Initiation of Coverage on VICOM at $3.61 - Part 1 (Financial Statement Analysis)

Hi all, this will be my first ever analysis report and pardon me if it may be slightly disorganised or even erroneous. And this first company that i have chosen is none other than VICOM, my favourite stock of all. For all my future analysis reports, financial statements analysis will always be the first as i believe that financial statements will never lie to us about the actual state of a company and will be able to provide unexpected valuable insights (the prerequisite will be that it is not being manipulated).

Fig 1 Income Statement

Fig 2 Income Statement Analysis

A look at the income statement shows a company that has managed to grow its profit yearly since 2004 at a average rate of about 15%. This trend also applies for its Earning per Share. Vicom also has very high operating and net profit margin of more than 25%. So does its Return on Asset and Return on Equity with a figure of around 20%. And one more very positive sign is that both its profit margin and ROE has been increasing constantly.

However, a closer look at Fig 2 shows something strange. Despite its average 15% increase in profit, actual rise in revenue has in fact been averaging only around 10%. 2007 and 2009 are 2 of the years where the anamoly actually amplified. This is the cost control effect that i have talked about in "http://sgyounginvestor.blogspot.com/2012/01/cost-and-expenses-how-it-can-perform.html". From the data, other than 2005, rise in operating expense has always been slower than the rise in revenue and is in fact a key driver of the profit growth. So now, let's examine the operating expense to gather some clues about its underlying economic.

Fig 3 Operating Expense Raw Data

Fig 4 Operating Expense Analysis

From Fig 4, one can see that Staff costs and Depreciation expense occupy 72% of the total operating expense. And other than 2005, increase in Staff Costs and Depreciation Expense has always been lower than the increase in Revenue. It is easy to understand why depreciation expense is able to increase at a much slower pace than revenue increase sine depreciation is a rather fixed cost. But this also shows that Vicom does not really need to increase Capex to generate extra revenue. As for staff costs, it is a good thing that it occupy 60% of the operating expense as it is in fact one of the easiest and fastest cost to be controlled simple by not hiring more than what is needed to handle the increase in revenue.

Fig 5 Balance Sheet (Asset)

Fig 6 Balance Sheet (Liabilities and Equity)

The balance sheet for Vicom is very easy to analyse as there is no long-term debt and the short-term liabilities can be repaid with its profit. Its cash has been growing and as of end of 2010 it stood at 49m. There is no point in applying any of the financial ratio in this case as it will probably be as useful as knowing that it has 49m cash and no long-term debt.

While some may comment that it is trading at a high P/B ratio of more than 3, i believe that P/B is rather useless too in this case. With a ROE of 20%, the stock must then be trading at a P/E ratio of 5 to get a P/B ratio of 1.

ROE = Profit/ Book Value

0.20= Profit/ Book Value

Book Value = 5 * Profit

Fig 7 Cashflow Statement

Fig 8 Cashflow Statement Analysis

Fig 9 CAPEX

For analysis of free cashflow, i will use FCF/Net Profit to determine how much free cashflow can be generated from the net profit. From Fig 8, we know that Vicom is able to generate more than 100% free cashflow from its net profit and this is a very positive sign. However, we can see that 2006, 2009 and 2010 produce a lower FCF/Net Profit percentage. From Fig 7, average capex is around 4 million dollar other than the 3 years i mentioned. In 2006, Vicom spent 5 million dollar on CDST. In 2009, Vicom built a 4.7m Vehicle Emission Testing Lab of which 2.3m is grant from LTA. In both instances, we can discount them as a one-off charge that stem from LTA's new regulations which in fact add additional source of revenue. In 2010, there is a significant increase in CAPEX. Fig 9 tells us that there was a 8.8m worth of capital work-in-progress. This is very likely to be the new building and laboratory built at Teban garden compound.

Through deducting these one-off items, Vicom's FCF has always been around 100% of the net profit for the past 6 years. While it might not be conservative to discount these as one-off capex, it is unlikely that Vicom will have such significant increase in capex in the future given that it has just finished building its HQ and that Vehicle Emission Testing Laboratory is able to test standard up to Euro 5 (This will be discusses in Part 2B). Even with additional capex, Vicom can still easily issue dividend at 60% of its net profit. Though this might in fact increase if the management feels that they are unable to put the cash to better use.

From the financial statement analysis, we are able to tell of the great fundamental of the business. Ever increasing profit margin, ROE, no debt and with great FCF, it is hard to find a similar stock.

For part 2, I will focus on Vicom's vehicle inspection business which contribute around 45% of its net profit and how LTA's policy on vehicle population growth will affect its business.

(vested)

Cost and Expense - How it can perform magic to the bottom line

CEOs and investors alike all wishes that their companies can grow its net profits yearly and of course the higher the profit growth the better it is. In this quest for higher profit, many always look for ways to grow the revenue through more marketing and advertising, acquisition of competitors, reduction of price to attract a larger customer base and e.t.c.

However, most people have in fact overlooked how a control in expenses can have a huge impact on the profit. Yes, as many have known the equation to calculate net profit is:

Net Profit = Total Revenue - Total Cost

But, the extent of increase in profit from a reduction in cost is not as simple as it seemed to be.

