Monday, September 10, 2018

Kingsmen Creatives - Revisiting The Thesis Part 2

Part 2 of this series exploring Kingsmen Creatives will focus on the Group's financials, namely revenue trends, margins and the all-important cash flow. I shall do this from a practical standpoint - what an investor looks for is essentially cash which a Company generates, in order to justify the valuation paid for a business. While profits are the most looked-at number when investors open up a set of financial statements, ultimately it is the cash flow that you receive which you can spend - you cannot spend profits! So this analysis shall focus more on the cash flow generative aspects of the business; as profits can often be affected and influenced by accounting policies, assumptions and also one-off exceptional items.

The above table summarizes the 8-year historical numbers for Kingsmen. I have deliberately left out the entire chunks of P&L, Balance Sheet (B/S) and Cash Flow Statement (CFS) even though I do have them all on file (include all quarterlies), because it would be too heavy for the reader and what I wish to do is to zoom in on important numbers and ratios to simplify the analysis. We shall therefore look at revenue trends, margin trends, expenses (and some line items), NPAT margins, cash and net cash balances and FCF generation. I will also briefly talk about dividends history for the Company in a later section within this post.

Revenue Trends

Kingsmen's revenue was on an uptrend from 2010-2014, and it was only in 2015-2016 that it took a dip, mainly due to the luxury segment for Interiors being negatively impacted. 2017 saw a year on year (yoy) drop of -6.8% in revenue, and this seemed to signal that growth had plateaued and that the Group could no longer increase top-line. However, Benedict (Chairman) did mention that increasing revenue was not an issue for the Group, but the problem was in getting decent margins for the work they did, and also whether they had the manpower and expertise to pull off these contracts in a timely and efficient manner. The conclusion from this is that the Company did not wish to merely "chase" contracts to make top-line look good and to show "growth", but instead remained selective on the type of work they chose in order to ensure they earned a decent margin and that they could deliver on their obligations. Of course, this was predicated on the fact that gross margins and also EBIT and net margins had been impacted due to the luxury spending slowdown which began in 2015 with China's Xi Jinping clamping down on lavish spending and corruption, which made many luxury brands rethink their strategy of rapid expansion and opening large stores in a roll-out campaign (recall that Kingsmen had a distinctive edge when it came to such roll-out programs as they could coordinate the simultaneous opening of stores by a specific brand across multiple countries due to their presence in these countries).

Of course, one could argue that with the current state of affairs (i.e. e-commerce remaining dominant and growing and replacing more brick-and-mortar business), Kingsmen's revenue would also be under pressure. But the E&T division would still be able to take on more jobs as the MICE industry is still booming and expansion, while more and more theme parks are sprouting up in Asia and the Middle East; plus the Interiors Division has restructured itself over the last 3 years to diversify its client base and also preserve gross margins. Hence, there would still be opportunities for revenue growth as Kingsmen tackles new trends (e.g. experiential malls like the upcoming Funan Centre), and this is also not accounting for potential new revenue streams from their planned IP division (more of this in Part 6).

Margin Trends

No discussion is complete without talking about margins, and here I would like to focus on the gross margin ("GPM") as well as the key expenses which flow down to the net margin ("NPM"). There will also be some discussion on future expenses, trends in expense movements and how I see margins trending over time.

GPM for Kingsmen is indicative of how well they can price their services and from the table, one can see that Kingsmen's GPM is remarkable consistent at around ~25%. However, quarterly earnings would show that post-2015, GPM actually dipped to around 22% (1Q 2016) as luxury retail expansion slowed and Kingsmen had to go for fit-outs for more mass market and affordable fashion-type clients. These jobs obviously have more contractors competing for the same pie and hence, Kingsmen had to price their services lower to remain competitive and hence suffered a fall in GPM. However, in 2017 and 2018, GPM has managed to stabilize at 25% over all divisions as Kingsmen has expanded their client base and also taken up different types of jobs in order to fill the order book (e.g. cafes like Greyhound Cafe). So my conclusion here is that GPM should not be a major issue for the Group going forward as their E&T division enjoys good economics and Interiors has also somewhat recovered.

