Sunday, 15 November 2020

Banks' Operating & Financial Metrics Explained

Recently, the 3 local banks reported a better set of results than expected. Banks have a unique set of operating and financial metrics that are different from other industries and their financial statements cannot be analysed based on the usual metrics. This blog post attempts to explain the various metrics used in banks' financial statements. I will use DBS' financial statements as examples for the metrics, but they are applicable to the other 2 banks.

Net Interest Income

At the core of a bank's operations is its business of taking short-term deposits and making long-term loans. Banks charge higher interest rates for the loans and pay lower interest rates for the deposits, thereby profiting from the difference in interest rates. This difference is known as the Net Interest Margin (NIM). The higher the NIM, the more profits the bank generates from its lending operations. In the last 6 months, the NIM of banks have come off steeply as the US Federal Reserve lowered interest rates sharply to stave off an impending recession caused by the COVID-19 pandemic. For DBS, its NIM has dropped from 1.86% in Dec 2019 to 1.53% in Sep 2020.

Many factors affect the NIM. One of them is the Loan-to-Deposit Ratio (LDR). This ratio indicates how much deposits are lent out as loans. The higher the LDR, the more loans are made from the deposits. However, it is never a good idea to lend out 100% of the deposits, because if depositors were to withdraw money from the bank at short notices, the bank would have to find other sources of funds to replace them. These alternative sources of funds are usually more expensive than customers' deposits. Due to the COVID-19 recession, depositors have flocked back to the safety of the 3 major banks. For DBS, its LDR has dropped from 89% in Dec 2019 to 83% in Sep 2020 as it receives more deposits than it could loan out.

Another factor is the Current Account Savings Account (CASA) Ratio. Banks obtain their funds from current accounts, savings accounts, fixed deposits, bank bonds, shareholder equity, etc. This ratio describes the percentage of deposits that are from current and savings accounts, which have the lowest cost of funds among all funding sources.Thus, the higher the CASA ratio, the lower the interest rate paid to depositors and the higher the NIM would be. For DBS, the CASA ratio went up from 58.9% in Dec 2019 to 69.5% in Sep 2020. This is likely due to the low interest rates offered on fixed deposits, which discourage depositors from renewing their fixed deposits. 

Credit Costs

Although banks profit from the Net Interest Income, there are also loans that might potentially go bad and have to be written off, which reduces the lending profits. The key metric is the Non-Performing Loan (NPL) Ratio. This ratio describes the percentage of loans that might potentially go bad. Note that this ratio reflects the total amount of outstanding NPLs at a snapshot in time and not new NPLs incurred during the reporting period. For DBS, the NPL ratio has largely stayed constant, from 1.5% in Dec 2019 to 1.6% in Sep 2020.

How banks deduct losses from bad loans is by setting aside allowances in the income statement. Note that these allowances do not necessarily mean that the bad loans are irrecoverable. If the economy recovers and the companies do well again, the bank could write-back the past allowances made, thereby increasing the profit in future reporting periods.

There are 2 types of allowances -- general provisions and specific provisions. General Provisions (GP) are for potential bad loans in the industry as a whole, while Specific Provisions (SP) are for bad loans of specific companies. For example, retailers are facing significant challenges from e-commerce and COVID-19. Banks might set aside more general provisions for loans to retailers. On the other hand, Robinsons' closure means that banks that are exposed to it have to set aside more specific provisions for loans to Robinsons.

In recent years, banks have adopted the Expected Credit Loss (ECL) model, which requires banks to estimate the expected amount of credit losses from the loans. There are 3 stages in the ECL model. ECL Stages 1 and 2 correspond to GP while ECL Stage 3 corresponds to SP.

For 3Q2020, DBS set aside $236M in GP and $318M in SP. As a percentage of total loans on an annualised basis, the SP credit cost is 0.31% or 31 basis points. The GP credit cost works out to be 23 basis points.

Thus, for 3Q2020, DBS made NIM of 1.53%, but had to set aside credit costs of 0.31% in SP and 0.23% in GP. After deducting the credit costs, DBS made 0.99% from its lending operations.

From another perspective, DBS' NPL ratio is 1.6%, which is close to the NIM of 1.53%. In other words, the Net Interest Income that DBS makes in 1 year is nearly sufficient to write off all the existing NPLs.

Allowance Reserves

The GP and SP set aside in each reporting period go to the allowance reserves. When the loan eventually cannot be recovered, the loan amount is deducted from the reserves. There is no further impact on the income statement.

There is another reserve known as Regulatory Loss Allowance Reserve (RLAR). Allowances for RLAR are set aside from retained earnings instead of from the income statement, i.e. profits are not reduced by the amount set aside for RLAR, unlike GP and SP. However, there is no free lunch. When the loan eventually cannot be recovered, the loan amount is deducted from RLAR and from the income statement.

