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Report Card for the period to 30 September 2013

Freshman in the share market

In 1993 I had a short but bitter fling with the stock market. The tryst ended quickly with the market winning and my pocket lighter. Losses compounded from having one-night-stands with these companies instead of committing to long term relationships. I learnt my first lesson: when you haven’t the faintest idea of what you are doing but do it anyway, it is downright stupid if not reckless.

The Killing of Tony Blair

Bubble what bubble? Australian properties are cheap compared to Shanghai and Beijing

Beijing and Shanghai, the center of political power and commerce gateway respectively holds many attractions for those pursuing political influence and wealth.  But who really wants to live in Beijing, a city that is slowly being encroached by the desert and adjectives such as 'deadly' or 'dangerous' routinely used to describe air quality.  How about overbuilt and congested Shanghai?  Boiling hot and humid in the summer and freezing in the winter?

SmarTone’s party fizzled and moved on

Two weeks ago SmarTone’s share price was trading at $10.64 but the day before results were announced it shot up as high as $12.70 to close at $12.50 for a 17.5% gain. 

The two weeks leading up to SmarTone’s annual results were filled with hope.  The hope fed the frenzy and now there must be some pretty disappointed punters.  So where is the source of that hope?  I can only surmise that it is the combination of the three events below.

Safe Harbours in Stormy Weather

The mere talk of taking the punch bowl away from the financial markets have caused convulsions in emerging markets.  Syria gassing its own people did not help.  The US military industrial complex have mobilized their propaganda machine in response to the apparent "red-line" that was crossed by Assad (no concrete proof he did it - yet).  Does not matter, the Assad regime must go. 

How convenient, the US debt ceiling will be breached in less than two months and this is just the excuse needed to raise the debt ceiling to pay for the missiles manufactured by Raytheon. 

Where US and its western allies go, trouble follows shortly.  Iraq and Libya, both oil rich nations are now laid to waste.  Incidentally Syria also produces oil, not a lot, for those who do not know.  But in this instance it is not about oil in the ground but rather the gas pipelines running from Iran-Iraq-Syria and eventually connecting to Europe.  The Qataris want to do the same but they are not on friendly terms with Syria.

The US has already made up its mind, the back pedaling to congress with behind the scene lobbying will eventually build consensus to give the invasion legitimacy. 

It is not if, but when, US will lay siege to Syria.

I don't slavishly follow markets, but lately thanks to unintended consequences of central banks' meddling when they should not and the threat of another Middle East war, I am thinking better safe than be sorry.

Defensive utility stocks and social considerations

I generally try to avoid water and energy companies, particularly in Asian markets.  The reason has nothing to do with investment merits but rather social.  I believe people should have access to clean water and energy at a reasonable cost, even to the point of it being subsidized.  After all, corporates defile the environment and leave the clean up costs to taxpayers. 

In the UK, since privatization, water and energy bills have risen way faster than inflation.  And this have thrown many people into fuel poverty.  People are making choices between heating the home or feeding the kids.  Older people die from not being able to heat their homes properly in the winter.  Despite this, huge profits are made by utility companies.  Increasing dividends and rising share price have certainly benefitted shareholders and management award themselves even larger bonuses.  I cannot resolve the dichotomy: Bad for the conscience; Good for the wallet.

Water and power generation companies in Asia still require heavy investments to improve water quality and construct more efficient plants.  Unlike in the West, these strategic assets remains majority owned by the government.  This means at any point social agenda can override profit motive.

Telecom operators are different, apart from government gouging operators for spectrum and now the occasional snooping, they largely leave Telcos to the fate of the free markets.  This makes it more palatable for me.

Is there any good value Telcos out there?

I have been playing Hay Day and Clash of Clans since May 2013.  Both games are developed by Supercell, a US based games developer.  It is extremely addictive; when you need to feed your chickens, milk the cows and sell fresh produce or upgrade your defenses or lay siege to your enemies you just have to have your wireless devices with you all the time.

If you are not an insider, gaming companies are impossible to analyze.  Mostly stock prices already trade at sky high multiples when it gets the attention of the general investing public.  Instead of looking for the next big game company my attention turned to the telecom sector.  So for the last two weeks I have been busy trying to get up to speed with the telecommunications industry as my understanding of it dates back to the days of Alexander Graham Bell.

