The Value Muse

I just saw the news about Jazz Hotel in Penang closing down its business after operating for just over a year. Honestly, I’m not surprised at all because somehow expected that since the first time I saw it. Well, I do not mean to be rubbing salt on the wound at this critical point in time when the whole hotel industry is facing an unprecedented crisis. The thing is, I struggle to think of a justification for its feasibility and the same goes for a lot of other similar hotels in other locations.

I’m not from Penang but my wife is, and because of that I have been travelling quite a bit to Penang since we got married. Her house is located in Tanjung Bungah which is fairly close to Jazz Hotel in Tajong Tokong and I regularly pass by this property. The doubts I have are quite straightforward:

1. It does not have access to the beach.
2. It’s so far away from the George Town’s tourist attractions and not near enough to Batu Ferringhi. Besides that, Batu Ferringhi has so many hotels providing better options to tourists.
3. It’s surrounded by residential area which adds little value.
4. It’s not accessible to any vibrant commercial or industrial areas, except Straits Quay which looks more like a glorified recreational park for the locals.
5. I don’t see what’s the attraction for the MICE (Meetings, Incentives, Conferences & Exhibitions) market. Being near the marina? How many visitors come in yachts? I jest.

Therefore it’s not fair to say that Covid-19 has killed the business because it has simply succumbed to the basic perils in business 101. In fact, its management has announced that the business has been suffering losses for months even before the virus outbreak. I don’t know what was the rationale for putting up a hotel there but I suspect it may be a trophy asset collection exercise.

The truth is, our market is full of similar examples. Owning a hotel, especially one managed by famous operator like Hilton or any of the Starwood brands, does give you lot of bragging rights. To a certain extent, the more expensive the price tag, the more face value you get. That is why a lot of developers love to put a hotel in their mixed development irrespective of the business sense because they can call themselves hoteliers during black-tie dinners before flipping it eventually. Whoever buys it is banking on another greater fool that appears later while enjoying the same bragging rights.

Does it really make money running a hotel? Yes and no. I think those budget/boutique hotels which focus more on cost efficiency and provide excellent customer service will generally be fine. Branded five-star hotels? I’m not that optimistic. I used to have a preliminary discussion with the senior management of Accor Hotel and found out that the capital expenditure (excluding building cost) for a five-star hotel is around US$180-200k per room and you are expected to recover that cost in 8-10 years. By the time you go past the fifth year, be ready for major repairs and refurbishment and that will add a few more years to your payback period. In short, most people who own assets like this don’t expect to make operating profits because they focus on capital gain. You better have a rock solid holding power in this case. Don’t believe me? Take a look at Hilton KL which was sold to Le Meridien in 2017 and the owner has accumulated RM46mil of losses and RM275mil of liabilities before the sale.

To own an asset that gives you massive negative cash flow over the years, you need to be rich to start off with. Another key factor in the whole mathematics is debt, without which the return doesn’t make any sense. I’ve always said that developers always build according to the availability of credit rather than actual demand because the brick and mortar is the banks’ favourite asset class. Whatever problems that come next, they can always refinance their way out of it. I personally think that there has been too much credit dished out to hotel builders in the past and this is a crisis waiting to unfold. Try driving around Klang Valley and you can easily see many hotels being built in questionable locations. Some were built as service apartments which were subsequently converted to hotels after failing to achieve meaningful property sales. Many of them are attached to an existing mixed development which I suspect were put together to spice up their funding proposal in the first place. All the recurring income thesis and glorified GRR schemes can easily make the bankers head spin in ecstasy. We all know how it’s done.

Covid-19 is a black swan event which is sweeping the entire industry like a tsunami. Like what Warren Buffett said, “Only when the tide goes out do you discover who has been swimming naked”. As demand is not expected to recover immediately, watch out for those hotels in lousy location and those who have their balance sheet supercharged with debts.

Just to give you some perspective before I end this. Some time beginning of last year, there has been a list circulating among the real estate community showing no less than 20 hotels in the Klang Valley for sale. Just imagine how long has this list grown right now.

After the recent political coup which has dealt a severe blow to investors’ confidence, our Prime Minister wasted no time dishing out the chairmanship of government-linked companies (GLC) and government agencies to certain politicians. This is undeniably the easiest way to shore up his political support in order to prevent another similar coup. Other than the ethical considerations, such action is perfectly legal and honestly speaking, I probably would do the same thing if I’m in his shoes. That leads me to ponder over some of the corporate governance issues in the market which have been haunting us since decades ago.

When I look at some of our GLCs like TNB, TM, MAHB etc, I can’t help salivating over the solid moat surrounding them due to the their monopolistic position. Take TNB for example, there is no way you can form another electricity provider in Malaysia even if you have RM10bil cash to on hand. I can also safely predict that we will continue to use electricity for the next 100 years. However, we still observe the subpar performance and embarrassing scandals among them. To me, the single biggest factor contributing to this scenario is the fact that the management has very little skin in the game. Some of the directors don’t even hold any shares in the companies and the chairpersons are usually parachuted from the political arena. How would this setup prioritise shareholder value?

Just look at the disgusting scandals that wipe out more than RM10bil of the market capitalisation of Felda Global Ventures Holdings Bhd (FGV). Imagine if you have invested in the IPO of FGV at RM4.55 per share and seen it plunge to the current price of RM0.85. That’s a whopping 80% of permanent loss of capital which you most probably will never recover at all. When the company has undertaken acquisitions at ridiculously inflated price, we all know where the money goes. As usual, those in charge are none other than political elites.

Another one of my favourites is Malaysia Airports Holding Bhd (MAHB) which has famously delayed the opening of KLIA2 by 2.5 years with RM2.3bil of cost overrun. If I remember correctly, the company has been headed by four different CEOs in the past ten years. I honestly cannot imagine how can a company being run efficiently if there is no alignment of interests at the management level. Capitalism can never run away from incentive and that’s the most powerful ideology I believe in. The corporate chieftains have essentially been playing the corporate coin-tossing game that says “head I win; tail you lose”. How many people have been prosecuted over corporate scandals among the GLCs? I honestly cannot remember.

