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Anti bioterror play for huge long term gains

Thesis: SIGA Technologies, an anti-bioterror pharmaceutical company, will double their stock price in a year and triple or quadruple it in two years. They are in an incredibly strong financial position: zero debt, future US government purchases that may be greater than their market cap, and low expenses for operations and forward research. They also have amazing future growth prospects as foreign governments will buy their meds to prepare for future pandemics. Their drugs treat smallpox which is both more contagious and deadly (IFR ~30%!) than the Wuhan plague.
Do you think absolutely no political or military leader will learn their lesson about pandemic preparedness? Do you think business leaders are going to put the pressure down since the cost of unpreparedness is orders of magnitude greater than preparedness? That’s what this play is all about.
The play: Buy $SIGA stocks and hold for 2 years.

Quick facts

Market cap: $560 million
Style: Value, when compared to other biotechs
Products: Their primary product is an FDA approved oral antiviral (TPOXX) that treats all orthopox viruses (e.g. the dreaded smallpox). They are currently developing additional products for IV and pediatric treatment, another small molecule drug for treating orthopox viruses, and are developing therapeutics that use orthopox viruses for delivery of anticancer antigens.
How SIGA makes money: 1) US government contracts to supply the Strategic National Stockpile, 2) US government contracts for research, 3) sales to foreign governments and potentially private parties. Note that their business doesn't care about prevailing market conditions and all of these are multi-year contracts.
Debt: $0. They paid off an $86 MM loan in March.
Cash holdings: $77.4 MM
Total assets: $118.6 MM
Net cash flow 2019: -$18.2 MM, as discussed below, 2019 was a transition year between govt contracts hence the low income. They made $400MM from closing contracts in 2018.
Net cash flow 2020, my estimate: +$53 MM, see cash flow section below for how I got this figure

How this play can win

- The US govt through BARDA accelerates their purchasing of TPOXX to be and look more prepared for future pandemics.
- Foreign governments purchase TPOXX for their own pandemic preparedness. Canada announced an intent to purchase in December. Others are likely to follow. IMO, the stock will hit $10 when 3 additional countries announce purchasing and $20 when they have a network of 10 purchasing countries plus additional research. The US gets a discount on TPOXX because they funded the initial research, others will likely pay three times as much per dose.
- The US govt offers much more research funding to SIGA to design antivirals for other possible pandemic viruses. 10 years ago they had a small BARDA contract to look into antivirals for Lassa fever, a nasty rat flu boogaloo. They might renew or add to this type of research.
- TPOXX gets additional approvals for IV use and prophylactic use (i.e. give to people in contact with infected, first responders or first city) and US buys more. They recently received a new $23 MM contract for developing this use.
- A larger pharmaceutical company announces that they will purchase SIGA for $10-$15 share in a year. SIGA already has connections with Pfizer.
- Large amounts of additional income help them pump with stock buybacks or fat dividends. I am totally convinced they are going to buyback or spit dividends in a year from now.

Risks

- Foreign governments don’t purchase TPOXX or don’t approve its safety/efficacy and rely on the vaccine for smallpox (but 1 in 5 people can’t take the vax and lots of deaths in first wave without TPOXX).
- US govt does not add to stockpile, only keeps refreshing expired TPOXX.
- US govt does not invest in additional pandemic preparedness research/invests only in competitors.
- TPOXX may later be discovered to have a severe side-effect. (Oral formula is already FDA approved though).
- There’s more risks listed in their 10-K, but I do not think they are significant enough to list here.

Resources for your own DD

Do your own research. Always.
Latest 10-K: https://investor.siga.com/node/13196/html
Latest 10-Q: https://investor.siga.com/node/13251/html
2020 Q1 earnings call: https://www DOT fool DOT com/earnings/call-transcripts/2020/05/07/siga-technologies-inc-siga-q1-2020-earnings-call-t.aspx
2019 Q4 earnings call: https://www DOT seeking NO SPACE alpha DOT com/article/4330138-siga-technologies-inc-siga-ceo-phil-gomez-on-q4-2019-results-earnings-call-transcript
Reddit doesn't like the above websites. Sorry for the garbled links
Press releases: https://investor.siga.com/press-releases
Smallpox wiki: https://en.wikipedia.org/wiki/Smallpox

Detailed DD

I’m going to start off this section by answering the arguments you’ve already thought of.
Who gives a shit about some old timey disease?
The world militaries. Smallpox is a nasty disease. It's basic reproduction number, R0, is between 3-6, like the Wuhan coronavirus. It similarly has a 7-14 day lag time before symptoms show, although it is not known to be infectious for the first several days.
Smallpox is also exceptionally deadly, ranging from 15-30% fatality rate depending upon the strain and in children and the elderly can reach a 75% mortality rate. Survivors are usually permanently scarred and may have life-long complications from the disease. A smallpox epidemic would actually make corona look like "just the flu."
Infection around day 20 mark. Bangladesh, 1973.
Bioterrorism or biowarfare with smallpox is a massive threat to the military and people and an obvious first choice of weapon for a bioterrorist. Careful governments will plan for it.
Isn't smallpox eradicated?
Yes. But. 1) There are still many samples across the world in government labs across the world. 2) The genome exists on computers in said labs. 3) Many other orthopox viruses exist such as cowpox and monkeypox. Monkeypox in particular has had more cases in subsaharan Africa in the last few years. There have even been small outbreaks in the US, UK, and Singapore within the last 20 years.
What about vaccines?
  1. Maybe you recall that in the 1790’s Edward Jenner discovered the first vaccine by giving people the milder cowpox to prevent smallpox. The state of the smallpox vaccine has not evolved significantly since then. The modern vaccine uses a two-prong poker to deliver a live smallpox virus that has been engineered to be very weak. However, it is still a real virus that can causes symptoms or spread the disease to others. One in five Americans have underlying conditions that prevent them from receiving this vaccine due to the symptoms it causes.
  2. What do you do when smallpox starts spreading rapidly? You need to be able to treat the potentially 100s of thousands of people who will be infected before the immunization takes effect. The US is well-prepared with the vaccine having 300 million doses, nearly enough for every American. But you need a treatment as part of the defense strategy.
  3. TPOXX is in the process of being approved as a prophylactic. I.e. if smallpox were to spread then people could be given both the vaccine and TPOXX at the same time to make sure they don’t get sick if they were exposed prior to vaccination. Prophylactic treatment could be extremely important to first-responders, military, and people in the most badly affected zones.

Fundamentals

I am no expert in reading 10-K filings, but SIGA's 10-K is not too complicated. I encourage you to do your own DD before making this play and if you've never read a 10-K filing before this is a great one to cut your teeth on. SIGA only has one key product line and their debt is uncomplicated (nonexistent); the only tricky parts is following the government money.

Balance sheet from most recent 10-Q
Balance sheet
So the things to look at here are:
  1. SIGA has plenty of cash. Enough for two years operating expenses without any sort of austerity. Even if the economic downturn affected their business model, they would weather it easily.
  2. They have $16 MM in inventory. That’s mostly TPOXX they’ve already manufactured. This is great because it means they will have low costs for meeting the current BARDA contract supply request for this year and that if they get more orders they can dedicate their supply chain to filling them.
  3. No debt. There’s no risk of them going tits up soon. Unlike your other favorite plays against highly-leveraged trash companies (looking at you Zillow), SIGA can ride out a credit crunch with ease.
  4. Stockholders’ equity aka book value. At a price to book of 5:1 this is a cheap biotech company, one of the reasons I see them as a value buy. Also of note, their property includes patents on TPOXX in virtually every country.

Cash flow
In 2019, SIGA took a $7 million loss while in 2018 they punched a $422 million gain. How did that happen? Their entire business runs on multi-year govt contracts. 2018 saw an older BARDA contract end with the orders completely filled to stuff the strategic stockpile. 2019 was a transition year.They have a new contract with BARDA to replenish expiring TPOXX and research then purchase new formulations for IV and pediatric use. So, looking at their 201910-K their earnings look abysmal, but their forward looking earnings are much better given their recent news releases.
Let’s look more at that contract since it is a principal revenue source. SIGA’s most recent 19C contract gives BARDA (Biomedical Advanced Research and Development Authority) the ability to purchase up to $602.5MM worth of product. The base contract guarantees $51.7 MM and BARDA announced the exercise of an additional $127.1 MM in purchasing for the next year as of a few weeks ago. Due to drug expiration and future preparedness, my opinion is that BARDA will exercise all of the purchasing options over the next 10 years.
Here’s my 2020 cash flow estimate, I am inexperienced at this sort of analysis. Pro 10-K readers, please give me some criticism.
-$24 MM from expenses for sales, admin, research, services ,patents. Average of last 2 years -10% because research activity is shut down
-$7 MM from additional costs of terminating loan. 10-Q
+$2 MM from part 1 of Canadian order. Press release
+$75 MM from three quarters of $101 MM exercise of BARDA contract. Estimated because they will supply TPOXX the next three quarters of 2020 and Q1 2021, press release
-$3 MM additional costs to fulfill orders. Estimate from BARDA contract’s allocation for supply costs
+$10 MM from contracts for research. Estimate by Q1 research revenue x 4
? a new $23 MM research contract with the department of defense was announced in June, unclear when they will receive the money at this time
$0 from stock buybacks and dividends, they have never had a dividend, but did do $800k in buybacks last year. They might have paid down their debt to put them in a position to do a lot more buybacks, so this is subject to change.
Total: +$53 MM
I expect the next few years to be cash flow positive now that they are out of the development phase and into the deployment phase. As they get additional international buyers they will also need to service their expiring stockpiles. This puts them at a forward price to earnings estimate of 10:1, still a value play in the current environment.
The high future cash flow is why I expect them to start pumping dividends or buybacks in a year. Since their research activities are primarily supported by the US government, they won't have other useful activities for the cash other than to return it to shareholders. Also, the guys who founded SIGA in the 90's probably want to retire on a fat dividend pretty soon. Dividends and buybacks are a big factor in how many analysts calculate stock prices so either development will push the share price up a lot.

International Sales
This is where SIGA make us gigatendies. The US sales are the bread and butter that will keep them afloat for years to come. International sales are where they grow. Their contracts with the US government let them sell TPOXX at about $350 per course because they funded the initial research, whereas Canada is paying about $950 per course giving SIGA a massive estimated 95% margin.
Let's see who might be interested in buying TPOXX as the China flu crisis unwinds: we've got most of western Europe/NATO--UK, France,Italy, Austria, Sweden, Switzerland, Germany, Spain; Pacific countries wary of being in the China sphere--Taiwan, South Korea, Japan, Singapore, Australia,Malaysia, Vietnam, Indonesia; and wealthy Middle Eastern countries that need to hedge against instability--Israel, Turkey, Saudi Arabia, UAE, Qatar; a smattering of other countries getting wise to viral threats--Russia, India,Brazil, South Africa, Mexico. That's a lot of potential buyers and it will only take a few for SIGA's price to shoot up. Also note that SIGA does not market internationally themselves, they are partnered with Meridian, a Pfizer subsidiary, for international sales.
SIGA also has an excellent moat internationally. They have patents for TPOXX and its analogs almost everywhere but China. Of course, there are still risks associated with international expansion, but the upside potential is yuuge. Let's hear it from the horse's mouth and see what SIGA had to say on their 2019 Q4 conference call:
Now let's discuss the international markets. The pursuit of international sales for oral TPOXX is a key focus for us at SIGA. Our partnership with Meridian Medical Technologies that we announced last June has been excellent. However as I've said many times the sales cycle is long for international government procurement of these types of products and each country has its own set of internal dynamics. ... I have been asked why we do not provide a country-by-country update on sales progress. We do not comment on specific progress with countries for two main reasons. First, we respect the confidentiality of our customers who would not want their deliberations to become public. And second, we would not want to signal to competitors which countries may be undergoing an expansion in their spending for biodefense. With that context in mind, we are pleased to share a progress report regarding the Canadian military, who announced in December and intend to issue contracts to support a Health Canada, regulatory filing and thep urchase of up to 15,825 courses of oral TPOXX for the Canadian military. A procurement order of this size would represent about 25%of the active military forces in Canada. Although this is a relatively modest number of courses it is precedent for military preparedness by a U.S. NATO ally.
What can we gather from that? They've got multiple sales in the works, but are keeping mum about it. Also, that it takes time to cut through government tape and announce these sales. Here's the single largest risk for this play: that it takes too long for international contracts to be announced. For this reason, I recommend buying stocks and not calls. The near term future is too unpredictable.

Research Activities
SIGA's main drug, oral TPOXX, is already completely FDA approved as safe in humans and effective in animals. A quirk of their niche is that since smallpox is eradicated, they can't ethically test the drug for effectiveness in humans. This helps their bottom line because they basically get to skip some of the trials of a typical drug development cycle.
SIGA's most important upcoming products are TPOXX for IV, liquid pediatric, and prophylactic use. Due to the current pandemic, all human trials are postponed, but the barriers for these trials are quite low. They only need to demonstrate human safety for the alternate ROA drugs. For prophylactic TPOXX, SIGA needs to demonstrate that TPOXX does not interfere with immunity acquisition from the smallpox vaccine. That way a potentially exposed person can both be treated and vaccinated at the same time. If they fail to meet these research goals, then I doubt the BARDA contract will be exercised for full value. Because of the delay in these results due to corona, I doubt that they threaten the trade that I'm proposing.
Orthopox viruses to deliver cancer therapeutics and older Lassa fever antivirals. I honestly don't know enough about their activities in these areas to make a comment. I think they are irrelevant to the base play, but could provide some surprise upside if there was a development.

Insider trading
The execs did more selling than buying last year which is perhaps bearish, but their most recent move was to buy a lot of stock in December after announcing the Canada deal. They sold stock at ~$5.80 in early 2019. Now, they're holding even though it is past $6. I think the COVID pandemic has massively increased SIGA’s value and their key people are holding at a price where they previously sold knowing that a lot more cash is coming in. I think there's also some possibility of acquisition at higher share price, being debt free makes them attractive to a buyer--just pick up all the shares, no liabilities to clean up.

