Croesus Retail Trust

This May, we will be seeing IPO of Asian Pay TV and Croesus Retail Trust (CRT). They are both business trust (not REITs), highly geared and most importantly offering a 8% yield. Where else on SGX can you find a 8% dividend yield? The question should then be why are they not pricing at lower dividend yield and hence leaving money on the table?

Total unit is 430,178,000, NAV is $378,337,000 or $0.88. The IPO price is trading 1.05x NAV.
CRT is made up of 4 main assets situated in Japan worth 57 billion yen. As seen from the table below, other than Luz Shinsaibashi, they are mostly located in small cities with population of 200,000 and below.

Figure 1 - Classification of Cities for Asset

Lease Structure

Figure 2 - Breakdown of NPI in 2014

The figure above shows the contribution of the 4 assets, where Mallage Shobu contributes the largest proportion of Net Property Income (NPI).

Aeon Town Suzuka and Moriya
Aeon Town Suzuka and Moriya are master-leased to Aeon Town, a subsidiary of Aeon Group, that catered towards neighbourhood shopping centre (NSC) as compared to Aeon Mall which specialises in higher end shopping centre. In a master lease, the owner of the property will lease it usually to 1 master leasee who will be put in charge of the sublease and running of the mall. The NPI margin will be much higher as most of the operation expense is bore by the master leasee which gives CRT a 90% NPI margin for its 2 master leased mall.

The master-lease is signed for a long period of 20 years from 2007 to 2027. Unlike most master lease we see in S-REITs, there is no step-up rental which means that the total rental revenue to be earned by CRT is FIXED for the next 20 years - 932 million Yen and 660 million Yen respectively. The good thing about master lease is that unit holder has a great certainty about what they are likely to get and will get. However, with no step up rental, the real yield after accounting for inflation (in Singapore) will get lesser and lesser. This is not unexpected as Japan has been in a deflationary environment for decade and hence no step up has been in place to account for possible inflation. In comparison, most leases in Singapore will take into account inflation, introducing step-up and positive rental reversion each year.

The only potential for growth for these 2 assets which account for 45% of total NPI will be a restructure of the lease, converting it from master lease to individual lease with the tenant. However, this option don't look much more attractive as Mallage Shobu (not a master lease) only has a NPI margin of 50% as compared to the 90% that these 2 assets enjoy. Such a conversion is not likely to bring in much positive as the margin will be lower and there will be an added risk of re-branding the mall and ensuring full occupancy.

In addition, the master lease has been structured such that from 2016 and 2017 onwards, contracts will be renewed every 2 years subject to agreement between both parties. Thus, there exists a risk that Aeon Town might not want to master lease the mall, leaving CRT in a lurch. Though this risk is remote as Aeon Group is the 2nd largest Japanese retailer by sale which makes them a strong counter-party, it is still something that unit holder should be aware of.

Luz Shinsaibashi
This is their prime asset in Osaka, though it accounts for only 14.4% of NPI. H&M is the major tenant here accounting for 58.4% of the space with the rest of the space occupied by 2 restaurant and 1 karaoke lounge. Once again, H&M has signed a long term lease that will only expire after 2024 and they accounts for 85% of the asset's total rental income. The 4 tenants have a lease term of 7-15 years which is very long lease term as compared to the standard 2-3 years in Singapore retail. While 2 leases are on variable rent, it is stated in the prospectus that "the Trustee-Manager expects that the turnover threshold which trigger variable rent will not be met."  Once again, growth is not to be expected. The earliest expiry of rental will be in 2017, where 1 leasee that accounts for 5.6% of the rental income of the asset will be up for renewal. This leaves us with only 1 asset - Mallage Shobu which accounts for the largest proportion of NPI.

Mallage Shobu
This is their only asset with the potential to grow the NPI as they are generally variable rental and not a master lease structure. They have 7 anchor tenant with lease term of 6-20 years and account for 1/3 of Net Lettable Area. The rest of the lease are variable rental and the contract term is typically 6 years. According to the prospectus, 151 out of 243 fix term leases are up for renewal in November 2014 and significant rental reversion is expected given the low rent signed during 2008.

These rental will account for 26% of gross rental income of CRT which works out to be 1.3 billion yen. From the prospectus, NPI in 2014 from Mallage will increase by 13% from 1.26 billion yen to 1.43 billion yen. Overall, the NPI will increase by 5% for CRT and the net impact to dividend yield will be that it will increase from 8.0% to 8.1%. Thus, their only hope for growth is not going to be of much impact in 2015. After 2015, the lease term will be on market rate and hence not likely to see much positive rental reversion. Given it is another 6 years before lease renew in 2021, this one-off reversion is not going to happen soon.

Examining Mallage Shobu, it is located in a mid-sized city called Kuki-Shi in Saitama. It is 7km from Kuki Station and 10km from Kitamoto Station which is really far away. The figure below is the age profile of those staying 5km within the mall. 44.5% of the population is older than 50 years and this is the highest among the location of its 4 malls and is higher than the national average. Population is stagnant and large-scale retail sales for Saitama has dropped almost every single year since 1998 other than in 2002 and 2005-2007. Thus, the variable rent structure is not going to be of much help.

Figure 3 - Age Profile within 5km of Mallage Shobu

Figure 4 - Large-Scale Retail Store Sales for Saitama

Macro Retail Trend

Figure 5 - Total Retail Sales

Figure 6 - Average Retail Floor Space

As seen from figure 5, the total retail sales of Japan since 2001 has been flat. Shopping Centre Sales only grown from 19.5% to 20.5% of total retail sales which is insignificant growth considering a 12 years period. However, from figure 6 the dark green line, retail floor space has grown and is on a upward trend. Thus the annual sales per sqm has dropped since 1991. This is obviously not a good sign for any shopping mall owners. The key to positive rental reversion is growth in sales of the tenant. Only when your tenant is making more money, will you be able to increase your rental as no tenants will enjoy a lower profit margin. This is perhaps why malls in Japan are generally master-lease or of long-term lease structure unlike in Singapore.

Figure 7 - Large-Scale Retail Store Sales for the perfecture of its 4 malls

Figure 7 is large-scale retail store sales for the perfecture of its 4 malls. As we can see for the past 15 years, they are all on a downward trend else flat. Ibaraki has done the best by staying flat while Osaka has seen sales dropping by 25%.

Figure 8 - Historical Shopping Centre Rents

Looking at the historical rental, they have also stayed flat just like the total retail sales. The perfecture which CRT's malls are located are Osaka (Orange), Saitama (Light Red), Ibaraki (Light Blue) and Mie (Purple). On the macro level, there really don't seemed to be much of a growth unless Abenomics is successful.

Leverage
Before people starts to jump into CRT for its 8% dividend yield, maybe the leverage should be considered. Leverage plays an important role in determining the dividend yield of a REIT. Assuming an unleveraged REIT with an Return on Asset of 3%, a unit holder who purchases the REIT at NAV will get a 3% dividend yield. This is obviously unattractive considering that some blue chips can yield 4-5%. Thus, REIT will often borrow more money to buy more asset, so that the dividend yield will be higher. By borrowing 30 cents on $1 of equity, the yield of the REIT will now be 3% x 1.3= 3.9%. This is why almost every single reit is borrowing near the 35% gearing ratio as allowed by MAS for those that do not get rated by a credit rating agency.

In the case of CRT, the gearing ratio (calculated by debt/value of property) is 48% whereas most S-Reit stays within 30-35% after learning their lesson in the GFC 2008. Thus, how can it be fair to compare the levered 8% dividend yield to a less levered yield reit? If we were to compare CRT with a S-REIT with a 30% gearing ratio, the 30% levered dividend yield will be 8% /(100/52) * (100/70) = 5.94%! What a big difference the high gearing can bring about. Leverage is always attractive and I am sure many folks are more than willing to dismiss it.

