The required return on equity, R

Required return on equity, or R, is an important building blocks for stock’s valuation. It is used in various valuation model i.e. DCF and other relative value method (i.e. P/E and P/B method).

Due to its importance, I have been searching for methods that produces a reliable result and is practical in term of availability of input data and simplicity of the model. After review of the CFA curriculum and online materials, I came across works done by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York who is teaching valuation and corporate finance in MBA programs. He was named by Business Week, in 2011 as the most popular business school professor in US. In his “Equity Risk Premiums(ERP): Determinants, Estimation and Implication (2013)”, he presented a number of methods to compute the ERP, which is one of the inputs for Capital Asset Pricing Model (CAPM), a popular model to determine the R. Besides his work on ERP, his website also provided an extensive range of data to facilitate the computation of ERP.  

Before detailing my selected method, I will give a list of general choices in determining R as below.

           A.   CAPM

Required return on stock i, R_i = Risk-free return, R_f + β_I (ERP)

               B.   Fama-French Model (Multifactor Models)

                              R_i = R_f + β^market RMRF + β^size SMB + β^valueHML

RMRF: R_m - R_f (Return on market (i.e. FBMKLCI) – Risk-free return)

SMB: Small minus Big (Return of SmallCap Portfolio – LargeCap)

HML: High minus Low (High Book/Price – Low)

           C.   Build-up Method

 R_i = R_f + ERP ± Risk Premia₁ ± Risk Premia_{2 ±} ……. ± Risk Premia_n

I will use the CAPM to compute R because

(i)                  it requires fewer inputs compare to the method B and C

(ii)                input data is more available (compare to, say, B that require return on SmallCap portfolio like FBMSmallCap, return data on FBMKLCI is more easily available)

(iii)               Damodaran’s site provide updated data for the computation of ERP, which is less work for me

Hence,

R_i = R_f + β_I x ERP

where:

R_i = Required rate of return of stock i

R_f  - Risk-free rate of return. Represented by Malaysia 5-Years or 10-Year Govt Bonds Yield depending my selected time-horizon

ERP =Equity Risk Premium for investing in the market(FBMKLCI), relative to the risk-free rate

Β_i – Beta of stock i against market. To obtain via regression analysis of FBMKLCI and stock’s return data

Method for the inputs are described above but ERP’s is following.

In his work, Damodaran explained that ERP for a country’s market can be obtained by, first, calculate the ERP of a matured market like US as the base. Then, a Country Risk Premium (RP) is added to the base for the additional risk.

ERP = Base ERP for mature market + Country RP

Based ERP is obtained by a method called Implied ERP. On a brief note, the Implied ERP is obtained by solving the R(required return) for the latest S&P500 year-end closing given an estimated future dividends growth. I will use the data provided by his site as I believe his work is reliable and the computation (if I choose to compute myself) is too data-intensive for me.

(Other that the Implied ERP, one can also use the historical ERP. It is can be obtained by subtracting Average Return of S&P500 with Average Return of T.Bond over a certain period of time. However, this method is backward-looking. A forward-looking method like the Implied ERP is more relevant)

For the Country RP, I will use the Melded CDS approach (describe in his work).

Country RP = Malaysia CDS Spread x Relative Standard Deviation (Equity Market/Bond Market)

The first term of the formula is the 5 years Credit Default Swap(CDS) rate of Malaysia (or 10-years, depending on my selection). It is the required rate of return for investors to provide insurance against the risk of sovereign debt default and the latest rate can be obtained from the Deutsche Bank Research website. The higher the CDS, the higher the probability debt default by Malaysia’s government. As the CDS only represent the risk of sovereign’s bond default, we need to covert the bond’s risk premium to equity risk premium. Hence the second-term is used, which is the relative standard deviation (or risk) of the equity market(FBMKLCI) vs bond market. In this case, I will used the data provided by Damodaran, which are based on 2 years weekly data.

(Alternatively, the CDS can be replaced by Moody’s Rating-based default spread according to Malaysia’s sovereign rating. It is more stable and do not change frequently compared to CDS, which is determined by the market and is fluctuating daily. As CDS is usually higher than default spread and it imply all the market’s expectation, I choose CDS as a conservative approach and most relevant to the current situation. )

In conclusion,

R_i = R_f + β_I x [Implied ERP_US  + (CDS Spread_Malaysia x Relative S.D.)]