For NPM, however, one can clearly see that Kingsmen has been hit badly in 2016 and 2017. Where NPM used to hover between 5% to 7% (and Benedict also mentioned that the Group managed this for around 10 consecutive years despite competition and overall higher costs), it has now dipped to 3.6% in 2016 and 3.2% in 2017. Management has taken pains to reiterate that this is NOT a situation which they are pleased with, and they are working hard to move NPM back up to the previous 5% to 7% level. The way I see it, this would be tough in the near-term as there has been a structural change in the retail sector (more on this in Part 5) which has permanently crimped spending by multi-national luxury brands. However, there are some mitigating factors which may lift overall NPM which I will detail below.

The 3 key items of expense for Kingsmen would be D&A (Depreciation and Amortisation), Rental Expenses (as their current premises at 3 Changi South Lane is rented) and staff costs (as the Group has many project management teams and offers services rather than products). Depreciation is slated to increase as Kingsmen has just completed construction of their new HQ in Changi Business Park (the building is named "The Kingsmen Experience") and will spend around $35m in total on the cost of the land + property. This translates to around $1m/year in depreciation, which is roughly the same as the ~$1m/year in rental expense which Kingsmen is paying. So this is simply substituting rental for depreciation and would have no P&L impact, but cash flow would improve substantially once Kingsmen shifts over. The lease, however, was signed up till April 2019 and so FY 2019 should see 4 months of rental expenses + depreciation expense, after which the financials would only see the depreciation expense bumping up from the new HQ.

As for staff costs, this has climbed relentlessly as Kingsmen builds its capabilities and teams and also because of inflationary factors (salary increments) as well as bonus payments (for achievement of targets in prior years, except 2017). As Kingsmen rewards staff based on net profit margin by division, this incentivises staff to try to achieve higher net margins for the division, while not compromising on work quality or standards. For 2Q 2018, Kingsmen saw a +8% increase in staff benefits expense mainly due to advance hiring for their new IP division (NERF FEC), which I will elaborate on in Part 6.

To summarize this section, the spot of light at the end of the tunnel may start getting brighter once the new IP division kicks off and starts contributing, as a lot of the costs are front-ended and sunk in earlier periods and we will only see contributions in later quarters. Net margins may be boosted by better economics from the new division and also better cost control measures undertaken by the Group for their existing Interiors and E&T divisions.

Cash Balance and Cash Flow

From the table, one can see that Kingsmen has significantly increased its cash balance from 2010 till end-2017, from $29.9m to $73.6m. This is despite significant spending in the years 2015 & 2017 (2015 - $15m for purchase of K-Fix & 2017 for the purchase of land for new HQ and on-going progress billings for construction-related costs). Borrowings have also not increased significantly up till end-2017 (at just $14.0 million), with net cash for the Group at around $60m. However, as at 2Q 2018, total debt had increased to $26m ($10.4m ST and $15.6m LT) while net cash had declined to $44m. This is in line with what Management had communicated regarding borrowings to fund part of the construction of the new HQ. Moving forward, I would expect the debt to increase more in order to fund the development and construction of Kingsmen's first NERF FEC, but this should be balanced out by healthy operating cash flow from their core business.

For the cash flow section, one can see that for every single year from 2010-2017, Kingsmen has generated positive operating cash flows. As explained, capex was elevated in 2015 and 2017 for above-mentioned reasons and for 1H 2018, capex has hit around ~$10m thus far (residual construction costs for the new HQ). There should be no more HQ-related capex for 2H 2018, and capex should decline significantly for the remainder of the year. I would expect 2018 to be another year of positive operating cash flow, as there are signs of recovery in the Interiors business and also good prospects for the E&T division (including new contracts won and announced by Kingsmen in 1H 2018). Capex would definitely be higher in 2019 as construction of the first NERF FEC should begin with gusto, but the plan is for some of the capex to be borne by business partners so that Kingsmen does not need to cough up too much cash. More on this in Part 6.

