Charts #50: More on Property - Offices

The pandemic upended offices with vacancy rates hitting all time high in some cities as the chart below shows. This has impacted property valuations and changed the landscape for entire vicinities.

Interestingly, it also reflects work culture in different parts of the world and different industries. Asian workers tend to head back to office while tech startups are resisting. 

But if we can stretch on the horizon, we should revert to norms over time and therefore it might be a good time to start buying office reits now!

Pepsico - FCF Generation Machine

This post first appeared on Substack a few months ago.

The human brain is weak. We are wired to succumb to temptations easily and we slide down slippery slopes and are unable to get back on our feet without tremendous effort. That is why it is so hard to lose weight, or stop swiping those TikTok videos or quit drinking or smoking. The common denominator for the above question is addiction. We just cannot stop ourselves when our brains from crazy over those dopamine hits. No pun intended but we are, in essence, not too different from zombies always going crazy for brains. They also cannot help it.

Businesses that leverage on this weakness become cash generating machines as consumers cannot stop consuming their products. Think sugary drinks, addictive games, new seasons of Game of Thrones and salty snacks. It gets so bad that governments have to clamp things down. Cocaine is illegal in most countries as with most drugs. 

Many countries has imposed sugar tax and China restricted kids from playing games after 10pm. But that does nothing to stop these companies from churning cash because people simply cannot stop themselves from wanting more. They will still consume even if you raise prices, reduce the volume per pack or even reduce the quality of the product.

Our idea today is one such consumer company with market cap of over USD250bn, which is roughly the size of New Zealand’s GDP and almost twice the size of Ukraine’s GDP and amazingly, a tad smaller than our Little Red Dot’s GDP. We shall discuss its investment thesis, moats, risks and valuation.

The investment idea today is a compounder and a household name which I have followed for a decade as an analyst but its brands are brands I have known all my life, as I am sure most of us do. We will be discussing Pepsico (Ticker: PEP), listed on the NYSE. The stock has compounded tremendous growth for the past 40 years.

1. Investment Thesis

Pepsico is the world’s largest potato chips manufacturer and the world’s second largest bottled soda drink maker behind Coca Cola. The company has a diversified portfolio of iconic brands such as Pepsi, Frito-Lay, Gatorade, Quaker Oats, and Tropicana, among others that creates great products which are well-liked because they are savory and addictive. It has also built a strong global procurement and distribution network in 200 countries on the back of its sheer size as one of the leaders in these two consumer sectors which provides Pepsico huge competitive advantages against smaller competitors.

Today, Pepsico ranks amongst the top 5 global FMCG (fast moving consumer goods) companies and has compounded growth at minimally high single digit pace for decades. In the recent 5 years, share price has also more than doubled from c.USD80 in 2018 to c.USD180 today. The following is Pepsico's simple financials and ratios:

Simple Financials

• Sales: 89.9bn 
• EBITDA: 16.3bn 
• Net income: 9.7bn 
• FCF: 8.3bn (current FCF in 2022 is 5.6bn) 
• Debt: 36.1bn, Mkt Cap 253.9bn

Ratios

• ROE 53.7%, ROIC 16.2% 
• EV/EBITDA 16.5x (Dec 24)
• PER 23.4x (Dec 24)
• PBR 14.5x
• Past margins: OPM 14-18%

Management

While Warren Buffett did famously say (below) it is not about management but more about the business, it is worth mentioning Pepsico’s previous and current CEOs. Pepsico’s success over the last two decades can be largely attributed to Indra Nooyi, who served 12 years from 2006 to 2018. Her Spanish successor, Ramon Lagurta took over well and has continued to drive growth. What Indra and her team did was both strategic and effective.

“ When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. ”

In the years prior to becoming CEO, Indra was CFO and SVP for corporate strategy and she famously spun out Yum! Brands which was Pizza Hut, KFC and Taco Bell. These restaurant businesses did not fit well with Pepsico’s core products even though conceptually they were supposed to fit back in those days. Since you sell carbonated drinks, why not own businesses that sell those drinks day in day out? Today we know that it doesn’t work. Indra sold those businesses and bought Tropicana and Gatorade which further strengthened Pepsico’s distribution network and its business moat.

Next, Pepsico reclassified its products into three categories: "fun for you" (potato chips and regular soda), "better for you" (diet or low-fat versions of snacks and sodas), and "good for you" (oatmeal). It was easy to understand and put Pepsico in a good light as the world moved to emphasize on ESG. Her legacy continues today as her successor continue to grow profits and dividends.

2. Business Moats

Buffett also said the most important thing about businesses is how they defend their market share. He coined “Business Moats” as the term to illustrate characteristics of strong companies that would help fend off competition. For the fun of it, I asked chatGPT, “What is Pepsico’s business moat?” and the following is what it churned out:

Pepsico's business moat is primarily built on its strong brand recognition and extensive distribution network. As a leading global food and beverage company, PepsiCo has a portfolio of well-known brands such as Pepsi, Lay's, Gatorade, Quaker, Tropicana, and Doritos, among others, that have become household names.

Additionally, PepsiCo has a diversified product portfolio spanning snacks, beverages, and other food products, which helps it to maintain a stable revenue stream in different market conditions. The company also invests heavily in research and development to create innovative and sustainable products to meet changing consumer preferences.

