Silent Warrior - Keong Hong Holdings (5TT.SI) | Company Analysis

Last week, in the post on the construction industry, I examined a list of 7 construction companies that the stock screener on SGX StockFacts returned. Companies were eliminated one by one until the list was narrowed down to just two counters: Keong Hong and KSH. So in this post I shall be examining Keong Hong, in much further detail.

 

Business Overview

Keong Hong (KH) has been in the construction business for over 20 years, having a track record in projects spanning from industrial and commercial to institutional and residential properties. Since its IPO in late 2011, KH has been engaged only in residential and institutional projects. The company also entered property development in 2011. It was awarded the BCA A1 grading for general building, allowing it to tender for public sector construction projects of unlimited value (this has yet to be fully utilised).

Here are some stats to look at before we go further in depth to the fundamentals:

Market Cap ($M)	101	EV/EBITDA	4.2
LTM Revenue ($M)	223	Dividend Yield	7.9%
Price/Earnings Ratio	3.0	Payout Ratio	29.7%
Price/Book Ratio	0.72	Total Debt/Equity	43.1%
Price/Sales Ratio	0.45	Debt/EBITDA	2.2x

At first glance, the seems to be undervalued, solely based on its extremely low P/E and EV/EBITDA ratios, and that it may well be a dividend cash cow, from that mouth-watering 8% yield.

But before outright declaring it as a good bargain and an obvious prey for yield hunters, we have to look beneath the surface and examine its inner workings.

Staying Grounded - The Income Statement

All figures in millions of SGD.

While “fantastic” does not describe the results here, KH’s revenue and net profit has held up well in the face of a slew of property cooling measures introduced in mid-2013. The effects of such measures has dented, but not demolished, the group’s revenues and profitability. That said however, the group’s order book over the years is a troubling statistic.

*Order book as of the beginning of each fiscal year

KH’s order book has almost halved from a peak of $611m the beginning of FY14 to $351m at the start of FY17. Worse still, the size of its order book reported at the conclusion of its most recent quarter (MRQ) dwindled further to $309m. About 60% of it comprised non-residential projects (likely Raffles Hospital), and it is estimated to provide income for KH until end-2018. 

Project	Location	TOP	Status
Skypark Residences	Sembawang	Aug ‘16	99.8% Sold
Jurong Gateway	Jurong East	Nov ‘16	100% Sold
The Amore	Punggol	Nov ‘16	100% Sold
Raffles Hospital Extension	Bugis	3Q17	Not Applicable
Parc Life	Sembawang	2018	29% Sold
Seaside Residences	Siglap	Apr ‘21	Sales start Apr ‘17

Most of these condominium projects are joint ventures (JVs) with other companies, mainly local developers and construction firms. While it is not explicitly stated how much revenue KH has recognised from these projects thus far, revenue is typically realised in stages as a project nears completion. Worth noting is that KH was appointed as the main contractor for all its JV projects. It does speak about the firm’s standing and reputation among property developers.

As is the nature of the construction/property development business, KH is reliant on keeping its order book filled. This means constantly “topping it up” with new projects in the pipeline. While some companies may bid aggressively for project tenders, KH’s management has a policy of taking a back seat and only pursuing projects with adequate returns. This explains the rather decent profit margins enjoyed by the company as compared to its peers.

 

 

On the flip side, in an environment where there is a dearth of business due to the property market slowdown, waiting for “the right one” to pounce on puts short term pressure on the order book and therefore revenue. Thankfully, KH sits tightly on a pile of cash while it waits for its chance to strike, which brings me to the next point.

Concrete Foundations – The Balance Sheet

While the building may look a little flimsy at the moment, rest assured that KH has laid good foundations. Its strong balance sheet is the cornerstone of its stability.

 

Short term liquidity has never been a problem with current assets usually around a comfortable 1.6x current liabilities (current ratio of ~1.6). Its large cash pile constitutes a large portion of its current assets (cash on hand is $66.4m as of 1Q17), and forms the bedrock of its sturdy foundations. 

Commendably, management has managed to keep total shareholder’s equity growing constantly despite the difficult operating environment and fluctuating revenues. While total debt has increased in recent years, possibly to improve liquidity and provide working capital throughout this difficult period, the company managed to stay in a net cash position in every fiscal year except 2016. (KH is in a net cash position of $6.1m as of 1Q17)

 

Factoring in its ample receivables against its payables together with net cash (total cash – total debt + total receivables – total payables), although an unorthodox method, further illustrates it’s solid net cash position.

