Has New Toyo move beyond being a cigar-butt investment?

Value Investing Case Study 09-3. I initially covered New Toyo on Feb 2021 based on the Annual Reports till 2019. This post is an update incorporating the FYE 2020 results.

Has New Toyo move beyond being a cigar-butt investment?

I first covered New Toyo International Holdings Ltd (New Toyo or the Group) in early 2021.  At that juncture the company was trading at SGD 0.175 per share (as of 29 Jan 2021) compared to its Asset Value of SGD 0.35 per share. I had classified New Toyo as a “turnaround”. 

My investment thesis then was that the packaging industry was not a sunset one. New Toyo losses were due to one-off problems that management had addressed. The first half results of 2020 showed signs of a turnaround.

I had concluded then that New Toyo was not a value trap.  However, there were some concerns so that New Toyo may be a cigar-butt type investment opportunity.  

It is now one year since I published that analysis.  Despite the Covid-19 situation, the Group had managed to sustain the first half 2020 performance in the first half of 2021.

The question now is whether the Group could improve on the 2020/2021 performance. In other words, could New Toyo move away from being a cigar-butt investment?

Join me as I try to answer this question.

If you are not familiar with the Group, I suggest that you first read the following articles. This post assumed that you have such a working knowledge.

Contents

  • Investment thesis
  • Management performance still not the best
  • Still poor track record in venturing into new areas
  • Still have the single customer risk
  • Greenwald analysis
  • Investing Risk
  • Margin of safety
  • Conclusion
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Investment thesis

My rationale in 2021 for why New Toyo may be a cigar-butt type investment were: 
  • Management performance was not the best among its peers.
  • There was a poor track record in venturing into new business areas.
  • The was the single customer risk.

To prove that New Toyo is no longer a cigar-butt investment I have to refute these 3 concerns. Unfortunately, I could not find any evidence to do so. I also looked at the prospects for New Toyo to achieve a situation where the EPV = AV. They were not good.

The conclusion is that New Toyo is still a cigar-butt investment opportunity given the current market price of SGD 0.20 per share (as of 25 Feb 2022). But it is not a value trap as the turnaround seemed sustainable. It also has the financial resources to withstand a longer than expected recovery of the economy from Covid-19.

Management performance still not the best

In my 2021 article, I had compared New Toyo's performance with that of a number of benchmark companies based on revenue growth and ROA. I had concluded then that:
  • New Toyo's revenue performance did not stand out.
  • In terms of return on assets, New Toyo's performance was near the bottom of the peer group.

The current revenue growth and ROA for New Toyo and the peers are shown in the table below. You can see that last year’s conclusion still stands.

New Toyo Peer comparison
Table 1: Peer Comparison
Notes
(a) Based on segment profits assuming 24 % tax rate.
(b) Based on ratio of segment profits to the group PBT/PAT. 


Still poor track record in venturing into new areas

In my post last year, I concluded that:
  • The top management had a good track record for investments within the tobacco sector and/or within the ASEAN regions.
  • There was concern about the track record outside the tobacco industry and or the ASEAN regions.

However, to generate a quantum leap in performance, New Toyo has to diversify ie venture into new business areas. But its track record had not been very encouraging given the Dubai and Tissue Paper experiences. Furthermore, while opportunistic, its venture into property development had yet to see any results.

In its 2020 Annual Report, management reported that they have taken back the running of the Dubai business. This was because the contracting party had decided not to extend the services. When New Toyo first announced the outsourcing model, it was pitched as a positive sign. It its 2019 Annual Report, this was reported as

“…a lower-cost approach business model… to ensure competitiveness via cost reductions in overheads and manpower, and boosts to production efficiencies, thereby contributing to future profitability.”

This turnabout reinforces my concerns about management’s ability to venture outside the ASEAN regions.

At the same time, it is worrisome that the Group had considered investing in the e-Bike project. No doubt the Group had decided not to pursue this venture. But the Group cited the Covid-19 situation as the reason for not pursuing the project. I would have thought that if the project was very sound, Covid-19 would only delay the implementation. It looks as if management had concluded that Covid-19 had changed the demand for electric bikes. I would have liked to see the management rationale for considering this project in the first place. On the surface, it would appear that the project feasibility was not reliable. It adds to my concern about the management capability to venture into new business areas.

The current management team is still the same as that of the past few years. There is no evidence to suggest that management had gotten new capabilities to tackle the new venture concerns.

