Centurion Corporation Investing Thesis Part III

This is a continuation of:

Centurion Corporation Investing Thesis Part I

Centurion Corporation Investing Thesis Part II

In the comments section of part II, a reader commented that he isn’t so sure about Centurion, and if anything, it’ll be a small punt rather than a core position in a portfolio. That, in a nutshell, describes how I feel too. Currently, at least.

Centurion has several things going for it, but as I described in part II, the debt is certainly a concern. Furthermore, as I judge that Centurion doesn’t have a moat around it’s business, it’s therefore difficult to project with certainty, the currently good CFs.

In the dormitory business, it is very difficult to get an enduring moat around your business as the main criterion for your clients, is the price they’re paying for their staff’s accommodation. I can see where Centurion’s management is moving with this though; they have tried to build a sense of reliability and efficiency around their business via the “Westlite” brand.

That helps, although I don’t think you’d get much traction in this business. Centurion’s management also has an entrepreneurial bent, they have shown several times that they’re not afraid to be the 1st mover, which can be a good or a bad thing depending on whether they’re right.

They’ve also shown that they have foresight to move into new markets early, without waiting for the business to deteriorate and  market forces (aka declining earnings and/or a share price) to force their hand.

Overall, I think Centurion’s management deserves high marks for how the business is being run currently, despite my earlier comments about the debt levels.

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So what’s in store for Centurion going forward?

My guess is that for FY16, the company’s earnings will not be very different from that of FY15. Probably just slightly below that of FY15.

On one hand, the company will be recognizing a one off write down of it’s dorm at Toh Guan from the URA’s decision. So that’s going to be negative for earnings.

On the other hand, FY15 had an extraordinary write down of $4.8mil from the carrying value of their dorm with Lian Beng (Lian Beng-Centurion (Mandai) Pte Ltd), which would not be present for FY16. I guess the abscence of a comparative negative makes a positive.

Dorm rates on a per bed basis has dropped from FY16 compared to FY15, but the company has had new revenue streams from their acquisitions in the student accommodation space.

As of 9M16, the earnings are just slightly lower than 9M15.

So on the balance of everything, there’re some pluses and some minuses, but it’s safe to project a FY16 earnings that’s somewhat similar to FY15, probably slightly lower.

I don’t think the markets are going to be very excited by that. And since in the short term, the share price will basically reflect the market sentiment of all these participants, I don’t think the share price will be very exciting either in the short term.

Oh yes, back to the $4.8mil write down in FY15. Yes, of course I investigated about why there’s this write down. Afterall, it’s very important that we know the reason for it. If it’s recurring, we may end up getting hit by more write downs in future for other dorms!

But I’ve verified with Centurion’s IR who has explained that it’s mainly accounting related.

Basically, the purchase consideration for the joint venture was satisfied by an issue of new shares at 10 cents per share at that time. However, in accounting, the share price, which had risen beyond 10 cents on completion of the acquisition, was used to record as the purchase consideration. As a result of the difference between the share price and issue price of 10 cents, a goodwill of $4.8 million was recorded.

So yes, it’ll likely be extraordinary and not recurring.

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Alright. Now I’m really moving on to the specifics. Let me try to project what lies ahead for Centurion.

(The guy standing there way ahead… yea that’s me!)

I deliberately left this part to the last, as it is very technical, and I don’t think anyone reading this without reading all the background given in Parts I and II, would understand what I’m saying.

Now, why am I monitoring Centurion? Thus far, from the facts I’ve put forth in my analysis, it doesn’t look like the company has a lot going for it. It almost looks like something that I should take a quick look at, and chuck it aside for eternity.

The reason why I’m still looking at Centurion in such great detail after 8 months, is because I think that at some point, if the share price continues to decline, Centurion would be one hell of a great investment opportunity. 

Well, yes I don’t know exactly when this point will be reached, I don’t think it’s right now though.

Let me substantiate.

I’ve already described how I think the management is pretty good, I’ve also shown how I’m optimistic about the company’s foray into student accommodation. I’ve substantiated my thoughts, and now we’ve seen how GIC is also competing on that front. So we shan’t talk about that again.