Given the high gearing, it is imperative that we look at the way the debt has been structured. Leverage is particularly dangerous for REIT/ business trust given that most practices 100% payout ratio on distributable income. Thus, when the time comes to pay the loan, they will refinance it as they have no mean to pay it back since they do not retain cash.

What struck me when I look at their debt is that they are only funded by 2 sources of debt - S$299.8m in loan and S$31.9 million in bond. Both debts are provided by only 1 bank, Mizuho Corporate Bank, and the tenor will be 5 years with an additional 2-year Tail period. The interest rate will be Base Rate + 0.5 % (0.75% for bond). The problem I have is that it is very dangerous to borrow from only 1 bank with the same repayment date when they need to re-finance their debt. If CRT just happen to have to refinance their debt during a crisis, bank will tighten their lending activity and CRT will find that it may not be able to borrow the same sum of money again. The result will be either to sell off your asset or to do a much dreaded cash call. A good reit/ business trust manager will not only diversify the source of funding but also spread the repayment date over several years.

For the issue of debt covenant, there do have quite a bit of buffer.2 main covenants will be to maintain a minimum stressed debt service coverage ratio of 1.3, calculated based on NPI dividend by 6.6% of debt and not to exceed the maximum loan-to-value ratio of 60%. Current debt service coverage ratio is 1.88 while LTV is 48%. NPI will have to drop by 30% which is unlikely given the master lease structure and value of property needs to drop by 20%.

Lastly, I find that the interest rate of 1.7% paid by CRT seemed a bit too low and is more than likely to rise in the future. If interest rate were to rise by another 1%, it will incur additional interest expense of 2.5 billion yen which will reduce the distributable income and hence dividend by 10%.

Corporate Structure
Why is CRT not offering it in Japan where the Japan Reit Index has an average dividend yield of 3-4%? In Japan, there is not limit on the gearing ratio and they will also be able to enjoy tax transparency. One possible reason could be that their asset size of 57 billion yen will make them the third smallest reit among the 40 listed in Japan. There was a wave of merger and consolidation since 2008 such that number of J-Reit has dropped from 42 in 2008 to 36 in 2010. Currently, there are 39 J-Reits that are listed after 2 new listing in 2013. http://jreit-view.ares.or.jp/jreit_e/pdf/monthly/ares_jreitreport_vol41_en.pdf

So why are they listed as a business trust and not as a REIT? Most J-REITs are highly geared as they do not have any limit on gearing ratio. CRT is highly geared and will have to get a credit rating agency to rate their credit standing if they want to be listed as a REIT. Since they do not want to be rated, it is better off for them to list as a business trust. Neither will they be required to distribute 90% of their profit to be exempted from paying corporate tax.

Fee Structure
I find the fees earned by the asset manager much higher than the almost all S-REIT. The base fee charged is 0.6% of the value of property and 3% of NPI. The common fee charged is 0.3% of value of property and 3% of NPI. I believe this is one of the highest management fees being charged.

Secondly, I find that the property management fee for Mallage Shobu is incredibly high at 9.5% of gross rental income and 30% of amount of net operating income in excess of an unspecified agreed figure. In comparison, ARA only earns 3% of gross rental income for managing Suntec Convention Centre. It seemed like Sojitz is getting a much better deal than unit holder. The reason given below seemed unconvincing.

"However, the Trustee-Manager believes that the incentive fee payable to the property manager of Mallage Shobu is commercially fair and reasonable for the reasons stated below.

Mallage Shobu faces competition from Viva Mall and Ario Washinomiya (newly opened in November 2012), both located within a 5km radius from the Property.
In addition, the property manager has been managing Mallage Shobu since November 2008 (being the opening of the retail mall) and is therefore well placed to continue with the management of Mallage Shobu given its knowledge and experience with Mallage Shobu. In the context of the competitive operating
environment, the experience of the property manager and the substantial level of operating and management effort required in respect of the large number of sub-tenants, the Trustee-Manager believes that such
incentive fee is commercially fair and reasonable to incentivise the property manager towards realising revenue growth for Mallage Shobu and achieving performances that are challenging to attain."

Other Risks
No Insurance Against Earthquake - Earthquake insurance is expensive in Japan given that it is a common phenomenon. Earthquake insurance will be taken up only "where the Probable Maximum Loss for a Property is in excess of 15% of current building replacement construction cost. Probable Maximum Loss is
defined as the probable maximum loss (i.e. repair and reprocurement expenses) that would be
incurred if a major earthquake struck. Specifically, it means the loss generated by the largest
earthquake that has a 10% probability of occurring during a 50 year assumed service life of a
building." The probable maximum loss for the 4 shopping centres are 1%,5.5%, 7.2% and 2.1%. I always have my doubt about such statistics and we should never forget about Taleb distribution.

Currency Risk - Currency risk is another real risk that we face.Successful Abenomics will cause Yen to depreciate whereas MAS is likely to continue letting SGD appreciate. Dividend translated will then be lesser by the amount of which Yen depreciate. Currency risk is a real risk that anybody should be prepared for. Just look at how much USD and GBP have depreciated against SGD.

One common counter-argument will be that if Japan succeeds in its monetary policy, inflation will resume and hence rental will go up which will counter-act the depreciation in Yen. However, the rental structure of CRT is long term such that the shortest lease is usually 6 years. It will take time to renew the rental at the market rate should the market rate goes up. Many leases expire beyond 2020 as many simply do not expect any inflation given the 20 years history.

Conclusion
While 8% yield is high, lets not forget that high yield usually comes with higher risk. The 8% yield is achieved as a result of its much higher gearing ratio. Unlike many S-REITs where we can expect organic growth coming from step-up or positive rental reversion, there is not going to be any significant growth for the years to come. It will also be hard to conduct any AEI as 3/4 leases are long term leases where it is unlikely that the leasee has the incentive to conduct AEI. Neither should we expect too much from Abenomics as there are certainly much better play out there on Japan's depreciating currency and inflation than CRT.

The debt seemed dangerously structured and lets hope that 2018-2020 will be recession-free else they will be having trouble refinancing their debt. All unit holders should also be prepared for a cash call given the high gearing. Any acquisition is going to come from the pocket of unit holder.

Inevitably, I am sure that this will be oversubscribed because there will be chase for yield and those that are going for a stag in expectation of those chasing the yield. Will be interesting to see what kind of yield and price it fetches when trading begins. Doing a simple Dividend Discount Model shows that at $0.93 it is rather fairly valued.

Review of 2012

The year 2012 marks my first full year as a serious fundamental investor, having indulged in 3 months of speculation in late 2011. It has been a great learning journey through the many ups and downs of the STI as well as my personal portfolio. Early in the year, STI rebounded sharply from the lows to the 3000 level and stayed there until May where the upcoming Greece Election resulted in a temporary flu that saw a 10% dip. Subsequently, STI broke past the 3100 level in October before dropping to 2945 in mid-November. And out of the blue, STI rebounded strongly past the 3100 level before ending at 3167.08 for the year.

My Portfolio

Anyone that has stayed invested throughout 2012 will have reaped substantial return with the STI returning 19.68% year-to-date so long as they have held tight to their stocks during some of the panics. My portfolio (including idle cash) has returned 37.28% through some luck as well as a highly concentrated portfolio that now only consists of 4 stocks: Boustead Singapore, The Hour Glass, Silverlake Axis and VICOM. Given the high concentration of the portfolio, return from any stock will have a huge impact on the portfolio return, be it negative or positive.

