CDW Holdings

cdwCDW Holding Limited is a Japanese-managed precision components specialist serving the global market focusing on the production and supply of niche precision components for mobile communication equipment, gamebox entertainment equipment, consumer and IT equipment, office equipment and electrical appliances. Being a reliable outsourcing partner with Japanese precision, CDW Holdings has grown from a private trading company in Hong Kong back in 1991 to what it is today.

Before I begin my analysis, all figures are in USD.

Fundamental Analysis:

(I)              Earnings:

cdw_isThe company is split into 3 business divisions, namely LCD Backlight Unit, LCD Parts & Accessories and Office Automation, with the LCD Backlight Unit being their core business segment taking up two-thirds of their revenue. Within their LCD Backlight Unit, it can be further split into two segments – Backlight Units for Handsets (mainly smartphones) and Gamesets (including digital cameras and global positioning systems for automobiles). While their LCD Backlight Unit is their core business segment, the company is focused on the production of backlight units for gamesets compared to handsets.

Over the years, the company has been performing relatively well, keeping gross profit margins consistent yet increasing their net profit margins. This reflects how management has been effectively managing operating expenses through methods such as vertical integration, evident by the recent acquisition of Mt Wuxi. In FY2013, we observe the dip in revenue due to their major customer starting to wind down orders for phased out products. In terms of the LCD Parts & Accessories, we see sales declining by approximately 40%, which is the main reason for the 10% decrease in revenue. The LCD Backlight Unit remained relatively stable due to their major customer releasing new models and maintaining order volumes in 2H2013. While for the Office Automation, their smallest division recorded a 4.1% increase in sales. This is attributable to the company restructuring this division, consulting with their customers, eliminating loss making products and commencing production of higher margin and profitable ones. While gross profits have declined in FY2013, net profits remained relatively stable due to 2 one off gains – disposal of the Suzhou Plant and the USD2mn gain on the acquisition of Mt Wuxi.

(II)              Balance Sheet & Cash Flows:

cdw_bsCDW Holding’s balance sheet is relatively clean with minimal debt, with cash increasing year on year. As of 1Q2014, the company’s cash position has increased to USD64mn, increasing its net cash position to USD55mn, a 2.3% premium over its market capitalization. Given how management has been quite ambiguous regarding who their major client is in their Annual Reports, the cash conversion cycle might be something that we have to pay close attention to. However, as of date, I do not think there is anything to worry about.

(III)              Financial Ratios:

cdw_ratioQualitative Analysis:

(I)              Business:

Gamesets being the company’s key revenue driver is heading downwards and it might not be something temporary given how the technology landscape is changing. From the images on their website, I am assuming that one of their customers would be Nintendo and we all know that Nintendo isn’t the Nintendo of the past anymore. Days where every kid owned a GameBoy or what they call Nintendo 3DS now is no longer relevant today. Today, we see strong competition such as tablets and smartphones taking over the role of gamesets be it in terms of Gaming/Camera/GPS. Looking at Nintendo, not only has their projections been off lately, they have been way off. Nintendo’s prediction of 18mn 3DS handhelds fell short of actual sale of 12.24mn, reflecting the declining of such gaming products.

“We already witness the effects of changing consumer behavior in the technology space. With advances in smartphone technology and increasing consumer preference for smartphones over other handheld devices for gaming, photo-taking and global positioning capability, the demand for gamesets is on the decline…we do not think the reduced orders for gamesets is simply temporary but indicative of a larger, permanent trend,” an abstract from AR2013.

Screen Shot 2014-07-13 at 6.52.07 pmTracking the production of Backlight Units for both Handsets and Gamesets, it is indeed true that the production of gamesets have been on the downtrend, while handsets have been slowly growing. Additionally, it is important to note how production is greatly skewed towards the production of gamesets.

(II)              Economic Moat:

Looking at the consistency in gross margins, I would say that the company enjoys a relatively sizable economic moat. Furthermore, with only a 3% swing between the high and low gross margin values, it is a relatively tight range, showing how the company is able to maintain its relationships with her customers and suppliers.

