Sunday, December 19, 2010

Tat Hong – 1H FY 2011 Financial Review and Analysis

Previous analyses done on Tat Hong have always dragged into three parts, which on hindsight seemed rather unnecessary considering there is not much change to key numbers such as gross margins and inventory levels from prior quarters anyhow. Hence, in the interest of brevity, I have decided to condense my entire analysis and review into just one post. Though this post may be a little on the long side (and not to mention devoid of the usual Excel tables which you see in most of my analyses), I hope to be able to touch base on all three aspects of the financial statements as well as discuss briefly on Tat Hong’s plans and prospects moving forward.

Profit and Loss Analysis
(Note: All numbers refer to 1H 2011 and NOT 2Q 2011)

It was rather disappointing to note that once again, the effects of a larger increase in COGS has offset any positive effects from an increase in revenue. Revenue may have risen 22% to S$294.4 million, but gross profit only increased 13% to S$108.4 million. Gross margins fell from 39.6% in 1H 2010 to just 36.8% in 1H 2011, and this was attributed to scaling down of major projects in Singapore and Malaysia, strong competition and higher cost of sales (for tower cranes). In my opinion, all these do not constitute very good reasons for the drop in gross margin, and it serves to show (rather glaringly) that even though Tat Hong is one of the largest crane companies in the world, it seems to lack persuasive pricing power and is unable to pass on the increase in costs to customers. At least, that’s what the numbers tell me. While the original rationale for the purchase of Tat Hong was the notion that being a top player meant that it would be able to exert some form of pricing power, recent events have proven otherwise. My recent article written on Porter’s Five-Forces and my intense reading on this topic has also broadened my knowledge of how companies are able to maintain sustainable competitive advantages. Apparently, I may have to revisit whether Tat Hong truly has much pricing power or competitive moat in this capital-intensive industry. If not, Tat Hong may well turn out to be my next major mistake after FLS Trust!

Administrative expenses and other operating expenses also increased by 37% and 30% respectively, both more than the % increase in revenues. For admin expenses, it was explained as increased professional fees for privatization of Tutt Bryant and increased recruitment expenses; so hopefully it is a one-off event and will not repeat itself. The explanation for the higher operating expenses is rather lengthy and can be found on Page 12 of 15 in the financial release, hence I will not go into detail. Suffice to say there is a one-off impairment of remaining goodwill of S$2.5 million relating to Kingston Industries, which contributed to the higher overall expenses.

The only really bright spark was the recovery in share of profits of associates, turning around from a loss of S$371K in 1H 2010 to a profit of S$4 million in 1H 2011. This follows the recovery in the global economy (no thanks to the massive printing of money by the US Federal Reserve) and companies such as Kian Ho Bearings and Yongmao reported better results, flowing down to Tat Hong’s bottom line. As the months go by, and the gradual recovery asserts itself, there should be more contributions from Tat Hong’s associates helping their bottom line and cash flows. Share of losses from joint ventures improved to S$318K from last year’s S$2.45 million, and could be a sign that things are turning up.

Overall, net margin was just a measly 5.9% against 7.1% a year ago, and this reflected the amount of margin which was literally eaten up by higher expenses during the year. It was already a disappointment to see gross margins declining 2.8 percentage points, but net margins have taken a further beating as well.

Balance Sheet Review

Tat Hong’s fixed assets amount continues to climb to S$573 million as they purchase more cranes and equipment to be used for leasing rather than trading. It is conceivable that this number will continue to rise as Tat Hong continues its strategy to beef up its rental income as compared to its trading income, in order to be able to tide over the cyclical nature of the construction industry.

Inventories fell slightly by S$14 million as Tat Hong winds down its trading inventory, and they have managed to keep trade receivables fairly constant in spite of the 22% rise in revenues. I shall touch on cash later as I feel the cash flow statement is another area of disappointment. Bank loans rose higher at a total of S$345 million compared to S$244 million six months ago, and this was attributable to the funding of the acquisition for Tutt Bryant (which the Company had declared to use a mixture of internal funds and bank borrowings) and for their tower and crawler crane expansion (including China expansion). This means that the Group is in a net debt position of close to S$250 million, which is a rather scary prospect considering all the companies I own so far are at least in a net cash position. This is another red flag which I am earmarking to monitor in case I need to justify a divestment. Subsequent quarters need to be carefully studied to see if the Tutt Bryant acquisition results in better profits and cash flows which will reduce Tat Hong’s debt to more acceptable levels.

