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Friday, April 27, 2007

LITRAK - A belated buy call

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...

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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.

9 comments:

boon chen said...

litrak is my biggest holding at the moment and have been my biggest holding since 2 years back. The only thing i am worried about this stock how the management handle the huge amount of cashflow they generate every year and whether they can handle the cash prudently.

well, they spend a lot of money building interchanges in Puchong few years back (140 million i think), whether that is money well spend, i don't know, whether the contract sum is way too high, i don't know. Since they awarded the contract to their parent : Gamuda one can only assume the contract sum wasn't negotiated at arms length and probably offer fat margin to Gamuda !

Last i heard they intent again to spend a lot of money (reported in the edge sometime in January) to alleviate jam in the toll road again ! if the management are generous on the capital expenditure, then don't think Litrak is such a good buy.

If the money Litrak make will be used in building interchanges or other capital expenditure, what is left for the shareholder ? If litrak were to build anymore interchanges, i am definately not holding on to this cash cow which is milked by someone else !

Appreciate if anyone can throw some light on this issue

Seng said...

Hi boon chen,

Thanks for your comments.

For me, I look at it a bit more simplistically. It would be a concern if LITRAK's capital expenditure, at this stage of its operations (> 10 years now), becomes greater than its operating cashflow. For FYE 2006 (31 Mar), LITRAK operating cashflow is around $200M. After the 1 Jan toll hike, I expect LITRAK's operating cashflow to be larger, say $300M to $400M(very roughly). LITRAK's capital expenditure approved after 31/12/2006 is smaller, approximately $40M. So, at this stage, I'm not too concerned, as there appears to be quite a large margin there.

From a toll operators perspective, LITRAK clearly wants more traffic. Building more interchanges to obtain greater traffic is not necessarily a bad thing either, especially if it's done in the earlier years than the later years. In my opinion, I expect LITRAK to progressively reduce the amount of capital expenditure as it gets closer to its expiry date, as the ROI term is short. If I have proof that my hypothesis no longer apply and there is no longer any reason for me to continue holding LITRAK, then, I will not hesitate to act although at this stage, I am actually adding more to my LITRAK holdings.

At 31/3/06, Gamuda owns 37% of LITRAK, and since then, has increased its holdings further. I look at the addition positively.

For a large conglomerate like GAMUDA who wants to be a key player in Corporate Malaysia in the long-term, it would be foolish for any of LITRAK's or GAMUDA directors to sign the annual statement that their transactions are arms length when they are not. In fact, it would be foolish to conduct non-arms length transactions, which then needs to be disclosed to the public, just to save a few million bucks and to lose their reputation which will certainly lose billions in the long term. Certainly, if I am the director, I would make sure that all transactions are arms length, especially if my focus in on the longer-term and the bigger Billions of dollars.

In stock investments, there are of course no guarantees. As potential shareholder investors, the key is to understand that some factors have major financial impacts, whereas others are smaller, or merely "cost of doing business". Of course, if one has a personal value system that one cannot compromise, it's best not to invest. However, if the goal is to make money, then, my advice for a value investor is to focus on the margin of safety, and not to put all your eggs in one basket. Despite the best research, there will always be unexpected "surprises".

Some of the doubts you have are certainly valid, and I don't think anyone, even LITRAK's MD, can ever fully remove your doubt, so, I hope you understand that I won't even try.

As usual, use your own judgement and invest at your own risk.

grahamsmun said...

Litrak would be a woderful business to invest if its life spend is in pepetual but in this case Litrak has a lifespend about 25 years of this more than 5 years has been utilised.
Since Litrak lifespan has a fixed limit its value must be value by its discounted cashflow over the lifespan.
Alot of investors when they buy into concession they forget the life span of the concession and over-pay.
Some ignorant investor are lucky when the co manage to extent the concession but expiry is always the risk.
In the case of Litrak what is the NPV if the concession expire is the 1st fundamental question for assessing the investment.

Seng said...

grahamsmun,

Actually, I agree with your first 2 paragraph, but your last 3 paragraphs are based on a faulty assumption/observation.

As you know, conceptually, the P/E factor is equivalent to the PV of future earnings.

You may not have the opportunity to apply PV techniques often. If you had, you would have known that when one "Present Value" a stream of future earnings at discount rates like 10%, then, the actual answer (when applying a finite term such as 21 years) will be quite close to the approximate technique I used.

For example. The PV of $1 p.a. discounted at 10%, where the $1 is assumed to occur in the middle of each year is 9.1 for a 21 year term, vs 1/10% = 10 approximate method.

However, the P/E is actually more sensitive to discount rate and the future earnings growth rate. For example, if I assume a modest 2% earnings growth, then, the 9.1 factor becomes 10.4, which turns out to be larger than the approximate technique I used, which is 10.

You will find, that when the projection term is long (like 20 years, or longer), the more important factor mathematically is the discount rate and the earnings growth rate, not the difference in the number of years. Yes, this is counter-intuitive, especially to new practitioners - after all 20 years seems short compared to 2000 years, but experienced mathematical practitioners knows this. If you don't believe me, I suggest you prove it to yourself - construct a spreadsheet and calculate the PV factor using different interest rates, different earnings growth rate, different terms, and compare the results with the approximate technique I used. The latter I found to be quite useful for quickly evaluating whether LITRAK is a Buy or a Sell. These mathematical shortcuts (such as Rule of 72, etc.) is one reason why Buffett could evaluate what appear to be complex (to us) business proposals in less than 10 minutes, because he knows them inside out (besides being a genius).

