Is Lysaght a value trap?

Value Investing Case Study 66-1. A fundamental analysis of  Lysaght Galvanized Steel Berhad to see whether it is a value trap or an investment opportunity.  

Lysaght Galvanized Steel Bhd’ (Lysaght or the company) share price in the early part of Aug 2024 seems to be at its 5-year high.

I was curious as this is a company that uses steel as its raw material. Steel prices in Aug have come down from their 2021 peak. Why would Lysaght's share price be moving in a contra direction to steel prices?

I invest in cyclical companies. I believe that its cyclical nature makes it more predictable when it comes to projecting its performance for valuation. Steel prices are cyclical and as such you should not be surprised to see my interest in steel companies such as Lysaght.

To get to the bottom of the steel price vs share price anomaly, I carried out a fundamental analysis of Lysaght. I looked at its past 12 years performance and found that while it is not a wonderful company in the Buffett sense, there are a few positive points.

I concluded that Lysaght is not a value trap. It is a cigar-butt investment opportunity.

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

Contents

• Company background

• Operating performance

• Financial position

• Valuation

• Is Lysaght a value trap?

• Conclusion

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Company background

Listed in 1994, the company has its origin from Lysaght Corrugated Pipe Sdn Bhd which was incorporated in 1972 as a joint venture between John Lysaght (Australia) Ltd., United Engineers Ltd., Singapore, and a group of Malaysian entrepreneurs.

Its root was in the manufacturing of corrugated steel pipes, guardrails, and highway furniture. The company later diversified in the design and manufacturing of poles, masts, transmission poles, transmission / telecommunication towers, and substation structures.

The company operates within a single business segment and as such does not provide any segment analysis. In 2023 about 54% of its products were exported. As can be seen from Chart 1, the contribution from exports has been growing over the past 12 years.

Chart 1: Domestic vs Exports

According to the company, the industry landscape has evolved. “What was once a market primarily seeking standard, off-the-shelf solutions has shifted towards a preference for customized designs.”

Operating performance

Over the past 12 years, revenue grew at 0.6 % CAGR while PAT declined at a 0.4 % compounded annual rate. The performance has not been consistent over the past 12 years. I could categorize them into 3 periods:

• 2012 to 2017.

• 2017 to 2020.

• Post 2020.

You can see from the left part of Chart 2 that from 2012 to 2017, PAT trended up even though revenue declined. This was due to the improvements in the gross profit margin that more than offset the declining revenue. Refer to the right part of Chart 2.

Chart 2: Performance Index and Margins

From 2017 to 2020, both revenue and PAT declined. The decline in the PAT was due to a declining gross profit margin.

Post-2020, revenue recovered so that the 2023 revenue was 6 % higher than that in 2012. Unfortunately, the gross profit margin while improving did not reach the 2012 level. As such while the 2023 PAT recovered from the 2020 bottom, it was lower than that in 2012.

The company did not give a breakdown of the revenue by products so it is hard to say whether the changes in the gross profit margins were due to changes in the product mix or operating improvements.

Given the declining trend in gross profitability, I am more inclined to think that there was no improvement in productivity or efficiency. This is supported by the declining contribution margin. Refer to the left part of Chart 2. 

A DuPont Analysis showed that asset turnover did not improve. But there were 2 positive signs

• Leverage increased as total assets increased at a faster rate than total capital employed.

• Selling, General, and Administration (SGA) margin was relatively stable over the past decade. This can be seen from the right part of Chart 2 as well as the left 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.

Given the volatile profits, you should not be surprised to find that returns were also volatile. From 2012 to 2023:

• ROIC ranged from 2 % to 20% with an average of 11 %.

• ROE ranged from 2 % to 14% with an average of 8 %.

Given the 8 % WACC and cost of equity, I would conclude that Lysaght did not create nor destroy shareholders’ value.

