VICOM - Part 4 (Conclusion)

The following table is the summary of all that have been discusses thus far:

Financial Statement Analysis

Positive Signs	Negative Signs
Average of 15% profit growth for the past 6 years	Profit Margin and Net Profit Margin not expected to increase further.
Net Profit Margin of 26.6%
Average ROE of more than 20% for the past 6 years
Net Cash, No Debt
FCF/Net Profit of at least 75%
Low CAPEX
Health Dividend Payout of 60%

Vehicle Inspection

Positive Signs	Negative Signs
Further tightening of COE supply will jack up prices and thus people are likely to hold on to their car longer	Vehicle growth to be stunted until 2014 before a review of the policy though the vehicle population growth will still remain positive
Such an impact has not been fully realized as monthly trend still points towards further aging of car population	Such impact is likely to be fully realized by the end of 2013
Closure of an important inspection centre in Ayer Rajah on Aug 2011 by STAI	While the Ayer Rajah centre will not be reopened again, no one knows if STAI will open another elsewhere. However, it will take $10 million and at least a year to open a new centre
The only one in the region to have a Vehicle Emission Testing Laboratory. VETL costs $4.7 million and VICOM was lucky to have been granted $2.3 million in fund. High cost might limit number of VETL being set up	Parallel import is at its lowest point currently
Adoption of Euro V std by 2014 will lead to further regulation of vehicle emission
A long term trend of more diesel cars on the road with the government doing a test trial on the impact of DPF on diesel vehicle	For each increase in diesel car, it will take another 2 years before the increase in revenue will be realized

SETSCO

Now, what is a fair value and target price of VICOM that i should be looking at. Valuation is something that is extremely tricky and I believe it to be much more of an art than a science. I will not be using DCF as I think that I am inadequately trained to do such a calculation yet. For valuation I will use expected earnings for 2011 given that 2011 FY has passed and the annual report is just 1 month away.

At $3.61 where I initiated my coverage, VICOM is trading at a P/E of 13 which is pretty high. However, if we take into account VICOM's net cash position, EV/EBIDTA is in fact only 7.87.

Even if we count in ITDA, EV/Earning will be 10.5.

Here's a question for everybody, will you choose a stock trading at PE of 10.5 but a EV/Earning of 13 or will you choose a stock trading at PE of 13 but a EV/Earning of 10.5?

No matter what your answer is, I still believe that VICOM is a fair buy given its high profit margin, ROE, high FCF, low CAPEX and a sound business model. While the current value might be on the high side, it is definitely undemanding. What's more a final dividend will be declared in a month time and distributed in May.

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While I initiated the coverage at $3.61, I got it at an average price of $3.40. The reason why I choose to initiate it at $3.61 is because it was the price of VICOM on that day. Initiating a coverage at $3.40 will in fact be giving me a 3 months hind side, but this is not to say that $3.61 is not a fair value to buy in.

VICOM - Part 3B (SETSCO's history and competitors)

Talk about SETSCO and i am sure that not even 5% of the population will know what it is and what it does. SETSCO started in 1981 from Singapore Institute of Standards and Industrial Research (Currently called SPRING after merging with PSB) to provide commercial testing services to the industry. It was also the first testing lab to be accredited by Singapore Accreditation Council for Civil Engineering. It is then privatised in 1987 and sold to Keppel Corp before becoming a part of VICOM in 2003.

Earlier in part 3A, we talked about the two largest firms in the ITC industry - SGS and Bureau Veritas, so now we shall compare SETSCO with them. It is of course unfair to compare SETSCO with the largest ITC companies which operate more than 1000 offices worldwide. However, we can at least compare their operating margins to see how lean SETSCO is as earlier we have already conclude that staff cost is the biggest expense of VICOM's business.

