Magni-Tech Industries Berhad

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas”— Paul Samuelson

"Slow and steady wins the race."

The Business

Magni-Tech Industries Berhad (Magni) is engaged in simple-to-understand businesses in the old economy stuff. The Company operates in two business segments:

1. Manufacturing and sales of garment for the export market which makes up 80% of its business
2. Manufacturing and sales of flexible plastic packaging, corrugated packaging products and display boxes focussing on consumables, pharmaceuticals, health care related products, food and beverage which are recession proof as well as having higher value added.

Both business operations are in the challenging industries due to rising labour costs  and rising level of competition. The business is durable and likely to last for many years. However, there is not much moat in this type of industry. So why am I interested in investing in this company?

Share price movement

Figure 1 below shows the steady increase in share price of Magni from 2009 to 2014. It has risen from an adjusted price of less than 90 sen to RM2.63 since 5 years ago, 192% increase in price or a compounded growth rate of 24% a year. It is really not bad at all.

So at this price of RM2.63, is Magni worth investing? As usual we will have to look at a few things;

1. The quality of the business,
   1. its return on capitals
   2. Cash flows
2. Capital allocation
3. growth and the last but not the least,
4. the value versus price.

Figure 1

Quality

First up is quality. We can use margins, especially a margin high up in the income statement such as gross margin to determine the quality of the business. However, different industries generally have different margins, and garment and packaging companies tend to have lower margins.

Return on capitals

So I prefer the quality metrics of the return of equity (ROE) and return on invested capital (ROIC). Ultimately these determine the profitability of your investment. If you put in RM100,000 to invest in something, and get a return of RM15,000, or 15% a year, that is pretty good, further considering that your business will grow.

Most investors are too concerned about earnings but few cares about this more important performance of return of capitals. Imagine, if a company wants to improve earnings per share (EPS), the management can always go out and borrow more money to make more EPS. Unless the return from the borrowing is higher than the borrowing cost, it doesn’t improve shareholder value. Instead it destroys shareholder value resulting of heavier debt burden.

Below are the equations for returns of capitals.

ROE = Net profit / Equity

ROIC = Earnings before interest and tax * (1-tax rate) / Invested Capital

Invested Capital, IC = Property, plant and Equipment + net working capital

Net working capital = Receivables + Inventories - Payable            

See link for ROIC and IC below : http://news.morningstar.com/classroom2/course.asp?docId=145095&page=9

Figure 2 below shows that Magni’s ROE has increased from 8.5% to more than double of 17.3% from 2009 to 2013. The interesting thing is this high ROE is achieved with no debts, and with substantial cash and cash equivalent. ROIC increased in tandem from 10.6% to 24.1%. This is a spectacular rise. The ROE and ROIC of 17.3% and 24.1%  are without doubt, much higher than the costs of capitals. Any growth with these rates is huge shareholder value enhancing.

Figure 2: Trend of return on capitals

Figure 2 above also shows the steady increase in ROE and ROIC of Magni from 2009 to 2013 for the year ended 30 April . That is pretty good as it shows the increasing trend of its efficiencies.

This stellar performance of the company could be due to the group strategy to contain costs, upgrading of its information technology system and hence enhance customer satisfaction by providing quality products and services, including timely delivery of customers’ orders, as described by the Chairman in the latest annual report.

Cash Flows

The next quality I am most interested on is the cash flow, in particular, the free cash flow (FCF).  As you can see in Table 1 below, cash flow from operations is always positive. Even FCF, after spending on capital expenses, is positive all these years. That is pretty good too.

Table 1: Cash Flows of Magni-Tech for year ended 30 April

The percentage of FCF over the revenue is low at about average of last two years of less than 5%. However, remember we said this business is of low margin, and hence low FCF in relation to its revenue. The more important metric is the FCF in relation to the amount of invested capital (IC). That number is very good at an average of about 18% last two years. As a matter of fact, any FCF, yes hard cash, which is above 10% of its invested capital is already fantastic.

Capital allocation

It is with this good FCF that the company is able to pay reasonable good dividend. Last year, the dividend was 13 sen a share, or a dividend yield of 5% at a stock price or RM2.63. This is very good in comparison with the bank fixed deposit. Who says the management doesn’t care about the minority  shareholders? The company could afford to even pay higher dividend as the capital expenses needed is low. I actual hope the company can use this FCF to buy back its shares when they are selling cheap as like right now as a good capital allocation practice. This business doesn’t seem to require much capital expenses for its growth.

