Wednesday, September 24, 2008

Tat Hong - Analysis of Purchase Part 2

To continue with my analysis of Tat Hong's purchase back on September 18, 2008, Part 2 will now analyze each business unit as well as the gross margins and their respective revenue contributions. I also briefly touched on the intangible aspects of the business which makes it attractive; while counter-balancing with some risk factors specific to the industry and company.

Gross Margin and Business Unit Analysis



By referring to the 2 tables above which I have prepared, I have made the following observations:-

1. Tat Hong is increasing its business focus by going into tower crane rentals, as they perceive the China market to be very large in future for this segment and they are positioning themselves in advance to prepare for future growth. However, at this point in time, tower crane rentals seem to have much lower GP margins at 37.6% compared with their principal revenue generator – sale and rental of crawler cranes. Whether this division pans out remains to be seen, but at least it is contributing to revenues and profits instead of losses.

2. Note that although sale of cranes took up 48% of revenues, gross margins for this division were only 20% and are the lowest among Tat Hong’s 5 business units. Sale of crawler cranes and sale of spare parts generated the highest GP margins, and these constituted 22.8% and 7% of revenues respectively for 1Q 2009. Moving forward, from reading of the company’s plans and strategies, they want to increase their revenue contribution from rental of cranes as they mention that Tat Hong will transform itself into a “Rental” company (whereby gross profit contribution from rental will exceed 75% of Tat Hong’s total gross profit in three years time). This strategy is a good one as Management intends to focus more on its very high GP margin business rather than build up a division which has high revenues but low gross margins.

3. Crawler crane rental GP margins have come down a little, probably due to higher cost pressures stemming from inflation. This is not expected to significantly impact the division as a GP margin of >60% is still very high.

4. The company’s focus is also on improving margins and this can be readily seen in their quarterly financials whereby revenues increase at a higher % compared to COGS. Overall, the company is doing well to increase gross margins.

Tat Hong’s Competitor

Tiong Woon (listed on SGX) is one of Tat Hong’s competitors and for FY 2008 (it has a March year-end), revenues were S$158 million with a net profit of S$28.3 million (net margin of about 17.9%). Stripping away exceptionals, net margin is around 12.8%.

By comparison, Tat Hong had an FY 2008 revenue of S$640 million and earned S$89.8 million (net profit attributable to shareholders). This is a net margin of about 14%.

Intangible Aspects for Tat Hong Holdings Limited

a. Largest crane company in South-East Asia – this gives it a competitive advantage in terms of being recognized as a leader, thus exposing it to potentially more lucrative contracts. Being in pole position also means more bargaining power.

b. Diversified operations in South-East Asia and Middle East. The scale of its operations means that there is a lot more potential for economies of scale and cost savings, as is reflected by their improving GP margins.

c. They have diversified into larger cranes which gives them a competitive edge (niche) as the supply is small; thus they can command premium rental rates.

d. The industry has high barriers to entry and significant capex will need to be invested by a new entrant in order to pose a credible threat to Tat Hong.

Risks relating to the Business and Company

i) A major slowdown or downturn in the construction industry will hamper the company’s ability to grow its earnings and top-line. This could happen if there is a global economic slowdown; however, Asia’s real estate market is somewhat resilient and may not be directly affected as infrastructure spending is usually government controlled and funded by the government.

ii) Another risk is the slowdown in oil and gas E&P activities because of the recent dip in oil prices below US$100 per barrel. However, this is not a major long-term concern as oil majors still need to spend eventually to drill oil and cranes will be used for such purposes. I also forsee that oil prices will remain above the US$100 barrel mark in the mid-term, thus spurring continual E&P activities from oil majors.

iii) Rental rates may fall or slow depending on the supply/demand dynamics. If Tat Hong does not renew their fleet often, they may fall behind in terms of getting best fleet for rental, or be unable to adequately service their clients.

iv) Tat Hong is in a high capex business and they need to spend significant sums on capital fixed assets. If operating cash flows drop drastically, the company could face high cash burn and be in trouble.

