March 2009 Portfolio Summary and Review

March 2009 can be said to be an “eventful” month, if you count the number of things happening with the White House and President Obama, as well as Treasury Secretary Geithner. Suffice to say I will NOT summarize all the moves and decisions they had made so far this month, for it would take up more than this post could hold and bore everyone to tears. Just surf on to New York Times or CNBC and they will give you the low down details. Basically, there were bailouts, plans for capital injections and stress-testing for banks, if it could be summarized in so few words. The world is of course awaiting with bated breath on when the US Economy and Banks will recover, but it’s a new world order now, and some of the old practices (e.g. huge bonuses at AIG and ML) may have to be totally revamped, at the risk of more public ire. Over the last 2 days, President Obama has also rejected the re-structuring plans for General Motors and Chrysler, forcing out the CEO of GM and asking Chrysler to merge with Fiat in order to survive. A forced bankruptcy looks likely on the cards unless the two auto makers can get their act together.

This month can also be termed the “Recovery Month” as news of an impending economic bottoming and subsequent recovery seems to fill the headlines closer to end-March 2009. Whether this is true or not remains to be seen, and as economists will probably tell you, it can only be obvious on hindsight. An investor’s job is not to predict the state of the economy or when things will get better; all he has to do is select good companies and stay vested in them.

Singapore seems to be doing relatively okay with most of the general public not really feeling the full effects of the recession (yet). Condominium property launches are still thronged with people, some armed with cheque books according to a friend. Travel fairs are swamped and tours sold out in hours while the recent computer fair at Expo Singapore saw a record turnout and an even better sales figure than 2008 ! So in spite of the deepening recession, it seems Singaporeans still retain their good old consumerism culture. It remains to be seen if the coming months will see a drop in retail spending and a move towards more conservative spending and cutting down on discretionary purchases.

The Singapore stock market has managed to rally 19% within 3 weeks after news of the supposed “recovery”, with some prominent analysts declaring that 1Q 2009 will be the worst quarter, so the market can only get better over time. My job is to just take the news as it comes because things are so uncertain that it would be foolish to hazard a guess as to when the crisis will really and truly blow over and businesses can start recovering. Notwithstanding, there are still companies out there running a decent business with decent margins and they will still continue to pay dividends (albeit lower ones). So it is still possible to stay fully vested, feel cosy and comfortable and continue to monitor corporate and economic developments as they unfold.


March 2009 turned out to be an unexpectedly “busy” month for Swiber as they came out with a slew of corporate announcements and updates. For my other companies, there was a little minor news here and there which trickled in, but not enough to constitute “significant” developments. For next month, I will be expecting Ezra’s 1H FY 2009 results in early April 2009, as well as results from FSL Trust and Suntec REIT. Corporate updates for my companies are as follow:-

1) Ezra Holdings Limited – On March 6, 2009, Ezra formally announced the cancellation of their 2 ship-building contracts with Karmsund, citing the bankruptcy of Karmsund and their inability to deliver the vessels as the reason. Fortunately, the deposit paid of NOK 186 million could be refunded as it was guaranteed by a financial institution unrelated to Karmsund. Subsequently, on March 17, 2009, Ezra announced the receipt of the monies.

2) Boustead Holdings Limited – During the month, Boustead that Salcon had reached full and final settlement for the project which was reported in their previous announcements between them and Lagan and could move on. On March 16, 2009, the disposal by GBI Realty was finally completed, and this should be recognized in FY 2009’s results due in May 2009. On March 30, 2009, Boustead announced that they had disposed of Salcon Holdings Philippines Inc and on March 31, 2009, Boustead also announced the disposal of PT Surya Teguh Cemerlang Perkasa. These are moves made to streamline its business and get rid of divisions which are non-performing. Though they are taking a loss to their books, there is no cash effect from these disposals.

3) Swiber Holdings Limited – It was a month of announcements from Swiber, after about 4 months of near zero news from them. First of all, on March 11 and 12, 2009, they announced the delivery of Swiber Concorde and Swiber Supporter, two vessels which had been delayed by the recent credit crunch and which had resulted in the damaging gross loss situation in 4Q 2008. The sale and leaseback arrangements were also completed for Swiber Concorde and it was immediately dispatched for work on a pipelay job in South-East Asia. On March 19, 2009, it was announced that Nitish Gupta was appointed to the Board of Directors. On March 23, 2009, Swiber announced that their diving unit, Kreuz Subsea, was awarded the IMCA Certification. This is an internationally recognized certification which is required before oil majors engage a company to do diving support for them. On March 25, 2009, Swiber announced that ICON Holdings from USA would be taking a 51% stake in Swiber Victorious and paying the Company a sum of US$19.125 million. They have ceded control of the vessel in order to manage their debts better. I can’t say this is an altogether good move but it does alleviate some gearing issues during the current economic downturn. Their AGM will be held in April 2009 and it will be good to be able to meet up with the Management Team to get some updates on the business and their future plans.

4) Suntec REIT – There was no significant news from Suntec REIT for March 2009, except that I received Suntec REIT’s FY 2008 Annual Report.

