## Friday, August 27, 2010

### DCF Valuation Explained - A Little

Say, someone was to sell you a vending machine. It is placed at a strategic place where it could consistently earns him RM1000 per year and is expected to increase at a rate of 5% each year. It has a lifespan that could last for another 5 years. How much would you pay for it?

This is where Discounted Cash Flow Valuation comes into play. That RM1000 is the net cash which is the coins you collected from the machine minus the maintenance cost....and so on. That is the amount of cash that goes into your pocket. And it is expected to grow at the rate of 5% for the next 5 years. So your free cash flow table would look like this:

If you sum it all up it is about RM6802. And if that person quote you this price, you can ask him to go to......well whatever you prefer. I bet most of you know there is a time value in money. RM1276 in 2015 does worth RM1276 today and the same goes the other way round. (Just like you char kueh teow. You use to buy it for RM3 5 years ago but now it is RM3.50). That is why the bank charges you interest when you borrow money from bank. And that's also why you need a discount.

So, what rate should you use? Let's go back to the bank. A bank charges interest at rate say 6% on loan because it thinks it can earns 6% if it has not lend you the money and invested it somewhere else instead. So, the bank thinks 6% is its opportunity lost and you will have to pay 6% extra when you return the money. Welcome to the world of capitalism. So for you, you are pretty sure the next RM1050 will arrive a year later and so on. By receiving the cash late, you have lost the opportunity to invest in something for a better return then you put a discount. The question is how much you more think you could earn elsewhere? That will determine your rate. You can use FD rate, EPF, or bonds you are able to purchase one. Let's just use 5.5% (roughly the average EPF dividend) for this. Your discounted cash flow table will now looks like this:

The one on the right most column is what those money worth today - for you. So you add it all up, and you'll get RM6299. That is the fair value for this machine. But it doesn't end here because you are not 100% sure you are able to get 5% return every year. So you need a margin of safety but what is the best rate? Any number that can make you sleep well at night. If you take 20%, RM5039 is the maximum amount that you will pay. Simple huh?

How bout for business then? The idea is the same, just that a little more homework is needed. You can try visit this wikipedia page about DCF; http://en.wikipedia.org/wiki/Discounted_cash_flow. Looks complicated huh? Forget about the mathematics, just click on the picture on the top right hand corner to enlarge it. It pretty much explains everything. A picture worth a thousand words ma.

Investing is a simple art but not easy. The trick here is to pluck in those numbers onto that table from left to right. What is the right number then? There is no right number, just numbers that make sense. Yea, you'll have to guess, assume or maybe just pluck from the air which ever makes sense to you. Whichever number that could make you sleep at night or more importantly makes you able to make DESICION.

DCF calculations can be explained in a few Greek letters. Since Greek can be difficult to understand at times, I'll try to explain in Manglish.
WARNING: You might fall asleep while reading this.

First thing you'll see is EBITDA. This earnings after you minus cost of sales and SGA expenses from revenue. The difficult part is to guess the future revenue. Okay la, forecast la..not guess. You can use historical earnings or growth consistent enough. Normally I use this for mature businesses. Or you can visit reuters.com, use the industrial average growth or S&P500 average growth to forecast its revenue. These are the average growth, value investor normally picks above average businesses. If the business consistently outperform the average results, you can be pretty safe using the average forecast. Will you undervalued a business if you do this? Yes you might.But what is the worst that can happen? You'll miss the boat. But remember Rule No.1 and No.2. Or if you are Buffett or Teng Boo, meet the management for forecast adn ask them to convince you how they come up with the number. Yes, if you read his letters, that's what he did. As for cost of sales and SGA expenses, consistency is the key. If the ratio for all these aren't consistent, chances are, you are looking at a company in a very competitive industry. So, you might consider to skip it.

And then you minus the capex, changes of working capital, taxes and whatever cash outflow that is relevant to the business. For these, I don't really have any guide to follow, they all depends on the business really or how they operate. To be comfortable, check all the announcements including pre-IPO plan see if there is any plan especially for Capex or talk to the IR see how the business works. If you are bit lazy, just use the average. That of course comes with higher risk lo. There you'll get the DFCF for the next few years.