Moreover, PepsiCo's extensive distribution network, which includes partnerships with bottlers and retailers, allows the company to reach customers across various geographies and demographics. This distribution network provides the company with a competitive advantage over smaller players who may not have the same level of reach.

Pepsico is committed to operating in a socially and environmentally responsible manner and has demonstrated ESG leadership. The company has set ambitious targets to reduce its environmental footprint, improve the lives of farmers and communities in its supply chain, and promote diversity and inclusion in its workforce. These initiatives not only benefit society but also position PepsiCo as a responsible corporate citizen and a leader in the ESG space.

Overall, PepsiCo is a well-established company with a strong brand portfolio, diversified revenue streams, and a commitment to ESG leadership. These factors, combined with its consistent financial performance, make PepsiCo a compelling investment opportunity for long-term investors looking for exposure to the food and beverage industry.

I must say this is really not bad! It picked up Indra Nooyi’s ESG leadership point as well! But alas for serious value investors’ deep dive, chatGPT is still not good enough. Maybe we can give it a few weeks and open access to Substack, after some more learning it’s game over for writers like us :)

Okay, before that happens, let’s get back Pepsi’s moats. ChatGPT got the two most important moats: brand and distribution. Brand is easy to understand, humans like familiarity and if businesses can deliver consistency, consumers will just keep coming back. Starbucks, Johnson and Johnson, L’Oreal, LVMH, Macdonald’s, Toyota, Singapore Airlines and Yakun Kaya Toast all built their businesses on consistency and reliability.

Distribution is key and towards the consumer, it is about securing shelf space in retailers, being able to restock products as soon as they run out, putting the right products in front of consumers in the right season. Drinks in summer, chips before big games. It is also vital in procurement. Get suppliers globally, procure at low costs but ensure consistent supply. Frito Lay became the largest potato chips maker because it can secure potatoes from growers all over the world. As it grows in size, it becomes harder and harder for others to secure potatoes and even if they do, competitors cannot buy at the same low price.

This is economies of scale at work. Frito Lay can procure potatoes cheaply because it has volume. This is the same for all other raw materials: packaging, PET bottles, syrup, oats etc. It can also secure shelf spaces cheaply, it then has more marketing dollars to spend, ensuring mind share with consumers.

Economies of scale → lowest cost producer → higher gross margins → more marketing spend → bigger market share

There is also a strong positive cashflow angle. Pepsico can always have better payment terms. It pays farmers some small upfront cost to grow potatoes. It pays distributors deposits to put its chips and drinks on shelves. These are cents per packet or per bottle. But when the consumer buys a packet of Ruffles at $5, the money goes to Pepsico fairly quickly because its systems are linked with retailers like Walmart and Costco. If we buy on e-commerce, then it gets money instantaneously. So Pepsico’s working capital cycle is very short. In fact, in 2022, it was negative. It was -USD6bn against revenue of USD90bn. Pepsico’s upstream supplier and downstream counterparties funds its day-to-day business operations.

As the company keeps improving its margins and cashflows, Pepsico realized it doesn’t really need a lot of equity on its balance sheet. So it kept buying back its own shares. ROE hit more than 50% since 2016. I believe there is room to further improve ROIC (c.16%) as well. It used to be just 27%! This is the beauty of FMCG businesses or in general, businesses with good economics.

3. Risks

Every investment comes with risk and we need to understand them well and see if there are any mitigating factors. Most of the time, risks can be mitigated if we buy cheap enough. For a name like Pepsico, the ability to compound also helps. It is akin to the current environment when risk free rate is 4%. If you lost 10% on some investment, cut loss and put in T-bills, you get it back and a bit more in 3 years. But with Pepsico, you just have to wait for compounding to do its work.

Anyways, let’s go through some of its key risks:

Market correction / valuation compression

As valuations are not cheap (25x PER and 18x EV/EBITDA), Pepsico and similar companies are vulnerable to any kind of market correction. Hedge funds, institutional investors will sell large, liquid and expensive names which in the past has caused 25-30% drawdown for Pepsico. This, in my opinion, is the biggest risk because it will take 4-5 years of compounding to clawback negative 25-30%. But if it falls that much, also means it will be a good opportunity to accumulate if the other risks listed below are non-issues.

Competition

This is another good point picked up by ChatGPT although its explanation was not good enough. Pepsico is constantly bombarded by competition. Arch-rival Coca Cola will not stop hammering at Pepsi’s drink business and in this new economy, there are endless shelves on Amazon and so part of its moat of having good distribution to supermarkets and good bargaining power for shelf space has become mooted. There are also new niche brands coming out every other day. Singapore’s own Dangerously Addictive Irwin’s Fish Skin and Potato Chips made such a big splash in the local scene in a few short years. You can imagine globally how many niche brands are chipping away Pepsico’s shares in both snacks and drinks.

Of course the mitigating factors are also spelt out above. Pepsico will enjoy lower costs, cheaper marketing dollars and a lot more resources to crush anyone because of its scale. Pepsico can just buy Irwin for USD250m tomorrow, which doesn’t move the needle at its USD250bn market cap and *poof* this competition is gone.