5) Pacific Andes Holdings Limited (PAH) – There was no significant news from PAH during this period.

6) China Fishery Group Limited – CFG announced that the original scrip dividend of 6.02 cents per share would be changed instead to a bonus issue of 1 for 10 shares. This is the first time I heard of a company “dis-declaring” dividends and converting it to a bonus issue instead; but it’s just cosmetic as the share effects are similar. I do look forward, however, to being able to average my cost in CFG. The bonus will be approved at the upcoming AGM to be held in April 2009 (usually in Raffles Hotel, I’ve noticed).

7) First Ship Lease Trust – FSL Trust has very kindly provided an update to shareholders on March 4, 2009 saying that no lessees are at risk of default and their leases are structured based on “Hell and High Water” conditions which means the lessees have to pay their leases no matter what happens. All very comforting but of course the high leverage, lack of growth opportunities and retention of cash for interest payments (hence lowering payout ratio to 75-80%) are not helping the Trust’s unit price. This is not surprising as freight rates are still very low and the whole shipping sector remains in a deep freeze, with the thaw just beginning in late 1Q 2009. At the risk of sounding over-pessimistic, I would think that this situation is likely to persist at least until mid-2010. Meanwhile, the nice glossy Annual Report for FY 2008 has been received and the AGM/EGM is to be held in Marina Mandarin on April 8, 2009.

8) Tat Hong Holdings Limited – There was no significant announcement from the Company for March 2009.

Portfolio Comments – March 2009

March 2009 was a good month to pick up more shares, as the Index had plumbed new lows in early March and based on that barometer of sentiment plus my build up of cash since October 2008, I added to my purchases. These are reflected in the blue highlighted prices in the portfolio summary for Swiber, Boustead and Tat Hong. All in all, I pumped in close to S$8,000 more in the three companies, with more of the funds being allocated to Boustead and Tat Hong as these companies have a longer track record. My portfolio has improved marginally from a total loss of 34.9% as at end-February 2009 to 34.1% as at end-March 2009. Since my portfolio is now more heavily skewed towards Boustead and Tat Hong, the fortunes of these companies would play a larger role in determining my portfolio value, as well as my realized gains too ! I will be expecting some dividends to be declared by May 2009 by these 2 companies, but my expectations should be tempered by the fact that both companies may need to conserve cash either for working capital purposes or for potential M&A activities.

As mentioned in my previous portfolio review, I was building up cash from monthly savings (of close to 40% of take-home salary) as well as my bonus in Dec 2008 to take advantage of new opportunities as they may arise. Fortunately these opportunities presented themselves in early March and I could purchase more of Swiber at 37.5 cents, Boustead at 46.5 cents and Tat Hong at 53 cents. Moving forward, the same strategy will be adopted by me: aggressive savings to build up opportunity funds, while maintaining a safe buffer of emergency funds equivalent to about one year’s worth of living expenses (including enough CPF balance to pay off 6 months of HDB housing loan).

My next portfolio review will be on Thursday, April 30, 2009 after market close.

Avoiding the Duds

I realize that so much emphasis has been placed on the choices that one has made in relation to companies that one had bought, that almost no one mentioned about those that one had correctly avoided ! I guess I could not think of a more appropriate title, hence "avoiding the duds" sounded reasonable enough. The same logic applies to mistakes as we can classify them according to "omission" and "commission". Commission means purchasing a company which is a dud and later makes you lose tons of money; while omission means NOT purchasing a company which later turns out to be a star, thus it is mainly opportunity costs.

If we turn the tables around, the same logic also applies. If one consistently avoids buying the "dud" or "over-hyped" companies, one can indeed prevent a substantial loss of wealth. Remember that preserving capital is also one good way of building wealth, as Warren Buffett advises us to "Never Lose Money". Even though cynical readers may point out that I have "lost money" due to this bear market and sharp recession, my argument is that over the long-term, I am confident of adhering to the mantra of "not losing money". This is because I feel that aside from choosing the right companies to take a stake in, it is also important to spot the danger signs for dud companies which may later implode.

Just to give some examples of the companies which I had considered but rejected, they fall into a few broad categories. One of them is "wrong business model", which is what happens when I first review a company's basic business model and decide that it cannot possibly sustain a competitive edge. Either that or the business model seems flawed, risky or inherently unsound. One of the more recent cases which comes to mind is the company GEMS TV, which was listed a few years back. This is a company which sells gemstones through television (akin to TV Marketing) and they had penetrated the UK and USA market. Back after its IPO, it was trading at around $1.50 and analysts were fervently touting for target prices as high as $3 (yes, you heard me right - I still have that report !). By studying the underlying business model, I decided that buying jewellery is a personal process and most people would rather go down to stores to try them out. Moreover, advertising is an expensive business and would require huge upfront capex with limited chances of success (it's a retail operation, not a contract-based business). Hence my decision to avoid the company even though analysts were bullish then. The benefit of omission has saved me a ton of money as the company has gone on to announce 4 consecutive quarters of losses and is now trading at 3 cents per share. It remains to be seen if the company can pick itself back up to its glory days when it IPO-ed.

