Friday, August 28, 2009

Swiber – Reasons and Rationale for Divestment

With the announcement on August 27, 2009 of Swiber’s issuance of a convertible bond (CB) of up to about US$78 million, with up-size option to raise a further US$22 million, I realized immediately that the Company’s cash position was in jeopardy and that my investment in the Company was becoming increasingly risky, which translated into an untenable situation of which I had to take action.

The terms of the CB are for a conversion price of S$1.20 per share, with the condition that the conversion price can be adjusted DOWN to S$1.08 if the average price falls below 90% of S$0.96 in the preceding 20 days prior to issue date. The conversion price reset can go as low as S$0.864, which means with each revision downwards in the conversion price, the potential dilution factor becomes ever larger. Total new shares converted without up-size option is 93.6 million, representing 18.5% of existing share capital of 507.76 million shares, and this can potentially increase with either the upside option being exercised or the revision in the conversion price. A dilution factor of 18.5% alone is already massive, but with the possibility of further dilution then I must say this is a bad deal for existing shareholders. Add to that the interest rate of 5% per annum payable semi-annually – this will increase their finance costs and reduce cash flows further for another 5 years. The worst part of the deal is that the funds are to be used for “working capital and general corporate requirements”, thus implying that there is no exact purpose for the fund raising (not for vessel fleet expansion, or for pre-emptive opportunities).

Considering that a share placement of about US$49 million was done (at 88 cents per share) just in June 2009, it is disappointing and highly suspicious as to why Management had decided to raise funds for a second time in less than 3 months. One of the immediate reasons which comes to mind is that the Company has cash flow problems and that their operating cash inflows are not enough to support both fleet expansion, working capital requirements and to pay interest on existing borrowings. This puts the situation in a whole new light and the issuance of this CB is (to me) an obvious sign of cash flow strain for Swiber, even though they had clearly and explicitly communicated just 6 months ago that they had enough cash raised from bank loans, internal funds and sale and leaseback transactions.

Other pertinent reasons relating to the divestment decision are as follows (in no particular order of significance):-

1) Depressed gross margins as reflected in the Income Statement. This had been going on for more than a few quarters and gross margin has been on a steady decline since 2007. The first few reasons given was that their vessel fleet was not ready and so many third-party subcontracting costs were incurred, thus bumping up their COGS and reducing gross margin. Then, the shocking announcement was made for 4Q 2008 financials that they had incurred a gross loss for that quarter, based on the same reasons as given and because their vessels (originally scheduled for delivery), had not been delivered in a timely fashion. Then, for 2Q 2009, they revealed that they had spent US$23.6 million on fabrication costs (relating to sub-contractors) compared to just US$10.6 million (a more than 100% increase) which pushed down gross margin; and this is even though their vessels had already been delivered in 1Q 2009. This persistent unpredictability of gross margin and rampant “shocks” do not reflect well on Swiber’s cost control, and my reason for investing is to ensure a certain level of predictability and stability; and not to see gross margins being subjected to a roller-coaster ride.

2) Increase in financing costs as a result of higher gearing will continue to impact both their profit and loss statement as well as their cash flow statement. In addition to new bank loans secured as well as their medium-tern notes, Swiber has now pulled off a CB and this will add to their debt significantly. Gearing is much too high for me to feel comfortable considering that their order book is not growing at a similarly fast pace.

3) US$71.2 million worth of bonds need to be repaid by 3Q 2010, and from their cash flow statement one can see that most of their cash is being generated from financing activities, and not operating activities (refer to my previous post on Swiber’s 1H 2009 financial analysis and review). This clearly shows that operating cash inflows are insufficient to sustain the business and provide working capital, so Management has had to constantly tap the capital markets for funds. With cash balance just hovering at US$59.4 million (as at June 30, 2009), there is sufficient concern that cash balances may be further strained to pay back the bonds, as well as any maturing bank loan facilities.

4) The dilution factor in the two most recent fund-raising activities cannot be simply ignored. The first fund raiser was back in June 2009 with 84 million new shares being issued at S$0.88 per share, diluting existing shareholders by about 20% of the then-issued capital base of 421,355,000 shares. Now, with the issuance of the CB, another potential minimum dilution factor of 18.5% will be applied to all existing shareholders, further reducing EPS ceteris paribus.

5) Contract flow has lessened considerably with the onset of the global financial crisis, and a weak point about Swiber (compared to Ezra’s business model) is that their contracts are of short duration and are not locked in for long periods (unlike Ezra with 3 to 5 year contracts with oil majors). This means that order book is constantly being depleted and has to be replenished quickly in order to keep the top-line healthy and to ensure cash inflows keep coming in. If one had noticed, tender book for Swiber had increased from US$2 billion to US$5 billion to a recently reported US$7 billion for jobs from 2010 to 2015. One must question how much of this tender book can actually translate into order book, as their “hit rate” has not been historically high. So far they only clinched US$80 million for 1Q 2009 and US$93 million for 2Q 2009, this implies that about US$340 million will be clinched for the FY 2009, by extrapolation. Comparing this to their more robust order book back in 2007 when they secured larger contracts of more than US$100 million per contract, this begs the question – if they have a larger fleet size and are able to bid for higher-value projects, then why are the current jobs secured in 1Q and 2Q 2009 smaller than the ones secured back in 2007 and 2008?

6) Many of the recent corporate actions undertaken by Swiber had also hinted to me of their urgent need for cash, as evidenced by the following:-

a. Swiber and ICON Capital to jointly own Swiber Victorious (announced in March 2009). If they had enough funds they would not sell part of their vessel to ICON and cede part of their ownership in this vessel;
b. Divestment of 30% share of OBT in April 2009 for US$3.9 million, at cost instead of at a premium. This had, to me, hinted that they needed cash or they would have negotiated for better terms relating to the divestment;
c. Sale of shares in Perfect Motive in June 2009 for RM 200,000, when the book value of Perfect Motive was RM 324,000. Another loss had been realized on this divestment. No motive or rationale for divestment was provided for both cases.