Most of the GLCs are involved in capital intensive industry with strategic importance to the country, such as telecommunication, utility, infrastructure etc. Therefore they usually have large capital expenditure to maintain their existing assets. For example, TNB has allocated RM9.5bil for its FY19 capital expenditure budget and there are a lot of contracts to be given out in the process. When there is so much money and opportunities available, who cares about shareholders?

We have this thing called corporate governance that usually occupy 20-50 pages of the annual reports of all public listed companies. I usually don’t even bother to print out these pages just to save the trees. Well, the idea of having independent directors on the board is a very noble idea that serves as check-and-balance. It’s like having a pack of fearsome Rottweilers guarding your interest that would instantly wag their tails upon seeing a sausage. If you probe further, it’s not uncommon to find that a lot of independent directors are actually friendly parties with the management and their relationships goes all the way back. Please let me know if you have heard of any cases of corporate misdeeds being flagged by independent directors because I really don’t know any. Do you really think we can rely on independent directors on the GLCs to protect investors’ interest? Try to think about how they get elected in the first place.

I’m in no way suggesting that all GLCs are rubbish, in fact, some are genuinely run by competent management (Petronas for example). It’s just that in my quest for investment return, the number one rule I emphasise is to avoid permanent loss of capital rather than chasing high returns. What’s the relevance here? Well, companies generally are exposed to market risks and operational issues which require the full dedication of the management. How can we expect them to fight at all cost if they are often subject to the change in political wind? What will happen if there is always a hidden hand at play when it comes to major decisions? GLCs may have all the natural advantage in the short-term but the political baggage is what worries me. What’s the point of being a 300-pound gorilla with its hands tied?

When it comes to investing in GLCs, I may miss out on some fantastic opportunities but I rather err on the side of omission instead of commission.

Yesterday I woke up to the news of oil price dropping below zero and started wondering what kind of world we are living in now. Just 12 years ago, I was sitting in the conference hall of Goldman Sachs Hong Kong listening to their presentation on why oil price would keep going above US$150/barrel and now it’s worth less than a bottle of water. Naturally, I thought the share price of oil companies will get hit badly but then the big boys like BP, Shell, Exxon etc seem to be doing okay. Then I realised most investors probably expect them to ride out this temporary storm on the back of their large balance sheet while the real casualty falls on the US shale operators with much higher cost of production and unsustainable debt levels.

Closer to home, we have Hibiscus Petroleum (“HP”) which is purely involved in oil exploration and production (E&P) and to a large extent, its share price fluctuates according to the oil price. I think a lot of retail investors pay attention to this company as it’s the most convenient way for them to speculate on oil prices. Most of the comments I’ve heard always say that its share price of RM0.45 is very cheap compared to its peak of over RM2 and you can make a lot of money when the oil price recovers. You know that this is one of the most speculated stocks when the housewives start talking about it. I’ve decided to have a look at it just in case I miss this once-in-a-lifetime opportunity to get rich.

Oil and gas E&P is a very capital intensive business besides the enormous risks involved in drilling. HP basically joined the game by taking over mature brown field assets from bigger players and try to squeeze the last drops of oil from them. It’s similar to picking up cigarette butts on the cheap and try to enjoy the last puff. The difference is, they still need to spend a large amount on “Production Enhancement” effort before drawing the last puffs. Currently, HP only generates income from its North Sabah PSC and the Anasuria Cluster in the North Sea while the rest of its assets in Australia are still in the development and exploration stage.

Again, I always start by looking at things that make me not so comfortable and there are plenty.

The production of crude oil is a commodity business and HP has absolutely zero pricing power because its daily production of over 8 thousand barrels per day represents only 0.01% of the world’s output and its crude oil has no difference compared to the rest of the world. What it needs to do is basically invest in the right assets (at the right price), develop and operate them in the most cost effective manner. However, it’s forever susceptible to a single factor totally beyond its control – oil price. As a shareholder of HP, you practically cannot go to bed everyday without praying to the God of Oil.

I think the management of HP has done a great job in keeping its production cost relatively low at US$20/barrel(2019) while conventional oil production costs US$30-40/barrel around the world, except Saudi Arabia who claims to produce its oil at the cost of below US$10/barrel. Hence we see commendable net profit of RM230 million reported in 2019 when HP managed to sell most of its crude oil above US$60/barrel. With the current oil price, it is certainly making a loss unless it can further push down production cost. I don’t have the technical knowledge and the relevant data to assess whether this is possible but I think it’s highly unlikely, given that it’s already 33% lower than the norm.

I have no doubt the oil price will recover but I don’t know when. I think it’s absolutely stupid to guess (some prefer the word estimate because it sounds more intelligent) the timing of oil price recovery and whoever does it instantly makes himself/herself look like an idiot. There are just too many factors on the demand and supply side affecting the oil prices that trying to estimate the timing is like shooting ten moving targets with one bullet. The key question is whether HP can survive the low oil price and ride out the storm?

Some say HP will be fine because its management is very prudent – it has zero debt and lots of cash on its balance sheet. That is true, but I also find it hard to believe that it can generate enough internal funds to finance its enormous capital expenditure. It has zero debt because most banks have been reluctant to lend to the oil and gas industry in the past five years and the management has openly admitted that it has problem accessing the debt market since 2014. Therefore, HP has no choice but to tap the equity market even though it usually costs more than the typical 5-7% cost of debt. For example, it has undertaken private placement of 144 million shares from Aug 2017 to Jan 2018, bringing in RM91mil to finance its operation. Even though share placement is easier for management but existing shareholders face an immediate 10% dilution to their holdings. At the same time, HP has issued 317mil warrants which can increase its share base by up to 20%. Right now most of the warrants have not been exercised because the strike price of RM1.00 is way above the market price. In other words, you have a company which is forced to be conservative with no debt but at the expense of higher cost of capital.

