Cash Flows and Latitude Tree Holding Berhad kcchongn

Author: kcchongnz   |   Publish date: Wed, 12 Mar 09:15

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Cash Flows and Latitude Tree Holding Berhad

When assessing the viability of investing in a stock, most people look at earnings, how much is the net profit or earnings per share of a company and decide in a quick and easy way based on price-earnings ratio. However there are a lot of rules companies can follow to reduce earnings or at times inflate them.
For example in 1997, Sunbeam  reported $189 million income came from accounting fraud by using channel stuffing and improper recognition of revenue on contingent sales and indulging in improper buy and hold sales and incorrect accounting for supplier rebates.
A construction company can also inflate its earnings by booking claims of doubtful work done and variation works which are not yet or may not even recognized by the clients in accordance to terms in the contract. These claims are grouped in the receivables in the balance sheet.
In both cases above, there was no cash received by the company but just merely accounting numbers. The level of gaming that can be done to earnings makes some investors jittery about trusting earnings.
The job of every company is to make money, and there is no money like cash. Cash flow can let you assign a quality to earnings. Cash flow from operations (CFFO) available in the cash flow statement is the purest inflow and outflow of cash in relation to actually doing business. From a company health perspective it is one of the most important measures
Companies require capital expenses (capEx) in purchasing and upgrading plant and equipment for growth. The money is not gone. It is carried on the balance sheet as an asset. The end goal is for the company to generate a return on the asset. Free cash flow (FCF) is what is left after those expenses.
Free cash flow is like the end all goal of companies. The point is to do so well that you make so much money that even after all the checks written to expand the business you still have a lot of cash. Cash is pretty much the most important thing, and FCF is the most flexible kind of cash there is. With this FCF a company can pay out dividend consistently, buy back its shares when they are selling cheap, pare down loans, or invest in other profitable ventures, all done without assuming more debts.
There are some companies doing so well that even after heavy expansion they have a lot of cash left over. Latitude Tree is one of them.

Cash Flow of Latitude Tree

Latitude Tree Holdings Berhad (LT) specializes in the manufacturing and sale of wooden furniture and components, particularly rubber-wood furniture. Its manufacturing activities are operated from its three factories in Malaysia, two factories in Vietnam and one factory in Thailand. It exports 99% of its products mainly to the United States.
For the financial year ended 30^th June 2013, LT’s revenue fell marginally by 5% to RM494 million. However, its margin exploded with gross margin improved by 40% to 14.4%. Net profit margin more than doubled to 6.5%. With that its net profit improved by 116% to 32m, and earnings per share (EPS) ballooned by 145% to 25 sen. Thanks to the lower cost of production in Vietnam.
At the close of RM2.57 today, the PE ratio is 10.3, not that cheap considering the industry average and its historical PE ratio. The attractiveness of investing in LT actually lies in its cash flow.
The quality of earnings of LT is very good as evidenced from its CFFO which is double of its reported earnings as shown in Table 1 in appendix below. After spending 5.2m in CapEx, FCF is abundant at 47.8m last financial year. This is 10% of revenue and 18% of invested capital (IC), in hard cash. It is like when you invest $10000 and you receive $1800 in cash end of the year.
Valuation of Latitude Tree using Free Cash Flow
Financial theory postulated by John Burr Williams in his “The theory of investment value” suggests that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. This is similar to what Seth Klarman described as the Net Present Value analysis in his book “Margin of Safety” which he said is the most appropriate method to be used to value a company of on-going concern. Arguably the best reason to like DCFA is that it produces the closest thing to an Intrinsic Value.
Anyone who is interested in this method can refer to the case study on Pintaras as shown in the appended link below:
http://klse.i3investor.com/blogs/kcchongnz/46864.jsp
Using the FCF of the fy ended 30^th June 2013 of 47.8m, a growth rate of 5% for the next 10 years and 3% subsequently, and a discount rate of 10% as it has a reasonable healthy balance sheet, the FCF attributed to common shareholders is RM6.13 per share as shown in Table 2 in the appendix. This represents a very wide margin of safety of 58% investing in Latitude Tree at RM2.57 at the close on 11^th March 2014.
Quarterly results of Latitude Tree on 31^st December 2013
Subsequently on 23^rd February 2014, LT announced its second quarter results ended 31^st December 2014. Its cumulative 6 months revenue and EPS has increased by 38% and 138% respectively compared to the previous corresponding two quarters. LT’s excess cash has also increased by 68% from 68.5m to 115m. Best of all, its CFFO and FCF has also increased both by 26m to 42.2m and 38m respectively for the two quarters.
With its already stellar cash flows for the last fiscal year, coupled with its vast improved quarterly results in its financial position, financial performance and cash flows, latitude Tree at RM2.57 offers an excellent investment opportunity.

K C Chong (12/3/14)

Appendix
Table 1: CFFO and FCF of Latitude Tree

Year	2013	2012	Average
CFFO	52921	36746	44834
CapEx	-5166	-13824	-9495
FCF	47755	22922	35339
CFFO/NI	165%	247%	206%
FCF/Revenue	10%	4%	7%
FCF/IC	18%	8%	13%

Table 2: Discount cash flow analysis of Latitude Tree

PV of FCFF	$814,000
Add cash	$68,487
Less debts	($98,567)
PV of FCFE	$783,920
Less minority interest	($187,871)
FCF common shareholders	$596,049
Number of shares	97208
FCF per share	$6.13
Margin of safety	58%

Gordon Constant Growth Model
Assuming the FCF grows at 3% forever in accordance to rate of inflation. Discount rate (r) as before at 10%, and the base FCFo of last year of RM47.8m.

PV FCF=

FCFo*(1+g)/(r-g)

PV FCF=	702681
Add cash	$68,487
Less debts	($98,567)
PV of FCFE	$672,601
Less minority interest	($187,871)	24%
FCF common shareholders	$484,730
Number of shares	$97,208
FCF per share	$5.00
Discount	48%

The intrinsic value of latitude is RM5.00 per share. This represent a margin of safety of 48% investing in Latitude at RM2.57 a piece.

A ballpark analysis of corporate exercise on LTIGL
The proposed acquisition of all subsidiaries of LTIGL by LT was completed on 23^rd January 2014 as shown in the link below:
http://www.bursamalaysia.com/market/listed-companies/company-announcements/1524261
As at 31^st December 2013, LT has a total cash of about 155m and an excess cash of 115m. That was enough to pay off the acquisition of all the subsidiaries of LTIGL of RM118m. Assuming LT maintains a debt-to-equity ratio of 0.36 as previously used for the analysis, all the present value of RM814m FCF now belongs to the common shareholders and there is no “excess cash” now as before. The computation of intrinsic value would be as follows:

PV of FCFF	$814,000
Add cash	$0
Less debts	($139,000)
PV of FCFE	$675,000
Less minority interest	$0
FCF common shareholders	$675,000
Number of shares	97208
FCF per share	$6.94

This intrinsic value of LT of RM6.94 is more than the previously computed figure of RM6.13 per share.