Fig 1 - SETSCO

Fig 2 SGS from Deutsche Bank report

Fig 3 Bureau Veritas

SETSCO's EBIT margin was a mere 7.3% in 2003 when VICOM acquired it from Keppel Corp but has steadily increased to 12% in 2008 before shooting up to 19% after that (same goes for 2011). While I have no idea what happened during 2009, it can be seen that SETSCO produced much more synergies with VICOM as compared to Keppel Corp. VICOM's management has also done a good job in doubling SETSCO's revenue and profit margin through expanding its range of accredited services. SETSCO's EBIT margin is better than that of Bureau Veritas and SGS from 2009 onwards. Will the move of VICOM's HQ further improves efficiency as mentioned by the chairman, this i will not be able to answer.

Competition is indeed fierce in this industry but how do the companies compete with each other? Price competition should be out as in the field of ITC, brand name is the most important. Aside from the brand, I believe that the next most important factor will be the number of accreditations that one have. Why is this important? The amount of products that a company has that require testing are often varied and numerous. For e.g. for a construction - concrete, steelwork, paint and tiles. For a can food producer - meat, preservative and tin can. The point that I am trying to make is if I need to hire only one company to test the whole range of products, why will I want to hire two companies for it. Therefore, the bigger the ITC company the more likely that it is going to get the larger contracts. Now, we shall review SETSCO's accreditations by sectors to understand the competitions. All information comes from Singapore Accreditation Council (under SPRING).

Fig 4 Products Certification

SETSCO is accredited to certified concrete and fire safety products(fire extinguisher, fire alarms, testing of fire resistance of all materials). In the area of concrete certification, SETSCO has only managed to garner a 5% market share because SETSCO was only accredited in October 2010 to do product certification. However, this signifies its push into the certification area to offer a full range of ITC services. TUV SUD is the current market leader in the certification business, accredited to certify electrical appliances safety and a lot more products than any other companies.

Fig 5 Inspection

It is the sole provider of inspection services in the Pressure Vessels and Lifting Equipment category for air receiver, tank and chain block. Air receiver is a pressure tank commonly used in the marine, oil and gas industry. For building construction and maintenance category, competition is slightly lesser with around 2-3 competitors in each of its accredited inspection area. And one last thing inspection service is a recurring income as inspection needs to be carried out regularly. Under the Building Control Act, a building that is not solely for residential purposes will need to be inspected every 5 years from the date of TOP and 10 years for residential building. The following tables will all be on Testing accreditation, where the left side will be on services SETSCO has been accredited with in that category while the right side will be its main competitors and their number of accreditation in that category.

Fig 6 Civil Engineering

Civil engineering is the construction of all types of buildings, bridges, MRT tunnels and roads. For civil engineering, a lot of different products are required as seen above. SETSCO is the sole tester for structural fixing and has the most number of accreditations in this category. Closest competitors will be Al Tech.

Fig 7 Calibration and Measurement

Calibration and Measurement is to ensure that measurement devices like thermometers and weighing scale are accurate. In this area, competition is slightly stronger with Singapore Test Services and Ming Deng Metrology Services, but SETSCO still has the most number of accreditation. In order to maintain the ISO 9001 standard, all devices need to undergo a recalibration every 3 years.

Fig 8 Non-Destructive Testing

Non-destructive Testing is a wide group of scientific techniques to evaluate properties of material, component and system without causing damage thus making it a highly valued technique that can save both time and money. Its applications range from Aviation, Power Plants, Construction, Marine, Oil and Gas and Submarine. SETSCO is once again the market leader here which got every accreditation possible in this category. NDT is often used in "Risk-based Inspection" and it is a requirement for refineries, oil platform and chemical installation to undergo the inspection regularly. http://en.wikipedia.org/wiki/Risk_Based_Inspection

Fig 9 Mechanical

Mechanical Engineering is the testing of materials and mechanical system and overlaps with aerospace, civil engineering and petroleum engineering. Competition is less intense here but SETSCO is also not the market leader here though it is the sole tester for 4 of the products.

Fig 10 Chemical Products

This is the testing of chemical properties and products. TUV SUD is especially strong in this area though competition is relatively sparse here.

