Saturday, March 28, 2020

What To Do With SQ’s Rights Issue

Last week, our beloved national carrier, Singapore Airlines (SIA), or SQ as it is known by its flight code, announced a bazooka rights issue and mandatory convertible bond issuance to shore up capital in the fight against the coronavirus. The two instruments amount to SGD 8.8 billion dollars but this is just the first wave. The firm alluded to further capital raise of SGD 6.2 billion if needed and subjected to shareholders’ approval within the next 15 months. 

In total, SIA is raising SGD 15 billion dollars which is roughly one year’s worth of revenue (last year’s revenue was SGD 16 billion) but probably 16 to 18 months of its annual cost base. It is also more than 15 years worth of last year’s net profit at c.SGD 900 million. From the balance sheet angle, 15 billion is also bigger than its equity base of SGD 12 billion. The firm cited many use of this massive amount of money but it’s not too important. We all know that without the capital raise, SQ will cease to exist. In accounting language, the firm will no longer be a going concern i.e. SQ will go bankrupt. This is serious! It's Singapore's national carrier, our pride and glory!

How is SQ falling?

Well, we are at war with COVID-19. These are unprecedented times. It was reported that all airlines will fail in three months. With global travel down 25-40%, no airlines can survive without new capital. Three days before the rights issue, SQ announced that it is cutting capacity by 96%. Ninety six percent! Then, we saw this SGD 15 billion dollar bazooka. To put this number in another perspective, this is 125% of its equity base and twice its current market cap. This magnitude is unprecedented and alarmingly dilutive. Essentially, existing shareholders will never see their invested capital if they don’t subscribe. 

SQ was trading at $6.5, the day before the announcement. The market cap was then SGD 7.7 billion dollars. This capital raise (the rights issue and the mandatory convertible bond or MCB) will be SGD 8.8 billion dollars. This means that the dilution will be more than 50% (53.3% to be exact). So whatever intrinsic value SQ should be trading at before, be it $10 or $12, it will only be half of that. We will show the number later in this post but it's hard to imagine SQ going back to $12, ever.

To be helpful with the math, SQ gives us a theoretical ex-rights price (TERP) of $4.4. This means that after the rights issue (just the SGD 5.3bn portion), all things equal, Singapore Airlines' share price should be traded at $4.4 vs the $6.5 the day before, because of the dilution. This does not take into account of the MCB dilution (SGD 3.5bn) and the additional capital raise (SGD 6.2bn) which is subjected to shareholders’ approval. 

That’s a lot of numbers to take in for most people. Some of the details are also not made public and only Singapore Airlines’ shareholders get to see all the numbers. Since I am not a shareholder, I can only analyse with what is available publicly. Here’s two simple conclusions to start with: 

Grounded or Bankrupted? Just kidding...

1. If you are a shareholder, you should subscribe to everything to maximize benefits. But that means coughing out a lot of money to stay in the game. So it's about how much dry powder you have. Do not use too much and don't ever use your savings. Royston Yang from thesmartinvestor reckoned that if someone bought 1,000 shares of SQ at $6.50 (initial capital of $6,500), he has to cough out another $7,450 to subscribe to the rights and the MCB. Do read his well-written post for the details. 

2. If you are not a shareholder, it might worthwhile to monitor SQ closely. It could fall below the theoretical ex-rights price or TERP of $4.4 and that makes it interesting. In an improbable but possible scenario, SQ might fall near or below its rights conversion price of $3. This is an arbitrage opportunity and one can earn a lot of money buying SQ at that ridiculous price (more on this later). Obviously nothing is ever 100%. If SQ falls to $3, it means the market thinks this capital raise is not enough or COVID-19 has won the war or something really apocalyptic. We have to then make a bet that the market is wrong. Remember it is never easy.

But first things first.

