Tat Hong - Analysis of Purchase Part 4

I apologize for the tardiness in posting this last portion of my analysis of purchase, but the last few weeks have been hectic and a lot of news has been released around the world. The entire global economy is a little topsy-turvy with the credit crisis (morphed from "sub-prime" into a larger Godzilla !) and currencies and interest rates (LIBOR) are going haywire.

My following analysis (based on Buffett's 12-step analysis) was completed on September 17, 2008 and one can see (on hindsight) that Mr. Market would price Tat Hong a lot cheaper over the next few weeks following my analysis. A current consideration of mine will be to average down my cost to ride out the next few years of downturn, which I am confident that Tat Hong can ride through with their established reputation, asset base and good management.

Business Tenets

1. Is the business simple and understandable ?

Tat Hong is a supplier of cranes and heavy equipment and its business consists of purchasing cranes and spare parts in order to lease them out to construction companies. The Company maintains a young fleet by constantly purchasing new equipment to maintain their fleet at less than 10 years old. The divisions within Tat Hong are as follows:-

a) Heavy Lift Department - Specializing in comprehensive heavy lift and haulage to customers. This division does rigging, project and site management, crane erection and provision of engineering services. This division looks like a service division which includes the rental of heavy lift and haulage equipment too.

b) Trading - Trades in new, reconditioned and used equipment. Products include crawler cranes, mobile cranes, earth-moving equipment and foundation equipment. Tat Hong has workshops in the region which repair and recondition used equipment and then re-sells it. There is a market for used equipment as it is cheaper than new equipment but can work just as well (in fact, less depreciation is incurred on used equipment as it is cheaper and may have its useful life extended through repair/reconditioning).

c) Machines - This department holds all the fixed assets of the company which are used to lease out to customers in order to generate revenue. The company also has a website at http://www.ecranes.com.sg/ to offer a one-stop portal for customers to browse for their preferred equipment. There is a search engine for cranes as well as spare parts and it was easy to navigate the site as it has a user-friendly interface and is customer-oriented. Tat Hong even provides training for crane operators through courses at its in-house training center (another source of revenue).

d) Spare Parts - Tat Hong also stocks up a wide inventory of spare parts for numerous renowned brands such as Hitachi, Linkbelt and Sumitomo. With such a good array of products, Tat Hong are able to provide service for a wide variety of clients, no matter what equipment they have.

e) Support Services - Provides repair and services for hydraulic systems, engines and other types of repairs to heavy equipment.

From the above, it would appear that the business is simple and understandable. The company buys cranes and either leases them out or re-conditions them to sell. They also provide training courses as a source of revenue and have a service department which caters to repairs and maintenance. +POSITIVE

2. Does the business have a consistent operating history ?

Tat Hong has been in this business of crane leasing since the 1970’s, and over the years has established itself as one of largest companies in the region supplying cranes and heavy equipment to industries such as oil and gas, and construction. Management are very experienced and have a good handle on the dynamics of the business (they are industry veterans). +POSITIVE

3. Does the business have favourable long-term prospects ?

As highlighted in the section on “comments on regional prospects” as well as the analysis of the Group’s prospects for growth (including their strategies to be undertaken and the state of the industry for crane leasing), it is reasonable to assume that growth is still present and the company will be able to leverage on this growth in the coming years due to their market leadership and their dominant presence. +POSITIVE

Management Tenets

4. Is Management rational ?

From the observations of how Management has grown the business (slowly but steadily) and how they have allocated capital to purchasing new cranes to keep up with a modern fleet; as well as the website ecranes set up to cater for customer login, Management appears to act rationally to build the business.

Recently, they had entered the China market through a joint venture and in Australia, they used their 70%-subsidiary Tutt Bryant to acquire Australian heavy lift and crane companies in order to expand their market share. I see these moves as being positive for the long run as it helps to build their market presence, penetration as well as expand their fleet to be able to offer more value-added services.

Management has also been observed to be buying back shares during the last few trading days. Ng Sang Kuey Michael (Exec Director) purchased 70,000 shares at S$1.50 on August 15, 2008, increasing his stake to 0.073%; Tan Chok Kian (non-exec Chairman) purchased 20,000 shares at S$1.51 on the same day, increasing his stake to 0.092%. Ng San Tiong (Managing Director) purchased 200,000 shares at S$1.35, increasing his stake to 1.60% on August 19, 2008. Further, on August 25, 2008, Ong Tiew Siam (Exec Director) purchased 30,000 shares in the open market at S$1.25, going from 0% to 0.006%. The next day, Low Seow Juan $(Non-Exec Director) purchased 40,000 shares at S$1.25 too, going from 0% to 0.008%. Finally, on August 27, 2008, Leong Horn Kee (Non-Exec Director) purchased 50,000 shares at S$1.25 from open market, raising his shareholdings to 450,000 or 0.089%. (Note this info was accurate as at Sep 17, 2008)

