My Reply to My Friend's Questions on KSH - Part 1

A friend who is aware of my blog wrote the following email to me after reading my article on KSH:
“I have gone through it once more and it is very convincing to readers. I have two points to make.
(1) Readers would like to know the potential risks involved. China projects are always risky and also construction costs in Singapore are rising. I guess the risk is moderate at most.
(2) If 55 cents is not a fair value, how do we determine the fair value? Based on PER?”

I like such questions because if I do not already have the answer, I have to find the answer because they point to issues which I have yet to consider.

The risks of investing in KSH are quite similar to those of Keong Hong as their businesses are very similar in nature – as a matter of fact, they are competitors. 

I have considered the following risks in investing in KSH and Keong Hong:
 

Risks of not being competitive in the construction business – Many investors do not like to invest in companies that depend heavily on projects for revenue and profit for the simple reason that these companies have to be able to continue to secure profitable projects to generate profits.  In addition, investors would not be able to value such companies based on discounted cash flow (DCF) as they cannot estimate how many new projects the company can secure and their contract values for the future.  As such, such companies usually have low valuation – this also presents good investment opportunity for certain types of investors.  I cannot foretell whether KSH and Keong Hong will continue to be competitive more than 2to 3 years down the road (as in most listed companies) but from the profits they have generated and the profit margins of their businesses for the last few years, I can see that they are running a profitable construction business with good Profit Before Tax (PBT) margins – more than 10% for KSH and more than12% for Keong Hong. 

From BCA’s projection and my understanding of Singapore government, the government will control public sector projects such that the total construction demand in Singapore is growing at a slow and steady rate.  This enables well-run construction businesses such as KSH and Keong Hong to make decent profits.  KSH has been able to continue to win public sector projects (as can be seen by their recent announcements on contract wins) and make it a business strategy to focus on public sector projects in the near future in consideration of the weaker construction demand in the private sector.  Keong Hong has chosen to focus on partnering with established property developers to co-develop Executive Condominiums by taking a minority stake and acts as the main contractor for these ECs.  My investment horizon for KSH and Keong Hong is between 1 to 2 years, and I believe that they will remain competitive for the next 24 months.  In addition, their construction order books are very healthy and the projects on hand would generate good revenue and profit for them for the next 2 to 3 years.  I do not think that their competiveness will be eroded within a 2-year horizon.

Risks of cost-overrun for construction projects – I have perused KSH and Keong Hong’s annual reports and financial reports in recent years and did not find information which suggests that they have incurred losses on construction projects.  Though there is no guarantee that they will not experience cost over-runs in existing and future projects, I believe both groups have experienced and competence executive directors and senior managers with proven track-records to be able to manage that risk.  Keong Hong’s IPO document did suggest that before it was listed, it has withdrawn from a winning bid for a HDB project due to under-budgeting and, as a consequence, it was penalized by being barred from HDB tenders for a year.  They have since put in place a system to minimize this risk.

Risks of China Projects – I am not sure what my friend meant by saying that China projects are always risky.  I think everything is risky for those who do not do their due diligence – be it in Singapore or oversea.  KSH has established a presence in China since 1997 and have completed two property developments – Tianxing Riverfront Square in Tianjin (currently held as an investment property), and Liang Jing Ming Ju in Beijing, which is now in Phase 4.  These projects have been profitable.  It is important to recognize that it is difficult for Singapore Laws to deal with errant non-Singaporean directors of foreign companies listed in Singapore Stock Exchange but the same does not apply to Singaporean directors.  In addition, there are a lot at stake to deter Singaporean executive directors of public-listed companies from committing frauds.

Rising construction cost – Rising construction cost is not an issue if the construction companies have budgeted in the anticipated cost increases in their project costing.  Though I am not familiar with constriction contracts, I do know that contracts could be drawn out such that certain costs could be adjusted in accordance with the market condition.  Any risks that are anticipated could be managed; and I believe both KSH and Keong Hong managements are well-aware of this risk.  Having said that, any unanticipated cost increases will affect KSH and Keong Hong’s profit margins --   I view it as the normal business risks which all businesses are exposed to, and  it is a matter of weighting the risk and potential reward.

Risks of the property development business – Property development is a leverage business, which is not unlike an individual purchasing a property by taking up a mortgage loan.  Basically a property developer will buy a plot of land and then build houses.  Most of property developers will register a subsidiary, which is a limited company with certain paid-up capital, for every property development project.  The developer will inject certain capital and get a bank loan to finance the project.  This has the effect of limiting the liabilities (and risks) of the property developer.  In Singapore, a property development project can be launched well before the construction is completed.  When a property is launched, a down payment will have to be made by the home buyers, who have to continue to make progressive payments based on the schedules outlined at the following URA website: https://www.ura.gov.sg/lad/HBG/progressPayments.htm. 

As long as the developer can sell the units well, it is a very profitable business.  This clearly shows up in KSH's finance – In FY14, its construction business contributed to 88.04% of its revenue but only 39.94% of its profit before tax while the property development and management business contributed to 11.96% of the revenue but 60.06% of its profit before tax.

Many of the property developers in Singapore have made obscene profits over the last few years; this has helped these developers to strengthen their balance sheets.  Most of KSH’s property development projects have been sold out or close to fully sold out.  This is one reason I think KSH will continue to do well for the next 2 years when it continues to book revenues and profits from these projects.  KSH and its partners are smart to move into mixed/integrated projects which consist of both residential and commercial units. This is a sound strategy as commercial properties command higher premiums and have stronger demands.  Keong Hong, on the other hand, has chosen to focus on executive condominiums and the development of the integrated commercial and hotel development in Katong. 

For the second question on the fair value, different investors have different ways of valuing businesses.  I will give my reply in the next article.