Eratat Lifestyle - Forward PE 1.5X

There are good points raised in recent posts. Investors should study the 3Q results + the latest SIAS/CIMB reports which can be extracted from  (  www.eratatgroup.com/v2/   ) and make their own decisions. The average forecasted EPS for YE2011 and YE2012 is 8 cts , so should you buy or sell at 12 cts or PE 1.5X ? There is also an interesting write-up on Eratat in the latest issue of The Edge.  Good luck .

looking at fuxing result, it seems like the impact on businesses due to rising labour costs and the tightening of credit in China have become a big problem for many businesses.
 
maybe, it was wise for Eratat to reduce the book order for next year... and restructure their shops and then ride the coaster again for an explosive growth when the economy expands.
 
almost every s-chip company seem to have trade receivable problem because of credit tightening issue there. while so, i think i am still bullish about the fundamentals of China.
 
i hv read both sias report and cimb report. most investors definitely prefer certainty and dislike uncertainty. But it is when uncertainty occurs, u profit from price anomaly. if everything is certain, u probably won't be able to buy at bargain price. But again, there's always a risk when u buy in times of uncertainty...
 
i got many friends say wait for Europe to crash, wait for greece to default... but seriously, what we are facing is macro and structural problem. no one can accurately say what actions the European politicians will do. if everyone all wait for default to happen and then comes in and buy, do u think the share price will be low again?
 
relaxing - u also vested in Eratat?
 
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[relaxing 15-11-2011]:

There are good points raised in recent posts. Investors should study the 3Q results + the latest SIAS/CIMB reports which can be extracted from  (  www.eratatgroup.com/v2/   ) and make their own decisions. The average forecasted EPS for YE2011 and YE2012 is 8 cts , so should you buy or sell at 12 cts or PE 1.5X ? There is also an interesting write-up on Eratat in the latest issue of The Edge.  Good luck .

Valuations are still extremely low imo... Those who have a shorter timeframe might wish to sell it due to the "lack of activity" in the security.. I believe there are still market participants in the market looking to go long with S-chips.. Growth might slow, but valuations arent that of a "growth" stock to begin with... Besides, there is a huge chunk of dividend payout with can act as a support for the stock price... That said, if the company suddenly spirals into debt or losses money, than we might have to reconsider the position... and also, It might be a stock which wouldnt realise the "intrinsic value" that we/you/i establish... Personally i would look at currencies or banking stocks for shorting... Just a thought..

