Tong Herr Resources Berhad: Investing in turnaround stock

“Turnarounds seldom turn.“       Warren Buffett

A hot growth stock can come crashing down with even the slightest rumour, bad news or perhaps even good news that wasn’t quite as good as anticipated. A stock that is already perceived as troubled, however, may hardly budge on that same news. With turnaround stocks investors have already anticipated the worst. In other words, a little more bad news is unlikely to impact that otherwise appealing turnaround stock.

Lucrative stock profit potential can be found among temporarily out-of-favour companies. The strategy with turnaround investing is relatively simple: Beaten down stocks with real value will prevail regardless of the overall market and/or short-term setbacks.

According to George Putnam, the founder of The Turnaround Letter,  the 15-year annualized return on stocks purchase based on the strategy of 11.5% as at 31^st July 2013 is more than 4x greater than the S&P 500's. Last year alone, the strategy yields an annualized return of 50% compared to about 32% of the S&P as shown in Figure 1 below.

Figure 1: Turnaround Letter Performance Compared to S&P 500 (through 12/31/13)

Source: Hulbert Interactive

Not only do individual investors shun turnaround stocks, so do investment banks, unit trust funds, insurance companies, institutional investors, in general. Unlike with the heavily-analyzed and traded "blue chips," and the rumour flying hot stocks in financial blogs and forums, knowledgeable retail investors can realize substantial gains with turnaround stocks.

We will look at a turnaround stock in Tong Herr Resources Berhad listed in Bursa.

The business of Tong Herr

Tong Herr Resources Berhad is involved in the manufacture and sale of stainless steel fasteners, including nuts, bolts, screws and all other threaded items, and aluminium products. The Company operates in Malaysia, Thailand and Vietnam. Its products are used in many different industries, including the solar energy industry, the petrochemical industry, machine assembling, food machinery, telecommunication and construction. 80% of its products are exported all over the world with the major markets in the US, Europe and Singapore.

Tong Herr business and Share Price Performance

Figure 2 below shows the share price performance of Tong Herr for the last 14 years from year 2000.

Figure 2

Tong Herr’s share price rose from its lowest after the internet bubble from RM1.10 13 years ago to its peak of RM6.60 seven years ago on October 8 2007. Imagine, the share price of Tong Herr was three times its present price seven years ago. In that year 2007, Tong Herr’s revenue and net profit was RM488m and 65m respectively, up by 60% and 29% respectively from the previous year. Earnings per share (EPS) was 51 sen. Operating margin was 25% and return on invested capital (ROIC) was at a whopping 45%. What a great growth story was that!

After the US Sublime crisis in 2008, it dropped to a low of RM1.60 on March 9 2009 when during that year, revenue and net profit plummeted to RM211m and RM12.5m respectively with an EPS of just 6.6 sen. Operating margin and ROIC contracted to 6.9% and 8.2% respectively. The share price moved up to RM2.77 on January 10 2011 when European market started to recover. In that year, revenue and net profit increased by 75% and 49% to RM601m and RM47.2m respectively.

Share price dropped back again to RM1.67 a year ago when the European Commission initiated an investigation concerning the possible circumvention of anti-dumping measures on all foreign imports of steel fasteners. The export of Tong Herr to this important market was seriously affected and the turnaround story seemed to fizzle out.

Tong Herr’s share price recovered to close at RM2.25 on 6^th September 2014 after the release of its third quarter result 2014 when the trailing twelve month operating margin expanded to 25% and ROIC improved to a respectable 10.2%, now above the cost of its capital. This was due to the termination of the investigation at the beginning of 2013 and there appears to be silver lining ahead.

For the last 5 years, the share price of Tong Herr has underperformed the broad market by more than 50% with the market rising 53% compared to 26% of Tong Herr. It is because of this underperformance of this share of a good company due to temporary setback that I am looking at Tong Herr as a good turnaround investment candidate.

Some simple valuation of Tong Herr

Table below shows some simple valuation ratios for Tong Herr based on its trailing twelve month financial results ended 30^th June 2014.

Table 1: Some simple valuation of Tong Herr

Earnings wise, at a share price of RM2.35 now, Tong Herr doesn’t appear to be cheap with a PE ratio of 16, and enterprise value (EV) more than 10 times its earnings before interest and tax (Ebit), resulting in an earnings yield (EY) of less than 10%. However, the price doesn’t appear to be high too when compared with the industry and sector average. With respect to sales, it is reasonably cheap with price only six tenths of its annual sales. The market capitalization of Tong Herr is also lower than its equity value and hence a price-to-book of less than unity. Price in relation to cash flow is also low at less than 10 times for both Cash flow from operations (CFFO) and free cash flow (FCF).

The investment thesis on Tong Herr here is a turnaround story with the termination of investigation of anti-dumping by the European Commission, and the commencement of production in 2013 of its Thailand second plant. With the commencement of production of the Vietnam steel mill, the associate company has actually shown a turnaround with a profit of instead of losses in its latest quarterly result ended 30^th June 2014. Margin has also improved with the increase in sales price. As the world economy recovers, its export business looks brighter and  increasingly promising. Let us make a discount cash flow valuation for Tong Her.

Discount cash flow analysis for common equity shareholders

During its glorious days in the year 2006, Tong Herr’s net profit margin was 18.4%, more than twice the average margin of 9% for the last 8 years. We will assume that its margin will improve to the average of 9%. So the net profit for the coming year, with a revenue of RM520m, will be RM46.8m.

The big assumptions are its growth in future earnings and the discount rate, or the required return of common shareholders. The future earnings is expected to grow at 10% for the next 5 years and 3% subsequently. A risk premium of 6% is added to the 4% long-term MGS rate, giving a required return of 10% which is reasonable in view of its stable earnings and consistent good cash flow and a healthy balance sheet. Other data and assumptions used are tabulated below.

Revenue                                                                              520m

Current dividend                                                              5% or 6.4m

Net current capital expenses                                      12.5m

Return on equity at stable growth                            10%

The discount cash flow analysis shows the business value attributed to the equity shareholders is RM560m. After minority interest, the value attributed to common shareholder is RM400m, or RM3.13 per share. This is equivalent to a margin of safety of 25% investing in Tong Herr at RM2.35.

Conclusion

Turnaround stocks give some of the largest returns in the market, but investors need be sure they aren't catching a falling knife.

Tong Herr’s business appears to be turning around with the end of the investigation of the anti-dumping measures by the European Commission and the commencement of productions of its Thailand and Vietnam plants. The European as well as the world economy at large is still improving. There is  promising hope that its revenue and margin will expand with all these silver linings. The discount cash flow analysis with reasonable assumptions also show it is selling at a reasonable discount to its intrinsic value

Tong Herr is poised to rebound. I have added Tong Herr as a stock in my portfolio.

K C Chong (9^th September 2014)