There has been a lot of talk in the media regarding Chip Eng Seng of late. I know. The story sounds good. Before I go any further, let me start off with a brief introduction of Chip Eng Seng’s business. It’s main business segment is construction where it operates as a contractor. Also over the last decade or so, it has also ventured into the property development business, hospitality and property investment businesses. Its construction and property development business makes up more than 90% of its revenue. On the whole, I think that management is forward looking and industrious.That is also the reason why Chip Eng Seng has branched into hotel ownership and property development. The  operations of a hotel business do provide a recurrent revenue base which would act to bolster returns. But even so, the hotel business is a cyclical one. So is the property and construction business. As investors, we should take note of that fact.

Let us get back to the numbers, the after tax reported earnings of Chip Eng Seng.

By all measures, 2014 was a great year for Chip Eng Seng. $280.7 million in after tax earnings was recorded in 2014.  In FY 2015,  there were 57.2 million in after tax earnings .

According to the media and Chip Eng Seng’s annual reports, some of the positives include the 4 ongoing residential projects in Australia, 1 joint venture residential project in Vietnam, an ongoing development of its first hotel and the upcoming launch of 722-unit Grandeur Park Residences, next to Tanah Merah MRT Station. What is not to like? Right?

The levels of debt relative to equity for the years 2014 and 2015 was clearly above 1 for Chip Eng Seng. If one were to look at the debt to equity ratio for the last few years, this is what it would look like.

The levels of debt to equity is greater than 100%. And that means that for every dollar of liability, there is less than a dollar in equity.

And then let us look at the levels of long term debt.

That is more than a billion dollars in debt and Chip Eng Seng’s market capitalisation is slightly more than 400 million.

Both bar charts look pretty similar to me. So what has happened is this. In order to build the hotel and fund its other development projects, the company has undertaken debt that has a nominal value greater than that in its prior years. To continue servicing this debt, the company would have to earn more in the future, which means that its bets had better pay off .

What about comparables such as Wee Hur, Perennial Real Estate, a property development company and AF Global as well?

For FY 2014 and FY 2015 respectively, Wee Hur’s Debt/Equity Ratio is 0.45 and 0.34, a lot less than Chip  Eng Seng’s.

For Perennial Real Estate, for  FY 2015, the debt/equity ratio is 0.6 , definitely a lot less Chip Eng Seng’s.

While Perennial Real Estate is a property development company with a footing in China, Wee Hur is a construction and property development company.

Let us also look at Amara Holdings, a pure hotel counter.

Its debt to equity ratio is around 0.8 over 5 fiscal years.

Even AF Global has a more conservative capital structure than Chip Eng Seng coming in at around 0.14 to 0.18 over the last 4 years.

Debt to equity ratio of Wee Hur.

With regards to the levels of debt, based on the historical reported figures, I think the levels of debt are a bit high for my comfort at this point. I would like to see some milestones playing out before I consider investing into Chip Eng Seng.

Since debt is at such a high level, could the  company procure more loans to fund a comparable revenue in 2017, 2018 and 2019 as compared to 2016? Remember, we are not even talking about growth here. And of course, without a doubt, its growth has been funded by debt in recent years. In cyclical companies such as Chip Eng Seng whose main businesses are that of construction, property development and property investments, wouldn’t a fall in revenues affect it  as its debt levels are very high?

A downturn coupled with high levels of debt is not good. Inability to pay debt is worse than the inability to obtain debt. For now, it is raising debt from the capital markets by issuing 120 million in debt paying a coupon of 4.75% . Here, the company has opted to raise debt in the capital markets instead of the banks. The obvious reason to me is that debt obtained from the bankers may be more expensive when obtained directly from the capital markets. So raising debt in the capital markets is really a bid to reduce interest expenses when they fall due.Now, Debt can be a great thing. But when a company is in the part of the business cycle that contracts, then, that debt is not good. The question is which part of the business cycle is CES in?

A satisfactory scenario would be that debt is used in the expansionary part of the business cycle and the company earns a satisfactory rate of return that enables it to pay down debt with its increasing cash balances. After which, hopefully if the company still has cash balances, the company could issue a special dividend to reward its shareholders. This is ideal but it does not occur often.

More debt may very well be accompanied by increasing returns. But sometimes, after paying off debt, very little is left for shareholders. And then, the company in question is back to square one. And sometimes the delta in debt taken on doesn’t lead to any significant corresponding  delta increment in the book value, and that also means that its asset turnover ratios are extremely low which is really the nature of this industry. Debt is one complicated topic I assure you!

Maybe, just maybe,  Chip Eng Seng still manages to still earn a decent revenue from its construction projects and property development projects but how likely  is that? In cyclical downturns, properties can’t be sold and construction awards dwindle. Order books can disappear and with regards to the hotel, it would take some time for the receipts to have an impact on the bottomline. And I don’t believe we are experiencing a full on downturn just yet.

Also, if things don’t work out well, there is a possibility of a rights issue taking place,to bring gearing levels down to acceptable levels. Of course, without a doubt, this would dilute shareholders on the earnings front. An argument was recently made that since Chip Eng Seng performed share buy backs at around 70 cents to 80 cents, it must be worth much more. That may very well be true but we have to consider the merits of an investment in the grand scheme of things, in this case, on the earnings front and its asset base.

So with regards to Chip Eng Seng, the milestones I would like to see is :

  • An improved gearing ratio by way of debt pay down through cash flows from operations or a rights issue.
  • Some signs that they are able to sell off their Tanah Merah properties without difficulty. This would improve the balance sheet.
  • Signs that the hotel is bringing in the receipts
  • A lower entry price for Chip Eng Seng and hence a higher margin of safety as my models show that CES deserves to trade at a price of close to $1 per share only if things work out right.

All said, I may be wrong on this one. Considering the popular adage that anything that can go wrong will go wrong, I would rather err on the side of caution. It is just one of those things where I, as an investor, would rather make an error of omission than an error of commission.

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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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