AlpacaInvestments

Understanding Sheng Siong Group's (SGX:OV8) Financial Statements

I have mainly been writing about reits as real estate is an asset class which I understand well. For a change, I would be analysing the financial statements of Sheng Siong Group, a supermarket operator based in Singapore. Sheng Siong has evidently been one of the few companies to benefit from the Covid-19 outbreak, as supermarkets are classified as essential services and remain open during this period of lockdown.

From a financial standpoint, Sheng Siong has posted strong results for their first quarter of FY20, with revenue and net profit rising 30.7% and 49.9% respectively from a year earlier. These strong operating results meant that Sheng Siong was able to provide employees with an additional month of bonus – very appropriate, in my opinion, given the risk that frontline workers put themselves in.

I looked at Sheng Siong’s past 5 years of financial statements, from FY2015 to FY2019 to get a better understanding of the company’s business model, and how it earns its profits. Although we are probably familiar with Sheng Siong from a consumer’s perspective, looking at the individual line items in the income statements provides us with a better understanding of the factors that affects its profitability, and an idea of how Sheng Siong can continue to grow its business going forward.

Gross Profit Margins

Firstly, Sheng Siong’s gross profit margins have increased from 24.7% in 2015 to 26.9% during the past 5 years. This means that in FY2019, for every dollar of sales Sheng Siong makes, the items cost them around 73 cents. This steady improvement in gross profit margins may indicate that Sheng Siong is has increasing bargaining power when purchasing from its suppliers. This could be due to increase economies of scale, as Sheng Siong may be able to negotiate for better prices if they are purchasing larger volumes.

While gross profit margin of 27% is on the low side, given Sheng Siong operates in the consumer staples sector with little product differentiation, it is understandable that Sheng Siong would not have much pricing power when selling to customers.

Increasing its gross profit margins would be one way for Sheng Siong to increase its profitability. This could come in the form of higher mark-ups on their products, or lowering the purchase price from suppliers. The first option may be tough for Sheng Siong, as it operates in a highly competitive industry where consumers are price sensitive. If Sheng Siong were to increase the price of its goods by too much, consumers would simply purchase their groceries from other supermarkets for a cheaper price. Hence, the second option would be more practical, and further increases in gross profit margins may instead have to come from its purchasing strategies, to be able to negotiate for more favourable prices from its suppliers.

Operating expenses

As selling and distribution expenses and other expenses only constitute 0.8% and 0.3% of revenue respectively, there isn’t much to elaborate on these as their impact on profitability is minimal.

Sheng Siong’s Administrative expenses form the bulk of the operating expenses, at around 17.4% of revenue for FY2019. Looking at the 5 year trend for administrative expenses, it has been creeping up gradually from 16.4% in FY2015 to 17.4% in FY2019. This can be attributed to an increases in depreciation and manpower costs which make up the bulk of administrative expenses.

Drivers of Revenue Growth

Basically, Sheng Siong can grow its revenue in three main ways.

1. Same store sales growth

2. New store sales growth

3. Overseas Expansion

In the table above, I have compiled the growth rates for each of the revenue drivers from Sheng Siong’s annual reports from 2015 to 2019. In 2019, Sheng Siong did not provide a breakdown, except for noting that growth was mainly from the new stores opened in 2018 and 2019.

Sheng Siong’s growth has mainly been driven by new store sales growth. This may be more unpredictable, as it depends on Sheng Siong being able to consistently identify locations to open new stores. There is also the competition from other supermarket operators when bidding for new retail space from the HDB. Conversely, same store sales growth would be a more stable source of growth. Regarding overseas expansions, Sheng Siong has two stores in Kunming, China. These stores contribute to less than 2% of Sheng Siong’s revenue.

Free cash flows

The table above shows Sheng Siong’s free cash flows for the past 5 years. Free cash flows are calculated by deducting capital expenditures from operating cash flows. This indicates that Sheng Siong is able to consistently generate strong free cash flows for shareholders.

Capital Expenditures

I have complied Sheng Siong’s capital expenditures incurred from 2015 to 2019, and included the breakdown of each of the categories. In 2017, Sheng Siong did not provide a breakdown of their capex.

Capex had fluctuated from year to year, but if we were to focus on the capex on old and new stores, we get a clearer picture of the capex incurred to maintain and grow the business. Going forward, we can also estimate the capex required per new store opened, to get better visibility of Sheng Siong’s future capex, hence estimating Sheng Siong’s future FCF.

The main uses of cash are to purchase retail space for its stores, however, these are harder to forecast, as Sheng Siong can choose to either lease or purchase the retail space. Hence, the cash outlay of 30 to 50 million incurred for the purchase of three locations over the past 5 years should not be viewed as a recurring capex.

