Is Kumpulan Fima a value trap? (Part 2 of 2)

Value Investing Case Study 14-2. This is Part 2 of the fundamental analysis and valuation of Kumpulan Fima.

Kumpulan Fima Bhd (KFIMA or the Group) is trading at RM 1.92 per share (as of 28 April 2021) compared to its Book Value of RM 2.90 per share (as of the end of Dec 2020).

The market seemed to be suggesting that this is a value trap.

The Group comprises two listed entities with oil palm plantations as the common operations.

Kumpulan Fima Bhd. The core businesses are plantation, food processing, and bulking.

Fima Corporation Bhd (Fima Corp) - this is a 60% owned subsidiary of Kumpulan Fima Bhd. The core businesses are manufacturing and plantations.

In 2017, the Fima Corp manufacturing segment lost a major Malaysian government supply contract. The revenue for this business segment dropped by half and even till today, it has not managed to recover. Despite this, the manufacturing segment is still profitable.

At the same time, the other businesses of the Group are still profitable.

These are not the sign of a value trap. Join me in Part 2 of this series as I show why the market is mistaken.

Should you go and buy it? Read my Disclaimer.

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.

Pulling it all together

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Did Top Management Seize Opportunities?

There are 7 members on the KFIMA Board of Directors.

The Group MD is the only Executive Director. He is 53 years old and has been with the Board since 2002. He also serves as the MD of FimaCorp.

4 are Independent Non-Executive Directors with an average age of 66. They have an average of 6 years of Board tenure.

There are 2 Non-Independent Non-Executive Directors with an average age of 47. They have been with the Board for 16 years.

The 2 Non-Independent Non-Executive Directors controlled at least 43 % of the shareholdings of KFIMA.

7 senior managers were featured in KFIMA 2019 Annual Report. On average, they are 48 years old and have been with the Group for 14 years. They are the heads of their respective departments/business units ie

2 positions (CFO and Company Secretary) served both KFIMA and FimaCorp.

2 are business heads of FimaCorp.

3 are functional/business heads of KFIMA.

I would classify a company as owner-managed if the Board and/or senior managers are also the controlling shareholders. In the case of KFIMA, the senior managers are not part of the controlling shareholders. At the same time, the controlling shareholders do not serve as Executive Directors.

It is likely that the day-to-day operational issues are managed by the professional management team. Family control is probably exercised at the Board level only. And it probably covers the strategic direction and the senior management remuneration.

Given this setup how did the senior management team perform relative to its peers?

Peer assessment is a challenge as there are no comparable Bursa Malaysia companies with the same 4 business segments as KFIMA.

Operations

In terms of TCE, the Plantation division accounted for almost half of the Group TCE for all the operating units (excluding the cash).

However, I do not think that we should use the Plantation companies as the benchmark. In Part 1, I have mentioned that KFIMA planted areas are less the 3 % of the respective planted areas of the top 3 plantation companies in Malaysia.

As such, I have selected as peers those companies with:

About similar hectares of planted oil palms as KFIMA.

Sizeable non-plantation businesses.

This is in line with the KFIMA profile where the non-plantation businesses are much larger than the plantation ones.

The table below shows the profile of KFIMA and the peers comprising

CB Industrial Product Holding Bhd (CBIP)

MKH Bhd (MKH)

Subur Tiasa Holdings Bhd (Subur Tiasa)

Table 1: Peer plantation stats

Notes

a) Based on the 2020 Annual Report.

b) The Annual Report only provided the total land bank of 44,000 ha. Its website stated that it has 13,000 ha of which 36 % were planted. I used this to factor in the 44,000 ha.

How did KFIMA perform?

In terms of revenue growth, KFIMA achieved an average performance. But note that all the companies had bigger revenue from different sectors. In other words, the respective revenue growth could be because of different sector growth rates. Hence, I would not draw any conclusion about KFIMA revenue performance.

Chart 1: Peer revenue index

In terms of ROE, all companies except MKH experienced declining ROE over the past 12 years. MKH returns improved in the first half of the period but subsequently declined.

If you view management's role as delivering returns to shareholders, then KFIMA management did not perform well. This is especially when the ROE has been declining while achieving some growth in revenue.

Chart 2: Peer ROE

Capital allocation

Over the period from 2009 to 2020, the Group generated a total profit after tax of RM 915 million. Of this,

RM 254 million was paid out as dividends. This is equal to a 27 % payout ratio.

RM 472 million was spent on Capex.

The cash balance increased by RM 245 million.

Note that the Group used up more funds than those generated from the profits during the same period. This was because:

The Group borrowed an extra RM 8 million.

There was RM 362 million depreciation/amortization.

From a capital allocation perspective, about 52 % of the profits were reinvested back into the operations.

