Saturday, June 26, 2010

Tat Hong – FY 2010 Analysis and Review Part 1

Tat Hong was pretty badly affected by the global economic slowdown for FY 2010, as can be seen from the recently released FY 2010 results in which revenue fell significantly, and where net profit attributable to shareholders plunged even more. Amid a difficult year though, there were some bright spots emerging for the Group; and hopefully for FY 2011, as the economy turns up, their business should also improve. One positive point is that they have managed to continue to pay out twice-yearly dividends, though of course these are greatly reduced as compared to prior years such as FY 2008 and FY 2009. Part of the reason is also because of the enlarged equity base due to the issuance of the RCPS (which are also entitled to all dividend declarations).

My analysis will take on the usual 3 parts, with Part 1 covering the financial statements, Part 2 covering the various business divisions and margins for each division, and then part 3 touching on prospects and plans as well as covering a little on Tat Hong’s crane fleet in terms of crawler and tower cranes.

Income Statement Review

For 4Q 2010, revenues actually showed a rise year-on-year of 18%, but the problem was this was more than offset by the higher COGS of 31%, effectively making the increase in gross profit more muted at just +2%. The reason for this was because of higher equipment sales as compared to crane rental, and though this gives better sales volume, it also translates into worse gross margins as this division traditionally has lower gross margins. Gross margins for 4Q 2010 stood at 37.1%, which was noticeably lower than the gross margin achieved for 4Q 2009 of 43.1%.

Cost control wise, distribution expenses were kept fairly stable but administrative expenses surged 54% to S$3.3 million. Other operating expenses (of which the bulk of expenses lies) fortunately managed to dip 15% to S$26.4 million in spite of the increase in revenues. One big bugbear of mine is that contributions from associates and joint ventures have all but shrunk as a result of the sharp financial crisis, to just S$400K from last year’s figure of about S$4 million (a 90% drop). This was one of the critical factors for the drop in net profit before tax of 14% for 4Q 2010 against 4Q 2009. Income tax expenses also ballooned 280% and caused net profit attributable to shareholders to slip 33% to just S$9.8 million, capping off a dismal quarter.

Looking at the full-year results, they were no less disappointing. For FY 2010, there were revenues of S$495.4 million, down 22% from last year’s S$631.8 million. The decline in COGS was in line with the drop in revenues; hence gross profit dropped 21% to S$190.9 million. Gross margin managed to remain fairly constant at 38.5% against 38.2% (showing a marginal improvement). This was largely due to the shift to a “rental” business model for Tat Hong which helped to cushion revenues and also allowed gross margins to stay high as rental margins are traditionally much higher than that of equipment sales. Distribution and other operating expenses fell in line with the drop in revenues, but there were higher finance costs of S$15.6 million (+26%) as more bank loans were drawn down to purchase equipment on hire purchase, and this also included a hedging loss. I realize that this is the problem with businesses armed with leverage; during bad times it certainly “cuts like a knife”!

The main culprit responsible for the fall in net profit was the 92% drop in share of profits from associates – this fell from S$12.9 million in FY 2009 to a mere S$1 million in FY 2010! For share of profits from JV, the situation was made worse as FY 2009 registered a share of profit of S$2.1 million but this was reversed to a loss of S$3 million for FY 2010. These two items alone dragged down net profit before tax for FY 2010 by 40% to S$58.3 million, while profit attributable to shareholders decreased by 44% to S$38.6 million.

From the above, it can be seen that there was a “perfect cauldron” of negative events and factors which served to pummel the Group’s top and bottom line and left it with a dismal performance for FY 2010. I myself was pretty horrified by the extent of the damage wrought on the Group, as I had thought that their business was fairly resilient due to the shift to “rental” model. However, it should be noted that Tat Hong is in a cyclical industry as their business tracks the rise and fall of the economy very closely, and also the status of the construction, oil and gas as well as infrastructure industries. Without a significant pick up in economic activity over the next 18 months, Tat Hong’s business could continue to come under severe pressure.