In summary, here are the positives and negatives of Sheng Siong:

Positives

Resilient to economic cycles: Operating in the consumer staples industry, Sheng Siong sells necessities which would be in demand regardless of the economic cycles. A good example would be the current recession; while most companies have seen their share prices hammered, Sheng Siong recovered after a brief sell off and has continued to hit all time highs.

Strong free cash flow generating business: As discussed above, Sheng Siong’s business has generated strong free cash flows for shareholders.

Risks

Low margin business: Susceptible to rising manpower costs. Given that Sheng Siong’s business model has low operating margins, Sheng Siong would have to manage its operating costs well.

Threat of e-commerce: A few years back when Amazon first entered the Singapore market, investors were concerned that Sheng Siong may face disruption from online grocery sales. However, a few years later, there seems to be little change in consumer spending habits, as Sheng Siong continued to post strong growth. Hence, the question that investors should ask would be whether consumer preferences for in-person grocery shopping would be likely to change anytime soon – will the Covid-19 lockdowns accelerate the switch towards home deliveries of groceries?

Increasingly saturated home market: Sheng Siong’s store count in Singapore has increased from 39 in end-2015 to 59 today, there are fewer neighbourhoods where Sheng Siong isn’t present. Hence, with the market becoming increasingly saturated, Sheng Siong would have to expand overseas for new growth areas. Currently, its China operations only contribute 2% of revenue, and could be a potential area of growth. However, overseas expansion brings about execution risks as well.

Conclusion

Sheng Siong’s business has definitely been doing well over the past 5 years, and the current situation has showed the resilience of its business. I hope this write up has provided investors with a clearer understanding of Sheng Siong’s financial performance.

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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Singapore REITs: Do Leasehold Land Tenures Matter for Valuations?

I had intended to write on this topic for the longest time, but school commitments meant that this was put on hold. With an entire month ahead before my internship begins, time is aplenty for me to do more in depth research into companies and sectors, so watch this space closely for more articles!

Recently, a conversation with someone on Reits led to the discussion on this topic – whether the underlying land tenure of a Reit matters when making an investment decision. In short, I believe that it does, even if this detail is often overlooked by investors, who may prefer to focus on the yield instead. I believe that while looking at the yield of a Reit is important, we should also consider the underlying land tenure of the Reits’ assets as an important decision making metric.

In this article, I would discuss the implications of the different land tenures for different classes of properties, focusing on the comparison of industrial assets against retail and commercial assets. In addition, I would also discuss the importance of looking at the average age of the properties – another metric that I believe investors tend to overlook. The average age of the properties is related to the underlying land tenure, and I believe that investors should consider both factors simultaneously when evaluating a Reit. I hope this article challenges the status quo of simply looking the dividend yield, NAV and price to book ratios, which I believe is myopic and would lead to issues in the longer term.

Firstly, I’d like to start off with the leasehold vs freehold debate. For the longest time, rightly or wrongly, many Singaporeans have held the belief that their HDB flats/Condos/Landed properties would be ever appreciating assets. A common belief was that even as a leasehold HDB/Condo ages, there would somehow be an opportunity to exit via an en bloc, or that HDB would want to redevelop the estate and compensate the owners. In 2017, many who held this belief received a wake up call when Minister Lawrence Wong cautioned that Singaporeans should not assume all HDB flats will be eligible for SERS – in fact, as of 2017, only 4% of HDB flats were identified for SERS since it was launched in 1995. I have included the article here:

https://www.straitstimes.com/singapore/housing/dont-assume-all-old-hdb-flats-will-become-eligible-for-sers-cautions-lawrence-wong

Mr Wong’s comments were in response to the trend of buyers increasingly forking out high prices for HDB flats that had relatively short land tenures left, in anticipation of SERS. His comments sparked quite a debate at that point of time, as it corrected the notion that leasehold assets would continue to appreciate indefinitely. Hence, buyers of HDB flats became more aware of the implications of having a short lease tenure left. The first batch of leasehold properties in Singapore have already been returned to the Singapore Land Authority – in short, when the lease runs out, the land reverts to the state, with zero compensation to the owners. You may read more about this here:

https://www.straitstimes.com/singapore/housing/geylang-private-homes-to-be-returned-to-the-state-when-leases-expire-in-2020-no

Therefore, if buyers of HDBs and Condos consider the remaining land lease tenure and the properties’ age when making investment decisions, then logically, the same decision making framework should be applied when we are evaluating a Reit as a potential investment.