Fig 11 Biological Products

This is more of the food safety standard. Nestle is not counted as a competitor as it is used to test their own products. Competition is very sparse here with only HSA, AVA and SETSCO testing most of the products and in fact these 3 bodies work in partnership. To be eligible for Food Export Health Certificate, an application need to be made to AVA for each consignment top be exported. After that

"On the appointed date, AVA officer will carry out an inspection of the food consignment intended for export. He will then draw samples from the consignment for laboratory analysis. Applicant should ensure that the consignment is ready on the day of inspection. The inspection date is scheduled according to the applicant’s request and 3 working days advance notice is required.

The samples will be sent to M/s Setsco Services Pte Ltd for microbiological analysis and/or Health Sciences Authority (Food Safety Laboratory) for chemical and radiation analysis, depending on the type of product and analysis required."

Normally, the ratio will be one-third of the products to SETSCO and two-third to HSA.

Thus, we can conclude that SETSCO has a very stronghold in the local ITC industry with the closest competitor being TUV SUD which is one of the 8 largest ITC corporations. It has the most number of accreditations in the whole range of services and this is its competitive advantage over all other companies. Notice how many of the services are in fact interlinked. A marine company will require certification on Air Receiver, Mechanical Testing and NDT. A construction project will require a testing of concrete, followed by civil engineering testing and maybe even NDT. After that, an inspection of the building might then be required to be carried out. A huge portion of the inspection services are required regularly due to regulations, like building inspection, recalibration of devices, NDT, food export and fire safety products. SETSCO's expansion into product certification is its bid to offer a full range of ITC services downstream and upstream, which is what SGS and Intetek are doing.

With such strength, it is no wonder why SETSCO is able to attract huge projects over the years.

2005-Moog Aerospace (undergo NADCAP), reclamation material for Tuas and Jurong Island, Water quality at Marina Barrage, Jurong Shipyard, SP Power, Hyflux, ExxonMobil and Seraya Chemicals Singapore

2006- Jurong Chemical Hub

2007- Fusionopolis, Orchard Turn, Singapore Art School, Horizontal Bulk Liquid Storage Terminal (Emirate National Oil Company), Henderson Bridge and Dubai Metro Rail

2008- Resort World, MBS, Pinnacle at Duxton, Keppel Bay and Exxon Mobile

VICOM - Part 3A (Understanding the ITC industry)

In 2003, VICOM purchased SETSCO (Scientific Engineering and Technical Services Company) for a sum of $15.7m. Currently, SETSCO accounts for 45% of VICOM's net profit, but information about it has not been very forthcoming, leaving many in doubt about what SETSCO really does. While some might feel that SETSCO is a completely different type of business from vehicle inspection, in fact the whole of VICOM business can be classified as being in the ITC industry.
Vehicle inspection is actually a niche area under the ITC (Inspection, Testing and Certification) industry which offers its services to a very wide variety of products ranging from food to buildings, from marine to aerospace.

The main purpose of this post is to let readers understand the functionality and fundamental of the ITC industry. This will be more of an informative post and most of the information is gathered from the following sources:

Deutsche Bank's Investor Day report of SGS
NZB's FY10 report of SGS
Bureau Veritas Investor Relation Presentation
TUV SUD Annual Report 2010
AL Tech

Before I start, I will like to warn reader to exercise some discretion in discerning between facts and opinions as 2 of the sources are analyst's report while 2 of them are company's annual report. Stuffs like market structure and past information counts as fact while things like valuation are more of an opinion. I have also highlighted important points in bold.

About the business

From Deutsche Bank Report

“Inspection Services: SGS inspects and verifies the quantity, weight and quality of traded goods. Inspection takes place prior to shipment at the manufacturer’s or supplier’s premises.
Testing Services: These services test product quality and performance against various health, safety and regulatory standards. It is done by SGS in state-of-the-art laboratories close to the customer’s premises.
Certification Services: SGS certifies whether products, systems or services meet the requirements of standards set by governments, standardization bodies (e.g. ISO 9000) or by SGS customers. SGS also develops and certifies its own standards.”

Market Structure

Fig 1 Market Structure from Bureau Veritas

From NZB Report

Competitive landscape
“The global testing, inspection and certification remains a highly fragmented market, with less than 20% of market value estimated to be outsourced to independent companies such as SGS. SGS, Bureau Veritas, Dekra, TUV, DNV and Intertek account as the six largest players in the industry though their combined share do not exceed 15%. SGS share does not exceed 5%.”

