December Portfolio Update

It's been a while since my last portfolio update in April 2020 (You may read it here: Portfolio Update: Staying the Course). At that point of time, my portfolio was down approximately 15% YTD, while it has since recovered to a YTD performance of -6%. While this is nothing spectacular, especially with US indices hitting all time highs, relative to the Straits Times Index which is down approximately 13% YTD, at least there's some outperformance. Accordingly, I intend to allocate a higher percentage of my portfolio to international stocks, especially US/HK tech stocks. I believe that we're in a time when one cannot exclude having tech exposure in our portfolios, given how tech companies have expanded to becoming an integral part of our lives. Indeed, this represents a shift from my value/dividend seeking approach to investing, but I aim to build a balanced portfolio with exposure to both growth and value stocks. 

Here's my latest portfolio as of 11 Dec 2020:

Brief commentary:

DBS/SGX: Not much to elaborate on for these two, as my entry prices provide me with decent dividend yields. DBS and SGX have recently announced a partnership to launch a digital exchange, which could start trading next week. I believe that this is a step in the right direction, and it's good to see these companies embracing new developments in the market. 

SATS: I am still bullish on the medium term recovery of the aviation sector, thus I had averaged down at $2.84 in May. Given my first entry price of $4.49, my average price stands at $3.41. After the news of the vaccine, I had reduced half of my stake at $3.50, which on hindsight wasn't a good decision. I would be looking to increase my position again if the price weakens to the $3.50 level again. 

Do check out my articles on SATS here

CICT: Bought at $1.91 just before the merger. Might be looking to reduce my stake slightly after the strong performance recently, as I believe that retail and office properties still face headwinds. I think that the year end valuation of its properties may be a wake up call for investors - but who knows - valuations may surprisingly go up (similar to Lendlease's mid year asset valuations), as it is ultimately more of an art than science.

I wrote about CICT's valuations here: Should there be Concerns over Gearing and Asset Valuations? 

FPL, Singtel and Jumbo: Re-evaluating these laggards in my portfolio to determine whether to divest any of them. Was waiting for the announcement of Phase 3 to provide some upside for Jumbo, but this seems unlikely for this year.

Cisco: This is more of a value buy, as CSCO's valuations were attractive to me. I think a bright spot would be CSCO's Webex video conferencing platform. Video conferencing market leader Zoom has a market cap of 113B, while CSCO's Webex ranks third in terms of market share. CSCO has also been transforming from a primarily hardware based company to a software company.

Alibaba: New position in BABA at 264 USD. Decided to buy the US listed ADR instead of the HK traded one because of the smaller lot size. The HK listed stock has a minimum lot size of 100, which costs approximately 4.5k SGD per lot. Hence the US ADR gives me more flexibility. I believe that the setback from Ant Group's IPO has been overblown, and while regulatory risks remain a concern, it would not be in the interests of the Chinese regulators to limit BABA's growth, if it wants Chinese tech firms to compete globally against its US peers. Tencent similarly faced some crackdown in 2018, but it eventually blew over as well. Additionally, BABA's cloud computing business is also another gem. I feel that Chinese tech companies seldom get the same premium valuation multiples that their US peers enjoy, and BABA deserves to be the next trillion dollar company.

Chiasma: This is just a punt after reading this post on TTI's blog, and doing some additional research by reading sell side analyst reports. It's a biotech company that supposedly developed a new drug which has received FDA approval. The position represents a small percentage of my portfolio, and would not do too much damage even if thing go south. Will wait and see how this plays out. 

ETFs: My ETF positions are intended for buying and holding "forever", thus I am not concerned about the daily price movements of my ETFs. In fact, I don't even check the prices of my ETFs on a daily basis, unlike my other active positions. What matters more to me are the stream of dividends that these ETFs provide, and at a yield of 3 to 4%, I am satisfied with that. Compared with yields of <1% for government bonds, I believe that holding these ETFs make more sense to me. I reiterate that these represent excess cash that I do not need, thus I am indifferent to the price fluctuations. In the long term, I expect these to deliver capital appreciation, barring a situation of Japan's equity market in the late 1980s, where prices have not recaptured the highs since then.

Divestments: Between the last update and today, I divested Hanwell Holdings and MCT. I sold Hanwell at $0.19, only for it to run up strongly a few months later to $0.29. Again, not the best decision. Sold MCT at $1.91 earlier this year and replaced it with CICT a few months later, as I believe it provided a better risk/reward.  

That's all from me, thanks for reading. Wishing everyone a great 2021!

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

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CICT (SGX:C38U): Should there be Concerns over Gearing and Asset Valuations?

In March this year, I wrote about the possibility of REITs having to raise capital through rights issues if Covid-19 were to cause severe declines in asset valuations (What Happened to REITs during the GFC?). Eight months on, this has not occurred, and although I believe that the likelihood of this has diminished, we cannot completely ignore it. In October, I initiated a position in Capitaland Mall Trust (CMT) at a price of $1.91, which has now merged with Capitaland Commercial Trust (CCT) to form Capitaland Integrated Commercial Trust (CICT). As a shareholder, I was curious to assess the likelihood of CICT having to raise capital through a rights issue, by analysing its gearing ratio and asset valuations.

