COMFORTDELGRO: A SAFE ENTRY PRICE?


ComfortDelGro has been on my watchlist since early this year, when it was trading at around $2.40. In my earlier post in February, I assigned a target price of $2.17 for CDG, on expectations that taxi earnings would be hit by the intense competition with private hire operators. 

Subsequently, CDG ran up to a high of $2.70 before going on a prolonged decline, and closed at a price of $2.08 yesterday. When CDG hit $2.17 a month ago, I did not initiate a position because I felt that its fundamentals have worsened. I have summarised my thoughts on CDG.


Strengths


Strong Financial Position


With $606.6 million in cash and cash equivalents and $377.1 million of borrowings, CDG is in a net cash position of $229.5 million. Some investors have suggested that CDG invests its cash outside of its core transportation business, similar to what SPH has done by venturing into the property segment.


Consistent Free Cash Flows



CDG consistently generates high free cash flows, as the bus contracting model has reduced capital expenditures. This possibly allows CDG to increase its dividend payout ratio. The management has pledged to payout a minimum of 50% of earnings per share, and the payout ratio has been steadily increasing. For 2016, the total dividends declared of 10.3 cents represented 70.1% of earnings. 


Stable Earnings from Public Transport Segment


Earnings to be supported by the public transport segment. The Downtown Line and North East Line have both reported steady ridership numbers and demand for rail travel would increase alongside population growth.


Challenges


Intensifying Competition with Private Hire Companies


With Grab offering CDG drivers huge incentives to switch over, CDG could potentially lose up to 2,000 drivers, according to this article. Quarterly earnings from the taxi segment has been falling.

http://www.straitstimes.com/singapore/transport/grab-out-to-snatch-comfortdelgro-cabbies-with-huge-discount

A month ago, news that CDG was in talks with Uber sent shares up by 10% in a day. Many expect this ongoing competition among the taxi companies to be a winner-takes-all contest, however, I believe that this outcome is unlikely - I don't expect Uber and Grab to kill off CDG. A more plausible outcome would be that the new entrants to the market permanently cuts the huge profit margins that CDG had enjoyed in the past. 

http://www.straitstimes.com/singapore/transport/comfortdelgro-in-talks-with-uber-on-possible-tie-up

In the past, CDG rented taxis out for around $110/day. Currently, the rental rates for Uber/Grab is around $50/day. Even after factoring in the 20% that U/G takes from drivers, the total cost would still be around $70-80, far less than what CDG used to charge its drivers. 

I believe that the deal would benefit Uber more than CDG, as Uber is still competing for market share, and this allows it to have access to CDG's huge fleet of taxis. For CDG, the outcome would still be the same - lower profit margins from the taxi segment.

Eventually, there would be equilibrium in the market - U/G can't continue to make losses and burn cash forever. Just that ultimately, the profit margins for the taxi segment would be razor thin, and CDG would have lost its 'monopoly' status as well as its dominant position in the market.

Lost Tender for TEL


CDG lost the tender for the Thomson East Coast Line to SMRT, which would have been a substantial growth catalyst. CDG's bid was 30% higher than SMRT's offer of $1.7 billion.


Valuation


I used a sum of the parts valuation to arrive at my fair value for CDG.


Source: ComfortDelGro's Q2 Earnings Report

Since its taxi business is declining, with an uncertain outlook, I have decided to value it separately from the other business segments. Based on the half-year results ending 30 June 2017, operating profits from the taxi segment was $72.3 million, down 15% from $85.1 million in the same period last year. This made up 34% of CDG's operating profit before interest and taxes. The rest of CDG's business segments, including Public Transport, Automotive engineering and inspection made up 66% of operating profit. 

Assuming a constant tax rate across all segments, and that finance costs are split proportionately, the other business segments would contribute $106.8 million (66% x 161.9) to the net profit attributable to shareholders for 2H 2017. 

For 2H 2017, net profit was higher mainly due to net income from investments rising $8.4 million from a year earlier. Therefore, my pro forma earnings for the full year would be lower. I arrive at an earnings per share of (106.8 + 100) / 2,162.8 = $0.0956. Applying an earnings multiple of 14x, which is the long term average P/E for CDG, we arrive at a value of $1.339 per share for CDG's business excluding the taxi segment. I believe that a 14x P/E valuation for the rest of CDG's business segment is rather fair, given that public transport earnings are more resilient. 


ComfortDelGro Annual Report 2016

For the taxi segment, I valued it at 1.2x net asset value. The worst case scenario would be to assign a valuation of 1.0x NAV or even lower to this segment, assuming that the management decides to exit the taxi business and sell off its assets. As CDG is currently valued by the market at 1.72x NAV, I believe that a valuation of 1.2x NAV would be a rather conservative estimate. 

I am unable to find data on the latest assets by segments, so I had to use figures from the Annual Report published earlier this year in April. The assets and liabilities of the taxi segment as of 2Q 2017 may be slightly different, given that the taxi fleet has been shrinking. As of 31 December 2016, the taxi segment had $1,330.7 million of assets and $318.0 million of liabilities. This gives us a net asset value of (1,330.7 - 318.0) / 2,162.8 = $0.468 per share. Applying a premium of 1.2x NAV, I arrive at a valuation of $0.562 per share

Therefore, my fair value estimate for CDG would be $1.339 + $0.562 = $1.90. Investors may decide to apply an appropriate margin of safety to this fair value estimate. Personally, I view any decline in share price to below $1.90 as a good opportunity to accumulate, as the dividend yield would be around 5.5%.


My Thoughts on the Management


I believe that the management was slow to react to the threat posed by private hire operators. They were probably complacent as they had enjoyed a near monopoly status for a long time. Contrast this to how the incumbent telcos reacted to the upcoming entrance of TPG - they have all revised their pricing plans in order to retain customers. I believe that CDG's management had underestimated the threat of private hire operators, otherwise, they would not have took a long time to reduce the rental rates. Here

While operating profits from the taxi segment only makes up slightly more than 30% of the total, how the management makes decisions for this segment is indicative of how responsive the would be to future challenges. CDG is lacking in this aspect.

If you're interested, I have attached an interview with one of Grab's co-founders. Notice how Grab is all about innovation, change and adaptability - qualities that CDG are lacking.

http://www.straitstimes.com/singapore/grab-whiz-happy-to-stay-low-key


Earlier post on CDG: Bumpy Road Ahead For ComfortDelGro


Note: As of writing, I do not have a long or short position in ComfortDelGro.


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Edit: It was earlier incorrectly stated that CDG operates the Circle Line. I have corrected this error. 

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