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Tuesday, December 05, 2006

Yongnam @ 13.5 cts ( Construction / Singapore ) 0 comments

Final Poll Results: 8:4

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1. Track record indicates margin volatility that should be factored

2. High financial risk

Some might be surprised at my pick of a construction company because it is clear that this is a sector on the upturn, and quite likely in the early waves too. I agree on this point, and yet obviously one should know from past construction cycles that euphoria can surround the valuation of construction companies, making them prone to price volatility.

The recent upsurge by Yongnam has been partly driven by industry talk regarding its possible participation in the IR projects (believe it is the Marina Bay IR). That, coupled with the speculative excitement surrounding the impending announcement of the winner of the Sentosa IR development, have created the buzz that has lifted all related boats (construction stocks). Yongnam was 2.5 cents as late as August 06; today it trades at 13.5 cents, up >5 times. That is a quantitative indication of speculative liquidity layered upon re-rated fundamentals.

Some background on Yongnam: its operations consist of three main arms -- structural steelwork, specialised civil engineering and mechanical engineering. The first two are the two major arms, making up about 80-90% of the group revenue; the structural steelwork division provides steel structural forms for buildings like Vivocity, One Raffles Quay and Fusionpolis; the civil engineering division's current main contracts are for the Kallang-Paya Lebar Expressway and the various stages of the Circle Line. The less important mechanical engineering arm operates out of Singapore, doing work like mechanical systems integration in power plants. Yong Nam's main revenue base is Singapore, where it has been operating for the past 20 years.

Frankly, it will be quite difficult to forecast the future results of Yongnam and I shall not attempt to. The company boasts a $150M order book which means probably two full years of work are secured. Supporters will argue that even if its PE looks high now (I will discuss it further below), what is to say that further orders (such as the IR construction) will not boost revenue and profits exponentially and make trailing PEs irrelevant? After all, the construction sector recovery is still early in its cycle.

Well, there are two main issues. The first is the inconsistency of the profit margins. For Yongnam, over 2001 to 2004, turnover ranged between $60-80M, but pre-tax profit margins ranged from negative (in FY01, FY02 and FY03) to >10% in FY04, and then down to 1% in FY05 and recently 3% in HY06. If we cast our eyes back to the last construction peak cycle in 1996-97, group margins ranged at 9-10% before sinking by half or more in 1997-98. The contractors' margins ultimately depend on the developers and main contractors, who can squeeze them to control costs, especially when number of construction suppliers is high and hence creating a state of perfect competition. That is why companies like Econ, L&M, Wee Poh and Chew Eu Hock have suffered badly during cycle downturns when margins contract. Many of these companies are gone from the scene now; however don't think that life will be much better for the remaining operators. In Yongnam's IPO prospectus its main competitors are listed are foreign suppliers and multinationals, particularly Japanese ones like Nippon Steel. It might be a big player on the local scene but there is no guarantee of fat margins despite big order books (or even if it secures any IR contracts, where I tend to believe there is no smoke without fire). Yongnam's track record of margin volatility should be accounted for by a lower, more prudent valuation.

The second issue is the heavy gearing of Yongnam. Losses sustained in the early 2000s have culminated in a balance sheet financed almost entirely by debt. Of the financing sources for the approximate $125M total assets (55M fixed, 55M work-in-progress and 15M working capital), $40M is normal trade and operating liabilities while $80M is bank debt; only $5M is shareholder's equity. That means a horrifying debt-equity ratio of 16X, and which translates to an annual interest expense of $4-5M per year. Interest coverage was just above 1 in FY04 and FY05 (ie. EBIT, earnings before interest and tax, was barely adequate to pay interest), and operating cashflow was negative in those two years. In HY06, a profit surge allowed interest expense to be covered comfortably. However, my point is that one has to be aware of the track record of the company in bad times and not just bet on the recovery cycle. The balance sheet financing dynamics mean that interest is going to be a drag on profits for a long time yet.

The recent winning of the case against UOB for the ownership of one level of Springleaf Tower will alleviate the situation, but only to the tune of about $10M (see the specifics of the court decision). That is not a lot.

Perhaps just to give a perspective, we annualise the HY06 results of Yongnam, which were relatively splendid when compared to past years' performances. Given the percentage-of-completion revenue recognition method it employs, where progressive project stages are successively recognised, the revenue and profit trend should be relatively smoothened. HY06 profit was $2.7M; annualised FY06 profit would be $5.4M. The outstanding shares amount to 746M; however this is not all because we need to factor in 220M Yongnam warrants with exercise price 3 cents which are now deep-in-the money due to the recent surge; total share base would then be 966M and diluted earnings per share = 0.56 cents, yielding PE of 24X. Not cheap for a stock with high financial risk as highlighted above, although sector outlook should be quite good.

For another perspective of Yongnam, look to the trading history. Comparing present sector optimism to another similar period in the late 1990s when there was a minor sector rebound, Yongnam's market cap peaked at ~$90M then. Then, it had just IPOed (its 1999 IPO price rated it at $65M market cap) and had enjoyed several years of profit, with price trading at close to NTA. Today, its market cap (let's exclude warrants here) is ~$100M, with a patchy track record over the previous 4-5 years. NTA per share is 0.6 cents; P/NTA is >20X! Financial risk has increased tremendously.

As always, the directors bought early into the recovery story, at prices from 3 to 6 cents. Note, recently, however, they have begun to dispose of large chunks of warrants at significantly higher prices. That might be useful information for those who believe in the power of insider transactions as a leading indicator of stock prices.

Poll(please vote)
I agree that Yongnam is a hot-stock-not: Yes/No




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