Value Idea Contest: Hong Leong Industries Bhd

Snapshot

Business

Hong Leong Industries Bhd (XKLS:3301, Financial) is an investment holding company dealing with consumer and industrial products through various subsidiaries and associated companies.

The primary driver for Hong Leong’s earnings is its consumer products segment, which has been taking up an increasing share of its revenue and profits. Its industrial products segment has also been making quarterly losses since the second quarter of fiscal 2018.

According to a 2016 RHB analyst report, Hong Leong’s main source of earnings is its motorcycle division. Due to space constraints, only an analysis of Hong Leong’s motorcycle business will be done here.

Consumer segment

Malaysia

Hong Leong is a leading motorcycle manufacturer in Malaysia through its 69.4%-owned subsidiary Hong Leong Yamaha Motor Sdn Bhd.

We took the performance of the company’s consumer segment as a proxy for its performance in the motorcycle market and compared the relative levels of revenue to industry sales volumes to arrive at an estimate for the company’s market share.

Estimated market share of Hong Leong

Outlook for the Malaysian motorcycle market

According to the Malaysian Automotive Association, there were 26,754,306 private vehicles (motorcars and motorcycles) in Malaysia as of December 2017. Assuming one vehicle per head, that would be 83.35% of the population owning their own personal vehicle. With Malaysia’s Department of Statistics data showing young population growth slowing, sales to first-time buyers will decline, making the motorcycle industry in Malaysia increasingly reliant on repeat buyers. Given the increasing wages in Malaysia, the future of this industry lies in providing consumers with increasingly higher-end motorcycles and ensuring that current motorcycle users continue using motorcycles instead of switching to cars.

Given all these factors, we believe the motorcycle market in Malaysia will still have modest growth prospects over the long term due to the tailwinds of Malaysia’s expected GDP growth into the next decade as a developing economy. However, given the headwinds and declining historical trends, we believe the growth will be on a continuous tepid decline from here on out.

Vietnam

Hong Leong Industries holds a 24% stake in Yamaha Motor Vietnam Co. Ltd (YMVN), an associated company that manufactures Yamaha motorcycles in Vietnam with an estimated 23.1% market share.

Estimated market share of Yamaha Motor Vietnam

Outlook for the Vietnamese motorcycle market

According to marketing and consulting firm Solidiance, the growing real wages seen in Vietnam have already led to a shift in demand away from motorcycles to cars. Hanoi is also limiting motorcycle access on major roads from 2025 to 2029 before banning motorcycles entirely in the inner city from 2030 onwards. Therefore, we expect Yamaha Motor Vietnam to be faced with tightening market conditions that are likely to result in slowing sales growth or worse, declining sales. Yamaha Motor Vietnam is also facing intense competitive pressures from the market leader Honda Vietnam Co. Ltd., which recently announced a 12% year-on-year increase in sales from April to September 2018, which gave it a sizeable 76.6% market share.

Associated companies

HLI’s associated companies are expanded below.

Profit from associated companies is a very important figure to take note of due to the fact that dividends from associated companies made up anywhere between 15% and 45% of the company’s unlevered free cash flow from 2013 to 2018. Below is a chart showing the historical and projected proportion of dividends from associated companies to the company’s unlevered free cash flow.

From fiscal 2013 to fiscal 2018, profits from associated companies grew at a compounded annual rate of 22.72%.

However, growth in profits has since tapered off in 2017 due to intense competition from Honda Vietnam. We expect growth in profits from associated companies to continue moderating lower to around 4-5%, a range below Vietnam’s and Malaysia’s historical growth in wages. We also expect these growth rates to continue declining, as we projected for the company's Malaysian motorcycle business.

As expanded upon earlier, we are not highly optimistic about the future of the motorcycle market in both countries. However, we believe that revenue and profit growth will be more resilient for the associated companies given the growth trajectory of Vietnam’s economy as well as the stable recurring sales from its spare parts business. Given the lack of disclosure regarding the performance of the associated companies, we have erred on the side of caution and projected no growth in profits for the associated companies in our valuation.

Industrial segment

The industrial segment has been a consistent underperformer in the company’s businesses. Its industrial segment consists of cement fiberboards, ceramic tiles and building materials businesses, all of which are understandably low-margin businesses. This segment has no competitive moat and faces intense competition from businesses, which has resulted in an oversupply of these goods. We believe that Hong Leong Industries' industrials will continue to fare poorly and contract over the next few years.