Regulations

Large companies are always vulnerable to regulatory risks and Pepsico, with its addictive sugary drink and salty snack portfolio is always in the cross-hairs of regulators’ firing squad. In the ten years from 2012 to 2022, a slew of countries passed sugar or soda tax laws to reduce consumption of sugary drinks because it became medically proven and established that sugar causes diabetes. Similar to tobacco taxes, this was argued to be good for humanity. Pepsico’s share price reacted negatively whenever announcement of countries passing the such tax bills hit the newswire. But compounding has since done its magic and it is not longer talked about today.

However, regulatory concerns will continue and in today’s context, extensive use of plastic and PET bottles could be targeted. Or anti-competitive moves could be picked up by the authorities. Lawsuits can also hit share prices. Johnson & Johnson was recently hit by Talc baby powder lawsuits (which we all used!) but a quick search will show it had been hit so many times in so many different products over decades.

While most companies survive such sagas, once in a while, we see companies falter and unable to recover. Recent examples not in the FMCG industries such as Bayer and BP come to mind. We just have to be mindful that this is part and parcel of investing in large prominent companies.

Poor execution

Highly cash generative companies can be more prone to execution risks because they are constantly being asked to distribute the cash back to shareholders if they have nothing better else to do with it. As such, management find it irresistible to buy things. Doing M&A is fun, you meet other companies senior executives, wine and dine with investment bankers’ money, get to travel and just in general being viewed internally as doing something transformative. But we also know that c.60% of all M&A fails and companies get saddled with debt.

Gladly, Pepsico does not have this problem for now. It has done very good M&As and it has also returned a ton of money to shareholders. We have a chart further below showing that the company executed 51 years of consecutive dividend hikes. Gosh, that’s more years than yours truly has spent on Earth.

4. Valuation

Today we will use four valuation methodologies (FCF, EV, PER and Dividend) to triangulate (or quadriangulate) the range of intrinsic value for Pepsico. 

This rest of this post is on Substack 

Huat Ah!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

Partnership with Globe Newswire

Globe Newswire provides salient financial news update and we have dedicated a page for readers to check out the news provided. Globe Newswire is part of the Notified platform. According to its website, Notified is the world’s only communications platform for public relations, investor relations, and event experiences to drive meaningful insights and outcomes. 

Notified works with more than 10,000+ global customers, from growing businesses and new IPOs to some of the world’s most recognizable brands. With a suite of world-class, award-winning communications solutions, Notified provides its clients the relevant tools to effectively reach and engage customers, investors, employees, and the media. With the partnership our infosite can also now leverage on this platform to share news and updates!

Huat Ah!

SGX

This post first appeared on https://8percentpa.substack.com/p/investment-idea-5

Exchanges are the core hubs of financial activity when it comes to stocks, shares, some traded bonds and in today’s context, ETFs, derivatives and a suite of financial instruments As such, today’s idea is another Singapore company that has built its business as the electronic trading marketplace for stocks, bonds, derivatives and other financial instruments. 

The Singapore Stock Exchange or SGX is Asia’s most international multi-asset exchange and is one of the most profitable companies in the Straits Times Index with operating margins at c.50% and ROE at c.30%. It has been a phenomenal compounder since IPO. It started trading at 30c back in 2001 and the share price today is $9 and its market cap is slightly shy of SGD10bn while its revenue topped SGD1bn for the first time in 2021.

1. Fundamentals

SGX, like many other global exchanges which are highly profitable, trades like a start up with its market cap at c.10x of its revenue (i.e. c.10x Price-to-Sales) but it is justifiable because profits are ridiculously high. The key difference: startups at 10x Price-to-Sales are usually still in red. They are selling a concept, a dream. Exchanges have made those dreams reality, churning out crazy profits. Importantly, valuations based on earnings, as we shall see later, make sense. We will also compare across different exchanges, they are all drowning in profits. 

Why are exchanges so profitable? 

First, the business has no cost of goods sold. The platform provides the venue for buyers and sellers to transact. There is some cost but it is negligible compared to a manufacturer requiring raw materials or airlines requiring heavy investments to buy airplanes. Furthermore, when the platform establishes itself as the venue of choice, naturally it attracts more buyers and sellers. Like grocery stores and marketplaces, exchanges are about connectedness. The more you connect market participants, the more others will want to join. In financial markets, this translates to liquidity, the ease to buy and sell shares, bonds and other financial instruments. If you wanted to buy shares of Singapore Airlines, well, the Singapore Stock Exchange is most liquid exchange to buy from and for some retail investors, it is also the only place to get those shares because they do not have global brokerage accounts or are simply not comfortable to buy the depository shares or receipts on other exchanges. 

This brings us to the second point. Exchanges are also monopolies. At the height of the FAANG boom, if you wanted to trade the FAANG* stocks, the natural venue is NASDAQ. Before that, if you wanted to trade the cool China internet names or industrial names during China’s boom in 2003-07, you got to go to the Hong Kong Stock Exchange and in the 1980s, if you wanted Japan exposure, there is only the Tokyo Stock Exchange. Singapore stocks do not have the same drawing power but the SGX team has more made up for this shortcoming by targeting very niche instruments and becoming the marketplace for trading such instruments. 

To list a few examples, SGX today has positioned itself to be the exchange for commodities like iron ore, rubber, some petrochemicals and certain types of forex and futures derivatives. In the past, SGX was also a pioneer in launching REITs and ETF products in Asia and continues the lead today with a large number of listed REITs and it recently established itself as one of Asia’s largest international trading venue for Chinese fixed income ETFs.

