#2 Investing Ideas – Elsoft Research Berhad (KLSE:ELSOFT)

#2 Investing Ideas – Elsoft Research Berhad (KLSE:ELSOFT)


This is Investing Ideas by ValueInvestAsia.com Hi, Stanley from Value Invest Asia. This week we have a very special guest, his name is MJ. He is a research analyst for Equitiestracker Holding Berhad which is a listed company on Bursa Malaysia. Equitiestracker Holdings they are mainly in the investment education business and MJ has been researching for them for quite a while, mainly focusing on stocks on the Bursa Malaysia market. I have known MJ for quite a while and MJ has always talked about very interesting companies and ideas within the Malaysian market. And this time around I am very privileged to chat with him where he introduced one of a very unique company called Elsoft Research Berhad which happens to manufacture machines to do testing for LED lighting. So I have a great chat with him and I think that you’ll find his idea and his thoughts on investing very unique and interesting as well. So here we go Hello MJ how are you? Hi Stanley absolute pleasure to be on the podcast. Hey very good, thank you very much for accepting our invitation. So maybe before we even begin, why don’t you share a little bit about yourself? How long have you actually been with EquitiesTracker and how long have you been investing? Yeah, so I’ve been investing for about four years now and I am currently a research analyst for EquitiesTracker for almost two and a half years as of today and what does EquitiesTracker actually do? So in a nutshell basically we help people invest better, and we help them invest better in two ways. Early on, Stanley you mentioned that we are in investor education. So education is one way and the other way we do it is through technology. So we try to merge the two and basically make life easy when it comes to investing in stocks. Ok and about yourself, how would you describe yourself as an investor, what was your investment style? So if I can be totally honest, even though I’ve been investing for four years, I think you know we always learned that in investing we need to invest for a long long time right? 40, 50 even 60 years depending on how how all of you live on. So you look at it from that perspective, four years really is very very small and because of that you know, I can say that I do not really develop a very strong philosophy. I’m still in a way open to a lot of different kind of strategies but only in relation to value investing. I’ll just like to add that because most of my personal investments and I manage funds for my family as well. I am mainly situated in Malaysia. And one of the good or bad thing, depending how you look at it, is that because we only have about 900 companies on Bursa Malaysia. So the opportunity set is a bit small but then small can mean niche right? So why am I telling you this? The reason it’s quite clear is that you cannot have a very specific strategy and say I want to invest, you cannot say I only want to invest in two sectors or I only want to do deep value investing or I only wanted to growth investing and so the bad part is that there’s this limitation. But the good part is that you are forced to actually entertain all different kind of investment strategy. So the way I would say it is you know more opportunistic. Because you know growth stocks, for example, growth investing is definitely good but we have a few of that. But we cannot be totally growth focused because you know valuations might get too high for it. This isn’t to say that all good stocks have high valuations. It just means that if you only do high growth stocks investing then you’re limiting yourself to a tiny opportunity set. So then the same time you cannot do the old school sort of statistical Graham-style investing because quite frankly there are not alot of companies trading and the you know 2/3 of working capital right now. Anyway even you find them you know you might wonder whether or not they’re actually good companies and then you try and sift through everything. We are left with one or two. I mean I can go on but I think the key things is that we are opportunistic. If it’s time to invest in the boring type investment, we will do that, if it’s time to go growth and if it’s deep value that’s the way I’ll do that. Or just a mixture of all three. OK, sounds reasonable but I think you’re a bit too humble because every time you share your ideas with me I find them very fascinating and certainly think that your investment at least your strategy is doing very well for you. Well, that’s only because I watch your stuff. Thank you, I think the main gist of our podcast of course “Investing Ideas:, is to look into some of the ideas that you are currently looking at and you basically is pitching to me one very interesting company which I do not know a lot about. Why don’t you introduce that to our audience and why do you like it? Alright, before I go on introducing I just want to make it very clear to listeners that what I’m about to share represents my personal view, not my company and just for the record I just wanna be clear. So the company that I’d like to introduce to you is actually Elsoft Research Berhad, listed on Bursa Malaysia. Some basic stats, you know as of the 13th of September (it has) RM610.7 million market cap. It is a company that’s been growing in term of revenue, profit and even the cash flows with operating or free. But what really is fascinating about Elsoft to me is that they’ve grown a lot of this with close to no liabilities. I mean there are no short term debt at all to speak of and the only some long-term liabilities. And fun fact for your listeners, it is actually the highest margin stock on Bursa Malaysia. I mean what it’s that the profit