Another category of companies which I will avoid are those with razor-thin margins. Some industries are effectively commoditized like semi-conductors and PCB Boards so the margin is extremely thin (close to 2-3% or maybe less). This means that a small escalation of costs from suppliers would trickle down into an avalanche for the company, who may have problems raising prices due to lack of pricing power. Some examples would include Chartered Semiconductor (which recently did a rights issue) and Jurong Technologies. The former has seen massive losses due to the plunge in worldwide chip demand while Jurong Tech has been suspended pending the outcome of judicial management proceedings as it was served statutory demands from several banks. Other companies which I have noticed with very think margins are Surface Mount Tech and also Olam* (surprisingly, this "blue chip" has margins of about 0.5-1% only).

*A Note here: If one had purchased Olam during its 2005 IPO at a price of 62 cents, one would still be sitting on nearly a 100% gain (more if you include dividends over the years). This was mainly due to its aggressive M&A strategy which saw many acquisitions (through gearing) over the last few years. These have been driving earnings in the near term. However, I am focusing on the margins which I am not comfortable with. The Company DOES have a sustainable competitive advantage in its total SCM business model, though.

A last category of companies I choose to avoid are - the over-hyped ones ! The hype can be done through various ways, either through analysts strongly pushing the company without taking a close look at the business model, operating risks, cash flow generation, capex and gearing; or else over-hyped on the basis of valuations alone (e.g. 20-30x PER meaning you need 20-30 years to recover your capital !). I guess most of the S-Shares would fall into the over-hyped category, as I remember the heydays back in 2006 and early 2007 when so many China-based companies came here to list. Gosh, there was almost one listing per month that time and if you got in at IPO it was almost guaranteed to make you money if you "stag" it. Such was the immense hype surrounding the "China Growth Story".

Of course, 2 years later, valuations have come down to 1-2x and a slew of scandals have hit S-Shares, notably in companies like Fibrechem, Oriental Century, China Sun and China Printing and Dyeing. This once over-hyped segment has faced almost a total collapse in confidence as investors flee S-Shares as if they were the plague. This situation sort of reminds me of the hype surrounding the dot.com companies during the dot.com bubble in 1999 before the eventual painful crash. Some examples I can think of for companies which I avoided include Synear Foods (trading at 30x PER back then - $2.00 and still being pushed by analysts), China Energy (their DME technology was touted as an emerging technology and valuations were pushed to stratospheric levels) as well as China New Town (ok, this was a dud to begin with, I don't know how SGX managed to get them to list here !).

So after all has been said and done, please do remember to give yourself a pat on the back for the companies that you correctly avoided ! Most people like to tell you about their winners or blue chips, but if you probe further they tell you in a quiet voice about the duds they had bought donkey years ago and are STILL holding on to them. In an environment where making the correct decision can greatly influence your chances of growing wealth, I would think a lot more due diligence should be demanded of the retail investor, or he may risk seeing his capital evaporate like puddles on a hot summer day.

When the going gets tough, the tough get....going ?

Investors who have stayed with my blog for the entire duration of the bear market (yes, 16 months so far) and have been invested fully throughout will probably be wondering if there is ever any light at the end of the tunnel ! The fact is that market conditions are always dictated by Mr. Market and he follows economic cycles to determine his mood swings, and whether he decides to pay a high price or a very low price for a business. As investors, our job is to evaluate the underlying business and not pay too high a price for it, in order to maintain margin of safety. The bear market and sharp recession has challenged my notion of margin of safety and also afforded me some insights into my investment choices, some of which I would admit to be mistakes which could have been either avoided or mitigated. When the going gets tough, frankly usually the tough get going (i.e. exit the market). But I am not about to succumb to Mr. Market's manic mood swings, even though the psychological effects of his swath of destruction have pummelled many an investor (including myself). A back to basics analysis would tell one if holding on and averaging down is wise; or if one should just cut loss and re-deploy the funds.

A more obvious boo-boo made by yours truly was to purchase companies which leveraged heavily for fast growth. Evidently, this strategy worked well during times of economic expansion and with the availability of easy credit. However, with a severe credit crunch under way and banks being unwilling to lend, these highly leveraged companies became prime candidates for implosion, due to their inability to refinance their short-term debt and also the cash flow burden which they had to bear in the meantime. Companies like Ezra, China Fishery and Swiber which geared up to expand found that the going was very tough over the last 6 months, to the extent that I did perspire quite a bit and went through a few sleepless nights wondering if they could pull through the crisis. Though Ezra and Swiber employed sale and leasebacks, there's no argument that operating lease expenses would still represent a major cash flow drain, while they still have bank loans to service and refinance. China Fishery had to issue senior notes at about 9.25% interest rate (extremely high), and though they are due in 2013, the huge interest expense is eating up valuable cash at an alarming rate. If not for the fact that China Fishery had good net margins and a lot of their debt is collateralized using their own vessels, plants and inventories, I suspect they may face financial problems similar to the ones recently faced by S-Shares.