From Deutsche Bank Report

“We estimate the global testing, inspection, and certification (TIC) industry serves a c.EUR60bn market. Out of this market c.30-35% is served by specialized and independent agencies such as SGS, Bureau Veritas and Intertek while the rest is not yet outsourced.

The industry covers all sectors (primary, secondary and tertiary), companies of various scales of operation (from small to large), and all regions. A large portfolio of services is offered, ranging from very basic (commodities quantity control) to tailored and sophisticated services(tests in laboratories, critical products / building conformity assessment). The market is still highly fragmented with only a few global players operating in multiple sectors (SGS, BV and Intertek) while the rest of the market (DNV, Dekra, TüV Süd and others) comprises mid-size organizations that often focus only on one region or on a limited number of sectors and areas of expertise. However, the industry is in a consolidation phase with large players like SGS focused on adding to their capabilities and increasing their local presence.”

Business’s Fundamental and Barrier to Entry

From TUV SUD Annual Report

“The key growth driver – not only in the CERTIFICATION strategic business segment, but also within the entire TÜV SÜD Group – is our service offering relating to the market readiness of manufacturers’ products, from development to marketing through to recycling. Here, we expect above-average growth rates in photovoltaic and in the inspection of textiles and leather goods. Overall, double-digit revenue growth is expected in ASIA PACIFIC.”

“In the ASIA PACIFIC region, revenue growth is primarily generated in the CERTIFICATION strategic business segment. However, the INDUSTRY and MOBILITY strategic business segments will increase their contribution to revenue in this region in the medium term. We see high potential for growth in the ASIA PACIFIC region, particularly in the area of environmental and energy technology.”

“In the CERTIFICATION strategic business segment, our business development in the ASIA PACIFIC region continued to be impacted by risks arising in Singapore due to higher administrative burdens, new certifications, and competition from the public sector. Furthermore, we are facing new risks in the region due to falling student numbers at the PSB Academy, tougher legislation in the field of education, and the new EduTrust certification scheme.”

From NZB Report

“Growth
VTIC industry has experienced CAGR of between 5-6% over the past 20 years, nearly 10% on average in the past 10. The industry has tended to decouple from traditional macro indicators such as GDP or World Trade volume growth, though a minor cyclical dimension is still conserved (some 35% of sector growth). Resilience of VTIC activities is on the account of the structural drivers behind sector growth combined with the upstream expansion of testing services in the product value chain, resulting in a lower dependence from final demand.”

“The industry is characterized by high barriers to entry, due to the need of an international network, extensive know-how and expertise as well as the need of accreditation from government bodies.”

From Deutsche Bank Report

“General overview
SGS’s customer base is relatively fragmented, i.e. the group’s top 100 clients together account for less than 15% of group sales. The contract scope is wide, ranging from basic quantity checks to very sophisticated tailor-made services involving laboratory testing.

Revenue patterns are quite predictable since a big portion is generated from recurring contracts. Customer loyalty is high as it can be expensive and time consuming to change from one provider to another. Furthermore, many services are specialized and only delivered by certain certification companies. Acquiring and processing the first certification cycle is costlier than subsequent recurring testing and certification processes.”

“Growth drivers
We believe globalization results in increased global trade flows, which are a major driver of growth for SGS, generating among other things the desire to trace the origin of goods.
Furthermore, we believe that protectionism, rather than freight forwarding companies, should be a growth driver for the sector. We believe that standards and testing are “great weapons” to be utilized by countries to avoid imports.”

Fig 2 Resilience to downturn from Bureau Veritas

Valuation

Fig 3 Deutsche Bank report on SGS's valuation


Fig 4 NZB Bank's report on VTIC peer group valuation

Cash Flow Generation

Fig 5 Cash Flow from Net Income from Bureau Veritas's Report

Fig 6 Deutsche Bank's FCF analysis of SGS

Here's for a better understanding of 2 of the many segments in ITC industry

Civil Engineering

Fig 7 AL Tech's brochure

Industry Service

From TUV SUD

“TÜV SÜD Industry Services provides services for the safe, reliable operation and optimization of industrial plant, buildings and infrastructure facilities. The division supports its customers with tasks including the planning, construction, operation, dismantling and disposal not only of plant and facilities, but also of refineries and power plants. The division focuses, in particular, on developing solutions in the fields of energy efficiency and renewable energy.”

