Tan Chong International - Deep Value

Weekend research, for comments and feedback please.

Tan Chong International is a distributor of motor and heavy commercial vehicles across various countries in Asia. The company is the exclusive distributor for Nissan motor vehicles in Singapore and also the exclusive distributor for Subaru motor vehicles in Singapore, Hong Kong, Taiwan, certain other ASEAN countries and certain provinces in PRC. Given majority family ownership and low trading liquidity, the company has been ignored by the market with no sell-side coverage. Trading at the current 0.4x P/B, we believe the company is significantly undervalued for the following reasons:
- Solid book assets with value held in liquid cash and securities exceeding current trading value
- Near-term catalyst in Singapore as the local market enters a cyclical upturn with significant number of vehicle quota license due to expire
- Strong management with a long-term view to business development and skin in the game (majority shareholders) brings greater comfort that company can continue compounding equity at ~10% per annum rate achieved since 2000. As such, even if P/B ratio does not improve from the current 0.4x, we can get a ~10% p.a. return assuming management continues to compound book value at the historical rate
- Strong 2015 interim results provide more evidence of strong underlying business across multiple markets, further highlighting irrational market valuation.

Assuming entry at current price of HK$2.48/share (As of 19 Sep 2015), we are looking at a potential 69% return with an intrinsic value of HK$4.20/share. There is thus sufficient margin of safety and low risk of permanent loss of capital. We provide further elaboration below.

Solid book value with cash and securities value exceeding current trading value
As of June 2015, Tan Chong International’s cash stood at HK$1.44/share while available for sale securities was HK$1.60/share. Company owns a 1.4% stake in Fuji Heavy Industries, the parent company of Subaru, which accounts for majority of the AFS value. Given the strategic nature of the investment holdings, it is unlikely that Tan Chong will ever sell the stake so long they remain one of Subaru’s key distribution partners in Asia. However, not selling the stake does not serve as an adequate reason for massively discounting the value of the stake, especially if the stake is not currently overvalued. We will tackle the question of the stake’s valuation in a later part of the writeup and assume for a moment that the valuation is fair. Cash and AFS will then add up to be ~HK$3.04/share which is already a premium of >20% compared to the company’s current trading price of HK$2.51/share (Closing price as of 16 Sep 2015).

The current price will also imply that we are getting all of its vehicle distribution business across ASEAN (2014 revenue of HK$7.4b), its existing property assets (more than HK$3b of freehold land and buildings) and a 51% stake in subsidiary - Zero logistics (The largest car transporter in Japan with a listed market cap of ~HK$1b) for free. The natural question that arise is that given majority family ownership (>70% family owned), there is little incentive for the management owners to unlock the balance sheet value (as evident by the huge cash pile). While such risk exists, we believe the upcoming cyclical upturn in the Singapore market as a result of large pool of vehicle quota license expiration will be the catalyst to alert investors of the huge latent value in the company.

Near-term catalyst from Singapore market cyclical upturn
Before delving deeper on the catalyst, it might be worthwhile to provide some background on Singapore’s vehicle quota system. The government uses the Certificate of Entitlement (COE), which is a quota license granting the holder the right to own and use a vehicle in Singapore for a period of 10 years, to control the vehicle population in the country. The government released a bumper crop of vehicle quota from 2004 – 2008 before starting to tighten the supply in 2009. For comparison, the bumper crop years averaged more than 100k car registration p.a. vs. the trough year average of ~27k car registration p.a. 2015 will be the first year where the bumper crop vehicle quota starts expiring. With the government committed to allowing vehicle population growth of ~2% each year, all of the expiring quota will be released back to the market, triggering the start of another bumper vehicle replacement cycle. (Consumers typically scrap their vehicles and purchase new ones when their COE expires at the end of 10 years and demand has never been as issue, meaning we can be certain all expiring quotas will translate into new vehicle sales)