In FY15, Centurion explored hiving off it’s dormitory assets into a REIT listing. Now, this is novel for sure, there are no REITs, and there never was ever any REIT, that holds PBWA assets. That’d really be a first of it’s kind.

See what I mean about the management being entrepreneurial?

Unfortunately, after consultation with SGX, they realised that they couldn’t as SGX considers it a “chain listing”. What exactly is a chain listing? SGX considers it a chain listing if the business of the hived off REIT, (or any listed entitiy for that matter), is a “significant” portion of the original parent.

Which makes sense actually. Since the dormitory assets are pretty much the bulk of Centurion’s business. It’s now a smaller proportion, but still the main bulk, because of the expanded student accommodation arm.

That’s a real pity for the company, because if they could successfully hive it off into a REIT, it’d be a major game changer for Centurion. It’d be the best thing they did since the RTO.

Why’d I say that?

Well, firstly, as I’ve illustrated, debt is a major concern for Centurion. With 1 move like this, the debt gets completely eradicated.

Tax savings would be another obvious positive. In FY15, $8.27mil of tax was paid, mostly related to the dormitories; in a REIT structure, most of this tax would’ve been saved.

Some of the dormitories have also reached full occupancy, and as such, they’re “fully valued” mostly. Obviously, this would be the best time to monetize the asset, free up CF, and recycle cash into other opportunities. Something that the management has shown that they’re very capable of digging up.

It all makes perfect sense. Centurion has avenue to deploy cash, but has high debt and is constrained (by market demands) by funds. They’re going to find it difficult to balloon their debt much futher from these levels. So if they can monetize mature assets, the timing would be great.

So it’s really too bad that they’re not allowed to. The company has indicated that they’re still keeping these thoughts for possible future listing into a REIT when the dormitory assets are no longer considered “substantial” enough for it to be considered a “chain listing”

Centurion’s IR has confirmed to me that there is no set guidance or percentage figures on revenue or earnings, below which the assets would not be considered as a chain listing. I didn’t really like this; so who decides if it’s a “chain listing”? It’s arbitrary? Some guy at SGX calls it a chain listing or not depending on his mood?

“The SGX definition for ‘Chain Listing’: A subsidiary or parent company of an existing listed issuer will not normally be considered suitable for listing if the assets and operations of the applicant are substantially the same as those of the existing issuer. In arriving at a decision, the Exchange will consider the applicant’s business or commercial reasons for listing. SGX did not disclose the % which they deemed as substantial for issuers to cross.”

I’m not disputing that in this instance, it shouldn’t be allowed. I’m saying that there should be some clear guideline given, a target that the company can hit, something that a deep value investor can use to gauge.

Anyway, as an academic exercise, I proceeded to stress test Centurion’s dorm assets vs other assets in existing REITs, just to simulate a scenario whereby Centurion is eventually allowed to list it’s dorm assets.

What I’m trying to understand is that, if Centurion were to list their assets in a REIT, would there be market demand for it? How attractive would such a REIT be, compared to other REITs?

This is what I came up with:

This means that at current valuations, if Centurion is an actual REIT, it is much more attractive (from a valuation perspective) than other existing REITs.

(well it’s actually become even more attractive cos the share price is lower than the $0.35 when I did this analysis)

The cap rate for Centurion’s dorm assets are calculated by taking the net income from the assets (before tax) divided by the NAV for the assets.

The cap rate, which I believe would be the key metric for most REIT investors, pretty much trashes the competition, and this is derived on the back of lower PEs.

Do note that the dividend yield seems lower, but that’s for Centurion corp as a whole, which is not reflective of how the REIT would look like. Obviously the yields would be much higher after accounting for the tax savings, the savings on interest expenses, and without the need to set aside cash for other business operations.

So there. This basically illustrates why Centurion’s management explored the hiving of their treasured dormitories into a REIT. The assets would likely garner better valuations, and be worth much more in a REIT than in a company structure. All this while recycling Centurion’s cash to higher growth, newer opportunities.

