AI #18: The hidden Asia tech-stock that’s critical to Big Oil

I’ve been looking to invest in an Asian tech stock for some months now. I must have scoured through a few kilograms of company reports. And when I was last in Asia before Christmas, it was one of the main questions in almost every discussion I had.

I've been looking to invest in an Asian tech stock for some months now. I must have scoured through a few kilograms of company reports. And when I was last in Asia before Christmas, it was one of the main questions in almost every discussion I had. Very few firms can scale up like a successful tech business, making it one of the best growth areas around.

But there is a very good reason why I haven't added a clutch of decent tech stocks to the Asia Investor portfolio already. It is very hard to find the right one at the right price.

That there is huge potential for growth in Asian tech is undeniable: a wealthier population will mean more gadget-buying, more use of the internet, more shopping and other transactions taking place online.

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However, the problem with is that it's a fiercely competitive sector, needing constant innovation and investment to stay on top. It's also glamorous and very high profile, meaning that companies often float at steep valuations and then just get more expensive.

For example, China's Tencent which runs internet portals, online messaging and games - trades on a trailing p/e of 42. Baidu, the dominant local search engine, is on a p/e of 84. Business-to-business trading portal Alibaba is on 53, while travel site Ctrip is on 39.

Why glamour won't do you any good

Instead, when I look for software and technology investments, I generally look for firms that are much less glamorous operating in industries that most people don't even think about. They're usually far cheaper. And many of them have very specialised expertise or a tied-in customer base that makes it much harder for them to be overtaken in the way that former darlings such as Aol, Yahoo and Palm were.

We've already got one such stock in the Asia Investor portfolio in Silverlake Axis, which is a leading supplier of systems to banks and financial institutions in Southeast Asia. And the stock I'm going to look at today is equally specialised. Much of its revenue comes from a niche that most of you have probably never thought about.

In fact, until a few years ago I only have a limited amount of knowledge of this industry myself. Somehow I had ended up at a three-day conference in Florida dedicated to the subject. And to be honest, it wasn't the most exciting trip I've ever made.

But I absorbed enough that when I first saw what my new recommendation, I was instantly interested

Today I also have a run of company results for this quarter: decent news from Silverlake Axis, very strong numbers for Hsu Fu Chi and disappointing ones for Etika. You can find these updates at the end of the letter.

But first the new recommendation a software stock that I think could make you 130% from here.

The unglamorous software that's critical to Big Oil

Singapore's CSE Global is one of the world's leading systems integrators. In a nutshell, this means that it provides software and hardware for linking together existing systems that were not designed to work together in the first place.

For example, in an oil refinery, the plant may have been built in stages, with each part controlled by a different software system from the lighting to the cooling systems and the controls on the distillation chambers.

The systems integrator brings all these together, displaying the output from each system within one interface to make it easier for the control room to keep track of what's going on.

The data collected can be saved into a database and fed into other, high-level ones to let management optimise their product between different plants, model the firm's financial position and outlook with real-time data and much more. This can obviously lead to huge improvements in areas such as safety and efficiency.

I've used the example of an oil refinery above, but this could apply to many different situation, industrial and otherwise. In fact, Silverlake Axis clearly has to perform some systems integration between its own solutions and others systems in the financial sector, although it's not predominately a systems integrator.

CSE Global is, though. The firm provides a range of control & automation solutions along the lines described above for refineries, oil rigs, pipelines and other facilities, as well as installing telecoms and surveillance systems for the energy industry. It also operates in healthcare, mostly in the UK, where the integration is about linking together a patient's case notes, appointments, treatment plans and so on. Smaller lines include electrical engineering (designed, engineering and supplying protection, conversion and control systems, mostly to the energy and mining industries) and thermal engineering (industrial furnace systems).

Oil and gas is the largest single division, while healthcare is a fast-growing contributor. Although a Singapore-listed firm, the vast majority of its revenues come from outside the city-state. Revenues are roughly equally split between Asia-Pacific, the Americas and Europe, Middle East & Africa.

Profits have been growing 33% a year

Despite the specialised nature of its business, CSE is no start-up. It's a very established and successful business with a wide client list of oil majors and large contractors.

Thanks to a combination of strong organic growth and smart acquisitions, revenues grew at an average of 16% per year over the last 10 years and 11% per year over the last five, even with the global crisis hitting investment spending in 2008-2009. Net profits have averaged even stronger annual growth of 33% and 18.5% over the respective periods.

