Hock Lian Seng – The Deep Pocketed Construction Firm (F)

Introduction

We presented the business analysis of Singapore listed construction firm Hock Lian Seng (HLS). Today, we are going to touch on the financial analysis of Hock Lian Seng, which is something new to us.

If you are a loyal reader of this blog, you might have noticed our preference for companies with healthy balance sheet, strong free cash flow (FCF) generating capability, strong Return on Invested Capital (ROIC) as opposed to more commonly used ROE, and attractive valuations. Our preference has resulted in respectable return in our portfolio (at least for now), but it also created another problem without us noticing. By screening stocks with our preset criteria, we unknowingly created a portfolio consists of stocks with very similar nature or even in the same industry, which exposes to high concentration risk. With such rigid stock selection process, some good investment opportunities (like property developers and major contractors) would have been filtered out in the first place due to their business nature and accounting methods.

HLS has both civil engineering and property development segments. And with its strong balance sheet (which explains the Title: The Deep Pocketed Construction Firm) and its clear cut eye-candy annual reports, made it perfect for our first attempt to study property developer and major construction firm. With our limited experience in analyzing such companies, we are afraid that this post would not be able to serve you as a complete guide to analyze property and construction firm, but it sure can give you some insights next time you analyze one.

Revenue Recognition

Construction  Segment (Civil Engineering)

First of all, in construction sector, there’s normally order book disclosure (well, avoid those who don’t Teven disclose their order book) in financial reports to get a rough picture of future earnings visibility.

 Illustration 1: The order book of HLS construction segment

(Civil Engineering segment)

The cash flow and earnings of construction segment is not as fluctuating as property segment, due to an invoicing method called progress billings. Here’s a brief definition for you if you are an office worker like me who is never familiar with terms in construction sector. For businesses that engages in projects with long timelines and large budgets, it can be pretty difficult to identify the fairest way to invoice clients. On one hand, clients don’t want to cut huge checks before any work has been completed. But from the construction firm’s perspective, it is almost impossible to keep up with all the costs of completing a large-scale project without any cash coming in the door. That’s when progress billing came into the picture. Progress billing is the process of incrementally invoicing clients for a large-scale project based on the percentage of work already completed.

Therefore, the revenue is being recognized in financial reports as soon as such certain percentage of work has been completed. In HLS financial reports you would see items like this:

 Taken from Pg 9 of HLS Q4FY16 Financial Report

 Taken from Pg 3 of HLS Q4FY16 Financial Report

The figures underlined in Red, SGD 117.5 million and SGD 77.4 million in FY16 and FY15 respectively indicate the revenue being recognized from the construction (civil engineering) segment.  The figures underlined in Blue indicate part contract works completed by HLS but yet recognized as revenue, and the figures underlined in Green indicate contract work already recognized as revenue but yet to be completed. In other words, as at Q4FY16, the net work-in-progress is – SGD 22.67 mil (SGD 30.385 mil – SGD 7.708 mil), indicating HLS has billed ahead of what they have completed building.

Property Segment

For property segment, revenue is recognized using either percentage of completion method (POC) or completed contract method (COC), two different accounting measures. Under POC method, Revenue, Developmental Costs and Profit (or Losses) from the property projects are being recognized periodically at certain stages of the project, along the entire project cycle. While under COC method, Revenue, Developmental Costs and Profit (or Losses) from the property property projects are only being recognized at the end of the project period, when Temporary Occupation Permit (TOP) is obtained. Now, it is essential to know which accounting measure is being adopted by the property developer being analyzed. 

In our previous HLS business analysis, we mentioned that HLS has completed 3 property projects, i.e. Ark @ Gambas, Ark @ KB and The Skywoods (via joint venture). The only remaining property project on hands is Shine @ Tuas South. From the financial reports of HLS, we found that the management is adopting COC accounting measure for Ark@ Gambas, Ark @ KB and Shine @ Tuas South, and POC method of The Skywoods (probably because it is a joint venture project).

So, you will see items like this in financial reports of HLS:

 Taken from page 34 of HLS FY15 Annual Report

 Taken from Pg 1 of HLS Q4FY16 financial report

The figures underlined in Red indicate the share of profit from The Skywoods joint venture project, which is recognized along the project the entire project cycle (SGD 43k recognized in FY14, SGD 8 million recognized in FY15 and SGD 11.5 million recognized in FY16).