margins are the highest in the whole of Bursa. Really? You found the most profitable business on Bursa Malaysia. Yes, I like to clarify that this is data based on financial year 2018. Now, because of the trade war and things like that. It might look slightly different this year, but nevertheless you know I’ll show you later what a bad year looks like. But what do they do actually, for this company? Okay, so the technical answer to this question is that they build what we call automated test equipment, automated test equipment, auto test solutions, tester plus automation. That’s the boring version, but you know to really simplify it, basically they develop tools or machines or testers mostly to test LED products for their defects and functionality. And to be more specific, the functionality means the voltage and the temperature. so like LEDs lamps, like lightbulb? Yeah that’s that’s one part of it. Essentially they have roughly four end product. Three then plus one. So the first one would be your smart devices. For example the iPhone, I’m not saying that they supply to iPhones, I’m just saying that for example. Those flash, those LEDs, on your phone, that’s what they test so again you can imagine that they in order for the flash to function on the iPhone then it needs to go through a series of testing and so they build the machine they use their intellectual property to manufacturing and then sell it to whoever wants to test the equipment so that’s the first segment and it is the largest segment at about 59% of revenue. Now next is smart devices followed by automotive. So you know things like your day running lights, your front tail lamps they also test those equipments. So roughly that’s about 49% in 2016, 41% in 2017, 2018 drop to 27%. So that’s the second largest segment and followed by what we call general LED lighting so that your lamp. Does that include LED screens? I’m not too sure but from my understanding is that there is a possibility of this that’s what they do. Because in fact it’s probably correct because they test LED lights in general. Last but not least, they are embarking on a new sort of a new product, what they called embedded controls which we will get into a little bit more later on. You talk about their business right, but what makes you interested in this company? Ok so let’s say you are new to investing and you really wanted to find out whether or not you know a quick-fire way to figure out whether the company has some moats, rights? Stanley you talk alot about moats in your videos, you know and the importance of moats. Now the truth is to understand the moat requires quite a bit of homework but there’s a shortcut way to find out whether or not, there’s a good chance to figure out and that is actually figure out what their margins are. Margin’s basically what’s left over after all the expenses have been paid off. Very simple. Now, just to use just to compare Elsoft and the other competitors; MMSV, Teradyne & Chroma ATE. Their pre-tax margins which is basically what is left over before they pay taxes, is about Elsoft is (2014) 46%, (2015) 53%, (2016) 49%, (2017) 45%, and (2018) 52%. So just to explain very simply right, every dollar of revenue they keep nearly well on average 50%. Why I believe that they have a moat, even let’s say I totally knew nothing about things like switching costs and no regulations and all that stuff. Their next closest competitor is MMSV, so from 2014 to 2018 is 26%, 26%, 28% and then down to about 21%. So the our closest competitors have half the margin. Then you look at international companies like Chroma from Taiwan 15%, 15%, 28%, 21%. Teradyne, based in the US, 6%, 15%, -3% and then I think it’s 25% to 22%. So they are quite frankly head and shoulders above the others. Why do you think that’s the case? So the truth is there’s actually many reasons but the largest reason is actually simply intellectual property. In fact, we spoke to the management of Elsoft. Other members in my research team did, and obviously I wouldn’t share all the technicalities but basically they are able to do lot faster and a lot more proactive when it comes to the designs of their machines and the efficiency so that gives them an edge because what you’re doing is you’re actually doing a cost saving for your client. When you do things faster and only that you can do things faster but your competitors cannot copy you, either they don’t know or you’re protected by IP. So that’s that’s the intellectual property and I’m not an engineer so I’m definitely not qualified to explain exactly what’s the intellectual property is but trust me. In fact we do study other companies with single levels or margin. What’s pops up very clearly you know in all findings is that intellectual property is by far the number one factor in determining the margins of a company. Right okay,and how are they actually growing nowadays? So as I mentioned early on, they are actually in LED. It’s the fact is that well LEDs are simply the most energy cost-saving things out there. When you compare it to things like fluorescent lamps and all that, they can actually reduce energy usage by 75% when it comes to lights. So it’s like there’s virtually no comparison. Now, a little bit of history, basically in 2010, LED really came to the fore meaning that they started adoption from 2000 and according to statistica for all products was 0.3 percent. All the lights that you see whether it’s automotive, general or smartphones used to be non-LED. By 2020 next year, it will be 61%. So there’s more and more adaptation into LEDs for future devices right? Yes absolutely and most interesting is that this new technology, alright the person who discovered white LEDs actually won a Nobel Prize way in 2014, it just cool facts