Hi all,
Just wanted to put in my perspective on Eratat using a fundamental focus based on a financial/management approach.Note that there are many other companies out there which are undervalued too.
However, I hope to point out that one of the key reasons why I'm vested in Erarta is precisely because of what newbiestock mentioned: The sense of asymetrical information and opinion bias across investors.Without information and opinion differences, the semi-strong market hypothesis would rule - and all companies would be more or less correctly priced at all times.
However, the semi-strong market hypothesis is a farce when it comes to small caps (despite it being taught at the University level). However, it's a fundamental benchmark which many use and it's something that is the best in class (how sad that the best in class is something that doesn't work well most of the time). The problem isn't about the semi-strong market hypothesis, but rather that it CANNOT be applied to
(1) a set of stocks where the broad market is not interested in (most of the liquidity and interest will follow the blue chips and companies with a larger market capitalization). - Support: Statistical (if you actually base it on market liquidity numbers)
(2) In addition, the analyst reports on small caps tend to be of much lower quality (I mean, if you are a firm, would you put your best analyst covering the blue chips or the small caps?). On top of that, Analyst covering these small caps might not even want to put in as much effort (Would you? if you were tasked with covering stocks that aren't seen as important to your colleagues?). - Support: Human Psychology based on Cognition and Cognitive Dissonance Theory; Economics - Transaction Cost Economics Theory.
(3) There is asymetrical information with regards to these companies because they are not covered as well most of the time (see point 1 and 2 for the rationalization). In addition, most small caps tend not to give information that is as rich or meaningful given their size and resources (although the standards have been increasing remarkably and this difference might get reduced - e.g. with SGX now getting small cap firms to publish reports on a more regular basis. Saying that, small cap firms still tend to underpublish reports and market related information) - Support: A scan over the published reports of companies on the SGX site will show you a strong correlation between size of firm and published reports.
There are actually a number of other smaller factors that influence why the semi-strong market hypothesis does not work for small caps... but I will not go into detail here. Just to mention some of them - (a) Corporate governance is weaker in general for small companies, leading to differences between private knowledge of insiders and selected individuals, and shareholders (the public), and (b) A lack of resources to develop control systems and to articulate control measures, etc to the public.
If the semi-strong market hypothesis doesn't work well for small caps, then why are so many individuals using it to try to judge value of the company? I believe that's where the difference between the believers of Eratat and the sceptics of Eratat lies.
From my observation of the points mentioned in the forums, the sceptics point towards all kinds of issues (e.g. receivables increasing, new orders being lower than the year before, etc)... and say that given the current price, these news should lead to a reduction of share price, etc. What they fail to recognize is that the current price is not an accurate base because it has accumulated a discount bubble over time. (It's similar to double or triple discounting the same issue, leading to an undervaluation). This happens because it is done over a period of time, instead of doing a fresh analysis at a given time, and adjusting the discount factor accordingly).
How then should we analyse Eratat then? Well, My approach is to do an analysis that is causal in nature, based on the fundamental drivers of value. Primarily, these would be:
(1) The ability of the firm to generate positive sales (i.e. sales that add to the bottom line - thus including a cost component intrinsically) - Eratat does this very well... with overall sales increasing significantly over a sustained period of time (I'm talking trend here, and not variance between various quarters). in addition, the margins of their products have been improving as they move up the value chain. This will likely run out of steam over time (first (a) the margins will run out of steam, then (b) the ability to generate positive sales (not just sales)). However, there's so much room to grow that (b) will run out of steam in the distant future if Eratat does it right, and (a) will last longer than most expect because Eratat has just mvoed into the Premium product, so product mix has room for improvement still. In addition, as they gain clout and bargaining power, margins can improve from a costing and distribution perspective. Improvement of branding over time (and brands are something that takes time to build up) will also lead to the ability to generate positive sales.
(2) The actual asset backing of the firm (current and potential) - Well, Eratat has a good backing at the moment. However, it's a small backing. As such, one of the risk they face is over-expansion, because that can actually dilute their backing per (fill in the relevant measurement unit you want to use here). Effectively, what this ratio means is that for every key measurement unit (e.g. store), they have a certain asset backing. Normally, a minimum asset backing is required to ensure sustainable growth and to cover any external shocks that might occur. Think about it as insurance and the limited use of leverage. If Eratat expands too fast and run into bad distributors or something, they might really be in deep trouble. However, my reading is that this is not a problem precisely because of what they've done. (a) They're trimming their distributors to reduce the risk per distributor/store, (b) They've controlled their expansion in a manner to make it more manageable and sustainable, instead of rushing to open stores and using more distributors, (c) They've focused on quality, not only in terms of product, but distributors and relationships between the company and core related players (mainly suppliers and distributors) - This includes the subsidy for their classic stores. Effectively, the routines used and articulated help show that Eratat is planning to grow in a sustainable manner that reduces risk.
