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Sunday, April 29, 2007

EUROSP - Business Proposition

Imagine you are a business analyst, and your neighbour came over to your house on a Sunday afternoon to seek your advice on a private business matter. Your neighbour is the sole owner of a private business, and is thinking of selling his business in its entirity. The business manufactures and sells a tangible product that is commonly found in most homes, including your own home. He would like to know how much he should sell his business in its entirity.

Since private owners own 100% of the business profits, you naturally enquired about that. Last year the business made $5.8M in after tax profits. This year, for the first 9 months (FYE 31 May), the business made $5M, and if Q4/07 follows Q4/06, then, the business can be reasonably expected to make $7.2M this year, or 24% profit growth. Ok, that’s not a bad growth result.

You further enquired about its balance sheet. Inventory low, receivables low. The company has from time to time made the necessary capital expenditure to maintain and upgrade its plant and equipments, but nothing fancy and kept capex tight. It also continuously kept tight control on costs. The company has no problems paying its suppliers. The company has no debts (neither short term overdrafts, nor long term loans). The business generates strong cash-flows, which nearly all goes to the cash till.

You learnt its management is fairly conservative and prudent. Whilst they have been consistently expanding their business, they have done so at a measured pace. According to your neighbour, the key management staff has been with the company for a very long time, and they are not expected to change.

You were informed that company revenue last year was $64M, and this year, is projected to grow to $74M, or approximately 16% growth.

What about future profit growth prospects? Well, according to your neighbour, the company thinks that whilst the costs of their raw materials are rising, they are continuously looking at ways to reduce usage of the more expensive material, and using cheaper alternatives that do not compromise quality and still meet their customer needs. They intend to spend more money on marketing, research and development to mitigate the effects of the rise in raw material costs. So far, their results have been encouraging, but no guarantees. Last quarter, profit after tax increased to $2.1M, up from $1.02M the same quarter prior year. This represents nearly 100% increase in after-tax profits.

So, the neighbour then asked you how much he should be asking if he wants to sell his private business.

Well, it might surprise you that this imagined “private” company is actually listed in the 2nd Board with the above characteristics. The Company is EUROSP, which is in the timber-furniture based business largely for exports. At last Friday’s closing price, the market is only valuing the company at a measly 2.3 times 2007 earnings. That’s right. EUROSP’s market cap is $39M, the company reported a net cash balance of $22.2M (28 Feb), i.e. EUROSP’s business is available for sale for only $16.8M. In a private market, that would clearly be a steal.

What is even more interesting is the fact that if one does a liquidation valuation for EUROSP, one could come to the conclusion that EUROSP is worth more dead than alive! Don’t believe me? Well, if one assumes only a conservative fraction of EUROSP’s assets in the balance sheet – say 50%, 50%, 80%, 100% of Plant Property Equipment, Inventory, Receivables and Cash – and subtract all stated liabilities in the Balance Sheet at 100% of the values stated, it would give a liquidation price of $0.99! Yes, that’s right. At $0.975, the market is valuing EUROSP lower than its liquidation value! Amazing isn’t it?

So, why does the stock market values EUROSP at such a low multiple? To me, I believe it’s due to several reasons:

1. Inefficient market in Bursa Malaysia, especially for micro-cap stocks and especially 2nd Board counters. Perhaps, there is a fear that micro-cap stocks earnings are rather volatile, although from a private business perspective, EUROSP is clearly much larger than most if not all “Mum and Dad” type private business. Even better, it is listed, its results audited by professional auditing firms such as KPMG and passed Bursa’s listing requirements (which private companies don’t need to comply), so, it should be safer than private investments.

2. No stock coverage by Bursa eResearch, nor any other stock brokerages that I am aware of. Investssmart covered EUROSP last year, and I recalled at least another blog also covered EUROSP. So, this makes it the 3rd blog, and I doubt I will be the last blog to cover it in future.

3. Absence of EPF, foreign investors, and mutual fund ownership, leaving the traded stock portfolio done by less informed retail investors. The Directors (the 3 Guan Brothers) collectively owns 55% of the outstanding shares. They didn’t sell, and interestingly acquired some more shares in 2006. So, management clearly eats their own cake. Institutions with long-term holdings like Ministry of Finance (#5, 3.3%), Lembaga Tabung Angkatan Tentera (#7, 2.4%), Lembaga Tabung Haji (#8, 1.9%), Koperasi Tanah Negeri Johor Berhad (#23, 0.4%) collectively holds 8%. This leaves around 37% of the outstanding shares owned by approximately 2,500 retail (less informed?) investors. It is my personal belief that as more retail investors become better informed, they should have greater appreciation for this stock.

4. It’s a generally thinly traded stock, with low liquidity on most days throughout the year, except the month before and after the ex-dividend date, during the bull run at the start of this year and the recent 228 correction.