Together, the GP and SP reserves and RLAR form a pool of allowance reserves to cover Non-Performing Assets (NPA). NPAs are similar to NPLs, but include other NPAs in the banks' non-lending businesses, such as wealth management, brokerage, etc.. The (Total Allowance & RLAR)/NPA Ratio indicates the percentage of NPAs which is covered by the total allowance reserves. For DBS, this ratio is 107% in Sep 2020, which means that all NPAs are fully covered by the reserves. If this ratio is less than 100% and if all NPAs were to be irrecoverable, any shortfall will have to be deducted from the income statement. If this results in a loss, it will reduce the bank's capital, which might affect the stability and liquidity of the bank (see next section). Thus, the total allowance reserves provide a cushion for bad loans before the income statement and bank's capital are impacted. Having said the above, there is no requirement for the ratio to be above 100%, since not all NPAs will end up being irrecoverable.

Some NPAs are secured by collaterals. For these loans, banks could take over and sell the collaterals to recover the loans. Hence, there is a corresponding ratio that considers only unsecured NPAs. This is the (Total Allowance & RLAR)/Unsecured NPA Ratio. For DBS, this ratio is 200% in Sep 2020, which means that the allowance reserves are sufficient to cover unsecured NPAs by 2 times. The high ratio helps to cushion instances whereby the collaterals are worth less than the loan amount.

Stability & Liquidity

Banks are systematically important to the economy and failure of a bank could lead to disastrous consequences. To guard against such scenarios, banks are required to have sufficient capital reserves to absorb loan losses. This is measured by Capital Adequacy Ratios (CAR). Capital can be classified as Tier 1 or Tier 2, with Tier 1 being more reliable than Tier 2. Tier 1 capital comprises share capital and audited retained earnings, while Tier 2 capital comprises unaudited retained earnings and general loss reserves. CARs are measured by dividing the specific tier of capital over Risk-Weighted Assets (RWA). Different types of loans have different risks (e.g. secured/ unsecured), and RWA considers the likelihood of the assets going bad.

The most important CAR is the Common Equity Tier 1 (CET1) Ratio. This ratio is most keenly watched by investors, as it has implications on the amount of dividends the bank can declare. If the CET1 ratio is too low for regulators' comfort, regulators could ask the bank to stop dividends so that earnings could be retained to build up the CET1 capital. Similarly, banks could also raise capital via rights issues.

In Sep 2020, DBS' CET1 ratio is 13.9%, which is above the bank's target ratio of 12.5% to 13.5%. For reference, the last time DBS carried out a rights issue was in Dec 2008, at the height of the Global Financial Crisis (GFC). Its Tier 1 CAR then was 10.1%. Post-issuance, the Tier 1 CAR rose to 12.5% in Mar 2009.

The GFC saw governments stepping in to rescue major banks that were at risks of failing. Since then, regulators have introduced 2 additional measures to ensure that banks would not fail again. The Liquidity Coverage Ratio (LCR) measures how much High Quality Liquid Assets the bank has to meet estimated total net cash outflows over a 30-day stress scenario. The Net Stable Funding Ratio (NSFR) measures the amount of available stable funding relative to the amount of required stable fuinding. The LCR and NSFR measure the short-term and mid/long-term resilience of the banks respectively and must be above 100%. For DBS, the LCR and NSFR are 135% and 123% respectively in Sep 2020.

The Leverage Ratio measures the amount of loans relative to the bank's equity. It is similar to the Debt-to-Equity ratio for other industries. For DBS, the leverage ratio is 6.9 times in Sep 2020.

Other Ratios

Other ratios include Return on Assets (ROA) and Return on Equity (ROE). These ratios should be familiar with investors since they also apply to other industries. Another ratio is the Cost-to-Income Ratio, which measures how efficient the bank is in controlling costs relative to income. Some banks also report the Non-Interest Income to Total Income Ratio, which measures how much income the bank generates outside its lending business. A higher ratio means that there is great diversity in the income sources.

Conclusion

This blog post explains the operating and financial metrics that are relevant to banks. With this information, hopefully investors will be able to understand the financial performance of banks better.


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Sunday, 14 June 2020

Things Don't Look Good for Retail Landlords

The massive sell-down in Mar brought many REITs to rare, multi-year lows. This re-ignited my interest in REITs, as I have been out of them for many years due to their increasing debt levels and decreasing yields. However, I passed up the opportunity while I analysed what could be the impact of COVID-19 on REITs. Despite the massive government interventions, things do not look good for retail and F&B companies. And when tenants struggle, their landlords will also suffer. In this blog post, I will examine the potential impact of COVID-19 on 2 retail companies and 2 F&B companies.

Before we begin, it is good to recap what are the measures the government has taken to cushion the impact on retail and F&B companies. 

Wage Support

Through 4 extraordinary budgets, the government will provide support to wages via the Job Support Scheme (JSS). The level of wage support varies across industries. The JSS will last for 10 months. For the first 2 months, it will cover 75% of $4,600 of wages of all local employees for all companies. The 75% support level will continue if companies are not allowed to operate during the gradual lifting of Circuit Breaker, until Aug. For the remaining months, the wage support will be as shown in Fig. 1 below.

