Multi-Chem's 2Q results - unexpected disappointment

Performance at first glance

While revenue and gross profit remain flat, profit plunged 183% against 2Q 2007 to end with a loss of 1,255m SGD. Given the world wide electronic slump, poor performance is expected but a loss is obviously not expected. Furthermore, Multi-Chem have two drivers of earnings, its struggling PCB drilling segment and a healthy IT security products distribution via its group of M. Tech companies (Mtechpro). The latter should have provided a cushion to the plunging profits.

A closer look

The sudden plunge in profit is actually due to a provision of bad debt, to a staggering 3m SGD (2.966m to be exact). Given that quarterly profit of Multi-Chem normally reached 1.5m, without the provision, profit could have remained flat (i.e. far from making a loss!).

The 3m of doubtful debt is attributed to 2 PCB customers in China. Given that the revenue attributed from China is 8.5m in 2Q 2008, against 8.4m in 1Q 2008 and 6.8m in 2Q 2007, the 3m in doubtful debt is indeed very significant! This brings me to wonder the risk profile of the customers Multi-Chem had OR the quality of the earnings reported in earlier quarters.

Sunshine beyond the storm?

Assuming that the provision of bad debt is a one-off "unlucky" event (I will watch this carefully, else I will issue myself another uncle warning). A look at their reported cash flow statement still show a strong cash generated from operations. So the warning light is still off, for now.

Segment review

PCB drilling

While the electronics sector is Singapore is still gloomy with no sign of recovery, the situation in China is still encouraging, at least for now. Revenue from PCB drilling in China improved 24.6% from 6.8m in 2Q 2007 to 8.5m in 2Q 2008. This includes a significant jump in revenue from laser drilling, i.e. from 0.19m in 2Q 2007 to 1.5m in 2Q 2008. Laser drilling is attributed to higher demand in handset PCBs while mechanical drilling is attributed to the automotive, computer and server PCBs.

IT security distribution

After several quarters of breakneck growth, this segment began to show signs of slowing down. However, given the fact that Mtechpro only recently expanded into India and Taiwan (and now into Australia), Mtechpro's still have many subsidiaries in their infancy. Once these centers become as matured as those in other parts of Southeast Asia, their revenue (and consequently profits) contribution to Multi-Chem will continue to augment that from PCB drilling.

Conclusion

Baring unforeseen circumstances, I am still hopeful Multi-Chem's potential is good beyond the dark clouds. Once the electronics cycle start to make a upturn some years down the road, their true potential will be shown, not forgetting the significant contribution from the Mtechpro then.

Inflation-linked bond funds, a good buy?

I read with interest an article on inflation-linked bond funds published n Sunday Times, 20th July 2008.

With inflation escalating around the world, and much higher rates closer to home in Southeast Asia, it seems like inflation threatens emerging economies here more than the prospective of a recession. For this reason, other then the traditional oil & gas and other basic resources investment theme, inflation busting vehicles are grabbing the limelight too.

Like any hot vehicles that are created at the onset of sudden interest (bubble tea & lohan fish), which mostly under performs once the interest wanes, does inflation-linked fund belong to the same category? I will like to find out.

How Inflation-linked bonds worked

In a conventional bond, a principal is fixed at inception and the borrower promised to pay a fixed interest, typically yearly or half yearly called a coupon. For an inflation-linked fund, the principal is not fixed and actually grow at the inflation rate and the interest is calculated on the adjusted principal.

For example:

Conventional 10 year bond:
Principal: $100
Interest: 5%
=> Yearly coupon is $5 and principal recovered in 10th year is $100

If inflation rate is 5%
=> Annual return = 5%
=> Real return = 0% (5 - 5)

Inflation linked 10 year bond:
Initial Principal: $100
Interest: 5%
Inflation: 10% yearly

=> (year 1): Principal becomes $110, coupon becomes $5.50 ($110 x 5%)
=> (year 2): Principal becomes $121, coupon becomes $6.05 ($121 x 5%)
...