Furthermore, in terms of production of gamesets, they are a key supplier in the wake of the reduction in number of suppliers, as abstracted from AR2012. While the gamesets are on a downward trend, it is still evident that the company commands a strong economic moat in withstanding competition, economic cycles and maintaining itself.

Valuation:

cdw_valuation cdw_valuation2At the current market price of SGD0.143, which translates to USD0.113 the company is definitely trading at low valuation multiples. With a P/E Ratio of 4.72, EV/EBITDA of -2.12 and normalized FCF yield of 13.6% definitely does indicate that the company is undervalued. Furthermore, if we were to base our calculations of Graham’s version of net-net, the company would fulfil it as well.

Conclusion:

CDW Holdings is an undervalued company backed with solid financials and fundamentals. However, the company has not indicated any plans on how they plan to tide through this difficult period, especially how it is not a temporary issue. Putting myself in management shoes, I would start focusing more capital in strengthening my production of backlight units for handset, given the current growth in the smartphone industry. However, I am no expert with regards to this and perhaps it is more complicated than just strengthening their production but difficulty in supplying to companies on the scale of Samsung, Apple and Xiaomi. Given how such key concerns not being addressed, at current prices, it does not offer a wide enough margin of safety for us to invest in it.

Disclosure: The authors have no vested interest in D38.SI

Why Growth Is Not Always Good

As a value investor, I find the overemphasis on growth to be rather unsettling; it is very common to see analysts place a target price based almost entirely on earnings growth, eking out an unremarkable 5 to 10 percent capital yield gain as a call to buy a particular stock. I am currently reading a book – Value Investing: From Graham to Buffett and Beyond and it raised a very interesting point that growth may not even be necessarily beneficial for shareholders.

Excerpts from the  book

Earnings Power Value

The traditional Graham and Dodd earnings assumptions are (1) that current earnings, properly adjusted, correspond to sustainable levels of cash flow and (2) that this earnings level remains constant for the indefinite future. Under these assumptions, the equation for the earnings power value (EPV) of a company is EPV = Adjusted Earnings x 1/R where R is the current cost of capital.

More importantly, there is an important and close connection between the EPV of a firm and its strategic situation, and the line of connection runs through the reproduction cost of the assets.  The relation between earnings, and hence growth, and the reproduction cost of assets is an aspect not commonly examined by investors.

Three Scenarios of Growth

When we consider economically viable industries, there are three possible scenarios.

In the first, the firm’s EPV may fall substantially below the reproduction value of its assets. In this case, the management is not using the assets to produce the level of earnings that it should. The cure is to make changes in what the management is doing.

In the second, the EPV and the asset value are more or less equal. This is the situation we would expect to see in industries where there are no competitive advantages. The return these companies earn on the capital invested in them just equals the cost of acquiring that capital, and there is nothing left over for the previous investors. Thus, the EPV that equals the asset value defines the intrinsic value of the company, regardless of its growth rate in the future.

In the third situation, if the EPV is significantly higher than reproduction costs of the assets, then we are looking at an industry setting in which there must be strong barriers to entry. Firms within the barriers will earn more on their assets than will firms exposed to the entrant of new competitors in their industries.  For the EPV to hold up, the barriers to entry must be sustainable at the current elvel for the indefinite future.

Difference between EPV and Asset Value

The difference between the EPV and the asset value is the value of the franchise enjoyed by the company in question. Competitive advantages enjoyed by incumbent firms constitute barriers to entry that protect the incumbents from profit-eroding competition. These advantages and barriers are responsible for the firm’s franchise. The defining character of a franchise is that it enables a firm to earn more than it needs to pay for the investments that fund its asset. The EPV is greater than the asset value; the difference between the two, as we said, is the value of the franchise. Therefore, the intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV, or those assets plus the competitive advantages of the firm that underlie its franchise.

So when is growth bad?