Cash Flow Statement Review

In one word, the cash flow statement looks – dismal. While cash flows from operating activities was positive at S$26.5 million, capex took up a solid S$51.7 million and resulted in negative FCF of S$25.2 million. It’s no big secret that Tat Hong has never been a provider of FCF, and it pains me to admit that this was not a big criteria for me to look at back in late 2008 when I first purchased shares in this company. It seems that this ignorance is now coming back to bite me in the butt. As expected, the bulk of cash was generated once again from bank loans and finance leases, and it is no wonder why the Company cannot afford to at least increase its dividend from 1c a year ago, when other companies in my portfolio are all raising theirs. The glaring difference and uncomfortable truth is that my other companies all generated FCF, but not Tat Hong. Therein lies the problem, and if this persists for several more quarters, then it is indeed a valuable lesson learnt and I shall have to decide to divest.

Plans and Prospects

There is nothing new in this section which I had not really mentioned in previous versions of Tat Hong’s plans and prospects. In fact, the Company themselves mention that the recovery is more than likely to be “patchy and gradual”, using their own words. I would take this to mean that earnings will probably recover slower than anticipated, and even then it may indicate that the quality of earnings may suffer, as only share of profits from associates had increased. Obviously, I had known that Tat Hong was in a semi-cyclical business, but somehow still chose to invest in it back in 2008. Management’s assertion that they can weather future “storms” by switching to a rental model has yet to be conclusively proven as it has not been tested, so right now it simply sounds good in theory.

I will not regurgitate what the Company has put forth in their Group Outlook statement, which can be found in Slide 27 of their presentation slides attachment which can be downloaded from SGXNet. Suffice to say that most of the strategies have already been reiterated time and again in every quarterly announcement, but have yet to bear concrete fruits. Although tower crane segment is expanding and growing, competition is also very stiff as can be seen by the lower gross margins on tower crane division compared to crawler crane, so even though Tat Hong has several significant JVs in China, all is not a bed of roses.

As to the potential of Tutt Bryant, analysts were quick to jump on the optimism bandwagon by asserting that the recovery in key industries in Australia such as mining and construction would provide a strong boost to Tutt Bryant’s earnings, which would then translate to higher revenues and profits in Tat Hong’s Group financials, now that Tutt Bryant is a 100% subsidiary of Tat Hong. I guess Tat Hong’s management must have seen something worthwhile in Tutt Bryant to commit the funds obtained from loans to increasing their stake in it, other than citing factors such as the pervasive lack of trading activity and the non-necessity for Tutt Bryant to raise funds. It may take a while though, for any improvement in Tutt Bryant to be noticeable, but it is one aspect I have to look out for.

Finally, I will be looking out for the usual key metrics, including gross margins, debt levels and cash flow generation, to justify if continual ownership of Tat Hong remains a good proposition. If not, this company may soon join my menagerie of mistakes.


Mr ICICI said...

may i ask wat's stopping you from selling this company right now?

fundamentals are deteriorating.

looking at another way, you wouldn't even touch this company if you hadn't buy it.

Musicwhiz said...


I have to monitor for a few more quarters to verify and establish that fundamentals have indeed deteriorated permanently, and to confirm that this is not just a temporary "blip" as Tat Hong is in a cyclical industry.

Looking at the current valuation, yes I would not buy it now; but that does not mean I would not buy it when it was trading at more attractive valuations, based on criteria I drew upon back in 2008/2009.

I guess the verdict will only be out some time later on Tat Hong, so stay tuned!


Singapore Stock Picker said...

hey! i tried to register for value buddies but they said that my details match those of a known spammer/scammer. Sigh

Musicwhiz said...

Hi Singapore Stock Picker,

Maybe you can try with another nickname? Thanks!


C-130_SPOOKY said...

Hi Musicwhiz,

What are your thoughts of drawing a correlation between attractiveness of the industry through Porter's analysis and the profitability margins of the company?

Second, I reckon that a net debt position of the company may be good because debt is a cheaper source of financing. Particularly for capital intensive companies like TH.

Your thoughts.


Musicwhiz said...

Hi C130 Spooky,

Well I think Tat Hong has a dominant position in this industry, and the years of experience have built up somewhat high barriers to entry for new players. That said, being small and nimble has its advantages as well, and Tat Hong will continue to be assaulted by small "attacks" rather than be bothered by the rest of the major players (who already had established their niches). I guess I have yet to do a detailed five-forces model on Tat Hong. I may or may not depending on time constraints.

As for debt, yes debt is cheap now but I still am not comfy with the idea of a net debt position and the Company taking on more leverage to grow (through Tutt Bryant). Perhaps more time needs to pass before I can see the benefits.