7) One aspect of Swiber’s business model which confused me was why they had to have so many alliances with regional partners, since they were prepared to grow their own fleet. Theoretically, with one’s own fleet, one should be able to bid for larger projects and contracts on one’s own merit, instead of having to share resources and rely on a partner’s help for their projects. Yet, it is the very nature of larger EPCIC contracts where more than one party is required; hence the total profits simply cannot accrue to one party. This makes me question the market dominance of Swiber, since there are other offshore players which are offering similar services in the region which act as competitors. Since Swiber had tied up with so many regional players since 2007, theoretically this should garner them more contracts, but it did not appear to be so. In fact, if we contrast Ezra’s business model, they are able to clinch contracts on their own with oil majors and national oil companies without relying on “synergistic” relationships as a catalyst. This in itself is an attestation to their brand name and reputation, of which I feel Swiber is lacking.

8) Swiber has also put several initiatives on hold, while others are mere talk or speculation. The first was the wildly hyped up Equatorial Driller, which was touted as an alternative to traditional drillers; but this plan and the entire project was shelved due to the onset of the global financial crisis, leaving the plan in limbo; and no more was said of this since then. The problem was that Swiber had hired a very experienced team of drillers headed by Mr. Glen Olivera, of which they had to pay monthly salaries, and in the end this team ended up with less work than originally intended, as Swiber only has a small drilling project with NuCoastal in Thailand. At the AGM, they clarified that they were selling services relating to drilling in lieu of the postponement of the Equatorial Driller plans, but does that justify the high cost of maintaining an entire drilling team?

9) The other initiative which was talked about in presentation slides was wind energy and wind farms, and how Swiber could technically deploy their vessels to service this new and growing industry. What made me uncomfortable was that Swiber seemed intent of moving out of their comfort zone without even having established a firm foothold in the EPCIC and drilling arena; and the plans sounded lofty and ambitious but without much substance. Ultimately, if something is being discussed and put into presentation slides, one would assume that Management has been working on something concrete but so far Management has not provided updates nor given a progress report on this planned initiative.

As a result of the above, and due to my nagging discomfort with the way the Company is being managed and issues with cash flow and dilution, I have decided to divest the shares of Swiber and have done so at a price of 95.5 cents, crystallizing a gain of 19% on my initial investment. With a holding period of about 2.5 years, this translates to a return of roughly 7% per annum (it will be lower if you factor in compounding). Please note that even though a gain was recognized on this transaction, it is still (and will be) classified as an “investment mistake”* because of the underlying principles behind the decision, which resulted in the move to divest much earlier than I had intended for. The proceeds will now be shifted to an opportunity fund to await deployment once I have identified another suitable investment opportunity. Proper care and due diligence will be exercised to prevent a mistake of a similar nature.

*Note: Every buy and sell decision which I make must be supported by justifications based on factual data and a complete and objective analysis of the facts at hand. There is no room for “falling in love” with a company and hugging its shares for dear life, even when something fundamental has occurred which frustrates my original intention for investing in the Company. This is in line with my investment philosophy of keeping a close watch on the companies which I own, to assess if they begin to diverge from my fundamental investment objective(s).

Disclaimer: The above are merely personal opinions and observations relating to my decision to divest the shares of Swiber Holdings Limited. It is NOT to be taken as an inducement to buy or sell shares in the Company, and I shall not be held responsible for any losses relating to said decisions. Please consult your lawyer, accountant or other qualified professional before undertaking important financial decisions which could have an adverse impact on your wealth.

Wednesday, August 26, 2009

Swiber – 1H 2009 Financial Review and Analysis

Swiber’s results were, frankly, not totally unexpected given the slump in the O&G segment since the spectacular fall in oil prices started to curtail spending on E&P by oil majors. However, since Swiber are responsible for the tail end work on most E&P projects, this means a lower chance of their contracts being cancelled (unlike what is happening at Cosco – a shipbuilder). The Company is also keeping a lower profile in terms of not overtly announcing new contract or LOI wins, even though it managed to chalk up new contracts of US$93 million in 2Q 2009, compared to just US$80 million in 1Q 2009. Instead, their IR Department seems to be going on overdrive in announcing details of tie-ups with regional partners, delivery of vessels and ongoing Management changes. While there is nothing overtly wrong with this, it does make one wonder – where are all the profits and cash going to come from eventually? I will address this and other issues in this analysis, but let me do the usual routine review and analysis of the three most important financial statement components first.

Profit and Loss Review and Analysis

Due to the fact that Swiber had completed just 4 projects instead of 6 last year, revenues dropped 11% from US$125 million for 2Q 2008 to US$111 million for 2Q 2009. Gross margin, however dipped from 25.9% in 2Q 2008 to 21.5% in 2Q 2009; while 1H 2009 gross margin also dipped from 25.9% to 20.9%. Contracts have been slow in getting secured due to the weakness in oil prices and also the fact that oil majors have begun holding back on their capex in light of the sharp downturn; and until clarity emerges on the horizon. Though at the time of writing, oil prices had risen sharply to a new 2009 high of US$74 per barrel, it remains to be seen if oil majors are willing to continue with their massive E&P spending plans.

Gross margins dropped mainly due to fabrication costs for an offshore project in India, as US$23.6 million was spent on sub-contractor costs in 2Q 2009 compared with just US$10.6 million for 2Q 2008. What I suspect is that they had to rely on third-parties most of the time to do their fabrication, instead of being able to rely on their own shipyard at Kreuz; hence incurring such high charges. This is possibly due to the distance of Kreuz from the site where the fabrication is supposed to take place.

