Boustead – FY 2008 Financials Review and Discussion Part 2

Segmental and Divisional Review and Analysis

The table below shows the breakdown of revenues by business segment, for FY 2008 versus FY 2007.

Engineering services formed the bulk of revenues, contributing 83.6% of total revenues. This was not much different from FY 2007 where it took up 81.2% of total revenues. However, the Engineering division saw growth of 31.2% in total revenue, and this is considered decent. Geo-Spatial technology, which involves selling technology systems which optimise resource-finding and are mainly used by government agencies, saw decent revenue growth of 8.7%. This is a cash cow division which brings in a lot of cash but has low growth prospects. I suspect Boustead is using this division to generate the cash to fund the growth of the Engineering Division. As mentioned in the operational review, the Australian business unit saw double-digit growth which was offset by the flat performance from the Asian business units.

A further breakdown of Engineering Services reveals some very interesting insights. The rest of the explanations into the increases can be found in the company’s financial statements and press release. I would like to highlight a few things which may not have been mentioned:-

The growth in Energy-Related Engineering (BIH and C&E) was slower than expected due to the integration of the recently purchased Australian business with the existing Indonesian Business. This move stunted the short-term performance of Boustead Maxitherm but enhances the long-term competitive edge and revenue contribution from this division, and can be seen as a positive move for the future. As a result, revenue contribution (to total engineering services) from this division dropped from 46.8% in FY 2007 to 37.4% in FY 2008.

Real estate solutions took over as the dominant division for FY 2008, contributing more than half (52.8%) of revenues for the Engineering Division compared to just 44.7% in FY 2007. Stripping out the sale of 2 industrial leasehold properties in FY 2008, comparative revenues actually increased 58.9% (according to company announcement) rather than just the 54.9% featured in the table. With the recent slew of contracts clinched by Boustead Projects, including the Libyan Township project, FY 2009 should set to be an even better year for this division (more on this in Part 3).

The disappointment is in Salcon, representing the water and wastewater division. Although revenues grew 50.8% to S$35.9 million, it was because of the low base, and FF Wong mentioned that the division had incurred a loss of S$14.8 million for FY 2008 (from audiocast transcript) compared to a loss of S$7.7 million for FY 2007. As explained by FF Wong in the audiocast, this was because of two unfortunate events which caused the division to slip into losses when it was supposed to have turned around. This was the only blemish in an otherwise excellent year for Boustead in terms of growing all its business units. Part 3 will touch on Salcon’s plans and also cover a little on the Libyan Wastewater contract offered to Boustead for FY 2009.

Mid-July 2008 Portfolio Summary and Review

The first half of July 2008 was relatively exciting, as there were several key business announcements and updates from the companies which I own, culminating into a busy half-month in terms of tracking and following my companies’ progress. Fortunately, most of the news reported has been positive (not always the case, when you consider that a fire broke out at Kreuz Shipyard just last month), and encourages me to know that despite the global downturn and the sub-prime problems, the companies which I own are still doing fine.

The most notable news from Wall Street and USA is the collapse of Indymac following a bank run, which basically translates into a crisis of confidence that the USA’s second-largest bank would be unable to honour deposits. The US Government had to provide financial support to the bank and it will now operate as Indymac Federal Bank. Separately, Fannie Mae and Freddie Mac, two of the largest mortgage institutions in the USA, suffered a massive selldown in the value of their shares after a similar crisis of confidence erupted that the two companies were technically insolvent and would be unable to honour their debt obligations. As at the time of writing, Congress had already come up with a plan to bolster the capital of the two companies if need be and they have prepared a rescue package to restore confidence in the financial sector (similar to the Bear Stearns issue back in March 2008). The sell-off across all markets has made valuations a lot more attractive and hopefully the good news will continue in the coming months as equities become more affordable.

The reporting season for 1H FY 2008 for my companies will begin very soon, not counting Ezra which reported its 3Q 2008 recently (and will be reviewed in a separate future post). FSL Trust will report results on July 22, 2008 while Suntec REIT usually releases its 3Q 2008 results close to end-July 2008. Following this would be Swiber 1H FY 2008 (mid-August), China Fishery 1H FY 2008 (end-Aug) and Pacific Andes 1Q FY 2009 (end-Aug).

Below is the summary of my investments and related news as at July 15, 2008 (STI at 2,830.75 points).:-

1) Ezra (Vested since October 6, 2005) - Buy Price $0.645 (bonus adjusted), Market Price $2.27, Gain 250%, YTD Loss 31.9%. Ezra released their 3Q FY 2008 results on July 10, 2008. Net profit was up 78% while revenues were up 85% for 3Q 2008, as a result of the delivery of vessels during FY 2008. Gross margins were down somewhat due to the delays in delivery of other vessels and so Ezra had to resort to third-party charter. In addition, construction projects also traditionally have lower margins and so dragged down the gross margin. I will comment more on their results in a separate future post.

2) Boustead (Vested since September 13, 2006; averaged down November 13, 2006) - Buy Price $1.295 (average), Market Price $2.46, Gain 90%, YTD Gain 2.1%. Boustead had a busy half month as it announced a slew of new contracts. First on the list was Salcon’s largest water contract to date announced on June 30, 2008, worth S$175 million in which Salcon has a 65% stake. Next was a S$37 million contract which Boustead Projects won on July 7, 2008 for building the Singapore Aero Engine Services Facility. Just two days later, Boustead Projects announced a S$67 million contract for the construction of a semi-conductor equipment manufacturing facility. As a result of these contracts, Boustead’s order book is at a record high and there is much anticipation for more contracts to be clinched as the Energy-Related Engineering Division has yet to announce any wins. Boustead’s AGM is on July 30 at 10:00 a.m. and consequently, they will be holding an EGM to approve the share split of 1:1 and also to approve the resolution allowing for the company to buy-back its own shares. Their Annual Report for FY 2008 mentions that the company will begin quarterly reporting starting from FY 2009, with the first quarter results due out in late August 2008. The company cautions, however, that due to the nature of some infrastructural projects, revenues and profits are likely to be lumpy (similar to a property development company). They therefore advise investors to use yearly figures for comparison rather than place too much reliance on quarterly numbers.