I have not ran the numbers to determine the gearing ratio of the merged entity, although Kah Kiat at Dr Wealth has calculated that the pro-forma gearing for CICT would be 38.3% post-merger. However, these figures were calculated based on the valuation of CMT’s and CCT’s assets as of 31 Dec 2019. Thus, it would be appropriate to note that as of 30 June 2020, CMT’s portfolio valuation has declined by around 2.7%, while CCT’s portfolio valuation has declined by 1.7% (refer to screenshots below). Thus, the gearing ratio of the merged entity would be slightly higher than the 38.3% calculated as of Jan 2020.

Given that we’re in the midst of a global pandemic that has resulted in an economic fallout rivalling the Global Financial Crisis in 2009, I decided to take a look into history to understand how CMT’s and CCT’s asset valuations were impacted during the GFC. As I had written in my previous article, CMT and CCT both had to undertake rights issues at heavily discounted prices, which resulted in existing shareholders being severely diluted if they did not participate in the rights issue. CMT undertook a 9-for-10 rights issue in Feb 2009, raising $1.23 billion through rights priced at $0.82 per unit, a discount of 43% to the closing price of $1.45 per unit. CCT undertook a 1-for-1 rights issue in May 2009, raising $828 million through rights priced at $0.59 per unit, a 44.3% discount to the closing price of $1.06. The rationale provided for the rights issues were to reduce leverage and strengthen the REITs’ balance sheets.

I went through both CMT’s and CCT’s quarterly financial statements from 2004 till 2011, to get a deeper understanding of the economic climate leading up to the GFC, the turmoil during the GFC itself, and the recovery post-GFC. In particular, I was curious to analyse how the valuations of the REITs’ properties had changed during the entire period, and how excessive leverage was a double edged sword that worked well in good times, but detrimental to the REITs during the crisis. What I have found was pretty interesting, and I have summarised my takeaways below. On a side note, I just want to add that the Powerpoint slides back in those days were indeed hideous.

 

Irrational exuberance leading up to the real estate bubble: My first observation was that the run up to the GFC was indeed a crazy period. Asset valuations had increased by double digits over 6-month periods – just look at that increase in valuation of 35.1% for CCT’s Capital Tower (Currently occupied by GIC, JP Morgan and Capitaland) from Dec ’06 to Jun ’07. To compare that against our current situation, I don’t think there has been a run up in valuations of a similar scale relative to pre-GFC, thus a spectacular fall in real estate prices may be less likely. Nonetheless, even without the irrational exuberance causing a real estate bubble, we have to be cognizant of the demand side shock affecting certain classes of real estate, which may drive valuations down.

Acquiring properties during the initial stages of a crisis is generally a bad idea: As seen from the valuation figures, real estate prices are generally a lagging indicator of a crisis. Stock prices adjust downward much faster to negative future expectations as compared to illiquid assets like real estate. Thus, there is the likelihood of overpaying for real estate when making acquisitions during the initial stages of a crisis. For example, CCT’s share price peaked in May ’07, and by Jun ’08 had fallen significantly from its peak. Yet, the valuations of CCT’s assets continued to climb, as seen from the broad increase in valuations across all properties from Dec ’07 to Jun ’08, which was when the asset valuations peaked.

Acquisitions made during the GFC proved to be poor deals, as evident from the valuations of One George Street and Wilkie Edge by CCT, and the acquisition of Atrium@Orchard by CMT. The valuations of these properties declined significantly after they were acquired, thus on hindsight, if the REITs had waited a year or two, they might have been able to acquire these properties at much more attractive valuations. Thus, for REITs which have been going on a shopping spree recently (think of private placement/preferential offerings from Ascendas REIT, MLT and FCT), I am skeptical as to whether this is the right strategy.

Gearing and access to credit has to be viewed together: CCT’s gearing increased from c.30% in Dec ’04 to 42.3% in May ’09, just before it raised equity to deleverage down to 31%. On this point, I am not exactly sure on the urgent need to deleverage at that point of time in May ‘09. From my understanding, before 2015, MAS’ rules for REITs was that gearing was capped at 35%, but allowed up to 60% for REITs with credit ratings from Fitch, Moody’s or S&P. CMT and CCT had ratings from Moody’s, thus would have been able to leverage up to 60% of their asset value. Thus, with their gearing ratios at 42-43% in early 2009, I am unsure of the urgent need to deleverage through rights issues.

My guess is that it was a combination of two main factors – 1. It was extremely difficult to refinance existing debt during the GFC, as banks were wary of extending credit to REITs when the global real estate market was crashing. Thus, CMT and CCT had to raise equity to pay off the debt. 2. Perhaps REIT managers expected the sharp decline in asset valuations to continue (as seen from the double digit declines in asset values in ’09), thus they wanted to pre-empt this (even though their gearing was some distance away from 60%) in order to stay within MAS’ gearing limits.

During the GFC, I was still an oblivious primary school kid, so perhaps if you’ve invested through the GFC and have better insights on the need for REITs to deleverage during that time, please let me know in the comments below, or feel free to drop me a direct message on my Instagram page and we can have a chat. Would greatly appreciate any additional insights on this matter!