Growth

This is the most favoured subject of many investors, buy growth stock (but never talk about price). I do know and appreciate the power of growth to the value of a stock as shown in my article below:

http://klse.i3investor.com/blogs/kcchongnz/45456.jsp

The problem is the “growth” we are talking about is the future expected growth, a forecast figure which is very difficult to predict. The growth estimate, especially those with very high rates often does not last long enough to justify the high valuations. Hence I am not willing to pay much for some kind of growth expectation. When I make an investment, it needs to be justified even if the business doesn’t grow. I certainly benefit from growth if it does.  But isn’t there any growth for Magni?

Table 2 below shows that the revenue and net profit grow at a compounded annual rate of 10.7% and 28.7% respectively for the last 5 years. If it is not growth, then what is it? But still I am not willing to pay a high price for that.

Table 2: Revenue and net profit for year ended 30 April

As I have not much interest in growth projection. What actually I am interested in investing in Magni? Yes its value. Value against the price I pay for is the most important criterion.

Value Versus Price

Let’s talk value. This one is simple. I look for a clear line in the sand. If there is a number I feel sure the company is worth more than, I want to pay that price.

Comparing the stock to others is often a shortcut. It’s not an actual valuation method. It’s just another way of trying to prove the stock is undervalued.

Generally stocks often trade at about 15 times earnings. I would only willing to pay for less than 10. Likewise for EV/EBIT- 10x EBIT would be pretty normal. I’d try to pay less than 7x EBIT.

So at an earnings of 33 sen per share last year, I am willing to pay RM3.30 based on PE ratio of 10, and a price of RM3.50 basing on EBIT of 46.5m last year. So Magni at RM2.69 is really a value buy for me. It is cheap for a company making profit every year, and increasing. It is cheap for a company having high returns of capitals, and consistent cash flows from operations and FCF every year.

Discount Cash Flow Valuation of Magni

Financial theory postulated by John Burr Williams in his “The theory of investment value” says that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. For those who are interested in this methodology, please refer to the following link:

http://klse.i3investor.com/blogs/edu_morg_star/31605.jsp

There are two major assumptions used in the computation for the intrinsic value, or the present value, of the expected future FCF of a company; FCF growth rate and the discount rate.

The discount rate is related to what is the required return by the equity and debt holders respectively; i.e. how much risk premium above the risk-free rate would be required. For most practical purpose, in contrast with the academic approach in capital asset pricing model, a risk premium applied is related to how stable the earnings and cash flow of the company and its financial health. The 10-year MGS rate at the moment is about 4%. Magni’s earnings and cash flows have been steady for the last 6 years. It has no debt. So it would be conservative to apply a risk premium of 6% above the MGS rate, or a required return for equity holder Re of 10% (4%+6%). The weighted average cost of capital (WACC) is the same as Magni has no debt at all. This WACC of 10% will be used as the discount rate for the valuation of the firm.

The more difficult part is the assumption of future cash flows of the company which is related to its normalized FCF this year and its expected growth rate. When I carry out the computation of intrinsic value (IV) to decide whether to invest in a company, I would prefer to use conservative assumptions. In Magni’s case, I start off with a normalized FCF of 16.6m being the average FCF of the last 5 years, a growth rate of 8% for the next 5 years, 5% for the subsequent 5 years and a perpetual terminal growth rate of 3% after that, in accordance to the rate of growth of GDP and inflation.

The intrinsic value attributed to the common shareholders of Magni is found to be RM3.62 as shown in Table 3 in the appendix. This represents a margin of Safety of 26% investing in Magni at RM2.69, or an upside potential of 37%.

Latest quarterly result ended 31^st January 2014

The results show that the trailing twelve months (ttm) revenue and net profit has increased by 17% and 33% respectively, much higher growth than my assumptions of growth of 8% in my DCF valuation. Ttm EPS is now 37.5 sen and forward PE ratio is only 7.0. Note that Magni has no debts. Instead it has 67 sen excess cash in its balance sheet.

Conclusions

Magni is a high quality company as shown in its long history of stable and growing earnings and cash flows, and high return on capitals. It has a clean balance sheet. More importantly, it is even selling at low market valuation. This has not taken into consideration of its much improved three quarters results ended 31^st January 2014. It is a low risk, high return bet. Heads, I win; tails, I don’t lose much. Hence at the closing price of RM2.69 on 2^nd May 2014, it continues to remain in my portfolio.

K C Chong in Auckland (3/5/14)

Appendix

Table 3: Discount free cash flow analysis