Personally, I do not expect such spectacular return every year and neither should you believe that anyone is going to deliver such return year after year. For our public listed companies, quarterly and annual result are sometimes of little guidance to how a company will perform in the long run. For our individual investment track record, it is not the 1 or 2 years of out-performance that counts but rather the total return in 1 full investment cycle (from one big bear [>50% decline] to the next) against the benchmark index return.

My targeted annual return will be 15% in the long run, which comes from a 4-5% dividend yield coupled with a 10% capital appreciation. Dividend has been an important factor for my return this year as they provided me with a 5% return in 2012. The 15% return will be achieved through investing in undervalued stock with great underlying business, through adopting a minimum investment time frame of 1 year and preferably 3 years and beyond. For more details, you can look at this post which I have written a while ago for my selection criteria of companies.

Portfolio Component

As of 31st December 2012, I have 32.1% of portfolio in cash and 67.9% invested in stock. Cash is king and especially in crisis where it can generate extraordinary return when rightly deployed. I have been building up my cash position as I have not bought anything for the last 6 months as a result of the market rebound and that there seemed to be no feasible target at the right price at the moment. Patience is a virtue in the market and I shall continue to wait for the right opportunity to surface. Preferably, I will hope to raise the invested portion to 80-85% to ride with the companies for the long term.

Boustead Singapore

Purchased in Mid-April 2012, this company has returned me one of the highest dividend yield among all my holdings. This is certainly a deeply-valued company that's not easy to understand with 4 divisions and 3 investments. Neither are the divisions easy to understand for the general public, being involved in Geospatial Technology as well as items like Process Heater and Waste Heat Recovery Unit.

The crown jewel in the company lies in its distributorship of ESRI as well as its slowly growing Design Build & Lease portfolio which generates recurring income. ESRI is likely to continue to enjoy double digit growth as GSI still has immense potential and coupled with the fact that both Indonesia and Malaysia have chosen ESRI as the official platform for the government.

Boustead International Heater is a well-established player in the field of process heater where competition is sparse. Their margin for this division has been slightly impacted recently due to their customer, the South Korea EPC, that has practically won almost all the contracts in Middle East with their competitive pricing and hence squeezing their subcontractors. Other than process heater, they are also involved in Waste Heat Recovery Unit for refineries. What the WHRU does is that it recycles the waste heat back into the system as a form of energy. This reduces energy cost and need to flare off gases which are important for refiners as they run on very tiny refinery margin. Every cost savings count. They also have a subsidiary Boustead  Control & Electric that is involved in the upstream business providing process control system.

Other than the current 100,000 sqm DBL portfolio, Boustead Project is the market leader in design and building of industrial building in Singapore, with an added capability of Green Mark with strong execution and delivery record. Lastly, that will be the poorest performing segment of all, Salcon Water which Mr FF Wong has not fully turnaround though its losses are no longer what they used to be. However, Salcon Water does have the technological advantage and is a different specie from the other water treatment companies found on SGX. It is pre-qualified by the Japanese EPC and provide industrial water treatment where the purity and quality are of utmost importance for the manufacturer.

What I like about the business model is that it is involved in the high-margin, asset-light area in the design, project management and execution while not being involved in the asset-heavy and high capex manufacturing which is outsourced to their pool of subcontractors. The problem with such a model is often the lack of control on the quality of manufacturing, but I believe that Boustead Singapore has done a good job to achieve where it is today.

With its net cash of $180m (representing more than one-third of its market capitalisation), strong free cash flow generation with its business model, and high ROE despite its $180m cash hoard and a capable leader, Mr FF Wong, who has certainly delivered more hits than misses - this is a company that I will hope to increase my position in if the price is right. The intrinsic value is certainly far away from its current price. However, this is certainly not a stock where one can expect strong return within months. This is the type of company where one should hold on tightly and ride with the company to enjoy great compounded annual return. As such, this is a stock where I have a investment horizon of 3 years and more, and will be willing to look beyond some of the poorer results that come with its partial order-book driven lumpy revenue. While time is needed to fully realise its value, the ~5% dividend shall be an appetizer during the wait. However, this is certainly not a company for the impatient.

The Hour Glass

Purchased in early January 2012, this company has delivered my highest return to date. A luxury watch retailer based primarily in Singapore, it has been a key beneficiary of the rising wealth of South-East Asia as a whole over the past decade. Luxury watch retailer does not really enjoy strong competitive advantage as the RSP and cost of watches are determined by the respective watch manufacturers ranging from Rolex to Cartier. In addition, retailer also suffers from the rising rental cost that is a further hit to their tight profit margin. So what is it that draw me to this company?

Strong management capability and a tight focus are what I see in THG. In fact, it has delivered one of the best performance I have seen in a pure retailer. Net Profit Margin in 2012 is 9% despite the increase in expenses in preparation for 2 new stores opening in 2012. ROA is very impressive at 14.9% and ROE at 17.7% considering the type of business and industry they are in. This high return on asset and equity is achieved through a respectable profit margin coupled with high inventory turnover that's traditionally more than 2x. For this upcoming fiscal year, inventory turnover has dipped below 2 times, as a result of a dip in macroeconomic condition and the added inventory requirement for the 2 new stores. However, this does not worry me as this is merely a temporary issue and the business is still sound. In any case, the financial metrics make it one of the best luxury watch retailer to be found.

Other than the financial metrics we have seen, there are many other positive signs. Looking back to its history, this company has been fond of diversification to irrelevant industries like selling pizza. However, since the current management, the uncle-nephew team, has taken over, the company has regained their focus in being a pure luxury watch retailer. Of course, the Gems TV mistake has been a bad one and I believe this will be a reminder for the management.

In early 2008, luxury watch industry in Singapore is still enjoying very strong demand. However, THG made a decision to reduce their inventory level despite the healthy demand they still enjoyed. This has been an amazing decision made as the demand collapse and the other retailers are forced to sell their inventory at a discount to generate cash. What this show is not only that they have great foresight but that they dare to act differently from the crowd.

In addition, the change in location of their stores over the year is also a positive sign of their focus. Before Mr Henry Tay mentioned about the Orchard Quadrangle in the 2012 Annual Report, it has been clear that they have executed the strategy with a high level of focus 4 years before. The company closed down the shop in Lucky Plaza and Peninsula Plaza by 2011 and has now secured shops in all 4 corners of the Orchard Quadrangle. At the moment, it has 6 shops in Ngee Ann City, KnightsBridge, Ion Orchard, Tang Plaza, Paragon and Orchard Central. It is amazing that the management takes the step to close down 2 profitable shops where they have been there for decades. Someone that is only focused on short-term profit will obviously not have closed down 2 profitable shops to reinvest in better locations. This is even more important for watch retailer where their working capitals are often tied in the inventory. The company has also waited for years before they open a 2nd store in Hong Kong when they are able to secure a favourable rental rate. They have often taken advantage of recession to expand and open new stores where the costs are often much lower. In 2008 GFC, while many other retailers are suffering, they chose to open 8 new stores across various geographic location over the next 3 years.

I have purchased this company at an average price of $1.14 which was approximately 5x PER and slightly less than the book value at that point in time. While the company boasts a very high ROA, I feel that this should not be a company that should trade at higher than 10x PER. The reason lies in the business model of luxury watch retailer where huge amount of capital is tied in the inventory. When the business grows, inventory in the balance sheet will also grow which means that higher free cash flow that stems from higher profit will be partially pumped in to feed the inventory growth. During a downtime, when revenue is down, inventory will be reduced, and that's when the company enjoyed the strongest free cash flow yield. However,  at the current price I believe that there's still a long way to grow when the economy recovers and with the 2 new stores (1 in Paragon and 1 in Hong Kong) enjoying a full year of operation in 2013. There's always reason behind why a company operating in the same industry can outperform its peers in terms of all the relevant metrics for a retailer. This will be another company where I have an investment horizon of 3 years and beyond. Should the price dip lower than its book value, I will certainly consider adding to my current position.