Hong Kong telecoms industry is super competitive

With a population of just under 7.2m and five telecommunications service providers, HK is one of, if not, the most competitive telco market in the world.  Little wonder, fighting over a slice of a small cake have driven service providers to be at their best.  HK currently ranks number one in the world for internet speed.  HK boast super fast internet connection 3 times faster than the global average.  The companies that compete in this space undoubtedly have to have huge financial power to compete in the global internet speed race.  These companies are subsidiaries of HK's largest companies:

• PCCW owned HKT (fixed line and mobile)
• Australian Telstra owned CSL (mobile)
• Hutchison Whampoa owned Hutchison Global (fixed line long distance carrier and mobile) 
• Sun Hung Kai owned SmarTone (mobile)
• China Mobile

Below are some statistics from OFCA, the industry's regulator.

• Mobile data usage 7.6 billion Mbs in 2012, it was 638 million Mbs in 2009 (3 year CAGR 129%)
• Mobile subscriber penetration rate is 231% (one of the highest in the world)
• 2.40m households, customers with home broadband at 2.25m, 94% penetration rate
• 2.5G and 3G/4G mobile subscribers 11m
• Public Wi-Fi access points 19,554

 

HK Telcos all fired up by Vodafone's sale of its Verizon Wireless stake

On Friday, 30 August 2013, Vodafone announced that is was selling its 45% stake in Verizon Wireless to Verizon Communications for $130bn perked up HK Telco's stock prices. 

SmarTone, the smallest of the five, largely tipped as a target jumped 4.66%.  HKT the market leader fell slightly possibly being viewed as the potential acquirer and Hutchison jumped 4.35% because it has to deal with one less competitor.

SmarTone underperformed its peers for the past two years

I have included Singapore's Sing Tel, StarHub and M1 for completeness given the similarities of the two island states.  It is unclear the reason for the underperformance of SmarTone.  It may have something to do with the negative publicity surrounding its parent, Sung Hung Kai and the Kwok brothers implicated in a corruption involving land deals. 

Business models of HK Telcos

PCCW-HKT is the market leader for fixed line/broadband with 63% market share of residential business and 12% of the mobile market.  Its dominance of the local fixed line market have not really been dented over the years.

Hutchison's owns an extensive fibre-optic network in HK and has a portfolio of submarine and terrestrial cable systems linking HK throughout the world.  Half of fixed line business is carrier services.  It has 28% share of the mobile market trading under the brand 3. 

SmarTone is a pure wireless provider.  SmarTone operates at the premium end of the market with 23% of the postpaid market share.  Based on a Credit Suisse report, SmarTone has the best network.

CSL is also a pure play wireless provider.  It reported revenues of HK$8.1bn and EBITDA of HK$2.1bn giving it a market share similar to SmarTone.  CSL's brands are 1010, One2free and New World Mobility.

Despite the intense price competition and huge investment outlays, market shares of each player have remain broadly stable which just goes to show how sticky the customer is once acquired.  Churn rates remains less than 2% overall.  All operators attempt to increase revenue and profit pool through better customer / service segmentation such as tiered plans and handset tie-ins.  All network operators have reported increased ARPU.  I suspect, it is the significant rise in data usage in the last few years rather than any clever marketing programs that have mostly contributed to increased ARPU.

Not an easy business

The huge cash flows operators make have not gone unnoticed by governments throughout the world.  Since the early 2000s when the UK government started the trend of auctioning spectrums, operators now have to pony up just to ensure they can stay in the game.

The pace of technological change from 2G, 2.5G, 3G and now 4G requires constant investment.  Even when no new technology is introduced, investments in maintaining network infrastructure is not cheap.  For example, over the past ten years, SmarTone spent on average HK$1.1bn or a quarter of revenues on PPE, licence fees and handset subsidies.  HKT and Hutchison spent HK$2.8bn (19% of average five year revenues) and HK$1.5bn (13% of average five year revenues) respectively over the period.

Consumer protection laws have made it easier for customers to change operators and made it easier for new entrants.  Global roaming charges have also fallen.  The constant roll out of new smartphones is both a blessing and a pain.  Subsidizing handsets to acquire new customers can be a drain on cash but conversely customers are tied into longer plans giving stability in revenue streams. 

Financial performance

SmarTone's last financial performance was relatively better than HKT and Hutchison. The 50% increase in revenues is mainly from 100% increase in handset sales and 24% in service revenues.  The combination of higher net margin, asset turnover and leverage results in higher ROE.

All three companies have decent cash flow generating abilities, with operating cash flows well above net income. 

SmarTone debt to EBITDA of 0.5X is the lowest amongst the three operators.  This reflects the recently issued US$200m guaranteed notes.  As the HK$ is tied to the US$, there is no danger of foreign currency risk.  I think it is quite smart of SmarTone to issue debt to lock in on rising interest rates.  The annual charges are well covered by operating cash flows so does not post a risk to the business.  Both HKT and Hutchison carry significantly higher debt loads.