Some people are salivating over the RM273mil cash balance shown in the FY19 balance sheet but they have overlooked the fact that it’s just a snapshot at a particular point in time. It’s rather meaningless if the company has high cash burn rate which usually relates to oil and gas company. In the case of HP, the same RM273mil has dwindled to RM90mil in the subsequent six months mainly due to the RM225mil capital expenditure incurred for both its Anasuria and North Sabah assets. Bear in mind there is still another RM22mil due in Mar 2020 for the last tranche of payment for the acquisition of the North Sabah assets.

With the current oil price, HP should be bleeding heavily and I won’t be surprise if it has to turn to issue more equity since the debt market is more of less shut. As its share is being traded at historical low, this is one of the worst time to issue share because it most likely has to issue at a discount to attract investors. Issuing share at a price way below intrinsic value is a sure way to destroy shareholder value. HP is essentially suffering from a double whammy.

The conclusion is, I don’t think I will pursue this at the moment due to the following:

1. It is inherently difficult to estimate the earning power of HP due to its erratic capital expenditure requirement and the volatility of oil price. Therefore whatever analysis and calculation of its intrinsic value is pretty much just a mental masturbation.

2. I foresee a lot of shareholding dilution going forward.

3. I am terrible in speculating oil price movements and I don’t intend to even start.

4. I can’t reliably estimate how it can ride out the current storm unscathed under some conservative assumptions. What if oil price recovers but stays at US$20/barrel for a considerably long period? Will it have enough cash to sustain its capital expenditure – in oil and gas, you cannot just postpone the spending until the sun starts shining.

5. I don’t like to invest in something that requires me to pray very hard everyday.

Having said all that, the share price of HP may go up after this because there is so much noise and speculation on this counter by all sorts of punters. At one point yesterday there was 11mil buy orders against 3 mil sell orders and don’t be surprised to get stock tips from your uncles or aunties regarding HP after this.

Coronavirus seems to have no sign of abating with the US becoming the worst hit country with over 20,000 deaths. Life is such an irony that with such technological prowess and economic might, it seems so helpless when the death toll keeps rising everyday. This is a very powerful psychological attack around the world – if the Humpty Dumpty can’t handle this, what’s going to happen to the rest of the less prosperous countries if they get hit? Understandably, market sentiment is terrible everywhere and this could well be an understatement.

Off the top of my head, I can imagine a few industries getting hit really badly – airlines, hospitality, retail and real estate. Over the years I’ve gathered some general understanding of their underlying economics that instinctively tells me whether I should stay away or dive in. There are undeniably some great companies within these industries but it’s not easy to correctly identify them and I prefer to look at something easier. After all, there are thousands of choices in the market.

Airlines

I’ve always thought that an airline is one of the toughest businesses on earth. It’s generally a hospitality business whereby you go through lots of pain to introduce top-notch customer service in a consistent manner. At the same time, it is very capital intensive and super competitive. There is very little brand loyalty as most of the travellers I know will not hesitate to go for cheaper fare regardless of which airlines serving the same route. Therefore we often see airlines invest heavily in marketing and loyalty programs to make sure they generate enough volume to support their massive fixed cost.

Even if you managed to build a super efficient organisation, you will still face several headwinds beyond your control – change in fuel price, regulations (it’s a heavily regulated industry) and currency fluctuation. Hence it’s not unusual to see airlines dabbling in the financial market by executing various derivative contracts to hedge their risks. These financial instruments become another distraction because they often cut both ways. In short, to make an airline successful, you need to do a lot of things right, all at the same time even though some of them are beyond your control. Imagine you pass 10 rounds of job interviews only to get rejected in the end because they don’t really like your face. You will get similar emotional pangs by running an airline.

Property Development

Property development is a very cyclical industry and it’s exceptionally tough in the current market condition. A lot of people think property development is sexy because of the huge profit reported and, to a large extent, the lavish lifestyle of property developers. Most of them look at reported profit, which is usually high, but conveniently neglected other parts of the financial statements. It’s not unusual to see property developer generate high profit, but poor cash flow coupled with high level of debt. Most developers construct new buildings based on the availability of credit before they consider the market demand for their products. There is this subconscious thinking that when you build, then the buyers will turn up and whatever not sold will become valuable assets.

A little example will help us understand why a developer has poor cash flow. Let’s say you build 2 houses that cost RM500,000 each and managed to sell one for RM800,000. It shows a nice profit of RM300,000 on the income statement but you suffer a negative cash flow of RM200,000. In the meantime, you probably have to dig out your saving to pay income tax charged on the RM300,000 profit you just made and cover all the existing overhead. Try asking a banker how much a developer usually wants to borrow and the answer could be the maximum the bank is willing to lend.

I find it hard to analyse the cash generating ability of most public listing property developers. Real estate projects usually take 3-5 years (some even longer) to materialise and developers are expose to all sorts of changes in the market demand, lending practice, government policy, construction cost, interest rates and competition which are very hard to predict. Revenue and profit reported during the project cycle are very much dependent on management’s estimate due to the accounting rules which in this case, could be very different from reality. At the same time, there won’t be enough public information disclosed on each project to allow proper assessment of the overall health of the developers. You won’t be surprised to see a developer with bloated inventory which doesn’t get written down (property value can only go up, isn’t it?) and growing amount of debt collateralised by the same asset. Bankers love to accept the these “hard assets” because their credit committee checklist allows it.

Retail

Retail is also a tough business but it’s one of my favourites during a crisis like this. Most of the counters got sold down so badly that the price is way below intrinsic value. The general thought is that retail earnings will get hammered badly because of the 6-week complete shutdown. Shoppers are expected to be more cautious when it comes to shopping in case the virus is still lurking around and they might even shift to online shopping permanently.

