SATS

SATS, Singapore Airport Terminal Service, "is the leading provider of gateway services and food solutions in the region". As stated by the description, SATS's 2 core businesses are in the Gateway and Food industry contributing 31.9% and 67.5% respectively. As majority of the food solution are meant for air passenger, aviation accounted for 59.8% of total revenue which means it is highly correlated with the travel and tourism industry in Singapore.

Figure 1 - Segmental Revenue 

Figure 2 - 5-Years Result Summary

I have compiled the more important numbers in figure 2 and we can see that revenue has nearly doubled over the past 5 years. However, do take note that it has also been driven by acquisition of new business. They acquired SFI in 2009 which contributed 2 months of revenue worth $110m in 2009 before making a full contribution in 2010. In 2011, they acquired 50.7% of TFK which contributed $73m in revenue for 3 months. 

Despite the increase in revenue, it has been noticed that net profit attributable to shareholder has not increased much since 2008. If you take in account that there is a $17m in exceptional item in 2008, then we will have seen a 10% increase in profit over the years as compared to 75% increase in revenue,

Profit margin has dropped sharply since 2009 from a high of 20% to 9.1% currently as a  result of the acquisition of SFI. So is the acquisition of SFI a bad move given that profit margin drops by such a huge amount? Looking at SFI's profit margin before it is being acquired, it is at a figure of around 4-5%. However, this certainly does not imply that it is a bad acquisition. If you were to look at the ROA and ROE, you will have only noticed a slight dip which goes to show that SFI have a high turnover and hence ROE.

In fact, things will have been much better without the consolidation of TFK in 2011 which contributed $73 m in revenue but $74.2m in operating expense, implying an operating loss of $1.2m. Paying $122m for operating loss of $1.2m, it is again not necessarily a bad investment. TFK has been unduly affected by the disaster in March 2011 which resulted in 11 of its airline customers suspending or diverting flight as well as a disruption to raw materials supply. When TFK starts to turnaround, we are going to see significant improvement to the bottom line. In 2010, TFK recorded a revenue of $353m and $27m in EBITDA on total equity of around $180m. 

With regard to the cashflow statement, FCF/Net Profit is at an average of around 90% ranging from 70% to 105%. SATS is not as capital intensive as 60% of the PPE are in leasehold building and land. However, capex has increased rather significantly after the acquisition of SFI though it is still able to generate a pretty healthy FCF.

Figure 3 - Segmental Result

The segmental result shows that the Gateway services is much more profitable as compared to Food solution. Of course, we have to make some adjustment here as the share of profit from associated/ joint venture companies does not contribute to the revenue. ROA for Food Solution is around 7.4% and 10% for Gateway Services. It seemed like the company has been doing while with its investment in associate as we see a ROI of 20%. Gateway Services has a higher profitability as it is more of a service provider unlike the Food Solution where cost of food is involved. Should there be a rapid rise in food prices, expect profitability to be hit.

Competition

For its Gateway and Aviation food services in Singapore, SATS is the clear market leader with DNATA being the only competitor. DNATA is owned by Emirate (wholly owned by the Government of Dubai) which helps it to secure contract with Emirate and other airlines. For Gateway, operators need to secure a license from the Changi Airport Group which has currently issued 3 licenses. SATS has a market share of 74% in this area with DNATA having the other 26% of the pie. ASIG, the 3rd licensee, has not been able to secure any business after 1 year of securing the license. In 2004, Swissport got a license to operate but exited within 3.5 years with $15m losses. As such, SATS has a rather strong grip in its market share and is poised to benefit from growth in traffic of Changi Airport Group. One possible risk is that as it is no longer linked to SIA, its chance of losing SIA's contract is slightly higher now.

In terms of aviation food solution, SATS has a market share of 86% as compared to 14% for DNATA. In this area, SATS get to benefit from its economies of scale as it delivers up to 80,000 meals a day through its central kitchen. SIA requires an average of 30-45m meals a day which there is no one in the market with the equipment and expertise to deliver presently.

For its non-aviation related food solution in SFI, around 30% of the revenue comes from military cook-house contract. It is not a monopoly though as NTUC FoodFare is also involved in the catering of food. However, I am pretty sure it is a monopoly in terms of the outfield ration as I always see the same green pack and accessory pack when I went outfield. SFi is also involved in the food distribution business with brands like Farmpride and Singourmet.

SFI has an excellent segment in Abattoir operation as it is the only one in Singapore licensed to provide pig slaughtering services. To understand its profitability, look at similar business in Elite KSB's chicken slaughtering business. They also conduct the Hog Auction market which conducts daily auction of live pigs. As a result, the revenue is highly correlated with the number of pigs imported into Singapore. ROA for this segment is as high as 30% though it only accounts for 15-20% of SFI's net profit.

Cyclical or Recession Proof?

Figure 4 - Operating Statistics

Figure 5 - Passenger Traffic

As shown earlier in Figure 1 that 40% of revenue are non-aviation, this part is likely to be a recession-proof business since a huge portion are from 5-years military contract as well as abattoir operation. As for the other 60% of the revenue, we will need to take a look at figure 4 and figure 5.

