Is DKSH an investment opportunity?

Value Investing Case Study 67-1. A fundamental analysis of DKSH Holdings (Malaysia) Bhd to see whether it is a value trap or an investment opportunity.

In the ever-evolving landscape of market expansion services, few companies can boast a legacy as rich as DKSH Malaysia Holdings Bhd (DKSH or the Group).

Over the past decade, DKSH has embarked on a strategic journey, marked by acquisitions and profit improvement programs. These have reshaped its business dynamics. The 2019 acquisition was a game-changer, leading to significant boosts in profitability.

Yet, beneath the surface, there are mixed signals. Revenue and profit margins have surged. But cash flow volatility and questions about long-term efficiency improvements overshadow its financial health.

Join me as I delve into DKSH's performance, efficiency trends, and valuation metrics. I will attempt to answer the following question: Is this Malaysian powerhouse a hidden gem for investors, or is it an investment risk?

I am more inclined to look at DKSH as an investment opportunity.

Should you buy it? Well, read my Disclaimer.

Contents

Company background

Operating performance

Financial position

Valuation

Conclusion

Use of AI

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Company background

Established in 1923 in Penang, DKSH is one of Malaysia's oldest and largest market expansion services providers.

DKSH Malaysia’s history extends back to 1867 when three enterprising managers left the Borneo Company Ltd. to start up on their own. Pooling their experience and expertise, S Gilfillan, W Adamson, and HW Wood set up Gilfillan, Wood & Co. in Singapore.

In 1886, Archie Charles Harper arrived in Selangor as its first European trader. He set up A.C. Harper & Co., initially to import horse fodder.

Harpers Trading (Malaysia) Sdn. Bhd. was incorporated in December 1974, as the trading arm of the Harper Gilfillan Group. Harper Gilifillan later sold its interests in Malaysia to Diethelm Keller (now known as DKSH Malaysia Sdn Bhd) in 1987.

In December 1994, the company was publicly listed on the Main Board of Bursa Malaysia Securities Berhad.

Following the merger and the effective creation of DKSH in 2002, DKSH Malaysia has established itself as a partner of choice in consumer goods, healthcare, performance materials, and technology.

2019 was a crucial year for the Group:

It acquired Auric Pacific (M) Sdn Bhd. Auric Pacific had a strong presence in the food service channel, serving hotels, restaurants, and cafes throughout Malaysia. It also covered chilled and frozen products in both food service and grocery channels. This includes own brands such as Buttercup and SCS Butter which are market leaders in the mélange and butter categories.

There was also a major improvement project undertaken within the Marketing and distribution segment to enhance the profitability of the existing business.

DKSH Malaysia today provides:

Full distribution services to small and medium-sized companies, who would normally outsource all aspects of their business except manufacturing.

Bespoke, tailor-made solutions to large and some medium-sized companies, such as:

Logistics, Sales, and product management of non-core brands.

Sales for selective channels.

Sales for some geographical areas.

In 2023, the Group reported its business under 3 segments:

Consumer Goods (previously known as Marketing and distribution services). In 2023, this segment accounted for about 56% of the Group revenue and 58% of the segment results.

Healthcare (previously known as Logistics services). In 2023, this segment accounted for 43 % of the Group revenue and 45 % of the segment results.

Others - Famous Amos chocolate chip cookie business and central overheads. In 2023, this accounted for about 1% of the Group revenue and reported a segment loss of about RM 4 million.

Operating performance

To get a sense of where the business is heading, I looked at the topline, bottom-line, and capital efficiency trends. Refer to the left part of Chart 1.

You can see that revenue had a continuous uptrend since 2012 growing at 4.3 % CAGR.

Excluding the gain from an asset sale, there was hardly any growth in profits till post-2019 following the Auric Pacific acquisition and profit improvement programme.

Note that the 2013 PAT spike was because of the RM 100 million gain from asset disposal. There was also some gain from asset disposal in 2012. As such I thought it was more appropriate to look at the PBT before the gain from disposal.

Looking at the right part of Chart 1, you can see that the profit growth post-2019 was due more to an increase in the gross profit margin than a decline in the Selling, General, and Administration (SGA) margin. In this chart, the gap between the gross profit margin and SGA margin reflects the profit margin.

Chart 1: Performance Index and Margins

Note: I used gross profitability (gross profits/total assets) as the capital efficiency metric.

Given the profit pattern, you should not be surprised to see similar patterns for the returns. Refer to the left part of Chart 2. Over the past 12 years:

ROIC averaged 12 % compared to the current WACC of 8 %.

