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Sunday, February 12, 2006

Hong Leong Asia @ 1.81 (Conglomerate/ Singapore) 4 comments

Final Poll Results: 0:5

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Main issues

1.High valuation based on ex-extraordinary items and on shareholder-attributable profit

2.Declining performance at Yuchai; thin margins at Xinfei

3.Excessive hopes on G-Pac pallets, which has not yet ramped up

It is rather coincidental that this is the second-successive Quek family-linked stock discussed here, after China Sky. Well, the focus is on the growth prospects and the stock valuation, not on any management concerns, in this case.

HL Asia, of course, was a favourite pick of the brokerages in 2003-04 who named it one of the top large-caps. The stock ran into some corporate governance issues in mid-2004 at its diesel engine arm China Yuchai and, coupled with lacklustre earnings at its Xinfei refrigerator subsidiary, industrial packaging and building materials arms, sank from a peak of ~$2 in early 2004 to <90 cents in mid-2005. However, the share price has recovered spectacularly since then, with the apparent solving of problems at its Yuchai subsidiary and a new growth arm in its patented environmentally-friendly G-Pac pallets.

When one looks at HL Asia's profits, it should be noted that the figure to concentrate on is attributable profits to shareholders. For holding companies which control 100% of their subsidiaries this is of course the same as net profit; however HL Asia has for example, only ~20% stake in China Yuchai, and hence profit attributable is substantially less than net profit from this arm . There are some publications that still publish HL Asia's profit figures as its net profit; note that this overestimates shareholder's profits.

Based on the above note, it should be emphasised that 9M05 attributable profit is S$27.8M, NOT S$105.7M (the total net profit, including minorities). This means, if annualised (a reasonable assumption since only 1 quarter remaining) to FY05 attributable profit, and excluding extraordinary items, earnings per share is only 8.5 cents. At today's price of $1.81, it is a (soon-to-be trailing) PE of 21 times.

Are core businesses expected to grow at 20% per annum (using Peter Lynch's PEG valuation methodology)? The two core businesses are China Yuchai (diesel engines) and Xinfei (refrigerators). Yuchai has recently be affected by falling sales due to credit tightening in China, with profit falling by ~25% in 9M05 (over 9M04). Xinfei has operational scale (2nd largest refrigerator maker in China), grows revenue consistently at ~25% per annum, but suffers from poor and declining margins which have effectively kept profits stagnant. Profit margins are only 4%, based on 9M05 revenue of S$625M and net profit (attributable profit of $12.9M / 50%, HL Asia's Xinfei stake) of $26M. This is not surprising, when one notes that the industry's leading player, Guangdong Kelon, has collapsed despite strong demand for its products: a sign that rising revenue does not necessarily mean proportionately rising profits. China Yuchai's margins, by comparison, is better at ~7%, based on 9M05 revenue of $926M and net profit (attributable profit of $13.9M / 22%, HL Asia's Yuchai stake) of $63M. Too bad HL Asia sees Xinfei as a core holding while not daring to increase its stake in Yuchai due to the spectre of corporate governance issues over 2004-05.

So what justifies broker target prices that run as high as $2? I noted with amusement that GK Goh actually used forward FY2006 projected earnings in its target price calculation, as early as 1H-FY2005. Surely that is counting the eggs before they are even fertilised? Of course, one must note that GK Goh had declared holdings in the stock in that same report.

Earnings are actually projected to double from S$38M in FY05 to S$74M in FY06, which would bring forward FY06 PE down to 19.4 cents and hence facilitating a
Buy recommendation. Never mind that FY05's projected profits would actually decline 10% year-on-year from FY04, indicating weakness in core businesses. The growth driver is seen to be the G-Pac pallet, and it is projected to contribute ~S$20M on S$80M worth of pallet revenue, based on sales of 4M pallets, in FY06. Now how bullish is that, taking note that initial good customer take-up rate was for the trial production units of only 6000 units/mth (or 72000 units per annum)?! HL Asia would have to ramp up production by >50 times, which it apparently intends to, but it just does not make sense to scale revenue and profits linearly up: trial production should have targeted the more receptive customers, and take-up rate may not be as good for the mass market. As it is, the market valuation for HL Asia might well have priced this optimism in; it looks like the only direction for it to go from now on is down, or at best "consolidate" (in broker-speak, while they distribute).

(1) CIMB-GK Goh Aug 31 2005 analyst report on Hong Leong Asia




Blogger Gallen said...

Hi Daniel, tuesday greetings :)

2/14/2006 11:01 AM  
Blogger Gallen said...

hey daniel, how is your wed?

2/15/2006 11:04 AM  
Blogger DanielXX said...

Today must have been a bad day for everyone except those heavy in cash :-)

For once, I was glad that my main portfolio stocks were traded in relatively low volumes.

2/15/2006 10:20 PM  
Blogger Gallen said...

hi daniel, good for you, not been a good week for me though.
take care.

2/18/2006 12:30 PM  

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