Quick Screening Series – ISOTeam(5WF.SI)

Quick Screening Series – ISOTeam(5WF.SI)

This column is written by @gordon_ong.
-Gordon has a demonstrable interest in equity investments, financial markets, and negotiating deals. As @NTUInvestmentClub president, he has an understanding of what factors drive an organisation’s success.

ISOTeam conducts building maintenance and estate upgrading. It has 4 segments: Repairs and Redecoration (R&R), Addition and Alteration (A&A), Coating and Painting (C&P), and Others such as interior designing, home retrofitting, renewables etc.

+ BCA forecasted that public-sector spending will increase during 2016-2020. In particular, government continues to invest in the renewal and rejuvenation of older estates through schemes such as the Estate Upgrading Programme and Home Improvement Programme. ISOTeam focuses heavily on government projects, in particular HDB estate upgrading.
+/= Opportunities include government initiatives into solar installation works, as well as town councils’ interest in ISOTeam’s newly developed water-based pesticide. These could possibly provide additional significant revenue drivers for the company in the mid-to-long term. However, in the short term, it is insufficient to compensate for declining R&R.
= Recurring and Defensive Industry
— Due to depressed property sector demand, contractors that traditionally restrict themselves to bidding for private projects are now encroaching upon ISOTeam’s R&R segment, causing heavy price competition. Management expects this condition to persist within the next 12 months.
— Tight reliance on foreign manpower makes it susceptible to rising labour salaries, higher levies, and other foreign manpower rules, serving as a long-term compressor of profit margins.
– Contract-based business: Revenues and earnings will inevitably be sporadic, and cash flows are

+ Strong network of business relationships with Town Councils and other government organisations, can win bids despite not being lowest bidder (proven track record in public sector projects)
+ Exclusive paint applicator for Nippon and SKK Paint in HDB and town council sector
+ 20% Market share in R&R and A&A ($400-$450m total market)
+ Management pragmatically recognises that R&R space is worsening, and chooses to focus on growing its A&A, C&P and green solutions which have higher margins.
+ Smart acquisitions with profit guarantee creating EPS accretion: Recent investment into Sunseap Group ensures steady stream of contract deals in future (Sunseap Group awarded SolarNova tender), and Rong Shun Engineering and Construction also comes with a SGD13.1m orderbook guarantee. In particular, SolarNova capitalises on the government’s drive towards renewables.
+ Expansion into Myanmar and Indonesia as possible price catalysts
+ Net cash position, increasing dividends (20% of PATMI), consistently buyback shares to provide investor value
+ Consistently increasing revenues, net income, cashflow from operations, and free cash flow
+ ROE consistently above 15% even with a net cash position
— Valuation: P/E normalised LTM 19.03x, P/Tang BV 2.0x; While P/E is high because E is unusually low, this is not a one-off or cyclical problem, but rather a structural problem. Results prove that there is a lack of any form of economic moat around R&R.

– Sub-contracting risk: ISOTeam subcontracts around 80% of its R&R jobs. This leads to executions risks and makes it hard for ISOTeam to control quality of its services. Moreover, labour costs are also driving up cost of hiring sub-contractors.s
+/- Order book is still large compared to firm’s size; however, number of new projects secured have been declining recently. Current 3Q17 order book size is $94.7m.

– Some of its private sector clients have recently filed for bankruptcy, causing ISOTeam to contend with possible bad debts. However, very low credit risk from public-sector clients (constituting the majority of its receivables).

The previous story of good business model with increasing contract values are challenged by hard financial results. R&R segment seems like a long-term losing bet, even management has recognised this fact and is trying to diversify away into other segments. Sudden price competition in R&R sector also teaches a valuable lesson: more hard evidence regarding barriers to entry is required especially in the highly-lauded new growth segments such as solar installations. Moreover, the increases in A&A, C&P and renewables revenue must eventually compensate for the decrease in R&R. If the investor is prepared to overlook the downsides, possibly can consider entering during next batch of order wins if volume is sufficiently high enough. Right now, there is insufficient evidence to support its previous fundamental story.

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