Vicom (Crack in Paradise?)

As mentioned previously, I like simple understandable companies. Sort of like lemonade stands – with simple business model, simple cash flows, and hopefully increasing earnings. However, even lemonade stand owners have worries eg. price fluctuation of lemons, declining customer traffic, increasing rents, a new lemonade stand next door, etc.

I am sure many Value Investors in Singapore would be aware of Vicom (read here). It is a small fish in the big ocean of our financial markets with a market capitalisation just north of S$570 million. To me it is one of the first original Singapore Value Growth Stock I have read about, and which I have invested in. I first bought Vicom in 2011, and have been sitting on some paper gains (not to mention dividends).

“Devote at least an hour a week to investment research. Adding up your dividends and figuring your gains and losses doesn’t count.” Peter Lynch

In fact if one is to search under Motley Fool, Vicom is listed as one of the 4 shares recommended for 2015 (read here). The others being Raffles Medical Group Ltd (SGX: R01), Silverlake Axis Ltd (SGX: 5CP) and Kingsmen Creatives Ltd (SGX: 5MZ).

As you are aware I like companies whereby there is little to worry about, and I tend to pay more attention to stocks which are not performing well eg. having paper losses (hoping to undercover value). Like the Straight “A” student that teachers neglect, I guess I have kind of neglected Vicom. Occasionally I would glance at Vicom’s quarterly earnings and be reassured that all is still well. I do not actively search for articles on Vicom as I do not feel compelled to (also for one, it is a thinly traded stocks which is not normally mentioned by major share analysts).

So it came as a surprise to me recently when I came across some negative reports on Vicom which I feel warrant some concern (actually some of them are old articles which I have stumbled across in the past but did not pay much attention to). There are 2 sets of articles. One set of reports paint a very bleak picture for Vicom (read here and here and here, also Value Buddies mentioned about the significant net decrease of inspections p.a. for the next 3 years, read here). Another set of reports paint a very different picture (read here and here).

NUS Investment Society report (dated 1 Feb 2015) recommended “Sell” with a price target of $5.45 while KGI Fraser Research report (dated 10 Feb 2015) recommended “Buy” with a price target of $8.55. Why such contrasting views and price target? Vicom current stock price is $6.55.

The reasoning behind NUS Investment Society Report is based on 3 pillars:

1. De-registration of Old Cars; Influx of New Cars
2. Gloomy Outlook for Construction and Oil & Gas Sectors
3. Lack of Transparency

Item 1 is quite straight forward. I think you can read in details from the links I have mentioned earlier (shall not write in detail about it here).

I like Vicom’s vehicle inspection and testing services because it is a major player in a small confined market in Singapore. I dislike Vicom’s vehicle inspection and testing services because it is a major player in a small confined market in Singapore. :p

Ok, so we know that there will be a shrinking pool of cars that are over three years old in the next few years starting from end 2015. A known fact that Vicom is unable to escape from (and which their management is well aware of). However, let me divert for a moment. I always liken Vicom vehicle inspection and testing services to a popcorn stand in a cinema lobby. Let’s say there are 2 popcorn stands in the cinema, Vicom is the bigger of the 2. We all know that a movie is a luxury (a ‘want’ more than a ‘need’) – cos we can always watch the same show via cheaper alternatives eg. rent, buy from cable TV, watch online – or don’t watch (we can survive with no movies). Similarly a car to most people in Singapore is more of a ‘want’ than a ‘need’. And we all know Popcorn bought at the cinema lobby is often overpriced (and often not as wonderful as those Caramel popcorn from Garrett downstairs) – but we all buy it nevertheless (cos the cinema in house rules forbid outside food bought elsewhere). Likewise car inspections are mandatory by law in Singapore. The movie business is a sunset industry, and so is the car industry in Singapore – the government will over time reduce the no. of vehicles in land scarce Singapore. So Vicom (like the Popcorn stand) has a toll gate effect. It is resilient and there’s earnings to show for it. But the catch is, it is confined to the small market in Singapore (growth in a way is limited). A catch 22 situation.