Since inflation rate is 10%
=> Annual return = 15%
=> Real return = 5% (15 - 10)


The idea is that whatever the inflation rate, the bond holder get the promised interest rate. If I can have access to such a bond and my aim is just to protect my wealth (I'm still trying to build some wealth to protect), I will be happy to invest in one.

How Inflation-linked funds worked

Such funds aims to protect the investor's capital in times of high inflation. Thus the primary objective is to beat the inflation; generation of real returns above the inflation is secondary. To achieve that, these funds can (not exhaustive list):

• Invest in inflation-linked bonds issued by governments in the emerging economies
• Corporate inflation-linked bonds
• Utilises sophisticated finanical instruments such as derivatives, interest-rate swops and forex contracts
  

How they actually perform

According to the article, only Fidelity Global Inflation-Linked Bond fund is available to retail investor. Hence I research a little more into it. The brochure can be downloaded here and the prospectus can be downloaded here. Since it is still relatively new, no track record is stated in the prospectus. The closest clue I can find it the following prospectus from MAS's website. The compounded annualised return is actually not very fantastic, it is about 2%.

Singapore's inflation rate (year on year changes, see my other article on inflation) normally hovers below 5% and hit an abnormal high of above 20% in 1974 and 1975. Assuming Singaore's economy stablises in the last 20 years, the annual compounded inflation rate is about 1.5%. Thus, most probably, after factoring the 0.5% mangement fee and sales charge of up to 5.25%, the fund will at most break even for investors.

Conclusion

Unless I can have access to an inflation-linked bond (which I think there's almost no possibly of losing money unless the bond issuer default), I will not consider such funds.

Re-looking into REITS

The recent bearish sentiment that plagued the stock market actually opened up many opportunities for serious investor who have the capacity to take a long term view. Rational investment during such bear market market will reap respectable returns when the bull returns, even if one does not catch the bottom. Such is just a regular recurring phenomena in boom-bust cycles as I had mentioned in my earlier article. In fact, quite a number of stocks have corrected to a level not seen since 2004. Many claimed to miss the boat during the last irrational exuberance prior to Aug 2007, yet so few are willing to pick up the same stock at a fraction of the price they claimed to miss.

Tip-off from e-mail

I received an e-mail regarding my view on REITs, given the recent correction. I recall a few years back when REITs suddenly clogged the limelight for being capital protective yet delivering relatively high yields. Their prices had appreciated quite a bit and lost their attractiveness in terms of yields. With the recent sell down that plagued almost every sector, they seems to look attractive again.

Some research

On the surface, REITs seems to be simple enough to understand. Their underlying assets are buildings and their revenue are lease or rental income which, after expensing all fees and expenses, are distributed to shareholders. More on REITs and business trust in general can be found on SGX website. Comparison amongst the many REITs can be found on a very informative blog, SGX - REIT Data.

A look beneath the skin

Yields

At the price they are trading, quite a number REITs are delivering yields above 8%. The question is whether this yield is sustainable. A typical REITs will have to take on a sizable debt to purchase the land and buildings and refinance them every 2 to 3 years. Hence their interest expense are subjected to change. Lease income, on the other hand, tend to be fairly stable as many usually have long term lease contracts with the tenants. The risk to the yields are then the variable expenses for the REITs and the default risk of the tenants. Given current high rentals, it won't be surprising if a number had to vacate for lower rentals else where.

Net Asset Value

Net Asset Value (NAV), or Net Tangible Assets (NTA) less intangibles, compared to share price are usually a guage whether the stock is trading below value or not. Quite a number of REITs are already trading below their NAV. At first glance, this might seems to mean these are undervalued, but a closer look tells a different picture. The main asset of REITs are their land and buildings. Their prices can be quite sentiment driven. During property gloom (between 2002 to 2005), most property are going at depressing levels. But only after 2006, their prices started to rocket and the bubble only started to deflate recently. Thus, the NAV of REITs are just as volatile as sentimental property prices.

