Silverlake Axis - Part 2 (Understanding the Core Banking System Industry)

Fig 1 Silverlake Axis Integrated Banking Solution

The most important question that will come to everyone's mind when we talk about Silverlake Axis will naturally be what is a Core Banking System (CBS), is it just a software like your Adobe or Office? This will be what this whole post will be about.

The "Core" in the CBS refers to Centralized Online Real-Time Exchange, something like your trading platform where information is updated Real-Time. Gartner defines CBS as "those applications responsible for processing and posting transactions in the domains of payments, current and saving accounts, loans and securities (such as performing current and deposit accounting, maintaining loan accounts, holding securities positions, clearing payments)." Basically, as seen from fig 1, it is a centralized system that handles every aspect of the bank's business. When you deposit your money into the bank, CBS will update your main account and distribute the information to your ATM, credit card, credit risk, customer information and e.t.c. I will treat it as the human brain that's in charge of processing of all information received from the five senses and that exert a centralized control over the body.

Changing a core banking system has been treated as a high risk, high cost and high reward project. Cost saving is often not a sufficient reason for bank to change them. The risk and cost comes from the fact that an error can damage the reputation of a bank as seen from the numerous debacles that DBS has got itself into. Changing the system also requires the old system to be put down before the new system is being put up, and this will create downtime for the bank. All the employees in the bank will also need to be re-trained and it will be sometime before they can get used to it. Cost of the project is often high and project overrun is normal due to the numerous constrain involved and that it will often has to be done only in the weekend.

Kevin Lomax, the erstwhile chairman of Misys – one of the largest independent software vendors (ISVs) focusing on the financial services industry – was once quoted as having said: “Changing a core banking system is like replacing the engine of a Boeing aircraft mid-flight.”

“The challenge of replacing a bank’s core IT systems has been equated with everything from open-heart surgery to replacing the engine in a moving car. It is without a doubt one of the most difficult and complex challenges a bank will ever face, with implications that cut across functions, products and geographies.”

http://www.deloitte.com/assets/Dcom-Shared%20Assets/Documents/08-1266%20CoreBanking%20preflight%20final%20web%20version.pdf

http://www.cimbbank.com.sg/index.php?rp=core+banking+faqs&tpt=cimb_sg

The above is an example of the impact of changing the CBS for CIMB Singapore, which only has 2 branches here.

Given the high risk high cost proposition, it is expected that many banks will not undertake such a project unless it is no longer a choice of theirs. As such, an adoption of a new CBS in a bank is likely to last them for at least the next 15 years and more. Please take note of this point as this is going to be the important for Part 3 later.

"While other system replacements tend to cycle every 5 to 10 years, a core banking system is expected to deliver capabilities and value for at least 15 to 20 years. Core systems are often viewed as a “once-in-a-lifetime” investment akin to a major factory replacement."

h20195.www2.hp.com/V2/GetPDF.aspx/4AA2-7566ENW.pdf

If that's the case, why are the banks starting to change their core banking system given the extreme high ROI needed to convince them? The answer is simple - survival of the fittest. There is no doubt as to the stickiness of CBS in a bank given that many banks are still using the old legacy system that date back to the 1970s and 1980s. Thus, these old systems are increasingly unable to meet the demand in today's world.

The ineffectiveness of the old legacy system is expected to cost banks in mature markets approximately US$200 billion annually according to the IBM Institute for Business Value Analysis. Up to 79% of a bank's IT spending are sometimes being used to maintain the old legacy system. This is just part of the reasons.

Increased regulation in the form of Basel III and other standards require a higher standard of information reporting as well as integration of the system. The wave of consolidation and M&A has also resulted in banks having multiple core banking systems that just add to the cost and the complexity of the demand today. So have most of the engineers that have been maintaining the old legacy system retired and it is harder to find people to fix the old system. Competitors that have done so have also proven to be leaner, faster and more efficient, and have managed to cut down on their IT spending. Thus, the time has come such that many of the old systems are to be overhauled since 2005.

Despite the current economic turmoil, Ovum's "Retail Banking Technology Spending Model through 2016" has predicted that global spending on retail banking technology will increase by $3.6bn (3.2%) in 2012 and will hit $135bn over the next five years. Banks in emerging economies in the Asia-Pacific region will grow the fastest at a rate of 8.3% in 2012. Therefore, room for growth in the banking technology market is still plentiful especially in Asia.

Part 3 will be on Silverlake's core revenue generation - Software implementation and Maintenance and Enhancement Service as well as its competitive advantage.

Initiation of Coverage on Silverlake Axis at $0.355 - Part 1 Financial Statement Analysis

As always, I will start with the analysis of financial statement as it is definitely one of the most important part of the process. However, the standard way of analysing 10 years financial statements will not work here due to the transformation of the company since it was listed in 2003. Neither do I think that the analysis of net profit margin and return on equity make any sense.

Before I start on the financial statement lets have a look at how the company has been transformed twice since listed.

The company started out as Axis Systems, a company that provide Front-end banking solution like ATM Processing and Check Processing. In 2006, the company acquired the back-end solution "Silverlake Banking System Solution", thus allowing the company to provide an integrated end-to-end core banking solution for its client. In 2010, 3 companies were acquired under Silverlake Axis. Silverlake Structured Business provides application maintenance service to user of Silverlake Integrated Banking Solution (SIBS). QR Tech provides a retail system solution and services to retailers like Robinson and John Little. SBI Card Processing provides card processing service for Japanese group SBI Holdings.