3) Swiber (Vested since February 14, 2007) - Buy Price $1.01, Market Price $2.14, Gain 111.9%, YTD Loss 37.6%. Swiber announced, on July 14, 2008, that they had clinched a “substantial” LOI in Vietnam (a market they have been targeting for some time) through their joint venture partner Vietsovpetro since September 2007. The contract value was not specifically stated (probably due to confidentiality reasons) but the company did mention that it will boost their order book past the US$476 million for May 2008. As part of the contract, Swiber will provide project management, engineering, transportation, installation and PLEM, including tie-in and pre-commissioning. The contract is expected to commence in 1Q FY 2009 and be completed by 2Q FY 2009.

4) Suntec REIT (Vested since December 9, 2004) - Buy Price $1.11, Market Price $1.40, Gain 26.1%, YTD Loss 18.1%. There was no news for the company for 1H July 2008. Results for 3Q 2008 should be out by end-July 2008, with dividend to be paid usually by end-August 2008.

5) Pacific Andes (Vested since March 29, 2006; Rights Issue July 11, 2007 at S$0.52 per share; averaged down August 17, 2007 and July 3, 2008) - Buy Price $0.5475, Market Price $0.44, Loss 19.6%, YTD Loss 30.2%. Details of the scrip dividend scheme have been released in a circular, and I had commented on this in detail in a previous post. The AGM of the company will be held at Raffles Hotel at around 3 p.m. o July 30, 2008.

6) China Fishery Group (Vested since November 20, 2007) - Buy Price $1.50 (average), Market Price $1.40, Loss 6.7%, YTD Loss 24.3%. China Fishery announced on July 7, 2008, that it had acquired additional 3 purse seine vessels from a fishing company in Peru for a total consideration of US$11.7 million. This will provide the company with an additional fish hold capacity of 550 Square Metres, bringing their total fish hold capacity to 9,945 square metres or 5.6% of the Peruvian Industry total. The company also formally announced the introduction of the ITQ system in Peru, which will probably be implemented within the next 2 fishing seasons.

7) First Ship Lease Trust (Vested since January 14, 2008) - Buy Price (Averaged Down) $1.105, Market Price $1.25, Gain 13.1%. FSL Trust will release their 2Q 2008 results and DPU on July 22, 2008. It is expected that they will pay US 2.77 cents per unit as per their previous guidance. Guidance for 3Q 2008 is currently US 3.05 cents per unit, pending the financing for the third Yang Ming vessel which may raise the DPU about US 0.02 cents.

Overall Portfolio

The gain on my current portfolio is 35.8% from a new cost of S$89.2K as at July 15, 2008. The market value of my portfolio is S$121.2K. Realized gains remain at S$6.2K until the ex-dividend of Boustead on August 4.

Comparison against STI

Using my new benchmarking technique:-

The FTSE STI had declined by 18.7% since the start of 2008. My portfolio (without FSL Trust and the new PAH purchase) has to date declined 25.1%. Therefore, I have under-performed the STI by 6.4 percentage points.

FSL Trust has gained 13.1% thus far from my date of purchase while the benchmark STI has fallen 12.0% (from my date of purchase Jan 14, 2008 when STI was 3,218.14); I am happy to report that FSL Trust has managed to out-perform the index for FY 2008 thus far.

The new Pacific Andes tranche which was purchased at 44 cents per share on July 3, 2008 will be analyzed separate from the rest of the portfolio. STI as at July 3 was 2,880.45 and STI today is 2,830.75, thus this represents a 1.73% loss. Current share price of Pacific Andes is 44 cents, representing no gain or loss. Hence, my purchase of Pacific Andes has managed to bear the index by 1.73 percentage points.

My next portfolio review will be on Thursday, July 31, 2008 after market close.

Boustead – FY 2008 Financials Review and Discussion Part 1

I guess this was long overdue, but a review and analysis of Boustead should not be done in a hurry anyway. The company is slowly and steadily growing its business and its order book, and the CEO has expressed optimism recently that a turnaround can be expected in the water and wastewater division. I will be analysing the P&L, Balance Sheet, Cash Flow Statement as well as commenting on Boustead’s 3 main divisions (not counting ESRI which does geo-spatial – I will touch briefly on this) for Part 1. Part 2 will analyze and comment on the segmental business units for Boustead and their performance and prospects. Part 3 will touch on the future – how Boustead has progressed thus far in FY 2009, the direction each division is taking, as well as future endeavours that the company is planning to make (from FF Wong’s interview in Pulses magazine as well as his audiocast replies).

Profit and Loss Review

If one takes a close look at the Income Statement, revenues for FY 2008 had increased 27.5% compared to FY 2007, while COGS had increased by 33.5%. As a result, gross margin dropped from 34.1% in FY 2007 to 31.0% in FY 2008. This can probably be attributed to the slew of constructions projects which Boustead Projects had taken up, in which the cost of materials had been rising in the past year. Some of these costs had not been hedged and the company would suffer some margin erosion as a result. Real estate solutions revenue for FY 2008 was S$193.3 million, making up about 44.1% of total revenues for FY 2008, hence the impact of the margin erosion would be substantial. Moving forward, the Company has mentioned that it will use cost-plus pricing for its Libyan Township project, so as to mitigate the effects of rising costs.

However, the company has managed to actually reduce its selling and distribution, admin as well as finance costs even though revenues had increased. It is interesting to note this and is a clear indication that economies of scale are present to be able to allow the company to grow its top line without consequently increasing its expenses. Many companies show impressive top line growth of 80-100% only to see its expenses balloon about 300-400%, effectively negating the increase in revenues. Hence, as a result of this, Boustead’s net profit is up 45.7% to S$58 million, which exceeds the increase in revenues of 27.5%. Net margin increased to 13.2% from 11.6% in prior financial year.

