Centurion Revisted

In my previous two posts, I spoke about the fact that Centurion is earning below it's cost of capital and has poor capital allocation abilities.

However, one thing that I admit to having missed out is the fact that the company's current earnings potential to the asset base does not fully represent the normalized returns. This is because a huge chuck of value in the asset base is dormitories that are not yet operational, thus current return on capital does not fully represent reality. In addition, I have failed to net out taxes from the cost of debt calculation. This post is to rectify this problem. 

In my opinion, when one attempts to go short a company, just as how one would identify a margin of safety for a long position, one should inverse and identify the best-case scenario and see if that gives one a margin of safety. This was what I did in my DCF calculations. 

I believe that the growth rate that I employ is aggressive. While consensus estimates EBITDA margin to compress slightly towards 50%, I assume margin remains at current levels. 

Next, I assume CAPEX % Revenue to be 45%. I believe this to be aggressive. This assumes that cost of lease per bed per month to be between $105 to $144 for the Singapore portfolio. This is at a 11% to 35% discount to a recent BCA tender of $161.50 per bed per month. 

Following this, I would calculate the company's cost of capital with the post-UK acquisitions expected capital structure. Doing so, WACC comes up to 5.41%. Again, this is significantly below the aggressive and optimistic CIMB research report of 6.9%. To add on, I use a 2.5% terminal growth rate, instead of the 2.0% used by the CIMB analysts. 

I believe this to be sufficiently aggressive. 

Using these assumptions, I determine the aggressive, or bull case, intrinsic valuation comes up to be SG$0.62 per share. This represents a 17% downside, or should I say upside, to current prices. 

I believe this that while the current is significantly below that of historical, shorting Centurion remains to be an attractive proposition. 

YAHOO: Sum of the parts

In 2010, the investment thesis that David Einhorn of Greenlight Capital had on Vodafone was as straightforward as it was strange. He argues that the market is ignoring the fact that Vodafone owns 45% of Verizon Wireless. While such an opportunity could be expected from small companies without institutional following, Vodafone is a massive entity.

The very same situation is occurring right now with Yahoo.

As you know, Yahoo is a technology search engine company with $4.6 billion in revenue in the LTM. At the current $42 billion market capitalization, this represents a 9.2x Price to Sales ratio. This is an exceedingly high ratio for a company that has mid teens digit EBIT margins and is losing revenue for the last 6 years.

The reason is because investors aren't valuing Yahoo solely on its operating assets, but also the assets that Yahoo owns.

Yahoo owns 35% of Yahoo Japan, an entity separate from Yahoo that operates in Japan. In addition, it owns 401.8 million shares of post-ipo Alibaba.

At current market capitalization, the market is implying that Yahoo Core is worth NEGATIVE $3.6 billion.

In my opinion this is ludicrous and represents an attractive opportunity.

With the sale of 127.1 million shares of BABA and Yahoo current balance sheet makeup, Yahoo Core Est. EV is NEGATIVE $12.47 billion. For a company that made $337M in EBIT in the LTM, this represents an amazing opportunity. 

So, how can one take advantage of this discrepancy?

An illustration: 

For every 1000 shares of Yahoo purchased, one should sell short 1932 shares of Yahoo Japan and 389 shares of Alibaba. By doing this, one can isolate Yahoo's core operating business. 

What is the right price? 

It is hard to say considering that Yahoo Core is in the midst of attempting a turnaround. However, I believe that ascribing a 0.3x EV/Revenue would be more than conservative. This would imply that Yahoo is trading at ~4x EBIT. 

At $54.36, buying Yahoo now represents a 33% upside. HOWEVER, if one executes the hedge and isolates Yahoo Core business, one can theoretically obtain an infinite IRR. Why so? Because at current valuation, the market is ascribing Yahoo Core at less than 0. 

Giordano: Risk Reward

Giordano is leading casualwear retailer in Asia with over 1369 self-operated stores, 842 franchised stores and 449 affiliated stores in 2013. It mainly operates in Greater China, Southeast Asia, Japan and Australia.

It currently trades at HK$4.58, or a normalized 13.9x EV/FCF or a 8.5x EV/EBITDA. I believe that Giordano is likely undervalued with tremendous upside.

While I do not have much of an unique insight in the apparel industry, I believe that the risk reward makeup on Giordano is more than enough to make up for this deficiency.

