Value Investing

Memtech International Valuation Analysis

Memtech International

Memtech International is a leading component solutions provider for the mobile phone, consumer digital and automotive industries. Over the recent years, we see the company transforming itself to better suit the changing environment of the technological sector. As of late, the company has two business divisions – keypads and plastics divisions, with major clients from both the mobile communications and automotive industry (e.g. Lenovo, Huawei, Alcatel, GM, VW and Tesla). The company has shut down its loss making touch screen division after the fire incident in 2012.

In this analysis, all figures are in USD and data from FY2004 to FY2007 were obtained from company’s website and not cross-referenced with the annual report. Through research, some of Memtech’s competitors would be Scintronix Corporation, Juken Technology and Fischer Tech all listed on SGX (Juken Technology was delisted in 2012, Scintronix Corporation is in the midst of getting delisted).

Fundamental Analysis:

(I)              Earnings:

Screen Shot 2014-06-15 at 1.57.39 pm Memtech International
Memtech International

Looking at Memtech’s earnings, we would see how volatile and inconsistent it is, and may immediately strike it out of our consideration. However, to get a better feel of these numbers, we have to understand how the business has been transforming over the years. First off, the huge decline of 48.3% and 95.9% in gross profit margins and net profit margins (NPM) respectively in FY2007 was due to the Global Financial Crisis. During this period, there was much weaker demand during the last two quarters of 2008, resulting in lower selling prices, increases in raw material cost and sales & marketing expenses. Following that, as we see the economy improving, margins begin improving in tandem. Despite markets recovering in FY2011, the blip in NPM was attributable to exchange rate losses.

Subsequently, in the technological sector, 2012 was a year we see increase dominance of the smart phones. If I were to remember correctly, 2012 was the year I witness an increasing number of people around me carrying iPhones. Before, that it was still the good old days of using the indestructible Nokia phones (I remembered using the N95, which to date I still have and it is still workingJ). That aside, to put some figures to this, the global market for mobile phones grew 1.2% on shipments of more than 1.7bn units shipped, of which 712.6mn were smart phones, indicating an increase of 44.1% compared to 2011. Memtech recognizing this trend, made the strategic decision to switch their manufacturing capabilities from that of resistive to capacitive touch screens in 2011 (pretty technical here, however in layman terms, before the touch screens we are so used today, touch screens back then weren’t that smooth scrolling).

Therefore, in FY2012, we see margins declining due to the lower demand for mobile phone keypads (Memtech’s main division). Another point to note would be before FY2013, Memtech never supplied to the automotive and consumer digital sectors but only to the mobile communications sectors. Hence, with the growth in smart phones, we see a huge decline in demand for keypads in the mobile communications sector. We observe revenue contracting by 38.2% and that accounted for two-thirds of their total revenue, showing how the keypad division is Memtech’s main business segment. With regards to the plastics division, it was growing steadily, reporting a 9.5% growth in revenue and 33% rise in net profits. Due to operational issues, the touch screen division reported net losses. While I am no expert in this area, my observation is that Memtech did not have the expertise within this business segment. Given a fire incident in the touch screen factory, management decided to shut down this loss making division. In some ways, this fire might have been a fortunate event for the company and shareholders alike.

In FY2013, with management diversifying their clientele, making inroads to the automotive, industrials & medical and consumer digital products, we see a huge improvement in gross profits. However, in that year, we still net losses due to exchange rate differences. It is my view that management has been pretty successful in this regard, having just started venturing into the automotive industry and been able to bag major clients like GM, VW and Tesla. Furthermore, the increase in gross profits was partially due to their restructuring efforts in FY2012 of their Huzhou operations. Management initiated a restructuring exercise of their keypad division production facilities, transferring their operations in Huzhou to the Dongguan and Nantong plants, consolidating group’s total production capabilities.

Going forward, we see in their 1Q2014 results, revenue was up 30.9%, gross profits up a whopping 292.6% and the company has reported a net profit. Revenue has been up mainly due to the automotive sector resulting in increase in sales figures and the company now offering a better product mix.

Overall, I would say given how volatile the mobile communications is, it has resulted in the volatility in the company’s earnings. However, given how the management has started to get a mix of industries such as exposing themselves to the automotives, consumer digitals and industrials & medical sectors, we should be able to see less of this. However, the major concern for me would be exchange rate differences, as this alone seems to be able to affect the company’s overall profitability.

Memtech International
Memtech International

Comparing Memtech to her competitors, one would observe that in this industry, how inconsistent the gross profit and net profit margins are. While to better understand why the margins are changing every year, we would have to understand how the business has been evolving every year, I did not conduct studies with regards to this.

Some common trends we can observe would be that during the Global Financial Crisis, none of the companies were spared from the decline in demand. However, Memtech fared much better where their decrease in net profits was much lesser. In FY2012, where there was a huge change in demand and increase in raw materials costs, none of the companies were prepared for this, resulting in their net profits decreasing. In this aspect, I would say Memtech fared much better again, due to the smaller decline in net profits and Scintronix Corp having started to discontinue most of their operations. In terms of margins, it can be seen how small the margins are within this industry and is not just something Memtech faces.

Something that Memtech is better than the other companies would be how Fischer Tech and Scintronix faced more than 2 years of negative net profits.