Let's try to come up with an intrinsic value for SQ. With that in hand, we can then verify that $3 is ridiculously cheap and justify buying SQ with a good margin of safety. I must say this is just a back-of-the-envelope kind of analysis. I have never been interested in airlines because its business model simply makes it difficult to generate cashflows and compound earnings. But if the share price do fall a lot from here (i.e. fall to $3), it makes an interesting arbitrage opportunity.

Singapore Airlines has never lost money since its listing and its net income hit SGD 1.3 billion in 2018. Its historical high was actually in 2007 and 2008 when net income powered north of SGD 2 billion for two consecutive years. Just looking at its own history, I would say that SQ can do a billion SGD in net income going forward. It has done this before and in the post COVID-19 world, it would be in a better position than most to continue pushing ahead. Singapore Girl Power!

Looking at its EBITDA, which is what most people like to analyze airlines with, we can also see that SQ has achieved SGD 2.5-3 billion dollar of EBITDA annually. Again, this is based on its past track record. I have subscribed to Warren Buffett's view that EBITDA is not worth looking at because it's not cashflow. We are using it here to help us triangulate SQ's intrinsic value. It is also worth reminding everyone here that SQ is not your typical high quality compounding value investor stock. This is just an arbitrage opportunity. If and when this analysis actually plays out, buy SQ close to $3 and sell it at close to $5. That's the thesis.

Okay, so we have the net income at SGD 1bn and EBITDA at SGD 2.5-3bn. Using PE of 12-15x, we have the first estimates of SQ's intrinsic value (IV) at SGD 12bn to 15bn. This is also where its market cap was over the last 5 years. With EBITDA, we would use a ballpark of 5-6x. At 5x, that gives us SGD 12.5-15bn as well! How coincidental!  (Actually, that is usually how valuation triangulation work, the no.s should come close to one another). Since SQ will have enough cash to cover all debt going forward, we can say that its market cap will be equal to its EV. So we have three sets of numbers that point to the same ballmark. I will add a fourth using 6x EV/EBITDA for a blue-sky scenario - SQ beats the coronavirus and rise to glory, take market share, blah blah. You know the story.

1. SQ's market cap at SGD 12-14bn
2. PE based IV at SGD 12-15bn
3. 5x EV/EBITDA based IV at SGD 12.5-15bn
4. 6x EV/EBITDA based IV at SGD 15-18bn (blue sky scenario, SQ did achieve SGD 20bn market cap before) 

Now, with this massive capital raise, SQ's share count will triple from current 1.2bn to c.3.6bn. By dividing the above IVs, we have a range of target prices from $3.3 to $5. I would say that we can take the median of $4.2 as our IV to work with. Coincidentally, this is within 10% of its TERP at $4.4. Recall that the rights issue and MCB allows the shareholder to get more shares at $3 and $1 (technically speaking, shareholders don't actually get it at $1, but simply even more shares), so if the current share price drops close to $3, we will be getting everything with a margin of safety of 40% (4.2/3).

Having said that, SQ is now at $6. It may not fall to $3. In fact, it's probably hard to imagine that happening. But it should fall. So if it falls through its TERP of $4.4, to say $3.9, then we have to start thinking hard. Maybe that's cheap enough. Remember its IV is anywhere from $3.3 to $5. As it gets close to $3, we have to act. In fact, the window will be super short at the bottom. Like just a single day or two. And all bets are off after the rights issue date, since we won't get the rights and the MCB. Hence it's important to have done the work before that.

Hope this helps! Huat Ah!

Tuesday, March 17, 2020

MMM Analysis - Part 2

This is a continuation of 3M's analysis.

In the last post, we gave the background on 3M and why it's a good stock. Today, we shall formally write down its investment thesis, analyze the other positive factors, look at its risks and finally determine whether valuations are reasonable. I find that documentation is really a good practice for all investors. It makes the whole process transparent and we can look at to learn what worked and what did not. So, do write down our thoughts before buying or selling, even if it's just one line.