Risk

Given the high leverage (common also to shipping trusts) securing funding is crucial to the survivable of REITs. Thus their ratings are of paramount concern. This is the reason why Allco REIT had to go all the way to take legal action to fight a lowering of their rating by Moody. Downgrading of a rating not only jeopardizes refinancing, but also make it harder (or more expensive) to raise debt for more acquisitions.

On my watchlist

Screening through the various REITs, I have decided to place cambridge industrial REIT into my watchlist. I would not consider a purchase if the yield does not cross 12%, the minimum I desire for any investment. The attractive nature of cambridge are (quoted from its annual report):

1. Diversified industrial portfolio in many sectors, manufacturing, service & commerce etc.
2. Long term lease of 5 to 15 years
3. Strategically located properties in key industrial zones spread across Singapore
4. Built-in rental escalations to provide organic growth
   

Conclusion

While it is still too soon for me to go into REITs now, sub 10% yield is still not attractive enough, I believe this bear market is still at its infancy and hence could create more attractive opportunities in months to come. Patience are always rewarded.

I upped my stakes in Manufacturing Integration Technology on 4th July 2008

Rationale

I had just purchased more of Manufacturing Integration Technology (MITech) at 12 cents a piece. At 12 cents, this is my 2nd purchase of any net cash company trading near or below its cash balance per share. (My first is Armarda). MITech had almost NIL outstanding loans but SGD 27.3m cash & equivalents. Against last known common shares of 218.8m, its cash per share is about 12.48 cents. Hence I just got another company for free. Fortunately, its had a very strong balance sheet to ride through it without any debt to hold it down.

Prospects

SIAS research recently issued a sell call on 9th July after MITech issued a profit warning on 4th July. Against the gloomy outlook of semiconductor industry and manufacturing services in general in forseeable future, MITech will be in for a rough ride through the storm.

The two most hopeful segment for MITech is the recently acquired AMS Biomedical and Aerospace component manufacturing using the existing Shanghai precision engineering plant. As Singapore continue to push into Biomedical and related services, it is a reasonable expectation that MITech, via AMS Biomedical, can get a share of the expanding pie.

The Aerospace component manufacturing is still in the infancy. According to the latest Annual Report, management expect it to stablise in only after 2 years. Profit contribution could take longer. One positive aspect is by leveraging on existing Shanghai plant means that little capex is required.

Thus I would expect MITech to exhibit a turnaround in 3 to 5 years. Going in now might seems too early, but so long as the price is right, there's no way I can tell how the future will turn out.

Conclusion

If the share continue to trade below its cash per share, I'll be happy to buy more for free... if I had the cash :). Incidentally, the chairman is still buying, the latest annouced purchase was on 9th July 2008.

Food Empire - Uncle Warning One, Potential Shenanigan?

Rationale

My current interest in Food Empire was due to the disproportionate increase in its account receivables for the last 3 years. Thanks to fellow value investor, donmihaihai, who brought this to my attention by leaving a comment on my earlier article and contributed significantly to my follow up article on its AGM. On his advice, I picked up the book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, by Howard M. Schilit. I am nearing the end and can't wait to finish the last few chapters before re-looking into Food Empire.

Financial Performance, a re-look


A few things to note from the above, especially those highlighed in red:

1. There was a restatement in financial performance in 2004 (due to some accounting changes) and coincidentally, sales started to languish from that year.
2. Net Profit, however, held up pretty well, with a particularly huge jump in 2004.
3. Since 2004, receivable growth had been outpacing sales growth.
4. Cash generated from operations had been lagging behind net profit for all years excluding 2003.
5. Since 2006, there is a huge plunge in the percentage of cash generated from operations with respect to net profit, accounting for around 20+%.
6. Free cash flow reduced drastically since 2006, partly due to the recent acquisitions.
   