Coming back to the implications for Tan Chong International, Singapore vehicle distribution accounted for between 85 – 88% of total company revenue during the bumper vehicle license quota years from 2004 – 2008 (Peak year revenue reached a high of HK$5.3b in 2005). This has since declined to trough revenue of HK$1.4b in 2013, accounting for only 15% of total company revenues. Taking into consideration the upcoming bumper quote expiration, we made the following assumptions regarding Singapore vehicle sales for 2016:
- Total vehicle quota expiring to approximate bumper year average of 105k p.a.
- All expired quota are released back to the market (as per government indication)
- Tan Chong distributed Nissan and Subaru market share remain constant to 2014 share of 6.3% and 2.2% respectively (Total vehicle sold est. at 12,355 in 2016, vs. peak of 22,077 achieved in 2005)
- Blended value per vehicle sold to remain constant to 2014 (meaning no mix change)
Singapore total vehicle distribution revenue is then expected to more than double to HK$4.7b vs. HK$2.1b in 2014. Assuming constant EBITDA margin of 10.8% (2014), Singapore vehicle distribution will contribute HK$500m of EBITDA for 2016, a more than 100% increase from HK$225m achieved in 2014 and more than total group EBITDA contribution from vehicle distribution across all regions in 2014. Surge in sales is also likely trigger news reports and catalyze greater investor interest in the company.

Strong management team with long-term view on business development
Company is chaired by Tan Eng Soon, whose grandfather founded the business in the 1950s and run by Managing Director Joseph Ong. Both have been with the business for more than 20 years and were responsible for growing the business from a HK$3b company in 1999 to a HK$10b company today. The company also has next generation leader in Glenn Tan (37), son of Tan Eng Soon, who has been with the business since 2001. Glenn has since established an impressive track record, building the Motor Image business (Subsidiary that distributes Subaru) from scratch having been appointed chief executive in 2003. Back then, Motor Image was selling 1,200 cars annually vs. more than 15,000 cars across 10 different markets by 2012. The company also acquired the 1.4% stake in Fuji Heavy Industries (Subaru parent) as a commitment to long-term partnership and a hedge to protect against potential change in exclusive distributorship structure, yet participate in the growth of the parent company in other markets.

Today, the management team continues to build out its business with an eye to the future, establishing a complete knock down factory JV with Fuji Heavy to assemble Subaru vehicles in Malaysia (this is to take advantage of the fact that ASEAN countries have zero import duties for vehicles assembled in any ASEAN country). While also increasing its stake in Zero Logistics (the largest vehicle transportation company in Japan) to better facilitate its supply chain in expanding its vehicle distribution business in ASEAN.

Solid 2015 interim results provide evidence of improvement across various markets
Total vehicle distribution business revenue grew by 19% yoy in 1H 2015, driven by 43% increase in revenue in Singapore and 40% increase in Thailand. Overall vehicle unit sales increased from 11,568 to 14,725 in 1H 2015 with double digit sales volume increase across Nissan, Subaru and Fuso (Heavy commercial vehicle) brands. It is clear that Singapore market upcycle has already started, while Thailand market is showing signs of recovery from 2014 when overall sales were disrupted by political crisis.

Valuation

1.4% stake in Fuji Heavy Industry (Subaru)
Shares in Fuji Heavy have gone on a tremendous run since 2012, increasing from a price of just under JPY700 to JPY4,386 as of Sep 18 close. This partly coincided with the expansion of discount to book value for Tan Chong International, suggesting that the market has discounted the value appreciation that came for the strategic stake. This is irrational in our opinion. We believe that the only rational reason to discount stake’s value is if the stake is currently being overvalued by the market which does not appear to be the case upon evaluating Fuji Heavy’ business.

For brief background, Fuji Heavy derives >90% of its annual revenue from the design, manufacture and sale of Subaru vehicles with the remaining coming from its legacy defense business and distribution of industrial engines. The Subaru brand’s key differentiating factors are its usage of horizontally opposed engine (Porsche is the only other automaker to adopt this engine which is perfectly symmetrical and provides for a well-balanced vehicle that allows quick handling response and better cornering), all-wheel drive (AWD) and safety features.