From Deutsche Bank

“SGS’s services in this segment increase safety and quality and reduce technical and commercial risks faced by various industries. SGS assures asset integrity (asset needs to fit purpose) from design to decommissioning, across all industries, globally. SGS has a large portfolio of service offerings addressing safety, quality, compliance, reliability, and maintainability issues for the overall production cycle in any industry including design, procurement fabrication, construction commissioning, operation, maintenance and modification.

SGS’s Industrial Services business primarily serves the oil & gas, power, construction and transportation industries. The different client segments that SGS caters to are plant operators/owners, EPC contractors, consulting companies, construction companies, suppliers of technical components, government authorities, investors, insurers, and trading companies.”

My Summary

While all these reports are mostly about the largest company in ITC industry with global operations, it does shed light on the industry itself. Competition inside the ITC industry is pretty strong as even the leader (SGS) can only garner a 5% share and the trend poinst toward more consolidation and acquisition. Companies compete through having more accreditions and services available as well as having a brand recognition. Such intense competition has also been recognised in VICOM's annual report and chairman's statement.

Despite the competition, high barrier of entry exists as one has to meet the high accredition standard of the country as well as brand name recognition. However, once one is able to secure a steady base of customer, recurring income is expected as these services may need to be performed on a regular basis (for e.g. safety inspection of plant). Cost of switching inspector is also not cheap as labels and certificates need to be changed while the whole range of products need to undergo a re-inspection.

Growth in the industry is not exactly dependent on economical growth as policies and regulations will still need to be obeyed. Despite the fact that most of the largest companies core operation are centered in Europe, the 2 largest SGS and Bureau Veritas has proven to be rather resilient. But, a portion, possibly one-third of its growths, might still depend on economic growth as services like inspection of oil rig and new construction are part of the revenue. The industry being one that offer its inspection and testing services to a whole range of products help to diversify its income source and reduces the risk from a global downturn. In fact SGS even has a 2014 plan in which they seek to double their income with a compounded annual growth rate of 13.7% and to achieve an operating margin of 20%.

The main source of growth in this industry will still be a tighter regulation, public and consumer's demand for better quality control and adoption of health and environmental standard. Events like Japan's Nuclear Plant incident and Avian Flu can have a positive effect on the industry.

FCF is also pretty high as capex will be spent only on acquiring of new technology and accredition. A huge proportion of costs come from employee which requires the company's management to be able to understand staffing requirement in relation to potential growth in revenue.

With high barrier of entry, a proven resilient business model and recurring income, these companies are often valued at a PE of 20. Despite being situated in Europe, currently SGS (Swiss) has a PE of 21, Bureau Veritas (France) PE of 21.2, Intertek Group (London) PE of 26.5. This does not mean that VICOM deserves a PE of 20 but that such valuation shows the confidence of investors in these stocks even though the Euro debt crisis is still developing.

Part 3B will be on SETSCO's standing in the Singapore's ITC industry and the competition that it faces.

Sources:

http://www.sgs.com/~/media/Global/Documents/Third%20Party%20Documents/Third%20Party%20Financial%20Reports/Third%20Party%20Analyst%20Reports/2011/sgs-analyst-report-nzb-10-Feb-11.ashx?force=1

http://www.sgs.com/~/media/Global/Documents/Third%20Party%20Documents/Third%20Party%20Financial%20Reports/Third%20Party%20Analyst%20Reports/2011/sgs_analyst_report_db_31-May-11.ashx?force=1

http://finance.bureauveritas.com/phoenix.zhtml?c=216209&p=irol-presentations

http://www.alt.com.sg/download_brochures.html

https://www.tuev-sued.com/uploads/images/1305622329473340510443/2010-tuev-sued-annual-report.pdf