Okay, here's 3M's investment thesis:

3M is an innovative industrial conglomerate that has built its brand in safety, healthcare and other niche segments in infrastructure and consumer businesses. It benefits from growth in Asia and US healthcare on the back of strong pricing power. The management understands capital and resource allocation well and has delivered a stellar track record of shareholder return. It is also one of S&P Dividend Aristocrat.

The Dividend Aristocrat is a list of stocks in the S&P500 index that has increased its dividend payout for at least 25 freaking years. As of 2020, there are 64 stocks according to the wikipedia page. The table below shows an old list with the annual returns and absolute price change. It seemed that one can get a high single digit return by any dividend aristocrat stock.  

Dividend Aristocrat - Old List

Let's return to 3M, so we have got the investment thesis. We would want to support it with a few strong points. In investment lingo, we usually call these positives. As alluded above, 3M has a few positives going for it. Its growth sectors are Asia, which makes up c.30% of sales and healthcare, which makes up c.25%. There could be some overlaps so growth in total might be 35-40% of sales. As these portions grow, earnings improvement could accelerate from the current low single digit levels to something closer to its historical performance (13% according to the table above).

How did we get these numbers? Can we be sure Asia and Healthcare makes up 35-40%? Well, we can never be 100% sure. It is just a ballpark. In the past, Warren Buffett spent all his time scouring through annual reports/10K year after year to figure all these out. We can still do that today, but analysts, Bloomberg and reports usually do a good job putting all these together. The following are the segment and regional splits we can get from its 10K. The parts in red are of our interest.

3M EBIT split, margins and short descriptions:

Healthcare 24%, OPM 25%, skin and wound care, infection prevention, patient warming and oral care, food safety indicators, coding and reimbursement software etc.

Transportation and Electronics 28%, OPM 23%, display materials and systems, automotive and aerospace, advanced materials and transportation safety etc

Safety and Industrial 34%, OPM 23%, personal safety, adhesive and tapes, abrasives, automotive aftermarket, roofing granules, electrical markets etc.

Consumer 14%, OPM 22%, consumer tapes, Post-It notes, home air filtration, cleaning products, bandages, braces and supports, retail abrasives etc.

Geography split:
US 39%
APAC 31%
EMEA 21%
Latam/Canada 9%

As we can see, 3M enjoys good margins across its business segments. None of the its businesses are below 20% margins. Its geography split is also well-balanced with growth regions making up half or more of its overall revenue. Its ROE is even more spectacular at 40-50% annually over the last few years. Besides its high ROE, we also know from the slide below that 3M is laser focused on good capital allocation and shareholder return.

As such, 3M's exposure to growth sectors (healthcare and Asia), its stellar track record of capital management built on the back of its strong brand rounds up the investment thesis for 3M. Needless to say, it benefits from idiosyncratic events such as the coronavirus outbreak precisely because of its strong brand as a safety and healthcare pioneer.The stock is also a leading barometer for the industrial cycle. It is usually the first stock to recover at the bottom of the cycle. Hence by having the stock in the portfolio, we then tend to be able to monitor the cycle better which helps with our assessment on the other stocks in our portfolios.

In the next post, we shall look at 3M's risks and valuations.

Huat ah!

Saturday, March 07, 2020

Coronavirus to COVID-19, the Woes Continues...

Markets collapsed c.15% over the last two weeks as COVID-19 (renamed from coronavirus) raged and spread across the globe. The infection hit 100,000 people and caused over 3,000 death in 94 countries. The panic buying of toilet paper and other daily necessities in Hong Kong and Singapore were copied in Japan, Italy, US and various other countries. It's a complete pandemonium!

It is inevitable that masks run out. It is logical that people buy up alcohol wipes and disinfectants. It's acceptable that people go stock up on dried food, instant noodles, bottled water and other important items. But why toilet paper? We do not poop more because of the coronavirus. Some patients do vomit but we do not wipe with toilet paper to clean up afterwards. We wash. Toilet paper is not a necessity, we can always wash. Hundreds of millions of people wash daily, because they don't have the luxury of paying for toilet paper. Money needs to be spent on food, clothes, gas, the real necessities.