Share of profit from associate and JV went up as a result of improved contributions from Swiwar Offshore Pte Ltd and Principia Asia Pacific Engineering Pte Ltd. Finance costs eased a little to US$2.9 million from US$3.2 million due to redemption of some of the bonds (US$11.7 million worth).

Net margins were also impacted by the higher sub-contracting costs and came in at 17.2% for 2Q 2009, against a slightly higher 17.8% for 2Q 2008. For 1H 2009, net margins were weaker at 15.7% against 16.7% a year back. Overall, net profit attributable to shareholders fell 18.7% for 2Q 2009, reflecting the weaker environment in the oil and gas industry. From Boustead’s analysis, they had mentioned that oil and gas contracts take longer to negotiate, so this fact will probably impact all players in the oil and gas sphere and Swiber will definitely not be left unscathed.

Balance Sheet Review

Swiber had managed to maintain a reasonably high cash balance of US$59.4 million, primarily through a share placement done in late May 2009 at 88 cents per share (placement of 84 million new shares).Of course, building up cash reserves through issuance of shares is dilutive to EPS and NOT a long-term solution to cash flow drainage. This will be elaborated on further in the Cash Flow Statement analysis, but I have to say right here that I was disappointed with Management’s cash management (or lack thereof). The reason given by Management was that there was a timing difference due to billing milestones being achieved, so presumably they will receive cash in the next quarter which will only be reflected in 3Q 2009’s report. The increase in Trade Receivables was significant (23%) from US$62 million to US$76.6 million.

Current ratio did improve somewhat from 1.36 as at Dec 31, 2008 to 1.44 as at June 30, 2009. This was primarily due to the increase in receivables as mentioned previously, offset by the decrease in cash and non-current assets held for sale (classified as current as they will be disposed of in the current financial period).

Non-current assets also increased by US$58.1 million as a result of Swiber’s fleet expansion program kicking in. Their operating fleet increased from 22 vessels as at Dec 31, 2008 to 27 vessels as at June 30, 2009. This would mean Swiber’s depreciation expense would increase over time; but since this is a non-cash expense, it does not worry me too much. I’ve learnt to concentrate more on cash flows rather than profits, lessons learnt from the harsh financial crisis of 2008.

Net debt to equity fell from 0.94 to 0.75 times as a result of the share placement, but at this level it is still too high for comfort. Swiber mentions that they have bonds worth US$200K payable in 3Q 2009, US$71.2 million payable by 3Q 2010 and another US$72 million payable by 1Q 2011. This would mean that they need to at least have cash of more than US$71 million by the time 3Q 2010 comes along, and this is only 1 year’s time! Considering they have the CUEL US$50 million recurring contract and new contracts of US$93 million for 2Q 2009, bringing their order book to US$509 million, how much of this will be translated into FREE cash flow is highly uncertain. Even though all the cash flows for their fleet expansion have been reserved and accounted for, the amount of cash retained from operating activities is currently not high enough to boost their cash balance; and Swiber, sadly, have yet to see sustained cash generation as a result of their aggressive expansion.

Cash Flow Statement Review

Cash flow from operating activities for 2Q 2009 was a negative US$34 million, and this was because of a net cash outflow of US$14 million from a timing difference in billing schedules and cash collection for Trade Receivables. At the same time, trade and other payables were also settled faster, resulting in a total net cash outflow of about US$30 million. This is in stark contrast to 2Q 2008 where there was an operating net cash inflow of US$18.5 million.

For investing activities, purchase of fixed assets continued and US$49 million was spent on this, resulting in a net cash outflow of US$37.7 million. Though this was lower than last year’s outflow of US$117.1 million, it is nevertheless a negative signal as operating cash flows are also negative for the period, and most of the cash is being generated through financing activities. This is in contrast to companies such as Swiber and China Fishery where a lot of cash is generated through operations, and thus it can sustain any fixed asset purchases or purchases of subsidiaries or associated companies.

Repayments of bonds and bank loans under Financing activities took up US$72 million, while a total of US$51 million was raised through the issuance of new shares and US$116.2 million through new bank loans. This is quite a frightening amount considering their revenues for 2Q 2009 amounted to about US$110 million, so it seems as if they are financing their entire 2Q through bank loans and equity instead of through recurring cash inflows.

This appears to be unsustainable in the medium-term and unless the company can start to generate positive free cash flows, I may decide to divest as the cash flow issue is viewed by me as pervasive and serious.

Prospects and Plans

One good thing about Swiber is that they always manage to churn up beautiful looking and well-prepared presentation slides, so at least shareholders are kept informed of Management’s plans and their strategies for long-term growth. The slides also provide a good overview of their fleet expansion status and their order and tender book, which I’ve read has grown to US$7 billion instead of US$5 billion as Swiber is now bidding for international contracts in Middle East which are larger than the traditional ones they have bidded for, due to their expanded fleet size. Management has said that their tender book reflects their hard work, but until a contract actually materializes and Swiber is able to execute it well, there can be no assurance that such efforts translate into top and bottom line, as well as the all-important cash inflows.