Positions
I have 5% of my IRA in SIGA and a couple of long dated $10 calls (volume is shit FYI) in my funny money account.
Thank you for reading my novel.
Disclaimer: Just because I can write two coherent paragraphs on a play does not mean I know what I'm doing. Do your own due diligence.
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Trade responsibly,

Good luck today guys, hope everyone makes some tendies
Edit 8:30PM Thanks for the love and awards guys, hope everyone ended the week off positive, enjoy your weekend.
Of note for Airlines (LUV, DAL, AAL, UAL), the Airlines for Americas trade association says the industry needs “immediate financial assistance” to protect the 11mln jobs it represents.
Of note for Banks (JPM, C, MS, BAC, GS), the Fed is encouraged by a notable increase in discount window borrowing as banks show a willingness to use the window as a funding source to support the flow of credit to households and businesses.
Of note for Car Rental Services (HTZ, CAR), both Hertz and Avis Budget Corp have requested aid from the US government.

Dow Jones

Apple Inc. (AAPL) supply chain is reportedly still facing supply disruptions even as China recovers due to factory closures of suppliers in Malaysia. Elsewhere, it has limited the number of purchases on its iPhones to two per customer in the US and China, according to Canalys.
Boeing Company (BA) is reportedly leaning towards a temporary halt of operations at its twin-aisle jetliner factories due to the spread of the coronavirus, according to people familiar with the matter, in a similar move to Airbus (AIR FP).
Johnson & Johnson (JNJ) Global Supply Chain Officer Wengel announced its supply chain is currently holding steady and meeting patient needs.
Walmart (WMT) announced it is planning to give special cash bonuses for hourly associates for their work during the current conditions with full-time associates receiving USD 300 and part-time associates receiving USD 150, which will equate to USD 365mln. WMT is to also accelerate its next bonus for store, club and supply chain associates which will equate to USD 180mln, overall it will equate to USD 550mln, the co. says. WMT is to also hire over 150k hourly employees as the number of shoppers increases.

Nasdaq 100

Amazon.com Inc. (AMZN)– Some sellers state its decision to stop receiving non-essential inventory in response to the coronavirus pandemic could limit sales they need to make payments on its loans from Amazon.
Tesla (TSLA) announced it decided to temporarily suspend production at its Fremont, California factory and NY Factory after March 23rd. Elsewhere, CEO Musk announced his factories are working on ventilators to address a potential shortage.
United Continental Holdings (UAL)Apollo Global Management (APO) has reportedly purchased part of the airlines USD 2bln loan from a group of banks, according to people familiar with the matter.

S&P 500

Accenture plc (ACN) had its PT cut at a number of brokers, however, they were positive on its ability to continue through the coronavirus crisis.
AFLAC Inc (AFL) American Family Life Assurance of Columbus and New York agreed to acquire Zurich North America's US corporate Life and Pensions. AFL expects the acquisition to be dilutive to 2020 adj. EPS by USD 0.02 to 0.03.
Altria Group Inc (MO) announced it is temporarily suspending operations at its Richmond manufacturing center.
Anthem Inc. (ANTM) announced it is offering up to 80 hours of paid emergency leave for qualifying needs, including if associates are experiencing coronavirus symptoms or for caring for young children whose school has been closed.
AT&T Inc. (T) announced it has cancelled is accelerates share repurchase programme of USD 4bln worth of stock, noting the impact of the coronavirus could be material although it cannot currently estimate the impact onto its financial or operational results.
Bank of America Corp (BAC) announced it is offering additional support for its consumer and small business clients in response to the coronavirus, where clients can request funds including overdraft fees, non-sufficient funds fees, and monthly maintenance fees through deposit accounts. Many customers can also request to defer any payments.
Carnival Corp. (CCL) preliminary Q1 20 (USD): EPS 0.22 (exp. 0.27), revenue 4.8bln (exp. 4.66bln); coronavirus resulted in a net loss of 0.23/shr.
Cintas Corporation (CTAS) Q3 20 (USD): Adj. EPS 2.16 (exp. 2.02), revenue 1.81bln (exp. 1.8bln), gross margin 45.5% (exp. 45.7%, prev. 44.9% Y/Y); announced it is not providing guidance for Q4 20 and it is suspending FY20 guidance due to uncertainty surrounding the coronavirus.
Coty, Inc (COTY) provided an update on the current situation: Expects Q3 20 revenue to fall approximately 20% like for like, with a meaningful impact on profit, it has also withdrawn FY20 guidance. It is recommending to the board that shareholders be given the option to receive up to 100% of their quarterly dividend in kind for the coming two quarters. Its largest shareholder JAB decided to fully repay the loan it used to finance the tender offer in 2019. It is taking initiatives to manufacture hand sanitizer. Notes activations on Amazon have seen US sales nearly double in recent weeks, as well as launching the Kylie skin-care Europe in upcoming weeks; it is also preparing for increased demand post coronavirus.
Danaher Corp. (DHR) announced the US FTC is on board with the acquisition of General Electric’s (GE) Life Sciences Biopharma Business. The closing of the deal is still subject to customary closing conditions as announced in the agreement, but DHR expects the deal to close on March 31st, 2020.
Ford Motor (F) announced it has plans to suspend production in Argentina and Brazil starting next week due to the coronavirus.
Kohl's Corp. (KSS) announced it is to close its stores nationwide through to at least April 1st, although customers will still be able to shop on its App. It also withdrew guidance for Q1 and FY20.
Mylan N.V. (MYL) announced it is increasing production of its malaria drug for potential use to combat the coronavirus.
Occidental Petroleum (OXY) is reportedly planning on naming its former CEO Stephen Chazen as its new chairman as it tries to improve amid weak demand and activism from Carl Icahn, according to WSJ citing people familiar with the matter.
Sysco Corp. (SYY) announced it will donate 2.5mln meals over the next four weeks as part of its response strategy to help against COVID-19. Elsewhere, it has withdrawn its three-year plan guidance due to the impact from the coronavirus.
Tiffany & Co. (TIF) Q4 19 (USD): Adj. EPS 1.80 (exp. 1.77), revenue 1.4bln (exp. 1.36bln); SSS +3%, SSS Ex-Hong Kong +5%, Gross Margin 63.3% (Prev. Y/Y 63.8%). Announced it will not be issuing FY20 guidance due to the pending merger with LVMH

Other

Crowdstrike (CRWD) Q4 19 (USD): Adj. EPS -0.02 (exp. -0.08), Revenue 152mln (exp. 137mln); FY21 Adj. EPS view -0.14 to -0.10 (exp. -0.18), revenue view 723-733mln (exp. 685mln)
Samsung (SSNLF) has reportedly been hit hard by Vietnam’s travel restrictions from South Korea, fueling concerns its Galaxy Note smartphones will fall behind schedule in its largest manufacturing hub outside South Korea
Teva (TEVA) announced it will be donating over 6mln doses of hydroxychloroquine sulfate tablets across the US to meet the urgent demand for the medicine as an investigational target to treat the coronavirus.

Additional US Equity Stories

Of note for casino names (MGM, CZR, WYNN, MLCO); Macau has halved its 2020 gaming revenue forecast due to the coronavirus and predicts a 56% fall from previous year to USD 16bln.
US Steel (X) Q1 20 (USD): Adj. EPS view -0.80 (exp. -0.84), EBITDA 30mln.
Coca Cola (KO) does not expect to meet its FY20 guidance, although does not foresee any near-term interruptions to its concentrate or beverage-based production. Meanwhile, it had its PT lowered at Deutsche Bank to USD 53/shr from USD 64/shr, although the desk reiterated its long-term buy rating.
Ross Stores (ROST) announced it is to temporarilty close all of its stores throughout the US due to the coronavirus.
Dollar Tree (DLTR) announced it is hiring 25,000 associates (both full and part time) to help across its stores in the US.
Synaptics Inc. (SYNA) downgraded to Underweight from Neutral at JP Morgan
Colgate Palmolive (CL) upgraded to Buy from Neutral at BofA
Accenture (CAN) upgraded to Buy from Neutral at MoffettNathansonMonster Beverage
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Covid-19 update Friday 24th April

Good morning from the UK. It’s Friday 24th April. My marigold seeds have taken off and are starting to sprout secondary stage leaves (marigolds are good companion plants; they ward off various pests in a vegetable garden whilst they can also be good sacrificial plants should a slug manage to somehow breach our electric barrier). Meanwhile, the first of my wife’s radishes seeds is starting to emerge from the compost she put in a recycled milk carton tetrapak a few days ago; she’s very excited by this. Advance warning, today’s post is a bit food supply chain heavy. Happy Friday everybody.

Virus news in depth


AP Story from Tuesday 21st April: UN food agency chief: World on brink of `a hunger pandemic’ - The head of the U.N. food agency warned Tuesday that, as the world is dealing with the coronavirus pandemic, it is also “on the brink of a hunger pandemic” that could lead to “multiple famines of biblical proportions” within a few months if immediate action isn’t taken. World Food Program Executive Director David Beasley told the U.N. Security Council that even before COVID-19 became an issue, he was telling world leaders that “2020 would be facing the worst humanitarian crisis since World War II.” That’s because of wars in Syria, Yemen and elsewhere, locust swarms in Africa, frequent natural disasters and economic crises including in Lebanon, Congo, Sudan and Ethiopia, he said. Beasley said today 821 million people go to bed hungry every night all over the world, a further 135 million people are facing “crisis levels of hunger or worse,” and a new World Food Program analysis shows that as a result of COVID-19 an additional 130 million people “could be pushed to the brink of starvation by the end of 2020.” He said in the video briefing that WFP is providing food to nearly 100 million people on any given day, including “about 30 million people who literally depend on us to stay alive.”
(Cont’d) Beasley, who is recovering from COVID-19, said if those 30 million people can’t be reached, “our analysis shows that 300,000 people could starve to death every single day over a three-month period” — and that doesn’t include increased starvation due to the coronavirus. “In a worst-case scenario, we could be looking at famine in about three dozen countries, and in fact, in 10 of these countries we already have more than one million people per country who are on the verge of starvation,” he said. According to WFP, the 10 countries with the worst food crises in 2019 were Yemen, Congo, Afghanistan, Venezuela, Ethiopia, South Sudan, Syria, Sudan, Nigeria and Haiti. He pointed to a sharp drop in overseas remittances that will hurt countries such as Haiti, Nepal and Somalia; a loss of tourism revenue which, for example, will damage Ethiopia where it accounts for 47 percent of total exports; and the collapse of oil prices which will have a significant impact in lower-income countries like South Sudan where oil accounts for almost 99 percent of total exports.

The Gulf Times takes a different slant on the story: ‘Instead of coronavirus, the hunger will kill us’; COVID-19 brings fears of a global food crisis - In Kibera, the largest slum in Kenya’s capital Nairobi, people desperate to eat set off a stampede during a recent giveaway of flour and cooking oil, leaving scores injured and two people dead. The coronavirus has sometimes been called an equaliser because it has sickened both rich and poor, but when it comes to food, the commonality ends. It is poor people, including large segments of poorer nations, who are now going hungry and facing the prospect of starving. “The coronavirus has been anything but a great equaliser,” said Asha Jaffar, a volunteer who brought food to families in the Nairobi slum of Kibera after the fatal stampede. “It’s been the great revealer, pulling the curtain back on the class divide and exposing how deeply unequal this country is.” Already, 135 million people had been facing acute food shortages, but now with the pandemic, 130 million more could go hungry in 2020, said Arif Husain, chief economist at the World Food Program, a UN agency. Altogether, an estimated 265 million people could be pushed to the brink of starvation by year’s end. “We’ve never seen anything like this before,” Husain said. “It wasn’t a pretty picture to begin with, but this makes it truly unprecedented and uncharted territory.”
(Cont’d) There is no shortage of food globally, or mass starvation from the pandemic yet continues the Gulf Times article. But logistical problems in planting, harvesting and transporting food will leave poor countries exposed in the coming months, especially those reliant on imports, said Johan Swinnen, director general of the International Food Policy Research Institute in Washington. While the system of food distribution and retailing in rich nations is organised and automated, he said, systems in developing countries are “labour intensive,” making “these supply chains much more vulnerable to COVID-19 and social distancing regulations.” On a recent evening, hundreds of migrant workers, who have been stuck in New Delhi after a lockdown was imposed in March with little warning, sat under the shade of a bridge waiting for food to arrive. The Delhi government has set up soup kitchens, yet workers like Nihal Singh go hungry as the throngs at these centres have increased in recent days. “Instead of coronavirus, the hunger will kill us,” said Singh, who was hoping to eat his first meal in a day.

Coronavirus-driven CO2 shortage threatens US food, water and beer supply, officials say - The Guardian reports that there is an emerging shortage of carbon dioxide gas (CO2) according to a Washington state emergency planning document. The document, a Covid-19 situation report produced by the State Emergency Operations Center (SEOC), contains a warning from the state’s office of drinking water (ODW) about difficulties in obtaining CO2, which is essential for the process of water treatment. The document says that the ODW is “still responding to [that day’s] notification of a national shortage of CO2”. It continues: “Several [water plants] had received initial notification from their vendors that their supply would be restricted to 33% of normal.” It further warns: “So far utilities have been able to make the case that they are considered essential to critical infrastructure and have been returned to full supply. However, we want to ask if CISA [the US Cybersecurity and Infrastructure Security Agency] can assess this through their contacts, if this is sustainable given the national shortage.”
(Cont’d) Asked to clarify the nature of this problem, ODW director Mike Means said in an email that his agency had first learned of potential problems when Seattle public utilities were “contacted by their vendor Airgas who supplied a copy of a Force Majeure notice”, warning them that their CO2 order would be reduced due to pandemic-related shortages. Force majeure is a contractual defense that allows parties to escape liability for contracts in the case of events – such as a pandemic – that could not be reasonably foreseen. In this case, Means wrote, “Airgas informed in their notice that they would only be able to do 80% of their normal service but subsequent discussions said to expect more like 33%”. At this point, he added, “we reached out to understand if this was a WA specific problem or national. We quickly understood it to be a national issue.”
(Cont’d) ODW had then contacted federal agencies such as CISA, the Federal Emergency Management Agency (Fema) and industry bodies such as the Association of State Drinking Water Authorities (ASDWA). The main reason for national shortages, according to the CEO of the Compressed Gas Association (CGA), Rich Gottwald, is a ramping down of ethanol production. “Back in the summertime, the [Trump] administration exempted some gasoline manufacturers from using ethanol. Then we had Russia and Saudi Arabia flooding the market with cheap gasoline. All of that led to an oversupply of ethanol,” Gottwald said. “As ethanol manufacturers were ramping down because there wasn’t a market for their product, along comes Covid-19, which meant people weren’t driving anywhere”, he added. This led to plant closures, including among the 50 specialized plants that collect CO2 for the food and beverage market. Gottwald’s association, along with a number of associations representing food and beverage industries, which together use 77% of food-grade CO2, issued a joint warning to the federal government about the shortage. In an open letter to the vice-president, Mike Pence, the coalition warns: “Preliminary data show that production of CO2 has decreased by approximately 20%, and experts predict that CO2 production may be reduced by 50% by mid-April.” It continues: “A shortage in CO2 would impact the US availability of fresh food, preserved food and beverages, including beer production.”