  

ERP of US Market (1-Jan-15)	5.75%
Malaysia 5-years CDS (22-Jan-15)	1.3115%
Relative σ (2 years weekly data)	1.27
ERP	7.416% (5.75% + 1.27 x 1.3115%)
Malaysia 5Y Bond Yield (22-Jan-15)	3.811%

Hence, R_i = 3.811% + β_I x 7.416%

For example, the R of FBMKLCI (β = 1.0) is 11.227%.

The application of the R, for example, is as below. We can extract market expectation on the current FBMKLCI level, based on Gordon growth model

                P₀ – 1803.08 (23-Jan-15)

                E₀ – 106.37 (estimate)

                D₀ – 59.354

                R – 0.11227

Solving the formula, I get g = 0.0768 (7.68%). The market is expecting FBMKLCI to have a constant growth rate of 7.68% (if based on Gordon Growth Model).

Reference: http://pages.stern.nyu.edu/~adamodar/

Prolexus Bhd - an undervalued gem with solid track record

1.0 Summary
Prolexus is a long-time apparel manufacturer with customer from international brands like Nike. Prolexus's has a healthy balance sheet with net cash position of RM0.20 per share. Sales and profit growth has been solid and consistent in the past 4 years. The stock has been trading with low valuation ranging 3.5-8.0x P/E in the past 1 year despite 4 years PBT's CAGR of 45%. My target price to this stock is RM2.28 (Kindly refer to Section 7.0 Projection and Valuation for the basis of valuation). I expect Prolexus FY15's PAT to growth 58% (on my optimistic scenario) due to (i) better economy growth and consumption prospect of US (ii) Weaker RM to boost competitiveness and provide forex gain (iii) higher operating margin after a surge in production wages due to minimum wage implementation in 2014.

2.0 Business Background

Core Business: Apparel Manufacturer

Established since 1976 and listed on Bursa Malaysia’s Main Market since 1993, Prolexus is mainly a garments manufacturer or Original Equipment Manufacturer (OEM) for internationally brands. In FY13, 2 major customers contributed to 87% of Prolexus total revenue. Nike Inc(Nike), is believed, to be the largest customer of Prolexus although the exact contribution is not known.

Porlexus has 3 factories in:

	Location	Build-Up Area (Acres)	Plant Revenue (FY13)
i)	Batu Pahat, Johor	1.8	RM172m (Malaysia)
ii)	Seberang Perai, Penang	0.6
iii)	Jiangsu, China	3.0	RM57m

63% of the sales is from US customers, Prolexus enjoys forex gain advantage from the raising USD as seen from the previous financial results. (63% could be a good proxy to Nike’s contribution to Prolexus’s sales)

Other Business: Outdoor Advertising

Prolexus also provide outdoor LED screen advertising services under the brand name “PowerScreen” which contributed to 3% and 10% of the group’s revenue and PAT.

Source: Company Website

Besides the companies shown above, under the Group is also Novel Realty SB, which is an investment holding company that hold Prolexus's non-core investment real estates (i.g. bungalow house and vacant land). The company has over RM14m of asset currently (24% of the Group's PPE)

2.1 Management

• Ahmad Mustapha Ghazali, Executive Chairman - aged 66, appointed since 1993 and become chairman in 2002. Member of a few overseas and local accountant associations and institute including Chartered Association of Certified Accountants (UK) and others. Have directorship in Tambin Indah Land Bhd, Malaysia Packaging Industry Bhd amd Global Maritime Ventures Bhd.
• Lau Mong Ying, MD – aged 65, is the MD since 1993 (21 years ago). Graudated with Bachelor of Commerce in Economics (Nanyang University of Sg)

Non-executive directors

• Lau Mong Ying, MD – aged 65, is the MD since 1993 (21 years ago). Graudated with Bachelor of Commerce in Economics (Nanyang University of Sg)
• Khadmudin bin Mohd Rafik -  aged 61, appointed in 2003. Used to be a Senior Police Officer and Assistant Superintendent of Police.
• Lin Cheng-Lang – Taiwaneses aged 75, appointed in 1998. Used to be MD with various textile companies in Taiwan
• Chin Chew Mun – aged 43, appointed in 2012. A Chartered Accountant.
• Boo Chin Liong – aged 53, appointed in 2013. An advocate and solicitor.