Changi Airport Group has shown strong growth in passenger traffic over the past 6 years and has proven its resilience in 2009. Do note that International Visitor accounts for around 50-60% of the total traffic which means that Singaporean accounts for the other 40-50% of it. Theoretically, for every international visitor that arrive, they will also have to leave which means by doubling the international visitor figure you will get their contribution to passenger traffic. Local passenger traffic seemed rather stable with most of the growth coming from international visitor. This has spiked up since 2010 with Formula 1 and our 2 Integrated Resorts.

If we look at figure 4, we can see similar growth and stability in most of the operating metrics other than in Cargo & Mail Handled as well as Inflight Meals Produced which shows an estimated 10% decrease in FY 2010. This does prove that the business of SATS is fairly resilient in a recession. The drop in Inflight Meal though Flights handled increases seemed to imply that that it has undertaken more budget airline business. However, I believe a similar crisis like SARS will still be able to hurt its top and bottom line greatly.

Figure 6 - Share of Result of Associate

While SATS has performed rather well, its associate seemed to get hurt much more during a recession, dropping by nearly 60% in 2009 from its high in 2007. SGD 30 million will be equivalent to around 15% of its net profit. Do take into account that this will also be negatively affected if Sing dollar continues to strengthen.

Therefore, it is likely to be hit by the greatest extent from its associate companies in a recession. Other than a SARS-like event occurring, profit should drop by around 20% (5% from themselves and 15% from associate) during the downturn. With free cash flow/ net profit at a decent percentage, it will not be hard for SATS to maintain a 70% dividend payout ratio throughout the business cycle.

Berjaya Sports Toto Berhad and Sports Toto Malaysia Trust (Toto Business)

As the name of the company suggests, Berjaya Sports Toto's core business is in selling 4D and Toto just like the Singapore Pool. The only difference is that Berjaya does not do sports betting as it does not have the necessary license. Here's all the games available:
http://www.sportstoto.com.my/m_how/6_52.htm

The business is pretty straightforward and simple in that they basically collect bets to form a pool of money. For digit games, the prize money is fixed and you will be awarded if you win a 1st, 2nd, 3rd, consolation or special prize. For lotto, the jackpot involves a fixed guaranteed sum + a percentage of the total pool money. After deducting all the prize payout and expenses incurred, the remainder will be their share of profit.

As with all in the gaming industry, the hold percentage is one of the most important ratio to look at. This is basically the statistically calculated odds that the house is expected to win in the long run. If the 4D has a hold percentage of 60%, it means that in the long run, the house is going to win $60 for every $100 of bets collected. We shall now take a look at the hold percentage of the respective games owned by Berjaya Toto.

Figure 1 - Toto 4D

All the payout and hold ratio are calculated using the probability of striking multiplied by the amount paid out. For the sake of simplicity, I will not show the calculation here. For Toto 4D, you can choose to buy big or small at RM1 per bet. The difference is that in Small, you are entitled to a higher 1st, 2nd, 3rd prize in exchange for not being able to win the special and consolation prize. To summarize, the gross margin (revenue - total payout) for the Toto 4D is 36% and 35% for Big and Small respectively.

Figure 2 - 5D

Figure 3 - 6D

Toto 5D is an extended version of 4D where you will be playing with 5 digits instead of 4 digits. Similarly for 6D, it is 6 digits. In this case the gross margin for 5D and 6D are much higher as compared to 4D at 66.2% and 66.6% respectively.

 Figure 4 - 6/52 Jackpot

 Figure 5 - 6/55 Jackpot

Figure 6 - 6/58 Jackpot

Berjaya's lottery games comprise of 6/52, 6/55, 6/58 jackpot game where you choose 6 numbers out of 52,55 and 58 numbers in total. The jackpot is earned when the 6 numbers you have chosen matched the 6 winning numbers. Do take note that the minimum guaranteed amount and prize pool differs for all the 3 games. The gross margin for the 3 games are 55.92, 52.93 and 52.42% which is higher than 4D but slightly lower than 5D and 6D. The odd of striking Toto for the 6/52, 6/55 and 6/58 games are 1 in 20.35 million, 1 in 28.99 million and 1 in 80.95 million.

Out of the total revenue collected from the pool betting business, 75% are from 4D alone while the other 25% are from 5D, 6D and lotteries (6/52, 6/55, 6/58). 4D is the most popular game in both Singapore and Malaysia and it is a unique game that is hardly played elsewhere. While 4D has one of the lowest margin, it is good to have it as a large proportion of revenue as it helps to stabilise the profit margin. All gambling and casino games make their fortune on the basis of the "Law of Large Number" where given a large number of trials, the results will be very close to the expected probability. 4D is more popular than the other games because it boasts a higher chance of winning though the size of the win is much smaller as compared to Toto. The revenue collected is also more stable as gamblers usually buy the same set of numbers for every draw days for fear of losing the chance to win.

Lottery is more popular among the youngster who wants to be a overnight millionaire. However, as a result of the very low probability of striking Toto, profit margin can fluctuate as a result of lack of sufficiently large number. Revenue collected also tends to fluctuate more as a high accumulated amount of jackpot is required to attract more people to buy. If the Toto strikes more often, the accumulated Jackpot will be reduced and hence the buying interest reduced. Therefore, this is the portion of business where luck is very important. Like casino, while the VIP often brings with them huge amount of chips, they are also the one that tends to create a larger fluctuation in profit margin.