As such, please be cautious when looking at the financial statement. Not only must 1 take into account the 3 different stages of the company, but also their revenue composition. And of course, all figures are in MYR currency, thus a need for you to convert them if you wish to compare to the market capitalisation.

Fig 1 Income Statement

A quick look and one will realise that gross margin is very high, varying from 60-78% of the total revenue. This is not unexpected given that software needs only to be created once and upgraded or maintained once in a while. The bulk of these cost comes from headcount and manpower. Total operating expense is usually between 10-20% of the total revenue. As such, profit margin is very high for this business. However, there is no much point comparing profit margin from year to year, this will be explained later on. As for profit and revenue, given the different forms that the company has taken, it will also be rather irrelevant.

Fig 2 Balance Sheet

The balance sheet is also quite clean, with min debt that can easily be cleared with cash in hand. Day Sale Outstanding ranges from 7 days to 188 days. This fluctuation is due in large part to the contractual basis of a large part of its revenue. When certain contracts get too big, it's not uncommon for receivables days to increase. As for amount due to related parties, this is in due to the difference between amount of work that has been recognised as profit, and the amount that has been billed to the customer.

Fig 3 Cashflow Statement

For the cashflow statement, capex for property, plant and equipment as well as software development accounts for less than 5% of the Profit before tax. The only exception was in 2007 where 7m myr was used to purchase a freehold land.

Fig 4 Financial Ratio

ROA and ROE are not very meaningful to me as all one needs to know is that the figures are high. Why is this so? Increasing its equity and retained earning are unlikely to be able to increase its revenue and profit as the only 2 asssets that matter are cash and its propriety software. Cash is needed for it to do its share buyback and for it to acquire other companies. As for its SIBS, it is an intangible asset that is very hard to value but is yet the core of the company.

Fig 5 Segment Reporting

And Fig 5 will explain why looking at net profit margin is irrelevant for this company. It has different segment with different profit margin. Maintenance and enhancement service is a more stable and recurring income and it generates a profit margin of 65%. The other 3 segments are all contractual and lumpy, and will thus affect the net profit margin year on year. Licensing of SIBS has the highest profit margin of 90%, followed by customised solution which is 40%. As for software and hardware product, the profit margin is at 20% as it is acting as a reseller.

Fig 5 also shows the difference between the Silverlake Axis before and after acquisition. The top part comes from the 2009 annual report where the acquisition has not taken place, while the bottom part is from the 2010 annual report which give a restated account of 2009 had the acquisition taken place then. This is what I called metamorphosis. If we check back the income statement, we will have realised that 2009 produced the worst profit to date since the acquisition of SIBS. However, given the acquisition, I highly doubt that its profit will fall to 19m MYR again.

The reason for purchase is likely to be much clearer by Part 3 and valuation will be discussed only in the last part. Part 2 will be on the Core Banking System industry of which Silverlake Axis is operating in.

Disclaimer - I am vested in Silverlake Axis which currently accounts for less than 10% of my portfolio.

An Exciting Weekend

Originally, I had planned to initiate a coverage on The Hour Glass this weekend, but I have chosen to postpone the report much later. Why? Because I have discovered an excellent stock while screening for a target since my divestment of UOB Kay-Hian. I compiled a list based on ROE as well as their ROA figures. It was definitely not easy given that it was until I reached "S" that I managed to found it. Yes, this is the hint, it starts with a "S". Given that this is a far excellent business as compared to The Hour Glass, I have decided to devote my whole Sat and Sun into it. Hopefully, by next weekend I will be able to do a write-up on it. It's moat and business model impresses me a lot and this might be the most expensive stock that I have ever purchased based on P/E. And in fact, it was a wonderful turnaround in 2010. Not the classic turnaround from red to green but from an above average business model to an excellent business model.

That's all for now, I shall continue to devote most of my time into researching it over the next few days.

Divestment of UOB Kay-Hian

UOB Kay-Hian bought at $1.65, sold at $1.67, total gain $1.42.

I sold it immediately this morning after the FY2011 result is announced despite a dividend of $0.06 being declared. The reason why I do so is that the calculation in buying the stock at the start was faulty.

Reasons why I bought the stock

1. High Profit Margin
2. High ROE
3. Dividend Payout Ratio of 60%
4. Conservative Management (one of the rare brokerage that likes to ban trading in hot stock)
5. Largest brokerage in Singapore with operations in Hong Kong and Thailand
6. It's a matter of time that the retails investor will return
7. Brokerage demand has high potential for growth given that only 12% of population are trading or investing. This compared to 30% in Hong Kong and 50% in USA

And the reason why I sold it off is definitely not because of unsatisfactory result. I do expect the weak result given that q4 is traditionally where market turnover is at its lowest and with the euro crisis still unsolved. The only reason why I decided to sell it off is that after keying in the data into my spreadsheet, I realised that my calculation of its ROE of 17% is faulty by taking into account Peak Earning in 2007 and 2008. Under normalized situation, its ROE should average around 11%, though in a hot bull like 2008 it can go all the way up to 28%.