With the most recent announcement on August 20, 2009 that Swiber was partnering Alam Maritim in Malaysia where they will co-own vessels and bid for larger contracts, Swiber has effectively partnered many companies all over South-East Asia in the last 2 years, as follows:-

1) Rahaman in Brunei (Swiber 51%: Rahaman 49%)– September 2007
2) PetroVietnam and Vietsopetro in Vietnam – September 2007 (MOU in October 2008)
3) Rawabi of Saudi Arabia (50:50 JV) – August 2008
4) ICON Capital of USA (51% stake in Swiber Victorious) – March 2009
5) CUEL of Thailand (51% CUEL: 49% Swiber) – June 2009
6) Alam Maritim of Malaysia (50:50 JV) – August 2009

One can immediately see that Swiber has effectively established alliances with many South-East Asian companies which have strong ties and contacts to oil majors and also to state-owned oil companies (in Vietnam). These alliances took 2 years to forge and gives them an advantage in bidding for larger and more complex contracts which they themselves may not be able to handle alone. However, the more recent alliances have yet to manifest themselves in securing larger contracts, and seeing their cash burn rate causes some concern, even though news flow has been positive thus far.

The Company also mentioned venturing further afoot to seek more lucrative opportunities, but perhaps they should concentrate on building their business back here in South-East Asia first, and with their new vessels they would be able to secure better deals and open up more possibilities.

Although I remain cautiously optimistic, the prognosis for now is negative, and Swiber’s business will likely remain in the doldrums unless it pull a giant rabbit out of its hat.

Note: At the time of writing, Swiber has been under a trading halt for 2 days, with no news or details being available. I will be updating this blog for any breaking news (as well as provide my views and analysis) so check back again soon for updates.

Friday, August 21, 2009

China Fishery – 1H 2009 Financial Review and Analysis

China Fishery reported a rather surprising set of 2Q 2009 results, with revenue falling 21.7% as the Company decided to shift their vessel allocation for the South Pacific ocean in anticipation of higher fishmeal and fish prices in 4Q 2009. However, for 1H 2009, revenue increased marginally by 6.8%. I will be reviewing China Fishery in the same fashion as per all my other companies; and this review and analysis will be the only one done as I only do two per financial year – one for half-year results and another for full-year results. There is only the requirement to re-look at the Company in the event of any significant corporate events taking place, of which I do not expect.

Profit and Loss Review and Analysis

It is interesting to note that the ITQ system kicked in during April 2009, and was in force throughout the entire 2Q 2009. The financial effects were pretty dramatic in that cost of sales for 2Q 20009 fell by 60.1% against a 21.7% drop in revenues. Charter hire expenses dropped as a result of lower utilization of vessels as some were deferred to 4Q 2009 where they will be deployed to the South Pacific to increase the quota there. However, for 1H 2009 cost of sales increased by 13.6% compared to a 6.8% rise in revenues; but overall cost of sales for FY 2009 is expected to drop further as the ITQ system continues to exert a positive effect on gross margins and to enhance cost effectiveness. Vessel operating costs fell by 29.1% for 2Q 2009 to US$44.6 million due to the drop in oil prices to around US$70 per barrel, compared to nearly US$147 per barrel during last June 2008. Unfortunately, for 1H 2009, there was still a slight increase in vessel operating costs of 7.6% (about US$8 million).

As a result of the reduction in costs, gross profit for 2Q 2009 only fell a marginal 0.6% and gross profit margin improved from 30.3% to 38.5%. For 1H 2009, gross profit also improved marginally from 36.9% to 37.3%. It is expected that with the ongoing ITQ system in place, this will allow for better control and rationalization of costs for CFG and gross margins should improve further moving forward.

Net margin for 2Q 2009 was 23.3% against 17.1% for 2Q 2008, with income tax expense increasing a significant 49.2%. Finance costs only dipped 3.3% and a still very significant worry of mine is the high interest expense they are paying both of their bank loans as well as their senior notes due 2013.

Balance Sheet Review

One immediately noticeable good sign in their Balance Sheet is the increase in cash and bank balances from US$7.6 million half a year ago, to the current US$20.4 million. This factor, coupled with an increase in trade and other receivables and a slight drop in current liabilities, helped to improve current ratio from 1.33 as at Dec 31, 2008 to 1.79 as at June 30, 2009. Inventories had also dropped from US$33.3 million to US$22.4 million, a sign that the large stockpile of fishmeal as at year-end was being cleared off.

Unfortunately, a glance at their debt shows that long-term liabilities increased from US$279 million to US$309.3 million, mainly due to an increase in long-term bank loans offset by a marginal drop in finance leases and deferred tax liabilities. Even though the press release maintains that net debt to equity fell from 92.2% to 81.7%, one should note in this case that the denominator had increased from US$335.8 million to US$403.8 million; but net debt in fact increased because long-term bank loans increased by US$33.7 million while cash only increased by about US$12.7 million. The press release conveniently glosses over this fact and a closer look at the numbers reveal that debt is not exactly being lowered in spite of the Group completing their upgrades for their supertrawlers. In fact, the Group may continue to maintain its high gearing to take advantage of the relatively untapped waters off the South Pacific to increase their catch of Chilean Jack Mackerel.

While it is noticeably certain that the Group is able to manage their gearing well as well as their high capex, it is obviously worrying to note that gearing is not being actively reduced, as the tenure of the senior notes has 4 more years to go, which means the clock is ticking for them to be able to generate enough sustainable operating cash flows to pay off this huge liability. The senior notes were issued in 2007 to be allow CFG to expand aggressively in Peru by purchasing supertrawlers, upgrading them, buying fishmeal plants and purse seine vessels. I would expect their expansion plans to at least taper off and die down by FY 2010 and that is when I would expect cash flow generation to improve greatly, thus reducing gearing drastically. I will have to observe their net gearing and cash generation capabilities in the next few quarters to reaffirm my understanding of their strategy; or else it would seem that this debt would not be paid off easily. The fact that they managed to secure an additional US$60 million 3-year term loan also attests to the fact that banks are very comfortable with CFG’s financial position and market power even in the midst of a severe downturn.