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The order book stood at S$415.3m at end September 2010. Energy, mining and infrastructure accounted for around 68% of this, and prospects for adding to this look good as investment in natural resources continues to ramp up: management seem to be particularly excited by opportunities from Australia's huge liquefied natural gas (LNG) projects.

But healthcare is likely to grow even faster in the near term. The current UK government's decision to tear up its predecessor's National Programme for IT in the NHS and devolve more responsibility for implementing new systems to local trusts should provide plenty of potential for CSE to win more business for its systems; it's already well established in many areas through a tie-up with BT, one of the two main providers on the current programme.

Overall, I think CSE could double in size over the next five years and on a p/e of just 11.5 times my estimated earnings for FY2011, it looks cheap given its potential. Writing the systems to control oil wells or store patient records may not be at all glamorous, and this stock isn't going to double overnight. But I think there's an excellent chance that it could deliver far better returns than more high profile Chinese internet plays over the long run.

It is also has the kind of structure that I look for in an Asia Investor stock

A long history and a wide shareholder base

One of the things that I look for see in an Asia Investor stock is at least a few years' profitable track record I'm not keen on profitless start-ups (the only real exception at present is Eredene, which is more of an investment vehicle). CSE has a reassuringly long history; it began trading in 1985 as part of Singapore Technologies, a government-controlled defence and engineering group. It was taken private in a management buy-out in 1997 and listed in the Singapore Stock Exchange in 1999.

Tan Mok Koon, who led the MBO, remains managing director and the largest single shareholder, with a stake of 13%. Apart from the large positions held by institutional shareholders that you can see in the table below, there are also a few others with smaller holdings, including the Scottish Oriental Smaller Companies investment trust, a fund I've often featured in MoneyWeek Asia. This makes CSE rather different to most Asia Investor recommendation, where there might be just a couple of specialist funds invested.

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This wide ownership provides us with more protection than usual against the possibility of minority shareholders being ripped off. The board also has plenty of experienced directors who hold reputable positions elsewhere. So unusually, our main concern is not that we might be buying into a company with governance issues, but rather that we might be looking at one that's already too well known and might be running out of upside.

However, CSE's valuation is still very reasonable given its growth potential, while a market cap of S$690m means that it's still too small to interest most funds. So I don't think this is yet an overexposed story.

Free float is around 35% based on Bloomberg data, while average daily volume over the past year has been around 1.5 million. For the purposes of any private investor, the stock is highly liquid and you will have no trouble taking a position of any size.

Three risks to remember

In addition to the usual risks of Asia Investor recommendations, I would stress three specific factors to be aware of with CSE:

First, CSE's revenues depend on oil and gas firms to invest in new projects or modernising old systems. A collapse in the oil price would probably lead to far fewer contract wins for the firm. I don't believe that this scenario is likely; however, more shocks to the global financial system perhaps caused by issues such as Eurozone defaults could lead to credit becoming harder to get and force projects to be postponed again.

Second, CSE has grown partly through making good acquisitions and integrating them well. It seems likely that management will look to acquire more businesses in future and there is always a risk that these don't go so smoothly. However, the firm's track record so far is encouraging on this score.

Third, CSE is showing good levels of profitability at present; its return on equity is typically in the high twenties to mid thirties. It has competition from firms such as Swiss-Swedish power automation specialist ABB and US engineering conglomerate Honeywell, but clearly competition is not cutthroat.

So there is a possibility that this level of profitability could attract aggressive new entrants, perhaps from India's impressive IT sector or China's growing one. Given that many of the areas that CSE operates in are mission critical systems where doing the job properly is vital, CSE's track record, experience and reputation may help to protect it from this. But it is a possibility that we'll have to keep an eye on.

CSE is still much cheaper than its peers

The table below shows recent results and my estimates for CSE. This stock is relatively well covered Bloomberg shows five analysts following it and my estimates are rather more conservative than the consensus, which is for 11 cents in the year just completed and 13.6 cents in FY2011.

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On its current share price, CSE trades on a p/e of just 11.50 times my FY2011E (since FY2010 is now over, it makes little sense to focus on it). The company doesn't have an explicit dividend policy yet, but seems to be targeting a payout of around 40% of earnings or just under. Thus I'd estimate it will pay out around 2.9% this year on the current price (dividends are typically paid just once a year, announced at the final results).

