The Issue of Ze Buy Recommendation made by iCapital.
A lot has been said about iCapital buy recommendation on Mieco Chipboard.
Why? The investment manager had a buy recommendation made on Mieco last Aug 2004. Mieco price then was 2.36.
This was what the company wrote in its conclusion to recommend the stock and its warrant as a longer term buy.
After the Lipis plant, no huge capital expenditure is expected from Mieco. At a price of RM2.36 and RM1.09 for its warrants, Mieco is capitalised at just over RM600 mln. With its expansion underway, the book value and level of sales would not be useful yardsticks. What we think is more relevant is to value Mieco based on its normalised level of expanded operations.
What would this be ? First, one has to bear in mind that the main factor driving Mieco in the coming years would be regional growth, especially China, which is more attractive than just local growth. Secondly, as i Capital expects China’s economy to do marvellously well in the coming decade, a well-managed exposure to China, either direct or indirect, can be exciting and probably very rewarding. Thirdly, Mieco is expected to fully utilise its enlarged capacity by 2007. With expected sales of around RM600 mln in the medium-term, this would imply a normalised earning power of around RM90 mln. Capitalised this at 7% would give us a value of RM4.14 per Mieco share or a 43% discount. In addition, with an expected dividend yield of around 4%, i Capital rates Mieco Chipboard as a longer term Buy.
For those who love warrants, Mieco has warrants that can be converted on a 1 for 1 basis at RM1.20 per share from Apr 2006 to Apr 2009. Proceeds from the warrants are expected to be used to repay its long-term loans. However, even though Mieco has long-term borrowings of RM149.6 mln, it also has cash of more than RM182 mln and strong cash flow.
let's understand and rationalise what iCapital had said.
Mieco, used to be a company operating with a huge cash hoard of over 180 million. So what does the company do? The company decides to emark on a huge capital expansion to built a state of art factory at a cost of over 300 million. To partly fund for this expansion, the company issued warrrants and raised some Islamic private debt securities to fund this exapansion.
Now with this expansion program, Mieco future is deemed to be great because there is regional growth, with China being touted as a huge prospect.
And once the factory is fully utilised, Mieco's earnings is targeted to reach some 90 million.
Do note that for fy 2001 Mieco earned 21 million, fy 2002 Mieco earned 26 million and fy 2003 Mieco earned 31 million. So based on the past earnings history, so iCapital is expecting Mieco's earnings to triple. (wah.. fairly optmistic hor!)
And then it seduced and introduced to the readers the potential in Mieco's warrants.
Also note the following issue.
When iCapital made its recommendations on 27th Aug 2004, Mieco had already announced its earnings on 20th Aug. Meaning, iCapital had a chance to review Mieco's performance before making those recommendations.
Oh, did i forgot not to mention that iCapital is known to have have vested interest in the stock then?
Anyway here is the compiled quarterly earnings table of Mieco ( Click here )
So how did Mieco do for its fy 2004 Q1 earnings? Obviously, the debt issue stood up like a sore thumb. The company went from a company with a nett cash of over 180 million to a company with cash balance of 176 million and debts of over 149 million. Well, some say debt is needed to finance growth. Let's leave this issue aside for now. Look at the profit and the profit margin box. Mieco's total net profit fell to around 6.377 million. Net profit margin also declined from 17-18% the past 3 quarters to just 12.8%.
How does one rate such decline in profitability?
A worry because a decline in proftiability would suggest huge price competition in their business (and iCapital acknowledged the following fact: Vanachai Public Co Ltd of Thailand, Mieco’s regional competitor, is believed to have a slightly larger capacity than Mieco.). And when you embark on a huge capex amidst huge price competition, from a business perspective, wouldn't you be worried?
Or perhaps that quarterly earnings is just a blip? No worries, everything will just be fine!
How?
Now matter what, in iCapital's judgement, Mieco is worth a longer term buy because they based their reasoning that once Mieco factory is up and running, iCapital ass-u-me-s that Mieco earnings power will reach some 90 million.
Was their buy reasoning justifiable?
What about the issue of debt build-up, depleting cash, decay in fundamental earnings (lower earnings and lower earnings margins)?
How?
At around 2.36, Mieco was trading around a pe of 15x current earnings.
Was this a justifiable buying opporunity then?