Prospects

Lysaght operates in the specialized steel pole sector. This does not look like a sunset industry but rather a mature one as exemplified by the following: 

“The Steel Lighting Pole Market size is expected to develop revenue and exponential market growth at a remarkable CAGR during the forecast period from 2023–2030. The growth of the market can be attributed to the increasing demand for Steel Lighting Pole owning to the Residential, Municipal Infrastructure, and Others Applications across the global level.” Verified Market Report 

“The global high mast lighting market was valued at US$ 1,269.8 million in 2023. Over the forecast period, (2024 to 2034) demand for high mast lighting is anticipated to rise at 4.8% CAGR.” Future Market Insights

“The global utility poles market size was estimated at USD 57.65 billion in 2023 and is expected to grow at a CAGR of 4.0% from 2024 to 2030.”  Grand View Research 

Peer comparison

There is only one other Bursa company in the steel pole business – Mestron Holdings Bhd. Given that a significant part of Lysaght's revenue came from exports, I also compared its performance with several international listed companies as shown below. These companies were extracted from the various market research reports quoted earlier.

• Valmont Industries (VMI).

• Mestron Holdings Berhad (Mestron).

• Hill & Smith (HILS).

Chart 4 shows the trends in the return on capital and EBIT margins for the panel. You can see that Lysaght had the worst EBIT margin and ranked near the bottom in terms of return on capital. This is not a good performance. 

Chart 4: Peer Return on Capital and EBIT margin

Note: The comparison was from 2019 onwards as Mestron's 2018 return skewed the return.

Summary

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

• While profitable throughout the past 12 years, returns were volatile.

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

• Compared to its peers, I would rate it as below average.

Financial position

I would rate Lysaght as financially sound.

As of the end of June 2024, 

• It had a debt-equity ratio of 0.1%. 

• It had RM 98 million cash, equal to 51 % of its total assets.

It has a reasonable capital allocation plan as shown in Table 1. The cash flow from operations was more than sufficient to fund its CAPEX and excess was returned to shareholders. 

Table 1: Sources and Uses of Funds 2017 to 2024

Over the past 12 years, it also had an average Reinvestment rate of 32 %. 

My main concern was with its cash flow generation track record. 

• Over the past 12 years, there were 3 years with negative cash flow from operations. 

• During this period, its total cash flow from operations amounted to RM 112 million compared to its total PAT of RM 130 million. This is not a good cash conversion ratio.

However, I think the positive points outweigh the cash flow from the operations.

Valuation

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

• I estimated Lysaght’s Asset Value to be RM 4.41 per share based on its Book Value as of June 2024.

• Its Earnings Power Value (EPV) based on its past 3 years average contribution margin and capital turnover was estimated to be RM 4.76 per share. 

• Its Earnings Value (EV with g) assuming a 4 % perpetual growth rate was estimated to be RM 5.26 per share. I also assumed the past 3 years' average contribution margin and capital turnover.

• The market price as of 2 Aug 2024 was RM 2.85 per share. 

The margin of safety under the various valuation approaches was 55 % under the Asset Value, 67 % under the EPV, and 85 % under the EV with g. There is more than a 30 % margin of safety under all the valuation approaches. Refer to Chart 5. 

Chart 5: Valuation

I would consider my valuation a pessimistic one in that I used the past 3 years' average contribution margin and capital turnover. If you look at Chart 3 you can see that the past 3 years average values were lower than the past 12 years values. 

Valuation model

I valued Lysaght 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 2 illustrates the calculation for the EV with g case. 

There are 4 key parameters in my model. 

• Revenue. I assumed this to be the Jun 2024 LTM revenue.

• Contribution margin. I assumed the average 2021 to 2023 margin.

• Capital turnover (Revenue/TCE). I assumed the average 2021 to 2023 value.

• The WACC was estimated based on Damodaran’s approach with a 2.4 % risk-free rate and Beta for the steel sector of 1.01.

Table 2: Sample calculation for EV with g

Risks and limitations

Lysaght key raw material is steel. While the company did not provide a breakdown of its raw material, I found the following from Chat GPT

“…the cost of steel typically accounts for about 70% to 80% of the total raw material cost in the production of galvanized steel poles. The remaining 20% to 30% would cover other materials and processes such as zinc for galvanizing, labour, and other manufacturing costs.”

Steel prices are cyclical making Lysaght a cyclical company. As such you may argue that it would be more appropriate to value it based on its performance over the steel price cycle.

To capture the performance over the steel cycle, it is more appropriate to look at its performance over the past 12 years. The logic for this is clearly shown in Chart 6.