A 6% difference in ROE is too much for me. A ROE of 11% is not a good sign especially if the profit margin is as high as 30% and will make it just an average company out there. And this is it - I will never buy an average company at an average PE of 10 for my long-term portfolio, as it will be without much margin of safety. Of course, unless special situation exists such that I believe that its normalized earning can grow in the future to a point that the PE of the current price will be 5. And given that SGX has a ROA of 15% and ROE of 30%, I will rather buy SGX at a price of 20 than UOB Kay-Hian at a price of 10.

It is definitely not that this is a lousy stock. If one will to hold it till a bull market and collect the dividend in the meanwhile, profit is rather guaranteed. This will be a good buy if one can get it at $1.15 and hold it with a mid-term view in mind. However, being without much margin of safety and being low on cash, it might be better to source out a better price for value company.

Berkshire Hathaway's 2011 Annual Letter to Shareholders

While there's a lot of Buffett books out there that sought to explain Buffett's stock-picking techniques, will not it be best to hear it from Warren Buffett himself? I shall share with you some of the more important point from his report. For the full text, you can check it out here:

http://www.berkshirehathaway.com/letters/2011ltr.pdf

"Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value."

Many companies have been doing aggressive share buyback in the recent correction, of which I supposed many are not putting the cash to good use. I supposed a easier way to see if the share buyback is well done will be first to check if the company has any high-interest yielding debt (Hyflux ?) that can actually be repaid. Secondly, perhaps we should ask ourselves if we will buy the company at the current price of which share buyback is being done. Else, distributing dividend might have been a better policy.

"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply."

For someone like me with no foreseeable cash-generating abilities in the near future, I doubt it will make a difference if the stock tanks. However, for the rest out there, this is once again a great advice. Do not rejoice over the fact that your holdings have caught the attention of institutional funds and analyst.

"At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained."

A structure of which we can use to assess insurance company...

"To fulfill its societal obligation, BNSF regularly invests far more than its depreciation charge, with the excess amounting to $1.8 billion in 2011.

Massive investments of the sort that BNSF is making would be foolish if it could not earn appropriate returns on the incremental sums it commits. But I am confident it will do so because of the value it delivers. Many years ago Ben Franklin counseled, “Keep thy shop, and thy shop will keep thee.” Translating this to our regulated businesses, he might today say, “Take care of your customer, and the regulator – your customer’s representative – will take care of you.” Good behavior by each party begets good behavior in return."

Our dearest 2 Public Transport Operators should really take note of this point. This is perhaps the difference in running a business with a owner's mentality. This is also why I do have a slight preference for a family-owned business sometimes.

"This group of companies sells products ranging from lollipops to jet airplanes. Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. A few, however, have very poor returns, a result of some serious mistakes"

Always take into account the leverage level when assessing return on equity or return on net tangible asset.

"The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. "

While I have always thought that gold can be a safe asset given the past Gold Standard, he really knocks the senses out of me with his reference to the tulip bubbles in the 17th century. While I have read about that story before, I will never have thought that this is precisely what Gold is all about now.

"My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment."

This is a short and sweet summary of what a long-term investment should be.

The annual letter does deserve a read and I have find that reading his letter to shareholder proves to be more worth it than many other books out there. And what's more its free, which implies an infinite return on investment:)

Eratat Lifestyle - My First Stock, My First Mistake

This was the first stock that I bought, after I was enticed by its growth story of positioning itself in the premium market where there is higher profit margin. Profit margin is growing and profit and revenue have been jumping higher and higher each year. Coupled with its high cash position and low P/E of less than 2, this seemed to be the ideal stock.

So what was my first mistake?

Lousy and basic accounting skill. Looking at the current financial statements, there's in fact quite a number of doubts in its statement that I should have spotted earlier on.

First of all, lets look at their growth story as written in 2010 annual report:

Since 2008, we have made strategic changes to reposition ourselves as a mass appeal and casual lifestyle company and away from the sportswear segment.

Is it really so? In 2008, they added 3 more production lines to a total of 5 to produce an annual output of 7.2m pair of shoes. And in 2009, they added another 1 more production line to increase total output to 8.4m pair of shoes. In 2010, they sold a total of 5.42 million pair of shoes and in 2011 they sold a total of 4.63 million pair of shoes. This is a 40% underutilisation of production capacity. This should has been the first warning - Management is not following what they have said.

And if we are talking about this company, we will definitely need to talk about its receivables. Ever since it was listed in 2008, profit has been jumping literally. From an EBIT of 46m rmb in 2007, it rises to 80m in 2008, 150m in 2009 and 200m in 2011. This is pretty similar to its total receivables. While it is plausible and reasonable that receivables should rise in tandem with revenue, it is definitely not when you see the receivables turnover jump from 32 days in 2007 to 56 in 2009, 94 in 2010 and in 2011 - 130 days. It should have been around 140-150 days if not for the so called Sales Incentive Award of 52 million rmb.

What about the inventory turnover? From 40 days in 2007, it has dropped all the way to 11 days in 2010 and 2011. This implies that its inventory is able to turnover at 14 times faster than the receivables. High inventory turnover can be a very positive sign for companies like those in FMCG and fast food as it helps to increase their working capital. However, in the case of Eratat, it is unable to collect its receivables in time, which means it will need an enormous sum of working capital to be able to fuel its high inventory turnover. Given its receivables turnover of 150 days, it will need a working capital of at least 200m rmb to function since its trade payable is only at 25m. This is why a placement is being done to raise 60m rmb in May 2011 despite the fact that it has 160m in cash (This should also has been an important red flag). And a high inventory turnover means that the product is very hot-selling, but then again why did the distributors face difficulty in paying them?