Balance Sheet Review

Tat Hong’s Balance Sheet, sad to say, is not exactly in the pink of health either. PPE increased significantly as Tat Hong shifted their cranes from inventory stock to fixed assets as they sought to boost their rental fleet. As a result, inventories amount fell a little from S$217.7 million to S$201 million. Trade Receivables climbed 15.4% from S$97.7 million to S$112.7 million, probably due to the upturn in sales volume towards the tail end of FY 2010 (i.e. 4Q 2010). Cash balance actually improved to S$76.6 million, but a more in-depth analysis on this increase shall be provided in the Cash Flow Statement analysis later on.

Current ratio stood at 1.41 as at March 31, 2010 compared to 1.29 as at Dec 31, 2009. The improvement came mainly from the increase in cash balances, rather than a drop in financial liabilities (i.e. bank loans). In fact, short-term bank loans had risen from S$85 million to S$91.2 million. Total loans stood at S$245 million as at March 31, 2010, significantly higher than the cash balance of S$76.6 million. Net debt stood at S$168.4 million, and on hindsight it would be disappointing to know that I had selected to invest in Tat Hong back in Oct 2008 even though it had a weak Balance Sheet as my focus then had not shifted from Income Statement to Balance Sheet and Cash Flows. Sensing that the nature of the business model is as such, and armed with a sufficient margin of safety in my purchase price, I will continue to monitor the Group for the next few quarters to see if the Balance Sheet improves, and if cash flows revert to being positive.

Cash Flow Statement Analysis

The Cash Flow analysis shows a positive operating cash inflow of S$29.3 million for FY 2010, and this was a significant improvement from the S$8.8 million cash inflow registered in FY 2009. The reason was that the increase in inventories was not as high as for FY 2009, which resulted in lower negative working capital changes being reflected.

However, a quick glance at investing activities shows that capex spending hit S$79.5 million for FY 2010, significantly higher than the S$28.2 million for FY 2009. As a result, there was negative free cash flow of about S$50.2 million for FY 2010, and this was another disappointing aspect of the Group. One would note that for FY 2006-FY 2008, there was consistent FCF generated but for FY 2009 and FY 2010, the negative FCF was very glaring. Whether this was due, in part, to the shift to the “rental” model and therefore is a temporary phase, or if it will be a permanent aspect of their cash flows, remains to be seen. However, I shall flag this out as a potential red flag to be addressed at the next upcoming AGM.

Under Financing activities, S$63.7 million worth of cash came from the issuance of RCPS to AIF Capital, while another S$94.4 million was obtained from bank loans. Hence, the bulk of the cash inflows still came from financing, and this was another big body blow for me. Considering the Group intends to aggressively expand into China’s booming tower crane market, perhaps this year is an anomalous one as they sought to raise both equity and debt in order to finance this expansion, which arguably will only bear fruit in many years to come. Obviously, with this new business focus, dividends have taken a back seat as dividends declared have dropped off from a year ago. This can only be interpreted as a good thing IF the ROE from investing such cash into new business ventures exceeds the cost of borrowing and equity (the dividend yield in this case). Apparently, Management is confident that it will succeed, otherwise the tie-up with AIF would not even have taken place. At this juncture, I do not share Management’s optimism as everything is still opaque and the benefits of this China expansion cannot be readily ascertained.

I would expect cash flow to come under more pressure in the coming quarters, as the recovery is tentative and the problems in the Eurozone still threaten to destabilize the global recovery. Maintaining realistic expectations is key to investing with a margin of safety and I shall watch over developments closely, while waiting for the Annual Report and AGM to arrive.

Part 2 of the analysis shall touch on business unit analysis, including reasons for the apparently dismal performance, and I will also comment on trends for each division moving forward.


cif5000 said...


1. Why should equipment sales have lower margins than equipment rental? Or for discussion sake, why should one be higher than the other. Historical data of 3-5 years meant nothing because the sell/rent dynamics are at least a century-old. It doesn't change.

