First off, I’d like to thank Joe at www.valueinvestingworld.com for alerting me to this idea, his site provides a great source of links/articles from around the web.
In my opinion, Zicom Group at around $0.20 offers investors a low risk and deeply undervalued exposure to a number of “GDP plus” growing end markets with a conservative and proven founding family operating the business. Whilst we wait for the market to re-evaluate the prospects of this business and it to trade at a premium to book value, like it deserves, we get paid a 5% plus dividend yield and allow management to opportunistically buy back shares to increase our ownership. The stock currently trades at a 20% plus discount to Net Tangible Assets.
Zicom has 3 main Divisions comprising the vast majority of revenues and profits.
1) Offshore Marine Oil & Gas (circa 40% of revenues)
2) Construction (circa 40% of revenues)
3) Precision Engineering & Automation (circa 15-20% of revenues)
Offshore Marine Oil & Gas (circa 40% of revenues)
Zicom is one of the world’s leading manufacturers of high spec, heavy duty winches and deck machinery for use on large marine oil & gas vessels. They supply to shipbuilders and ship owners, some of their winches can weigh up to 300 tons and therefore are very large pieces of kit! The key variable for long term winch demand is deep sea oil & gas exploration.
Orders for deck machinery products lag orders for the production of new rigs or vessels by about 12-18 months, this means that the current weak orders still reflects a bit of a hangover from the implosion of demand during the financial crisis. The order book still looks weak at only SGD $42m, or around half of what it was a year ago. We might be hopeful that in 12 months time the order book looks much better.
The main competitor to Zicom in the manufacturer of winches is the UK’s Rolls Royce, obviously a giant in comparison which has its pros and cons. This is clearly a non core business for Rolls Royce and this perhaps allows Zicom to get an edge on customer relations/meeting client needs.
Demand for offshore products in general is likely to be relatively robust above $80 per barrel. The oversupply of vessels from the boom/speculation era and the subsequent slump is starting to clear and E&P companies are starting to spend on projects again.
In the 2011 Directors Report there is reference to a resurgence of demand for offshore rigs which they say has resulted in a “gradual build up” in enquiries which they expect to gain momentum in the next 12 months.
The “Offshore” Marine Oil & Gas division also designs, builds and installs “onshore” turnkey gas processing plants and gas flow regulation systems across Asia. This is a relatively new line of business and is still growing, orders are lumpy and can have a large affect on numbers. There is a goal to grow this part of the business so that is equal with the winch business in doing around SGD $60m per annum revenue.
Zicom supplies process plants for the recovery of gas from refineries. This captures the gas that is normally flared off as part of the process of extraction, separates it and sends it to the refinery. Each plant has a cost of around SGD $10m so they are substantial orders. Alas, the current natural gas price probably is a disincentive for these projects but they still could have a payback period of under 5 years.
As an example of the group’s long term focus and using their robust balance sheet in their favour, they used weakness in May 2008 to deploy SGD $5m into the building of a new factory in Singapore for this division to position it better for the future.
There is a further growth avenue available in “Remotely Operated Vehicles” which are increasingly required for offshore deepwater drilling. The construction division manufactures the frame and the offshore division tailors it to customer spec.
Construction (circa 40% of revenues)
I view the Construction segment as the boring, dependable part of the business. The core of this division is the manufacture of concrete mixer trucks for which they have a dominant 70-80% market share in both Australia and Singapore.
The secondary part of the construction division is the “foundation equipment” business which hires equipment like large vibratory or piling hammers or boring machines. Zicom owns the largest vibratory hammer in SE Asia weighing in at 42 tons!
The division has been revolutionised by the opening of a new production facility in Thailand which consolidates their Australian and Asian facilities and which allows them to increase efficiencies dramatically helping margins. The new facility was a SGD 10m investment to improve the long term prospects of the business and this is already starting to show in margins. Concrete mixer and foundation equipment demand is of course quite cyclical due to a dependence on construction activity but their geographical diversity and market share helps.
The Australian subsidiary has further diversified into the distribution of gas generators and is looking into waste digesters and biogas generators.
Precision Engineering & Automation (circa 15-20% of revenues)
This division is a specialist equipment manufacturer and niche engineering service provider to customers who require a high degree of specification in their goods, ranging from inkjet cartridges to fully automated production lines to biomedical equipment.