Silverlake Axis

Purchased in March 2012 where I also initiated a research report on the company at around the same time. Being a core banking software company, it enjoys wide moat and strong competitive advantage in the form of extreme high switching cost. Core banking system is equivalent to the central nervous system of a bank, where it is highly critical for a smooth operation. To change it comes with huge risk such that many are still using legacy system dating back to the 1980s. It is also certainly the market leader in the Southeast Asia region and in numerous countries like Singapore, Indonesia, Malaysia, Vietnam and Brunei.

Software company with a strong moat are often worth looking into as they have a high ROA, strong free cash flow generation, high margin and a huge portion of recurring income. These are characteristics that Silverlake Axis have with a 90% profit margin for licensing, and 65% profit margin for its recurring maintenance and enhancement services. While the profit margin for licensing is ridiculously high, it is not what that really matters for Silverlake. What that matters to me is that after they enjoy the one-time 90% profit margin, they get to enjoy the 65% profit margin maintenance recurring revenue for as long as the customers deployed their CBS. The maintenance income is approximately priced at 15% of the licensing fee which is much lower than many other competitors where their rate is around 18-20%. In addition, every 3-5 years, when the new version is created, there will also be additional revenue for the update. And for Silverlake Axis, all that's needed is to develop a one-time CBS which is a fixed cost that can be reduced as more banks chose their software.

To have an idea of the high switching cost involved, the management said that in their 20+ years of operations, only 2 customers have switched to another system. And in both instances, they came back to Silverlake Axis which means that they have never lost any maintenance customers. Such high switching cost allows Silverlake Axis to REPRICE their maintenance contract by around 2-3% per year whenever they expire. Of course, the management prides themselves on the ability to value-add in justifying the reprice of the maintenance contract. Such a business model is certainly a no-brainer and one of the best gems that's found on SGX though it is a Malaysian company.

When I purchase the company, it really seemed very expensive at a price of $0.350 and PER of 20X and that the licensing fee is a one-time. However, when I work out the profit to be derived from all the contracts that it has secured, this company certainly looks attractively valued given its immense growth potential and strong fundamental. This is a company where the sky is the limit subjected to the number of new contracts that they can secure and of which can change the valuation dramatically given its highly scalable business model. Of course, sky will obviously not be the limit given that high switching cost can also prevent them from stealing market share from their rivals.

They are also likely to be a key beneficiary of the trend where the banking system in the Southeast Asia is still highly fragmented and of which consolidation and M&A are likely to continue. When 2 banks operating 2 different systems merge, it is likely that the larger bank will preserve its systems. And in the customer profile of Silverlake Axis, their clients are of the largest in their respective market, namely OCBC, UOB, CIMB, Maybank, Hong Leong Bank, Bank Mandiri, Bank Rakyat, VietcomBank, BIDV, Bank Islam Brunei Darussalam and TAIB. Notably, 2 Malaysian Bank, CIMB and MayBank seemed to have been very aggressive in their regional expansion in the past few years. Merger contract comes with approximately 40% profit margin and the greater reward will be in the expanded customer base.

Another trend will be the outsourcing done by financial institution as they stick to their core operations. Obviously, the cost of developing the necessary software and maintenance is much higher for the banks themselves than vendor like Silverlake Axis. Of course, for large banks like Citibank, JP Morgan and HSBC, they might have the sufficient resources and the scale to develop their own CBS. However, for our banks in the SouthEast Asia, it is much cheaper to outsource it to Silverlake Axis. Given that many banks are still relying on the legacy system, it seemed like the potential revenue base is still huge.

Despite its spectacular rise, there still seemed room for further upside. Firstly, its associate Global InfoTech should be listing on the Shenzhen exchange in 2013. Secondly, the new RM 135 million contract add more visibility to its orderbook and comes at a time where there has been hardly any new contract of significant size announced. Thirdly, I believe that there's still quite a huge amount of maintenance income from its CIMB contract that has yet to be realised.

While valuation is rich, I do expect its intrinsic value to grow with the company. New contract will certainly be sparse due to the uncertainty that banks are undergoing, but when dust settles new contract win momentum should continue. In the meanwhile, as the maintenance and enhancement services continue to enjoy its slow steady growth, I shall continue to enjoy its quarterly dividend paid. Silverlake Axis simply has too much cash to spend. Mr Goh has also been forward-looking as he no longer view his company as a core banking software provider but rather delivering a Digital Economy Solution. This has been his direction for the company for this decade and reflects the changing dynamics of the banking IT industry.

VICOM

Purchased in September 2011, this company has been my first stock purchased and has delivered a remarkable return. I also did an initiation on this company on January 2012 over here. VICOM is in the Inspection, Testing and Certification industry with its 2 core business in VICOM (Vehicle Inspection) and SETSCO (Non-Vehicle Inspection).

Regulation is what that allows the industry to thrive. In Singapore, cars have to undergo inspection every 3,5,7,9 year while buses and taxis have to undergo inspection twice every year. This not only forms a very stable recurring revenue, but also one that will roughly grow with the slow overall growth in the total vehicle population in Singapore.  The tightening of COE has been the key driver of growth for VICOM. In 2005, only 30% of the car population and 110% of the Goods & other Vehicle population undergoes inspection. In 2011, 45% of the car population and 132% of the Goods & other Vehicle population undergoes inspection. This is on top of the annual 3% increase in vehicle population in the past. Hence, what we see is a multi-bagger and one with revenue and profit growth for 9 straight years this coming fiscal year. In addition, it has a 75% market share in Singapore that has further expanded with the closure of Ayer Rajah Inspection Centre by STAI in August 2011.

Given its remarkable growth, it seemed like the time has arrived where VICOM is likely to enjoy slowing single-digit growth going forward. Growth will still be maintained by various policies like the Carbon Emissions-based Vehicle Scheme which will encourage take up of diesel vehicle as well as further tightening of vehicle population undergoing inspection. Vehicle population has also grown by around 1-2% this year. Looking at the chart below, one can see that in November 2012, the age distribution of car has reached what is roughly called a Normal Curve. This certainly means that further upside from increase in age distribution profile of vehicle population will be limited

 

Age Distribution of Vehicle Population

As such, I do hope that its time that SETSCO will take over the growth momentum from VICOM. SETSCO is involved in the inspection, testing and certification of many products that range from chemical, biological, environmental, electrical and mechanical industry. There will be a portion that's highly resilient which include building inspection, food products while another portion will be depended on the economy like civil engineering and e.t.c. While not as attractive as the vehicle inspection business, the return on asset still beats many other businesses out there. Of course, they do have to face certain level of competition but I believe they will prevail with their wide range of services.

Valuation is rich and if we use Peter Lynch's PEG as a measurement, it seemed like it is certainly no longer a buy. This will be one in which I will consider selling should the price continue to rise and should there by a buying opportunity else where. In the meanwhile, I will collect its 4% dividend while awaiting a better switching opportunity.