The 'land army' needed to keep the UK's food supply chain going as thousands of tonnes of food risks going to waste - ITV has done a piece on the UK farming supply chain. Farmers are desperate for help. Without their usual influx of migrant workers from the EU, thousands of tonnes of food risk going to waste in fields up and down the country, just as the summer crops come into season. Every year our farming industry needs 90,000 seasonal workers. Like Robyn, many have put themselves forward - but in no way near the numbers needed. Others are finding the application process hard to navigate. Mark Thorogood, whose family have run the Essex farm for three generations, says it’s a perilous time for the food supply chain. "If we can't get the labour – it doesn’t get picked. That’s the crux of it", he said. Meanwhile, the charity The Food Foundation claims more than one and a half million Britons are going without food for at least a day because of the pandemic and three million have experienced hunger since the lockdown. On top of all that - the reality that nearly 50% of our food comes from abroad. With the numbers of ships crossing the Channel reduced and port workers hit by the virus, this is now under threat too. So could this crisis see a permanent change in how we feed our nation? The country's leading voice on food security, Professor Tim Lang gave us a grave warning: "The entire world food system is being disrupted. More disruptions are coming. Plantings not happening, food being wasted. "Britain only produces about 50% of its food - the country that can only half feed itself has got to wake up". (Personal note: this is why I’m putting effort into growing veg)

Virus news in brief


Sources: The Guardian, CNN or (to get an alternative spin) Radio New Zealand









Supply chain news in depth


Hidden threat: Japan only has a 2-week stockpile of LNG (Liquid Natural Gas) - If supplies stop, it will cause major power supply problems in the country says Nikkei’s Asian review which has an article highlighting the continuing energy supply chain vulnerability in Japan ever since the Fukushima nuclear disaster. It takes about one month to ship LNG from the Middle East to Japan explains the article but if the coronavirus outbreak prevents ships from docking in Japan it could have a big impact on the country's power supply. The physical properties of LNG mean it is poorly suited for long-term storage hence the country only holding a two-week stockpile. Despite this, the country depends on the fuel for 40% of its electric power generation needs, and all of the LNG it uses is imported from the Middle East and Southeast Asia. Tokyo Bay, which stretches across the prefectures of Chiba, Tokyo and Kanagawa, is Japan's most important LNG power generation hub. JERA operates many of the power plants there, all of which run on LNG. Accounting for about 30% of Japan's total LNG power generation, these plants produce 26 million kilowatts of electricity. If, for instance, the coronavirus was to force these plants to stop, the Greater Tokyo area would immediately lose its power supply (Personal note: that’s a population of approx 38.5m people).
(Cont’d) Today, LNG is a pillar of Japan's electricity. Before the March 11, 2011, earthquake and tsunami in Japan, LNG made up 28% of the country's power generation. That increased to 40% in fiscal 2017 as the nation's nuclear power plants went off grid, one after the other, following the Fukushima nuclear crisis. While some of Japan's nuclear plants have come back online, based on the strictest standards in the world, only three of the 10 electric power companies have been able to do so. Moreover, the coronavirus is inching closer and closer to the nuclear plants. Recently, a contractor working at the Genkai Nuclear Power Plant in the southern prefecture of Saga tested positive for the virus and construction at the site was stopped temporarily. Japan has traditionally tried to maintain a diverse mixture of power sources -- including nuclear, LNG, fossil fuels and renewable energy -- due to its reliance on imports as an island nation. "It is highly unbalanced to depend close to half of our energy on LNG alone," an official at the Ministry of Economy, Trade and Industry concedes. With shipments arriving constantly, a few missed shipments will not immediately signal a crisis. But an extended cutoff will spell trouble for the country.
(Cont’d) Japan was already facing a power shortage this year, "so the timing is very bad," said a power industry source. The Sendai nuclear power plant in Kagoshima Prefecture was shut down last month because it failed to meet antiterrorism standards. The No. 3 reactor at the Ikata nuclear power plant in Ehime Prefecture is offline following a court injunction. The number of nuclear reactors in operation this year is expected to temporarily fall by half from nine, so Japan cannot rely heavily on nuclear power. Japan's energy self-sufficiency stands at about 10%, well below the 40% for food. The movement to shift away from carbon has led to a backlash against domestic coal-fired power plants, so dependence on LNG could rise further. One reason that Tokyo Electric is rushing to restart its Kashiwazaki-Kariwa nuclear plant in Niigata Prefecture is because "heavy concentration in LNG power in Tokyo Bay is a major risk to the stable supply of power," according to an official at the utility. The coronavirus pandemic is testing whether Japan's government and utilities can diversify energy sources to prepare against the risks that threaten supplies.

USA meat packing plant Covid-19 problems worse than originally thought - A rash of coronavirus outbreaks at dozens of meatpacking plants across the nation is far more extensive than previously thought, according to an exclusive review of cases by USA TODAY and the Midwest Center for Investigative Reporting. More than 150 of America’s largest meat processing plants operate in counties where the rate of coronavirus infection is already among the nation’s highest, based on the media outlets’ analysis of slaughterhouse locations and county-level COVID-19 infection rates. These facilities represent more than 1 in 3 of the nation’s biggest beef, pork and poultry processing plants. Rates of infection around these plants are higher than those of 75% of other U.S. counties, the analysis found.
(Cont’d) While experts say the industry has thus far maintained sufficient production despite infections in at least 2,200 workers at 48 plants, there are fears that the number of cases could continue to rise and that meatpacking plants will become the next disaster zones. "Initially our concern was long-term care facilities," said Gary Anthone, Nebraska's chief medical officer, in a Facebook Live video Sunday. “If there's one thing that might keep me up at night, it's the meat processing plants and the manufacturing plants." Factory workers, unions, and even managers say the federal government – including the U.S. Centers for Disease Control and Prevention and the Occupational Safety and Health Administration – has done little more than issue non-enforceable guidance. On its website, for example, the CDC has released safety guidelines for critical workers and businesses, which primarily promote common-sense measures of sanitization and personal distancing. USA Today says that state health departments have also taken a backseat role in all but a few places. There’s more in the article here.

Supply chain news in brief









Good news


Meet the 12-year-old who rode 36 hours on Zwift alongside Geraint Thomas - The Tour De France winner and double Olympic gold medalist earlier this week did 3 12 hour cycling sessions to raise money for the UK’s NHS (National Health Service), eventually earning £350,000. Alongside him rode a 12 year old Mak Larkin who by the end of the 36 hours of cycling had managed to cycle 740km (460 miles). Proud mum Lynsey told Cycling Weekly: “Lockdown was really getting to Mak, being that he was so eager to race this season as it was his first year at national level road and mountain bike cross country. “He saw Geraint’s 36-hour challenge and told us he wanted to do some of it with him for something to do and to support the NHS. He then told us a few hours later that he wanted to do the full challenge and wanted to raise some money himself. At time of writing his fundraising page (also for the NHS) stands at £5,772 (approx €6,605 or $7,111 USD). Cycling weekly has more here.

A toddler has been able to hear for the first time after a groundbreaking remote switch-on of her cochlear implants - The BBC reports that audiologists in Southampton activated the devices for 18-month-old Margarida Cibrao-Roque via the internet as they are unable to see patients in person due to Covid-19 measures. Professor Helen Cullington said the procedure took "technical creativity". Margarida's father said it had "opened a big window" for his daughter. Margarida, who has been deaf since birth because she has Ushers Syndrome Type One, had received her cochlear implants in an earlier operation. Staff at the University of Southampton's Auditory Implant Service (USAIS) used specialist software and were able to monitor progress via videolink to the family's home in Camberley, Surrey. During the switch-on levels of electrical stimulation were gradually built up and Margarida's responses were constantly monitored. It is hoped her new cochlear implants will, over time, help her to hear and to communicate more easily. Margarida's mother, Joana Cibrao said the team were "just brilliant and made it happen" despite the lockdown restrictions. "The possibility of Margarida calling me mummy one day would mean the world," she said.

Donations


Several asked if they can send me $/£/€ via Patreon (in some cases because I've saved them time or money, others for no reason at all). I don't need the cash (that's lovely though) but as you may have read above, food bank charities are getting really hit hard with all this panic buying. Please consider giving whatever you'd have given me to a foodbank charity instead:
UK: https://www.trusselltrust.org/
France: https://www.banquealimentaire.org/
Germany: https://www.tafel.de/
Netherlands: https://www.voedselbankennederland.nl/steun-ons/steun-voedselbank-donatie/
Italy: https://www.bancoalimentare.it/it/node/1
Spain: https://www.fesbal.org/
Australia: https://www.foodbank.org.au/
Canada: https://www.foodbankscanada.ca/
USA: https://www.feedingamerica.org/
Thanks in advance for any donations you give. If there's foodbank charities in your country and it's not listed above, please suggest it and I will include it going forward.
submitted by Fwoggie2 to supplychain [link] [comments]

BAT – A Wonderful Company at A Wonderful Price (8x PE, 15% dividend yield, 100% ROE)

 
In 1987, Buffett famously stated, "I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."
“The best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett
“Invest at the point of maximum pessimism.” – John Templeton
 
Warren Buffett’s best winners have always been stocks which were bought during times of maximum pessimism. GEICO was bought on the brink of bankruptcy. AMEX was bought during the Salad Oil Scandal. Goldman Sachs was also bought with bankruptcy looming. Wells Fargo was a bank with a largely residential loan book bought during a housing crisis. Coca-Cola was bought at a time of massive overdiversification. And so on and so forth.
It’s not often that one has the opportunity to put into practice the all-encompassing philosophy of buy low, sell high. But even when that opportunity rears its ugly head, it’s the rare investor who has the aptitude and the stomach to back up the truck. Thankfully, these opportunities do exist, but it takes a keen eye to discern the difference between a falling knife and a once-in-a-lifetime opportunity.
 
Overview
British American Tobacco (BAT) Malaysia is one such example. Currently trading at just 8x PE, sporting a 100% ROE, and giving a 15% dividend yield, it’s hard not to salivate a little at the financial statistics. But why is such a high ROI stock – a cigarette company no less – trading at such awfully low valuations?
First, some history. BAT Malaysia is the largest cigarette company in the country, with a roughly 50% legal market share and 12% total industry market share. If you’re observant, you’ll notice that Malaysia’s illegal cigarette market share takes up a whopping 65% share of the pie. This was largely due to the massive excise duty (i.e. sin tax) hike in 2015, which brought illegal market share from a reasonable 33% before the hike to 65% and rising today.
As a result, BAT Malaysia has suffered massive share price declines, with the share price falling by 85% in the past 5 years (from RM 60 in 2015) and 70% in the past 12 months alone (from RM 37 in early-2019). This was largely due to revenue declines of nearly 20% and earnings decline of 40% over the past 3 years, with a corresponding shortfall in dividends (the company has a 90% dividend policy). ROE has also fallen from approximately 200% to around 100% today.
Thus, it’s not surprising that the stock has taken such a beating. Indeed, over the past two weeks alone the stock price has fallen by about 30%. But is investing in it now simply trying to catch a falling knife?
 
Business Narrative
The source of the problem can largely be traced back to the sin tax hike in 2015, which brought illegal cigarette market share from 33% to 65% over the past 5 years. The Malaysian government has not been very accommodative to local industry players, rebuffing efforts to reduce the sin tax and dragging its feet when it comes to the enforcement of existing laws and the introduction of new ones. The local Customs department, working together with the police, has had some success in recent years tackling the illegal cigarette cartel – arresting the decline in legal market share from 20%-30% annually to just above 10% in the past year – but efforts are largely seen as too little, too late. On top of that, the illegal vaping scene has blossomed in Malaysia, with nicotine-related products claiming up to 10% of total industry market share.
This backdrop has inspired analysts to impose doomsday scenarios for the legal industry players (i.e. BAT, PMI & JTI), according present values to the companies which reflect a resumption of historical revenue and market share declines. Indeed, when parsing the financial statements of BAT, it’s not impossible to forecast revenues declining to a point where they fall below operating costs (i.e. EBITDA of zero), rendering the equity essentially worthless valuation-wise.
The main reason for the government’s lack of progress is bureaucracy. Different governmental ministries have drawn different interpretations of their legal jurisdiction regarding the matter, and thus shuffle the responsibility of arresting the illegal trade to their peers. For instance, the Ministry of Health (MOH) has stated that it has no authority to enforce legislation against illegal cigarettes, while the Customs department disagrees and says it is the MOH’s prerogative to clamp down on illegal cigarette packets which don’t portray mandatory and unsightly health warnings (illegal cigarette packets tend not to include them). As a result of the red tape, there has been little progress on the front lines, and legal industry players are lesser of for it.
BAT and JTI (the two largest cigarette players) have resorted to shutting down their manufacturing operations and implementing an importation business model, where legal cigarettes are imported from Indonesia into the country to be sold. BAT has also gone through one round of layoffs last year, with a second round expected in 2020.
 
