When Cheap Isn’t That Cheap

Foreword from ShareInvestor

This article “When Cheap Isn’t That Cheap” by Cai HaoXiang was first published in The Business Times on 12 Jun 2017 and is reproduced in this blog in its entirety.

        Only by detecting the traps and adjusting around them can you begin to evaluate a company objectively

Sometimes, a stock you come across seems ridiculously cheap.

Why, after excluding a gigantic cash pile, is a toymaker famed for making action figures from a famous cartoon trading at just over two times 2015 earnings?

Or why is a casino stock with a long-term monopoly in an Asian capital, a 40 per cent operating margin, and consistent free cash flow through the years, trading at under seven times 2016 earnings and sporting a 7 per cent dividend yield?

Before you jump in, three gigantic neon-lit words should be flashing in your brain, punctuated by ambulance sirens and music from the scariest horror movies: “It’s a trap!”

When encountering numbers that seem too good to be true, there’s almost always a problem somewhere.

Sometimes it takes you a few minutes on the Internet to figure out what it is. Sometimes it takes weeks of trawling annual reports and announcements.

It doesn’t mean that the company isn’t a good buy despite all the bad stuff you’ve learnt. But it does mean the company won’t be as cheap as you thought it was.

Both examples above are from the Hong Kong Stock Exchange, which holds a number of rather intriguing ideas.

Turtle Power

The first company is Playmates Toys. Go beyond the sniggering and you’ll realise the company has been around for just over 50 years.

Originally founded as a doll maker, Playmates first began making Disney-related dolls in 1982. In 1987, it acquired an exclusive worldwide master toy licence to make toys of Teenage Mutant Ninja Turtles.

With the success of the Turtles and other toys, the company shifted its focus from production to design and marketing.

It takes some poring through Playmates’ historical numbers and understanding its business model before you realise how immensely unpredictable the toy business is.

The company made just HK$45 million (about S$8 million) in revenues in 2011. But that swelled to an incredible HK$2.2 billion in 2014, when the Turtles craze was at its height with a new movie and a TV relaunch.

The hype seems to have faded, with the company reporting large revenue and profit decreases.

The problem is this. While those who possess licences to make toys for famous franchises enjoy a barrier to entry, there is intense competition for the limited attention spans of children. Sales also depend on what everyone else likes.

Moreover, lucrative licences do not last forever. Playmates used to make Disney Princess dolls, a licence that is arguably one of the most valuable to own out there. Unfortunately, it lost the business around 2008.

For that matter, Disney Princess dolls were also made by Barbie doll maker Mattel. But in a stunning upset in 2014, Mattel lost the business to rival Hasbro.

There is good reason why, by the end of 2016, Playmates Toys was sitting on cash of HK$1 billion, had racked up net income before extraordinary items of HK$1.3 billion in 2013-15, but had a market capitalisation of just HK$1.6 billion.

This is a classic boom and bust stock. It is very difficult to forecast future earnings. The company barely broke even for profit before tax in the first three months this year. Perhaps only when the company is trading closer to its net cash can it be considered a deep bargain.

Can Playmates Toys continue to hold its own against the two giant US toymakers Mattel and Hasbro? When will Ninja Turtles fever strike again? With the smartphone boom and developments in virtual reality, would digital games become more popular and cause the toy industry to decline? Investors have to tread with care.

The Cambodian Gamble

The second stock mentioned is NagaCorp, a company which owns Phnom Penh’s only licensed casino, NagaWorld. It has a monopoly there till 2035. From its beginnings on a river barge, its operations have grown into an integrated entertainment, hotel and casino complex.

The company tried but failed to get listed in Singapore in 2003, due to regulatory and money laundering concerns. It finally succeeded in Hong Kong in 2006.

On the surface, its numbers look good. With a monopoly, a high dividend yield, very impressive operating margins and an oddly low valuation, what’s there not to like?

Look closer at the company’s capital structure, and you’ll realise that the company has issued a substantial amount in convertible bonds to founder Chen Lip Keong. If fully converted, minority shareholders will be significantly diluted.

Indeed, the company announced in March that he planned to convert a portion of bonds into shares, which would result in him and concert parties raising their stakes from 38.98 per cent to 61.13 per cent.

So the low valuation numbers need to be adjusted significantly upwards to account for the dilution, for a start. Its juicy dividend yield will drop.

There are other reasons holding back the valuation. There is frontier market risk, along with uncertainty over new gambling laws and taxes, and potential competition from other casinos in the region eroding the firm’s profitability.

The Asian casino business is also rather volatile. It is an open secret that casinos are a way for mainland Chinese to get their money out of the country. The authorities have been clamping down with some success.

All these don’t mean NagaCorp isn’t a buy at a low double-digit earnings ratio, especially with the Naga2 expansion, a stone’s throw from NagaWorld, becoming operational this year. Yet, it won’t be an obvious steal. You need to judge if the price compensates for all the risks.

So there will always be counters out there that appear cheap, especially if you just do a shallow screen.

But there is no free lunch. Only by detecting the pitfalls and adjusting around them can you begin to evaluate a company objectively.