Fig. 1: JSS Support for Remaining Months

Thus, both retail and F&B companies will get the following wage support:
  • 3 months of 75% wage support (assuming they are allowed to reopen in Jul)
  • 7 months of 50% wage support
This translates to 48% reduction in annual wage costs for FY2020 (assuming that all wages of employees are at $4,600).

Rental Relief

In addition to wage support, the government has also implemented measures to help companies cope with rental costs. The Government will provide property tax rebates and cash grants equivalent to 2 months' rent for qualifying commercial properties and 1 month's rent for industrial and office properties for Small and Medium Enterprises (SMEs) with annual turnover of less than $100M. On top of that, the government also passed a law requiring landlords to waive 2 months' rent for commercial properties and 1 month's rents for industrial and office properties for SMEs that have seen a significant drop in their monthly revenues. The total amount of rental relief for SMEs in commercial and industrial/ office properties is summarised in Fig. 2 below.

Fig. 2: Rent Relief for SMEs

Thus, retail and F&B SME companies will get up to 4 months of rental relief, translating to a 33% reduction in annual rental costs for FY2020.

Revenue Hit

COVID-19 has stopped people from shopping and dining out, either because of government-mandated lockdowns or fear of contracting the virus. It is anyone's guess how soon people will go back to their normal lifestyles after shops and F&B outlets are allowed to operate. China is the first country to exit the lockdown and provides the first glimpse of how consumers would react in a post-COVID world. Figs. 3 and 4 below from Capitaland Retail China Trust's (CRCT) investor conference in May shows that shopper traffic is only picking up gradually after the end of the lockdown. Year-on-year, total shopper traffic and tenants' sales in 1Q2020 declined by 37.6% and 42.5% respectively.

Fig. 3: Shopper Traffic at CRCT Malls in 1Q2020

Fig. 4: Tenants' Sales at CRCT Malls in 1Q2020

For the revenue hit on retail and F&B companies, I assume the following:
  • 3 months of closure during Circuit Breaker: 0% revenue
  • 2 months of gradual re-opening: 50% revenue
  • 7 months of recovery: 80% revenue
This translates to a 45% decline in annual revenue for FY2020. Will retail and F&B companies survive this kind of harsh business conditions? Let us take a look at 2 retail companies and 2 F&B companies.

Retail Companies

Company F

Company F is a barely profitable retail company. In FY2019, it generated net profit of $0.2M. See Fig. 5 below for its income statement for FY2019.

Fig. 5: Company F's Income Statement for FY2019

It is insightful to note that of the gross profit of $64.7M, staff costs ($21.4M) take up 33% of the gross profit and rental costs ($22.3M) take up another 34% of the gross profit. In total, staff and rental costs take up 68% of gross profit. It is no wonder that the government had to act quickly to relieve the pressure of staff and rental costs on companies!

Applying the estimated declines in revenue, staff and rental costs above (plus some other assumptions for other costs), Company F might see its net profit turn from positive $0.2M to negative $5.4M. See Fig. 6 below for the computation.

Fig. 6: Estimated Impact of COVID-19 on Company F

As at end FY2019, Company F had cash of $7.8M. The estimated loss of $5.4M is equivalent to 69% of its cash and 10% of its equity.

Company C

Company C is a fairly profitable retail company. In FY2019, it generated net profit of $17.7M. Applying the same analysis as Company F, Company C might see its net profit reduced from $17.7M to $9.1M. See Fig. 7 below for the computation. Company C will likely have no problem going through the COVID-19 situation.

Fig. 7: Estimated Impact of COVID-19 on Company C

F&B Companies

Company S

Company S is a barely profitable F&B company. In FY2019, it generated net profit of $0.8M. See Fig. 8 below for its income statement for FY2019.

Fig. 8: Company S's Income Statement for FY2019

Like retail companies, staff and rental costs take up a large portion of the gross profit of F&B companies. Staff costs ($14.3M) take up 43% of gross profit and rental costs ($7.9M) take up another 24% of gross profit. In total, staff and rental costs take up 66% of gross profit.

Applying the same analysis, Company S might see its net profit turn from positive $0.8M to negative $2.6M. See Fig. 9 below for the computation. The estimated loss is equivalent to 32% of its cash and 27% of its equity as at end FY2019.

Fig. 9: Estimated Impact of COVID-19 on Company S

Company J

Company J is a fairly profitable retail company. In FY2019, it generated net profit of $10.9M. Applying the same analysis as Company F, Company J might see its net profit reduced from $10.9M to $1.9M. See Fig. 10 below for the computation. Company J will likely have no problem going through the COVID-19 situation.

Fig. 10: Estimated Impact of COVID-19 on Company J

Conclusion

We have run through the estimated impact of COVID-19 on 2 retail and 2 F&B companies. Staff and rental costs consistently take up around 2/3 of gross profits. When there is no or poor business due to government-mandated lockdowns or fear of contracting the virus, the impact on the bottom lines of retail and F&B companies is very significant. As in all crises, stronger companies with leaner cost structures and/or significant retained earnings will be able to weather the storm while weaker ones will end up in losses, despite the extraordinary government interventions. 