Under many commonly encountered strategic situations, growth in sales and even growth in earnings add nothing to a firm’s intrinsic value.  As we explained earlier, growth on a level economic playing field creates no value.

Growth in sales that finds its way to net income would seem to imply that there is more money available to investors. But growth generally has to be supported by additional assets, more receivables, more inventories, more plant and equipment. These extra assets that are not offset by higher spontaneous liabilities have to be funded by extra investment, whether from retained earnings, new borrowings, or sales of additional shares. That cuts into the amount of cash that can be distributed and thereby reduces the value of the firm. For firms that are not protected by barriers to entry, the new investment produces returns that are just enough to offset the cost of the net investment, resulting in zero net gain.

When EPV is equal to the replacement value of assets, a $1 million investment for example, should produce an additional $1 million in adjusted earnings. Nothing has been value-added to the amount and as a result, intrinsic value does not increase because it is as good as changing a dollar bill for another dollar bill.  For firms operating at a competitive disadvantage, additional growth will actually destroy value (think of it as paying a dollar for fifty cents).

My 2 cents – what does this mean to an investor?

Whenever I read a book, the chief question that hangs in my mind will inevitably be – how do I apply this to my analysis? To me, a mix of practicality and theory would provide the best value for fundamental analysis (contrast this with the concept of beta). While determination of the replacement value of assets requires several adjustments and calculations which I have yet to cover in my reading, I am apprehensive of the degree of knowledge that us retail investors can gather for an estimate of replacement value.

Nevertheless, the insight put forth by the book does seem valid to me and an alternative method that I am I considering would be to compare the 5-year CAGR of CAPEX/Operating Cash Flow (OCF) against 5-year CAGR of OCF. Capital expenditure is essentially the amount of reinvestment made into the business by the company; when CAPEX/OCF growth exceeds OCF growth it means that every additional of reinvestment is generating less than a dollar of additional cash. The idea here is that if CAPEX/OCF growth significantly exceeds OCF growth, it may be a cause for concern. Be it due to diseconomies of scales or what not, under such a scenario, shareholders would be better off receiving the additional CAPEX as dividends.

In employing such a method, one should also be aware of its limitations in order to make a sound judgement. Firstly, there is might be a time lag between capital expenditure and the benefits of it depending on the nature of capital expenditure. You don’t have to be an Einstein to know that it takes a few years for a factory to be built and using a 5-year CAGR is meant to reduce the impact of timeliness. Secondly, CAPEX only increases supply-side potential. The underlying assumption of using the 5-year CAGR of OCF is that there is sufficient demand in market to meet the increased supply. When there is insufficient demand, it would be difficult to conclude strictly that a dollar of CAPEX yields less than a dollar in cash. Of course, the nature of the lack of demand – cyclical or non-cyclical is important for your judgement. Cyclical falls beyond management control may be short term and do not imply that growth is bad. Non-cyclical ones indicate poor management and more cash should be returned to investors rather than be used for expansion.

To conclude, this episode reminds us that as fundamental analysts, there are boundless opportunities for critical thinking and evaluation, for even something so typified as the quintessential quality of stocks can have another side to it. Who knows what else we have left out?

Market Valuations

Many are familiar with market valuation indicators such as trailing, median P/E ratio, P/B and dividend/price ratio. In this article, I am not explaining the use of such indicators but wanted to introduce one that is relatively not known to many these days. Personally, I only found out about it recently, given my preference of using the long favored market valuation ratio, one even Warren Buffett pointed out to be ‘probably the best single measure of where valuations stand at any given moment.’ That would be the ratio of Total Market Capitalization to US GDP (TMC/GDP), which would stand at approximately 1.241 as of today, indicating that markets are significantly overvalued.

Everyone would be familiar with the term ‘Net-Net’ coined by the great Benjamin Graham, which just means to a company being priced below the value of its current assets less all liabilities. While we understand the implications of a company being a net-net, what are the implications when used on a market level?