Debt wise, KH has an outstanding medium term note (MTN) with a 6% coupon due in 2018, and two other loans of about $5.48m and $5.69m each, with interest rates of approximately 3.25% and 2.64% respectively. This brings the weighted average borrowing cost to about 5.45%, which seems a little on the high side.

 

The hallmark of stable small companies in Singapore, they are usually have little or no net debt, and are sitting on sizable piles of cash relative to their market cap. While arguably the cash could be better utilised elsewhere, or used to enhance shareholder value via share repurchases, many a time, a pile of cash is the company’s cushion against shocks. It also supposedly boosts the balance sheet, enabling them to obtain more favourable borrowing rates on their debts.

A Bumpy Ride - Cash Flows

And now for the cash flows. 

 

Cash flows from operations (CFO) have been very volatile, reiterating the nature of the business and the difficult operating environment. Nonetheless, free cash flow (FCF) produced remains healthy and dividends paid constitute only a small percentage of FCF.

The company invested heavily in new machinery and staff training from ’13-’15, explaining the surge in capital expenditures (capex). Such seems to be a shrewd move on hindsight, utilising this difficult time to improve factors of production, so the company would emerge from the downturn on stronger footing.

Still, it pays to keep an eye on the CFO figure as the company reports each quarter. Dividend payout could take a beating should this unpredictable figure plunge violently.

Returns, Returns, Returns

 

However, profitability metrics paint a bleaker picture of the firm, as they have declined by about a third. As a whole, profitability of the firm has been broadly lower since 2012, most likely hurt by the difficult operating environment.

Ambitious Diversification

As Singapore faces a property market slowdown, and in the longer term severe land constraints, KH has made it a policy to diversify overseas.

It first forayed into the Maldives by constructing resorts. Two resorts and an airfield are current under construction. Mercure, the “middle class” resort, is expected to commence operations in 1H17, while Pullman, the “high end” resort, opens in 2018. These projects came at an estimated cost of US$120m.

As usual, KH is undertaking these projects through a JV, Pristine Island Investments, in which it holds a 49% stake after buying new equity, making it the single largest partner. (The other partners are Sansui, BRC, L3 and HRC) KH can then realise revenues from tourism operations once the projects launch. While I have not looked up visitor statistics, KH claims in its annual report that visitor arrivals to the Maldives increased 4.2% in 2016, and 1.72m visitors are expected in 2017. Resorts there typically see a 74% occupancy rate. Assuming everything turns out in its favour, KH will stand to benefit from this diversified source of income.

However, its track record in local hospitality leaves much to be desired. KH has 20% interest in two local hotels – Holiday Inn Express Singapore Katong and Hotel Indigo Singapore Katong, which commenced operations in Jun ’16. While its initial investment was $200k, it is appalling that KH’s share of losses so far runs at $585k (down from $925k loss in 2015). This somewhat taints the credibility of the diversification story and could be a red flag if losses are not brought under control before long.

This does not impede the firm’s march toward diversification though. KH has another JV project involved in residential development in Nha Be, Ho Chi Minh City, in which it has a 15% stake. It owns a commercial property in Osaka, Japan, which is mainly occupied by offices and 85% tenanted. (somewhat like a REIT) I won’t be surprised if KH spins off these holdings as a REIT one day in the distant future.

Despite ongoing efforts to diversify overseas, KH still remains very exposed to the ebbs and flows of the Singapore property market, with 89.5% of its revenue derived locally. Revenue from the Maldives comes in at 10.3% and Japan a distant third at 0.18%. Clearly, more has to be done to make a concerted diversification overseas. CEO Ronald Leo has remarked in the 2015 annual report that “overseas investment opportunities will figure more prominently as an engine of growth and continued sustainability” and that the firm is “seeking opportunities in Japan, Australia, Vietnam and Malaysia”. If such plans are actively pursued, we should be hearing from KH about an overseas project or acquisition soon.

Welding Together Synergies

KH acquired a 15.12% stake in Kori Holdings at $0.455/share in back 2015, and holds a 5% coupon $5m convertible bond issued by Kori maturing in Sept ‘17. Kori considers itself as a “specialist builder in structural steel works, piling works, ground support and stabilization works”. It has a track record of MRT projects in Singapore, having secured contracts from all 3 stages of the Downtown Line and $30m worth of contracts for the upcoming Thomson-East Coast Line.