So it's apparent from the above that my choice of companies with such heavy leverage has been less than exemplary, and my original focus on value investing may have been viewed by some skeptics as little more than a distorted version of Peter Lynch's "Growth Investing"; albeit with high risk ! Since the job of the value investor is to minimize risk in his investments by requiring a good understanding of a business with little or no debt, I am somewhat guilty of violating this rule ! But we live and learn and it's not the end of the world because of these errors of judgement; I take it in stride and will make sure I am more wary of such complex financing schemes and such high leverage when evaluating future potential companies.

With the current bear market reaching new lows in early March 2009, I did take the opportunity to re-balance my portfolio by purchasing more of Tat Hong and Boustead; as they are more established and cash-rich. This has boosted my stake in both companies to levels above that which I own in Ezra and Swiber; and this acts as a buffer in case Ezra and Swiber encounter any critical problems in managing their debt. As for China Fishery, the recently declared bonus issue of 1 for 10 shares will allow me to average down my cost at no extra cash outlay. Just for info, Tat Hong was purchased on March 3, 2009 at 53 cents and Boustead was purchased on March 9, 2009 at 46.5 cents. This has reduced my cost in Tat Hong and Boustead to 68 cents and 55 cents respectively, and will be updated in my month-end portfolio review.

This bear market and unprecendented crisis has taught me a lot about companies, how they operate, risks and valuations. It's a very enriching learning experience though it will probably end up being an expensive one if anything untoward happens to my companies (touch wood !). As we are not out of the woods yet, there is still some potential for trouble though the probability has been greatly reduced since October 2008.

There will be more of such candid admissions in the months to come, and sometimes I feel I could compile my own "mistakes checklist". For readers out there, please feel free to criticize (constructively, please) and give advice. We are all learning as we go along.

Can Minority Shareholders influence Management ?

As a minority shareholder myself in several companies, the question which has always popped up in my mind is the extent of influence which minority shareholders have on the Management of the companies which one owns. After all, as part-owners of a company, minority shareholders should have some influence or say on the running of the business, besides just showing up to attend AGM and voting on perfunctory matters. However, let's explore how this could be done in a more constructive way, and whether Management actually responds in ways which would enhance shareholder value.

In the kind of economic environment we are in now, companies have started bombarding (yeah, carpet bombing) shareholders with rights issues. Hapless minority shareholders have to choose between forking out cash or else get diluted (sometimes massively so). So can this be taken as a sign that Management has ignored the plight of minority shareholders and went ahead with such issues due to the backing of the majority shareholder (in most cases, it's Temasek). How can aggrieved minority shareholders voice their displeasure and disappointment ? It would seem that there are currently no proper channels or avenues besides the EGM; and even then the majority shareholders' votes would more than negate the small voices of a majority of the minority shareholders. This is indeed worrying and should be properly addressed by SGX.

Another avenue which shareholders can make themselves heard is through the so-called IR department (an abbrieviation for Investor Relations). Some companies have their own IR department while others engage a PR firm as their IR contact. Shareholders can call in to ask questions about the business or to request annual reports (I've done so myself). However, the flip side is that the person whom you're asking is unlikely to be the top Management or someone from the Board of Directors; which means the answer you probably will get is a standard one. Since companies do not like to disclose price-sensitive information, you may just get a curt reply that they are not in a position to comment further. Companies hiring the PR firms are more "marketing" by nature - they tend to use nicer language in press releases and to phrase things more positively. Nothing wrong with that, but sometimes the truth is the truth so let's just call a spade a spade. Companies I own which engage such PR firms are Ezra (Oaktree Advisors) and Swiber (August Consulting). Companies such as Boustead and Tat Hong have their own IR department.

A more effective way of getting your views heard by top management is, of course, to attend the AGM and/or EGM. I've always found that I can engage the top management in conversation to ask about the latest developments surrounding the company, as well as to find out about the company's plans for the future. Most companies have Management teams which patiently entertain all shareholder queries, which is a very good thing indeed. However, whether any suggestions by shareholders on how to run the business are taken seriously or not is in question, as minority shareholders are not assumed to know enough about the business to be able to contribute anything constructive. This I am fully aware of, but I feel that during such unprecedented times, Management should remain open to constructive suggestions and filter out the bad ones; as they themselves may be facing problems in growing their business.

As a shareholder who studies the business intently, I would very much hope that any suggestions which I make can be seriously considered so that Management can take the best measures to enhance shareholder value. This would indeed be a synergistic co-operative effort by both Management, Directors and Shareholders !

Survivorship Bias - Is the Index indicative ?

It was with much interest that I read about the recent revamp of the Straits Times Index (FTSTI) in March 2009 and that the Index would be reviewed and revamped twice a year in March and September to ensure a fair and true representation of stocks listed on the Stock Exchange of Singapore. The latest revision removed 2 property companies - Yanlord Land and Keppel Land; while adding two transport operators - ComfortDelgro and SMRT. Interestingly enough, the reason given was that property was in a slump and that the market capitalization of Yanlord and Keppel Land was lower than that of the 2 transport companies, thus removing them from the index would ensure a better representation as transportation was seen as a more "resilient" industry.