Checking the balance sheet for any red flags, CSE appears to be in sound shape for growth. The current ratio - current assets to current liabilities, a measure of short-term liquidity stood at a solid 1.97 as at end September. Borrowings had began to mount at the end of 2009 as a result of acquisitions, but cashflow from operations and the sale of treasury shares has helped to pare this; net debt to equity was down to 7.4% at end September from 38.6% nine months before.

Valuation-wise, CSE has traded on a p/e above 15 in the past, and even above 20 at the peak of the market in 2007. The systems integrator peer group is not a homogeneous one, but Bloomberg data suggests a median p/e of just under 20.

That seems a little high to my mind, but I think a p/e of 15 is justifiable given CSE's position, track record and prospects: over the next five years or less, I think earnings could double. And as the business grows and the stock becomes large enough to interest more institutions, I would expect it to rerate towards that multiple.

Thus I think we could be looking at a potential gain in the order of 130% or so in the medium term, although I would expect this to be steady appreciation rather than an overnight jump.

For a starting point, I'm going to value CSE initially on around 15 times my FY2011E, discounted back by one year at my minimum target rate of return of 15%. This gives us a buy limit of up to S$1.53 now.


Buy: CSE Global

Ticker: CSE (Bloomberg), CSES (Reuters), 544 (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$690m

Bid/mid/offer prices: S$1.35/S$1.35/S$1.36

Buy limit: S$1.53

52-week low/high: S$0.82/S$1.43

Lot size: 1,000 (most brokers will only trade the shares in multiples of this amount)

ISA eligible: Yes (broker permitting)

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Let's turn now to the updates

A 59% jump in revenue for Silverlake Axis

Results season is now in full swing and I'm expecting most of our stocks to have their updates out in time for my next full quarterly portfolio review at the beginning of March. But with three already out in the last couple of days, let's take a quick look at them.

Silverlake Axis turned in a decent set of second half results, posting a 59% increase in revenue and a 48% increase in net income for the first six months of the current year. The effects of its S$210m new contract wins in 2010 are now starting to come through. Management continue to sound optimistic about the outlook, reporting growing interest from its core clientele of banks and financial institutions, while also looking at opportunities to supply IT solutions to conglomerates and retail groups.

Overall, prospects here continue to look encouraging for growth. And with relatively low capital needs, Silverlake can be a respectable dividend payer at the same time; the firm announced a second interim dividend of 0.3 cents, to add to the 0.2 cents declared in the first quarter a payout ratio of around 50%.

I'll update my numbers fully in my review, but for now, Silverlake remains a BUY up to a limit of S$0.4.

Very disappointing numbers from Etika

First quarter results from Etika, the Malaysian dairy and food group we recently added to the portfolio were less encouraging in fact, they were pretty shocking. The company posted revenue growth of 26% year-on-year, ahead of my expectations, yet net profit plunged by 78%.

What happened? Digging into the detail, there were two main factors. First, rising commodity prices sugar, milk, palm oil and tin (for cans) clobbered margins. Cost of goods sold rose 44%, pulling down the gross margin from 29% in the same period last year to 19% this year. Separately, expenses also rose sharply as a result of foreign exchange effects and expensing employee stock options; this added around 17% to operating expenses on top of increases in admin, selling and distribution expenses that would be expected in line with the rise in revenue.

I'm not so concerned about the second problem, since this doesn't represent direct operational issues notional forex gains and losses frequently reverse from quarter to quarter. But the commodity price issue is much worse than I expected. I noted in my original report that commodity prices could be a headwind in the near future, and in my estimates had allowed for margins to slip five percentage points or so but Etika has lost twice that.

It looks as if management's relatively upbeat stance towards the end of last year on their ability to pass on price increases to customers may have been optimistic. Reading between the lines, I suspect that trying to do this is having to take second place to building and defending market share. That may not be a bad thing in the long run, but it doesn't make for pleasing earnings in the short term.

I still think Etika is an extremely interesting medium-term story with great growth potential. I'm certainly not going to write it off on the basis of a poor quarter and I think there's every prospect that the second half of the year will be much better. But while a bit of short-term earnings volatility doesn't worry me too much, I need to look into this carefully and try to make sure that management hasn't overstretched integrating its new acquisitions and taken its eye off the core business.

