Is Hap Seng an investment opportunity?

Value Investing Case Study 74-1: A fundamental analysis of Hap Seng Consolidated Bhd to see whether it is a value trap or an investment opportunity.

The Malaysian property market has been soft for about a decade, so finding a good investment in the property sector can be challenging.

Enter Hap Seng Consolidated Berhad (Hap Seng or the Group), a diversified investment holding company with a rich history from 1976. With robust operations spanning key sectors - primarily focused on property development - Hap Seng presents a compelling case for investors.

As the Malaysian economy rebounds from the challenges of recent years, Hap Seng stands poised to capitalize on emerging opportunities in the property market, supported by its strong financial foundation and diverse revenue streams.

Join me as I delve into the investment thesis for Hap Seng, examining its segment performance, financial health, and growth prospects. Sadly, while it is a profitable Group, there is no margin of safety at the current market price.

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

Company background

Operating performance

Financial position

Valuation

Conclusion

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Company background

Hap Seng, founded in 1976, is a diversified investment holding company. The Group operates across various sectors with the following reporting segments:

Plantation: Cultivates oil palm and processes fresh fruit bunches into crude palm oil.

Property Investment & Development: Holds and develops residential, commercial, and industrial properties.

Credit Financing: Offers financial services such as hire purchase, leasing, and term loans for small and medium enterprises.

Automotive: Operates as a dealer for Mercedes-Benz vehicles, including trucks, buses, and passenger vehicles, as well as spare parts.

Trading: Supplies various fertilizers and trades in building materials like steel bars, cement, tiles, and more.

Building Materials: Produces and sells quarry and asphalt products, clay bricks, and agro-chemicals.

Others.

The Group operations are predominantly in Malaysia with market presence in Singapore, Indonesia, China, and the United Kingdom. In 2023, Malaysia accounted for about ¾ of the Group revenue.

As can be seen from Chart 1, the Trading segment was the biggest revenue contributor. But in terms of profits, the Property Investment & Development segment was the biggest contributor.

Chart 1: Segment Performance

However, in terms of return, the Credit Financing segment delivered the best results as can be seen from Table 1. The Automotive segment had the worst returns among the operating segments. This was because it incurred losses during the Covid-19 years.

I tend to focus on where the funds are allocated to get a sense of the core business. In 2023, about 70% of the net assets were deployed for the Property Investment & Development segment. As such I would consider Hap Seng as a property company.

Table 1: Segment Returns

Operating performance

I would consider Hap Seng a mature company. Over the past 12 years, revenue grew steadily at 4.0 % CAGR. Refer to the left part of Chart 2.

You can see the drop in revenue in 2020 due to “the slowdown in economic activities and the negative market sentiments brought on by the COVID-19 pandemic.” 2020 Annual Report.

While revenue recovered, there was another decline in 2023 attributed to “price correction in the Crude Palm Oil (CPO) and fertilizer markets, mitigated by an increase in sales volume of both commodities” 2023 Annual Report.

When you compare Chart 1 with Chart 2, you can see that a big part of the revenue decline from 2019 to 2023 was due to the decline in the Property Investment & Development segment revenue.

You can see from the right part of Chart 2 that from 2017 to 2022 the Group was selling land to make up for the decline in property development sales. Land sale is not a long-term strategy for a property developer.

Chart 2: Performance Index and Breakdown of Property Segment Revenue

When you look at profits, you can see from the right part of Chart 1 that the Property Investment & Development segment contributed a big part of the profit growth from 2013 to 2021. But there was hardly any profit contribution from this segment in 2023.

Looking at the right part of Chart 2, you can deduce that a big part of the profits from 2017 to 2022 came from land sales. There was no land sale in 2023 and this led to a loss from the Property Investment & Development segment.

I think that Hap Seng has not been too transparent in this. While the land sales were reported in the financial statements, there was no mention of this in the Management and Discussion part of the various Annual Reports. By leaving this out, the Group is not providing a clear picture of the performance of the property development activities.

Looking at the property sales in the right part of Chart 2, I would say that this needs a turnaround.

Returns

Chart 3 shows the return trends for the Group. You can see that all the 3 metrics in 2023 were lower than those in 2012.

After peaking in 2014, the ROIC was relatively stable for many years before declining over the past 3 years. ROIC averaged 7.6 % over the past 12 years compared to the current 7.7 % WACC.

The decline in the ROE was more pronounced. After peaking in 2015, there was a continuous decline. Over the past 12 years, ROE averaged 14.4 % compared to the current cost of equity of 9.9 %.

CFROIC was very volatile with a 4% average return for the past 12 years.

Comparing the returns with the respective cost of funds, Hap Seng managed to create shareholder value.

Chart 3: 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

With limited revenue growth, the focus of the Group should be on improving operating and capital efficiencies.

You can see from the right part of Chart 3 that there was no improvement in the contribution margin.

The left part of Chart 2 showed that capital efficiency as measured by gross profitability (gross profits/total assets) declined.

