Is Eksons a value trap? (Part 2 of 2)

Value Investing Case Study 01-2: This article on the valuation and risk assessment of the Eksons Group was first published in Jun 2020. There is now an update. Revision date: 2 May 2021.

Eksons is cheap with a market price of RM 0.57 per share on 1st June 2020 compared to its Graham Net-Net value (a proxy for liquidation value) of RM 2.28 per share based on its Balance Sheet on 31st Dec 2019.

But how can you tell that it is not a value trap?

Many will say that for Eksons to be a value trap either one of the following must happen:

The Group is not able to turn around the Timber segment and as such the market will continue to view it negatively.

The cash and securities are wasted away causing a substantial decline in its Asset-based value.

Is this the correct way to assess a value trap?

By the end of Part 1, I hoped that you have got a good picture of what Eksons do, the problems it faced, and its outlook.

In Part 2, I will complete my case on why Eksons is not a value trap. There is now a May 2021 update.

Now as to whether you should go and buy Eksons - see my Disclaimer.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you. Learn more.

Did Top Management Seize Opportunities?
Is there an Awesome Buying Opportunity?
Will there be Spectacular Growth in Shareholders' Value?
How to Secure Your Investment by Minimizing Risk
How to Benefit from the Case Study

Did Top Management Seize Opportunities?

In assessing senior management, there are two broad criteria, one behavioral and the other about capability.

All investment textbooks say that you look for senior management with a clear track record of integrity and who acts in shareholders’ best interest.

When it comes to capability, the ideal is for senior management to be both a good operator as well as a good capital allocator.

I always had difficulty trying to assess senior management when it comes to behavior.

How can you tell that they are honest and acts in shareholders’ interest from the Annual Reports? Even if you meet them, it will only be for a short while when they will be on their best behavior.

One way is to look into the past Annual Reports to see whether what they said was consistent over time. I also compared what they have done against their stated strategies.

As for assessing capability, this is relatively easier to infer from the Annual Reports.

But how do you tell whether management is acting in the best interest of shareholders?

In the USA, shareholders try to achieve this with a share option scheme for senior management. This is because over there especially for the larger companies, the founders are no longer with the companies.

We can debate whether this works.

Luckily in Asia, there are still many family-controlled listed companies so that this criterion is automatically met when the controlling shareholder is also part of senior management.

Eksons is one such case.

The Group Deputy Executive Chairman owns about 46 % of Eksons. At the same time, the Chairman’s son has about 13% interest in the company.

What can you infer about Eskons’ senior management?

Concerns:

1) They have not used their funds well. Go back to Part 1 and look at Chart 3 showing the funds used and performance by segment. The Group holds lots of cash and securities. They got lousy returns from this.

You can argue that part of these “excess funds” resulted from scaling down the plywood business. But even before the scaling down began, the Group had around RM 50 million “excess cash” every year, equivalent to about 18% of its SHF.

You would expect senior management to find better use of the funds. If there is no better use, it should have been distributed to the shareholders. A capital allocation issue.

2) As for the Timber segment, senior management have the experience to handle the turnaround. But I think it is more than an operational issue. Looking at the Annual Reports, senior management has not talked about the strategic direction. Rather they talked a lot about operational issues – cost control, new markets.

3) There is no senior management for property development featured in all its Annual Reports. I take it that they have yet to establish an in-depth team. Why?

Positive side

1) For a piece of land costing about RM 60 million, I estimated that the Group has generated about RM 100 million profit from the sale of land and shops, and still has about RM 68 million of inventory. Thumbs up.

2) The 3 Executive Directors and 2 senior managers collectively have been with the Group for about 14 years. With long tenure and control, they can have a long-term view of the business.

Can you think of more plusses?

You have to ask whether the team has a vision for a quantum leap or are they focused on incremental improvement. This will affect your view of the Group’s future.

Is there an Awesome Buying Opportunity?

Why are we spending so much time looking at the business?

It is to get to a stage where you can make an educated guesstimate of what the Group is worth.

Yes, it is a guess because not even senior management knows how the Group will turn out in 10 to 15 years’ time. Yet you need this long-term view for any meaningful valuation.

One component of my valuation methodology (the earnings value method) takes this long-term view. Of course, the asset value method is more current-based.

I use them together to see whether the market has mispriced the Group.

Chart 1: Valuation Comparison

The chart and table sum up Eksons’ valuation.

The value of Eskons Group derived from a conservative earnings-based valuation (Refer to Note 1) is significantly below the Asset value. This is not surprising as the Group is not utilizing its resources well.

Over the past 5 years and even currently, the market price of Eksons’ share has been below both the Asset value and Earnings value. In fact, the company is trading below its Net-Net (a proxy for liquidation value) of RM 2.28 per share.