Toto and Gaming Industry in Malaysia

Malaysia (50% are Muslim) is a highly regulated and taxed gaming market as compared to the world due to the fact that Gharar is prohibited in the Muslim culture. Other than the operator's license, factors like the number of draw days, prize payout ratio, type of games allowed are all being tightly regulated. The operators need to seek permission to reduce payout ratio or to introduce new games. Taxes are high with the following charges: 8% pool betting duty on net gaming revenue, 8% gaming tax on gross gaming revenue, 25% casino tax, 10% NSC contribution on gaming pretax profit and 10% royalty on gaming pretax profit. In the case of Berjaya Toto, it needs to pay gaming tax, NSC contribution and pool betting duty on top of the corporate tax.

As it is a highly regulated industry, Berjaya Toto only has 2 other similar competitors in 4D - Magnum and Tanjong. Berjaya Toto is the market leader with the largest network of 680 outlets in Malaysia and an estimated market share of 40%. Currently, Berjaya Toto has a monopoly on the Toto segment of 6/52, 6/55 and 6/58 as well as 5D and 6D because the other 2 competitors do not have the lottery license. Basically, the government does not wish to grant too many license to avoid backlash from the Muslim community of encouraging Haram activities. This is also part of the reason why Berjaya has not been successful in vying for a sport betting license.

Other than the usual "luck" factor that will affect the total revenue and  another factor that can create some fluctuation will be the number of draw days allocated. Berjaya Toto conducts its draw 3 times a week on Wednesday, Saturday and Sunday. 365*7/3 will give us 156.429 days, which means total number of draw days a year is likely to be 156 or 157. This will have a marginal impact on the revenue. Each of the 3 NFOs are also allocated extra draw days called special draw. The number of special draw days differs from year to year according to the mood of the government and usually ranges from 5 to 12. In 2010, Berjaya Sports Toto was allocated with 20 days, but revenue does not actually increase. The reason is that instead of a special draw, all 3 NFOs are allocated common special draw day as compared to the exclusive specival draw days in the past which will generate higher revenue.

With regard to illegal betting, which is a common sign around the world, Berjaya Toto is not as impacted as compared to its competitor. The reason again lies in the type of games they have over their competitors. 4D, 5D are games that bookies can easily take the bets as the payout is not substantial to the extent that they will suffer a huge loss due to "luck". However, for games like Toto 6/52 and e.t.c, the payout is extremely high and one needs to reach a certain scale to be assured of profitability.

In conclusion, we can expect to see up to 10% fluctuation in revenue and profit depending on numerous factors including total prize payout (luck), number of draw days, size of jackpot as well as possible changes in taxation. Generally, revenue and profit will still be relatively stable as 75% of revenue comes from 4D which enjoys the law of large number theory to the largest extent. As compared to a casino business, capital outlay is also much lower. However, between Berjaya Sports Toto and Sports Toto Malaysia, it seemed like  Berjaya Sports Toto might be a better bet as it is selling off a mature business at a PE of 17. That aside, Berjaya Sports Toto will still control Philippines Gaming Management which is in the business of managing lotteries business and has a very high profit margin.

Berjaya Sports Toto Berhad and Sports Toto Malaysia Trust (Financial Statement)

Berjaya Sports Toto Bhd has proposed to spin off Sports Toto Malaysia (STM) into a Sports Toto Malaysia Business Trust. This has prompted me to look into BST and I will share my findings in a 2 parts analysis. This is my first time going into an analysis of foreign share and I have realised the additional difficulty of securing information. Under the deal, Berjaya Sports Toto will hold on to 79.5% of the shareholding of STM and they will get RM 670m in cash and RM 527.4m in promissory note. As always, we will start off with the financial statement analysis.

Figure 1 Income Statement

Looking at figure 1, we can see revenue increasing slowly over the year, peaking in 2009. Subsequently, revenue has dropped by 8.2% in 2010 before a 1.2% increase in 2011. The 2010 drop in revenue is as a result of lower 4D sales (due to a new 4D Jackpot by competitor) as well as lower jackpot which in turn attracted less buying interest. One reason for a lack of strong topline growth has been due to a maturing of market in Malaysia and that Number Forecast Operators (NFO) are not allowed to introduce new games and drawing days without seeking permission.

For profit wise, it seemed to have stayed range-bound from 2006 onwards. One point to note is that there is a write-back on over-provision of RM 50m in tax in 2006 which created a RM 50m boost in profit. The drop in profit in 2010 is in line with the drop in revenue in 2010. For 2011, profit margin has been affected as a result of a hike in pool betting duty from 6% to 8% for all Number Forecast Operator. 

The reason for fluctuating profit margin over the year is as a result of the "luck" factor often involved in gaming operation. A higher number of Jackpot and 1st prize paid out in lottery and 4D will affect the profit margin. This will be discussed in more depth in part 2. Profit margin has traditionally been 10-15% over the years. Do take note of the high corporate tax rate of 25% in Malaysia as the EBT has always been more than 15%.

Figure 2 Balance Sheet

For the Balance Sheet, there is a huge amount of cash and deposit of RM 450m and a RM600m intangible asset. The intangible asset is as a result of goodwill arising from consolidation dating way back before 1992. So long as Sports Toto remain profitable, a write-down on intangible asset is unlikely. For the liability, there will be a concern on the borrowing for the past few years as well as the RM 550m Medium Term Note in 2011. The MTN was taken up in 2011 with the main aim of refinancing its bank borrowing. The question will then be why should such a profitable company be having such borrowing in the first place?

