Value Idea Contest: Vantage International Holdings Ltd.

Long: Vantage International (Holdings) Ltd. (HKSE:00015, Financial)

Financial ratios

Ovierview

Vantage International Holdings mainly engages in contract works business, property investment and development, and business and provision of finance business in Hong Kong. Vantage International carries out its contract works business through ABLE Engineering Holdings Ltd., an indirect non-wholly-owned subsidiary of Vantage International.

As of the end of the first half of fiscal 2019, the group had approximately HKD550,000,000 in properties, owned by its property development business, held for sale. The property development business has the highest operating margin among all the group’s business segments (approximately 25%). We believe the Group will be able to sell these properties within the next two years to boost its bottom line significantly.

Currently, we feel that the market is valuing the remaining of the group (all businesses except for Able) too cheaply for the cash flows that the group could generate from these businesses.

This is mainly due to the recent slowdown in Hong Kong’s property market and uncertainty from the U.S.-China trade war. The majority of the froup’s revenue is derived from Hong Kong, which is indirectly affected by the U.S.-China trade war.

With higher earnings from the group’s profitable segments (property investment and development), we believe the market will reprice the security to a higher multiple as well as a slightly higher earnings per share to catalyse significant capital appreciation in the security.

History

Vantage International was founded in 1976 and is currently headquartered in Kowloon Tong, Hong Kong. It has been listed on the Main Board of the Hong Kong Stock Exchange since Sept. 8, 2000 (Stock Code:15).

Able Spin-off: Vantage International engaged in a partial disposal of Able Holdings by listing ABLE Holdings on the Main Board of the Hong Kong Stock Exchange on Feb. 20, 2017. Through the listing, Vantage International’s equity interest in ABLE Holdings was diluted to 75% from 100%.

Contract work has consistently made up more than 95% of Vantage International’s revenue, with the exception of fiscal year 2018.

Vantage International’s profit margins since 2013 are shown in the chart below.

Management

Vantage International’s leadership board comprises seven directors – three executive directors, one non-executive director and three independent non-executive directors. The chairman and CEO of Vantage International are brothers-in-law. The senior management, mostly comprising executive directors of Able Holdings, directly reports to the leadership board of Vantage International.

The chairman of Vantage International, Chun Hung Ngai, along with his son and daughter-in-law, are directors for other property investment and contract works companies. However, Vantage International’s board vests business decision-making upon the entire board, and any director deemed to run the risk of conflicting interest is required to abstain from voting. Aside from this, no other directors have interests in any business that competes or is likely to compete with the group.

To date, there has been no corporate governance violations with the HKEX with a minor exception of a concentration warning back in fiscal yeah 2002.

Business

Contract work

The group’s contract work segment under ABLE Holdings engages in contract work as a main contractor or sub-contractor, primarily in respect to building construction and repair, maintenance, alteration and addition works. Project contracts on hand mostly consist of building construction and maintenance contracts that have been awarded by both private and government entities, including Hong Kong's Housing Authority. As of Sept. 30, 2018, when the latest interim report was released, the estimated total contract values and estimated total outstanding values of the group’s substantial contracts on hand were approximately HK$4.549 billion and HK$1.297 billion, respectively. These contracts were all from the public sector and are expected to be completed in around one to two years.

In general, gross profit margins from public sector customers are relatively lower than those from private sector customers as the credit risk and other risks associated with public sector customers are commonly lower. With the government’s consistent focus on increasing public housing and facilities, the business is projected to have strong growth moving forward.

On a going-concern basis, we believe Able is fairly valued, if not slightly undervalued. We list Able’s ratios here:

On a first look, it is hard to refute that Able is selling cheaply for its consistent profits, zero debt, modest return on invested capital and robust forward implied dividend yield.

We believe the core reasons Able is cheaply valued are the volatility in its net income and free cash flow, as well as the group’s majority overall control that overrides external investors.

As seen from the charts, there is very little consistency in the company’s year-to-year performance. More alarmingly, it appears that Able is losing its ability to generate free cash flow due to a clear downtrend in its free cash flow since fiscal year 2016. Able’s trailing 12-month free cash flow decreased substantially as compared to fiscal year 2018 due to one main reason: the Man Shung Industrial Building acquisition. This is the primary downside of the group’s majority control in Able, thus requiring a further discount for risks involved.

