Multi-Chem's Annoucement to purchase drilling equipemnt on 10th Aug 2007

The facts

Just when I thought Multi-Chem's most promising segment- IT distribution segment was fast catching up with its disappointing PCB drilling segment, Multi-Chem dropped another bomb shell by announcing another capital expenditure- to purchase more drilling machines.

The addition of these machines is expected to increase mechanical drilling capacity by 30% and laser drilling capacity by 200%.

The reason they give

1) The capital expenditure to purchase the machines is prompted by the demand from "certain key customers".

2) Based on "indications from customers, the demand for outsourced services is expected to remain strong till end of the year".

My concerns

1) If the key customers stopped outsourcing contracts to Multi-Chem, Multi-Chem will be left with over capacity.

2) They take up mammoth loans just to satisfy certain key customers. Isn't these too much risk to take?

3) Aren't there avenues to mitigate such risk, e.g. leasing instead or buying the machines? Though the margin will be lower, the risk of being left with over capacity if the demand plunge in these cyclical business will hence be much lower.

The impact

Other than the perceived contributions to earnings and net tangible assets, the following are the immediate consequences of taking the mammoth loan.

1) As at June 2007, Multi-Chem has current borrowings of 17.4m and 15.6m of long term borrowings. Finance expense was 0.619m for 3 months ended June 2007. Assuming interest at 1.8% per quarter ~ 0.619/(17.4+15.6), taking another 14.5m USD (multi-chem has neligible "internal resources" compared to 14.5m) implies another 0.27m SGD of interest per quarter. This sums up nearly 0.9m per quarter of interest! With net earnings coming in at only 1.5m in Q2, a further increase of 0.27m in interest expense will amplify any deterioration in earnings in coming quarters.

2) The current global (US + Europe + Japan) liquidity crisis that arose from subprime issue in US might result in higher interest rates ahead. Hence interest expense might even be higher than the estimated 0.27m.

My view

I originally hope the company can turned around in 2Q 2008 with the help of its IT distribution segment (by then, its profit contribution alone could have touched 3m. Multi-chem's best quarter was 4m in earnings).

However, factoring the new capital expenditure, if demand and the consequential earning contribution are lower than expected, the turn around will be as late as 2009 or beyond, bearing more capital expenditure from the company. I'm no longer that optimistic.