That's for the first part. For the second, you'll try to get the terminal value. Market will eventually gets saturated. So growth are now limited. Or if not, competitors may arrive to have a slice of the pie. For this, free cash flow growth is lower than the discount for the terminal value equation to work. If you can't understand the equation, nevermind. It is basically like this. If growth < discount, you'll see or future FCF decreasing BUT leh, it'll never reach zero until it gets brankrupt or the end of the world. So you can see that it is converging. What this formula does is to add up all the numbers until the convergence that never happens. Confused? Nevermind, that's calculus. So just use the formula.

Now you have two numbers. Add them up and you'll get the fair value. Apply some margin of safety to it. And there you have it. Tada!

This is just the quantitative side of a valuation.

Sun Tzu: "Attack only when you know you are winning"

## Thursday, August 26, 2010

### Another Buffett's Lesson

Found this interview from Motley Fool UK. Prem Jain is the author of the book, Buffett Beyond Value.

These are some key important takeaways from the interview:

• Ensure that the downside risk of an investment is extremely low. A classic investment rule "Rule No.1, don't lose money; Rule No.2, don't forget Rule No.1"
• A company's profitability has to be sustainable and has a business economics for possible growth. Talking about business predictability
• Track record, cost consciousness, ROE and integrity are all important criterion when you look at the management. This is to ensure the management not just grow the shareholders value but most important of all, don't destroy it.
Okay, all these advices sounds simple but they aren't easy to do. If being Buffett was so easy, everyone would have achieve a result like him. But it is NOT impossible.

I bet if you read any book about Buffett or even his letters to shareholders, they are all gonna be the same.

## Tuesday, August 17, 2010

### The Good: Kawan Food Berhad

Just had a pretty informative day last Saturday from Tan Teng Boo's Investor Day; though he didn't presented much as mostly are done by his - I guess students. Anyway is quite good. For those who went there and who have heard about the Malaysia's economics outlook and got freak out, I have something that might interest you here. For those who haven't, I wish I could get the data one day to show you where we are and where we are heading.

For those who plan to sell all their Malaysian shares tomorrow or plan to own some companies with business which have more international exposure, Kawan Food Bhd might interest you. Established in 1977 under the name of Kim Guan Trading Co, it started as a supplier of pastry products kulit popiah and kuih bakul to local groceries and supermarket. The founder Gan Thiam Chai and Gan Thiam Hock don't seem to have much to do with its companies name. Today, it has grow into manufacturing and sale of frozen food products such as spring roll pastries, wanton and dumpling pastries, glutinous rice balls, stuffed pancakes, rolls, buns and loaves, pita breads, frieds, wedges and veggies, sauces, curries and mantou, among others mostly under the name of "Kawan" and "KG Pastry". About 60.5% of its sales are derived from international sales and majority of them come from North America.

Sales Distribution Chart FY2009

Sales Chart

As we can see from the sales chart above, sales across continent except South Africa have seen a double digit annual growth over the past 5 years. And as for FY2009, they have yet to penetrate into China's market in the Asian segment - although I wasn't quite sure how well roti praathas will be accepted in China.

Products and Brands
Kawan - Mostly West Asian foods such as roti praathas, naan, etc
KG Pastry - Oriental East Asian foods such as man tou, rice dumpling, etc
Veat - The goreng-goreng stuff
Kayangan Manisan - Chinese kuih such as Ang Ku, Multi-layered cake etc
I did try one of their man tou the other day. Hey, there are quite good. Really soft and yea, as they claimed, taste is consistent. And also, "just like handmade" if not better than most - really

Fundamentals
Non of Kawan Food direct competitors are listed on Bursa so I can't get much of their information. Anyway they do look quite strong with gross profit margin of 37%-43%. Although there is a question of how much they are able to adjust their prices to inflationary pressure because the rise of wheat flour prices does seem to have eaten their margin a little.