Retail properties more resilient than office properties: As seen from the changes in valuations for both CMT’s and CCT’s portfolios, CMT’s assets only recorded one period of decline in valuations, from Dec ’08 to Jun ’09. Whereas CCT’s portfolio was hit much harder, with asset values falling >20% from ’08 to ’09. To compare that against CICT’s current gearing and asset valuations, assuming CICT has a gearing of 40% currently, asset valuations would have to decline by 20% for it to breach MAS’ gearing limit of 50%. Going by history, the risk may be greater for office properties instead of retail properties. Of course, we are in an unprecedented pandemic, and the impact on retail and office properties may still surpass that of the GFC.

Closing Thoughts

I think a key distinction to make between the GFC and our current situation would be that the GFC was primarily a real estate bubble that led to a financial crisis, whereas what we are currently facing is a demand side problem cause by movement restrictions due to Covid-19. Of course, there is the possibility of the domino effect causing a real estate crisis, especially for sectors such as hospitality, retail and office, whereas sectors such as logistics and data centres have been doing well.

A mitigating factor for CICT would be that the enlarged asset base provides some form of diversification, as retail properties have shown to hold their assets values better than office properties during the GFC. With regard to the impact of WFH policies on commercial property valuations, my view is that the downside would be limited. As we have seen, tech firms have still been taking up prime office space in the CBD, and ultimately, I believe that there would be some form of equilibrium between WFO and WFH. Offices would not be redundant so soon. Additionally, as I have written in my previous article – Will WFH change real estate trends? – I believe that the land that commercial properties occupy still hold significant value. As we have seen from the redevelopment of Funan Mall, integrated developments seem to be the way forward, and office properties may potentially be converted to integrated developments (subject to zoning restrictions) if remote working does indeed threaten the existence of office buildings.

To conclude, with CICT’s gearing level at approximately 39%, I am slightly concerned as it is a relatively high level compared to its historical average. Recently, we have seen FCT using part of its $575m raised from its private placement to pay of a $325m revolving credit facility and an $80m bank loan. Personally, I would prefer that the REIT manager acts to reduce CICT’s gearing ratio, perhaps via a private placement to reduce its debt position slightly, even though the MAS gearing limit for REITs was recently increased from 45% to 50%.

If you've read to this point, and are still keen to learn more about REITs, I have written two other posts about Singapore REITs here:

1. How do we analyse REITs?

2. Do leasehold land tenures matter for valuations? 

Note: As of writing, hold a long position in CICT at an average price of $1.91. 

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

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Thoughts on SATS' 1Q results (SGX:S58)

SATS released their 1Q FY2021 business updates on 24 August, which was for the period of 1 April 2020 to 30 June 2020. Headline numbers were a 55% fall in revenue to $209.4m, and a net loss of $43.7m. Aviation revenue decreased 72.9% to 110.6m while non aviation revenue rose by 73.3% to 96.9m.

Despite the challenging operating environment, I believe that the long term outlook for the aviation industry is still positive. In short, as the middle class gets wealthier, demand for air travel should increase as well. I believe that this is a long term secular trend that has only been temporarily disrupted by Covid. While Covid has probably resulted in many executives re-thinking the necessity for business travel, I believe that leisure travel would still recover strongly due to all the pent up demand. Even if business travel were to never recover to pre-Covid levels, I believe that growth in leisure travel would more than offset the fall in business travel. Furthermore, falling business travel volumes would hurt airlines more, as compared to a ground handler like SATS, because airlines earn a significant proportion of their revenue from business class passengers, whereas I believe that the differential in revenue to SATS from a business class traveler and an economy class passenger is much lower. 

Current projections are that the aviation volume would only return to pre-Covid levels by 2024. Hence, I think the key question that we should be asking ourselves as investors or potential investors would be - at the current level of losses, can the company's cash burn rate be sustainable until 2024?

The answer to this question is by no means straightforward. In addition to economic factors, there are regulatory and policy decisions, as well as the likelihood of an effective vaccine, that would affect our projections. But looking at SATS' cost structure and cash burn rate would be a good start.

Cost structure 

Staff costs make up the largest proportion of operating costs for SATS, at 39% for this quarter. This compares with 57% in ordinary times. One reason for the reduced staff costs was the $61.7m of government reliefs received from the Jobs Support Scheme (JSS). The JSS was extended in August to cover wages up to March 2021, but the co-funding was reduced to 50% of wages (capped at gross wage of $4,600) instead of 75% previously for the aviation industry. 

Depreciation costs are mostly non-cash in nature, however, with the change in accounting standards due to IFRS 16, right-of-use assets are depreciated as well, hence a portion of the depreciation costs actually represent an outflow of cash for the current year.  

Operating cash flow was -$61.1m for the quarter. Comparing this to PATMI of -43.7m, and accounting for depreciation of $33.5m (largely non-cash expense apart from IFRS 16 changes), I believe that the difference may be due to the timing of receiving the JSS grants of $61.7m. For example, the JSS payout computed based on wages in June to August 2020 would only be paid out in October 2020. Capex came in at $10.4m, comparable to Q1 FY20 which was also $10.4m. Hence, we are looking at a free cash flow of around -30m to -40m for this quarter if the cash received from the JSS payouts were adjusted for.

