Construction counters

[Musicwhiz]

Hi MW,

Pardon my ignorance, but what is a shareholder's loan ? I see it quite a few times with regards to project financing.

Thanks

Hi Nick,

There are essentially two ways in which shareholders can inject money into a company. One is through equity, whereby the issued share capital of the Company is increased and a resolution has to be passed. This method makes it difficult to extract money from the company when it is profitable as the issued share capital cannot be reduced unless a capital reduction is approved or a dividend is declared. Entry is as follows:-

Dr Cash At Bank
Cr Share Capital (Equity)

The other method is through a shareholder's loan, which is usually interest-free and with no fixed terms of repayment. In this way, it is easier for the shareholder to recover his capital as the Company will just record it as a return of loan.

Dr Cash At Bank
Cr Shareholders' Loan (Current or LT Liability)

There are some requirements for increase of share capital at times, like when you intend to take a large loan from a bank, they may require a company with share capital of at least $XXXX, so shareholders have no choice but to inject it as equity if they want to secure the bank loan. But if there is no such requirement, it is usually structured by way of a shareholders' loan for the reasons I mentioned above.

Hope this explains.

[vader1671]

I'm currently looking at some financial statements from a couple of construction companies and I have a couple of questions

1) What is the difference between construction and property development? I am assuming that a construction project means that the company will build something on behalf of someone else (e.g. HDB). Does property development mean that the company designs, builds and then sells some property by itself (recognizing profit only after the property is sold)

2) I can't really find how much a particular development is worth in the accounts, is there any way to tease this information out?

3) I'm used to looking at REIT portfolios and I always like to see a portfolio which has particular developments coming online in regular intervals. This reduces the risk and improved revenue stability. I can't seem to find this information in the financial statements, is it available anywhere else?

4) Anything else I should be looking out for?

[yeokiwi]

Some non expert opinion but hope it helps.

Construction projects typically refer to building of infrastructures on behalf of some entities. It can be road, buildings, flyovers, mrts, tunnels or whatever. The construction companies derive profit by controlling the material, labour and financing costs.
Some companies in SGX are doing pure constructions eg. OKP, Koon etc. I had not seen them participating in any property development yet.

Property development refers to development of a building. The building can be condos, malls, factories, warehouses etc. The costs incurred are typically the land cost, design, construction cost, financing cost and a bit of marketing cost. The profit derived can be from selling the units in the building or renting of units to businesses.

Normally, construction projects and property developments are treated separately even though the construction company may hold some share in the property development.

Eg. Lum Chang. They own part of Esparina Residences and at the same time, they were awarded the construction project to build Esparina. The accounting of the profit will be done separately.

Construction companies are hard to evaluate due to its fluctuating profit margin. If the cost is not managed properly, they may run into negatives easily. Not to mention the occasional mishaps and accidents that may delay the project schedule and lead to a higher cost of construction.

So, i think the safer way to buy construction companies is to ensure a good margin of safety in NAV.

[psslo]

Assuming construction counters on a uptrend next year, has anyone bought warrants for YongNam, TatHong & OKP to ride the upside? The earliest expiry is end 2012 which offers good probability of profit.

[Musicwhiz]

So, i think the safer way to buy construction companies is to ensure a good margin of safety in NAV.

Thanks yeokiwi,

Your opinions are certainly very helpful, thanks! This makes the distinction clearer in terms of "pure" construction companies and property development companies.

But in terms of margin of safety with respect to NAV, if what you say is true of their fluctuations in profits and cash flow, then I would probably wish to avoid altogether rather than try to determine if there is margin of safety. This is due to unpredictability and also, the industry is subject to brutal market cycles.

[vader1671]

Ok guys, I've completed an initial analysis of two construction counters that seem to have rock solid fundamentals. I'll post the first one here for you guys to take a look. I have a few important decisions to make for the new year (this being one of them) and this was an important step.

Just sharing whatever I managed to unearth, but I hope someone finds this slightly useful. Caveat emptor.

---

CHIP ENG SENG
Business
Construction company with some interest in property development. Specializes in building residences (condominiums). A significant number were developed for HDB, the rest were private developments. 90% of its revenues are contributed by construction and 10% of its revenues are contributed by property development.

There is a large amount of competition in the residential construction space with several companies like Koon and KSH also active. The industry itself has incredible barriers to entry from the number of certifications required and the need for a solid tracking record so at least there is little risk of new entrants anytime soon.

Fundamentals
I’ve looked up the numbers over the past 10 years and taken a harder look at the past 5. I do like what I see. I have compared it with LKH. Both companies are in the residential construction business with side interests in property development and both have a comparable market cap.

I've attached a picture of the numbers I've pulled out. Please take this with a gain of salt. Numbers are a combination of mine as well as some stock sites I use. These are quite rough. Caveat Emptor. Once again, this is just for my benefit, really, don't use these numbers as the sole basis (or any basis at all, really) for any of your investing decisions.