The next question will then be how much cash has been generated from operation given that its profit has increased 5 folds in 4 years. From 2008 to 2011, a total of 557m of EBIT has been generated of which a total of 118m has been paid out as income tax, giving a total net profit of 339m. However, net cash generated from operation in that period sums up to only 60m in cash. In 2007 where profit is only half the amount of 2008, the company actually manage to generate 35m in cash from operation. So what has happened to the rest of the 279m of cash? it has been turned into trade receivables.

Many will then be concerned now if the 222m cash in the balance sheet is real. The answer is yes given that the auditor has checked with the bank. Why am I so confident that the cash is real given that it has only managed to generate 60m in cash so far? Well, through IPO, warrant and share placement they have raised a total sum of 300m in cash of which they have only used around 70m of it. 25m was used to create the production line for shoes in 2008 and 2009, 21m was used to purchase PPE in 2010 and another 25m was used in its acquisition of subsidiaries, Fujian Haimingwei. Therefore, the cash balance is likely to be real since it is in fact just shareholder's money that's not yet used. This raises another question, if it does not need that much of a working capital, why did it even bother listing in the first place?

And finally, the tripling in ASP (Average Selling Price) of Eratat's apparel to 242 RMB is rather surprising in FY2011 Autumn/ Winter. It is not just the fact that revenue increases by 50% that puzzled me, but the fact that gross margin remains the same at 38.2%. Using simple maths, we can easily figure out that if ASP triples and gross margin remain the same, it means that the cost of production has also tripled. So, if ASP has not tripled, will not Eratat has made a loss?

Being blinded by a growth story without checking its financial statement is definitely a road to self-destruction. I have a realised lost of 20% on this investment and it has been one of the most painful lesson I have learnt. All I have to thanks for is that my capital invested in it is rather modest and I have divested it after I realised something was wrong in Q3 2011.

The most important lesson I have learnt from this experience is that financial statement will never lie about the actual state of the company. Even in the case of a financial shenanigan, there will definitely be tell-tale sign like how the annual report will be too complex for one to understand.

Singapore Budget 2012 and VICOM

Yesterday, we have discussed about how SBS Transit is going to be negatively impacted by the implementation of the Budget for the new fiscal year. VICOM, however, stands to gain from what might be a loss to SBS.

Under the Bus Services Enhancement Fund, 800 buses will be added by 2016 of which 550 will be funded from the government. Now, we can understand why it took nearly 20 years for the PTOs to add 800 buses in the past. With more buses entail more inspection revenues for VICOM, so we shall see how much of a revenue will be added.

As public buses, they have to be inspected every 6 months paying $68 per inspection. Being diesel operated, they will also have to undergo CDST for $26. This gives us a total of $188 per bus added per year. 800 buses = $150400 annually. While this might represent a very small sum given VICOM's $25m profit, it is a form of recurring income that they will enjoy.

While the bus might be a small bonus rewarded to VICOM, what's more important is the continued change in attitude of the government towards diesel vehicle, that will signify long-term income growth for VICOM.

http://sgyounginvestor.blogspot.com/2012/01/vicom-part-2b-market-share-of-vehicle.html

In the above post, I have discussed about how the government has been slashing taxes for diesel car and how diesel car population has been growing. Here's the latest figure

Before 2009 - <20

2009 - 43

2010 - 138

2011 - 346

31/01/2012 - 374

Under the latest policy change announced, the annual Special Diesel Tax will be cut by 68% to around $320 - $500, which make it on par with petrol car driver whose petrol pump prices has been incorporated a duty of 41-44 cents per litre of fuel. As quoted from The Straits Times:

"Singapore will adopt the Euro V standard for diesel vehicles in 2014, and the slashing of the Special Diesel Tax is meant to encourage an earlier adoption of newer and cleaner diesel technologies, the minister explained."

This confirms my speculation that diesel vehicle will continue to grow until it accounts for a significant proportion of the vehicle population. It will definitely not be surprising if diesel vehicle population hit 1000 by end of the year given its growth rate, as diesel is a much more cost-effective and efficient fuel than petrol. All this will imply an extra $17 in inspection revenue for every diesel vehicle in the long term.

And with this, it shall lead to our Vehicle Emission Testing Laboratory, the one and only in the whole of SE Asia region and one of the world's few to be able to test for Euro V standard. As mentioned above, the special tax only applies to Euro V compliant diesel car and not to any of the diesel car out there. With the latest policy announced, our dear parallel importers will start to import more Euro V compliant diesel car models which has to be certified under the Mandatory Fuel Economy Labelling Scheme which only VETL can support. The price for each inspection will be 2-4k per model.

As such, the government has definitely handed a pretty nice Ang Pow to VICOM and I shall thank you on their behalf :)

Feel free to share which other company do you think has been affected by the latest budget

(Vested)

Singapore Budget 2012 and SBS

Minister for Finance Tharman Shanmugaratnam revealed the Singapore Budget 2012 yesterday with the main aim of building an inclusive society, helping the aged, the poor and the disabled. 3700 hospital beds will be added over the next 8 years and proportion of foreign workers allowed to be hired will be reduced in a bid to gear up the productivity of firm. Among them all, the government announces a $1.1 billion funding for the Bus Services Enhancement Fund, where total bus capacity will be increased by 800 from the current 4000 fleet operated by SMRT and SBS.