Cash Flow Statement Review

Net cash flow from operating activities was healthy at US$35.1 million (for 2Q 2009) compared to US$31.5 million a year ago (2Q 2008). At first glance, this looks roughly comparable with not much difference. However, looking at 1H 2009 there was a net operating cash inflow of US$53.3 million against a much lower net operating cash inflow of US$15.3 million for 1H 2008. The much improved numbers at least helps to instil confidence in me that CFG’s operations are generating very healthy cash inflows, and as soon as their capex plans (upgrading of supertrawlers, purchase of additional purse seine vessels) are done with, their cash balance would dramatically improve.

For investing activities, CFG spent US$73.1 million in 1H 2009, presumably on their capex plans for upgrading (elongation) of supertrawlers to increase fish hold capacity. The amount spent was much higher than 1H 2008’s amount of just US$5.3 million, as CFG had, in 2008, scaled down on their capex due to the (then) sharp economic downturn and drying up of financing. Only about US$8.6 million was spent last year acquiring a subsidiary (Peru fishmeal plant). It remains to be seen if the Group will spend even more on capex in 2H 2009, though I hope that most of the elongation and deployment will be done by 4Q 2009. For FY 2010, I would expect them to scale down capex unless absolutely necessary, in order to be able to slowly reap the cash flow benefits from their aggressive spending.

As mentioned in Balance Sheet review, the cash flow statement shows up that additional bank loans of about US$34 million were taken up in 1H 2009 (net off additions of bank loans against repayments), compared to an addition of just US$13 million for 1H 2008. I suspect these additional loans were taken up as short-term financing for their capex and for working capital requirements.

Prospects and Plans

The Group plans to shift more of their vessels to the South Pacific to be able to capture a higher quota there, and they are deploying their vessels there during 2Q 2009 to be positioned and ready. Since they are also considering leasing additional vessels, they must feel that there is vast potential in the South Pacific which has yet to be properly tapped and exploited.

With the Peruvian Government implementing the ITQ, this will result in more sustainable fish resources and a slower depletion of natural fish habitats, thus enabling CFG to continue to milk ocean catch and to make it more desirable than say, fish from aquaculture (which is also gaining in popularity). All fishing companies will enjoy better utilization of their vessels which in turn will reduce costs significantly (one example is Copeinca which reported a 20% rise in EBITDA as a result of ITQ); in time to come China Fishery should be able to reap the full benefits of the new system as compared to the “racing” Olympic system.

Management also hopes that with the gradual recovery in the economy, fish and fishmeal prices will slowly trend up and they can improve their selling prices. This may prove to be a further impetus for higher gross margins. However, with improved economic conditions also come higher oil prices, and this will offset the higher margins a little. I look forward to 2H 2009 when Management reports on their South Pacific strategy, and hopefully are able to provide clear direction and articulation of their strategic intentions for FY 2010 and beyond, with a focus on reduction of debt and paying off their senior notes by 2013.

Sunday, August 16, 2009

Successful Survival Instincts in Companies

This is a follow-up post to the previous post on “Investing in Adaptability”, and I will highlight 4 aspects which a Company needs in order to adapt and survive to ensure the corporation can prosper and carry on in the future. These are taken from the book ‘The Living Company” by Arie De Gaus and he highlights the four factors as follows:-

1) Sensitivity to Operating Environment – Companies which can react fast and decisively in the face of changing circumstances will have a better chance of survival as they evolve not just their business model, but also their products and services to suit customers’ needs and wants. Companies should constantly be on the ball and alert about the changing economy, and how the various factors which affect their industry come together to produce subtle changes in the environment which may cause their competitive advantage to either strengthen, or erode. For example, a company in the oil and gas industry has to keep up with trends in oil prices, as well as E&P activities of oil majors to see if they can secure business, and how best they can serve these customers and in what ways. Companies should also be alert of how they can offer new products or services or to re-package them (as Ezra had) to make their existing offering more attractive to potential customers. There could be shifts in their environment which caused them to react in certain ways; and to be pro-active and a first-mover is always more advantageous than being a mere follower. A firm has to be innovative and to be able to anticipate changes before they occur; a passive Board of Directors and Management Team will always lag behind the competition as they are unable to innovate to stay ahead.

2) Cohesion and Identity – This is more an internal trait which will permeate the entire organization and is part of the overall corporate culture. I believe that companies which can articulate a coherent set of procedures, processes and guidelines to all staff concerned is in a better position to forge a distinct and clear path to corporate success. This is because the goals and objectives of the organization are aligned and with all employees in agreement and understand, this facilitates inter-personal working relationships and helps to create better efficiencies at work. An example is Swiber’s “Cause No Harm” policy which is instructed to all staff and is already assimilated as part of the corporate culture (one can visit Swiber’s website for more details). A company which implements such a policy (as well as related, similar policies) can help to create a shared corporate identity and foster cohesiveness.

3) Ability to tolerate decentralization of control and diversification – From this phrase, I will take it to mean that an organization must be able to effectively decentralize in order to create a more interactive working culture, which in turn will promote constructive feedback and spur improvements in all areas of work. This will in turn translate into greater efficiency and effectiveness amongst staff. From what I learnt in Management Theory back in school, an organization is considered to have a mechanistic, task-oriented structure if it has many layers of Management and titles. Examples would be assistant, executive, senior executive, supervisor, assistant manager and manager. A more “flat” and organic structure which is representative of decentralization would just mean there is one layer of assistant, executive and manager; effectively removing the need for so many “sub-layers” and redundant titles. A flatter structure means that sharing is more effective (less layers to pierce to get the final message across) and work can be completed in a more expeditious manner. Diversification will refer to the breadth of activities which an organization engages in, and it especially apparent when a company wishes to expand its product and service offerings. In the process, new relations are forged with suppliers, customers and other stakeholders (e.g. bankers), and it is important that ties are kept close with existing stakeholders as well, in order to avoid projecting an aura of neglect for established stakeholders and a preference for the “newer” ones. Thus, new staff needs to be hired and separate teams assembled to tackle the increase in volume of work, and to ensure intra-company and inter-company ties are not strained or lost in transition. If all this sounds too theoretical, then it can be summed up in a nutshell – take care of your stakeholders, be they new or old, and they in turn will take care of your welfare.

