FAVCO (7229) - Stock Pick: Favella Favco Berhad (FAVCO) kcchongnz
When crude oil plunged from a high of USD115 from June 2014 to less than USD30 within a year or so, the share price of Favco, with its major business involved in supplying cranes to the oil and gas industries, fell sharply too in tandem from the adjusted price of RM3.80 less than three years ago, to a low of RM2.30, or 40%, before recovering to RM2.58 on the close just before the Chinese New Year on 27th January 2017 as shown in Figure 1 below.
Figure 1: Share price movement of FAVCO
Is there a good opportunity to invest in Favco at this price of RM2.58?
The inclusion of FAVCO as one of my stock picks in i3investor for 2017 as shown in this link here represent my point of view.
http://klse.i3investor.com/servlets/pfs/71070.jsp
“The secret of success in investing is to buy good companies when they are selling cheap”
The Business
Favelle Favco Berhad (Favco) is involved in the designing, manufacturing, supply, servicing, trading and renting of cranes. Favco offers four types of cranes: tower cranes, which are used in dam building, bridge building, shipyards, power plants and high rise structures; offshore cranes, which are used on platforms, on jack-up barges, on vessels and submersibles; crawler cranes, which are used in general construction work sites and pipe laying works, and wharf cranes, which are used in shipyards, bulk handling terminals and general purpose terminals.
FAVCO’s revenue has been relying more on contracts for supplying of offshore cranes for oil and gas companies for the last few years. Most companies which are related to the oil and gas industry has suffered somewhat due to the abrupt plunge in crude oil price. Favco is not an exception, with its revenue plunged by double digits, and seriously and adversely affecting its bottom line.
Brent crude oil price has since recovered to about USD56 now, about doubled from its lowest, following the recent OPEC agreement on production cut. This may imply that the worst for oil prices is now behind us and a gradual resumption in oil and gas activities is likely. This gives some breathing space to the O&G companies. Most analysts are projecting the oil price will stay around this level for some time. This will auger well for FAVCO.
Besides, there seems to be increased activities in the USA in line with the improvement of the economy in general, and the construction industry in particular, including that of Malaysia. In the last two months, FAVCO has received purchase orders for supply of tower and offshore cranes amounting to RM134m, bringing the total order book to about RM750m, to be completed by year 2017.
Quality of Business
FAVCO has been in the crane business for a long time before Muhibbah Engineering acquired it about 20 years ago. There is always demand for cranes in the offshore oil and gas and construction industry, locally and abroad. Hence this business is likely to last for some time to come.
Let us first look at the quantitative aspects of the quality of the business of FAVCO. I separate the quality of a business into three categories; Profitability and growth, Return on capitals and cash flows.
Profitability and growth
For the past 9 years, up to 31st December 2015, Favco’s revenue has been increasing steadily from RM358m in 2006 to RM792m, or a good compounded annual growth rate (CAGR) of 8.2% as shown in Table 1 in the appendix. Operating and Net profit have increased by much higher CAGR of 22.4% and 28.4% respectively to RM113m andRM94m respectively, due to margins expansion. It has been having stable earnings all this while and has had not a single year of losses.
There is a clear expansion of margins over the years. Operating margin increased from just 5.1% nine years ago to 14.1% in 2015; and net profit margin improved many folds from just 2.8% in 2006 to 11.8% now. Both the recent operating and net profit margins have improved to double digits, in contrast to the margins of most other construction companies.
With the plunge in oil price and shrinking order from O&G sector, the most recent trailing twelve months’ revenue shrank by 16% to RM666m, and a corresponding decrease in profit to RM79m. Earnings per share, however, is still commendable at 35 sen.
At RM2.58 now, FAVCO is trading at a reasonably low price-to-earnings ratio of just 7.4.
Return on capital
Return on equity (ROE) of Favco goes up in tandem with the increase in revenue and profit margins. In the last 5 years, ROEs were all over 15%, way above its cost in equity of about 10% as shown in Table 1 in the Appendix. Net cash has built up to RM300m, and a net cash holding of RM1.36 per share now, from a net debt position since 6 years ago, all from the internally generated earnings from its ordinary operations.
Taking into considerations of the investment from the debt holders, and netting off excess cash not needed for the operations, the return on invested capitals (ROIC) is much higher at 27% for the latest 12 months, easily doubling its weighted average costs of capitals, up from just 6.9% 9 years ago.
The beauty of this business is it is able to grow RM1 in a year, just by using RM3.64 of capital!
That was half of the story (the goodness part) of why FAVCO was chosen as one of my stock picks in i3investor for 2017, the identification of a good company, as defined by Joel Greenblatt in his Magic Formula Investing, as shown in the link below.
http://klse.i3investor.com/blogs/kcchongnz/113511.jsp
Of course, the “Return” in the ROE and ROIC is the return, or earnings in the future which is relevant, not the past. History may not repeat itself, but it rhymes. The pertinent question is, what is the likelihood that its future earnings will continue to deteriorate unabated from the present level now?
Cash flow
“Revenue is vanity. Profit is sanity. Cash is reality.”
In investing, everyone chases “earnings”, including all the analysts and investment bankers. Few people care about cash flows. I have read and seen enough cases that just purely basing on “earnings” in investing, without looking at other things can yield disastrous results. Hence for me, I place great emphasis in the quality of earnings as articulated in this article, “Investing in Bursa, Cash is King”,
http://klse.i3investor.com/blogs/kcchongnz/93172.jsp
I have added just one check, the metrics of cash yield to augment the Magic Formula Investing in my selection of FAVCO, to put in equal emphasis on cash flows and free cash flows.
