The efficient market theory has got its flaws. The markets are vastly efficient when it comes to some of the more storied stocks that we can think of. In Singapore, those typical names range from companies such as UOB, DBS, OCBC, Singtel, Starhub and many others. In USA, these names are often the FANNG stocks and companies like Walmart and Costco.

And very often, the market capitalisations of these companies are well into the tens of billions. Their histories and stories have been followed by many. Looking at the shareholder registries of some of these brand names would show a vast following by the institutions and retail investors. They also happen to be extremely well covered by research analysts for the simple reason that reports on such companies generate the most commissions for brokerage firms. That itself is not a secret. Since investing is a game of meta analysis where your actions relative to the general crowd determines success or failure, it makes sense to think that a lot of these well covered “giants” so to speak are usually quite fairly valued, with perhaps a plus minus 10% to 30% disparity to the intrinsic value.

From an expected returns basis, even in the long run, investing in some of these companies does not make sense. If you are looking to generate alpha and beat the market, my opinion is to avoid the big names. In a scenario where the general growd is active in, the alpha tends to be non existent. I have had my fair share of failures and since investing knowledge is cumulative, this has always been something that I have been aware of. Of course, avoiding some of these big names tend to be something that most investors, even professional ones can’t do. Apparently, we have been wired by evolution to follow the herd.

On the contrary, small and mid cap firms have experienced more than reasonable declines in their share prices that it almost seems that we are in a small and mid cap recession. The large caps hum along quite nicely but compared to some of the smaller, underfollowed companies out there, a good number of them seem to be mispriced for a whole host of reasons.

In a previous article entitled “The Next Few Years May Offer Intelligent Owner Operators Opportunities For Delistings & Take Privates”, I wrote in brief that intelligent owner operators are beginning to take a serious look at their companies, in which they own a substantial share of. If the market prices diverge to the point where these companies trade at less than their intrinsic value, asset values and debt capacity, it would give an owner of such a company more than a few reasons to actually delist them and take them private.

And one such company in my mind is Challenger Technologies, Singapore’s very homegrown IT retailer with a store footprint of 38-40 stores, the last I checked. If you look back on Challenger Technologies’  history it’s not too hard to figure out that delisting was an option that it’s promoters could take in the process of realizing value for themselves. In this article, I’m just going to highlight some of the details and the signs that were evident in the financials of Challenger Technologies.

In essence the market has completely ignored what management of the company had done over the years to improve the business. As I have mentioned before a lot of small caps have been taking a beating. in that sense it seemed as if we are experiencing a small cap recession currently. Whether the current conditions persist or not remains to be seen. But anyhow let’s get back to the matter at hand.

Challenger Technologies

The business of Challenger Technologies is one that is not too difficult to understand. It is simply an IT retailer that was founded in 1982. With a history that stretched far beyond the dot com bubble and the Asian Financial Crisis, the management had done a terrific job in my opinion of growing the business. Just to give you a sense of that, the revenues was $67.3 million in FY 2003 and in that same year, it attained a pre-tax profit of just $4 million. In 2009, it attained revenues of $191.6 million and a pre-tax profit of $13.7 million. Even in such bad times, Challenger managed to churn out extremely good profits and cash flows. In 2017, Challenger Technologies had $320.6 million in revenues and and a pre-tax profit of $19 million. A table below summarise the growth of Challenger Technologies. And if I may add, it looks pretty impressive.

Revenues (MIllions)$67.3$191.6$320.6
Pre-Tax Profit (MIllions)$4$13.7$19
Gross Margin( % )17.921.9721.12

Now of course, I am selective on the information here but it sure gives one a general overview of how the company had done under drastic economic conditions during the dot com bubble and the the subprime financial crisis. These “stress” years may highlight the durability of the business.

Challenger Technologies Current Valuation

Source : Google

Challenger Technologies currently has $61 million in cash and no debt. From that perspective, the company trades at an undemanding PE Ratio excluding cash of 8.14 with stellar return on equity of between 19% and 30% over the last 5 years.

ROE (%)30.7823.3825.6515.8519.63

It’s Enterprise Value to EBITDA is about 4 which is really cheap and Price to Free Cash Flow is around 7.5. These levels are completely undemanding and begs the question – Why is Challenger Technologies trading at such undemanding levels? What is the problem with Challenger Technologies?

5 Year Highlights Of Challenger Technologies

Source : Challengers Technologies Annual Reports

Looking at 5 years results of Challenger, it seems that one of the reasons for Challenger’s undemanding valuations is concerns over growth. The last few years had seen a change in the landscape and the retail environment had gotten increasingly tougher. With the rise of ecommerce, Challenger had to find a way to reinvent itself and it did so by introducing, its own online marketplace. The idea was to capture growth from the online audience as well. However, looking at the net profit numbers, it seems that year to year growth has been nearly non existent at times. As such, there are no clear “uptrends” which the markets tend to favour. Another reason of course is the much talked about liquidity in Singapore’s stock markets. But I believe that to be a temporary situation and liquidity will eventually come back to Singapore’s stock markets. Nonetheless, Challenger’s operations remain profitable and you can discern that for yourself with its increasing net tangible assets over the years

Leverage Capacity

Ignoring all growth concerns for now, we look towards Challenger’s cash flow abilities. The company is enormously cash generative and has not raised funds from the public markets for 8 years. The average EBITDA/share is $0.13 for the last 5 years and if you think about some of the buyouts that have been occurring at EV/EBITDA multiples of 10 times with about 6 times of net debt to EBITDA employed, which is incidentally incredibly rich in my opinion, it is not too hard to fathom that 4 to 6 times EBITDA of debt can be placed on the company’s debt free balance sheet. That means that the company has an approximate debt capacity of $0.52 to $0.78 per share. Now, at the time of this writing, even with a the offer to delist, the company trades at just $0.56 per share which is around or less than the debt capacity of the company. We are not talking about a scenario  where a company is taken private at 10 times EBITDA. We are talking about a company that is being taken private at slightly more than 4 times EBITDA. And I have to say that that is extremely cheap, looking at the history of Challenger Technologies.