Financials
As alluded to earlier, revenues have declined by 20% over the past 3 years while net profit has declined by 40%. This was surprisingly not due to a contraction of Gross Margin (which you’d expect as costs go up when switching from a manufacturing model to an importation model), but largely as a result of revenues falling while operating costs remain the same. This can be seen in the Operating Margin falling from a high of 24% in 17Q3 to 18% in 19Q3, and net margin contracting from 18% in 17Q3 to 13% in 19Q3.
On the balance sheet side, things look much rosier. Intangibles take up the lion’s share of assets (40%), while Inventories and Receivables have declined slightly in line with the fall in Revenue. Net cash is negative owing to a revolving credit facility which the company has drawn presumably for tax reasons. The debt is current in nature and can be paid back in full with 2 years of Free Cash Flow. The company doesn’t have much fixed assets remaining following the closure of its manufacturing plant, indicating that liquidation value (approximately zero) falls far short of market value. Current ratio is reasonable at 0.8x. Share capital has not changed for at least 3 years.
Receivable days and Inventory days have respectively increased by roughly 50% over the last 3 years – indicating a struggling business which is facing business challenges from its illegal brethren. Payable days have remained static over the same time period. As a result, Cash Conversion Cycle stands at 79 days, up by double from 33 days in 2018.
Cash flow is still stable, with cash receipts approximating revenues. Free Cash Flow is almost equal to Operating Cash Flow, exemplifying the asset-light nature of the current business. The company pays out the entirety of its FCF as dividends (and then some), leading to a dividend yield of 15% at the current share price and a 118% dividend payout ratio.
 
Risks
The risks are apparent. If the government doesn’t do something about the illegal trade and allows it to run rampant, it’s possible that illegal market share increases from here and revenues continue to decline. In the worst-case scenario, it’s not hard to envision revenues falling below operating costs and EBITDA reaching zero, implying the shares are worthless and that dividends will be cut or even stopped entirely.
The current share price of 8x PE (RM 10.00) reflects this doomsday view. The market is basically pricing in declining earnings growth into perpetuity and giving no stock to a potential turnaround. Government intervention to address the illegal trade is widely perceived as sorely lacking and possibly not existing, with analysts imputing revenue declines of up to 30% a year into their models. Share price targets range from RM 11 – RM 15, although the share price has fallen by some 20% since the last revision of analyst reports. All in all, it seems like bad news for BAT.
 
Opportunities
The opportunities for BAT, while less apparent, do exist. For one, the government could by some miracle successfully enforce existing laws and put the brakes on illegal trade – it has already slowed the latter’s advance by some 50% since the sin tax hike. Alternatively, the government could recognize the disadvantages of the narrowing tax base from legal cigarettes and decide to reverse or reduce the sin tax, leading to a reclaiming of legal market share by industry players to previous highs. By some back-of-the-envelope calculations, if legal market share rises to just half of their historical levels, BAT’s earnings and share price could double from here. PE ratios would also expand in such a scenario.
BAT’s parent company in London could also decide to acquire the Malaysian subsidiary given the depressed prices. A fair market price given the circumstances would be roughly 15x PE, which assuming earnings continue to decline by 30% from today, would put the acquisition price at around 120-130% from current share prices.
BAT has also been experimenting with nicotine-related products, such as the Heat-Not-Burn (HNB) device known as Glo (PMI has a branded competitor known as IQOS). Both have received glowing reviews from former cigarette users and is expected to help the companies transition into the post-smoking era (i.e. 20-30 years from now). So far, Glo has developed a 1% total industry market share in Malaysia despite only being launched 2 years ago, showcasing its popularity and potential success.
Finally, the government is preparing the release of new legislation regarding vaping, which is due to see light by mid-2020. While legalization is still not guaranteed, government officials have publicly admitted the difficulty of enforcing laws if a vaping ban were to be instituted. If vaping is legalized, the legal industry could see a 10% increase in market share overnight as they introduce their own products to supplement the demand for currently illegal products.
 
Risk : Reward
In my opinion, current share prices have priced in all the risks while discounting all the opportunities. Even assuming earnings decline at an average annual rate of 10% into perpetuity, it would take just ten years to reclaim your initial investment. This is assuming illegal market share continues its rise unabated and legal market share never sees the light of day again. Keep in mind that the company has a 90% dividend payout policy, and has kept this rate despite recent struggles in its business, so you’d get a return of capital regardless of the share price performance.
In this worst-case scenario, the parent company would either push for an acquisition or liquidate the Malaysian operations. An acquisition at fire-sale prices would probably yield at least 5x PE, while a liquidation would yield nothing given the current ratio of 0.8x. The latter is highly unlikely because it would mean that BAT ceases to have a presence in Malaysia completely, a growing South East Asian nation with GDP growth of 4-5% and potentially bright future. Hence, given the probabilities and an estimate of expected value, you’d already come out on top at the current PE of 8x.
What about the alternative? Before we get into the valuation from an opportunity set perspective, let us consider BAT’s business model. As Buffett says, this is a company with unit economics of a penny per cigarette, selling them at a dollar per cigarette, fantastic brand loyalty and a captive audience. Imagine if you could have owned Altria in the USA in the 1970’s. Today, you’d own Altria, Kraft Heinz, PMI and a smattering of profitable businesses around the world. While I don’t mean to draw a direct comparison between BAT Malaysia today and Altria USA of the 70’s, it’s not hard to imagine a similarly wonderful future for a company with such an attractive business model.
As far as economic moats are concerned, the cigarette business is probably one of the few businesses you can say will be around in another 20-30 years. Sure, they’re facing headwinds in the form of a burgeoning illegal cigarette trade today, but who says they will still be facing the same demons 10 years from now, or even 5 years? If there’s one thing for certain, it’s that the business environment is fluid – and chances are good that things won’t remain the same as today, whatever they may be.
 
A Reasonable Bull-Case Scenario Valuation
Let’s put the humdrums aside for a moment and imagine a brighter future for BAT. What would this future look like? For one, it’s possible that within the next 5 years the government realizes it can’t contain the illegal cigarette problem and decide to reduce the sin tax to previous levels. The wider tax base resulting from such a move would result in the same absolute amount in taxes even at lower tax rates – so there is no financial disincentive not to do so – while at the same time reducing the illegal market share. If legal market share even reclaims half of their former levels, the share price of BAT could double from today.
Furthermore, what’s stopping BAT from resuming earnings growth, assuming the business environment recovers? Even if earnings grow by just equal to GDP growth (i.e. 4-5% a year), it would justify a 15x PE at the minimum considering a long-time horizon of 20-30 years. Combine a doubling of earnings with a 15x PE, and you’re looking at a potential quadrupling (4x) of the current share price.
 
A Best-Case Scenario Valuation
If BAT reclaims its former glory and returns to its historical market capitalization of RM 18 billion, we’re talking about a 600% increase in share price.
That’s just for the next ten years. What about dividends beyond that? Let’s imagine the best possible scenario for BAT. Assume for awhile that you’re planning to hold BAT for the next 30 years. Assume also that in ten years’ time, BAT’s share price skyrockets to 600% of current levels, and then grows earnings by 4% a year into perpetuity and pays out 90% of earnings at dividends. Account for 3% inflation and zero percent cost of capital (i.e. growth funded from retained earnings). By the end of year 30, you’d end up with 27x your initial investment, or 2700% of your capital. That’s a 12% CAGR.
In other words, a $40,000 investment in BAT today could potentially yield a million dollars in 30 year’s time. And that’s with reasonable assumptions. Tweak the numbers further and you’ll could potentially reach Buffett-like returns.
 
Conclusion
To sum things up, it appears that current share prices already impute the worst-case scenario, while the best-case scenario is a 600% capital appreciation potential in ten years, or 2700% over 30 years. Giving a margin of safety, let’s dial the ten-year return of 600% down by 50% - we still get a 300% reward scenario. That’s a 12% CAGR over ten years. Not too shabby.
Assuming 50% downside from today’s prices, the upside-to-downside ratio at 300% upside would still be a healthy 1:6. Now that’s a margin of safety.
If you believe that BAT has no future in Malaysia and will ultimately be acquired or liquidated, expect share prices to fall by up to 50% from here. If you expect that the legal industry will recover to former highs and that BAT is well-positioned as the largest cigarette player in an ASEAN country with 4% GDP growth (alongside Vietnam, Singapore, and Indonesia), you can expect share prices to rise by at least 300% over the next 10 years.
More realistically, share prices will fluctuate by 20% from current levels both to the upside and downside over the next year or so. If you can stomach that kind of volatility, BAT makes for a wonderful risk-reward component of your hopefully diversified emerging market portfolio.
 
A Value Investor’s Perspective
As mentioned above, Warren Buffett has a history of buying companies for pennies on the dollar when the share price reflects maximum pessimism. This does not mean to dive blindly into freefalling stocks which you do not understand. It does mean that you should do your homework, and when you spot an attractive risk:reward ratio in stocks where others are running for the exits, you should be comfortable holding a large position.
Buying a leading cigarette company in its market while it’s beaten down represents one of the most potentially profitable investments imaginable. For reference, take a look at Altria. If you had bought $1,000 worth of shares in Altria in 1970, and reinvested all the dividends, you would be sitting on a fortune worth $5 million by today. That’s an astounding 18% CAGR over an extraordinarily long period of 50 years. Can BAT Malaysia repeat this tier of performance? Probably not, but you don’t need to in order to make a satisfying profit from it.
Buffett espouses thinking long-term when it comes to investing. Think about the long-term when it comes to BAT Malaysia. Is it likely that illegal cigarette’s share of the market will remain elevated at 65% or above for the next 20 years continually? If I was a betting man, I’d wager that it won’t. More likely than not, some kind of unforeseen development will unfold which will bring market share back into the folds of the legal industry – it could be vaping, HNB products, a newly yet unrevealed form of nicotine-device, or even an evolution in the way smokers think. What can be relied on however is that in 20 years smokers will still continue to view nicotine, and by extension smoking-related products, as a form of entertainment and relaxation.
Then there’s the dividends. The dividend yield on one share of Altria bought in the 1990’s held until today would exceed 30%. This is because the dividends have grown over the years in tandem with earnings growth. Extrapolate that to BAT Malaysia, which currently has a dividend yield of 15%. Assuming an average of 4% earnings growth going forward, that dividend yield would grow to just about 45% in 30 years. That’s the power of compounding.
Buffett also champions the idea of owning companies with fortress economic moats. Some of the companies which he owns have such moats, including Coca-Cola, Wells Fargo, GEICO, American Express, etc. It’s hard to argue that BAT Malaysia doesn’t have such a moat. Even in such trying times where revenues have contracted by 20%, it still sports a high-flying ROE of 100%, and stable gross margins of 30%. I would go so far as to compare BAT Malaysia today to a Coca-Cola or American Express when Buffett bought them during times of pessimism.
Think about the future of BAT in 10 years, or 20 years’ time. It’s likely that it will have overcome the temporary hurdles which it faces today by then and resume earning high returns on significant capital invested over a long period of time. This is truly a compounding machine if there ever was one. Or as the title suggests, a wonderful company trading at a wonderful price.
Remember that Buffett’s best buys in the public markets have all been investments made during trying times, such as what BAT is facing today. AMEX could have gone bankrupt over the Salad Oil Scandal. GEICO was literally months away from being unable to service its insurance liabilities. Goldman Sachs was teetering on the brink of financial collapse under the heavy weight of subprime mortgage obligations. Coca-Cola was not the company it is today – it was an overburdened, overdiversified conglomerate with little growth outlook. Wells Fargo was staring at a huge, unserviceable loan book immediately following the Californian earthquakes given its significant residential exposure. It’s definitely nice to pay fair prices for wonderful companies, but it’s even better to be able to pay wonderful prices for wonderful companies.
 
In times like these, it pays to reflect on some words of wisdom for guidance:
Buy when there’s blood in the streets.
Be greedy when others are fearful.
In the short-term, the market is a voting machine; in the long-term, it is a weighing machine.
Price is what you pay, value is what you get.
It is far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.
Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.
 
May the investing odds be ever in your favor!
 
Stock code: 4162.KL Stock name: British American Tobacco (Malaysia) Berhad Financial information and financial reports: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=4162
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Hibiscus Petroleum Berhad (5199.KL)


https://preview.redd.it/gp18bjnlabr41.jpg?width=768&format=pjpg&auto=webp&s=6054e7f52e8d52da403016139ae43e0e799abf15
Download PDF of this article here: https://docdro.id/6eLgUPo
In light of the recent fall in oil prices due to the Saudi-Russian dispute and dampening demand for oil due to the lockdowns implemented globally, O&G stocks have taken a severe beating, falling approximately 50% from their highs at the beginning of the year. Not spared from this onslaught is Hibiscus Petroleum Berhad (Hibiscus), a listed oil and gas (O&G) exploration and production (E&P) company.
Why invest in O&G stocks in this particularly uncertain period? For one, valuations of these stocks have fallen to multi-year lows, bringing the potential ROI on these stocks to attractive levels. Oil prices are cyclical, and are bound to return to the mean given a sufficiently long time horizon. The trick is to find those companies who can survive through this downturn and emerge into “normal” profitability once oil prices rebound.
In this article, I will explore the upsides and downsides of investing in Hibiscus. I will do my best to cater this report to newcomers to the O&G industry – rather than address exclusively experts and veterans of the O&G sector. As an equity analyst, I aim to provide a view on the company primarily, and will generally refrain from providing macro views on oil or opinions about secular trends of the sector. I hope you enjoy reading it!
Stock code: 5199.KL
Stock name: Hibiscus Petroleum Berhad
Financial information and financial reports: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=5199
Company website: https://www.hibiscuspetroleum.com/

Company Snapshot

Hibiscus Petroleum Berhad (5199.KL) is an oil and gas (O&G) upstream exploration and production (E&P) company located in Malaysia. As an E&P company, their business can be basically described as:
· looking for oil,
· drawing it out of the ground, and
· selling it on global oil markets.
This means Hibiscus’s profits are particularly exposed to fluctuating oil prices. With oil prices falling to sub-$30 from about $60 at the beginning of the year, Hibiscus’s stock price has also fallen by about 50% YTD – from around RM 1.00 to RM 0.45 (as of 5 April 2020).
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While the company is domiciled in Malaysia, its two main oil producing fields are located in both Malaysia and the UK. The Malaysian oil field is commonly referred to as the North Sabah field, while the UK oil field is commonly referred to as the Anasuria oil field. Hibiscus has licenses to other oil fields in different parts of the world, notably the Marigold/Sunflower oil fields in the UK and the VIC cluster in Australia, but its revenues and profits mainly stem from the former two oil producing fields.
Given that it’s a small player and has only two primary producing oil fields, it’s not surprising that Hibiscus sells its oil to a concentrated pool of customers, with 2 of them representing 80% of its revenues (i.e. Petronas and BP). Fortunately, both these customers are oil supermajors, and are unlikely to default on their obligations despite low oil prices.
At RM 0.45 per share, the market capitalization is RM 714.7m and it has a trailing PE ratio of about 5x. It doesn’t carry any debt, and it hasn’t paid a dividend in its listing history. The MD, Mr. Kenneth Gerard Pereira, owns about 10% of the company’s outstanding shares.

