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Sunday, September 21, 2014

London Biscuits Bhd - Irresistible Bite! kcchongnz


London Biscuits Bhd - Irresistible Bite! kcchongnz

The above is the title given by Kenanga Investment Bank, not me. Generally I like to write about good stocks. However without knowing what is bad, how are you going to avoid falling into the pit when your investment bankers, remisiers, sifus from forums keep on persuading you to buy the next best stock in Bursa? For me avoiding losing money in lemons is equally if not more important than catching a good stock to invest in.

This article is written by me purely for sharing and discussion purpose.

Recommendation from Kenanga Investment Bank

The report on London Biscuits published by Kenanga on 5th May 2014 is appended in the link below.

“Undervalued; Rare Malaysian consumer gems” as suggested by Kenanga.

I like to emphasize the term “Rare”. Within a week, its share price shot up by more than 10% to 91.5 sen. Today its share price hovers around 83 sen. The interesting question is whether most of the retail investors profited from this report by buying London Biscuits at about a low of 80 sen just before the call was made and able to sell it at its high of about 93 sen a couple of months later, for a gain of 16%; or a paper loss now by buying close to its high at 93 sen and still holding the stock. I will leave it to your ingenuity to make a good guess.

Let us just forget about the share price movement as you know, you can’t predict share price movement. Even if London Biscuit is really so good as investment as described by Kenanga, its share price may not be fully reflected especially in the short term. Let us look at Kenanga’s thesis on LonBis and its business if it is really good or “turning around”.

Kenanga’s report mentions that “LonBis has registered 12 consecutive years of profitability”. That is 100% true. Nobody can argue about that. But what kind of profitability? How are they achieved? Are they satisfactory with the capital invested? There are whole loads of questions. However Kenanga has not address a single one of them. What are the questions? Why are they important?

London Biscuit: Grow Baby Grow

If you are a growth investor looking for a small capitalization high growth company to invest in, this is it! Its revenue grew from 82m in 2005 to 360m (Table 1 in Appendix), for a compounded annual growth rate (CAGR) of 18%. Believe me, it is hard to find a company in Bursa growing at that rate for a long period of time. But how did it achieve this rate, and what is the bottom-line of this growth?

LonBis keeps on issuing new shares and borrowing money to keep on buying plant and machineries to increase its assets and revenue. Its outstanding number of shares has almost tripled from 68m in 2005 to 164m as at June 2014. Despite the additional money collected through the right issues, its total debt is still increasing consistently every year from 68m 9 years ago to 264m now. Its balance sheet is becoming precarious now with total debt 70% of equity, and current and quick ratios way below unity. The money is mostly spent on buying property , plant and equipment (PPE). PPE ballooned by more than 4 times from 141m to 571m from 9 years ago.

Yes, huge growth in every aspect; revenue, PPE, number of shares, total debts. But what is the bottom-line with this huge capital investment through right issues and bank borrowings?

The Bottom-line Cry Baby Cry

Net income is basically flat throughout the years. Earnings per share actually plummeted from 20 sen 8 years ago to just 8.7 sen for the financial year ended 30th June 2014. How come with so much increase in assets utilized for its operations, with so much borrowings from banks, and increase in share base from right issues, its EPS is deteriorating so badly that its dividend has to be reduced from 15 sen to just 1 sen per share?

One answer lies on its margins and efficiencies.

Margin and efficiencies

Comparing with the margins and efficiencies of another confectionery company, Apollo Food, why is that the other confectionery is so much better than LonBis?
Apollo’s net income of 32m is twice of LonBis , although it uses only 20% of LonBis’s PPE.
Apollo’s net profit margin of 14.4% is three times that of LonBis of just 4.8%.
Apollo’s return on capital of 19.2% is almost 5 times that of LonBis of just 4.2%.
And the 4.1% return on capital of LonBis is way below its cost of capital, and hence a huge shareholder value destroyer, every year, consistently.

We must realize that a high growth company with return on capital lower than its cost is a shareholder value destroyer which investors should shun away. By the way, haven’t I mentioned that LonBis has been growing at CAGR of 18% for the last 9 years, and what has been the result? Well even Kenanga Investment Banks doesn’t realize it (really?), where does a small time retail investor stand?