Balance Sheet Review

Boustead’s Balance Sheet is one of the “cleaner” ones I have seen during my investing lifetime, as compared to my other companies as well. Most companies would carry significant amounts of debt, receivables or inventory in their Balance Sheet, which creates risk of uncollectibility (receivables), obsolescence (inventory) and high finance costs (debt). Boustead avoids taking on excessive debt and instead relies on short term loans (just S$5.8 million) for its contracts. In fact, long-term debt was paid off in FY 2008 compared to FY 2007, and total debt decreased from about S$20.4 million to just S$14.5 million. The company’s receivables also did not increase in tandem with revenues, but was only a 13.1% increase. Its inventories are kept low (S$8.8 million) and most of its current assets consist of properties held for sale as well as costs capitalized from uncompleted contracts (to be billed later on as progress billings). Hence, I would say the Balance Sheet is very “clean”. Current ratio had dropped slightly from 1.83 in FY 2007 to 1.67 in FY 2008, mainly due to an increase of 51.5% in trade and other payables.

Cash Flow Statement Review

It is very clear from the cash flow statement that Boustead generates a lot of cash from operating activities, as net cash from operations amounted to S$81.4 million, an increase of 70.7% from FY 2007’s net cash inflow of S$47.7 million. In a further testament to Management’s move to enhance shareholder value, cash flows were used to acquire shares from minority shareholders (S$9.6 million), which consists of acquiring the remaining 10% interest in Boustead International Heaters on June 20, 2007. Purchases were also made of fixed assets and quoted equities (available for sale investments) amounting to a total of about S$12.5 million, while the disposal of a property (warehousing facility at 40 Changi North Crescent) yielded a gain on disposal of about S$6.4 million (recognized in Income Statement) and cash of S$10.2 million. Overall, net cash outflows from investing activities amounted to S$10.1 million.

Clearly obvious too, is Boustead’s ability to fund their contracts and projects from operational cash flows, as the cash flows from financing activities do NOT include taking up bank loans or issuance of any form of debt securities. Neither does it entail the issuance of any equities or rights, which is admirable indeed. Many businesses (including those which I own) need to grow through debt and equity issuances in order to fund purchases of fixed assets which then help to generate recurring revenues, but Boustead is able to carry on growing its business purely on cash flows alone. During FY 2008, they paid down some long-term bank loans of S$8.3 million and also paid dividends to minority shareholders. The bulk of cash outflows actually came from dividends paid to majority shareholders of S$17.1 million.

Overall, the company is in a very strong cash position with a cash hoard of S$163.1 million, which the CEO had mentioned will be used to acquire businesses which generate a sustainable recurring source of revenue.

Part 2 will continue by reviewing each of Boustead’s divisions and commenting on their performance.

Pacific Andes – A Discussion of the Scrip Dividend Scheme

The circular for the proposed scrip dividend scheme implemented by Pacific Andes (PAH) had just arrived yesterday, and I spent some time reading it and digesting the facts; and some more time after that lying in bed thinking about the ramifications, possible effects and choice to be made. Suffice to say that this scheme is new to me as well as I had never invested in a company which came up with a scrip dividend scheme before, and I am now analyzing this scheme using my own understanding of how it works (as described in the circular) as well as my own personal interpretation of the merits and demerits of this scheme.

First of all, some of the salient points in this scheme should be mentioned:-

a) The scrip dividend scheme is optional. This means that shareholders can opt for the cash dividend or for the scrips, depending on their preference. They can also issue a standing order for all future dividends to be paid out as scrips, which can be terminated at any time in writing should the shareholder wish to revert back to receiving the dividend in cash.

b) You CANNOT elect to opt for only part of your holdings to be paid in cash, with the rest in scrip. This means that you either choose for ALL of your shareholders (as at books closure date) to be paid fully in cash or all in scrip (additional shares of the company). Unless one receives more than one Notice of Election (NE), this is not possible and anyway it would be an administrative nightmare should the company allow for this.

c) The computation for the number of scrips issued is based on the formula X = (A x B) / C, where X is the number of scrips issued, A is the shareholding as at books closure date, B is the dividend per share declared (net of corporate income tax) and C is the issued price of each scrip share. The interesting part is how C is computed, as A and B are known variables and are objective facts. The price per scrip is taken as the arithmetic average of the closing market price of PAH for the last twenty (20) market trading days prior to books closure date, with a maximum allowed discount of 10% to this price.

a. Note the word arithmetic is used and not weighted average, thus this means the simple average of all the closing prices taken from 20 days BEFORE the books closure date (i.e. not inclusive of the actual day of books closure);

b. 20 days is used as a benchmark seemingly to even out any fluctuations in the share price which may result from speculation or panic selling, and I think it is intended to assuage investors that they are getting a fair price based on market conditions;

c. A maximum discount of 10% is allowed to this average price, but is up to the sole discretion of the directors, which means this is the only wild card in the equation which cannot be determined by shareholders until AFTER books closure date. Thus, the discount can be anything from 2% to 10%, but of course everyone who chooses the scrip option hopes for 10% so that they can get the maximum number of shares for a lower price.

The analysis of these facts yields the following conclusions:-

i) By choosing the cash dividend instead of the scrip, one must believe that one is able to grow the amount of money which is received at a higher rate of return than that which PAH can provide. This is because choosing the scrip is actually a form of reinvestment of dividends, and is similar to what Berkshire Hathaway does when it chooses NOT to pay dividends but instead reinvests them for higher compounded annual growth. If one believes that one’s ability to grow his/her own money is better than that of the company, then one should choose to take the cash and reject the scrip.

ii) Choosing the scrip dividend has advantages to the company itself as well, as they would be able to conserve cash for reinvestment into the business and also grow their equity base at the same time. The amount of dilution to earnings will be very minimal and immaterial, and I think PAH’s intention to declare this scrip dividend was precisely for this reason – they are hoping more shareholders choose scrip over cash so that the company can conserve cash for expansion.

iii) Shareholders should also note that should they choose NOT to accept the scrip dividend, they will suffer mild dilution as the equity base of the company will grow but their shareholdings will remain the same. Thus, the pie will grow larger but your share of the pie (in percentage terms) will be reduced. However, the effect is not very pronounced and can also be considered immaterial.

