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Sunday, May 29, 2016

Heveaboard Berhad: From an ugly duckling to a beautiful swan

Heveaboard Berhad: From an ugly duckling to a beautiful swan

Author: kcchongnz   |   Publish date: Sat, 28 May 2016, 11:19 PM 

Heveaboard’s share price shot up to a peak of RM1.73 on 5 January 2016, and finally retreated to close at RM1.18 on 27th May 2016. The gain to date is a whopping 410% in less than three years.

What causes the spike of its share price? Is it still worth investing?

Company Business
HeveaBoard Berhad engages in the manufacture and trading of particle board. The company also produces rubber wood based particleboard and manufactures 'Ready-To-Assemble' (RTA) furniture. It also manufactures furniture for home and office applications. The company's furniture components are used for manufacturing dining sets, speaker boxes, door manufacturing, and office systems. The company markets its products in China, Vietnam, India, Korea, Japan, Singapore, Sri Lanka, Philippines, Hong Kong, Taiwan, Australia, Africa, France, and United States, with Japan its biggest export market.

Hevea has gradually shifted its particleboard product range from conventional to higher value low-emission eco-friendly products which serve higher-tier customers, resulted in higher revenue and profit margin for the company. HEVEA has also made substantial capital expenses in its ready to assemble sector for FY13 & FY14 to the tune of RM20m in order to achieve higher automation and wider range of higher value product diversifications.

I first wrote about Hevea just three years ago when its adjusted share price was just 23.5 sen apiece, together with other furniture stocks as appended in the link below.

All those furniture companies mentioned in the article, including Hevea 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, Hevea’s earnings per share (EPS) has increased by four folds from 4.2 sen in 2012 to 16.9 sen for FY ended 31st December 2015, coupled with the subsequent expansion of its valuation, its share price shot up like a rocket.  What has happened?

Financial Performance and position
For the past 10 years, Hevea’s revenue has been increasing steadily from RM148m in 2005 to RM503m in 2015, or a good compounded annual growth rate (CAGR) of 13% as shown in Table 1 in the appendix.  Net profit increased by a much higher CAGR of 23% from RM9.1m in 2005 to RM73.8m for the year ended 31 December 2015. Thanks to the spike of its net profit margin to 14.7%, a historical high due to the drop in oil price and hence its main cost in resin, not because of the strengthening of USD against Ringgit in the past as most people think as it was having a high loan denominated in USD.

The great growth story of Hevea was accompanied with some hardship tough. From 2005 to 2007, it spent a huge amount of capital expenses to the tune of RM250m and incurring interest expenses of more than RM13m a year. It couldn’t even earn enough to pay for this interest. Just when the roof was leaking, the rain not only fell, but it poured, when the US subprime housing crisis hit hard world-wide soon after that in 2008 and Hevea went into first time losses. Hevea was at the brink of bankruptcy when it owed bankers RM225m in debts when its share price dropped to just a few sen.

Thanks for the swift recovery of the US and the world-wide markets, Hevea was making increasing profit soon after from RM18.9m in 2009 to RM73.8m for the last financial year. Free cash flows (FCF) have improved by leaps and bounds to RM140m from a huge negative of RM100m in 2005 as shown in Figure 1 below. This FCF now amounts to a whopping 27% of revenue and 47% of its invested capital. What a great cash generating machine!

The precarious financial position of Hevea with a huge debt of RM225m in 2007 has turned into a net cash position of RM66.6m for the most recent financial year.

With this healthy balance sheet and excellent FCF, Hevea, which has not been paying much dividend, but instead doing the right thing by paying down debts, has started to pay dividends now for FY2015.

The return on equity and invested capitals, both of which are my favourite metrics to measure “goodness” of a company, have both shot up to 22%, way above its costs.

A good company is not necessary a good investment. It all depend on what the offer price is, in relation to its value. That is why FA practitioners always carry out some valuations to have a feel of the value of the company, and hence to compare with its price.

“The success of investing is not from buying something good, but from buying something right.”

Some Simple Valuation of Hevea

Table 2 below shows some simple valuation metrics for Hevea with its closing price of RM1.18 on 27th May 2016.