The “Man Shung acquisition” consisted of three separate acquisitions to accumulate ownership of the entire Man Shung Industrial Building (No. 7, Lai Yip Street, Kwun Tong, Kowloon) at a total transaction price of HKD 648.9 million.

As Able is meant to specialize in contract works, we believe this acquisition is a misallocation of resources by Able that was done to avoid further leveraging the property business of the group. Effectively speaking, the Man Shung Industrial Building is in fact a property investment without rental income for the group.

Since the gross floor area for the Man Shung Industrial Buildings is 12 times that of Able’s former premises, we believe that another property acquisition is highly unlikely and that this capital expenditure is non-recurring.

Since we want to value Able as the construction company that it is, we will therefore adjust the capital expenditures for fiscal year 2018 to obtain the free cash flow for fiscal year 2018 (excluding outflow from Man Shung acquisition)

After this adjustment, the historical free cash flow of Able looks like that of below:

Property investment and development

The group’s property investment and development segment engages in investment in retail and commercial premises for their rental income potential and the development of properties for rental or sale purposes. The group’s investment properties were valued at an aggregate value of HK$2.039 billion as of Sept. 30, 2018. The rental yield for the trailing 12 months was approximately 4.0%.

The group only sold its first property development project in fiscal year 2018 since the group was publicly listed. The following margins are calculated based on SG&A expenses being wholly borne by the property investment and development business, which best mirrors actual operations:

As the property sales revenue to be recognised in the second half of fiscal year 2019 comes from the same source as that recognised in the first half of fiscal year 2019, we believe the margins achieved should be very similar to that of the first half of fiscal year 2019.

The group’s pipeline of projects is sparse with only one property under development that is expected to be completed beyond 2021 as well as four more properties held for development.

Financing

The financing business was started in fiscal year 2016. Loans and interest receivables have grown from HKD48,818,000 to approximately HKD278,126,000 as of April 16, 2019. Despite the high-paced growth in the group’s loan portfolio, we do not consider this business a significant operation for the group. In the trailing 12 months since the first half of fiscal 2019, the interest income from this business made up just under 6.0% of the group’s total net income. Therefore, we believe it is more of an avenue for the group to deploy idle cash as their loans have a maximum maturity of one year.

Valuation

We are valuing the group with the sum-of-parts method.

As of May 14, 2019, the current market capitalisation of Able is HKD920 million, valuing the group’s stake in Able at HKD690 million. This leaves a market valuation of the remaining of the group’s business to be approximately HKD490 million.

Contract work (Able Engineering)

We first establish our margin of safety by estimating the net-net value of the group. It is important to note that approximately 68.02% of the group’s total assets consists of property assets. Due to this circumstance, we estimated the "fire-sale" value of the other assets on the group’s balance sheets, using the difference between the group’s market capitalisation and the group’s net-net-value ex-property assets to give us a rough estimate on how much the market is pricing the properties on the group’s balance sheets.

We assigned a straightforward 50% discount on the receivables of the group, mainly contract assets (in essence, outstanding contract work value), accounts receivable and loans and interest receivables. We also assumed that accounts receivables and loans and interest receivables will be willingly bought up by debt collection companies at this steep discount.

We assigned a variable to the discount to the properties and land held on the group’s balance sheet. By continually adjusting that variable to arrive at the market value of the group (net-net value of Able stake plus the net-net value of the remaining Vantage group), we estimate that the market is pricing the group’s properties and lands at approximately 45.8% of their respective book value. To add some perspective, the Hong Kong property crash of 1997 led to an almost 70% drop in home prices in nominal terms for six consecutive years. Hong Kong property prices peaked in August 2018 and are currently down 10.7% from this high.

In this scenario, we estimate that the net-net value of Able is approximately HKD600 million, meaning the Group’s stake in Able should be worth a minimum of HKD450 million.

We are not recommending this trade as a net-net trade but are using the net-net value of the Group as a margin of safety for this trade.

Currently, Able is priced by the market at approximately HKD910 million, meaning the Group’s stake in Able has a market value of approximately HKD682.5 million.