3.0 Macro Outlook

US – Overall improvement in consumer spending

A series of optimistic economic data showing US economics is growing fairly well and consumer spending is generally on the rise with lower unemployment rate, rising retail sales and better Consumer Confidence.  Overall, US economic is growing and the consumer is spending more.

On a forward looking note, US consumers are expected to be spending even more due to (1) higher disposable income thanks to lower fuel and energy cost (2) strengthening USD boost consumer spending power on import goods (3) expected continuous improvement in US economy

Hence, Prolexus’s sales to US’s consumers is expected to growth at a higher rate in the next FY.

Euro – Slow growth ahead

With Unemployment rate still high above 10%, Euro economy is moving like a snail. Industrial production rose slowly, even the powerhouse of Eurozone, Germany see its Manufacturing PMI only slightly above 50.0 level (51.2 in Dec 2014). IMF expect a moderate Real GDP growth rate of 1.8% in 2015.

 

Weakening RM a boost to Prolexus’s sales and earning

Against USD, RM is the biggest losers compared to some of other apparel exporters’ currencies. The RM depreciation will not only improve the attractiveness of Prolexus's products, strengthening USD will give Prolexus forex gain due to its exposure to USD-based asset and export.

Rising China Manufacturing Cost

Cost of manufacturing in China has been rising in the recent years and eroding the profitability and attractiveness of China manufacturers. Minimum wages of China are rising at a double-digit rate. Base monthly wage of a factory worker in China is over $400, compared to $130 in Cambodia. Many factories has moved their operation to Vietnam and Cambodia, where operating cost is much lower. 

Improving Nike’s Apparel Sales

As the largest customer of Prolexus, Nike’s apparel sales performance have a significant relationship to Prolexus’s sales. Nike apparel sales has been improving in the past few years. In Nike’s 2Q Quarterly report ended 30 Nov 2014, Nike’s worldwide futures orders (for Nike Brand footware and apparel) scheduled for delivery from Dec 2014 to Apr 2015 were 7% higher (11% if excluding currency changes). Accelerating Nike’s orders indicate a good prospect to Prolexus.

4.0 Financial Analysis

4.1 Past 5 Years Performance

Revenue growing every year in the past 4 years with CAGR at 24%. PBT’s growth was remarkable in FY2012 and FY2013 due to significant efficiency improvement, cost rationalization programmes as well as improvement in China’s plant profit. PBT’s growth normalized to 25% in 2014 (from 84% in 2013) as operating margin reach a plateau.

4.2 Financial Analysis

i) Income Statement

Sales continues to grow at a steady rate of 25% in FY14 (FY13 : 24%) contributed by sales growth across all 3 main customers regions (US, Euro Area and Others).

PAT growth decelerate to 21% in FY14 (FY13: 58%). PAT growth is contributed by Revenue growth and Gross Margin improvement but dragged by higher operating cost rise and higher effective tax rate.

In contrast with 21% PAT growth in FY14, Apparel business actually recorded a 1.8% lower PAT despite sales and EBIT grow at 25% and 7.1% for the business segment. EBIT Margin is lower due to higher production wage cost while PAT is lower due to higher effective tax rate. Prolexus's effective tax rate is lower than Malaysian statutory rate at 25% as they have Unabsorbed tax losses (at RM18.5m in FY14), capital allowances and reinvestment allowance. Realization of tax benefit is lower compared to last year, hence the higher effective tax rate.

 In fact, the Group's FY14 higher PAT (+RM3.6m yoy) is over-contributed by higher PAT from the Investment Holding segment (+RM3.8m). In 2014 Annual Report of the Group, the chairman attributed the higher PAT, among others, to better margin achieved through production efficiency. However, the number  is telling a different story where the EBITM in FY14 is actually lower (to 7.1% from 8.3%).