It seems that management’s ambition is to make Kori an associate company one day. Should they convert the bond into equity (which seems likely given that the conversion price is $0.42/share and Kori currently trades around $0.47/share), KH’s stake would increase to about 25.8%.

Acquisition of a company involved in civil works is much in line with management’s strategy of “actively exploring opportunities to participate in civil and structural engineering and infrastructure works for the extension of the existing MRT network”, and undertaking “high-value infrastructure projects, especially in the MRT segment, through possible joint ventures and/or suitable acquisitions”, as highlighted in their 2014 annual report.

Turning Kori into an associate would give KH exposure to up and coming large scale civil infrastructure projects, once again diversifying its source of revenue away from developing and building condominiums. In the meantime, the 5% coupon on the convertible bond can be used to roughly finance the interest payments on two of its ~$5m outstanding loans.

Ownership & Management – Fingers Deep in Their Pie

 

It is always a positive sign when company insiders own a significant portion of their own pie, aligning their interests with that of shareholders.

Chairman and CEO Ronald Leo owns about 30% of KH. While not explicitly stated, it is possible that insiders and related parties own shares through the various nominee accounts listed.

The company itself has conducted periodic share buybacks, and treasury shares comprise 4.5% of all outstanding shares. The shares bought back are mainly used for employee share option schemes.

Management’s track record is fairly decent so far, and their conservative stance has helped the company maintain double digit net profit margins even in challenging times. However, they may not be the most apt at selecting investment properties, as evidenced by the large losses from their local hotel JV. So far, management has been following through with its plans of diversifying sources of income, but at present its talk of “stepping up efforts at securing public sector works” and its plans to participate in MRT-related civil works have yet to be fulfilled.

A “Fair” Price?

Construction counters have a long term average P/E ratio of about 5.5x. While KH is currently trading for 3.0x P/E now, a 5.5x P/E valuation assuming earnings remain constant would mean a “fair” value of about $0.80/share, or an 80% appreciation from current prices. 

And should the stock revert to its P/B ratio of about 1.0x, again assuming book value remains the same, it would imply a “fair” value of about $0.61/share, or a 39% appreciation from current levels. However, these are mainly simple approximations and should not be taken for an ultimate target price.

Piece by Piece Assembly – Putting Together Tangible Book Value

For this valuation approach I am going to keep things simple by only looking at a few items. This gives a basic approximation of the company’s “bare bones” worth as measured by tangible book value, without including the expected value of future earnings and so on.

Property Assets	+$35m
Cash/Cash-Equivalents	+$66m
Total Receivables1	+$208m
Total Debt	-$60m
Total Payables	-$136m
Convertible Bond (excluding coupons and embedded derivative)	+$5m
Stake in Kori	+$7m
Total	$125m

*Figures as of 1Q17.

¹Note that about $46m of receivables is classified as retention sum, or accumulated revenue from contract work to be recognised in future

So a rough estimation of KH’s tangible book value would be about $125m. This trumps its current market cap of $101m. It seems like that market is undervaluing KH’s shares by about 20%.

But for a better “margin of safety”, consider if we discount its property portfolio by 20%, and cut the value of its stake in Kori by 40%, owing to the illiquidity of Kori’s shares. We arrive at a tangible asset value of about $107m. By this measure, KH is about fairly valued. Since this value includes unrealised earnings of about $46m, it can be said that the market has only priced in the value of contracts already obtained. This does not factor in any potential earnings from new contracts in future, implying that they come for free (yay!), of course assuming that KH is able to clinch them.

Kick out the convertible bond and equity stake, discount its properties by 20%, throw out the retention sum of $46m, and we end up with a tangible value of about $60m. Only under these conditions can KH can be viewed as overvalued.

Trying the DCF Approach

And now, for a traditional valuation method used by equity analysts, the Discounted Cash Flow model.

Over here is a simple DCF model created using Excel. However, since the beta of KH is so low, at only 0.205, the model becomes very sensitive to changes in beta. A larger beta would greatly increase the intrinsic value per share. Thus, I have decided to leave out the calculations of cost of equity using the capital asset pricing model (CAPM), and just estimate a 10% cost of equity instead.

Assume that KH suffers a 30% fall in FCF this fiscal year, considering their FCF was negative in 1Q. FCF falls a further 5% before levelling out in years 2 and 3 respectively, and then grows at 10% annually as the industry recovers. In the long run, assume that FCF grows at 1% per annum. This gives us an intrinsic value per share of $1.05, and KH is currently trading at a 58% discount to that value. 