An exit from the industrial segment is certainly a possibility. Assuming that Hong Leong Industries had sold its industrial segment business in fiscal 2016, it would have seen an expansion of net margin by 393 basis points to 18.12% from 14.19% and by 629 basis points to 20.91% from 14.63% in fiscal 2018. Should the company announce the sale of its industrial segment, we believe its price-earnings multiple will most likely be adjusted upward from the current 9.47 to a range between 10 and 12.

Summary

We expect the company’s consumer segment to maintain its decent rate of growth in sales but expect it to be on a tepid decline from now on due to the headwinds faced by its most significant contributor, Hong Leong Yamaha Motor.

We expect the industrial segment to continue declining as there is no visible moat, and competition will only get even fiercer as the Chinese government directs more loans to Chinese businesses struggling under the weight of the trade war and slowing economic growth. Eventually, we see a possible sale of the business in order to rein in costs and add shareholder value.

History

Hong Leong Industries’ website states that Hong Leong Industries was incorporated as a private limited company on May 5, 1964, and commenced as a mosaic tile manufacturer under the name of Fancy Tile Works Ltd. It was converted into a public limited company on March 13, 1970, and was officially listed on the Stock Exchange of Malaysia and Singapore on July 14, 1970. Hong Leong Yamaha Motor commenced operations in 1978, with the signing of the franchise agreement between Hong Leong Industries and Yamaha Motor Co. Ltd. of Japan, to venture into the manufacturing, assembly and marketing of Yamaha motorcycles in Malaysia.

Hong Leong Industries has placed multiple subsidiaries under voluntary liquidation in recent years, with the most significant case being the liquidation of Malaysian Newsprint Industries, a 33.65% associated newsprint business that has been incurring significant losses, in August 2017 for a full impairment provision of RM171.5 million.

Management

In essence, Hong Leong Industries is run in a de-centralized manner where each business unit is led by a managing director, who reports to the chief financial officer of Hong Leong Industries. (Hong Leong Industries does not have an CEO.) The chief financial officer acts as a guide and bridge between the key senior management and the moard. Aside from one non-executive director being the daughter of Hong Leong Industries’ chairman, none of the directors and key senior management has any family relationship with any director or major shareholder of Hong Leong Industries. There is 40% female representation in the board of directors.

None of the directors and key senior management has any disclosed conflict of interest with Hong Leong Industries or has been convicted of any offences (excluding traffic offences) within the past five years, and there were no public sanctions or penalties imposed by the relevant regulatory bodies during the financial year ended June 30, 2018.

Financial strength

Costs aside, we believe the improvements in working capital efficiency as well as inventory management will continue to improve in the wake of headwinds ahead. The following determinants are worked into our base-case valuation.

COGS/payables ratio: We believe this ratio will continue to increase at the same rate over time. Hong Leong Industries' balance sheet is cash-heavy, and it is very clear that the management does not have a suitable avenue to reinvest or spend this cash in a manner that will earn a good return on investment capital. Furthermore, Hong Leong Industries' borrowing has been consistently paid down over the years to near negligible levels. Its borrowings consist of approximately 38% of bankers acceptances, and the remainder is revolving credit. We believe that the need for revolving credit would eventually be close to nil soon, as the operations can be funded purely by equity. With its favorable equity position and lack of opportunities for reinvestments, Hong Leong Industries can afford to pay off more of its payables over time.

Inventory turnover ratio: As revenue growth starts to slow, we believe that Hong Leong Industries will be able to respond to the slowing demand growth by scaling back its operations. In the 2008 credit crisis, the company experienced a contraction in revenue of approximately 15.5% with inventory levels shrinking by about 18%. With more efficient operations than the past, we believe that it will not be much of a problem for the company to reduce output in response to market demand. Thus, we continue to extrapolate improvements in its inventory turnover ratio.

Receivables turnover ratio: We assume that dealers and distributors will respond accordingly to a slowdown in sales of Hong Leong Industries' products, hence the ultimate slowing in revenue growth. Thus, we believe that the receivables turnover ratio can continue to improve in spite of the growth slowdown. That being said, we would like to be conservative and will cut the extrapolated improvement in this ratio by an arbitrarily decided 50% to reflect the worsening outlook for the motorcycle industry by itself.

Catalyst

There are two main catalysts for this thesis, the first being a more short-term boost from a special dividend to regain Shariah compliance and the second being the divestment of the company’s industrial segment.

