Homepage
PR Newswire
I would add that Cheung Woh's recent woes are hardly surprising. This comes from observation of the economics of their business and other businesses similar to theirs.
First, they produce goods that are difficult to differentiate from their direct competitors. Sure, there might be small differences in quality and cost, but it's safe to say such differences are insufficient to differentiate them from their competitors. Whether or not they get the business orders would depend on their quality, after-sales service, timing of delivery, and perhaps most importantly, cost. Every part of its operations is likely squeezed by its customers in order for it to retain the business. I describe such goods as having commodity-like characteristics.
Second, they produce goods that are used in the manufacturing of an end-product that faces high pressures in innovation. There is a higher possibility of HDDs being made obsolete one day than say, Gillette shavers, Coca-cola, deposit accounts, insurance policies, cotton fibre, chicken meat or apples. In terms of the tech world, you can argue that HDD is competing against other forms of technology on the basis of lower cost (due to overhanging inventory and the existing PPE used to produce them). If Seagate and Western Digital are competing on cost, you can be certain that their suppliers will not be having an easy time extracting profit margins either.
Lastly, it's such a cyclical industry. Because businesses cannot forecast future demand accurately, we will always see boom and busts for business supporting goods like computers, HDDs, printers etc. For such goods, many factors lead them to be susceptible to boom and busts. First, there is a long lead time to produce them. Second, there is tremendous economies of scale to produce them on the cheap. So if it can be produced cheaply at a large scale rather than a small scale, people will tend to over-produce it when times are good and orders are coming in thick and fast. So if I can produce 2X the number of goods with 1.1X the amount of costs, I would do it.
The above reasons add up to incent producers of technical, commoditized goods to produce too much when times are good, thus requiring them to cut down significantly when times are bad. Compare a Cheung Woh-like small HDD parts manufacturer vs Apple. This can tell you the difference between a tech commodity and a differentiated tech good. Demand for one is subject to business cycle boom and busts, and the other creates its own demand. Then think about a Cheung Woh-like small HDD parts manufacturer and an insurance underwriting company. This can tell you the difference between a tech commodity and a financial commodity. Both are subject to low margins but one is subject to the boom and busts of the business cycle while the other, not so much.
There are many other factors that I have not touched on, which impact the economics of the business too, such as obsolescence of inventory and globalization of competition. These also have impacts on income statements, balance sheets and consequently, free cash flow, but I reckon the above points should be sufficient to make the conservative investor skeptical of the attractiveness of the industry in general.
Moving on, here are what I think would be the quantitative impacts of such economics on the company's business performance:
1. Gross revenues will be cyclical. As orders fluctuate with business cycles, the company's top line will be impacted. (see: Spindex, Cheung Woh's HDD segment, Innovalues, Micro-Mech etc.)
2. Margins will be cyclical. As utilization rates of production capacity rise and fall, as well as the scale of production, margins will be impacted. Couple this with revenues that fall just when margins are impacted, and you have a big impact on net profits. (see: Spindex, Cheung Woh's HDD segment, Innovalues, Micro-Mech etc.)
3. Capital expenditure will be ever increasing. As the industry strives to keep costs low, they will be more and more willing to spend on bigger, better and faster machines to produce the small parts that they sell. This would be useful if their order books are always increasing, as you can be sure of maximizing the use of your machines. If order books rise, well and good; if they tank, then you would have just made a very expensive capital allocation exercise (see: Innovalues Ltd)
In either case, the fundamentals of this capital expenditure exercise likely sucks because you are likely to be paying for new technology to produce old technology. That's because sometimes, you cannot buy the old technology that you once used anymore, and are forced to pay up to buy the new technology. Ever-increasing capital expenditure means that depreciation will likely to be lower than capital expenditure. And this means that reported net profits over-state free cash flow.
4. Inventory obsolescence and working capital pressure from customers mean that the "net changes in working capital" section in your free cash flow calculations will be a significant part. This is not purely academic. It means even more that net profits over-state free cash flow (and dividends are paid out of free cash flow). Some firms maintain a high level of trade receivables to trade payables, which means that they can pass on lengthening receivables to their suppliers, which is well and good. For others, who are not able to pressure their suppliers, they have to maintain a higher level of cash in their balance sheet for working capital, to facilitate payment of bills, to capture new business opportunities etc. So the high level of cash you see in many of these firms does not mean that it can be readily paid out as dividends. They should be counted as part of working capital. (see: balance sheets and dividend history of Spindex, Micro-Mechanics etc.)
In conclusion, I guess my point is this: it is erroneous to take the last reported earnings of such companies, slap a P/E on them, and say they are cheap. For one, you cannot expect earnings on cycle peaks to be representative of annual earnings going forward. And two, reported earnings likely over-state the true free cash flow, or owner's earnings if you like, of the company. In light of these, here are two relevant questions:
A. What then is the best way, to value such companies?
B. If they are difficult to value, are they still viable options for investment or speculation?
I'm sure many in this forum are aware of the points mentioned above, but nevertheless, I think it is worthwhile writing them down to remind ourselves, and perhaps refresh the knowledge base in our grey matter.