How is that even possible? Yes it is, in our extremely inefficient equity markets. But think about it  this way. Even with $269 million in debt based on a debt capacity that is 6 times EBITDA, we are looking at $16 million in interest expenses which can be sufficiently covered by the company’s operating income of $40 million.

Essentially, when a cash rich, debt free, high cash generative company such as Challenger Technologies can do is a leveraged recapitalisation. In a hypothetical leveraged recapitalisation of Challenger Technologies, what the company can do for its shareholders is to issue $269 million in bonds/debentures to its shareholders. After the leveraged recap, the shareholders now own bonds/debentures which are worth $269 million. Now, remember that the company’s market capitalisation is just $193 million. Either that or the company can borrow $269 million of debt from a consortium of banks( I am simplifying it here) and then give a $269 million dividend to its shareholders. This is typical of a dividend recapitalisation.

So as a shareholder, you stand to gain 2.69 million of value for every $1.93 million of share that you own in the case of a recapitalisation. That is a pretty decent deal if you ask me.

In this hypothetical scenario, the company will then pay down the debt gradually and be debt free once again. As debt is paid down, the equity portion increases. Now, do note that this can only happen in deeply undervalued stocks such as Challenger Technologies, where the debt capacity constitutes a large fraction or exceeds the market capitalisation of the company. This is not purely theoretical. It has been done before and this is the realm of private equity. That is the reason why it is important to look at the price at which private owners are willing to pay for a company.

But that aside, can you imagine how ludicrous it would be if you went to a pawn shop and pawned your gold worth $1000 and received $1500 in return. Or just imagine this scenario where the house you would like to purchase is valued in the open market at $2 million but your bankers are willing to lend you $3 million for it? This usually never happens in real life. But in the equity markets, it does.

From a bankers point of view, if a bank assesses that it is willing to lend you $200 million to $300 million based on your business and the ability of the cash flows in the business to pay off its interest and debt, then wouldn’t it make sense that a debt free company with $200 million to $300 million of leverage capacity be worth at least its debt capacity, and perhaps even more with some financial engineering ? Hence, the enterprise value of a company cannot be worth less than the comfortable amount of debt that it can service. That is purely commonsensical if you ask me.

Enter Dymon Asia Private Equity

So we all know that the company is undervalued and at the very least, I have painted it as such. You can choose to disagree with me of course. But the fact of the matter is that quite recently, Challenger Technologies founding family and managers of the Loo family and Dymon Asia Private Equity have teamed up to make an offer to delist the company at a price of $0.56.  Again, looking at the numbers above, it is quite a no brainer in my opinion. 56 cents is roughly 4 times EBITDA and the deal is most certainly one that will displace minority shareholders and squeeze them out. The narrative from management is that they are facing a tough retail environment and are unlikely to give dividends in the years to come. I humbly beg to differ on this point. They will be able to give dividends in years to come. Ecommerce will change retail but investors have to understand that there is also an adaptation phase for companies such as Challenger Technologies. They still have distribution relationships with their suppliers and manage their sales and inventory in a satisfactory way. It is not something that can be replicated immediately. And furthermore, Challenger still has the option to sell their inventory online, leveraging of the relationships with suppliers which they have built over decades.

So the deal that Dymon Asia has made is a purely commonsensical one. It made sense from so many different angles for the eventual private owners. The founding family owns about 78.64% of the common stock outstanding and Dymon will come it and inject the rest for the offer, which is worth about $41 million, nearly 10% of the Dymon Asia PE Fund II’s coffers of $450 million. That is what I believe anyway. I have to add that I am not privy to the details of the deal. This is calculated speculation on my part.

While minority investors have been lamenting the low ball offer price, in a capitalist society such as ours, it is a situation where “who dares wins”. Dymon Asia has stepped up to the plate and in a sense acted as an activist for themselves and the founding family. There is a lot of opportunities for activism in Singapore’s markets and that is another article for another day. I do have some ideas on activism though.

Anyway, this is what I see going forward. The business will be private for a few years at least. Since the acquisition or offer is not reported to be funded by debt, the company can be relisted at some 8 – 12 times EBITDA when the economy looks rosy  again. This is at the discretion of the private owners, Dymon Asia and The Loo family. Another option is that the Challenger Technologies can be relisted in Hong Kong where the valuations are higher and the markets are more liquid.

From this blog and other avenues, I have always had the opportunity to meet some incredible individuals. If you share the same sentiments on deep value investing, net current asset value investing, private equity, leveraged buy outs and have ideas on your own, I am open to a healthy discussion on such matters whatever your background is. Thank you for reading. As always, may you be blessed with prosperity, health and happiness!

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I have been an investor for 15 years now and my journey has meandered from Warren Buffett to Ben Graham. My start, like many, really was the naive idea that Buffett's skills could be replicated in some fashion. I was proven wrong when some of the supposed stock picks that I chose had dismal performances. Then, I learnt that it is no point trying to be someone I am not. Gradually, through failure and some success in deep value investing, my approach towards stocks gradually shifted to an approach based around Graham's techniques. So, I give credit where credit is due and to Ben Graham, I and many other investors around the world, owe him a great deal. So, if you want to read up on biographies, read about Ben Graham. His seminal work, Security Analysis is a gem. My books are just rich interpretations of what he has taught.

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