1. Regaining of Shariah compliance

Hong Leong Industries was newly classified as a Shariah non-compliant security on Nov. 30, 2018. We believe that Hong Leong Industries was deemed non-Shariah compliant because its cash-total assets ratio exceeded the Shariah-compliant threshold of 33%. As of the second quarter of fiscal 2019, the company’s cash-total assets ratio stood at 45.59%, approximately 273.1 million ringgits above the Shariah benchmark. Hong Leong Industries' share price plunged 19.87% following the non-compliance announcement to its low on Jan. 3. After multiple trading sessions with high selling volume, trading volume was virtually non-existent for four sessions following Dec. 13, 2018. We believe that institutional selling to comply with Shariah laws has been completed, and the subsequent 16.35% recovery in the share price is most likely due to retail investors buying and short-sellers covering their shorts.

The Securities Commission Malaysia updates its list of Shariah-compliant securities twice yearly, in end-May and end-November. As published in the company’s 2018 annual report, three of its 30 largest shareholders are Islamic or Shariah funds holding a total of approximately 4 million shares, which translates to 1.3% of total shares outstanding, or approximately 5.1% of the float. Under Shariah-imposed guidelines, Islamic funds are required to dispose all holdings in re-classified non-Shariah compliant securities.

We expect Hong Leong Industries' management to take the opportunity to increase shareholder value and recover its Shariah-compliant status by returning excess cash back to shareholders through issuing larger-sized special dividends in the coming years ahead rather than to increase share buybacks. As 74.57% of the company is owned by Hong Leong Manufacturing Group Sdn Bhd, which is owned by the ultimate parent organization, Hong Leong Group, a share buyback program would result in cash leaving the entire Hong Leong Group as a whole, which is undesirable for the management.

By increasing the dividend payout ratio, not only will the management be able to reduce their cash position to a level that will allow them to regain Shariah compliance, but 74.57% of the cash outflow from the dividends will go back into the Hong Leong Group’s entities’ balance sheets, in this case Hong Leong Manufacturing Group Sdn Bhd.

This presents a likely situation with two catalysts creating continuous upward pressure for Hong Leong Industries' stock price. The first catalyst is the foreseeable increase in dividend payouts, and the second catalyst is the subsequent regaining of Shariah-compliant status.

Assuming that the company regains its Shariah compliance, we believe that Shariah and Islamic funds will buy back their original positions in the company. This is the point where we believe speculators may come in. As Shariah and Islamic funds start buying up shares in the company, speculators may ride the buying wave and push the share price up to and possibly beyond our estimated intrinsic value of the company.

The company’s quarterly results schedule is as follows:

It is important to note that the dividend announcement for the company comes at end-April, in line with the third quarter results release, and early November, whereas the Shariah compliance announcements will be released at end-May and end-November. The Shariah Advisory Council reviews the latest audited financial statements as made available on Bursa Malaysia’s website.

We see the trade materializing in the following manner:

The next two dividends distributions will be increasingly larger, resulting in a gradual reduction in the company’s cash position. This will be mirrored by increased buying among retail investors. After regaining Shariah compliance in May 2020, Shariah and Islamic funds will again buy shares in the company. Ultimately, this scenario would result in consistent buying of shares and a steady march towards our target price. We view this as the most likely scenario.

2. Divestment from industrial segment:

As discussed earlier, a divestment of the industrial segment will increase the net margin of Hong Leong Industries by approximately 400 basis points. Not only will the divestment proceeds likely to be distributed back to shareholders, further strengthening the first catalyst, the market will likely re-price Hong Leong Industries on higher earnings multiple due to its higher profitability.

Valuations

Due to the lack of transparency on the disclosure of revenue and costs, we will be using the motorcycle business as a proxy for the whole business. We assume the strength of the company’s marine business and weakness in its industrial and ceramic tiles business to roughly balance each other out, allowing us to use the main motorcycle business as our proxy for our analysis.

In our model, we are projecting future free cash flows for the next five years before either applying an exit multiple or a consistent decline in free cash flow into infinity. We attributed a 15% probability to our bull case, 55% probability to our base case and 30% to our bear case scenarios based on Hong Leong Industries' historical financial trends and macro outlook.

A quirk for our bear case is that we would expect a meaningful number of consumers to switch back to motorcycles from cars should economic conditions worsen. Motorcycles are generally cheaper to purchase, maintain and operate than cars are. While new unit sales may certainly slow in a recession, we believe that sales of second-hand motorcycles should increase given the same economic conditions.

We have kept all margins and ratios steady throughout our bear case model though it is important to note that Hong Leong Industries will definitely be able to find ways to cut costs, even if at a slower rate than the historical trend. As such, our bear case is fairly conservative where Hong Leong Industries could actually do better than we project in our base case, under similar economic conditions.