Taken from page 60 of HLS FY15 Annual Report.

The figures indicated in Orange indicate the revenue recognized from own property project ( Ark @ Gambas and Ark @ KB), which was only recognized when TOP was obtained, using COC method. The TOP of Ark @ Gambas was obtained in FY14, therefore revenue of SGD 192.9 million was recorded in that financial year. And TOP of Ark @ KB was obtained in FY15, contributed SGD 89 mil to the group revenue in FY15. 

Taken from page 38 of HLS FY15 Annual Report

With COC accounting measure, not only the revenue to be recognized only when TOP was obtained, but the cost as well. Therefore, before TOP is obtained, every cost incurred in property development is recorded at Current Assets, highlighted in Blue, and every progress billing to property buyers are recorded at Current Liabilities, highlighted in Green. 

Once you know the accounting method for the property segment adopted by HLS, you would know Illustration 2 below has very limited meaning. The  sales of Ark @ Gambas (SGD 192.9 million )and Ark @ KB (SGD 89 million) was being recognized in FY 13 and FY 14 (using COC method), resulted in outstanding performances in the two financial years. Without the contribution of property segment, no wonder FY 16 results look bad from the book. 

 Illustration 2: Revenue, Gross Profit and Net Profit of HLS

from FY11 to TTM Q4 FY16

Here’s what it is like (Illustration 3) when we took out the property contribution from HLS books over the past 5 financial years. We are only able to show you the Revenue (without Gross Profit and Net Profit) because the breakdown of costs was not presented in annual reports. The performance of HLS in FY15 and FY16  doesn’t look that bad after all.

Illustration 3: Revenue of HLS from FY11 to TTM Q4 FY16

Management Efficiency

Management efficiency metric is another topic we would like to cover when analyzing property developer and construction firm. Return on equity (ROE), Return on assets (ROA), and Return on invested capital (ROIC) are the three most prevalent metrics used to obtain an idea of the returns a company generates. The widely used ROE (Net Income/Shareholder’s Equity) looks at how effectively a business is using the shareholders’ equity (which is why it is most relevant to us as shareholders). However, as Assets = Liabilities + Equity, the more debt taken by the company would result in smaller percentage of equity to the total assets, pushing up the ROE. ROA (Net Income/Total Assets) metric on the other hand, doesn’t have the same concern as it remains stable throughout all capital structures. But then, it has its own limitation when a company is holding a lot of cash or assets for sale which is not generating any income. These assets, while not expected to generate income are used in the calculation thereby causing the return on assets to appear lower than that which the company’s actual productive assets generate. The limitation of ROA has led to the invention of ROIC, some would consider ROIC as the enhanced version of ROA. ROIC (Net Operating Income/ Total Assets – Non-interest bearing Current Liabilities –  Excess Cash) strips out all the non-operating assets (like cash, financial instruments) so that the current assets that aren’t expected to generate core earnings are not included in the calculation. Non-interest bearing liabilities (like payables, provisions for tax) would also be excluded from the denominator because these are not capital invested by the company itself to generate return.

The efficiency ratio of HLS is interesting as they indicate inconsistent results. While ROE shows a decent return, ROA shows a subpar return and ROIC shows a sky-high return as indicated Illustration 4.

 Illustration 4: Management Efficiency of HLS

Let’s start with our favourite metric ROIC. Unlike ROA and ROE, the formula of ROIC is not as straightforward and standard. There can’t be one-formula-for-all when it comes to ROIC, as we need to determine manually what is the invested capital (the capital utilized by the company to generate core net profit). We are now going to examine the balance sheet of HLS in latest financial report. As mentioned above, we will identify the operating assets of HLS (where we will put “+” marks) and take out non-interest bearing liabilities of HLS (where we will put  “-” marks).

  Taken from Pg 3 of HLS Q4FY16 financial report

Some explanations: 

1) Investment in joint venture – Included as Invested Capital because it contributed to joint venture profit (The Skywoods)

2) Investment properties – Included as Invested Capital because it contributed to the rental income of Revenue.

3) Development properties – Included as Invested Capital because it contributed to revenue from property segment.

4) Contract work-in-progress – Included as Invested Capital because it contributed to construction segment in revenue.

5) Prepayment and deposits – Included as Invested Capital because it is necessary for the business to carry on.