This brings us to the very obvious conclusion that the Index seems to be "revamped" every other time such that the components are switched for other companies. The issue of survivorship bias will certainly be raised - this bias can be explained by the fact that the index continues to persist and climb higher over time not because shares on the whole keep rising, but because the components in the Index are substituted with stronger companies over time, while leaving out the laggard companies which do not perform. This is especially pervasive if you consider the fact that bellweather companies such as Creative used to make up the index until they were dropped due to declining sales and profits.

To cut a long story short, what I am trying to say is that if one uses an Index as a benchmark for stock market performance, one is likely to get results which are highly skewed due to this bias. When weak companies are dropped in favour of good ones, isn't it very obvious even to the layman that the index will continue to rise in future instead of stagnating or even falling behind over time ? Thus, the many articles written about stock markets always returning about 6-8% per annum may not be totally 100% true after all, if we account for this bias and the fact that the index is simply NOT representative from one period to another. For simplicity sake, I will confine my discussion to the Singapore Stock Market as some may point out that the Dow Jones Industrial Index (DJIA) had so many switches in its components since its inception that the Index is almost a totally different animal today than it once was 70 years ago.

This begs the question - how representative is an Index of the broad market and should investors rely on such indices to gauge market sentiment and relative price levels ? Some points to ponder on:-

1) The high weightage of the three local banks (DBS, UOB and OCBC) plus SingTel skews the Index towards these 4 companies. In fact, the rise and fall of just these 4 companies can have a drastic and sharp effect on the Index even though other index components ma not fluctuate much. My argument here is that the weightage is skewed too much towards financial stocks currently.

2) The usage of just 30 stocks to represent a universe of about 700+ companies seems to undermine the representative strength of the index. In the USA, though the DJIA is the bellweather Index which is still used by a broad array of investors, there are also two other important indices - the NASDAQ and the S&P 500. Of the 2, the S&P 500 is considered to be the most representative index because it includes 500 companies in it - this obviously makes it more representative than the DJIA which only includes 30 blue-chip companies (some of which are not so "blue-chip" any longer). My suggestion is for Singapore to have such an index incorporating about 40-50% of the companies on the 2 Boards, in order to show a more representative sample.

3) There are many other indices as mentioned by SGX in their press release some days ago, such as the FTSE ST Mid-Cap Index, Small-Cap Index, Fledgling Index and even an ST China Index. However, all these indices are not prominent enough and are usually not even mentioned by commentators or news reports (with the exception of the China Index since S-Shares seem to be taking a severe battering these couple of weeks). I was hoping SGX could come up with more useful indices which are better recognized rather than the existing ones which seem (to me) to be rather defunct.

4) How are dividends accounted for in terms of computing the returns on an Index ? Besides the fact that an index suffers from survivorship bias, another problem is also that of dividends which are declared and paid out by index constituents over the years. Are these accounted for by the Index ? I doubt so. There are researchers, however, who assume the dividends are reinvested into the Index and compute a median return for that. Suffice to say that such literature remains buried amongst the scholarly and those who study the stock market for a living, and has yet to be mentioned in a mainstream media article or given due attention.

All the above seek to highlight the problems with STI and indices in general. I would appreciate opinions on this issue as well as it is also quite a new area for me to blog on, and I will approach this subject again in the near future should I discover new insights.

The Dangers of Deflation

With the world in the grip of the worst financial crisis since The Great Depression, one should definitely consider pertinent issues relating to the broad economy, in addition to evaluating one's personal wealth. Though much of what had transpired so far could not be reliably predicted, and the way forward looks uncertain and murky, there have been several topics which have been highlighted in the media and in financial circles in recent months so as to warrant significant attention. Most of these topics cover issues ranging from the bursting of the US Housing Bubble as well as the ruthless and relentless disintegration of once vaunted financial institutions in America and Britain. Another issue which immediately comes to mind may not sound like a big deal at first but has many important ramifications: Deflation.

Deflation is defined as a persistent slide in prices over an extended period of time, and is the exact opposite to inflation, in which purchasing power in eroded. In the case of deflation, purchasing power of the dollar is increased over time as the prices of goods and services become lower, and consumers enjoy lower costs and expenses as everything from transport costs to electricity tariffs are lowered. Sounds like a very joyous occasion and a reason to celebrate right ? However, there are many dark aspects of deflation which have been put forward by economists to explain why deflation is anything but good for the economy, and the most pertinent example is that of Japan in the 1990's (also termed as the "lost decade").

To immediately illustrate my point, Japan had undergone the bursting of their real estate bubble in the late 1980's, and subsequently their stock market (the Nikkei) crashed from a high to its present level of around 7,000+ (a 25-year low). What was more damaging was not the immediate fallout from the real estate and equities crash, but that of persistent deflation lasting about 10+ years which caused many companies to fail and pushed the savings rate of Japanese up, thus exacting a heavy toll on the economy. Government efforts to inject liquidity and put cash in the hands of the final consumer did little to halt the slide of prices, and this had a detrimental effect on the Japanese Economy which spluttered along like a terminally ill patient on life support for more than a decade ! Let's examine the process of what I term the "Deflationary Spiral" and explore why it is so damaging to economies, and what can be done to prevent a similar occurrence in Singapore. *Note: This scenario is unlikely to occur in the USA at present due to the massive injection of liquidity through the printing of US dollars, thus raising the prospects of devaluation of the US Dollar and increasing inflation in the years to come as the purchasing power of the US Dollar drops.

