15
Shares Outstanding = 1801.4 (million)
Market Cap = S$7,565 (million)
P/E (TTM) = 9.70
P/NTA (mrq)= 1.51
ROE (ttm) = 14.91%

SEMBCORP INDUSTRIES BUSINESS

I wouldn't go into details about the business but will probably highlight a few things so that the reader can get a general understanding about its operations. I encourage you to look at the Company's Website as it provides a comprehensive overview of its businesses here.

Sembcorp Industries is listed in the SGX and its business consists of 3 main segments:

Utilities

Developer, owner and operator of energy and water assets over 6 continents with an established presence in Asia and growing presence in emerging markets. The company has established a niche as a global leader for the provision of bundled energy, water and on-site logistics to customers in energy-intensive industrial sites, and as a developer, owner and operator of large-scale combined power and water plants.

Sembcorp Utilties Network

As shown in the picture, the Utilties segment already has a global footprint (including emerging markets) and the guidance was that there's still potential for expansion. This segment of the company is what probably attracts many investors now due to its natural moat, source of recurring income as well as potential growth.

Marine

Separately listed in the SGX, this segment is a leading global marine and offshore engineering group specializing in a full spectrum of integrated solutions in ship repair, ship building, ship conversion, rig building and offshore engineering and construction. This segment is likely causing the steep decline as it is highly related to the oil industry. 

Urban Development

Sembcorp owns, develops, markets and manages urban developments such as industrial parks, business, commercial and residential spaces in countries like China, Vietnam and Indonesia. The company's early involvement in the development of industrial, residential, business and commercial areas also provides potential opportunities for the provision of utilities and other solutions.This is smallest segment contributing less than 10% to bottom line.

I don't want to bore the readers with in-depth study of the business model but please do have a look at the company website and annual reports regarding its business strategies and the like.

FINANCIALS

Sembcorp Industries 5-year Summary

The 5-year financial summary seems to show that on aggregate, the company is performing reasonably well in terms of revenues and earnings. The free cash flow is pretty lumpy as expected due to the capex heavy nature of the marine industry as well as the growing phase of the utilities business. Something that I don't quite like is that the company is currently in net debt and with debt/equity ratio of  65% - but I argue that the overall earnings power is more than sufficient to finance this and the S$2200M cash on hand is definitely enough to pay out the S$930M borrowings due within 1-year. The company has been paying dividends as far back as more than 10 years ago and the past 5 years shows a payout ratio of about 30%-40%. Assuming dividends is maintained at S$0.17, yield is about 4.1%.

Another worrying trend is the decreasing ROE from 20.6% to 15.7% over a period of 5 years. A 15% ROE is still pretty good in general but its also good to pinpoint the reasons for the decline.

Sembcorp Industries Segment ROE

Obviously, we would prefer a business that is able to at least maintain its rate of return whilst employing incremental amounts of capital for expansion over an extended period of time - the Utilities segment is one good example. From 2009 - 2013, while using increasing amounts of capital, ROE for the Utilities business is relatively stable fluctuating between 15.6% to 19.6% while Marine is showing a consistent decline from 38.2% to 20.8%. Kudos to the Utilities segment in this aspect. Of course, we can't discount the fact that Marine's current rate of return is still very decent, but its inability to maintain this may be a cause for concern.

Perhaps a 10-year summary can provide a more meaningful insight of Sembcorp Industries 2 core operations:

As can be seen, both segments registered huge growth in both revenue and net profit over the past 10 years. The clear winner here is no doubt the Marine segment having registered 420% and 259% growth versus Utilities at 140% and 183% growth in revenue and net profit respectively. Are these growth sustainable enough for the analyst to make a decision with regards to its earnings power?

10-year Revenue & Profit Chart for Utilties & Marine

A look at the chart above shows that in general, the earnings of the Marine is volatile especially since 2007 while that of the Utilties segment is more stable, with earnings contribution surpassing the Marine segment since 2012.

10-year Net Profit Margin Chart for Utilities & Marine

The 10-year period net profit margin confirms this view point. Although the Marine registered a higher average net profit margin (7%) than Utilities (6.2%) over this period, the Utilities segment's margin is more stable at between 4% to 9% versus Marine's 3.5% to 11.5%. Do note that the 9% margin achieved in 2013 includes non-recurring income which when adjusted, should bring it lower to about 7.5%.

It is not wrong to say that due to the nature of its industry, typical utilities businesses are quite stable. For Sembcorp Industries, with the support of the statistical exhibits from the revenue, earnings, ROE and Net Profit Margin, I argue that its Utilities business is inherently stable and because of this predictability and stability, the Utilities business warrants a higher valuation as compared to other businesses. For the Marine segment, because of its dependence on order book & oil prices, coupled with its statistical showing, we can't for sure say it is a stable operating business. But based on its leadership position in its industry and strong features like ROE, it is also unfair to conclude that it is a lousy business that is worth a very low valuation.

