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Monday, July 20, 2015

Latitude Tree, Cyclical and Earnings Power kcchongnz

This article is purely for sharing and discussion purpose. It is not a recommendation to buy or sell a stock.

Rule number one, most things will prove to be cyclical.
Rule number two, some of the greatest opportunities for gain and loss come when people forget rule number one.”               
Howard Marks

[Posted by blank > Jul 18, 2015 11:59 AM | Report Abuse
Definitely this stock is a laggard. The directors are not proactive and zzzzzzzzzzzzzz... collect their directors fees and not think of shareholders. Sickening. Look at all the other furniture counters... Lii Hen, Poh Huat, Hevea have all moved. Lastly they give a miserable div yearly and expect shareholders to be happy.]

Figure 1 below shows its share price performance for the last 5 years. A picture paints a thousand words. Just what else do you and other investors want?
Don’t you think the management has created tremendous shareholder value the last few years by looking at the share price performance as shown in figure 1 above instead of scorning the management as the opening post above?

I first wrote about Latitude Tree just two years ago when its share price was just RM1.26 apiece, together with other furniture stocks as appended in the link below.
All those furniture companies mentioned in the article, including Latitude Tree were performing very well with high return on capitals and selling dirt cheap with low single digit price-earnings ratios and enterprise value (EV) with respect to their earnings before interest and tax (Ebit) at that time.
With its explosive earnings the last couple of years, earnings per share (EPS) has increased by seven folds from 10 sen in 2012 to a trailing twelve months EPS of 69 sen on 31st March 2015, coupled with the recognition of its value and the subsequent expansion of its valuation, its share price closed at RM6.10 last Friday on 17th July 2015. The gain is 384% in less than two years.

Less than one and a half year ago on 12th March 2015, I wrote about its excellent cash flows and its good reinvestment opportunities, and did some valuations on it when it was RM2.57. If you have bought it then, the return till now is still very high at 137%.
Just 8 months ago on 21st December 2014, I wrote about it again when its share price was RM3.58, reiterating their high return on capitals:
And still with cheap valuations:
http://klse.i3investor.com/blogs/kcchongnz/67260.jsp

Even if you have bought just 8 month ago, the return of investment is still a whopping 73%.

No, I am not selling medicine here on the road side but just to put things in perspective. That is already history. The pertinent question now is, what is the likelihood of its future financial performance and more importantly for many investors, its share price performance will be? Oh how I wish I have a crystal ball in front of me.

The past financial performance of Latitude Tree
I already knew that some people will say “This time is different”. The past has no relevance about its future. It is already history. But just bear with me with this ranting about its past performance first.
History doesn’t repeat but it does rhyme”           Mark Twain

Table 1 in the Appendix shows revenue of Latitude has been increasing at a CAGR of about 6.3% from RM412m in 2007 to the all-time high of RM673m as on 31st March 2015.  Net profit, profit margin and EPS are all at all-time high of RM72.6m, 10.8% 69 sen respectively. We can see that profit margin varies quite substantially over the years with profit margin at a low of just 2.1% during the subprime housing crisis to the recent highest of 10.8%. That is a huge difference of 5 times. The average net profit margin is 5.4%, and that is only half the most recent profit margin.

At the close of RM6.10 on 17th July 2015, Latitude is trading at a current PE ratio of 8.9 and an enterprise value of 6.7 times its operating profit. Is this price cheap? Should one buy, buy more with margin, hold or sell? But this thinking is just the first level of thinking.

Second level thinking about cyclicals
The opening quote from Howard Marks reminds us about the importance of second‐level thinking about “most things will prove to be cyclical.” It requires us to be very careful in recognizing that equities are not simply a claim on this quarter or next quarter, or even this year, or next year’s forward operating earnings, but are instead a claim on the very long‐term stream of cash flows that will actually be delivered into the hands of investors over time. It would seem to encourage the question
What is more strongly correlated with actual subsequent market returns? Is it the raw, unadjusted multiple of stock prices to expected earnings to continue to increase or decrease at the same rate, or is it the valuation of stocks after properly adjusting for the predictable cyclicality of earnings or profit margins?”
Ben Graham was aware of just this kind of problem, arguing that stocks should be evaluated on long-term average earnings over a cycle of 5 to 10 years, rather than on one or two quarters, or even a year or two of current earnings as propagated most analysts, investment bankers and many other market players.