Part 3 will discuss Tat Hong's regional plans for growth as well as the strategies they intend to use, and I will comment on whether I think they have long-term potential as well as to evaluate their effectiveness. I will also be touching on the regional prospects with regards to the infrastructure and construction spending for each country as outlined by Tat Hong, and to comment briefly on that.

18 comments:

cif5000 said...

For me, I simply value the company based on its NTA for the fact that the company is a rental company.

Competitive advantage:
1. Size of company matter less than what equipment is available for rental.
2. Diversification in location does not improve competitiveness or economy of scale, it spread resources thin, in fact. GP improved due to the increased rates and shortage of supply.

Some thoughts. GTG for work now.

musicwhiz said...

Hi cif5000,

Thanks for your thoughts. Just curious on why you use NTA simply because the company is a rental company. There can be potential for earnings growth through organic growth as well as M&A.

Assuming they know what equipment to acquire for future high rental rates, the company can steer towards that direction to ensure rates remain high in a tight supply market.

I feel that diversification in location is not just spreading itself; but a way of increasing capacity and volume of business and also to add new business units (e.g. tower cranes in China) to its existing business. GP is likely to remain fairly constant amid short supply and since Tat Hong is the market leader, they have some bargaining power in negotiating rates and setting prices.

Just some thoughts too...

Cheers,
Musicwhiz

Aspellian said...

Being a rental company, it is important to have regional market diversification. the management can easily transfer its equipments across regional markets in accordance to demand and supply.
I have seen company business models that pull out of certain non-performing markets and easily redeploy their rental assets to profitable markets.

so the company is not putting all its eggs in one basket/country and dependent on the country's prospect. eg. small construction companies that only focus on spore market, many went belly-up 10 years ago because of limited business.

unless of cos there is a GLOBAL slowdown... as pointed out by MW.

cif5000 said...

I imagine competitiveness as having a customer to choose one similar crane over another. Therefore, diversifying locations is one way of reducing location-related risk and increasing reach, rather than improving competitiveness. By going oversea, they only "beat" those who don't but they will still face competition from the players over at the foreign land.

Nevertheless, both are considered positive, just my narrow-focus on the words.

To me, competitiveness should be doing or providing something that the competition is not doing. In TH case, what would that be? Providing free hydraulic oil inspection every week? Having a senior engineer on-site? Unless a TH crane is better than a XYZ crane...but there is no TH crane, as they bought them to rent out.

cif5000 said...

The earning is unpredictable as it depends on demand/supply. When supply is high, rates will drop and earning will diminish.

As the cycle goes:
1. low construction activity, crane not in demand, marginal earning
2. construction picks up, crane in demand, charges higher rates, margin and profitability increase.
3. high rates attract competitors, competitor invest on more (or better) cranes
4. construction industry gets enough supply of cranes, rental companies reduce rates, margins fall.
5. construction activity slows down, demand falls, but the original supply is still there. rates fall further. small time player will go below cost just to sustain cash flow.
6. those that cannot sustain will die, remaining companies return to marginal profitability.

So, my feel is not to value the company base on earnings. Because in the long run, the overall earning depends on what you have for renting out. If you have one crane, the profitability depends on:
1. rental rates
2. utilization rates
The rental rates depends on demand, and utilization depends on the management (sales and planning)
If you have more cranes (like TH), the most you (management) can do is to improve the utilization rates, but you will still have to surf the rental tide.

Pardon my rumblings.

cif5000 said...

Sorry it's me again...so the premium over the NTA is actually the price you pay for the management capability.

donmihaihai said...

Hi,

I agree with cif5000 on the earnings cycle. But I have one more point to add on equipment rental business generally

When demand increase, cost of equipment increase sharply. When demand goes down, these expensive equipment will be sitting somewhere rusting(read about construction equipment in US currently). With limited life span, those expensive equipment may not worth what is on their books. When cycle turn, it is time to raise capital and buy expensive equipment again.

Hmmm.. premium over NTA is also price for the near term super normal earnings beside management capability.

musicwhiz said...

Hi Aspellian,

Thanks for your comments. I was thinking along that line yes. But the main risk now is of a global slowdown, though I do not expect infrastructure spending to taper off too much in the near term.

