Ming Fai International Holdings: 200% upside?

A reader pointed me in the direction of Ming Fai International Holdings. The company is based in Hong Kong and is primarily active in the amenity business. They manufacture and sell products suchs as soaps, toothpastes and towels to hotels and airlines. What makes the company interesting are the solid operating earnings – especially when we look past a loss making subsidiary that has been shut down – in combination with a nice dividend yield, a large cash balance, significant real estate holdings and high insider ownership. As usual first some simple valuation metrics to get an idea of what we are looking at:

Last price (Jul 25, 2014): HK$0.74
Shares outstanding: 697,763,697
Market Cap: HK$516.3M  (US$66.6M)
Free float: 55%
P/B (mrq): 0.40x
P/E (ttm): 12.9x
EV/EBIT (ttm): 3.4x

Financials

Ming Fai appears to be cheap when we look at book value and at the EV/EBIT ratio, but when we look at the current earnings ratio it’s not an obvious bargain. I have compiled an overview of the historical financials in the table below:

Ming Fai historical financials

As is visible earnings/share show a downward trajectory and the dividend has been cut as a result. This probably explains why investors aren’t enthusiastic about the company, but when we dive deeper in the various operating segments we will see that things aren’t as bad as they look. And too be honest: things don’t really look that bad to begin with. The company is currently valued at roughly HK$500 million while it has investment property worth a bit more than HK$200 million and a net cash balance of HK$300 million. You get the operating business for free!

Whether or not the investment property is really worth book value is a good question. The company recorded HK$4.8 million in rental revenue and HK$0.6 million in operating expenses for a NOI of HK$4.3 million which implies a cap rate of just 2.1 percent. Apparently this is normal in Hong Kong, but I wouldn’t buy this stock if the investment case would hinge on the valuation of the real estate. It’s certainly not cheap.

What makes Ming Fai interesting is that the true earnings power of the business is a bit obscured. A relative small issue is that the reported earnings are a bit hard to understand due to the consolidation of the partially owned “Everybody Labo Limited” subsidiary. The company owns just 51% and since this subsidiary is generating sizable losses in most years line items such as operating profit underestimate the earnings that are attributable to equity holders of the company. A quick and dirty estimate of the earnings of the retail segment that are attributable to shareholders of the company:

Ming Fai retail segment after minority interests

What is more interesting is that the profitability of the various operating segments of the company is very different. The core business – supplying amenity products to hotels and airlines – has been pretty solid. Revenue has grown straight through the recession at a 10% CAGR since 2007 while segments earnings before taxes have been a bit more erratic:

Ming Fai amenity segment revenue and profitability

The reason that we don’t see this solid performance back in the earnings statement is the fact that the two other segments: laundry and retail have been a lot worse. The laundry segment is new venture of the company that was started in 2011 in an attempt to expand the range of services they offer to hotels, but it’s fair to say that this has been a failure since it has never been profitable. The retail segment – that includes the 51% stake in “Everybody Labo Limited” – has been profitable in the past, but performed very poorly last year:

Ming Fai revenue and EBT by segment

Luckily management has realized that the laundry business isn’t a good one, and they have decided to exit the venture before 30 June 2014 and this will obviously improve the performance of the group going forward. Note that other income, primarily revenue generated from the investment properties, is also reported in this segment so the laundry business is even worse than it looks in this table.

How the retail business will develop will be though to tell at this point in time, but I do think this has more potential since it has been profitable in the past. Perhaps it will return to profitability, and if it doesn’t it seems that management is rational enough to pull the plug.

Valuation

The value of Ming Fai is the sum of the cash, real estate and of course the operating business. The first two pieces of the puzzle are easy to value: book value should be accurate enough, although the conservative investor might want to add a discount because of the high property values in Hong Kong. The value of the operating business is a bit more complex, because the laundry segment has been shut down while the performance of the retail segment has been erratic.

