Is FoundPac a value trap?

Value Investing Case Study 65-1. A fundamental analysis of FoundPac to see whether it is a value trap or an investment opportunity

FoundPac Group Berhad (FoundPac or the Group) is currently trading at 40 % of its 2020 peak share price. You would have thought that with 2020 being the COVID year, FoundPac's performance for that year should not be one of its better ones.

I was curious why the market has such a negative sentiment towards FoundPac. My interest in FoundPac was also partly because it was in the precision engineering business. 

This was the same business as Notion Vtec. I missed the Notion Vtec share price run-up a month or two ago and wanted to see whether FoundPac could have the same price run-up.

Join me in this fundamental analysis of FoundPac. In this analysis, I also use a Monte Carlo simulation to get a probabilistic picture of the value of FoundPac.

FoundPac's performance is among the better compared to the Bursa precision engineering companies and global peers. However, being better did not translate into improving returns. As such while it is not a value trap, it is not an obvious investment opportunity.

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

Contents

• Company background

• Operating performance

• Financial position

• Valuation

• Is FoundPac a value trap?

• Conclusion

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.

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.

Company background

The Group IPO in 2016 as a precision parts business. It designs, develops, manufactures, and markets precision engineering parts such as stiffeners, test sockets, hand lids, and related accessories. 

It has today widened its products to cover laser stencils, industrial equipment, and machinery as well as cables.

The Group’s customers are primarily large multinational semiconductor manufacturers, outsourced semiconductor assembly and test companies, and printed circuit board design houses.

The Group currently reports its performance under the following business segments:

• Precision engineering. This covers the design, development, manufacture, marketing, and sale of stiffeners, test sockets, hand lids, and related accessories.

• Laser stencils.

• Cables and connectors.

• Automation. This covers the manufacture of industrial equipment and machinery.

• Others. 

The Precision engineering segment is the biggest revenue contributor. As can be from the left part of Chart 1, the other segments are relatively new. For example, the Group ventured into:

• The cables and connectors business in 2022.

• The automation segment in 2021.

The Group focuses on the global market although the contribution from Malaysia has grown substantially from 9% of the 2017 revenue to 35 % of the 2023 revenue. Refer to the right part of Chart 1.

Chart 1: Revenue 

Operating performance

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

• The left part of Chart 2 tracks the trends of 3 metrics – revenue, PAT, and gross profitability (gross profits/assets).

• The right part of Chart 2 tracks the trends of 3 return metrics – ROIC (NOPAT/total capital employed), CFROIC, and ROE. 

You can see that revenue and PAT have taken different paths especially post-2020. While revenue has an upward trajectory, PAT seemed to have declined.

The main reason was the declining gross profit margin that went from 54 % in 2020 to 26 % in 2024. At the same time, Selling, General, and Administration (SGA) margin got worse. It was 20 % in 2024 compared to 16 % in 2020.

The Group attributed the lower gross profit margin to the lower margins from the accessory cable and connectors segment.

Chart 2: Performance Index and Returns

Note: The 2024 performance was based on Mar 2024 LTM results.

While the Group has 4 main business segments, the bulk of the contribution came from only one – Precision engineering. Table 1 shows the relative return on net assets for the various business segments.

The lower returns for the non-precision engineering segments meant that as the Group ventured into them, the Group’s return got worse. 

Table 1: Segment returns

Given the poor profit performance, there were also declining returns. Refer to the right part of Chart 2. 

The returns have been declining since its 2016 IPO. There seemed to be a turnaround in 2019. But this seemed to peak in 2020. The returns in 2024 for the 3 metrics were lower than those in 2020. 

The ROIC and ROE over the past 3 years (2022 to 2024) averaged 10 % and 7 % respectively compared to the current 9 % each for the WACC and cost of equity. This is not exactly a great performance. 

Unless the Group can turn around and/or improve the performance of the non-precision engineering segments, we are not going to have any improving return.

Productivity and efficiencies

You can see that the challenge is not topline growth. Rather it is about improving the operations so that there are better margins. 

In this context, I could not find any clear signs of improving productivity or efficiency over the past 9 years.

• Capital efficiency as measured by gross profitability has been declining since 2016. Refer to the left part of Chart 2.

• While the contribution margin improved from 2016 to 2020, it had declined since then such that the 2024 margin is lower than that in 2016. Refer to the left part of Chart 3. 

• Fixed cost as a % of total cost went from 21 % in 2016 to 29 % in 2023. This is in line with the higher SGA margin.

• A DuPont Analysis shows that there was no improvement in asset turnover or leverage. Refer to the right part of Chart 3.

Chart 3: Operating Profit and DuPont Analysis

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

Prospects

I see FoundPac as being in the same business as Notion ie precision parts. 

“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

Over the past 9 years, FoundPac revenue grew at 5.4 % CAGR. If it can continue to maintain this pace of growth, I would say that FoundPac would not do too badly in the context of revenue growth.