Regards,
Musicwhiz

musicwhiz said...

Hi cif5000,

Sorry, but I have to disagree with you on the use of NTA to value the company on the basis that its earnings are not predictable and that they are cyclical. I will raise a few points in my argument:-

a) You speak of the construction cycle which I had taken into account while researching on Tat Hong. Yes, I know of the rise and ebb of the construction cycle and how cranes can alternately be in demand and out of demand. As you say, rental rates largely depend on the demand/supply dynamics. However, my counter-argument is that Tat Hong has established itself as a regional heavy-weight in terms of crane tonnage and heavy machinery inventory, so in a sense they control a lot of the supply and are in a competitive position to set prices (i.e. more bargaining power).

b) Even though construction may slow down in certain countries, the fact that Tat Hong has diversified its earnings stream away from Singapore (into Australia and China) means that any slowdown will be mitigated. Unless there is a GLOBAL slowdown in construction and infrastructure spending, I think that Tat Hong's earnings base should remain fairly stable.

c) The company is a different animal from the FY 2000-2002 years when it was still building its asset base and customer base. They are now a regional player with a new fleet and the fact that they are a big player means that they are more likely to survivie downturns - note also that they have FCF for every financial year since 2005.

d) In terms of competitiveness, as you mentioned, they have a website www.ecranes.com.sg which customers can use to select products and services. I think this customer-oriented focus should serve them well and allow them to provide good service to retain customers.

e) For utilization rates, evidence can be cited of many countries in South-East Asia spending more in the next five years on construction activity to build everything from highways to buildings. All these need cranes and I would expect utilization to remain high (70%+).

f) Rental business also has its pros as it means the company is not subject to manufacturing cycles and inflation as well as capacity constraints (in the traditional sense). I think Donmihaihai pointed out the problems with rental companies but it is taken to an extreme if you say that equipment can be lying around rusting. This equipment is needed for construction work and is not extremely specialized (unlike an oil and gas AHTS for example), thus I disagree that utilization will be low should the cycle turn down.

Thus, based on the above factors, I would still maintain that the company can be valued based on earnings flow and earnings growth; hence I applied a PER model when assessing the company. Management quality and other intangibles are also factored into my research.

Thanks,
Musicwhiz

cif5000 said...

No problems, it's all for discussion and good to know the different images of the same company.

littlecupid said...

buying a cyclical company with the cycle going down is a no-no regardless of its seemingly attractive PE....just my comments. China and Australia are facing slowdown.

musicwhiz said...

Hi littlecupid,

If you are referring to an impending global slowdown, then we will have to wait and see. In Part 3 I will present some info I have gathered on each country's plans to spend on construction and infrastructure in the next 3-5 years. This should at least sustain the demand for cranes and heavy equipment.

Hope you can elaborate more instead of passing a very general remark, thanks.

Cheers,
Musicwhiz

donmihaihai said...

Hi Musicwhiz,

It is ok if you think that an extreme outcome is unlikely. But when down cycle come, Tat Hong is unlikely to earn ROE of almost 30% and what are the impacts on the capital expenditure, debts and dividends if Tat Hong ROE dropped to a respectable 10 to 15%?

For rental slowdown on specialise or big price equipments, try reading on plane (parking in desert), rig and offshore support vessel(1980s to 1990s), car, construction equipment. So far I haven't come across an industry that is able to escape from this fate. How long and serious the downturn usually depend on the competition and the prior bloom.

But if you think that crane is not cyclical then.....it is another story.