That is true in the near term, possibly in the next 12 months. I don’t know how long exactly this will last but I expect retail to be one of the first to recover after the crisis is over. Malaysians are generally addicted to shopping malls because they can get whatever they need there and the hot weather generally stops them from going to the outdoor park. Try asking a typical family in Klang Valley how they spent the last weekend and you know what I mean. Online shopping is popular but what about family activities while you are busy browsing the websites?

The thing I like about retailers is the relatively understandable and predictable business model. Retailers also enjoy negative working capital which is essentially free money to finance the operation. Due to the asset light model, the return on equity can be rather attractive and there are no cumbersome capital expenditures that eat up free cash flow. At the same time, you generally don’t see too much debt loaded on retailers and that’s probably because they don’t have many hard assets to show the bank in the first place.

There are of course certain downsides face by retailers, such as thin margin, huge competition (especially e-commerce), currency fluctuation, inventory obsolescence etc but I think these are relatively more manageable compared to problems like regulatory risks. I generally don’t like highly regulated businesses because a lot of things are beyond control and they are exposed to political changes as well. Retailers, in my opinion, have less things to master in order to do well, unlike the airlines industries. Why is it important? Imagine you need to solve 10 questions to pass an exam and you have 90% chance of getting each question right. It sounds rather favourable but your probability of passing the exam is only 35%. I would rather go for an exam which only has 2 questions with 70% chance of getting each right – 49% chance of success.

***

I don’t think it’s a no-brainer to simply invest in any retailers because each has very different fundamentals. By narrowing down to one industry does not mean I adopt a macro analysis because that’s a totally different angles which has far lower chance of success, at least according to my own ability. I’m just trying to narrow down my focus because this industry seems to be most feared at the moment. It’s not easy to be contrarian but the reward is there if you get it right.

Lately, I come across two groups of people with completely different reactions to the recent crash in the stock market. The first are the more conservative ones who would stay away because the price drop looks scary. Ironically, they are also the ones who would buy whatever they can grab in the departmental store during the year end sales. The same company that has become 50% cheaper overnight is so frightening but a pair of jeans that suddenly cost 20% less is a newly found treasure.

The second group of people are more business minded and would recommend me to buy a share that has drop from, say RM6.00 to RM2.00 simply because it’s comparatively cheaper now. Some would even say it’s dirt cheap compared to its highest record of RM9.00 two years ago and I can easily make a 350% return on investment when it rises back to RM9.00. How I wish it’s that simple. By the way, these are also the people who would hesitate to buy a house that cost 10% cheaper than the neighbouring lot because they suspect something must be wrong with that house.

Honestly speaking, I exaggerated the above examples a little bit but the essence is true and that probably explains some of the irrational behaviour in the market. That’s also why we have people who have misunderstood speculation as investment and I have my fair share of making the same mistake, not once but many times. The first lesson I’ve learned is to ignore all this noise and fall back on some simple common sense. Stay away from speculation.

I generally love to look at companies with falling share prices and start investigating what’s happening. That’s what all great investors do anyway but it’s always easier said than done. That’s a lot of hard work because the amount of information to go through is painful and sometimes you can’t even get what you want and therefore need to make a judgement with limited data. There are some assumptions to be made before coming to a conclusion and then you realise that a slight tweak in the assumption makes a wild difference in the outcome. Sometimes the whole angle of analysing the business is wrong in the first place. I call this information overload.

Suffice to say that the second lesson I have learned is to focus on the downside of the investment. What are the things that could go wrong and look for red flags. It’s simply impossible to gather all the information to justify how good that investment is, I might as well focus on what could go wrong. Very often, I find that most companies’ annual reports look like they are written by the marketing department because they will tell you a hundred reasons why you should invest in the company. Hence it’s more important than ever to find out what can actually kill the business. Even Warren Buffet used to lose billions of dollars buying a large amount of ConocoPhillips stock without realising that oil price was near its peak at that time. In this case, the concern with oil price should take precedence over other business fundamentals.

Thirdly, I’ve also learned to stay away from businesses I don’t fully understand. There could be 200% upside in an engineering company making electronic components for the aerospace industry but I know practically nothing about the business. I don’t understand how does the current technology employed fare against competitors or whether there is a paradigm shift in the aerospace industry. Drawing from my own experience, I used to be a junior auditor doing a stock count audit on the inventory of an aerospace company based in Farnborough, United Kingdom. At that time, 99% of the items within my vision are so alien to me that I couldn’t even distinguish between a finished good and a piece of scrap metal on the floor! Now you know how much you can trust an auditor’s opinion. In short, I just think it’s not worthwhile to sweat and stress myself over this when there are many companies out there with far simpler business.

There are a few more lessons I have picked up but the list goes beyond my current attention span as it’s already past midnight now. Perhaps I can talk about it some other time.

I just pulled my mini trigger and invested in Padini Holdings Berhad (Padini), even though fashion is always as foreign to me as Swahili. Despite the fact that I can’t tell the difference between a pair of blue pants from a pair of purple ones (colour blind), I do understand some of the economics of the business. Starting from 06 Mar 2020, the share price of Padini plunged 40% from RM3.10 to RM1.84 mainly due to the worsening coronavirus crisis. As dangerous as it is, will this virus wipe out 40% of Padini’s value? Probably not.

The MCO has effectively locked down the entire country for one whole month, and it will probably be extended. With domestic sales accounting for 95% of Padini’s revenue, that’s a pretty painful hit in the nuts, especially when it has very negligible online sales channel to take advantage of the stay-at-home shopping spree. This coming quarterly earning will probably see a 60-80% drop while the outlets remain shut with other overheads running. Will this bring the company down to its knees? I think it will just be like the usual pain in the nuts – lasting just for a while without damaging one’s productivity.