Building on core bases such as fixed income and cash equity trading and clearing, securities settlement and depository management, SGX has also branched into the indices and connectivity (co-location) businesses, which provides market data and collects licensing and subscription fees, which forms the base of its recurring revenue. This helps to reduce the volatility of earnings as these businesses are less impacted by market volume. By my estimate, recurring earnings from such operations contributes c.25% of overall profits and will continue to grow (see segment information above). 

The crux of the exchange business is also its scalability on the same platform with very little additional overheads required when growing revenue. This can drive supernormal profits thanks to the proliferation of electronic trading. Trading systems are not as expensive as banking systems and capex intensity is very manageable at c.3-4% of revenue (c.SGD30-45m). Additional trades simply create revenue that drops straight to profits. For banks, their systems need to handle ATM withdrawals, cross-border money transfer, fraud detection which incurs a lot more costs.

Besides systems, SGX has labor cost as the other big cost component, as with most other exchanges. It employs c.1,200 people and pays out c.SGD240m in salaries. There is also processing costs and royalties but those are smaller compared to IT systems and salaries. The end result is this high margin (OPM at c.50%) cash generating machine churning out almost half a billion in net profits which is almost fully paid out as dividends annually.

This story is the same as we look across global exchanges:

SGX is also highly free cashflow (FCF) generative. It only had a single year of negative FCF in 2001 when the dotcom bubble burst. Since then, the company made c.SGD300-600m of FCF annually over the last 10 years which it is mostly paid out as dividends to shareholders. The largest beneficiary of which is Temasek, which owns 23% of SGX and therefore receives SGD60-120m annually which has more than covered the original investment cost after collecting this amount for the last many donkey years and yet the stake is still worth c.SGD2.3bn today. 

*FAANG was the acronym for the hottest internet stocks from 2015-2022: Facebook, Apple, Amazon, Netflix and Google, before Facebook and Google changed their corporate names to Meta and Alphabet respectively.

Risks

Is it too good to be too profitable? The affirmative answer to this question is one of the key risk for SGX. When the company has money coming out from its ears, management simply cannot resist the urge to spend. Over the last few years, SGX spent more than half a billion dollars buying companies and goodwill on its balance sheet is now SGD708m which is c.45% of its equity. If this is impaired, the share price would collapse. 

The second risk is competition and how can SGX stay relevant. As alluded above, Singapore is not Hong Kong or NASDAQ and we do not have sexy stocks or sectors that can drive investors to come to trade. The SGX model is built diligently on niche markets which could simply migrate elsewhere tomorrow. SGX’s management knew this and desperately wanted to create stronger business moats. In 2011, SGX tried to make a joint bid for the London Metal Exchange (LME) after failing to acquire ASX, the Australian Exchange. LME was ultimately sold to SGX’s arch rival HKSE for c.USD2.2bn.

It is difficult to say if SGX have strong moats around its niche instruments. The mitigating factor is that SGX has managed to grow its revenue steadily from c.SGD200m in 2013 to more than SGD1bn today. In some ways, the SGX growth story draws parallel with Singapore’s own story. We have nothing yet we built a modern city state that thrives on efficiency and effectiveness. Things just work and foreigners loved it! Now Singapore is well-known as a global financial hub and that has contributed to SGX’s moat directly.

2. Technicals

Despite the strong business model, SGX’s share price has gone through a roller coaster ride during the pandemic. It rode to a $11 high and then dropped almost 1/3 to $8 and is now closer to $9 today. The main reason could be the dividend, which wasn’t increased when everyone expected them to do so for FY ending Jun 2023. The other could the risk that we discussed above, the company is squandering away the money into bad M&As. 

For the above reasons, share price is not too far from the pandemic low of $8. Recall that this is a level at the height of global pandemonium during covid and market participants capitulated. The most bearish sellers sold out and the stage is cleared with all selling pressure abated. As such, prices then (around Mar 2020) marked a strong support level and we are at a mere 10% above that. This makes things interesting.

$8 has been a very strong support for the stock over the last 5 years and if we go further back in time it was hovering at $6 for a long long time. But it is very hard to imagine SGX would trade to that level because that would mean that dividend can be c.6% and PER is at 13-14x which would make it the cheapest exchange (based on the peer list above) by 7-8 turns and provide us the opportunity to buy a high 15-20% sustainable ROIC at c.8% FCF yield. 

So I would draw the downside at $8 and not $6. Conversely, the upside is dictated by the recent $11 but also the valuations of its peers which can be as high as 30x PER, 19x EV/EBITDA and as low as 3% FCF yield. Assuming SGX can generate 50c in EPS in the near future and applying 25x to that, we are talking about the stock going to $12.5. This does not account for the net cash it has on its balance sheet. 

So in terms of risk reward, we have the risk of falling to $8, which is 20% downside from here, but the upside could be $11-12 which is 15-25% upside. Even if we assume the stock falls to $6 which is a scary 47% downside, we have strong compounding as the tailwind which means the stock should double over next 6-7 years. The strategy would be to buy on dips if the stock for some reason collapses to $6, then we will buy more and enjoy much more compounding in the years ahead.

3. Valuations

As with the previous ideas, let’s use the usual three valuation methodologies (FCF, EV and PE) to triangulate to a more concrete intrinsic value. On FCF, we have it at c.SGD500m and using the same 3.5% FCF yield that we used for Vicom given its strong fundamentals, we get to SGD14.3bn and adding back its SGD200m cash, we get to SGD14.5bn of market cap. 