The companies I analysed above are all listed companies. How about unlisted companies? Would they have stronger financials than listed companies? Some food for thoughts.

Last week, Department of Statistics released the retail and F&B sales figures for Apr 2020. Fig. 11 below shows that retail sales declined by 13.3% in Mar (before Circuit Breaker) and 40.5% in Apr (during Circuit Breaker) on a year-on-year basis. Almost all sectors were impacted, with the exception of Supermarts & Hypermarts, Mini-marts & Convenience Stores, and to some extent, Computer & Telco Equipment.

Fig. 11: % Changes in Retail Sales

Fig. 12 below paints a similarly bleak picture for F&B sales, with a decline of 23.6% in Mar and 53.0% in Apr on a year-on-year basis. No F&B sector escaped the decline.

Fig. 12: % Changes in F&B Sales

Lastly, Fig. 13 below shows the tenant mix at Frasers Centrepoint Trust's Malls.

Fig. 13: Tenant Mix at Frasers Centrepoint Trust's Malls

F&B accounts for 38% of Gross Rental Income. Fashion takes up 14% while Beauty & Health accounts for 11%. All these sectors will be impacted by COVID-19. The only sector that has a roaring business during COVID-19, Supermarts & Hypermarts, contributes only 5% of the Gross Rental Income.

In conclusion, COVID-19 has resulted in a very challenging business environment for retail and F&B companies. When tenants struggle, landlords will also suffer. Things do not look good for retail landlords.

P.S. I am vested in Capitaland.


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Sunday, 5 April 2020

Not All Hospitality Trusts Are Created Equal

In the past 2 months, investors have been selling off Hospitality Trusts (HTs) listed on SGX due to travel restrictions imposed by governments around the world to stem the spread of COVID-19. There are 6 HTs listed on SGX, namely:
  • ARA US HT
  • Ascott Residence Trust
  • CDL HT
  • Eagle HT
  • Far East HT
  • Frasers HT
While all hotels will suffer revenue decline due to the travel restrictions, not all HTs will be impacted by the same extent. One important factor affecting the impact on HTs is their operating models. Traditionally, hotels have been owned and operated by the same party, but there are increasingly more investors who wish to invest in hotels but might not have the expertise or time to manage them. Thus, hotels might be owned by one party but operated by another, with revenue-sharing agreements between them. If you buy into HTs, you are buying into the ownership of the hotels. The operating model adopted by the HT will affect how the revenue and/or profit are shared between the owners (i.e. HTs) and the operators (i.e. hotel chains like Mariott, Hilton, Accor, etc.).

Some of the major operating models are as follow:
  • Owner Operated - The owner owns and operates the hotel, bears all costs and risks, and receives all profits. HTs usually do not adopt this model.
  • Master Lease - This is the simplest model when the owner and operator are different parties. The owner leases the hotel property to the operator in return for a fixed rental fee. The operator bears all costs and risks of operating the hotel. The owner does not have any share in the profits from operating the hotel. Nevertheless, there are variants to this model in which the rental can be variable and pegged to a percentage of the hotel revenue and/or profit. 
  • Management Contract - In this model, the owner engages the operator to run the hotel. The operator receives a management fee which is pegged to a percentage of the hotel revenue and profit. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and management fee to the operator.
  • Franchise - In this model, the owner runs the hotel using the franchisor's brand. The franchisor receives a franchise fee which is pegged to a percentage of the hotel revenue. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and franchise fee. A variant of this model is the owner outsources the operation of the hotel to an independent third-party operator. This arrangement is similar to a management contract, except that the third-party operator is not associated with the franchisor.
Fig. 1 below summarises the responsibilities of the owner and the operator/ franchisor in running the hotel.
Fig. 1: Various Hotel Operating Models

Needless to say, given the severe travel disruptions currently in place, the master lease model (especially the fixed rental model) would have the least impact to the revenue received by the HTs. Let us look at the operating model adopted by each of the HTs. Do note that a lot of these information are sourced from the annual reports. For HTs whose financial years end in Dec, the FY2018 annual reports are the latest ones available.

ARA US HT

ARA US HT owns 41 hotels, of which 38 carry the brand of Hyatt and 3 carry the brand of Mariott. Fig. 2 below shows the operating model adopted.

Fig. 2: ARA HT's Operating Model

The figure shows that all of ARA US HT's hotels are franchised by Hyatt and Mariott and operated by independent third-party operators.

As explained in the section above, under the franchise model, all costs and risks are borne by ARA US HT, which is not a good thing during the current COVID-19 situation.

Ascott Residence Trust (ART)

ART owns 87 hotels and serviced residences. It recently merged with Ascendas HT to form the largest HT in Asia Pacific. ART adopts a combination of master leases and management contracts. Fig. 3 below shows the breakdown of gross profit from the various operating models in 4Q2019.