iv) The choice will also depend on whether the scrip is being offered at a price which is attractive relative to one’s own cost of investment. I will use a hypothetical example to illustrate my point. Assuming Mr. T has 10,000 shares originally purchased at 60 cents per share. The arithmetic average of the closing price of the last 20 market trading days is about 48 cents per share (as at today). Hence, assuming a discount of 5% (to be prudent), this works out to be 45.6 cents per share. Mr. T would then receive a total of 453 scrip shares based on the final dividend of 2.07 cents per share for FY 2008. Thus, his total cost would now be S$6,206.57 on a base of 10,453 shares, which means his new average cost per share will be reduced from 60 cents to 59.38 cents. This simple example shows that this is one good method for averaging one’s cost assuming the final scrip dividend price is lower than one’s original buy price. One more additional plus point is that such scrip dividends do not incur brokerage costs or commissions and are free of transaction costs.

v) One negative aspect of this exercise is that one would almost surely end up with odd lots (i.e. shares which are not rounded to the nearest thousand which are traded as board lots on the SGX). This means that disposing of the additional scrip shares may prove a problem as one has to sell it in the odd lot market, which is generally more illiquid and has wider bid-ask spreads. However, if one adopts the perspective of a value investor and is willing to hold on to their additional scrip as the company’s value increases, then he will eventually reap the fruits of his patience.

Based on the analysis above, as well as my personal perspectives of the company and its growth potential, I will prefer to opt for scrip dividend. It allows me to increase my stake further to participate in the growth of the company, allows the company to conserve cash, allows me to average down my current cost and also prevents me from being diluted when others exercise their choice for scrip dividend.

Pacific Andes - Rationale and Reasons for Increase in Stake

On July 3, 2008, I increased my stake in Pacific Andes at an attractive price of 44 cents per share, thereby taking advantage of Mr. Market's manic and depressive mood swings. Below are a list of reasons (including some risk factors outlined) which underlie my decision to purchase more of this company. This move was a calculated and well-thought out decision and was not made on the spur of the moment as I had been studying and reading up on the company and industry since my first purchase, and have been waiting for Mr. Market to sell to me at an attractive valuation. Please feel free to criticize or discuss the reasons below:-

1) Pacific Andes is in an industry which has high barriers to entry. Only a few large players have access to fishery resources and many players are limited by the high capex which is required to operate a fishing SCM system and fishmeal plants. Smaller players only own a few vessles and cannot achieve the economies of scale which will make their operations more efficient; thus they risk being bought out in an industry consolidation (which has been occurring during the last few years). PAH also owns 64.1% of CFG which is growing its business with respect to its trawling operations and has expanded its activities and fleet through their 3rd and 4th VOA. CFG has plans to grow its revenues and bottom line which will enhance the earnings flowing to PAH.

2) Dividend yield is attractive at my purchase price of 44 cents per share as the final dividend declared is 2.07 cents per share. This translates into a yield of 4.7% which is 5.3 times better than the prevailing interest rate offered by Maybank’s iSavvy account (0.88%) where I am stashing my opportunity fund.

3) Peru had recently, on June 28, 2008, introduced the ITQ (Individual Transferable Quota) system, and this will be applicable for the next 2 fishing seasons once all the applicable regulations and legislation are passed through. The benefits of this system are as such:

a] Ensuring the long-term sustainability of fish sources and preservation of the environment – this move will prevent over-fishing and is good for the long-term future of the industry and for all players within the industry;

b] Austevoll Seafood ASA and Copeinca have both commented on the ITQ as opposed to the old method using the “Olympic” system. Austevoll says that this will ensure a move away from an “expensive” way of harvesting to one which is more focused and will reap economies of scale and improvements in the quality of raw materials and finished products. This would translate into higher prices for the industry overall as higher prices accompany higher quality. Copeinca has also commented that it envisions a 30-40% increase in EBITDA as a result of greater efficiencies in fishing processes and deployment of vessels (in a separate press release). However, one small downside is the imposition of a new fee of USD 1.95 per ton of fish unloaded which is to be set aside for the fisherman’s retirement fund (this also helps to build loyalty among the fishermen and minimizes strikes and riots which could disrupt operations);

c] The new ITQ system makes it easier to schedule and plan for vessels to be allocated to various fishing grounds as it is no longer a “mad rush” to fish as much as you can before the season ends and the quota is reached. Thus, this benefits all players within the industry as they can now selectively deploy their vessels and schedule them for maximum efficiency; further enhancing economies of scale.

4) In the last 2 quarters (3Q 2008 and 4Q 2008), there has already been evidence of PAH achieving better efficiencies in terms of lowering their COGS with respect to their revenues. The growth of revenue is greater than the increase in COGS, which implies economies of scale from the Peruvian acquisition of fishmeal plants and vessels should be kicking in and showing its effects. For China Fishery’s 1Q 2008 financials, the results are very dramatic in that revenues dropped 2% while COGS dropped 42.3%, thus it shows the dramatic efficiencies being achieved for CFG with respect to its new fishmeal business as well as trawling operations. The ITQ system should help to enhance this efficiency and make it even more pronounced, but this will take time (probably in 2-3 years).

5) Valuations are attractive as PAH is only trading at a historical PER of 6.2 times (using net profit attributable to shareholders of HK$481 million @ 1:5 divided by share capital of 1.35 billion shares to get EPS of S$0.0713). Compared to global peers such Copeinca which are trading at 10-12x, this makes Pacific Andes under-valued (perhaps due to the China inflation factor depressing the valuations of many S-shares listed on SGX, regardless of the nature of the business or inherent characteristics of the company).

6) Management has a good track record and understanding of the business and they have built up many years of growth for the company by using strategies to grow their fleet organically (through fleet enhancements) and through acquisitions. It is because of this track record that I have confidence that Management can steer through any rough patches (which any normal business will encounter). Many Chinese companies have just come into the market (in 2 to 3 short years of operation) and hence lack a good track record to justify purchase.

7) Management is planning to add a new revenue stream from July 2008 by deploying 3 upgraded super-trawlers to South Pacific to fish in Chile. They will target a new species (Mackerel) and a new market (South Africa). This will add to the company’s top line and hopefully, bottom line as well.

