The writer is an avid NextInsight reader and value investor, who owns shares in Asia Enterprises.
Background: Rising Iron Ore Prices
In late March 2010, Brazilian iron ore mining giant, Vale SA, broke away from convention and pushed through a new contract that sets iron ore prices on a quarterly basis instead of an annual basis. The other iron ore majors, BHP Biliton and Rio Tinto, followed suit with similar changes of their own, citing that the quarterly spot market basis for determining iron ore prices was more transparent.
This new practice has seen steelmakers fighting back as they envisage substantial price increases for the raw material of steel. But already, Japanese steelmakers have caved in to a 90% price increase for iron ore contracts with Vale SA.
A drastic increase in iron ore prices will translate into higher steel prices, and push up prices for just about any product in the world that uses steel as a manufacturing material. Closer to home, the marine and construction sectors are most likely to feel the pain as steel represents a substantial portion of costs in any project.
What is a serious investor to do about such circumstances? As Charlie Munger, the vice-chairman of Berkshire Hathaway, is apt to say “Invert, always invert”, investors can take a page from his playbook and invert their thinking and focus on which companies might actually benefit from the increase in steel prices.
One such company is Asia Enterprises, which is listed on the Singapore Exchange but uncovered by the analyst community. (The lack of coverage is not a bad thing. Invert, always invert.)
Father-daughter team at Asia Enterprises: Executive chairman Lee Choon Bok and MD Yvonne Lee.Photo: annual report
Company and Industry Overview
Asia Enterprises is a major distributor of steel products to industrial end-users in Singapore and the Asia Pacific region. The company supplies a wide variety of steel products to customers involved primarily in shipbuilding and marine relation services, oil and gas, construction, precision metal stamping, manufacturing and engineering industries.
Asia Enterprises also has a joint venture with Marubeni-Itochu Steel Inc through which it provides precision steel processing services.
The company began life in 1961, entered the steel distribution business in 1973 and was listed on the Singapore Stock Exchange in 2005.
The steel distribution business is a notoriously tough business environment to operate in. Steel distribution companies operate as the middleman between the steel production mills and the end users. Stockists are required by the nature of their business to maintain an inventory of steel products to service their end-users and it is the maintenance of an inventory that makes this business a dicey affair.
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To remain profitable, the stockist has to make two correct ‘calls’ regarding the price of steel - once when purchasing the steel from the mills, and another when selling the steel to the end user. In a rising market, stockists have little to worry as they most likely able to on-sell their inventory to end-users at even higher prices.
It is in a peaking market where most stockists find their profit margins on shaky ground. Peaking markets are followed by a period of depressed prices when market conditions correct. This leaves stockists with steel products bought at peak market prices which have collapsed in the ensuing down turn.
While volatile market conditions produce a deluge of red ink for the industry, they also readily separate the boys from the men. One has to consistently gauge market conditions, and buy low and sell high, a scenario that is considered ideal by any trader but not easily achieved.
Any changes in conditions on either side of the market would affect the selling prices and margins of the stockist.Coupled with the fact that the steel distribution business is a fairly commoditized business, each stockist has no competitive advantage or pricing power to speak of. Steel products from stockist A is almost a perfect substitute for steel products from stockist B. Competition amongst the stockists is likely to be entirely based on price. The cheapest offer wins.
Track Record
Given the bleak industry conditions, you would expect that the players suffer from poor margins and lumpy profit records. While there are quite a handful of steel stockists listed on the SGX, few if any at all can boast a track record as sterling as that of Asia Enterprises.
In fact, Asia Enterprises’ track record seems to be an outlier in this field. Since entering the steel distribution business in 1973, Asia Enterprises has maintained a 36-year track record of profitability. With its profit for 2009, the company extended its profit streak to 37 years.
This track record comes as a surprise especially in the context of 2008 market conditions, which saw unprecedented volatility for the global steel market. After peaking in July 2008, the ensuing credit crisis and economic downturn crushed steel demand from end-users, resulting in a sharp decline in global steel prices, particularly during the last quarter of 2008.
Still, Asia Enterprises managed to record S$7.5 million of net profit on the back of S$177.3 million in revenue. These results were delivered despite a S$24.7 million write-down in the value of their steel inventory in view of the severe decline in steel prices.
Prior to 2008, the company had been maintaining net margins of about 10% each year, a result that is very respectable in the steel distribution business.For FY2009, the company’s net profits inched forward to S$8.1 million despite a decline in revenue to S$145.6 million.
Management Policy
Perhaps one of the main reasons Asia Enterprises has been able to maintain such an operating record is their corporate policy of eschewing volume in favour of margins. By doing so, the company does not need to maintain too large an inventory, thereby avoiding tying up capital and subjecting itself to price volatility. This focus on margins allows the company to maintain decent returns on equity.