Table 2: Some simple valuation metrics for Hevea

The attractiveness of investing in Hevea is its cheap market valuation as shown in Table 2 above. Despite its high return on capitals, stable earnings and good cash flows, its market valuations are all below some relatively stringent benchmarks. The enterprise value of just 5.2 times its earnings before interest and tax, or earnings yield of 19.1%, is particularly attractive. The cash yield (FCF/P) of Hevea, using the average FCF of last 5 years, of more than 10%, double that of my requirement of 5%, is befitting to be a No-Brainer investment.

Let us carry out a discounted cash flow analysis of Hevea using a conservative model to get a feel of its value to compare with its price.

Gordon Constant Growth Model (GCGM) for Hevea
The Gordon growth model is a model for determining the intrinsic value of a stock, based on a future series of free cash flows that grow at a constant rate in perpetuity, the model solves for the present value of the infinite series of future free cash flows. Here we value the enterprise value of entire firm, and then add its excess cash and then deduct the total debts. We will also use the Black-Scholes Option Pricing Model to estimate the value of its outstanding warrants to be deducted from the equity value.

This is quite a conservative valuation method by ignoring any super normal growth, and assume the company has become matured and its revenue and earnings are growing according to rate of inflation. Besides the 5-year average FCF of RM53.5m is used for the initial FCF, instead of the high FCF of RM135m for the most recent year.

The formula for the GCGM is as shown,

FCFF= FCF* (1+G) / (WACC-G)

FCFF is the free cash flows for the firm
FCF0 = Normalized Free cash flows for this year using the average of the past 5 years FCF
G = Constant growth
WACC= Weighted average cost of capital of the whole firm
Table 3 in the Appendix shows the computation of WACC to be 9.44%.

Table 4 shows the step-by step calculation of the intrinsic value of Hevea. After obtaining the enterprise value of the firm, the excess cash is added, total debts and option value of warrants holder deducted to get the present value of FCF due to equity shareholder in the amount of RM952m, or RM2.18 per share. The margin of safety in investing in Hevea at RM1.18 is at 46% as shown.

Hevea first quarter 2016 results
Hevea Board reported its first quarter 2016 financial results on 27th May 2016. A summary of its results is shown in Table 5 in the Appendix.

Revenue for the period increases by 25.4% to RM146m while profit before tax improved by 61.7% to RM23.6m compared to the corresponding period last year. Both business segments have increased revenue and increase in profit.

The particleboard segment registered an increase in revenue and PBT of 8.3% and 31.5% to RM51.7 and RM10.2m respectively. The Ready-to-assemble (RTA) products segment has a higher increase in revenue of 37.2% to RM94.2m with its PBT almost doubled to RM13.5m.

Compared to the immediate preceding period, revenue dropped marginally by 3.3% while PBT decreased by 22%. This is due to the seasonality as a result of festive seasons which reduced the number of working days in this period.

Basing on the latest trailing twelve months’ result, return on equity and return on invested capital have improved further to 22% and 28% respectively, more than double that of its cost of capitals.

The company has further paid up and reduced its debt to just a nominal RM13.2m, from RM58.4m during the end of last year. It now has a net cash of RM80m, or 18 sen per share. Besides it has started to pay better dividend, a dividend of 2.75 sen for last financial year, or a reasonable dividend yield of 2.3% at the present price of RM1.18, commensurate to what one can get from bank interest. Going forward, I would expect Hevea to increase its dividend due its healthy balance sheet, good earnings and cash flows.

Hevea, in the past few years, has transformed itself from a very risky company with huge debts facing a financial crisis in 2008 to a highly profitable and safe company with net cash now. It exhibits high growth in recent years and earns high return on capital with excellent cash flows and free cash flows. In another words, Hevea has transformed itself into a great company.

The investment thesis of Hevea lies in its low market valuation with earnings yield of 19.3% and its high cash yield of more than 10%, more than twice that an investor can get from putting his money in bank fixed deposit.

The conservative GCGM with growth assumption just matching the rate of inflation shows that Hevea is worth RM2.18 per share, or a margin of safety of 46% investing in it at RM1.18.

I see little risk in investing in a good company at a cheap price, but potential in extra-ordinary gain.

The secret to successful investing is to figure out the value of something and then-pay a lot less” Joel Greenblatt

K C Chong (29th May 2016)


Table 1: Financial performance of Hevea

Table 3: Computation of weighted average cost of capital

Table 4: Gordon Constant Growth Model for Hevea

Table 5: Hevea first quarter 2016 results

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