Sunday, 29 October 2017

Which Offshore Support Vessel Companies Will Survive?

Following the success of the minion strategy described in The First Class of Minions, I have continued to use it to place speculative bets on companies which have a reasonable probability of turning around. These include the Oil & Gas (O&G) companies. The first batch of O&G minions are from the upstream Exploration & Production (E&P) companies, as they are the first to benefit from the rise in oil price. See The Missing Link Between Oil Price & O&G Profitability for more info. This group of minions (Interra, KrisEnergy and Ramba) is not particularly successful, with Ramba currently having paper loss of more than 50%.

Nevertheless, it has been 3 years since the oil price crashed in Jun 2014, and it is perhaps time to look further downstream along the O&G value chain, which brings me to the Offshore Support Vessel (OSV) companies. Many companies in this sector are in trouble, such as Ezra, EMAS Offshore, Ezion, Marco Polo, etc. Is this sector poised for a turnaround? While there are some good news for the O&G industry recently, I still have doubts, which explains why these are minion positions instead of full positions. For now, it is more a bet on which companies will survive rather than which companies will turn around and start making profits.

Compared to the semiconductor industry described in The First Class of Minions, the factors that I consider are slightly different. Debt-to-Equity is a common factor for both industries, as companies that have high debts will have difficulty surviving regardless of which industry they are in. Beyond that, there are factors unique to each industry. In the OSV sector, 2 key recurring themes are asset impairments and receivable build-up/ impairments.  

Asset impairments arise because when the companies bought the OSVs during good times, the vessel prices were high. Currently, the vessels are facing low utilisation and low charter rates, which requires their book values to be written down. Receivable build-up/ impairments arise because most companies in the industry are facing financial difficulties and customers might not be able to pay up when the bills are due. Thus, to minimise asset impairments, the companies should have low Asset-to-Equity ratios. Because some companies could own vessels in joint ventures and associate companies, I included joint ventures and investments in associate companies together with Property, Plant and Equipment to determine the asset value that might be written down. 

To check that receivables do not build up, I considered the year-on-year (YOY) changes in Cashflow from Operations (CFO). The preferred period of measurement is for the latest quarter, e.g. 2Q2017 vs 2Q2016, as this reflects the most current business environment, but not all companies disclose the CFO for the latest quarter. Some disclose the CFO for the 6 months or the full Financial Year. 

Finally, there is 1 other factor to consider, which is whether there are any bonds maturing soon. Bonds are held by institutions and individuals and they might not be so willing to consent to extending the maturity of the bonds and/or reducing the interest rate. When that happens, the bonds are in default and could trigger other creditors to also demand for payment. In contrast, banks sometimes have no good alternatives but to continue extending the credit lines to the companies. See The Type of Debts O&G Companies Have Matters for more info. 

Thus, a compilation of the OSV companies based on the above factors are as follows. The 4 last companies have been suspended, but they provide a useful reference for comparison.

Company Period Asset/Eq Cash/Eq Debt/Eq % YOY CFO Bond Maturity
Atlantic Jun 17 1.99 0.02 0.88 -75% (6M) -
CH Offshore Jun 17 1.02 0.04 0.10 -210% (FY) -
Falcon Jun 17 1.74 0.06 0.91 -41% (FY) Sep 20
Mermaid Jun 17 0.81 0.29 0.25 -78% (6M) -
Pac Radiance Jun 17 2.48 0.14 1.97 N.M. (Q2) Aug 18
POSH Jun 17 1.91 0.02 1.12 45% (Q2) -
Vallianz Jun 17 2.29 0.05 1.83 N.M. (Q1) -
EMAS Offshore Nov 16 10.96 0.12 6.47 -61% (Q1) -
Ezra Aug 16 3.22 0.17 3.16 -23% (Q4) Apr 18
Ezion Jun 17 1.83 0.07 1.11 -108% (Q2) Aug 18
Marco Polo Jun 17 -0.60 -0.04 -1.64 162% (Q3) Oct 19

Firstly, on Debt-to-Equity ratio, CH Offshore and Mermaid have low D/E ratios, thus their debts are  more manageable. In particular, Mermaid has more cash than debt. Having said that, CH Offshore is a subsidiary of Falcon Energy, which has high D/E ratio of 0.91. A potential risk is that Falcon might direct CH Offshore to take on more debts and send money to the parent either through special dividends or buying over Falcon's vessels. 