right, Mr. Shuji Nakamura and what happened was that or rather was startling to me is not so much the growth but how fast it is for a new technology. Usually like the Internet or the car or airplane usually takes a while, like a decade or two before it starts to gain traction right? We see it now with blockchain especially. But this LED really took up really really fast and and you know that’s where the growth is coming from. So just some stats, so that’s the past right, so what can you look for in future in terms of the entire market based on our research, it will be expected to grow at about 14% over the next five years, four years until 2023. And the entire addressable market we should say, how big the market can be is roughly about USD105 billion dollars. So that’s how big you’re looking at. Ok yeah, but having said that, that’s the LED market and not the LED testing market right? Yes correct. Well okay I get your point, but of course you see if there are more LEDs then there’ll be demand for more testers and internal capacity will have to increase. Yeah fair enough okay. So there is wear and tear and capacity issues, these kind of things. For this company, they do a few sectors, which one are you actually more optimistic about? Okay so I would say it would be the automotive. Now why? It’s because in 2012 the EU actually mandated that every single car in Europe will have to have what we called a front running lights in terms of your front lights. Now long story short, it just means that if you’re not using an LED, if your car does not have LED lights for your front lights, it’s illegal. Oh okay. Yeah this is actually illegal. And the reasons because Europe is in terms of global warming the most the fastest right, they’re the most concerned about global warming. So you know because LED reduces energy usage and therefore carbon emissions by 75% so that’s why they are (supportive). And in the US as well the trucks are already mandated to have day running lights so you know what happens there eventually will also happen in Asia. That’s why I would think that is the fastest growing of all. Interesting interesting and if they’re the case for you know a company that has so much potential, do you have a stats like how much market share they really have because with a market cap of only RM600 Million, it’s actually quite a small company. I don’t have the stats for that because it’s actually quite difficult as you can imagine for companies with alot of IP, being private & confidential is very important. So we can reverse engineer the numbers but really we can only guess like big is the market. But I don’t think they’re that big. The second thing I will point out is that it’s not so much about market share. To me is not the most important, the most important thing is that is margins. Okay okay and talking about margins, you’re right, they could have something spectacular in terms of IP that is giving them such a high margin but in terms of the risk side, what kind of possible risk are you thinking about? Because from just looking at it right, to me it could mean yes they’re very good company or maybe it could be a fraudulent company. Do you see that as a risk? I don’t think so, I think that because they don’t play around with their accounting so much based on their past ten years. So I wouldn’t say they’re fraudulent. Look, at the end of the day we can never know but to me it’s more important that the investors understand the business model because why would someone or a business owner commit fraud? The reason he would commit fraud is because he believes he can make more money being a fraud rather than actually running the business. This gentleman has been around for a long time and you know, revenues actually fell very very sharply during from 2006 and 2008 and he struck the course, nothing change and he was there through the hard times and now he’s doing pretty well in the good times. Back to your original question which is risk, it’s definitely true that there is risk. The first one is actually LED saturation. Just to repeat right, so next year it will be 60% saturation. So in 10 years, it went from zero to 60% Because it’s compounding, so from 62% to 100%, Let’s say 99% 98%, it’s going to be a shorter time. So as a result, the company is really relying on something that has a product life cycle between three to five years. So that is definitely one reason of concern. In the IP risk, the knockoffs from our big neighbors in Asia, that’s definitely a possibility. Because in certain countries, intellectual properties don’t really matter, so for sure that is really a risk. Now, I just want to say that let’s say even if adaptation does happened, adaptation to 100%, it’s not possible but let’s say it’s 100% what happens after that is the growth will not be there anymore. Or rather the growth will not be as fast anymore. Because those existing LED products will need to be replaced correct? So when they are replaced by newer more high-tech products maybe, recently the iPhone has now three cameras, so as you can imagine the camera lens makers would have to make more, to produce more. So it’s a boom for them. It is no different as LEDs get into cars, get into houses, to keep replacing them it means that there’ll always be a demand for testing for LEDs and therefore the demand for LED testing. The key thing to understand is that it’s not going to be as smooth. That’s one of the way to look at it. You mentioned about the trade war or the tariffs between US and Chinese have an impact on this company, why would that be the case? So the truth is that the trade war is quite a complex thing right? Because it’s complex, because political leaders especially across the Pacific from here can be quite erratic, So that is one