Reserves (Total recoverable oil) & Production (bbl/day)

To begin analyzing the company, it’s necessary to understand a little of the industry jargon. We’ll start with Reserves and Production.
In general, there are three types of categories for a company’s recoverable oil volumes – Reserves, Contingent Resources and Prospective Resources. Reserves are those oil fields which are “commercial”, which is defined as below:
As defined by the SPE PRMS, Reserves are “… quantities of petroleum anticipated to be commercially recoverable by application of development projects to known accumulations from a given date forward under defined conditions.” Therefore, Reserves must be discovered (by drilling, recoverable (with current technology), remaining in the subsurface (at the effective date of the evaluation) and “commercial” based on the development project proposed.)
Note that Reserves are associated with development projects. To be considered as “commercial”, there must be a firm intention to proceed with the project in a reasonable time frame (typically 5 years, and such intention must be based upon all of the following criteria:)
- A reasonable assessment of the future economics of the development project meeting defined investment and operating criteria; - A reasonable expectation that there will be a market for all or at least the expected sales quantities of production required to justify development; - Evidence that the necessary production and transportation facilities are available or can be made available; and - Evidence that legal, contractual, environmental and other social and economic concerns will allow for the actual implementation of the recovery project being evaluated.
Contingent Resources and Prospective Resources are further defined as below:
- Contingent Resources: potentially recoverable volumes associated with a development plan that targets discovered volumes but is not (yet commercial (as defined above); and) - Prospective Resources: potentially recoverable volumes associated with a development plan that targets as yet undiscovered volumes.
In the industry lingo, we generally refer to Reserves as ‘P’ and Contingent Resources as ‘C’. These ‘P’ and ‘C’ resources can be further categorized into 1P/2P/3P resources and 1C/2C/3C resources, each referring to a low/medium/high estimate of the company’s potential recoverable oil volumes:
- Low/1C/1P estimate: there should be reasonable certainty that volumes actually recovered will equal or exceed the estimate; - Best/2C/2P estimate: there should be an equal likelihood of the actual volumes of petroleum being larger or smaller than the estimate; and - High/3C/3P estimate: there is a low probability that the estimate will be exceeded.
Hence in the E&P industry, it is easy to see why most investors and analysts refer to the 2P estimate as the best estimate for a company’s actual recoverable oil volumes. This is because 2P reserves (‘2P’ referring to ‘Proved and Probable’) are a middle estimate of the recoverable oil volumes legally recognized as “commercial”.
However, there’s nothing stopping you from including 2C resources (riskier) or utilizing 1P resources (conservative) as your estimate for total recoverable oil volumes, depending on your risk appetite. In this instance, the company has provided a snapshot of its 2P and 2C resources in its analyst presentation:
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Basically, what the company is saying here is that by 2021, it will have classified as 2P reserves at least 23.7 million bbl from its Anasuria field and 20.5 million bbl from its North Sabah field – for total 2P reserves of 44.2 million bbl (we are ignoring the Australian VIC cluster as it is only estimated to reach first oil by 2022).
Furthermore, the company is stating that they have discovered (but not yet legally classified as “commercial”) a further 71 million bbl of oil from both the Anasuria and North Sabah fields, as well as the Marigold/Sunflower fields. If we include these 2C resources, the total potential recoverable oil volumes could exceed 100 million bbl.
In this report, we shall explore all valuation scenarios giving consideration to both 2P and 2C resources.
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The company further targets a 2021 production rate of 20,000 bbl (LTM: 8,000 bbl), which includes 5,000 bbl from its Anasuria field (LTM: 2,500 bbl) and 7,000 bbl from its North Sabah field (LTM: 5,300 bbl).
This is a substantial increase in forecasted production from both existing and prospective oil fields. If it materializes, annual production rate could be as high as 7,300 mmbbl, and 2021 revenues (given FY20 USD/bbl of $60) could exceed RM 1.5 billion (FY20: RM 988 million).
However, this targeted forecast is quite a stretch from current production levels. Nevertheless, we shall consider all provided information in estimating a valuation for Hibiscus.
To understand Hibiscus’s oil production capacity and forecast its revenues and profits, we need to have a better appreciation of the performance of its two main cash-generating assets – the North Sabah field and the Anasuria field.

North Sabah oil field
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Hibiscus owns a 50% interest in the North Sabah field together with its partner Petronas, and has production rights over the field up to year 2040. The asset contains 4 oil fields, namely the St Joseph field, South Furious field, SF 30 field and Barton field.
For the sake of brevity, we shall not delve deep into the operational aspects of the fields or the contractual nature of its production sharing contract (PSC). We’ll just focus on the factors which relate to its financial performance. These are:
· Average uptime
· Total oil sold
· Average realized oil price
· Average OPEX per bbl
With regards to average uptime, we can see that the company maintains relative high facility availability, exceeding 90% uptime in all quarters of the LTM with exception of Jul-Sep 2019. The dip in average uptime was due to production enhancement projects and maintenance activities undertaken to improve the production capacity of the St Joseph and SF30 oil fields.
Hence, we can conclude that management has a good handle on operational performance. It also implies that there is little room for further improvement in production resulting from increased uptime.
As North Sabah is under a production sharing contract (PSC), there is a distinction between gross oil production and net oil production. The former relates to total oil drawn out of the ground, whereas the latter refers to Hibiscus’s share of oil production after taxes, royalties and expenses are accounted for. In this case, we want to pay attention to net oil production, not gross.
We can arrive at Hibiscus’s total oil sold for the last twelve months (LTM) by adding up the total oil sold for each of the last 4 quarters. Summing up the figures yields total oil sold for the LTM of approximately 2,075,305 bbl.
Then, we can arrive at an average realized oil price over the LTM by averaging the average realized oil price for the last 4 quarters, giving us an average realized oil price over the LTM of USD 68.57/bbl. We can do the same for average OPEX per bbl, giving us an average OPEX per bbl over the LTM of USD 13.23/bbl.
Thus, we can sum up the above financial performance of the North Sabah field with the following figures:
· Total oil sold: 2,075,305 bbl
· Average realized oil price: USD 68.57/bbl
· Average OPEX per bbl: USD 13.23/bbl

Anasuria oil field
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Doing the same exercise as above for the Anasuria field, we arrive at the following financial performance for the Anasuria field:
· Total oil sold: 1,073,304 bbl
· Average realized oil price: USD 63.57/bbl
· Average OPEX per bbl: USD 23.22/bbl
As gas production is relatively immaterial, and to be conservative, we shall only consider the crude oil production from the Anasuria field in forecasting revenues.

Valuation (Method 1)

Putting the figures from both oil fields together, we get the following data:
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Given that we have determined LTM EBITDA of RM 632m, the next step would be to subtract ITDA (interest, tax, depreciation & amortization) from it to obtain estimated LTM Net Profit. Using FY2020’s ITDA of approximately RM 318m as a guideline, we arrive at an estimated LTM Net Profit of RM 314m (FY20: 230m). Given the current market capitalization of RM 714.7m, this implies a trailing LTM PE of 2.3x.
Performing a sensitivity analysis given different oil prices, we arrive at the following net profit table for the company under different oil price scenarios, assuming oil production rate and ITDA remain constant:
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From the above exercise, it becomes apparent that Hibiscus has a breakeven oil price of about USD 41.8863/bbl, and has a lot of operating leverage given the exponential rate of increase in its Net Profit with each consequent increase in oil prices.
Considering that the oil production rate (EBITDA) is likely to increase faster than ITDA’s proportion to revenues (fixed costs), at an implied PE of 4.33x, it seems likely that an investment in Hibiscus will be profitable over the next 10 years (with the assumption that oil prices will revert to the mean in the long-term).

Valuation (Method 2)

Of course, there are a lot of assumptions behind the above method of valuation. Hence, it would be prudent to perform multiple methods of valuation and compare the figures to one another.
As opposed to the profit/loss assessment in Valuation (Method 1), another way of performing a valuation would be to estimate its balance sheet value, i.e. total revenues from 2P Reserves, and assign a reasonable margin to it.
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From the above, we understand that Hibiscus’s 2P reserves from the North Sabah and Anasuria fields alone are approximately 44.2 mmbbl (we ignore contribution from Australia’s VIC cluster as it hasn’t been developed yet).
Doing a similar sensitivity analysis of different oil prices as above, we arrive at the following estimated total revenues and accumulated net profit:
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Let’s assume that the above average of RM 9.68 billion in total realizable revenues from current 2P reserves holds true. If we assign a conservative Net Profit margin of 15% (FY20: 23%; past 5 years average: 16%), we arrive at estimated accumulated Net Profit from 2P Reserves of RM 1.452 billion. Given the current market capitalization of RM 714 million, we might be able to say that the equity is worth about twice the current share price.
However, it is understandable that some readers might feel that the figures used in the above estimate (e.g. net profit margin of 15%) were randomly plucked from the sky. So how do we reconcile them with figures from the financial statements? Fortunately, there appears to be a way to do just that.
Intangible Assets
I refer you to a figure in the financial statements which provides a shortcut to the valuation of 2P Reserves. This is the carrying value of Intangible Assets on the Balance Sheet.
As of 2QFY21, that amount was RM 1,468,860,000 (i.e. RM 1.468 billion).
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Quite coincidentally, one might observe that this figure is dangerously close to the estimated accumulated Net Profit from 2P Reserves of RM 1.452 billion we calculated earlier. But why would this amount matter at all?
To answer that, I refer you to the notes of the Annual Report FY20 (AR20). On page 148 of the AR20, we find the following two paragraphs:
E&E assets comprise of rights and concession and conventional studies. Following the acquisition of a concession right to explore a licensed area, the costs incurred such as geological and geophysical surveys, drilling, commercial appraisal costs and other directly attributable costs of exploration and appraisal including technical and administrative costs, are capitalised as conventional studies, presented as intangible assets.
E&E assets are assessed for impairment when facts and circumstances suggest that the carrying amount of an E&E asset may exceed its recoverable amount. The Group will allocate E&E assets to cash generating unit (“CGU”s or groups of CGUs for the purpose of assessing such assets for impairment. Each CGU or group of units to which an E&E asset is allocated will not be larger than an operating segment as disclosed in Note 39 to the financial statements.)
Hence, we can determine that firstly, the intangible asset value represents capitalized costs of acquisition of the oil fields, including technical exploration costs and costs of acquiring the relevant licenses. Secondly, an impairment review will be carried out when “the carrying amount of an E&E asset may exceed its recoverable amount”, with E&E assets being allocated to “cash generating units” (CGU) for the purposes of assessment.
On page 169 of the AR20, we find the following:
Carrying amounts of the Group’s intangible assets, oil and gas assets and FPSO are reviewed for possible impairment annually including any indicators of impairment. For the purpose of assessing impairment, assets are grouped at the lowest level CGUs for which there is a separately identifiable cash flow available. These CGUs are based on operating areas, represented by the 2011 North Sabah EOR PSC (“North Sabah”, the Anasuria Cluster, the Marigold and Sunflower fields, the VIC/P57 exploration permit (“VIC/P57”) and the VIC/L31 production license (“VIC/L31”).)
So apparently, the CGUs that have been assigned refer to the respective oil producing fields, two of which include the North Sabah field and the Anasuria field. In order to perform the impairment review, estimates of future cash flow will be made by management to assess the “recoverable amount” (as described above), subject to assumptions and an appropriate discount rate.
Hence, what we can gather up to now is that management will estimate future recoverable cash flows from a CGU (i.e. the North Sabah and Anasuria oil fields), compare that to their carrying value, and perform an impairment if their future recoverable cash flows are less than their carrying value. In other words, if estimated accumulated profits from the North Sabah and Anasuria oil fields are less than their carrying value, an impairment is required.
So where do we find the carrying values for the North Sabah and Anasuria oil fields? Further down on page 184 in the AR20, we see the following:
Included in rights and concession are the carrying amounts of producing field licenses in the Anasuria Cluster amounting to RM668,211,518 (2018: RM687,664,530, producing field licenses in North Sabah amounting to RM471,031,008 (2018: RM414,333,116))
Hence, we can determine that the carrying values for the North Sabah and Anasuria oil fields are RM 471m and RM 668m respectively. But where do we find the future recoverable cash flows of the fields as estimated by management, and what are the assumptions used in that calculation?
Fortunately, we find just that on page 185:
17 INTANGIBLE ASSETS (CONTINUED)
(a Anasuria Cluster)
The Directors have concluded that there is no impairment indicator for Anasuria Cluster during the current financial year. In the previous financial year, due to uncertainties in crude oil prices, the Group has assessed the recoverable amount of the intangible assets, oil and gas assets and FPSO relating to the Anasuria Cluster. The recoverable amount is determined using the FVLCTS model based on discounted cash flows (“DCF” derived from the expected cash in/outflow pattern over the production lives.)
The key assumptions used to determine the recoverable amount for the Anasuria Cluster were as follows:
(i Discount rate of 10%;)
(ii Future cost inflation factor of 2% per annum;)
(iii Oil price forecast based on the oil price forward curve from independent parties; and,)
(iv Oil production profile based on the assessment by independent oil and gas reserve experts.)
Based on the assessments performed, the Directors concluded that the recoverable amount calculated based on the valuation model is higher than the carrying amount.
(b North Sabah)
The acquisition of the North Sabah assets was completed in the previous financial year. Details of the acquisition are as disclosed in Note 15 to the financial statements.
The Directors have concluded that there is no impairment indicator for North Sabah during the current financial year.
Here, we can see that the recoverable amount of the Anasuria field was estimated based on a DCF of expected future cash flows over the production life of the asset. The key assumptions used by management all seem appropriate, including a discount rate of 10% and oil price and oil production estimates based on independent assessment. From there, management concludes that the recoverable amount of the Anasuria field is higher than its carrying amount (i.e. no impairment required). Likewise, for the North Sabah field.
How do we interpret this? Basically, what management is saying is that given a 10% discount rate and independent oil price and oil production estimates, the accumulated profits (i.e. recoverable amount) from both the North Sabah and the Anasuria fields exceed their carrying amounts of RM 471m and RM 668m respectively.
In other words, according to management’s own estimates, the carrying value of the Intangible Assets of RM 1.468 billion approximates the accumulated Net Profit recoverable from 2P reserves.
To conclude Valuation (Method 2), we arrive at the following:

Our estimates Management estimates
Accumulated Net Profit from 2P Reserves RM 1.452 billion RM 1.468 billion

Financials

By now, we have established the basic economics of Hibiscus’s business, including its revenues (i.e. oil production and oil price scenarios), costs (OPEX, ITDA), profitability (breakeven, future earnings potential) and balance sheet value (2P reserves, valuation). Moving on, we want to gain a deeper understanding of the 3 statements to anticipate any blind spots and risks. We’ll refer to the financial statements of both the FY20 annual report and the 2Q21 quarterly report in this analysis.
For the sake of brevity, I’ll only point out those line items which need extra attention, and skip over the rest. Feel free to go through the financial statements on your own to gain a better familiarity of the business.
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Income Statement
First, we’ll start with the Income Statement on page 135 of the AR20. Revenues are straightforward, as we’ve discussed above. Cost of Sales and Administrative Expenses fall under the jurisdiction of OPEX, which we’ve also seen earlier. Other Expenses are mostly made up of Depreciation & Amortization of RM 115m.
Finance Costs are where things start to get tricky. Why does a company which carries no debt have such huge amounts of finance costs? The reason can be found in Note 8, where it is revealed that the bulk of finance costs relate to the unwinding of discount of provision for decommissioning costs of RM 25m (Note 32).
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This actually refers to the expected future costs of restoring the Anasuria and North Sabah fields to their original condition once the oil reserves have been depleted. Accounting standards require the company to provide for these decommissioning costs as they are estimable and probable. The way the decommissioning costs are accounted for is the same as an amortized loan, where the initial carrying value is recognized as a liability and the discount rate applied is reversed each year as an expense on the Income Statement. However, these expenses are largely non-cash in nature and do not necessitate a cash outflow every year (FY20: RM 69m).
Unwinding of discount on non-current other payables of RM 12m relate to contractual payments to the North Sabah sellers. We will discuss it later.
Taxation is another tricky subject, and is even more significant than Finance Costs at RM 161m. In gist, Hibiscus is subject to the 38% PITA (Petroleum Income Tax Act) under Malaysian jurisdiction, and the 30% Petroleum tax + 10% Supplementary tax under UK jurisdiction. Of the RM 161m, RM 41m of it relates to deferred tax which originates from the difference between tax treatment and accounting treatment on capitalized assets (accelerated depreciation vs straight-line depreciation). Nonetheless, what you should take away from this is that the tax expense is a tangible expense and material to breakeven analysis.
Fortunately, tax is a variable expense, and should not materially impact the cash flow of Hibiscus in today’s low oil price environment.
Note: Cash outflows for Tax Paid in FY20 was RM 97m, substantially below the RM 161m tax expense.
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Balance Sheet
The balance sheet of Hibiscus is unexciting; I’ll just bring your attention to those line items which need additional scrutiny. I’ll use the figures in the latest 2Q21 quarterly report (2Q21) and refer to the notes in AR20 for clarity.
We’ve already discussed Intangible Assets in the section above, so I won’t dwell on it again.
Moving on, the company has Equipment of RM 582m, largely relating to O&G assets (e.g. the Anasuria FPSO vessel and CAPEX incurred on production enhancement projects). Restricted cash and bank balances represent contractual obligations for decommissioning costs of the Anasuria Cluster, and are inaccessible for use in operations.
Inventories are relatively low, despite Hibiscus being an E&P company, so forex fluctuations on carrying value of inventories are relatively immaterial. Trade receivables largely relate to entitlements from Petronas and BP (both oil supermajors), and are hence quite safe from impairment. Other receivables, deposits and prepayments are significant as they relate to security deposits placed with sellers of the oil fields acquired; these should be ignored for cash flow purposes.
Note: Total cash and bank balances do not include approximately RM 105 m proceeds from the North Sabah December 2019 offtake (which was received in January 2020)
Cash and bank balances of RM 90m do not include RM 105m of proceeds from offtake received in 3Q21 (Jan 2020). Hence, the actual cash and bank balances as of 2Q21 approximate RM 200m.
Liabilities are a little more interesting. First, I’ll draw your attention to the significant Deferred tax liabilities of RM 457m. These largely relate to the amortization of CAPEX (i.e. Equipment and capitalized E&E expenses), which is given an accelerated depreciation treatment for tax purposes.
The way this works is that the government gives Hibiscus a favorable tax treatment on capital expenditures incurred via an accelerated depreciation schedule, so that the taxable income is less than usual. However, this leads to the taxable depreciation being utilized quicker than accounting depreciation, hence the tax payable merely deferred to a later period – when the tax depreciation runs out but accounting depreciation remains. Given the capital intensive nature of the business, it is understandable why Deferred tax liabilities are so large.
We’ve discussed Provision for decommissioning costs under the Finance Costs section earlier. They are also quite significant at RM 266m.
Notably, the Other Payables and Accruals are a hefty RM 431m. What do they relate to? Basically, they are contractual obligations to the sellers of the oil fields which are only payable upon oil prices reaching certain thresholds. Hence, while they are current in nature, they will only become payable when oil prices recover to previous highs, and are hence not an immediate cash outflow concern given today’s low oil prices.
Cash Flow Statement
There is nothing in the cash flow statement which warrants concern.
Notably, the company generated OCF of approximately RM 500m in FY20 and RM 116m in 2Q21. It further incurred RM 330m and RM 234m of CAPEX in FY20 and 2Q21 respectively, largely owing to production enhancement projects to increase the production rate of the Anasuria and North Sabah fields, which according to management estimates are accretive to ROI.
Tax paid was RM 97m in FY20 and RM 61m in 2Q21 (tax expense: RM 161m and RM 62m respectively).

Risks

There are a few obvious and not-so-obvious risks that one should be aware of before investing in Hibiscus. We shall not consider operational risks (e.g. uptime, OPEX) as they are outside the jurisdiction of the equity analyst. Instead, we shall focus on the financial and strategic risks largely outside the control of management. The main ones are:
· Oil prices remaining subdued for long periods of time
· Fluctuation of exchange rates
· Customer concentration risk
· 2P Reserves being less than estimated
· Significant current and non-current liabilities
· Potential issuance of equity
Oil prices remaining subdued
Of topmost concern in the minds of most analysts is whether Hibiscus has the wherewithal to sustain itself through this period of low oil prices (sub-$30). A quick and dirty estimate of annual cash outflow (i.e. burn rate) assuming a $20 oil world and historical production rates is between RM 50m-70m per year, which considering the RM 200m cash balance implies about 3-4 years of sustainability before the company runs out of cash and has to rely on external assistance for financing.
Table 1: Hibiscus EBITDA at different oil price and exchange rates
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The above table shows different EBITDA scenarios (RM ‘m) given different oil prices (left column) and USD:MYR exchange rates (top row). Currently, oil prices are $27 and USD:MYR is 1:4.36.
Given conservative assumptions of average OPEX/bbl of $20 (current: $15), we can safely say that the company will be loss-making as long as oil remains at $20 or below (red). However, we can see that once oil prices hit $25, the company can tank the lower-end estimate of the annual burn rate of RM 50m (orange), while at RM $27 it can sufficiently muddle through the higher-end estimate of the annual burn rate of RM 70m (green).
Hence, we can assume that as long as the average oil price over the next 3-4 years remains above $25, Hibiscus should come out of this fine without the need for any external financing.
Customer Concentration Risk
With regards to customer concentration risk, there is not much the analyst or investor can do except to accept the risk. Fortunately, 80% of revenues can be attributed to two oil supermajors (Petronas and BP), hence the risk of default on contractual obligations and trade receivables seems to be quite diminished.
2P Reserves being less than estimated
2P Reserves being less than estimated is another risk that one should keep in mind. Fortunately, the current market cap is merely RM 714m – at half of estimated recoverable amounts of RM 1.468 billion – so there’s a decent margin of safety. In addition, there are other mitigating factors which shall be discussed in the next section (‘Opportunities’).
Significant non-current and current liabilities
The significant non-current and current liabilities have been addressed in the previous section. It has been determined that they pose no threat to immediate cash flow due to them being long-term in nature (e.g. decommissioning costs, deferred tax, etc). Hence, for the purpose of assessing going concern, their amounts should not be a cause for concern.
Potential issuance of equity
Finally, we come to the possibility of external financing being required in this low oil price environment. While the company should last 3-4 years on existing cash reserves, there is always the risk of other black swan events materializing (e.g. coronavirus) or simply oil prices remaining muted for longer than 4 years.
Furthermore, management has hinted that they wish to acquire new oil assets at presently depressed prices to increase daily production rate to a targeted 20,000 bbl by end-2021. They have room to acquire debt, but they may also wish to issue equity for this purpose. Hence, the possibility of dilution to existing shareholders cannot be entirely ruled out.
However, given management’s historical track record of prioritizing ROI and optimal capital allocation, and in consideration of the fact that the MD owns 10% of outstanding shares, there is some assurance that any potential acquisitions will be accretive to EPS and therefore valuations.

Opportunities

As with the existence of risk, the presence of material opportunities also looms over the company. Some of them are discussed below:
· Increased Daily Oil Production Rate
· Inclusion of 2C Resources
· Future oil prices exceeding $50 and effects from coronavirus dissipating
Increased Daily Oil Production Rate
The first and most obvious opportunity is the potential for increased production rate. We’ve seen in the last quarter (2Q21) that the North Sabah field increased its daily production rate by approximately 20% as a result of production enhancement projects (infill drilling), lowering OPEX/bbl as a result. To vastly oversimplify, infill drilling is the process of maximizing well density by drilling in the spaces between existing wells to improve oil production.
The same improvements are being undertaken at the Anasuria field via infill drilling, subsea debottlenecking, water injection and sidetracking of existing wells. Without boring you with industry jargon, this basically means future production rate is likely to improve going forward.
By how much can the oil production rate be improved by? Management estimates in their analyst presentation that enhancements in the Anasuria field will be able to yield 5,000 bbl/day by 2021 (current: 2,500 bbl/day).
Similarly, improvements in the North Sabah field is expected to yield 7,000 bbl/day by 2021 (current: 5,300 bbl/day).
This implies a total 2021 expected daily production rate from the two fields alone of 12,000 bbl/day (current: 8,000 bbl/day). That’s a 50% increase in yields which we haven’t factored into our valuation yet.
Furthermore, we haven’t considered any production from existing 2C resources (e.g. Marigold/Sunflower) or any potential acquisitions which may occur in the future. By management estimates, this can potentially increase production by another 8,000 bbl/day, bringing total production to 20,000 bbl/day.
While this seems like a stretch of the imagination, it pays to keep them in mind when forecasting future revenues and valuations.
Just to play around with the numbers, I’ve come up with a sensitivity analysis of possible annual EBITDA at different oil prices and daily oil production rates:
Table 2: Hibiscus EBITDA at different oil price and daily oil production rates
https://preview.redd.it/jnpfhr5n9br41.png?width=814&format=png&auto=webp&s=bbe4b512bc17f576d87529651140cc74cde3d159
The left column represents different oil prices while the top row represents different daily oil production rates.
The green column represents EBITDA at current daily production rate of 8,000 bbl/day; the orange column represents EBITDA at targeted daily production rate of 12,000 bbl/day; while the purple column represents EBITDA at maximum daily production rate of 20,000 bbl/day.
Even conservatively assuming increased estimated annual ITDA of RM 500m (FY20: RM 318m), and long-term average oil prices of $50 (FY20: $60), the estimated Net Profit and P/E ratio is potentially lucrative at daily oil production rates of 12,000 bbl/day and above.
2C Resources
Since we’re on the topic of improved daily oil production rate, it bears to pay in mind the relatively enormous potential from Hibiscus’s 2C Resources. North Sabah’s 2C Resources alone exceed 30 mmbbl; while those from the yet undiagnosed Marigold/Sunflower fields also reach 30 mmbbl. Altogether, 2C Resources exceed 70 mmbbl, which dwarfs the 44 mmbbl of 2P Reserves we have considered up to this point in our valuation estimates.
To refresh your memory, 2C Resources represents oil volumes which have been discovered but are not yet classified as “commercial”. This means that there is reasonable certainty of the oil being recoverable, as opposed to simply being in the very early stages of exploration. So, to be conservative, we will imagine that only 50% of 2C Resources are eligible for reclassification to 2P reserves, i.e. 35 mmbbl of oil.
https://preview.redd.it/mto11iz7abr41.png?width=375&format=png&auto=webp&s=e9028ab0816b3d3e25067447f2c70acd3ebfc41a
This additional 35 mmbbl of oil represents an 80% increase to existing 2P reserves. Assuming the daily oil production rate increases similarly by 80%, we will arrive at 14,400 bbl/day of oil production. According to Table 2 above, this would yield an EBITDA of roughly RM 630m assuming $50 oil.
Comparing that estimated EBITDA to FY20’s actual EBITDA:
FY20 FY21 (incl. 2C) Difference
Daily oil production (bbl/day) 8,626 14,400 +66%
Average oil price (USD/bbl) $68.57 $50 -27%
Average OPEX/bbl (USD) $16.64 $20 +20%
EBITDA (RM ‘m) 632 630 -
Hence, even conservatively assuming lower oil prices and higher OPEX/bbl (which should decrease in the presence of higher oil volumes) than last year, we get approximately the same EBITDA as FY20.
For the sake of completeness, let’s assume that Hibiscus issues twice the no. of existing shares over the next 10 years, effectively diluting shareholders by 50%. Even without accounting for the possibility of the acquisition of new oil fields, at the current market capitalization of RM 714m, the prospective P/E would be about 10x. Not too shabby.
Future oil prices exceeding $50 and effects from coronavirus dissipating
Hibiscus shares have recently been hit by a one-two punch from oil prices cratering from $60 to $30, as a result of both the Saudi-Russian dispute and depressed demand for oil due to coronavirus. This has massively increased supply and at the same time hugely depressed demand for oil (due to the globally coordinated lockdowns being implemented).
Given a long enough timeframe, I fully expect OPEC+ to come to an agreement and the economic effects from the coronavirus to dissipate, allowing oil prices to rebound. As we equity investors are aware, oil prices are cyclical and are bound to recover over the next 10 years.
When it does, valuations of O&G stocks (including Hibiscus’s) are likely to improve as investors overshoot expectations and begin to forecast higher oil prices into perpetuity, as they always tend to do in good times. When that time arrives, Hibiscus’s valuations are likely to become overoptimistic as all O&G stocks tend to do during oil upcycles, resulting in valuations far exceeding reasonable estimates of future earnings. If you can hold the shares up until then, it’s likely you will make much more on your investment than what we’ve been estimating.