ROE averaged 14 % compared to the current cost of equity of 10 %.

With returns greater than the respective cost of funds, I would conclude that DKSH created shareholders' value.

You can see that CFROIC was quite volatile. I will discuss this a bit more when I look at DKSH's financial position.

If you look at the right part of Chart 2, you can see that the contribution margin post-2019 was significantly higher than that pre-2019.

The other key feature of DKSH is that its fixed cost is a very small component of the total cost. In 2023 the fixed cost only accounted for about 5% of the total cost.

Chart 2: 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.

Efficiencies

The Group seemed to have a strong focus on efficiencies with similar statements stated in the various annual reports.

“The improvement project has led to improved operating costs, working capital management, client portfolio, route-to-market development, sales force efficiency, inventory management…” 2020 Annual Report

“We continued our focus on route-to-market optimization and sales force efficiency to drive accounts receivable collection, employee productivity, and inventory management…” 2021, 2022, and 2023 Annual Reports

While there are improved gross profit margins and contribution margins, these seem to conflict with the other measures of efficiency.

In this context, Chart 3 shows the trends for both the operating and capital efficiencies. You can see mixed results.

Operating efficiencies post-2019. While operating profit margin and ROA trended up, there did not seem to be much improvements in the operating expense ratio, asset turnover, and inventory turnover.

Capital efficiency post-2019. While gross profitability improved, there was not much improvement in the capital turnover (revenue/TCE). The cash conversion cycle also got worse.

Looking at the various charts, I am more inclined to think that the acquisition of Auric Pacific provided a one-time boost to efficiency. Thereafter the improvements have levelled off.

Chart 3: Operating and Capital Efficiency Trends

TCE = invested capital = Equity + total debt - cash.

Peer comparison

At its core DKSH is a trading cum distribution company. While there are several other similar Bursa Malaysia companies, they have different products. The closest to DKSH in terms of products is Harrisons Holdings.

I compared DKSH's performance with the following companies.

Engtex Group engages in the wholesale and distribution of pipes, valves, fittings, plumbing materials, steel-related products, general hardware products, and construction materials in Malaysia.

Harrisons Holdings (Malaysia) markets, sells and distributes building materials, industrial and agricultural chemical products, liquor products, and consumer goods primarily in Malaysia and Singapore.

Luxchem Corporation imports, exports, and distributes petrochemicals and other related products in Malaysia and internationally.

You can see from Chart 4 that DKSH had the lowest EBIT margin. But this is not comparing apple-to-apple as the peers have very different products. In this context, you should not be surprised that Harrisons EBIT margin is the closest to DKSH.

However, when it comes to return on capital I would rank DKSH No. 2 among the 4 peers. While Harrisons has a better EBIT margin, its return on capital was not as good as that of DKSH most of the time.

Chart 4: Bursa Peer Return on Capital and EBIT margin

Summary

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

2019 seems to be the lowest returns for the ROIC and ROE over the past 12 years. Pre-2019, these 2 metrics were trending down. But they have reversed direction post-2019.

There are clear signs of improving gross profit margin and contribution margin. However, there are mixed results when assessing the improved efficiency.

Compared to its peers, I would rate DKSH's return as above average.

Financial position

I would rate DKSH's financial position as at best average.

I have already mentioned about the deterioration in the cash conversion cycle and the volatile CFROIC.

This was because of the volatile nature of the cash flow from operations. Over the past 12 years, despite being profitable every year, there were 2 years with negative cash flow from operations. In total DKSH generated RM 532 million cash flow from operations compared to the cumulative PAT of RM 898 million. This is a poor cash flow conversion rate.

The other concerns are:

As of the end of March 2024, it had only RM 33 million cash, equal to 1 % of its total assets.

Over the past 12 years, it had an average Reinvestment rate (Reinvestment/NOPAT) of 85 %. This is a high rate. Of course, part of this was due to the acquisition of Auric Pacific.

Its capital allocation was not good. Refer to Table 1. You can see that its cash flow from operations was not sufficient to fund the CAPEX and dividends

Table 1: Sources and Uses of Funds 2012 to 2023

The main positive point was its Debt Equity ratio of 0.65 as of the end of March 2024. This had come down from its 2019 high of 1.07.

Valuation

In estimating the intrinsic value, I considered the 2019 to 2023 performance as a good representation of the future. Based on this, I estimated the value of DKSH to be as follows:

I estimated DKSH Asset Value to be RM 5.91 per share based on its Book Value as of Mar 2024. It has substantial goodwill in its books. As such DKSH’s NTA came to RM 3.62 per share.