The logic of deflation is that once people start to realize that prices are falling, they tend to hold back their purchases of goods and services as they believe things will get progressively cheaper. This has the effect of causing companies to lower the prices of their goods, while at the same time firms get hit by a double whammy of falling demand. The end result is that factories and manufacturing plants get hit by low utilization where production plants lay idle. Whatever inventory the Company has can only be sold at prices which are constantly falling as a result of deflation. The predictable result from the low utilization, falling demand and lower prices is of course, retrenchments and layoffs as companies seek to aggressively cut costs in order to maintain profitability and conserve cash balances.

As a result of these mass layoffs, people will lose their purchasing power ability as their source of income dries up. Families then seek to re-budget and decide to cut back even more on spending on discretionary items. Those families which were not directly affected by the layoffs would similarly tighten their belts in anticipation of bad times as they may expect pay freezes or pay cuts, or they may do so for fear of getting into a cash crunch themselves should the previously unthinkable happen. All of these generate a negative feedback loop which reinforces falling prices as more and more people hold back purchases and spending, forcing businesses to further cut prices to induce people to buy their products - and so the vicious cycle is perpetuated. Businesses are also likely to halt or put off plans for expansion, cutting back on capex and pulling back from M&A deals as liquidity dries up amid slumping sales, so this will put added pressure on the economy as the money supply contracts.

So it would seem that there is no solution to this vicious cycle of falling prices, falling demand and forced savings. Call it the "Paradox of Thrift" if you will, but the irony is that saving more actually penalizes the economy rather than helping it to grow at a steady clip, as the GDP equation consists of consumption, investments and Government spending. So how do economies break free from this cycle and restore growth - in order words, making people spend again !

Governments have a major role to play in breaking deflationary cycles, and they do this by adopting fiscal spending measures such as tax breaks for businesses to reduce costs, lowering rentals on government property to ease expenses; while for the individual, they may put money directly into the hands of consumers (e.g. rebates, GST Credits) to encourage more spending. Consumers need to feel that now is a good time to put their money to use and thus increase their spending, so as to break the cycle of deflation. At the same time, businesses, once assisted, can stop cutting jobs and thus prevent the problem from escalating by ensuring individuals have enough income to put food on the table.

To summarize, the dangers of deflation cannot be over-emphasized, as Japan is one classic example of what could happen if deflation was allowed to fester over an extended period. The damage to the economy could be long-lasting and irreparable; thus I hope the Singapore Government is able to tackle this problem before it rears its ugly head. A good start has been made through the Resilience Package, and more off-Budget measures are set to be introduced in the coming months as the economy, and inflation, head downhill.

Swiber – FY 2008 Analysis and Commentary

On February 28, 2009, Swiber released their FY 2008 financials, and basically dropped a bombshell on shareholders – there were delays in the deliveries of 2 vessels which ultimately meant that project work on some contracts could not be completed in time, resulting in higher costs recognized without associated revenues. The effect of this was a plunge from a net profit to a net loss for 4Q 2008, which dragged down the performance for the entire FY 2008.

After going through the numbers, facts and figures, below is my analysis of the situation and comments on whether the Company can steer through the difficulties it is currently facing, and also to determine if this surprise loss is a one-off incident, or may likely occur again in future. As shareholders and investors, we should be most concerned about what our asset (business) is doing and whether it can continue to give us steady returns over the long-term.

Profit and Loss Analysis

As mentioned, the 4Q 2008 numbers are not pretty mainly due to the late deliveries of 2 vessels – Swiber Concorde (pipelay barge) and Swiber Supporter (dive support work barge). This resulted in delays in completing work for pipeline installation and subsea tie-in and led to increased cost of goods sold without associated revenue being recognized. In addition, a confluence of other factors such as higher sub-contracting costs for an offshore fabrication project as well as costs associated with rapid mobilization and de-mobilization of vessels to handle projects in different locations resulted in a gross loss of US$12.3 million (gross loss margin of 12%). Net loss margin for 4Q 2008 stood at 10.9% as a result too of higher administrative costs associated with increased staff strength due to the expansion of the company, but part of the costs were defrayed by the higher share of profits from associates Principia Asia and Swiwar Offshore. Finance costs rose about 150% due to the increase in bank loans and bonds taken up by the company to finance its capex requirements. This will be dealt with under the Balance Sheet analysis.

For FY 2008, gross margin compression caused gross margin to fall from 28.3% in FY 2007 to just 15% for FY 2008, principally due to the performance of the 4Q 2008. Stripping out exceptional gains from sale and leaseback transactions (S&L), net margin would have been 6.35% for FY 2008 against 18.5% for FY 2007, a drastic drop no doubt.