Fig. 3: Breakdown of ART's Gross Profit in 4Q2019

25% of the gross profit comes from master leases, while another 13% comes from management contracts with minimum guaranteed income.

Notwithstanding the above, there are fixed and variable rent components in the leases. ART disclosed that its operating lease receivable within 1 year of FY2018 is $70.3M. This is based on the fixed rent component in the leases. This amount represents only 14% of both the gross rental income and total revenue (rental and other income) in FY2018. In the worst case scenario whereby there is only fixed rental income, ART could see its revenue dropping by 86%.

CDL HT

CDL HT owns 16 hotels, 2 resorts and 1 retail mall across 8 countries. It has a combination of master leases, management contracts and owner-operated hotel. Fig. 4 below shows the operating model.

Fig. 4: CDL HT's Operating Model

Of the 19 properties, 13 are under master leases, 4 are under management contracts and 2 are owner-operated.

Although master leases form the majority of the hotels, they have fixed and variable rent components. Fig. 5 below compares the minimum and actual rental income received in FY2018.

Fig. 5: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income from all master-leased hotels forms only 49% of the actual rental income received in FY2018. As a percentage of total revenue, the minimum rental income constitutes only 35%. In the worst case scenario whereby there is only minimum rental income, CDL HT could see its revenue dropping by 65%.

Thus, although the majority of CDL HT's hotels are under master leases, the variable rent component in these master leases reduces the stability of income received by CDL HT in situations like COVID-19.

Eagle HT

Eagle HT was listed on SGX recently. It owns 18 hotels in US, most of which carry the brands of IHG, Mariott and Hilton. The operating model appears similar to that of ARA US HT, i.e. franchise model.

Far East HT

Far East HT owns 9 hotels and 4 serviced residences in Singapore. Fig. 6 below shows the operating model adopted.

Fig. 6: Far East HT's Operating Model

All their hotel and serviced residence properties are master leased to its sponsor, Far East Organisation and its related subsidiaries. Although Far East HT did not disclose the fixed and variable rent components of the master leases, it disclosed that its operating lease receivable within 1 year of FY2018 is $85.1M. This is based on the fixed rent in the master leases. This amount represents 93% of the rental income received from master leases and 75% of total revenue in FY2018. In the worst case scenario whereby there is only fixed rental income, Far East HT could see its revenue dropping by 25%.

Frasers HT

Frasers HT owns 9 hotels and 6 serviced residences in 6 countries. 14 of the properties are under master leases and 1 is under management contract. Like all HTs, the master leases have fixed and variable rent components. Fig. 7 below shows the minimum and actual rental income received in FY2019.

Fig. 7: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income forms only 49% of the rental income received from master leases and 38% of total revenue in FY2019. In the worst case scenario whereby there is only minimum rental income, revenue can fall by 62%.

Conclusion

The table below summarises the operating models adopted by the various HTs listed on SGX. For HTs with master leases, the table also shows the minimum rental income from master leases as a percentage of their total revenue.

Hospitality Trust Operating Models Min. Lease Rental
as % of Revenue
ARA US HT Franchises Not Applicable
ART Leases, Mgt Contracts 14%
CDL HT Leases, Mgt Contracts & Owner-Operated 35%
Eagle HT Franchises Not Applicable
Far East HT Leases 75%
Frasers HT Leases, Mgt Contracts 38%

Like most REITs, HTs have been well-liked by dividend investors. However, as this blog post shows, the revenue received by HTs is highly variable, depending on the operating model adopted. In theory, master leases provide the greatest stability compared to management contracts and franchises. However, most master leases of HTs have fixed and variable rent components. The higher the variable rent component, the more variable is the revenue stream. Dividend investors should really consider whether HTs should form part of their portfolios.

Although the segregation of roles and responsibilities between the owner (i.e. HT) and the operator through the various operating models splits the risks between them, it is ultimately a zero-sum game. When the hospitality industry faces a severe downturn like the current COVID-19 situation, neither the owner nor the operator wins. Even when the owner is relatively shielded at the expense of the operator via master leases with fixed rentals, investors need to check the credit risks of the operator. If the operator cannot pay the fixed rentals, the owner will also lose. Investors in hotel companies and HTs can only pray that the COVID-19 crisis is resolved quickly.


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Sunday, 8 September 2019

Burnout

How time flies. It has been exactly 7 years since I started this blog. It has not been a continuous process, though, as I stopped blogging for exactly a year from Jun last year to Jun this year. The cause? Burnout.

For 5 over years, I have tried to blog at least once a week. It gives readers continuity, as they know that I am always around. This is especially important during times of market stress, as readers know that I do not talk about investments only during good times and leave them in the lurch during bad times. Also, they only need to check my blog once and only once a week. The inspiration for a weekly blog came from a current affairs blog that I regularly visited in the past -- www.littlespeck.com, which is now no longer updated as the author has passed away. I liked the regularity of his week blog, which provided updates on a sufficiently regular basis but is not too frequent to follow. I thought too that I could achieve the same kind of regularity, but alas, trying to think up an idea, research about it, organise the thoughts and write it out, and then repeating the cycle 52 times a year proved too much to bear and I burned out.

