This analysis is for sharing purpose. Please make sure you havedone your own study or seek professional assistance before investing.

Dear participants,

KESM share was first introduced in my learning blogs by an active participant of our group about two and a half years ago when it was trading at RM2.83 apiece. It was a stock pick in my stock pick service and I wrote a detail analysis and an investment thesis on 18^th July 2016 and published in my blogs, just before we had our gathering in Hotel Sri Petaling in Kuala Lumpur on 24^th July 2016. I had emphasized this pick in the gathering again. Its share price was RM5.59 then.

Original Investment Thesis

KESM was selected based on the investing strategy of “Value on the Move”, i.e. a stock which meets some value criteria and there was momentum in its price movement then. This strategy was inspired by Professor Josep Lakonishok which had made barn-storming return using this strategy.

The main value metric for KESM was its low price-to-book, price-to-cash flow as well as price-to-earnings values, coupled with potential growth then, especially in its focus in automotive burn-in and testing service, with some earnings surprise. My discount cash flow analysis shows that the intrinsic value of KESM was RM9.19 per share, or a wide margin of safety of 39% investing KESM at RM5.59 then.

For momentum measure, the following criteria were used.

·         6-month relative strength (% gain Vs KLCI) above zero

·         3-month relative strength equal to or higher than 6-months relative strength.

Note the RSI described here is different from the common relative strength index used in the industry. At that time, the common RSI used was above RSI of 70% (Not sure why it should be 70%, and not 60% or 80%), signifying an overbought positive and the share price was poised for an imminent downward correction, which never come. The share price shot up to RM8.00 all the way as shown in Figure 1 below.

“The secret to successful investing is to figure out the value of something and then-pay a lot less” Joel Greenblatt

Share price movement

KESM’s share price has risen to the close of RM8.00 a piece on 20^th September 2016 now, it has gone up in price by 43%, in just 2 months. Figure 1 below shows its share price movement for the past two years. Note the sharp rise of its share price in the last three to four months. At this price, is it still good to hold or is it better to sell and realize the profit now?

Figure 1: Past two years share price movement of KESM Industries

Let’s take a closer look at its just-released final quarter result ended 31^st July 2016 to make a better judgment if should we sell, buy more or buy some if you haven’t bought any?

The final quarter 2016 results

KESM has just released its final quarterly 2016 result on 20^th September. Compared to the corresponding quarter last year ended 31^st July, revenue increased by 8% from RM68.9m to RM74.5m due to the higher demand for burn-in and test services. Excluding the “other income”, interest and dividend income, the operating income increased by 9% from RM7.94m last year to RM8.67m. Profit before tax, however, reduced by 4% to RM9.37m, mainly due to the foreign exchange gain and reversal of sundry payables total of RM1.9m during the last corresponding quarter. Net profit reduced further by 23% as there was a tax credit for the last corresponding quarter. KESM actually did better in its bottom line this quarter than the last corresponding quarter if we stripped off the abnormal foreign exchange and tax effect.

For the whole year, revenue this year was 9% higher at RM285.7m as a result of higher demand for all services. Operating income, excluding interest and dividend income, and other income, is higher by 73% to RM33.1m. Net profit was 46% higher at RM30.7m. Earnings per share, EPS, for the financial year ended 31th July 2016 is 71.3 sen.

The best thing about the result of this financial year is its good cash flows. Cash flows from operations has increased to RM88.2m, the highest in history. Free cash flows, FCF, is also the best so far as it did not require to spend too much in capital expenses after the last two years of high capital expenses. FCF amounts to RM58.6m, or RM1.36 per share, or a very high cash yield (FCF/MC) of 17%.

ROE and ROIC has improved further to 10.7% and 14.3% respectively, higher than its costs of capitals, indicating a shareholder value maximizing performance. The balance sheet has improved by leaps and bounds with net cash increased to RM81m now, or RM1.88 per share.

The management guided that the world-wide automotive integrated circuit market is forecast to grow at a healthy rate of 7.2% to a revenue of USD23.8 billion in 2017. This augurs very well for the growth of the business of KESM in the near future as it has its main focus and with its core competence in this industry.

Some Simple Valuation of KESM

Table 1 below shows some simple valuation metrics for KESM with its closing price of RM8.00 today on 20^th September 2016 using its latest annual financial results ended 31^st July 2016.