To put things in perspective, one has to analyze the factors behind this occurrence and put forward a conjecture on whether it is reasonable to assume that it is likely to occur again in the near future. According to the Company’s press release, the vessels which were delayed are slated to be delivered in 1Q 2009 instead, where they will then presumably be able to finish up the job and complete the projects. What was not mentioned though was the probable loss in confidence from their customers as a result of this fiasco, which would hurt Swiber’s reputation for timely project execution. While it can be argued that clients should understand that this credit crunch is unprecedented and was the principal cause for the shipyard’s delay, I would think that Swiber’s reputation would still be somewhat tarnished after this unfortunate incident. This may affect their ability to clinch new contracts and also strain relations with existing customers. However, the Company did announce US$70 million worth of new contracts clinched in the first 2 months of FY 2009; so one can infer that the reputational damage should be fairly contained and customers may dismiss it as a mere one-off incident. Shipyard delays make it difficult to schedule project work and Swiber must have felt this very keenly in 4Q 2008 when global trade financing came to a near standstill and freight rates also plunged. This caused problems for companies such as Ezra as well as they had to cancel their MSFV orders with Keppel Singmarine and Karmsund.

So it can be seen that the effects of the crunch have affected all companies; hence it can be concluded that the reputational damage is mitigated by this fact and also the fact that Swiber has established long-term relationships with customers prior to such an event occurring, which makes it unlikely for the relationship to strain further. I view this as a one-off unfortunate incident for the Company, but it pays to observe if things will go as planned for 1Q 2009 with the eventual delivery of the 2 vessels. Mr. Raymond Goh did mention in the Business Times today that he does NOT forsee any more delivery problems as “the situation has changed (from one of over-capacity in the yard) to one whereby the yards are more desperate for work now”.

Balance Sheet Review

To be honest, Swiber’s balance sheet has considerably worsened from FY 2007 to FY 2008, due mainly to the higher gearing (debt level) as well as the drop in the current ratio. Due to Swiber’s ambitious expansion plans, it had issued bonds and taken up more bank loans in FY 2008, with non-current bank loans increasing by 500%, non-current bonds increasing by 200% and trade and other payables nearly doubling as well. The result of this was a drop in the current ratio from 2.15 in FY 2007 to 1.37 in FY 2008. Most of the current assets for FY 2008 was made up of cash and work-in-progress, which are unbilled portions of completed projects. This will likely reverse itself in FY 2009 to bills or trade receivable and by observing the trade receivables balance for FY 2008 compared to FY 2007, the increase of just 38% compared to an increase of 183% in revenues shows that collections are not a problem. Understandably, this should be because of the nature of Swiber’s customers (mainly oil majors and state-owned oil companies).

Debt-Equity ratio hit 1.01 for FY 2008 as a result of higher gearing to fund their vessel expansion plans. This was a significant rise from FY 2007’s D/E of 0.53 and is a worrying sign amidst this credit crisis. The interest paid on their debt totals about US$11 million and can be comfortably managed by operating cash inflows, but they have a portion of debt due within a year amounting to about US$81 million. Comparing this with their cash balance of US$74.7 million as at Dec 31, 2008 and considering the fact that no other major capex requirements are un-funded, coupled with the steady contract flow for Swiber; I do not forsee the repayment of this debt to be a major problem and there is also a remote chance of a rights issue to shore up their Balance Sheet, heavily geared though it may be. This will be covered in detail under future plans and also the Cash Flow Statement analysis.

ROE (annualized) is 18.9% for FY 2008 but much of this can be attributed to the increase in debt, meaning the quality of the ROE is in question. ROA was pathetically low at just 5.6% for FY 2008 compared to a more robust 13.3% for FY 2007, mainly due to lower earnings for FY 2008 as a result of the aforementioned losses in 4Q 2008 and also the Group’s asset base increasing as it expands its fleet. In future periods, this ratio is likely to stay depressed as the Group grows its asset base further; but it is hoped that earnings can increase at a correspondingly healthy rate to be able to make up for this drop.

Cash Flow Statement Analysis

It is quite deceiving to just look at the Income Statement as the drop of about 20.6% in full year net profit might lead one to assume that cash flows are corresponding poor as well. But in fact, the cash flow for FY 2008 was more robust than FY 2007 mainly due to the previously mentioned 38% increase in trade receivables when revenues surged so much, as well as the fact that there was a net operating cash inflow of US$2.2 million compared to a net operating cash outflow of US$16.8 million for FY 2007. Though small, it shows that the Group can maintain positive cashflow even with decreased earnings, higher income taxes as well as higher interest payments. The main reason for the cash inflows not being higher than they could be can be attributed to the work-in-progress accumulation which has not been billed and collected from customers (a possible timing difference) which could result in more cash flowing in during 1Q 2009.

For investing activities, the capex is pretty apparent for both years as US$92 million was paid in FY 2007 and US$226.3 million paid in FY 2008 to purchase PPE. However, do note that cash also flowed in from disposals of PPE and assets held for sale, as Swiber attempts to replace their older fleet with a newer one. All in all, 10 vessels were acquired in FY 2008 while 6 vessels were disposed of. The details can be found in Swiber’s powerpoint presentation material which can be downloaded from the Company’s website. Net cash used for investing activites ballooned nearly 400% to US$206 million, and constituted a major drag on cash.