Land lease tenures of different types of properties

In Singapore, Retail and Commercial properties are usually on 99 year leases, with a minority of them on 999 year or freehold tenures. For industrial properties, before 2012, industrial properties were sold with 60 year land leases, which was cut to 30 years in 2012. Since 2019, certain newer industrial sites for ‘heavier industrial use’ were sold with only 20 year leases.

https://www.straitstimes.com/business/economy/singapores-industrial-land-supply-reduced-again-for-first-half-of-2020

Looking at things from an IRR perspective

In real estate, we usually evaluate the merits of an investment using the internal rate of return (IRR). The IRR of an investment takes into account the initial capital invested, and the cash flows that we receive during the period that we hold on to an asset. The higher the IRR, the better.

To simplify things a little, consider this hypothetical situation where we have two HDB flats, one with 30 years left on the lease, while the other has 99 years left on the lease. Assume both are now selling for $500k each, and yielding 5% a year, which is 25k.

From an IRR perspective,

For the first property, we are investing 500k today at a 5% yield, and will receive 25k a year over the next 99 years. The IRR would be 4.96%. I used a financial calculator to calculate this, but you can also use the calculations using the ‘=IRR’ function on excel, or find an IRR calculator function online.

For the second property, we are investing 500k today at a 5% yield, and will receive 25k a year over the next 30 years. The IRR would be 2.85%, which is much lower than the first scenario.

Therefore, from an IRR perspective, the first property is definitely the better investment, because we are collecting the rental payments over 99 years instead of 30

Now, you would be thinking: Why would anyone buy the second property, when we can get a much higher IRR by buying the first property? Surely the second property would have to provide a higher yield (and hence, sell at a lower price), in order to compensate for the shorter land tenure left?

If you think this doesn’t make sense, this is exactly what’s happening in the markets now, where the yields of industrial /logistics reits are comparable, or sometimes even lower, than the yields on retail and commercial properties.

Of course, due to the current Covid-19 situation, prices of retail and commercial reits have been pressed down, and it would not be a fair comparison. I agree that it would not be fair to make a comparison now, but even if we were to look at prices in late 2019 and early 2020, before the Covid-19 outbreak, industrial reits have been trading at yields which are comparable to office/retail reits. Some industrial reits were trading at yields of high 4%, while some office and retail reits were trading at yields of low 4%.

So how do we explain this unique situation? Mitigating factors 1 and 2 provide some possible reasons.

Mitigating Factor 1: Industrial rental growth to outpace office/retail rental growth?

Investors who are bullish on industrial reits may argue – industrial rents are going to outpace office and retail rents due to the e-commerce trend, which results in an increased demand for logistics and industrial space. In fact, some may even hold the view that office rents will fall due to WFH being a long term trend, while the lockdown would accelerate the downfall of retail. These perspectives make sense, but considering the much shorter land tenures of industrial land (30 – 60 years), how much more can the rents increase to compensate for the shorter land tenure, in order to make the IRR from the investment in industrial assets comparable to the IRR from office/retail assets? And if you’re expecting industrial assets to somehow be worth more than office/retail sometime in the future, wouldn’t landlords of malls simply convert their empty malls into storage spaces?

Additionally, industrial/logistics reits may also be perceived to be more resilient in times of uncertainty. This is due to their long WALEs which ensure that landlords lock in their rental rates for a longer period of time. To me, the ‘safety’ of industrial/logistics reits are not entirely convincing. The long WALEs are only applicable if the tenants are still in business. While it may be correct to claim that industrial and logistics tenants are benefiting from the e-commerce trend and the current lockdown, there are certain groups of tenants who may also be affected in the current downturn. Firstly, consumer discretionary businesses who face bankruptcy may default on their warehouse rental payments – for example, if a clothing store goes bankrupt, it is unlikely that they would pay for rental owed to the landlord of their warehouse. Secondly, SMEs in the manufacturing sector who are in more cyclical sectors (oil and gas, aviation etc) are also at risk. These SMEs rent manufacturing space from industrial reits too, and may run into cash flow problems.

Overall, yes, while ecommerce companies like Amazon or third-party logistics providers like DHL may benefit, there are certain tenants of industrial and logistics reits that are at risk as well. Hence, the stability of industrial reits may be overestimated.

Mitigating Factor 2: Will industrial/logistics reits be able to renew their land leases upon expiry?

I have found the answer here:

https://www.sla.gov.sg/state-land-n-property/land-sales-and-lease-management/lease-management/lease-policy

To summarise, generally, the Govt’s position is to allow the leases to expire without extension. This is because Singapore is land scarce, and the Govt would want to be able to reallocate land to meet changing socio-economic needs. However, there would be exceptions granted, such as if significant investment has been made on the property, but these would be evaluated on a case by case basis.

If the Govt does indeed grant an extension, the landowner would still have to pay a land premium to obtain the extension of the lease. If the reit is able to win approval to extend its land lease tenure, that would affect the IRR calculations, hence we would not discuss this in depth here, given that there is no certainty of this happening in the first place.