Learning Journey

The best investment that any investor can make is always to invest in his personal education. In 2012, I have attended 7 AGMs (including 1 as an observer) and 17 seminars/events. This has been remarkable for me given that I have started school in August 2012 and that there has been numerous instances where I have to pull out of seminar due to school commitment. I believed that I have down at least 30 investment books in the year, including 6 books from the fisher investment series. Some of the more memorable books include Ken Fisher's Super Stocks, Pat Dorsey's The Five Rules for Successful Stock Investing, Bruce Greenwald's Value Investing: From Graham to Buffett and Beyond as well as local writers Dr Michael Leong's Your First Million - Making it in Stocks and Bobby Jayaraman's Building Wealth Through REITs. These are very insightful and offer varying perspectives to the game of investment.

I believed that I have grown quite significantly in terms of emotional stability and principles where it comes to investment. Not only am I now immune to the day-to-day and intraday changes in prices, I have now look towards 3 years as an appropriate investment horizon. Boustead Singapore and The Hour Glass are 2 such companies which I have convinced myself to give them 3 years to grow. Even in the daily life decision, I always remind myself to look at the long term and not the short term.

Going forward, I will strive to make further progress on knowledge and skills. Knowledge will be to understand and gain more breadth and depth of industry. Attending AGM and seminars have been extremely helpful in this aspect. The more one gain the faster it is as one will realise how cross-industries knowledge can come in handy for companies in other industry. Skill will be on valuation as well as on financial statement analysis. While I was lucky to have been barely scarred by S-Chip, Olam has reminded us once again that any company can turn out to fraudulent regardless of their backing. Due diligence is of even higher importance for a highly concentrated portfolio like mine. Hence, I will hope to brush up on my skill on spotting financial shenanigans. Of course, I am highly confident of companies in my current portfolio as they are excellent business with strong cash balance and strong free cash flow generation.

As for the blog, post will be more sporadic as I have to juggle my studies, my investment and the blog. While the post might be less frequent, the quality will still be kept at a high standard. If there is nothing worthwhile to write, I will rather not write anything. Just like if there is nothing worth investing, I will rather not invest in any company.

2012 has been an awesome year and I hope 2013 will be another spectacular year not only in investment return but my growth as an investor. In addition, I will like to thank all my readers for allowing me to hit above 84000 visits in a year which equates to 230 visits a day.

Wish everybody the best regardless whether STI will move up or down :)

Sales of SIA Engineering

SIA Engineering purchased at average price of $3.562 and sold at average price of $4.107 with total dividend received of $0.10 in early November 2012. Total gain is 18.1% in a timespan of 10 months.

Before we review the rationale for sale, it is important to look at the rationale of purchase. At that point in time (Dec 2011), it was 3 months into my investing journey and I had given up on speculation. At that time, SIA EC drops to $3.55 and it looks like one of the blue chips that I can rely on after drifting into the red. MRO is a growing business and SIA EC has quite a strong market share in MRO and line maintenance with its link to SIA. Both segment of the businesses are pretty resilient given the regulation in place for checks to be conducted. It has a very clean balance sheet and shows a respectable ROE. Strong free cash flow yield and dividend from associate results in a close to 6% dividend. In other words, safety was my key concern then.

Rationale for Sale

And in 2012, we witness a mild bull run among all the dividend stocks, be it in REITs or in the high-dividend paying blue chips. This yield compression is as a result of the uncertain gloomy economics condition, continued monetary easing and the low interest rate circumstances which investors are stuck in with no other place to go. Will interest rate continue to stay low forever? Perhaps for the next 2-3 years until US's unemployment rate falls below 6.5%. In any case, there seemed to be a limit to further yield compression though Mr Market can be really unpredictable at times. Hence, the upside seemed limited on the assumption of the same dividend paid.

While all along I have known the importance of the JVs and associates to SIA EC, it was only after attending  the AGM that I realised the amount of cannibalisation going on during the past decade and that 3 particular associates account for a highly significant proportion of the results from associates and JV. And the problem is that I am unable to fully understand ESA and SAESL though their profitability seemed to be amazing. I hate it when I cannot get a good grasp of all there's to know about the company especially when these are significant contributors to the bottom line.

As for its growth potential, there's seemed to be some factors that might slow the growth. Slow is the word and not no growth. Firstly, almost all of its associates and JV's revenues are earned in USD. And as everybody knows, the USD has been depreciating against the Sing dollars and over the decade this has greatly reduced the absolute Sing dollar growth from its associate. If they reinvest all their profits, then this exchange rate problem will be just a mere accounting problem. However, since it is so highly reliant on its associate and JV to fund its dividend, those USD will have to be converted to SGD and hence growth will continue to be impacted by the movement in exchange rate. Margin will be impacted as labour cost is paid in SGD. For as long as USA still prefers to print money to resolve its debt and economic problem, USD will continue to weaken.

Another factor will be that new aircraft has much lower maintenance cost as compared to other aircraft. For e.g. Boeing 787 Dreamliner will only need to undergo a D check after 12 years as compared to the traditional 4-5 years for normal aircraft. In all, Boeing claims that it will reduce the maintenance cost by 30%. It seemed to be a trend that newer aircraft requires much lesser maintenance as compared to the previous generation.

Fundamentally, the overall growth of the MRO sector seemed intact but I believe that the 2 factors mentioned above will be a drag on its growth. And on a portfolio basis, as the STI continues to rise, it seemed like holding on to the cash option sounds much more attractive. As I have advanced in my investment journey, small cap and mid cap will be preferred over the blue chip unless great opportunities arrive. I believed that more opportunities will exist in the small cap and mid cap space where they are less covered and attract less attention from the institutional investor.

Genting Singapore - Part 2

For this part, we shall have a look at the business of Genting Singapore. As everybody knows, the key attraction of Genting Singapore is that it is one of the only 2 IR operators in Singapore and many believe that casino and duopoly equate to a highly profitable business as seen from the prosperous Macau.

Understanding the business model of a casino

More than 80% of Genting Singapore's revenue come from its gaming revenue while the other 20% comes from hotel, USS and Marine Life Park. Hence, gaming is at the core of Genting Singapore and will be the focus of the post today. To operate a casino, one needs a license from the government and in the case of Singapore, the area of casino is capped at 15,000 sqm. Thus, within this limited 15,000 sqm area, a casino will have to optimize its area by placing the table and machine at the appropriate place to maximize its revenue per sqm. Next, for each table it has to maximize the turnover by having as much game played as possible. Finally, odds are calculated in such a way that the casino operator will always have an edge over the gambler. Win rate for the casino operator is often much lower at 1-8% as compared to much higher rate than Toto, 4D or lottery operator. Hence, volume is much more important for casino and the higher the volume, the higher their profit and the more likely the win rate tends to their edge due to the law of large numbers. Another reason why volume is important is that casino requires huge initial capital expenditure and outlay as seen from Genting's balance sheet where PPE accounts for 55% of their asset.  There's also high fixed cost in the number of dealers, tables and cards which need to be paid for regardless whether there's only 1 gambler at the table or there're 10.

Industry Outlook

It is indeed true that the casino operators in Singapore enjoy a very healthy duopoly market structure which should theoretically bestow upon them high profit margin and ROE. However, many have not realized that for the casino in Singapore to prosper, they will need to rely much more on foreigner rather than the locals. Singapore certainly has a much lower population compared to other countries in the region which means that to generate higher volume of gamblers, Singapore will need to continue to attract tourist and foreigners to come to Singapore to gamble. What this means is while we can safely say that it is a duopoly in terms of capturing the local market, it seemed to be a regional competition for foreign gamblers that is much more important.

However, as a results of its initial success for its 2 IRs, there are now increasing competition in the region as we see numerous countries in the region opening new casinos from 2012 -2015. Vietnam, Philippines and Cambodia will be opening new casinos in 2012 and 2013. Russia and South Korea will also be building new casinos to attract the tourist while Taiwan has already legalized casinos. Both Japan and Thailand are also debating on the issue of legalization of casinos. As such, it seemed like competition is fierce within the region with better and newer casinos built over the next few years.