Secondly, on Asset-to-Equity ratio, the same 2 companies (CH Offshore and Mermaid) have the lowest A/E ratio, hence, any potential asset impairments would be smaller than the rest. Do note that the high A/E ratio for some companies may be because some of these companies have already carried out 1 or more rounds of asset impairment. By right, companies that have carried out asset impairments should be safer than those that have not, but I prefer to err on the conservative side and stick to companies that have low A/E ratios. It is also possible that 1 round of asset impairments is not sufficient to fully write down the vessel values to their market values.

Thirdly, on CFO YOY changes, most companies have declining CFO in the latest available quarter. This is due to declining vessel utilisation and charter rates, and customers facing difficulties in paying bills. The only 2 companies that managed to report an increasing CFO are POSH and Marco Polo. However, Marco Polo's CFO before working capital changes is negative. Hence, the only company that passes this criterion is POSH. In addition, POSH is majority owned by the Kuok family, thus it has backing from the owners and the banks. Nevertheless, given that its D/E ratio is a high 1.12, there is possibility of a rights issue to lower debts.

Originally, I also had another criterion based on market capitalisation, which is based on the assumption that the largest companies would survive. On this count, Ezion and POSH have the highest capitalisation.

Thus, my picks for the OSV sectors using the minion strategy are CH Offshore, Ezion warrant, Mermaid and POSH. All 4 have their unique risks on top of industry risks. Ezion was suspended the day I bought the warrants. Let us see how they turn out.

Just a reminder, this post is not a recommendation for anyone to buy or sell any O&G stocks.


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Monday, 23 October 2017

The IQ, EQ and AQ in Investing

To be successful in investing, it takes more than just having a high Intelligence Quotient (IQ). As Warren Buffett said, "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ." Besides IQ, Emotional Quotient (EQ) and Adversity Quotient (AQ) also play important roles in determining the outcome of our investments.

Intelligence Quotient (IQ)

IQ is about the ability to rationalise our investments. It involves setting up a framework to determine asset allocation, risk management, stock selection, stock valuation, buying and selling rules, etc. If you are an active investor who picks stocks or unit trusts, IQ is at work most frequently in the last 3 activities. Nevertheless, being able to spot a good investment is important, but not sufficient, as we shall see in the section on EQ later. 

It is also not necessary for an investor to have high IQ to be successful. If an investor recognises his limitations in picking stocks, he could become a passive investor and buy a basket of market indices and still be able to reap good results. See All I Want Is To Invest Wisely for more info.

Emotional Quotient (EQ)

EQ is about the ability to control our emotions from running wild and interfering with our investment rationale. Examples are: not being influenced by peers or market rumours, not getting too excited when we spot a good investment and buy beyond our means or position limits, not chasing the stock as it goes above our target buy price for fear of missing out, not losing our nerves as the stock keeps on rising or falling, etc. Essentially, it is about making sure that we do not do something stupid that we might later regret had we thought through more comprehensively. If we have the IQ to spot a good investment but do not have the EQ to hold on to it until its full potential is realised, our competency as investors will be diminished. 

Personally, EQ is my weakest link. There have been countless examples where I get too excited, chase a stock or sell too early. I also have loss aversion bias, which means that I sell my winning stocks too early and hold on to my losing stocks. In addition, I have phobia about financial crises, having gone through both the Asian Financial Crisis and the Global Financial Crisis. EQ is the area I have to work on if I wish to improve my investment results.

