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.

Multi-chem, ready to unlock its potential for shareholders?

History

I wrote about Multi-chem about 2 years ago, highlighting the 2 main businesses it is involved, PCB drilling and IT security products distribution. More know about Multi-chem as a PCB driller than its IT segment. Hence, in most reports, it is classified as"manufacturing"

PCB drilling is highly lucrative (from the profit margin point of view) but requires high capital expenditure and suffers from the cyclical nature of the electronics business. IT security distribution business is fast gaining ground but due to its low profit margin nature, it requires a huge gain in revenue before it can match the profit of the PCB drilling segment in absolute terms. Given the robost growth and current market demand for IT security products and services, there is no reason why the profit contributed by the IT segment cannot match that from the PCB drilling any time soon. The true potential of Multi-chem, lies not in its PCB drilling business, but in its IT distribution business.

Good business, low market valuation?

Since the market perception of Multi-chem is centered upon its PCB drilling business, it is no wonder

• still trading slightly below book value
• had a P/E below 5 and
• ROE above 20%.

The litmus test for being undervalue is positive. A more in depth valuation give about 52 cents in my first post on it.

Unlocking its potential for shareholders?

In an annual web based Q & A with shareholders, the management mentioned the following in response to a question on the company's roadmap for it PCB and IT segment. The company's reply is quoted below:

The Company will continue to develop both businesses but will look to spin off the IT business as a separate listing in the future to unlock the value of the business.

If the above can be implemented, the potential returns for shareholders already vested in the company should be substantial. Hopefully, my long wait on Multi-chem is worth while after all.

Multi-Chem 3Q results on 30th October 2007 - Mixed results

Heartening results
Overall profit finally improved 37% quarter on quarter even though overall profit for first 9 months still lagged last year by 19%, due to poor Q1 and Q2 results.

Drilling Business
The better results was contributed mainly by its stunning growth in drilling services in PRC while Singapore posted only marginal growth.

3Q 2006 - 3Q 2007
12.6m - 16.9m --- 34.2%

2Q 2007 - 3Q 2007
11.4m - 16.9m --- 48.5%

IT distribution
After several quarters of record growth in revenue, 3Q 2007 shows signs of slowing down.

3Q 2006 - 3Q 2007
11.9m - 20.5m --- 72.2%

2Q 2007 - 3Q 2007
21.8m - 20.5m --- (5.8%)

But...
Referring to my earlier post on 2Q 2007 results, the unexpected slow down in IT segment might derail the target of 42.9m revenue required to match the earnings contributed from the drilling segment within 2 quarters, i.e. 1Q 2008. Bearing further slow down in this segment, I'm cautiously optimistic that revenue could only hit 42.9m by end of 2008.

Risk
Multi-chem's has tremendous resources tied up in the capital intensive drilling business segments. Its high operating leverage nature works to its favour when all the machines are ultilised, resulting in better profit margin from increasing economy of scale.

However, due to cyclical nature of drilling business, it is inevitable to encounter down cycles. When that happens, machine utilisation rate may fall so low that this segment starts to incur losses due to the high fix cost.

Thus I can only hope its IT segment can grow quickly to match the earnings from the drilling segment in order to stablise future earnings.

Going forward
Bearing unforeseen slow down in both major business segments, drilling and IT distribution, I am hopeful that 2008 will be a good year for multi-chem.

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.

Multi-Chem 2Q results on 25th July 2007

Bad results...
As expected from the current electronics slump, profit attributed to shareholders tumbled another 49%. This is the 3rd decline in 3 running quarters.

But...
Fortunately, the entire picture painted by Multi-chem is not all dark and gloomy. Its IT distribution segment continue to grow specularly, on track to be its saviour in years to come.

Reading between the lines...
Its IT distribution segment revenue (selling and supporting IT security products) grow from 12.2m in 4Q 2006 to 21.8m in current quarter, 2Q 2007:

• 4Q 2006: 12.2m
• 1Q 2007: 16.2m +32.7%
• 2Q 2007: 21.8m +34.5%

...

PCB segment contributed about 76.1% of the earnings for financial year 2006 which was a good year. Quarterly earnings was about 4m and thus PCB contributed about 3m. In order for the IT distribution to match this 3m, the revenue will have to grow to 42.9m per quarter (Traditionally, the IT distribution business operating margin is about 7 to 8% before tax)

Thus, assuming revenue growth of IT segment to maintain at 30% and margin to remain at 7%, it will take at least 3 quarters for the IT segment to match the PCB earnings in their best quarter, and hence maintain Multi-chem's overall earnings per quarter at 4m.

Expectation
Hence I expect to see earnings improve significantly by 1Q 2008 or latest 2Q 2008. Looking at it another way, I have 3 more quarters of bad results to load up more after each results announcement. Time to queue for more tomorrow.

