Divestment of Tat Hong – Analysis and Lessons Learnt

My previous post on Tat Hong’s 1H FY 2011 results ended on a pessimistic note, as I had mentioned that I will be keenly monitoring the Company’s 3Q FY 2011 results to review margins, revenues, utilization rates and overall profitability and cash flow generation. Well, the jury is out – Tat Hong released its 3Q FY 2011 financial statements on February 14, 2011; but it was more of a Valentine’s Day nightmare than a gift, for the numbers were quite horrendous by any standards. This post is not just to highlight the numbers and the deterioration of the business, but also serves as a lesson and wake-up call to yours truly (yes, ME) on which companies I should choose to avoid in future when searching for a value investment. Note that this investment in Tat Hong was made back in September 2008, when my criteria for strong Balance Sheets and Free Cash Flow was not as rigorous as in 2009 and 2010.

Just for the record, the divestment was made on February 15, 2011 at a price of S$0.895 per share, and capital gains to be recognized amount to about S$5.2K. Taking into account the holding period of Tat Hong, including dividends and subsequent purchases during the bear market, my annualized gain is about +17% per annum. Admittedly, this could have been much better if I had recognized and heeded the many red flags and warning signals which popped up all over the place, but I chose to stubbornly ignore them and hang on as I felt the positives and economic recovery would kick in and lift earnings and margins. Anyhow, let me go point by point on Tat Hong to dissect the decision to completely divest myself of this investment.

1) Gross Margins – For 3Q 2011, gross margin deteriorated significantly from 38.0% to 34.4%. While this in itself may have been a temporary “blip”, the commentary is chilling in the sense that it casts a pall over the gross margins by stating that lower margins were obtained in crane division (55.6% versus 63.0%) due to more intense competition in local and Malaysian markets (Page 12), and that distribution also saw lower margins of 18.0% versus 19.7% due to strong competition and weak market conditions. Another worrying point was that Tower Crane division in China also contributed to the weaker gross margins due to higher COGS and keen competition, and gross margins fell significantly from 30.1% to just 21.8%. The common theme among these three pieces of negative news was the word “competition”. Note that in the first place, the crane industry is very fragmented; and that even though Tat Hong is one of the major players, there are still many smaller companies that can buy a few cranes and then lease them out, so this makes it a very price-competitive environment. The fact that Tat Hong is succumbing to keen competition signals that this is a permanent problem which is likely to persist, as competition does not just disappear overnight. It is one of the most difficult problems for a company to tackle, and if they did not have a very strong competitive moat in the first place, the first signs of weakness will show up in the gross margins, as what Tat Hong is demonstrating.

2) Finance Costs – Finance costs have been rising steadily, and for 3Q 2011 it went up 25% to S$4.7 million, against just a 1% increase in gross profit. For 9M 2011, finance costs hit S$14 million, up 26% from a year ago. The increase in debt was ostensibly to fund the acquisition of Tutt Bryant, but with the recent massive Queensland floods, it remains to be seen if this will have an adverse impact on Tutt’s operations. The fact is that finance costs are climbing and with a combination of slower revenue growth and lower gross margins, this signals a big red flag.

3) Expenses – Looking at 9M 2011, it is clear that expenses have risen more than revenues or gross profits. Administrative expenses were up 25%, while other operating expenses rose 23%. Apparently, keeping a tight lid on expenses is an effort for the company, as they are hiring for their new subsidiaries in China and also spending more money on upkeep and rental of their machinery in Australia. This has occurred not just in one quarter but I have observed the trend of higher expenses amid lower or flat revenues and earnings, and as a shareholder one should be rightfully worried. Controlling costs should be of utmost importance, and if companies such as Boustead can reduce costs even while growing revenues, then I would expect it of the other companies within my portfolio as well. Tat Hong has certainly not been able to control its expenses effectively, as can be seen in their bottom line performance.

4) Debt Levels – It was always worrying to me that Tat Hong held such high debt, and Management was constantly talking about net debt to equity ratios instead of concentrating on going net cash. I guess this points to a fundamental flaw in my original logic for purchasing Tat Hong – that it is involved in a high capex industry and therefore needed to rely on a lot of bank loans and financing for daily operations. Financial liabilities (ST) increased from S$91.2 million to S$142.9 million, which is a 56.7% increase; while LT financial liabilities increased significantly from S$153.8 million to S$227.7 million (a 48% increase). Total debt therefore increased from S$245 million to S$370 million, and the cash balance of the Company was just S$73.5 million as at Dec 31, 2010.

5) Persistent absence of Free Cash Flows – One of my major gripes was that Tat Hong’s cash flow statement always shows a persistent lack of free cash flows, as cash from operations is seldom sufficient to cover capital expenditures. The result of this, of course, is that Tat Hong has to rely on other sources of funding such as bank loans (as mentioned in point 4), and the recently issued RCPS to AIF Capital. For 3Q 2011, the situation looked even more dire as there was negative operating cash flows of S$15.2 million, while capex was S$12.4 million under “Investing Activities”. Needless to say, most of the cash came from the raising of bank loans (S$43.8 million) once again.

6) Company Characteristics – Tat Hong is a company which is similar in nature to Ezra and Swiber, in that there has to be constant high capital expenditure for it to function effectively. The buying and selling of cranes ensures that capex has to remain high, and even to replace old, worn-out cranes and equipment for rental would entail high capex as well. Considering the Company has diverse business operations in Australia and Asia, this means that upkeep and maintenance of this equipment necessitates high expenditures, and this is a characteristic of the Company which must be taken into account. Sadly, when I was analyzing the Company, I focused more on its size, scale and market leadership rather than these more important characteristics, and which resulted in this mistake.

The above points were sufficient to justify the decision to divest, and to deploy the monies at a suitable time and when a suitable investment-grade company can be identified. I will strive to actively avoid making the same mistakes, and focus a lot more on debt and free cash flows in future analysis of purchases. In fact, this had started with the purchase of MTQ, and then moved on to GRP, Kingsmen Creatives and lastly SIA Engineering. Thus far, their businesses have been more resilient as compared to Tat Hong, even in the face of an uncertain economic climate.

This divestment and change in my portfolio will be reflected in my month-end portfolio review. With the divestment of Tat Hong, it also means I lose an income stream which amounted to about $500 a year (assuming last year’s dividend history), and at a dividend yield of 2.9% (yes, nothing to shout about). Note that the cash will be kept in a bank account until suitable opportunities can be found to deploy it. There will be no rush to invest in a company until ALL the factors are in my favour, and if I have the requisite margin of safety. Capital preservation remains the cornerstone of my investing philosophy.