It was not just blogging that I stopped. Almost everything connected to personal finance stopped. I stopped tracking my expenses, which I had done for the past 24 years. I also stopped monitoring the performance of my portfolio, which I had done for the past 20 years. Naturally, since I stopped blogging, I also stopped thinking about specific stocks and bonds.

During this 1-year hibernation, I wondered whether my blog has added clarity to investment issues or simply contributed to the noise. Individually, each blog might have very good reasons for their recommendations, but because different blogs have different opinions on even the same topic, to a person who is trying to search for some clarity on the internet, he might end up being more confused after reading these blogs than before he started. Nevertheless, my wife consoled me that I have done my best to value-add to the investing community. There will be some readers who would appreciate the unique opinions that I have.

Although I stopped thinking about specific stocks and bonds, I was still keeping up with financial news and there were issues that bothered me and made me want to blog about them. Such issues include the restructuring of Hyflux and DBS Vickers' plans to move the retail stock trading into the bank. Although upset, I did not have the time and energy to restart my blog. 

The issue that finally made me restart my blog was the IPO of Astrea V bonds in Jun. Coincidentally, my last posts before I stopped blogging were on the Astrea IV bonds. In my second-to-last post, I had blogged that I would not be applying for the Astrea IV bonds, although I corrected my initial thinking in my last post of 2018 and acknowledged that the Astrea IV bonds had sufficient safeguards. Fast forward to 1 year later, I decided to apply for the Astrea V bonds and I thought I should come out and reiterate my thoughts about the Astrea bonds before I applied for them. See Astrea V 3.85% Bonds – Understanding What You Are Buying Into for more info.

Once I restarted, the inertia was overcome and it became easier to continue blogging again. Nevertheless, I am conscious of the demands of a weekly blog and I would only be blogging whenever time permits and when ideas come to me. It is more sustainable this way. 

During the 1-year hibernation, although there were issues that made me want to restart blogging, there was also an incident that made me felt that all these years of blogging had been wasted. In Jan this year, I attended the Astrea Investor Day. During the Question & Answer session, one participant asked "could we have more of Astrea bonds?". This was despite the ongoing debacle of the Hyflux preference shares and perpetual capital securities. While I acknowledge that the Astrea bonds have safeguards to protect retail investors, I do not think that they are sure-win investments. Is it a case of the bonds having no risks at all, or that particular participant being blissfully ignorant of the risks? After coming back from hibernation, I wrote a series of posts on the Astrea/ Private Equity (PE) bonds. They can be found here. Readers can read and gauge for themselves whether the Astrea/ PE bonds are really risk-free or not.

That question really hurts. It hurts much more than if someone were to criticise my blog posts. For so many years, I have been blogging and keeping the blog free for all so that it could add value to the investment community and make a small difference to the world. That question just proved that it was probably my wishful thinking and my blog never really made much of a difference. It made me wonder whether I should still continue blogging. So, please, do not let me hear such questions again. It really hurts. 

Finally, for readers who have been regularly reading and supporting this blog, I thank all of you for your time and sharing of your views.


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Sunday, 18 August 2019

Possibly The Worst Time to Invest – 5 Years On

US-China trade wars, Hong Kong protests, US yield curve inversion, etc. You probably would be thinking now is a bad time to invest. I had the same feelings 5.5 years ago in Dec 2013, when the Dow Jones Industrial Average was then near an all-time high and interest rates near an all-time low. You can read more about it in Possibly The Worst Time to Invest. Nevertheless, I still went ahead to initiate a plain vanilla passive portfolio comprising 70% in global equities and 30% in global bonds. In 2015, I also added a more spicy passive portfolio comprising 70% in US equities and 30% in Asian bonds.

Each year, I would blog about whether that decision in Dec 2013 turned out to be correct or not. Each year, the blog post would say the passive portfolios were up and there is inherent defence mechanism to manage the fearsome stock market crashes through portfolio rebalancing. These once-a-year blog posts on this series almost sound like a broken record.

This year, the plain vanilla portfolio is up by 39.5% since inception 5.5 years ago, while the spicy portfolio is up by 34.7% since inception 4 years ago. You can read about last year's figures in Possibly The Worst Time to Invest – 4 Years On.

Each year, there are bound to be events that worry us and stop us from investing. But each year, the stock market would somehow manage to shrug off the worrisome events and continue its upwards march, reaching new highs which previously seemed unimaginable along the way. A couple of years later, would you still remember the events that stopped you from investing? Do you still remember the taper tantrum in 2013, the threat of Grexit and yuan devaluation in 2015, the shock Brexit vote and US presidential election in 2016? Some of these events have faded from memory, and some people might wonder what was the fuss that stopped anyone from investing in 2013/ 2015/ 2016, etc. But when these events were playing out, the mood was cautious and the stock markets were falling. A couple of years from now, would most people still remember the US-China trade wars, Hong Kong protests and US yield curve inversion that are causing the stock markets to drop currently?

