Stop Press:

“ECS ICT bags Apple Watch Distribution Rights: Astar Sdn Bhd, a wholly owned subsidiary of ECS ICT bhd, has received the rights to distribute three latest smartwatches-apple Watch, Motorola’s Moto 360 and Asus ZenWatch 2”

I wrote an article on ECS ITC a couple of weeks ago here deliberating its investment thesis:

http://klse.i3investor.com/blogs/kcchongnz/90072.jsp

There are some good comments. I will here give my personal views, starting with this one.

[Posted by shinado > Jan 19, 2016 10:55 PM | Report Abuse

KC, I have this stock in my watchlist. Apart from the lower ROAE and FCF vs Revenue, this company tick most of the boxes in my selection criteria. Especially for the high ROIC & CROIC of above 20%.]

The margins of ECS’s business is low, and yes the free cash flow is also low in relative to its revenue, but that is the nature of this kind of business.

What is more important to determine if it is a good business is its return on assets (ROA), return on equity (ROE), and cash return on invested capital (CROIC). A ROA and ROE of 7.1% and 13,3% respectively are very decent numbers, boasted by its high sales in relation to its assets as shown in Table 1 in the Appendix. The other more appropriate return metric of return on invested capital (ROIC), and CROIC are even much spectacular at more than 20%, as rightly pointed out by the commentator.

Here are more good comments:

 [Posted by speakup > Jan 19, 2016 05:56 PM | Report Abuse

many malaysian companies have deffered making IT purchases due to the weak RM vs strong US$. This will negatively affect ECS revenue in the near term.]

[Posted by talkcockbotakchek888 > Jan 19, 2016 09:25 PM | Report Abuse

Agreed with speakup: weak domestic demand which reflected in their 3Q15 results.
"Attractive business model with some moat". Given that the margins have decreased from 2% to 1% over the years, what are the moats of this attractive business model?]

 [Posted by speakup > Jan 20, 2016 09:52 AM | Report Abuse

ECS imports goods quoted in US$, which is opposite of "export" theme which is pushing up shares like Latitude, Poh Huat, Evergreen, VS, .... ]

[Posted by speakup > Jan 20, 2016 09:54 AM | Report Abuse

Due to the weak ringgit and strong US$, plus the deteriorating malaysian business sentiment, I will rate ECS a Sell.]

The revenue of ECS for the latest quarter has not suffered. Instead, it increases by 28.6% compared to the corresponding quarter the previous year.

The main focus of the above comments is the weak Ringgit, affecting the costs of its imports, and hence its margins and bottom line. I do agree that this argument may be valid, and in fact, it has affected its third quarter results somewhat.

However, I think the following comment is timely.

[Posted by NOBY > Jan 20, 2016 11:31 AM | Report Abuse

Yes. We know that USD strengthening will impact ECS bottom line/revenue. Question is if its already priced in.]

The other question is what do you think is the direction of the foreign exchange rate in the future? Will oil price and Ringgit continue to weaken?

I personally have no idea at all, and I doubt anyone is so good in making prediction about it. Hence I do not like to think too much about the macro thingy, but rather concentrate on micro and company specifics.

Moat wise is subjective. A low cost producer has also got some moat. A company which can consistently earn high accounting as well as cash return on invested capital of more than 20% must have something good in it. It doesn’t need much capital expenses. Reinvestment is all in its working capital requirements, due to its good growth, which is good.

Relative Valuations

I consider ECS ICT a good company due to its high returns on capitals, both in earnings and cash flows wise as discussed above. Equally important, is ECS selling at a reasonable price at today’s price of RM1.54?

I have addressed this question in details in my last article here:

http://klse.i3investor.com/blogs/kcchongnz/90072.jsp

 The conclusion is “All valuation metrics above show at RM1.57, ECS is selling cheaply in all aspects.”

Let us walk an extra mile. In this article, I will deal with the absolute valuation of ECS using discounted free cash flow analysis.

Discounted free cash flow analysis

I have used this DCFA numerous times for a number of companies as published in i3investor. One of them is appended here which shows some theoretical background of the analysis.

http://klse.i3investor.com/blogs/kcchongnz/86127.jsp

Some people here will scorn at this and label it as “useless theory”, “Jargon”, “Bullshit” etc. But before that listen to what Seth Klarman, a very successful hedge fund manager in the US says:

“To be a value investor, you must buy at a discount from underlying value. Analyzing each potential value investment opportunity therefore begins with an assessment of business value…. While a great many methods of business valuation exist, there are only three that I find useful.”