8) Mr. Dennis Chan has mentioned in an earlier interview that PAH intends to increase its investment in Peru, though he did not give details due to disclosure confidentiality requirements. The fishing industry there is still very fragmented (according to a discussion with him during CFG’s AGM) and there are many opportunities for PAH to acquire smaller players in order to boost their fleet.

Risks involved in this investment decision

9) Even though a key risk is bunker costs rising as a result of record high fuel prices, this is an industry which can raise prices without affecting demand too much as it is controlled by a few large players, and fish are part of the staple diet of much of the world’s population and also a good source of protein. Hence, I see short-term price pressures which may push down net margins due to high fuel costs; but the trend for fish and fishmeal/fishoil prices is upwards over time, due partly to food inflation and rising consumption of fish by the world. In the long-term, I believe this risk will be mitigated.

10) PAH has always had high gearing and finance costs are a major source of expense which will eat into their net margins. However, CFG and PAH are in a business with high operational cash inflows, as observed by their financials over several quarters (adjusted for some timing difference in recognition of receivables and inventories). Thus, I see this gearing as merely assisting them in aggressively expanding their fleet, which they can then use to generate FCF to pay off their loans, bonds and notes gradually. As mentioned in a previous posting on leverage, it is difficult to determine the optimal amount of leverage required for a company operating in a certain industry, unless we are keenly aware of how that industry works. For example, Olam is also aggressively taking on debt in order to finance acquisitions which are earnings accretive to its business, and which help it to vertically integrate. Thus, it can be argued that high gearing is not necessarily bad as long as the company knows how to properly manage it and not to let it get out of hand.

11) As a result of high finance costs and record-high oil prices (US$146 as at time of writing July 3, 2008), PAH and CFG could see short-term margin squeeze which would affect profits in the next few quarters. However, taking a long-term perspective, there is much to look forward to with regards to their business model and expansion plans as Management have a clear vision of what they wish to achieve and are NOT in a hurry to execute. Instead, they are adopting a more cautious stance amidst the current economic slowdown and choosing to conserve cash; while trawling out (mind the pun !) for quality opportunities to increase their asset base through acquisitions of vessels or plants.

My average cost has been reduced from 65.5 cents per share to 54.75 cents per share as a result of the purchase. This will be reflected in my next portfolio review due on July 15, 2008.

Personal Finance Part 8 - Defining your investment and retirement goals

On the topic of retirement, many books and articles on the Net have been written about this but truthfully, one must always apply the principles to one's own unique situation and circumstances in order for it to be relevant. Most books can only give a guide as to what constitutes a proper retirement when it comes to finances, planning and budgeting; but each person has different needs and time horizons; thus it can be a pretty difficult topic to properly advise on unless one does a mental self-reflection first.

To start off the topic, please see Panzer's post on retirement which I think sums up the idea of retirement very nicely. Retirement can be defined as "one stopping work as he has enough passive income to continue to support himself through his golden years". Of course, many of us may have our own interpretation of what constitutes a proper and satisfying retirement. As I was discussing this with my wife, it occurred to me that no two people can have exactly the same definition of retirement. On one hand, one may wish to continue doing something he enjoys while being "retired", while another may consider retirement as travelling the world and enjoying the sights and sounds which one never had the chance when one was working in the ratrace.

For myself, retirement is more of a financial situation where I have achieved financial independence, rather than a specific age such as the government-mandated retirement age of 62. As Panzer rightly pointed out, at a certain age we can have access to our CPF monies; and assuming we have the minimum balance in place, can enjoy a "windfall" gain. My opinion is that CPF is hardly sufficient to tide us through retirement and our senior years; even as the Government introduces CPF Life scheme which promises to pay an annuity to us till the day we die. The CPF, being a compulsory savings plan, cannot tailor itself to meet the needs of every single citizen as it is just a general plan catering to the man on the street. One definitely needs passive income sources and his own cache of cash to tide him through the years after he officially stops earning active income.

The idea of financial independence is not new and I had mentioned this before in several posts. Basically, your passive income sources from dividends, rental or interest need to be able to sustain your current lifestyle; thus one technically can stop working and yet enjoy the same quality of life without compromising anything. This is, of course, easier said than done. With uncertainties such as illnesses and inflation, one's carefully built nest egg may suffer sudden "shocks". Hence, it is always good to maintain a buffer when one is planning for retirement; which means getting it in surplus rather than doing an exact computation. This is to provide for contingencies and unforseen events (which usually do tend to crop up as one goes through life !).

Investing is one method I use to grow my net wealth in preparation for retirement. By ensuring I have steady dividend income as well as capital appreciation from my investments, I can slowly but surely move towards building up enough funds to ensure I can have a comfortable and worry-free retirement !

End-June 2008 Portfolio Summary and Review

The second half of June 2008 was peppered with bits of news from the companies I own. Ezra announced the completion of their first FPSO (under 48.9% owned EOC) and the clinching of a significant charter contract worth US$400 million over 3 years. I remember Ezra first announcing the news of the FPSO back in October 2006 and the buzz surrounding the news at the time. Now, the company is poised to continue growing as it undertakes expansion into the deepwater oil and gas segment. Boustead was also relatively active in announcing news (please refer to the section below on Boustead for more information).

With respect to the economy, the flow of data continues to pour in relentlessly from Wall Street, on everything from factory output, unemployment to inflation. It’s a wonder one does not go crazy from the constant influx of information ! The most important and note-worthy piece of news is that the USA Federal Reserve has kept the Federal Funds Rate capped at 2% (which was largely anticipated) due to fears over mounting inflation. Back in sunny Singapore, inflation for May 2008 managed to stay “constant” at 7.5%, despite consensus estimates that inflation would hit close to 8%. Wow, what a relief, I am SO HAPPY that inflation is ONLY 7.5% (mind the sarcasm).

The reporting season for 1H FY 2008 will begin in late July 2008, and I am expecting results and dividend announcements for both Suntec REIT and FSL Trust. The rest of the results are expected to flow in during mid to late August 2008, and Annual Reports for Pacific Andes and Boustead should also come in by then and will be separately reviewed on this blog.