VALUATION

On 8 Dec 2014, the market cap of Sembcorp Industries is about S$7500M while that of Sembcorp Marine (listed separately with code: S51.SI) is S$6100M. Sembcorp Industries owns 60.7% of the Marine business. With this, the implied valuation of Sembcorp Industries excluding its stake in the Marine business is S$3800. This necessarily means that the market is valuing the Utilties and Others segment at a low P/E (2013) ratio of  7.9x. That's really quite interesting.

Originally, I would prefer to use cash flows to value Sembcorp. However, the free cash flows are not very consistent owing to the heavy capex required, presumably for future growth. Coupled with the lack of guidance in estimating maintenance capex, perhaps its better to value the entire business on an earnings basis.

Utilities Valuation

Removing one-time items from the IPO of Sembcorp Salalah in Oman and impairment charges at Teeside in UK, the adjusted 2013 earnings would be about $$380M. As shown above (table and chart), the Utilities segment has shown sustained growth in revenue and earnings in the past decade. We know that this segment is still in the midst of expansion and track record has shown management to be prudent in this aspect.. From this, I think its fair to say that 2013 earnings for Utilities is a nice guide for future earnings. At what multiplier should be fair for this segment then?

Sector P/E extracted from Gurufocus

I shall now run the risk of being criticized by fellow investors with the following. As seen in the Sector P/E extracted from Gurufocus, the P/E ratio for Utilities segment in S&P 500 is about 22 (Yahoo Finance shows similar numbers). Of course, S&P 500 concerns the US market plus the current P/E provided may be a poor indicator etc and there are other valuation methods. But for simplicity's sake, i decided to use this as a reference. I had also alluded above that because of its business characteristics and strong statistical showing, the Utilities business is inherently stable and probably deserves a high valuation. I'm not going to use P/E of 22 for the reason that its way too high. Of course, P/E of 10 is unfair too. A reasonable estimate should be probably about P/E=15 which means the Utilities segment is worth about S$5700.

Marine Valuation

The Marine segment is in a relatively volatile business affected by things like its orderbook, oil prices and sentiments. What I am looking here is for a long-term average of what Marine can consistently earn in the future. Perhaps its better to normalize the earnings and take the average result of the past 10 years, giving us an earnings power of about S$285M. A long term P/E of about 12-13 should be decent enough for a company like Marine, considering its long operating history and track record, despite its supposedly fluctuating business environment. This means that Marine is worth around S$3550M.

Adding them together, the Valuation should be about S$9250M (or price of about $5.15) as compared to current market cap of S$7,565 implying a margin of safety of 18%. I've decided to ignore the Urban Development segment since it probably is too small (for now) to affect the overall valuation significantly (I'll consider it as an x'mas gift).

True, the business is currently priced in the market above its book value and on this basis some may feel it is liberally priced. However, accounting treatment has its own constraints and certain non-quantifiable information such as Sembcorp's strong reputation, customer relations and capacity for innovation is not captured directly in the financial statements. I believe these intangibles is definitely worth something for Sembcorp (unlike many companies out there) but I hesitate to come out with a value. Anyway, compared with many blue chip companies, a price to tangible book of 1.5 is actually quite low. As an ongoing business, it is usually the earnings power of its assets rather than balance sheet valuation that really counts and based on these considerations I'm comfortable with the above indicated valuation.

SHARE BUYBACK

Sembcorp Industries has been buying back shares recently. However, a quick check at the total shares outstanding for the past years does not show a decreasing trend. This is likely due to the company's policy of issuing stock options. There's not much to conclude about the value of the company here.

It is worth highlighting that a director of Sembcorp Marine has bought some shares during the recent price decline, possibly indicating that Marine segment is undervalued as well.

CONCLUSION

Sembcorp Industries is an industrial conglomerate with its core operating business earning a decent return on capital. Based on the market price of Sembcorp Marine, the implied valuation of the market clearly undervalues the Utilities segment. An investor who wants to take part in the undervaluation of the Utilities segment probably could buy Sembcorp Industries and correspondingly short an equivalent proportion of Sembcorp Marine. However, I prefer not to bet against the Marine segment. Looking it at another point of view, buying shares of Sembcorp Industries could bring about a natural industrial and geographical diversification from the Utilities, Marine and Urban Development businesses.

The concern here is whether the margin of safety is enough to justify a purchase. I'm here reminded about a similar concept (we call this 'safety factor') during my university days studying Engineering. To put it very simply, we were taught that if the consequences are severe or gravely (For eg, when building a bridge for cars and which may involves lives of many people), the typical safety factor should be high. Similarly, if we were to build a chair (that probably won't kill someone if it collapse), a small safety factor should do fine.

For a company like Sembcorp Industries, I believe we don't need too high a margin of safety to justify a purchase. 20%-30% should be fair enough. However, this is not to say that a margin of safety as low as 5%-10% is sufficient. This would mean that investors who bought at about S$5.00 even though Sembcorp Industries dropped from a high of S$5.50 may not be putting their money to good use.

All in all, I believe this analysis is consistent with our stock investments philosophy (read more about it here) and should do quite okay in the long term. I'll really appreciate if you can share some insights about this company. Thank you!


Disclosure:
Long Sembcorp Industries (U96.SI) @ S$4.15 with the hope it'll go down for further accumulation
No position in Sembcorp Marine (S51.SI)