Having said the above, the good news is that EQ can be managed to some extent using IQ. For example, by setting rules on stock valuation, position limits, target prices, etc. and following them strictly, emotions of fear and greed can be managed to some extent. See Have a Plan for more info.

Adversity Quotient (AQ)

AQ is about the ability to survive difficult times, such as at the depth of a market crash. Do you give up and sell out, or do you rationally look at the situation and identify potential silver linings among the dark clouds and act accordingly? In a way, AQ is related to EQ, but there are some differences with EQ. The emotions that I associate with EQ are greed and fear, while the emotion that I associate with AQ is despair. They are different emotions and some people can handle one emotion better than another. For me, I can handle actual losses (both realised and unrealised) much better than the fear of losses. A case in point is my Oil & Gas (O&G) portfolio. Although the unrealised losses are heavy, they have not seriously dented my confidence in managing them. I am still taking steps to turn them around.

Conclusion

To be a really good investor, you not only must have high IQ, but also high EQ and AQ. I am still trying to improve in these 3 areas.


Sunday, 15 October 2017

The First Class of Minions

3 years ago, I embarked on a new strategy of placing small, speculative bets into loss-making companies with the potential to make a turnaround. That strategy is now affectionately known as the "minion" strategy. The first class of minions is from the semiconductor sector, which has risen strongly this year. Most of the minions have been sold in the last 1 year, and they have graduated with flying colours.

The triggering point for initiating this strategy is that I realised that although there were many semiconductor stocks listed on SGX, only 2 made good profits and gave out good dividends. The vast majority were not. See the table below, which is based on the financial results for FY2013, which were the latest available results at the time when I initiated the strategy in Mar 2014. Please note that the figures are not adjusted for consolidations and other corporate actions.

Company EPS Div D/E NTA Price P/NTA NTA/EPS Max EPS
AEM -0.92 0.00 2.5% $0.150 $0.079 0.53 16.3 1.53
ASTI -2.32 0.00 14.9% $0.120 $0.057 0.48 5.2 2.58
Ellipsiz 0.86 0.20 4.5% $0.190 $0.085 0.45 N.A. 3.85
MicroMech 3.69 3.00 0.0% $0.270 $0.570 2.11 N.A. 4.92
MIT -2.98 0.00 35.7% $0.130 $0.072 0.55 4.4 1.74
STATS -2.50 0.00 93.4% $0.560 $0.310 0.55 22.4 6.50
Sunright -1.40 0.00 7.3% $0.610 $0.125 0.20 43.6 5.00
UMS 8.40 6.50 0.0% $0.560 $0.655 1.17 N.A. 8.40

The intriguing question I had was why both Micro-Mech and UMS could make money but the rest could not. Some even had fairly large losses. The divergence in performance raised an interesting question, which was that would Micro-Mech and UMS follow the rest into losses, or the rest would follow Micro-Mech and UMS into gains. Thus, I decided to explore placing speculative bets into the loss-making companies, with the hope of them turning around and becoming multi-baggers. These bets were mentally written off the moment they were invested (see Meet The Minions for more info).

Having said that, it is not just anyhow throwing money away. Nobody likes to really lose money. Thus, there are 2 guiding principles in the minion strategy. Firstly, the companies must demonstrate they have the ability to survive at least for the next few years, so that there is sufficient time for a potential turnaround to happen. They should also not have to call a rights issue, else it would be throwing good money after bad ones. Secondly, there must be reasonable probability of a turnaround happening. If either of these 2 conditions are not present, the minions would likely lead to losses.

On the ability to survival, the companies should not have high Debt/Equity ratios and the Net Asset Value should be sufficient to absorb the loss per share for the next few years. Surprisingly, all the semiconductor companies evaluated above had low Debt/Equity ratios, with the exception of STATS ChipPAC. The NTA/EPS ratio for loss-making companies show how many years they could last, assuming they continue to make the same losses every year. Again, in this aspect, all the companies could survive for the next 4 years at least.