Cash position

SATS currently has a cash position of $723.5m, an increase which is mainly due to the increased borrowings. Debt to equity ratio of 42% (55% if IFRS 16 was considered) as compared to 26% the previous quarter seems moderately high to me, but the total debt of $876.1m as compared to the cash position of $723.5m puts things into perspective. 

Assuming SATS continues a cash burn of around 30m to 40m per quarter (this assumption largely hinges on JSS payouts), then it seems possible that the company would be able to ride out the storm, given that hopefully, the worst quarter is behind us, and aviation volume gradually increases.

Closing thoughts

The aviation industry's troubles are unlikely to go away soon. Airlines are still in trouble. SIA reported that within 2 months, it has burnt through half of the $8.8 billion raised through their rights issue in June. 

Budget carriers may be at greater risk as compared to national flag carriers, due to the lack of state support - governments have vested interest to bail out their national flag carriers as opposed to budget carriers. Would this bode well for SATS when demand returns? Possibly, given that budget carriers, without the inflight meals, SATS earns less per passenger.

For me, I would prefer to bet on SATS for a recovery in aviation, rather than on airlines, mainly due to the differences in cost structure and cash burn rate.

Note: As of writing, hold a long position in SATS at an average price of $3.41. 

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

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Is There Value in Valuetronics? (SGX: BN2)

The last time I wrote about Valuetronics was in late 2019, when I published this article (Valuetronics Research). I had done some research on the company as part of my internship application to an asset management firm. Subsequently, Valuetronics’ share price climbed to a high of $0.86, before falling to a low of $0.435 during the selloff in March.

After a strong recovery, Valuetronics’ share price tumbled again this week, as the management guided for a poor outlook in the near future, due to the renewed US-China trade tensions, which causes Valuetronics’ exports to the US to be subjected to tariffs ranging from 7.5% to 25%. Consequently, management indicated that some customers in the auto and consumer electronics segment were considering a switch of suppliers, and warned of “significantly lower financial results in FY2021”.

Company Overview

Source: Valuetronics FY20 Presentation

Valuetronics is an electronics manufacturer headquartered in Hong Kong. The company provides integrated manufacturing, design, and development services. It operates in two segments, the Consumer Electronics segment, and the Industrial & Commercial Electronics segment. The CE segment accounts for 39% of revenue, and 61% of revenue is derived from the ICE segment. The company’s products include smart lighting, printers, automotive and communications products.

FY2020 Earnings Review

Trade tensions have adversely impacted Valuetronics’ FY2020 results, as revenue declined by 16.8% from 2.83 bil HKD to 2.35 bil HKD, while gross profit margin expanded slightly from 15.2% to 15.4%. Net profit fell from 199.5 mil to 178.9 mil HKD, a decline of 10.3%, while net profit margin increased from 7.1% to 7.6%.

The positives

Source: Valuetronics FY20 Presentation

Continued diversification out of China, with further expansion in Vietnam ongoing. US-China trade tensions had an adverse impact on Valuetronics, given that c.41% of the company’s revenue is derived from US shipments.

Valuetronics has been working to mitigate the adverse impact of tariffs by building up its production facilities in Vietnam. Mass production at its Hanoi plant began in June 2019, while trial production at a second facility started in May 2020. The company also acquired a plot of land in an industrial park in Vietnam to build a manufacturing campus, which is projected to commence mass production by 31 March 2022. This would further boost production capacity, and diversification of its production base beyond China.

Robust balance sheet with a net cash position, reducing downside risks. Valuetronics’ net cash per share stands at 44 cents, with a NAV of 50 cents. This compares with the closing price of 59.5 cents on Friday. With its net cash position making up c.66% of its market capitalisation, downside risks would be mitigated. However, it would be good to note that 200 mil HKD is earmarked for the capex for their new facility in Vietnam.

The negatives

Escalation of US-China Trade War – Currently, c.41% of Valuetronics’ revenue is derived from shipments to the US, which are subjected to tariffs ranging from 7.5% to 25%. Further escalation in trade tensions may pressure more customers to seek alternative suppliers.

Potential Upside?

Positive developments from the US-China trade negotiations – Perhaps if Trump fails to get re-elected, this may be a positive for Valuetronics if trade tensions are resolved?

Valuation – Discounted Cash Flow

I didn’t want to go into the details of how the FCFF figures were projected, because that would involve many detailed assumptions of revenue drivers, expenses, margins etc. Thus, a high level view of estimating the future FCFF would suffice instead.

The following assumptions were used for the Discounted Cash Flow valuation of the company.

1. Drop in FCFF for FY21 and FY22 due to falling revenue as more North American customers switch suppliers, followed by a recovery in FY23 due to the opening of the Vietnam campus in end FY22.

2. Discount rate of 10% to reflect the small cap premium as well as uncertainty around longer term earnings. 0% terminal growth rate was used as a conservative estimate.

3. FCFF of c.10 – 85m for the projected years, which is significantly lower than the average of c.180m for the past 6 years. FCFF for the past 6 years were fluctuating mainly due to the changes in working capital. If we looked at cash flows before changes in working capital instead, we get a relatively consistent number of 200 – 250 mil, with income tax paid of 10 to 20m annually.

4. Annual capex of 120m HKD for the terminal value, with FY21 and FY22 at 150m to reflect the higher capex commitments of c.200m HKD for the new Vietnam facility.

