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Sunday, May 13, 2007

HEXZA - An Updated Analysis

Since my last posting on HEXZA yesterday morning, "grahamsmun" has made some insightful comments on HEXZA raw material costs and HEXZA's share investments. It has led me to rethink my earlier (and lazy) approach to valuing HEXZA. I have decided to do a proper job, and share the updated results with you.

Raw material costs for Ethanol Division (Chemical Industries)
In one of HEXZA's annual reports, I learned that the main raw material cost used in the production of ethanol by HEXZA is molasses. For those of you who don't know what is that, molasses according to Wikipedia is a thick syrup by-product from the processing of sugarcane (or sugar beet) into sugar. As such it doesn't seem unreasonable to expect molasses price trends to follow sugar prices trends. I managed to find a nice long-term graph of sugar prices which could be worthwhile to take a look:

Quick comments:
1. Note the exponential rise in sugar prices from mid 2005 to mid 2006.
2. According to the Chairman's Statement in 2005 Annual Report, molasses price skyrocketed from Dec 2004 to April 2005. It affected HEXZA since local production of molasses are clearly insufficent, and they needed to be imported from overseas. This is consistent with the above chart where in Dec 2004 to Apr 2005, sugar prices has just came out from a bottom at 2003. The reason given was due to the severe draught in India and Thailand. India - a usual exporter - became importer. The Chairman expected the high prices to remain until the next harvest season in Dec 2005. This is consistent with the above chart where prices continue to escallate sharply (due to limited global supply) and peaking at the start of 2006, and then fall as the next harvest comes in.
3. More interestingly, in 2007, sugar prices seems relatively stable, and a slight drop towards the end.
4. Whilst HEXZA might actually pay different prices for molasses, the sugar price chart above suggests that if the trends are similar, then, we can perhaps expect HEXZA raw material cost to come down over the near term. I suspect there should be some time-lag effects, although at this stage, I am only speculating that the period might be say over the next 1-6 months?.
5. But there is no doubt that there is a clear secular / cyclical pattern to sugar prices, when looked from a long-term perspective. I expect this to apply to both HEXZA and its competitors that uses molasses as the main raw material.

Raw material costs for Resins (timber) Division (Norsechem and Hexzachem)
The main raw material for Resins Division are methanol, urea, phenol and melamine. According to a past Annual Report, the prices follow Crude Oil and Liquified Natural Gas. Fortunately, I've also managed to find a fairly long-term graph of light crude oil (Nymex). Again, the actual prices paid by HEXZA will be different, but hopefully, the price trends will be a close enough approximation.

Quick comments:
1. Note the escallating crude oil prices since the bottom at end 2001, which steadily rise to a peak in mid 2006, before declining towards the end of 2006.
2. What I find most interesting is that during this long period of escallating raw material costs, HEXZA bottom line actually grow over the same period. To me, this is a good sign since it shows that the company knows and have proven themselves to know how to manage escallating raw material costs over a fairly long period.
3. In 2007, crude oil prices has risen again. It is unclear if there is a time-lag in HEXZA's actual raw material costs. Certainly, the Resin Division and the Ethanol Division are 2 different and separate processes. It is possible that maybe there isn't significant time-lags - perhaps more knowledgeable readers can comment further.
4. Nevertheless, I take some comfort that there seems to be diversification benefits - whilst crude oil prices have increased from the start of 2007, sugar prices on the other hand has came down.
5. At this stage, my own personal conclusion (based on the little that I know so far) is that maybe, the raw material cost increase reported in the latest earnings report is a temporary event (i.e. assuming earnings to fall by 30% permanently might be a bit drastic). More likely, HEXZA management should be successful in controlling its raw material costs, as they've demonstrated over the last 4-5 years at the very least.
6. As usual, more knowledgeable readers are welcome to correct me. :-)

Other comments on raw material costs
1. As stated in one of the annual report, "most of our raw materials are imported".
2. It seems HEXZA does not have any outstanding foreign currency forward contracts (none disclosed in latest earnings report and annual report).
3. Thereby, an appreciating RM can be reasonably expected to reduce the cost of its imports, and vice versa.

