Is Coastal Contracts an investment opportunity?

Value Investing Case Study 68-1: A fundamental analysis of Coastal Contracts Bhd to see whether it is a value trap or an investment opportunity.

In an industry dominated by giants, one company's transformation from shipbuilding to gas processing and energy infrastructure solutions is turning heads - but not necessarily in a good way.

Once a leader in shipbuilding, Coastal Contracts Bhd (Coastal or the Group) found itself on the brink during the 2016 oil price crash. The plummeting demand forced them to pivot sharply, moving into onshore gas processing and offshore vessel chartering.

Their first major win? A gas sweetening plant in Mexico. But while their revenues have steadily climbed, the underlying numbers tell a more troubling story.

Despite a resort project in Sabah and a 2023 profit spike, this transformation has come at a steep cost - declining returns, bad debts, and questionable capital efficiency.

Is this company truly on the road to recovery, or are they just delaying the inevitable? Join me as I assess this ambitious pivot.

I am concerned about management's ability to improve the Group's performance significantly. As such I do not see it as a walkover investment opportunity.

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

Company background

Operating performance

Financial position

Valuation

Conclusion

AI perspective

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Company background

The Group described itself as a global integrated oil & gas services and energy infrastructure solutions provider with 4 business segments:

Onshore Gas Processing. This division focuses on pursuing larger-scale and complex energy-related projects. The first successful project was an onshore gas sweetening plant venture in Mexico operating since 2021. Subsequently in 2023, the Group also completed the EPC and started the O&M for the Papan project. Together, these two plants serve about 10% of Mexico’s daily gas needs.

Offshore Vessel Owning and Chartering. The fleet includes various types of offshore support vessels.

Shipbuilding and Repairs. The ships built range from barges, landing crafts, and tugboats to more sophisticated offshore support vessels. The Group operates two shipyards in Sabah, Malaysia with a combined land area of over 97 acres.

Hospitality. The Group’s latest investment is a ground-breaking 5-to-6-star twin resort development located in Semporna, Sabah.

In 2012, the focus of the Group was shipbuilding. But the business profile changed in 2016/17.

According to the Group, in 2016 it faced one of the most challenging cyclical downturns of the oil and gas industry. The drastic decline in global oil prices, occurring on the back of oversupply and weaker economic growth, prompted major revisions in the strategies.

“We would continue to focus on diversifying our earnings stream beyond the fabrication…Our efforts have thus far been translated into a successful venture, comprising the long-term charter of a high-value O&G asset to Mexico’s O&G sector” 2016 Annual Report.

The impact of this change can be seen in Chart 1. In 2012, the Group considered itself a shipbuilder with the segment contributing the bulk of the revenue and profits. Today the shipbuilding operations are a negligible revenue and earnings contributor. Rather, the Group is more like a provider and operator of production platforms.

Looking at Chart 1, I would differentiate the performance of the Group into pre and post-2018.

Pre-2018. Both the shipbuilding and vessel charting businesses were profitable.

2018. The Shipbuilding segment incurred losses due inventory write-down of about RM 528 million.

Post-2018. The shipbuilding business is a negligible revenue and earnings contributor. The bulk of the profits came from the Onshore Gas Processing segment.

In this context, in its Q3 FYE 2024 announcement, Coastal stated the following:

“In line with our sustainable growth strategy, the Group will be scaling down its shipbuilding activities and to focus more on gas-related infrastructure projects, as well as to pursue new opportunities in the renewable energy segment”

Chart 1: Segment revenue and profits

Operating performance

To get a sense of where the business is heading post-2018, I looked at the topline, bottom-line, and capital efficiency trends from 2019 to 2024. I used the LTM March 2024 to represent the 2024 performance. Refer to the left part of Chart 2.

Revenue had a continuous uptrend since 2019 growing at 3.4 % CAGR from 2019 to 2024.

There was a PAT spike in 2023. This was due to the one-off gain of RM 140 million gain from the disposal of 3 offshore support vessels. Even ignoring this, there is a profit uptrend.

The 2022 to 2024 PAT was boosted by effective low tax rates that averaged 13%. These were due to lower effective tax rates in other jurisdictions as well as having substantial income that is not subject to taxation.