Below is the summary of my investments and related news as at June 30, 2008 (STI at 2,947.54 points).:-

1) Ezra (Vested since October 6, 2005) - Buy Price $0.645 (bonus adjusted), Market Price $2.65, Gain 311%, YTD Loss 20.2%. Ezra announced on June 24, 2008 that EOC took delivery of its first FPSO, Lewek Arunothai, and that it is on a charter contract worth US$400 million over 3 years. There is also a two-year extension option for this charter, and EOC will continue to explore the FSO and FPSO market. I forsee significant earnings accretion to Ezra Group from this contract even though Ezra only owns 48.9% of EOC. Immediately on June 25, 2008, Ezra announced that it had established a multi-currency medium term note programme (similar to Swiber’s a while back) for S$500 million in order to fund future capital expenditures and for working capital purposes. In the current low interest rate environment, it makes good sense for the company to issue debt in the form of notes/bonds to capture and lock in the low cost of financing, rather than issue equity for which they may have to pay higher dividend yield (not to mention diluting existing shareholders).

2) Boustead (Vested since September 13, 2006; averaged down November 13, 2006) - Buy Price $1.295 (average), Market Price $2.36, Gain 82.2%, YTD Loss 2.1%. Boustead had, on June 23, 2008, announced the clinching of a turnkey contract by Boustead Projects (91.7%-owned) of S$60 million to build Singapore Freeport. This is a state-of-the-art facility which will be used primarily for the safe storage, display and trade of the world’s finest collection of valuables and antiques. The project will be in two phases, with Phase 1 to be completed by end-2009 and Phase 2 by 2011. On June 25, 2008, Boustead also announced that its 40% associated company GBI Realty Pte Ltd had entered into an arms length transaction to sell a property for S$200 million. The proceeds will be used for general working capital purposes, and the Group will recognize a gain of S$26 million for FY 2009. On June 26, 2008, Boustead announced that it had obtained in-principle approval for the share split. Management will proceed to issue a circular to all shareholders and convene an extraordinary general meeting (EGM) to seek shareholders’ approval for the split.

3) Swiber (Vested since February 14, 2007) - Buy Price $1.01, Market Price $2.47, Gain 144.6%, YTD Loss 28%. There was no significant news from Swiber, but the company was doing a road show in Hong Kong recently and the analyst who went with them mentioned that the Equatorial Driller will most likely be built by a smaller yard as Keppel and Semb Marine already have their hands full. The company should be releasing more details of the ED soon.

4) Suntec REIT (Vested since December 9, 2004) - Buy Price $1.11, Market Price $1.36, Gain 22.5%, YTD Loss 20.5%. There was no news for the company for June 2008.

5) Pacific Andes (Vested since March 29, 2006; Rights Issue July 11, 2007 at S$0.52 per share; averaged down August 17, 2007) - Buy Price $0.655 (rights-adjusted), Market Price $0.48, Loss 26.7%, YTD Loss 23.8%. There was no news from the company for June 2008. I am still awaiting more details of the scrip dividend scheme to assess if it will be good to choose shares over cash.

6) China Fishery Group (Vested since November 20, 2007) - Buy Price $1.50 (average), Market Price $1.70, Gain 13.3%, YTD Gain 8.1%. There was no news from CFG except for an amendment to the senior notes issued and due 2013.

7) First Ship Lease Trust (Vested since January 14, 2008) - Buy Price (Averaged Down) $1.105, Market Price $1.22, Gain 10.4%. There are still no updates from FSL Trust as at the date of writing this post, regarding their financing of the third vessel and their plans for growing their portfolio.

Overall Portfolio

My overall portfolio has increased by 65.2% without taking into FSL Trust’s cost. If included, the gain is 50.0% from a cost of S$80.4K as at June 30, 2008. The market value of my portfolio without FSL Trust is S$96.3K, and if FSL Trust is included then the portfolio value is S$120.6K. Realized gains have increased to S$6.2K due to the dividend from Ezra to be paid on June 18, 2008.

Comparison against STI

Using my new benchmarking technique:-

The FTSE STI had declined by 15.36% since the start of 2008. My portfolio (without FSL Trust) has to date declined 17.5%. Therefore, I have under-performed the STI by 2.2 percentage points.

FSL Trust has gained 10.4% thus far from my date of purchase while the benchmark STI has fallen 8.1% (from Jan 14 – my date of purchase); I am happy to report that FSL Trust has managed to out-perform the index for FY 2008 thus far.

My next portfolio review will be on Tuesday, July 15, 2008 after market close.

Leverage - A Double Edged Sword

Leverage is a word often heard of these days, especially with the sub-prime credit crisis in full swing affecting everything from major US banks to far flung Japanese banks. Apparently, the amount of debt which investment banks take on is enough to cause a ripple effect and add to the major headaches experienced by reputable financial institutions, who have had to write down amounts of CDO and debt-related instruments to the tune of billions of USD. All these problems actually stemmed from debt, or leverage as it is known. There have been countless articles written on the ongoing sub-prime debacle, and George Soros has even written a book about it; so I will not delve further into this issue. Instead, let's examine the effects of leverage on companies and how it can make or break them.

As readers may know, many companies (public and private) grow by taking on debt into their Balance Sheets. The reason for taking on debt is to use the money to grow the business and to earn a return on investment which is HIGHER than the interest rate charged on the debt. In effect, you are using money to build more money. Of course, one may argue that there are businesses out there which employ purely equity or cash flows from operations to grow organically and expand, but these "great" businesses are few and far between. Warren Buffett has personally identified the "great" business of See's Candy, which I will elaborate on in a subsequent post; but he admits that companies can also be "good" yet take on substantial leverage in order to grow the business. He is referring to companies which gear up to either grow the business through asset acquisitions, construction of new plants to increase production capacity, or to grow the business organically through vertical or horizontal integration.