And if we were to take 2005 sales off, their sales growth from 2006 to 2009 is at the CAGR of 18.6% and net operating profits grow 20.9% annually. The rise of wheat flour prices is felt at the bottom line as well when  operating profit margin is squeezed to 15% and 16%.

Liquidity wise, Kawan Food should have no problem servicing its short term debts and historically they have been quite prudent.

They are able to turn their inventories into sales in a month or two. Receivables are collected in less than 3 months. So they are doing okay here.

Kawan Food 5 years average ROE has been above industrial average at 15.3% and pretty much above most of the food manufacturers in the country. This could be down to the strong demand for their products and effective management.

Locally, Kawan Food does everything by itself from manufacturing, to packaging, to sales and up until distribution. All that to ensure the quality and freshness of their products as it is pretty sensitive to temperature.  However, their exports are handle by third party local distributors.

With 60% of its sales come from exports, I think this is what we call an international company. Although I'm not quite sure how well our Malaysian foods are accepted by the foreigners and I don't think they have reach Mat Salleh either. Most exports sales are contributed by the Asian communities living in those countries particularly the Indians as foods that are sold under the brand of Kawan bare their origin from India. Currently, Kawan Foods product are only sold in local convenient stores and yet to reach the likes Tesco or Carrefour supermarkets. So there are some room for growth over there given the Indian populations are the second largest in the world and like the Chinese, they are everywhere - mostly in UK, US and Canada.

The group has set its priority to develop its market in China. Foods will be manufactured in Nantong which has become the subsidiaries of Kawan Food (HK) Ltd for tax saving purposes. I'm not sure if they'll sell roti praathas there - perhaps try to carve a niche market. Selling Chinese kind of food might put them into heavy competition. Like, what I've said many time, China's market are huge but so as the competitions. But does that means we shouldn't enter the Chinese's market at all? No no. In fact, we should. It is an ocean full of sharks. But that doesn't mean there are sharks in every part of a sea. They just have to find their way through. Perhaps they could just make friend with those sharks. Kawan mah...

What I like about Kawan Food is their continuous investment into R&D and automation of their manufacturing facilities. These investments have not just improve the quality and consistency of their products but it could be more cost efficient as well. Besides, they are making high value job opportunities which are badly needed by the country. If only there are applicants for such job.

Some might argue, it is still quite cumbersome to defrost, reheat and makan for a lazy people like me. Personally I still do prefer to go mamak stall to have my roti canai together with my Milo kosong panas (if they ever listen) which they charge more than RM1.50 per cup. Yes Bandaran, they still do that. But...we can't deny not just Malaysian, people are more health conscious nowadays. Sorry la, macha...but continue to make good food still ya. So, there are definitely people who still prefer to less oil or less "reusable" oil in their food.

Substitute? Instant mee? Hey, those rotis are substitute for instant noodle as well la. Trust me, I've been through that. You are not going to eat instant noodle 4 days straight. You'll get "mual" after some time. And I think of rotis when I feel tired of all these instant noodles. That's me la....

Valuation
For this valuation, I've make an assumption or guesstimate as below for 5 years average:
Revenue: I take the industrial average growth from Reuters at 6%
Cost of Sales is 60% of sales
SGA expenses will be at 25% of revenue
Depreciation roughly about RM3.8million all year
For Capex, I assume about RM7million 5 years average factoring the facilities in Nantong and assuming no new facilities to be build.
Income tax is at 25%
Discount is at 10%

With 20% margin of safety, Kawan Food is fair valued at RM0.98. So, I guess it is pretty expensive for me now.

## Friday, August 13, 2010

### The Great: Hai-O Enterprise Bhd

Well, I have been working to get some conservative valuation on Hai-O, which has taken a heavy beating losing 32% of their market value ever since hitting the heights at RM4.93 to RM3.34 (yesterday closing price). I remember a guy asked me is it time to accumulate this stock?

Well, before I come to that lets have a recap on what make the market suddenly turn bearish. I'm not really that good looking at charts or graph but I don't really see there are smart money "cooking up" or playing around with stock by looking at the volume - apart on the period when the stock splits which somehow excite ....people. Yea, and also the point where support seems to have broken. In fact, I told my friend the other day when it stucked around RM3.40 that my "crystal ball" the price going to drop further. So, I am a good gypsy - with an accuracy rate of what........1/10 maybe.