[Image: chipn.jpg]

1) PE
PE of CES is now quite good thanks to a drop in the share price over the years and a significant increase in EPS. With PE currently at 4, this stock is now quite cheap. The PE for LKH is comparable, which is good for comparison since both are valued at about the same price.

2) ROE
ROE is now excellent at about 30% and has remained so in the since 2006 (which includes a recession).

ROE for LKH is a less impressive but still very very good 24%. However, LKH’s ROE over the years before hasn’t even gone above 15% for many years which makes the CES ROE that much more impressive.

3) ROA
ROA is good as well, but has taken a hit due to the amount of debt that the company carries. With it hovering at about 10% over the past since 2007, the ROE is still very respectable.

ROA for LKH is just slightly less due to the fact that LKH has next to no long term debt (unlike CES).

4) Debt to Equity
Going by the Financial reports, the company takes up some debt to prepare for a large new development. IIt has taken a slug of 100m extra long term debt in the 3Q 2010 to bring debt up to 220m. With only about 100m of cash, this bears some watching. However, judging by past performance, management should be prudent enough to manage this well. I don’t mind some debt, especially with ROE at 20%, but this bears watching since this increases debt to equity to uncomfortable margins.

LKH has negligible long term debt, which is excellent as always.

5) Dividend Yield
Yield in 2009 was a ridiculous 6.5%. This is significant in comparison to past few years where dividend next breached 5% since 2006. This is due to 2 large factors. The first is the spike in EPS and the second is due to the lower share price. Dividend is very nice and makes the stock look much better. In the past few years, the company seems to distribute a good portion of the profit after tax (it even managed to distribute about 10% in the recession of 2008). This looks good.

LKH on the other hand distributes at a 8% yield which equates to a significant 35% of their EPS. LKH seems to be very dividend happy in the past few years. There was even a past distribution of a 90cents based on some savings from a tax credit, but that was a one off.

6) EPS Growth
EPS has been growing well along with revenue as the company bulks up and takes on multiple projects.

7) Project uptake
Without a better breakdown of how ‘good’ each project is, I’ve decided to track how many projects the company is currently developing and how many it finishes in a given FY. As seen in the chart the company has taken on an increasing number of projects over the past few years which shows the growth of the company.

Since CES (and LKH for that matter) don't show how much each project is worth this is an incredibly rough number at best. I didn't really like this and I do know that other construction companies do list the worth of each project.

8) NAV
The company is trading at NAV so I don’t believe that it is not too expensive. It’s a bit difficult to find a good construction counter trading below NAV.

9) Valulation
Using my normal conservative DCF method with a 11% Discount rate, the stock should be at 0.80 in 5 years.


Points of concern
1) There are a large number of players in the residential construction space in Singapore. With the property boom and the large number of housing projects planned by the government and private sectors, I believe that there should be enough for everyone for now but we need to watch out when the market heads south.

2) Minimal overseas exposure. CHIP ENG SENG has dabbled in Australia for the past few years and it seems that it has developed a couple of properties in Australia. However, Australian exposure has remained insignificant over the years (<5% of revenue). It dropped to 1% in 2008 and reached 2% in 2009. While the Singapore market is no where near saturation, I think overseas exposure should be monitored.

3) Increase in debt in 3Q 2010 bears taking a look at. I’m not too concerned with this, but I wonder why did the company need to double its debt. We’ll see what the 2010 financial reports and dividend look like.

4) Construction Segment is loss making. I’ve gone through their financial reports and it seems that their construction segment is loss making, whereas their property development segment makes the bulk of the profits. This puzzles me a lot. 85% of the company’s revenue is in construction but that segment is loss making. 15% of the company’s revenue is in property development but it makes so much money that it covers the bulk of the construction segment’s loss and allows the company to have a record profit year.

This confuses me quite a bit. I can only assume the following:
1) Normal construction activity is marginally profitable
2) For projects under property development, the construction segment handles it at cost (or a loss) which allows the property development to generate large profits
3) Therefore, the construction segment runs at a small loss

Otherwise
1) If only property development is profitable, why bother with normal construction?
2) If all construction is not profitable, why even bother with that at all?
3) If property development is so ridiculously profitable, why not just ditch construction?

Incredibly, LKH’s construction segment was also loss making for most years, but it managed to turn a profit in 2009. I wonder whether this is normal and just some accounting thing which they used to split the segments.

Summary
The company has fantastic numbers and has managed to maintain those numbers in a recovery (2009) a crash (2008) and a bull run (2007/2006). The numbers are generally better than LKH’s. This shows that management is solid and the company seems to be able to weather most economic cycles.