Giordano is a company which has tremendous cash generating capabilities. This is reflected in it having a normalized ROIC of 96.0%. This is possible because the company has a large, albeit cyclical, franchise base. This also explains why the company would choose to return capital back to shareholders via dividends instead of reinvesting it.

However, due to a challenging outlook in 2014 and the reality being as such. Giordano suffered a 49% decline in earnings in 1H14. The result? A faltering share price. But, as the adage goes,
"Be fearful when others are greedy, and greedy when others are fearful", I believe this is the time to be greedy.

At HK$4.58, the market implies that Giordano would have a steady state growth rate of -0.68%. While this is possible, I do not find it probable, considering its geographical location and product offering. In addition, the company has a 6.2% CAGR for the last 9 years and the market does not seem to have a good reason to explain such a large discrepancy.

Even if I am wrong, from my DCF sensitivity chart above, you can see that the downside from getting the terminal growth rate wrong is much lower than getting it right. I believe that probability would be skewed towards the upper end of the growth rate because Giodarno operates in regions with mid-single digits inflation rate.

At HK$4.58 and a terminal growth rate of 2.5%, this represent a 106% upside. In the meantime, you will own an undervalued company that pays a 7.5% dividend. In a yield-starved environment, this represents an excellent opportunity.

Centurion Corporation: Completion of Acquisitions of UK Student Accommodation

On the 2nd of September, Centurion has finally completed the acquisition of four student accommodation asset for the total price of £77 million (S$157 million). This is significant as this represents an increase of 37% of the company's long term assets. It may then strange that I did not mention this is my prior post. This is with good reason.

When you are short a company which is planning to make extremely poor capital allocation decisions and at the same time signals weakness is its existing business, you keep quiet and let it do it. 

The acquisition of the four UK student accommodation is significant in many ways:

1) Leverage.

With a S$68 million cash balance, Centurion must finance the acquisition with debt. The announcement of the acquisition stated that the company would tap into its S$300 million 5.25% Multicurrency MTN program and borrow S$100 million. 

Using a listed UK student's accommodation company, Unite Group, as a proxy to determine EBITDA/Assets margin, Centurion should generate an additional S$10.5 million in EBITDA. I believe this estimate is aggressive as this assumes that Centurion has not overpaid on its acquisition and that they are as efficient run as Unite-Group. 

From this, Net Debt/EBITDA would rise from 7.2x to 9.2x, Interest Bearing Debt/EBITDA would rise from 2.7x to 4.5x, and EBIT/Interest Expenses would drop from 4.4x to 3.0x. This adds tremendous pressure to the company.

For a company that is trading at an adjusted net income of 47x, every incremental risk unit adds an increasing amount of pressure on valuation.

2) Inability to renew Westlite Tuas

Centurion's Westlite Tuas lease is soon to expire in 2017. Using a recent BCA tender as a proxy, expected cost of renewal of a 9 year lease would be S$150 million*.
*This assumes a cost of $161.5/bed/month. 

With Centurion's current financial situation as stated out in 1), Centurion likely would not be able to finance their Tuas dormitories, UNLESS, the company puts the financial health of the current company in jeopardy (Another S$100 million would bring Interest Bearing Debt/EBITDA to 8.4x from 4.5x) or the company issue equity (which would be dilutive to existing shareholders).

Given the situation, Centurion would most likely lose a significant portion of its earnings when the lease runs out. This is what I believe to be the most likely scenario. Given that the majority portion of Centurion's earnings is derived from their Singapore portfolio, and the Westlite Tuas dormitory is estimated to be over 35% of the Singapore portfolio returns, I expect the damage to be material. Putting further pressure on valuation multiples.

However, on a positive note, I was informed that my adjusted net income and EBIT is inaccurate in my previous post as I did not normalize net income for upcoming projects such as the Westlite Woodlands project. However, the effect of such would not offset much of the damage caused by the Westlite Tuas expiry.

3) Decision to acquire

It seems strange to me that the company's management would divert their attention from their apparently highly profitable and growing Singapore workers' dormitories business to the UK student accommodation market, which is mature and competitive. This is likely due to a couple of reasons: A) The company is an operator of workers' dormitories, not a construction company. They are restricted by the number of workers' dormitories available for acquisition in Singapore and it seems that they have ran out of options. B) The prospects of the workers' dormitories market is likely not as attractive as once sought out to be. The market has virtually no barriers of entry, and has high replacement cost. A combination of the two would result in margin compression and low EBIT margin.