6) Trade and other payables – Excluded from Invested Capital because it is  capital invested by HLS suppliers or contractors (as opposed to HLS itself)

7) Progress billings in excess of work-in-progress – Excluded form Invested Capital becasue it is capital invested by HLS clients (as opposed to HLS itself)

Perhaps now we know why ROIC of HLS is high as a kite! The invested capital of HLS is so low (even negative) if it wasn’t for the Development Properties (underlined in Blue) in Current Assets. This is because progress billings in excess of work-in-progress is higher than contract work-in -progress in current assets (underlined in Green), which means HLS is always claiming ahead of what they have completed. On one hand, it can be read as positive as HLS doesn’t need to invest its own capital to generate the core profit. On the other hand, it is hard to justify it from business perspective, and especially when the figure is in negative.

We move on to analyze ROA. The low ROA of HLS is partly because HLS is holding a large chunk of cash and investment products (underlined in Pink) in its balance sheet. These assets are not generating core income therefore not included in ROIC, but inlcuded in ROA. Second, remember we mentioned one of the main reason ROA is preferred over ROE because it won’t be affected by capital structure of the company (highly leverage companies tend to have higher ROE). In the case of HLS, ROA is being dragged down by the high current liabilities. But to be fair, little of the liabilities are actual debts taken by HLS. The major component of current liabilities is excess in work-in-progress as mentioned above.

Therefore, in the case of HLS, the limitations in ROIC and ROA makes ROE the next most suitable metric to measure the management performance. ROE of HLS shows rather unstable in Illustration 5 below. This is due to the distortion in earning effect created by the property segment. Remember, with COC accounting measure, the earnings from property segment of HLS was recognized in FY14 and FY15 (upon TOP). Furthermore, before TOP, the development cost of HLS was recorded as Development Properties in Current Assets, resulting in higher assets in previous year, lowering ROE. With current Shine @ Tuas South project on hand, we expect to see more cash spent for the project without any return before TOP, therefore lowering on management efficiency. Investors can average the ROE to get a fairer number.

 Illustration 5: ROE of HLS

Balance Sheet

Unlike most of the property developers and construction firms, HLS has a very strong cash position. As at TTM 4QFY16, HLS is maintaining a net cash of RM 195 million or 38 cent per share, equivalent to 61.65% of market capitalization at time of writing. This net cash of 38 cent per share is including recent dividend announcement on 23 February 2017. P/S: the management announced special dividend (10 cent) + Interim Dividend (2.5 cent per share). After the payout, the dividend will be deducted from the cash of HLS to the hand of shareholders. 

While we like the strong cash position of HLS, we notice that HLS has a very inconsistent free cash flow due to its property segment. Property segment always incur high cash outflow for land acquisition in particular year. Free cash flow is one of the most important aspect to assess the future dividend paying ability of a company. Therefore, we don’t think the payout of special dividend is likely to incur again.

Valuation

At price of SGD 0.62 at time of writing, HLS is trading at EV/EBIT of 5.07x. Assuming a standard EV/EBIT of 8x, the target price of HLS would be SGD 0.76, with 22.2% potential gain. Before arriving to the intrinsic value of HLS, here are some considerations made:

1) EV/EBIT of 5.07x was arrived with core earnings of TTM 4QFY16 results (which was without property segment contribution, and has stripped out other income and joint venture profit). In other words, the target price of SGD 0.76 is arrived with the assumption of no profit contribution from property segment in coming years. P/S: nor we assume any losses to be incurred in the property segment. Any profit contributed from Shine @ Tuas South in coming year will be a positive surprise to us, vice versa.

2) Since the valuation of HLS is derived only from the construction segment of HLS, we need to justify the sustainability of earnings from construction segment, at least at FY16 level. Our justification is that, from Illustration 1, HLS is currently having record-high order book.

Conclusion

In previous post, we presented full business analysis on Hock Lian Seng. In this post, we point out the accounting measures adopted in property development segment and construction segment, which would affect the revenue recognition and management efficiency ratio of the company. We give a target price of SGD 0.76, based on EV/EBIT of 8x, conservatively assume no profit to be made from the property development segment, and on the back of record high order book.

References:

HOCK LIAN SENG Annual Report FY 2013 to FY 2016

HOCK LIAN SENG Financial Report  1QFY16-4QFY16, 1QFY15-4QFY15, 1QFY14-4QFY14, 1QFY13-4QFY13

Philip Capital Research Report dated 4 July 2016

UOB Kay Hian Research Report dated 16 February 2017

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