Conclusion

Wrapping up what we’ve discussed so far, we can conclude that Hibiscus’s market capitalization of RM 714m far undershoots reasonable estimates of fair value even under conservative assumptions of recoverable oil volumes and long-term average oil prices. As a value investor, I hesitate to assign a target share price, but it’s safe to say that this stock is worth at least RM 1.00 (current: RM 0.45). Risk is relatively contained and the upside far exceeds the downside. While I have no opinion on the short-term trajectory of oil prices, I can safely recommend this stock as a long-term Buy based on fundamental research.
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Long on HOLI

Hollysys Automation Technologies Ltd. (HOLI)
HOLI is a leading provider of automation and systems solutions in China, with overseas operations in eight other countries throughout Asia. The majority of its business is done in the industrial automation (IA) and rail transportation sectors, though it has low-margin operations in mechanical & electrical (M&E) and medical solutions as well. A miniscule debt-to-equity ratio, healthy historical cash flows, promising growth based on planned expansion in relevant sectors, and the Great Wall of China doubling as an economic moat all suggest taking a long position while the stock price hovers near its 52-week low.
Business Profile
Founded in 1993 and listed on NASDAQ since 2008, HOLI has grown from research team specializing in automation control in the power industry to a multinational company with customers in sectors including power, petrochemical, high-speed rail, and urban rail. In IA, HOLI provides automation hardware, software, and services spanning field devices, control systems, enterprise manufacturing management and cloud-based applications. In rail transportation, it provides advanced signaling control and supervisory control and data acquisition (SCADA) systems for high-speed rail and urban rail.
HOLI designs and manufactures all its products in-house at its facilities in Beijing and Hangzhou. Its core hardware is a printed circuit board, manufactured and assembled at the two Chinese facilities. Raw materials include bare printed circuit boards and various electronic components needed for assembly.
Approximately 82% of the company’s total consolidated revenues are derived from integrated solutions contracts won through the bid process. The remainder of revenue is generated through sales of spare parts, maintenance, and training services after the warranty period from the contracts has ended.
Ok, I kind of get it. So why should I be interested?
  1. An Impeccable Balance Sheet: After paying off its 20M convertible bond in Q1 of FY20, the company has total debt of only 2.5M. That’s good for a D/E ratio of 0.003, quite a bit lower than the 0.557 average of its competitors. It’s average OCF margin over the last three years is 19%, well above industry averages, and its average CFO/NI ratio over the same period is 0.99.
  2. Urbanization: Rapid industrialization and warped demographics has manifested in dramatic urbanization and economic integration, which in turn creates a critical need for infrastructure. Grand infrastructure goals are what a planned economy like China does best. While the world awaits the details of the PRC’s 14th Five Year Plan, you can bet HOLI will be busy servicing Chinese needs for high-speed rail and subway transit.
  3. Limited Domestic Competition: While large multinationals account for the majority of global automation market share, to the extent this is true in China does not extend to the verticals in which Hollysys makes most of its profits. Specifically, the high barriers to entry for servicing nuclear power plants and high-speed rail gives the company an enviable moat around a significant portion of its revenue share.
Valuation
Currently, HOLI’s sustainable competitive advantage comes from its specialized offerings of high-speed rail signaling systems to ensure the safety of passenger train movement. The China Train Control System (CTCS) is a country specific high-speed rail standard and therefore is different from international standards propounded by European organizations or Japan. This barrier to entry makes HOLI the largest provider in a growing market. In fact, their 39% market share from 2015-2018 for total automatic train protection (ATP) sets sold made them the largest Chinese company in the domestic automation market. Rail is also the division in which the company has its highest profit margins.
HOLI’s revenue comes from three main offerings: IA, Rail, and M&E. Historically, the revenue share between the three divisions has been very stable: 40%, 36%, and 23%, respectively. In 2019 and 2018, the company had a GP% of 37% and 38%. Over those two years, IA posted a GP% of 41% and 40% while Rail posted a GP% of 48% and 52%. M&E were by far its lowest margin operations with a GP% of 13% both years. The company does not provide revenue figures by geographical area for each division, but it does break out total revenues by geographical area. We can infer from this breakout and from other financial and marketing materials that almost all IA and Rail revenue is derived from business in the PRC while M&E revenue is generated from its foreign subsidiaries in Singapore, Malaysia, and the Middle East.
China’s high-speed railway operating mileage, currently the largest in the world, has grown from 19,000km in 2016 to 32,000km at the end of 2019, covering 80% of China’s major cities and surpassing the 30,000km goal by 2020 laid out under the 13th Five Year Plan. Though the details of infrastructure goals won’t be released until the next five year plan in 2021, high-speed rail is expected to be at least a $4.4 billion industry by 2023, with maintenance and replacement accounting for a rapidly growing share of expenditures. Higher growth is expected in the urban rail transit sector, which is expected to grow from 5,500km to 9,276km by 2023. In general, infrastructure needs are driven by the rapid urbanization and regional economic integration and is supported by ambitious policies such as the five year plans, Eight Horizontal and Eight Vertical High-speed Railway Corridors project, and the Belt and Road Initiatives. With its leading market share in these industries, HOLI is well positioned to take advantage of this growth. ­
China’s industrial automation market is similarly poised for accelerated growth. Total contract amount from industrial automation in China grew at a 4.9% compound annual growth rate (CAGR) from 2014 to 2018 and reached a total value of $30.1 billion. The market is estimated to accelerate that growth to 11.1% CAGR from 2018 to 2023 and reach $50.6 billion. Over that same time, petrochemicals and power are expected to grow at CAGRs of 14.5% and 5.8%, respectively. While competition in the industrial automation market is stiffer, HOLI’s roots in automation for power and petrochemicals, growing name brand recognition in China, advanced technology, and cash-rich position give it a good position to increase its market share. Importantly, HOLI has a unique advantage when it comes to nuclear power.
The 2011 Fukushima nuclear disaster threw a major wrench into China’s plans for nuclear power. To reassure the population that the country was not a risk of a similar catastrophe, the PRC placed a moratorium on the construction of new power plants. After lifting that ban in 2019, the country has 47 nuclear reactors in commercial operation, with twelve more under constructions and more on the way. The impetus for nuclear power in China has increased due to air pollution from coal-fired plants and as a result the country has subsidized nuclear power with an aim to match and surpass the world average of 15% for total electricity generated by nuclear power (currently at 4.75%). HOLI is the only qualified local automation and control product provider to the non-safety control for nuclear power stations. In the nuclear automation segment, HOLI competes with multi-national corporations such as Siemens, Areva, and Invensys, but with the abnormal glut in demand created by the Fukushima disaster HOLI has a prime opportunity to increase its market share.
The M&E division offers solutions through Concord and Bond Groups, two subsidiaries acquired by HOLI in 2011 and 2013, respectively, in Southeast Asia, the Middle East, and Hong Kong. While this division has the lowest revenue and profit margins in relation to the company’s other operations, it also offers its greatest opportunity for business expansion and diversification. A 2019 partnering with the London engineering consulting firm Arup signals a willingness to expand the M&E offerings, potentially through more acquisitions. While profitable, the revenues generated by this division do not significantly affect our valuation of the company. Barring any interesting acquisitions, the only growth we forecast for M&E is over the long-term.
An important measure in our valuation comes from HOLI’s dedication to research and development. Historically, the company spends 6-7% of revenue on R&D, and 40%, or 1,500 employees, of the 3,200 person company work in R&D. Their proprietary technology is at the center of their rail and power offerings – as of June 30, 2019, HOLI held 221 software copyrights, 126 authorized patents, 64 pending patent applications, and 44 registered trademarks. The Chairman and CEO, Shao Baiqing, has been with the company for more than 25 years starting as one of the founding engineers, and “is widely regarded as an industry leader with significant influence in China.”
Despite the fact that EBITDA has grown over 60% since FY17, HOLI has an EV/EBITDA multiple of approximately 3. Not only is this well below the historical multiple for the company, it is also low enough to be a solid multiple for a coal company. Taking into account the growing industrial automation and high-speed transit sectors in China, while accounting for some slowdown in infrastructure spending in the current year as the window of the 12th Five Year Plan is closing having already surpassed expected rail mileage, we use a conservative estimate of 5% revenue growth rate YoY. We see no reason for net income growth to lag behind this rate. Using consistent conservative estimates to project unlevered free cash flow, and re-levering the beta to reflect average competitor beta, we arrive at a fair value of $25 per share, close to a 60% discount rate.
Risks
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BAT – A Wonderful Company at A Wonderful Price (8x PE, 15% dividend yield, 100% ROE)

 
In 1987, Buffett famously stated, "I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."
“The best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett
“Invest at the point of maximum pessimism.” – John Templeton
 
Warren Buffett’s best winners have always been stocks which were bought during times of maximum pessimism. GEICO was bought on the brink of bankruptcy. AMEX was bought during the Salad Oil Scandal. Goldman Sachs was also bought with bankruptcy looming. Wells Fargo was a bank with a largely residential loan book bought during a housing crisis. Coca-Cola was bought at a time of massive overdiversification. And so on and so forth.
It’s not often that one has the opportunity to put into practice the all-encompassing philosophy of buy low, sell high. But even when that opportunity rears its ugly head, it’s the rare investor who has the aptitude and the stomach to back up the truck. Thankfully, these opportunities do exist, but it takes a keen eye to discern the difference between a falling knife and a once-in-a-lifetime opportunity.
 
Overview
British American Tobacco (BAT) Malaysia is one such example. Currently trading at just 8x PE, sporting a 100% ROE, and giving a 15% dividend yield, it’s hard not to salivate a little at the financial statistics. But why is such a high ROI stock – a cigarette company no less – trading at such awfully low valuations?
First, some history. BAT Malaysia is the largest cigarette company in the country, with a roughly 50% legal market share and 12% total industry market share. If you’re observant, you’ll notice that Malaysia’s illegal cigarette market share takes up a whopping 65% share of the pie. This was largely due to the massive excise duty (i.e. sin tax) hike in 2015, which brought illegal market share from a reasonable 33% before the hike to 65% and rising today.
As a result, BAT Malaysia has suffered massive share price declines, with the share price falling by 85% in the past 5 years (from RM 60 in 2015) and 70% in the past 12 months alone (from RM 37 in early-2019). This was largely due to revenue declines of nearly 20% and earnings decline of 40% over the past 3 years, with a corresponding shortfall in dividends (the company has a 90% dividend policy). ROE has also fallen from approximately 200% to around 100% today.
Thus, it’s not surprising that the stock has taken such a beating. Indeed, over the past two weeks alone the stock price has fallen by about 30%. But is investing in it now simply trying to catch a falling knife?
 
Business Narrative
The source of the problem can largely be traced back to the sin tax hike in 2015, which brought illegal cigarette market share from 33% to 65% over the past 5 years. The Malaysian government has not been very accommodative to local industry players, rebuffing efforts to reduce the sin tax and dragging its feet when it comes to the enforcement of existing laws and the introduction of new ones. The local Customs department, working together with the police, has had some success in recent years tackling the illegal cigarette cartel – arresting the decline in legal market share from 20%-30% annually to just above 10% in the past year – but efforts are largely seen as too little, too late. On top of that, the illegal vaping scene has blossomed in Malaysia, with nicotine-related products claiming up to 10% of total industry market share.
This backdrop has inspired analysts to impose doomsday scenarios for the legal industry players (i.e. BAT, PMI & JTI), according present values to the companies which reflect a resumption of historical revenue and market share declines. Indeed, when parsing the financial statements of BAT, it’s not impossible to forecast revenues declining to a point where they fall below operating costs (i.e. EBITDA of zero), rendering the equity essentially worthless valuation-wise.
The main reason for the government’s lack of progress is bureaucracy. Different governmental ministries have drawn different interpretations of their legal jurisdiction regarding the matter, and thus shuffle the responsibility of arresting the illegal trade to their peers. For instance, the Ministry of Health (MOH) has stated that it has no authority to enforce legislation against illegal cigarettes, while the Customs department disagrees and says it is the MOH’s prerogative to clamp down on illegal cigarette packets which don’t portray mandatory and unsightly health warnings (illegal cigarette packets tend not to include them). As a result of the red tape, there has been little progress on the front lines, and legal industry players are lesser of for it.
BAT and JTI (the two largest cigarette players) have resorted to shutting down their manufacturing operations and implementing an importation business model, where legal cigarettes are imported from Indonesia into the country to be sold. BAT has also gone through one round of layoffs last year, with a second round expected in 2020.
 