There will be a time when the stock market crash really arrives. But no one can predict reliably when it will arrive. The best way to deal with it is not to stop investing, but to have a good defence mechanism in place while investing.


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Monday, 12 August 2019

Effects of New Accounting Rule on Leases

Did you notice that in recent quarters, companies have been reporting better EBITDA (Earnings before Interest, Tax, Depreciation & Amortisation) and Free Cashflow figures? Do not be happy too soon, as the improvements could merely be due to a change in accounting rule for leases.

Before this year, companies that lease properties, equipment, etc. could choose to treat the leases as operating leases if they meet certain conditions and expense the rents as they fall due. There are no assets and liabilities on the balance sheet associated with these operating leases. This poses a problem when comparing against companies that own the properties and/or equipment. In reality, is a company that leases property very different from another that owns a leasehold property? In terms of the rights to use the property, the differences are small, but financially, the differences can be quite significant. On the balance sheet, such property-owning companies would have more assets and probably more loans to fund these assets. On the income statement, these companies would not have to pay any rent but would have higher depreciation and probably higher interest expenses.

Starting from this year, all companies have to adopt the Singapore Financial Reporting Standards (International) SFRS(I) 16 on Leases, which standardise the way companies report leases on their financial statements. Companies can no longer choose to treat their leases as operating leases and expense the rents. Companies have to treat their leases as financial leases and include the asset as a Right-of-Use (ROU) asset and a corresponding lease liability on the balance sheet. The lease liability is the present value of all future lease payments. At the start of the lease period, both the ROU asset and lease liability must match and balance out each other.

Companies only have the rights to use the ROU asset for the duration of the lease. Hence, at the end of the lease period, both the ROU asset and lease liability have to be reduced to zero. ROU asset is reduced to zero through depreciation. Lease liability is reduced to zero through amortisation. This is similar to loan repayment, in which the remaining loan amount each year is increased slightly by the interest expense, but reduced by a larger amount by the loan repayment. Both depreciation and amortisation affect the income and cashflow statements. It would be clearer to illustrate the changes using a company's actual financial statements.

The example used here is Hour Glass, which is a watch retailer that leases properties to operate its shops. Its business is generally stable, making year-to-year comparison valid. Furthermore, it separates out ROU assets and depreciation while most companies combine them with Property, Plant and Equipment (PPE), hence, allowing a clearer view of the effects of SFRS(I) 16. Companies should be encouraged to adopt the same practice.

Balance Sheet

Fig. 1 below shows the balance sheet for Hour Glass in 1Q2019.

Fig. 1: Balance Sheet

Hour Glass adopted SFRS(I) 16 starting from this Financial Year (FY), which began in Apr 2019. It added ROU assets of $113.8M and corresponding lease liabilities of $116.1M. The ROU assets are nearly twice as much as Property, Plant and Equipment (PPE) which amounts to $58.7M. This shows that the value of rental properties could be as much as or even more significant than the leasehold properties that the companies own. Note that not all companies report ROU assets separately; some companies report them together with PPE.

Income Statement

Fig. 2 below shows the income statement for 1Q2019.

Fig. 2: Balance Sheet

On the income statement, rental expenses are reduced significantly from $7.6M in 1Q2018 to $1.2M in 1Q2019. On the other hand, there is additional depreciation of $6.9M on the ROU assets. Finance cost is also higher by $0.5M to account for the interest expense incurred on the lease liabilities. Assuming all other factors remain constant, the net effect of these factors due to adoption of SFRS(I) 16 is a reduction of $1.1M in operating profit for Hour Glass in 1Q2019.

However, if you compute EBITDA, EBITDA computation excludes depreciation and interest, among others. Changes in depreciation and interest do not affect EBITDA. Hence, only the change in rental expenses affects EBITDA. Holding all other factors constant, EBITDA would have increased by $6.4M in 1Q2019. In 1Q2018, Hour Glass' EBITDA was $19.2M. The change in accounting rule for leases has increased Hour Glass' EBITDA by 33%!

Cashflow Statement

Fig. 3 below shows the cashflow statement for 1Q2019.

Fig. 3: Cashflow Statement

For Cashflow from Operations (CFO), depreciation from ROU assets is added back to the operating profit. For Cashflow from Financing (CFF), payment of lease liabilities, i.e. rental expenses, is included. 

Previously, rental expenses would have been deducted when computing the operating profit which is used as the starting point to compute the CFO. The rental expenses have been mostly replaced by depreciation of ROU assets, but in computing the CFO, the depreciation of ROU assets is added back. Hence, the net effect is an increase in CFO, by an amount equivalent to the payment of lease liabilities, which is now moved to CFF. Holding all other factors constant, the net effect is an increase in CFO by $6.1M, or 53% from 1Q2018!

