I’ve been hunting for the next gem ever since the divestment of Hock Lian Seng and Metro Holdings. My portfolio currently holds a large proportion in cash, but I’m in no hurry to reallocate capital unless I find a compelling opportunity. In the meantime, I’d dabble in selling options and Forex.
Logically, the 1st and easiest place to hunt for opportunities is to revisit some of my previous investments. Asia Enterprises Holdings (AEH) is one such case. The advantage of revisiting previous investments is that I don’t have to spend an additional 2 months researching on the background and the qualitative aspects. I just have to update myself on what has happened.
I invested and subsequently divested from AEH some 4-5 years ago, having accumulated at around $0.19 and divesting at around $0.23, excluding dividends. AEH was a great dividend payer then, now, not so much.
It helps that AEH is a simple business to understand. Being a steel middleman, what it does is to act as the bridge between the steel mills and the end users.
Steel mills want to sell steel in a standard format, and in bulk. Variety adds to complexity and costs. Selling in small quantities is not feasible for low cost commodity suppliers. They’d also like pre-orders as it gives them predictability.
End users, on the other hand, usually needs a variety of steel in various shapes and forms. They need relatively small quantities, and they need their orders fast aka on-demand. They also obviously do not like commitments aka making orders way in advance.
This is where AEH comes in.
It’s main clients are from the marine and offshore industries, steel stockists and construction companies, particularly from Indonesia and Singapore.
AEH has been in business for a long time. In the decades of its existence, it has been profitable in every single year…. except 2015. It went through all the busts and crises in recent memory, and yet couldn’t escape slipping into losses last year. This shows how severe the correction in the steel industry is.
Here’s the multi-year income statement:
As you can see, the earnings have come under pressure and is generally lower compared to a decade ago. The stress is most clearly seen in the revenue. Revenue in FY15 is barely 1/6 that of FY07!
For commodity companies, I think it’s really important to look at multi year, long term data instead of just the recent 3-5 years. This is because during a boom, the earnings may suddenly jump and look fantastic for a couple of years, but during a bust, it’d tank just as quickly. Looking at longer term data gives one a better perspective as to how the company is doing relative to the entire commodity cycle. It doesn’t take a genius to do well during a commodity boom, but it takes a genius to NOT do badly during a commodity bust.
The key thing to understand about AEH though, is that the inventory is carried in the books at a “weighted average” price. This means that if prices are falling, the newer inventory is bought at a lower price, and this serves to lower the average price of the inventory (as a whole).
On top of that, AEH reviews the inventory yearly, and marks the entire inventory to reflect an accurate picture of its worth (based on recent prices). Like I said, AEH is pretty conservative.
In good times, this gain would provide a boost to earnings. In bad times, it’d feel like swimming against the tide. The losses that AEH incurred in FY15, is largely attributed to such a writedown.
Hence, although I am a bottom-up value investor, I strongly believe that in the case of AEH, valuations take a back seat and macro factors, particularly steel supply and demand and consequently, steel prices, are the main determining factor on how well the company does.
Still, we should take a brief look at the valuations.
The good news is that AEH has a rock solid balance sheet. It has always been ultra conservative.
No rocket science here. The bulk of the equity is usually held in cash. As of FY15, the total equity is $92.7mil, of which $68.4ml is in cold hard cash, with zero loans!
This is both good and bad. Good because your investment is relatively safe. It is in cold hard cash. You’d avoid a situation where you’re overpaying. Bad because all that cash is wrecking havoc on the ROE/ROA figures. In short, the money ain’t generating any returns while it remains as cash.
On top of that, if one looks at the “Inventories” row, you’d see how badly AEH’s inventory has shrunk. While part of it is due to reduced stocking, a substantial portion is due to constant writedowns to reflect the shrinking steel prices.
AEH is cheap if one looks solely at the books. Assuming a price of $0.18, the company trades at a 33% discount to book value of $0.27. Of the $0.18, the company holds cash (as of FY16Q2) of $0.2! Of course, we’d have to consider it’s liabilities like the payables etc, but still this is a classic net-net situation. For every 18 cents, you inherit 20 cents.
After AEH was featured recently in a TheEdge article, interest has increased substantially. Traditional Graham-like fans have jumped onto this as the quintessential value investment.
I beg to differ.
To begin with, I think the classic Graham “net-net” has been over emphasized. Although Graham focused strongly on valuations, in his earlier lectures, one can tell he has a global macro perspective. (I’m currently reading a book – The Rediscovered Benjamin Graham, which is a compilation of his lectures, this will go in my book list when i’m done)
Alright, let’s get back to AEH.
Some characteristics about AEH:
They’re exposed to forex risks. Inventory is purchased in USD, and sold in SGD. The strong USD is not doing them favors, although they have tried to hedge it somewhat.
Their revenue is traditionally highest in Q1, and lowest in Q4. This fact gives a little hint of how they’d do on a full year basis, as the year progresses.
The business is generally FCF generative. I can’t find a year where the FCF is negative. I guess it’s the nature of the business. There isn’t much capex to talk about. They just earn on the spread of the bulk purchase price vs the sale price.
As their profits is proportional to the steel prices, AEH benefits from higher margins when steel prices rise. Revenue may not rise if steel prices rise only moderately (as fewer orders come in), but margins rise accordingly. Hence, moderate rises/falls in steel prices may not be reflected accordingly in their earnings. (For eg. Revenue may drop but margins rise such that earnings are constant)
Steel mill suppliers deliver the steel to AEH 2-3 months after they have ordered. This means that for orders placed in the current quarter, the steel price effect will show up in the weighted inventory cost (carried in the BS) in the next quarter or so. Slight lag time there. Inventory replacement generally has a delayed impact on the Group’s cost of sales due to delivery lead time which is typically around two to three months.