According to the Budget, the government will provide funding for 550 buses while public bus operators will add another 250 buses on their own. The sum of $1.1b will be used to cover the cost of purchase of 550 buses as well as their running costs for the next 10 years. Such a huge sum seemed to be a big bonus for the Public Transport Operator (PTO), funding the provision of extra capacity. However, on a closer look, such scheme might turn out to be a big bane for the PTO.

Since SBS has a 75% market share in terms of bus fleet, we shall examine how they are going to be affected by this funding. I will be using the Annual Report FY10 of SBS as reference for the figures. Given that bus ridership is not likely to increase by 20% because of this extra capacity, we can conclude that if the funding is not able to cover the running cost, SBS is going to have its profit margin lowered.

The funded 550 buses

As the cost of purchasing buses is being sponsored, we shall check if the remaining fund will be able to meet the operating cost for the next 10 years. Last year, SBS ordered a total of 600 buses for $268 million. Therefore, of the $1.1 billion, around 250 million will be used to buy the buses, giving us a remaining sum of $850 million to cover the running cost of 550 buses for the next 10 years.

With a 75% market share, it is likely that SBS will get around $650 million to fund the running cost of approximately 425 buses for 10 years, or $65 million per year.

From the annual report,

SBS's bus segment has an EBIT of $15 million on Revenue of $549 million, while depreciation expense is $45 million. Operating cost of 3000 buses (SBS's fleet size) work out to be 549-15-45= $490 million.

Thus operating cost of 425 buses in a year work out to be 425/3000*490m = $69 million, which is $4 million more than what the government funds. This figure will be rather accurate given that most of the expenses in running a bus are variable costs like wages, fuel expenses, repair and maintenance.

Even if we will to say that my figure is inaccurate, there will still be a depreciation expense on the income statement though this will not affect its cashflow. Given that buses are depreciated over 17 years on a straight-line method, this will work out to be an extra $10 million in depreciation expense.

The non-funded 250 buses

Similarly, using 75%, it is likely that SBS will have to pay for around 185 buses on their own. The cost of purchase will work out to be $82 million

Operating expenses will be 185/ 3000 * 490m = $30 million

Depreciation expenses will be another $ 4.9 million

Total Additional Expenses incurred from the 800 buses

Funded - $4 million in operating expenses and $10 million in depreciation expense

Non-Funded - $30 million in operating expenses and $4.9 million in depreciation expense and a cash outflow of $82 million

Total - $49 million of expenses in income statement each year and a one-time sum of $82 million

To be more conservative since my figures may not be accurate, I shall cut the sum by 50% to $25 million

Against an EBIT of $15 million, SBS is still going to face a loss of $10 million from its bus segment. To counter such a loss, SBS will then have to increase their bus revenue by at least $200 million a year using a EBIT margin of 5%, which means it will have to increase its revenue by 40%.

I believe that SBS will rather that government funds its MRT which has much lower operating cost but a higher fixed cost. SBS is going to suffer rather badly in the years to come even with the government funding. After the 10 years funding period, SBS will then have to fund an additional operating costs of 425 buses.

VICOM - FY 2011 Quick Update (Edited)

FY 2011 result has been announced today and I will do a short summary before the annual report is released.

For the Financial Year 2011, VICOM has achieved a profit growth of 14.2% to achieve a profit after taxation of $25.5m. While revenue increases by 8%, operating expense increases only by 6.4%, thus resulting in a 14.2% profit growth. Operating profit margin and net profit margin reach a new record of 33% and 28.1% respectively.

For the balance sheet, Cash and Bank Balances increases by 6 million to reach a high of $55m and of course without any debt. Trade receivables increases from $7m to $10.5m. Vehicles, Premises and Equipment increases from $49m to $55.5m, likely due to the finished construction of new building at Teban Garden.

FCF is at $18m due largely to purchase of Vehicles, Premises and Equipment of $12m. For the past 2 years, spending on this area has been at record high due to the construction of new building and laboratory. With its completion, FCF will be able to improved significantly baring any unforeseen circumstances. However, FCF/ Net Profit is still at a very healthy 70% despite this increased spending.

A final dividend of 7.5 cents and special dividend of 3.2 cents has been declared, totalling 10.7 cents, compared to a final dividend of 6.6 cents and special dividend of 3.2 cents. Total dividend for FY 2011 is 17.5 cents, which is a 4.49% yield based on current price of $3.90.

The only part that I am unhappy about is the increase in share capital from $31.4m to $34.4m, which results in a modest increase of 11% for EPS. This will have to wait until the annual report is out but from what I know the share option available is around 10%.

I just got the options and share capital figured out.

For FY 2011, a total number of 1,505,000 options were exercised, representing a 1.74% increase in total number of shares from 86,358,000 to 87,863,000. 779,000 options are not yet exercised and represent 0.89% of total share capital.

The reason for the 10% increase in share capital is that the original share was issued at a price of $0.50. This latest exercise of share option was done at an average price of $1.91, thus increasing the total share capital by a huge amount.