Basically, Berjaya land owns 43.5% of Berjaya Toto and they require huge amount of capital to settle their loan as well as for their property development project. If you have noticed the yellow, blue and red highlight, they stand for share buyback, distribution of treasury share and capital reduction respectively. Not only has Berjaya engaged in share buyback activities and paying special dividend, they have also engaged in huge capital reduction activity. From 2005 to 2007, total equity goes down from RM 1.57 billion to RM 418m as a result of capital reduction and share buyback. With its high minimum dividend payout ratio, Berjaya will then go into some debt for working capital requirement. A year of EBIT can easily cover this seemingly huge amount of debt.

Figure 3 - Cash Flow Statement

The cash flow statement is unlike many other companies. The receipts from customers is actually around 8% higher than the revenue reported. This is as a result of a deduction of 8% gaming tax of total receipts from customer before it is reported as revenue. A huge amount of the cost is the prize payout as well as to supplier and other expenses. Another interesting statement is "Payments for pool betting duties, gaming tax and other government contributions" which is actually the sum of the Pool Betting Duties as well as Gaming Tax which will be explained in Part 2. They have managed to generate around 10-15% of cash from total receipt from customer.

Looking at acquisition of PPE, we can see that this is an asset light business as purchase of PPE is only around 5% of net cash generated from operation. Net cash used in investing activities hardly have a negative impact on cash flow other when they are acquiring additional interest in their subsidiary in 2009 and 2010. For financing activities, debt recycling can be seen from 2006 onwards with constant repayment and drawdown of borrowing. We can also see that dividend payout and capital distribution has been really good to shareholders.

Figure 4 - Key Performance Metrics

The operating profit margin of 15%-20% and net profit margin of 10%-15% have been discussed earlier on. The key reason for such profit margin has been due to prize payout ratio of around 60% as well as government taxes. Adding on all the taxes and dividing by total revenue, we can see that of every $100 earned in revenue, $20 will be paid out to the government in the form of taxes over the past 8 years.

Despite the average profit margin, the company has been enjoying a high ROA figures of more than 20% on average. Return on Equity has been inflated as a result of debt undertaken since 2006. This high ROA ratio arises from its high asset turnover as the business is essentially very scalable. The company FCF/ Net Profit yield has been really fantastic, maintaining at an average of 105% since 2007. The ratio for 2006 should also be more than 100% as a RM 50m over-provision for tax has been reversed but this does not represent any cash inflow.

Figure 5 - Historical Chart

From the historical chart, it seemed like shareholder does not have much capital gain to speak of if they have bought at the start of 2004. However, the company has actually rewarded their long term shareholder immensely as shown below.

Figure 6 - Return to Shareholder

With hindsight, if you have bought the shares in 2003, you will have been awarded with $2.70 of ordinary dividend, $1.35 of special dividend, $1.00 in Capital Distribution which sums up to be a total return of $5.05 over 10 years. On top of that, you will have been awarded with 1 more share for every 14 shares that you own and that the company has bought back approximately 8% of the total share. While the stock price has lingered over the years, long term shareholder of the company will have been very happy with their return. Fluctuating dividend comes not only from fluctuating profit but that the company does not have a fixed dividend payout ratio as the guidance is only a minimum of 75% payout ratio.

Regarding the spin off of Sports Toto Malaysia into a business trust in Singapore, it is likely to be yet another   move to reward their shareholder (Berjaya Land owns 43.5%). Should the proposed listing be completed, Berjaya Sports Toto will hold on to 79.5% of the total shareholding of Sports Toto Malaysia. They will be entitled to an annual ~RM 20m in trust manager fee as well as a total of RM 670m for divesting their remaining stake. Other than the entitlement, Berjaya Sports Toto will also enjoy a RM 527.4m worth of promissory note owned by Sports Toto Malaysia. After the spin off, the only remaining asset should be Philippine Gaming Management Corp which enjoys management fee for managing BPI which is a subsidiary owned by Berjaya Sports Toto and leases out on-line lottery equipment in Philippine.

To conclude, Berjaya Sports Toto will get a total of RM 1197.4m in cash and promissory note in return for divesting 20.5% of stake in a business that generates RM 345m in 2011 which work out to a PE of 17. While Sports Toto Berhad will not be a bad deal considering the estimated dividend yield of 5-6%, it is obvious that Berjaya Sports Toto will get the better deal at the end of the day. Part 2 will be on the business of Toto and lottery as well as the gaming industry in Malaysia.

Characteristics of stocks that I look for

One important lesson that many have learnt from the ongoing Euro Zone turmoil is the importance of owning high quality stocks in their portfolio at all time. Macroeconomics condition is ever-changing and no one has the ability to predict the future accurately. However, a good stock is one that will continue to prosper through the ebb and flow of the business cycle. This is not exactly what we called defensive stock, but these are companies that are able to survive a hit or two and yet able to grow fast during period of growth. The following are the characteristics that I always look for in my target:

Business
Recurring and Predictable Income
Favourable Long-term Business Economics
Sustainable Competitive Advantage

Accounting 
High ROA and ROE
Clean and Strong Balance Sheet
High FCF/Net Profit Yield
Dividend Yield

Recurring and Predictable Income - Recurring income exists in many forms, with some being more explicit than others. Things like licensing fee, rental income, regulation and toll road are pretty straightforward. For other less obvious form, this involves your bread which you eat for breakfast everyday, the printer cartridge you need or the cable TV subscription. It is always good that the business has some form of recurring income as this is the portion that will keep the business afloat during a recession or unforeseeable Black Swan. So long as the business does not make a net loss, shareholder's equity will continue to grow.

