When we consume packaged food and drinks, we seldom notice the manufacturers of the packaging and their businesses. SCGM Bhd (SCGM:KLS, stock code: 7247) are factories in Malaysia that process input materials such as PET, PP and transform them into consumer products in food packaging. SCGM is a very typical Malaysian founder-operated business that started almost from scratch to eventually listed in the main market in KLSE. Here is a nice corporate milestones captured from its annual report 2016.
Family Lee has four brothers who are all executive directors. They have an ambitious production capacity expansion plan for the next three years. What if they could successfully execute their plan? How would its sales and net profits play out in future? Has the current PE multiple 26 already fully capitalize its growth potential?
Which growth model is useful to SCGM valuation?
One need to know the growth model of SCGM before estimating its future growth. If the growth model is demand-led, it means the limiting factor to growth is sales; if it is production capacity-led, then the limiting factor to growth is production capacity. Let’s firstly examine the historical growth pattern of SCGM in the past ten years. The 1st chart shows sales and gross profit margins in the past ten financial years. With the global financial crisis as background in 2008, demand shrank significantly within a year; sales declined by 5% in FY2009. However, the production capacity of the packaging industry was inelastic in such short time, resulting in significant over-capacity and great pressure on gross profit margins. Except some inventory re-stocking phenomenon in FY2010, the gross profit margins remained low at around 20% till FY2013. To see more evidences of changing growth pattern in FY2013, let’s examine the 2nd chart that shows SCGM’s EPM (Equipment, Plant and Machinery) assets turnover. By definition, EPM assets turnover tells us how much sales is generated per EPM assets (measured at the beginning of financial year); if EPM assets are fully utilized in given financial year, the corresponding EPM assets turnover should be the highest and vice versa. In FY2009, EPM assets turnover drastically dropped, reflecting low EPM utilizations. The lowest point came at 4.48 in FY2011.
Based on these gross profit margins and EPM assets turnover trends, I will argue that from roughly FY2009 to FY2013, SCGM experienced a demand-led growth period. No matter how much EPM could SCGM possibly add, it could not increase sales without sacrificing gross profit margin. Since around FY2013, however, I will argue SCGM’s growth path has increasingly become capacity-led. EPM assets turnover was on the rising trend, with maximum at 6.2 in FY2015. EPM (net) has also been expanding faster in the same period. The 3rd chart details how much EPM was added and depreciated over time. EPM investment rate shows a consistent trend of low investment rate during demand-led period and rising investment rate during capacity-led period. We may obtain more insights from the management discussions. Particularly in FY2012, the board intended to “carry out a private placement exercise which will enable us to raise more funds for further expansion”. Although it did not materialize immediately, the board eventually completed the private placement of 10% of new ordinary shares in FY2016, raising RM31.3m to fund its expansion plan; the size of this new equity capital is almost the same as that of the sum of EPM additions during FY2012 to FY2016. Otherwise, SCGM should have seen more expansion in the past three years.
Given fore-mentioned analysis and the management expansion plan committed so far, I will assume production capacity be the limiting factor of growth in the next three to five years. In other words, capacity-led growth model should be more useful for SCGM valuation in medium investment time frame (3 to 5 years).
The capacity-led growth model
Under the capacity-led situation, SCGM were as if it is the only fishing boat in the ocean; it catches fishes as much as it can. The only limitation is its capacity to catch. The core productive assets of SCGM is EPM, so the capacity of EPM is the limiting factor to sales growth; and the capacity of EPM is represented by EPM assets in monetary unit (RM). In mathematical expression,
EPM assets (net) * EPM assets turnover = Sales
where EPM assets (net, in RM) are measured at the beginning of financial year and EPM assets turnover is a multiple; both are independent inputs that determines sales as an output. Assuming a constant EPM assets turnover, the growth of sales is directly proportional to the growth of EPM assets. By contrast, under the demand-led situation, expanding EPM assets does not translate into growth of sales because demand is the limiting factor.