Anonymous said...

since management of the company is important, like what warren buffet says, could you do some background check on management, in particular the ppl in charge? what did they do during the last financial crisis in 1997? do u know what happened to the company during the last financial crisis? what were their actions? what did the company do in the past, during times when government expenditure was at it lowest? i mean, it's so easy to say the prospect of this company is bright right now. but what if things get ugly? what happened to the company during those bad times? u should bear in mind u r investing in a company that is going through some prolonged good times now. and u r investing at a time when things for the company just seem to can't get any better.

and to be fair, maybe you could come out with 3 positive and 3 negative points abt the ppl in charge? and maybe not just superficial stuff like 'they spend too much capex', 'they should have sold more crawler cranes instead of tower' etc. maybe something more in-depth. like is management highly respected and looked up upon in the social circle? any bankruptcy case? did the boss personally make substantial donations to society that we were not aware of? any other personal properties that the ppl in charge own? do they own stakes in any other companies that we r not aware of? is the boss a thrifty guy? and if members of management had other investments, what happened to those investments? were those investments a success, or failure? of course your views must be balanced and unbiased, and probably u have to put a disclaimer too...haha(or else it could get u in trouble!), but it would be more value-add if you could dig up some of this hard-to-get info. and let us decide whether it's worth it to put money with this company. and these information r extremely important. it will definitely have a bearing on whether i decide to invest in this company or not.
- john

littlecupid said...

hehe...there are alot of signs of global infrastructure slowdown... some signs that you should look into
In China, look at the property prices dropping after enormous expansion the last decade
look at steel prices....dropping 30-40 % in a short time....
look at BDI dropping .....
I guess you can do more research.... looking at past data looks pretty....as investors/business partners we should look forward not just numbers.....just some comments :)

musicwhiz said...

Hi donmihaihai,

Thanks for sharing your knowledge of cyclical industries. I would think even if the company's ROE falls to 10-15%, it is still very respectable. It is very difficult (if not impossible) to maintain ROE at very high levels (i.e. >20%) for a sustained period of several years.

I understand where you are coming from in terms of slowdown, but my view is that Tat Hong, having market leadership and a large fleet, will be able to tide through slowdowns better than smaller players who may go bust or be priced out of the market. Of course, whether Tat Hong can survive or not is a big question mark and I for one might be very wrong; but until time has passed, it will be impossible to truly judge the effects and so far we are just going by theoretical discussions.

Don't get me wrong, I do think cranes and construction are cyclical, but am willing to bet that Tat Hong, being a different company than what it used to be in the early 2000, can make it through.

Regards,
Musicwhiz

musicwhiz said...

Hi John,

Yes, you are right to say I did not plough into data stretching back 10 years to see how the company got through the Asian Financial Crisis. But the fact that the company did make it through and are still going strong now says a lot about them being able to cope with crises. And just to offer some counter-balance to your point about the company "going through prolonged good times", isn't that why investors choose companies in the first place ? Because they have a good track record of growing the business ? I dare say for companies like Boustead in 2002, when they were still loss-making, no one would have dared to invest in it as they had debts instead of cash and had hardly any track record to speak of (as well as a lot of unprofitable "baggage" subsidiaries). So a decent track record of 4-5 years would at least QUALIFY a company for selection and value investing; though by no means is such a company always investment-worthy.

Regarding your other suggestions in your second paragraph, it would seem to be something of a "dig up as much dirt as you can on senior Management". While I don't dispute that we should find out about senior Management (scuttlebutt), I think there is also a limit as to the amount of pertinent information one can find before it becomes a case of "analysis paralysis". For me, I take cues from the way the company is run and the numbers it produces to show if Management is rational and capable; and so far I have NOT heard of any strange news on any of the directors or senior management which may impact my decision to invest in the company.

Please also note that I am providing my own personal perspective of the company from my own independent research. I would strongly advise readers such as yourself to also conduct in-depth research into areas which you feel are pertinent to your investment needs, should you feel they need to be touched on. I think my disclaimer was placed in Part 1 of this analysis.

Regards,
Musicwhiz

musicwhiz said...

Hi littlecupid,

I did do some reading up on China and it seems they are still building quite substantially and that there are many land banks waiting for development into industrial zones or residential areas. This is depsite the global slowdown in which China's GDP is expected to fall to ONLY 9+% (considered low by China's standards). Even then, gaining a foothold in China should ensure that all players have some slice of the pie as it is a very huge country. My take is that even though growth may slow, there will still be business for tower crane rentals.

I think you should wait for Part 3 of my analysis where I put up some evidence of how Tat Hong is able to leverage on prospects in the region and also to elaborate a little on their growth plans.

Thanks,
Musicwhiz