I think it’s pointless to estimate how many months the Covid-19 crisis will last and how many months of potential revenue lost for Padini – my guess is as good as yours. However, I strongly believe that it will not last more than a year and therefore, I mainly consider 3 important aspects:

1. Do I understand Padini’s business model and the underlying economics?

2. Can Padini sustain the near-term impact (potentially net loss) and ride out the storm?

3. Is there a fundamental change in the economics of the business affecting Padini?

First of all, I’m a fan of Padini and I shop for most of my clothes at Brands Outlet. I know I can’t say I buy its share because I like to shop there without sounding like a bimbo, but the truth is I have a genuine perspective as a customer. It gives me the first instinctive smell.

Looking at its latest financials, Padini incurred an average of RM400mil selling and distribution expenses in a year, which I conservatively estimate 80% is fixed. Together with administrative cost of RM85mil, I put its overhead at RM405mil. Finance cost is negligible and it mainly relates to trade financing which will not be utilised when there is no purchase of goods. Now imagine all Padini’s outlets are closed for one whole fucking year while it’s still paying RM405mil of overhead on time. With a cash pile of RM586mil as of 31 Dec 2019, it should still have RM181mil left after one year of vacation for everyone in the company. In other words, with such a huge cash pile and 1% gearing, I’m confident that it can ride out the storm.

The biggest risk in my mind is the competition within the cut-throat world of fashion, especially from the booming e-commerce. A lot of retailers went extinct because their brick-and-mortar business model cannot compete with the low-cost e-commerce and the massive change in shopping habit. For Padini, its online sales is mainly done through its own website and collaboration with Zalora but the revenue is so insignificant that management can’t be bothered to even split out the revenue number in its annual report. This was openly admitted by the directors during the 2017 AGM. Forever 21 is the latest high-profile fashion retailer that collapsed due to the gruesome competition from both brick-and-mortar retailing and e-commerce. Perhaps I can try to draw some lessons from there.

E-Commerce

In my opinion, I’m not overly concerned by this. Padini’s market is generally the middle or mid-lower income group who emphasise value for money and to a certain extent, quality of the garments. E-commerce giants like Amazon and Alibaba are killing a lot of traditional retailers because they have cost advantage and shipping is becoming more and more affordable with the huge amount of resources invested in the development of logistics infrastructure specifically catering to it. It’s not unusual to see people visiting electronic stores to check out the design and quality of the products, then proceed to buy from Lazada at cheaper prices. For fashion, this is unlikely to happen because other online retailers will not carry the same products you see in the store and every piece of garment is rather unique. Furthermore, buying a piece of clothing item requires the right fitting and physical checking of the quality – even colour may look very different when shown online. A piece of dress may look stunning on photos but not on you and vice versa. The best place to find out is still the fitting rooms.

I don’t consider Padini being in the fast fashion market whereby the latest designs are quickly translated from the catwalks and there is an insatiable hunger for new stock. As the target audience is millennials with fast-changing tastes, the chances of getting everything right is relatively harder. Fast fashion is mainly booming through e-commerce as millennials are heavy users of the internet and they tend to buy trendy garments at rock bottom prices despite the low quality because they never expect themselves to keep wearing the same thing. The idea was to keep buying new clothes and look trendy even though their income is not bottomless. Forever 21 was riding on this market but with a brick-and-mortar expansion model, which transformed itself into a 300-pound gorilla – not easy to feed and manage. It effectively pitted itself against online retailers which do not need to fork out jaw-dropping rental on high street. That was one of its strategic failures which was very hard to reverse no matter what management talent it engaged. Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

About 10 years ago when I was still in the UK, I started to witness a paradigm shift in the retail industry whereby high street retailers were getting butchered and online retailers sounded sexier than ever. Zalora was founded in 2012 and quickly expanded in Malaysia and became a poster child for the local online fashion industry. Did it affect Padini in anyway? I don’t know, but I do know that Padini’s sales has continuously increased from RM726mil in 2012 to RM1.8bil in 2019, without a single year of decline.

Expansion

Forever 21 went from 7 countries to 47 in less than 6 years and at one point operate over 700 stores across the Americas, Asia, the Middle East and the UK. At the same time, it was pitting itself against well capitalised giants like H&M and Zara in their home turfs. Such an aggressive growth pushed their sales to $4.4bil in 2015, but the house of cards quickly tumbled after that. This reminds me very much of WeWork which also collapsed under the weight of its physical expansion that often defied business common sense.

Padini has gone the other way round by cutting its store and counter number by half from 281 in FY2014 to 141 in FY2019. This mainly involved cutting down its consignment counters for Seed, Miki and Padini, and moving to standalone Brands Outlet and Padini Concept Stores. I guess the strategy is successful with the growing sales and profit over the years. Right now, it still generates over 95% sales from domestic market and most of its overseas businesses (40 outlets) are managed by licensees and dealers. That means it’s pretty much free from the capital commitment and operational risks in these countries. The only stores operated directly by Padini are those in Thailand and Cambodia. I think their overall expansion is pretty modest and Cambodia does offer a growing middle class which should be its target market. I’d be far more doubtful if the locations chosen are London, New York or Hong Kong which usually attract enormous glamour for the CEO at the expense of shareholders.

Debt

What attracts me is the conservative use of debt by Padini. As of Dec 2019, the gearing ratio was a negligible 1% (2018: 3%). Its debt is usually short-term banker’s acceptance credit which usually gets settled quickly, a common practice in the purchase of goods. For example in FY19, 90% of its short term borrowings consists of banker’s acceptance (FY18: 89%). The corresponding cashflow statement shows RM137mil of short-term borrowing drawdown against RM148mil settlement within the same year, which is in line with my understanding. All the other long term borrowings are negligible especially against the backdrop of RM586mil cash pile sitting in the bank account. The 2QFY20 financial shows an increase of lease liabilities of RM496mil but I’m not too concerned as this was due to the adoption of MFRS16 in relation to lease, which doesn’t affect the nature of the business at all.