Leverage itself is NOT a bad thing, as long as one is mindful of the potential risks and pitfalls involved. It's a little like medication - enough of it is good for you and will cure your ailments and even make you healthier in some cases, but too big a dose may cause permanent harm and the effects may be irreversible. There are examples of companies listed on SGX which have taken on more bank loans and issued debt securities (e.g. notes or debentures) in order to grow their business. Recent examples include Olam in order to scale up the business through acquisitions, and also several China companies which have issued convertible debt to fund asset enhancements. Growth at a reasonable price (GARP) is a concept which is taught in some value investing books, and states that growth can come as a result of a debt being carried at a certain price (i.e. interest rate); provided the debt is cheap and the growth can be justified. In cases where growth is not sufficient to justify the debt taken, then the debt should be avoided and the company should seek alternative sources of financing (e.g. equity financing).

The situation becomes more problematic and dire when companies take on excessive debt over and above what would be required to grow the business. Firstly, this is a sign that operating cash flows are insufficient to grow and sustain the business, which results in a vicious cycle of borrowing to grow (this gives the investor the illusion that a company is growing, while its current ratio falls below one). Second, finance costs may become prohibitively high and eat away at gross margin, leaving the net margin in tatters. Thus, a company with a decent gross margin may still be left with little profit after accounting for financing costs. Of course, one has to be careful in assessing what is the "right" amount of debt for a company to take on, as this can be industry specific (some industries are highly capital intensive) and there may also be a short-term reason for taking on additional debt which justifies bumping up the leverage ratio. In short, there is no hard and fast rule for "sufficient or excessive leverage" as one must look at companies on a case-by-case basis.

Looking at my current portfolio of companies, Ezra, Swiber and Pacific Andes/China Fishery take on substantial amount of debt to grow their businesses, in the process fortifying their balance sheets with more fixed assets. For Ezra and Swiber, they have been able to "avoid" taking on excessive debt by using sale-and-leaseback, a form of vessel financing. However, for CFG and PAH, their issuance of senior notes and convertible bonds has added to their gearing substantially, and this represents a risk for the company should growth stagnate and their finance costs balloon above their ability to generate operating cash flows. Hence, this is one of the risks I take on as a shareholder. Seeing how Management have a good track record of growing the company despite having high leverage the last 10 years, I continue to be confident that their additional debt can be used effectively to grow the business and generate high ROE/ROI. Only one of my companies, Boustead, is sitting on a substantial pool of cash (S$150 Million) which it can deploy for acquisitive opportunities during a bear market and crisis. This is also one of the advantages of having cash instead of debt, the opportunity costs of NOT being able to take advantage of good deals during bad times.

To close off this topic (which I am sure should invite a considerable number of comments), I will talk about a company called OSIM and how they used a leveraged buyout scheme to purchase a company in USA called Brookstone back in 2005. Before the acquisition, OSIM was flushed with cash from their strong sales of their products; however after the acquisition they ended up in a net debt position which they are still trying to clear after 3 years. Unfortunately, the debt which they took up did not help to grow their bottom line to the extent that they were hoping for, and the result is that the debt is becoming a burden as they have to pay for high finance costs while suffering from declining sales and an erosion of their competitive edge. Their last corporate action was raising money through an issue of warrants to subscribe for shares at 30 cents, as a direct equity raising was not feasible. It remains to be seen whether the company can pull itself out of the doldrums and justify that the gearing they took up was indeed worthwhile.

Pacific Andes - FY 2008 Financial Review and Analysis

This review and analysis was long overdue, I admit, but analysis takes time and I did not want to do an analysis that was too short and shoddy in case I missed out something important. As it is, there was recently an interview with Pacific Andes where CFO Dennis Chan gave updates on PAH's plans for CY 2008 and on how to tackle rising costs. More on that later.

Profit and Loss Analysis

For FY 2008, revenues were 32% up from HK$5.3 billion to HK$7 billion, while cost of sales only increased 26.3% from HK$4.3 billion to HK$5.5 billion. This reflects better efficiencies which PAH was able to employ in their operations, and gross margin improved from 17.8% in FY 2007 to 21.6% in FY 2008. However, selling and distribution expenses rose significantly (by 214%) as a result of higher expenses incurred in selling fishmeal and also PAH's expanded operations. Finance costs also ballooned to HK$402 million (up 76%) due to additional bank loans taken (HK$1.1 billion), coupled with the senior notes and convertible bonds.

As a result, net margin after tax for FY 2008 was 11.8%, when it could have been higher if not for the increased expenses. Still, it was better than FY 2007's net margin of 10.6% (after removing the exceptional item HK$385 million on gain on dilution of a subsidiary). Net profit after tax increased by 47.1% from HK$561 million to HK$826 million, reflecting the increase in business activity as PAH and CFG expanded their operations into Peru and into the fishmeal business in CY 2007. Profit attributable to equity holders increased by 25.2% to HK$481 million, and a dividend of 2.07 Singapore cents per share was declared. At my purchase price of 65.5 cents, this represents a yield of 3.16%.

Balance Sheet Review

For the balance sheet, the most obvious sign of PAH's increased operations is the increase in fixed assets to HK$1.6 billion, up from HK$864 million a year ago. This ws due to CFG acquiring 3 fishmeal plants and 11 additional purse seine vessels, plus the supply chain management division acquiring 2 reefer vessels to increase transportation efficiency.

Current ratio for March 31, 2008 stood at 1.52 versus 1.91 for March 31, 2007. The decrease was mainly due to higher short-term borrowings for PAH, increasing from HK$1.25 billion to HK$2.48 billion. Signs of increased borrowing are not always positive but as the (fishing) industry is capital intensive, I see it as a necessary evil for PAH to borrow so extensively. Whether or not this makes commercial sense, only time will tell and it also depends on Management's ability to utilize assets to generate more cash and earnings. A check on quick ration showed that it had dipped to 1.23 from 1.51 a year back. Cash position had improved slightly but this was mainly due to cash generated from financing activities, which means FY 2008 is a year of "borrowed money". Let's hope FY 2009 will see more cash flowing into the company from operations and investments, rather than financing.

