Is Notion Vtec a value trap?

Value Investing Case Study 56-1: A fundamental analysis of Notion Vtec to see whether it is a value trap or an investment opportunity.

I first bought Notion Vtec Berhad (Notion or the Group) in 2007 for an average price of RM 0.49 per share. After holding for about 2 years, I sold it off at an average price of RM 0.52 per share. Together with the dividends, I made about RM 0.07 per share. A reasonable 14 % total return considering that I was just learning about value investing.

The next opportunity came in 2014 when I bought it at an average price of RM 0.58 per share. In mid-2017, the price had gone up to as high as RM 1.31 per share so I sold it at an average price of RM 1.27 per share. Together with the dividends my total gain came to RM 0.72 per share. I guess this is a small multi-bagger.

Over the years, I have kept a watch on Notion with the hope that there could be another multi-bagger opportunity.

The market price of Notion as of 6 May 2024 was RM 0.53 per share. There was a significant jump in price as its price as of mid-Feb 2024 was only RM 0.31 per share. I wanted to find out why the price spiked and see whether there was another investment opportunity.

Join me as I review the past 12 years' performance of Notion and try to under the reason for the price spike. Unfortunately, my analysis showed that Notion is facing operating problems. While the sector it operates in is a growing one, I am not sure that over the long-term Notion will benefit from it.

Should you still go and buy it? Well, read my Disclaimer.

Company background

Operating performance

Financial position

Valuation

Is Notion a value trap?

Conclusion

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Company background

The Group described itself as a global supplier of high-quality and precision-machined components. Founded in 1995, the Group today has manufacturing facilities in Malaysia (Selangor, Johore) and Thailand (Ayuthaya).

The core business of the Group is precision-machined components. In 2023, this accounted for 98 % of the Groups’ revenue. The balance came from Personnel Protection Equipment.

Notion’s precision-machine components are used in the manufacturing of various end-products. The contribution from the various components has changed over the years driven by the changing demand of the end-products.

Hard Disk Drive. In 2023 this accounted for 23% of the total revenue. This has shrunk from 37 % in 2012.

Automotive. In 2023, this accounted for 32 % of the total revenue growing from 14% in 2012. In its 2021 Annual Report, the Group stated that it would focus on the growing number of Electric Vehicles.

Electronics Manufacturing Services (EMS)/Camera. In 2012, camera components accounted for about half of the revenue but this had reduced to 5% in 2023. On the other hand, the EMS and other components had grown from 12 % in 2019 to 39 % in 2023.

The Group ventured into PPE in 2020 to:

“…provide us with a more diversified income stream for future growth. We started with the manufacture of certified face masks but…venture into the glove business given the increasing demand from the healthcare and related sector.”

However, in its 2023 Annual Report, the Group stated “…that the Personal Protective Equipment (“PPE”) business is being sidelined until an opportune future time…”

This is not the first time that the Group has ventured beyond its precision-machined component business touting it as a good investment only to pull back after a few years.

In 2013, the Group also acquired a 19.9 % stake in Alcyone Resources Ltd, a silver producer listed on the Australia Stock Exchange (ASX) for about RM 14.7 million.

In its 2013 Annual Report, it stated that this “… is a mid-term investment that we hope will turn around early 2014.”

But Alcyone financials deteriorated less than a year after the Notion’s investment and went into receivership. Notion wrote off the investment in 2014.

Operating performance

I looked at 2 groups of metrics to get a sense of where the business is heading. Refer to Chart 1.

The left part of Chart 1 tracks the trends of 3 metrics – revenue, PAT, and gross profitability (gross profits/total assets).

The right part of Chart 1 tracks the trends of 3 return metrics – operating return (NOPAT/total capital employed), ROE, and ROA.

You can see that the performance was not good. Revenue only grew at 1.0 % CAGR over the past 12 years. Gross profitability over the past 11 years was lower than that in 2012.

There were 4 years of losses over the past 12 years.

The loss in 2014 was due to lower revenue and lower gross margins due to production problems.