Free Cashflow (FCF) is generally computed as CFO minus capex. Since CFO increased by $6.1M, FCF would have increased by an equivalent amount. Assuming no change in capex, FCF for Hour Glass in 1Q2019 would have increased by 68% simply from a change in accounting rule!

Conclusion

The above discussion summarises the key changes arising from the change in accounting rule for leases. There are other changes required to reconcile the balance sheet items for each company. For more details, readers are advised to read the companies' financial statments.

Also note that all the improvements in EBITDA and FCF compared to the previous FY mentioned above are also because companies do not have to restate the financial statements for the previous FY. Effectively, the financial statements for this FY are not comparable to that of the previous FY. Do not be too happy when you see an increase in EBITDA and FCF figures this year!

P.S. I am vested in Hour Glass.


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Sunday, 28 July 2019

Does SIA's 3.03% Bond Have Sufficient Margin of Safety?

Following up from last week's blog post on Will Temasek Bail Out SIA Bondholders In Event of Default?, here is the analysis on SIA's 5-year 3.03% bond based on Benjamin Graham's criteria as described in The Lost Art of Bond Investment. Surprisingly, the bond is not as strong as I initially thought based on a simple Debt-to-Equity ratio check. Below are the computation of the earnings coverage and stock value ratio based on SIA's latest financial statements for Financial Year 18/19 ending in Mar 2019.

Earnings Coverage
 
Profit before tax = $868.6M
Adjusted for:
- Deduct: Share of profits from joint ventures = $23.2M
- Add: Share of losses from associates = $97.4M
- Add: Rental on leased aircraft = $679.7M
- Add: Finance cost = $116.1M
Total earnings available for covering fixed charges = $1,738.6M


Current finance cost = $116.1M
Adjusted for:
- Add: Rental on leased aircraft = $679.7M
- Add: Interest for $600M @ 3.16% MTN 007 series = 3.16% x $600M

= $19.0M
- Add: Interest for $750M @ 3.03% MTN 001 series = 3.03% x $750M

= $22.7M
Total finance cost = $837.5M


Earning Coverage = $1,738.6M / $837.5M

= 2.08

Several adjustments were made to compute the total earnings available for covering fixed charges and total finance cost. The more unusual adjustment in SIA's case involves adding the rental of leased aircraft to both figures. This is because SIA leases aircraft in addition to buying them. The leases range from 6 to 12 years and cannot be cancelled, although there are options for early termination for up to 2 years before the original lease expiry. The leased aircraft do not appear on the balance sheet.

On the other hand, for aircraft that SIA owns by borrowing money from the banks, the aircraft appear as a asset and the loan appears as a liability on the balance sheet. On the income statement, there is no rental required, but SIA incurs depreciation and interest on the loan.

Hence, for the leased aircraft, even though SIA does not incur a finance cost, the rental is effectively a fixed charge that SIA has to cover, as the leases cannot be cancelled and SIA needs the aircraft to continue its operations. A similar adjustment needs to be made for the balance sheet, as discussed in the section later.

The current finance cost is also adjusted for interest on a $600M 3.16% Medium Term Note (MTN) issued on 26 Oct 2018 and the $750M 3.03% bond issued on 29 Mar 2019 which is the subject of this blog post. Although both bonds already appear on the balance sheet as at 31 Mar 2019, their first interest payments will only be made in FY19/20, Hence, their interest payments need to be added to compute the actual finance cost.

Based on the above adjusted figures, the earnings coverage is computed to be 2.08 times, which is below the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares = 1,199.9M
Share price = $9.62
Market value of shares = $11,542.6M


Current borrowings = $6,654.4M
Adjusted for:
- Add: Liability for rental aircraft = $2,200.0M
Total borrowings = $8,854.4M


Stock value ratio = $11,542.6M / $8,854.4M

= 1.30

As mentioned above, adjustments need to be made to the balance sheet for the rental aircraft. The rental aircraft is effectively an asset for SIA. Correspondingly, there should be a liability to account for the loan that SIA would have borrowed to purchase the aircraft outright. In fact, International Financial Reporting Standard (IFRS) 16 on Leases came into effective starting from Jan 2019 that requires companies like SIA to account for leased assets on their balance sheets. SIA has disclosed in its Annual Report that the assets will be increased by $1.7B while liabilities will be increased by $2.2B.

Considering the $2.2B increase in total borrowings, the stock value ratio is computed to be 1.30, which is higher than the minimum stock value ratio of 1.0 for industrial companies.

Quantitative Assessment

Thus, based on the above figures, SIA's 5-year 3.03% bond does not meet the earnings coverage criterion but meets the stock value ratio criterion. Based on Benjamin Graham's criteria, the bond does not have sufficient margin of safety.

Other Considerations

As mention in my blog post on Will Temasek Bail Out SIA Bondholders In Event of Default? last week, I believe Temasek will come to the rescue of SIA bondholders in the event that SIA could not pay interest and/or redeem the bond.

P.S. I am vested in SIA's 3.03% bond.


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