Given these various forms of competition, it seemed like Macau is still going to be the most thriving gaming countries in Asia. More casinos are going to open in the Cotai Strip and Macau easily outclassed the 2nd largest casino market, Las vegas, by 2-3x more in revenue. Despite supposed slowdown in China in lieu of the changeover of leadership, Macau is still expected to grow by 10-15% this year as compared to 5% for Singapore according to S&P. In the next 5 years, Macau's gaming industry is expected to grow by 15% as compared to 5-8% for Singapore. So what exactly is the secret to Macau's success that is hard for Singapore's 2 IRs to replicate? What is the reason to Macau's average ROA of 20% and ROE of 60% as compared to Genting Singapore's 10-15%.

The business model of Macau's casino

Essentially, Macau's casino runs on a junket model where the junket accounts for 75% of their revenue. Junkets are middleman who will bring in the high net worth individual (HNWI) to the casino and will take in a portion of the HNWI's total chips played. The casinos will also offer rebates and free chips to HNWI to attract these big whales to play in the casino. Hence, in such a model, the profit margin for the casino operators will be much lower. However, they will be able to attract the volume which is essential for the casino as the fixed cost of a casino is high.

In fact, junket has been the critical factor for the success of Macau's gambling industry that other countries are unable to replicate. These junkets are like the private bankers that establish the relationship with important clients and bring in the revenue. Many of the HNWI from China will prefer to go in a group lead by junket as they enjoys special rebate and networking opportunity. Coupled with its close proximity to China, Macau is the natural destination for the wealthy Chinese which takes on a more active attitude towards gambling as compared to the Westerner.

However, in the case of Singapore, the government does not allow and is very cautious of junket operation. Even for the 2 operators allowed for Genting Singapore, they are called as International Market Agent and they are very small players based in Malaysia and not Macau or Hong Kong. This is bad for RWS and MBS as the mass market often stagnate within 2-3 years and it is the junket that is needed to drive VIP's volume growth.

High DSO and impairment loss of receivables

In part 1, I have discussed about the high DSO of 5 months for Genting Singapore and the frequent impairment loss on receivables of 17% for Genting Singapore.This is in fact linked to the lack of junket operation in Singapore. In Macau, not only does the junket brings in the HNWI, they are also responsible for the collection of the debt. As such, Macau has very low receivables on its balance sheet and is able to enjoy higher ROA and better working capital management. Debts are often a problematic issue for VIP customers for casino as they are also afraid that being too aggressive in collection of debt will deter the clients from visiting their casinos again.

For Singapore, due to the lack of junket operation, the 2 operators have been slack on their credit policies in a bid to attract the VIP customers. They allow them higher credit, longer term of collection and these results in the high receivables amount as seen on its balance sheet. If we were to take into account that the mass market often produces no receivables as no credit is to be issued to them, the actual DSO from the VIP business is much higher. As seen, the implication of junket is not just a higher revenue but a better working capital management as well as higher quality of earning.

Given the huge differences in growth potential, ROE, DSO, it seemed like the 2 casino operators pale in comparison to the many Macau's casinos listed on the Hong Kong exchange who are also able to offer much higher dividend yield as compared to Singapore. Unless the government approves the junket operation in Singapore (which is very unlikely), it seemed like Genting Singapore is going to face a stagnant market where growth will at best be single digits and the fact that 16% of its receivables have to be impaired annually.

Genting Singapore - Part 1 (Financial Statement Analysis)

This is likely to be one of the last New company that I will do an analysis on for the next 2-3 months as I intend to focus on my studies which has been a bit overloading at times. Nonetheless, I do hope to be able to resume research on new company when holiday is here. I will still continue coverage on VICOM and Silverlake Axis whenever possible.

This will be a 2-part analysis and as always I will start off with financial statement analysis. Genting Singapore operates one of two casinos in Singapore, owning 6 hotels with 1800 rooms as well as 2 key attractions of USS and Marine Life Park. While price might have fallen quite a bit from its peak, it may still have been overvalued at its current price. For the past few years, investors have been pricing in high teen growth rate for this company that seemed to have a long way to go. However, it seemed like RWS might have reached a stagnant market already.

Figure 1 - Income Statement

For the 1st half of 2012, Genting Singapore reported decline in gaming revenue of 19% and 4% for the first 2 quarter which seemed to imply that they have been affected by the decline in macroeconomic condition. Total revenue dropped by 14.2% and 2.9% in Q1 and Q2 2012 as 80% of Genting's revenue comes from gaming. And the decline was as a result of lower rolling chip volume and not lower hold rate (luck factor of casino). In Q2 2012, VIP rolling volume dropped by 14% and Mass volume contracted by 4% in spite of a slightly higher win rate of 3.1% than the theoretical win rate.

There has also been decline in the profit margin which the management has attributed to pre-opening expense of Marine Life Park. However, pre-opening expense increase is very insignificant and the fact is simply a lower gaming revenue. Despite 2 of its hotels, Equarius and Beach Villas, being opened in Feb 2012 which results in 8% increase in room inventory, non-gaming revenue only rises by 1%. RWS also recorded higher average room rent of $432 and occupancy rate of 92% as well as higher visitation rate. These did not lead to    significant increase in non-gaming revenue which could imply the use of its non-gaming asset as complementary to attract the VIP players. If this trend continues, then we should not expect much from the non-gaming revenue as well.

 Figure 2 - Balance Sheet

For the balance sheet, the right column of 2012 Q1 and Q2 is where I transferred the $2.3 billion worth of perpetual securities to the long-term debt. While it is being accounted as equity, it is clearly a form of debt of which the company will have to pay $118 million in interest tax per year, representing 9.6% of FY 11 net profit. While the company has the right not to pay out interest, it is cumulative and will hurt the company's reputation. Of course, debt level is still manageable as it can be cleared by Genting with 3-5 years of profits.

In any case, the company has not proven its need to raise cash through perpetual securities though the cost of debt is lower than its ROA of ~8%. Instead, "the Group invested in a portfolio of quoted securities, unquoted equity investment and compounded financial instruments amounting to S$1,148.9 million" in Q2 2012. This amounts to 9% of its total asset and yet there is a lack of transparency as to what sort of equity investment and financial instrument did Genting Singapore decide to play with. In any case, equity investment is definitely not a core competency of Genting Singapore.

Figure 3 - Receivables

Figure 4 - DSO Not Accounting the Mass Market Revenue

Figure 3 is something that I don't find very comfortable with, which is that Days' Sale Outstanding of Genting Singapore is as high as around 3 months and have been rising ever since RWS commenced operation in 2010. And if we take into account the fact that casino is not supposed to grant any Singaporeans and PRs credit unless they are Premium Player (deposited $100k as credit balance), the actual DSO is much higher as seen in Figure 4.  In fact, it has gone up as high as 150 days in 2012 1H which is equals to 5 months of receivables. This is just the tip of the iceberg...

Figure 5 - Impairment Loss of Receivables

In actual fact, Genting Singapore has been taking significant amount of impairment loss ever since RWS started. It has ranged at an average of 17% of total receivables and 4% of total revenue which is not a small amount. This figure is not shown explicitly in the Income Statement as it is hidden in the "PROFIT/ (LOSS) BEFORE TAXATION – CONTINUING OPERATIONS" under rows of figures. Alternatively, it can also be found in the cash flow statement. Performing impairment losses every quarter is something that's worth noting about and I will elaborate on the reasons for the receivables in Part 2.

