Tat Hong Holdings Ltd: Holding out for inorganic growth

1Q10 performance fell short of expectations. Tat Hong Holdings Ltd's (Tat Hong) 1Q10 results came in below expectations. Revenue slipped 37.2% YoY to S$120.1m and net profit tumbled 63.9% to S$10.6m. Stripping away the impact of non-core items such as forex, core net profit would have fallen by a larger 67.4% to S$8.2m. Sequentially, sales improved by 8.5% but core net profit decreased by 58.6%. No dividends are declared for 1Q. Broad-based revenue decline, with the exception of Tower Crane.

With the exception of the Tower Crane division, all other segments posted weaker revenue. Equipment Sales recorded the steepest fall (-60% YoY) as customers reigned in on capital expenditure in light of the economic crisis. Crane Rental, on the other hand, remained relatively stable with revenue contracting by just 2%. We expect stable rental income to partially offset the steep decline in equipment sales in FY10.
Profit margins contracted. While we had anticipated weaker revenue, the sharp drop in 1Q10 earnings came as a surprise. Although gross profit margin improved by 2.6ppt to 39.4%, operating expenses did not fall as significantly as revenue, and this resulted in a 4.6ppt drop in EBIT margin to 17.1%. Poor results from associates further dragged down its bottom line, with net profit margin contracting by 6.5ppt to 8.8%.

Holding out for inorganic growth. Management continued to paint a cautious outlook for FY10 as weak equipment sales are expected to dull the group's performance. On the bright side, economic stimulus plans may support its rental income. In our view, the environment for organic growth remains highly challenging in the near term. Tat Hong's next phase of growth is more likely to be driven by inorganic growth. Following AIF Capital's recent S$65m strategic investment, Tat Hong is equipped with the financial flexibility to expand via M&As or JVs. In addition, AIF Capital could introduce new growth opportunities that were previously unavailable to the group.

Maintain HOLD. We have cut our FY10 earnings forecast by 20% following Tat Hong's poor 1Q10 showing, bringing our fair value estimate slightly lower to S$1.13 (previously S$1.15). While we note the risk of continued near term earnings pressure, we maintain our HOLD rating on the stock given the enhanced likelihood of inorganic growth following the emergence of a strategic investor, coupled with a relatively decent 3.6% dividend yield.

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Tat Hong - Preference Share Issuance Is A Positive

Reiterate Buy — We view the CRPS issuance positively: 1) provides additional capital to embark on a more aggressive M&A strategy in China and Australia, leveraging on TAT’s M&A execution capability; 2) good record of AIF Capital identifying value and growth in its investment commitments; 3) terms of the agreement suggests AIF Capital’s shareholding commitment is not short term.

Details — TAT is raising net proceeds of S$63.5mn from the issuance of 65mn Convertible Redeemable Preference Shares at S$1.00 each to AIF Capital. ~80% of the proceeds will be used for expansion of its Australian and China businesses. The agreement is structured such that the net impact to ordinary shareholders is quite similar to that of undertaking a private placement, but without the requirement of mark-to-market accounting by TAT or AIF.

Background — AIF Capital is an independent private equity firm headquartered in HK, and oversees a broad-based investment portfolio. Established in 1994, AIF has received investor commitments for its funds, including co-investment, in excess of US$1.5bn. While performances of its private equity investments are unavailable, its investments in Singapore-listed companies suggest a good record in identifying value and growth investments.

Impact – We factor in 11.4% EPS dilution for TAT resulting from the CRPS issuance, ceteris paribus. Our TP is unchanged despite our lower EPS est. as we raise our FY10E PE multiple from ~10x to ~11x (above the historical average PE since 2001), justified by more aggressive M&A strategy. Assuming all CRPS are converted, management will still control TAT with a 51% majority.

Tat Hong - Investment in Sino-foreign Joint-Venture

Taking of 53.8% stake in joint venture (JV). One day after Tat Hong’s announcement of AIF’s S$65m investment, the Company announced the formation of a JV with Yong Mao and Mr Yuan Zheng. Mr Yuan’s company, Guangzhou Hailin Resource, manages around 113 mid– to largesize tower cranes and is a well-regarded player in the southern and south-western provinces with various awards under its belt.

Mutually-beneficial arrangement for all parties. For Tat Hong, the opening up of the prosperous southern PRC market by partnering with an experienced hand excites us. Mr Yuan will inject relevant assets comprising tower cranes (valued at about RMB90m) and finance leases into the JV for a 30% stake. He benefits with Tat Hong’s injection of nearly RMB70m of fresh funds in 2 tranches into a bigger entity and the possibility of further expansion if the venture takes off. The third partner, Yong Mao, holds a 16.2% stake and is the exclusive tower crane supplier to the JV.

Adequate supervision through Board of Directors and Supervisory Committee. Following the establishment of the JV, the Company will have 3 directors on the Board and 1 member to the supervisory committee .

Big market in China. The JV increases Tat Hong’s tower crane fleet, which stands at 262 units as at 31 Mar 09, by nearly 50%. Even with this enhanced fleet, we expect them to be just a blip amidst strong demand for tower cranes from infrastructure and power sector projects in China. A financially-strong venture with established and well-connected people paving the way gets a healthy share of the rapidly expanding pie.