Seng said...

grahamsmun,

You might also want to take a look at Deutche Bank's analysis on LITRAK for another view. They called LITRAK a Buy with a TP of $4.6. The basis is based on discounting future cashflows based on certain assumptions regarding discount rates and other factors that affect future earnings. Their 2008 EPS is conservative, at $0.25. I am quietly confident that LITRAK will generate higher 2008 EPS than that. Anyway, a TP of $4.6 with $0.25 EPS would suggest a P/E of 18.

You might also want to take a look at investssmart's past write-ups on LITRAK. His assumption of a P/E of 15 is also not unreasonable in my opinion.

I think whichever way you look at it, at $3.5, LITRAK is clearly under-valued, and is mispriced, especially after the huge toll rate hike, and the government compensation, besides the future right to increase toll rates further that is potentially larger than the one we saw in Jan 1, 2007.

As always, my focus is on investing and not on long discussions about matters not concerning LITRAK buy / sell decision. However, if you have a different view and think that LITRAK is a sell, then, I would always welcome to hear your views and your reasons.

Regards,

grahamsmun said...

I m not recommending a sell in fact i m wondering whether your computation has some fundamental flaws bearing in mind at the moment it is a net borrower and PE 18 time is still appear modest.
The company need to earn enough to pay its debt on top of that it need to cover the expected investor return of say 10% p.a.(your reqn rate of return)
If u have done the cashflow exercise well n good !
Please note PE is not equivalent to Present Value bcos PE we are basing on pepetuality.In the case of Litrak it is equivalent to bondlike investment instead of equity like.

Seng said...

Young grahamsmun,

A person who "genuinely wonders" about a topic will not post phrases like

"... forget the life span of the concession and over-pay."
"Some ignorant investor are lucky ..."
"In the case of Litrak what is the NPV if the concession expire is the 1st fundamental question for assessing the investment."

(This sounds more like a professor lecturing a class)

Further, a person who genuinely seeks to learn will not use phrases like

"If u have done the cashflow exercise well n good !"

(Imagine a teacher who has just explained a concept to you, and you then proceed to tell the teacher "If you have done it, well n good!")

In case if this is still not clear to you, it is very clear to me (from here, and numerous past comments elsewhere) that you do not "genuinely wonder". It's also clear to me that you have a completely different motivation when you post comments in my blog. And frankly, you are simply wasting my time, and the time of genuine readers in this blog.

Please don't come here and reply to my advise. My purpose in creating this blog is to share and exchange views with people who are genuinely interested in making money off the stock market. I welcome opposite views (e.g. genuine reasons why LITRAK should be a sell), but I don't welcome your attitude.

Good day.

PS. To the genuine readers, my apologies for not implementing comment moderation earlier to approve comments first, and having caused you to waste your time reading long comments like this. If grahamsmun replies, then, I will proceed to apply comment moderation to ensure we no longer have to waste our time in future.

Seng said...

In grahamsmun latest comment on Apr 28, he mentioned a valid point regarding the need to pay off the debt before the expiry date, and to earn a suitable rate of return.

Interested LITRAK readers in investssmart chatbox may recall me mentioning that there is a news article (dated 17 Jan 07) that I referred to where Datuk Lin (Gamuda MD, and LITRAK Director) commented to the press regarding the debt issue. It is worthwhile repeating that here. "... despite the toll hike, the bulk of the revenue would go towards repaying Litrak's loans over the next 8 years ...".

The 8 year period looks reasonable. LITRAK's 2006 cashflow from its operating activities is at least $200M, or higher in 2007. It's total debt (short and long term) stood at around $1B. If LITRAK is focussed on reducing its debts, I believe 8 years is not an unreasonable period. I would not be surprised if they achieved that goal sooner, although for other reasons, they might still maintain some level of debt and return some of the excess cash to shareholders during that 8 year period. Given that the concession period still has at least 21 years to go, and the pending toll hike in 2010 and 2017, and the relatively low capex going forward, it is clear that LITRAK's return will be a superior one. I am going to take a Buffett approach here, that where there is a more than sufficient margin of safety (with lower downside risk), I will not do detailed projections. Of course, if anyone else have spare time, they are welcome to do so, and to present the results here.

Cheers.

Seng said...

Since my last commment, I have received a reply from grahamsmun. The comments relating to LITRAK are

"...As for NPV, what we need to get (is) a feel for the rate, if it's 10% and positive then it has fulfil the investment requirement."

grahamsmun,
To me, if I can buy LITRAK at $3.50, and the price rises to above $4.5 say within the next 12 months, then, I am happy to own it without doing a detailed projection. My personal investing style is to make sure that I am abreast with major developments affecting LITRAK. Nevertheless, if you wish to do a detailed projection before buying, I will not stop you from doing so. My motto is "whatever works for you best".

Cheers.