Too bad it can’t be done now. Looking at the market conditions, it sure looks like it can’t be done anytime soon either.

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Since I mentioned about the cap rate, let me move on to talk about the cap rate for Centurion’s debt. (Debt is a recurring theme in this investing thesis cos it’s really the elephant in the room)

A bit of accounting 101 here:

Borrowings can be specific or general in nature.

The specific borrowings are done in relation to the acquisition of a qualifying asset, and no other reasons. It is easy to calculate the cap rate in this type of instances, as we just have to capitalize the actual interest costs incurred, less any income etc earned from the borrowing.

The borrowings that are general in nature though, are more difficult to capitalize as we have to determine how much of the loan is used for the specific asset. So for example, a business may take out a $1mil loan, but use only $700k the build the dorm, while the $300k is used for other purposes.

The cap rate would then be calculated as the weighted average of the borrowing costs applicable to general pool.

To find out the specific interest costs, we then have to multiply this cap rate by the portion of the borrowings that relate specifically to the dorm ($700k).

Let me illustrate with an example:

If Centurion borrowed $600k at 5%, and another $400k at 7%,

This $1mil loan is used for general working capital purposes, as well as to build a dorm.

To build the dorm, Centurion used $400k from the 1st loan, and another $200k from the 2nd loan. (Total of $600k)

What is the cap rate?

The cap rate is the weighted average of the borrowing costs…. so it is calculated as such:

[5% x $600,000/($600,000 + $400,000)] + [7% x $400,000/($600,000 + $400,000)]

=3% + 2.8%

= 5.8%

The actual borrowing costs is thus calculated as (5.8% x $400,000) + (5.8% x $200,000) = $34,800

Assuming that amount used to build the dorm was used for 1 yr exactly. If it’s more or less, then simply time weight the borrowing costs.

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Alright, so why the trouble going through the above accounting 101 lesson above?

Well, because Centurion’s borrowing costs on general financing are capitalised at a decreasing rate over the years.

FY12: 1.19%

FY13: 0.87%

FY14: 0.6%

FY15: 0.53%

From AR15:

What can we conclude from this?

This means that the total borrowing costs, as a proportion of the total debt, has been decreasing.

Since the total debt has been increasing, we can then conclude that the more recent debt have lower interest costs compared to the earlier debt. Alternatively, it could also mean that the interest rates applied to the total debt are floating and has been dropping as a whole.

Either way it’s definitely a good thing for the company as it indicates that the interest cost per dollar of debt has dropped.

The quantum of the total interest costs has increased dramatically, but as a function of the total debt, it has actually dropped.

Certainly something important to assess and understand, seeing that debt is the major concern for Centurion currently.

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No investing thesis can be complete without some analysis of the future prospects of the company, qualitatively. Particularly so because Centurion’s prospects will be greatly influenced by government policies as well as general economic factors.

Troubles with foreign workers in recent years made the government sit up and look into the living conditions of our foreign workers. A famous instance is the bus driver strike back in 2012:

(Credit to The Guardian)

Since then, there has been rigorous debate on our foreign workers’ living conditions, particularly the dormitory sector. Check out this long discussion by the Workers’ Party in Parliament:

http://www.wp.sg/debate-on-foreign-employee-dormitory-bill-mp-pritam-singh/

The government has responded by trying to “encourage” employers to house their workers in suitable dormitories. This means clamping down on illegal dormitories that do not meet the regulatory standards.

http://www.theonlinecitizen.com/2015/04/10/68-illegal-dorms-discovered-in-geylang-only-tip-of-the-iceberg/

On top of that, there are now new rules for dorms housing >1,000 beds. My guess is that the government will slowly eliminate the smaller dorms. Why else would there be additional rules for the large dorms, while the smaller dorms <1,000 beds are not limited by these rules?

This is taken from the Foreign Employee Dormitory Act:

So in summary, here’s the government’s plan.