The Group attributed the loss in 2015 to forex and derivative loss amounting to RM 44 million.

The loss in 2021 can be attributed to the COVID-19 measures. The Group attributed the loss due to “Delays in approval from the authorities, higher aluminium prices, interruption to global supply chain, partial operations and infected workers, labour crunch in the Klang factories…”

While the 2023 revenue was a bit higher than that in 2022, there was a lower gross profit margin and higher Selling, General, and Administration (SGA) expenses. These led to higher operating loss compared to that in 2022. In 2022, the Group benefited from an insurance claim of RM 33 million that turned the operating loss into a profit before tax.

Chart 1: Performance Index and Returns

Given the poor profit performance, there were also poor returns. The peak return was in 2012 with declining trends since then. Over the past 12 years:

Operating return averaged a negative 4.8 %. Over the past 12 years, there were only 3 years with positive Operating returns.

ROE ranged from negative 11.8 % to positive 16.1 % with an average of 1.4 %.

ROA average 1.0 %.

The average Operating return and ROE were lower than the respective current cost of funds. In other words, the Group did not create shareholders’ value.

The other characteristic was that the operating return was lower than the ROE most of the time. This is because a significant part of the profits came from other income.

Furthermore, in 2018 and 2022, the ROE increased when the Operating return declined. This was because there was a RM 159 million contribution from an insurance claim following a fire in one of its manufacturing facilities in 2018. There was another insurance claim of RM 33 million in 2022.

Over the past 12 years, the Group generated RM 128 million PBT. A breakdown of the PBT over the past 12 years showed that the operations did not generate any profits. Refer to Table 1. Rather the bulk of the profits came from non-operating sources specifically insurance claims.

Table 1: Sources of PBT 2012 to 2023

Notes:

Operating income = Revenue – Cost of Sales – SGA.
Insurance claims were extracted from the Notes to the accounts under the PBT section.
Non-operating income = interests, investment income, others.

To get a better understanding of the operations, I broke down the operating profit into various components as shown in the left part of Chart 2. The gap between revenue and total cost (fixed and variable cost) represents the operating profit.

Contribution margin has been declining over the past 12 years. You should not be surprised as the gross profit margins have declined from an average of 19 % in 2012/13 to an average of 9 % in 2022/23.

Fixed cost had grown from an average of 19 % of the total cost in 2012/13 to an average of 27 % in 2022/23.

Given the contribution margin and fixed cost trends, there have been hardly any operating profits since 2017.

Chart 2: Operating Profit

Note to Op Profit Profile. I broke down the operating profits into fixed costs and variable costs.

Fixed cost = SGA, Depreciation & Amortization and Others.
Variable cost = Cost of Sales – Depreciation & Amortization.
Contribution = Revenue – Variable Cost.
Contribution margin = Contribution/Revenue.

I also carried out a DuPont Analysis of the operating return as shown in the right part of Chart 2. Over the past 12 years, there has been no significant improvement in asset turnover or leverage. In other words, there was no improvement in operating or capital efficiencies. Changes in the operating margin accounted for the bulk of the changes in the Operating return.

Q1 2024

For the first quarter ended 2024 (end Dec 2023), the company reported revenue growth of 13 % compared to the first quarter of 2023. More important was the improvement in the gross profit margin of 23% compared to the 11 % in the corresponding 2023 quarter.

I am a long-term value investor and I tend to look at quarterly results as “noise”. I suspect that the market may be looking at the results and see this as a turnaround. This might be the reason for the Feb price spike.

Is this the start of a turnaround that can be sustained over the long-term? Or is this a short-term benefit resulting from global geo-political tensions? I do not have a crystal ball and as such I tend to rely on historical trends to give me a picture of the future.

Prospects

Notion is in the precision parts sector.