Chart 2: Performance Index and Margins

Note: I used the 2013 values as 1.0 for the various index values.

The disappointing picture was that there was no clear sign of improving operating or capital efficiencies.

Operating efficiencies. Refer to the left part of Chart 3. Except for the improving ROA, the performance of the other metrics got worse from 2019 to 2023. This was reinforced by the narrowing gap between the gross profit margin and SGA margin as shown in the right part of Chart 2. In addition to the narrowing gap, the Group had significant bad debt provisions of RM 135 million in 2020 and RM 124 million in 2024.

Capital efficiencies. Refer to the right part of Chart 3. The performance of the 3 metrics declined from 2019 to 2024.

Coastal Chart 3: Operating and capital efficiencie

Chart 3: Operating and capital efficiencies

The other negative picture was that while there was profit growth, the returns picture was mixed. Refer to Chart 4. There were declines in the ROIC and CFROIC from 2019 to 2024.

Only the ROE showed an uptrend. I have already mentioned that the higher PAT over the past few years was due to lower effective tax rates. This may explain the discrepancy between the ROE and the other 2 metrics.

There is more bad news. From 2019 to 2024

ROIC averaged negative 1 % compared to the current WACC of 9 %.

ROE averaged 6 % compared to the current cost of equity of 10 %.

With returns less than the respective cost of funds, I would conclude that Coastal did not create shareholders' value.

Referring to the right part of Chart 4, you can see that there is also no discernible trend for the contribution margin. The chart also illustrates a key feature of Coastal – fixed cost is a large component of the total cost. In 2023, it accounted for 90% of the total cost.

Chart 4: Returns and 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.

Peer comparison

In my article ”Are there opportunities in the Bursa Energy Services sector?” I compiled the base rates for the Bursa energy services and equipment sector.

I used the data from that article to compare Coastal performance with the sector median performance.

From a capital efficiency perspective, Coastal gross profitability and ROE were worse than its peers especially post-2018. Refer to Chart 5.

From a financial perspective, Coastal had a lower Debt Equity ratio and higher cash flow from Op to PAT conversion ratio compared to its peers. Refer to Chart 6.

Chart 5: Bursa Peer Gross Profitability and ROE

Chart 6: Bursa Peer Debt Equity ratio and Cash flow from Ops/PAT

Summary

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

A change in the business direction in 2016/17 enabled it to be profitable post-2018. If Coastal continued to focus on its shipbuilding business, its performance today would be worse off.

While there was profit growth post-2018, ROIC and CFROIC returns declined. Only the ROE showed an uptrend. Coastal did not create any shareholder value.

There were no clear signs of improving capital and operating efficiency.

Coastal financial position was better than its peers. However, the peers did better when looking at capital efficiency.

Financial position

I would rate Coastal as financially sound. While there were some negative points, they were more than offset by the positive ones.

The main positive points were:

As of the end of March 2024, it had RM 358 million cash, equal to 17 % of its total assets.

In the peer comparison, I have pointed out its better cash flow conversion rate. From 2013 to 2024, it generated RM 1.2 billion cash flow from operations compared to its PAT of RM 0.8 billion. This is a good cash conversion rate.

From 2013 to 2024, it generated positive cash flow from operations every year. This was despite incurring 2 years of losses during this period.

It had a Debt Equity ratio of 0.03 as of the end of March 2024. This had come down from its 2016 high of 0.35

On the negative side, I have already mentioned the deterioration in the returns.

The other concern is the poor capital allocation plan as shown in Table 1. You can see that the cash flow from Ops was just enough to cover the CAPEX. But in mitigation, this was offset by the negative Reinvestment from 2019 to 2023.

I defined Reinvestment = CAPEX – Depreciation & amortization + increase in Net Working Capital. The negative values arose because the amount spent on CAPEX and/or Net Working Capital was smaller than the Depreciation & amortization.

Table 1: Sources and Uses of Funds 2012 to 2023

Valuation

I looked at several valuation metrics to assess whether there is a margin of safety. Refer to Table 2. You can see that there are only margins of safety under the Asset Value and Acquirer’s Multiple.

Table 2: Valuation metrics

Notes

a) EV / (Average past 3 years EBITDA)

b) (Free cash flow from valuation model)/market price

You can see that the Earnings Value is significantly lower than the Asset Value. This is clearly illustrated in Chart 7.