Based on the above, I would conclude that management had yet to overcome the concerns about the venturing into new areas. 

Still have the single customer risk

In its 2020 AR, New Toyo did not report on the single customer sales. However, it reported the sales for the top 2 customers.  Look at the following statistics:

2020 – Contribution by top 2 customers = 52.49 % of Group revenue

2019 - Contribution by top 2 customers = 52.90 % of Group revenue

2019 – Contribution by single largest customer = 41.4 % of Group revenue

I think this risk remains.  But I would not be too concerned as this customer concentration has been a feature of the business.

Over the past 11 years when the information was reported, a single customer contributed an average of 48% of the Group revenue. Although not specifically mentioned, I believe that this is BAT. 

Greenwald analysis

According to Professor Bruce Greenwald you can get strategic insights by comparing the Asset Value and Earnings Power Value. In my article last year, I had estimated the following for New Toyo:
  • Asset Value – SGD 0.35 per share.
  • Optimistic EPV – 0.25 per share.

Given that the current performance is about the same as that for last year, I do not think that there is any need to revise the above valuation. OK the Asset Value would have improved a bit but my focus is on the gap between the Asset Value and EPV.

In New Toyo case with the EPV < Asset Value, this reinforces the point that it is a cigar-butt investment. The assets are under-utilized. In order not to be a cigar-butt we should have the EPV = Asset Value.

The question then is whether there are opportunities for New Toyo to improve its asset utilization. In last year's article, I had shown that not all the business segments were operating effectively.

An update of this analysis showed the following:
  • There have been improvements in the Specialty Papers and Printed Carton & Label segments.
  • The Others segment performance got worse.

Refer to the chart below that shows an updated segment returns compared to those estimated previously. 

New Toyo segment performance
Table 2: Segment Performance
Notes:
a) The return was computed as the respective past 12 years weighted average profits divided by the latest TCE.
b) The Group has the following business segments:
  • Specialty Papers. This focuses on the production of laminated foil paper, coated paper, and metalized paper. The division has manufacturing plants in Singapore, Malaysia, Vietnam, and the United Arab Emirates.
  • Printed Carton & Labels division. This has gravure, lithography, or offset printing of packaging materials. The division operates in Malaysia (6 plants), Vietnam (two plants), Australia, United Arab Emirates, and Indonesia. 
  • A trading segment that focuses on tobacco packaging-related materials.

I am confident that management would be able to continue to improve the performance of the legacy businesses. These are the Specialty Papers and Printed Carton & Labels segments. The challenges then are:
  • If the Others remain as they are, would the improved legacy businesses more than make up for the “shortfall”? In other word, would the Group then generate a return > cost of funds?
  • Alternatively, would the Group be able to venture into new business successfully so that we have all “cylinders firing?”

To answer the former, I looked at the past 12 years history. The best results from these 2 segments were in 2010 when they had total revenue of SGD 239 m and 8 % segment margin. Based on these segment performances and the other being on a standstill, I projected the following:

New Toyo ROE projection vs cost of equity
Table 3: Projected ROE vs Cost of Equity
Notes
a) This analysis assumed that the funds allocated to each segments remain unchanged even if there are better profits

This back-of-the-envelope analysis indicates that it is unlikely for New Toyo to generate a return greater than its cost of equity via the legacy businesses. The assumption here is that the Specialty Papers and Printed Carton & Label segments returned its historical best performance. 

The other option then is to deploy the funds under Others into new ventures.  This is where I have concerns as management do not have a good track record here.

The conclusion is that New Toyo is still a cigar-butt investment. 

Investing Risk

The risks of investing in New Toyo as a cigar-butt investment are that:
  • The turnaround is not sustainable.
  • The economic recovery from C0vid-19 may take longer than expected.

To address the former, I looked at the current performance and found that its gross profitability had improved. 

To address the latter, I looked at its capital structure and financial resources. I found that it has a low Debt Equity ratio and a good track record of generating Cash Flow from Operations.

Current Performance

The Group reported a YTD PAT of SGD 6.0 million for the half-year ended 30 June 2021 compared to a YTD PAT of SGD 5.1 million for the same period last year. 

This was despite achieving a lower YTD revenue of SGD 117.1 million for the half-year ending 30 June 2021 compared to SGD 129.4 million for the same period last year. Management attributed the lower sales to lower demand.