Management

I don’t know much about the management except the fact that the board mainly consists of family members. The founder generally has impressive track record for steering the company over the past few decades but I’m not sure about any professionals he has brought in to sustain the business – none of this is disclosed in the annual reports except directors’ profile. I don’t believe a company of this size can just rely on family members who carry the founder’s genes. By going through the AGM’s Q&A, I have a feeling that the board is rather reserved and not very open or articulate when it comes to addressing shareholders’ concern. One of the shareholders asked whether the management has gained any insights from the failure of fashion retailers such as Top Shop and Forever 21. One of the directors answered by saying that management was aware and will learn from those mistake, full stop. This kind of answer somehow shows you are either not aware of what’s happening in the market or you don’t know where does your company stand.

I’m a bit disappointed that management doesn’t have any plan for share buyback according to its intention stated in the AGM. When the share price falls way below its intrinsic value, share buyback will be one of the best way to reward shareholders. Now could be the time.

***

Right now, the share price at RM2.13 should be pricing in about 25% drop in sales for FY20 according to my own estimation backed by certain assumptions. If sales drops further there might be another round of sell off – good buying opportunity as long as the long-term business prospect is intact. The overall financials look healthy and the margins do not run very far from global giants like Inditex (Zara, Massimo Dutti, Bershka) and Fast Retailing (Uniqlo). It’s also encouraging to see consistent return on equity in excess of 20% over the past 5 years and this is done without loading huge debt on the balance sheet. Based on its cash generating power after factoring inventory loss and capex, I’m expecting a 35-40% margin of safety. I’m not looking to be 100% accurate on this because I don’t believe anyone can be. What’s more important is to avoid being precisely wrong.

p/s: EPF has been busy acquiring over 4 million shares of Padini since 10 Mar 2020. Though minuscule compared to its asset of RM1 trillion, it’s still comforting.

Malaysia Airports Holding Berhad (MAHB) recently caught my attention simply because it has lost over 50% of its market capitalisation over the last 6 months.

The plunge in its share price is understandable given the Covid-19 crisis is crippling air travel in an unprecedented way. In fact, the current price is the lowest in the past 5 years and that prompted several analysts making buy recommendation based on its depressed PER ratio compared to its 5-year-average PER of 60. I can’t help but cringe a little bit because that is pretty much the only reason given. What I’m more interested is whether the company is being undervalued due to panic selling. I’m certainly not an expert in airport management or aviation but decided to do some digging.

I like the business model of airport operation because it has super solid moat due to its monopolistic position. I don’t foresee any replacement for air travel during my lifetime and the barrier of entry is enormous because this is a highly regulated industry. Managing an airport is pretty much like running a small city and the residents keep growing year on year. Even though MAHB is perceived as a private commercial entity, the government of Malaysia still holds 1 golden share which allows it to appoint most of its directors, effectively having huge influence over its major decisions.

MAHB derives around 75% of its revenue (RM3.9bil) from managing 39 airports in Malaysia, pretty much all airports in Malaysia (except Senai Airport) and 25% revenue (RM1.3bil) from managing 1 airport in Turkey. Under the Operating Agreement signed with the government of Malaysia, MAHB is given the operating rights to operate all these airports until 2069. Out of its total revenue (FY19), 95% relates to airport operation while the rest is from non-airport operation such as hotel management, agriculture (palm oil plantation around KLIA) and project services. For airport operation, it mainly generate income from airport services (passenger service charge, landing and parking fees, ancillary charges to airlines, rentals from terminal tenants, car park charges, F&B operation etc). More notably, MAHB also directly operate Eraman Duty Free (largest in Malaysia) which contributed RM850mil revenue (23% of airport operation) in FY19.

Now the main question is what’s the impact of Covid-19 to MAHB’s revenue in FY20 which involves some guesswork. In Feb 20, MAHB alrady reported a 23.4% drop in passenger traffic compared to the same month last year due to Covid-19, but that’s before things got a lot worse and the implementation of MCO with absolutely no flights allowed. Even after MCO is lifted, air travel will take some time to recover because the rest of the world like US and Europe are still in deep shit. It’s reasonable to expect that most people will refrain from travelling for quite a while because the virus could be lurking around and it’s better to be safe than sorry.

Let’s say MAHB’s revenue drops by 50% in FY20 (which is not unlikely), I expect its EBITDA to drop even further by percentage because a large component of its cost should be fixed. Just like a hotel, the incremental cost of serving an additional passenger is minimal. Let’s say EBITDA drops by 70% from RM2.4bil to RM715mil, its barely enough to service its finance cost of RM720mil (FY18: RM756mil). A fall in profit before tax predicted by most analysts could very well be a net loss in my opinion.

Looking at its balance sheet, MAHB has RM1bil of Islamic Medium Term Note (IMTN) maturing on 28 August 2020 which will eat up most of its existing cash pile of RM1.45bil. The balance cash will probably just enough to support its capital expenditure of estimated RM300-400mil (based on average capex in the last 5 years). I think it shouldn’t have problem refinancing its IMTN as its gearing ratio of 73% is still below 125% limit under the existing covenant and it has solid backers on its shareholder register (Khazanah 33.2%, EPF 9.5%, KWSP 2.3%). Alternatively, it can choose to liquidate its RM1.75bil investment in unit trust, which may result in massive loss in the current market condition. Lastly, they can go for a rights issue just like Singapore Airlines’ SGD5.1bil rights issue which will mainly be taken by by Temasek.