5. Cash of 800 mil HKD was used in the calculation of equity value, to account for the 200 mil HKD earmarked for the capex in Vietnam.

With the above assumptions, a DCF derived price of $0.66 was obtained.

Why P/E may not be meaningful

I think that while a P/E ratio is easy for investors to understand, it may not be an appropriate metric to evaluate a contract manufacturer like Valuetronics. Bear in mind that the following thoughts are coming from a business student with zero knowledge of the manufacturing industry, so please take them with a huge pinch of salt. For those with more in-depth knowledge on the relationships between suppliers and customers in the manufacturing industry, please let me know in the comments.

While I mentioned P/E as a valuation metric in my previous article, I am currently of the view that P/E would not be a good valuation metric, mainly because of the nature of the manufacturing industry. A P/E valuation would be more reliable for companies with stable and predictable earnings – for example, consumer stocks like Sheng Siong. However, while Valuetronics’ earnings have been relatively stable over the past few years, the certainty of earnings is questionable, because once a manufacturing contract expires, the customer may switch over to another supplier if the costs are lower. As we are witnessing currently, the certain customers have indicated that they may switch suppliers due to the tariffs imposed on the shipments from China. For Valuetronics, if earnings were to drop in a given year, using a P/E multiple on that year’s earnings would give a significantly lower valuation.

Hence, to compare Valuetronics’ P/E ratio to a bunch of peers like Venture Corp, AEM or UMS may not provide the best estimate of its valuation, because of the each of these companies are vastly different. Venture’s market cap is significantly larger than Valuetronics, thus Venture may have greater bargaining power or economies of scale for production. For a smaller manufacturing company, I believe that the firm would more likely be a price taker, with less bargaining power when negotiating with larger customers. Whereas AEM and UMS have extremely concentrated customers, which itself brings about an entirely different set of benefits and risks.  

Conclusion

Source: Valuetronics FY20 Presentation

I like the company as it has been operating very conservatively by building up a huge cash buffer over the years. Before the Covid-19 crisis, I have questioned the need for the company to build up such a huge cash reserve, but I think the Covid-19 crisis has shown us the importance of companies having a strong balance sheet. Valuetronics business has also been incredible at generating positive free cash flows, which is what I look out for in any business. As shown above, Valuetronics has managed to increase its cash holdings from 689 mil to 1 bil HKD over the past 5 years through its strong cash flows. This gives them the ability to fund expansion plans without taking on any debt.

While earnings would be impacted in the short term, I believe that any downside would be well supported by its net cash per share of c.44 cents, while a successful diversification of its production facilities to Vietnam would be beneficial to investors in the longer term.

Note: As of writing, I don't not hold a position on Valuetronics. 

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

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Will Working From Home Change Real Estate Trends?

Will Working From Home Change Real Estate Trends?

With 80% of Singapore’s workforce said to be working from home over the past two months, I would like to share my thoughts on the longer-term implications of the trend towards working from home (WFH). I will be touching on two main issues – firstly, the viability of working from home, with regard to office culture in Singapore, and secondly, the impact of working from home on commercial real estate, especially in the CBD and business parks.

To begin, I’d like to say that I firmly support the trend towards working from home. For me, the main benefits of working from home are the time saved without the daily rush hour commute and the increased flexibility. The lack of social interaction may be a concern, but I believe that these can be mitigated through socialising in the evenings and the weekends. Moreover, in a normal, virus free situation, my ideal arrangement for working from home would probably include one or two days in the office per week, as I believe that building camaraderie and a team culture is important as well.

Are we over-hyping the trend towards WFH?

A few months back, Jes Staley, the CEO of Barclays, said that “the notion of putting 7,000 people in a building may be a thing of the past”. He said that in the longer term, the bank would adjust how they think about their location strategy. This implied that commercial real estate may see an irreversible shift in tenant preferences.

Interestingly, within a month from those comments, Hong Kong office workers are mostly back to work. HK has been very successful in curbing the spread of the virus, and banks based in HK have reported that they have been running their offices at 50-70% capacity recently, with plans to allow more employees back to their offices. Thus, if WFH is here to stay, why the rush to get employees back to the offices?

With regard to this, I think that we as humans tend to extrapolate certain current trends into the future, and draw our conclusions based on what we’re seeing at present. However, my counterargument to that would be that as leases for office space tend to be of longer durations, by the time these office leases are due for renewal in 4 to 5 years’ time, the pandemic may have blown over by then, which results in changing priorities at the point of renewing the leases.

Social and cultural issues standing in the way

Humans are hard wired to seek social interaction. We form communities and rely on family and friends for support. If we were to be working from home permanently in the future, how then do companies form strong cultures which are a key selling point for recruitment? Think of Google’s offices which include bowling alleys and sleeping pods – aren’t these amenities part of what makes Google such an attractive company to work for?

Thus, I believe that the ideal balance would probably involve in-person team bonding activities at least once a week. People would need places to meet and network, and therefore maintaining a physical office space may still be necessary to support these activities. In this situation, it is very likely that commercial tenants would downsize their space requirements, as the number people in the office at any given time is reduced. One trend which is already taking place would be the practice of hot-desking, which is popular among the Big 4 accounting firms.

