Is CSC Steel a Value Trap? (Part 2 of 2)

Case Study 04-2:  This post focuses on the intrinsic valuation of CSC Steel. It is a continuation of the fundamental analysis carried out in Part 1. 

Steel is a commodity.

As a commodity company, CSC Steel sells its products at the prevailing international market prices. CSC Steel’s profitability will be affected by the prices for its raw materials (hot roll coils) and its finished cold roll coils. 

When commodity prices are on the upswing, all companies that produce that commodity benefit. 

During a downturn, even the best companies in the business will see the effects on operations.

In Part 1, I have shown that despite being in the down cycle and with minimum trade protection policies, CSC Steel has managed to be profitable. 

With a price that is below its Graham Net Net (a proxy for its liquidation value), is the market suggesting that there is no upturn in sight? 

In Part 2, I will argue that the CSC Steel has the financial resources, track record, and technology to meet the challenges of a downturn. It is not a value trap. Rather it is a steal, a bargain. 

The value is still growing.   It will be enhanced in an upturn and/or when the Malaysian government introduces some trade protection measures. 

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


Contents

  • How well did Top Management Seize Opportunities?
  • Is there a great Buying Opportunity?
  • Will Shareholders’ Value continue to be created?
  • How to minimize Risk and secure your Investments
  • How to Gain from the Case Study

Is CSC a value trap or bargain?


How well did Top Management Seize Opportunities?

Top Management

There are currently 7 members in the Board of Directors.  
  • 4 are Taiwanese who have served with the parent company - China Steel Corporation of Taiwan.
  • The other 3 Directors are Malaysians. They are non-executive directors with an average tenure of 7 years with CSC Steel.
Over the years, the Managing Director has always been seconded from the parent company and served between 1 to 2 years in CSC Steel.

The Executive Director (s) have also been seconded from the parent Company. 

In its 2016 Annual Report, the Company went as far to state

“… stakeholders can be rest assured that the frequent changes of the Managing Director will not adversely affect the organisational effectiveness....has a clearly defined organisational structure and managed by an experienced team ... who are experts in their own fields.”

CSC Steel's competitive edge, technology, and products come from China Steel Corporation of Taiwan. 

The current top management team comprises 
  • The Managing Director and the Executive Director in charge of Finance, 
  • The VP of Production (Taiwanese) and 2 Malaysians in the commercial and production functions. 
Together with the other Directors, top management has an average of 25 years of steel industry experience. 

Due to this organizational structure, 
  • Our review of whether management interests are aligned with those of the shareholders is not relevant.
  • Any review of top management as capital allocators and operators is actually a review of China Steel Corporation of Taiwan’s strategies.

How has top management and the parent’s “strategists” performed?

In part 1, I have shown that they are not so good at investing in new ventures.

The chart below shows how CSC Steel has performed compared to other cold roll steel players in the country.   Note the following in the comparison
  • Mycron - we excluded the pipe operations
  • Eonmetal - we covered only the steel and flats segment
  • YKGI - we excluded the gain from property revaluation and assumed that the cold roll plant has not been sold

CSC Steel:  Peer Return on Total Assets
Chart 1: Comparison of Return on Total Assets


CSC Steel has performed well as it topped the peer companies in 10 years out of the past 12 years. Well done

The performance appears more credible when you compare the size of the Total Assets of these companies
  • CSC Steel - RM 898 million
  • Mycron (flats segment) - RM 443 million
  • Eonmetal (steel segment) - RM 178 million
  • YKGI (before the sale of coated coil business and property revaluation) - RM 237 million

What about capital allocation?

Over the past 12 years, CSC Steel generated RM 806 million net cash from operations. Of this
  • RM 407 million was paid out as dividends
  • RM 63 million was invested in bio-coal and Tatt Giap ventures
  • RM 265 million was added to Property, Plant and Equipment (excluding the bio-coal venture and the disposals/write-offs)
  • RM 66 million was to increase cash

Note that during the same period, CSC Steel generated a total of RM 525 million in profits after tax. The dividend was equal to 78 % of the profits.

Similarly, about 50% of the profits after tax was reinvested into the Property, Plant, and Equipment. This gives credibility to the top management position of upgrading its production facilities. 

You can conclude that the top management is a good operator and capital allocator, in spite of the bio-coal and Tatt Giap blip.


Is there a great Buying Opportunity?