According to Professor Bruce Greenwald, this suggests underutilization of the assets. You should not be surprised as:

Cash accounted for 17 % of the total assets.

We have declining returns and the Group did not create shareholders value.

The key is whether the Group can turn around its performance and deliver better returns.

Chart 7: Valuation

Given its history of asset write-downs and significant bad debts, I would prefer a margin of safety based on the Earning value (intrinsic value) rather than the Asset Value.

Intrinsic valuation model

I valued Coastal 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 Gross profit margin – SGA.

I included the provisions for bad debt in the SGA.

The reinvestment rate was = 0 based on its historical performance.

I assumed g = 4%.

Table 3 illustrates the calculation for the Earnings value with growth.

There are 4 key parameters in my model.

Revenue. I assumed this to be the 2019 to 2024 average revenue.

Gross profit margin. I assumed the average 2019 to 2024 margin.

Capital turnover (Revenue/TCE). I assumed the average 2019 to 2024 value.

WACC. Based on the first-page result of a Google search for the term “Coastal Contracts WACC” as shown in Table 4.

Table 3: Sample calculation

Table 4: Estimating the cost of funds

Case Notes

The Acquirer’s Multiple is a financial metric used primarily in value investing to identify undervalued companies. It was popularized by Tobias Carlisle for evaluating companies as potential acquisition targets.

The formula for the Acquirer’s Multiple is = Enterprise Value / EBITDA.

While the Acquirer’s Multiple can be used by comparing with those of its peers, Tobias Carlisle has suggested that a company with a value of 5 or 6 can be considered cheap.

If a company has a low Acquirer’s Multiple and also offers a significant margin of safety it may be a good investment opportunity. Conversely, if the margin of safety is small or negative, even a low Acquirer’s Multiple might not justify the investment.

This approach helps investors find undervalued companies that not only look attractive from an acquisition standpoint but also offer a cushion against risk, increasing the chances of long-term investment success.

Different valuation metrics will give different answers. The ideal is to have all pointing in the same direction. The challenge is not just using different valuation approaches. Having different perspectives of the company is equally important.

One way to have this is to look at what others have done. A site like Seeking Alpha* is a good source of such information. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.

Risks and limitations

In estimating the intrinsic value, I have taken a conservative approach to the earnings, costs, and tax rate.

The key challenge in estimating the intrinsic value of Coastal is projecting its future earnings. While I have assumed that 2019 to 2024 revenue and efficiencies, they are conservative:

I have ignored the impact of the hospitality segment. I have assumed that its value is currently captured under the non-operating assets.

In its 2023 Annual Report, Coastal reported that it had completed and is now operating the EMC Papan onshore gas conditioning plant. I have assumed that the 2023 performance reflects the future performance. I suspect that the Papan plant will boost its profits beyond what was achieved in FYE 2023.

I found it difficult to assess the impact of EMC Papan from the March 2024 YTD performance as the Gas Processing segment performance was impacted by the “temporary suspension of bareboat charter hire of JUGCSU.”

Secondly, in estimating the SGA costs, I have included the bad debt provisions. These are sizeable even if averaged out. If I ignore the bad debt, the SGA expenses will be reduced, and the intrinsic value will increase to RM 2.63 per share.

Finally, in my valuation model, I used the average 2013 to 2023 positive tax rates. This worked out to be 21%. I have mentioned that over the past few years, the average effective tax rate was lower at about 13%.

If the Group continues to operate in locations with low tax rates, then the 21% is an overestimate. However, the impact on the valuation is very small. For example, a 13% tax rate would only increase the intrinsic value to RM 1.36 per share.

Conclusion

I would summarize the positive aspects of Coastal Contract as follows:

It adopted a new business direction in 2016/17 that has enabled it to deliver improving profits.

The Group is financially ok.

Unfortunately, there are several operating concerns:

There are no clear signs of improving capital and operating efficiencies. I suspect that these may account for the declining ROIC.

There were 2 years with significant bad debt provisions.

From a valuation perspective, the margin of safety comes from the Asset Value supported by the low Acquirer’s Multiple.