Go for scale for efficiency. Limit the smaller players, but regulate the bigger players. Make sure the living conditions provided by the bigger dormitories are acceptable – good.

But it’s not just the dormitories. As I mentioned in Part I, PBWA covers factory converted quarters as well. These have also come under scrutiny and certain rules have been put in place. Come on, everyone loves free Wi-fi:

http://www.straitstimes.com/singapore/manpower/mom-sets-new-quality-standards-for-dorms

On top of all that, foreign workers from certain sectors (that are non-Malaysians) are no longer allowed to be housed in HDB flats:

http://www.propertyguru.com.sg/property-management-news/2014/11/73198/foreign-workers-in-certain-sectors-barred-from-public-housing

So where is the industry headed to in the long run?

The smaller dormitory players will find it economically unfeasible to compete. Land sizes set aside for dormitories will be of a certain size to encourage large dormitories of 1,000 beds. Illegal dormitories will be cracked down upon. These regulations would ensure that only competent and efficient operators will survive.

All that is obviously good for Centurion.

But even amongst existing large dormitories and their operators, there’d be more requirements placed on these dormitories. The standard of the living conditions would have to improve over time, and all these would add to the operating costs of the business.

That’s not good for Centurion.

How about the demand for beds?

Here’s some data I’ve compiled:

Notes:

1. Data may not add up to the total due to rounding.

2. “Other Work Passes” includes Letter of Consent (LOC) and Training Work Permit (TWP). Training Employment Pass (TEP) was included in “Other Work Passes” from March 2014 onwards.

3. In 2014, estimated that 160,000 workers stay in PBWA (dormitories)

4. Assume that half of the WP holders are malaysians who stay in residential apartments or commute daily to Singapore. Of the other half, assume 80% stay in dormitories.

I don’t have the data for 2016, but we can already see stagnation or a slight dip starting in end 2015, I think it’s safe to assume that the demand has continued dipping in 2016.

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CONCLUSION

I think Centurion is one company to watch for the future. Well run, sharp management with a good track record thus far.

Unfortunately, the industry headwinds in the near term are strong, and there’s nothing much they can do about it.

I’ll be monitoring the new growth areas: the student accommodation business here and overseas, to see if the occupancy figures hold up. It’d be difficult for Centurion to do more acquisitions for now, until they can get their debt levels down.

This is a period of consolidation, I’d be hoping the share price continues dropping while I monitor the company. There’d come a time when this becomes a fantastic opportunity to allocate capital.

Lastly, for additional reading on Centurion, I’d just link to one of my fellow bloggers’ (TUB) post here:

http://tubinvesting.blogspot.sg/2016/10/one-with-dormitory-business.html

Happy Holidays!

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Centurion Corporation Investing Thesis Part II

In Part I, Centurion Corporation Investing Thesis Part I, I’ve mainly described Centurion’s industry characteristics, as well as the characteristics of the company.

Let’s take a closer look at the financials of the company:

Centurion did well growing their topline over the past 4 years, with revenue growing at a steady clip. As of 9M16, Centurion’s revenue has already hit $85.5mil, compared to $76.3mil for 9M15.

If we look at the profit attributable to equity holders though, that has fallen sharply in FY15 compared to the 2 prior years.

Why so? Why is the company raking in more $$$, but keeping less of it?

The answer lies in all the operational and interest expenses in between:

The company conveniently groups the COGS, distribution and administrative expenses together in their AR (something unusual). I guess this applies well for the company because well, what exactly is the COGS for a dormitory operator?

Anyway, if we see it in it’s totality, for FY12-FY14, the sum is fairly stable at $44-$46mil ++

In FY15 though, this figure shot up very rapidly to $57.4mil, and this is the reason for the sharp drop in EPS, despite increasing revenues.

As of 9M16, this figure has continued to rise to $59.1mil, and as it stands, already exceeds the expenses for FY15!

Why the ballooning expenses?

From the table, we can see that this is attributable to the rising administrative expenses, as well as the massive finance expenses, which stands at $15.9mil for FY15 and as of 9M16, is already $16.5mil.