These results were supported by other measures of capital and operating efficiencies. For example, there was no improving trend in all 4 metrics of operating efficiencies as shown in the left part of Chart 4.

While there were mixed results for capital efficiencies as can be seen from the right part of Chart 4, the overall picture is not one of improving trends.

Capital turnover (revenue/TCE) and asset turnover declined.

While the cash conversion cycle declined from 2012 to 2020, there has been an improving trend since then.

There was a clear sign of improvement in the moving average Reinvestment margin (Reinvestment/revenue). This indicated that less Reinvestment was required to grow the revenue – a good sign

Chart 4: Operating and Capital Efficiency Trends

Peer comparison

Given its focus on property, I compared Hap Seng's performance with diversified Bursa property companies as listed in Table 2.

Hap Seng had the larger 2023 revenue with reasonable revenue growth from 2016 to 2023.

Table 2: Peer revenue

Note: The comparison started in 2016 as Sime Property data was only available from this year.

I looked at the trends of 4 metrics to get a sense of how well Hap Seng performed compared to its peers – return on capital, EBIT margin, Free Cash Flow margin, and EPS. Refer to Charts 5 and 6.

Hap Seng demonstrated strong financial performance, achieving the highest return on capital and ranking second in EBIT margin among the four companies. Additionally, it boasted the best earnings per share (EPS) and secured a second-place ranking for its levered free cash flow margin.

Chart 5: Bursa Peer Return on Capital and EBIT Margin

Chart 6: Bursa Peer Levered Free Cash Flow Margin and EPS

Note that Sime and IOI also have plantation operations but these are under different listed entities.

For more insights into the performance of the Bursa property and plantation companies refer to the following:

Will the Malaysian Property industry turn around by 2024?

How the Malaysian plantation sector performed over the past 10 years

I also have a case study of another property company with a plantation segment. Refer to “MKH – will there be another multi-bagger opportunity?”

Financial position

I would rate Hap Seng's financial position as average. While there were some negative points, they were more than offset by the positive ones. Its negative points were:

Over the past 12 years, it generated positive cash flow from operations for 8 of the 12 years. During this period, it generated RM 4.8 billion cash flow from operations compared to the total PAT of RM 11.3 billion. This is not a good cash flow conversion ratio.

It did not have a good capital allocation plan. Refer to Table 3. The cash flow from operations was not sufficient to fund its CAPEX. Dividends were funded by debt and divestments.

Table 3: Sources and Uses of Funds 2012 to 2023

Its positive points were:

As of Jun 2024, it had RM 3.6 million cash and marketable securities. This is equal to 19 % of its total assets. It did not have any borrowings.

From 2012 to 2023, it had a negative Reinvestment. I defined Reinvestment = CAPEX + Acquisition – Depreciation & Amortization + increase in Net Working Capital. The negative value implies that the amount spent on CAPEX and/or the increase in Net Working Capital was smaller than the Depreciation & Amortization. This is a good position as it meant that the company did not have to allocate funds to support its growth.

But I do not think that any company can grow over the long-term with zero Reinvestment rate. The negative rate was because of the divestments. If I excluded these, the Reinvestment rate would be 37%. This is a reasonable rate.

It had an improving Free Cash Flow to the Firm (FCFF) as can be seen in the left part of Chart 7. From 2012 to 2023, FCFF grew at 6 % CAGR. One of the reasons for the high FCFF is the negative Reinvestment rate.

Chart 7: Free Cash Flow and Valuation

Valuation

I based my valuation of Hap Seng on the following picture.

This is a mature Group with revenue growth at the long-term GDP growth rate of 4%.

Its different business segments are impacted by different economic factors. Its past 12 years of performance provide a good picture of its long-term performance in terms of its operating and capital efficiencies.

The property sector is cyclical and it is more appropriate to “normalize” the performance over the cycle. The past 12 years average performance represents this normalized performance.

On such a basis, I estimated Hap Seng’s intrinsic value to be RM 4.13 per share compared to its market price (30 Sep 2024) of RM 4.03 per share. The right part of Chart 7 illustrates the value of Hap Seng relative to the market price and the past 5 years' high and low market prices. You can see that there is not enough margin of safety.

Valuation model

In valuing Hap Seng, I based it on the operating profit model shown in the right part of Chart 3. I valued it based on the single-stage Free Cash Flow to the Firm model.

FCFF = EBIT(1 – t) - Reinvestment.

EBIT = Revenue X Contribution margin – Fixed cost.

Reinvestment was derived based on the Reinvestment margin.

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

Table 4 illustrates the calculation. The WACC was based on the first-page result of a Google search for the term “Hap Seng WACC” as shown in Table 5.

Table 4: Sample calculation

Table 5: Estimating the cost of fund

Sanity checks

The see whether the assumptions used in my valuation are grounded in reality, I compared the results of my valuation model with the historical performance of Hap Seng and its peers.

Refer to Chart 8 where I have overlayed the base value of the 4 metrics (red dotted lines) onto the historical performance of Hap Seng and its peers. You will agree that I have not been aggressive with my assumptions.