As a result, growth rate embed in valuation seems ever more detached from reality.

4)  A sign of euphoria

Unite-group, which uses the same, if not more conservative, accounting method as Centurion trades a ~1.0x book value. This makes sense as Unite-group basically did the valuation work for investors.

However, when the acquisition was proposed by company's management, stock price rose from 47.5c or 1.37x book value then to a high of 76.0c or a ~1.8x book value. This seems illogical as 1) Centurion has the same, if not more aggressive, accounting policy as Unite and 2) If a significant portion of your assets is going to have a comparable which is trading at 1.0x book value, it doesn't make sense to me for multiple expansion. I believe this is a sign of euphoria.

All in all, I believe this company is a good short with a bull case of 42c per share. However, as the company is actually destroying value in growth as said in my previous post, and has a balance sheet with growing leverage, I believe the bear case is much more compelling.

British Petroleum - BP

There are generally 3 types of situation which creates great value propositions: Unknown, Unloved. Special Situations. In the case of British Petroleum, it is unloved.

http://www.forbes.com/sites/robertwood/2014/09/05/bp-grossly-negligent-in-gulf-spill-eyes-18-billion-penalty-and-tax-deduction/

While the work was not mine, David Einhorn of Greenlight Capital estimated that the Net Asset Value (NAV) of BP was $70 per share, after allowing for a more negative legal outcome. Although the actual legal outcome was probably far more severe than expected, I believe that value still exists.

BP has also been selling down non-core, unproductive downstream assets which they hold so as to return capital to shareholders. This is value accretive for two reasons.

1) The company can create value by selling assets at or above NAV and buy back stocks at a discount to NAV.
2) The remaining company would be a more focus and higher ROC company.

Over the long time when the legal situation slowly subsides. I believe BP would at least trade at NAV, which using Einhorn's estimation, be at least $60 per share. $60 per share allows for a $30 billion in additional legal damage. I believe this is conservative.

At the current $46/share, this represents a 30% upside. In the meantime, you will be holding an industry leader that trades at 12x earnings with a 5% dividend yield.

JAPFA Ltd Stock Pitch

Link to Stock Pitch: https://www.dropbox.com/s/o32mut4oo36087e/JAPFA%20LTD%20STOCK%20PITCH.pdf?dl=0


Link to Financial Model: https://www.dropbox.com/s/y7dyb0x5owhmv5x/JAPFA%20FINANCIAL%20MODEL.xlsx?dl=0

The Risk of Financial Modeling

In my previous post, I spoke about Japfa Ltd and my belief that the company would not be able to keep up with industry growth rate. In addition, I believe that the industry might undergo fragmentation which would compress margins.

In this post, I would like to retract some of my thoughts on Japfa Ltd. For one, I realized that I have made a mistake in my model which blew maintenance CAPEX out. I erroneously used inflation rather than D&A with inflation as a proxy. When adjusted, the risk of Japfa drops tremendously. 

For example, (EBITDA-Maintenance CAPEX)/Interest Expenses is now at a healthy 1.5x, and  ROIC is in the low-mid teens range. This is critical as this means that the company has the ability to generate value by adding debt to the business, and they are more than able to do that with a 1.5x (EBITDA-Maintenance CAPEX)/ Interest Expenses. Concurrently, even with expansionary CAPEX (Includes growth required to maintain market share), the ratio remains above 1.0x. 

This has tremendous implications. For one, it means that the company is no longer destroying value in growth. For another, it means that industry fragmentation (while still a risk) is less likely to occur. It is even possible for Japfa to do expansionary+ (growing market share) CAPEX. 

A complete 180 degree turn from a single mistake. This is the risk of using a financial model, a single mistake could wreck your model. The morale of the story: Double check your work (especially if you are posting it online for the world to see). 

JAPFA Ltd: Analysis & Risk

Link to Japfa Ltd financial model: https://www.dropbox.com/s/y7dyb0x5owhmv5x/JAPFA%20FINANCIAL%20MODEL.xlsx?dl=0
The problem with capital-intensive company with high margins is that is is hard to sustain that margins. This is because if whatever is driving high margins is a result of capital expenditures, existing industry players or new entrance could easily lever up and drive down margins. Japfa Ltd has this risk.