Peer comparison

I also compared FoundPac's performance with other Bursa precision engineering companies. Refer to Chart 4.

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

Chart 4 shows the trends in the return on capital and EBIT margins for the panel. You can see that FoundPac was among the better performers based on these 2 metrics. 

Chart 4: Bursa Peer Return on Capital and EBIT margin

The precision-machined component industry is a global one. In other words, FoundPac has to compete globally. In this context, FoundPac did well compared to some of its international peers for 2 metrics. – return on capital and EBIT margin. Refer to Chart 5.

Chart 5: International Peer Return on Capital and EBIT 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 FoundPac returns declined since 2016, it was one of the better performers compared to both the Bursa and global peers.  

• There does not seem to be improving operating or capital efficiencies. 

• 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 FoundPac has a sustainable moat. 

Financial position

I would rate FoundPac as financially sound.

As of the end of Mar 2024, 

• It had a debt-equity ratio of 2%. 

• It had RM 30 million cash, equal to 25 % of its total assets.

Over the past 9 years, it generated positive cash flow from operations annually. During this period, its total cash flow from operations amounted to RM 130 million compared to its total PAT of RM 99 million. This is a very good cash conversion ratio.

It has a reasonable capital allocation plan as shown in Table 2. Looking at the Table, you may be concerned about the comparatively high amount spent on CAPEX. 

Table 2: Sources and Uses of Funds 2017 to 2024

My main concern is the high Reinvestment rate incurred by the Group. Over the past 9 years, this averaged 55%.  This high Reinvestment rate is in line with the high CAPEX shown in Table 2.

I defined Reinvestment = CAPEX + Acquisition – Depreciation & Amortization + Increase in Net Working Capital.

Reinvestment rate = Reinvestment / NOPAT

Of course, you may argue that this high Reinvestment rate is because the Group was driving revenue growth and that it would come down as the Group matures. 

Valuation

My usual approach is to triangulate the intrinsic value of a company by looking at its Asset Value and Earnings Value. I looked at 2 scenarios when it came to the Earnings Value.

• I estimated FoundPac’s Asset Value to be RM 0.20 per share based on its Book Value as of Mar 2024.

• Its Earnings Value (EV history) based on its historical average rate was estimated to be RM 0.45 per share. This assumed 4% perpetual growth rate. The Earnings Power Value was estimated to be RM 0.33 per share.

• Its Earnings Value (EV max) assuming the best rate and 4 % perpetual growth rate was estimated to be RM 0.83 per share. 

• The market price as of 26 July 2024 was RM 0.40 per share. 

There is no margin of safety for its Asset Value. The EV history only provided a 13% margin of safety. I do not consider this sufficient. Refer to Chart 6.

While there is more than 30% margin of safety under the EV max, I do not consider this realistic. This will mean that the Group has turned around its performance to deliver the historical best margin and capital efficiency on an ongoing basis. 

Chart 6: Valuation

I would consider my valuation an optimistic one in the sense that I have used a Reinvestment rate of 22 % for the EV history scenario. While this was based on the fundamental growth equation, this is about half the historical rate.

The small margin of safety under the EV history should make you think deeply before investing in FoundPac. 

Valuation model

I valued FoundPac using a single-stage Free Cash Flow to the Firm model.

Value to the firm = FCFF X (1 + g) / (WACC – g).

FCFF = EBIT(1 – t) X (1 – Reinvestment rate).

EBIT = Revenue X Contribution margin – Fixed cost. This was based on the operating profit model as shown in the left part of Chart 3.

The reinvestment rate was derived from the fundamental growth equation g = Return X Reinvestment rate.

For the EPV case, I assumed g = 0. For the EV case, I assumed g = 4%.

Table 3 illustrates the calculation for the EV history case. 

There are 4 key parameters in my model. I assumed the following for the EV history case.

• Revenue. I assumed this to be the 2022 to 2024 average revenue.

• Contribution margin. I assumed the average 2017 to 2024 margin.

• Capital turnover (Revenue/TCE). I assumed the average 2017 to 2024 value.

• WACC. Based on the first-page result of a Google search for the term “FoundPac WACC) as shown in Table 4. 

For the EV max case, I assumed the following

• Revenue based on the max of 2022 to 2024. 

• Contribution margin and capital turnover based on the respective best of 2017 to 2024. 

Table 3: Sample calculation for EV history case

Notes

• Item c. This was based on the 2022 to 2024 average fixed costs + average 2017 to 2024 write-downs. 
• Item q. I treated the excess TCE as non-operating assets.