4) Financially Conservative – Companies which are financially prudent in their spending are able to conserve cash for opportunities, and also attract financiers to support them in times of need due to their strong balance sheet. By this, I mean that the company keeps a cash stash and does not expand too aggressively during good times, so as to prevent a “Ferrochina” kind of situation from occurring once the tide suddenly turns and demand (as well as financing) dries up. Plans for capex (capital commitments) and pursuit of expansion into new territories (which generally cost money as you need to set up new subsidiaries or joint-ventures to establish a firm foothold) should be well-calibrated decisions which take into account the most dire of situations, in order to properly buffer against any sudden storms (such as the current sharp and protracted downturn). A company should ensure it has strong operating cash flows and also strong support from its bankers before it embarks on any expansion involving debt, because once the plug is pulled, the company will be like a fish without water! A very conservative company will always weigh and mull over their decision to expand against the backdrop of the economy and take into account any uncertainties relating to the industry or political situation in order to arrive at a well-thought out decision. For example, China Fishery had scaled back plans to acquire more purse seiner vessels and fishmeal plants in 2008 when the crisis swept across the globe and dried up financing, and they began to consciously conserve cash by withdrawing capex plans and also by declaring a share dividend instead of a cash dividend.

The above 4 factors are just the tip of the iceberg when it comes to corporate survival, and my previous post on adapting will add on to what has been said and discussed here. Readers are free to contribute their thoughts and ideas as well on what makes a company able to survive through the years.

Note: I will be covering China Fishery and Swiber’s 1H 2009 results briefly in a subsequent post, but will not touch on Boustead and Tat Hong as it is their 1Q 2010 results release. For a summary of Tat Hong and Boustead’s results, kindly check my portfolio review as at end-August 2009.

Tuesday, August 11, 2009

Investing in Adaptability

I was reading my usual dose of Business Times when I came across a rather interesting article (or rather, set of articles). Basically, these articles (called “The Secret to Corporate Longevity”) were written on the longevity of companies and the secrets behind them being able to survive through thick and thin, through booms and downturns; through world wars and periods of economic turmoil. The companies which were mentioned included SPH, Eu Yan Sang as well as Boustead. The articles can be accessed either through Business Times archive or through Boustead’s website at (Media); but what I wish to highlight is something Mr. FF Wong (CEO of Boustead) mentioned and the context in which it applies to investing in companies. He speaks about adaptability and evolution in the following paragraph:-

"A highly successful product or service today may not be successful tomorrow. A stubborn company will try its best to hold on to products and services, even when they are irrelevant. Companies that enjoy longevity do things differently. They evolve. They create a different business and adapt to prevailing times.”

I think the above embodies the essence of corporate survivability in the long-term and what it takes for a company to remain successful amidst a rapidly changing global landscape; and also as events become more fast-paced in today’s computer-driven environment. Mr. Wong touches on evolution, adaptability, corporate culture (resistance to change versus embracing change) as well as succession planning and “AQ” or what he terms “Adversity Quotient”. Companies which can adapt well to the changing needs and wants of their target consumers will be able to survive and thrive, while companies which stubbornly hold on to past glories (e.g. Creative and its “Sound Blaster Card”) but cannot innovate are left behind in the relentless pursuit for profits in our capitalistic society.

Adaptability represents a company’s ability to read the changing landscape and adapt its business model to fit the new realities, and to package its products or services in different and more innovative ways in order to continue to retain their target consumer segment. In marketing parlance, this involves “re-branding” and “re-positioning” and a company must be ready to alter and evolve its culture gradually to account for changing mindsets, trends and fashions. Change Management is also an integral part of an organization and it involves galvanizing the staff to take up the mantle to lead in terms of changing the way things are done, or challenging long-held beliefs which may be antiquated. Such a culture fosters an environment of continuous improvement and can only benefit the organization in the long-run, while also keeping staff highly motivated and driven to perform.

Succession planning is another aspect of a successful corporate culture, as it represents a conscious effort undertaken by Management and the BOD to instill a the same kind of culture and drive which caused the company to be so successful in the first place. This is akin to having a Disaster Recovery Plan in place in case something drastic occurs and the organization may be left in tatters or unable to function normally; hence severely disrupting operations and curtailing sales and other functions.

The above are just a summarized list of some of the points brought up by Mr. FF Wong in explaining what makes an organization survive through adversity; but in a future post I will touch on other salient aspects which also contribute to a successful company – and all these are qualitative and not quantifiable on a Company’s Balance Sheet. As a value investor, one must engage in appropriate scuttlebutt to discern if a Company has the above positive traits, and whether Management and BOD are candid and are of unquestionable integrity.

I would, at the same time, also wish to highlight some of the strategies which my companies had undertaken in recent months to demonstrate the essence of evolution and adaptability in the face of changing circumstances:-

1) Ezra Holdings Limited – Ezra announced their next lap growth strategy last month and if one read it in detail, they would immediately notice that this represented a significant shift away from their previous growth culture. The main difference is that from 2003 till 2008, the focus was on growing their asset base through newbuilds and taking on debt, placing out shares and arranging for sale-and-leaseback transactions. However, their next 5-year growth plan stretching till 2014 involves using their existing assets and package them into innovative services for their customers in order to enjoy higher margins and larger contracts. Thus, they are adapting their business model to focus less on capex and more on bundling their service offerings and going into a new and sustainable segment called deepwater subsea services. Whether this plan turns out well or not is unknown at this point in time, but at least the Company embodies the idea of change and evolution in its business model to ensure continued growth, and to stay ahead of competitors.