On the probability of a turnaround, I really had no insights into this industry (and why Micro-Mech and UMS made money but the rest did not) and was relying heavily on the guess that convergence among the companies (in either direction) was probable. Exactly how long the turnaround would happen was unknown. Based on the earlier discussion, if the turnaround were to happen within the next 4 years, then all the stocks evaluated would rise.

Besides checking whether the companies could survive, I also considered if a turnaround were to happen, how much money could the companies make. This is where the highest EPS in the past 5 years came in. It is not much use if the companies only made small profits at the peak of an industry cycle.

Next, the stocks must be selling at a cheap price relative to valuation. If they are not cheap enough, the profit potential is reduced. This is why even though Micro-Mech and UMS are profitable companies, they do not make good candidates as minions. The Price/NTA ratio shows that most of the companies have low P/NTA ratios of around 0.50, except for the 2 darlings which are Micro-Mech and UMS. In particular, Sunright only had P/NTA ratio of only 0.20.

Finally, diversification is extremely important. Despite all the checks, I cannot tell for sure which stocks would tank or call a rights issue. To manage this risk, I buy more than 1 stock.

Based on the considerations above, I selected ASTI, Ellipsiz, MIT (Manufacturing Integration Technology), STATS and Sunright for my speculative bets in Mar 2014. Each position was a small one, and I had 5 stocks to spread out the risks. Most of these stocks were sold in the last 1 year. The results are as shown below.

Company Bought Sold % Profit Remarks
ASTI $0.055 $0.056 2% Sold in Apr 17
Ellipsiz $0.283 $0.380 34% Sold in Sep 16
MIT $0.066 $0.220 233% Partially sold in Jul 15
STATS $0.335 $0.625 87% Sold in Sep 14
Sunright $0.125 $0.305 144% Sold in Mar 17
Average

100%

Among the 5 minions, 1 is a dud, 1 is a 2-bagger and 1 potentially could be a 3-bagger (assuming fully sold at the current price). The average gain is 100%. Many of them rose further after I sold.

So, the above are my first class of minions. They have graduated with flying colours and gave me enough confidence to continue my minion strategy.

Just a final note, in case you go away thinking minions are very profitable, they are actually high risk, high gain positions. Not all will make money. Some will show unrealised losses for long periods of time. Some will be completely wiped out. One of them, Ezion warrants, got suspended the day I bought into it. Do not attempt this unless you fully understand and are prepared to take all the risks.


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Monday, 9 October 2017

The Accounting for Hyflux's Water Treatment Plants

Hyflux develops and operates various types of water treatment plants for municipals and industrial companies in concessions of 20 to 30 years. It has a strong order book of $3,187M as at Dec 2016, of which $1,916M is related to future revenue from the operations & maintenance (O&M) of the water treatment plants over the concession periods. Fig. 1 below shows Hyflux's order book.

Fig. 1: Hyflux's order book

Yet, despite the strong O&M order book, Hyflux lost money in recent quarters from the operations of the Tuaspring Integrated Water and Power Project. In 1H2017, Hyflux lost $25.4M, of which $47.9M was due to Tuaspring. The reason given for Tuaspring's loss is the continuing weak power market for Singapore and losses are expected for the next 2 quarters. Accounting-wise, why did Tuaspring lose money, despite it having a 25-year concession from the Public Utilities Board (PUB) to sell water and excess power from the plant?

Firstly, some background on Tuaspring. Tuaspring is a Design-Build-Own-Operate-Transfer (generically called BOT) project with a 25-year concession from PUB. The plant generates desalinated water and power, some of which is used for the operation of the plant. The excess power can be sold to the National Electricity Market. During the concession period, Hyflux will receive guaranteed minimum payments from PUB. It will also receive additional revenue from the sale of water and excess power. At the end of the concession period, the plant will be transferred to PUB's ownership.

Traditionally, when companies build plants, there is no revenue and there is investment in the Property, Plant and Equipment (PPE) account in the balance sheet during the construction phase. When the plant is operational, the company generates revenue from the sale of goods/ services produced by the plant and depreciates the PPE until the plant reaches the end of its economic life. 