This behavior of all these players accounts in good part for the wide fluctuations in stock prices, which largely parallel the changes in their earnings between good years and bad. Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in its reported quarterly profits. A private business might easily earn a few times more in a boom year as in poor times, but nobody will be willing to pay a few times more for a business in a boom year than in poor time. Will you? I know there are investors who are prepared to pay a few times more for the stock during the boom time than the bust time. That to me is more of a speculative endeavor. I also know big money is made speculating on quarterly results, but research has also shown more money has been lost hoping that trees growing to sky.

Cyclical Valuation of Latitude Tree
Rather  than  rely  upon  current  earnings  Graham  had  a  simple  yet  powerful  alternative Normalized Earnings Power, or average earnings, or average profit margin. As Graham opined:

“The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.”

As Latitude Tree is in the furniture industry which has been historically cyclical, fluctuating with general economic cycles, we will apply this principle here to check if the price is reasonable.
Over a cycle of 9 years as shown in Table 1 in the appendix, the net profit margin averages at 5.4%. With this profit margin and the trailing twelve month (TTM) revenue of RM673m, the normalized earnings is RM36.4m. At RM6.10, the normalized P/E ratio is 16.3. Is the price reasonable?
Latitude Tree with its latest financial performance, its return on equity and return on invested capital are excellent at 17% and 21% respectively. These ratios will be somewhat lower if there is a mean reversion of its earnings. But still these ratios are quite good for me. This PE ratio of 16.3 also meets the maximum price he is willing to pay is 16 times earnings, but just. So in this respect, it appears that it is okay to hold Latitude Tree at this price.
A check with the Stock Performance Guide by Dynaquest shows the historical PE ratio of Latitude Tree over a cycle of 12 years, with my update for 2015, as shown in Table 2 in appendix. The PE ratios of Latitude Tree varies from a low of 2.9 in 2013 to the highest of 12.4 in 2007 when earnings was depressed due to the subprime housing crisis. The market historically seems not willing to accord too high a PE ratio of this type of cyclical stocks.
So with a current PE ratio of 8.9, a normalized PE ratio of 16.3, is Latitude Tree cheap? Should you buy more, buy more on margin, hold or sell? Your opinions with rationales are highly appreciated.
Oh yeah, also bear in mind the shares are quite illiquid and its share price can easily be manipulated.

K C Chong (19th July 2015)

Appendix
 Table 1: Past financial performance of Latitude Tree
Year2015ttm
2014
2013
2012
2011
2010
2009
2008
2007
Revenue, 000
673210
651025
493687
517863
500664
506866
397378
404176
411706
Net Profit, 000
72609
64333
32046
14847
19741
36483
13213
8485
8793
Net Profit margin
10.8%
9.9%
6.5%
2.9%
3.9%
7.2%
3.3%
2.1%
2.1%
EPS, sen
68.8
56.6
25.1
10.2
12.8
42.8
21.6
16.7
15.8


Table 2: Historical price range and P/E ratio of Latitude
Year
Price Range
PER Range
2004
0.80
1.33
6.9
11.4
2005
1.15
1.37
7.6
9.1
2006
1.11
1.32
5.4
6.5
2007
0.79
1.31
7.5
12.4
2008
0.49
0.86
4.4
7.7
2009
0.50
1.25
3.5
8.7
2010
1.01
1.77
3.5
6.2
2011
0.60
1.32
4.7
10.3
2012
0.57
0.78
5.6
7.7
2013
0.70
2.50
2.9
10.2
2014
2.04
3.93
3.6
6.9
2015
3.63
6.50
5.3
9.4


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