However, the lack of overseas exposure worries me. Throughout the years, 2005 onwards, the company repeatedly goes on about how it intends to develop land overseas, but the exposure is still very low for something that seems to be one of the company’s objectives. Does this mean that management decided to wait it out? Or are they half hearted in their pursuit of overseas expansion?

The large shot of gearing in 3Q 2010 and the strangely loss making construction arm worries me as well (the loss making more so). With all their profit being derived from property development, will this construction counter suffer in a property downturn?

All in all, the numbers are very tempting and there seems to be a lot of upside especially in the next few years with the property and construction sectors improving, but there are enough red flags to warrant caution.

As a side note, I didn't really like LKH's financial reports. The 2007 report put an incredible weight on the 90cents special dividend and how this was fantastic for yield and one of the best dividend yields ever, when it was obviously just a one off. But maybe that's just me.

[vader1671]

The second business that I took a look at was OKP, their fundamentals are excellent and they definitely deserve a good once over.

OKP
Business
Construction company that focuses on civil engineering (mostly roadworks and drainage). 70% of the revenue is contributed by construction and 30% was contributed by maintenance. The company has had overseas forays (built a runway in Saipan) and is supposedly actively pursuing further contracts in far flung companies in Africa. However, currently the company derives 100% of its revenue from SIngapore.

There are limited competitors in road building, but then again its a small niche, so OKP has a fairly significant competitive advantage in this area. OKP has successfully branched into oil and gas construction and is currently taking on some residential construction in order to diversify its revenue streams however these two sectors are significantly more crowded. It’ll be interesting to see how OKP will manage to grow in these new sectors.

Fundamentals
I have compared OKP with Hock Lian Seng (HLS). It is an imperfect comparison at best. While both companies are involved with roadworks, OKP takes on smaller, shorter projects such as road widening and normal road extensions. Hock Lian Seng takes on mega projects such as building of bridges and expressways. OKP’s largest project is about $100m, Hock Lian Seng’s smallest project is $300m.

Hock Lian Seng is also a fairly new market entrant. It did an IPO in 2009 so there is not much historical data to go by, but it will give us a general idea of what a roadworks construction’s number should look like.

The numbers for these two companies are in the graph below. Once again, these are very rough number churned out by me. Take them with a cartful of salt. Please don't use them to make your investment decisions. Caveat Emptor.

[Image: okpz.jpg]

1) PE
Comapny is valued at about 10 PE, which is one of the more expensive construction companies out there. Looking at its past PEs, the current 10 PE valulation is not far off from what it has been valued at previously.

HLS is a fairly new entrant but it trades at 7 PE, cheaper than OKP probably resulting from the lack of a track record.

2) ROE
Excellent ROE of > 18% over the past few years (since 2006) and the last 3 years have seen ROE > 20%. Impressive especially since these numbers were gained during a recession.. The company had a spectacular profit collapse in 2005 due to a few delays in some of their construction projects but it looks like the company has made amends since.

HLS’ ROE is comparable at 28% but its difficult to do much comparison without a solid track record. But it does prove that OKP is in the correct ballpark for its figures.

3) ROA
ROA is excellent as well (> 10% over the last few years). This is largely due to the fact that the company has next to no long term debt. It has quite a few current liabilities but the current ratio is quite good, so there are no concerns there.

HLS’s ROA is very slight less than OKP with 11%. Excellent performance by both companies.

4) Debt to Equity
No long term debt = fantastic Debt to Equity Ratio. I do not mind some gearing for a company especially with such good ROA, but I certainly don’t mind a debtless company either. HLS is also without debt so it’s excellent all round.

5) Dividend Yield
A bumper 2009 led to a bumper Dividend yield. I am slightly concerned at the company’s history of distributing 50% of their EPS. This is not a REIT so I’m not too sure why management has decided that it can afford to distribute so much (especially since it does not carry debt). Good for shareholders in the short term, but I wonder whether the company can do the necessary capex for growth. Not such a red flag, but a point of caution.

HLS distributes less of its earnings and has a lower yield than OKP. IT is possible that HLS is retaining more of its earnings for future growth while OKP wishes to distribute the wealth quickly.

6) EPS Growth
EPS Growth is fairly steady (Barring the collapse in 2005). certainly no complaints here.

7) Project Uptake
The financial statements were excellent and gave me a very good view of what projects were coming online and how much each was worth. Going by the statements, the company has had a large spike in construction contracts in 2009 and 2008. However, this is entirely due to the $110m CTE contract that it received which should be completed in 2011. Once this project is completed, I believe we can expect the total value of construction contracts to decline slightly (depending on future wins of course)

Maintenance contracts have grown by about 40-50% since 2005, but as befits the construction industry, the total value of the contracts have gone up and down in the past few years.