Anyway, what I say is, the current price drop is likely due to investors concern about its business. So if the market if so efficient, there must be something wrong with the business. I can basically categorize their business into, wholesale and retailing, MLM, energy-thing and the rest which are so-so and not so large. To cut long story short, retailing is doing well and that normally means wholesale is doing well. That heat transfer (or if don't understand energy-thingy) is promising. The rest are the rest. MLM...no so good. So the worry must be the MLM which contributes more than 80% of its sales. All these due to Hai-O pro active measures to restructure its MLM segment to comply with the new DSA ammendment which sounds something like this:

(a) Presentation of scheme not to be misleading
(i) In the presentation of the direct sales scheme, a person who carries on any direct sales business shall not mislead participants by overemphasizing on disproportionately high bonus or bonus payout.
(ii) Each participants shall be provided with sales kit that includes the marketing plan and code of conduct of the company.
(b) Payment of incentives
Any person who carries on a direct sales business shall provided an incentive based on the volume or quantity of goods or services sold or distributed by each participant and not based on recruitment of persons into the scheme
(c) Participants not to purchase goods or services in an unreasonable amount Each participants is required to purchase goods or service in an amount that can be expected to be resold or consumed within a reasonable period of time.
(d) Agreement (i) Any person who carries on any direct sales business shall provide each participant with a
written contract or statement which described the material term of the agreement.
(ii) The agreement shall provide the following:
a. The participant shall be given not less than ten working days from the date of the
recruitment to cancel his membership (Cooling Of Period);
b. Upon the cancellation of his membership under Paragraph ‘a' the participants shall be
refunded all of payment as specified in the agreement; and
c. At the request of the participant, a person who carries on any direct business shall buy
pack any marketable goods sold to the participant with the previous six months at the
price not less than ninety percent of the amount paid. (Company must have a buy back
policy).
d. Any person who contravenes or fails to comply with any provision of these regulation
commits an offence.

I've taken a look at their MLM business model. They should have no problem with (a) and (b). But clause (c) might give them a little trouble as I know there are member who purchase big loads of stocks...just Google Hai-O Marketing. Clause (d) is the one that is likely impact the earnings and in fact not just Hai-O but all other MLMs that operate in Malaysia.

I take the same view as their management or I shouldn't say that because no matter how many times any one of us calls or email their IR, they are always bullish. But, yea, I have to agree with RHB who somehow seems always bullish as well. Yes, there will be an negative impact on the shorter term but look at the longer term and what (d) could do on the longer term. You'll get quality products + committed members (no one shouting scam...hopefully) = sustainable growth.

Gosh, you gotta love the market don't you if you invest long-term don't ya. Chances are, business "hiccup" or "below expectation" performance are likely to happen within that period. Remember how excited the experts were few months back? And now how depress they look?
Well, I use 3 scenarios. Since the main contributor for Hai-O is from their MLM business - as for now, I take the average industry sales growth rate of 5% (got this by searching Amway on Reuters).

Scenario 1
All variables are the same as my previous valuation except I take a more conservative approach by using industry average for sales growth at 5% for the next 5 years. It'll show me RM5.15. Too optimistic?

Scenario 2
Sales take a EXTREMELY bad hit next financial year, sales drop by 50% by growing back to 5% CAGR next 4 years. I get RM3.50. Hmmmm.........

Scenario 3
If you are a bit speculative, maybe you can try wait for the next quarter report which is going to out soon and hope it turns out badly so that you can buy it even cheaper. Anyway, those investment bankers are "predicting" a bad one for the coming 2 quarter.

1, 2, 3...which one? So fickle minded one. If you ask me, I'll just say it is a good price.

