Asia Enterprise Holdings

[egghead]

There is one part of the stockist business that I don't understand.

Aren't the industries that these stockist serve been around for ages where standards (in terms of steel qualities, thinkness, sizes) are well established? If so, is the risk of inventory obsolescence as high as say electronics products?

[Blackjack]

My understanding is that there are indeed standard specifications of steel components i.e. H-beams, I-beams, angle bars, hollow tubes, channel bars etc etc over the years that engineers commonly work with. However there are also so many multiple permutations of the dimensions in any single type to begin with. For instance I-beams are essentially H-beams inverted! For such reasons there are actually thousands of different components that may possibly be used.

In addition, the shift to performance based design in past years also meant that architects and civil engineers have greater liberty in the use of fancy columns and beams to play around with. This meant that a steel stockist would increasingly have to foresee what the trends of new custom-made requirements would be, yet the dilemma is that they are not specialists in that field. The risks purportedly would be much higher since effectively if the current assets does not serve the existing demand, they increasingly have to be cleared at more competitive prices so that released capital can be used to manufacture new specifications.

I'm only an engineer by training, not by practice, so feel free to point out any mistakes.

[d.o.g.]

Aren't the industries that these stockist serve been around for ages where standards (in terms of steel qualities, thinkness, sizes) are well established? If so, is the risk of inventory obsolescence as high as say electronics products?

The standard products are carried by everyone. They are commodities and low-margin, however they generate cash flow as turnover is quick.

The non-standard products are where the stockists make their money. But because they are non-standard, the turnover is extremely slow. It can take a year to sell a non-standard item.

Steel products are seldom completely obsolete unless you have a custom-made part and the customer goes bust before paying up. Rust can be prevented with oil.

Usually, you just sit on the item and hope that one day, someday, a customer will ask for it. Which of course leads to the other problem - unpopular inventory can slowly accumulate over time, sucking up working capital. Sure, it will sell one day, but when?

[cif5000]

The management comes for free because it's not worth anything to a buyer. A competitor buying the business will already have their own management in place - they are only after the inventory and the land/warehouse. This particular management is committed, has a dividend policy and is fiscally conservative. These characteristics have value to a long-term minority shareholder. But they are of no value to someone buying the business, for reasons already stated.

You are assuming the buyer is a competitor.

If a business is worth $1 on paper but will only sell for $0.70 in a liquidation or trade sale, then the true realizable value is $0.70. In order to have a good margin of safety, it would be wise to pay $0.50 or less. The "double discount" is required because there is no realistic chance of getting $1. The appropriate reference is $0.70, not $1. The stock market may give you $1 for your shares, but that would be a function of market sentiment rather than fundamental valuation.

The margin of safety comes for buying the assets at a sufficient discount to prevent the loss of capital. A buyer paying $0.70 will have his capital safe. An investor would not pay $0.70 to liquidate it at $0.70.

Off topic:
How much money he is expected to make should be measured differently (although both are expressed in $$). In this case, it would come from the probability of the business continuing to convert inventory into cash. This provides the expected return.

e.g.
ER = (P1) x 0.70 (liquidation value) + (P2) x 1.0 (realizing inventory value without profit)
where P1 = 5%, P2 = 95%
ER = 0.985 or 40% upwards of the purchase price

Steel unfortunately has similar characteristics. In the right size, shape and thickness, it can sell for $1,000 a ton or more. In the wrong dimensions, it may fetch only $200 per ton or less as scrap.

I may not have fully understood this because $0.20 on a dollar is quite unbelievable for wrong dimensions. Wrong dimensions come from 4 main areas
1. Customer gave the wrong specification
2. Supplier delivered the wrong material
3. AEH ordered the wrong material
4. AEH processed the raw material wrongly

All these can be remedied before the steel hits scrap.

This site shows steel / iron scrap prices http://metalprices.com/FreeSite/metals/fe/fe.asp#

[egghead]

I just checked their 3Q-2010 report and it was mentioned that the inventory turnover has lenghthened to 200 days from 153 days a year ago...meaning that some day is about 200 days later...