From the data, we know that the company is fast expanding, but the costs of doing so are expanding just as rapidly.

There are positives though, if one were to peer hard enough:

Despite all the expenses, the company still enjoys crazily high margins at every level.

Taking the traditional metric of NPM based on the earnings may not be suitable for Centurion, as the company recognizes a lot of fair value gains on the dormitories it holds. Instead, we should strip away all the extraordinary, non cash gains to derive a more accurate picture.

Even then, the “true NPM” (as I term it), stands at a massive 30+%! This would be higher than many other business’ GPM…

Another positive that I’ve gleaned going forward, is more obscure:

The company has consistently amortized its goodwill/intangibles to the tune of $4.9mil annually. (see the table 2 diagrams above)

As of 9M16, as it stands, the BS holds only $3mil of goodwill:

This means that in FY17, the reduced amortization will provide a small tailwind for the company’s earnings, and in FY18, as it stands, we can expect 0 amortization with a resulting $4.9mil boost to earnings.

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Moving on to the balance sheet, the company has boosted it’s investment properties portfolio massively, at the cost of taking on more debt.

Total debt has ballooned as the company took on more debt to acquire land and build dorms. 

This is currently, IMO, the biggest factor holding back investors.

There is real, valid concern about the debt currently, simply because we do not know how the forward picture would look like in terms of demand for the dormitories.

If the company hits a rough patch, and the demand for it’s dormitory beds suddenly dry up, the debt would become a real headache to service.

On a +ve note, Centurion’s management understands this, and has been trying to allay concerns. Their outstanding $100mil worth of notes were redeemed in Oct 2016, and hence we should be expecting the total borrowings to be cut substantially when FY16 results are released.

Even then, the company is not out of the woods yet. It’s cash holdings of $116.3mil as of 3Q16 will be slashed to a mere $16.3mil since the company paid off $100mil worth of notes. (Assuming no new loans/status quo)

The total borrowings though, would only drop from $$705.1mil to $605.1mil after the repayment, although $559mil of this $605.1mil is non-current.

Owing debt of $605.1mil, when you hold only $16.3mil in cash, is certainly not very comforting is it?

To add to the uncertainty… and this is something that I believe the vast majority of investors do not understand, the $891mil value parked under “Investment Properties” isn’t the true value of the properties!

Why do I say that?

Well, this took me a long time to understand and figure out actually. We all learn something new once in a while.

Centurion capitalizes part of it’s finance costs.

This is taken from page 82 of AR 15.

As we can see, part of the borrowing costs annually are “capitalized in investment properties”.

This is mostly an accounting manoeuvre.

Basically what this means is that of the $18.8mil of interest expenses for 2015, Centurion recognized only $15.9mil as a business expense, and parked $3.6mil under “investment properties” as a future asset to be capitalized in later years.

Ditto for the prior years.

What are the accounting rules that determine how much gets capitalized and how much gets expensed?

Interest costs that are directly due to the land acquisition, construction or production of the dormitories are capitalized. All other interest costs are expensed in the period that they are incurred.

This is because the interest costs are treated as part of the costs of acquiring or bringing the particular asset to an operational state.

Think of the capitalized interests costs as a “goodwill” within the investment properties. Hence my statement that the figure doesn’t reflect the “true” market value of the properties.

Now, all this is rather arcane for someone like myself who is not accounting trained, and I took a long time to understand this. Actually, a quick check with an accountant friend of mine revealed that even accountants may not understand this either.

I wonder how many investors would really understand this point. It may sound simple now, but it took me quite some time to figure out what exactly is happening and why the company is delaying some interest costs to later years, and finally, why this cost is parked under investment properties.

Anyway, the next obvious question that should pop into anybody’s mind now, is that, exactly how much of this $891mil (that’s in FY15. As of 9M16, the figure is $937.5mil!) is made up of “capitalized interests”?

There’s no breakdown given in the AR, hence I queried IR, who obviously cannot handle such a specific and detailed question. IR passed on my queries to CFO, who basically said that yes, I’m right, it’s parked under Investment Properties, but no, we can’t give you a breakdown. That’s it.