The precision engineering division secured “ISO 13485” accreditation in 2010 which means they can now manufacture entire medical devices in house rather than only being able to make component parts. This accreditation also marks them out as a high quality operator. This competitive advantage has a margin and earnings impact due to pricing power too. The aim here is for the business to partner in co-designing biomedical devices and to make sure that the manufacturing is all done in house too.
Zicom has focused on using its scale to its advantage, focusing on niches and only accepting business that is likely to be profitable and ideally recurring so that a relationship can be built with the customer and revenues become more predictable.
In the last 2 years the group has made a substantial commitment to this part of the group by doubling the floor space of their factory and by making three strategic investments in start up companies which possess “disruptive technologies” which can be manufactured and monetized through this division’s expertise. Zicom has targeted “high valued added synergistic products” that have the potential to revolutionize their industries, these are clearly high risk/high reward targeted investments in areas close to their existing operating circle of competence. Any one of these products being a “hit” could result in exponential earnings growth and they already have the factory capacity to grow into.
3 Shots at a Home Run within Precision Engineering
1) BioBot Surgical (46% ownership for SGD $3.5m)
This is a surgical robot for taking prostate samples for biopsy. This robot has been proven to increase sample accuracy and minimises patient embarrassment and invasion. A study in Singapore’s largest hospital showed that over 4 years it doubled detection rates. The product has received regulatory approval in Singapore, Australia, Europe and the USA.
2) Curiox BioSystems (40% ownership for SGD $3.2m)
Pharmaceutical research and diagnostic testing scientists require plates for their assays. Curiox has developed a “drop array” technology which has proven to be more accurate, increase the speed of the cleaning process, improve productivity and lower costs. Testing with a “leading US Pharmaceutical company” showed a reduction in cost of use of 85% and a 60% saving in time. Curiox has sold 2 units so far (as of June 2011) to the US company and to a Japanese pharma who are now using it for real production.
3) Orion Systems Integration (54% ownership for SGD$2.55m)
Progress has led to computer users expecting greater power on smaller devices over time which requires chips to be smaller and lighter too. Orion possesses a technology in “Thermal Bonding” which overcomes the limitations of conventional bonding whilst improving performance.
The attractive thing about this basket of investments relative to the share price is that most of the investment is complete having purchased the equity stakes and secured regulatory approvals/testing. The cost of failure from here is minimal but yet the upside is potentially very high.
History of the Company
Zicom was established in 1978 by the Chairman GL Sim and took itself public in 2006 by way of a reverse takeover. The business has grown via small acquisitions and organic growth. This is, and has always been, a family business with a focus on long term, profitable relationships and a strong internal culture. GL Sim owns 35% of the business and is Patriarchal figure which ensures very low staff turnover and a collegiate approach. Both of his sons are in the business after completing their education at prestigious US Schools
JK Sim also owns 10% of the company. The Chairman’s two sons own 1% of the company between them.
Insiders have purchased 1.3m shares over the course of 2012 so far. Looking further back, they have purchased 15.6m shares (7.3% of shares outstanding) in the open market since May 2010. This is a very strong signal that those closest to the company believe it is substantially undervalued. Some of these purchases were done 50% above current prices and 500,000 were bought at double the current price. I couldn’t find a single insider sale in that period. Either the family are just totally wrong about their business, which is possible, or they are really taking advantage of Mr Market’s myopia.
Capex done, now for the rewards?
Capex has been at a high level for the last few years with the investments and new floor space in Precision Engineering, the Thai factory in Construction and the factory in Singapore for the Marine business. Going forward, management have guided that this will be lower although they retain flexibility to make strategic acquisitions/investments into the disruptive technologies they are starting to favour.
In the 2011 annual report management highlighted that they had forecasted $3m of capex in the current year, the reality is likely to come in below $2m, an indication of their prudence.
It is worth highlighting that the cash pile within the company and the quality of their PPE has been growing and improving throughout the last 5 years which has included dividends, all that expansionary capex and a global financial crisis. If they were to start to run the business for current profits or cash flow the effects could be remarkable.
Ownership Structure – Long Term Family Business
The comments of the Chairman GL Sim ooze conservatism and suggest a broad macro perspective, giving me great comfort that he is the steward of this business. From his November 2011 Chairman’s Address
“The world’s global economic situation has deteriorated with the possibility that the fall-out could be worse than the 2007-2009 Global Financial Crisis.”
“It is therefore prudent to assume that the current financial crisis that follows seamlessly from the GFC can be expected to inflict serious damage that may last for some years to come…..(economic) cycles for changes have become shorter and sharper.”