Figure 6 - Profitability Ratio

Figure 7 - Profitability Ratio of Macau Peers

I have always thought that being one of two casinos in Singapore should have made it very profitable, but it seemed otherwise with its average ROA of 7-8%, ROE of 12-13% and ROIC of 12-13%. While some might have thought that the $2.3 billion perpetual securities have dragged the profitability, ROA and ROE are at 7% and 12% after taking away the perpetual securities. Such profitability ratio seemed to imply an average company and not one with sustainable competitive advantage.

Now, compare to Macau Peers with an average ROA of 20% and ROE of 60%, it seemed like RWS really pale in comparison especially as an Integrated Resort company operating in a duopoly structure. Given that Genting Singapore has a high profit margin of 23% to 31%, it means that its asset turnover ratio is very low. Not forgetting that Macau's casino are subjected to a 40% tax on gross gaming revenue as compared to 12% in Singapore. Looking back at Figure 2, PPE accounted for 45% of total asset, which means that volume is much more important than profit margin in order to drive operating leverage. Macau's peers does have a lower  profit margin, but they are able to make it up with high asset turnover. This will be explained in Part 2.

Figure 6 - Cash Flow Statement

Figure 7 - Cash Flow Analysis

Free cash flow has been unstable as the company is still at an investment phase as the West Zone and Marine Life Park is not yet opened. Until the investment phase is over, we will not be able to see a clear picture of the maintenance capex and derive a stable state FCF.  However, as a guide, PPE as a percentage of revenue has been around 20-40% of revenue during this phase and I expect the maintenance figure to be around 5% -8% of total revenue when it is done with the initial investment.

In conclusion, we can see from its financial statement that it is certainly not a company with a very strong business model. In that case, it seemed to have been overpriced at PER of 16x and 18X based on FY 11 results and forecast FY 12 result. Part 2 will be on the industry and Genting's business model. 

VICOM - 2012 1H Update

With the release of 2012 1H results, VICOM has hit an all-time high of $4.70 after PAT increased by 10.7% in 2012 1H.

Figure 1 - Income Statement

The 1st quarter has been the most spectacular with profit growing by 13.2%. Comparatively, Q2 2012 has not been as fantastic, delivering a 8.1% growth on profit after taxation. Revenue for both period grows at an average of 7.9%. Unfortunately, VICOM no longer discloses the segmental result after the change of CEO. Personally, I believe that both segments should be delivering similar growth at 7-8% and not that one particular segment has been driving the growth. 

Back to operating expense, total operating expense increases by 8.6% in 2Q 2012 and 3.1% in 1Q 2012. Staff cost increases by only 0.4% in 1Q 2012 due to write-back of provisional bonus while in 2Q2012 it is in line with total revenue growth. Depreciation expenses increase as a result of higher depreciation coming from the new building at teban garden. All other operating expenses continue to increase above the increase in revenue which makes me wonder if cost-saving is indeed achieved from shifting the HQ to teban garden.

With the help of lower taxation in 2Q 2012, VICOM managed to achieve a 8.1% growth in profit. Lower taxation comes from "enhanced capital allowances on qualifying expenditure under the Productivity and Innovation". http://iras.gov.sg/irasHome/page04.aspx?id=13838

Figure 2 - Balance Sheet

After the distribution of $9.4m in final dividend, cash and bank balances manage to increase by $600k despite a $3.5m reduction in trade and other payables. Nothing else worth mentioning about the balance sheet other than that compared to FY2011, vehicles, premises and equipment decreases from $55.5m to $54.7m which shows that depreciation is more than total capital expenditure.

For cash flow statement, VICOM generated 81% operating cash on net profit after taxation. It is supposed to be higher as trade receivables increased by $1m and trade payables decreased by $3.5m. Total capital expenditure is only $1.9m for 1H 2012 which is about 15% of net profit. Personally, I do expect a 100% and above FCF/Net Profit Yield for FY 2012. As capex has been significantly reduced with the completion of new HQ at SETSCO, the interim dividend declared increases from 6.9 cents to 7.5 cents. This is still a very comfortable payout ratio for VICOM and there's certainly room for another 10-20% more. Total dividend paid for the interim will be $6.6m which is approximately net profit for a single quarter.

Prospect

Just last month, Minister Lui has announced a few measures to ease the spike in prices of COE which are marginally beneficial to VICOM. Initially, car population growth rate is supposed to be cut from the current 1.5% to 0.5% by August this year and continued until 2014 where the growth rate will be subjected to change. The authority has since delayed the cut to 0.5% to February 2013 while maintaining a 1% growth rate from August 2012. According to LTA, an additional 390 COE will be made available per month which works out to an extra 2340 vehicles in total.

The clawback of oversupply of COEs will also be delayed by a year to July 2013, making available 266 more COE per month, which is 3192 in total. In another move, LTA has set the taxi fleet growth rate at 2% pa from Aug 2012 to December 2013 and they will not be bidding for COE. While the 2% growth rate will come at the expense of Cat E COE, a taxi contributes 7x the revenue of a civilian car in a 3 years period.

These measures are temporary moves that will only defer the cut so as to alleviate the spiking COE prices which played an important role in our CPI. Most importantly, they signal the will of the government to resolve the problem of overcrowding vehicle population.

Figure 3 - Age Distribution Data

The age distribution data has been one of the most important data that I monitored monthly from the LTA site as it determines the proportion of the population undergoing inspection. The continued ageing profile of vehicle population has continued to amaze me. As seen from Figure 3, the proportion of vehicle aged 6 years and above has increased by 9.7% in July 2012 as compared to December 2011. When this ageing will start to peak is beyond my ability though I do expect the trend to continue at least until the end of this year. For as long as the price of COE remains at the current level, I do not foresee any significant reversal in the age profile.

As for SETSCO, I am not aware of any new service that they have been accredited in FY 2012. As for inspection of central alarm monitoring station (CAMS), they are currently still the only one with the appropriate accreditation.

Should the earning growth continues, we should expect a minimum of 8-10% profit growth in FY 2012. Assuming a 10% growth, total dividend to be paid out for FY 2012 will be $0.194 based on similar payout ratio of 60%. At the current price of $4.56, it will give us a 4.25% dividend yield, PER of 15.4x or Forward PER of 14.3. Many will definitely ask me whether it is the right price to buy or not and my answer will be that the margin of safety at the current price will be limited. However, I will still be holding on to my shareholding as I believe that the growth story of VICOM is not yet over and will be able to prove its resilience during this period of economic uncertainty.

Healthway Medical Corp Ltd - Turnaround probably not in the short term

Healthway Medical Corp is one of the few companies in the healthcare sector listed on the SGX, operating the biggest clinic network in Singapore. Other than operating GP clinics and dental services, they are also involved in specialist & wellness healthcare division which is involved in Paediatrics, Orthopaedics and Aesthetic Medicine.

Figure 1 - Income Statement

FYI, 2005 to 2007 results are PRO FORMA results found from the IPO prospectus and hence might differ from the actual figure that you see from the FY 2008 annual report. In fact, the pro forma result in 2007 is the highest level of profit that the group has ever recorded in its operating history. The trouble in Healthway occured in 2010 when a group of specialists decided to leave en mass which created a vacuum and losses of customers. What happened is the start of a drop in profitability which accumulated till 2011 where a $58m of intangible asset is being written off. In 2010, they should have also been in the red if not for gain from acquisition of Crane Medical and disposal of Healthway Medical Enterprises. 