The chart and table sum up CSC Steel’s valuation. 
  • The Earnings value is below the Asset value. This is not surprising as the return on total capital employed is below its cost of capital. 
  • Over the past 5 years and even currently, CSC Steel’s share price has been below the Asset value. 
  • Over the past 5 years, CSC Steels’ share price was trading above its Earning Power Value for only a month or two.  This was between the end of 2016 and the beginning of 2017.  
  • We have an unusual situation where the Earnings Value with growth at RM 1.69 per share is lower than the Earning Power Value of RM 1.75 per share. This is because the return is less than the cost of funds and growth will not add to shareholders’ value in such a situation.
CSC Steel Valuation
Chart 2: CSC Steel's Valuation


CSC Valuation metrics
Chart 3: CSC Steel's Valuation Metrics


At its current price of RM 0.835 (as of 1 Sep 2020), it is even trading below its Graham Net Net of RM 1.53 per share (as of 30 Jun 2020). Given its profit track record and its ability to generate cash, there is an ample margin of safety.

But even if you ignore the assets, the current price is below its Earning Power Value of RM 1.75 per share. 

In deriving the Earnings value, I have assumed the past 12 years' average performance represents the future.  This means that
  • If you believe that the future is better, then CSC Steel’s Earnings Power value will be higher than RM 1.75 per share
  • However, if you think that it will be worst, then the RM 1.75 per share is over-estimated

When you look at the peer companies’ performance, you will conclude that the past 12 years have been very challenging for the industry.  

Even with this challenging situation, CSC Steel Earning Value is conservatively estimated at RM 1.75 per share.

I would conclude that there is an ample margin of safety for the Earning Power Value given the RM 0.835 market price. 


Will Shareholders’ Value continue to be created?

If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value. 

With CSC Steel Earning Value < Asset Value, will it be able to create shareholders’ value?

CSC Steel has an overall Q rating score of 0.47 placing it in the middle rank of the panel companies.

The rating reflects the strong financial position and low-risk profile. However, the rating highlights its poor growth. 

I will interpret the rating to mean that CSC Steel would be able to sustain its earnings but do not expect to see significant earnings growth.

CSC Steel Q Rating
Chart 4: CSC Steel Q Rating


How has CSC Steel actually performed in terms of growing shareholders’ value?

From 2007 to 2020 if you assumed that no dividend was paid, the shareholders’ funds would have grown at a compounded annual growth rate of 5 %

This is below its cost of funds.

Is it possible for CSC Steel to enhance its shareholders’ value? 

There is RM 295 million cash and cash equivalent (as of the end Jun 2020) that is not generating enough returns. 

Given its track record of generating about RM 35 million free cash flow, the cash could be returned to shareholders.  Note that free cash flow is after Capex and working capital requirements. 

Given its poor track record in venturing into new areas, returning cash to the shareholders is a better choice. It would also help to reduce the shareholders’ funds and boost their returns.

Furthermore, if there is a positive change in the operating environment eg trade protection measures, the performance of CSC Steel would be much better.

As a cyclical industry and given the importance of the steel industry to the country, both of these are likely to happen.

Conclusion?
  • CSC Steel will continue to add to shareholders’ value even if it just performed as what it did over the past 12 years. 
  • But for this to benefit the shareholders, the return must be greater than 10%.  This will be dependent on an upturn in the steel cycle. Also, if there are some trade protection measures, the returns will improve.

How to minimize Risk and secure your Investments

Risk

The 2 main risks that you have to be aware of when investing in CSC Steel are 
  • Privatization risk
  • Cyclical risk

Privatization

You have to worry about privatization under the current economic environment.  This is because the share prices of many Bursa Malaysia listed companies are trading below their fair values.

You may think that you would be able to invest in companies at a significant discount to fair values. And you gain when the market eventually comes to its senses and re-rate them based on the fundamentals.

However, this investment thesis assumes that these companies would not be privatized.  

The history of privatization exercises over the past year is that 
  • The offer prices are definitely above the market prices,
  • But they would be below the intrinsic values.

According to the Malaysian Minority Shareholders Watch Group, there were 13 Bursa Malaysia privatization offers during 2019 - 2020. Of these, 12 were offered at discounts to their fair values.
  
I personally had a recent privatization experience with DeGem Berhad. 
  • The offer price was RM 1.10 per share compared to its net asset of RM 1.93 per share. 
  • I had gone in at RM 1.05 per share some time back thinking that there was a large margin of safety. The privatization offer killed such hopes. 