I broke down the Earnings Value into the Earnings Power Value ignoring growth (EPV) and Earnings Value with 4 % growth. I obtained an EPV of RM 7.19 per share and an Earnings Value with 4% growth of RM 9.60 per share.

The market price as of 9 August 2024 was RM 5.10 per share.

Chart 5 illustrates the valuation relative to the market price and the past 5 years' high and low prices. You can see that the Book value only provided a 16 % margin of safety.

However, the margin of safety is 41% for the EPV and 88 % for the Earnings Value with growth.

Chart 5: Valuation

Valuation model

I valued DKSH 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 right part of Chart 2.

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 Earnings value with growth.

There are 4 key parameters in my model.

Revenue. I assumed this to be the 2023 average revenue.

Contribution margin. I assumed the average 2019 to 2023 margin.

Capital turnover (Revenue/TCE). I assumed the average 2019 to 2023 value.

WACC. Based on the first-page result of a Google search for the term “DKSH WACC” as shown in Table 3.

Table 2: Sample calculation

Table 3: Estimating the cost of funds

Case Notes

Companies tend to embellish what they do. DSKH is a good example by describing itself as a group providing market extension services.

Market extension services refer to activities or services provided to help businesses expand their reach into new markets. Market extension services may include:

Market research and analysis.

Regulatory and compliance support. This may involve assisting businesses in understanding and adhering to local regulations, standards, and requirements.

Marketing and sales strategy development.

Distribution and supply chain management.

Partnership and network building. This will involve facilitating connections with local partners, distributors or other stakeholders that can help in market penetration.

Localization of products, services, and marketing materials.

Customer support and service.

Looking at the above, you can see that an extension service company does more than conventional distribution and supply chain management.

Unfortunately, DKSH does not provide a breakdown of its services. Rather it reports performance by products. It is hard to tell whether it is a full-blown extension service company or more of a conventional trading and distribution company.

This will affect how you see its future. One way to overcome this is to see how others have described the services provided by the company. 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

There are 2 reasons for the high earnings-based valuation.:

Based on 2019 to 2023 performance.

Low WACC.

I used the 2019 and 2023 contribution margin and capital turnover to represent the long-term values based on my analysis. If I had used the 2012 to 2023 average values, the intrinsic value would have been about the same as the market price.

As shown earlier the Group delivered good performance from 2019 to 2023. Given the efforts to improve efficiency, I do not think that my assumptions based on 2019 to 2023 are overly optimistic.

If you look at Table 3, you can see that the WACC has a wide range. If I used the maximum value in the model, the Earnings value with growth is reduced to RM 4.33 per share. You can see that it is very sensitive to the WACC. You could of course argue that I should use the low end and get a larger Earnings value with growth.

Rather than argue about the WACC, the other valuation metric is to look at the Free Cash Flow yield = Free Cash Flow per share/market price per share. The WACC does not come into the picture for this metric.

The Free Cash Flow per share = 79/158 = 0.50. Refer to item “m” and w” in Table 2.

The Free Cash Flow yield = 0.50 / 5.10 = 10%.

Looking at the FD interest rate, I would say that 10% is a good yield.

I also look at the Acquirer’s Multiple to get another perspective. This is defined as = EV / (Operating income + Depreciation).

EV = Market cap + Debt – Cash = RM 1,378.

The 2021 to 2023 average Operating income + Deprecation = RM 286 million.

Acquirer’s Multiple = 1378/286 = 4.8

According to Tobias Carlisle, an Acquirers’ Multiple less than 6 is considered cheap.

Conclusion

I would summarize the positive aspects of DKSH as follows:

Revenue growth. The company has demonstrated consistent revenue growth, with a 4.3% CAGR since 2012.

Profitability. ROIC and ROE are above the respective costs of capital, indicating value creation for shareholders. The post-2019 improvements in profit margins suggest effective cost management and successful integration of acquisitions.

Valuation. The stock is trading below the estimated EPV and Earnings Value with growth, offering a margin of safety. The Free Cash Flow yield of 10% is also attractive compared to fixed deposit interest rates. DKSH is also cheap from the Acquirer’s Multiple perspective.

But I have some concerns:

Cash Flow volatility. Despite profitability, cash flow from operations was volatile. There were two years of negative cash flow from operations over the past 12 years. This indicates potential challenges in converting profits into cash.

Efficiency improvements. While there are signs of improved gross and contribution margins, other efficiency metrics such as asset turnover, inventory turnover, and operating expense ratio have shown mixed results. This raises concerns about the sustainability of post-2019 improvements.