2012 1H looks like a pretty good set of result that shows some turnaround occurring with Healthway recording a 10% margin for 2 straight quarters. The question is then has it really turned around? In actual fact, it seemed like the company has largely relied on its other income to boost its profitability. Looking back into the annual report 2011, the company has deferred booking $7.1m in income due to prudent reason of which it has booked approximately $1.6m in 2012 Q2 and perhaps another $1.2m in 2012 Q1 under other income. For more details regarding the deferred income, please refer to http://info.sgx.com/webcoranncatth.nsf/VwAttachments/Att_6AF4D9F6C8EC525F482579E10075BE16/$file/HMCMaterialVariances.pdf?openelement
Now, I shall present the pro forma income statement for 2012 Q1 and Q2 after stripping out these deferred income from 2011.

Figure 2 - Pro Forma Income Statement for 2012 1H

What we see is that nothing much has changed for 2012 1H after taking away the deferred income from 2011, and the company is obviously still struggling to maintain its profitability. Since these deferred income is non-recurrent in nature, it seemed like the company is still stuck in the limbo.

Figure 3 - Operating expense ratio

Figure 3 will allow us to understand the loss in profitability of the company since 2010. From figure 3, we can easily see that the main cause of the losses has been staff cost which has risen from around 44% in 2008 and 2009 to approximately 56% of revenue ever since 2010. In 2012 Q1 and Q2, this has also been held true which goes to show that the level of profitability is similar to that in 2010 and 2011. Do take note that actual percentage for 2011 should also be around 55% as the company chose to "derecognised staff cost recharges of $4.5 million to a 3rd party which remained unpaid" (part of the $7.1 million in deferred income).

However, it is not all bleak from the above figure. The cost of medical supplies and other operating expense as a percentage of revenue have held pretty steady which means that the company has been able to pass on increase in medicine cost and rental to its customers. Another positive point to note lies in its staff cost which in fact provide huge potential for operating leverage given that this is largely a fix cost. If Healthway can focus on increasing its revenue per clinic per doctor, it will definitely be able to return to its profitability in 2009. However, it seemed like the company's main focus is still on further expanding their services be it in specialist, aesthetic or in China.

Figure 4 - Balance Sheet

This is definitely not the ideal balance sheet that any company should have and the biggest problem will be in the intangible asset which stands at $119m compared to $198m in total asset and $160m in total equity. I will discuss about the intangible asset later on. The new management has done a pretty good job in reducing the total debt from a high of $68m in 2008 to the current debt level of $17m. Cash has unfortunately dwindled down to a worryingly level of $5m which raise the prospect of some form of financing option in the short term. However, the group has a loan receivables of $15m which are supposed to be returned to them in the current financial year and this will hopefully strengthen their balance sheet.  

Intangible Asset

Let's explore the intangible asset which is worth $179m at its high in 2007. When company A uses $10m to acquire company B with net tangible asset of $5m, the excess $5m over the NTA will be booked under intangible asset. Therefore, we have to trace back the history of HMC to understand how did such a huge amount of intangible asset appears in the first place.

Founded by Dr Wong Weng Hong in 1990, HMG expanded its network of clinic to 15 by 1997 and 31 in 2002 before it went on to acquire 4 clinics under "Singapore Family Clinic and Surgery". A management buyout was carried out in 2006 by the founder together with Fan Kow Hin, Dr Jong Hee Sen and a few other investors. By the end of 2006, the group only has a total of 38 clinics, which paled far in comparison to the 80+ they had by the time they were listed in 2008. In the mere span of 1 year, the group went on a massive acquisition spree paying $72.32 million for "Silver Cross" and "Peace" group of family clinic, "Aaron" and "Universal" groups of dental clinics, "Paediatric Centre", "BCNG Laser and Medical Aesthetics". They also went into agreement to acquire IOC, IOCH, SBCC Clinic and SBCC S&T for $107.9m. Therefore, by spending $180m the group managed to expand from a sole family medicine clinic chain into specialist and wellness healthcare services before they got themselves listed on the exchange. Given that they do not have that much cash at that point in time, the acquisition was done through offering of share which lead to its specialist leaving en mass in 2010.

Figure 5 - Intangible Asset

Figure 5 shows us the breakdown of intangible asset as well as the impairment loss carried out in 2011. We can see that the bulk of the write down are for Paediatrics and Orthopaedics which falls under the specialist segment. Family medicine is probably their strongest division as no write-down has been carried out so far. It seemed like it has been a huge mistake for the firm to acquire IOCC, Paediatrics Centre and SBCC in 2007.  

The greater concern currently will then be is the write-down in 2011 the last of impairment loss? Unfortunately, what I see is that another $60m in intangible asset needs to be written down. The calculation of impairment is based on DCF calculation using a discount rate of 8.5% and projecting a terminal value based on the EBIT "from the 6th year at annual growth rate of 1% to 3% to perpetuity." This is definitely acceptable to me. The devil is in the detail where the cash flow growth is projected for the first 5 years. For Family Medicine, Dentistry and Wellness and aesthetics, expected annual revenue growth is approximately 4% from 2012 to 2016.

However, for the Paediatrics and Orthopaedics division, the anticipated annual revenue growth is 9% from 2012 to 2016! Remember that these 2 divisions were the ones that have to be written off in 2011, then why does it have so much higher projected revenue growth than the family medicine? Specialist and Wellness segment produced a loss of $3.7m on revenue of $25.6m before the impairment loss. What's more, the anticipated annual revenue growth in FY 2010 for  Paediatrics and Orthopaedics was at 4% and after 1 year of poor performance, they are now expected to deliver double the revenue growth in FY 2011. I believe that the increase in anticipated annual revenue growth from 4% to 9% is done so as to reduce the amount of impairment loss being recognised in 2011 for both Paediatrics and Orthopaedics division. In any case, I believe that it is pretty reasonable to expect a complete write-off of total intangible asset of $59.5 m for these 2 particular divisions. Garbage In, Garbage Out, but not unexpected from a firm that seemed to love performing financial engineering since they are listed.

Figure 6 - Profitability Ratio

Many might have pointed out that its ROA even in its most profitable year is unimpressive at 7.7% based on the Pro Forma statement. However, if we were to strip out the intangible asset, it seemed like we have a highly profitable business at least before what happened in 2010. As for free cash flow, it seemed like has the ability to generate good cashflow in the long run should profitability stay or improve. Total capex for 5 years are only at $8.5 million of which majority occurred in 2010 where multiple specialist clinics are opened especially the ones at Tripleone Somerset. 

From a valuation point of view, despite the fact that price has tumbled since IPO, the company does not look attractive. With a PSR of 2.0, even if the company manages to return to a 10% profit margin, it will be a PER of 20 which is just slightly lower than the well-run Raffles Medical Group which has a much better track record and balance sheet.

To conclude, an actual turnaround has not really occurred despite the return to profitability in 2012 1H. Discounting the deferred income from 2011, profitability probably remains the same as the past 2 years. For as long as the intangible asset stays in the balance sheet, I believe it will be a time bomb that will not be welcomed by investor. While it is reasonable to say that some gestation period is needed for new clinics to turn in profits, it seemed like there remains numerous loss-making clinics around.

Without doubt, things have definitely changed for the better with the new CEO, Mr Lam Pin Woon in Jan 2011 as we see debt being pared down and a much lower staff turnover rate. Discounting the intangible asset, it is likely that they do have a crown jewel in family medicine clinic and management of clinic and asset. However, it seemed like the company has yet to internalise the importance of focus in operation as they embark on their expansion plan in China and specialist division in Singapore at a point where their balance sheet is weak and certain operations are bleeding. Whether the strategy will work out remains to be seen though it is likely that any turnaround will be visible only in the middle to long term, especially when their clientèle base for specialist and wellness builds up.