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Abnormal earnings drive a firm's value
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lg_6273
Elite |
02-Dec-2006 20:04
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Published December 2, 2006 Abnormal earnings drive a firm's value A study of 3 food companies to see how efficiently capital is deployed to earn profits By TEH HOOI LING SENIOR CORRESPONDENT IN the past couple of weeks we've discussed how, at the very fundamental level, it is the efficient use of capital to yield above-cost returns that will create value in a company.  One way to calculate a valuation for a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth. This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock. Book value is the original capital invested by the company in its various assets to start up its business. On the other hand, if the company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value. This formulation also implies that a company's stock value reflects the cost of its existing net assets - that is, its book equity, plus the net present value of its future growth options (represented by cumulative abnormal earnings). Now, let's apply the formulation to three food-related companies listed on the Singapore Exchange (SGX). Two are relatively new listings, while the third has been around a while. Hsu Fu Chi makes confectionary for sale in China. Synear makes frozen dumplings. And Want Want produces snacks. Hsu Fu Chi's shares started trading yesterday. Synear was listed in August. And Want Want is the grand-daddy - its shares have traded on SGX for just over 10 years. The business terrain of all three is highly competitive. And the key success factors for all of them are brand name, distribution network and cost control. Hsu Fu Chi was founded in 1992, with its base in Dongguan, Guangzhou province. It now makes candy products, cakes and cookies, and Sachima products. In terms of products, Hsu Fu Chi is closer to Want Want, which, incidentally, originated in Taiwan and later ventured into mainland China in 1992. Today, Want Want produces snack products, beverages and related products. Going by total revenue, it is more than twice the size of Hsu Fu Chi. As for sales growth, Hsu Fu Chi has a profile similar to that of Want Want. In the past two years, the former grew its top line by a compounded rate of 19.4 per cent a year. Want Want was a tad lower at 16.7 per cent, but that was due to a sales bottleneck the group took slightly more than a year to work out. In its latest six months, Want Want's sales grew 27 per cent year on year. Both are similar in terms of gross profit margin - about 38 per cent. But in the latest results, Want Want's net profit margin is slightly higher at 13.4 per cent, compared with Hsu Fu Chi's 10.3 per cent. As for bottom-line growth, Hsu Fu Chi is ahead, with a compounded annual growth rate (CAGR) of 11.8 per cent versus 6.4 per cent for Want Want. Synear, meanwhile, is in quite a different league in terms of the market it serves and the rate at which it has been growing. It is the youngest company, having started its business in 1997. Today it makes about 70 varieties of savoury dumpling products, 50 varieties of glutinous sweet dumpling products, 30 varieties of glutinous rice dumpling products and 60 varieties of specialty desserts and snacks. In the past two years, its sales climbed at a very steep rate - a whopping 82 per cent a year between 2003 and 2005. The pro-rated full-year sales of Synear for 2006 are about three-quarters those of Hsu Fu Chi's full-year sales to June 30, 2006. Distribution costs Synear is in a newer market, in which demand is exploding as China urbanises. It is providing one of the staple foods of the Chinese in a very convenient form. Having been one of the earlier entrants, and having built up a relatively strong brand name, it is in a sweet spot now. To cater to demand, in August Synear completed a Phase 1 expansion that raised its annual production capacity to 316,800 tonnes from 288,000 tonnes. And in October, it completed a Phase 2 expansion, raising its total annual production capacity to 360,000 tonnes. Its gross margin, at 32.8 per cent, is the lowest among the three. But surprisingly, it has the highest net profit margin of 21.7 per cent. The reason is unbelievably low distribution and administrative expenses. According to Synear's results, in the first nine month of the year it spent only 5.3 per cent of sales revenue on distribution costs and another 1.4 per cent on administrative expenses. That's a combined 6.7 per cent of sales - a number consistent with those of the past three years. Meanwhile, Want Want had to fork out 14 per cent of sales as distribution costs and another 10.3 per cent as administrative expenses. That's a total of 24.3 per cent - more than three times Synear's. As for Hsu Fu Chi, its distribution costs amounted to 18.5 per cent of sales and admin charges came to 9 per cent of sales, for a total of 27.5 per cent. This could mean two things. One is that Want Want and Hsu Fu Chi are operating in a much more competitive environment, and so must spend aggressively on advertising and promotion to maintain their sales growth. On the flip side, there is room for them to be more efficient when it comes to administrative charges. But for Synear, at an already low 1.1 per cent, there is literally no more fat to cut. Arguably, the only way to go - both for distribution and administrative costs - is up. Now we come to the crux of the matter - how efficiently the capital has been deployed to generate earnings. Based on their pre-IPO numbers, Hsu Fu Chi's return on capital (ROC) worked out to 17.8 per cent for FY06 and its return on equity (ROE) was 18.8 per cent. Its numbers are more or less in line with Want Want's ROC of 16.2 per cent and ROE of 19.4 per cent. Going forward, one will have to see whether Hsu Fu Chi can utilise its IPO proceeds of almost $130 million efficiently to continue to generate abnormal returns. Meanwhile, Synear, due to its very fat net profit margin of nearly 22 per cent, chalked up an enviable 53 per cent ROC and 123.5 per cent ROE. ROE for 2005 was significantly higher, as more than half of Synear's investments were funded by borrowings. After its IPO, Synear has paid off the bulk of its loans. Should Synear continue its first nine months' performance for the rest of the year, its ROC and ROE are still a solid 46.9 per cent and 57.5 per cent respectively. Market expectations Given its high growth expectations and high ROE, the market has duly accorded Synear the highest valuation among the three. It is now trading at 8.3 times book value. In other words, the market expects Synear to generate a net present value (NPV) of $1.6 billion over and above its cost of capital going forward. This is 29 times its nine-month earnings of $55 million. As for Want Want and Hsu Fu Chi, despite their rather similar characteristics there is quite a significant valuation gap between the two. At its closing price of $1.06 yesterday, Hsu Fu Chi is trading at 2.9 times book value. This compares with just 1.8 times for Want Want. So the market's expectation is for Want Want to generate abnormal earnings of about $900 million going forward, or just under seven times its latest nine-month net earnings of $130 million. As for Hsu Fu Chi, it is implied that it will rake in NPV of $550 million, or 13.1 times full-year earnings to June 30, 2006. Based on the above analysis, Want Want appears to have a better chance of meeting or exceeding market expectations - more so than Hsu Fu Chi and Synear. |
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