Favourable Long-term Business Environment - As with all stocks that we buy, we are expecting that the business and net profit will grow. Having favourable environment allows a company to grow its business much easier as compared to one that is going against it. For e.g. ageing population and healthcare tourism are inevitable trends that will benefit those in the healthcare sector. Growing population will favour those in the FMCG and transport sector(if they have sufficient capacity). Demographics is just one of the more obvious and inevitable trend out there in the world. Kodak, print media and non-smartphone are the few that are destined to collapse in the long term (definitely not immediate as they will just die a slow death).

Sustainable Competitive Advantage - This is a term that has been repeated throughout the book Buffettology and has been seen as a key criteria of Warren Buffett. Why is sustainable competitive advantage so important? A business with this characteristic is like a castle with a wide and deep moat to fend off competition. Any good business that can deliver high returns will always be assaulted from all direction as a result of capitalism. As in the classic bubble tea case, new competitors seeking lower return will just lower the return of the existing business. A moat is one that allows the company its high return over a long period of time, be it through market share, mind share, monopoly, or monopsony. Example of moats include network effect, government regulation, strong brand name, patent, high switching cost and lowest cost structure.

High ROA and ROE - I have always viewed Return on Asset and Equity as one of the most important financial ratio. ROE is basically dividing net profit by total shareholder equity, while ROA is changing the denominator with total asset. High ROE and ROA is highly favourable as a company with the higher ratio will be able to grow its equity faster assuming the same dividend payout ratio. To illustrate, company A has a ROE of 20% while company B has a ROE of 10%. Assuming they are not listed company, every $100 pump into company A will yield a return of $20 annually as compared to $10 for company B. As such, it is very logical why this is important.

One reason why ROA is also being used here is that ROE= ROA x equity multiplier ((Total Equity+ Total Liabilities)/ Total Equity ). Therefore, a company can easily boost its ROE by taking on extra debt. To illustrate once again, we have company A and B earning $100 in Net Profit with Total Asset of $1000. However, company A has equity of $1000 with $0 liability while company B has equity of $100 with $900 of debt. Both companies will have ROA of 10% but company B will have a ROE of 100% as compared to 10% for company A. Company B will be an obvious choice if we were to choose solely based on ROE. However, does not it make sense that company A should be worth more than company B given that the only difference they have is that company B has extra $900 in debt? Though there is an exception to this which is when the liabilities are interest-free non-debt that are offered to the company.

Clean and Strong Balance Sheet - A balance sheet of this kind is one where there is very little debt, especially those bank loans. Debt can be a useful leverage for company seeking to expand their business beyond the ability of their equity. However, the problem comes where too much debt is undertaken beyond the company's ability to service them in the worst case scenario, typically a recession. A company with strong cash buffer and no debt can easily remain a going concern even if it were to face perhaps 5 consecutive years of losses.

High FCF/Net Profit Yield - Free cash flow is basically the amount of cash a company get after deducting all working capital needs as well as capital expenditure. It is a important factor to look out for as cash and not profit is what that keeps a company going. FCF represents the amount of cash a company has to invest, payout as dividend, pay debt or to add on to its cash holding after it has used up whatever is necessary to keep the business ongoing. FCF/Net Profit represents the amount of FCF that a company can generate from its net profit. These are often idle cash that can be used to grow the company or the shareholder's wealth. A company with very low FCF/Net Profit will find it hard to invest or to payout dividend

Dividend Yield - this is basically the amount of cash that the company returns to shareholder annually as a percentage of the price the stock is purchased. While I am not always looking for very high dividend yield of more than 6%, I find it more comfortable to purchase stocks that offer a decent dividend yield of around 4-5%. I viewed dividend as a form of margin of safety should the business not grow in the way that I have thought it will be. Dividend also provides important cash flow for your personal finance especially since undervalued stocks can usually stay undervalued for long. One reason why I am not preferring a company with dividend yield of more than 6% is that such company will not be able to grow their business much as equity injection is lower. However, there's company that recognises that they will not be able to grow their business much and choose a close to 100% dividend payout. These will be the kind of stocks that you should be going for if the main goal of your portfolio is to earn steady dividend.

One last part to add, many of these factors are in fact inter-linked together. A company with sustainable competitive advantage will in most cases has high ROE figures. High ROE can be sustained easier by a company with a high dividend payout ratio. FCF/Net Profit Yield will determine the dividend payout ratio that shareholders get. A company with strong business model can afford to take on a more debt-fuelled balance sheet, though in most cases the company will have a clean balance sheet as its high ROE is sufficient to grow the business. With a recurring and predictable revenue base, a company will also be more willing to pay higher dividend to its shareholders. Therefore, when you find a company that shows a few of these symptoms, it is good to dig out more about it as you will be likely in for pleasant surprise.