element of complexity but complexities actually in its supply chains. Now it’s very hard to discern as to why the trade war is causing a bit of, you know like a confidence crisis. Is it because it’s a truly economic reasons or is it because it’s a confidence or psychological issue? Of course, once volatility returns back to normal and clues become more stable. So I don’t know is it psychological or economical I am not too sure. Okay so so in terms of maybe some of the customers are holding on to all this and not ordering so much that could potentially impact their business. Because they still need their customers to make LEDs in order for them to have more successful for the testing machine right? Okay that’s interesting and I’ve been just looking at the stock chart it has been quite hammered due to this. Let’s start on valuation, do you find this attractive right now and you know how do you look at the valuation? Yes so you know one thing that I actually learned from you is that valuation is like this very arcane, it’s like something out of a Harry Potter book but really I think what you have told me also is that you’ve managed to really simplify it into three boxes. The first one will be basically a multiple base or P/E or price to cash flow or price to book or multiple. Then there’s a second valuation where you look at the balance sheet and the cash and the third cetera and then also next would be the net present value or the discounted cash flow model. But what I realized also is that you can actually co-mingle more than one of the valuation techniques. Meaning you can use multiple and in this case you can combine a multiple based and asset valuation base. So when you do that basically, when you buy a company you’re also buying the cash and the debt of the company, you’re buying the property, plant, equipment and all that. At least that should be the mentality going into the stock market. It’s like buying the whole business, you are buying the assets of the company, you’re also buying the cash flow of the company. So when you combine that and you add the fact that it has a relatively high dividend payout. And so the payout, just for your information, is roughly between 63% in 2014 to over 77% (2018). Can you imagine it has such high margin already and then they pay out so much dividends right? That’s why it’s no surprise that the dividend is about 4.7% last year. So when you take that into account, you’re looking at buying something at eleven times earnings. Which give you roughly 9.1% returns going forward. So when you buying this stock, you are expecting a 9.1% return. Now that might not be interesting to your viewers. Now, let’s run through that, how do you come up with that expectation, that you can expect a 9.1% return from this stock? What’s your thinking behind? Ok, so I’ve always follow the principle that fundamentals will determine future stock prices. If fundamentals don’t determine future stock price, then value investing is dead. So the fundamentals in this case would be the the operating cash flow that the company is generating. And in this case, you’re looking at a 11 times operating cash flow multiple. And if you invert that, you will get a 9.1%. Because it’s the yield you are getting. Ok, it’s not exactly the cash flow yield, it’s the cash flow yield plus the asset valuation. So basically I take the market cap and then I net off whatever cash and debt it has. I use that as the new market cap and then I plug in the operating cash flow inside. It’s about 9.1%. The fancy Wall Street term is cash adjusted price. It’s very similar to enterprise value technically. Now, so 9.1% might satisfy some people because the Bursa Malaysia price to earnings ratio right now is roughly 16-18 times, so you’re looking at 6% maybe 7% return going forward. So a nine percent will represent beating the market so but that might excite some people, that might not excite some people. Now if you looking for double-digit returns and you go and if you want but if you want to get up double digit return on this, you have to take advantage of the high dividend payout and dividend yield. When you receive those dividends, if you reinvest those dividends into the same stock then you can actually boost your returns from 9% to between 10-13% by my own calculation. Okay if you reinvest it and assuming that they continue to grow and produce that kind of return. If you don’t use the dividends to buy iPhones, yes then you can, there’s a good chance you can do that. Now this is more like an absolute kind of valuation but when I compare it to peers and those four same peers right so Elsoft is about 11 times earnings as I mentioned. MMSV is about 14 times, Teradyne 15x and Chroma is at 37x. So on a absolute basis, there is a good chance that you can beat the market with the stock but on a relative basis, compared to its peers, it is quite attractive. Of course that’s all assumes that the management, the same thing that they’ve always been doing. I have very high respect for management but they might do the wrong thing or they might have succession problems or whatever. So that’s a risk. That’s very fascinating looking at its margin and the things that they do really reminds me of this company, Vitrox. Well actually if you understand Vitrox you understand how similar they are. Thank you so much MJ for this wonderful explanation on Elsoft Research Berhad. If you guys want to check out more about MJ or Equitiestracker you can find them on Facebook and just search Equitiestracker you should be able to follow some of their own research and also what they have been up to. It has been a pleasure talking to you MJ, thank you so much! It’s my pleasure as well Stanley, see you!

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