In addition to Management’s purchases, the company has also been actively buying back shares since September 9, 2008. 105,000 were acquired at S$1.2388 starting September 9, 2008, and the buying back continued on Sep 10, 2008 with 180,000 bought back at S$1.2161 and another 25,000 at S$1.244; making a total of 310,000 shares thus far. Share buybacks reduce the number of outstanding shares in the market and hence enhances EPS for shareholders. (Note: At present, the total shares re-purchased by the Company amount to 1,961,000 at an average price of S$0.9054). +POSITIVE

5. Is Management candid with its shareholders ?

To be honest, I have not engaged Management in a face to face conversation over the Group’s business, so am unable to accurately determine if they are candid. However, from reading the Chairman’s statement, I feel he is candid enough to highlight areas of success/failure and potential areas for growing. Not enough attention is paid to bad news, however, and this could either be because the Annual Report is a piece of PR document (it usually is) or that there is genuinely no bad news to report ! This tenet cannot be convincingly answered unless I can engage Management in depth. NEUTRAL

6. Does Management resist the institutional imperative ?

Unfortunately, I don’t think the Group passes this test so easily. They are into acquisition and joint venture mode and it is unclear if Management did their due diligence independently before considering these purchases, or if they were advised by an internal team which showed the numbers the Management would like to see (hence, institutional imperative). From the numbers over the years I can at least tell that they did not over-leverage, and neither did they stray far off from their core business. NEUTRAL

Financial Tenets

7. Focus on return on equity (ROE), not earnings per share (EPS)

ROE has been consistently improving since FY 2005, even as gearing has not gone up much (remained relatively constant over the years). From 11.7% in FY 2005, ROE is now an annualized 28.9%, and for FY 2008 it was 22.7%. This shows that the Group has been enhancing shareholder value over the last 4 financial years. +POSITIVE

8. Calculate owner’s earnings (i.e. Free Cash Flows or FCF)

The formula for FCF is changes in operating cash flows (working capital changes) minus capital expenditures. Looking at the table, FCF has been healthy since FY 2005 and for every year, there is positive FCF. This is because the Group has an established business and they are able to generate strong operating cash flows to offset any replacement of fixed assets. The FCF for 1Q 2009 was about S$21.8 million, which is a healthy sign for the Group moving forward as they tackle the slowing economic conditions. +POSITIVE

9. Does the company have high profit margins ?

Net profit margins of the Group started out fairly low, but have been increasingly steadily over the past 4 financial years to hit about 15.3% recently. Starting off at 6.7% for FY 2005, the company has steadily but surely increased its profit margins through diversification of its market segments (in China and other regions) as well as strengthening its core fleet of cranes by keeping them up to date, thereby creating economies of scale. +POSITIVE

10. For every dollar retained, has the company created a dollar of book value (and hence market value) ?

The company’s book value has been increasing at a steady rate, and in a bear market such as the current, there is no equivalent dollar of market value for each dollar retained. However, the long-term prospects of the Group seem favourable at this point in time. Note that the NAV (as at October 29, 2008 is stated as S$0.8015 per share). NEUTRAL

Market Tenets

11. What is the value of the business ?

The value of the business is the sum total of its future earnings, plus a lot of intangible factors like market leadership, penetration, brand recognition, market reach and Management quality. I don’t rigidly look for an intrinsic value per se; as long as the valuation using PER is not demanding, and the company has other factors which make it a good investment. It’s a multi-prong approach which makes use more of common sense and “soft” factors which are then supported by hard numbers. Thus far, this approach has served me well. NEUTRAL

12. Can the business be purchased at a significant discount to its value ?

The current forward PER of the business is about 5.3, which offers a relatively good margin of safety. By adding in factors mentioned and discussed above, the business does seem to have favourable characteristics which would lend itself to better earnings over the years. Of course, this could very well be a cyclical industry but the presence of more building and construction activity in the SEA and Middle Eastern areas will provide business for many years to come. In addition, the Group is more diversified now as compared to the late 1990’s and early 2000 years when it made flat revenues and profits – so one can argue that it’s a different animal now. However, there is still a real possibility of capital loss if the company’s earnings cannot take off as projected, in an uncertain economic climate. I have mentally prepared myself for such an eventuality, that earnings will decline and dividends will be cut. +POSITIVE

As at today's closing price of S$0.40, the Company is trading at a mere 1.74 times historical PER and also at 50% discount to NAV. Though the CEO has mentioned that earnings will slowdown in FY 2010, as an investor my time horizon is far beyond 2010. Looking ahead into the future (FY 2012 and beyond), there will still be many opportunities for Tat Hong to capitalize on growth in Singapore, China, Australia and perhaps even India in future.

The Company will be releasing its 1H FY 2009 results in mid-November 2008. It will be good to get an update from them on prospects and the current industry conditions for the construction sector.