With (1) and (2) being positive for Eratat, it creates a strong fundamental base. However, having a strong fundamental base isn't meaningful for the investor. The stock must still be undervalued relative to this base (and for that, I have to thank the sceptics)
To determine undervaluation, we need to now look at the proxy ratios (NOTE: PROXIES... but these are based on the fundamentals described in 1 and 2).
(3) Earnings is estimated at 8 cents for FY 2011. From here, you can use PE, etc
(4) Liquidity Ratios like the acid test ratio is very good. (I will not do an actual calculation here, but I have looked at the Balance Sheet and you can do one yourself). Other useful ratios relavent to this would be your NTA per share (and I ALWAYS EXCLUDE goodwill for my calcs).... so NTA NOT net asset. It's safer.
(5) You can also look at growth on a yearly basis (since fundamentally, value is a function of current value of the firm plus future value - or a forward estimation of income stream).
Just using 3,4,5 (you can add your own here), we get a firm where its asset base is way higher than it's share price. In addition, the earnings it generate is so high, then it can cover share price in less than 2 years. So, we've established that Erata is CLEARLY an undervalued stock... with good fundamentals.
Now that we've etablished that, it's still not all clear. You'll have to determine if WYSIWYG (or what you see if what you get). Eratat is an S chip and the S chips have had a bad reputation... and rightfully so (except that that's again a flawed assumption, despite it being "rightfully so). I'll explain here, but it's another long analysis and explanation, so I'll save it for some other time when I'm feeling the "itchy fingers" syndrome) - or you could hire me as a consultant and I'll spend all my time explaining stuff to you. hahaha.
Anyway, to determine WYSIWYG, we need to look at how trustworthy the data they're providing is, their corporate governance, etc. Doing a quick analysis on this area, I've come up with this:
(6) Corporate Governance - well, they've done very well in this area, as documented by their rankings, especially among S Chips. A side note is that a lot of management is Singaporeans (which does make me feel better than if a lot of management were Chinese). I'm not being bias against the Chinese, but the institutional environment where one grows up in does affect this area. Support - check out Institutional Theory - both economic and sociological (read on mimicry and isomorphism).
(7) Communications (Truth in intention) - Eratat has tried to communicate with its shareholders at multiple points to explain their story. This gets touchy because the sceptics will say that "there's a reason for anything"... and I have to agree with the sceptics. You have to take everything with a pinch of salt and keep your eyes open. However, you can try to piece their story together and figure out if it's a lie or truth. Such skills are actually taught in the US and used in police forces, etc to determine if someone is lying or not. Some people call it instinct. However, a more statistical approach is to determine the crombach alpha of the various statements being made after grouping into relevant categories (or constructs). From there, you can test for the strength of the relationship. In this case, too high a crombach alpha (WITHIN the same category) can signify lying, because the story is too perfect. On the other hand, too low will also signify lying. Comparing it ACROSS categories, a lack of fit would signify lying and good fit will signify truth. Now, this approach is conceptual and if someone actually tried to do it this way, it'll be extremely tough and given the realities of the world, quite infeasible. My take on Eratat - They seem to be making statements that are true and honest in general. Statements made over time and across components (e.g. their stated strategy, their receivables story, their distributior story, their subsidizing story, the finanicals, their cashflow, their dividend policy, etc) seem to suggest that it is truthful... despite having some issues. The issues make it more believable in my opinion, although I'd rather have slightly more capable management to reduce these sources of friction.
( Believing their Books - The last point which I will bring up will be whether we can actually believe their books. Have they actually cooked up numbers, etc. This is normally INCREDIBLY difficult to determine. Fortunately, for Eratat, we have 2 big thing in our favor - (a) They're a newly listed company... which means that we can follow thie cash, etc since inception as a public listed company, and (b) They operate in a highly visible industry. If we only have 1 out of the 2 points, it would be difficult to ascertain whether their books are clean, because it would be very opague (over time, it's easier to hide sruff under years of information, and if there's no visibility of what hey do, then it's also easier to hide stuff). Either way, we know how much cash they've raised, and we can see where that cash is going into. Some of the forummers have done estimations, etc... and the overall feel is that the money can be tracked quite nicely. In addition, Eratat does provide with margin numbers, etc.. and those seem to make sense. They also do follow a dividend policy despite growing. This is in line with they approach of sustainable growth, and a signal to show that what they have on their balance sheet is real.
After doing (6,7 and , I've come to the conclusion that Eratat is a fundamental sound company that is very undervalued, and the risks of a default based on some endogenous event (such as corporate fraud) is relatively low.
That's my very hefty 2 cents. What's your take?