Ah great. I hate hitting road blocks.

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So, as it stands, I’ve illustrated how Centurion’s business enjoys nice fat margins, and the company is growing topline rapidly but keeping less of the cash due to cash drain from interest and administrative expenses.

I’ve gone through some of the specific accounts, and we’ve also seen clearly how the debt is a big eye popping question mark currently.

The next logical question is, is this debt sustainable/serviceable?

The answer to this question, obviously lies within the cashflows. Cold hard cash that they company’s cash generating business must create.

And since the company holds (projected) $16.3mil of cash whereas debt sits pretty at $605mil, we know that the company BETTER have some nice cash generation going on.

Fortunately, Centurion’s FCF are pretty reassuring:

FCF +ve in the past 4 years.

Also, in this nice table, we can see the amount of $$$ that goes into “Additions to investment property”.

Of course, the way I’ve described it may be a bit simplistic.

In reality, I think the company will constantly “roll over” debt maturities with the bank, using the investment properties as collateral. So although total debt is high, practially all this debt is secured debt.

In scenarios like these, the key question then is, will the CFs generated from the assets pay for both the interests expense, as well as pay down the capital? Or is it enough to pay down only the interests?

Think of it from the angle of personal finance:

If you bought a house and rent it out, is:

1. Rent < Interest
2. Rent = Interest
3. Rent = Monthly Instalments (Interest + Part of the total loan)

In scenario 1, you’ve a big problem

In scenario 2, you’ll look good for a while, and after that the story can turn real bad. Scenario 2 is basically reminiscent of the interest-only subprime loans given out prior to the GFC. It can work…. if the value of the underlying assets keep appreciating unabated.

Scenario 3 is what any prudent borrower has to do.

Therein lies my concern about the debt. This brings me all the way to my point right at the start when I mentioned that the debt is the greatest concern.

If “rent” drops, or interest costs rise substantially, scenario 3 can quickly deteriorate to scenario 2.

“Rent” aka dormitory fees, have ALREADY dropped. Competition is strong, and the Westlite brand currently sits in a sweet spot in terms of fees, charging a bit higher than the norm, but not the most expensive. Occupancy rates are thus still well supported.

As for the other part of the equation, interest costs, well I am not a global macro kinda guy, but almost everything I’ve read points towards rising interest costs.

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Valuations wise, Centurion is certainly undemanding.

Currently, the company trades at 0.6 times book value, with a PE ratio (based on true earnings) of 6.8 times.

Centurion gives a full year dividend of 1.5 cents, and that works out to a yield of 4.7% based on the current share price of $0.32.

ROE figures have dropped in line with the drop in NP in 2015, as well as the expanded equity base.

One big negative for potential investors, IMO, is the outstanding warrants. The company currently has 75.6mil warrants outstanding, each with an exercsise price of $0.5 for each share. The warrants expire on the 17th Oct 2017.

Looking at all the factors and figures I’ve discussed thus far, my immediate thoughts are that I wouldn’t want to buy any shares above $0.5. With all these considerations, it doesn’t make sense to get diluted by warrants getting exercised. I’d rather wait till they expire in another 10 months.

These warrants act as a “cap” on the share price right now. Once it crosses $0.5, you’d have a huge chunk of dilutive shares coming onboard. Of course, the share price is not exactly close to $0.5 right now.

In any case, the warrants are currently non-dilutive. I still don’t understand the company’s rationale of issuing such warrants though, it didn’t seem to give the company any benefit.

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We certainly cannot fault Centurion’s management for not having vested interests though.

Centurion is very heavily owned by it’s management. The substantial shareholders are all insiders:

On top of that, the company carried out several rounds of share buybacks in recent years.

Despite all the buybacks though, the share price has continued falling, albeit at a slower pace.

In Part III, I’ll conclude by discussing the forward picture for Centurion, including my view on the prospects of the business and the industry.

Please let me know of any thoughts that you might have, either via email or the comments section below.