Due to the nature of the BOT arrangement and concession payments from its water treatment plants, Hyflux adopts Financial Reporting Standard (FRS) 112. Under FRS 112, there is no investment in the PPE account during the construction phase. Instead, all the projected payments during the concession period are discounted to the present value and considered as financial receivables (for guaranteed payments) and intangible assets (for non-guaranteed payments). During the construction phase, these 2 accounts are progressively increased in the balance sheet instead of the PPE account.

Correspondingly, in Hyflux's cashflow statements, negative cashflows show up in "changes in financial receivables/ intangible assets arising from service concession arrangements (SCA)", which we do not usually find in other companies' cashflow statements. Traditionally, it is the PPE line under the Cashflow from Investing that is negative during plant construction. In the case of Hyflux, it is these 2 numbers in Cashflow from Operations that are negative.

Fig. 2: Hyflux's Cashflow Statement

There is another major difference between Hyflux and other companies. Traditionally, when a company builds the plant, it is recorded on the balance sheet at cost, i.e. the cost that the company pays for the plant. However, Hyflux does not pay other companies to construct its plants; it builds them itself. Hence, it is able to recognise a construction revenue for the plants during the construction phase. Since concession grantors like PUB do not pay for the construction of the plant, the construction revenue is the financial receivables and the intangible assets arising from SCA described above. Note from the earlier discussion that the financial receivables and SCA intangible assets are computed as the present value of the projected payments over the concession period. Thus, by the time the plant is completed, all the projected payments over the 20- to 30-year concession period would have been largely accounted for.

When the plant is completed and operational, Hyflux generates revenue from the guaranteed payments from PUB and the sale of water and excess power. On the other hand, it has to amortise the financial receivables and SCA intangible assets over the concession period. Thus, if the actual payments match the projected payments, what Hyflux earns during the operational phase is the interest from the financial receivables and SCA intangible assets, based on the discount rate used to compute the present value. If the actual payments exceed the projected payments, Hyflux earns more profit. Conversely, if the actual payments fall below the projected payments, Hyflux earns less profit or loses money. In the case of Tuaspring, due to the weak power market, actual payments came in below projected payments and Hyflux lost money on it.

Thus, contrary to conventional wisdom, the 20- to 30-year operational phase of a water treatment plant may not be the most profitable phase for Hyflux. A lot will depend on whether the actual payments exceed the projected payments. In contrast, the construction phase of the water treatment plant can be quite profitable.

In FY2016 financial results, Hyflux reported a net profit of $4.8M. It also mentioned that profits from Engineering, Procurement and Construction (EPC) were substantially wiped out by losses from Tuaspring, which amounted to $113.2M. This shows that the EPC profits can be quite substantial.

Fig. 3: Earnings Review for FY2016

Thus, based on current understanding, Hyflux might not generate the most profits from operating the water treatment plants during the 20- to 30-year concession periods. It probably generates more profits from constructing them.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell Hyflux's shares or perps. Please read the accounting policies in Hyflux's annual report and do your own due diligence.


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Monday, 2 October 2017

Know Your Customers Well!

Ouch! I just lost $33K on Triyards after it got suspended last month. Triyards is a shipbuilder and a subsidiary of Ezra, which is now under Chapter 11 bankruptcy protection. By right, if you read my post on My Upstream Oil & Gas Rescue Operations, ship and rig builders have not seen the worst of the Oil & Gas (O&G) long and harsh winter and I should not have invested in Triyards in Mar this year. However, Triyards has successfully diversified away from the O&G sector. Among its new orders for the financial year ending in Aug 2016 are chemical tankers, research vessel, passenger ferries, river cruise vessel, wind farm support vessels, etc. New contract wins in such non-O&G vessels totalled USD226.2M in FY2016. Including O&G vessels, total contract wins represent 84% of the revenue in FY2016. The orders-to-revenue ratio is an important metric for me when investing in O&G stocks, as described in Oil & Gas, Show Me the Orders!

