Wednesday, August 31, 2016

Are you getting fucked by management?

Hello again! Recently, a company which I invested a lot of money in fired their CEO because he was under investigation for insider trading or some shit like that. The stock of the company in question (Northern Oil & Gas) of course took a significant hit. This incident got me to thinking if Northern Oil & Gas’ management has done anything else to fuck me and other shareholders over. I don’t have any evidence that Northern Oil & Gas are cooking their books. But nevertheless, a falling stock price because the former CEO may or may not have done something shady can make a guy like me very paranoid. So, I did some thinking and some googling to try and find out what are some signs that management aren’t flying straight. Again, I’m not saying that Northern Oil & Gas’ management have done anything wrong as there is no evidence for that. This article simply highlights some of the things investors should look out for when researching companies in general.

Disclosure: The intention of this article is not to influence investors to sell or buy shares in Northern Oil & Gas. Investors should do their own research. I personally do not know what I’m going to do. I might sell my shares in Northern Oil & Gas or add to my position in Northern Oil & Gas in the future. What I may or may not do in the future depends on a variety of factors. I’m also thinking about using options to hedge my position in Northern Oil & Gas so that I can sleep better at night. The problem is that I don’t think I can buy options on U.S. stocks through Malaysian brokers. I would have to find a reputable online broker, and I would also need to make sure that I’m not breaking any Malaysian laws by opening an account with an online broker.

An increase in accounts receivable as a percentage of sales (or days sales outstanding if you prefer)

An increase in the accounts receivable/revenue ratio could indicate that the company might be lowering their revenue recognition standards (which could result in higher sales returns) or booking sales that do not exist. Investors should pay attention to the company’s operating cash flow as it takes into account changes in accounts receivable. Investors should also look into how the company recognizes its revenue to see whether or not the company is loose in booking sales. For example: Recognizing the entire lump sum payment for a multi-year contract as sales in the current period.

One-off items

One-off gains obviously will result in higher accounting earnings. This is easy enough to get around by just excluding one-off gains in your analysis. Investors also exclude one-off losses to get a more accurate representation of a company’ financial performance under normal circumstances. And there’s nothing wrong with that if those expenses are indeed non-recurring. But if a particular non-recurring cost keeps recurring, then maybe investors should factor in that non-recurring item in their valuation model.

An increase in accounts payable as a percentage of sales

A company can improve its operating cash flow by delaying payments to its vendors. I think that vendor financing is overall a good thing as it frees up more cash for the company to reinvest in the business or pay dividends. However, a significant increase in the accounts payable/revenue ratio could indicate that the company is fucking around with its operating cash flow (perhaps to appear in compliance with debt covenants), or worse, having problems paying their vendors.  

Capitalization of expenses

Companies could dress up their earnings by capitalizing costs that should be expensed in the current period. This essentially moves some expenses that should be reflected in operating cash flow to investing cash flow. I get around this problem by calculating free cash flow which accounts for capital expenditure.

Other income

I get nervous as fuck when I see a large other income figure as who knows what kind of shit management has stuffed under other income. I usually exclude other income when valuing companies unless I’m confident that certain items under other income are likely to be sustainable.  

An increase in inventory as a percentage of sales

An increasing inventory/revenue ratio could indicate that the company was too optimistic in its demand projections, and overproduced or over ordered inventory. It could also indicate that management has delayed writing down inventories which could result in a significant writedown somewhere down the road.

Off-balance sheet arrangements

Management might hide liabilities off-balance sheet to make the company’s financial condition look better than it really is. Therefore, it’s important for investors to check whether the company has potentially material off-balance sheet obligations.

A good way of reducing the risk of getting it up the ass from an unethical management team is to invest in companies where management actually owns a lot of stock in the company they run. People are less likely to fuck themselves, not intentionally anyway. Thanks for reading. Take care and stay rational.

Sunday, August 21, 2016

Analysis of Hua Yang

Please read the disclaimer here: Enjoy the article, bitches!

What’s crackin’ fam? The markets seem to be getting better, so that’s pretty awesome. The Olympics is going on, so that’s kinda cool if you’re into some of the sports. I watched some of the swimming events mainly because of Michael Phelps. And while Phelps was amazing as expected, Katie Ledecky absolutely blown my mind. I got teary eyed when I watched Ledecky finish the race at least half a lap ahead of her competitors to win a gold medal and break her own world record. It was just inspiring to watch the payoff for all the time and effort that she dedicated to becoming great at what she does. Anyway, in this article I will be analyzing Hua Yang. The group is engaged in property development in Malaysia. According to Bloomberg, the group had a market cap of RM480 million at market close on August 19, 2016. If memory serves me right, I bought the stock a few months back at RM 1.87 per share. This is my first time investing in a property developer, so there is a significant risk that I might screw up and make at least some mistakes in my analysis.

Update on the Greedy Dragon portfolio: I recently sold all my shares in First Republic Bank and 75 shares in Natural Resource Partners for USD 71.26 per share and USD 27.5 per share respectively. I added to my position in Oasis Petroleum, Northern Oil & Gas, and Maybank for USD 6.82 per share, USD 3.43 per share and RM 8.02 per share respectively.