In deriving the Earnings value, I have assumed that in the past 12 years' average performance represents the future. This means that

If you believe that the future is better, then Eksons’ Earnings value will be higher than RM 1.82

However, if you think that it will be worst, then the RM 1.82 is over-estimated

While there is the turnaround issue, the assumptions covered 4 years of poor performance so that if Eksons pull off the turnaround much faster, the RM 1.82 is under-estimated.

Valuation metrics		Value
Valuation date		1 June 2020
Price at valuation date:	RM per share	0.57
Conservative Earning Power Value (EPV) (Note 1)	RM per share	1.48
Conservation Earning Value (EV)	RM per share	1.82
Asset Value (AV) (based on Dec 2019)	RM per share	2.68
Magic Formula (based on FY 2019)	%	-35%
Acquirer’s Multiple (based on FY 2019)	Ratio	1.5
WACC	Number	0.08
Table 1: Comparative Values

Probing deeper into the Asset value, you will find that the Net-Net contributed a big chunk. The Net-Net is shorthand for its liquidation value so any price below this gives you lots of margin of safety.

Conclusion - the market price pendulum has overswung on the way down.

Case Notes

There are 2 main approaches to using discounted cash flow to value a business

Based on a free cash flow model

Based on the residual income model

The former starts with determining the free cash flow generated by the firm. Free cash flow is defined as the after-tax EBIT after deducting CAPEX and additional working capital but adding back depreciation. It represents the cash flow available for distribution to the shareholders.

On the other hand, residual income is defined as the after-tax income after deducting a capital charge.

Both methods will result in the same answer as long as there are consistent assumptions. In practice, there are differences in the results. I used both approaches in the valuation and then take the average as the final value.

Valuation is not an exact science so using the results from both approaches probably makes more sense than trying to figure out where the inconsistencies occurred.

I am assuming that you are numerate and have the business knowledge to value companies. If you do not have the skills to do so, but still want to be a value investor, one way is to rely on other experts to assess and value companies for you. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice.

Will there be Spectacular Growth in Shareholders' Value?

In investing, I consider quality from the perspective of creating shareholders’ value.

A high-quality company will have a good likelihood of increasing shareholders’ value.

A low-quality company is one that is likely to destroy shareholders’ value.

The Q Rating assesses this dimension.

Despite its profitability and growth challenges, the Group is financially strong with a debt to equity ratio close to zero and RM 201 million in cash and securities (as at end of Dec 2019).

Even with the past 4 years' losses, the Group's past 4 years of cumulative cash flow from operations is still positive - but a large part is from the reduction in working capital.

Eksons has an overall Q Rating of 0.34 placing it in the bottom 1/3 rank of the panel companies. (Refer to Note 2). This is not surprising given the poor historical performance.

It has a very high Financial score meaning that it has low financial risk

It has a zero Profitability score implying poor return prospects

Chart 2: Q Rating - ranging from 0.00 to 1.00 with 1.00 as the best

Relating the Q Rating with the valuation profile, I think Eksons would have a tough time increasing shareholders’ value.

How to Secure Your Investments by Minimizing Risk

When you look at risk, you have to consider not only business risk but also your own risk as an investor.

The main business risk revolves turning around the Timber segment

Your personal risk covers the risk of Eksons being privatized

a) Turnaround

The Board and key senior managers have a long history in the plywood sector and would be in a strong position to address the key issues of log supply, cost control, and regaining sales.

If I tell you that at its peak the Timber segment generated about a 15 % return on capital, you would agree that there is a good economic reason to try to turn it around.

But don’t get too carried away.

If the Timber segment is turned around with RM 300 million sales annually, the Group would need about another RM 80 million in working capital i.e. the current cash and investment in securities would be reduced significantly. (Refer to Note 3)

It is a double-edged sword. Successful turnaround means a return to profitability. But money in the bank would be reduced.

Are there reasons not to undertake a turnaround?

Probably. If there is a paradigm shift in the Malaysian mid-stream wood processing industry, the Group could be wasting its time. Think of an analogy with the palm oil industry. In Malaysia, palm oil mills that process the palm fruit bunches are integrated with the plantation activities.

Eksons’ plywood operations are not integrated with any logging activities.

It will have to join the other independent plywood factories to fight for the reducing supply of logs. I think the integrated plywood factories would have an advantage.

The government policy is not very encouraging.

“.. the production of logs from these forested areas would decline… the policy on the ban of exports of logs by several timber-producing countries would further affect the supply… Hence, the industry would have to adjust their operations to the limited supply of both domestic and imported timber resources.” National Timber Industry Policy, 2009-2020

If you look at Chart 3, you can get a sense of what the timber mid-stream sector is facing from the revenue index of a number of listed timber companies with mid-stream manufacturing. It is not an encouraging picture as the revenue for all of them has not grown since 2008.