The main reason for the better profit performance this year was the higher gross margins. The challenge was whether the margins can be sustained once the Group rebuild back the sales volume. 

You can get a sense of this by looking at the Performance Index chart. Gross profitability (defined as gross profit/total assets) is a metric favoured by Professor Novy-Max. According to his study, this metric is a very good indicator of stock returns. Going by this, I would say that the turnaround has gained traction.

New Toyo Performance Index
Chart 1: Performance Index
Note: I estimated that the Gross Profitability Index for 2021 (based on extrapolating the half year performance) to be 1.12 compared to 0.99 for 2020

Capital Structure

The chart below shows the capital structure of the Group. The bulk of the business is funded by shareholders funds. The Group has a low Debt Equity ratio and the positive thing is that over the past 12 years, there was only one year with negative Cash Flow from Operations. On a cumulative basis, the Cash Flow from Operations was 2.2 times the cumulative PAT for the period. It demonstrates that this is a financially healthy Group.

New Toyo sources and uses of funds
Chart 2: Sources and Uses of Funds


Case Notes

There are many ways to look at the margin of safety. I adapted Professor Bruce Greenwald’s approach of comparing Asset Value (AV) and Earnings value (EV) for a different perspective.

I looked at the margin of safety in the context of the AV and EV analysis with the following 4 scenarios:

Greenwald analysis - scenario 1

Scenario 1: Excellent margin of safety. In this case, the market price is significantly below both the AV and EV.

Greenwald analysis - scenario 2

Scenario 2: Acceptable margin of safety. In this case, the market price is higher than the EV but lower than the AV. If you invest in a company under this scenario, it must be because you believe that the company would be able to turnaround. In the worst-case scenario, the value of the assets would offer some protection if the business fails.

Greenwald analysis - scenario 3

Scenario 3: Better than an acceptable margin of safety. In this case, the market price is higher than the AV but lower than the EV. In this scenario, you believe that the company’s competitive edge would provide you with some margin of safety.

Greenwald analysis - scenario 4

Scenario 4: No margin of safety: In this case, the market price exceeds both the AV and EV. The only rationale for investing in such a company is that you believe that the EV will increase over time. You believe that this is some growth company whose future value has yet to be captured in the current EV. 

As you can see there are many ways to analyse and value companies. You should complement your analysis with those by other value investors so that you are not blinded by your biases or oversights.

There are many 3rd parties that provide fundamental analysis. Those that 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.




Margin of safety

The company analysis shows the same picture as that of last year.  As for the valuation:
  • The latest Asset Value would have gone up relative to that last year given the additional profits generated. The current Asset Value is now SGD 0.33 per share.
  • I do not see any reason to change my assumptions used in deriving the EPV. As such I do not see the need to revise last year’s EPV.  The Optimistic EPV is still SGD 0.25 per share.

While the Optimistic EPV provides some margin of safety, there is more margin of safety from the Asset Value. In the case of New Toyo, I would consider the Asset Value a more accurate estimates of the intrinsic value.

Looking at New Toyo through the Greenwald AV vs EPV lens, I would conclude that there is a good margin of safety.  But the situation of the EPV being less than AV indicates that this is more likely a cigar-butt investment.

What does all this mean when buying New Toyo as a cigar-butt investment? As long as the company remains profitable, the Asset Value will continue to grow. 

Then to narrow the gap between the EPV and the Asset Value I can think of the following scenarios: 
  • The Group improves the existing operations as per what is discussed earlier.
  • The Group liquidates the non-operating assets and return the cash to the shareholders. This is equal to reducing the Asset Value.
  • The Group deploys the non-operating assets into new ventures.  I am sure the property development project would require additional funds. Alternatively, there could be new ventures that the Group could pursue.

My point is that the margin of safety from the Asset Value should not be looked down.

Conclusion

This post is about following up on a turnaround case. The goal is to see whether New Toyo can be transformed from a cigar-butt opportunity into a quality value or growth stock. 

I addressed this by looking at the reasons why I considered it a cigar-butt in the first place. I wanted to see whether the reasons no longer apply. Unfortunately, in the case of New Toyo, I could not find any evidence to refute the reasons for it to be classified as a cigar-butt investment.

Nevertheless, there is still a margin of safety based on the current market price. I would not look down on cigar-butt investments. If you have situations where there are limited growth companies, cigar-butt investments backed by strong Asset Values are good options.


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