The company’s recent year price growth has been largely driven by its 5x earnings increase from JPY50b in FY11 to JPY260b in FY15. Growth came on the back of strong sales growth with total units sold growing from 657k (FY11) to 911k (FY15), improvement in operating margins from 5.3% (FY11) to 14.7% (FY15) and currency tailwind from Yen depreciation. Much of the improvement has been a result of continued focus on the US market, where the company developed its core models of Legacy/Outback, Forester and Impreza to cater to a niche segment of the market. Overall, US accounted for 58% of total unit sales with Subaru’s market share increasing to 3.2% YTD vs. ~2% in 2011 (98% of Subaru’s total unit sales growth from FY11 to FY15 is driven by increase in US market). With the US average vehicle age rising to 11.4 years and tailwind from increased consumer spending and low fuel prices, demand for replacement vehicles will likely remain strong going forward (not forgetting that Subaru is still facing issues with supply constraint in the US on strong demand).

From a valuation standpoint, Fuji Heavy is trading at a trailing P/E of 11.6x (As of 19 Sep 2015) vs. 5Y average of 13.1x and 9.5x on a forward basis vs. 5Y average of 10.2x, which is reasonable and nothing close to being frothy in our opinion. If we look at analyst consensus target price (not to say that they are right but just to get an indication of valuation range), analyst are forecasting hi/lo/median of JPY6,200/3,500/5,200. If we take the most conservative estimate of valuation of JPY3,500, the value of Tan Chong’s 1.4% stake will be HK$1.23/share.

Core business valuation
For the core business of vehicle distribution, some property rentals and logistics (Zero logistics), we have adopted EV/EBITDA approach with the following assumptions:
- Forward EV/EBITDA ratio of 6.4x based on median of peer 10Y average (Peer list include China and Asia vehicle distribution companies)
- Assume 1H15 EBITDA pro-rated to full year, adjusted for incremental EBITDA contribution from Singapore due to start of bumper cycle (this is conservative as we did not include potential incremental EBITDA from Thailand in 2H15 despite 1H15 results suggesting upturn of business performance partly driven by launch of new Fuso product range and partly driven by normalization from political crisis in 2014)
- Assume zero gains from revaluation of investment properties
- Full year 2015 EBITDA estimated to be HK$1.1b vs HK$1.5b in 2014 (includes revaluation gains)
Estimated EV is thus HK$7.2b and equity is HK$6.0b after subtracting net debt of HK$1.2b. This equates value of core business to HK$2.97/share.

Overall
Value of 1.4% stake in Fuji Heavy and core business thus totals to HK$4.20/share, representing a premium of 69% vs. current trading price of HK$2.48/share.

Why should we not invest in Tan Chong International?

- Declines in other markets could offset gains from Singapore upcycle
Biggest concern will be the China market given its much reported slowdown. However, it only contributed HK$31.2m in 2014 representing 2% of total EBITDA attained in 2014

- Singapore upcycle might bring increase domestic competition, loss of market share or lower margins that does not necessarily translate to better earnings
Singapore car distribution market is mature; we do not believe upcycle will trigger increased discounting/competitive action any more so than in a downcycle. In fact, one can argue that in an upcycle when there is more business for everyone, there will be lesser need for competitive actions to fight for customers. Strong recent sales performance by Nissan also provides more comfort (Nissan accounted for highest SUV and crossover sales in 1H15 and Subaru second. This highlights the popularity of Nissan/Subaru new product lines which has help the company improve market share from 3.7% in 2013 to 8.5% in 2014)