The picture becomes clearer with the following graphs:




Interpretations - Potential Implications

Account receivables outpacing sales

The fact that net profit (Pt 2 above) is holding up well usually imply that sales should be comparatively strong but that's not the case (Pt 1). To add to the confusion, account receivables growth outpaced the slowing growth in sales. In fact, account receivables to sales ratio had been increasing almost every year since 2001. My guess is that either Food Empire is more aggressive in recognising revenue or giving a more favourable credit terms to boost sales.

Real hard cash falls short of net profit

Cash from operations (cash flow statement) is a fraction of net income (Pt 4 & 5). This is something rare in other companies in my portfolio. To me, its seems to confirm there's some sort of aggressive accounting here. Its pretty fine when cash flow from operations sometimes dip below net profit, but not all the time! What's alarming for Food Empire is that its cash flow from operations is only 20 odd percent of its reported net profit. It really bring one to wonder the quality of its reported earnings!

The larger number items that cause the reduction in cash flow from operations compared to net profit is usually:

1. Increase in receivables (under working capital changes)
2. Increase in inventories (under working capital changes)

Both of which are not a good sign for a company claiming outstanding financial performance.

Negative Free Cash Flow

Free Cash Flow (FCF) turned negative since 2006, partly due to recent acquisitions, e.g. Petrovskaya Sloboda brand. Negative FCF is not necessary a bad thing, if it's due to huge investment which can imply improved future returns. But for Food Empire, the negative FCF is due to plunging cash from operations and acquisitions (investment), hence another sign of concern.

Changing of reporting currency

With effect from FY 2008, Food Empire begun using USD as the reporting currency. Even though the reported reason for this (quoted from 1Q 2008 quarter report) was to better reflect the Groups' results as majority of its transactions are in US dollars, I would think the underlying reason should be due to the depreciating USD against SGD.

USD transaction had been dominating Food Empire's business for many years, why the change now? Using SGD will paint a even more deteriorating picture, not something pleasant. Already in the published, unaudited FY 2007 results, it was mentioned (quoted):

... Currency fluctuations affected the Group’s results as the vast majority of its transactions are in US dollars while its reporting currency is in Singapore dollars. If the Group’s performance were reported in US dollars, revenue would have increased by 25.5% (unaudited) and profit after tax and minority interests would have risen by 24.8% (unaudited) ...


It seemed to me that the reporting currency would be chosen based one whichever painted a nicer picture. (USD used to be relatively strong right up to 2006, so no incentive to change the reporting currency). I would be please if the good results are due to operational performance, but not due to 'better packaging'.


Comparing with Super Coffeemix, Tsit Wing and Viz Brandz

Super Coffeemix's cash from operations began to dip below net profit since 2006 while that for Tsit Wing was always way above net profit. Food Empire and Super Coffeemix shared one thing in common, both displayed specular growth story (in terms of sales and profit) in the double digits while Tsit Wing languished in the single digits.

However, it might be unfair to compare this way because Food Empire and Super Coffeemix sold to consumers while Tsit Wing sold to retailers, bistros etc. i.e. They operate with different models.

To further quash my doubts, I looked at Viz Brandz. It also sold to consumer (like Super Coffeemix and Food Empire) but had cash flow from operations exceeding net profit. However, it also show signs of preceding the two:

1. FY 2007 sales improved 18% to 137.9m from 117.2m for FY 2006
   
2. FY 2007 profit improved nearly 6 times to 9.213m from 1.627m for FY 2006.
   
3. Cash flow from operations only improved marginally to 11.5m from 12.9m
4. Account receivables jumped 33.7%
   

Seems like the genetics for growth are the same of coffee businesses?

In Conclusion

I would say the numbers Food Empire (possibly Super Coffeemix too) churned out are a cause of concern, but not a red flag yet. Anyway, I would monitor future announcements and results closely, and wait for my chance to quiz the management again in the next AGM or EGM, which ever earlier, and decide my next course of action from there, no hurry... yet.