[bluechipstamp]

I look at book value per share because it also captures the effect of corporate actions like rights issues, placements and buybacks. HG Metal and Hupsteel do not measure up so well in this regard.

My numbers actually show Hupsteel to be the better performer in this regard, when compared over the same period (from AEH's IPO).

From 2005 till now, AEH didn't raise any cash. Hupsteel only raised cash once fr a private placement. The 2 rights issues were accompanied by huge bumper div (to utilize sect 44 credits), and didn't dilute sh who participated. Ditto with the bonus issue.

Hupsteel
Jun 2005 Equity (sh): 115.463m
Jun 2010 Equity (sh): 201.67m
Dividends paid from Jun 2005 to Jun 2010: 56.115m
Private Placement (2007): 26.781m
Jun 2010 Equity Adjusted = 201.67 + 56.115 - 26.781 = 231.004m.

Jun 2005 # shares: 301.549m
Jun 2010 # shares: 627.371m
Jun 2010 # shares (normalized): 627.371/1.875 = 334.598m
(Every 1 share in 2005 has become 1.875 shares without additional capital outlay, due to the rights + bonus).

Jun 2005 Book Val/sh = 115.463/301.549 = 0.383
Jun 2010 Book Val/sh = 231.004/334.598 = 0.690
CAGR = ((0.69/0.383) ^ 1/5) - 1 = 12.49%


AEH
Dec 2005 Equity (sh): 77.999m
Sep 2010 Equity (sh): 103.399m
Dividends paid from Dec 2005 to Sep 2010: 25.722m
Sep 2010 Equity Adjusted = 103.399 + 25.722 = 129.121m
# of shares = 273.534m (no change throughout)

Dec 2005 Book Val/sh = 77.999/273.534 = 0.285
Sep 2010 Book Val/sh = 129.121/273.534 = 0.472
CAGR = (0.472/0.285 ^ 1/4.75) - 1 = 11.2%

(Edit: Corrected Jun 2005 # shares for Hupsteel. Thx cif5000)

[d.o.g.]

You are assuming the buyer is a competitor.

Yes, because it is highly unlikely that anyone would choose to enter the industry given the mediocre economics.

The margin of safety comes for buying the assets at a sufficient discount to prevent the loss of capital. A buyer paying $0.70 will have his capital safe. An investor would not pay $0.70 to liquidate it at $0.70.

$0.70 would be safe only if it was absolutely certain the business would fetch at least that much in liquidation. I do not know enough about the steel stockist business to say that AEH would definitely fetch at least 70% of NAV in liquidation proceeds. So I would prefer to be more conservative. In case I am wrong, and liquidation produces only 50% of NAV, I am still OK, having paid only $0.50. And if it does produce $0.70 then I have a decent profit.

I may not have fully understood this because $0.20 on a dollar is quite unbelievable for wrong dimensions. Wrong dimensions come from 4 main areas
1. Customer gave the wrong specification
2. Supplier delivered the wrong material
3. AEH ordered the wrong material
4. AEH processed the raw material wrongly

All these can be remedied before the steel hits scrap.

This site shows steel / iron scrap prices http://metalprices.com/FreeSite/metals/fe/fe.asp#

If the customer gave the wrong spec that is the customer's problem.
If the supplier delivered the wrong material that is the supplier's problem.
If AEH ordered the wrong material or processed it wrongly it cannot be fixed - either it goes into inventory in the hope of a future sale (most likely) or it gets scrapped.

The scrap prices shown are on a FOB delivered basis. So whoever owns the scrap has to pay freight to send it to the said mills. Iron ore prices have gone up a lot recently, so $200/ton is probably not accurate now. $300/ton seems about right, leaving $30-50/ton for freight.

[cif5000]

Thanks for the mind stimulating exercise...

Yes, because it is highly unlikely that anyone would choose to enter the industry given the mediocre economics.