Chart 3: Peer Companies Revenue Index

Unless the Group forms some strategic alliance with a logging group for long-term logs supply, I think that Eksons’ efforts would be better spent on scaling down and/or divesting from this sector.

OK, this is a very strong view, but not unrealistic.

b) Privatization

I have personally faced 2 types of privatization exercises:

Share purchase with funds external to the company

Capital reduction with the company’s internal funds

In Eksons case, with the 2 major shareholders collectively controlling about 59 % of the company, any plan to acquire the remaining 41 % at the current market price of RM 0.57 per share would require about RM 37 million.

The company has cash and securities of about RM 201 million (as of Dec 2019). So, it would be possible to take it private via capital reduction. Would the controlling shareholders privatize the company then?

Generally, a company remains listed because:

It would be easier to raise funds

It would be easier to attract joint venture partners

It would be able to attract a higher caliber of staff

For the Group, the most likely reason for additional funding is to expand the Property Development segment with an aggressive land acquisition programme. There is no history of such activities although in 2012 there was a proposal to acquire about 60 acres of land in Gombak for RM 20 million that eventually did not go through.

At this juncture, there is no economic reason why it should not be privatized.

However, the other negative against privatization is that if the Timber segment is turned around, most of the cash and securities would be required as working capital. With privatization using internal funds, the Group may have to consider our sources of funds to finance its operations.

Of course, I cannot read the minds of the controlling shareholders. I am only providing privatization as one investment risk.

c) Value trap

Remember what was said at the beginning of Part 2 i.e. for Eksons to be a value trap either one of the following must happen:

The Group is not able to turn around the Timber segment and as such the market will continue to view it negatively

The cash and securities are wasted away causing a substantial decline in its Asset-based value.

This is not the correct way to think about a value trap as it confuses market price with the value of a company.

A value trap occurs if you buy a company because it is cheap only to find out that the assets are not what you think they are and/or there is no future i.e it is cheap for fundamental reasons.

If it is cheap because the market has mispriced it, then it is not a value trap.

I have shown that despite its challenges, Eksons' intrinsic value is higher than its current price. Its cash, securities, and other assets are not going to be wasted away.

It is not a value trap.

While a turnaround of the Timber segment will be a catalyst for a market re-rating, this is a market pricing perspective.

What happens in the event of further deterioration of the Timber segment business? Could there be an impairment?

It doesn’t matter. Even if all the RM 35 million of plant and machinery (under FY 2019 PPE) were to be written off, this comes to about RM 0.22 per share. Given the RM 2.28 per share Graham Net Net value, there is a sufficient margin of safety.

How to Benefit from the Case Study

What is our investment thesis?

Both business segments are facing headwinds. Being the larger contributor, the Timber segment has to turn around for the Group to have a return greater than its cost of funds.

The Timber segment's long-term prospects will depend on a different log supply strategy. Failure to do so will lead to continued lackluster performance.

The Group is financially strong and not burning cash giving it time to put its recovery plan into action. But note that with the turnaround, a significant portion of the financial assets would be deployed for working capital.

A turnaround of the Timber segment would be a catalyst for a re-rating. But I think it will probably take 2 to 3 years for both business segments to get back to where it was before.

You are buying into the belief that the owner-manager is not happy just earning interests and/or dividends from the cash and securities. Looking at its history of diversifying into property development, you expect the Group to be looking for good investment opportunities.

This is a classic Graham Net Net long-term investment – you have downside protection and you bet on the upside.

End of Part 2 of 2

The May 2021 update was published on 2 May 2021

Notes

1) Based on assuming that the future earnings = historical earnings assuming no growth. For further details about the assumptions used in the valuation model refer to the posting "The Basics Of Valuing A Company"

2) About 80 companies across a number of non-financial sectors are covered annually. For further details, refer to the posting "Q Rating"

3) In 2007 and 2008 with about RM 330 million and RM 362 million revenue respectively, the Group had 0.34 net working capital (excluding cash and loans) to revenue ratio. Based on this, a RM 300 million revenue would require about (300 - 67) X 0.34 = RM 79 million additional net working capital.

Reading guide

If you are a first-time visitor to this blog, you may not be familiar with some of the concepts that I have used in my analysis and valuation. I suggest that you check up the Foundations series - Fundamentals 01, Fundamentals 02, and Fundamentals 03. I also have a Definitions page in case you are not familiar with the terms I have used.

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I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.

I may have equity interests in some of the companies featured.

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