The rest of this post is on https://8percentpa.substack.com/p/investment-idea-5

Huat Ah! 

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

Thoughts #32: Tharman wins!

Singapore has its first Presidential Election in 12 years and the ruling party's chosen candidate Tharman Shanmugaratnam has won with an overwhelming 70.4% share of the vote. Our First Lady would be Jane Yumiko Ittogi, a lawyer of mixed descent whose father was Japanese but she grew up speaking Teochew in Singapore. Tharman would be Singapore's first elected non-Chinese President by the people. 

As the saying goes, the stock market is a voting machine in the short run but a weighing machine in the long run. We do not vote rationally and most market participants do not buy stocks rationally. Hence we see bubbles and crashes all the time and stocks can trade at 50x PER and people buy them knowing they are getting 2% earnings yield ignoring the fact that they can buy T bills and earn 3+% risk free.

However, in the long run, the dues will always come. The stock market is a weighing machine and weighing machine never lies. Mr Tharman's track record as a formidable politician provided him the win today but will be judged again during his term as President. Hopefully he can propel Singapore to ascend further in the global arena and more of our stocks can trade at higher valuations, validating what he said about Singaporeans enjoying the Singapore premium.

Huat Ah!

China's Lehman Moment

When the GFC broke out, we discussed that the repercussions will be felt worldwide across many years. In 2015, it hit Europe hard with the Grexit crisis and it was said that Asia and China needs to see its own Lehman moment. 

I think we just witnessed that - Country Garden's default and the collapse of Evergrande.

The buildup of woes at Evergrande was well known but no one thought that the biggest developer Country Garden could face issues. Now, all is laid bare and we know how deep the issues are. Property is a huge part of China's economy and when this piece of the chain breaks, it threatens the entire financial system. China's GDP growth may fall below 5% and there are concerns about China going into deflation, following Japan's experience in the 1990s.

Chinese authorities recently launched a stimulus bid by allowing major banks to reduce mortgage and deposit rates to boost sentiments. The stock market reacted positively for two days but the bullishness has since faltered as investors confidence remained low. The draconian measures to curb the Chinese private sector, notably private education and internet / gaming sectors remained fresh on people's minds and many market participants are still licking their ghastly wounds.

The representative stock would be Tencent (chart above). Once the darling of Chinese stock market, along with Alibaba, it is now trading not far from its pandemic low and the drawdown from 2021 to the bottom this year was a whopping 70%. The broader market is similarly trading near all time lows. See 2828 HK below.

China has been the world's growth engine for the past two decades and with this engine gone and with US equity valuation still high, it is unclear to me how markets can continue to rally. With risk free rate at 3-4%, the big question is why would anyone buy anything at 40-50x PER? We might be due for a big correction but as ex-Citi CEO Chuck Prince famously said in 2007:

"As long as the music is playing, you gotta keep dancing"

So, we continue to buy 50x PER names and not worried about just getting 2% earnings yield even though it doesn't make sense any more because risk free rate (or yield) is now 3-4% in the US. Interestingly, we can buy Chinese banks at 5x PER and receive 6% dividend yield but no, investors will still prefer 50x PER concept stock in the US rather than invest in China.

Many global investors believe that China could be an un-investable market as long as Xi continues to rule with an iron fist with the wrong advice and motivation from his top echelons advisors and inner circle. While he is not Putin, he needs to be more pragmatic and focus on the economy rather than his ego and China needs to return to the pre-pandemic days of embracing innovation, restore diplomacy and providing entrepreneurs freedom to grow their business domestically and then expanding globally to challenge western rivals.

Let's hope that can happen.

Huat Ah!

Vicom

I have written about this name in 2017 and not much has changed since then. The stock did well and the thesis played out and it seemed that it should continue to perform. The company entered a rough patch during COVID and I think this presents an opportunity for us to buy / add today. 

The following is what I wrote on Substack a few months ago and am reproducing here.

Vicom is Singapore's leading testing and inspection company with two core businesses. The first is the vehicle inspection business which it has 70% market share across 7 inspection locations in Singapore. The second business housed under the brand SETSCO does industrial testing and calibration. It also provides certification services to various industries. The important ones are construction, oil and gas, aviation amongst food, sanitation and other test-heavy industries.

1. Fundamentals

I believe little has changed since my last analysis a few years ago. Vicom enjoys very strong fundamentals with stable demand that comes from regulatory requirement for vehicle testing. It conducts tests for 500,000-700,000 vehicles annually across its 7 test centres in Singapore. There is room to increase pricing as with everything else in Singapore.

SETSCO which makes up its second business in industrial testing, benefits from the global ESG* global trend. There will be more requirements and demands for tests and certifications in various industries. Singapore, the South East Asia’s hub for many industries, can also attract companies to do tests from other countries and SETSCO stands to benefit from this.