Why we are running out of toilet paper

The only reason, politically correctly speaking, is baseless fear. FOLO: fear of losing out or FOMO: fear of missing out. The crude Singaporean way of saying it not nicely goes like this. All these people stupid lah, monkey see monkey do, indiscriminately buying toilet paper without using their monkey brain. Most countries do not import toilet paper from China and is self-sufficient. But obviously, if every household chooses to buy and stock up 24 months of usage, no amount of production will be enough. This is human psychology at work and one of the key reasons market goes into bubble and panic mode so often.

The market is going into panic mode today. Highly leveraged companies find themselves in trouble as they lose revenue with the virus causing a huge global supply chain disruption, major slowdown in travel and reduction in consumption. In a normal world, they have access to bank loans, temporary credit lines, their suppliers and customers will give flexibility on payment terms. But as the COVID-19 crisis unfolds, all this goes out of the window.

We already saw Flybe, a UK carrier, going bankrupt. Unfortunately, more bankruptcies will come. Credit default swaps (CDS) are rising for many listed corporates. CDS measures the possibility of default on bonds. It is the insurance that bondholders pay in case the bond goes into default. In normal times, most companies with bonds see their CDS trading at 100-200bps but in recently weeks, CDS are rising by 20-30bps in a week and some companies have seen their CDS spiked.

This is not good. Corporate defaults will put stress on the banks or other parts of the financial system. Frankly speaking, our modern financial system is not very robust. Every crisis had started with stress at the weakest link which hit major financial institutions bringing about the crisis itself. The GFC started with sub-prime, a small niche sector in the US property market. The Asian Financial Crisis (AFC) was triggered by the Thai central bank breaking the Thai baht's peg to the US dollar. This in turn triggered the collapse of a hedge fund called LTCM.

When Genius Failed: The story of LTCM

This is where things get interesting, as we had seen with toilet paper - the actions of market participants causes a snowballing effect which ultimately leads to unfavourable outcomes.

LTCM was a huge hedge fund with 140 billion dollars of asset under management. In 1997, three years after the establishment of the firm, the AFC hit global markets. It turned out that LTCM had bet on many Asian currencies to strengthen and was bleeding. The was because the unpegging of the Thai baht had a contagion effect, and many worried about the ringgit, the rupiah, the peso and even the Singapore and the Hong Kong dollar. 

So most Asian currencies started to fall, worsening the woes at LTCM. What's worse, many other hedge funds had followed similar strategies and held similar positions. The market started to realize they needed to unwind the same trades before others. Just like consumer rushing for the same toilet papers before others bought them clean, traders rushed to put in phone calls to unwind these trades.

LTCM, being the biggest elephant, couldn't move fast enough and was at the verge of collapse. It was believed that while LTCM only had 140 billion dollars, its leveraged trades had nominal values north of a trillion dollars. The Fed had to step in to rescue LTCM because they believed if LTCM failed, it would bring down the whole financial system, triggering massive defaults, bankruptcies and bring about widespread panic.

This was "monkey see monkey do" at its worst.

Okay, back to today's crisis. It looks like it would get worse before it gets better, but it's really hard to time the bottom. My optimistic view is that 12 months from now, things would be better, we would have regretted not buying more. But right here, right now, we can only take incremental steps. Buy some stuff if you see it's cheap enough but leave some dry powder. It can get cheaper.

There is a tail risk that we do get a lot worse, like a pandemic at the scale of the 1918 Spanish Flu (500 million infections and 50 million deaths) or the Black Plague, then we won't be thinking about how our portfolios are doing. We will really run out of water, food and the real necessities. Everybody will wash. Definitely no toilet paper. The only asset in the portfolio that can help us if that happens is real physical gold, not even the gold ETF. Let's hope that scenario will just remain as a discussion topic here.

Meanwhile, fingers crossed. Don't hoard toilet paper.