Free-Cash-Flow ("FCF") has always been positive with the exception of 2015 (purchase of K-Fix). FY 2017 FCF yield is a low 1.5% as this was distorted by the construction-related expenses for the new HQ. If we assume a steady state maintenance capex amount of $2.5m/year, FCF for 2017 would be around ~$11m and FCF yield would be around 10% - a very compelling proposition indeed.


Dividends are an important component of total returns for any investment and also form the main reason why I purchased Kingsmen and a few other companies. My thesis is for both growth and yield, and Kingsmen's payment of regular dividends over the years provides good support for retaining this investment, while I have, over the years, reinvested the dividends from Kingsmen into other promising companies. It can be seen from the table that during the good years (2010-2014), Kingsmen paid out a total of 4c/year twice-yearly, for a pay-out ratio of between 40% to 50%. Dividends only started falling from 2015 through 2017 as earnings got hit by higher expenses and poorer retail sentiment, but Kingsmen still managed to pay a total of 2.5c/year for 2016 & 2017, which translates to a steady yield of ~4.6% at current market price of 55c.

From dialogues with Management and recent communication, I believe 2.5c/year is a sustainable level of dividend even after accounting for higher debt levels and the impending capex for the IP division. Therefore, investors purchasing at current market price can enjoy a steady 4.6% yield while waiting for catalysts to play out.

Part 3 of the analysis will delve into the different divisions of Kingsmen, their overall performance and also talk a bit about their prospects. This will differ from the industry outlook as it is more focused on the clientele, margins, mix and other numerical details.


Unknown said...

Hi MW,

Hope you dont mind if I ask a general acct qn.

Is some of their own employee expenses included in "Cost of Sales" if their work is considered as direct labour, and the rest of their own employee expenses is under "Employee benefit expense" (indirect labour)?


Musicwhiz said...

Hi Unknown,

Yes, I believe if the staff costs are directly associated with project-related work, then it should be parked under COGS and matched to revenue recognized. The rest would be marketing and distribution staff and general and admin (back office) staff which are parked under Employee Benefits Expense.


Singapore Dividend Collector said...

Amazing stuff. I own a little bit of Kingsmen, and I like the numbers and management. The company have decent free cash flow to continue to pay our delicious dividends. Thanks so much for your analysis. I love it.


Musicwhiz said...

Hi Singapore Dividend Collector,

Thanks for the compliments and also for dropping by. Stay tuned for the others parts which will be coming up in due course.

Anonymous said...

Hi MW,

Some of my comments for your thoughts.

1. You did a similar analysis 7 years ago, but the company had gone no where after 7 years. What went wrong? What is the lessons learnt as an investor? Should you still be invested in this company for the next 7-10 years?

2. Why do you leave out the ROE metric that you used 7 years ago for the current analysis? I thought this is an important metric to show how strong the co is, in using the company's equity.

3. The Nerf partnership can be a boon and bane for the company. What if the partnership is not successful (as they are new in such venture, lack experience, high fixed cost etc.), i.e. the big risk ?

4. Will you stll be invested in this company, a) if you were not vested in the first place; b) if the Nerf partnership is a failure?

5. Instead of narrating the numbers and management's actions(usually with bias from management, eg. "going for high margin" rather than "losing the bid"), maybe it is good to find out how strong the company really is - to determeine whether to remain vested. The rolling out of stores in diff countries, thematic works, nerf partnerships etc are not moats at all in my opinion.

All the best!


Musicwhiz said...

Hi M,

(Reply Part 1 - too many words)

First of all, I would like to thank you for your comprehensive comments and I also appreciate that you are very frank in asking me tough questions. This is good for me as it allows me to critically review my thesis without suffering from both confirmation bias and the endowment effect. Let me proceed to address your queries:-

1) You are right that I did my analysis of Kingsmen back in 2011, but I would not totally agree that the Company has gone "nowhere" in the last 7 years. Note that the Group was doing consistently well up until FY 2016 when profits collapsed due to higher expenses and stronger competition in relation to the Interiors space, and 2017 saw more of the same phenomenon. Otherwise, the Group was generating very healthy profits and also FCF and building up their competencies and capabilities over the years. If you are referring to the share price (rather than the business), don't forget also that the share price back then (my last post was written on August 11, 2011 and the share price was $0.545 - closing price) also had not accounted for the many years of dividends received in the years 2012 through to 2018 (amounting to a total of 20c/share). So what you see now may be a 55c share price as quoted on the exchange, but the Group has already paid out the 20c as realized returns over the years to me as a shareholder.