Most independent advisers would state that the offer is not fair but reasonable. 
  • It is not fair because it is lower than the fair value
  • It is reasonable because it provides an exit at a price greater than the historical market price

Unless you were lucky to have gone in at the rock bottom price, you are most likely left feeling dissatisfied with the privatization offer. 

But this is the risk of investing in the prevailing economic environment. There will be some controlling parties taking advantage of the situation. This was well summed up by one Malaysian research house early this year. 

Kenanga Research had in its April 2020 report on the property sector opined that 

“… a window of opportunity could open up for major shareholders to take private their listed companies at bargain-basement prices.”

Would CSC Steel be privatized?
  • With owning about 46.3 % of CSC Steel (as of April 2020) and at the market price of RM 0.835 per share, it would cost the parent company RM 166 million to take CSC Steel private.
  • Given CSC Steel RM 295 million cash and cash equivalent (as of June 2020), this could be achieved with a capital reduction exercise.  The parent company does not have to come up with any funds. 
  • CSC Steel would still be left with substantial cash after the privatization exercise. 

You have to judge for yourself. 

On the positive side, you can argue the following
  • If the parent company wanted to gain from any privatization exercise, it would have done so in March 2020 when it was trading at RM 0.44 per share. 
  • Since its listing in 2004, CSC Steel has focussed on operations and there have not been any corporate activities

Cyclical risk

Steel is a cyclical industry and the 30 years’ price chart illustrates this aptly.  
  • The price movements were more volatile post-2005 compared to the period prior to 2005
  • Over the past 12 years, the sector has undergone two cycles. 
  • We are currently in the down part of a cycle but the current price is not as low as that in 2009 or 2016.  It may not be the bottom yet.
CSC Steel: Global cold roll steel prices
Chart 5: Global Cold Roll Price Index
Source: US FRED Research 

Investopedia has this to say about cyclical risk. 

“Cyclical risk is the risk of business cycles or other economic cycles adversely affecting the returns of an investment, an asset class, or an individual company's profits. 

Cyclical risk does not typically have a tangible measure but instead is reflected in the prices or valuations of assets that are deemed to have higher or lower cyclical risks than the market.”

The cyclical risk if you invest in CSC Steel today can be summarized as follows
  • Both the business and your investment will benefit if the industry has reached the bottom of the current cycle
  • If the bottom of the current cycle has yet to be reached and steel prices decline further, your margin of safety is from the conservative valuation. 

Remember that the Earning Power Value is based on the past 12 years' performance which covered the low prices of the 2009 and 2016 periods. 

The main point is that you are not investing at the peak of the cycle if you take a stake in CSC Steel currently.


How to Gain from the Case Study

CSC Steel is in a commoditized cyclical sector. 

When the combination of investment and growth is in their favour, cyclical stocks can give large returns in a very short period of time. 

What is our investment thesis? You have downside protection while waiting for a re-rating.
  • CSC Steel is financially strong with zero borrowings and RM 295 million cash. It would be able to weather a longer downturn if this happens.
  • It has a strong track record of being profitable during the past 12 years which covered two peaks and two troughs of the price cycle.
  • There is an ample margin of safety at the current market price. 
  • It has paid an average of RM 0.08 dividend per share over the past 12 years. At the current price of RM 0.835 per share, it is equivalent to about 10% annual dividend yield. Not a bad recurring income while waiting for the capital gain. 
  • CSC Steel is the best performer in the Malaysian cold roll industry. The biggest companies are often the safest.
  • There is the potential for enhanced performance.  This is in the event the Malaysian government adopts some trade measures to protect the local industry.  This will of course depend on how MegaSteel reactivates its business.
  • As part of China Steel Corporation of Taiwan, CSC Steel will have access to expertise for both product and process innovation to remain competitive.

In a perfect world, a good investment strategy might be to buy cyclical stocks at the start of the upturn and sell them just before a downturn begins. Unfortunately, trying to predict the timing of a future cycle is a losing battle.

Therefore, if you invest in CSC Steel, it has to be part of your portfolio of cyclical and defensive stocks. 

That way, you’ll be well-positioned to 
  • Prosper when the economy is growing, 
  • But will have some downside protection when the economy takes a turn for the worse.


End of Part 2 of 2

Coming Next on Sun 11 Oct 2020: Petron Malaysia



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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Disclaimer
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 in this website may not be suitable to 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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