Remember the issue that prospects does not necessarily equate to net profits? The regional growth prospect and China is but a prospect. And what about Thailand's Vanachai? Do you think that this Thailand company would not compete for this rice bowl?
Anyway, a year later, in Aug 2005, Mieco announced its 2005 Q1 earnings.
Net earnings 2.486 million (vs the poor 6.377 million a year ago)
Net earnings margins 4.3% (vs the poor 12.85% a year ago)
Piggy bank cash 18.133 mil (vs 182 million a year ago)
Total loans 190.6 million (vs Zero debts some 7 quarters ago!)
How?
Based on the above facts, isn't it very clear that the fundamentals of the company and the economics of the company's business has simply deteriorated very badly?
And common sense tells one that this is the CON of the stock. One can argue that this might be a temporary thingy BUT woudn't it be wrong to consider this as a clear and present issue?
The pros? The prospects. The potentials. But when will it happen? How good will it be? And until the company does convert its potential into reality, these pros for Mieco is just an unknown factor. A possibility.
Now commonsense thinking lah.... clear and present vs unknown future.
Weigh out the pros versus the cons. Which side does it make sense to bet on?
Well, RAM recognised the serious deterioration in Mieco's earnings and balance sheet issues and RAM downgrades Mieco with a negative outlook on Mieco's Islamic notes in Sept 2005.
The increase in revenue, however, did not equate to an increase in profitability as profit declined due to weaker selling prices, lower optimal capacity utilisation rate of its new plant and to a lesser extent, the rising costs of raw materials.
Mieco was trading around a price of 1.90. And it soon tumbled after this downgrade from RAM!
Ah, with the tumbling price, iCapital quickly issued some press statements. Now, instead of acknowledging the serious deterioration in iCapital's fundamentals and acknowledge the fact that perhaps iCapital has simply err-ed in their recommendation of Mieco, iCapital instead made the following statement.
“The fall in price will be a temporary phenomenon. Due to strong demand for chipboards both locally and internationally, it is only a matter of time before prices recover. Another contributor to the fall in margin was the increase in raw material prices. But even with the falling margin, operating profit held up well,” says independent investment advisor Capital Dynamics Sdn Bhd.
Temporary. Everything will be all right according to them.
But...but.... buttt.....
yes, falling prices could be temporary phenomenon. However, the main issue is whether if company has a product that is competitive advantage to withstand this so-called temporary phenomenon. And as Capital Dynamics note themselves that the fall in margin is caused by increased in raw material prices.
So what does this mean?
Materials cost increase, the company's margins get hit, so doesn't it mean that the company product is simply not competitive enough to allow Mieco to pass the cost down to the end-users?
Shouldn't one have considered this issue?
"So it's a matter of time before prices recover due to strong demand for chipboards locally and internationally"
Oh yes... there is always a possibility that prices would recover... but when? What if it takes much longer to recover? When? Hold till the new factory starts to contribute earnings? When? When will this happen? Next earnings? or the next? or the next? Say the turnaround can be seen at the next earnings, which will be Nov 2005. That's another 2 months plus.... would the stock price hold till then? Meaning when waiting for the earnings to recover, what if the stock slumps another 20%? or 30%? or 40%?
Mieco had now slumped to a price of around 1.40. Down significantly from the recommended longer term buy at around 2.36 a year ago.
And on 26th Sept 2005, iCapital issued another report.
Once again, Mieco Chipboard (Mieco) has caught investors' attention, after a local rating agency belatedly revised its rating on Mieco's Al Murabahah Commercial Paper (MCP)/Medium-Term Note Programme (MMTN). At RM1.37, Mieco is currently capitalised at only RM288mln plus RM55 mln for its 100.0 mln warrants. Is the downgrade justified?
LOL! Was the downgrade justifiable or not? You be the judge.
Anyway, in its conclusion, iCapital mentioned the following.
i Capital views that a decline in Mieco's operating profitability, if it happens, will not strain Mieco's debt-servicing ability. This is because Mieco's positive operating cash flow, future conversion of warrants and its ability to raise additional borrowings, if necessary, can raise cash for Mieco to retire its maturing MTTNs. On the chipboard industry, the strong demand for chipboards will not allow the pressure on pricing arising from the additional capacity, to sustain in the longer run. China’s economic growth is picking up momentum again. So is Japan’s. On the other hand, if the low price is more prolonged than expected, the smaller players in the region or those whose capacity come on-stream later will probably close down first, and in the process, allowing the price of chipboard to rise again. One should not forget that chipboard prices are also cyclical. Should one downgrade a palm oil plantation company because palm oil prices have dropped ? Therefore, i Capital does not see the need for an outlook downgrade on Mieco's Islamic debts. With this, i Capital retains its rating on Mieco Chipboard as a Buy for the longer term.