Chart 8: Sanity checks: Comparing the valuation results with the historical performance

Note: The valuation base values are shown in red dotted lines.

The other sanity checks are shown in Table 6. I would consider the company as cheap if the Acquirer’s Multiple is less than 6.

The contradictory picture here is the Free Cash Flow yield of 9%. This is better than keeping your money with the bank. You should not be surprised by this metric given the growing trend shown in the left part of Chart 7.

Table 6: Comparative valuation

Notes

a) EV / (average 3 years Op profit + Depreciation).

b) Past 12 years average Free cash flow/market price.

Next, my base FCFF is RM 492 million. Refer to item m in Table 4. This is very conservative compared to the historical FCFF shown in the left part of Chart 7. I also projected a 4% growth rate compared to the 6% historical growth in FCFF.

The valuation model also resulted in a Reinvestment rate (Reinvestment/NOPAT) = 211/703 = 30%. Refer to items k and f in Table 4 respectively. This is a conservative view as the historical Reinvestment rate was negative.

Case Notes

To ensure that your valuation is grounded in reality, there are several sanity checks that you can do.

Cross-check against other valuation approaches. I used the Acquirer’s Multiple and the Free Cash Flow yield in this case study.

Compare with historical performance as I have shown in Chart 8.

Compare with the sector as I have shown in Chart 8.

Perform sensitivity analysis with a Monte Carlo simulation. This will give you a picture of the range of possible valuations and the probabilities.

Look at other analysts’ reports.

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.

Risks and limitations

Land sales were a significant contributor to the Group’s performance during the 2017 to 2021 period. This was the time when the property market in Malaysia was soft.

I have taken the view that land sale is part and parcel of the property activities. An alternative approach was to treat the land sales as extraordinary items and exclude the revenue and profit from the operating performance. I did not adopt this approach. In mitigation,

I used the 2023 revenue as the base for my valuation. There was no land sale in this year.

I used the past 12 years' performance for the contribution margin, capital turnover, and Reinvestment margin. These covered periods where there were both land sales and without land sales.

At the end of 2023, the Group had about 180 acres of land. I assumed that the land sales did not impact future property development.

The other notable point is that some of the land sales are related-party transactions. From a negative perspective, you could see this as the controlling shareholder ensuring that the Group has some property income during the soft property market.

On the positive side, you could think that this practice would continue in future downtrend leg of the property cycle. This meant that there would be more “stable” profits throughout the property cycle.

The model works on the basis of 30% Reinvestment rate. If I followed the historical Reinvestment rate of negative (by setting it to zero in the model), the intrinsic value increases to RM 6.52 per share. But I do not think that any company can grow over the long-term with zero Reinvestment rate.

Monte Carlo simulation

The valuation shown in Chart 7 is a point estimate based on a certain set of assumptions. To get a better picture of the possible other values, I carried out a Monte Carlo simulation.

I adopted the triangular distribution for the following variables where, except for the WACC, the range was set from – 10% to + 10% of the respective values shown in Table 4. These resulted in the following ranges:

Revenue ranging from RM 5.47 million to RM 6.70 million .

Contribution margin ranging from 25.5 % to 31.1 %.

Capital turnover (Revenue/TCE) ranging from 48.7 % to 59.5 %.

Reinvestment margins ranging from 3.1 % to 3.8 %.

WACC ranging from 6.8 % to 9.5 %. Note that the range for the WACC was set to the minimum and maximum shown in Table 5.

Chart 9 illustrates the distribution of the intrinsic values.

About 60% of the intrinsic values were lower than the market price. I do not consider this a good margin of safety.

There is a 5% probability that the intrinsic value would be greater than RM 5.33 providing you with about 30 % upside.

Chart 9: Monte Carlo Simulation

Since a majority of the calculated values are below the current market price, it may indicate that the market is overvaluing the company. The market could be pricing in expectations that may not be justified by the underlying fundamentals.

Conclusion

Hap Seng is a diversified property Group. Over the past 12 years, about 1/3 of its profits came from non-property activities, mainly from its plantation and financing operations.

This is a profitable Group with returns that created shareholders value. I would also consider Hap Seng as financially sound.

But this is a mature company with a revenue growth at the long-term GDP growth rate. Its diversified operations together with land sales had enabled it to grow profits despite the Malaysian property sector going through the trough part of the property cycle over the past decade.

A conservative valuation of Hap Seng showed that the market has fully priced its long-term business performance. There is no margin of safety at the current market price.

Investment thesis

For those seeking exposure to the Malaysian property market through a diversified company, Hap Seng is a good choice. However, the land sales during the past few years illustrate the challenging property market. But the company’s strong financial position, steady revenue growth, and potential for recovery in the broader market provide a compelling investment case. Unfortunately, there is no margin of safety at the current market price.

The challenge is to be patient and wait for the market price to drop by 30%. You can of course be a risk taker and view the Monte Carlo simulation results as a reasonable chance of an intrinsic value upside.

Chart 10: Investing in Hap Seng

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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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