The company stopped disclosing the business splits years ago. We can only speculate that revenue is split roughly half in each and margins also more or less similar at 20+ percent. Putting the two businesses together, Vicom comes out as a solid compounder. Its revenue has grown from c.SGD50m in 2003 to c.SGD100m today. Similarly, its operating profit expanded from c.SGD11m to SGD30m with margins maintaining at 20-30% throughout the last 20 years

The ompany has never had a single year of negative free cashflow (FCF). It averages c.SGD20m over the last 20 years and is poised to generate a higher average over the next 10 years. In some good years, it has achieved over SGD30m and as you can imagine, cash has piled up nicely, reaching SGD100m back in 2017 but is at SGD65m today after returning some to shareholders. Its ROE is a healthy 18-20%, mostly on the back on strong margin and high asset turnover

Risks

That said, Vicom is not without risks. Every investment idea will have downside and it is vital to get these out in the open. Nothing is worse than being blindsided by obvious risks that we should have considered. Even when we have identified the risks, we have to keep monitoring and make sure things are under control. It will take willpower and courage to cut loss when things go wrong. Case-in-point is Hyflux, Singapore’s poster child in water purification that went bankrupt. I lost 100% of my capital even though I identified the key risk!

For Vicom, the key risk pertains to its passenger vehicle business. While this business does not account for the majority of revenue (only c.30% or less of overall revenue by my estimate), it is very visible and top of mind. Analysts and market participants immediately think about the drop in the number of passenger vehicles in Singapore when stratospheric COE prices and vehicle quotas are announced. These announcements come regularly!

It may be true that the number of passenger vehicles in Singapore will not increase much. But the majority of inspections are actually made on commercial vehicles (trucks, lorries, buses and also taxis) and importantly, there is room to raise prices to offset any volume decline. As such, the bigger risk, in circumspect, is the cyclicality that comes into Singapore’s economy for both vehicle inspection and industry testing and certification businesses

Vicom's end customers are subjected to the whims and fancies of business cycles. This is more pronounced in Singapore because we are a small open economy in the global ocean with big fishes generating bigger waves. In 2016, Vicom suffered a small revenue decline in more than a decade as the global economy plunged into crisis with China slowing down and Europe imploding on Grexit and Brexit. Although the share price did not react much, it did stagnate until 2019 and only crossed $1.5 for the first time around June in the same year.

Then in Mar 2020, at the height of the pandemic, share price suffered a 20% drawdown and fell through $1.5 again. On hindsight, that was also a good opportunity to add to this rare Singapore compounder

2. Technicals

This is a good segue to talk about technicals. As mentioned, all stocks have risks and the even best compounders suffer from drawdowns. With Vicom, we face a similar situation as the share price dropped from $2.1 to $1.9, c.10% decline in the last few months of 2022. This was likely due to:

• a slight decrease in dividend and special cash over the calendar year when comparing 2022 against 2021 (8.5c vs 9.2c). Singapore shareholders hate dividend cuts. So, they voted with their feet (or sell orders in this case).
• the relentless increase in COE prices bringing the initial cost of owning a car to SGD150,000-200,000 which was enough to buy a small 3-room HDB flat just a decade ago. Market is postulating that the Singapore car population will decline, therefore the number of inspections will decline and hence the share price weakness

This presents the opportunity for buying as the risk reward is now favorable. We shall further illustrate below:

The pandemic low for Vicom was $1.75 in Mar 2020. We always refer back to this period because the market exhibited complete pandemonium as panic and uncertainty gripped the world back then. As such, share prices around this time should mark the low price where shellshocked shareholders cowering in fear will capitulate when everything is messed up.

This is not to say that prices will not fall below this level. We have seen a lot of stocks trade below their Mar 2020 lows, like Netflix (until recently) and Peloton, the Netflix + bicycle gym stock darling of 2020-21 (PTON US) and Zoom Video Communications (ZM US). But for Vicom, with its stable business profile, $1.75 should represent some sort of threshold and we are here today!

In terms of risk reward, downside is limited from here, but the upside could be $2.4, which was the recent high. This is c.26% upside. Since this is a compounder, assuming that it compounds at 7%, the stock should double in 10 years (the famous rule of 72). So we are talking about c.9% downside but c.40% upside over a few years. Meanwhile we are also getting c.4% dividend annually

To add a cherry on top of the icing, Vicom is 67% owned by Comfort Delgro, the transportation conglomerate in Singapore that operates taxis, buses and the North East Line. For historical reasons, and because its fleet of taxis represent one of Vicom’s largest source of business, it has held to this 67% stake and suffers a 33% leakage to minority shareholders.

If Vicom gets too cheap, Comfort Delgro (CD) can simply take the whole company private. This is how the math can work. To buy the remaining stake that CD does not own today, it will require approximately SGD260m. This is assuming we put a 20% premium to buy out Vicom at market cap of SGD800m. Vicom has SGD65m on its balance sheet and churns out, say, another SGD75m in 3 years. So, technically, CD only has to fork out SGD120m (SGD260m - SGD140m). At a certain lower share price, for CD, putting some cash upfront to take Vicom private pays for itself.

Therefore we always have this situation that some kind of floor will be put on the share price. Of course, this is a theoretical exercise. We do not know whether CD will ever take Vicom private. But history has also shown that past share price drawdowns rarely exceeds 30%.

3. Valuations

Intuitively, we know Vicom can be worth a lot. Let’s use the usual three valuation methodologies (FCF, EV and PE) to triangulate to some intrinsic value. On FCF, we have alluded to Vicom capable of generating c.SGD30m per year. It did c.SGD18m last year and to be conservative, let’s assume it would do SGD25m on average for the next few years. Assuming it should trade at 3.5% FCF yield given its strong fundamentals, we get to SGD714m and adding back its SGD65m cash, we get to SGD780m of market cap

Based on experience, companies with strong business moats seldom trade above 5% FCF yield (except during crisis) and it gets to expensive to buy them at 2+% FCF yield. As such, I believe 3.5% FCF yield is a good level to get in.