The only concern I have is that given its cash position (with low returns), more should have been paid out as dividends. On a positive note, the Group would have the funds to expand the plantation business. This generally a cash consumption activity while waiting for the palm oil trees to mature.

Is there an Awesome Buying Opportunity?

The chart and table below summed up KFIMA’s valuation.

The Earning Power Value (EPV) accounted for the majority of the Earning Value. In other words, the growth component is very small.

The Earning value is slightly less than the Asset Value. It indicated a situation of a slight under-utilization of the assets. We should not be surprised given that the non-operating assets accounted for a significant portion of the Earning value.

Over the past 5 years, KFIMA's share price has been lower than both the Asset value and Earning value.

Chart 3: Valuation

At its current price of RM 1.92 (as of 28 Apr 2021), KFIMA is even trading below its Book value of RM 2.91 per share (as of 31 Dec 2020) and Earning Power Value of RM 2.45 per share.

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

If you believe that the future is better, then its Earnings Power Value will be higher than RM 2.45 per share.

However, if you think that it will be worst, then the RM 2.45 per share is over-estimated.

The Earning Power Value assumed zero growth and provided a 28 % margin of safety. With the growth component, the value increaseg marginally to RM 2.55 per share.

Table 2: Valuation metrics

I used 2 valuation methods to derive the intrinsic value:

The discounted Free Cash Flow method as per Damodaran.

The discounted Residual Income method as per Penman.

I then took the average from both methods as the final computed intrinsic value. This was for both the EPV and the Earning value with growth.

When it came to growth:

I used the fundamental growth equation to derive growth for the Discounted Free Cash Flow method. This is Return X Reinvestment rate = growth.

For the Residual Income method, I computed the growth trendline based on the historical residual income.

In both cases, I capped the growth at 5%.

The results you see in the table were based on these computations. You will note that the growth component of the Earning value was very small.

Case Notes

Risk tolerance refers to your ability to psychologically endure the potential of losing money on an investment. It is the amount of loss you are prepared to handle.

Your risk tolerance is not set in stone and can change throughout your life.

Investing without considering risk tolerance can prove to be fatal. You must know how to react when the value of investments falls.

But more importantly, how can you put risk tolerance into practice when value investing? In other words, how do you set your risk tolerance level?

I think the best way to view risk tolerance is from the margin of safety perspective. You should have a higher margin of safety if you are less risk-tolerant. If you are very risk-tolerant, you can lower the margin of safety.

I am a conservative investor and I looked for a 30 % margin of safety. For me, a very good buy is if all the 3 metrics - margin of safety, Acquirer’s Multiple, and Magic Formula - pointed in the same direction.

My threshold is for the following 3 conditions:

30 % margin of safety.

Acquirer’ Multiple < 6.

Magic Formula > 20 %

If you follow the above, you will realize that we are inverting the conventional idea of higher returns for higher risk. This is because a higher margin of safety will mean a lower risk. But a higher margin of safety means a larger discount from the intrinsic value. Indirectly this means a higher gain.

Lower risk, more gain.

As you can see, fundamental analysis is more than just using some formula. There are choices to be made in terms of which approach to use and what to assume.

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.

There are several financial advisers who provide such analyses.

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Whether KFIMA is an awesome buying opportunity would depend on your risk tolerance. The Case Note above provides one way to assess KFIMA in the context of your risk tolerance.

Another risk perspective is to look at the market price relative to the Earning value and Asset value.

In my article on “How to mitigate risk when value investing” I had pointed out 4 scenarios when comparing market price with the Earning value and Asset value.

KFIMA's current market price is less than both the Earning value and Asset value. This provides the best margin of safety.

Will there be Spectacular Growth in Shareholders’ Value?

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 KFIMA Earning value almost the same as Asset value, you must wonder whether shareholders’ value would be created.

I looked at the following metrics to assess shareholders' value creation.

Over the period from 2009 to 2020, assuming that no dividend has been distributed, the shareholders’ funds would have increased by a CAGR of 10.4 %. This is lower than the 12.1 % cost of equity.

I estimated that KFIMA weighted average cost of capital (WACC) to be 11.2 %. Over the past 12 years, the Group achieved an average 11.2 % return before interest and tax. This return is computed as EBIT(1-t)/TCE assuming a 24 % tax rate. The return is comparable to the cost of funds.

If a shareholder had bought a share at the start of 2009 and held onto it till the end of 2020, he would have achieved a CAGR of 13.6 %. Compare this with the 12.1 % cost of equity.

Table 3: Shareholders' gain

KFIMA has an overall Q Rating score of 0.44 placing the Group in the average ranking of the panel companies. The rating reflects the strong financial position which has offset the low growth score. Note that the low growth score is consistent with the computed lower Earning value with growth.

Chart 4: Q Rating

If you look at the results from an overall perspective, I would rate KFIMA shareholders’ value creation as acceptable.

