Starting with Nam Cheong, I am a little amazed by how it can remain profitable despite being in a highly cyclical shipbuilding industry. Shipbuilding industry is closely linked to the economy as ships are usually in high demand when international trade volume is high. In recent years, the shipbuilding industry suffers from over-capacities and recession, causing the Baltic Dry Index to fall from a high of 11,793 in 2008 to 1341 currently. Over at the newspaper, what I read about shipping is that the overcapacity requires years to correct and it is turning out to be a subprime crisis of its own kind where the bank restricts financing and more ships get defaulted, pushing prices lower and lower. I have not dare to venture into this area as I don't even understand what freight rate is, but I am now more comfortable with it after spending days understanding it.
Business model and financial statement are often interlinked, both can often tell you a lot about the other. To understand how is it able to maintain its profit during tough time, we have to look at its business. Nam Cheong's core business is in building of OSV which stand for Offshore Support Vessels. While oil rig builders are often considered support services to the Oil Exploration and Production, OSV provides support services to oil rig in the form of a transportation for all the goods and equipment needed to build and maintain an oil rig. Therefore, actual demand for OSV depends on Oil Rig which depends on the Oil E&P, which means there will be a significant lag time behind a demand surge.
Looking at the above Income Statement, one thing that caught my attention is the low operating expense to total revenue ratio which stands at an average of 5-7%. Low operating expense ratio is critical for a company in a cyclical industry as sharp drop in revenue is often a norm and operating expense is not something that can be cut as easily as cost of goods sold. And the reason behind this low operating expense lies in its asset light model where it only operates on a 12/6 hectares of land in Sarawak. This yard has a annual capacity of 12 ships and they only have 100 full-time employees at the shipyard as the rest are outsourced. The question will then be - how scalable will this business be?
The management has come up with a scalable model that allows them to scale up and down in both upturn and downturn. They have linked up with shipyard in Fujian where they will outsource production of ships when demand outstrip their capacity. Thus, the company has been operating on an asset light model where they will not face overcapacity and cost overrun during a recession. Till date, they have successfully delivered 70 ships outsourced from 5 yards in Fujian. Fujian is chosen as it used to be the hometown of their chairman. The most important aspect of this outsourcing model is not the ability to scale up but the ability to quickly scale down during a recession. This has also helped to reduce capital expenditure greatly and increases FCF yield.
Profit margin wise, they are better on average than their peers like STX OSV and Otto Marine by a number of percentage point. The reason for their higher profit margin lies not in their outsourcing model but in their "build-to-stock" business model. Normally, companies operate on a "build-to-order" or a "pull" inventory management system where they will produce when their inventory is running out soon or upon order. In the rare "build-to-stock" model, the company will manufacture the product in advance of order which makes it susceptible to the problem of overstocking.
In the case of Nam Cheong, they will build ships in advance of orders according to the demand they predicted for the year. This can work for the shipbuilding industry as a ship takes 18-24 months to be built which equates to a lead time between oil prices and actual deliveries. And the group has also realised that in 80% of the time, customer's orders are homogeneous. In mass producing in advance, the group also stands to benefit from economics of scale through saving engineering man hour.
Therefore, by building in advance, customers will be willing to pay more as they are able to have their ships delivered earlier and this reduces the customer risk that demand will fall by the time ship is delivered. This has been why they have managed a higher profit margin than peers, though the risk of overstocking is high as they are debt-financed. In such a case, the management's integrity and competence is of utmost importance.
In terms of barrier of entry, they has been well-supported by the protection coming from Malaysia's government as seen from the above. As such, Nam Cheong is rather well-shielded from competition from its foreign peers unless MNCs are willing to concede part of the shareholding. As a result of its build-to-stock model, it is able to provide "Letter of Authorization" for owner-charterer bidding for contract with Petronas. Under this system, Nam Cheong promises to deliver the ship for the contract bidder should he win the contract with Petronas which will enhance the contract bidder's chance of securing a contract. And the reason why this work for bidding with Petronas is that they have in 2008 announced that they "may award future long term charter contracts in Malaysia to OSVs built in Malaysia". As such, Nam Cheong has become the preferred OSV supplier within Malaysia's OSV operator. They are also going to benefit from Petronas's 5-years capex plan of RM300 billion which is 80% more than spending from 2006-2010.
Nam Cheong is the largest OSV builder in Malaysia and is the first in Malaysia to build the AHTS and DP2 OSV. As shown below, Nam Cheong is a clear market leader among the OSVs builder in Malaysia with a large portion of international clientèle base. Even in Asia, it is also one of the biggest OSVs builder in the region.
Competition and Market Share among the regional OSV shipbuilder
However, the net gearing on the balance sheet makes me feel uncomfortable about this company. With total borrowing of RM$320m, of which RM$300m is on short-term credit that is on demand (Overdraft, Revolving Credit), a mistake coupled with a financial crisis can easily cripple this company. Interest rate is also pretty high at a range of 4.5-7%. While the company has RM$20m in cash and RM$470m in Due from customers on contracts, if financing option is not available to their customers, neither will Nam Cheong be able to collect back the amount. The bulk (80%) of their RM$960m asset comes from customer contracts, inventories and receivables, which makes the balance sheet even weaker since these assets are susceptible to similar systematic risk.
Here's some critical questions that need to be answered regarding the company:
- With the build-to-stock system commanding higher profit margin, why is it not being copied by other builder?
- If ships can be completely outsourced for production to the Chinese shipyard, why can't non-Malaysian customers source directly from the Chinese at a cheaper price?
- In the case of a sudden downturn and there's surplus ships, is Nam Cheong able to convert them for chartering purpose? Will there be sufficient demand to take up the chartering?
- Other than the build-to-stock model, what else is stopping other Malaysian OSV shipbuilder from issuing a Letter of Authorization for contract bidding?
- Are they impacted by the recent announcement of minimum wage in Malaysia given that a huge portion of workers in their shipyard are contract workers?
- How can we be confident that the company will be able withstand a crisis just because they has ridden through the 2008 GFC unharmed?
In conclusion, Nam Cheong does has its various competitive advantage over its local rivals as a result of its build-to-stock model, technical competency, outsourcing model and Letter of Authorization. However, these advantages can turn out to be the pitfall of the company especially in this particular industry where overcapacity and its cyclical nature are unavoidable. The company will need to beef up its balance sheet for to reduce the risk of its build-to-stock model which required huge financing in advance. In all, this might be a multi-bagger worth catching during a downturn when they have proven to have the foresight to reduce its build-to-stock and debt in advance.