With Enterprise Value or EV, Vicom will likely achieve an EBITDA of c.SGD45m in Dec 23. Using 15x which is near its last 5 year historical average, we get to EV of SGD675m and again adding back cash of SGD65m, we get to market cap of SGD740m.

Lastly, using Price Earnings or PE, Vicom should be able to achieve Net Income of SGD30m in Dec 23 and using PER 25x on the basis of its inherently strong business, we get to SGD750m and adding back its SGD65m cash, we get to market cap of SGD815m

Intrinsic Value

Taking the average of the three market caps, we arrive at SGD780m and translating this into share price, we get to c.$2.2 in terms of intrinsic value per share. This is 28% upside from today’s price and not as mouth-watering but that’s simply a function of the market’s efficiency. As we hold out stock for a couple of years and wait for compounding to do its job, we should see the stock going back to the recent high of $2.4 and exceed that in time to come.

Huat Ah!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

Books 20#: Play Nice But Win

Michael Dell depicted his life story in this riveting book starting from his high school days to his battles with Carl Icahn and finally the birth of Dell Technologies, a USD36bn market cap company today. It was an eye-opening journey into the world of private takeovers, corporate sabotage and how to play nice but win. This book really resonated with me and hence this post to detail my takeaways.

1. Form your team

This is a lesson that most leaders would know. You cannot do much alone. Even Superman needs the Justice League and we have to assemble our own Avengers team to take on the world. Not just any team, but the Avengers team, the best people you can find. Early on in Dell's journey, he sought out people who can help him and that was how he kept scaling and grew Dell Technologies to what it is today.

2. Persistence

In Michael Dell's words, this is the all-important quality and we must always persist and not be defeated by failures. He kept mementos to remind him in bad times how fortunate he was and that kept him going. We give up too early sometimes and that happens a lot with younger and younger generations. I think this is a good reminder for everyone to simply persist.

3. Dell Process

Somewhere in page 284, Dell talked about a proven Dell process, when faced with difficult decisions, lay down the Facts and Alternatives and then decide on the Choice and Commit to it. These are simple truths but in our busy lives today, we tend to just forget and decide base on emotions and other trivialities. 

In my own experience, it is very much about discussing with other smart thinkers. All my bad investment experiences were made alone. I thought it was a good idea myself and went ahead and bought and sold stuff. Only to suffer the consequences. Somehow, for me, talking to people clarifies most things and allow for better decision making. As such, it is important to cultivate a good decision making process, just as Dell did. He even said it is proven! Q.E.D.

4. Play Nice But Win

The most riveting parts of the book has to be his battles with corporate greenmailer Carl Icahn. When facing adversaries, all the above comes in. You need a team, you have to be persistent and you need a good process. Dell fought hard and finally triumph and he did play nice and win. It is not easy because most people don't play nice. If you do, you are playing with one arm tied behind your back. But it is possible. Michael Dell proved it. Just so hard that most people give up. 

That said, Play Nice But Win is a motto that really resonates. Difficult to achieve but the victory that comes afterwards makes it that much sweeter. 

Huat Ah!

Charts #49: HK property prices

I recall thinking HK was the ultimate litmus test on whether property in Asia always goes up. With all the issues, protests and 2047 - full return to China looming, can prices actually hold?

Over the last few years, data has shown that what goes up must come down. On the broad aggregate basis, prices have fallen 5-7%. Amongst the developed cities in Asia, it is by far the worst performing city on a 5 year basis. 

A closer look at the price index chart shows that the drop is worse. From the peak of the index at 400, it has dropped c.15%. That means that some properties could be deep in red, having fallen 30-40%. Those owners could be in a lot of financial trouble.

Our own little red dot has done well so far. But we never know. My advice would be, don't trade your only property. Don't be too greedy and over leverage on multiple properties and in today's interest rate environment, pay down that mortgage fast!

Alphabet / Google

This post first appeared on 8percentpa.substack.com, as part of a new effort to share investment ideas. It is updated in Jun 2023.

Alphabet / Google (ticker: GOOG) needs no introduction. The company is the largest search engine in the world and the giant in the world of online advertising. It controls 40% of the online advertising market while Meta / Facebook has another 20%. Today, GOOG generates the bulk of its revenue from ads via search and its own services (such as Gmail) and Google Networks - websites that hosts its ads. GOOG also provides a slew of critical services that we all know well: Youtube, Google Maps, Android, Chrome and DeepMind amongst many others. In 2015, CEO Larry Page announced that a parent company Alphabet will be created to house Google and its sprawling empire of subsidiaries. 

Thanks to shrewd business strategies and acquisitions, GOOG has managed to grow phenomenally almost without interruption from the beginning. The world might not have seen such a growth juggernaut. It has one quarter (or maybe two) of revenue decline since IPO! The company grew well above 20%YoY for more than a decade and continues to grow into new verticals which it can. These include cybersecurity, cloud services and A.I. enabled voice search could become very big with proliferation of smart speakers in our homes. 

