Post-mortem of Hock Lian Seng Divestment

I think it’s very helpful to analyze an investment after one has divested, whether it’s been a successful or unsuccessful one. In fact, the unsuccessful ones are usually the most instructive ones.

History of events

I first initiated a position in Hock Lian Seng (HLS) about 3 years ago, at a price of between $0.24-$0.25, and continued adding till it reached $0.3. At the peak, I owned 1,000,000 shares of hock lian seng.

I shan’t go into detail about why I had invested in HLS as the reasons are mostly stated in my HLS investing thesis post. But generally I like, in decreasing order of importance, their severe undervaluation then, management’s focus on margins, and the large gain on earnings recognised upon TOP of their 2 industrial projects.

Severe undervaluation – I cant remember the exact figures but it was trading at around 60% of book value, with constant FCF generated and PE was <5. I dunno how much lower can these figures go.

Management’s focus on margins – I watched as foreign construction companies came into Sg to outbid many local companies on government projects, mainly the MRT track projects. Many companies cut their margins to try to match their bids. HLS has stayed out of the bidding war. Their margins are the absolute craziest. Just to illustrate my point:

I compared these margins to related peers like BBR holdings and Koh Brothers. None were anywhere close. It seems the norm for NPM would be around 5% or so. Having had some experience running a business myself, I can appreciate when management focuses on margins. In business, the 1st and easiest reaction when faced with competition, is to cut prices to try to maintain market share. If HLS can actually maintain (and later subsequently to my delight, grow) their margins, they must have some competitive edge.

Large gain on earnings recognised upon TOP of industrial projects – This is an accounting “gimmick” for construction companies. Their 2 industrial projects, Ark@ Gambas and Ark@KB, have earnings recognised via a “completed contracts” method, instead of a “percentage of completion” method.

Basically for construction companies with multi year project developments, there are 2 ways to recognise revenue/profits for projects. The percentage of completion (POC) method recognises revenue/profit/losses at periodic moments along the entire project cycle. The completed contracts  method (CC) recognises profits only at the end of the project, usually upon TOP.

A very simplistic example: A certain development costs $60mil to build within 3 years. The developer sells it for $100mil.

POC method

• Year 1: Revenue $30mil, Developmental costs $20mil, Profit recognised $10mil.
• Year 2: Revenue $30mil, Developmental costs $20mil, Profit recognised $10mil.
• Year 3: Revenue $40mil, Developmental costs $20mil, Profit recognised $20mil

Total Revenue upon TOP $100mil, developmental cots $60mil, Profit of $40mil recognised over 3 years

COC method

• Year 1: Revenue $0mil, Developmental costs $0mil, Profit recognised $0mil.
• Year 2: Revenue $0mil, Developmental costs $0mil, Profit recognised $0mil.
• Year 3: Revenue $100mil, Developmental costs $60mil, Profit recognised $40mil.

Total Revenue upon TOP $100mil, developmental cots $60mil, Profit of $40mil recognised in the 3rd year

Of course this is a very simplistic way to put it but it illustrates the difference. Bear in mind that I’m talking only about the income statement here. Whichever method it is, the costs and billings and receivables and earnings will all still show up in the balance sheet and the cashflow statements. They are just not recognised in the income statement till the end of the project when it is handed over under the CC method.

I was confident HLS would do well as I could see the projects moving along, sales were good and everything was recorded in the balance sheet. It was just too unknown a company for most people to pay attention to it. I was betting that as the earnings get recognised, the headline news about the record earnings will  make most people sit up and notice. And I was right.

Now the mistakes.

Well, not exactly a mistake, but I could’ve exited my position earlier and gotten a much larger gain. The main issue was greed. The bumper dividends of 4 cents and 2.5 cents in the past 2 years was too attractive for me. On hindsight, I should’ve expected that it’s also too attractive for the masses.

To get outsized returns, it’s hardly ever right to be part of the masses

Hence, the small mistake would be having waited to collected the dividends before trying to exit. Also, because of the large position sizing, exiting takes days, perhaps weeks even.

To my credit I did divest 250,000 shares at a relatively higher price of $0.45.

My net entry price, inclusive of dividends, is approximately $0.167 (inclusive of dividends for 3 years), and my net exit price is approximately $0.375.  Total ROI: 124.5% in 3 years. Total quantum gain: $208,000.

My Thoughts

I exited HLS as I think it has reached fair value. At my exit price, it is trading at approximately 0.9 times book value, with a PE of about 7. (assuming earnings of 6 cents) I did not take the previous year’s earnings as they are bulked up by non recurring charges from the COC method of revenue recognition as I mentioned earlier.

Going forward, I expect HLS earnings to normalize to the 4.5-6.5 cents range. There are some signs that convinced me to divest. For starters, HLS has lost their dorm as the lease is up. Earnings from this dorm accounted for almost 20% of gross profit in FY12 and FY13.  That works out to be about $5mil of gross profit. Not something to be scoffed at.

There are also no major catalysts to earnings from now till FY18. In the meantime, HLS has to spend money to continue to build it’s Tuas industrial project. Property development, like the property market, moves in cycles. This is the time when HLS has to invest and build, without getting any returns yet.

Here is a list of their ongoing projects and some notes that I’ve compiled:

The red ones are completed projects.

I monitor the projects closely and try to relate them to what I see on the earnings and balance sheet. Assuming no new contract wins, the bulk of HLS’ activity and earnings will come from the Changi airport project, the Maxwell station project and the stabling at Gali Batu project. These have already started and are contributing to earnings. I have no way of projecting accurately where each project is along the project cycle, as their contribution to earnings varies.

However, the gross profit from civil engineering has already dropped from FY16Q1 compared to FY15Q1. At least for these 3 projects, I believe HLS will show margin compression compared to previous years.

The government usually pays a small fee at the start of the project (around 5%), and continues to pay up at certain milestones along the project. The bulk of the earnings would be at the middle to the end of the project in  most instances..

The Shine@Tuas South industrial project will be an “investment” of sorts for HLS. They’d have to pump in resources to build, and revenue recognition is only expected sometime in 2018.

While I have divested HLS, I would still be keeping an eye on this company. My initial thesis (point 2) about the strong, experienced management has not changed, although points 1) and 3) are no longer valid. I would still be monitoring as I love companies with capable management.

In this instance, my reasons for divesting is not because the company is going to do poorly. I actually expect HLS to continue to perform reasonably well, and outperform in the future. I  just think that I can deploy my capital elsewhere for a higher ROI than HLS for the next 2 years. The markets are fickle, and sentiment is too easily affected by headline news. I think the share price would face some headwinds and not reach it’s highs, without some obvious catalyst.

Lastly, on a technical basis:

I noted the bearish signal from a TA perspective, but still decided to wait for the bumper dividends of 2.5 cents. As noted earlier, this was a mistake. I had a 2nd chance to sell after collecting the dividends, when the share price went below both 50 and 150 day MAs, but stuck to my insisted price. Again a mistake.

Moving forward, the trend is still a downtrend, although I think it’ll form a base around the $0.35 mark. Aside from this, I have a highly cautious global macro view and will be monitoring this carefully.