P/E and forward P/E are very simple minded ways to look for value in a stock.
If things were that simple, market forces would drive all the ‘smart’ money into stocks with lower P/Es and within no time the P/Es of every listed stock would be the same, achieving the ‘market equilibrium’ that such a simplistic perspective would demand.
The truth is, trailing P/E is about as important to a stock as your earning’s last year are to your entire lifetime of net worth, while forward P/E is about as important to a stock as your earnings next year are to your entire lifetime of net worth. The reality is that one year’s worth of earnings mean very little in the context of one’s lifetime earnings and net worth.
In actuality, the ‘smart’ money knows that the true value of a stock is contingent upon the expected or estimated value of all future earnings in the form of cash flows, based on what we can estimate or predict about the future based on the knowledge we currently have.
The value of a stock therefore fluctuates according to the smart money’s predictions of future cash flows, based on our knowledge of current market, industry and company-specific data, in accordance with micro and macro- economic events. As this data and these events develop and evolve over time, the predictions of a company’s future cash flows also fluctuate accordingly.
Therefore when one judges the value of a company such as Eratat, one cannot simply just look at trailing or forward P/E.
There is a reason why companies like China Animal Healthcare, incidentally also an ‘s-chip’ can trade at P/Es of 10-12 even at such uncertain times as now, while companies like Eratat trade at a P/E at merely 1.5. The reason for this must be that the ‘smart money’ thinks that China Animal Healthcare has far more certainty and likelihood of strong future cash flows than Eratat, and that its current cash flows are far more likely to be sustainable and even expanded than is the case with Eratat where the market feels there is far more uncertainty.
Many factors can account for this, such as the fact that the market feels that China Animal Healthcare is far more firmly established in an industry where there are far higher barriers to entry and that over the next 10 years or so, it is far more likely to be able to sustain and grow current cash flows than is Eratat. Note that the market/the smart money doesn’t claim to be certain about the future, its predictions are merely based on probabilities about the future based on current knowledge of what the future may be like. This may change over time, accounting for fluctuations in stock prices.
Ego, whether in the form of self-aggrandizement or an overly self-centered perspective, plays a big part in investment – people are always inclined to over-estimate themselves and place undue belief in the quality of their own judgments. We do this because it makes us feel better about ourselves and it boosts the ego.
The overly self-centered perspective is the same concept that drives the lottery into a profitable enterprise for its organizers, because everybody believes that they can be the ‘special one’. When analyzing stocks that they own and the glass is ‘half-empty’, retail investors are often inclined to look at only the positive side and see it as ‘half-full’, as stomaching a loss, especially a huge one, is often very difficult to take emotionally.
The problem is this psychology becomes addictive, and even as the negative signs start adding up and the glass becomes emptier with more and more negative news, many retail investors are inclined to twist things around and only look at the positives and still see the glass as half full, even when there isn’t much water left. Unfortunately no matter how positive your perspective, the price doesn’t lie, if there isn’t much water left, you won’t be able to sell it for anything much, even if you’re still looking at the glass as half full.
In stocks you always have to go by predictions and estimations of future cash flows, and as is the case with predictions, the element of probability always comes in. You can never be 100% sure about the future but based on current knowledge and trends, you can make reasonable estimates of the future, and you got to go by that.
It’s a probabilities game and everyone is playing it. If you wait until you’re 100% sure that a stock is  a bad investment because all the signs are absolutely negative, it probably won’t be worth anything much by then, you’ll simply be one of the unlucky few left with the baton. Waiting for crystal clarity is therefore a very risky game.
In the case of Eratat, the FY 11 estimated P/E may seem very attractive at 1.5, but it would be far too simple-minded to look at one year alone. There are many factors that may be giving cause for doubts about the value of cash flows.
Some examples are:
1.       Highly competitive market with low barriers to entry, including many global fashion brands entering the market in China to compete. As the Chinese middle class grows and becomes more affluent, will they prefer foreign/global brands just consumers in many developed Asian cities?
2.       Extremely high working capital requirements with no signs of going down. Even if there is demand for their goods from distributors, will they be able to raise sales without raising cash again through diluting shares?
3.       Decreasing number of distributors. Were the distributors who left unable to make enough from selling Eratat products?
4.       Initially, growing receivables to a huge portion of NAV to help distributors renovate and directly own their stores because the management claimed they did not want to compromise on profits by offering subsidies. Now they say they’ll offer subsidies to help them renovate their stores. Contradicting strategies? Endless concessions to distributors? Are the distributors holding all the cards over Eratat because Eratat products are not selling well enough for them to go all out on their own unless they are offered many concessions?
5.       Controlling shareholders sold entire stake roughly 1 year after listing. Although some shares went to the chairman, the floating % increased significantly. Classic case of hit-and-run after IPO?
6.       We already know that FY2012 earnings are very likely to decrease due to decreased order book. How expensive will the subsidies be? Given 1000 stores and a subsidy of 50k per store, the cost would be 50 million, 80% of Eratat’s current market cap. Even with a subsidy of 20k per store, the cost would be 20 million, 33% of Eratat’s current market cap. How much damage will this do to earnings and Net Asset Value?
7. If the management felt their shares were undervalued, why did they dilute shares by 15% at a P/E of merely 3 even though they would still have had over 100 million in cash without the placement, after fulfilling 2H2011 orderbook? Very strange.
These are some of the factors that may be affecting the ‘smart money’s’ valuation of future cash flows, resulting in a present P/E of merely 1.5. Of course, market, industry and company-specific factors could evolve over time and change the ‘smart money’s’ valuation of their future cash flows, but it’s all a probabilities game. How much are you willing to bet on that based on what you know?
If you wait until it’s 100% positive or 100% negative, the stock will either be too expensive to buy or too cheap to sell by then.
Right now based on the information I have based on the likelihood of future cash flows, I would rather place my money elsewhere. 