Many might have been worried about the share option, but I have just found out that this was in fact due to the "2001 VICOM share option scheme":

"* EXPLANATORY NOTES ON SPECIAL BUSINESS TO BE TRANSACTED

Resolution 11 is to authorise the Directors to issue shares upon the exercise of options in accordance with the 2001 VICOM Share Option Scheme. This scheme was approved by Shareholders at the Extraordinary General Meeting held on 27 April 2001 and has a maximum duration of 10 years. The aggregate number of shares over which the Committee may grant options under the scheme for its entire duration is limited to 15% of the issued ordinary shares in the capital of the Company excluding treasury shares from time to time. 2010 was the last year for which new options were granted under this scheme. The Company is not seeking a renewal of the scheme.

From 2006 onwards, no options would be granted to non-executive Directors."

Through some calculation, total number of share options granted in FY2011 stands at 24,000, which is likely to be only for the top management. Thus, option will not be a concern for those who have bought in 2011 onwards since only 0.89% is not yet exercised. However, we do need to be careful if the company is seeking a new share option scheme.

"GROUP OUTLOOK
The number of vehicles due for inspection is expected to remain high as the de-registration rate of vehicles continues to be low.
With a comprehensive range and variety of services, it is expected that the test and inspection business will continue to sustain its performance despite the anticipated economic slowdown."

(Vested)

Extraordinary Item - How They Should be Treated

The much awaited reporting season is here again and a careful review of any vested company should be done for an understanding of the direction of which the company is heading towards. Such a review can be timely to provide sufficient reasons in divesting or investing in a company, especially so when the reason for investing in it has changed for better or for worse. However, we may face with extraordinary items which can have a massive impact on the company's bottom line which will seriously complicate the matter.

Extraordinary items are usually stated in the financial statement in a separate line from the revenue. They are meant to be a one-off and infrequent event that should not occur often in the normal course of business. In fact, I will seriously consider part of the revenue as extraordinary profit so long as they are not generated from the core business or as mentioned "should not occur often in the the normal course of business". This is so that one can be conservative in the calculation and since one should not expect it to reoccur again in the next year or so.

Therefore, the frequency and likelihood of occurrence are to be the first factor in assessing these extraordinary item. If they are indeed that unlikely to occur, then they can be easily dismissed. In such a case, I will want a huge extraordinary loss so that I can buy at a much cheaper price provided that the company has sufficient financial strength to survive through it. Such example might be "Act of God", selling off of operation, lawsuit settlement or compensation.

However, in certain cases, such one-off event can be recurring of which then requires some careful examining. For e.g. the company might have a factory located in a flood-prone area in Thailand. After the flood, if the management treats this as a one-off event and not implement any measures like relocation or implementation of anti-flood measures, you can expect to have recurring extraordinary item year after year. Just look at how many times Wendy's at Liat Tower has suffered a loss for it, from damage to equipment to loss of income from closure of shop.

While extraordinary items are infrequent and should be discounted from the bottom line, they are not meant to be simply discarded. At the end of the day, they will still have an impact on the company's balance sheet and financial strength. One should be happy with the selling off of a high capex, unprofitable, cash-bleeding non-core operation. A lump-sum investment gain or settlement losses can double or halve the cash holding of a company and can even affect the dividend paid. In certain case, the company might return cash to the investor like in the case of San Teh. While the Japan's earthquake and nuclear incident are an Act of God, the company will face huge losses of physical asset and will have to fork out a rebuilding cost unless a catastrophic insurance is purchased.

In another very special case, a company in a recessionary financial year might choose to take extraordinary provision or losses since losses might be expected anyway. What happens might then be that losses that should have occurred in the next FY or so has been accounted in the current one. For the next FY, the company will have a huge turnaround with massive profit gain where in fact the gain should have been minimized. It will then be very hard to assess the company's profit other than perhaps to combine the results for the past years and average it out.

To conclude, extraordinary items should be treated with extraordinary care and caution. A comprehensive analysis is needed for an understanding of its impact to the 3 different financial statements. The worse of all will be if the management fails to recognize a one-off event or if a "Big Bath" is being taken.

Young Investor Series - Why Should you invest in the stockmarket (Part 3)

One likely pitfall that many thinking of starting young will face will be their limited capital. With a minimum charges of around $30 ($25 for commission and another $5 for GST and clearing fee) per trade, a trade of $3000 will cost $60 of brokerage fees to buy and sell, equating to a 2% loss. However, a smaller capital outlay at the start can prove to be a better investment in the long run.

First of all, let's face the fact that it is highly unlikely for one to be generating high returns continuously in the long run when one just started out even if one may have read tons of investment books. Knowledge is just a tiny portion of investing as compared to experience, emotional stability and patience.

Personally, I have make all kinds of mistakes right at the start which has allowed me to learn in a much less painful way. Think about those who started in a hot bull market, where everything they buy just rises spectacularly and they can double their capital in weeks as they believed they have the "Midas touch". They will continue pouring all their savings into their so called investment, trade with margin and when the bull cycle ended, many faced a near total wipe-out of their capital.

My point is not whether one should start in a bull or bear market, but the younger one is, the lesser capital one will have and thus the lesser the mistakes will cost. Be it a 10% or a 90% loss, one will lose lesser in the absolute term and it will be likely that one can earn those money back by saving and working harder. And of course, unlikely that one will have to support his family. Imagine a 40 years old who losses his lifelong savings and has about 20 years more before he retires.