The other crucial factor is that Asia Enterprises operates in a net cash position. It maintains a cash position of S$32.6 million and carries no debt on its balance sheet. This pristine balance sheet condition gives Asia Enterprises the ability to hold on to inventory and wait out soft market conditions. It would not be forced to churn revenue (at the expense of margin) or conduct fire sale of its inventory just so it can meet interest or principal payments.
In addition, operating from a net cash position has its advantages as well. It allows the company to capitalize on soft steel prices to build up an inventory in anticipation of a market recovery. It might even allow the company to profit from inventory fire sale conducted by competitors.
Moving forward, the management of Asia Enterprises expects to carry on business in exactly the same manner as it has done so for the past 37 years. Management continuity is almost assured in hands of the Lee family. But judging from the track record of performance, shareholders should be loathe to demand any change in management. Five or ten years from now, barring any shift in management policies, the company is still likely to sport a lean operating structure backed by a strong balance sheet.
Value Gap Asia Enterprises is currently trading at 0.75 times of NAV. Looking at the balance sheet condition and track record of the company, one would be hard pressed to explain why the company is trading below NAV. 54% of the market capitalization is made up by the company’s net cash hoard. The bulk of its net asset value comprises its cash hoard and inventory. Logically, by trading the company at 0.75 times of NAV, it seems the market is discounting the value of its inventory (since it would be absurd to discount cash). Given the impending rise in steel prices, it is unlikely that inventory would be written down. If anything, the inventory would be worth significantly more than its carrying value on the balance sheet since there is a lag time of 3-4 months between the placement of orders and the arrival of inventory. From the EV/EBITDA point of view, the company is trading at a rather cheap 4.4, due to its large cash holdings on the balance sheet. If rising steel prices do translate into higher earnings, this ratio would be further compressed, offering a rather compelling value story. As such, the reason for a profitable (and likely to be increasingly so) company to trade below NAV is Mr Market is simply not paying attention. Mr Market may have cast this company out during the economic downturn of the last two years and have written it off. At the very least, the company ought to trade at book value, returning an investor about 25% for holding an unloved stock. |
Dividend payout ratio
Since 2006, the company has stuck to a 40% payout policy, which has translated into a steady and respectable income stream for an investor.
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Given the current climate of rising steel prices, and baring any unforeseen circumstances, the company should not face much difficulty in maintaining its 2009 payout level of 1.2 cents per share.
In fact, the company should be able to increase earnings between 20-25%, roughly translating into a dividend of 1.43 cents per share.
At the present price level of $0.28, that is a 5.1% yield. Effectively, the company is paying investors a rate that is much higher than fixed deposits or government bonds to wait for the value gap to narrow.
Investors should note the payout levels for 2006 and 2007 when the economic cycle and steel prices were at a peak. It offers a glimpse of the effect of rising steel prices on the company’s earnings.
One Man Show
One concern, however, is that the success of Asia Enterprises appears to hinge on the presence (and continued presence) of Mr Lee Choon Bok. It would not be an exaggeration to say that he was the key man in delivering the company’s track record.
As of January 2010, his daughter, Ms Lee Yih Chyi, was appointed to succeed him as Managing Director. Mr Lee continues as Executive Chairman. Ms Lee is not new to the company but it remains to be seen whether she is able to deliver similar results.
Impediments to rising steel prices
Given that steel is an important commodity used in practically every facet of industry, the iron ore miners may face some headwind in their attempt to raise prices. The World Steel Association, which includes 19 of the top 20 steelmakers and comprising 85% of global steel output, has called for market regulators to examine the market for iron ore and the market behaviour of the three iron ore majors.
In a similar tone, the China Iron and Steel Association has expressed its opposition to the 90% price increase that has been accepted by Japanese steel mills. Considering that the three iron ore majors control about two-thirds of the iron ore trade, their ‘oligopolistic’ attempt to raise prices will not be looked upon kindly.
Nevertheless, some steelmakers have already accepted higher iron ore prices as a forgone conclusion. In fact, some Chinese steel makers have said negotiations with the iron ore companies will probably be futile. In the clearest sign of resignation, ArcelorMittal, the world’s largest steelmaker, announced on 31 March 2010 that it would raise prices by $150 a metric ton this quarter.
Conclusion
Based on current steel market conditions, Asia Enterprises should offer pretty good value for the next year or so. The company is helmed by able management that has not failed to deliver in the past 37 years.
Coupled with an industry tail wind, the company should exceed its performance for 2009. In addition, investors are being paid a steady dividend to wait for the value gap to close. Why then is the market valuing the company at 0.75 times of NAV? Perhaps this is one of those companies that is small enough to escape the radar of the analyst community. History has shown that it pays to dig where the market ignores.