Table 4: Estimating the cost of funds

Case Notes Monte Carlo simulation is a mathematical technique that enables you to account for uncertainty by simulating a model's outcome multiple times with varying inputs. This technique uses random sampling to generate possible outcomes and assesses the probability of different results. Unlike deterministic models, which use fixed input values, Monte Carlo simulation incorporates the uncertainty and variability inherent in financial markets by using probability distributions for inputs.  Rather than have a single-point estimate, Monte Carlo simulation provides a range of possible outcomes. This gives you a better understanding of potential risks and rewards. The challenge with Monte Carlo simulation is that you will have to provide the distribution of the various variables. Given this, you can understand why I seldom use Monte Carlo simulation.  Then to find out the other possible valuation, I look at what others have done. A site like Seeking Alpha*. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.

Case Notes

Monte Carlo simulation is a mathematical technique that enables you to account for uncertainty by simulating a model's outcome multiple times with varying inputs. This technique uses random sampling to generate possible outcomes and assesses the probability of different results.

Unlike deterministic models, which use fixed input values, Monte Carlo simulation incorporates the uncertainty and variability inherent in financial markets by using probability distributions for inputs. 

Rather than have a single-point estimate, Monte Carlo simulation provides a range of possible outcomes. This gives you a better understanding of potential risks and rewards.

The challenge with Monte Carlo simulation is that you will have to provide the distribution of the various variables. Given this, you can understand why I seldom use Monte Carlo simulation. 

Then to find out the other possible valuation, I look at what others have done. A site like Seeking Alpha*. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.

Sensitivity analysis

Some may argue that using the average historical performance to represent future performance may not be realistic. And it is not about the future being different and better.

It is also that the historical values were volatile and that there were times when the margins and capital turnover were better than the average. You may argue that if I had used the higher values, then the value of FoundPac would be higher.

To address this issue, I used a Monte Carlo simulation of the valuation. I assumed that the key variables follow a normal distribution as shown in Table 5.

Table 5: Parameter for a normal distribution

Note: The mean and standard deviation for each variable were based on the historical data covered by the respective years.

I next used the EXCEL function to simulate the value of FoundPac for 500 trials. Each trial would be based on a random selection of the 4 key variables shown in Table 5. I then created a histogram of the 500 valuations as shown in Chart 7.

Chart 7: Histogram of valuation based on Monte Carlo simulation

You can see that the valuation is a bit skewed to the right. 

• About 43 % of the values fall below the market price. 

• The most common value falls within the RM 0.34 to RM 0.38 band.

The challenge here is setting the target for the market price. From a conservative perspective, I would consider FoundPac as underpriced if the market is such that about 20% of the values fall below the market price.

You can see from Chart 7 that my criterion is not met. 

With 57 % of values greater than the market price, why did I not consider this a good investment opportunity?  This is because I have doubts about the validity of the distribution of the 4 variables. 

Apart from assuming that they are normally distributed, I used the historical data points to establish the standard deviation. 

• The business profile had changed over the past 9 years. Using the historical data does not capture the current business profile.

• Secondly, a quick and dirty check showed that the distribution is more likely to be log normal than a normal distribution.

In other words, I think the Monte Carlo simulation introduces its own set of uncertainty. I am not sure that this help to provide a better valuation. 

Is FoundPac 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, FoundPac should appear to be undervalued. However, based on my valuation, 

• There is no margin of safety based on the Asset Value and EPV.

• There is not enough margin of safety based on the Earnings Value. This is from both the static valuation (as per Table 3) and the Monte Carlo simulation (as per Chart 6) perspectives.

In other words, FoundPac is not a cheap stock. As such the question of it being a value trap is irrelevant. 

But I hasten to add that while not a value trap, it is not an obvious investment opportunity. This is because its fundamentals are not that strong and the lack of a sufficient margin of safety.

Conclusion

While FoundPac had been able to deliver revenue growth over the past 9 years, profits were declining. This was because revenue came from the Group venturing into new product segments that did not have good margins.

I have shown that the precision engineering business has delivered good returns. But the newer segments such as cables and connectors and even automation are not pulling their weights.

On the negative side, it implied that there is a limit to growth for its original precision engineering business and the Group has to rely on new segments to deliver new growth. 

On the positive side, you may think that the Group is going through a learning curve with the new business. As such in a few years, it would be able to turn the losses into profits. But to do this, I think the Group has to be more productive and efficient. Unfortunately, there is no track record of improving operations.

However, the Group is financially strong although I have some concerns about its Reinvestment rate. This financial strength would only be meaningful if the Group used it to improve its operations. 

My current valuation showed that there is no margin of safety based on its Asset Value or EPV. While there is some margin of safety from the Earnings Value, it is much lower than my 30% target.

If you assume that its future is going to be very similar to the past, then this is not an investment opportunity. 

Of course, all is not lost. My Monte Carlo simulation shows that if can deliver better productivity/efficiency there is a good chance that the business value would be greater than the market price. 

The question is are you going to rely on luck or are you going to wait for signs of better performance before buying? 

END

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 

How to be an Authoritative Source, Share This Post

If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play. PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play.

If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

Disclaimer & Disclosure

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.

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.

Your link text