We raise our FV to S$1.39 and recommend to ACCUMULATE. Since yesterday’s announcement, we have been waiting for the trigger to revise our fair value upwards. We believe the JV is that trigger. Tat Hong did not achieve major headway in China for the past one year without a strong local partner and, from our chats with Management, we could feel they were still feeling their way around then. The JV potentially marks the start of the next phase in the Company’s venture into the huge China market. Furthermore, their investment in the JV of about S$15m is a small proportion of the S$50m the Company stated they would spend on expansion from AIF’s investment, suggesting perhaps more initiatives to come. In view of the above, we increase our growth assumption for the tower crane segment and overall gross margins to reflect a changing product mix that is more focused on the rental business. We arrive at a FV of S$1.39 vs our previous FV of S$1.07 and recommend investors to ACCUMULATE.

Tat Hong Holdings : Stabilising outlook

Valuations looking more attractive now. Shares of Tat Hong Holdings Ltd (Tat Hong) have fallen by as much as 21% since our downgrade two months ago, bringing the stock to more reasonable valuations. We are upgrading our rating to HOLD given that the stock now trades at a less demanding 7.1x FY10F PER and is backed by a decent dividend yield of 5.6% as well as proven management expertise. Just as the group emerged stronger from the previous downturn, we believe that Tat Hong will not only tide through the current turbulence, but will also strengthen its foothold in the industry by expanding its fleet via purchases of distressed assets during the current downturn.

Stabilising outlook. To recap, Tat Hong posted a 35.4% YoY slide in its core 4Q08 net profit as the recession weighed on revenue and gross profits across almost all its business segments. In particular, equipment sales recorded a steep plunge as customers scaled back on capital investments in the absence of credit availability. Thankfully, the group's overall performance was supported by rental income, which continued to be fairly resilient despite the downturn (exhibit 1). While we are not expecting a marked improvement in its upcoming 1Q10 performance, the brightening economic outlook, gradual pick up in private sector construction activity, as well as the pipeline of projects from government pump priming initiatives suggest that the sector outlook could be stabilising. Furthermore, with rental income forming 73% of the group's gross profit, Tat Hong's earnings will be fairly resilient to volatility stemming from equipment sales.

Still too early to call for a recovery. Tat Hong is expected to release its 1Q10 results on 14 Aug 2009. Key aspects to note include its rental rates, utilisation levels and equipment sales. We are projecting a 10% fall in crane rental rates in FY10 as demand has weakened from a year ago. In addition, we expect equipment sales to post a steep YoY drop given its record high performance in 1Q09. While the overall outlook for the construction industry appears to be stabilising, we reiterate that it remains premature to call for a recovery in the near term. Hence we maintain our S$0.99 fair value estimate. We will turn buyers at S$0.90 and below.

Tat Hong - No signs of recovery yet

4Q09 earnings in line with expectations. Tat Hong Holdings Ltd (Tat Hong) reported a 39.7% YoY slide in 4Q09 revenue to S$110.7m accompanied with a 48.5% fall in net profit to S$14.6m. Stripping away the impact of non-recurring items such as forex and impairment of investments, core net profit would have fallen by a smaller 35.4% to S$19.8m, in line with our estimates. For the full year, revenue contracted by 1.3% to S$631.8m while net profit declined by 23.3% to $68.9m. Core net profit grew by 11.9% to S$94.2m thanks to a stronger 1H09. A final dividend of 1.5 S cents has been declared, bringing the group's full year payout to 5.0 S cents, or a yield of 4.4%.

Weak performance except for Tower Cranes. With the exception of its Tower Crane division, all segments recorded lower revenue and gross profits in 4Q09. In particular, the group's Equipment Sales segment recorded sharply lower sales on lacklustre capital spending among its customers. Revenue from this segment slid by 67.9% YoY, while gross profit registered a 74.3% fall. Management expects equipment sales to deteriorate further. On a brighter note, the Tower Crane division turned in a 119.0% surge in revenue as well as a 54.2% improvement in gross profit. We expect this division to support the group's performance in FY10 given the strong demand for tower cranes in China. Strength from this division, however, will not beable to offset the overall decline given that it constitutes only 4.3% of the group's gross profit.

No clear signs of recovery yet. While pump-priming activities will cushion Tat Hong from the full impact of the global recession, the group is not immune from the downturn. The outlook of Australia's construction industry, which forms the bulk of its revenue, remains shaky with experts predicting further declines in construction activity (exhibit 1). We have raised our margin assumptions as the group has demonstrated its ability to sustain its margins. Nevertheless, we are projecting a 24.5% contraction in FY10 core net profit to S$71.1m as we expect revenue to recede. While we are confident that Tat Hong is poised to ride out these challenging times, we are of the view that it shares have run ahead of fundamentals, and are downgrading our rating to SELL. Our valuation has been rolled over to FY10F NTA and our peg has been raised to 1.3x (from 1.0x) in line with the re-rating of its peers, bringing our fair value estimate to S$0.99 (from S$0.72).