Investment in Quoted Securities / Other Investments
Grahamsmun brought to my attention that HEXZA actually hold listed stocks in its portfolio. Thinking about what Grahamsmun said, and reflecting on the balance sheet further, I note that I have been extremely conservative in my calculation of P/E and Liquidation Price in the past. In both cases, I have assumed a nil value, when they are clearly not nil. (I'm sure even if I ask HEXZA very nicely to part with their quoted stocks, I believe they are unlikely to give it to me for free :-) ). So, there's clearly value there - the only question is how much? It's clear that we need to study Note 16.

Note 16

Quick comments:
1. The book value basis is "at cost".
2. The book value of listed shares (including warrant, etc.), less allowance for dimunition in value is $12.3M.
3. The market value of the same listed shares is $12.3M also, i.e. there doesn't seem to be a significant unrealized gain at 31/1/2006. (This is not too surprising, as the bull run only started later in 2006).
4. There is unquoted shares at $3.9M.
5. Note all these are out-dated values at 31/1/2006. For updated values, we need to check the quarterly earnings report.
6. In that report, at 31/3/2007, the total investment at cost is $14.0M. Total investments at market value is $18.5M. Not surprisingly, there is unrealized gain of $4.5M (KLSE has been good recently).
7. I suspect that if one is forced to liquidate its shares today, probably one could easily fetch 95% of that stated market value of the quoted shares. However, the stock market is volatile, and much depends on the timing of liquidation. There is no guarantee that in future, the market value of those stocks will rise (even though we might expect the market as a whole to rise). Since we simply don't know exactly what stocks HEXZA hold, we have to be prudent and assume a safety margin. For my liquidation valuation, I have assumed a prudent factor of 75%, and yes, it is debateable, and yes, your factor can be validly different than mine.

Updated Liquidation Valuation

Quick comments:
1. Liquidation Price 1 is the old liquidation price that I previously reported here.
2. Liquidation Price 2 is adding 75% of the quoted shares at Market Value, with other % unchanged. (see original posting). At 31/3/2007, this comes out at $13.9M (= 75% x $18.5M). Based on this revise basis, the latest liquidation value is $0.76.
3. Looking at liquidation price 2, it is interesting to note the trend over time. Back in FY 2001, when the company quoted shares is only $2.9M, both Liquidation prices are close to one another. Over time, the gap has steadily increased, and today, there is actually a $0.11 difference. This quite a significant difference, even though I have assumed a 75% factor.
4. Note that in my liquidation valuation, I am still assuming nil value in HEXZA's other assets as I am lazy, and it is a conservative valuation.
5. It is interesting that at last Friday, HEXZA happened to trade at $0.77, which is just slightly higher than its liquidation valuation. Had I done a proper job earlier, I would have considered grabbing as much HEXZA shares as possible when it was selling at well below $0.70 ... as it was clearly trading below its liquidation valuation ... oh well ...

Scenario Testing
It is a fairly common analytical technique where when there is uncertainty about one or two variables, that the analysis considers the possible ranges of the variables in order to get a feel for the impact on the final result. Here, I foresee 2 possible variables - the first is on earnings (whether earnings will stay the same, or fall by say 30% forever due to the recent rise in raw material costs), and the second is on whether the business should be valued including / excluding 75% quoted shares. For completeness, I have also considered the superficial P/E (where one ignores Net Cash completely).

Quick comments

1. My base case is actually Scenario 3, where I've taken out Net Cash (= Cash + equivalents - Total Borrowings) as well as 75% of shares from the current price. At current price of $0.76, it suggest that the business is available for sale at $0.37 = $0.76 - $0.27 - $0.11. The EPS for the Trailing 12 Months (TTM, which I've approximated, assuming uniform distribution of earnings in Q1/07 and taking a third of that) is $0.11. This suggests that at last Friday's closing price, HEXZA is still trading at a fairly undemanding valuation of 3.5 times.