Financials
As alluded to earlier, revenues have declined by 20% over the past 3 years while net profit has declined by 40%. This was surprisingly not due to a contraction of Gross Margin (which you’d expect as costs go up when switching from a manufacturing model to an importation model), but largely as a result of revenues falling while operating costs remain the same. This can be seen in the Operating Margin falling from a high of 24% in 17Q3 to 18% in 19Q3, and net margin contracting from 18% in 17Q3 to 13% in 19Q3.
On the balance sheet side, things look much rosier. Intangibles take up the lion’s share of assets (40%), while Inventories and Receivables have declined slightly in line with the fall in Revenue. Net cash is negative owing to a revolving credit facility which the company has drawn presumably for tax reasons. The debt is current in nature and can be paid back in full with 2 years of Free Cash Flow. The company doesn’t have much fixed assets remaining following the closure of its manufacturing plant, indicating that liquidation value (approximately zero) falls far short of market value. Current ratio is reasonable at 0.8x. Share capital has not changed for at least 3 years.
Receivable days and Inventory days have respectively increased by roughly 50% over the last 3 years – indicating a struggling business which is facing business challenges from its illegal brethren. Payable days have remained static over the same time period. As a result, Cash Conversion Cycle stands at 79 days, up by double from 33 days in 2018.
Cash flow is still stable, with cash receipts approximating revenues. Free Cash Flow is almost equal to Operating Cash Flow, exemplifying the asset-light nature of the current business. The company pays out the entirety of its FCF as dividends (and then some), leading to a dividend yield of 15% at the current share price and a 118% dividend payout ratio.
 
Risks
The risks are apparent. If the government doesn’t do something about the illegal trade and allows it to run rampant, it’s possible that illegal market share increases from here and revenues continue to decline. In the worst-case scenario, it’s not hard to envision revenues falling below operating costs and EBITDA reaching zero, implying the shares are worthless and that dividends will be cut or even stopped entirely.
The current share price of 8x PE (RM 10.00) reflects this doomsday view. The market is basically pricing in declining earnings growth into perpetuity and giving no stock to a potential turnaround. Government intervention to address the illegal trade is widely perceived as sorely lacking and possibly not existing, with analysts imputing revenue declines of up to 30% a year into their models. Share price targets range from RM 11 – RM 15, although the share price has fallen by some 20% since the last revision of analyst reports. All in all, it seems like bad news for BAT.
 
Opportunities
The opportunities for BAT, while less apparent, do exist. For one, the government could by some miracle successfully enforce existing laws and put the brakes on illegal trade – it has already slowed the latter’s advance by some 50% since the sin tax hike. Alternatively, the government could recognize the disadvantages of the narrowing tax base from legal cigarettes and decide to reverse or reduce the sin tax, leading to a reclaiming of legal market share by industry players to previous highs. By some back-of-the-envelope calculations, if legal market share rises to just half of their historical levels, BAT’s earnings and share price could double from here. PE ratios would also expand in such a scenario.
BAT’s parent company in London could also decide to acquire the Malaysian subsidiary given the depressed prices. A fair market price given the circumstances would be roughly 15x PE, which assuming earnings continue to decline by 30% from today, would put the acquisition price at around 120-130% from current share prices.
BAT has also been experimenting with nicotine-related products, such as the Heat-Not-Burn (HNB) device known as Glo (PMI has a branded competitor known as IQOS). Both have received glowing reviews from former cigarette users and is expected to help the companies transition into the post-smoking era (i.e. 20-30 years from now). So far, Glo has developed a 1% total industry market share in Malaysia despite only being launched 2 years ago, showcasing its popularity and potential success.
Finally, the government is preparing the release of new legislation regarding vaping, which is due to see light by mid-2020. While legalization is still not guaranteed, government officials have publicly admitted the difficulty of enforcing laws if a vaping ban were to be instituted. If vaping is legalized, the legal industry could see a 10% increase in market share overnight as they introduce their own products to supplement the demand for currently illegal products.
 
Risk : Reward
In my opinion, current share prices have priced in all the risks while discounting all the opportunities. Even assuming earnings decline at an average annual rate of 10% into perpetuity, it would take just ten years to reclaim your initial investment. This is assuming illegal market share continues its rise unabated and legal market share never sees the light of day again. Keep in mind that the company has a 90% dividend payout policy, and has kept this rate despite recent struggles in its business, so you’d get a return of capital regardless of the share price performance.
In this worst-case scenario, the parent company would either push for an acquisition or liquidate the Malaysian operations. An acquisition at fire-sale prices would probably yield at least 5x PE, while a liquidation would yield nothing given the current ratio of 0.8x. The latter is highly unlikely because it would mean that BAT ceases to have a presence in Malaysia completely, a growing South East Asian nation with GDP growth of 4-5% and potentially bright future. Hence, given the probabilities and an estimate of expected value, you’d already come out on top at the current PE of 8x.
What about the alternative? Before we get into the valuation from an opportunity set perspective, let us consider BAT’s business model. As Buffett says, this is a company with unit economics of a penny per cigarette, selling them at a dollar per cigarette, fantastic brand loyalty and a captive audience. Imagine if you could have owned Altria in the USA in the 1970’s. Today, you’d own Altria, Kraft Heinz, PMI and a smattering of profitable businesses around the world. While I don’t mean to draw a direct comparison between BAT Malaysia today and Altria USA of the 70’s, it’s not hard to imagine a similarly wonderful future for a company with such an attractive business model.
As far as economic moats are concerned, the cigarette business is probably one of the few businesses you can say will be around in another 20-30 years. Sure, they’re facing headwinds in the form of a burgeoning illegal cigarette trade today, but who says they will still be facing the same demons 10 years from now, or even 5 years? If there’s one thing for certain, it’s that the business environment is fluid – and chances are good that things won’t remain the same as today, whatever they may be.
 
A Reasonable Bull-Case Scenario Valuation
Let’s put the humdrums aside for a moment and imagine a brighter future for BAT. What would this future look like? For one, it’s possible that within the next 5 years the government realizes it can’t contain the illegal cigarette problem and decide to reduce the sin tax to previous levels. The wider tax base resulting from such a move would result in the same absolute amount in taxes even at lower tax rates – so there is no financial disincentive not to do so – while at the same time reducing the illegal market share. If legal market share even reclaims half of their former levels, the share price of BAT could double from today.
Furthermore, what’s stopping BAT from resuming earnings growth, assuming the business environment recovers? Even if earnings grow by just equal to GDP growth (i.e. 4-5% a year), it would justify a 15x PE at the minimum considering a long-time horizon of 20-30 years. Combine a doubling of earnings with a 15x PE, and you’re looking at a potential quadrupling (4x) of the current share price.
 
A Best-Case Scenario Valuation
If BAT reclaims its former glory and returns to its historical market capitalization of RM 18 billion, we’re talking about a 600% increase in share price.
That’s just for the next ten years. What about dividends beyond that? Let’s imagine the best possible scenario for BAT. Assume for awhile that you’re planning to hold BAT for the next 30 years. Assume also that in ten years’ time, BAT’s share price skyrockets to 600% of current levels, and then grows earnings by 4% a year into perpetuity and pays out 90% of earnings at dividends. Account for 3% inflation and zero percent cost of capital (i.e. growth funded from retained earnings). By the end of year 30, you’d end up with 27x your initial investment, or 2700% of your capital. That’s a 12% CAGR.
In other words, a $40,000 investment in BAT today could potentially yield a million dollars in 30 year’s time. And that’s with reasonable assumptions. Tweak the numbers further and you’ll could potentially reach Buffett-like returns.
 
Conclusion
To sum things up, it appears that current share prices already impute the worst-case scenario, while the best-case scenario is a 600% capital appreciation potential in ten years, or 2700% over 30 years. Giving a margin of safety, let’s dial the ten-year return of 600% down by 50% - we still get a 300% reward scenario. That’s a 12% CAGR over ten years. Not too shabby.
Assuming 50% downside from today’s prices, the upside-to-downside ratio at 300% upside would still be a healthy 1:6. Now that’s a margin of safety.
If you believe that BAT has no future in Malaysia and will ultimately be acquired or liquidated, expect share prices to fall by up to 50% from here. If you expect that the legal industry will recover to former highs and that BAT is well-positioned as the largest cigarette player in an ASEAN country with 4% GDP growth (alongside Vietnam, Singapore, and Indonesia), you can expect share prices to rise by at least 300% over the next 10 years.
More realistically, share prices will fluctuate by 20% from current levels both to the upside and downside over the next year or so. If you can stomach that kind of volatility, BAT makes for a wonderful risk-reward component of your hopefully diversified emerging market portfolio.
 
A Value Investor’s Perspective
As mentioned above, Warren Buffett has a history of buying companies for pennies on the dollar when the share price reflects maximum pessimism. This does not mean to dive blindly into freefalling stocks which you do not understand. It does mean that you should do your homework, and when you spot an attractive risk:reward ratio in stocks where others are running for the exits, you should be comfortable holding a large position.
Buying a leading cigarette company in its market while it’s beaten down represents one of the most potentially profitable investments imaginable. For reference, take a look at Altria. If you had bought $1,000 worth of shares in Altria in 1970, and reinvested all the dividends, you would be sitting on a fortune worth $5 million by today. That’s an astounding 18% CAGR over an extraordinarily long period of 50 years. Can BAT Malaysia repeat this tier of performance? Probably not, but you don’t need to in order to make a satisfying profit from it.
Buffett espouses thinking long-term when it comes to investing. Think about the long-term when it comes to BAT Malaysia. Is it likely that illegal cigarette’s share of the market will remain elevated at 65% or above for the next 20 years continually? If I was a betting man, I’d wager that it won’t. More likely than not, some kind of unforeseen development will unfold which will bring market share back into the folds of the legal industry – it could be vaping, HNB products, a newly yet unrevealed form of nicotine-device, or even an evolution in the way smokers think. What can be relied on however is that in 20 years smokers will still continue to view nicotine, and by extension smoking-related products, as a form of entertainment and relaxation.
Then there’s the dividends. The dividend yield on one share of Altria bought in the 1990’s held until today would exceed 30%. This is because the dividends have grown over the years in tandem with earnings growth. Extrapolate that to BAT Malaysia, which currently has a dividend yield of 15%. Assuming an average of 4% earnings growth going forward, that dividend yield would grow to just about 45% in 30 years. That’s the power of compounding.
Buffett also champions the idea of owning companies with fortress economic moats. Some of the companies which he owns have such moats, including Coca-Cola, Wells Fargo, GEICO, American Express, etc. It’s hard to argue that BAT Malaysia doesn’t have such a moat. Even in such trying times where revenues have contracted by 20%, it still sports a high-flying ROE of 100%, and stable gross margins of 30%. I would go so far as to compare BAT Malaysia today to a Coca-Cola or American Express when Buffett bought them during times of pessimism.
Think about the future of BAT in 10 years, or 20 years’ time. It’s likely that it will have overcome the temporary hurdles which it faces today by then and resume earning high returns on significant capital invested over a long period of time. This is truly a compounding machine if there ever was one. Or as the title suggests, a wonderful company trading at a wonderful price.
Remember that Buffett’s best buys in the public markets have all been investments made during trying times, such as what BAT is facing today. AMEX could have gone bankrupt over the Salad Oil Scandal. GEICO was literally months away from being unable to service its insurance liabilities. Goldman Sachs was teetering on the brink of financial collapse under the heavy weight of subprime mortgage obligations. Coca-Cola was not the company it is today – it was an overburdened, overdiversified conglomerate with little growth outlook. Wells Fargo was staring at a huge, unserviceable loan book immediately following the Californian earthquakes given its significant residential exposure. It’s definitely nice to pay fair prices for wonderful companies, but it’s even better to be able to pay wonderful prices for wonderful companies.
 
In times like these, it pays to reflect on some words of wisdom for guidance:
Buy when there’s blood in the streets.
Be greedy when others are fearful.
In the short-term, the market is a voting machine; in the long-term, it is a weighing machine.
Price is what you pay, value is what you get.
It is far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.
Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.
 
May the investing odds be ever in your favor!
 
Stock code: 4162.KL Stock name: British American Tobacco (Malaysia) Berhad Financial information and financial reports: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=4162
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What trading on margin means and how to use it  The Dough ... Margin Trading  Trading Terms - YouTube How To Use Bursa V Trade Demo Account for Bursa Malaysia Day Trade Margin Margin Trading 101: How It Works - YouTube

Margin multiple: This is a multiplier on the value of the pledged collateral which defines the maximum amount of financing available. E.g.: A bank provides 2.5x financing for pledged FD. So by pledging a FD of RM50,000 you would get: Available trading limit = RM50,000 x 2.5 = RM125,000 To start investing or trading the stock market, the first thing that you got to do is to open a stock trading account. Opening a stock trading account is actually pretty simple, and in this article, we are going to discuss some of the things that you should take note of before opening your stock trading account, and HOW to open one!. p. Step 1: Decide if you are opening a Direct CDS or a To trade in Malaysia, you would have to open two accounts; a trading account with a brokerage and a Central Depository System (CDS) account. A CDS account is a depository for you to keep your Malaysia stocks after you buy them. A RakuMargin is Malaysia's latest and most innovative 3rd party margin financing trading account. This next generation margin trading account operates like a credit card allowing you to trade using available funds and/or with a pre-approved facility limit powered by Kenanga Investment Bank Berhad (KIBB). MARGIN FINANCING. With our margin financing services, you can now boost your investment power using cash and/or securities as collateral. Open an individual or corporate margin trading account with us for as little as RM10,000 in either cash or approved marginable securities.

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What trading on margin means and how to use it The Dough ...

What is margin trading? What is a margin? What is the difference between a cash account and a margin account? In episode #34 of Real World Finance we dive de... Margin Account vs. Cash Account - Options Trading For Beginners - How To Trade Options - Duration: 6:00. Option Alpha 77,289 views Cash and Margin Trading Accounts and Which is Right for You - Duration: 8:32. 1215 Day Trading 830 views. 8:32. $1 MILLION in UNDER a YEAR Trading Stocks!!! - Duration: 51:25. One trading jargon that you’ll hear very often is margin. It’s usually in terms like margin account, margin trading and even margin call. It seems a bit comp... Learn and practice using demo account for Bursa Malaysia

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