Based on research done, just from the number of net-net companies compared to the S&P 500 Return, we are able to have a feel of the valuation of the market.

Screen Shot 2014-07-08 at 12.21.18 am

From the research conducted by Graham Theodore & Co. Ltd., we are able to observe the inverse relation between the number of net-nets in the market and the S&P 500 Return. The greater the number of net-nets, it would indicate a more bearish market, with market valuations on the low side and vice versa. With that said, looking at the current market today (NYSE MKT LLC, NYSE, NASDAQ) there are only a total of 59 net-net companies and the average annualized returns from 2012 to present would be approximately 21%. Compared to the initially mentioned TMC/GDP ratio, it would indicate that market valuations are indeed overvalued.

Looking at past history, the highest point TMC/GDP ever reached was 1.48 during the technology bubble in 2000. What does it mean for us going forward now? I am not saying that we should all start winding down our portfolios and sit on cash, however, it would be best that we hold a larger proportion of our portfolios in cash and consider realizing profits for companies nearing their fair value.

Asia Fund NAV Update July 2014

Screen Shot 2014-07-01 at 12.40.27 pm

Initial Net Asset Value (per unit): $10,000

Net Asset Value as of July 2014 (per unit): $13,248

Screen Shot 2014-07-01 at 12.40.49 pm

The 1H2014 was generally a good period. Our Asia Fund was up 11.14% in the first six months of 2014, against a 2.24% return of our weighted benchmark. The Hang Seng Index was down 0.64% while the Straits Times Index was up 2.55%. The performance of the fund was significantly affected by the drop in UMS Holdings share price due to the sale from the CEO and AMAT. However, it is in our view that fundamentals of the company are still intact and the dividend payout is still sustainable based on current free cash flow levels.

In the 2Q2014, we would observe major changes within the portfolio. We have completely divested our investment in New Toyo. We felt that with our revised calculations, New Toyo does not offer us a wide enough margin of safety as initially calculated especially with the uncertainty of the business operations going forward. Also, we have been reducing our stake in Kingsmen Creative, in attempt to align our overall portfolio’s investment strategy.

At the same time, we took positions in Memtech International and SHC Capital. SHC Capital has recently announced a disposal of all their operations, and if successful would value the company at 37c per share. Current share price remains depressed due to investor’s skepticism of the deal going through and perhaps the lack of coverage on such a small-cap company. However, such a scenario is something similar to what we encountered in 2012 (Elite KSB).

Please feel free to email us if there are any questions regarding our investments.

Penny Stocks

Ever heard of the phrase, “never judge the book by its cover”? Well, the same goes for investing in stocks, especially penny stocks. Recently, I read an article on fifthperson regarding the dangers of penny stocks. While I do agree with their points brought up, however, I feel that there is this stigma attached to the term “penny stock” especially how they associate it with speculation. Every time I bring up buying penny stocks to more seasoned investors, their initial response would always be how risky it is.

In SEC terms, any stock that has a value of less than 5 dollars per share and also which is not exchanged on the major exchanges (like NYSE or NASDAQ) is called a penny stock. These types of stocks are traded over the counter and they are listed in exchange boards such as Pink Sheets or in the OTCBB. In the context of Singapore, they are just stocks trading under a dollar.

There is this misconception that penny stocks are priced so low due to reasons such as consistent poor performance, the company usually reporting a net loss or reasons to believe that there is accounting fraud. They aren’t wrong as we do see such cases such as Scintronix (T20.SI) trading at 0.1 cents due to consistent poor performance or s-chips like China Fibretech (F6D.SI) due to the public’s fear of accounting fraud. However, to just throw the baby out with the bathwater is not very fair. There are many other unloved penny stocks that are hidden gems waiting to be discovered. As long as we do proper research, we will realize that many of these penny stocks are undervalued, offering us a large margin of safety and huge potential gains. As one would observe, I owe my portfolio’s performance largely to such penny stocks. One of my darling penny stocks would be Silverlake Axis (5CP.SI) purchased at SGD0.35 and giving me a total return of over 170% including dividends within a time frame of about 1.5 years. Furthermore, if one were to actually hold the stock till now, it would translate to a total return of 237%!