AmFraser Day - Nam Cheong, OSIM and MIIF

Nam Cheong

• At the peak of the oil prices, many OSV builders built the more sophisticated deep water OSVs. However, Nam Cheong's focus is more on the shallow water OSV which are continuously needed for production. Production for the shallow water will normally continue until oil prices really hit to the low of USD 30 per barrel.
• Nam Cheong's built-to-stock model takes around 21-24 months to complete building the ships.
• The China's shipbuilder that Nam Cheong outsourced to are state-owned enterprise and are what that has been recommended by the officials there. Their chairman has a close relationship with the officials since the 1980s.
• Some of their major clients and number of ships ordered include Bumi Armada Berhad (13), Perdana Petroleum Berhad (8), Vroon B.V (7), Topaz Energy (6) and Tidewater (3). 
• Under the Petronas's bidding system, bidders are split into 2 tiers between "Malaysian Flagged Builder" and "Non-Malaysian Flagged Builder". As such, through the LOA by Nam Cheong, bidder will have an advantage over those without the LOA.
• As for ship financing during a recession, it was said that so long as their customers secured a contract with Petronas and e.t.c, banks will be willing to lend to them to buy a ship from Nam Cheong. 
• Going forward, Nam Cheong will improve their build-to-stock model by allowing more flexibility such that they hope to be able to cater to 90% of demand.
• They will also be building more PSV as there's a low supply of Asian sea truck.

OSIM

• OSIM itself contributed more than 80% of their profit and 75% of their revenue.
• China is the number 1 market contributing 28% of the business's revenue. Other major market contributors are Hong Kong and Taiwan (16% each). 
• uDivine has been sold out during Mother's day and they have a waiting list of 1 month.
• As for GNC, it has been said the the Singapore and Malaysia operations are one of the most profitable and the CFO describes it as cash cow. However, I am sure profit margin is not as high since they have to pay a 5% franchisee fee on their revenue.
• For Richlife, OSIM owns the brand which I feel is a good thing since they need not pay franchisee fee. It has not yet been profitable as they say health supplement shops are usually lose-making in the first few years.
• For TWG, they have been warmly welcomed by malls and hotels as they bring about one of  the highest profitability among the shops in the mall. Their franchisee in Dubai is Dubai Mall itself which is the mall with the tallest tower in the world. 
• For Brookstone, they have learnt some key lessons. One of them is to make sure that they have a controlling interest. For Brookstone, while they have a majority share, they are unable to control the company as permission is needed from the other 2 private-equity funds shareholder. It's said that these PE funds are more interested in the short-term interest while OSIM is looking it from a long-term business point of view.
• Brookstone will still have a chance at IPO in 3-4 years time if the recovery continues.
• They have also learnt not to depend on bankers though I still don't like their issuance of convertible bond.
• Private bankers have looked for Ron Sim to privatise the company since it is extremely cheap at 5-6 cents during the 2008 GFC. However, Ron Sim chose not to do so as he wants to protect and maintain their established reputation. 
• The company has also started changing their made-in-Japan model to made-in-China model as they understand that the made-in-Japan model is unsustainable. By shifting production of uDivine in Nov 2010 to their JV factory in China, they have managed to reduce its ASP from $9000 to $5000+. The lower ASP has provided a more consistent revenue with higher volume without impacting the margin.
• Replacement cycle of the product is around 3-5 years and they say 25% of their revenue comes from recurring customers.
• They also have their house brand health supplement under the brand "LAC" and its LAC Activated Liver Protection is their top seller now with sale of 200 bottles a day.

MIIF

• Characteristic of infrastructure fund - High barrier of entry, Long operational life, stable predictable cash flow, low demand elasticity
• Most of the debt in its various infrastructure are project-financed, which means that there is no recourse to MIIF. 
• For TBC, Taiwan is split into 51 regions, TBC has a monopoly over 5 of the regions.
• Owning all the cables infrastructure, their license is renewed every 9 years. However, MIIF believes this to be not of any issue.
• They aim to grow through 3 areas namely Broadband, Digital and Cable TV. Cable TV is really cheap in Taiwan as it cost USD 15 to have access to 100 channels.
• For HNE, detolling of Xin Guang has lead to a slight drop in total revenue. However, it has also lead to congestion of Xin Guang and they are starting to see lost toll coming back.
• 2012 opening of Guang He expressway is likely to bring about 6 to 8 % growth in traffic.
• As the current road has a high capacity, there is no need to have additional capex to widen it.
• A key risk highlighted is that China is planning to standardize the toll rate in Guangzhou and this will impact HNE earning. The background is that tollroad built after 2003 is standardized at 60 cents per km. However, part of HNE's road toll is negotiated before 2003 of which the toll rate is negotiable. 
• The impact will only be for the phase 1 whose current toll rate is 75 cents per km. As such, even if MIIF fails to negotiate in maintaining the toll, maximum impact will be around 10 percent.
• For CSP, MIIF has managed to grow the revenue by diversifying the cargo.
• As Chinese steel is cheaper than international steel, there has been a lot of exporting of steel from China recently.
• 40% of all paper and pulp import into China goes through CXP.
• Previously, the 5.5 cents dividend is partially paid from cash balance as they are not fully covered by OCF. This is because they have invested additional equity in TBC. For 2012, they expect dividend to be fully covered by OCF.