During my research into AEH, I’ve read several reports and comments on how cheap AEH is by looking at the book value and the massive discount to BV, as well as the fact that the share price is supported by the high cash holdings.
It’s true… but I’m not entirely convinced.
The issue is these analyses are using their idea of cheap, in an industry where cheap alone is not enough. The company has to be disgustingly, horribly cheap.
Think about it, if AEH is a private company, and you’d like to acquire it. Would you pay a sum that’s equal to it’s book value? In other words, would you pay to buy the company’s inventory at market price?
I wouldn’t. Because if I am going to get it at market price, I might as well buy all the steel inventory from the steel mills myself, buy my own warehouses to set up shop and there is a AEH in the making. Why buy AEH?
This means that the true value if AEH were to sell itself in it’s entirety tomorrow, must be a huge markdown from the stated book value before someone would consider buying it.
What I’m trying to say is that a 30% discount to BV would be a crazy amount for most other industries, but for AEH, it’s still considered relatively expensive. A 35-40% discount to BV would be what a good negotiator would get for the company in times like these. But since I have self professed to be looking for DEEP VALUE situations, I’d be asking for a 45-50% knock off from the stated BV.
Lastly, the company’s management has also indicated that they’d be seeking a mandate to do share buybacks as they think AEH is undervalued. Well, I don’t think they’d be doing much buybacks. Has anyone looked at the volume transacted? AEH has infamously high illiquidity. Any buybacks will further increase the illiquidity.
Alright, so far we have established that AEH is dirt cheap. We know management is experienced, the company has been around for decades, and has been fairly resilient. We also know that the company is FCF generative, conservative in it’s accounting and tries hard to give out fair dividends. What is there to NOT like about AEH?
Well, the key to AEH’s success IMO, (and I believe this is not commonly emphasized enough), is simply demand from the marine and offshore sector, and correspondingly, steel prices.
All the great stuff about the company takes a back seat to the demand for it’s products, and the steel prices (which determines the margins AEH gets).
This means that any investment thesis on AEH has to establish an opinion on how the marine sector in the region would look like in the near future, as well as establish an opinion on how the steel prices will move.
Suddenly, an investment in AEH is not as simple as it seems.
Sure, valuations according to Graham’s principles are cheap. But who doesn’t know that? That’s the simple stuff. Anyone with a calculator can input some data and derive this information.
I’m no expert in the offshore and marine sector. We all know the troubles in O&G and in the commodities sector, both of which are the major clients of the marine sector.
On the other hand, we can try somewhat to establish how the steel prices would look like, by looking at demand and supply.
Here is a very nice, self explanatory chart about world steel demand in 2016, and the projected demand in 2017:
The 2nd part of the equation is obviously supply. China has always been BY FAR, the biggest supplier of steel. When times were good a couple of years ago, China went on a guzzling spree, scooping up as much commodities as the world’s players could supply. The huge steel production fed it’s own construction boom.
With the slowdown in the Chinese economy in the past couple of years, all this supply has been flooding the global markets, causing steel prices to crash.
Global steel prices look like this in the past decade:
btw: ROW = rest of the world.
Yes, China produces more steel than the rest of the world COMBINED. (including the other major players like India and US).
Well, one can form one’s own conclusions by looking at the data above. Here’s mine:
While AEH is certainly cheap by most standards, I believe we must have an exceptionally large MOS for AEH. Hence, I’d only consider if the discount to BV is >40%. At the current BV of 27 cents, that means I’m only comfortable with CONSIDERING an investment if the share price is around 16.5 cents or lower.
AEH is a fairly well run company, caught in a bad sector currently. They dynamics of the business is also not fantastic. As with all commodity companies, there are no real competitive edges. (The company website states it’s capital intensive business nature as a moat, but as an investor, I consider that as a disadvantage instead. IMO, that’s kinda like saying that the business dynamics is so bad that we are unlikely to have new competition)
Although AEH is well capitalized to survive in this tough environment, surviving is not the same as doing well. It is hard to see how demand can increase significantly in the near future. Any major worldwide or even a China-centric crisis will easily affect AEH to a great extent.
On top of all this, the strength of the USD is likely to remain relatively high. That’s one of the negatives for AEH.
I’d still be keeping an eye out for AEH, but at the current price of $0.182, I do not think it fits my criteria of DEEP VALUE.
I’ve always maintained that it’s a fool’s game to try to accurately predict share price movements in a specific manner in the short term. Still, I’d attempt to be a fool by stating that my best guess is that AEH’s share price will remain within a tight range of between $0.17-$0.19 thereabouts for a long time. Perhaps till the end of 2017.
Looking at the chart above, if one makes an investment in AEH sometime in late 2009/early 2010, you’d have seen almost no real capital appreciation since almost 7 years ago.
I’d reassess the company again if the share price approaches $0.165, before determining whether to take a position in the company.
Finally, I’d like to stress that I do not have a negative view on the company per say. I just don’t think there’s sufficient MOS at this price for me. The company may do ok, or even moderately well in the short to mid term. All I am saying is that this isn’t the deep value, contrarian opportunity that I’m hunting for. If I already own shares in AEH, I wouldn’t be selling out at this level either.