Despite recent noise about chatGPT and upcoming competitors, we believe the company will manage this transition better than it did during the PC-to-smartphone switch years ago. One test of a strong business moat is how our lives would be impact if hypothetically, the company cease to exist. For example, what if there had been no Pfizer, how would our lives have changed? Well, maybe a significant percentage of us wouldn’t be alive since there we won’t be vaccinated for COVID-19. Similarly if Alphabet / Google disappears today, a billion or more people including most of us here will not be able to function. So, the question is, what if chatGPT disappears today? 

Meh, let’s see what’s new on Google News.

1. Fundamentals

We showed a stylized version of Google's revenue breakdown, courtesy of FourWeekMBA a few weeks ago. Google's own disclosure has always been super high level. The following is from its recent quarterly earnings results.

Amazingly, GOOG generates more than the GDP of Singapore with c.70% of its revenue from search and Google Networks, platforms that uses Google to manage advertising. The other three buckets are important by themselves. Youtube, something most kids and teenagers cannot live without today, Android, something most phone users cannot live without today and last Google Cloud, an upcoming formidable competitor to Amazon's AWS and Microsoft's Azure. Perhaps, someday, most business cannot live without these cloud services.

Here's following snapshot of GOOG’s important financial numbers and ratios: 

•  Revenue (2022): c.USD282bn 
•  3 year revenue growth 23% 
•  Gross margin 55% & Operating margin 26% 
•  ROE 24% & ROIC 22%
•  FCF USD67bn and FCF yield 4.3% (Jun 2023) 
•  Net cash on balance sheet c.USD90bn

2. Risks

Every investment has risks and Google's biggest threat today is none other than ChatGPT. As a frequent user, I must say I see how ChatGPT can disrupt Google. It is simply a better way to get answers. That said, Google has launched its own A.I. called Bard. Given Google's early foray into A.I. with its c.$500m purchase of DeepMind in 2014, it should have a good headstart in this arms race. I would believe that the verdict is not out yet. Even if Google eventually loses, we will have time to get out.

The bigger risk today is anti-trust and lawsuits. Google has dominated the search world for more than two decades and governments around the world has tried to break this dominance. According to chatGPT, the following are the biggest fines against Google over the last 10 odd years.

1. European Commission Fine (2018): In 2018, the European Commission imposed a record-breaking fine of €4.34 billion ($5.1 billion) on Google for violating antitrust laws. The Commission found that Google had abused its dominant position in the mobile market by imposing illegal restrictions on Android device manufacturers and mobile network operators.

2. European Commission Fine (2017): In 2017, the European Commission fined Google €2.42 billion ($2.7 billion) for favoring its own shopping comparison service in search results and demoting rival services. The Commission considered this practice to be an abuse of Google's dominant position in the search engine market.

3. European Commission Fine (2020): In 2020, the European Commission fined Google €1.49 billion ($1.7 billion) for abusive practices in the online advertising market. The Commission found that Google had imposed restrictive clauses on third-party websites, preventing them from displaying ads from Google's competitors.

4. Federal Trade Commission (FTC) Fine (2012): In 2012, Google agreed to pay a $22.5 million fine to settle charges by the FTC. The charges were related to Google's tracking of users of Apple's Safari browser without their consent, in violation of an earlier privacy settlement between Google and the FTC.

As we know, ChatGPT is known to have accuracy issues. So we need to verify the details. A simple search showed that EU indeed fined Google c.USD5bn in 2018 and the litigation process is still underway today. Google's legal team has 400 lawyers and Google's court cases have its own wikipedia page with a long list of past lawsuits. 

https://en.wikipedia.org/wiki/Google_litigation

3. Technicals

GOOG peaked at c.$150 and was at c.$100 just a few months ago which was attractive. Share price has since rallied to $123 and I would argue that the margin of safety is no longer big enough. In market cap terms, it is USD1.6trn today and USD2trn at its peak. Share price bottomed at $84 in Nov 2022. At the height of covid in Mar 2020, it was c.$50. The stock went for a 20 for 1 split in July 2022 and these are no.s post split. 

If we use $50 as the low, $123 for current price at $150 for the upside. The risk reward is now skewed towards the downside. We have to make the assumption that share price can see $200 or more before the risk reward becomes palatable. As such, based on the above, Google is not too attractive for entry today, but since I am holding on to it, I will continue to do so unless there are more attractive similar opportunities out there.

4. Valuations

The chart below compares Google with its associated peers which may or may not be direct competitors. We can see that Google trades below this peer group average for all measures (PE, EV/EBITDA, Price-to-Sales or PS and FCF yield). It is worth noting that Free Cashflow (FCF) was USD11-13bn in 2012 and if we extrapolate its growth from then till now, it should be able to generate USD100bn in FCF in a few years alongside Apple. Although Apple would probably also grow its FCF bigger, maybe to USD150bn!

Triangulating the various valuation metrics below, we can see that Google's upside range from -9% to 17% which, as discussed above, does not warrant enough margin of safety.

If we bump up the multiples across (FCF to 30x, EV to 18x, PER to 25x and PS to 8x), we do get some upside but that's really stretching and not wise with the global recession looming and the disruption of chatGPT uncertain.

Previously at Substack, we had GOOG’s intrinsic value at $150 which was its peak in 2022. Perhaps things shouldn't be changing too much in just 6 months. Alphabet / Google is a HOLD now.  

Huat Ah!