If you believe that the Group can turn around its performance and generate returns greater than the cost of funds, then it is an investment opportunity.

But if you are like me with a pessimistic view of management performance, you should spend the time looking at other companies. I would not rely on the Asset Value to provide the margin of safety.

AI perspective

There are today AI tools that supposedly can carry out a fundamental analysis. I have been exploring FinChat.io checking to see whether its answers were in line with my analysis. I would conclude that they were close as exemplified by the following:

Business fundamentals

I asked the AI in Finchat.io the following:

“How would you rate the business fundamentals of Coastal Contract Bhd in the context of poor, average, or good”

Finchat.io uses CoPilot to analyse the data in its database covering those from 2015 to TTM. After listing several metrics, it provided the following summary:

Profitability: The company has a high net profit margin but a negative operating margin, indicating potential issues with operational efficiency.

Growth: Both revenue and EPS have shown significant declines over the long term.

Valuation: The P/E and P/B ratios suggest the company is relatively undervalued compared to its earnings and book value.

Capital Efficiency: The negative return on capital employed indicates inefficiency in using capital to generate profits.

The AI’s concluded as follows:

“Based on the provided data, Coastal Contracts Bhd's business fundamentals can be categorized as average. The company shows strong net profitability but struggles with operational efficiency and growth. The valuation metrics suggest it might be undervalued, but the negative growth rates and capital efficiency are concerning.”

I think its answer is close to mine. But I have more supporting analysis. When I asked the same question the next day, I obtained the following:

“Based on the analysis, Coastal Contracts Bhd's business fundamentals can be rated as average. The company has shown strengths in reducing debt and maintaining healthy gross profit margins, but these are offset by long-term revenue declines and high volatility in net income. The inconsistent interest coverage ratio also raises concerns about financial stability.

To improve its rating, Coastal Contracts would need to demonstrate consistent revenue growth, stable profitability, and a clear strategic direction to address market challenges.”

Don’t you think that the 2 answers are similar enough?

Financial position

When asked whether the Group is financially sound, FinChat.io gives the following answers:

Profitability: Coastal Contracts has a high net profit margin of 86.2%, but its operating margin is negative at -48.76%, indicating operational inefficiencies.

Debt Position: The company has a very low Debt-to-Equity ratio of 0.03, suggesting minimal reliance on debt. The Interest Coverage Ratio of 9.19 indicates that the company can comfortably cover its interest expenses.

Ownership Structure: Significant insider ownership, with the top insiders and investors holding substantial shares, which can be a positive sign of confidence in the company's future.

Coastal Contracts appears to be financially sound with a strong net profit margin and minimal debt. However, the negative operating margin and declining revenue growth are areas of concern. The company's ability to cover its interest expenses is strong, and the significant insider ownership suggests confidence in the company's prospects.

Valuation

When asked to calculate the intrinsic value, had a value that is significantly different from mine. There is not enough details to see the reasons for the differences.

It provided the following summary

Sum of Discounted Cash Flows: MYR 1,055.44M.

Discounted Terminal Value: MYR 362M (using an exit multiple EV/FCF of 4.12).

Net Debt: -MYR 309.32M.

Total Equity Value: MYR 1,726.76M.

Intrinsic Value per Share: MYR 4.70.

Current Share Price: MYR 1.75.

Upside/Downside: 168.36%

It listed the following key assumptions

Cost of Equity: 9.29%.

Cost of Debt (after tax): 27.77%.

Capital Structure: 94.28% equity, 5.72% debt.

Weighted Average Cost of Capital (WACC): 10.35%.

One problem I came across with FinChat.io is that it may not find the data even if it was there previously. For example, if failed to answer the following questions citing unavailability of data when I explored FinChat.io the following day:

How has the business changed over the past 12 years.

Can you provide a 12-year history looking at the changes in the contribution from the various business segment.

What is the reason for PAT growth from 2019 to LTM 2024?

Was there improvement in operating and capital efficiencies?

Is Coastal Contract financially sound?

Can you estimate the intrinsic value?

However, after coming back to Coastal after asking questions about other companies, it provided the answers.

For Coastal Contract, it would appear that FinChat.io has yet to cover the Management Discussion and Analysis part of the Annual Reports. It also did not have the segment data.

END

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