Valuation

HKT trades at a higher multiple reflecting its near monopoly of the residential fixed line business and cash generating ability.  On a PBV basis, HKT is carrying significant amounts of goodwill which is more than the reserves.   

 

SmarTone lower PE I suspect is because its FY2013 revenues are expected to be lower than FY2012.  Its PBV is a bit on the high side but not much more. SmarTone's share price is underpinned by a 100% dividend payout ratio. 

 

From a valuation standpoint, I believe Hutchison offers better value providing a decent dividend yield and a lower PBV (ex goodwill).  Its business is also better diversified compared to SmarTone and its income profile is much more stable overall compared to SmarTone.   

 

 

Slipping on its own sausage skin, Shenguan's disturbing interim report

It has been awhile since my last post as I have been preoccupied by the half year reporting season in Hong Kong.  So far, the half year results have not been too bad.  I do not have hard data but overall, its been pretty bad for the manufacturing and basic materials sectors.  But I would not classify it as a disaster.  Where there have been positive news, it has been tempered with rising costs and slower revenue growth compared to the experience of the last 3 years.  

News on the street that China / Hong Kong markets are cheap, I believe, are wide off the mark.  In fact a lot of the quality names are trading at quite high multiples.  Case in point, SaSa (PE 28), Want Want (PE 31), Tencent (PE 41), AAC Tech (PE 20), Mengniu (PE 36) amongst others.  Hong Kong's cheapness, I believe is due to its large financial and real estate sector.  It is only appropriate that investors demand a margin of safety where there are concerns over asset quality and mounting debts in the system. 

For the careful investor, stock picking not index buying is the rule.  And you should be asking "why I should own this stock" not "why shouldn't I own this stock."  This change of emphasis should help to lessen your chances of making stupid mistakes. 

Shenguan needs to become more transparent 

I reviewed Shenguan Holdings Ltd. (0829.HK) a couple of weeks ago and decided that, despite its seemingly high profit margins and favourable prospects, the careful investor should give it a wide berth.  Shenguan gave a good story at its IPO in Oct 2009.  Now approaching its fourth year as a public company, the cracks have started to appear.  And it is not so much about cracks in industry prospects, which remains intact, but rather cracks in its corporate governance and management's less than frank assessment of the business.

Shenguan's revenues and net income over the period is down 1.3% and 2.6% respectively.  Management blamed the drop in revenues down to customers running down stocks and a preference for shorter wieners (no jokes here).  The greater fall in net income is due to the rise in utility and raw material costs and higher depreciation charges.  Operationally, the business have been impacted by the move to using whole pieces of cattle inner layer skins which have affected efficiency during the transitional period and the installation of new heating technology interrupted production.

Floating pig carcasses down the Huangpu River and bird flu outbreak clearly did not help the situation.

This all seems plausible, and it is a good story for a not so good result.  But without disclosing production data of casings produced and the number of production plants it has installed since it stopped reporting the number half way through 2011 is a red flag for me.  Indeed I have already raised the point about the decreasing level of disclosure in the MD&A section post IPO.  Instead, the "wishy washy" MD&A section, which any person with moderate intelligence can get looking at the numbers, leaves you none the wiser.

Another area of concern I have is the never ending capital expenditure.  Net PPE have been growing faster than revenues in 4 out of 5 years and increased 12% in the first six months.  Perhaps it is justified but without production data, I can only conclude the capex number is highly suspicious.  This suspicion is warranted because the company have made it clear that shareholders come second after the company dished out RMB92m in soft loans to the local government during the last financial year.  One wonders how much of the capex are actually soft loans or money that has just disappeared down the rabbit hole as opposed to enhancing production capability which will benefit the future.

Another area of concern is the huge increase in inventory.  Inventory turnover came in at 2 times compared to 3.4 times in the previous period.  It is carrying 70% (RMB144m) more inventory compared to the previous period.  No explanation have been given for this sharp rise.  Either the company have made a monumental mistake carrying too much inventory or it is simply pushing costs out to later periods or both.

If this be a small company, not Asia's largest sausage casings manufacturer, I'd be inclined to take a leap of faith and overlook some of the poor disclosures.  In this instance I'd rather keep my distance regardless of my previous good experience with UK listed sausage skin manufacturer Devro PLC.

The combination of lower profitability, higher inventory and capital expenditure have pushed the bank balance lower by RMB394m since the start of 2013 to RMB491m.

Clearly I am not the only one who is sceptical of this stock.  The company's stock had dropped over 4% since its interim results.  Even the announcement of a special dividend of HK2.8cents and share buybacks have not been able to stem the slide to HK$3.30. 

Shenguan remains a young public company, and the accounting gimmicks can only fool investors so long.  I think Shenguan will surprise on the downside in its 2013 annual results - there I said it here first!