FY14 saw a staggering rise in staff cost to RM58m from RM44m in previous year, which is a 32% rise. Expressed at a percentage of Revenue, staff cost rised to 19.7% of FY14's revenue from 18.6% previously. The rise in staff cost is mainly due to implementation of minimum wage. There was no significant addition of Plant and Machinery in FY14 which indicate that the Group are not heading to automation aggressively to address the issue of rising wage. 

ii) Balance Sheet

FY14 saw an increase of Fixed Asset at RM17m to RM58m mainly due to purchase of a vacant land in Tanjung Kupang, JB (Land) with carrying amount at RM8.7m and a vacant factory in Pontian (RM5.6m). Both purchases are for investment purpose targeting capital appreciation. 

Prolexus is very cash-rich with RM35m of total cash and deposit and 80% of it is in USD. Net cash at RM24m.Though the cash hoard, Prolexus do not provide high dividend payout nor cash distribution. Instead, they are constantly looking for investment opportunity. 

iii) Cash Flow Statement

Good Operating CF at RM26m compared to PBT of RM24m. FY14 saw a high capex at RM21m funded by CF from Operation and drawdown of new Term Loan. RM5m of net cash is generated in FY14, boosting the cash hoard to RM34m.

FY14 saw a better Gross Margin at 17.5% (from 16.8%) but EBIT margin unchanged at 8.3% due to rising operating cost. This lead to flat PBT margin YOY. Together with higher effective tax rate, Net Margin fall 0.2% to 7.1%.

iv) Ratios

ROE and ROA is remarkable at 20.6% and 13.9% respectively. Prolexus has good liquidity with Current Asset and Cash cover Current Liabilities at 2.1x and 0.8x. Cash-to-cash cycle improved to 29 days (from 33days)

4.3 Recent 8 Quarters Performance Review

Revenue increased YOY in all of the past 4 quarters at 14 to 32%.

PAT rised 32 to 62% YOY in the past 4 quarters except a 12% YOY drop in 3QFY14 due to an Unrealized Forex Loss of RM1.7m from weakening USD at that period. 

5.0 Future Prospect

i) Continuous growth in revenue

Prolexus has a good track record of sales growth in the past 4 years with CAGR at 21% and the increase is across customers from all regions. Moving forward, I am comfortable with the Group’s ability to secure more orders from existing customers. Besides that, with better prospect of US economy and consumption, orders from the US customer will have a brighter prospect.

ii) Weak RM against USD a gift to competitiveness and earning

RM has been weaken for over 10% against USD and generally against other currencies since FYE 31-Jul-2014. This will translate to higher sales value and Gross Profit in RM for orders to US and oversea counties in the coming quarters. In the longer term, oversea customers will request Prolexus for a lower selling price in their home countries to take a share of the benefit. Eventually, weak RM will boost competitiveness of Prolexus’s production in Malaysia and increase their sales. In 2014 Annual Report, the Group has net exposure to USD asset of RM29m and with every 10% strengthening of USD will increase Prolexus’s 2014 PBT by RM2.9m. Though this is just a one-time effect and may reverse itself if RM recover, but Prolexus 2QFY15 PAT is expected to be boosted by the forex gain. Prolexus’s China operation is generally not beneficial to the weak RM.

iii) Oversea operation expansion
With a stronghold of cash, good OCF and net cash position, Prolexus is financially capable of taking up big investment like setting up new plants in other counties like Vietnam and Cambodia where they can exploit the cost advantage. Should this happen, operation cost and depreciation charge will be higher in the near term before any earning contribution come in. However, it will facilitate the Group's long-term expansion.

