I believe it's better to be late than never. So, here is my Buy Call which I had repeatedly called in investssmart chatbox quite some time ago, and only found the time to do a write-up. As usual, apply your own judgement, and invest at your own risks...
In Berkshire’s annual Chairman’s Letter, Buffett sets out his 6 acquisition criteria. Whilst LITRAK does not meet the requirement in terms of size (LITRAK is too small for Berkshire despite being a solid mid to large cap in Bursa) and debt, I believe Buffett might have considered LITRAK in his much younger days (when he has a much smaller capital to work with) for the following reasons.
1. Consistent earnings power. (with an economic moat)
2. Business earns good returns on equity. Whilst LITRAK might not have met this requirement in the past, I expect the rise in the toll rates since 1 Jan 2007 to allow LITRAK to meet this requirement.
3. Management in place.
4. Simple business (LITRAK’s primary business is operating and maintaining the LDP toll-way, which is a simple and understandable business. It is definitely not high tech - you know what the business is going to look like in 5 years time - and even if the stock market closes for the next 2-5 years, I would not be the slightest worried about LITRAK’s strong earnings).
5. An offer price (which appears daily from the stock market quotes)
In addition, I seemed to recall that Buffett (or Graham) would make an exception to the debt requirement, if it is a utility company (with highly predictable and secured earnings). To me, LITRAK would certainly fall within this category, even though strictly, it is not a utility (power) company because it seem to share many of the same economic and financial characteristics with utilities.
If a stock met all of Buffett’s requirements, his typical approach would often be just to sit tight and do nothing, until the market provides Buffett with a "fat pitch" to buy. If Buffett was a Malaysian, I am 100% sure that he would have swung his bat, when the market provided an excellent opportunity to buy LITRAK at $2.60 during the end Feb correction. At that price, it is only half of LITRAK’s Intrinsic Value. Even at yesterday’s closing price of $3.52, I am still excited by LITRAK, as I believe the market has not yet priced in much of LITRAK’s strong future earnings, and is cautious.
Now, why did I say LITRAK’s Intrinsic Value is above $5+? 3 reasons.
1. LITRAK has raised toll rates by 60% on 1 Jan 2007. The rise in the toll rates are expected to contribute to the bottom line, as LITRAK’s long-term costs have not really changed (with perhaps more maintenance as the roads get older). Given that LITRAK has consistently run at around 45% gross profit margin, this is a huge boost to LITRAK’s long-term earnings starting from1 Jan 2007. (Imagine if you sell an item at $1 previously with $0.45 profit. Now, the item is $1.60 - you can reasonably expect profit to be close to $1, which is more than twice your old profit of $0.45, if revenue don't contracts). Note that this is a once in a decade boost, and the best gain in LITRAK’s prices is expected to be around now (actually, since Mar 5, up to the next earnings report in May 2007), as LITRAK will not increase rates again until 2011 and 2017, which is around 4 to 10 years from now.
2. In addition to the toll hike, LITRAK will also be compensated by the government for charging lower than contractual rates (which is $2.10 instead of $1.60). This is $150M over a 4 year period, or approximately $37.5M per year. In the last 12 months, LITRAK’s gross profit is $113M, so, an additional $37.5M is a huge boost.
3. In addition to above, LITRAK is contractually given the right to further increase rates 10 years from now. I seemed to recall in the original prospectus projections (from another blog) that the rate increase in 2017 is a huge one, that will increase LITRAK’s profitability many times from now. Notwitstanding this, we will ignore this factor for the moment, as my Intrinsic Value of $5+ is not dependent on this.
4. LITRAK also reported that one of its wholly owned subsidiary has recorded a realized gain after 31/12/2006 of $11.4M. I expect this to boost the coming quarterly results, although this is an extraordinary gain.
Because there is such a huge and fat safety margin, I have not bothered to do a detailed projection to LITRAK’s financials. But to be extra conservative, let’s assume that LITRAK’s long-term PAT is doubled last year (this is very conservative). That is, instead of $0.16, let’s say LITRAK’s long term earnings is $0.32. How much should we value LITRAK, given its earnings characteristics?
To me, LITRAK’s earnings is mostly dependent upon traffic volume and growth, which in turn is probably a very stable thing that can be predicted with quite a high degree of precision over the long-term. Yes, initially, after the toll-hike, traffic volume can be expected to decline. Unfortunately, I live in Penang, and don't use the LDP after 1 Jan 07, so, I don't have first hand information about the traffic there. However, I have used the LDP many times before, and in my limited experience, the alternative routes are just terrible. Initially, I probably would try using alternative routes just to save $0.60, but after some time, I would probably accept the toll rate increase and re-use LDP. In other words, I believe LITRAK's revenue problems (if any) will be a temporary one, and not a permanent one.
The risk of management doing something stupid, whilst not zero, is probably quite small. LITRAK’s economic characteristics is so good, that even an average management probably can’t do much harm (unless they go on a spending spree that doesn’t add value, but that would be a stupid management, not an average management). So far, I have not seen any signs of mis-management, but a few signs of prudent management.
If I have to apply a discount rate to valuing LITRAK’s future earnings, I would probably apply an interest rate that is not higher than twice 10 year government bond rates. 10 year bond rates currently runs at 3.5%. Double is 7%. If LITRAK’s future earnings were equivalent to government bond, then, the P/E multiple is 1/7% = 14. This is a conservative multiple in LITRAK’s case, due to point 3. above.
This suggests that LITRAK’s Intrinsic Value is at least $0.32 x 14 = $4.5 or higher. Again, this is a conservative valuation.
A more realistic valuation would probably apply a slightly lower rate of discount, such as 6%, which suggests a P/E of 17. This is close to LITRAK’s historical P/E and would suggest an Intrinsic Value of $5.4.
Of course, this assumes that LITRAK’s long-term PAT is $0.32 which is conservative, since the actual toll hike plus government compensation (i.e. revenue) is more than doubled. Now, think about this for a moment. Even TENAGA, when it raised its rates, only raises it around 12%-16%, not doubled! It will not surprise me if LITRAK’s long-term PAT turns out to be closer to $0.35 or even $0.40. If so, it would suggest an Intrinsic Value much higher than $5.4. In fact, I will not be surprised if LITRAK were to trade above $6 within the next 2 years.
Another view is that at yesterday’s closing price of $3.48, LITRAK seems to be valued at a P/E of 10. For a business with LITRAK’s economic characteristics, this is a steal.
I would not hesitate to recommend LITRAK at current prices to anyone who fits the following criteria:
1. Don’t have time nor inclination to monitor the stock market.
2. Has a lot of cash sitting on F.D. and is certain that he will not use that money in a year’s time.
3. Does not want to buy a stock right now due to fear that the market is close to all time high.
4. Can buy and forget about the stock until say a year later.
5. Who wants to earn superior return than F.D. rates of 3.7% per annum.
To me, it is practically certain that LITRAK will out-perform F.D. within 12 months time.
If you are afraid that LITRAK is currently trading at record levels, then, just buy 20%-33% of the amount you intend to buy, and leave the rest as "spare bullets". I have a feeling that LITRAK might not trade below $3.30 again, the first time that I realized that LITRAK was really a steal.
As usual, use your own judgement, and invest at your own risk.
Disclaimer: I own LITRAK since last year, and has more than doubled my holdings. LITRAK is by far my biggest holding, and is more than twice my next largest stock (MAYBULK & EUROSP). I strongly believe that LITRAK downside risks is disproportionately lower than its upside gains. There is no need to take higher risks for higher returns, despite conventional wisdom.