On the point of cultural issues, perhaps the following observations are more prevalent in Asia as compared to the West. Firstly, Japan has a bizarre culture which glorifies falling asleep on the job – which supposedly serves as a signal to bosses that the employee has been working to exhaustion. Japanese office culture also frowns on the practice of junior staff leaving the office before their superiors. Additionally, Chinese companies are known for the backbreaking 9-9-6 culture - working from 9 to 9 daily, 6 times a week. With companies increasingly implementing WFH arrangements due to Covid-19, the lines separating work and personal life have become blurred.

When faced with such drastic change, how do managers who are used to these styles of management cope? I have heard horror stories of how some micromanagers have constantly called up their staff to check if they are working. Ultimately, it boils down to trust – trusting employees to get their job done regardless of where the are working. And herein lies the issue – trust is not built overnight, or even over a matter of months. My view is that change in management styles may not go away in the near future, perhaps it may take years, or even an entirely new generation of senior managers to impose change.

City fringe office space over CBD?

One possible trend that has been cited would be the increased demand for suburban office space, while the CBD hollows out. The assumption here is that companies would shun pricey CBD locations in favour of city fringe or suburban areas such as business parks, where rents are lower. The relocation of office space towards suburban locations has already happened for some time; think of banks shifting their back office functions to Changi Business Park, or MNCs opting to relocate their HQs to city fringe locations such as the Paya Lebar Quarter.

For this issue, I don’t think we can look at these two segments in isolation. After all, they are closely interdependent. An intuitive conclusion to make would be that demand for suburban office space would rise, pushing rents up, while demand for CBD office space would fall, pushing rents down.

To me, this is a fallacy, because CBD rents are likely to continue to hold a premium over city fringe rents. Think about this – current Grade A CBD rents are around $10-11 psf/month, while business park rents at areas such as MBC costs around $6 psf/month. Hence, if we were to expect CBD rents to fall and city fringe rents to rise, then the premium between both areas would narrow considerably, maybe to $8 psf/month for city fringe offices and $9 psf/month for CBD offices. Would this be logical? In that situation, why would companies still prefer city fringe locations, if they can get a prime CBD location by just paying slightly more?

Hence, I won’t expect suburban office to perform any better. If CBD rents fall, then rents across the entire spectrum of office locations should fall as well.

Would prime CBD offices be repurposed?

One mitigating factor for CBD office buildings would be that their prime locations still command a certain value. Thus, even of some office space becomes redundant, the land itself can still be sold or redeveloped, most probably into residential or mixed-use developments. URA had launched the CBD Rejuvenation Incentive Scheme in 2019, which encourages the conversion of older office buildings in the CBD, to develop more mixed-use projects to create a more friendly live-work-play environment.

Thus, I wouldn’t completely write off commercial properties, because the land themselves still hold considerable value.

Would cities become less attractive?

This applies more for countries with large rural areas, for example, the US. Some people were prediction a mass exodus from cities, with people moving to rural areas to work remotely. Staying in a ranch or farm while keeping their city jobs. To me, that sounds completely ridiculous. Sure, some people may prefer the slower pace of life there, but think about it – the allure of cities is the ease of access to everything: having your family and friends around you, entertainment options, and basically just having that connectivity. Yes, the novelty of the slower pace of life may appeal to some, but think about our current situation – we can’t even get people to stay home for a couple of months. Apparently, boredom kills. How different would that be if people who spent their entire lives in cities get to work remotely from a farm in Arizona or Texas?

Macro factors driving real estate investments

Macro factors driving real estate prices are equally important when considering the long-term direction of the real estate market.

While rents may drop due to the demand and supply imbalances with regard to tenants, if there is still significant demand for investment properties from investors, we may simply see a compression of rental yields, which means that real estate values hold steady even as rents fall.

Institutional investors or high net worth individuals may continue to view real estate as a hedge against inflation, and simply accept that lower rental yields are the new normal. With interest rates back at record lows after a brief ascent over the past few years, real estate continues to offer attractive spreads to investors.

Think about the trend of Mainland Chinese buyers bidding up the residential real estate prices in Sydney or Vancouver. The main factor driving property prices up in these areas was more because of the influx of deep pocketed buyers rather than the underlying demand from end users (residential tenants). Thus, do consider the larger macro factors at play, instead of being overly fixated on the possibility of falling rents.

Conclusion

While I am highly supportive of the entire WFH exercise, I think the idea that a large majority of us would be working from home permanently would probably remain distant a dream. And the idea that being able to work from home results in a mass exodus from cities into rural areas is even more ridiculous. There are social, cultural, and practical issues which limits an overhaul of how we view cities.

On the impact on real estate prices, post Covid-19, there would definitely be a change in how we utilise office space. But to simply conclude that commercial properties would become redundant would be too premature.

My view is that sprawling cities are here to stay. After all, as the saying goes, when it comes to real estate, it is always about three things: Location, location and location.

Do let me know your thoughts in the comments!

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

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Why I Averaged Down on SATS (SGX:S58)

In early February, I bought SATS at $4.49. Back then, the Covid-19 situation seemed to be largely confined within China, with just a few cases in Singapore. I think at that point of time, most of us would have expected Covid to blow over fairly quickly, and be able to get on with our lives.

