Valuing Hengyuan - Discounted Cash Flow Method

david_tan

Publish date: Thu, 15 Mar 2018, 08:07 PM

Subsequent to my analysis titled ‘Hengyuan – No Doom For 2018’, there have been strong discussions on the need to use the Discounted Cash Flow (“DCF”) method to value HRC.

There are various methods to value a company and DCF is certainly a popular method. Personally, I have reservations about this method as it involves too many crucial variables where minor tweaks to these variables will lead to the valuation result to differ significantly. And it goes without saying that everyone will have an opinion on what constitutes the best numerical value when it comes to applying these variables; this inevitably makes for even more disagreements on the result of the valuation. Furthermore, DCF requires projection far into the future; 10 years is a common time period used. My opinion is the further the projection into the future, the less reliable the numbers are.

But the use of DCF is not without merit. Personally, I find that DCF is useful when valuing a stable company where the operations are mature, the industry it operates within is stable, and its historical accounting numbers do not fluctuate significantly. Under these conditions, the analyst is allowed to work within a more predictable environment leading to more reliable numbers being used in the forecast and projections. Unfortunately, I do not see HRC falling within these criteria as the refinery business is highly volatile. Nevertheless, I am also intrigue by what sort of numbers may possibly come up for HRC via applying the DCF method.

PROJECTING GROSS PROFIT

Here are some key assumptions:

1. Average gross profit for the past 8 latest reported quarters (1 January 2016 to 31 December 2017) is used as the base number. In determining this average, quarters with the highest and lowest gross profit were disregarded to eliminate unusual fluctuations.

2. Based on information available from the quarterly reports, a minor 3-week shutdown was identified in Q2 2017. The gross profit for the said quarter was normalised for our averaging purpose.

3. Major shutdown of 75 days is assumed in Year 2018.

4. Statutory shutdowns of 25 days each is assumed in Year 2021, Year 2024 and Year 2027 on the basis that a statutory shutdown is required every 3 years.

5. Post Year 2018 plant upgrade exercise, capacity of HRC is increased by 10% beginning Year 2019.

NEW TERM LOAN IN 2018

Here are some key assumptions:

1. US$300,000,000 was drawndown on 23 January 2018 to repay existing term loans. At foreign exchange rate of 3.927 on that date, the new term loan amounted to RM1.178 billion.

2. The tenure of the new term loan is 5 years.

3. In 2016, HRC’s effective interest expense rate was 3.62% per annum to 5.27% per annum (2015: 1.36% per annum to 4.44% per annum). The average interest rate is 3.67% per annum. (Source: Latest available audited financial statements)

4. Based on this average interest rate, monthly loan repayments amount to RM21,520,000 (including interest expense) with 1^st repayment in February 2018.

LOAN FOR MAJOR PLANT UPGRADE IN 2018

1. US$160,000,000 has been budgeted for this exercise. Based on US$ exchange rate as at 14 March 2018 of 3.9085, the loan amounted to RM625,360,000.

2. The tenure of the new term loan is 5 years.

4. Monthly loan repayment amount to RM11,424,000 (including interest expense) with 1^st repayment in October 2018.

OTHER INCOME

Other income is assumed at the average of the past 8 most recent quarters (1 January 2016 to 31 December 2017). In determining this average, quarters with the highest and lowest other income were disregarded to eliminate unusual fluctuations.

MANUFACTURING EXPENSES

1. Average manufacturing expenses for the past 8 latest reported quarters (1 January 2016 to 31 December 2017) is used as the base number. In determining this average, quarters with the highest and lowest manufacturing expenses were disregarded to eliminate unusual fluctuations.

2. Manufacturing expenses for Q2 2017 was normalised for our averaging purpose due to expenses incurred for an unplanned maintenance shutdown.

3. Manufacturing expenses is adjusted accordingly based on number of production days in the year.

ADMINISTRATIVE EXPENSES

1. Average administrative expenses for the past 8 latest reported quarters (1 January 2016 to 31 December 2017) is used as the base number. In determining this average, quarters with the highest and lowest administrative expenses were disregarded to eliminate unusual fluctuations.

2. Inflation rate of 3.5% per annum is applied for each progressing year.

TAXATION EXPENSE

1. Current taxation rate of 24% is assumed for all years.

2. Reinvestment allowance amounting to 60% of 2018’s major upgrade exercise amount to RM375,800,000.

3. Depreciation is assumed as capital allowance for taxation purpose. Average depreciation expense for the past 8 latest reported quarters (1 January 2016 to 31 December 2017) is used as the base number. In determining this average, quarters with the highest and lowest depreciation were disregarded to eliminate unusual fluctuations.

4. Capital allowance of 14% is applied for capital expenditure incurred in 2018’s major upgrade exercise.

5. Interest expense is recognised proportionately at 8.8% of loan repayments made.

CHANGES IN WORKING CAPITAL

1. Working capital is calculated as current assets less current liabilities.

2. The annual change in working capital is determined based on the percentage change of gross profit.

DISCOUNT RATE OF 3.17%

1. The discount rate is calculated based on the the Weighted Average Cost Of Capital method.

2. Market value of HRC's equity is determined based on it's share closing price as at 14 March 2018 of RM8.53 i.e. RM2.559 billion.

3. Market value of HRC's debts amounted to RM1.205 billion as at 31 December 2017.

4. Cost of equity is determined at Maybank's fixed deposit rate of 3.35% per annum.

5. Cost of debt of HRC is 3.67% per annum as discussed above.

VALUATION

Using the discounted cash flow method of valuation based on the assumptions and estimates presented above, HRC is valued at RM19.55 per share.

[The following was inserted into this article after it had been initially posted. Updated on 16 March 2018, 1.40pm]

There are comments that the discount rate used was too generous. As I have mentioned in the beginning of the article, the DCF method always draws disagreements to assumptions and estimates used. Nevertheless, for discussion purpose, lets try a discount rate that is more conservative.

Using the Weighted Average Cost Of Capital ("WACC") again to calculate the discount rate, I revisit inputs for cost of equity and cost of debts.

The cost of equity I previously selected was that of Maybank's fixed deposit rate as that will be the opportunity cost of the fund used to invest. Here, I will be using the cost of margin facililty instead - this being the interest expense that you will have to pay for investing using bank borrowings. Maybank's current interest rate for margin facility is 4.65% per annum.

The cost of debts was previously taken as the average term loan interest rate of HRC for the past 2 years as extracted from HRC's audited financial statements. For this illustration, I am selecting the upper most interest rate incurred by HRC in the past 2 years of 5.27% per annum.

Based on the above inputs, the discount rate using WACC is 4.44% and HRC is valued at RM18.25 per share.

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arv18

David, thanks for taking the time out to do this.

2018-03-17 12:33

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