Cash Flow Statement Review

Cash inflows from operating activities was weak at only HK$103 million, compared to HK$436 million a year back. This can be attributed mainly to the high finance costs paid for and much higher income taxes due to operations in Peruvian waters. As a result of this, there was substantially less operating cash inflows, and I hope this situation will improve when PAH releases their numbers for 1Q 2009.

Most of the cash outflow for investing activities went to acquire the additional stake in CFG, upping it from 28.8% to 64.1%. The company paid HK$2.37 billion for their increases stake in CFG. Seems expensive, until you realize that a lot of the value had crystallized from CFG into PAH as a result of the stake increase; and I think there will be long-term benefits coming from this increase in stake. Though of course the question remains whether PAH paid too much for their stake in CFG !

For financing activities, most of the cash came from 3 sources: proceeds from issue of convertible bonds, proceeds from 1:1 rights issue and additional bank loans taken up. This resulted in a net cash increase of just HK$53 million, and PAH are cutting it pretty close by raising just enough money for operations and investment. Since the acquisition of increased stake in CFG is a one-off event, I am not worried about future cash outflows to the tune of HK$2 billion ! Let's hope the company can manage to generate more free cash flows in time to come.

Prospects and Plans

PAH has highlighted several initiatives to grow revenues and to diversify its revenue stream moving into FY 2009. One of these is to deploy 2 additional reefer vessels to improve efficiency and increase performance, another is to send 3 upgraded supertrawlers to South Pacific Ocean for the fishing of new species, to be shipped to new markets. In the XFN interview with Mr. Dennis Chan on June 16, 2008, he mentioned that the aim of this deployment would be to ship 60,000 tons of Chilean Jack Mackeral to Nigeria (Africa). Africa would represent a new market for PAH but there are currently no plans to ship this species to China.

Rising fuel costs were cited as a major concern for PAH as their vessels and trawlers use fuel extensively to fish. I expect increased fuel costs to negatively impact margins in the next few quarters, with the result being a possible dip in earnings as the increase in revenues may not be able to fully compensate for the increase in cost of sales as a result of increased bunker costs. Assuming Management can control selling and admin expenses, net margins will probably dip and PAH may report lower earnings in the near-term. However, a long-term view of the business should see it sailing through the rough patches as it extends its footprint.

Mr. Chan also did not rule out potential future acquisitions within Peru as the fishing industry there is still very fragmented (he did mention this during the CFG AGM back in April 2008). PAH has managed to increase catch volume at Peru and Alaska, its 2 key fishing areas. Mr. Chan also alluded to the fact that PAH will have a "significant share" in the global catch of anchovies and Alaskan Pollock, though he did not provide further disclosure due to confidentiality reasons. I would conclude that it is prudent for one to be cautiously optimistic of PAH and CFG prospects, amid a high inflationary environment and high fuel costs.

Behavioural Finance Part 3 - Over-Reaction Bias

To continue with this series on behavioural finance, I now touch on the concept of over-reaction bias. The first two parts dealt with the problems of mental accounting (compartmentalization of money into distinct and discrete "accounts") and over-confidence (a typical human trait where most people feel that they are infallible). Over-reaction bias is a type of behaviour which results in human beings over-reacting to certain news, which is another way of saying you "let your emotions override your good sense".

When applied to the stock market, over-reaction bias typically causes investors to over-react to BAD news, and react too slowly to good news. Why could this be so ? This is due to human being's tendency to panic and let fear grip him; thus over-reacting to bad news or negative information. Note that this is a natural human tendency which, from our caveman days, would have saved us from mortal danger as our bodies tend to respond to such negative stimuli by producing more adrenaline (yes, the fight or flight hormone), thus it allows us to have heightened senses and more energy to run in case we encounter danger (e.g. predators in prehistoric times). It is always better to over-react to real physical danger as we only have one life; but in the market, over-reaction bias can cause us to lose our rationality by conveying a similar "fight or flight" response. Since there is no one to "fight", most people will choose "flight" instead and sell away their investment when there is any small hint of negative news !

When viewed objectively and rationally, this might seem a very foolish, downright silly choice. After all, negative news flows in all the time and one cannot predict the sequence, extent or nature of such news accurately. On one day, it might be record inflation; on another day, it could be high oil prices and on yet another day, it may be increased unemployment or shrinking GDP growth. The point is that bad news is supposed to be part and parcel of investing and one cannot live in a fantasy world expecting nothing negative to happen to one's investments. By mentally insulating oneself from such mental shocks, one can develop better fortitude when hearing such negative news. Even for my own investments, I had recently encountered negative news in the form of record inflation in Vietnam (which affects my investment in Ezra as they have 2 yards in Vietnam) as well as a recent fire at Kreuz Shipyard which is 100% owned by Swiber.

My first reaction upon hearing this news was to calmly examine the facts of the case and to objectively assess the economic impact of the bad news. As an investor, one should be mindful of over-reaction bias causing the bad news to seem a lot worse than it sometimes is. In my case, it turns out that I discovered that Ezra's shipyards are securing contracts in USD, thus mitigating the risk of the depreciating VND; though one consideration is still rising costs of manpower as inflation kicks in. The impact will be minimal and is not likely to be long-lasting. For Kreuz, the incident was regrettable but will also not cause any serious economic harm to the company or its business. Thus, by objectively and rationally reviewing the facts of the case and delving into some research, one can pinpoint whether the bad news may have a permanent detrimental impact on one's investments; hence making the decision on whether to sell a more logical, rational one. Most of the time, if one had done sufficient research and due dilligence, I would conclude that most bad news is temporary in nature and should have already been factored in one's risk assessment when one purchases a company. Only if a black swan event occurs should it give a very compelling reason to sell an investment immediately (e.g. natural disasters destroying key assets).

To conclude, over-reaction bias is a pervasive mental force when one invests. To avoid its effects, one should always keep their wits about them when faced with bad news, and move on to objectively and coolly assess the news before taking any action. Actions taken during an adrenaline rush are usually ill-thought out and one is more prone to make costly mistakes. Always ensure that decisions made with regards to buying and selling investments are approached in a busines-like manner, which is how investing should be viewed.