6.0 Risks

i) Customer concentration risk

Sales of 2 major customer contributed to over 80% of the Group sales. Loss or significant reduction of order from one of these 2 customers will have a serious impact to Prolexus’s financial. This is a low-risk-high-impact event.

ii) Competition risk

Apparel manufacturing is a globalized business. Just like manufacturing, competition is always happening among the major manufacturing counties like China, Vietnam, Cambodia, North America and other counties. Any sudden or systematic rise in competitiveness for their competitors from other counties may cause the Group loss in market share. The weaken RM is an example of the change in competition environment, though it is in favor of Prolexus. 

iii) Rising production wage cost

A continuous rising wage cost in China manufacturing will erode Prolexus's China profitability and competitiveness. Besides that, the Group has constantly facing difficulties in recruiting production operators, which may cause higher wage cost in order for the operation to recruit enough operators.

iv) Investment risk from non-core asset

As noted earlier, the Group's investment holding has RM14m worth of investment real estate in the form of vacant bungalow and several vacant lands. It is 9% of the total asset. Prolexus has low dividend payout rate (14% in FY14) but choose to invest the cash generated from operation in non-core real estate. The investment is not expected to generate much shareholders'value in the medium-term as it is not cash-flow generating (due to its vacant condition). Shareholder can only see value if there are sales of the asset or revaluation done in the future. Should the management distribute the cash to shareholders and let them decide what investment is more proper to them? Besides that, lower asset base also give financial reporting benefit and support better valuation.

7.0 Projection and Valuation

7.1 Current Market Valuation 

Based on closing price on 16-Jan-2014

As on 16-Jan-2014, the market give Prolexus a 7.5x P/E valuation, way lower than FBMSmallCap P/E of 14.77 despite good track record of growth in the past and bring prospect ahead. EV/EBITDA at 5.2x shows the acquisition cost of the Group can be recouped with 5.2 years of FY14's EBITDA. That seems to be cheap considering the Group's ability in generating cash and stability of EBITDA in the past.

Optimistic Scenario is based on:

i) Higher sales value in RM due to depreciating RM. 

ii) Stronger sales order from customer due to stronger demand from US customers and lower price of Malaysia goods (due to weak RM)

iii) After implementation of minimum wage in 2014, wage cost rise normalized. EBIT Margin improved to 7.8% (before considering forex gain)

iv) Forex gain of RM2.9m

Conservative Scenario is based on:

i) Lower sales growth despite weaker RM

ii) Higher EBIT Margin due to continuous rise in wage cost. 

iii) New capex that cause higher operating cost, depreciation charge, higher interest cost (new borrowing) and lower interest income (from cash drawdown). 

iv) Lower forex gain of RM2.0m

v) Higher effective tax rate.

My target price is set at RM2.28 (61% upside from 16-Jan-2014 closing). I think the optimistic scenario is 75% possible as (i) Weak RM situation will sustain longer to benefit Prolexus (ii) Operating cost growth should normalize in FY2015 after a big jump in FY2014 (iii) No significant action or plan in capex yet. 

Factors for revaluation:

My TP will be revised if:

i) There are announcement of significant capex

ii) Stronger than expected RM recovery

iii) Actual result deviate significantly from my estimate as review quarter by quarters

Disclaimer: This  research is not a recommendation to buy or sell the securities, but only for informative purpose to help reader to understand the company better. Despite my target price is higher than current market price, the stock price may not reach the target price due to various factors, including significant deviation of my estimate with the actual figures. Readers are advised to perform due diligence before making any investment and after reading my research as my estimation and projection can be highly fallible. 

OKA Corporation Bhd (OKA) - A stable construction play

A) Summary
OKA, one of the largest precast concrete manufacturer in Malaysia, is an attractive value investment and a small-cap proxy to construction play due to:
(a) sustainable demand for its manufacturer goods with decent sales and profit margin growth opportunity ahead
(b) solid sales and profit growth track record in the past 5 FY
(c) good fundamental with net cash position

I project sales and net profit to grow 12% and 28%-12% in FY15-FY16 period and give a target price of RM1.13 based on 9.0x FY16F P/E, a 33% upside (based on 14-Jan closed at RM0.85).

B) Business Background
Established since 1981 and listed in 2002, OKA core business is in manufacturing and sales of pre-cast concrete products and its products are mainly used in the drainage, sewerage, buildings and water related infrastructure works. Pre-cast concrete products are part of Industrial Building System (IBS), which is a construction technique where construction components (i.e. pre-cast concrete) are manufactured or cast in factory (instead of in construction site). The components are then transported to site for installation. This technique is gaining popularity due to its benefits in reducing reliance on site manpower (thus, foreign workers), save time and operating cost especially for large-size projects and suitable for construction in city center where casting concrete on-site is challenging.