The ability of a property developer to sustain its business is dependent on its landbank. According to Hua Yang’s financial year 2016 annual report, the company’s available landbank could potentially generate a total estimated gross development value (GDV) of RM3.8 billion. Klang Valley make up 45% of the total potential GDV; Johor, Perak and mainland Penang accounts for the rest of estimated potential GDV in almost equal proportion. I couldn’t find out how long this could keep the group busy in the 2016 annual report. However, it was mentioned in the 2015 annual report that a potential RM3.3 billion GDV could sustain the group’s development activities for 6-8 years. Of course Hua Yang should be able to continue developing properties for significantly longer than 8 years as it can acquire more land. A property developer’s estimated GDV shouldn’t be thought of as the company’s lifespan. It should be thought of more as a margin of safety for the developer to maintain a healthy pipeline of new projects.

Landbank & GDV is only one part of the equation. Investors should be able to make an educated guess as to how much profits a property developer can make on its estimated potential GDV. As this is my first analysis of a property developer, my method may seem like something you would come up with over a roti telur double at a mamak shop at 2 in the morning. Here is how I estimated the potential profits Hua Yang could earn on its estimated potential GDV:

Disclaimer: The potential profit is just an estimate, and can vary significantly from actual profits. My model also doesn’t include some items such as other income, under provision of development expenditure on projects completed in prior years, and etc.

Figures in millions of Ringgit
Estimated potential GDV as at March 31 2016

Development expenditure
Selling & marketing expenses
General & administrative expenses
Finance costs
Potential profit before taxes
Corporate taxes
Potential profit

Development expenditure was estimated by taking the 3-year average ratio of development expenditure/revenue which came to approximately 0.60 and multiplying that figure by 3,800. I used development expenditure instead of property development costs as I assume that the group would have already made the investment for its current available landbank. Development expenditure also made up a much larger percentage of property development costs than freehold and long-term leasehold land. Selling & marketing expenses was estimated by taking the 3-year average ratio of selling & marketing expenses/new sales which came to approximately 0.046 and multiplying that figure by estimated potential GDV. General & administrative expenses was estimated by multiplying financial year 2016’s general & administrative expenses by 8. As estimated potential GDV as at March 31, 2016 was higher than potential GDV as at March 31, 2015, I will assume that it will keep Hua Yang busy for 8 years. General & administrative expenses will also be higher if you take a longer time frame, and I prefer to be a little bit more stringent with my models. Finance costs was estimated by multiplying 8 by financial year 2016’s finance costs including amount capitalized in land held for property development and property development costs. I’m probably double counting at least some of the finance costs as a significant portion of it could be accounted for in development expenditure due to capitalization, but I like to be stringent to have a built-in margin of safety in my estimates. The corporate taxes estimate is simply 24% (which is Malaysia’s corporate tax rate) of potential profit before taxes. Actual corporate taxes could be lower than my estimate as I didn’t take into account tax shields such as stuff like depreciation.

Of course the potential profit in my model is only for current estimated potential GDV as at March 31, 2016. Hua Yang can keep adding to their landbank so that they keep launching new projects, and therefore sustain their business for the long-term. For instance, in financial year 2016 Hua Yang acquired land in Penang for RM45 million which it has earmarked for a RM311 million project. Before I invested in Hua Yang, I was afraid to touch property developers because I was always worried that land prices will soar and eat into their profits. I mean I always hear stories about some old dude who bought a few acres of land for a few thousand ringgit when he was young, and now his land is worth millions of Ringgit. But after looking into the numbers, the main expense under property development costs was development expenditure. Development expenditure made up an average of 91.14% of property development costs over the past 3 financial years. I ain’t saying that the cost of replenishing the landbank isn’t something to think about, because it’s indeed important. I’m just saying that it’s useful to look at the big picture as well.

Hua Yang has been able to generate good returns on capital. In the period of financial year 2012-2016, the group achieved returns on equity of between 20%-24%, and returns on assets of between 10%-12%. Hua Yang has net assets of RM 2.05 per share which is higher than the stock’s Friday closing price of RM 1.82 per share which indicates that the stock could be undervalued. According to Bloomberg, Hua Yang has a Price/Earnings ratio of 4.62 based on the stock’s closing price on August 19, 2016 which is another indication that the stock might be undervalued. However, I think that part of the reason the stock is trading at such a low multiple of earnings is that the market is pricing in the risk that property developers’ earnings might take a hit due to the soft housing market. The group only has a net gearing ratio of 0.34. So, unless there is a severe downturn in the housing market, Hua Yang should be able to comfortably meet its financial obligations. The board did not recommend a final dividend as they wanted to strengthen their cash reserves. I agree with their decision as the current operating environment is more challenging than the past few years, and more cash will give the group greater flexibility. I would also like to point out that the board has demonstrated their willingness to reward shareholders with healthy dividends in the past. This gives me confidence that the board could raise the dividend once the housing market recovers.

Aight guys, I think I will end the article here. I hope my first investment in a property developer delivers attractive returns in the long-term. I’m sure I still have a lot to learn about the property development industry. As always, thank you for reading. Take care and stay rational.