For the latest annual financial results ended December 31st 2015, net income for FAVCO is RM94m while its cash flows from operations (CFFO) is 72% more at RM161m as shown in Table 2 in the Appendix. This signifies the good quality of its earnings. It spent a considerable amount of money in capital expenses of RM24.4m, or 27% of its net operating profit after tax (NOPAT), some to reduce its short-term debt, and yet there is still abundant free cash flow, FCF, of RM137m left. This FCF is a high 17% of revenue and a whopping 50% of invested capital (IC), in hard cash. It is from this FCF that RM26.3m, or 15 sen a share, was paid out as dividends last year, or a pay-out ratio of just 28%, and yet plenty is left in the balance sheet for future dividends and growth.
Over the last 5 years, Favco has produced a total FCF of RM404m which it used to pay down its debts, invest in profitable ventures and paying dividends to shareholders. What a cash generating machine is Favco!
From the three measures above; Profitability and growth, return on capitals and cash flows, it is undeniable that Favco has been a good company which has shown to perform very well in for the past. A company with the same management which has been performing very well in the past is likely to do well in the future too, compared to one which has not shown to be so.
But more importantly, is it a great investment investing in it at RM2.58 apiece now?
“A good company is not necessary a good investment if the price is not right.”
Some Simple Valuation of Favco
Table 3 below shows some simple valuation metrics for Favco with its closing price of RM2.58 on 29th January 2017.
Table 3: Some simple valuation metrics for Favco
The attractiveness of investing in Favco is its cheap market valuation in every aspect, firm wise or equity wise as shown in Table 3 above. Despite its reasonably good return on capitals, stable earnings and cash flows as described above, its market valuations are all below some relatively stringent benchmarks. The PE ratio of just 7.2 and enterprise value only 3.3 times its earnings before interest and tax, or earnings yield of 30%, is particularly attractive.
The Cash Yield of 11.8% will straightaway make it a No-Brainer Investment as described in this link.
http://klse.i3investor.com/blogs/kcchongnz/93172.jsp
And this is basing on its average free cash flows of RM67.4m for the last 5 years, although its FCF for the most recent year is RM136.7m.
Its price-to-book value is also very cheap at 1.0. It is hard to find one company which has stable earnings and cash flows, and yet selling at a price-to-book at unity.
Another low risk feature of Favco is with 15 sen dividend, its high dividend yield of 5.8%, with a pay-out ratio of just 43%, provides regular good income to investors, much better than bank interest rate, while still leaving substantial amount of earnings for future growth. Besides, it has net cash holding equivalent to RM1.36 per share, providing sustainability to its future dividend payment.
If one assumes the future resembles the past, the above market valuation of Favco clearly shows that it is undervalued at the present price of RM2.58. It is really hard to find a good stock selling at such enticing valuations out there now.
Earnings Power Valuation of Favco
Earnings Power Value (EPV) was postulated by a Columbia University Professor Bruce Greenwald. It is an estimate of the value of a company from its ongoing operations only without any growth. First we would assume that current revenue is sustainable. We then normalize the earnings to the business cycle. This eliminates the effects on profitability of valuing the firm at different points in the business cycle. This means that we are considering the average % operating profit over 5-8 years. This average would then be applied to current sales.
The beauty of EPV, for value investors, is that the numbers used to calculate it are no growth FCF. By using no growth FCF, we eliminate the predictions of future growth and as such arrive at a number which we can be fairly certain of. This isn't to say that some companies can't expect significant growth, but as value investors we refuse to pay for it.
In this method, we still need to have a weighted average cost of capital (WACC) to be used as a capitalized rate. As almost all the capital in the company is that of the equity shareholders, a rate of 10%, 6.5% over the fixed deposit rate of 3.5% is used.
Table 4 in the Appendix shows the step-by-step EPV for Favco. We start from the trailing twelve months’ revenue of RM666m as the base of estimation, and using the average earnings before interest and tax, or ebit margin for the last 10 years of 11.4%. It is assumed the long-term tax rate is 24%, although it is paying only a tax rate of 10% now.
Disregarding any future growth, not even growth according to inflation, or the growth of GDP, the capitalized earnings (Ebit/WACC) of Favco is worth RM550m. After adding back the excess cash and other investments, and deducting the total debt, the EPV of FAVCO is RM866m, or RM3.91 a share. The EPV of FAVCO is 52% above its price of RM2.58. The margin of safety is a high of 34%, which is above my 30% requirement, even with this conservative EPV which ignores any growth in the future.
Conclusions
Favco appears to be a good quality company with resilient and easy-to-understand businesses which should last for some time to come. It has long history of stable earnings and cash flows. Revenue and earnings have been growing steadily for the last 10 years. It has an excellent set of balance sheet with abundant cash and little debt. The investment thesis of Favco lies in its characteristics of a good company, low market valuations and its high intrinsic value obtained from a conservative discount cash flow analysis using EPV, in relation to its market price. Best of all, it pays out good and increasing dividends over the years. At RM2.58, its dividend yield is high at 5.8%, much higher than bank fixed deposit. Its high net cash holding is likely to provide the sustainability of the high dividend payment.
With some new contracts procurement and prospect of improving oil prices ahead, Favco provides a good investment opportunity.
Investing in a good company of FAVCO at a low price fits the principle of the Magic Formula Investing. It also satisfies the Dhandho Principle of Investing of Mohnish Pabarai,
“Heads we win big; Tails we don’t lose much”
That is why FAVCO is a pick in my i3investor for 2017.
K C Chong at ckci3invest@gmail.com
Appendix
Table 1: Operating performance of FAVCO
Table 2: Cash flows of FAVCO
Table 4: Earnings Power Valuation
FAVCO (7229) - Stock Pick: Favella Favco Berhad (FAVCO) kcchongnz
http://klse.i3investor.com/blogs/kcchongnz/114879.jsp