The shortfall for this capex has to come from financing activities, of course. During FY 2008, US$235 million was raised from bank loans alone, and another US$92.2 million from the issuance of bonds. While hindsight would dictate that gearing up so quickly in one of the worst recessions in 70 years was a bad idea, it is at least a comfort to know that Swiber has already obtained its bank lines and successfully sold its bonds (which have a 3-year maturity by 2011). Interest costs of US$11 million per annum should be manageable only if the Group can secure sufficient contracts in the next 10 months of FY 2009, which I perceive as a key risk and uncertainty given this protracted downturn. On the other hand, also note that US$133.4 million worth of bank loans were repaid during FY 2008, about 64.7% more than the US$81 million due within one year. If you add in the interest, this comes up to about US$92 million worth of cash outflows for financing activities for FY 2009, which I am confident the Group can comfortably handle due to its order book of US$596 million as at end-FY 2008. Do not forget to factor in the additional US$70 million worth of new projects for 2M 2009, bringing the total order book for end-Feb 2009 to US$666 million, most of which will be recognized in FY 2009.

Prospects and Future Plans

After announcing the scrapping of their plans for the much talked about Equatorial Driller (a relief considering the huge capex burden it would have entailed), the Group now plans to focus its business efforts on managing costs and also on timely execution of projects. According to its press release, a total of 17 new vessels will be added to its fleet for FY 2009, most of which will be delivered in 2H 2009. Assuming Swiber Supporter and Concorde are delivered in 1Q 2009, this means that more of the revenue will be recognized in 2H 2009 due to most of the deliveries being timed for that period. It would also signal lumpy revenues and that quarterly results should not be relied upon too stringently (a case similar to Boustead).

As Mr. Raymond Goh had mentioned, Swiber has the manpower and the contracts awarded to it from Thailand (CUEL), India, Middle East, Indonesia and Malaysia. The only thing lacking are the vessels which are critical to perform the job well and free Swiber from the usage of third-party charters which are not only costly but also run the risk of problematic scheduling. I personally perceive that problems may continue into 1Q 2009 and the early part of 2Q 2009 before things stabilize, which means the Group may see more volatile earnings and margins ahead.

The good news (if it can be considered good) is that no further capex plans are underway, and that all planned capex is fully funded by S&L, bank loans and disposals. It’s akin to the Company just sitting back to wait for the vessels’ arrival, then to use these vessels to generate revenues and recurring cash flows. In order to remain asset-light, Swiber has made use of S&L as well as to jointly-share assets with their partners in the Middle East (Rawabi) and other regions too. They plan to target the shallow water domain in South-East Asia, where they have fewer competitors; as well as sub-sea opportunities in the Indian and Middle Eastern region. Though oil prices have come off a high if US$147 per barrel to currently about US$42 per barrel, Mr. Goh still sees a consistent demand for shallow water EPCIC work as projects which have already begun would not be terminated prematurely, and Swiber has the advantage of being involved in the end-stage of the oil and gas extraction process; so it is very unlikely for contracts to be cancelled. This is unlike Keppel’s business model where oil rigs can be cancelled or deferred as they represent the E&P (Exploration and Production) phase of the oil and gas cycle. This acts as a natural buffer to Swiber’s business and allows for more clarity of cash flows and contract revenues.

On a final note, the Group has also mentioned the possibility of moving their expertise to serve the offshore windpower industry. No additional capex is required and the skills set is apparently transferable as well, thus opening up a window of opportunity for the Group. Though this is just “talk” at the moment, it could be a possible avenue for Swiber to branch out into in future and may become a separate business unit if the potential is large enough.

For industry prospects, most of the presentation material features updated research and quotes from Feb 2009 which support the fact that investment in oil and gas E&P will continue, and the sharp drop in demand for fossil fuels would only exacerbate this under-investment scenario past FY 2010. As a result, most oil companies are continuing to inject monies for capex and oil field discoveries, and they are unlikely to taper off anytime soon.

Conclusion

Ultimately, the value of a company should be determined not just by the quality of its assets and its growth potential, but also the quality of the Management and their ability to allocate capital efficiently to achieve a high ROE without excessive use of leverage. With the credit crunch affecting companies such as Ferrochina, it pays to be prudent and Swiber should focus on generating more FCF once their fleet expansion is complete by end-FY 2010. While some may lament the lack of clarity in the Company’s growth moving forward, the key focus now should be to hunker down and build up vital cash to tide over the protracted downturn, so as to emerge into the sun in future with the necessary resources to take advantage of new opportunities.

In view of this analysis*, I have added to my position at S$0.375 yesterday. My new average cost for Swiber is now S$0.802 and will be updated in my March 2009 portfolio review.

*Disclaimer: This analysis is personal and is not an inducement to buy or sell shares of Swiber Holdings Limited. The author of this blog will NOT be held responsible for any losses incurred due to the reliance on this article for investment decisions or for speculation opportunities.