“The precision parts market plays a key role in numerous industries by providing highly accurate and precisely manufactured machine components. These components are typically based on custom specifications from industrial and machine-based companies…” Kings Research

This is not a sunset set. According to various market research companies:

“The global Precision Parts Market was valued at USD 185.53 billion in 2022 and is projected to reach USD 387.89 billion by 2030, growing at a CAGR of 9.87% from 2023 to 2030.” Kings Research

“Precision Parts Market…witnessing around 13.3 % CAGR during the forecast period ie 2023 to 2035…” Research Nester

“The global precision engineering machines market size…is expected to grow at a compound annual growth rate (CAGR) of 6.8% from 2023 to 2030.” Grand View Research

Given the market outlook and growth rate, Notion did poorly in the context of revenue growth.

Peer comparison

Although Notion is classified under the Bursa technology sector, its business is more like a precision engineering company. As such I compared its performance with other Bursa precision engineering companies. Refer to Chart 3 and Table 2.

I must add that apart from precision components, the other companies have other business segments. As such the comparison is a rough guide.

Chart 3 shows the trends in the return on capital and cash flow from operations for the panel. While Notion's return on capital is among the bottom half, it did well when it came to cash flow from operations.

Chart 3: Bursa Peer Return on Capital and Cash Flow from Operations

As can be seen from Table 3, Notion is the biggest among its peers in terms of the 2023 total assets. But its performance did not stand out.

In terms of revenue, growth it ranked in the bottom half.

It ranked second last in terms of average ROA over the past 12 years.

In terms of average gross profit margin, it was in the bottom half.

Table 2: Bursa Peer Comparison

Notes:

a) Revenue growth from 2012 to 2023.

b) Average ROA based on 2012 to 2023.

c) Average Gross profit margin (GP margin) based on 2012 to 2023.

The precision-machined component industry is a global one. In other words, Notion has to compete globally. In this context, Notion did the worst compared to some of its international peers for 2 metrics. – return on capital and levered free cash flow margin. Refer to Chart 4.

Chart 4: International Peer Return on Capital and Levered Free Cash Flow Margin

Notes: The peers were identified from the Kings Research report.

B - Barnes Group Inc.
DAR - Datron AG.
MRE - Martinrea International Inc.
6954 – Fanuc Corporation.

Summary

What are the key takeaways from the above analyses of the operating performance?

While Notion delivered marginal revenue growth, there were declining margins as exemplified by the gross profit margins, and contribution margins. It could mean that Notion could be reducing its bid prices to secure new orders. Is this a sign that there is more competition?

There does not seem to be improving operating or capital efficiencies. The Group is incurring more SGA and becoming less efficient.

Except for cash flow from operations, Notion's performance does not stand out compared to its Bursa and international peers.

This is a sector where every player touted high quality. This is the base requirement to be in the sector and not a competitive advantage. Looking at its returns and declining trends I am not sure whether Notion has a sustainable moat.

The Q1 2024 results are encouraging but I think that Notion has to reverse a 12-year trend to turn around. I would prefer to wait for a few more quarters to be confident that it is on a sustainable turnaround.

Case Notes

According to Investopedia, the technology sector is the category of stocks relating to the research, development, or distribution of technologically based goods and services.

Investopedia has a narrow definition of technology limiting it to:

“…businesses revolving around the manufacturing of electronics, creation of software, computers, or products and services relating to information technology.”

I prefer to think of a technology company as one that primarily focuses on the development and implementation of technological products, services, or solutions.

Given the above, you can understand why I prefer to compare Notion’s performance with the engineering components manufacturer rather than the Bursa IT companies. If you want to have a sense of the business characteristics of technology companies from an investment perspective, have a look at sites such as Seeking Alpha*.

Financial position

Notion has a strong Balance Sheet and Cash Flow from Operations. As of the end of Dec 2023,

It had a debt-equity ratio of 0.09. Its highest debt-equity ratio was in 2012 of 0.34.

It had RM 52 million cash, equal to 10% of its total assets.

It had a 2.54 current ratio.

Over the past 12 years, despite 4 years of losses, there were only 2 years of negative cash flow from operation. Its total cash flow from operations amounted to RM 376 million compared to its total PAT of RM 65 million. This is a very good cash conversion ratio.