Given its success in diversifying away from the O&G sector, Triyards is similar to another ship builder, Vard, which has also diversified away successfully and was the subject of a voluntary cash offer by its parent company in Nov 2016. However, unlike Vard, Triyards' parent company, Ezra, is not in any financial position to offer a cash offer. Nevertheless, Ezra had pledged all its 60.9% shareholding in Triyards equally to both DBS and OCBC in Jul 2016. Any sale of the shares to recover the loans by any one bank would have triggered a mandatory cash offer. When I first bought into Triyards at $0.288 in Mar, its net asset value was USD0.673 as at end Feb 2017. Its debts were USD187.9M, translating to a debt-to-equity ratio of 0.86, which was very high. However, most of the debts were used to finance working capital and trade receivables were USD238.6M. When the bills are collected, there will be cash to pay down the debts.

On 19 Mar, Ezra announced Chapter 11 protection under US laws, instead of the usual judicial management under Singapore laws, which means that creditors cannot foreclose and sell the assets pledged to them. In other words, both DBS and OCBC cannot sell Ezra's Triyards shares to a third party except with the approval of the US courts or consent by Ezra. Since the banks could not sell off the shares, there would be no cash offer, at least not in the near term.

Upon Ezra's bankruptcy protection, Triyards disclosed on 21 Mar that it had approximately USD41.5M exposure to Ezra, mostly in the form of joint corporate guarantees. This represents 19% of Triyards' equity, reducing the net asset value to USD0.545. In Triyards' 3Q2017 financial results announcement, it announced another USD45.1M in impairment losses. As at end May 2017, the net asset value was reduced to USD0.478. Including the exposure due to joint corporate guarantees of USD38.5M mentioned above, the net asset value would be USD0.359. Ezra was a huge body blow to Triyards, but not fatal. Triyards itself was not under Chapter 11 bankruptcy protection and continued trading on SGX despite Ezra's troubles and trading suspension, until 4 Sep.

The company that has a bigger impact to Triyards has a name that also starts with "Ez", but it is not Ezra, it is Ezion. On hindsight, Ezion is a major customer of Triyards, much more so than Ezra. Ezion subscribed to 29.5M warrants in Triyards at an exercise price of USD0.563 in Jul 2015. One of the conditions for the issue of warrants to Ezion is that Ezion enters into shipbuilding contracts with Triyards worth at least USD150M. Based on outstanding order book of USD422M as at Oct 2016, this represents 36% of Triyards' order book. On 23 Feb 2017, Ezion announced that it had indefinitely deferred delivery of 4 service rigs worth USD270M to reduce capital expenditure. A cross-check between Ezion's and Triyards' announcements of contract wins in 2014 suggests that 3 of these orders worth a total of USD162.5M are Triyards'. That means USD162.5M of the outstanding trade receivables of USD230.0M could not be collected, dealing a serious blow to Triyards' cashflow. Triyards' 3Q2017 financial results also suggest that banks, despite "owning" 60.9% of Triyards, have grown cautious about providing further loans to it. On 6 Sep, Triyards suspended trading of its shares.

Triyard's problem is similar to Keppel Corp's and SembMar's problem with Sete Brasil, which had deferred offers and stopped payments. Keppel Corp and SembMar survived, because of strong backing of their parents, Temasek, and continued support of their banks. Triyards have neither, and its chance of surviving is a lot lower. For Triyards to survive unscathed, either its banks continue to provide financing to complete the ships ordered by other customers, or Ezion takes delivery of some of its ships, so that Triyards can convert the receivables into cash and pay off the debts.

Actually, I also did not expect Ezion to go into restructuring. Ezion's market capitalisation was one of the highest among the mid-cap O&G stocks before it was suspended on 14 Aug. In fact, I had just bought into Ezion warrants just before it was suspended.

Triyards is the biggest loss on a single stock. The lessons I learnt from this episode is to know your customers really well!