2) Boustead Singapore Limited – Boustead had, in its FY 2009 Annual Report, announced that due to the unprecedented global financial crisis, it had affected the property market and sentiments relating to capex in property; thus negatively impacting its 91.7%-owned Boustead Projects, which deals with Real-Estate Solutions. Recall that in the last 5 financial years, Boustead had managed to sell at least one leasehold property per year from its design and build orderbook. This created a good stream of income and cash inflows but Boustead has since tweaked this model to move from Design and Build (D&B) to Design, Build and Lease (DB&L). Though margins are smaller on DB&L projects, they will ensure a good recurring cash inflow and steady revenue recognition which is what Boustead wishes to build as its current projects are too order-book driven (especially so in O&G Projects and also Salcon). Future acquisition targets are also geared towards sustainable revenues and cash flows which is a departure from its traditional project-driven revenue; and this demonstrates adaptability and evolution from its old business model.

3) Tat Hong Holdings Limited – Tat Hong had communicated its intention to shift its focus from being a crane and heavy equipment re-sale company to one doing rentals; and this stemmed from Management’s experience from the previous crises which had caused wildly fluctuating profit and loss levels. To ensure a more stable revenue and cashflow base, Management has subtly but surely modified its business model to one of being a “rental” company, as detailed in my previous post on Tat Hong’s FY 2009 AGM. By adapting their business model to become more resilient, it has managed to weather the current sharp downturn relatively well, and in the process is also in the planning phase for their China expansion.

4) China Fishery Group Limited – Though not much has been written or reported recently about the Company, it was highlighted in previous interviews that Management are exploring new sources of fish in South Pacific (new region) as well as considering possible harvesting of krill (tentative plan). This also showcases Management’s commitment to exploring additional sources of revenue, as well as tweaking and adapting their business model to ensure sustainable fish sources are maintained and that their revenue stream is not rudely disrupted.

The above are just a few examples of corporate adaptability in the face of changing economic and industry conditions. There are, of course, many other successful companies which had undergone changes and emerged stronger; but there are almost an equal number which have failed to adapt and gone under.

The moral of the story is that for a company to survive through adversity, its “adversity quotient” or “AQ” should be high and the Management Team should be prudent and experienced. This involves taking calculated risks and not to over-extend themselves. It’s not an exact science but it is something the avid investor should still attempt to judge on his own, as it will significantly affect his decision to invest or not.

Thursday, August 06, 2009

Tat Hong – FY 2009 AGM Highlights

Let me start off by saying that Tat Hong’s office is extremely hard to locate and get to, and for me, using public transport meant that I had to figure out which MRT station was the nearest to Tat Hong so that I could minimize my cab fares in. It was only when I got there that I realized I could have taken a bus and alighted along Woodlands Road, then walked in along a narrow path beside a canal ! Anyhow, it was a good learning experience for me on how to navigate my way around Singapore.

The AGM started somewhat punctually, at about 10:05 a.m. with more shareholders trickling in close to ten o’clock. The room used for the AGM was a very simple room, spartan yet well-equipped; and it had some old equipment lying around, which gave it the semblance of having been used as a storage room once upon a time. Immediately outside this room was a pantry area with chairs, tables and a long table where the food and drinks were located. The whole atmosphere looked and felt cosy and homely, unlike the usual business-like settings during other AGMs, which are held in conference rooms or large board rooms with slide projectors.

Meeting the Board of Directors and Management Team for the first time was indeed refreshing, as they are the ones who work for shareholders to enhance value. Taking into account the fact that the Board themselves are shareholders (Ng Family own about 60% of Tat Hong), this is where interests are aligned. The Chairman Mr. Tan Chok Kian was surprisingly sharp, witty and humourous for his age (he is in his 70’s!), and managed to elicit sporadic laughter while reading out the ordinary business of the AGM. Overall, the mood was relaxed but a few shareholders did raise queries about Tat Hong’s strategic direction and expressed concern over how the business was faring amid the worst recession in 60 years.

Mr. Roland Ng (CEO) was very candid with the crowd and offered to provide an update of the situation after the business of the Meeting was concluded; and all resolutions were passed henceforth. He mentioned that Tat Hong has thus far steered through every crisis and emerged stronger, as a result of their prudent policies and also because they take advantage of the situation to grow. Recessions will put some smaller competitors out of business, which is good for Tat Hong as they have the size and scale of business to survive; plus now that the Company is moving towards a “rental” model, this ensures steady earnings and cash inflows. In fact, one of the notable things Mr. Ng mentioned was that during good times, companies build; during bad times, the Government builds! So it was a case of always having the contracts and work to allocate their cranes and heavy equipment to; and the countries of Australia and China also hold good promise as the Governments there are churning out massive fiscal stimulus packages to jump-start the flailing economy.

I shall divide the discussion into three distinct sections for presentation, namely by territory:-

1) Singapore – There are many ongoing construction and upcoming infrastructure projects such as the Marina and Sentosa IR, Marina Coastal Expressway and MRT Downtown Line which will keep Tat Hong busy for quite some time. Mr. Ng did mention that there would be pricing pressure for crawler crane rental as the recession meant that customers wanted to negotiate for lower rates. For their distribution business (sale of cranes), this would remain a problem due to the ongoing credit tightening situation by banks and financial institutions, which limited many companies’ ability to finance large capex spending and thus deferring purchases till the economy recovered. Since Tat Hong is positioning itself to be a “rental” company, Management will use most of its cranes for rental instead of re-sale; thus ensuring a continuous and recurring stream of income and cash flows for the Group.