MAHB is loaded with quite a huge amount of borrowings, RM2.5bil in FY10 to support the construction of KLIA2 and RM2bil in FY14 to support its Turkish operation. As for KLIA2, I still remember the massive scandal whereby its construction cost has increased from RM1.7bil to RM4bil (a massive overrun of more than 100%). Moreover, the target opening date was delayed 5 times and it finally opened in May 2014, even though the original date was supposed to be Sep 2011 (2.5-year delay). That has pretty much shown the quality of management but I don’t intend to dig into the shenanigans back then and let’s hope that the episode is over, especially with the change of government (twice!). Even the CEO and CFO have been changed several times in the past 8 years with the latest change of CEO just three months ago. With such a management revolving door at the c-suite level, I wouldn’t be surprised with short-term thinking and further rounds of mishaps. Touching on debt, MAHB also has a number of contingent liability in relation to lawsuits and the notable ones are KAF (RM480mil) and Air Asia (RM456mil). I’m not too concerned with that as the relevant cost generally takes quite long to materialise, if it ever does.

MAHB definitely face a huge challenge in the short term but will it fare well over the long term? If it can maintain its performance in the past 5 years, then I’ll estimate a free cash flow of around RM0.35 per share and that should give a value of RM7-8 per share. However, the biggest blind spot right now is the uncertainty over the implementation of Regulatory Asset Based framework by the government whereby the airport tariff can only be increased if MAHB’s return on invested capital (ROIC) is below its weighted average cost of capital (WACC). Well that’s a mouthful of jargon but it essentially will limit the increase of tariff and reduce the revenue upside for MAHB. Additionally, there will also be penalty imposed on MAHB if certain service quality is not maintained. Basically the whole airport business is highly regulated because tariff such as passenger service charge is set by the government and there are tonnes of regulations to be adhered to. There is also this uncertainty over the newly formed government in terms of its competence and commitment in this area, not to mention its own stability.

For that, I believe I should toss this onto the tray labelled “too hard” for the moment.

The recent government stimulus package has been widely criticised for failing to take care of the small medium enterprises (SME). On the other hand, there is also a corresponding backlash saying that taxpayers’ money should not be used to save private businesses. After all, SMEs should be prepared to take the risk in the first place – this is part and parcel of capitalism. Some have gone to the extreme of attacking entrepreneurs for being greedy because what they visualise is the fancy cars and fine dining enjoyed by these bosses and now they are crying for help. I see the merits from both sides but there is way more to ponder if we look deeper.

First of all I don’t agree with government bailing out any business because they will create moral hazard and those who think they are too big to fail will take this opportunity to see how far they can go. At the same time, we cannot deny the fact that SMEs currently contribute close to 40% of the country’s GDP and majority of them are in the service industry which also means they provide a lot of jobs. Metaphorically, you cannot protect the eggs and leave the hens to die in a thunderstorm just because the former are more vulnerable.

The recent wage subsidy announced by the government is certainly laudable but I’m not very sure how many will benefit from it because you have to show a 50% drop in sales from January 2020 and you cannot impose any unpaid leave or cut salaries of employees. Judging from the fact that market demand will not recover quickly in the next 6 months, I believe some SMEs might as well impose a significant pay cut or retrench their workers. What’s the point of receiving RM600 subsidy per worker if the net cost of retaining them is way higher. Furthermore, if businesses recover faster than expected, they can always hire again from a large pool of unemployed workers at more favourable terms. Job losses over the next few months is inevitable as I believe most employers will go through the same evaluation.

Almost everyone who borrows money from the bank enjoy loan repayment moratorium for 6 months but there is no rent moratorium mentioned at all. Most SMEs suffer because rental constitutes a large part of their fixed cost, especially retailers and F&B operators. Imagine landlords who get loan moratorium but still enjoy the cash flow from rental income. Isn’t this a form of subsidy to them even though they are the least vulnerable ones? Landlords with loans tied to their commercial properties should only be given repayment moratorium if they provide rental deferment to their tenants at the same time.

Most SME owners I know are generally surviving the crisis provided the MCO is not further extended. That means they have cash buffer of more than a month, which shows good liquidity management. I’m glad that it strengthen my faith in SMEs which I always admire for their survival instinct and adaptability. Personally, most of the products and services I enjoy are mainly provided by SMEs which tend to be more customer centric. For those who cannot survive the current crisis, they will inevitably go through constructive destruction which is prevalent in capitalism. After all, there could be many other economic factors which can impact short term market demand even if there is no Covid-19. Those who survive will emerge stronger and more robust in their risk management because we all are now convinced that it is indeed possible to have zero customer for a month.

One thing is for sure, most people including businesses will go through self-imposed austerity in the coming months. Coupled with job losses, there will be a massive draining of confidence in the market which leads to recession. The economists will tell you that confidence is one of the biggest determinants in economic activity. In layman terms, it’s what you believe you can do that matters instead of what you can actually perform. When everybody thinks that recession is on the way, it becomes a self-fulfilling prophecy.

Right now, all the indicators I know are pointing towards a difficult time in property, construction, retail, hospitality, travel, automobiles, banking, oil & gas etc. Will there be good value to be unveiled? Hopefully.

Since I started working in the real estate development industry in 2013, I began to consider real estate as a far better asset class compared to publicly traded stock due to a few observations I made.

1. It’s not uncommon to make superior return on equity in excess of 300% over 3 years by using maximum leverage of up to 90% loan-to-value ratio (LTV). The LTV can even be increased to 110% by grossing up the property price, a widely known and accepted secret.

2. Bank financing is cheap (4.5% interest p.a.) and easy to get as banks readily accept real estate as collateral. Your creditworthiness can be artificially boosted via creative methods if you know the right people, not to mention you can get multiple housing loans approved at the same time by different banks before they update each other about your application.

3. Property prices generally go up over the long term and they do not swing up and down frequently because they are not traded in an exchange. That saves a lot of heartache.

4. The amount of research required for a property investment is extremely little compared to stock. It’s easy to understand the location of a property compared to assessing the earning power of a public listed company. You also don’t have to regularly monitor the performance of your property investment other than collecting rental and fixing broken pipes.