“The key planks of the Group’s sustainable growth strategy consists of continuous focus on strengthening our organic growth while embarking on synergistic acquisitions and investments in disruptive technologies fully financed by internal resources. These form the buttressed foundation of our growth platform, to position us to weather economic adversities rearing in our horizon.”
“The group is continuously looking for opportunities for expansion….Such opportunities may arise during periods of adversity. We position ourselves to be ready for it.”
From the 2011 Annual Report
“The group achieved record revenue and profits for the year just ended. These results have been achieved from the groups focused efforts and directions. The Group’s focus in continuously growing organic growth and, at the same time creating avenues for horizontal growth, by investing in disruptive technologies from its internal resources has buttressed the Group to achieve sustainable growth into the future.”
GL Sim, the chairman, has committed to the business for a further 5 years with his salary frozen at 2007 levels – something that even more closely aligns his interests with the performance of all the equity he owns.
Balance Sheet Strength – Trading Below Tangible Book Value
The last time the shares were trading at this level in September 2010 coincided with the company initiating its first buyback programme. The share buyback programme was renewed on September 1st 2011.
It’s worth remembering too that the A$28m of Property, Plant and Equipment on the balance sheet is supported by the substantial investments made in 2008 and 2010 in large, new factory space which will likely still be worth around the same amount. The point being that these book values are not unrealistic prices.
Knowing that Zicom Group is trading below Net Tangible Assets we already know that we have a margin of safety in the stock, now we can make a conservative assessment of what the stock might be worth if the market afforded it a reasonable valuation.
To be conservative, we will assume that all three investments in the disruptive technologies flame out and produce no earnings. This seems extremely unlikely since they have already started generating sales and seem to provide genuine advantages over their incumbent technologies but let’s run with it.
Over the last 6 years which includes the GFC the average earnings for Zicom were A$0.045 per share. Six years ago Zicom had a much smaller capital base and had revenues of only A$35m which is only about 30% of 2012 expected revenue.
Putting an 8x multiple on these cyclical earnings we get to a share price of A$0.36 which is almost a double from here. I think we can agree that these are very conservative estimates.
It is also worth re-iterating that the company has remained profitable throughout the crisis and has the balance sheet strength to capitalise on economic weakness rather than fall victim to it.
Exchange Rate Risk in Earnings
ZGL earns the majority of its revenue in Singapore Dollars but yet the listing and earnings will be in Australian Dollars. Therefore there is substantial conversion risk each quarter to make earnings more volatile than they truly are. Weakness in the Australian Dollar will make earnings appear better than they actually are, strength in the Aussie will make earnings appear weaker than the economic reality.
Way Below the Radar – Sloppy Analysis
“Overseas Discount” – one of the very few research reports I could find of Zicom stated that the fact that management are based in Singapore and operations are based in Thailand and Singapore that this is sufficient to justify a permanent valuation discount. Ehm, the last time I checked Singapore was pretty “first world”, I don’t think this makes any sense at all. The rule of law is very much applicable in Singapore.
One broker ceased coverage of ZGL despite previously having a price target of $0.85 (a four bagger from here!) because they have a lack of confidence in forecasting earnings due to inconsistent outlook statements. I suspect that it might be more to do with a “what’s in this relationship for us?” though process.
The stock “will not appeal to many investors” due to the smaller market cap and limited liquidity. Unfortunately, this is probably correct but just because it doesn’t appeal to institutions that like to play on the safest of grounds doesn’t mean that it doesn’t offer an attractive opportunity.
The “share buyback should be suspended”, this was justified in that it makes an illiquid stock even more illiquid by retiring shares that were once in the free float. However, at such a steep discount to tangible value there is a substantial value add to buying back shares at current prices and this mindset has no consideration of an ownership mentality.
Why has the Share Price collapsed?
One large passive owner (Ventrade Pte) owned 8% of the company and has been liquidating their stake over the last year, this has resulted in an uptick in volume and a consistent, fairly inconsiderate seller.
The tiny market cap of only $40m AUD ($20m free float) means that anyone with a capital base of more than $10m will struggle to pick up sufficient stock or bother doing the due diligence.
The most recent earnings report was very weak with revenues, margins and profits all declining substantially. This means that the stock has seemingly poor operating momentum and doesn’t look particularly cheap on a multiple of current year earnings basis. These factors above plus the cyclical nature of their business operations means most investors will stay well clear until there is greater clarity on the outlook.