SINGAPORE(Mar 19): This week’s article comprises two sections. The first is a lesson on how we can be misled by reported financial numbers; the second is on our macro outlook for emerging markets.
Two weeks ago, Muda Holdings reported a set of fabulous financial results for its financial year ended Dec 31, 2017. Revenue grew from RM1.22 billion ($408.3 million) to RM1.45 billion, up nearly 19%, but pre-tax profit more than doubled from RM31.5 million to RM65.4 million. Even more impressive, net profit shot up from RM18.8 million to RM58.8 million, or by more than 200%.
Its stock price nearly doubled, from RM1.30 pre-results to as high as RM2.47 in less than a month, with analysts universally bullish (see Chart 1).
The reasons articulated by management and analysts for the strong performance were that costs fell with the lower price of waste paper used for paper mill recycling while selling prices for paperboard remained on an uptrend.
Demand for its paperboard product, used for making corrugated boxes, will grow as e-commerce takes greater hold in Malaysia. On the other hand, waste paper costs fell, owing to restrictions on imports imposed by China arising from environmental concerns. This resulted in excess supply outside China.
While the arguments are sound, the actual reasons behind the improved reported financial results have more to do with non-recurring items than the underlying operations of the business, specifically, the net charge and one-off insurance compensation for a fire that occurred at the company’s plant in Tasek in August 2016.
Net loss from the fire totalled RM11.8 million in 2016 and depressed that year’s earnings. As a result, pre-tax profit fell from RM41.1 million in 2015 to RM31.5 million in 2016. In 2017, Muda recognised net compensation claims of RM23.3 million, which accounted for 36% of the year’s pre-tax profit.
Combined, the depressed base of 2016 and the compensation gains in 2017 resulted in the tripling of net profit. It also explains why 2017 has a low effective tax rate, of just 8%, compared with 34% in 2016.
How do we know all these? It is right there in the explanatory notes of the company’s results announcements to Bursa Malaysia — item 4 on page 10 of its 4Q2016 release and items 1 and 6 on pages 14 to 16 in the latest 4Q2017 results.
In the table, we revisited the historical financial performances of Muda and show what the results would have been if we “normalised” it by adjusting for the non-recurring and extraordinary items (since fire at the plant must be non-recurring).
Pre-tax profit would actually show a slight decline from RM43.3 million in 2016 to RM42.1 million in 2017. Net profit would have increased by 15.9% instead over 200%. This is still commendable; just not what was inferred originally. But besides earnings, one must also look at the balance sheet. Net debt for Muda increased by more than RM85 million to RM526.2 million. Why?
Aside from capex totalling RM74.5 million, inventories and trade receivables both shot up by RM58 million and RM64 million, respectively, or more precisely, by 29% and 27% y-o-y, respectively. It suggests customers are paying up slower and sales are lagging production, resulting in built-up inventories. What could account for this?
What I know is that selling prices for paperboard products have started falling this month, even as demand remains strong. Customers are holding back, sensing that prices will retrace, in line with the lower waste paper prices.
For the longest time, this is an industry where selling prices are marked up by a margin over cost. Over time, it has a fairly stable but competitive margin. Case in point: Muda’s Ebitda, or earnings before interest, taxes, depreciation and amortisation, margin ranged between 10.3% and 10.9% from 2012 to 2016. It actually fell to about 9% in 2017 (on average) despite rising sharply to 11.3% in 4Q2017. Adjusted for extraordinary items, Muda’s net profit margin stayed between 1.5% and 2.5% and return on equity between 2.7% and 3.9% since 2012.
This is why I do not expect the higher Ebitda margin in 4Q2017 to be sustainable, even with higher demand for paperboard product. Barriers to entry are low and there is excess capacity. Indeed, paperboard prices have started falling in March, mirroring the drop in waste paper prices. The lag of several months is not unusual as selling prices adjust and margins normalise.
To understand this better, you need to look at Muda’s competitors. Oji Holdings is one of the largest players in Malaysia; it is the largest pulp and paper manufacturer in Japan and one of the largest in the world. Its net profit margin has also been consistent, between 1% and 2%. Chart 2 shows its revenue and net profit margin for the past 10 years.
Finally, Chart 3 shows the relative valuations of companies operating in this space, using my EV/Ebitda and Ebitda growth tradeoffs. There is no reason to believe Muda is relatively undervalued.
Perhaps there is more to this than meets the eye. Perhaps the incredible rally recently had nothing to do with Muda’s latest results after all. Perhaps the spike in interest could have been driven by a possible merger and acquisition instead?
AbsolutelyStocks’ proprietary algorithm indicates a high likelihood of corporate exercise for Muda. You can check out more details on the company on:
www.absolutelystocks.com
The second section relates to the views we recently expressed, which is that markets are showing more volatility even as the rally grows older and the list of worries longer.
To quickly recap, investors are fretting over each data point as it is released, watching for signs of accelerating inflation, which could force central banks to hike rates faster than current expectations. Already, rates are to trend higher under monetary policy normalisation and reverse quantitative easing.
Earlier this month, US President Donald Trump added to concerns of a wider trade war after he imposed tariffs on steel and aluminium. That resulted in the resignation of his chief economic adviser. To top this, the president then fired his secretary of state, underscoring the revolving door at the White House and raising the ante in terms of policy unpredictability. There is talk of more tariffs targeted at China on the drawing board.
Typically, investors will turn more riskaverse as worries grow. And that usually means shifting out of emerging market equities and currencies, which are perceived (real or otherwise) as risky, and into safe-haven assets such as US Treasuries and currencies such as the yen and Swiss franc.
On top of global worries, there is also the added uncertainty with regard to Malaysia’s upcoming general election. Markets hate uncertainties.
The benchmark index, FBM KLCI, and super big-cap stocks are holding up, supported by local institutional funds, but the rest of the market is definitely feeling the hurt in recent weeks.
Stocks in my Malaysian Portfolio mirrored this weaker sentiment. Total portfolio returns hit a record high of 78.1% in the week ended Jan 4. Since then, however, all of the stocks have come under selling pressure. As a result, total returns were pared down to 69.3% currently. Nevertheless, we are still doing way better than the benchmark index’s 0.8% gain over the 3½ years since inception.
As a value investor, we should not be overly concerned by short-term price gyrations driven by sentiment. It is impossible to time the market perfectly. Otherwise, I would have sold everything in January. Hindsight is always 20/20. I do not know for certain if prices will continue to fall further or rebound in the coming days.
Having said that, I believe it is prudent to take a small step back. The portfolio has done well and it would not hurt to take some money off the table. I raised cash holdings from 6% to 15% of total portfolio value for the Malaysian Portfolio and will likely pare my investments further.
I have also raised cash in the Global Portfolio in recent weeks, from a low of 12.6% to about 20% of total portfolio value. The portfolio is now up 8.4% in the three months since inception, outperforming the benchmark index’s 1.8% gain over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
*Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