I think simply valuing the retail segment at zero is a decent choice. Either the retail segment will return to (historical?) profitability and it will be worth a decent amount, or it could struggle and lose money for a couple more years before management shuts it down. The weighted average of those two outcomes is probably not too far from zero.

So what really matters is the value of the amenity segment. While it has shown strong revenue growth the growth in earnings has been mediocre so a 10x multiple seems reasonable to me. A good question is what kind of tax rate we need to apply to the pretax earnings. The effective tax rate last year was 44.4% which is more that double the average tax rate of the previous six years. It’s unclear to me what the exact reason is, but I think this is a temporary phenomenon since the corporate tax rate in Hong Kong is just 17.5% and it’s 33% in China. Using the 27% rate that the company paid in 2012 seems like a better guess.

This creates the following picture:

Ming Fai valuation

I’m the first to admit that this is not the most conservative valuation possible, but with this kind of upside potential there is a large margin of safety when some of your assumptions are a little bit too optimistic. Maybe taxes will be higher in the future, maybe book value overstates the value of the investment property or maybe the retail segment will continue to generate losses and has in fact a negative value. It could all be true and you would still have a decent amount of upside.

Insiders

Insiders own 30.33% of the outstanding stock which is in my opinion a great amount. They own more than enough to care more about the success of the business than their salary, but they don’t own enough to be able to ignore outside investors. Unfortunately their ownership stake is making it hard for the company to repurchase shares because insiders would be required to launch an offer for the whole company if they cross the one-third ownership threshold. Sucks, because repurchasing shares would be an great way to spend some cash.

What I do like is that the company has a solid history of paying out a large percentage of income as dividend since their IPO in 2007. The average pay out ratio is above 40% and even though earnings are currently depressed that still translates to a 4.7% dividend yield. I expect that this will go up next year after the exit of the money losing laundry business.

What’s perhaps the biggest risk is that management will spend more cash on unsuccessful ventures like the laundry business, and the retail business doesn’t look that great in hindsight either. But I don’t know if this is really a big deal. They tried to enter businesses that were adjacent to their main business, and not everything you try will be a massive success. But as long as you are willing to exit when it doesn’t work some diversification isn’t a disaster, and their ownership stake is big enough to give them the right incentive. Would probably be better if they would only focus on the core business though.

Conclusion

There is a lot to like about Ming Fai at the current price. The amenity segment could be worth twice the current market cap of the company, and you also get a bunch of cash and real estate thrown in the mix as well. Of course not everything is perfect when you buy a stock this cheap, but I don’t think there is anything seriously wrong with Ming Fai. It seems to me that a lot of investors simply have trouble looking past the headline revenue and profitability numbers, and don’t give the company credit for shutting down the money losing laundry division and the possibility of turning around, or exiting the retail segment.

Disclosure

Author is long Ming Fai International Holdings

Jewett-Cameron’s segment revenue in two graphs

After my short post on Jewett-Cameron Trading I received some comments that by basing my valuation on net operating profit I was missing what was going on within the various segments, and this was certainly true to some extent. The graph below shows how Jewett-Cameron’s revenue mix has evolved the past ten years, and as visible it is fair to say that the company is now in a completely different business than a decade ago:

Jewett-Cameron revenue mix

Note that the column labeled 2014 is in reality the TTM and includes one quarter of 2013, but that’s something I’m unable to fix in Google drive. While the lawn, garden and pet segment has grown to be a very large part of Jewett-Cameron’s business the absolute growth of the segment hasn’t been that stellar. Revenue increased from $24.8 million in 2009 to $33.4 million today, representing a 6.5% compounded annual growth rate. If we don’t pick the lows of 2009 as starting point but the previous high of 2008 the compounded annual growth rate drops to 3.2%: not bad, but not great either.