5. There is a widely accepted conformity that owning property is the safest and surest way to get rich while investing in stock market will get you burned eventually. There are just too many examples of stock market speculators jumping off the buildings. In other words, by investing in property you can a lot of psychological assurance because you are joining the herd.

6. As property price increases over time and the loan gets paid down, the equity value in the asset grows without much effort. You can harvest the fruits by refinancing the asset and roll the money into another property in a similar fashion and create your property empire.

The above is true to certain extent but I have also experienced some of its downside. The biggest disadvantage is the illiquidity of such investment. It took me 6 months to sell the service apartment I used to live in at a loss and another 5 months to receive the payment. The process was so painful that I wished I had just rented the apartment from the beginning. No matter how sound is an investment, a lot of things can go wrong if the selling process takes long and the complications will increase the risk in the process. Another problem with illiquidity is that it hampers your ability to take advantage of better investment opportunities. Take the same example above, if you have to wait 11 months to get the cash from the sale of your property, the present investment opportunity would have been long gone.

Most of the advantages of property investment listed above involves the aggressive use of debt and we all know the perils of debt when the tide is against us. The cost of debt at 4.5% per annum is manageable especially if the property is rented out with an equivalent yield, but most people conveniently ignore the capital repayment that often put a big strain on their cashflow. Throughout the past 5 years, it’s extremely rare to find a property that generate enough rental to cover the monthly repayment of loan with 90% LTV. Hence most people invest by only looking at the upside from capital appreciation but a lot of them are not able to hold it long enough to see that happen. This is actually quite similar to stock speculators that got wiped out via forced selling by their brokers who provide margin financing.

I have come across a few people who employed the following tactic in their property investment, which I would rather call speculation. They would buy a property with real value of say RM500k but at a gross price of RM600k and borrowed 90% against it. Immediately they received RM40k upfront cash back which was used to cover the transaction cost and service the loan repayment. Now imagine the same modus operandi was repeated across 10 different properties. When they saw that the lump sum cash back and rental was more than enough to cover the next 12 loan repayments, they start collecting luxury cars. Some even went to the extent of replicating this by using other people’s name as the borrowers. How did they manage to convince the borrowers? Go join some “coffee sessions” organised by some self-proclaimed property experts and you can find out easily.

The so called property experts conveniently forgot the fact that developers are busy ramping up the production of housing not because of demand but cheap credit given by the bank. When tenants fled for newer properties and buyers in secondary market dried up, they realised that their debt amount is way more than the underlying asset value because the theory on asset appreciation was simply not true. Therefore it’s not uncommon to see some residential buildings riddled with foreclosure notices. Unlike a troubled company which can be turned around by a high calibre management, a lousy building in a less desired location is extremely difficult to be turned around especially when there is an oversupply of similar products.

When assessing an investment, we ideally asses the asset’s intrinsic value against its current price. Very often the price of real estate is simply based on what the neighbour is selling for with no regards to what cash flow can be generated from the asset. This is prevalent among land owners who demand for astronomical price in line with their neighbour despite different land use allowed by the government. In Malaysia, there is always this dangerous belief that you can change the land use to whatever you want as long as you can afford the extra grease.

In Malaysia, the hefty real property gain tax (RPGT) of up to 30% makes a lot of investments not worthwhile. I’ve considered refurbishing run down houses and subsequently resell for profit but the RPGT will effectively wipe out all profit. Coupled with the long duration required for the selling process, I’ve decided that there are better opportunities elsewhere. Comparatively, there is zero capital gain tax imposed on the profits made on selling public listed stock and the selling process takes a few minutes provided it’s not some thinly traded counters.

Despite all the above, I’ve also seen really successful property investors who have built a solid property empire that produces amazing cashflow. This is often done with very careful deployment of debt in line with their holding power in order to avoid permanent loss of capital a.k.a foreclosure. This is also usually done over a long period due to the nature of property being illiquid and the time it takes to achieve meaningful capital appreciation. Therefore, it usually sends chill down my spine when I hear overnight success story of a young property guru in early 30s driving a Ferrari. I mean, you can be lucky enough to buy a severely undervalued asset from a desperate gambler, but what is the likelihood of finding another one?

Coronavirus has hit the whole world badly with almost a quarter of the population in lockdown and that includes myself. It’s day 16 of the lockdown since 28 March and I’ve decided to start writing again to kill some time. I don’t know whether this journal will get abandoned later but at least not for the next 12 remaining days of the lockdown.

A lot of things have happened in the past 2 weeks, with the tumbling of the stock market capturing most of my attention. I re-visited a lot of value investing materials which I delved into more than 10 years ago when I was still working in the United Kingdom. Most of the ideas centre around “Value Investing” championed by the world-renowned Warren Buffett, which is the only investment philosophy I believe in. It is also the only method that generated positive returns for me as opposed to some dumb speculations I did in the past by acting on stock tips from questionable sources.

One thing I observe is that great investors are usually brilliant writers apart from being voracious readers. I strongly believe that once you can put your thought clearly on a piece of paper, you have successfully mastered and internalised what you have learned. I’ve always been a voracious reader but I don’t have a yardstick to measure how much knowledge I’ve mastered. This could be the best avenue to test it out. Apart from that, I hope that this can be a great album to capture my thoughts at a particular point in time, just like a photo album that serves as a memory lane.

What kind of topics I should write about? It will not run too far away from current affairs, business and finance as these are the only areas I pay attention to apart from politics, which I have no intention to write about. To be fair, I enjoy other things in life too, such as cooking and sports but I don’t want to make a mockery of myself by talking about that because I have absolutely no idea what to say.

As usual, just like the beginning of each book with an Acknowledgement Page, I start mine by thanking the government of Malaysia for imposing a 28-day lockdown to control the spread of Covid-19. Without this, I wouldn’t have the time to start writing again.

Right now, my thoughts and prayers are with the medical frontliners battling the current crisis.