Though pre-cast concrete products can be used in a wide range of construction situation, OKA's products is specialized in drainage and other water related infra works. So OKA is stand to benefit from construction of highway, new township and rail/MRT projects.

Projects that have used OKA products as below:

Source: Company website

OKA's head office is in Ipoh and have factories in Perak, N.Sembilan, Pahang, Johor and Kedah. 

C) Industry Outlook

Construction sector will stay busy for at least the next 2 years as existing projects with long-gestation period like West Coast Expressway, MRT and other highways projects will help OKA's manufacturing capacity being taken up. Any new construction works start like LRT3, MRT2 and new highways in Klang Valley will provide better long-term earning visibility to OKA's financial.

D) Financial Analysis

i. Past result analysis 

OKA's sales growth is rather mature. With constant single-digit annual sales growth in the past 4 years, it is a slow but steady growing company. In FY2014, PAT, however, grow 136% to RM13.4M from RM5.7M mainly due to higher sales of special products and lower operating expenses. Hence, it registered a significant jump in Gross Profit Margin (18% from 12%) and PAT margin (9% from 4%). 

Management Opinion on FY2015 (Source: FY2014 Annual Report)

Challenges:

- uncertainties in raw material pricing & effect of GST

Strategies:

- emphasis on productivity, efficiency & cost saving

- increasing production capacity to diversify products

- continuous development of new & innovative products

- plan for improving use of factory floor space to increase 

View on FYE2015:

- fairly optimistic that the Group will continue to grow for FYE2015

FY2013 up to 2QFY2015 (Past 2 and half year)

ii) Latest Financial Review (2QFY2015)

iii) Past 8 Quarter Performance

Gradual rise of sales in the past 8 quarters.

Profit margin rising gradually with the latest 2QFY2015 being the best quarter in term of PAT margin. This should be contributed by the Group continuous effort in improving productivity and efficiency.

E) Projection and Valuation

i) Financial Projection

Future growth is expected to be driven by moderate sales growth and operating efficiency improvement.

RHB Research has on 27 Nov 2014 published a research report. My financial projection vs RHB's as below:

ii) Valuation

Share Issued: 152.282m

EPS for FYE on 31 Mar 2016 : 12.6 cent

I give OKA a target P/E of 9x FY2016F which translated to target price of RM1.13 based on:

a) Demand for OKA's products is very stable with moderate growth opportunity in the coming years

b) Good earning visibility due to robust construction sector

c) Healthy fundamental with proven track record of performance

iii) Risk

a) Government's spending cut on infrastructure work

iv) Re-rating catalyst

a) Awards and start of any mega-infrastructure project like MRT2, HSR and new highways projects should cause positive sentiment on construction stock and cause better forward earning visibility and valuation.

b) Better than expected operating effeciency improvement. FY16F EBITM at 15% while latest 2QFY15A's EBITM at 17%.

F) Technical Analysis

OKA share price is in Short and medium term uptrend crossing above 20 & 50 MA lines. Long-term uptrend will be confirmed (a)if price do not retrace below 200MA and make a new high, and further confirmed if (b) 20MA cross above 50MA. Near-term support at RM0.90 and all-time high at RM1.04 (after price adjustment). Uptrend momentum is highest in 6 months time based on MACD and RSI reading. Price should retrace to 200MA and trendline support before continue its uptrend movement after being oversold in a 1 month rally starting on mid-Dec 2014.

Although OKA's is fundamentally stable, but due to its SmallCap natural, price retrace 50% from the recent selldown from RM1.04 high to RM0.52 without any changes in fundamental. It shows that market risk still play a big role here, traders/investor should form their entry/exit strategy in any investment. Warrant Buffet-like hold-forever strategy may not be suitable to everyone.

Chart from ChartNexus charting software

Disclaimer: This research is for informative purpose, not a buy or sell recommendation. I do not take any responsibilities on investment actions caused directly or indirectly by this articles. Readers are advised to do their own due diligent as information provided may subjects to errors.