Debt Levels. Although the Debt-to-Equity ratio has improved from its 2019 high, the company's financial position is still considered average. The low cash balance is another concern.

DKSH offers an above-average return on capital and is trading at a price below its intrinsic value. However, the risks related to cash flow volatility, efficiency improvements, and financial position should be carefully considered.

If you believe in the sustainability of post-2019 improvements and are comfortable with the company's risk profile, DKSH could be a good investment opportunity, particularly given the attractive valuation metrics.

However, if you are risk-averse, it might be prudent to monitor the company's cash flow performance and efficiency improvements before committing to an investment.

Personally, I think it is currently a cigar-butt investment opportunity.

Use of AI

I have been exploring the use of AI in my fundamental analysis. I am currently testing FinChat.io and found that it could not answer the following questions. Note that these questions are related to the analysis covered in this article.

Is DKSH Holdings an investment opportunity?

What was the reason for DKSH profit growth post 2019?

What specific strategies did DKSH implement to achieve profit growth after 2019?

However, it was able to provide a good summary of the history of the company. But the question has to be specific about the providing the history. A general question about providing the company background would not give the history.

Investment risk

When asked about the risk in investing in DKSH, it gave a very general answer as exemplified by the following:

“While…appears to be financially sound and has demonstrated consistent growth, potential investors should carefully consider these risks. Conducting thorough due diligence, including reviewing the company's financial statements…is essential before making any investment decisions. Additionally, consulting with a financial advisor...”

Financial strength

It also provided a different answer (compared to mine) when asked whether DKSH is financially. It provided the following basis and conclusion:

Profitability: The company has a modest gross profit margin of 7% and an EBITDA margin of 2.8%. While these margins are not exceptionally high, they indicate that the company is able to generate profit from its operations.

Capital Efficiency: The return on total capital (8.97%) and return on capital employed (18.27%) are healthy, suggesting that the company is efficient in using its capital to generate returns.

Valuation: The P/E ratio of 6.8 and P/B ratio of 0.85 indicate that the company is relatively undervalued compared to its earnings and book value. The EV/EBITDA ratio of 4.67 also suggests that the company is valued reasonably in relation to its earnings before interest, taxes, depreciation, and amortization.

Growth: The company has shown consistent revenue growth over the past 3, 5, and 10 years, with CAGRs of 4.51%, 4.19%, and 3.94%, respectively. The EPS growth is particularly strong over the past 3 and 5 years, with CAGRs of 13.26% and 30.61%, respectively.

Dividends: DKSH has a dividend yield of 3.37% and a payout ratio of 22.93%, indicating that it returns a portion of its earnings to shareholders while retaining enough to reinvest in the business.

Liquidity and Solvency: While specific liquidity ratios (like current ratio and quick ratio) are not provided, the company's ability to generate free cash flow per share (MYR 0.5) and operating cash flow per share (MYR 0.58) suggests that it has sufficient liquidity to meet its short-term obligations.

Based on the provided financial metrics and analysis, DKSH appears to be financially sound. The company demonstrates consistent revenue and earnings growth, efficient use of capital, reasonable valuation, and a healthy dividend payout. However, for a more comprehensive assessment, it would be beneficial to review additional financial statements and ratios, such as the balance sheet, cash flow statement, and liquidity ratios.

Valuation

When asked to estimate the intrinsic value, it provided a 5-year projection to support its valuation of:

Intrinsic Value per Share: MYR 12.29.

Current Share Price: MYR 5.04

Is listed the following discount rate and terminal value:

Cost of Equity: 8.78%.

Cost of Debt (after tax): 3.62%.

Equity Financing: 58.20%.

Debt Financing: 41.80%.

Weighted Average Cost of Capital (WACC): 6.62%.

Sum of Discounted Cash Flows: MYR 473.16M.

Discounted Terminal Value: MYR 804.62M (using an exit multiple EV/FCF of 10.80).

Net Debt: MYR 387.68M.

Total Equity Value: MYR 890.1M.

Intrinsic Value per Share: MYR 5.65 (compared to the current share price of MYR 5.04, indicating a 12.02% upside

The Equity Value method estimates the value of a company’s equity by calculating the market value of its outstanding shares.

Equity Value = Enterprise Value − Net Debt

Concluding remarks about the AI

Overall, the FinChat.io does well when the answers were based on projecting trends. But if you want to go behind the numbers and understand what was driving them, the AI is yet to be able to do this. I suspect that it had yet to incorporate the Management Discussion and Analysis into its fundamental analysis. Until the AI can incorporate the descriptive and numerical parts, it is not ready to replace the human analyst.

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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.

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