Jewett-Cameron lawn, garden & pet segment revenue and profitability

The reported segment earnings before taxes also show few signs of operating leverage. Earnings before taxes grew at a 4.0% rate if we start measuring from 2009 and just 1.7% if we start at 2008. With those kind of growth rates just taking the average operating earnings of the past five years or so seems a pretty reasonable approach to me. You need a little bit of nominal growth to keep-up with inflation anyways.

I do agree that there might be some positive optionality if the industrial wood segment recovers. I don’t want to call this a free option since the segment has shown declining sales for five years in a row and is a bit below break even. They also do have some excess real estate that they will be able to monetize at some point in the future. But don’t think this is enough to revise my previous conclusion that the company is currently fairly valued.

What’s basically the case is that the lawn, garden and pet has been such a big part of Jewett-Cameron’s business for an extended period of time that drilling deeper doesn’t add a whole lot of value. What’s happening in the other segments is almost irrelevant now.

Disclosure

No position in Jewett-Cameron Trading

Boom Logistics market update

Boom Logistics released a market update yesterday to give some insight in what to expect when the FY14 results are released next month. The company will post a big loss, but mainly because all goodwill has been written down to zero. What is more interesting is what we can learn about the companies asset value from the latest developments and impairment charges. Boom Logistics recognized an A$4.5 million impairment on assets held for sale. With $15 million in assets held for sale after this write-down this implies a 23% discount.

A 23% discount is great at current prices, but the asset value is likely even higher because Boom Logistics has a history of writing down assets for sale and consequently booking profits on sale. The second half of 2014 wasn’t an exception:

Quote from Boom Logistics trading update

Also note that part of my initial thesis here is confirmed, namely that the company would be able to sell its equipment internationally. A crane that can be used world wide will maintain Its value even when business sucks in Australia. A small impairment of fixed assets in Western Austrailia also confirms that the equipment value is still there:

Quote from Boom Logistics trading update

What’s also positive is that net debt has been reduced A$102.0 from to A$89.5 million the past six months. It’s not only good news though. The company spent $16 million in 2014 on new equipment which seems a bit excessive given the amount of idle equipment they presumably already have, and the fact that there have been no share repurchases is also a negative. Doubt if that’s an optimal allocation of capital…

Disclosure

Author is long Boom Logistics

Jewett-Cameron Trading: a cannibal at fair value?

Jewett-Cameron Trading (JCTCF) ended on my research list after I noticed that they repurchased more than 10% of their outstanding shares in the latest quarter. This wasn’t the first time either that the company bought back stock: in the past five years the number of outstanding shares has dropped with more than 40%. Companies that aggressively repurchase their shares are in my opinion very interesting. It usually says something positive about the capital allocation and shareholder friendliness of the management team, and if it’s done below intrinsic value the share repurchases can create a lot of value. Before trying to figure out if this is also the case for Jewett-Cameron some numbers:

Last price (Jul 17, 2014): 9.29
Shares outstanding: 2,749,678
Market Cap: $25.5 million
Net cash: $4.2 million
P/B (mrq): 1.40
P/E (ttm): 10.88
EV/EBIT (ttm): 5.65

Valuation

Jewett-Cameron is a pretty straightforward business to understand. They operate four segments: industrial wood products; lawn, garden, pet and other; seed processing and sales, and industrial tools and clamps. The lawn, garden and pet segment is by far the biggest and accounts for almost 80% of revenue. The company writes in their latest 10-K that this segment is less sensitive to downturns in the US economy than the market for new home construction. While that might be true the company’s revenue dropped significantly in 2009 and has never really recovered since. But thanks to lower expenses operating profit is back to roughly the same levels as before. See the table below for some historical financials:

Historical financials Jewett-Cameron

The favorable impact of the shrinking share count is clearly visible when we look at earnings per share. Despite little progress in the business itself earnings per share have almost doubled compared to 2008. When we look at the development of the revenue numbers it’s also clear why the stock has been a poor performer for the past three quarters. Revenue is almost back to the 2009 level, and it now appears doubtful that this company can grow at a meaningful rate in the future.