<continued from posting above>

5. Your point on 5 is irrelevant. I believed another forummer had brought up the point about how initial investors do cash out and realize gain, and there's nothing wrong with that. Nothing suspicious to be honest. In fact, since the company had not collapsed, the test of time has supported that there's nothing suspicious about it. In addition, additional investors had entered, and this usually means due diligience being made at that point of time, which adds an additional layer of safety.

You also make the big mistake of treating an endogenous variable as an exogenous variable, as well as, use ex post information in an ex-ante manner. What this means is that you treat the controlling stakeholders as if they know what the future would be like, and so when they cash out, it makes no sense... given that the company is doing well today. Apparently, you believe them to be god-like and infallable. Your conclusions are thus based on an ex-post analysis when dealing with ex-ante facts (if you don't understand the terminology, google it... sorry. It's latin, but commonly used).

Endogenous variables are choice variables compared to exogenous variables, which are random-like variables. Either way, mistreatment of the analysis means that your conclusions cannot be trusted. (Support - Endogenity versus Exogeneity, Ex-post versus Ex-Ante, the concept of risk-return from the perspective of investors, venture capitalists, etc)

6. You make it cound like Eratat is in the business to help their distributors to succeed at their expense. You also base your guessimate on figures which are drawn out of nowhere. You once again treat endogenous variables as exogenous variables. There's so many issues with your statements.

Firstly, you conclude that FY2012 earnings is very likely to decrease... well, I don't necesarily disagree with you. However, earnings is a function of many things - product composition, margins on various product types, cost control, etc. As such, I don't really think your statement has any real meaning.

So what if earnings fall... to what 6 cents? 7 cents? So what if they decide to consolidate? Does that make Eratat expensive? ... with a share price of 12 cents at the moment? I believe you made a moot point there.

With respect to your guessimates, I'm not even going to bother to challange your numbers because they clearly are nonsensical. Why would a company the size of Eratat want to give away 50 million of subsidies when that's their worth? Either way, you should remember that Eratat's mangement make their money by ensuring the well being of the company, and not the well being of their distributors.

They might want to ensure distributor success because there is a correlation between the success of both entity types... but that should be about it. Eratat is making a CHOICE decision on the subsidies (endogenous). Don't treat it as exogenous and throw in nonsense figures. (Support - Self interest, endogenity versus exogeneity, psychological foundations, network theory, basic valuation techniques based on corporate finance valuations, not investment valuations, governance mechanisms)

7. This is one question which I feel I cannot explain. I totally agree with you, and thought that they should not have done it. When they first announced it, I was very unhappy with it because I thought that there were selling it at a discount that was not required.

However, after following the forums and seeing how sceptics can trash valuations based on very little foundations, and after thinking about it for some time... I'm actually ok with it. If you look at it now, wouldn't it seem like they made a great move? I mean, P/E is less than 2 now, and when they did that, it was 3. However, one cannot look at it that way.

Otherwise, it would be doing an ex-post analysis on an ex-ante situation. What I can guess using an ex-ante analysis, was that management felt that by having strategic investors, they could potentially tap into new resource types (possibly informational resources, network related resources) or gain a sense of legitimacy and credibility by having institutional investors. In addtion, management have shown a lot of signals and focus on good corporate governance.

The addition of institutional investors acts as a governance mechanism because of ownership reasons.

Perhaps they felt that these gains will outweigh the costs or discount involved. After all, as a small cap firm, we all know that for returns to investors to materialize (i.e. to increase share price), you need to get the attention of the market... otherwise, you'll always be overlooked and under-appreciated. (Support - Signal theory, institutional theory, corporate governance drivers, network theory)

Don't assume that the "smart money" is causing current valuations to be true. the semi-strong market hypothesis is almost useless (but you should still use it smartly ) when it comes to small caps... because of many reasons (the main ones being covered in my earlier post). To do so would contradict many investment philosophies - wuch as contarian investing and value investing. I wonder how Warren Buffet would react if you think that the market is always right with valuations? I agree with following the smart money... the only difference is that your definition of "smart money" seems to be based on proxy variables - i.e. the market.

My definition of smart money is based on fundamentals. i only use proxis when they're good and accurately represent the fundamentals. Many proxies don't do that. Basically, I understand the basis of your questions. There is logic behind them. However, we're on a different paradigm. All I can say is "try to look deeper" for the meaning, the fundamentals behind the observations. Cheers