The markets have been wicked to small and nano cap stocks over 2018 but a slight recovery attributable to a number of factors such as positive expectations, sentiments and possible inking of a favorable trade deal by March 1st 2019 has pushed the markets back up to near the recent highs. A few charts perhaps may shed some light on what I am trying to illustrate.
Russell 2000 Index
The Russell 2000 index, representative on small cap stocks has fallen to from above 1600 points to less than 1400 points and then making a recovery to close to 1600 points currently. However, the markets in Asia has not followed suit.
FTSE Bursa Malaysia Small Cap Index
FTSE ST Small Cap Index
The FTSE Bursa Malaysia Small Cap Index and the FTSE ST Small Cap Index have experienced weaker recovery as compared to the Russell 2000. The charts have been abysmal with trading volumes declining especially so in Singapore. But if anything at all, understand that the game of investing is best viewed through the lens of a contrarian. The poor performance of the stock market is actually an opportunity for investors to buy on the cheap. Owner-operators of companies in Asia are alerting to these opportunities and I believe that a good number of them, based on the financial strength of the entity they control and unused leverage capacity will actually step up to the plate and take their companies private.
What is the rationale for taking a company private anyway? To understand this, one must understand the rationale for leveraged buy outs. A crude but realistic example of this would shed some light on the matter. Suppose John is an owner of a company that manufactures screws and bolts that generates $90 million in revenue and has $15 million in EBITDA. Now, the company has no debt. As a publicly listed entity, a case can be made that the company should trade at a market capitalization of 10 times EBITDA, which means that it really should be valued at $150 million.
But John is in a terribly unexciting business and the business trades for 2.5 times EBITDA in the public markets which means that the business currently trades at a market capitalization of $37.5 million. Furthermore, growth in such a business is little to none. But the thing is cash flows are extremely consistent. And just to add that bit of certainty, capital expenditures over the next 5 years may be extremely low at $2 million per year, considering that they have just made additions to the plant, property and equipment account of their balance sheet.
That means that the EBITDA less CAPEX generation per year works out to be around $13 million. A private equity firm looks at this and says that this is interesting. Considering that John is a second generation owner and perhaps wants some way of cashing out at greater than $37.5 million, there is an impetus to do a deal with a private equity firm that actually makes sense for him and the private equity firm, a win-win scenario if you will.
So the private equity firm will probably go to a syndication and leveraged finance expert at a bank and ask for a loan to purchase John’s company. Now, the bank may look at the deal and say that since the company can generate approximately $13 million in EBITDA less CAPEX per year, it would make sense on the lender’s part to give a loan that is approximately equal to 4 times EBITDA. So, next, the private equity firm may offer 5 times EBITDA to John and the other minority shareholders for the entire firm which amounts to $75 million, an offer greater than current market capitalization of the $37.5 million.
$75 million less $60 million which is 4 times EBITDA, is $15 million, which means that the private equity firm has to put in $15 million in equity to do the deal. The private equity firm essentially pays $75 million for John’s company with $15 million of equity and $60 million in debt financing which is equivalent to 4 times of EBITDA. John and the minority shareholders get bought out at a premium to the market’s price and they are quite happy with the offer.
What is in it for the private equity firm then? Well, for one, the private equity firm gets to enjoy the difference between the purchase price of $75 million and its estimate of intrinsic value, whatever that may be. Considering that companies such as these can trade for 10 times EBITDA in public markets when participants are salivating for it, it would make complete sense for the private equity firm to actually execute on the transaction in the manner as described above.
And so the deal is executed and the company is taken private or delisted.
Now there are few ways that a private equity firm has up its sleeves to actually create value in the company. The first and most obvious way is to grow the topline revenue, which means the growth of EBITDA. With growth of EBITDA, the company can be relisted at a higher price. Even without an expansion of multiple, say in 3 years, the EBITDA is now $20 million. At a 5 times EBITDA multiple, the company can be relisted at $100 million. So this is one way but is perhaps the hardest way in my opinion. A lot of times, growth comes at a cost and unless hurdle rates are met where the return on investment capital exceeds the cost of capital, it may not make sense to devote resources to growth. So the question when it comes to pursuing growth is whether it is worth it from a capital allocation point of view. If it makes sense, by all means. But this is often the hardest to execute on in my view because it requires an enormous amount of operational expertise. The supposed operational expertise of private equity firms is really overrated in my opinion.
Operationally, it can be difficult to grow the topline but one of the easiest ways to improve EBITDA is by cutting all those unnecessary expenditures. When that is done, EBITDA expands. Cost cutting is perhaps something that any manager can do. But it has to be somewhat controlled and not done at the expense of employee morale and other factors.
When it comes down to it, what I think most private equity firms have is expertise in capital allocation. And the easiest way to allocate capital in a leveraged capital structure is to devote resources to paying down debt. Deleveraging is probably the easiest thing to do especially if a company has consistent and proven operating cash flows. By deleveraging, there is an expansion in the equity component of the business and that creates value for the private equity firm. So perhaps, the private equity firm can pay down debt over 7 years or so and make the company debt free again.
The last thing that a private equity firm can do is to prime the company for multiple expansion. The company can be improved on operationally, putting the right systems in place, risk management systems and the markets may view it as a different entity as compared to when it was delisted. In a hypothetical scenario 7 years down the road when the company is debt free, if EBITDA is now $20 million instead and the company is listed again at 10 times EBITDA, the value of the company now would have swelled to $200 million. Now remember that the company was purchased at $75 million, implying an internal rate of return of approximately 15% per year, quite decent if you ask me.
So the rationale for taking a company private is really to enjoy the spread between the buyout price and the estimate of the company’s intrinsic value. And sometimes, intelligent owner-operators of companies who are sensitive to their industry’s environment would try to delist the company in order to enjoy the spread between the offered price and the intrinsic value of the company. After all, too much of a good thing can be wonderful isn’t it?
Now that Asian small and nano caps have been beaten, some quite badly by the markets for a whole host of reasons, there are opportunities for businesses to be taken private. And one such company came into view. That company is Suiwah Corporation Berhad, listed in Malaysia.Suiwah Corporation Berhad has several business segments. It is an operator of supermarkets , a property developer, a trader of construction materials and a manufacturer of printed circuit boards. And one of the reasons why the company is trading at such discount to its book value is because of a poor showing in the construction and property sector in Malaysia.
The company had been languishing at slightly above $2 when its tangible book value per share was $3.90. It’s Enterprise value to EBITDA is 7.9. Recently, the founder and managing director, Datuk Hwang Thean Loong has proposed to delist the company by way of capital repayment of about $110 million ringgit , amounting to $2.80 per share. It’s EBITDA is about RM$0.28 per share on average over the last 5 years. Considering its unused leverage capacity and other factors which I will not go into with this article, we can make the argument that the company deserves to trade at least near its tangible book value in the long run.
Source : FT.com
In general, the entire construction and property markets in Malaysia have been lacklustre. Suiwah Corporation Berhad is just one of those bargains that falling markets have produced and there are many more to come. How can we as investors take advantage of this? Well, the same message I have always had for investors is this – Buy with a margin of safety. Buy value and ignore the crowd. Ignite that contrarian streak in you and seek out bargains that others dare not tread on. Who knows? An offer may just come your way.