Another way to look at this will be that the earlier one learned from his mistakes, the longer a period that he has to compound his win. Assuming a super bull cycle of 10 years, a 20 years old will only be 30 years old when he learned his lessons, gained experiences and maintain emotional stability.

Last but not least, investing in stocks will be beneficial to students studying economics, accounting and business, or exploring career path in these area. While I have the habits of reading The Straits Times before I started investing, I will always skip the Money section as I think that it is just too complicated. Now, I read Bloomberg and CNBC even before I have my breakfast. Understanding what's happening in the financial sector will definitely put one at an advantage over his peers when it comes to finding a job.

Thus, starting young is beneficial in many ways and there's not much reason why not to other than maybe the younger one is the more rash and impatient one will be. Even if one is afraid of capital loss, there is no harm in playing around with paper trading though one need to be careful when one decided to switch to real stock investing.

Young Investor Series - Why Should you invest in the stockmarket (Part 2)

Earlier in part 1, we have discussed about how inflation has been eroding our wealth, while the stockmarket has proven to generate a much higher return in the long run. Some may say that with the current macroeconomic environment, inflation is not that high and it might be safer to put in fixed deposit with the bank. They will want to wait till they got much older and with more capital before they start investing. While there's nothing wrong with that, the younger one starts, the better one can enjoy the effect of compounding interest. Warren Buffet who started an age of 11 in fact thought that he should have started even earlier.

Using a 6% rate of return (considering historical 9% return for stock index) and 55 years old as the end year with an initial starting capital of $10,000, here are the differences in return:

At 55 years old,

Start at 20 -> 76,860

Start at 25 -> 57,435

Start at 30 -> 42,918

Start at 35 -> 32,071

Start at 40 -> 23,966

Start at 45 -> 17,908

For every 5 years younger that one start, it can equate to a lesser return of $10,000, which is your initial starting capital.

Here's another scenario: Assuming the same condition previously but that one add an additional sum of $1000 every year (Saving up $3 per day).

At 55 years old,

Start at 20 -> Total Sum Invested = $45000 Total Return= $194,981

Return Earned= $149,981

Start at 25 -> Total Sum Invested = $40000 Total Return= $141,237

Return Earned= $101,237

Start at 30 -> Total Sum Invested = $35000 Total Return= $101,075

Return Earned= $66,075

Start at 35 -> Total Sum Invested = $30000 Total Return= $71,064

Return Earned= $41,064

Start at 40 -> Total Sum Invested = $25000 Total Return= $48,638

Return Earned= $23,638

Start at 45 -> Total Sum Invested = $20000 Total Return= $31,880

Return Earned= $11,880

Therefore, the earlier that one starts, the higher the absolute return that one can get.

My definition of Margin of Safety

Margin of Safety is a very important concept in the field of value investing and of course comes from no other than our dear Benjamin Graham. In the Intelligent Investor, he mentioned that "margin of safety is always dependent on the price paid". Basically, if the intrinsic value is $1, you should purchase the stock at as much a discount as possible. Do note that intrinsic value and book value are not the same. The reason why margin of safety is needed is because that we are always susceptible to a huge downturn or error in judgement. Should anything happen, losses will be limited as we have bought it at a discount. However, the crucial part in the calculation of margin of safety lies in the estimation of intrinsic value, which makes it very very dangerous for those untrained or inexperienced, like me. Valuation methods differ from comparable, DCF, PE, PB and more than often using of different methods give you different intrinsic value. This is one reason why I never try to do valuation (I will try to learn though) for my stock. So how should the layman ensures his margin of safety? Here is how I do it:

Never Overpay

I will be very careful whenever the PE is more than 15 and will very likely not consider it at all if the PE is more than 20. This only works for company that has regular products and services being sold, else I will have bought into OUE whose PE is 2. For companies in the property sector or whose income is highly dependent on their assets, P/B will be more useful. P/B can also be used for banks and financial company as they essentially depend on borrowed money and lending it out. Discount to P/B differ for different sector, thus it will be better if one will to compare it with the sector and their historical P/B value.

Research and Understand the Company

Knowing as much as possible about the company that you buy into is very important. Be it whether it is in your circle of competence, one should at least understand the type of products and services that the company provides, its market share, competitors and the industry at large. In such a case, one will be able to react well should anything unexpected happen like maybe a lawsuit, new competitor, recession and e.t.c. If sufficient research is done, one will be able to sleep well at night without fearing the unknowns. This is also a criteria for you to be able to take advantage of Mr Market, by understanding about the company more than your fellow shareholder.

Good Business Model confirmed with Financial Statement Analysis

With a good business model, a company will be able to maintain its profit in almost all circumstances. So long as a company is able to grow its bottom line, its intrinsic value will be achieved sooner or later. As Warren Buffett says "You should invest in a business that even a fool can run, because someday a fool will". Thus, after you have identified a good business model, you should start to examine its past annual report and financial statement. If the business model is indeed sound, it will usually be confirmed by the financial statements like consistent profit growth, high profit margin, net cash, high ROE and e.t.c. If the analysis proves otherwise, it only means two things: 1) A fool is indeed running the business or 2) The business model is not as sound as you think it is.