How to Secure Your Investment by Minimizing Risk

I normally look at 2 categories of risks - investment risks and business risks. In most of my Bursa Malaysia case studies, the main investment risk is privatization risk.

However, for KFIMA, I do not expect this to be a major risk. Firstly, if there was any plan to privatize the Group, it would have been better to do so in mid-2020 when the price was around RM 1.20 per share.

At the current market price, especially when prices have risen over the past 6 months, it does not make economic sense to privatize it. I do not see this as an investment risk.

However, in the context of a value trap, there are 2 business risks to consider:

The Manufacturing division transport document business.

The Indonesian plantation land title issue.

Manufacturing

The Manufacturing business is a legacy business from the privatization of the government printing arm. In its 2020 Annual Report, KFIMA had reported: “…secular decline in volume as well as facing strong competition.”

It would appear that the division’s growth has been tied to the Malaysian government activities.

Any slowdown of the government activities would affect the division revenue.

Any major supply contract loss would affect the business.

Currently, about 70% of the division business comes from transport documents. The Group has not stated the number of contracts that are associated with this business. It is possible that there are one or two major contracts. If so, then this is a business risk.

As the loss of the travel document supply contract has shown, there would be much lobbying for the transport document supply.

KFIMA lost the travel document contract after being the supplier for more than 20 years. It lost the 5 years contract to a party that pitched a “digital tech” solution. In other words, digital tech has provided competitors with an entry point. KFIMA's long supply history may not be enough to provide the barrier to entry for the transport document supply.

KFIMA has stated that it has now upgraded its digital technology capabilities. But the Group has not been able to make any significant headway in selling these "digital" products to the neighbouring countries. It does illustrate that it is not easy to supply to any government in a large manner.

Indonesian Plantation

The Group has an 80% subsidiary PT Nunukan Jaya Lestari (PTNJL) that owned about 19,974 hectares of land in Kalimantan, Indonesia.

This is the Group only plantation operation in Indonesia.

This Indonesian operation accounted for about 2/3 of the total plantation land bank of the Group. I estimated that it also accounted for about ½ of the Group's mature land area.

There is currently a dispute with the Indonesian authority over the actual acreage owned by the Group. The dispute is over 2 parcels:

17,765 hectares that overlapped with some forest areas.

3,500 hectares that overlapped with another 3rd party right to use the land.

There is actually an outstanding legal suit that was started in 2016 that had gone through several judicial levels.

There have been several swing judgements. There was a point when it looked as if KFIMA had lost all the disputed land. There was then a subsequent judgement that KFIMA had the rights to all the areas except for the 3,500 hectares the overlapped with the 3rd party.

The current situation is that KFIMA only has the right to 2,809 hectares of land. The current status is that the Pengadilan Negeri Jakarta Selatan has dismissed the PTNJL suit. PTNJL had then filed a notice of appeal against the decision.

About 3,693 hectares of KFIMA planted acreage are affected by the land area dispute. KFIMA had made the appropriate provisions for this.

Pending the resolution of the dispute, the local authorities have allowed KFIMA to continue with its plantation operations.

It is not clear whether during this disputed period the Group will continue to expand the planted area owned by PTNJL. Based on the FFB yield, I estimated that the current total mature area owned by PTNJL to be 6,300 hectares. This mean

About 2/3 of the mature area is the disputed area.

There are 13,674 hectares that are not cultivated. It is not clear how much of this is within the 3,500 hectares that overlapped with the 3rd party.

I would point out that since KFIMA has made the appropriate provisions, there is unlikely to be an impairment to the PPE. In other words, the Asset value is realistic.

Nevertheless, there are 2 business risks:

The Group is currently operating on the disputed land. I estimated that about 1/3 of the current Plantation division operations would be disrupted if KFIMA does not win the land dispute. Indirectly the current division performance could be significantly affected.

The other risk is the expansion of the plantation activities. The disputed area represented about 85 % of the Group's uncultivated area. This will certainly affect the planting plan. But, if we based the value on an EPV ie assuming zero growth, there should be minimal impact on the Earning value.

Pulling it all together

The analysis has shown that:

The Group is financially sound and has been profitable every year over the past 12 periods covered.

There is still growth potential. While this may not be double-digit, it looks to be better than what the Group had achieved from 2009 to 2020.

Management had a reasonable capital allocation track record. It has been able to maintain shareholders' value despite the loss of a major supply contract and the Indonesian land dispute.

There is a sufficient margin of safety at the current price.

KFIMA does not look like a Group facing insurmountable problems. A value trap is a stock that while appearing cheap is actually a dud because it is facing some insurmountable problem.

A good investment need not be one that has good growth potential. Rather if you have the patience and holding power, a good investment is one that is trading at a significant discount to its intrinsic value. You have to judge whether KFIMA fits this description.

END

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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