Yes, we shouldn’t focus on earnings growth but return on capital. After all a company borrows $1 billion, hugely increases its bankruptcy risk, and earns $10 million a year, or just 1%, it will still grow its EPS. But why does most investment banks focus on earnings growth, EPS, and talks nothing about return on capital? Beats me.

The “Bright” Side? Cash flow of LonBis

If you look at the cash flow statement, LonBis appears to have good cash flow.

The cash flow from operations (CFFO) is almost always positive, and they are generally more than the net income throughout the years. Few investors realize that that is because of the huge amount of depreciation, which is non-cash, is added back to CFFO. Why not, they spend millions and millions buying PPE every year? Money spent on capital expenses is capitalized in the balance sheet and not expended in the income statement. It is only after looking at its cash flow from investment activities that you can see tons of money is thrown as capital expenses consistently every year, and yield poor bottom-line and a huge destroyer of shareholder value.

Yes even cash flow can be deceiving.

Ok ok ok, we shouldn’t always talk about the past. In investing, it is the future which is important. LonBis’s business is turning around. That is the theme in Kenaga’s report. Really?

Latest annual results ended 30th June 2014

Its latest financial results shows an increase in turnover by a fair bit of 24% to RM360m, not bad at all. However, net profit increased by 14% to RM17.2m, or a miserable net profit margin of 4.8%. The huge RM737m in total assets utilized for the business yields just 2.3% return a year. There is no details of its capital expenses as the cash flow from investing activities is not broken down deliberately (?) but I can see it PPE has increased by another 10% to a whopping 571m now. This is despite of what Kenanga said in its May 2014 recommendation:

“Historically, LONBISC earnings decline from FY10 to FY12 is caused by its high investment to upgrade its capacity and expansion to modernise its equipment and machinery. However, the period of high capex should be coming to an end”

And what about its high debt?

“its cashflow has improved and is now being used to pare down debt to a healthier level.” Said Kenanga.

But I don’t know why, I can’t see its total debt reduced from 2013 to 2014. In fact it has increased by 400k, not much, but still an increase, definitely not decrease. Furthermore, its cash holding decreased from 27.2m last year to only 13.9m now. Where got pare down debts?

What about this?

“We expect FY14E net profit to improve by 15% to RM14.2m”.

Again you only talk about earnings growth, what about improved margin, improved ROE and ROIC to above costs of capitals? If your return on capital improved from 4.1% by 50% to 6%, the return on capital is still way below the cost of capital. It is still a shareholder value destroyer. But I don’t know why, its latest annual results still shows deterioration in return on capital compared to last year. So where is the turnaround?

Surely there must be some positive things investing in LonBis. Yes, its price. Very cheap.

“- Undervalued; Rare Malaysian consumer gems at below 10x Forward PE (FPE). LONBISC is currently trading at 9.2x FPE which is at a 16% discount against its peers”

“In addition, LONBISC is trading at only 0.42x of its book value of RM2.17”

My question is how come Kenanga doesn’t understand that PE ratio is related to things like ROE, ROIC, cost of capital, health of balance sheet etc. It has also something to do with the payout ratio and expected dividend as the value of a company is the discounted present value of all its future expected dividends, instead of just a simplistic PE ratio?

Has Kenanga looked at what kind of quality is the assets of LonBis. What is it made up of? And hence what is its quality book value.

For me, those are entirely different stories, long winded stories.

The moral of the story is, do not blindly follow rumours and hypes.

“No one protects the retail investor-not corporate officers, not brokers, not analysts and investment bankers, not the media, not even government agencies and elected officials whose job is to do so. An investor must use his own best judgement, all the information available (bearing in mind that publicly available information is never equivalent to insider information), and be very conservative.”

Total return of LonBis for the last 5 years

Appended here is the interesting comparison of return on share price of LonBis (in green) and the broad market of KLSE (in blue) for the last 5 years. A picture paints a thousand words.

K C Chong (20th September 2014)

Table 1
Net Income
EPS, sen
DPS, sen

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