2. If you depend on the margin of safety with your purchase price to keep this stock and continue monitoring it, does that mean that there no margin of safety at the current price? If there is a margin of safety now, your purchase price is quite irrelevant. From the way you phrase it, it seems that there is no safety now. Then, selling will be the right thing to do. What I am trying to say is that your purchase price should not act as an anchor for any selling/holding decision. Just because one has bought something cheap (and lousy) doesn't mean that he can sell it dear. Selling it fair might be good enough. Or someday, he would have to sell it cheap too.

Musicwhiz said...

Hi cif5000,

Actually, I was anticipating a question like this, and indeed it has been asked by you!


1) My take on this is that equipment sales tend to have lower margins due to price-cutting by Tat Hong to induce companies to buy equipment, as many companies are now hesitating because of the global financial crisis and the lack of financing options. These same companies would be more willing to rent, and hence Tat Hong can charge a higher mark-up for rental as it is now the "preferred" mode of utilizing assets. You mentioned historical data of 3-5 years, care to elaborate? I do admit this is a cyclical industry and once things return to "normal", then renting may not garner such good margins.

2) I've been reading a book on Behavioural Finance and it's very thorough, so I can fully relate to the "Anchoring" bias which you have mentioned. But let me approach this from the point of view of "Framing", which is how you frame the situation or question. Your question is does a margin of safety exist at such a price (i.e. current market price), but as investors we should consider instead if a security was "over-valued" at current price with respect to intrinsic value. If "yes", then the logical thing to do would be to sell. Since I have made no further purchase at current market price, why should I consider the relevance of the current market price as my margin of safety? In fact, I should focus on the business metrics and fundamentals of the company (including its business model) to determine if it has potential to continue to grow revenues, earnings and margins. From there, I can deduce if the company was over-valued or fairly valued based on such data.

To be very candid this (Tat Hong) was not one of my best decisions, I admit. But seeing that its a cyclical industry and their business can follow the upturn in the economy gives me confidence that they would be able to grow further. Also remember one thing - the COmpany had made use of two previous recessions to grow and expand, and right now I do see that happening with them in China, albeit slowly and steadily. Whether this translates into results or not remains to be seen, but I am willing to monitor this for at least a few more quarters.

In the meantime, I can enjoy a fairly decent yield of 3.6%, which is higher than the May 2010's reported inflation rate of 3.2%.

Hope this explains.


Createwealth8888 said...

which are the ones in your current portfolio that you will consider as no-mistake or better-decided purchases? Kingmens, MTQ, GRP and any more others?

cif5000 said...

It's ok. The questions are actually for you to answer to yourself and if you like your own explanation, good! I keep to my belief that how good an investor is depends on how quickly and successfully he challenges his assumptions.

Musicwhiz said...

Hi Createwealth8888,

Well, the 3 most recent purchases MTQ, GRP and Kingsmen were selected with much more rigorous value investing criteria (i.e. net cash, balance sheet focus, FCF etc) rather than those before (i.e. FSL Trust and Tat Hong). So in terms of being more stringent, yes it began with MTQ as my investment philosophy was also still evolving at the time. Recall that I only switched to a value philosophy in late 2007, and even then it was still rather "raw". After much refinement, I would say my criteria has become more stringent up till 2009 and more so for this year as well.

As to whether they are "mistakes" or not, only time will tell as these are investments which I plan to hold at least 3-5 years. Check back again then!


Musicwhiz said...

Hi cif5000,

Thanks, yes I agree with you that as investors we should always question ourselves and try to be as rational and objective as possible. This isn't easy at all with all the cognitive and emotional biases out there, from what I've read! (The book I am talking about and which I recommend is "Behavioural Finance and Wealth Management" by Michael M. Pompian)

I've been meaning to ask you as well on how you manage and re-balance your portfolio. I understand that you hold shares in about 30+ companies. So how often do you track their businesses and how do you decide if there was no longer a margin of safety? Amongst your companies, I am sure there will be cases of companies which report falling revenues/profits or which may suffer setbacks in their expansion/growth plans. How do you decide to re-balance and whether to sell, or even buy more? Just curious on your methodology if you could explain it? Thanks!


cif5000 said...

Sorry for not replying may want to read what I had written previously in my blog if you are interested in the answers for that string of questions. You know the url.