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To sum it up, I hope this post will help alleviate investor’s fear of penny stocks and to some extent their view towards penny stocks being riskier than blue chips. Honestly, what is risk? Imagine, Person A buys a penny stock offering 50% margin of safety compared to Person B who buys a blue chip that is 50% overvalued. To me, Person B is actually at a greater risk as he is overpaying for a stock and in the event that the share price normalizes in the long term, he is actually facing a potential loss of 50%.

Disclaimer: The authors have no vested interest in 5CP.SI, T20.SI, F6D.SI

How to Value Property

As fundamental investors, the art of valuation is our main weapon against the irrationality. In a land-scarce country like Singapore, property holdings are a common and significant source of value, even for companies not in the property business. Today, I would like to share my method of valuing properties. It may not be the most accurate, but as always, the objective here is to broaden perspectives.

I categorise property valuation under two categories – Earnings and Asset Value.  Earnings is derived mainly from rental income while Asset Value refers to the fair value of the land and building if it were sold. At a deeper level, the two are actually converge as you can convert earnings into a pseudo-Asset Value using a DCF or rental yield model.

Before we jump into the nitty gritty of the two categories, there are a few key terms that you should know when it comes to property valuation.

Gross Floor Area (GFA)

When you buy a plot of land, you do not just simply build a one-storey house. By building more than one-storey, you are able to increase the gross floor area even though your land area remains unchanged.

Gross Floor Area ratio (GFA Ratio)

The GFA ratio is simply the ratio of your gross floor area to your land area. The higher the ratio, the greater number of floors you can build for a unit area. Everything held constant, a plot of land with a higher GFA ratio will be worth more than one with a lower GFA ratio. This GFA ratio is set by URA.

Net Lettable Area (NLA)

A building will not be able to rent 100% of its GFA. Out of the entire GFA, some of it would have to be used for common areas like lifts, corridors, toilets etc. Such areas do not earn rental income for landlords. Therefore, adjustments would have to be made to the GFA to obtain the NLA for which rental income would be charged. While the exact adjustment would be hard to determine, I usually apply a discount of about 20% to the GFA, after all, every owner would want to maximise the NLA so I think 20% is a sufficiently conservative amount.

Now we move on to the actual valuation in terms of Earnings and Asset Value which are actually very similar.

1. Determine land area

If it is a new acquisition, this will be disclosed in the announcements. Otherwise, you can find the information in the notes of Annual Reports.

2. Find the gross floor area

To do this, you first need to know the GFA area. This information can be obtained from URA’s Master Plan. Simply search for the address of the land and it will zoom in and display its corresponding GFA ratio. Once you have that figure its simple arithmetic to find the GFA. Make the necessary adjustments and you would have your NLA.

A1

3. Average rental/price per unit area

This is usually the most challenging and the most critical part of the research. My general principle is to base it on recent transactions in the vicinity (the nearer the better).  To find such information, you can use sites like propertyguru or commercialguru which property owners use to advertise their properties for sale or rent. While this isn’t exactly a recent transaction, it does give a flavour to what the market rate is for properties in the area. However, one disadvantage is that new property launches may not use such platforms for their marketing so you may not be able to find timely information in such scenarios. There are ways around this; if you are loaded (the subscription fee isn’t cheap) you can subscribe to URA’s REALIS where you will be able to find records of all recent transactions.  Squarefoot Research is a much cheaper alternative – the free account provides sufficient information about transaction prices and there’s always the option of a paid subscription. I’m not paid to advertise for them by the way.

A2

Depending on the situation, choose the appropriate valuation method based either on rental or sale price, multiply it by the net lettable area and you will arrive at your final figure. The method of valuation depends largely on management intention – do they intend to dispose of the property to unlock shareholder value or to retain it as a source of income? In scenario A, if the company owns the land and is sitting on the premises as an office or factory space, asset value would be the way to go. In scenario B, if it is redeveloping a land and intend to rent the units out as an additional source of income, I would go with earnings.