I like to think of it as the industry being dynamic enough to equilibrate at an optimum number of players.

$0.70 would be safe only if it was absolutely certain the business would fetch at least that much in liquidation. I do not know enough about the steel stockist business to say that AEH would definitely fetch at least 70% of NAV in liquidation proceeds. So I would prefer to be more conservative. In case I am wrong, and liquidation produces only 50% of NAV, I am still OK, having paid only $0.50. And if it does produce $0.70 then I have a decent profit.

Swinging at $0.50 is for the home-run whereas $0.70 gets you to the first base. Less desirable definitely.

If AEH ordered the wrong material or processed it wrongly it cannot be fixed - either it goes into inventory in the hope of a future sale (most likely) or it gets scrapped.

Wrong material: Negotiate with supplier to return at a loss.
Wrong processing: QC would limit the exposure, highly unlikely to hit the entire inventory. The wrong dimension material may be further processed into other usable dimensions.

Steel unfortunately has similar characteristics. In the right size, shape and thickness, it can sell for $1,000 a ton or more. In the wrong dimensions, it may fetch only $200 per ton or less as scrap.

I may not have fully understood this because $0.20 on a dollar is quite unbelievable for wrong dimensions.

Indeed I misunderstood.
$1,000/ton = very good profit
$200/ton = scrap
The carrying cost is somewhere in between, say around $400/ton
Then the discount is not 20%, probably still closer to 50%.

[d.o.g.]

I like to think of it as the industry being dynamic enough to equilibrate at an optimum number of players.

Fair enough. As I pointed out, in Singapore it's a friendly neighbourhood. Nobody wants to "spoil market".

One of the reasons the stockists are all fairly small is that there is a limit to how much they can individually supply to the customers. The customers do not want to be tied to a single large supplier, so they spread the business around. More competition also allows them better bargaining power. If the stockists merge, the enlarged company would probably get less business as a combined entity.

$1,000/ton = very good profit
$200/ton = scrap
The carrying cost is somewhere in between, say around $400/ton
Then the discount is not 20%, probably still closer to 50%.

From what I remember in my past discussions with people in the business, the "normal" gross margin is 10-15%. More than that is for unusual items or those needed urgently. The economic boom from 2004-2007 saw many stockists report high gross margins, partly from inventory gains and partly from high demand.

The carrying value is essentially the current price of steel plus freight. Steel (coil/plate/wire/section etc) is currently about US$700-800/ton. Scrap is US$330-US$350/ton FOB delivered. So the melting+processing spread is about US$350-450/ton. Call it US$400/ton.

So basically, in exchange for a small chance of losing US$400/ton, the stockist keeps inventory with a high chance of making US$100/ton. As long as they guess right at least 80% of the time they will break even at the gross level. Of course, they need to do better to cover fixed costs like salaries, rent and interest.

So far, they seem to have done a decent job at it. But we are of course looking at the survivors of 30+ years of business. Over time, those stockists who couldn't manage their inventory properly would have gone out of business. That the survivors have prospered is without a doubt. But for minority investors the steel stockist business is just one of many choices. At the right price, a steel stockist could be a safe investment. As to what price that ought to be... that is the $64,000 question.

[BlueKelah]

This is an area that I am paying more attention on. Numbers don’t lie, but numbers alone is not good enough to predict the future. Take for example Asia Enterprise, a company I invested since 2007. This company has an unbroken track record of profitability since inception. It has a solid BS with high cash and little debts, plus a track record of paying at least 40% of profit as dividends. However, I am not able to see the coming collapse of steel price that beset the company for the next few years. Till now, it is still trading at lower price that my buy price, fortunately, it remains profitable every year and continue to pay dividends every year.

Yes, indeed finance person is different from accounting person. Thanks.

Dun worry, no one saw the coming boom of USA / china property prices either. Steel prices will revert to mean, in fact steel billet has been up >20% few weeks now but AEH and Hupsteel dont seem to have responded.