Multi-Chem, butterfly in a cocoon?

I read with interest the latest company report posted by DMG & Partners Securities.

As with many previous reports on Multi-Chem by other firms, it focused on its PCB Drilling business and choose to ignore (or unaware???) its growing & lucrative IT Security Products distribution business.

Declining Margins

Multi-Chem have 3 business units, PCB Drilling, PCB Chemical distribution and IT Security Products distribution, via subsidiaries under the M.Tech umbrella. Of these, PCB Drilling garner the highest (though declining) profit margin, in the 20+%; PCB Chemical distribution is lost making; and IT Security Products distribution make do with around 8% margin due to limited value it can add.

IT Security products distribution business unit is currently growing as recent expansion effort pays off and regional centres start to contribute to the bottom line. However, by virtue of low profit margin, tremendous increase in revenue in this segment is required in order to match the profit contributed by the PCB drilling segment. Thus it is a normal consequence that as this segment continue its specular growth, profit margin for Multi-Chem, in general will decline.

But the report choose to view it negatively (quoted as follows):

... On the surface. Multi-Chem saw 1Q08 earnings jump 40% from S$1.7m to S$2.4m while revenue increased by 21% from S$28.4m to S$34.3m. While this may seem impressive at first glance, we note that margins have generally fallen across the board as sales growth in the Distribution segment (which commands lower margins) had exceeded that of its Manufacturing segment. ...

Segment Performance

In order to see the big picture, I consolidated the segment performance from 1Q 2006 to 1Q 2008 as shown below (click to enlarge):

The numbers

A few comments on the above table:

1. I compile the above table using quarter (unaudited) results from 1Q 2006 to 1Q 2008.
2. Using segment results found in 2006 & 2007 annual reports, I estimated the operating profit margin for each business unit (see bottom of the table).
3. From the estimated operating profit for each segment, I estimate a total operating profit before interest and tax (EBIT). (The reason I use EBIT is because segmental results given in footnotes of annual reports are normally EBITs. And I'm using it to estimate operating profit margins)
4. Contrast the estimated total with the actual reported operating profits. The discrepancies arises mainly due to assumption of constant operating profit margin and loss making PCB chemical distribution unit.
   

Revenue trend

Picture speaks a thousand words, the following is the chart showing the revenue trend contributed from each segment from 1Q 2006 to 1Q 2008. (click to enlarge):

A few comments on the above chart:

1. Notice that revenue contributed from the IT Security Products Distribution segment already surpass that from PCB Drilling since 4Q 2006.
2. Whereas PCB Drilling segment is highly dependent on the electronics cycle and showing signs of slowing down, IT Security Products Distribution is generally fast growing.
   

Estimated Operating Profit trend

The following is the chart showing the estimated operating profits from each segment and the overall reported operating profit from 1Q 2006 to 1Q 2008. (click to enlarge):

A few comments on the above chart:

1. Notice that the profit contribution from the IT Security Product Distribution segment is rising and I will expect this to catch up with the PCB Distribution segment in the coming few quarters, especially when the PCB drilling business slows down further.
   
2. My estimate of the operating profits deviate quite badly from the actual results. Nonetheless, the overall operating profits amplify the underlying trend in the PCB Drilling.
3. Going forward, as the profits from IT Security Products become more significant, it will tame the wild swings in overall operating profits.
   

Butterfly in a cocoon?

Multi-Chem started out as a PCB Driller. Given the entrenched reputation, it is not surprising many still see it and classify it under "manufacturing - tech". How long it will take shake of this biased image will depend on whether IT security segment can sustain its growth and performance. As far as the latter is concerned, I have reasons to have faith (I work in IT Security Sector):

1. IT Security products sells on fear and awareness.
2. As businesses grow, the need to protect and ensure business continuity grows
3. Malicious attackers (Black hats) and security defenders (White hats) are in constant cat and mouse chase. There are no media reports about defenders thwarting any attack, but new successful virus or worms attacks get reported and free publicity.
   
4. All these merely drive up the demand for IT security products in emerging markets like Southeast Asia, China and India.
5. While Multi-Chem is not the only one operating in the market, it is the only one listed on SGX that I can purchase.
   

In short, it is a butterfly stuck in an ugly cocoon. When the "time" is right, it will most probably be noticed when the butterfly emerges. However one thing I am sure, as the chinese saying goes 人无千日好，花无百日红。(no man is good for a thousand days, no flower blooms for a hundred days) , I will most probably disposed it when its IT Security segment get noticed.

Forex Gains

A few words on Multi-Chem forex position that I failed to notice if I had not read the report by DMG & Partners Securities.

The following chart shows all the receivables, payables and debt in various currencies (taken from FY2006 and FY2007 annual reports):


A few comments on the above table (click to enlarge):

1. Despite its growing IT Security Products distribution segment, it is still a high capital expenditure (capex) company due to its PCB Drilling business.
2. Accounts receivables: Chinese renminbi have been slowly appreciating, and yet there are still many voices calling for chinese renminbi to appreciate even further, hence having it dominating the accounts receivables (52.7%) will result in positive forex gain for Multi-Chem, because they would collect more than what they initially expected.
   
3. Accounts payables: USD accounts for the majority, 36.89%. Due to the current ongoing USD devaluation (no foreseeable respite unless US can get its economy back its on feet again, surely but not so soon), the USD portion will also results in positive forex gain, because they would pay less than what they initially expected.
4. Bank borrowings: The debt incurred is significant. Fortunately, bank borrowings are dominated in USD. Thus the debt (USD portion) is actually "shrinking" because USD devalues faster (>10% p.a) than the interest rate (~6.5%).
5. Due to global economic and political climate (in US and China especially), the forex gains enjoyed by Multi-Chem will be a recurring affair for many quarters to come.
   

Conclusion

Going foward, while small kinks in profits are inevitable, I would think Multi-Chem should enjoy good performance by virtue of its IT Security Products distribution, provided its PCB Drilling business does not burnt more cash in capital expenditure. The former is its sole cash cow now.

While Multi-Chem does not rely on it, the forex gain it enjoy with continued USD devaluation and Chinese Renminbi appreciation will just be an extra shot in the arm for many quarters to come.