How wrong were we. And how wrong was I to initiate a position in SATS in early Feb. Over the next few months, with most countries imposing travel bans, air travel and tourism were completely decimated. By March, SATS’ share price had collapsed to around $2.50, more than a 50% decline from its 52-week highs.

When I bought SATS at $4.49 in Feb, in theory, it seemed a pretty straightforward strategy – Covid would surely affect SATS, but if we don’t know exactly how serious the impact would be, thus it’d make sense to dollar cost average. My purchase at $4.49 was my first tranche, and I had the ability to average down one or two more times if necessary. After all, Warren Buffett said that if one is a net buyer of stocks, then one should be happy that stock prices are falling, right? But in practice, when the entire market sells off, when you look at the US market swinging with 5% to 10% moves in a single day, and you look at your entire portfolio declining across the board, it’s not as easy to simply stick to your plan.

Now that things have cleared up a little, I’ve spent the past week looking at SATS again. Make no mistake, fundamentals have changed drastically. Passenger flights are almost non-existent – in April 2020, at grand total of 25,200 passengers passed through Changi Airport – a 99% decrease from a year ago.

Today, it is no longer about projecting revenue growth, or expecting SATS to even turn a profit in the near term. Instead, it is about survival – analysing whether SATS would be able to survive the Covid crisis and emerge stronger.

Here are the reasons why I believe that SATS would be able to survive the Covid crisis:

1. SATS’ profit guidance released in April estimated that they would suffer a 50 to 70m loss for Q1 FY20/21.

https://links.sgx.com/1.0.0/corporate-announcements/L5NKKF5YPBP061IE/b2c8c2b43d28e4026ca6b30064127d320bf1c8ee7b7b6a2eb7597f2c1c33ff20

The estimated 50-70m loss is “after taking into consideration grants received from governments”.

Given that this is for the 3-month period from April to June 2020, where we are already in full-blown lockdown with a complete ban on all tourists and transit passengers, I believe that this is as bad as it gets. The only passengers at Changi Airport are returning Singaporeans, or foreigners leaving the country. Which make up a grand total of 25,200 passengers.

Source: Changi Airport Traffic Statistics

https://www.changiairport.com/corporate/our-expertise/air-hub/traffic-statistics.html

2. SATS started off on a strong cash position, and has the ability to raise more debt

SATS last reported their financial results on 31 Dec 2019. As at 31 Dec 2019, SATS had 212m in cash and 103.6m in short term and long term debt, with a debt to equity ratio of 18%.

Note that the increase in debt to equity ratio from a year earlier was due to recognising changes from IFRS 16. For those with some accounting background, IFRS 16 is basically a silly rule that requires companies to recognise their long-term lease liabilities as a liability, instead of recognising them in their P&L each year. For example, if SATS leases an office for 10 years, then they would have to record these 10 years worth of future lease payments as a liability, which distorts the ‘true’ financial position, because it is not exactly a ‘debt’. Excluding the impact of IFRS 16, SATS noted that their ‘actual’ debt to equity ratio still remains at 6% as at 31 Dec 2019.

Subsequently, SATS announced that they completed the acquisition of Monty’s Bakehouse, for a total consideration of S$48.4m, which includes a deferred earn out consideration of up to S$18.3m. To simplify things, I’ll just assume that a total of 48.4m was paid.

SATS also announced their intention to raise S$500m thorough their MTN programme. To date, 300m has been raised, with 200m @ 2.88% p.a. and 100m @ 2.60% p.a., which I believe are reasonable borrowing rates and reflects the financial stability of SATS. The remaining 200m of notes have not been sold yet. Even if SATS were to raise up to 500m of debt, based on their total equity of c.1.8b as at 31 Dec 2019, their debt to equity ratio would rise to 30-40%, which is still reasonable to me. Hence, I believe that SATS can still tap the debt markets if necessary. Personally, I would be comfortable with a debt to equity ratio of up to 50-60%.

Therefore, if we were to estimate SATS’ cash level as of 31 March 2020, the ballpark figure would be 212m – 48.4m + 300m, which gives us a total of $463.6m. Of course, this is assuming that the quarter from Jan to Mar had delivered at least a net cash inflow, which is likely possible, because the effects of the travel bans only started in March. Hence, if SATS’ burns cash at a rate of 60-70m per quarter, they should still be able to last for at least more than a year. If 200m more is raised, their cash runway then increases to beyond 2 years.

3. Government wage subsidies and relief for rental & license fees

SATS currently benefits from some of the measures undertaken by the govt to alleviate the impact on the aviation sector:

• 75% wage subsidy for local workers, capped at a maximum salary of $4,600
• Subsidies for retraining of workers for redeployment
• License fees relief for ground handlers
• Rental relief for ground handlers

Given that the average salary of SATS’ employees was $52,304 in 2019, it would be reasonable to assume that a sizable proportion of their workforce would be included in the JSS. The key assumption underpinning my analysis of SATS would be the continued subsidies from the govt. This is because SATS’ operating costs in an ordinary year is c.800m, hence without the various subsidies, it is likely that SATS’ losses would be far greater than the 50-70m they projected for Q1 FY2021.