So I'm moving Etika to HOLD while I review the numbers and try to get some answers from management. I'll update you in two weeks, or sooner if I feel we need to take urgent action (which I believe is unlikely).

A storming performance from Hsu Fu Chi

Etika's struggle to pass on costs reinforces the distinction between a decent commodity business and a genuine dominant consumer firm. On the latter score, we saw that our Hong Kong soymilk superbrand Vitasoy seemed to be coping okay in its latest results, but I was more concerned about our confectionary group Hsu Fu Chi, where underlying margins seemed to be slipping a little.

Well, Hsu Fu Chi just seems to have put those concerns to rest with some spectacular second half results. The company reported a 41% increase in revenues and while margins suffered a little cost of goods sold was up 48% - it still managed a 43% increase in net profit. That's a first half earnings per share of 59 renminbi cents, versus my full year estimate of 79. The fact that Chinese New Year Hsu Fu Chi's peak sales season fell earlier this year helped, but it's an impressive performance by any standards.

I'm increasingly enthusiastic about the potential of this firm, which I think has every prospect of being one of those stocks that you end up holding for a very long time. I'll do a fuller update in the next issue the results only came out last night so I haven't had time to rework my numbers fully yet. But my tentative revised estimate for this year is around 95 renminbi cents per share; on a p/e of 20, that points to a buy limit of S$3.7, moving the stock back to a BUY.

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Cris Sholto Heaton

ASIA Investor

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Five Year Performance Of Buys Updated This Week
Year200620072008200920102011 (to date)
CSE Global+84.17%+40.63%-68.75%+130.67%+50.29%+4.65%
Hsu Fu Chi (Dec 2006)+35.29%-6.09%-21.30%+152.94%+95.93%-2.72%
Silverlake Axis+165.45%-17.81%-85%+261.11%+7.77%-2.90%
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ASIA Investor Portfolio
StatusStockTickerExchangeAI DateAI Issue No.Offer Price ThenBid Price NowChange %Buy Limit
BuyEredene CapitalERELondon26/05/10Report18.5p16.75p-9.46%22p
BuySilverlake AxisSILV, SLVX, 5CPSingapore26/05/10ReportS$0.29S$0.33515.52%S$0.4
BuyHsu Fu ChiHFCI, HSFU, AS5Singapore08/06/10#1S$2.32S$3.5050.86%S$3.7
BuyVitasoy345Hong Kong22/06/10#2HK$6.00HK$6.7612.76%HK$7.00
HoldARA Asset ManagementARA, ARAM, D1RSingapore06/07/10#3S$1.09S$1.6450.46%S$1.47
BuyICICI BankIBNNew York20/07/10#4US$ 37.97US$46.1321.49%US$50.4
BuyPetra FoodsPETRA, PEFO, P34Singapore03/08/10#5S$1.44S$1.611.11%S$2.0
BuyXinhua Winshare Publishing and Media811Hong Kong20/08/2010#6HK$4.28HK$4.55.14%HK$5.00
BuyYHIYHI, YHII, Y08Singapore28/09/2010#8S$0.275S$0.31514.55%S$0.35
BuyFirst REITFIRT, FRET, AW9USingapore27/10/2010#10S$0.703*S$0.745.26%S$0.8
BuyBreadtalkBREAD, BRET, 5DASingapore26/11/2010#12S$0.63S$0.6757.14%S$0.72
HoldEtikaETK, ETIK, 5FRSingapore21/12/2010#14S$0.45S$0.39-13.33%UNDER REVIEW
BuyUni-President China220Hong Kong18/01/2011#16HK$4.32HK$4.24-1.85%HK$5.70
BuyCSE GlobalCSE, CSES, 544Singapore15/02/2011#18S$1.36S$1.35-0.74%S$1.53
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Average 13.04%

Prices as of 15/02/11

* Adjusted to assume take up of the five for four rights issue at S$0.5 announced in November 2010. First purchase price was S$0.955

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used to prepare this report:

CSE annual reports 1999-2009

CSE Q3 FY2010 results

CSE Q3 FY2010 results presentation

CIMB research report on CSE 02/12/2010

Silverlake Axis Q2 FY2011 results

Etika Q1 FY2011 results

Hsu Fu Chi Q2 FY2011 results

Data from Bloomberg