5. Up till 2005, the stock paid a paltry dividend or no dividend (in the 2 loss years), causing it to acquire perhaps a boring reputation. However, this looks to be changing in recent years. The company has been steadily increasing dividends in the last 3 years, from 2.1% to 3.1% to 5.9% net of tax dividend yield (based on latest price of $0.975). I am speculating/ expecting the company to continue to pay a higher dividend in 2007, due to its higher earnings results this year compared to last year and its growing cash hoard. Potentially, there might be a lot of room to improve, since the last dividend payment only took 32% of earnings. If the company adopts a 50% dividend payout ratio, 2007 dividends could increase by 50%, potentially causing a fairly large jump in prices. However, it might be safer (albeit potentially lower returns) to look at the Director’s stock movements, to see if they acquire more shares in 2007. If they do, it may be a positive sign that the directors will increase dividends further in 2007, although this is not a guarantee.


It is clear that EUROSP is clearly an under-valued stock. There seems to be some appreciation for the stock, since the stock price jumped more than 7% to close at $0.975, as a result of an excellent earnings announcement. Despite closing at $0.975, it is still trading below its liquidation valuation of $0.99.

Putting on my value investing hat, it is very hard for me to contain my enthusiasm, when I see a stock like EUROSP. Initially, there were some doubts that the appreciating RM and the higher timber prices may cut into EUROSP’s margins. However, the latest earnings results showed that instead of cutting its margins, EUROSP superb management has managed to improved profits by 100%. In a sense, this is not surprising, because EUROSP controls its costs well. Compared to its high debt competitors, its margins are not burdened by high finance costs, giving it a competitive advantage. Further, it’s operations in northern Malaysia probably carries lower wages. It’s high cash position gives it considerable business flexibility. In this sense, I believe EUROSP has some economic moat over most of its Malaysian competitors. As EUROSP’s underlying business and earnings continues to improve, I get more and more excited about the future prospects of this stock, notwithstanding its price action. I will also not be surprised if like ROHAS, one day, the substantial shareholders decide to take the company private, due to its consistently poor valuation by the stock market, and the large cash hoard in the company.

Whilst there is clearly a much higher upside, I believe its downside is rather limited for a long-term investor who is quite content to collect a net of tax dividend yield of 6% per annum.

Mark Tier, in the book “Winning Investment Habits of Warren Buffett & George Soros” describes 3 different successful investor types on page 126. The Analyst (personified by Buffett), the Trader (epitomized by Soros) and the Actuary (who invests similar to insurance companies, such as Graham buying a basket of under-valued stocks. He often doesn’t know which stock will go up (like insurance companies not know who is going to die), but he is quite certain that provided he buys a pool of undervalued stocks – e.g. below liquidation value –then, the stock as a group is almost certain to go up, just like the way insurance companies makes a profit by underwriting a pool of lives at correct prices.). I believe EUROSP is very suitable for either the Analyst, or the Actuary. Either way, I would not recommend anyone to hold more than 5% of their stock holding in EUROSP, not because the downside risk is limited, but because it might take some time for the stock price to appreciate.

As usual, comments welcomed. Use your own judgement, and invests at your own risk.


grahamsmun said...

Dear Seng,
It is nice you have identified companies with large margin of safety co-Eurospan a company involve with furniture(an unpopular and neglected company for analyst).
Keep up with the good work and try to identify more companies as Ben Graham system needs a basket of undervalue stock inorder to manage the risk of neglected stocks continously staying low. As usual this is a patient investment as this company need some time before its true value being discover/accepted by the market.

There is also another company-TAFI which operate in same industry also having about the same profit and cashflow.I think Eurospan & Tafi is the 2 most efficient co in this sector.Please take a look.

Seng said...

Dear Graham,

Thank-you for your kind suggestion on TAFI. You may be aware that TAFI is covered by Bursa eResearch - S&P and MIDF (both Buy) - you might want to check there first. Personally, I prefer EUROSP, but that might just be a personal preference. I also prefer not to have too much weighting in this sector, if it is at the expense of other under-valued sectors.

My own application of Graham's basket of stocks is a personal modification. Graham would just use readily available parameters to purchase 100 "under-valued" stocks, whereas for this basket, I would hold much fewer stocks - I have more than 10, but I think 10 carefully selected stocks would be sufficient, if they are further screened based on other criteria with catalysts.

I also believe that it is important for value investors to learn how to fish for themselves. My hope from my past writings is that they have provided a working guide. I would be happiest when someone else has succeeded in making more money than I have, as a result of encountering my blog. Perhaps one day, when the time is right, you will decide to create your own blog to write about TAFI, or other stocks which you feel is under-valued.