Table 1: Some simple valuation metrics for KESM

The attractiveness of investing in KESM is its reasonable market valuation in every aspect, firm wise or equity wise, except for its low dividend yield of just 0.9%, as shown in Table 1 above, despite its bright near term growth prospect. The enterprise value only 2.9 times its earnings before interest and tax, depreciation and amortization is low. The Cash Yield of 17% is particularly very attractive.

Discounted free cash flows analysis of KESM from structural growth

“The secret to successful investing is to figure out the value of something and then-pay a lot less”.               Joel Greenblatt

In this analysis, I will attempt to value KESM using DCFA by estimating the FCF from the fundamental growth determinants, i.e. growth is generated internally without having to borrow more money or issue more debts.

Estimating Free Cash Flow of KESM

We start with the estimation of future free cash flow for firm from its top line revenue using the year 2016 as the base year, and at the most recent operating margin of 12.4%.

We will estimate the reinvestment rate and then the FCF based on the sustainable growth rate internally which we assumed is the 10% for the next 5 years and subsequently at 3%.

Sustainable growth rate, g = Reinvestment rate * ROC

Return on capital, ROIC of KESM in 2016 was computed to be 14.3%.

Hence RR = g/ROIC =10%/14.3% = 70%

After five years, it is assumed that its FCF will grow at 3% forever, something close to the growth of GDP, and its long-term ROIC reduced to 12%, which is about its long-term cost of capital. These are quite normal assumptions.

Terminal reinvestment rate = Growth rate/ ROC = 3% / 12% = 25%

The tax rate is assumed to increase progressively from 15.3% now to the corporate tax rate of 24% at terminal growth phase.

It can be seen that with the lower terminal growth, the reinvestment rate is lower, and it is time to reap its FCF. The FCF for KESM is computed and tabulated in Table 3 in the Appendix using the above assumptions.

The weighted average cost of capital of firm, WACC

I start with a required return for equity shareholders, Re, and required return of debt holders, Rd, for KESM of 10.0% and 6% respectively.

The WACC is worked out to be 9.5% as shown in Table 2 in the Appendix.

Discount Free Cash Flow Analysis of KESM

Table 4 in the Appendix shows the detail step-by-step calculations of the intrinsic value of KESM.

The present value of free cash flow for the firm was obtained by summing up those of first 5 years of supernormal growth value of RM43.6m, and the terminal value of RM324.2m, totalling RM367.8m. After adding the excess cash of RM116.9m, and deduction all debts of total RM36.0m, it gives the intrinsic value of KESM attributed to common shareholders at RM448.7, or RM10.40 per share.

This shows KESM still has an upside of 30% at a market price now of RM8.00 apiece at the close on 20^th September 2016. The margin of safety (MOS) is reasonable at 23%. For buying, one may require a higher MOS say 30%, but it may be still too early to sell as there is still substantial upside potential.

Risks

The economic slowdown in China, where KESM has some exposure, has a profound impart in the financial markets. Several major economies in the world, including ours, are facing uncertain times, exaggerated by the looming of rate hike in the US. These events may have an impact on our economy as well as the business of KESM. However, I don’t remember there isn’t any problem locally as well as around the world for all these years. It is a matter how the management is going to manage all these risks, and the management seems to have done things right these years.

At RM8.00 and with only 43m shares, the market capitalization is only RM344m, a small cap company and with a free float of 22%, hence expect high volatility in its share price.

Conclusions

KESM is a reasonably good company earning above its cost of capitals. It is still selling at reasonable market valuations at RM8.00 at the close on 20^th September 2016. Its balance sheet has improved vastly with a net cash of RM1.88 per share. It has excellent CFFO for all these years and started to have good FCF now. However, it is hopeful that with the improved efficiency and potential more jobs in the future, they can provide good profit growth and cash flows, and higher dividend payment in the near future.

Using the DCFA from the basic principle with internally generated growth and some reasonable assumptions based on its latest performance, KESM’s intrinsic value is worked out to be RM10.40. It appears that KESM is still not overly expensive at the present price of RM8.00 apiece.

K C Chong

Appendix

Table 2: WACC computation for KESM

Table 3: Free cash flows estimation for KESM

Table 4: Discount cash flows analysis for KESM