In terms of what went wrong, in a nutshell, it was due to China's clampdown on luxury goods spending in 2015 which led to many luxury brands curtailing their budgets and spending instead of smaller stores and fewer stores. The increasing influence of e-commerce also had a part to play with retail businesses needing less physical space, all of which contributed to Kingsmen losing out revenue in the high end segment and having to compete in the more crowded space in the mid-range, affordable fashion segment where they had less pricing power. The lessons learnt as an investor is to have a margin of safety in case something went wrong - and something did indeed go wrong! So obviously my returns would have been much more impressive had something bad not happened to the business, but overall compounded returns are still averaging 5% to 6% in spite of the problems Kingsmen faced, which I feel is not a bad result.

As to whether I should still be invested, yes. The Company is embarking on the NERF project and to IP ownership rather than relying on a pure contractor model, plus a lot of bad news has been priced in and they are also paying a sustainable 4.5% dividend yield. There is a lot to look forward to as JEWEL is coming up and so are more theme parks in the region, and their new IP division may also see more newsflow soon.

2) You are right and apologies for leaving out the ROE portion. ROE numbers as follows:-

2010 - 25.4%
2011 - 24%
2012 - 22%
2013 - 19.9%
2014 - 17%
2015 - 17.2%
2016 - 10.1%
2017 - 7.6%

So you can see from the above that ROE was at very healthy levels until the drop in profits in 2016 & 2017, which caused ROE to dip below 10% in 2017.

Musicwhiz said...

(Reply Part 2)

3) Regarding NERF, I will elaborate more in Part 6, but I had spoken to Management on their venture and also the risks portion as I am also very concerned about what you mentioned - never been done before, new concept etc. To summarize, they are calling for JV partners in order to lessen the financial risk involved, and also tapping on operators with some experience in managing attractions to do the overseas NERF. However, for SG they will be hiring a team which has experience in managing such attractions. The initial cost for NERF FEC is not prohibitively high (~SGD 6-7m for the SG one), and they are exploring multiple streams of revenue to come from NERF and they also have Hasbro on the marketing/sales support. So I would say that yes this is a new concept, but Kingsmen being conservative would have ensured all angles and aspects are covered and they are will not take things to chance, so we will have to wait for more updates on this in future quarters. But please wait for Part 6 to comment on the NERF venture as I will be sharing much more then.

4) I would still want to own Kingsmen if I did not own it in the first place, as evidenced by my recent purchases both in my cash account and CPF IA. I approach it from the point of view of whether I should own more at current valuation, and ignore the sunk cost bias. Even if the NERF partnership is a failure, I would still want to own Kingsmen as I have trust and faith in the Management - that they will continue to explore viable IPs to grow the business and that they will operate with integrity and candor. Retail is also gradually recovering and theme parks/exhibitions/events are still booming in the region, so I will want to ride on the growth of these industries.

5) May I ask how you would objectively determine if the Company is "strong"? I have spoken to Management, read up on the relevant industries and also analyzed their competitors (Pico FE desktop research) and met up with Cityneon IR to discuss the industry. Though Kingsmen may seem to be the "snail" in terms of IP and that they also got hit badly by Interiors (unlike Pico which is more China-HK exposed and not much into retail), the Group does have prudence and a strong balance sheet and they are very careful not to leverage to the hilt. Part 4 will talk a bit about Management's attitudes and also how they approach the strategic growth of the Group. I prefer slow and steady to quick and "may burn out".

On your point about the moat, I would argue that other contractors would not be able to achieve the roll-out Management, not have a competent enough project team to handle theme park works and also not have the reputation and track record to be able to engage with a global toy giant to clinch the NERF deal. Therefore, the fact that Kingsmen was able to shows that they have a strong moat which enables them to differentiate themselves from other smaller, less well-known contractors.

Thanks again and I hope the above addresses all your queries!