Multi-Chem‘s Joint Venture in India, 11th May 2007

Multi-chem's IT distribution arm, M.Tech is its only hope for Multi-chem when its other dominant business segment, PCB drilling, is struggling due the current electronics slump.

I am thus delighted to see that it managed to form a deal to venture into India via a new Joint Venture between Multi-Chem's wholly-owned subsidiary, SecureOneAsia Pte. Ltd. ("SOA") and Virtual Netcomm Pvt Ltd ("VNPL"), the sole distributor of Blue Coat (www.bluecoat.com) products in India. VNPL, wholly owned by Mr Rajendra Shah ("RS") is headquartered in Ahmadabad and has offices in Bangalore, Delhi and Mumbai.

Under the terms of the JV agreement, a new company, to be known as M.Tech-Virtual India Pvt Ltd ("MTIN"), with SOA and RS owning 51% and 49% respectively.

Most importantly, to carry the business strategy that made M.Tech a success, MTIN will also be principally engaged in the distribution of IT products, primarily the best-of-breed IT security products other than Blue Coat. Interesting to note, to avoid any conflict of interest, RS has undertaken that first right of refusal of any products VNPL wishes to take up has to be given to MTIN. I presume this last statement to mean that MTIN can choose to carry products while denying VNPL the right to do so. I will raise this question again in the next AGM or Q & N after the full year results, both scheduled for next year, first quarter 2008.

The joint venture thus extends the reach of M.Tech westwards into India and once fully operational, M.Tech will have a network of 15 offices in 9 countries across Asia. From Singapore, M.Tech extended its market penetration to other parts of Southeast Asia, e.g Indonesia, Malaysia, Thailand, then to China and now into India.

Though the management stated the joint venture will not impact this year's financial results, I believe it will positively lift up the earnings once the MTIN goes into operations and profit can be recognised. I will find out the estimated schedule in the next AGM or Q & N after the full year results too.

Fortunately the expected poor performance of the PCB drilling segment had been clouding the good prospects of IT security product distribution segment to result in low share price (last traded at 22.5 SGD cents at 18th May 2007). Thus I could snap up more of Multi-chem with my combined retirement fund I just setup with my wife (wholly managed by me).

Multi-Chem 1Q results on 27th April 2007

Profit tumbled by nearly 60% due to slow down in PCB drilling & routing demand in Singapore and China. I almost fainted when I see that. But on closer look at the financial statement, I was relieved to learn that its IT distribution grew more than 87.4 % this quarter, 1Q 2007 compared to the same quarter last year 1Q 2006 and 33% compared to 4Q 2006.

Thus, Multi-Chem's IT distribution business was still on track to smoothen out the cyclical earnings of its PCB drilling and routing business. I am still confident that its IT distribution business will continue maintain a strong growth in the next 2 years.

December 2006, I bought Multi-Chem

The disappointing performance of Surface Mount Technology highlighted the cyclical nature of manufacturing industry, especially for those without clear competitive advantage in a competitive market. Thus I normally do not take interest in companies in the manufacturing sector while shopping for bargains.

However, Multi-Chem caught my attention while I was stock screening based on profit margin and ROE. During stock shopping, I would quantitatively make a first cut selection of stocks, qualitatively assess its business and if these 2 test were passed, I would then make a more thorough quantitative forecast to determine its intrinsic value with my spread sheet program.

Multi-Chem had 3 business segments:

1. PCB Drilling and routing
2. Distribution of speciality chemicals and other PCB related products.
3. Distribution of IT security products

1 and 3 were the its main revenue contributor while 2 was getting less significant with time. I was particularly attracted to its business of distributing IT security products.

Multi-chem conducts distribution of IT security products via an almost entirely owned subsidiary called M.tech. Their business strategy was to carry only the leading IT security products (e.g. Nokia, Tipping point, Check Point) and regularly conducts courses, seminars with product vendors to raise IT security awareness. The end result was growth in sales quarter after quarter. M.tech also formed strategic partnerships with these vendors and Nokia even gave it exclusive distribution rights.

Though PCB drilling and routing was cyclical in nature, IT distribution business enabled it to smoothen out any possible dip in earnings should electronics demand go down in foreseeable future.

I worked in the IT security industry, I knew the recent interest in IT security amongst business would work in favour of M.Tech, (and hence Multi-chem).

However, things were not all rosy. From the segmental information given in the Annual report, I found out that revenue due to IT distribution rose more than 50% year on year, making it comparable to revenue from PCB drilling and routing. Yet, the profit IT distribution brings in accounted for only a quarter of that from PCB drilling and routing. The much lower profit margin from IT distribution business meant that this segment would had to grow to 4 times that of PCB drilling and routing in terms of sales to even out the company earnings. Even if IT distribution business could grow at 40% per year, it would take it at least 4 years to deliver the profits PCB drilling and routing brings in now.

Bearing any down turn in electronics demand and assuming continue good growth in IT security products distribution, I estimated Multi-chem's intrinsic value to be about 52 cents, with cost of capital at 10%.