We computed the three-year moving average of both figures to smooth out the volatility and to capture the average time period for contract work projects.

Using our computed moving averages, Able is actually trading at 6.5x fiscal year 2019 trailing 12-month three-year moving average of net income and 6.0x fiscal year 2018 three-year moving average of net income.

Based on fiscal year 2018’s three-year moving average of free cash flow, we projected an annual contraction of 5.0% growth in free cash flow to fiscal year 2038. Given Able’s current share price of HKD0.455, the implied internal rate of return is approximately 17.0%.

Equity Risk Premium for Hong Kong

According to Market-Risk-Premia.com, the equity risk premium for Hong Kong companies as of February 2019 is 8.84%. Given the volatility of earnings and free cash flow, as well as it being a small-cap company (USD115.9 million), we believe an equity risk premium range of between 14% and 15% seems more appropriate for Able. Able’s share should be priced at HKD0.488 and HKD0.505, or a market capitalization of HKD976 million to HKD1.01 billion, in order to achieve this range of IRR, representing an upside of between 7.3-11.0%. Using the LTM net income with respect to the first half of fiscal year 2019, the implied price-earnings ratio at this price is 5.84 to 6.04. It is possible that the market is pricing in a possible second property acquisition of this size. We can’t say for sure.

Looking at Able from an acquirer’s perspective, it is currently trading at an EV/Ebitda value of 0.51. We believe that there should be a premium applied to the group’s stake in Able since it is essentially owned by the group. Given the unsteady stream of revenue from government projects, we believe that an EV/Ebitda ratio of 1.0 to 2.0 is modest enough for Able. This value may not be reflected on the actual market value of Able, but it should be reflected in the group’s market value.

Taking the middle ground between our IRR-based target price and EV/Ebitda-based target price, we believe that Able’s market value should be approximately HKD1.0465 billion.

Property investment

Our assumptions for the rental portion of the property investment business are as follows:

• There will be no further addition to investment properties. This is a valuation of the current income stream as it is.
• Rental yields will hold constant at 4.0%.
• Property costs associated with renting out properties will follow the logarithmic trend since fiscal year 2013. [Rental costs percentage of investment property value] equal -0.0009ln(year) - 0.00275.
• Discount rate for the rental income stream is 11.19%. This is the CAGR of the Hang Seng Property Index since its bottom in March 2009. For the income due to fair value gains in the value of the investment properties, the discount rate is 20% to reflect the relative illiquidity and unpredictability for capital appreciation side of the business.
• Percentage fair value gains of the group maintain 22.19% correlation with the CCL Index. This is the average historical correlation from fiscal year 2013 to fiscal year 2018, excluding fiscal year 2016 when the correlation was negative.
• Centaline Leading Index will follow the logarithmic trend since fiscal year 2013. [CCL level = 1314.7ln(date) - 13865.
• The leases of the group’s investment properties will continue to be renewed.
• Net income from this business is equal to free cash flow.

The table below details our future expected net income stream from this business:

We value this business at approximately HKD450 million.

Property development

The property development business was especially tricky to value because there is a lack of financial data regarding the margins and expected revenue from the project pipelines.

The historical average of the operating margin of this business since fiscal year 2018 is 29.6%.

The pipeline of projects and our corresponding assumptions are as such:

• Properties for Sale (the first half of fiscal year 2019: HKD549.97 million)
  • Pokfulam Peak
    • HKD233 million of sales is expected to be closed in the second half of fiscal 2019.
    • We assume that the remaining HKD271 million of this property will be sold by fiscal year 2020.
    • The operating margin is expected to follow that of the first half of fiscal year 2019 (32.18%), where sales of only a Pokfulam property were recognized.
  • Belfran Peak (HKD278.97 million)
    • We assume this project will be take three fiscal years to be fully sold. Revenue from this project is equally split (HKD92.99 million) from fiscal years 2020 to 2022.
    • We assume the operating margin for this project to be 25.0%, slightly lower that the historical average for conservativeness in valuation.
• Properties under development (first half of fiscal year 2019: HKD421.577 million)
  • Lugard Road Project
    • As detailed in the fiscal year 2018 annual report: “It is expected that the development period of this project would be longer than four years.”
      • We believe the group will try to complete the project and start marketing it in time to make a sale by fiscal 2024. Ideally, the first sale of this project should take place in fiscal 2023 to avoid a fiscal year with no property sales revenue.
    • We assume the operating margin for this project to be 20% due to the “geographical location of this project and road conditions of nearby areas” which has led to the longer expect development period and therefore higher costs.
• Properties Held for Development (first half of fiscal year 2019: HKD434.393 million) (two properties)
  • To estimate the price that all these properties would be sold at after development, we:
    • Estimated the cost of development (dividing current value by 75% to estimate selling price) and added on the cost of properties held for development.
    • Estimated the operating margin (we are assuming 25%).
    • Divided the cost by (one-operating margin) to get the estimated selling price.
• The discount rate for this business is 15%.
• No new projects will be done. This assumption does not hold as there are acquisitions in the pipeline that are in progress for this business. We will expand on this later. For now, this valuation will estimate the value of the current projects on hand.

The table below details our expected revenue schedule and the corresponding income from these sales:

We estimate the business to be worth approximately HKD200 million.

Financing

The group’s financing business was started in fiscal 2016. Since its start, none of the loans that it issued have been defaulted on. As we do not view the financing business as a key part of the narrative, we will value it only as a discounted loan portfolio instead of a business. As of the first half of fiscal 2019, the group had HKD106,225,000 in secured loans and HKD51,901,000 in unsecured loans. We have chosen to discount the book value of the secured loans by 15% and the unsecured loans by 50% in order to reflect the higher risks from unsecured loans. The Group made a HKD120 million secured loan in the second half of fiscal 2019 with an implied yield of approximately 4.23%, meaning the loans and interest receivable due to this loan is HKD125,081,000. For the second half of fiscal 2019, we estimate the discounted value of the loan portfolio to be HKD222.56 million. To simplify, we have rounded down this figure to HKD220 million.

Concluding Valuations

To summarize:

Target market value of the group’s stake in Able Engineering: HKD785 million

Current market value of the group’s stake in Able Engineering: HKD682.5 million.

Estimated net-net value of the group’s stake in Able Engineering: HKD450 million.

Estimated value of loan portfolio: HKD220 million.

Estimated value of property development business: HKD200 million.

Estimated value of property investment business: HKD450 million.

Remaining of group’s cash and cash equivalents: HKD453.29 million.

Remaining of group’s bank borrowings: HKD1,366,708,000.

Given that we have a multitude of valuations for various assets and businesses of the group, the table below details the varying valuation under different circumstances:

The price-earnings multiples from fiscal 2013 to the first half of fiscal 2019 are as follows:

The figures in brackets under fiscal 2018 and the trailing 12 months are the adjusted price-earnings ratios after separating the group’s results from Able after Able’s listing. As we can see, fiscal 2018’s price-earnings multiple was a modest 5.70 (4.08) for a profitable small-cap company with a sizeable cash and comfortable debt position.

We believe the higher price-earings ratio is due to the market pricing in additional revenue streams from the group’s property development business. Thus, it is reasonable to guess that the market will place a multiple range of approximately 4 to 5 for the remaining income of the group.

In the first half of fiscal 2019, the remaining of the group managed to earn approximately HKD100 million in net income (excluding any gain in fair value on investment property and non-recurring income). As property sales for the second half of fiscal 2019 are expected to be lower by approximately HKD50 mllion and interest income from the financing business is expected to be marginally higher, we believe that in fiscal year 2019, the group should recognise approximately HKD175 million to HKD190 million in net income (excluding any gain in fair value on investment property and non-recurring income).

A repricing of price-earnings ratio for the remaining of the group (excluding fair value gains of investment properties) to the range of 4 to 5 would translate into a market value of HKD700 million to HKD950 million.

Ultimately, this means our target value for the group is approximately HKD1.485 billion to HKD1,735 billion or a share price range of approximately HKD0.88 to HKD1.03.

Therefore, our target price range is HKD1.00-HKD1.50 per share, representing upside of 51.5-127.3%. We believe that how high the share price climbs is dependent on how favorably the market digests the catalysts.