In their profit guidance dated 30th April, SATS’ projection of a 50 to 70m loss for the quarter included the effects of govt subsidies, hence a major assumption of my valuation would depend on the continuation of these subsidies.

4. Food solutions and cargo flights are still operating

While c.65% of SATS’ revenue is derived from Singapore, mostly from Changi Airport, (some from Marina Bay Cruise Centre), the few bright spots for SATS would be that their food solutions segment and the handling of cargo flights are still in operation. Air freight volume has fallen by a lesser degree as compared to passenger volume, because cargo flights are still necessary for the import and export of goods.

Source: Changi Airport Traffic Statistics

Recently, there was also news that SATS has started catering meals for some of the quarantined foreign workers. This is positive for the company, although the returns from this would probably be rather insignificant, given that margins for food solutions tend to be lower.

5. Aviation remains a strategically important sector to Singapore

https://www.straitstimes.com/singapore/government-determined-to-see-sia-through-covid-19-crisis-pm-lee-hsien-loong

During PM Lee’s latest speech, he mentioned that aviation remains a strategically important sector to Singapore. “Air transport is fundamental to Singapore's role as a global and regional hub.” SIA is strategically important as our national flag carrier, and the govt has indicated their intention to ensure that SIA survives this crisis. SATS plays a crucial role in our aviation ecosystem too. Think about them as being similar to Boeing for the US or Airbus for Europe – strategically important companies that should be backed by the state during a crisis.

With Temasek being a major shareholder in SATS (39%), if things get really dire, would we see them take corporate action, similar to that for SIA? I don’t know, and I don’t wish to speculate.

Valuation

I used a simple DCF model to estimate SATS’ valuation. The assumptions are rather straightforward, and I didn’t want to dive too deep into the P&L projections because these are just ballpark figures.

The main assumptions are:

1. Covid lasts for 2 whole years – from FY2021 to FY2022

As SATS’ financial year starts from 1 Apr, that means 2 full years of losses (cash burn) from 1 Apr 2020 to 31 Mar 2022. Think of that – no overseas holidays until April 2022!

Beyond Apr 2022, hopefully, a vaccine is developed or we achieve herd immunity. Air travel returns to pre-covid levels for FY2023.

2. Cash burn of S$250m for FY21 and S$250m for FY22

I derived the cash burn based on SATS’ projected 70m loss per quarter – that implies a full year loss of 280m. However, this 280m loss would reflect the accounting losses, hence we have to add back depreciation, which is a non cash expense. For FY19, depreciation amounted to c.80m, which we will add back. Additionally, capital expenditures are assumed to be 50m for FY21 and FY22, on the assumption that capex would be scaled back due to the crisis. Hence, that gives us a cash burn of 250m per year.

Again, I want to reiterate that these assumptions are based on the expectation that SATS continues to receive govt subsidies.

3. Return to pre-Covid levels in FY23 (from April 2022 onwards)

Pre-Covid FCF was c.200m per year based on SATS’ annual report. The discrepancy between the FCF, OCF and Capex is mainly due to SATS only including ‘cash capex’ in their FCF calculations. Capex of 100m per year is assumed.

SATS Cash Flows from FY15 to FY19
Source: SATS FY19 Annual Report

4. Discount rate of 7.5% and terminal growth rate of 1.5%

To explain why I have chosen these inputs, the finance-y answer would be: Due to SATS’ historically low beta, their more efficient capital structure as a result of raising more debt, and in light of the lower interest rate environment going forward, a WACC of 7.5% is derived.

But the short answer would be: Just use any discount rate you’re comfortable with. For a comparison, DBS used a WACC of 5.7% and TGR of 3% in their SATS research dated 5 May 2020.

Conclusion

I have averaged down on SATS at $2.84, and it has become my second largest position, at an average cost of $3.41. I believe that the long term bet on aviation remains intact. 

Additionally, it was reported that Changi Airport would start to allow transit passengers from June 2, after the circuit breaker ends, subject to strict measures. Hopefully, this would be the first small step towards resuming airport operations. I await SATS’ results by 31 July 2020 for greater clarity.

Additional details not covered in my analysis:

1. Upside potential: Projection of revenue growth was based on the assumption that passenger capacity at Changi Airport remains at 85m across 4 Terminals; the impact of T5 is not included, as I don’t believe that it can be meaningfully estimated. Hence, the DCF derived value for SATS may potentially be higher, if the increase in passenger capacity upon the completion of T5 is included.

2. Downside risk: Bankruptcy of airlines resulting in default of payments. SATS had $373.9m of receivables as at 31 Dec 2019. If certain airlines go bankrupt, SATS may have to write off some of the receivables owed by these airlines. Additionally, the solvency of SATS’ individual associates were not considered. If some of their foreign associates/ subsidiaries do not receive adequate government aid, they may be at risk of bankruptcies too.

If you are keen to learn more about SATS, do check out my other articles on the company:

1. How SATS earns its Revenue

2. Estimating SATS' cash burn

Note: As of writing, I hold a long position on SATS at an average price of $3.41. 

Disclaimer: This article is intended for informational and discussion purposes only, and do not constitute financial advice. When in doubt, please contact a licensed financial adviser.

If you enjoy my articles, please 'Like' my Facebook Page at: 

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