To facilitate an interactive valuation experience, the financial model of SCGM and the investment valuation model are programmed in Stella® Architect by isee systems inc. The models require the following inputs to compute the present value of SCGM shares:
- Inputs to SCGM financial model
- Net profit margin
- EPM investment rate
- EPM depreciation rate
- EPM assets turnover
- Dividend payout ratio
- Inputs to investment valuation model
- Holding period
- Expected PE multiple when selling SCGM shares
- Required rate of return
Using this model and user-defined inputs, we can simulate the present value of all SCGM shares by discounting all cash dividends received and proceeds of selling all shares during the holding period. The financial model of SCGM are validated by its historical financial data from FY2007 to FY2016 as shown in the table. Note that the initial (FY2007) value of EPM (net) is in fact an input.
Now I’m ready to simulate “What if” scenario to conclude my investment case in SCGM. Based on my gut feeling, I assume the following inputs to SCGM financial model in the next five years.
Net profit margin:
I take the same margin from FY2016; that is, 15% flat in the next five years. In fact, if I had researched SCGM more in-depth, I would possibly figure out how its net profit margin would be improved due to economy of scale. Since I did not, I rather take a conservative side.
EPM investment rate:
Firstly, I try to align it according to the management discussion in FY2016; RM 15m in FY2017, RM 16.5m in FY2018, and RM 16.5m in FY2019 (note: 33m/2 = 16.5m). By backward calculations, I find that the corresponding EPM investment rates are 49%, 41%, and 33.3% respectively. For the remaining FY2020 and FY2012, there is no guidance from the management. So, I’m a bit conservative and I assume just 25% each.
EPM depreciation rate:
According to SCGM’s Significant Accounting Policies, the principal annual deprecation rates used for EPM are 10% – 20%. My assumption is 18% flat in the next five years.
EPM assets turnover:
Economy of scale plays a role in EPM assets turnover. Again, I rather assume a conservative number – 6.0 in the next five years; because I do not have sufficient insight.
Dividend payout ratio:
I simply assume 65% in the next five years.
The table below shows my inputs and the simulation outputs. For simplicity, I remove the past nine year data and show only the future five year data.
Regarding to investment valuation, I create my investment case as follows.
SCGM management so far gives us their production expansion plan till 2019. So, I prefer my investment time frame to medium term three years.
PE multiple when selling shares:
As of today, the trailing PE multiple is around 26 to 27. Is it high? Here we need careful judgement. My gut feeling is to take 20.
Required rate of return:
I demand 16% average compounded rate of return in this investment case.
With all the inputs, I simulate my investment case and get the results in the screen shot below. The conclusion is that, if I require 16% rate of return over three years holding period, I should buy SCGM shares at around RM 623m. Currently market cap is around 620m, which means this is a right price to my investment case. My investment total return would be 54.5%, consisting of 43.2% capital gain and 11.3% dividend income.
How about margin of safety? We can find it out by setting required rate of return to be risk-free rate! However, which rate is appropriate? Should we simply use Malaysia government 10-year bond yield, currently standing at 4%? This could be a debate topic. Nevertheless, I simply apply 4% in this investment case. Then the calculated market cap is RM 857m. It means that the margin of safety in my investment case is around 27% (= 1 – 623m / 857m).
Simulate your own investment case
You can simulate your own “What if” scenario and create your own investment case. You may agree with me that the capacity-led growth model is useful to SCGM valuation; nevertheless, you may NOT agree on some other key assumptions like EPM investment rate and future net profit margin; or you may prefer to a five-year holding period and believe that you have high chance to sell your shares at PE multiple 25. Then take control of your own investment case by applying your preferred input settings and simulate your investment results! Here is the link to SCGM Investment Simulation. Have fun and good luck!
 SCGM has financial year ended on 30 April in every year
 EPM is equipment, plant and machinery. EPM (net) is stated at the end of the financial year whereas EPM assets turnover is calculated by dividing EPM (net) at the beginning of the financial year into sales. Although EPM assets could change within a financial year, this simple definition is sufficient to reveal the trend over few year time span
 EPM investment rate is calculated by dividing EPM (net) at the beginning of the financial year into EPM (addition) during the financial year
 Surely there is finite number of fishes in the ocean. The assumption here is that the number of fishes available to be caught far exceeds the capacity of the fishing boat
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