Intention to hold it for a significant period of time

Having a long term view is important since more than often we are never that fortunate to pick a stock when it reaches its lowest point. If you have abide by the above three principles, the last thing that you need to do is to hold it out so long as the initial reason for the purchased is unchanged or wrong. Just like an antique collector that knows the worth of his collection, he will never sell it at a discount even if you may try to convince him that it is overvalued. What he will do will be to wait until he is being offered a price that he deemed fit. Similarly, the market might offer you a deserving price only in the long run, perhaps years.

These I believed will be much more meaningful than trying to calculate the intrinsic value and hence the price that you should buy a stock.

Young Investor Series - Why Should you invest in the stockmarket (Part 1)

I have decided to start the Young Investor Series to encourage and educate more young students and adults to invest in stock because I have believed in the merits of starting young. While I am obviously way too inexperienced, it has been a very meaningful journey for me thus far especially since I started my journey at this time of uncertainty and turbulence. In fact, I believed that I have learned much more than I will have from having started in this current mild bear market. From getting very excited at how the price tick when I first began, I will only get as excited now when I discover a company of great fundamental.

The first reason why you should invest in the stockmarket is that while cash is king, it is never wise to have 100% of your wealth in cash (other than possibly waiting for the next huge financial crisis) because cash has proven to be a depreciating asset due to inflation. Inflation results in the erosion of wealth as the price of goods increases but your cash remain the same. Your 50 dollars note will only provide you with $50 of value next year even if your chicken rice costs you an additional 50 cents. Average inflation has been around 3.5% for the last 100 years, this may seemed little but in fact it is very scary if you will to compound the 3.5%. Using the rule of 72, your wealth will be depleted by 10% every 3 years and half every 20 years. The total amount of inflation from 1913 to 2006 is at a staggering 1929%. Neither should you expect the inflation trend to discontinue as it was only during the Great Depression of the 1930s that you have a long period of deflation.

On the other hand, stockmarket has generated an average of 9% return over 100 years. The key is 100 years, which means such a return is likely only if one invest with a long term outlook. Thus, it is wise to have some of your wealth invested in stockmarket be it directly or indirectly through some form of stock mutual fund or ETF. The stockmarket has over the long term be able to deliver a return that way exceed the inflation rate. One need not put all its wealth into it in order to combat inflation as putting 30% of it in stockmarket will be sufficient to avoid erosion of wealth. This is especially true in Singapore where our bank pays a meagre amount of 0.125% interest on deposits. For every $1000 that you have, the bank will pay you $1.25 yearly.

While many might have heard stories of people going bankrupt from PLAYING with the stockmarket, one can choose to be a passive and defensive investor which does not requires much of your time and effort to be.

In conclusion, one's wealth will be drop by an average of 3.5% yearly if one does not take any action to protect it. Part 2 will be on the magic of compounding interest and why the younger you are the better a magician you are.

Scuttlebutt in the 21st Century

In Common Stocks and Uncommon Profits, Philip Fisher devoted a chapter to write about scuttlebutt and how it can reveal precious information about the company. Scuttlebutt involved talking to the customers, competitors, suppliers, employees and key management of the company. Through the technique, it can tell us about the competition, popularity and quality of the products and how strong is its brand name.

However, for some of these people, it might be really inaccessible to us, the retail investor. Some companies might have also expanded overseas of which it will be rather expensive and time-consuming to have a look at them. Or a company might just have more than 50 branches all over Singapore. Supplier of which you have no business interest in might not be bother about you as certain information revealed might sensitive or simply confidential.

These applies more to the Fisher era where the internet is not as developed yet. In this era today, the potential of internet in the scuttlebutt research process is tremendous. This development has narrowed the knowledge gap between the retail investor and the professional fund managers. Now I shall elaborate on how can we make use of this tool to access information that Fisher might have to spend weeks to gather in the past.

Forum and Review site

Nowadays, whenever we wish to find out about which brand of laptop has the highest quality, which mobile phone has the longest battery life or utility, we can just Google it or find the answer on the forum. These site allows customer to badmouth about their bad experiences or to compliment a company for its excellent product. Without the need to fly overseas, we can easily find out about how popular a product is elsewhere. More than often, there will be two sides of argument like though product A's design is not as nice, it is still the most reliable and durable.

IR, PR and customer service

While not all IRs are willing to answer your questions faithfully, there are some that will be ready to help out with most of your enquiries and try their best to provide you with the necessary information. For PR, it is more of how well they can handle the media and how well they are being received by the general public. The reputation and brand name of a company can be maimed when you notice how people started scolding or even threatening to boycott it. Or try sending an email as a customer that has just met with some problem after a purchase to check the quality of service.

Employee

What's a better avenue for a disgruntled employee to scold its boss or lament about the organisational inefficiency other than the web where one can comment anonymously. Or simply to share the benefits and perks they enjoyed with potential future colleague.

Industry Data

Other than having your annual report online, industry statistics can also be found through government website, university research or some other research project. News archive may also be available online for free and provides a history of problems the company has faced before.

Book

While this has nothing got to do with your internet, it is much easier nowadays to find a book commenting on maybe how Google becomes the search engine giant or how GSK manipulated the pharmaceutical scene. Of course, this mostly applies to big corporations with extensive operations.

While the above that I have listed are all that I can think of, the potential of it depends on how creative you are in sourcing for your information. One word of caution though, because of the anonymity you need to exercise your discretion in processing the information. And no matter how positive your Scuttlebutt is, never forget to analyse the financial statements of the company for you might never know what you will come to know about the company.

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.