- Market downturn could see Fuji Heavy stake suffer revaluation losses that depress net income. While the market did not give credit to revaluation gain from the stake, we cannot be sure the market will not penalize the company if it ends up loss making on potential revaluation losses
We have little defense for this one as there is no clear answer and the risk of a market downturn is real (one who follows recent news will see the increased volatility in global markets and concern over emerging markets). However, what gives us comfort is 1) Singapore market sales will see little impact from downturn given how expiring COE supply is always mopped up by demand 2) Fundamentals of Fuji Heavy likely to be intact given fair valuation and management’s conservative expansion plan meaning that the company will not be caught out by sudden fall in demand (low risk of big capacity coming online coinciding with sharp fall in demand due to downturn) 3) Management team’s track record suggest that they will continue to make long-term business decision independent of short term market fluctuations

- Potential privatization of company at current undervalued market price
Company has been listed for more than 15 years and has no prior history of exploiting minority shareholders (No dilutive share issuance or excessively high management salary for example)

- Potential removal of exclusive distributorship by either Nissan or Subaru
Company has established long-term relationships with both brands suggest low likelihood of change. Furthermore, company owns equity stake in Subaru which further demonstrates commitment to partnership. Subaru itself has also been cited that ASEAN is not core of its expansion strategy, thus making Tan Chong an even more valuable partner in helping to drive growth in that region

Conclusion
As evident by the long list of why we should not invest in Tan Chong International, this is by no means a simple no brainer and is a company we have revisited multiple times before deciding on an investment. Ultimately, after spending considerable amount of time inverting our investment thesis, we were convinced that its deep discount to a solid book provides sufficient margin of safety to protect us against most of the risks cited above. Furthermore, this is a deep value counter with a ready catalyst that is already happening in the form of Singapore bumper COE cycle and some optionality for further improvement in the Thailand market. Coupled with a vested management team with a solid track record of building long-term value, we see little risk of permanent loss of capital and a good upside potential of 69% at current price of HK$2.48/share (IV of HK$4.20/share).

Disclaimer:
We are vested in the above company. The write-up is meant for information only and should not be taken as investment advice. Please perform your own diligence before making any investment decisions.

Sources:
- Company filings
- Capital IQ
- www.stcars.sg/guides-articles/yes-my-fathers-the-boss-87994
- www.lta.gov.sg/content/dam/ltaweb/corp/P...1_New_Reg_by_COE.pdf
- www.lta.gov.sg/content/dam/ltaweb/corp/P...New_Cars_by_make.pdf

Thank you for your long post. Regarding "Value of 1.4% stake in Fuji Heavy and core business thus totals to HK$4.20/share, representing a premium of 69% vs. current trading price of HK$2.48/share" --- I have a question.

Does your valuation look at current state of things, or does it look forward to 2016 and 2017 which will see a subst. increase in contribution from the COE upcycle?

Hi Gal,

The 4.20 is arrived based on forward 2015 estimated EBITDA for Tan Chong's core business which does not fully incorporate benefit from full peak year cycle. But the point I am trying to make is without incorporating the full peak cycle benefit, the company is already significantly undervalued. But that of course is still assuming no significant decline experienced in the other markets or its logistics business.

At the end of the day, this counter is deeply undervalued, risk is a value trap which some other folks at valuebuddies have highlighted. But catalyst in the form of bumper cycle can potentially lift interest and unlock some latent value in the company.

TQ.
I read your citing 7% div yield for TCIL. Shouldn't it be 4+%? In FY 2014, the company paid 10.5 cents HK, which was the same as in FY13. Thus the running yield is 4.25% on current shre price of 2.47.

Sorry i'm not sure if I cited any 7% dividend yield.

If you were referring to the valuebuddy forum post. 7% is the 10Y compounded annual return. Meaning returns from capital gains + dividend paidout each year assuming you bought and held since 10 years ago. This is to highlight that in the long run, returns tends towards the return on equity the business generates.

re "Meaning returns from capital gains + dividend paidout each year assuming you bought and held since 10 years ago."

This applies if you have been holding it all these years but for new entrants, the div yield is about 4% (based on the past 3 years' payout) and uncertain capital gains. I would venture that the div yield in the next 2 or 3 years would go up as TCIL's earnings rise with the COE cycle.