First, they produce goods that are difficult to differentiate from their direct competitors. Sure, there might be small differences in quality and cost, but it's safe to say such differences are insufficient to differentiate them from their competitors. Whether or not they get the business orders would depend on their quality, after-sales service, timing of delivery, and perhaps most importantly, cost. Every part of its operations is likely squeezed by its customers in order for it to retain the business. I describe such goods as having commodity-like characteristics.
Second, they produce goods that are used in the manufacturing of an end-product that faces high pressures in innovation. There is a higher possibility of HDDs being made obsolete one day than say, Gillette shavers, Coca-cola, deposit accounts, insurance policies, cotton fibre, chicken meat or apples. In terms of the tech world, you can argue that HDD is competing against other forms of technology on the basis of lower cost (due to overhanging inventory and the existing PPE used to produce them). If Seagate and Western Digital are competing on cost, you can be certain that their suppliers will not be having an easy time extracting profit margins either.
Lastly, it's such a cyclical industry. Because businesses cannot forecast future demand accurately, we will always see boom and busts for business supporting goods like computers, HDDs, printers etc. For such goods, many factors lead them to be susceptible to boom and busts. First, there is a long lead time to produce them. Second, there is tremendous economies of scale to produce them on the cheap. So if it can be produced cheaply at a large scale rather than a small scale, people will tend to over-produce it when times are good and orders are coming in thick and fast. So if I can produce 2X the number of goods with 1.1X the amount of costs, I would do it.
The above reasons add up to incent producers of technical, commoditized goods to produce too much when times are good, thus requiring them to cut down significantly when times are bad. Compare a Cheung Woh-like small HDD parts manufacturer vs Apple. This can tell you the difference between a tech commodity and a differentiated tech good. Demand for one is subject to business cycle boom and busts, and the other creates its own demand. Then think about a Cheung Woh-like small HDD parts manufacturer and an insurance underwriting company. This can tell you the difference between a tech commodity and a financial commodity. Both are subject to low margins but one is subject to the boom and busts of the business cycle while the other, not so much.
There are many other factors that I have not touched on, which impact the economics of the business too, such as obsolescence of inventory and globalization of competition. These also have impacts on income statements, balance sheets and consequently, free cash flow, but I reckon the above points should be sufficient to make the conservative investor skeptical of the attractiveness of the industry in general.
Moving on, here are what I think would be the quantitative impacts of such economics on the company's business performance:
1. Gross revenues will be cyclical. As orders fluctuate with business cycles, the company's top line will be impacted. (see: Spindex, Cheung Woh's HDD segment, Innovalues, Micro-Mech etc.)
2. Margins will be cyclical. As utilization rates of production capacity rise and fall, as well as the scale of production, margins will be impacted. Couple this with revenues that fall just when margins are impacted, and you have a big impact on net profits. (see: Spindex, Cheung Woh's HDD segment, Innovalues, Micro-Mech etc.)
3. Capital expenditure will be ever increasing. As the industry strives to keep costs low, they will be more and more willing to spend on bigger, better and faster machines to produce the small parts that they sell. This would be useful if their order books are always increasing, as you can be sure of maximizing the use of your machines. If order books rise, well and good; if they tank, then you would have just made a very expensive capital allocation exercise (see: Innovalues Ltd)
In either case, the fundamentals of this capital expenditure exercise likely sucks because you are likely to be paying for new technology to produce old technology. That's because sometimes, you cannot buy the old technology that you once used anymore, and are forced to pay up to buy the new technology. Ever-increasing capital expenditure means that depreciation will likely to be lower than capital expenditure. And this means that reported net profits over-state free cash flow.
4. Inventory obsolescence and working capital pressure from customers mean that the "net changes in working capital" section in your free cash flow calculations will be a significant part. This is not purely academic. It means even more that net profits over-state free cash flow (and dividends are paid out of free cash flow). Some firms maintain a high level of trade receivables to trade payables, which means that they can pass on lengthening receivables to their suppliers, which is well and good. For others, who are not able to pressure their suppliers, they have to maintain a higher level of cash in their balance sheet for working capital, to facilitate payment of bills, to capture new business opportunities etc. So the high level of cash you see in many of these firms does not mean that it can be readily paid out as dividends. They should be counted as part of working capital. (see: balance sheets and dividend history of Spindex, Micro-Mechanics etc.)
In conclusion, I guess my point is this: it is erroneous to take the last reported earnings of such companies, slap a P/E on them, and say they are cheap. For one, you cannot expect earnings on cycle peaks to be representative of annual earnings going forward. And two, reported earnings likely over-state the true free cash flow, or owner's earnings if you like, of the company. In light of these, here are two relevant questions:
A. What then is the best way, to value such companies?
B. If they are difficult to value, are they still viable options for investment or speculation?
I'm sure many in this forum are aware of the points mentioned above, but nevertheless, I think it is worthwhile writing them down to remind ourselves, and perhaps refresh the knowledge base in our grey matter.