It has a reasonable capital allocation plan as shown in Table 3. Looking at the Table, you may be concerned about the comparatively high amount spent on CAPEX. This was because about RM 162 million was added to Property, Plant, and Equipment in 2017 to replace items damaged in the 2017 factory fire.

Table 3: Sources and Uses of Funds 2012 to 2023

Valuation

My usual approach is to triangulate the intrinsic value of a company by looking at its Asset Value and Earnings Value.

I estimate Notion’s Asset Value to be RM 0.74 per share and its Earnings Power Value (EPV) to be RM 0.14 per share. The market price as of 6 May 2024 was RM 0.53 per share. There is only a margin of safety from the Asset Value. Refer to Chart 5.

The low EPV is because it was based on the past 12 years' performance. I have shown that the past 12 years' results were not something to shout about.

Chart 5: Valuation

The Earnings Power Value was determined based on the average of 2 valuation approaches:

Free Cash Flow to the Firm model as per Damodaran.

Residual Income model as per Penman.

I used the past 12 years’ time-weighted values to determine the relevant inputs. The cost of equity of 10.8 % and WACC of 10.2 % was based on Damodaran’s build-up approach.

To give you another perspective, Table 4 compares Notion on several valuation multiples with its international peers. I would not consider Notion cheap based on the Enterprise Value/EBIT or even the Price to Sales multiples.

Table 4: International Peer Valuation Multiples

Turnaround valuation

The key challenge in valuing project-based companies like Notion is forecasting the earnings. It is obvious that for a higher Earnings Value, the performance has to improve significantly. It is not just about growing revenue but also improving operating and capital efficiencies.

There is not enough data to realistically project the turnaround results. However, to get a sense of the turnaround value, I look at the following scenario.

The revenue is the annualized Q1 2024 revenue.

The contribution margin and capital turnover (Revenue/TCE) is the best past 12 years margin.

The fixed cost is the average of the past 12 years fixed cost.

I valued Notion using a single-stage Free Cash Flow to the Firm model assuming 4% steady growth. The Earnings Value of such a basis was RM 0.73 per share as shown in Table 5.

Table 5: Turnaround case valuation

The above valuation assumed that Notion would be able to achieve the turnaround in 2024. If it takes longer, the value would be reduced due to the time value of money. I am not sure that there is enough margin of safety here to bet on Notion.

Is Notion a value trap?

A value trap is a situation where a stock appears to be cheap. The trap occurs when the stock price fails to reflect the true value of the company due to underlying problems that are not immediately apparent.

To be a value trap, Notion should appear to be undervalued. However, based on my valuation, Notion is only undervalued from an Asset Value perspective. From an Earnings Power Value perspective, Notion is not undervalued.

The Asset Value is based on the view that the assets represent a store of value.

The Earnings Power Value is based on the view that the value of a company is related to how the assets are used to generate value.

Notion is a manufacturing company. As such I would place greater emphasis on the value generated from using the assets.

In this context, I would not consider Notion a value trap. This is because it is not a cheap stock from the Earnings Power Value. Notion is not a value trap but neither is it an investment opportunity.

Conclusion

While Notion had been able to achieve marginal growth over the past 12 years, it faced declining performance on many fronts:

Returns were declining with average returns less than the respective cost of funds.

There were declining operating and capital efficiencies as exemplified by the gross profitability and contribution margin.

I have also shown that over the past 12 years, a significant part of its profits came from insurance claims rather than from operations. %. Over the past 12 years, there were only 3 years with positive Operating returns.

However, the Group has a strong Balance Sheet and Cash Flow from Operations. This financial strength would only be meaningful if the Group used it to improve its operations.

Notion needs to turn around its business. It has tried to diversify into new business areas over the past 12 years, but the results have not been good. As such it would still have to rely on the current precision-machined component business.

While this is not a sunset sector, this is a low-moat sector where the competitive advantage seems to be being the lowest-cost producer.

My current valuation showed that there is only a margin of safety based on the Asset Value. For any meaningful margin of safety based on the Earnings Value, we have to assume a sustainable turnaround immediately. I am not sure of this. As such I would not consider Notion an investment opportunity this time round.

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