The primary target is HKD1.00. However, should the management initiate share buybacks, our target will be raised to approximately HKD1.15. In the event of a divestment from their Tin Ma Court or Kam Ying Court, there is little reason to doubt that the market will bid the stock up to HKD1.50 on the back of optimism and yield-chasing.

Catalysts

We believe the main catalyst for the group will be derived from a fresh streak of cash flows from their property development projects, which may result in increased dividends and share buybacks.

Pokfulam initiated development in 2008 while Belfran initiated in 2011. During the years leading up to fiscal 2018 to fisca 2020, the group experienced cash outflows due to costs associated with development of these properties. That being said, revenue (expected operating income) for property development projects in the next few years are as follows:

Fiscal 2019: $518 million ($166 million)

Fiscal 2020: $364 million ($110 million)

Fiscal 2021: $94 million ($23 million)

Fiscal 2022: $94 million ($23 million)

Income and cash flow will be sustainably higher for the next few years. This will mean there is a higher chance of increased dividends since these incomes are actual cash incomes instead of a paper gain like fair value gain in investment property.

Second, the management initiated approximately HKD90 million worth of share buybacks at a range of HKD1.15 to HKD1.20 per share. Currently, the group is essentially trading at net-net value. A share buyback would generate significant shareholder return. In fiscal 2019, no share buybacks were reported to the HKSX. However, given the significant cash inflows from the group’s development projects over the new few years as well as the uncertainty surrounding the U.S.-China trade war, we believe it will be logical for the management to simply buy back shares on the cheap. A HKD1 million at current prices will result in an approximately 8.9% reduction in shares outstanding.

Last but not least, most of the value of the company is locked up in its investment properties. Based on the annual report, "approximately half of the aggregated value of the Group’s investment properties portfolio referred to the investment properties at Tin Ma Court, Wong Tai Sin and Kam Ying Court, Man On Shan acquired in May 2016." Most of the fair value gain in investment properties in fiscal 2018 was attributed to these two properties. There is currently no indication by the management of any desire to sell these investment properties. However, we can expect the stock to start trading higher should any such news be released.

While the multiple catalysts may have uncertain timings, because of the extremely low trading value of the stock, we believe that this trade would have a highly asymmetric risk-reward profile where the downside is limited by the group’s liquidation value and upside has many multiple supporting catalysts.

Technicals

Monthly time frame

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The stock is currently trading close to the lower limit of its monthly trend channel since late 2003. The trend channel generally increased at a rate of approximately 5.66% a year, indicating sub-par "quality of growth"Â for the group relative to the market.

Weekly time frame

On the weekly time frame, the price has broken out of the bearish weekly trend channel since September 2016, rejecting the HKD0.90 resistance due to a lack of positive catalysts for a breakout above this level.

Technically speaking, we believe that the price has officially broken out of this bearish weekly trend channel but is lacking sufficient catalysts for a sizeable bull run.

Daily time frame

On the daily time frame, the price is approaching the end of a descending wedge, a bullish indication for a reversal. We think that it is particularly interesting that the end of this wedge falls on June 19, 2019, which is within the range of dates when the group’s annual results are released. This leads us to believe that the group’s annual results may play a crucial role as the catalyst for the next leg up. Furthermore, the MACD indicator signal lines have more or less been "squashed together," indicating a possible reversal to this current downtrend, only lacking a catalyst.

To conclude for technicals, we believe that there are currently no clear signs of a breakout that may precede a big move in prices. However, there are a number of indications that the stock is ready for a reversal, just that it is lacking the push that it requires from fundamental catalysts.

Conclusion

In conclusion, we view the group as a fair company selling at a wonderful price. Because the company is already selling so close to its net-net value, if we were to retrace to the lows set in late October 2018, the loss would be approximately 20%. The risk-return profile for our target price of HKD1.00 would be 2.54. (HKD1.15 [3.69], HKD1.50 [6.38]).

Obviously, we do not expect this company to be a multi-bagger years into the future. However, since it has a number of catalysts for a higher stock price and a sizeable margin of safety, we believe it has a modest prospects for capital appreciation into the short to mid-term future.

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

This report was completed by Daniel Fok Chun Hoe and Peh Shin.