It seems pretty straightforward at this point but it won’t always be that easy. When it comes to Asset Value, the valuation described above is based on Sale Price x Net Lettable Area.  There are times where the sale price is for per land area rather than per net lettable area depending on where you get the information from, therefore caution would have to be exercised in multiplying by the correct denominator.  In any case, I think using either would be fine as value from building (net lettable area) and land (land area) are mutually exclusive since they are just linked by the GFA ratio (for a large part).

I would like to end with a warning against converting asset value to earnings for example, in the case where a company (like a property developer) develops a condo and sells the units. Upon conversion, asset value becomes merely a top line in your income statement, so remember to account for margins.

China Residential Market

From the latest results from the National Bureau of Statistics of China, we can observe that in terms of supply of real estate, the Central Government’s policy is working. China’s real estate sector slowed in May where investments in real estate rose 14.7% during the first five months of 2014, slowing from the overall rate of 16.4% recorded during the period from January to April 2014. Furthermore, we see new construction starts decreasing 18.6% during the period of January to May compared to that of last year.

However, if one were to look deeper, the government’s policy may not be working that well. Looking at demand, we see home sales for May alone to be down 11% compared to that of last year. This translates to an 8.5% slowdown in property sales from the period of January to May 2014, compared to that of last year. Furthermore, Soufun reported earlier this month that 62% of China’s cities recording falling home prices for the month of May. A survey by China Index Academy, a unit of Soufun.com, saw average home prices dropping 0.3% in May compared to April. Furthermore, it was previously reported that only home prices in smaller towns in China saw home prices falling. However, we see home prices in first tier cities, where homes in Shanghai Commercial Centre saw prices fall by 0.4% compared to last month. Among China’s 10 largest cities, Nanjing saw the biggest drop in May of approximately 1.4% and only 2 cities recorded increases in home prices – Bejing and Tianjin.

While we see the slowdown in supply of real estate, this is partly attributable to problems developers are facing. Developers are facing the problem of tighter cash flows, where housing brokers complain about unpaid commissions.


A third of all developers that we are helping sell projects have not paid us commission fees according to the payment schedule

Director of Hopefluent Group Holdings, Fu Wai-Chung commented. The firm operates 280 branches across the Mainland, and was marketing about 600-700 property projects.


Developers are deferring their payment from 90 to 120 days as credit tightening and a decline in property sales hurt their cash flow

Furthermore, Head of Residential Sector at DTZ Greater China, Alan Chiang Sheung-Lai agreed that their company was in the same boat.


Small developers are not only the ones that owe us money, but also major players

Chairman of Centaline China’s parent Centaline Group, said. Developers owed the firm RMB1bn in unpaid commissions for this year, lifting its accounts receivable to RMB2bn. Furthermore, one such developer, Huizhou-based Guang Group had paid Centaline commissions in the form of several flats, and they had sell them at below-market prices.

Despite it all, an official from China’s think tank said that the current real estate market correction is under control and that the country’s economy is strong enough to manage its impact.


Based on our research, risks for the property market still controllable

Vice President of the China Academy of Social Sciences, Li Yang commented. Furthermore, given how the value of properties held by individuals is still much higher than their mortgage obligations, this limits the risk of panic selling.

I attended a happy hour for professionals within the real estate industry yesterday night. The surprising thing was that I actually met other professionals from other sectors such as someone from uber, the hospitality sector etc, which was really interesting. One could actually see how interconnected industries are, where I even saw someone from the carpet industry attending this social event to network with property developers. Anyway all that aside, after talking to the industry’s professionals, it is their view that it is unlikely that China would enter into a recession, where the property bubble will not have repercussions as bad as that of USA. Furthermore, the Chinese government has more fiscal might to bail companies out in the event of such a scenario. That said, I won’t be better against this from happening.