OSIM

Once a market darling until the notorious leveraged buyout of Brookstone in 2005, OSIM has regained its past fame being the renowned super multi-bagger company in recent years. Founded by Ron Sim in 1979, the company underwent a revamp to bring in healthcare product in 1989 and continue positioning itself as the market leader in home health-care product in its major market in Asia today. Having fully written down its flawed $144m investment in Brookstone, OSIM became a great turnaround story increasing its net profit from $99m losses in 2008 to $69m profit in 2011.

                                                      Figure 1 - 2001-2011 Financial Statement

OSIM has always been able to deliver more than 20% in return on equity before the investment in 2005 as well as from 2009 onwards after the write-down on Brookstone. Using the Du Pont financial ratio, ROE is the multiplication of net profit margin x asset turnover x equity multiplier. With this in mind, I shall delve further into the business model of OSIM.

Figure 2 10 Years Profit Margin Figure

For most of the 10 years period, OSIM has been able to maintain a net profit margin of 10% other than in 2007-2009. For 2006, it is as a result of finance expense as well as Brookstone losses, else its net profit margin will be around 10% too. How has OSIM been able to maintain a 10% profit margin despite its high advertising expenses as well as aggressive expansion?

Branding. This has been the key word to OSIM's success to date as mentioned here:

"I had to shift from being a trader to being a builder. I thought the best way was really to create your own brand, create your own products, designs,concepts and services because if you can't differentiate, over time, you will lose control. As a Singapore company, we have a very small domestic market. So how can you grow if you do not build on your brand? Since 1989, when we embarked on brand building, we have grown 20 to 30 per cent."

Source : http://www.scribd.com/doc/80778051/OSIM-Research-Info

Figure 3 - Price Comparison

Brand has not only been the key factor that has allowed OSIM to secure a very strong market share such that when we talk about massage chair the name of OSIM naturally comes to our mind. It has also allowed OSIM to price its product above its competitor without losing significant market share as the price comparison chart shown above. Of course, to be able to continue holding on to this mind share requires significant advertising expenditure which will naturally eat into the profit margin.

Between 2007 to 2009, net profit margin even after excluding Brookstone drops tremendously as a result of recession to 5% and below. This drop in net profit margin is accompanied by a drop in revenue which hints that either gross profit margin is affected or fixed cost accounts for a huge percentage of revenue.

Figure 4 - Gross Margin

From figure 4, we can infer how OSIM has been able to grow its net profit so fast during the past 2 years. COGS as a percentage of total revenue drops rapidly from 37% during 2007-2009 to 34.6% in 2010 and 31% in 2011. It is more than likely that OSIM has priced their goods higher than that they have managed to reduce their COGS as this is a period of economic recovery and strong growth. However, this is still unable to explain their 50% profit growth in 2009 where revenue only increases by 5%.

                                      

Figure 5 - Financial Statement for 2007

Figure 6 - Financial Statement for 2009

Figure 7 - Financial Statement for 2011

From figure 6, we can also easily understand how profit expanded by 50% in 2009 without an increase in gross profit margin. Ignoring "Changes in Inventories of Finished Goods" as well as "Finished goods purchased" since they stand for Cost of Goods Sold, its pretty obvious that the rest of the cost hardly changes. Something surprising is that despite all the revenue fluctuation from 2006 to 2011, employee benefits expense, other operating expenses (this was much higher in 2006 as OSIM had undergone a restructuring exercise in 2007) and depreciation expenses hardly changes throughout the 6 years. Therefore, we can conclude that OSIM has a high fixed cost business that cannot be easily sized down even during recession. This fixed cost as whole is around $250m to $300m annually which comes to around 50% of the total revenue. 

What the above 2 paragraphs serve to show is that should a recession comes, OSIM will be hit badly as a result of higher fixed cost % (due to drop in revenue) as well as shrinking of gross margin coming from pricing down of goods. This is not totally unexpected as OSIM's product is not really a luxury good and it is something that is not necessary especially during a recession. As such, OSIM can be viewed as a cyclical stock though its core business did not create losses during 2007-2009. Another point to note is that as OSIM is a franchisee of GNC, it has to pay 5% royalty fee on its total revenue which can easily be a matter of profit or losses.

Figure 8 - Summarised 5 years Balance Sheet

For asset turnover ratio wise, it has ranged from 1.5 time to 2x (total asset is current asset + the non-curren asset reflected right above the current asset). However, I feel that the 2 x asset turnover ratio from 2008-2010 is not a very good ratio to use though there is nothing wrong theoretically. As seen above,  the huge write-off of $90m off the shareholders equity (more than 50% of the equity in 2007) sort of falsely inflated the asset turnover ratio for the next 3 years. If you are thinking in terms of ROIC, there seemed to be no mistake as the leftover equity is the capital that they are really using to fund their core business. However, OSIM has previously been using those 166m equity to fund most of OSIM's expansion before that, which I feel should be accounted for when calculating the actual ROE of the business from 2008-2010. For 2011, expansion has been using funds generated during the past year, as such using 168 million as the equity is acceptable.