This comment is based on my personal thoughts, opinions and my risk tolerance. It should not be considered as an investment advise. Please consult your financial advisor or do some research of your own before making any decision. You might have your own thoughts. I would love to here from you. You can always place your comments here and or email me privately atluzeeker@gmail.com

## Sunday, August 8, 2010

### What the Heck is a 'Super Stress Test'?

I've been getting some question about what is a 'super stress test'. Well, you won't find this in books it is just a ratio I come out with. That is why the name sounds a bit weird.

In a normal liquid test, we use (Current Assets-Inventories):Current Liabilities to test the liquidity of a company. The logic behind this as what Buffett has mention before, inventories can't be taken as a liquid asset as it is difficult to turn inventories into cash in the case of emergency and definitely not within a day or 2. Even if a company manages to turn them into cash, it might be well below its current value written in the balance sheet because if this were to happen, the company becomes a desperate seller.

So how about 'super stress test'? This test exclude another element, Trade Receivables, where liquid assets become Current Assets-Inventories-Receivables or just Cash & Equivalent. Okay, this is an extreme case and it is not really relevant to most product based companies. However it is more applicable to project based companies or a company who has less diversify customer base (for me I take less than 10). It is to see, how well a company could cope if its customers were to default payment. One good example is LCL and DIS Tech. LCL especially looks good in the liquid test but they have extremely high receivables. And worst of all, most of them (90% if I'm not wrong) come from a single customer which is in Dubai. So when this 'you know who' defaults payment, LCL run into the mess that they have today.

However, this is an extreme case test where it is assume all receivables are defaulted. It is pretty unlikely to happen to companies with huge customers base.

## Wednesday, August 4, 2010

### GENM "Friend-Friend" Deal

Call it friend-friend, brother-brother, sister-sister deal, there are definitely few questions asked for yet another RPT deal.

I just read The Edge last week issue which covers the latest Genting Malaysia (GENM) RPT deal. Okay, the author does mention about why making a big fuss out of this RPT deal. With several bad deals made over the years, I think you can pretty much understand its shareholders concern. After reading the article, I can sum up the rationale behind the deal - price and timing. According to GENM president and COO, Datuk Lee Choong Yan (not sure about his relationship with our Datuk Lee Chong Wei), they aren't just acquiring the 44 casinos licenses but also a property that has not been revalued for the seven or eight years. Wow, that's pretty long and if it is given to any Malaysian MD or CEO, he would have revalue it every year to show his briliance for acquiring a good asset if it is. And it couldn't be a better timing than now considering the global market is still recovering from the post 2008 trauma and the recent P-I-G-S drama. Datuk Lee stress, if they were to do it, it has to be done within a year and a half or so.

Grandpa Lee (he isn't that old anyway) also said "We have 40 years of expertise in this industry, it will be a terrible waste if we didn't move forward". Agree. The Malaysian market is pretty much saturated now not to mention the competition it is getting, they definitely will have to look elsewhere. BUT, that raises another question and it'll worries me if I'm the shareholder. Because it also means 40 years of blessing of monopoly, no competition and pretty much not too many worries on the home-soil operations. Genting UK will be a different story altogether. Are they able to deal with the way more intense competition? No disrespect, but try ask our Malaysian government to open up the auto industry, see how Proton goes.

Second question: RPT. Why would GENS sell its UK business if it is a good business? And from the words of Grandpa Lee, it does sound that GENM gets a good bargain from her sister. So they are telling GENS are so dump that they sell off their UK casinos "cheaply" to GENM? And all this happen under their mothers watch, Genting? Now, who is the one getting ripped off here?

All these activities do raise a third question of what is it gonna be like in the future if Genting UK does turn out to be a shitty asset. Lets assume, Genting UK is a piece of shit. Now we all know GENM has lots of cash. GENS is holding a piece of shit that it needs to get rid of. So today, GENM helps GENS by taking this piece of shit away from her. Will they pull off "you help me, I help you" stunt again in the future?

Only time will tell. Nevertheless, one can't deny Genting Malaysia superb ability to generate free cash on the local front and it is unlikely to change. Probably, I'll just wait and see.

Do check out aboi's coverage on Genting Malaysia Bhd which covers its fundamental and other information on its industry such as competition.