Further metric to consider: Age of the properties

This brings me to the second point that I would be discussing – the age of the buildings themselves. While we have earlier discussed the lease tenure of the assets, practically, it would be unrealistic to expect the buildings to last the entire duration of the lease tenure. For example, an office building built on a 99-year leasehold land would not be expected to continue to be in use at the end of the 99 years. At some point in time, wear and tear takes a toll on the building, and newer buildings built with better technology become more attractive to tenants. This trend has already played out in Singapore’s CBD, as the newer buildings (MBFC, Marina One, Asia Square, ORQ etc) have attracted tenants to move away from the ‘traditional’ CBD area of Raffles Place. In part, this is due to the larger floor plates in the newer buildings which allows tenants to optimise their office layouts, and the newer amenities.

Hence, what would be a reasonable age of a building before we can expect a property to be redeveloped? Going by the precedent cases, URA had launched the CBD Incentive Scheme in 2019, which aims to rejuvenate the city centre. Some of the properties identified to benefit from this scheme would be Shenton House and International Plaza, which were built in the late 1960s and early 1970s. As these buildings are still standing today, it would be reasonable to conclude that commercial properties can be expected to last at least 50 years before they are slated for redevelopment.

However, there are also properties which undergo redevelopment or major asset enhancement initiatives much earlier, for example, Chevron House was sold by Oxley to real estate fund AEW for $1.025 billion. Chevron House is currently undergoing major asset enhancement works which is expected to cost around $100 million. Chevron House was completed in 1993, which means that the building is approximately 27 years old at the point of commencing the major uplift.

Thus, if you’re buying a Commercial/office reit that owns properties with average ages of 20+ years, in practice, you’re probably only getting the rental payments for another 30-40 years, before it would be scheduled to undergo major redevelopment works, even if the land lease tenure is 99 years or longer. That means if the reit does not sell off the property to a third party, past the 30 year mark, there could potentially be more redevelopment or asset enhancement costs for unitholders.

What’s the ideal outcome for investors?

Having discussed the implications of both the leasehold land tenure and the age of the assets themselves, what would be the best outcome for reit investors? The two issues discussed above may have painted a rather bleak picture for reits, but I still believe that reits have a place in our portfolios, as they provide exposure to real estate, and in ordinary situations, provide a steady stream of income to investors.

The ideal scenario for reit investors, which would mitigate the effects of a short remaining land tenure and an older portfolio age, would be if the reit is able to continually make yield accretive acquisitions over time. These new acquisitions, assuming that they are assets with long land tenures and newer properties, would continue to allow the reit to increase its portfolio average land tenure, while lowering the average age of its properties.

Here’s the catch – acquisitions funded by rights issues would mean that the investor has to come up with the cash to subscribe to the rights. However, if the acquisition is yield accretive, then the investor who does not want to come up with the cash may choose to sell his rights, as the yield accretive acquisition means that his dividends would not be diluted. Alternatively, reits may raise cash through a private placement, usually to institutional investors or high net worth individuals. Generally, if the private placement is intended to fund a yield accretive acquisition, then it is beneficial to existing unitholders, as private placements are usually done at a lower discount than rights issues, so there is less dilution for all unitholders. In short, existing unitholders would be benefiting from the capital of new unitholders.

Furthermore, reits may also take a proactive asset management approach, selling off their older properties to recycle capital into newer assets.

Conclusion

While investors are right to look at popular metrics such as dividend yield, DPU growth, NAV and price to book values, I believe that it would be appropriate to consider the land tenure of the properties and the portfolio average age as well. The leasehold nature of properties is more common in Singapore, whereas for reits that hold overseas assets, those properties tend to be freehold assets. Hence, only the issue of average portfolio age would be applicable to these reits. Some examples include Manulife Reit’s US Office portfolio, which are 100% freehold, while Frasers L&C Trust’s Australian logistics portfolio are freehold as well.

I have complied the land lease tenure of a few popular reits in the table below. While researching on the data, I realised that most reits do not specifically state the age of their properties. However, we can simply calculate it by referring to the date of completion of the properties, which are provided in the annual reports.

Source: Various Annual Reports, Quarterly Presentations

As discussed, the land lease tenures of industrial properties are usually shorter than retail and commercial properties. Hence, it would be logical for industrial reits to provide investors with a higher yield, in order to compensate for the shorter land tenures.

Taking this into account, it would be good if investors consider the land tenures and building age when making investment decisions. While there are macro factors (as discussed in Mitigating Factor 1) that are positive for industrial reits, in situations when industrial reits are trading at similar yields to commercial and retail reits, it would be wise for investors to ponder whether the market has priced in and accurately accounted for the shorter land tenures of industrial assets.

Note: As of writing, I do not have any positions in any of the securities mentioned in this article. From time to time, I may take up positions in the aforementioned securities, without updating this blog.

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.