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When that ‘bargain’ may be an illusion

IN THE thick of the Asian financial crisis, some listed companies were actually trading below their net cash value; in other words, the leftover cash in their bank accounts after paying off all their liabilities was higher than market capitalisation.

So theoretically, someone who had the money could have gone into the market and bought up 100 per cent of the shares in order to gain control of the company. He could then have used the company’s cash to pay off all its liabilities. The remaining sum of cash would still have been more than the amount he used to buy the 100 per cent stake, leaving him with some profit to pocket.

In addition, there would have been other assets like buildings or investments which he could have liquidated. These would have been the icing on the cake!

Of course, in practice it may not be so easy. There would be the controlling shareholder to contend with. And the traders out there, once they sense a big buyer, may pounce on the stock.

But the point is: for companies whose market value is below its cash net of all liabilities, it may be an indication of market mispricing.

Back in June 2003 in this column, I highlighted three companies that were trading at near their cash value. I noted that in a prolonged bear market, investor aversion is so severe that very often stocks end up trading way below their asset values. And in extreme cases, the share price is even lower than the cash holdings of the company after netting all liabilities.

‘Of course, if the company has no intention to return the cash to shareholders and its operations are bleeding cash, then the share price may well have reason to be trading below the cash net of liabilities per share,’ I wrote then. ‘Unless there is a turnaround in the business, the cash will eventually be depleted.’

The three companies that had a high component of cash in their share price then were Auric Pacific, General Magnetics and k1 Ventures. Then, Auric’s cash net of its total liabilities worked out to 99.7 cents a share. Its share price at the time was 90 cents. General Magnetics’ net cash per share was 13 cents versus its share price of 14 cents. And k1 Ventures’ net cash was 18.4 cents per share, compared with a share price of 20.5 cents.

Fast forward to today, and all three have underperformed the general market. So ultimately, it is the business that drives the share price. But still, there is something appealing about trying to identify companies with a strong balance sheet, and decent business, yet trading at a low valuation.

This week, I attempted to screen some of the stocks for such criteria.

Most of the stocks which showed up on the list were China stocks, and most were loss making. This explains the deep discount in their share prices to their asset value. For example, United Food barely had any liabilities in its accounts as at Sept 30, 2007. Its cash and deposits amounted to $92.4 million or about 8.3 cents a share. Take into consideration other assets like inventory, accounts receivable, properties and land use rights, and the net asset value per share for the stock came to 40.7 cents. In the market yesterday, United Food last traded at 14.5 cents. That’s a discount of about 63 per cent.

Is the market correct in factoring in such a big discount for the company when the business is producing a profit, albeit a declining one?

Perhaps. As mentioned, the group’s earnings have been declining for years now. The management has proved to be rather poor in charting out a viable strategy for the group and executing it. United Food and People’s Food were established in China in the early 1990s and were listed in Singapore around the same time, in the early 2000s.

In their latest third-quarter results, People’s Food registered a net profit of 84.5 million yuan (S$16.7 million) on revenue of 1.8 billion yuan. United Food, on the other hand, managed only 14.8 million yuan of net earnings and revenue of just 745 million yuan. And there’s no sign of things turning for the better as yet. The directors themselves are not positive about the group’s prospects.

Meanwhile, United Food’s operations continued to drain cash. Its inventory and accounts receivable were rising despite lower sales. That’s not a good sign. Still, at such a deep discount to its net asset value – assuming all the numbers are reliable – any positive news will give a big boost to the stock price.

In screening the stocks, I also considered whether the company is currently generating positive cash flow, and whether the management is positive about the immediate future.

Presumably, if both are positive, and yet the stock is trading at a deep discount, then perhaps the stock deserves a closer look.

Based on the above criteria, China Flexible Packaging showed up on the radar. In its latest quarter, revenue grew 7 per cent to 284 million yuan, and net earnings edged up 9 per cent to 43 million yuan. Gross and net profit margins are 30 per cent and 15 per cent respectively. Its cash amounted to some 350 million yuan and its accounts payable and liabilities came to about 90 million yuan. The other assets are plants and equipment and accounts receivable.

As mentioned, the group’s operations are generating cash. However, rising oil prices are a threat to the margin of the group. The group said it is working on ways to improve its efficiencies to mitigate higher raw material costs. It added that it is ‘optimistic about the group’s performance in 2008’.

The ‘consensus’ estimate – I think there’s only one analyst covering the stock – is 9.9 cents earnings per share for the year ending Oct 31, 2008. That’s quite an ambitious 22 per cent increase from FY2007. If that happens, China Flexible Packaging would now be trading at four times its forecast earnings for FY2008.

Meanwhile, the group has recommended a dividend of 1.91 cents per share. If approved next Friday at its AGM in Guangzhou, then the dividend yield works out to some 4.5 per cent. The thing is, the group has disappointed investors before. It remains to be seen if its optimism is justified. But with the current 30-plus per cent discount to its net asset value, the downside is perhaps limited.

The other two stocks which are trading at a discount, and yet have a positive operating cash flow as well as a positive management outlook, are Plastoform and China Powerplus. Their discounts, however, are not as steep as China Flexible Packaging’s.

Source: Business Times 23 Feb 08


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