As for equity multiplier, the figure has been at around 2x -3x even after the write off of Brookstone. With such high equity multiplier, question must then be asked regarding the strength of the balance sheet as well as the type of liabilities that it holds. Since 2009 onwards, OSIM has learned from its LBO mistakes and has quickly paid all its term loan as we seen from Figure 8 where term loan has been fully paid by 2009. However, in 2011, OSIM has once again issued a $120 million convertible bond at an interest rate of 2.75%. Next, we shall look at the current liabilities.

Figure 9 - Current Liabilities

Figure 10 - Current Asset

Looking at Figure 9, interest loan only takes up 10% of the total current liabilities which means OSIM has a relatively strong balance sheet currently. This is taking into account that it has not spent much of the $120 million from issuing of convertible bond as seen in the fixed deposit. Should they decide to spend it in a huge acquisition, OSIM will then have a weak balance sheet. 

As for the other 90% current liabilities, these are supposed to be treated as interest-free loan that OSIM has earned through its own ability. Owning a 30% stake in the OSIM-Daito subsidiary as well as a 20 years relationship with key contractor Oriental Export & Import Co has allowed OSIM to have a low working capital requirement. Owning $100 million in payables, OSIM only has a receivables of $50 million, which means OSIM enjoys a $50 million free short-term working capital. This is a definitely a key advantage of OSIM as it has definitely helped to mitigate its huge debt in the past. Therefore, before 2011 OSIM has a healthy equity multiplier which rightly boosted its ROE. However, taking on a $120m convertible bond, the ROA might now be a better ratio to use over ROE when analysing OSIM.

In conclusion, OSIM's key competitive advantage lies in its brand, premium pricing, relationship with suppliers as well as its negative working capital. However, it is subjected to recessionary pressure which will not only erode gross margin but also increases its fixed cost per unit sold. Another key risk will be that OSIM returns to its Brookstone path through aggressive acquisition and expansion through debt as seen from its issuing of $120m convertible bond. At the current price, I will not dare to touch it not only because that I might be catching it at the peak earning but that its expansion might drag it down should recession comes. As in 2008, this is a stock worth catching perhaps after the balance sheet is cleared and net profit falls drastically.

Silverlake Axis - FY 2011 9M Result Review

Silverlake Axis delivered an outstanding quarter once again, not very surprising given that an estimated RM 5650 million worth of projects are to be recognised from 2012 to 2014.

For Q3 2012, revenue increases by 21% while net profit increases by 63% compared to Q3 2011. Surprisingly, there's a 50% fall in Selling and Distribution costs as well as Administrative Expenses. This was as a result of "the RM8.4 million charge on grant of shares awards pursuant to the Silverlake Axis Ltd Performance Share Plan ("PSP") in Q3 FY2011." not occurring in Q3 2012. Therefore, net profit margin excluding extraordinary item remains the same at around 43% for the quarter as revenue mix did not change much.

From the above figure, we can also see that quite a sizeable portion of the profit from the MYR 390m licensing contract for HNA Group and CIMB Group has not been recognised yet. To date, a total of MYR90m has been recognised for Software Licensing, while MYR 40m has been recognised for sales of hardware product from FY 2011 and FY 2012. Therefore, conservatively there's still at least another MYR 180m for software licensing to be recognised. Assuming 90% profit margin, that will be a MYR 162m profit coming solely from Software Licensing over 2 years and 1 quarter.

For the balance sheet, trade and other receivables decreased from RM121m to RM107m. Amounts due from customers for contract work-in-progress increases from RM 10m to RM 57m, this segment is what that has been recognised as revenue in the financial statement but that they have not yet billed the customer for it. Cash balance drops from RM 73.4m to RM 65.7m as a result of RM 33.5m used for acquisition of ISIS as well as RM 52m being paid out as dividend so far.

Other than the release of result, Silverlake Axis has also released the news that it has won a new licensing contract with Malaysia Building Society Berhad (MBSB). This is going to be very significant as licensing contract has the highest profit margin at 90%. In term of asset size, MBSB' total asset is 1/6 that of the sixth largest bank of Malaysia, AmBank. While this contract size should be worth at least 10m SGD, the best thing is that Silverlake Axis has finally secured a contract for the financial year. This contract will be fully realized by FY 2013 and let's hope it marks the start of new contract win for Silverlake Axis. The more important contract is still Touch N Go by CIMB of which there is no new yet.

For this quarter, a dividend of SGD 0.5 cents has been announced to be paid on 20th June 2012, which makes the total dividend yield so far at 3% for the first 9 months. Outlook is very positive for Silverlake in terms of profit as there's still quite some bit of licensing fee that's not yet recognised. Finally, it is of great significance that they have finally secured 1 contract for the financial year, lest they go into FY 2013 without any new contract secured the previous year.

Nam Cheong Limited

Has anyone ever heard of Nam Cheong Limited? I doubt so since it is based in Malaysia and has only been listed last year May through a RTO of Eagle Brand (Not even an IPO). Neither am I aware of this stock until I catch it from AmFrasher "Up Close with Management" event advertisement sent by SGX to my mail. A quick look at the 4 companies and I realises that these 4 are not the average companies out there. They are in no order of merit : Nam Cheong, OSIM, Kingsmen Creative and Macquarie International Infrastructure Fund. Though they are certainly not the best business out there, they are definitely companies producing above average return.

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.

Average OSV production Output among Malaysian OSV builder

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.