(II)             Balance Sheet & Cash Flows:

memtech_bs

As we can see, the company’s cash levels have been constantly fluctuating given the inconsistency in company’s profitability. However, a good point to note would be that management has been paying down their debts over the years, though they did take on a debt of USD10.2mn in FY2011. I deduce that the debt was taken on to finance their increase in capital expenditures as you would see that in these two years, capital expenditures have increased significantly. Furthermore, looking at their footnotes, one would observe that in these two years, additions to leasable land & buildings and plant & equipments was significantly high. In 2011 it was approximately USD15.7mn and 2012 approximately USD9mn. In 1Q2014, we see cash levels increasing to USD44.7mn, which is a definite good sign. While short term loans still remains at USD1.11mn, it is not something the company is unable to handle while long term loans have decreased slightly to USD3.055mn.

Looking at their cash conversion cycle, I have nothing much to comment. Moreover, given how most of their clients are major players in the world, I do not see many problems in that. However, their cash flow is definitely inconsistent. We can see how in some years there is positive free cash flow (FCF), while in some negative. Once again, this is attributable to the business nature of the company. One major thing I would like to add here would be my calculation for FCF. In the past, I have always just taken net cash from operating activities minus capital expenditure. While it does not make a huge difference because the companies I look at mainly have minimal debt, however, it would be quite significant for companies with higher debt levels. In this new calculation, I have excluded the adjustments made for interest expenses and income. The reason being FCF being the money attributable to equity holders, interest expenses should be attributable to debt holders instead of us equity holders.

(III)            Financial Ratios:

memtech_ratios

Again, I have nothing much to add to the ratios. While the current ratios have started to hit slightly above 3, I feel it is fine and still indicated that Memtech is a healthy business and able to meet short term obligations. ROE and ROA figures have been rocky; however, this is attributable to the rough patches the company has been through.

comp_ratios

Compared to Memtech’s competitors, we would observe that on all ratios, Memtech could be considered the better of the three.

Qualitative Analysis:

(I)              Management:

Qualitatively, I find the way management runs the company ideal. Looking back at the balance sheet, one would note that the total outstanding shares have been decreasing every year from FY2008 onwards. There are no data on that for years before 2008 due to me being unable to obtain the ARs. However, if one were to do a backward calculations based on total NAV and NAV per share, we can see that the number of outstanding shares those few years have been fluctuating as well. From some digging, I know the company did raise capital during those periods by issuing new shares and all. Hence, the fluctuation in number of total outstanding shares you would observe if one tries calculating. This decrease in shares is a good sign as the company has constantly been buying back shares, increasing shareholder’s value. Such as in FY2013, we see the company buying back 3 million shares at the price range of SGD0.70. In FY2012 1.5 million shares was bought back and in FY2011 1.7 million shares at the range of SGD0.095 – SGD0.13. This signifies that at this price range, management feels that the company is still trading at price lower than the company’s fair value.

Furthermore, we can see that management is prudent with respect to dividend payouts. When the company is not performing well, management still maintains paying out a dividend but lesser such as in FY2008 and FY2012. However, when the company starts improving again, management would reward shareholders by increasing the dividends paid such as in FY2010, FY2011 and FY2014.

(II)             Economic Moat:

From Memtech’s margins, it can be seen that they do not have much of an economic moat. However, compared to her competitors it can be said the same. In terms of business, Fischer Tech is most similar to that of Memtech. Also, upon further digging, we would observe that the clients that Fischer Tech has are mostly different from that of Memtech. It can be seen despite what may seem to be a lack of economic moat within this industry, the companies do not really have the same clients.

Valuation:

Screen Shot 2014-06-15 at 1.58.14 pm

Screen Shot 2014-06-15 at 1.58.22 pm

At the price of SGD0.09, which translates to USD0.072, based on our usual indicators of P/E, FCF Yield and EV/EBITDA we would be unable to get a true feel of the company. This is because earnings and free cash flow levels have not reverted back to normalized levels. However, one thing to point out would be that Memtech is a pure net-net company. However, this would really be subjective to what net-net formula one uses. Using a more conservative net-net formula, we would derive with a liquidation value of USD0.065.

Conclusion:

Having to come to a conclusion, I would say that it took me quite a while. Eliminating Scintronix was easy, even if it were not going to be delisted soon. Qualitatively I had quite a few doubts that I would have eliminated the company without looking into its financials deeper (however, for the purpose of comparison, I still did it). However, for Fischer Tech it was definitely a more difficult case. It was a company whose earnings have normalized yet still trading at cheap valuations – P/E of 3.93x, EV/EBITDA of 2.4x and FCF Yield of 14.1%. If it was just a case of investing in the best of the three, I would not have faced such a headache and it would definitely be Memtech, net-net being the deal breaker. However, what I was pondering about was if I just wanted to accumulate a basket of undervalued stocks, would Fischer Tech make it inside. After close to 2 hours of pondering, I came to the conclusion of no, especially after looking at the 10-year data for Fischer Tech.

To those who do not understand the point of net-net, I would explain it now. Net-net companies are companies that are trading at or below liquidation value. Essentially, no company should be trading at such valuations, and given time, would normalize back to near its NAV. This is because, if we were to do a research on the market, most companies trade near its NAV. One may read up on Ben Graham’s research for more information about this. Assuming we take the more conservative net-net formula, at a price of USD0.072 vis-à-vis the liquidation value of USD0.065, our downside would be we lose 9.72% of our capital. However, our upside is when it normalizes back to near or more than it’s NAV, our returns are approximately 100%. Given how Memtech is now supplying to the automotive sector whose landscape is not changing as quickly as the mobile communications, the probability of the company producing positive results going forward is quite high. With such odds, I would say that the odds are largely in our favor. Honestly, investing is like poker, where we only play our hand if the odds are in our favor.

Disclosure: The authors are long M26.SI