To be pessimistic, I further discount the DCF number by 30% to arrive at a “fair” value of about $0.73. So assuming all the assumptions in the model hold true, then KH is trading at about a 40% discount to “fair” value, meaning it has the potential to appreciate about 67%. It also implies a rather ample margin of safety at the current price.

Feel free to point out any mistakes I may have made in the model.

Moo Moo – A Dividend Cow?

Remember that eye-popping 8% dividend yield mentioned at the beginning? 

Fiscal Year	Dividend/Share	Dividend Payout Ratio	Dividends/FCF
2012	$0.02	15.8%	16%
2013	$0.025	25.5%	673% (oops)
2014	$0.0225	23.8%	13%
2015	$0.045	10.7%	12%
2016	$0.035	29.7%	39%

KH usually pays its dividends twice a year, once around May, and the bulk of the dividend usually around end-February.

While counters that yield 8% are typically vulnerable to dividend cuts, as dividend burdens eventually become too much to bear (or stock prices collapse thus pushing up yields, but usually for good reason), KH’s case is very much the exception, with its dividend payout ratios never above 30% of net income. Ignoring the anomaly in 2013, we see that dividends are most likely financed by real cash flows generated (dividends/FCF), as opposed to borrowed money or clever financial engineering.

Considering these factors, dividend payouts can be expected to remain steady for the foreseeable future, provided revenue and income do not nosedive. Factor in that 8% dividend yield and the stock seems like a fabulous candidate for dividend milking.

Price Charts – A Look at the Technicals

In the immediate term the 61.8% Fibonacci retracement level and previous weekly high at $0.445 serves as resistance, but $0.45 and $0.46 may also be difficult to overcome, being strong support levels for much of 2016.

On the downside, the 50% Fibo retracement at $0.425 serves as support. If broken, prices may fall to challenge the next support at $0.405, the 38.2% Fibo retracement and a previous significant low. Failing to break through either resistance or support could see prices stuck in a $0.02 range from $0.425 to $0.445. 

That said however, KH historically trades at a P/B ratio of around 1.0x. Its current P/B of 0.72x seems like a big deviation and in this sense mean reversion should take place moving forward. Expect bargain hunters to swoop in should the stock approach $0.40 (and the yield approaches 10%). 

While KH has a very low 500-day beta of just 0.205, its volatility over the longer term can be rather significant, the result of it being a thinly-traded small cap stock. Recently, it also tends to plunge drastically after becoming ex-dividend (completely normal), only to remain at that depressed level and consolidate for a long time (not so normal).This behaviour reminds of me bond prices, which tend to creep up slowly before a coupon date (a concept known as accrued interest), and dropping after the coupon payment. Perhaps that 8% yield is making investors treat this stock like a bond?

Key Risks

Order Book

The lifeline of the firm has to be monitored closely for warning signs of severe deterioration. Should contracts dry up, the firm will have no revenue in future and this would quickly put pressure on its balance sheet. It is of utmost importance that management is able to secure a litany of contracts in the pipeline as reassurance to shareholders of earnings visibility. 

Industry Risk

Construction is very much a cyclical industry and revenue can be very volatile at times. Not forgetting the government’s property cooling measures introduced back in 2013 still keeping a lid on the industry (although measures were recently relaxed a little). Competition is also very intense as there are many firms with exactly the same business model and no single firm has a dominant market share. The firms therefore, all operate without a protective “moat” and can be trampled on by competitors anytime. Forming JVs with other companies to bid for projects partially mitigates this risk.

Liquidity Risk

Daily turnover rarely exceeds 500k shares, and on average is around 200-300k shares. Multiplied by its share price and daily total transaction value is only about $100k, in contrast to blue chip counters which see daily turnover worth millions of dollars. This should not be a concern if one is a small investor, as there should be no problem transacting small chunks of shares. However, if one intends to take a sizable position, bear in mind the liquidity risk. Being a small cap stock with hardly any institutional ownership or trading, the floor might fall out of the market (aka no bid prices) if suddenly confronted with panic selling, leading to a huge crash in stock price.

The Final Word

All things considered, Keong Hong looks like a very attractive value investing proposition, and a very promising candidate for dividend investing. However, the stock has its inherent share of risks as well and those need to be weighted properly against potential returns. 

Nonetheless, with the stock trading under the estimated tangible book value and boasting such an attractive dividend yield, one could adopt the “buy-and-hold” strategy, collecting the delicious dividends in the meantime while waiting for its value to be realised.

Just my two cents.