Because of that I think the most appropriate valuation is to simply take the average operating profit from the past 5 years, apply the average tax rate, throw a 10x multiple on it and adjust for the cash held by the company. This generates the following picture:

Jewett-Cameron valuation

As is visible this valuation indicates that the company is trading at roughly fair value, and the implication is of course that the share repurchases aren’t generating an above average return on capital. It’s in my opinion still an excellent use of cash. Buying your own stock at a 10x multiple basically means that you are generating a 10% return on your money. That’s a lot better than having it linger in a bank account like so many other companies are doing.

Conclusion

Jewett-Cameron is a very interesting company, but unfortunately not very cheap and that significantly reduces the value that is created by buying back shares. Buying back fairly valued shares is in theory a neutral transaction, except that it is usually better than a lot of alternatives (hoarding cash, growth acquisitions and dividends depending on tax situation).

Luckily Jewett-Cameron is not expensive either, and at the current prices it will probably generate a fair return for shareholders. Perhaps that it could be a great idea when you have some specific opinion on how the housing market in the US will develop, and how that will impact Jewett-Cameron. But that’s not a prediction I want to make or can make, and since there is not much of a margin of safety at current prices I’m staying at the sidelines.

Disclosure

No position in Jewett-Cameron Trading at the time of writing.

How I generate my ideas

How I generate my ideas is probably the question I get asked the most. So I figured I should do a blog post to answer this once and for all. The honest answer is that I usually don’t really generate any idea’s: I simply wait for someone else to write-up a convincing thesis. I thought that this was pretty obvious because a lot of my write-ups start with something along the lines of “Previous week blogger X took a look at company Y…”. The handful of blogs that are displayed at the right-hand side of this post are a major source of inspiration, and I follow another 50 blogs or so as well using Feedly.

Blogs are of course not my only source of ideas. I also follow a bunch of authors on Seeking Alpha and I follow even more people on Twitter. There are also a couple of funds that I follow (again using Feedly) and the great thing about running a blog yourself is that people often e-mail interesting idea’s as well. Like minded investors are in my opinion a great screen for potential idea’s.

Buffett is known for advising people to simply start with the A’s and look at everything while a stock screener is also a popular method to find potential interesting companies. I rarely do this. I have no doubt that this can be successful as well, but I doubt that it is a time effective method. When you look at everything you also spend a lot of time looking at stuff that isn’t even remotely attractive. When you use a screener you often run in data quality issues for micro caps and foreign stocks, and another problem is that usually the cheapest stocks don’t show up on a screener. I’ll happily let my fellow investors do the heavy lifting.

The number of ideas that I can research is limited, and by mostly looking at stocks that like minded investors find interesting I think I’m significantly increasing the odds that I’m looking at a company worth investing in. You don’t get points for originality as an investor. The only score that matters is the risk-adjusted return that you are able to achieve.

I also think that a lot of investors have a bit of a misplaced believe that they need to buy something that is truly undiscovered, and that going through all stocks or using a screener is a way to accomplish that. But the reality is that a stock is almost never undiscovered. Unless you are buying in an IPO there is always a group of people that already know the stock and own the stock. Doesn’t matter how obscure a company is: there is probably someone out there that has owned it for years and knows everything there is to know about it.

What should be noted is that while I almost always borrow my ideas from someone else I never invest without doing my own research 100%. When I find a potential interesting company I always start my research from scratch. If you don’t read the annual reports yourself you don’t know what someone else might have missed, and when you don’t built your own valuation model you don’t know what kind of assumption were exactly used. It’s in my opinion critically important to fully understand the investment thesis. If you don’t it will be hard to interpreted news releases and to decide what to do when the price changes. Do you have the conviction to buy more when the price drops but intrinsic value remains constant? Is it even possible to know what happened to intrinsic value without fully understanding your investment? Seems like a though task to me.