Refer to the following tables for an illustration:

For company with 5% Net Profit Margin

For company with 10% Net Profit Margin

For company with 20% Net Profit Margin

Using CIMB trade tool, of the 741 companies in SGX, 115 have net profit margin of more than 20%, 110 of them 10-20%, 131 of them 5-10% and remaining 385 with less than 5% margin.

From the above table, one can see that a 5% increase in revenue without any increase in cost can easily result in an increase of 25%-100% in profit. And another important point to note is that the impact of control in cost is being magnified the lower the profit margin of the company.

Of course, some will question that this is quite impossible given that a huge proportion of cost comes from raw material or inventory purchased. This brings me to the next 2 points:

1. While it may be quite impossible to achieve a 5% revenue growth without any increase in cost, it is not impossible to expect a slightly lesser increase in cost compared to revenue. For a company with margin of 10%, a 5% rise in revenue and 4% increase in cost result in profit growth of 14% and this figure is 24% for a company with margin of 5%. This is possible through economies of scale like bulk purchase, a lower staff cost, depreciation and interest expense per unit, and more importantly the awareness of the management to control cost.
   
   
2. It is possible though to achieve a growth in revenue at a minimum increase in cost for company providing a service instead of selling products. For these type of companies, the bulk of the cost is usually fixed cost and not variable cost as they are not working much from the inventory which often occupies most of the variable cost. For e.g. for a brokerage firm, a significant increase in trading volume will not result in much increase of cost as at most a few more people will be hired to handle the volume, but such cost will not be in proportion to the rise in revenue. This explained my preference for companies with similar cost structure.

In conclusion, cost is a very important variable in the profit equation that people might not have been concerned with. However, there is definitely a limit as to the extent that a company is able to grow its revenue infinitely. But, neither is it feasible for a company to be able to cut its cost forever. What i wish to emphasize then is that management should pay more attention to cost control. During a recession, there will always be news that company XXX will be exercising cost control through a retrenchment exercise or other methods like cutting down on sponsorship or advertising. In the first place, why can't a company keep itself lean right from the start to enjoy a fatter profit margin and higher cashflow?

Books recommended for Investor

The following books are the more significant ones that I have read so far
and will recommend any Investor to read them be it whether you are a beginner
or an amateur with years of experience in investing.

Stock Investing
1. The Intelligent Investor by Benjamin Graham
2. New Buffettology by Mary Buffett and David Clark
3. Common Stocks Uncommon Profits by Philip A.Fisher
4. The Essay of Warren Buffett: Lesson for Corporate America Compiled by Lawrence A. Cunningham
5. One Up on Wall Street by Peter Lynch
6. The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb

Accounting
1. Warren Buffett and the Interpretation of financial statements by Mary Buffett and David Clark
2. A Step-By-Step Guide to Understanding and Creating Financial Reports By Thomas R. Ittelson
3. The Essentials of Finance and Accounting For Nonfinancial Managers by Edward Fields

The Intelligent Investor is a MUST read for all even if one does not align to the value investing philosophy. The first 10 chapters cover the key principles of investment that will help anyone to minimize losses in the long run, while the following chapters will cover the more technical aspect of evaluating a company like the margin of safety. Inside the book, chapter 8 is the most important as it addresses “Mr. Market” – the guy who will bring you great wealth if one is able to control it.

The other books are mostly about stock picking methods that are very helpful. Though no one knows if what Buffettology wrote is really how Warren Buffett works (I supposed Buffett do not use such fixed systematic and mathematical method), it’s pretty useful in providing you with a basic framework for finding a stock. Peter Lynch, the legendary fund manager who managed to attain more than 20% return for more than a decade, teaches retail investors how to utilize their advantages in stock picking. Common Stocks Uncommon Profits is a Classic that focuses on how to look for a growth company. Warren Buffett says that he is “85% Graham and 15% Fisher”, a testimony to how it has remained in print since 1958.

Special mention goes to The Black Swan though it’s not exactly a stock investing book as it helps to realign one’s definition and understanding of risks. Risk is definitely not just about probability or the Modern Portfolio Theory, but instead the possibility of the occurrence of any event. The history of Wall Street (for e.g. The infamous Long Term Capital Management advised by 2 Nobel Laureates in Economics) might not have been as shameless if they have really understand what it really means when we say “risk”. However, a word of caution for all, this is a very “heavy” reading as it is philosophical.

As Warren Buffett says “Accounting is the language of business”, one should avoid investing in stocks and bonds without being able to decipher the three financial statements of a company. Warren Buffett and the Interpretation of financial statements is a good introduction book as it is a pretty light reading and helps one in understanding the basic of financial statement analysis. A Step-By-Step Guide to Understanding and Creating Financial Reports is also a great textbook as what the title suggests, it guide you through the process of creating financial reports. One will go through the process where the financial statement is being changed when for e.g. one sold an item and shipped it to the customer.

The Essentials of Finance and Accounting For Nonfinancial Managers is for those who at least have a basic understanding of financial statement and it will go through in depth on financial statement analysis and the financial ratios. It teaches you how to interpret stuffs like how much cash should a company have and what to make of an increased in inventory and e.t.c.

A Young Investor's Diary - Introduction

I created this blog after I had started investing 5 months ago. The main purpose of this blog is for me to reflect on my investment's philosophy and mistakes as penning it down on the blog will certainly help to prevent me from committing investing mistakes that many, especially young investors, are prone to due to Greed and Fear.