2. It is possible that some of us might still be a bit nervous that the raw material costs could stay permanently high, despite the charts that I've shown and despite the appreciating RM. It's probably worthwhile to consider (for peace of mind) what would happen if HEXZA's earnings were to stay 30% below forever. This is Scenario 6, and it suggests that at current prices, HEXA P/E would be 5 times. Still fairly undemanding (now I can sleep ...).

3. A novice fundamental investor might only consider the market price and the EPS. This is Scenario 1, and the implied P/E is 6.9. Still undemanding. In the worse case, if EPS drops 30%, this is Scenario 4, and the P/E is about 10.

4. My personal conclusion is that HEXZA is really trading at a fairly undemanding P/E, even at last Friday's closing price of $0.76.

Updated Intrinsic Value
As I mentioned above, I believe that my base Scenario should be Scenario 3. It is clear that this is different from what I had written earlier, due to the new information (new to me) and updates that I mentioned above. Under this scenario, a natural question might be what could be an appropriate Intrinsic Value for HEXZA?

Again, this would boil down to what should be the appropriate P/E for HEXZA. Personally, my discount rate could be different from yours, but if I demand a minimum return of say 15% p.a., then, if HEXZA earnings has nil growth, then, my P/E will be 1/15% = 6.7 times. This I think is fairly conservative and prudent. So, my own intrinsic value is $1.14 = 6.7 x 0.11 + 0.27 (cash) + 0.11 (75% share). This is higher than SBB's Intrinsic Value of $1, both of which are higher than current price.

If you don't know what Intrinsic Value is, then, basically it's just what I think the company is worth and what I think a rational businessman would consider paying, if he wants to buy HEXZA in its entirity, without changing anything at all (including not changing its management). If you want to know more about Intrinsic Value, I recommend you to read Berkshire's Annual Reports. There's no single right answer to Intrinsic Value. But as Buffett likes to say "It's better to be approximately right than precisely wrong". This is the spirit as to how I estimate HEXZA's Intrinsic Value.

Still, there might be other shareholders who might not be as demanding as me, in terms of applying a P/E of 6.7. They might use a higher P/E, say 7 to 10. If so, this will naturally raise their own estimate of HEXZA Intrinsic Value.

However, you might validly think that raw material prices will permanently decrease HEXZA earnings by 30%. In that case, the Intrinsic Value might be $0.90 = 6.7 x 0.077 + 0.27 + 0.11. In which case, it would be slightly lower than SBB Intrinsic Value. So, maybe SBB's Intrinsic Value of $1 might not be too bad after all for prudent investors.

For the readers of this blog, I encourage you to form your own opinion on what is HEXZA's Intrinsic Value, based on the data that I have provided here and elsewhere.
For me, I believe that HEXZA is still trading at a fairly undemanding P/E, despite last Friday's price increase. I believe there is more potential upside. However, it is possible that the market might not agree with me. That is always a risk. However, if you believe Buffett, that in the long run, the market is a weighing machine, then, there is only one conclusion. (buy)

You already know I don't work for HEXZA.
You also know I own HEXZA shares, although in a moment of temporary insanity, I sold some of my holdings earlier to bring down my average cost ...
You know constructive comments are welcomed, especially when they are different from my own.
And you know my usual Disclaimer - "as usual, use your own judgement and invest (i.e. buy, hold, sell) at your own risk".
Happy investing!

1 comment:

grahamsmun said...

If u based on peer comparison the nearest competitor is Ancom.
The company has a subsidiary under the name of Fermpro which i think was disposed to Nylex(another subsidiary of Ancom) using PE of 8 times(around2003/2004).
Fermpro control 30% of Ethanol mkt make about Rm 3m a yr whereas Hexza make about Rm 9m to 10m a yr.