2) Australia – The crawler crane fleet is being expanded in Australia and it should remain strong within the next 3-5 years as it services the oil and gas as well as mining industries there. General Equipment rental business (Caradel and Compactor Hire) follows the economy and with economic recovery, this division should see better revenues. For the equipment sales division in Australia, Mr. Ng mentioned that Australia does not manufacture equipment, hence it has to import all its required equipment and with a large agriculture base there, this means equipment needs to be continually replaced and this will create the demand for the purchase of equipment. The exchange rate of AUD:SGD has also improved (it is currently about 1.20 to the SGD), and business is slowly improving.

3) China – Tat Hong’s main growth market is centred on China, as it is a huge market there for Tower Cranes. According to Mr. Ng, China has about 300,000 tower cranes, while the two current JVC only own about 262 tower cranes (partnering with Yongmao), so this makes up about 0.1% of the total Chinese capacity! Therefore, there is room to expand in China and with the August 5, 2009 announcement of the formation of a new 53.8% JVC to capture the south and south-western regions in China, this proves that Tat Hong is mapping out its strategy to grow this division. Mr. Ng mentioned that the Group was actively seeking out partners with which to form JVC in order to grow their tower crane fleet there, and he also elaborated on the methodology which the Group would use to penetrate the Chinese market (I have left out describing the key aspects as they deem it to be sensitive information which may be copied by competitors).

Other than the above, I have also clarified certain aspects of their business as well as their Annual Report 2009. I shall list these down below as separate points for clarification:-

a) Hedging Policy – Management were quizzed about the unrealised losses of S$16.1 million incurred in 3Q 2009, and whether hedging policies were in place to prevent the recurrence of such a debilitating loss. Apparently, this was due to the weakening of the AUD against SGD (impacting Tutt Bryant’s revenues) and the strengthening of the JPY against SGD (thus impacting liabilities to suppliers). The reply was that the violent swings in currency were not witnessed for the last 30 years, and were unlikely to occur again; hence this was a one-off issue and no amount of hedging can adequately prepare a company for volatility of this magnitude. Management assured that appropriate measures were in place to hedge against normal foreign exchange transactions by entering into forward contracts (if necessary) to lock in favourable rates. Note: All the losses are realized!

b) For their rental business, utilization levels are expected to remain around 60% to 75%, and contract duration stands at 9-12 months for Australia and 3-9 months in Singapore; implying that the duration is pretty short. However, with the upturn in construction spending by the respective Governments, utilization should remain high though rates will probably soften slightly. Mr. Ng did point out that utilization levels are a function of their crane base (denominator) and since they are deploying more cranes toward rental rather than re-sale, this rate would naturally go down in the near-term; but he assured that there was no cause for alarm.

c) Crane obsolescence was not an issue as most of the cranes are new ones, and they can always shift some cranes over to Australia if the demand there increases. Management hopes to enter into longer-term contracts for their cranes. The next growth area they are targeting is Malaysia and Indonesia. Management also reiterated that their market share stands at about 20% to 30% as there are many small players, but my opinion is that their size and reputation as one of Asia’s largest crane companies will give them an edge in securing contracts and negotiating for better prices.

d) Management will stick to its policy of paying out about 40% of its earnings as dividends.

Since I started this post on Tat Hong’s AGM 2009, there has been news on AIF Capital injecting funds into Tat Hong for an 11% stake, but in the form of RCPS (Redeemable Convertible Preference Shares) on the basis of 1 preference share to 1 ordinary share if converted. I will not go into detail on the terms of the agreement as they are quite technical, but suffice to say that such a method of capital injection prevents immediate dilution and allows the Group to raise S$63.5 million (after fees) in cash for M&A activities in Australia and China (they have slated 80% of the proceeds for this). Should the share price in the 30 days before the first anniversary exceed S$1.50, one-third of the RCPS will be converted to ordinary shares. It is in Tat Hong’s best interests to convert ALL RCPS before the fifth anniversary as after that, the RCPS attract a dividend rate of 25% (cumulative 5% for 5 financial years).

Immediately one day after the announcement of a strategic partner, Tat Hong followed up with an announcement that they had formed an equity Joint Venture Company (EJVC) with BJTH and Mr. Yuan Zheng for a 52.98% stake (direct + indirect) in a newly-formed Company called Si Chuan Tat Hong Yuan Zheng Machinery Construction Co., Ltd. The principle activity of the Company is to engage in tower crane rental in the south and south-western parts of China, and this will help to expand Tat Hong’s fleet of Tower Cranes in China and give them a stronger foothold in the Southern region of China. A total of US$10.25 million will be injected in two separate tranches into the Company, while Mr. Yuan Zheng will do his part by injecting the capital assets and tower cranes. Tat Hong will ensure Board representation as they will appoint 3 members to the Board and one to the supervisory committee.

The above announcement serves to cement Tat Hong’s status as a leading tower crane player in China and their previously announced plans to penetrate the Chinese market are moving ahead. My opinion is that the fund raising for S$63.5 million is another step towards securing more M&A in China through such EJVC, and Management should be aggressively expanding during turbulent times, as valuations of companies will generally be cheaper during such recessionary times. Of course, such acquisitions should be earnings accretive in order to offset the cost of funding which is 5% per annum (excluding declared ordinary dividends). The hurdle rate is not very high and Management can leverage on the contacts, expertise and network provided by AIF Capital in China to expand their reach and grow their business.

I look forward to more potentially accretive M&A announcements from Tat Hong. Their 1Q 2010 results will be released on August 14, 2009, and Management should provide an update on their business units and the prospects for the rest of FY 2010.