“For a going concern, the Net present value would be most applicable. A frequently used but flawed shortcut method of valuing a going concern is known as private-market value”.

That is the discounted free cash flows analysis to obtain the present value, or the intrinsic value of a stock. We have also dealt with the “private-market value” in our previous valuations.

Of course I do not expect everyone is a value investor as mentioned by Seth Klarman.

Another great investor, not a theoretician, Warren Buffett also seeks to estimate a company's intrinsic value. He projects the future owner's earnings, something similar to FCF, then discounts them back to the present to get the intrinsic value of the company and hence its stock.

Discounted free cash flows analysis of ECS ICT

The discount rate

Since public listing, ECS has stable earnings and cash flows all these years. Its balance sheet is squeaky clean with a cash holding of RM124m, or 69 sen per share., and with zero debt. I will use a discount rate of 10%, a risk premium of about 6% over the bank fixed deposit rate. This I consider as a conservative rate in view of its good financial performance and position.

Estimating future free cash flows

In this analysis, the average free cash flows (FCF) for the last 5 years from 2010 to 2014 of RM27m as shown in Table 3 in the Appendix is used as the base of estimation for the future FCF. It is assumed that FCF will grow at a compounded annual growth rate (CAGR) of 8% for the next 5 years, somewhat similar to its past 5-year growth rate, and 3% subsequently for the rest of its economic life, something resembling the rate of inflation.

Discounted Free Cash Flows Analysis

Table 4 in the appendix show the data and assumptions and the two-stage DCFM computed using FCF on a spreadsheet. The present value of all future FCF attributed to the equity shareholders from the ordinary business using this method is shown to be RM492m. Adding the total cash and cash equivalent of RM124m, the total present value attributed to equity shareholders is RM616m, or RM3.42 per share.

This present value, or intrinsic value of the stock represents a margin of safety (MOS) of 55% investing in ECS at today’s price of RM1.54 on 4^th February 2016.

For a company like ECS, a MOS of more than 30% is what I am looking for as an investment.

Reverse Discount Cash Flow Analysis (RDCFA)

Projecting future cash flow of the business is an art. There are simply too many uncertainties when trying to forecast this future cash flow.  A small error can result in a drastic change in the value. Rather than starting your analysis with an unknown, a company's future free cash flows, and trying to arrive at a target stock valuation, start instead with what you do know with certainty about the stock: its current market valuation.

By working backwards, or reverse-engineering the DCFM from its stock price, we can work out the amount of cash that the company will have to produce to justify that price. If the current price assumes more free cash flows than what the company can realistically produce, then we can conclude that the stock is overvalued; if the opposite is the case, and the market's expectations fall short of what the company can deliver, then we should conclude that it is undervalued.

Basing on the market price of RM1.54 for ECS, and the assumptions of future FCF and the discount rate, the RDCFA shows that the market is expecting its business to deteriorate at 6% for the rest of its economic life from now on. Do you think this is a reasonable growth expectation for ECS, after taking into consideration of its recent past performance and that the inflation rate and GDP growth is about 3%-4%?

Conclusion

The discount cash flow analysis basing on a growth rate of its FCF of 8% for the next 5 years and 3% subsequently estimated the intrinsic value of ECS to be RM3.42. There is a high margin of safety of 54% at its market price of RM1.54.

The reverse DCFA shows at RM1.54, the market is expecting its business to deteriorate at 6% from now on for the rest of its economic life.  One has to judge if this expected deterioration is realistic.

Well like what Joel Greenblatt said,

“The secret to successful investing is to figure out the value of something-and then pay a lot less.”

Many people invest in the stock market with tens, hundreds of thousands, or millions of Ringgit. Do you think it is good to know how to figure out the value of a share and then pay a lot less in order to be successful in your investing experience? Or if you are not sure a stock which you intend to pour in tens of thousands into, to engage someone to help you?

Feel free to contact me for online investing course to learn the language of business in order to identify good companies for investment and to do valuation of what a stock is worth for a small fee at

ckc14training2@gmail.com

K C Chong

Appendix

Table 1: Financial performance of ECS ICT

Table 2: Relative valuations of ECS

Table 3: Past cash flows of ECS

Table 4: Discounted free cash flows analysis for ECS