Japfa Ltd is an agri-food company that produces multiple protein food (poultry, milk, etc) in five emerging Asian markets, most notably, Indonesia. 

In the Indonesian segment, the poultry industry is highly concentrated, with the top 2 players owning over 50% of the DOCs and Animal Feed markets. This market concentration has led to Japfa Ltd to have a significant margin on their revenue in comparison to its western comparables such as Tyson Foods. Tyson Foods operates primarily in the United States, where the protein industry is fragmented, and thus has lower margins. For example, Japfa Ltd has a 9.5% EBITDA margins, while Tyson has a 5.8% EBITDA margin. This is a massive premium.

At the same time, operating in emerging markets means that expected growth rate is significant. When you have a capital intensive company that operates in a high growth environment, capital is crucial as capital expenditure will be high. The Indonesia poultry market is expected to grow in the mid-high teens for at least the next 5 years, and the China dairy market (which Japfa Ltd also operates in) with similar, if not higher growth rate. This is massive growth. 

So now the real question is this. Can Japfa Ltd meet the expected growth rate in the industry in which it operates in?

I believe the answer is no.

Japfa Ltd already has a (EBITDA - Maintenance CAPEX)/ Net Interest Expense ratio below 1, maintenance CAPEX being an adjusted inflation rate by geographical segment, let alone expansionary CAPEX. What this means is that the company is unable to service its interest expenses after spending cash on CAPEX. As a result, maintenance CAPEX cannot be fulfilled, UNLESS, the company is able to fund its CAPEX requirements from external sources, such as through an equity and debt offering. This was what they did. The problem with doing an equity offering is that it dilutes value if the stock price is undervalued.

By the way, what I mean by maintenance CAPEX is the cost required to keep current production going. Expansionary CAPEX, on the other hand, is the cost required to maintain market share. 

So the alternative is a debt offering. A debt offering would be accretive to value, so long as the return on incremental capital is above the cost of debt. With a headline ROIC and a cost of debt of 16% and 6.8% respectively, this seems to be the way to go. However, if this is indeed true, the company should not have done an equity offering as that would be dilutive. There must be a reason. 

I think the reason is two-folds.

1) Headline ROIC and cost of debt is erroneous. I believe true ROIC is below the current 16% as a result of a highly inflationary environment. Such an environment would result in future replacement cost (maintenance CAPEX) to be higher than historical cost. If one uses maintenance CAPEX in lieu of D&A, ROIC would drop below cost of debt. In addition, cost of debt might be depressed as total debt includes ~$400 million of revolving credit, which interest may not be reflected on the income statement. Since a debt offering would in fact be damaging to results, an equity offering is the alternative. 

2) Listing in the SGX allows the company to gain access to a more liquid financial market. This allows the company to refinance at lower rates. However, this would not be helpful as the return on incremental capital will likely still be below the adjusted cost of debt. I believe this is true because in 2013, Japfa Comfeed, a subsidiary to Japfa Ltd, issued $225m of SECURED SENIOR debt of 6%. This is above the adjusted ROIC of sub 4.0%. 

Back to answering the question, if the company is unable to produce returns above the cost of debt, this means that the company should not raise debt to finance its maintenance CAPEX, as that would ultimately be value destructive. Thus, the company would not be able to keep ongoing operations running, lest they raise capital through further equity offering (which is dilutive), let alone keep up with the industry expected growth rate. 

However, growth rate has to flow somewhere and I believe it would follow to industry players that are not as levered as Japfa Ltd. An example would be Malindo, which has a Debt/EBITDA of 1.7x and a (EBITDA - Maintenance CAPEX)/Interest Expenses of 4.8x, as compared to Japfa Ltd, which has a Debt/EBITDA of 3.8x and a (EBITDA - Maintenance CAPEX)/Interest Expenses of <1x. 

What this implies is that the industry is likely to undergo fragmentation and this would depress EBITDA Margin, which would further accelerate fragmentation. With a 9.5% EBITDA margin compared to Tyson Foods' EBITDA margin of 5.8%, margin compression has a long way to fall. 

Margin compression, massive debt burden and elevated valuation multiple...this could be a recipe for disaster.