Concluding valuations

Based on the projected future free cash flows and the probabilities assigned to each scenario, our model projects a compounded annual growth rate of free cash flow of approximately -2.99%. The historical compounded annual growth rate of free cash flow since 2013 is approximately 22.90%. The significant growth in free cash flow since 2013 was mainly attributable to strong growth in the consumer segment and associated companies, both of which we expect to grow at slower paces in the next 10 years. The significant drop is mainly due to the significantly lower assumption of the dividend payout ratio of Hong Leong Industries' associated companies. The dividend payout ratio of associated companies in 2018 was 115.56%. Given that the median free cash flow-net income ratio for the past five years for Hong Leong Industries is 91.33%, we doubt that this level of dividend payout ratio is sustainable over the long run.

In our model, we have projected free cash flow for the next five years. Free cash flow from year five to year nine has been pegged at the levels of year five. From year 10 to year 20, free cash flow will keep declining at a rate of 5% a year. This is as close as we’d like to get to a perpetual growth model.

The implied internal rate of return of our 20-year projection is 8.66%. Given that the company is nearly debt-free and cash-generating, we believe that the implied discount rate should be at most that of the expect return of the market, or even lower.

Currently, the implied expected market return as of Jan. 31 stands at 7.11%. It is more suitable to value the company as an ongoing business for the next 20 years, compared to a sale in the near future as it generates a healthy amount of cash flow for the Hong Leong Group and selling off the whole of Hong Leong Industries would be a reduction in the footprint of the Hong Leong Group. Hence, we are comparing the implied IRR of 8.99% to the expected market return of 7.11%. The implied IRR-EMR spread is approximately 1.88%.

According to our model, a share price of approximately ringgit 11.24 will achieve an IRR of 7.11%.

We are not big proponents of the CAPM as we do not view volatility of prices as a risk as far as trades driven by fundamentals are concerned. However, we like to compare the spread between our model’s implied IRR and the expected market return according to WACC as a way for us to assess the margin of safety of the trade.

To follow up on our theory of a possible sale of the company’s industrial segment business in the next few years, we have also re-priced our fiscal 2019 projection of earnings per share (1.22 ringgits) to an earnings multiple ranging from 10 to 12, resulting in a price target range of 12.18 to 14.61. The current price-earnings ratio is 9.67, implying a share price of 11.79 ringgits. The implied IRR at this price is 6.44%.

Risks and assumptions

Fundamentals

• Deterioration of the company’s relationship with Yamaha: low likelihood due to the company’s consistent performance and no meaningful announcements about Yamaha apart from when it started its marine business (positive news as there was a strengthening of both companies’ relationships).
• ”‹”‹”‹Deterioration of Malaysia’s economy.
• Cost-cutting programs no longer effective.
• Relatively low liquidity: We were unable to find out exactly what the float is but excluding Hong Leong Manufacturing Group’s stake in the company, the float is 25.43% at maximum.

  Low likelihood due to the company’s consistent performance and no meaningful announcements about Yamaha apart from when they started their marine business (positive news as there was a strengthening of both companies’ relationships.)

Technical

• A 61.8 retracement on the daily time frame will also start a formation of a head-and-shoulders pattern (completing the first shoulder and head), possibly setting a bearish breakout of the monthly channel, which will likely be a rather violent plummet, as there is no meaningful support levels to stop a decline.

  A 61.8 retracement on the daily time frame will also start a formation of a head and shoulders pattern (completing the first shoulder and head), possibly setting a bearish break out of the monthly channel, which will likely be a rather violent plummet as there is no meaningful support levels to stop a decline.

Regarding disclosure, the financials in the company’s results are not very transparent. For example, it is not disclosed what "other income/(expenses)" refer to. The sources of dividend incomes are only disclosed as "quoted investment in Malaysia" and "short-term investments." Not knowing any more information than this, we can only assume that these dividends will remain constant.

Overall conclusion

As far as timing is concerned, we believe that it is imperative to buy before the end of April 2019. The company's earnings release for the third quarter at the end of April is when it releases its special dividend. While the possibility of a special dividend dwarfing the ordinary distribution is 2 to 1, we are completely uncertain as to how many special distributions it will announce to reduce cash levels to Shariah-compliant levels or how long it will take.

The company will not be able to regain compliance during the May release of the Shariah compliance list since the cash from the special dividend will exit the balance only after the third-quarter release. However, any announcement of an above-average special dividend during its third-quarter release will surely move the share price by a magnitude that might make our risk-return profile unfavorable.

We believe an appropriate time horizon would be anywhere between one and five years.

Disclosure: Authors do not currently have a position in Hong Leong Industries but are keen to enter into one.