Ahem! Despite those clear and present issues in Mieco, iCapital adamantly retained its rating on Mieco as a BUY for the longer term. (pls note the vested interest in Mieco was acknowledged by iCapital)
Price of Mieco then 1.37.
On November 22nd 2005, Mieco announced its 2005 Q3 earnings.
Quarterly rpt on consolidated results for the financial period ended 30/9/2005
Mieco posted a net loss of 3.742 million!
Piggy bank is now only 16.883 million!
Total loans stood at 210.849 million.
Remember the issue of waiting for the next quarter? or the next?
Well the Nov result showed a loss!
Are we gonna to hold and hope that the factory starts to deliver its promised results?
Compare the end result of holding on to the stock from Sept 2005 to now.
Is it wise to use a hold and hope investing strategy on a stock whose earnings is clearly on the downtrend?
Now remember the roundtable discussion Star Biz had recently? ( Investors need longer time horizon ).
iCapital mentioned the following:
We still have a buy on Mieco Chipboard, basically because the company's decline in earnings was due to a change in accounting standards and the cyclical factor – most of the capacities came in at the same time, in Thailand and in Malaysia.
So, the price of chipboard fell but the underlying demand is actually very strong, and being in a cyclical industry (and the fact that a chunk of the production is geared towards the fast-growing Asian region) it's a question of time the prices will have to stabilise. In fact, I think there are signs that prices have started to recover.
iCapital described Mieco performance as a decline in earnings!!! WOW!
Eh?
Mieco's ytd (3 quarter) net loss is 1.136 million.
How nicely put! A decline in earnings.
Anyway, iCapital cited the change in accounting standards and the cyclical factor is causing the decline in earnings.
Makes me wonder. Especially the cyclical factor. What about the optimistic strong regional growth mentioned by iCapital last Aug. How come Mieco's chipbooards is now deemed to have a cyclical factor?
Anyway, again ass-u-ming that the cyclical factor is real and should not be discounted... then what then for Mieco?
Cyclical mah. So when will the wheel of fortune smile on Mieco again?
Big issue now, isn't it? When?
You know why? Cos Mieco now has a huge balance sheet issue. And with the cyclical factors affecting Mieco's product pricing, shouldn't this be a huge issue? A huge, huge handicap to Mieco's business and an even bigger handicap for Mieco's minority shareholders.
And if so, don't you find it very strange that iCapital still has a buy on Mieco?
Hmmm.... and what is even more interesting is the following...
1. At 2.36, a buy for the longer term.
2. At 1.37, still a buy for the longer term.
3. At 1.00 (yup Mieco is now trading at 1.00!!), Mieco is still a BUY!!!
:P
And all this while... Mieco's fundamentals is clearly decaying. Cash is clearly depleting. Loans building up. Profitability margins have been eroding. And worse of all, Mieco is now losing money.
And wouldn't you find it strange that iCapital still has a buy rating on it?
Now consider the vested interests it has, do you rate their ratings and recommendations as partial or impartial?
Oh... here's another important issue to consider.
remember Bandar Raya's plan to distribute Mieco shares?
now just for info ... this deal is still pending... now assuming it goes thru...
let's work out some implications..
Mieco has 210 million shares total.
Out of this portion... Bandaraya plans to distribute 119.1 million to its shareholders. (wah that's some 56% wor!)
Now.... key issue for them minority Mieco shareholders is... what will these Bandaraya shareholders do after receiving these shares?
Will they keep? or will they sell?
Reason to keep? Err... err.... Mieco too cheap to sell? Hold for long term mah!
Reason to sell? Hoi.. Mieco losing moola mah. so Mooooola in me pocket better than paper money which might diminish if Mieco's performance does not improve soon! Tiok boh?
soooo how?
what do you reckon will happen?
(part one can be found here: mieco
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