The company has won about $80m worth of contracts in 2010, which should replace the about $90m of contracts completing in 2010. I do wonder what’s going to replace the $110m CTE contract though. The company is growing, but it is doing so quite slowly at least on a order book basis.

8) NAV
The company is trading at double NAV, which makes it quite expensive as far as construction counters go. HLS does not fare much better with it being priced at double NAV. The market looks kindly upon roadworks counters it seems.

9) Valulation
Using my normal conservative DCF method with a 11% Discount rate, the stock should be at 0.55in 5 years which makes this particular counter fairly valued now.

Points of concern
1) There are a number of civil engineering companies in Singapore now, but OKP is the leading road builder in Singapore. With the government’s increasing desire to spend on infrastructure, it seems that this particular market itself will be sufficiently large to support this company for the medium term.

2) Total lack of overseas exposure. Management has correctly pointed out that the company needs to create opportunities overseas and develop the business off the island. However, they’ve only really done one project (in Saipan) over the last 5 years. They’re trying to break new group in Africa now, but I’m not too sure why management is going all the way to Africa to achieve growth. Is the civil engineering sectors in nearby countries really so saturated or impossible to break into?

3) Growth company?
It seems that the order book growth is not growing as quickly as I expected a 20% ROE company to have. It seems that the book is growing slowly year on year (but its at least growing). It has 50% of its order book in the CTE Expansion development and I wonder what’s going to replace that large development and how the company is going to grow its order book.

The large dividend yield also makes me wonder about whether the retained profits are going to sufficient to fund growth. The large ROA/ROE leads me to believe that the majority of the profit growth was created via cost reduction (which is good). I would like to have seen larger growth though.

Summary
The company has fantastic numbers and it seems that the lessons in 2005 were learnt pretty well. This shows that management is good and consistently strives towards delivering value to the shareholders.

The company has expanded out of pure roadworks into the oil and gas industry and seems to consistently take on one or two projects of such a nature. In addition OKP has recently won a contract for the construction of a condominium. Management should be commended for this action as it has successfully spread the risk of the business and diversified the income streams. It is always challenge when a company moves out of its core competency, but judging by past performance, I believe that the OKP management will handle this well.

However, I’m concerned that the this particular company is not growing as aggressively as I would like. The order book is growing slowly and consistently distributing 50% of earnings seems to me like the policies of a mature cash cow which isn’t bad of course.

I’m also concerned at the company’s attempts to grow overseas. It looks a bit haphazard (doing something in Saipan and then running off to Africa). It is good that management recognizes that it should move overseas but I’m concerned that it hasn’t managed one overseas project since the Saipan one in 2006.

All in all, this is an excellent company to own, but a little on the expensive side. The numbers are solid, management is very competent and there are no huge red flags anywhere. A couple of points to monitor though.

As a side note, I must say that OKP's annual report was a pleasure to read. The information was excellently presented and how each part of the company from HR to the construction projects was shown to be working toward's management's goals was very well shown.

[mrEngineer]

This confuses me quite a bit. I can only assume the following:
1) Normal construction activity is marginally profitable
2) For projects under property development, the construction segment handles it at cost (or a loss) which allows the property development to generate large profits
3) Therefore, the construction segment runs at a small loss

Otherwise
1) If only property development is profitable, why bother with normal construction?
2) If all construction is not profitable, why even bother with that at all?
3) If property development is so ridiculously profitable, why not just ditch construction?

Hi Vader, thanks for your detailed analysis. I would like to thank you also for the heads up on the construction loss-making and property development high profits. Although, I am unable to offer a solution but I would like to point you to 2009AR segment information that the revenue of property development is actually lesser than its profits. How is that possible? I do not know. But I believe it may have something to do with some of the revenue from construction transferred and recognized as under property development. If you know the exact answer, pls share with us.

Secondly, I do not think it is a good idea to value construction companies using DCF. The reason is simple, the cashflow are extremely unstable as it depends on how many projects are they undertaking. Moreover, construction industry is extremely cyclical. Do note that many companies actually disappeared in 1997 crisis due to poor management of cashflow. In fact, this is the greatest risk IMO for the case of CES. They seem to have too many projects and they are slow compared to CDL, MCL where most of them have projects fully sold before the property curb measures are announced

For me to judge CES, I would estimate the margins and potential dividends in each development. HDB websites offer good places to search for tender wins.

[yeokiwi]

Wow, vader1671, that's a very detailed analysis.

For LKH, there are other pts to take note.
1) 40% stake in Minton Rise. Kheng Leong and LKH acquired the land at very low cost.
2) undervalued assets. Duxton hotel group.

The Low family had spent quite some money early this year taking over GCB and GCB held more than 50% of LKH.
I thought they must have pretty good confidence in value of LKH.

[freedom]

from what I read, it is quite difficult to value a construction company. even more difficult for a construction company with property development...