Chart 6: Steel prices

However, when I estimated the intrinsic values based on the past 12 years' performance, I obtained values higher than those shown in Chart 5.

This is because Lysaght's performance pre-2017 was much better than those in the past few years. 

So, we have an anomaly. In the past 3 years, steel prices were much higher than those pre-2020. Yet the past 3 years were not the best performance for Lysaght.

Does it mean that Lysaght's performance through the cycle should then be lower than what I have assumed?

I think that the only way to mitigate this is to look for a high margin of safety. Lysaght with 67 % to 85 % margins of safety under the earnings valuation, should provide sufficient bottom-side protection. 

Simulation

To get an understanding of how the valuation would change assuming a cyclical performance, I carried out 1,000 simulations with the following assumptions

• The mean revenue would be based on the Jun 2024 LTM revenue.

• The mean contribution margin and mean capital turnover would be average 2021 to 2023 values scaled by a cycle factor of 0.85.

• This factor was derived assuming that the high prices would be 20% of the time. Factor = [ (400 X 0.2) + (200 x 0.8) ] / 300 = 0.8. The 400 represents the average high steel price as per the top part of Chart 6 while the 200 represents the average low steel price. The 300 is the current steel price as per Chart 6

I assumed a normal distribution for all of the above variables with a standard deviation of 10% of the respective mean.

The result is shown in Chart 7. You can see that most of the time, the values are below the market price. 

Chart 7: Histogram of simulated values

Case Notes One of the key principles of value investing is bottom-side protection. This refers to the strategies and measures an investor employs to protect themselves against potential losses when the value of an investment decreases. This concept focuses on minimizing downside risk, ensuring that even in adverse market conditions, the investment retains a portion of its value or mitigates losses. Some key elements of bottom-side protection from a value-investing perspective include: Having a margin of safety. Having a conservative approach in your fundamental analysis and valuation. Having a diversified portfolio. Looking for companies with a good track record. As you can see, fundamental analysis requires expertise and time. That is why I created the Fundamental Mapper to shortcut the process. Download the Fundamental Mapper app now on Xifu to get investment insights into Bursa Malaysia companies.

Case Notes

One of the key principles of value investing is bottom-side protection. This refers to the strategies and measures an investor employs to protect themselves against potential losses when the value of an investment decreases. This concept focuses on minimizing downside risk, ensuring that even in adverse market conditions, the investment retains a portion of its value or mitigates losses.

Some key elements of bottom-side protection from a value-investing perspective include:

• Having a margin of safety.

• Having a conservative approach in your fundamental analysis and valuation.

• Having a diversified portfolio.

• Looking for companies with a good track record.

As you can see, fundamental analysis requires expertise and time. That is why I created the Fundamental Mapper to shortcut the process. Download the Fundamental Mapper app now on Xifu to get investment insights into Bursa Malaysia companies.

Is Lysaght 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. 

With more than a 30% margin of safety, Lysaght is considered cheap. The question then is whether this is due to market sentiments or some insurmountable problems facing Lysaght.

While my fundamental analysis did not identify Lysaght as a wonderful company in the Buffett sense, it is not a company facing some fundamental issues. It is not in a sunset sector and there is no sign of digital disruption.

With AV = EPV, I would say that it is in a competitive environment. The assets are well utilized. Furthermore, it is financially sound with half of the assets held as cash.

As such I think it is not a value trap. Rather the under-pricing is due to market sentiments. 

Conclusion

From a big-picture perspective, Lysaght has been able to maintain its revenue and profits over the past 12 years. This is not a good performance considering that this is not a sunset sector with global demand projected to grow at around 4% CAGR.  

Lysaght's performance also did not stand out compared to its peers. I also could not find clear evidence of improving operations.

But the company is profitable. Its average returns over the past 12 years were such that shareholders' value was maintained. The company is also financially ok with about half of its total assets in cash form. 

I have shown that Lysaght is not a value trap. But if you invest in Lysaght, it is more like a “cigar-butt” investing rather than investing in a compounder.

But I would not look down on this cigar-butt as my earnings valuation was based on conservative assumptions. While I do not have any idea how its share price will trend up, I am confident that there is downside protection at the current market price. 

END

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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. 

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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.

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