I do not dispute the fact that there will be a shrinking pool of cars that are over three years old in the next few years starting form end 2015. However, as stated by KGI Fraser Research, there is a high possibility of a vehicle inspection rate hike (a general increase of S$2 across the board was assumed) in FY15. Yes, there will be complaints, hate mails, debates in parliament :p etc …. but at the end of the day what is $2 for a once every 1, 2 or 3 years inspection for the car owner (when a typical new car can easily cost more than $100,000 already)? Vicom cannibalizes most of the market share. There are still some competitors in market such as STA and JIC. However, Vicom owns 70% of JIC which effectively reduces their competitor down to STA. And if I am a car owner, even if STA offers a lower rate, I would rather consider more on the inspection centres’ locations and whether I want to spend my precious time queuing up (just to save $2). Being the major player in the duopoly, Vicom would easily be the price setter while STA would be the follower…. and like commuters trapped in the latest fare hikes in public transports, vehicle owners have little choice but to pay. According to analysts, as of 9 May 2014, the last time Vicom had raised fees was in 2006. Any potential fee hikes could be a boon for the company (read here).

In 2010, the company’s vehicle inspection business and other ancillary services had provided roughly one-third of its revenue and two-third of its profits (Vicom has stopped breaking down its revenue and profit segments from 2011 onward).

 

Since 2012, the company has switched to reporting both segments as a single entity in its financial reports. However, from the past figures, the vehicle inspection and testing segment contributes roughly half of net profit.

Item 2 (Gloomy Outlook for Construction and Oil & Gas Sectors) Although not as profitable as the vehicle inspection segment, management nevertheless expects the non-vehicle segment to continue to grow despite the keen competition.

As mentioned by in the NUS Investment Society report:

• SETSCO is the sole provider of inspection services in the Pressure Vessels and Lifting Equipment category for air receiver, tank and chain block.
• SETSCO also participates in the building construction and maintenance inspection, competition is slightly lesser with around 2-3 competitors in each of its accredited inspection area. Inspection is a recurring income as under the Building Control Act, a building that is not solely used for residential purposes will need to be inspected every 5 years from the date of TOP and 10 years for residential building.
• SETSCO’s strength lies in it having the most number of accreditations in the whole range of services.
• Customer loyalty tends to be high as it may be costly and time consuming to switch between such service providers, and even more so in specialized cases that can only be delivered by a few certification companies.

The argument by NUS Investment Society report for why the outlook is gloomy in this segment is due to the decline in growth of construction and oil and gas sector. That is without a doubt correct. However, as stated above, Vicom does have a degree of moat in this business as well (sole provider, lesser than 2-3 competitors, recurring income & costly and time-consuming to switch). So there is a fair bit of chance in raising price as well in view of declining growth.

 

So the big question is should I hold on to my stocks or sell them? Knowing when to sell a stock is extremely difficult, even for professional investors. Let’s assume the worse eg. NUS Investment Society’s target price of $5.45 (or even lesser).

We continue to make more money when snoring than when active. … [Y]ou simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.    Warren Buffett

The last sentence gives us the first clue about when to sell: if the company no longer provides “excellent economics” or is no longer run by “able, honest management.” Thus, if your original investment thesis is no longer valid, consider getting out regardless of the stock price.

(read here)

Well not sure about excellent economics, but I trust that Vicom’s management is able and honest. The only achilles heel in Vicom’s business is its narrow focus in the Singapore market. It would be excellent if the business diversify more overseas (eg. like what they doing to the non-vehicle segment). However it is easier said than done.

 

Perhaps a better evaluation would be from this website (read here)

• Warning Sign #1: Your stock has a shockingly high price-to-earnings ratio (P/E ). Vicom’s PE is relatively high but not shockingly high. Normal for a growth stock.
• Warning Sign #2: The company’s competitive advantage is in danger.  Nope. More like due to external factors. Its moat is intact (at least in Singapore).
• Warning Sign #3: The company makes drastic changes in its direction or leadership.  Nope. 
• Warning Sign #4: The company’s sales are stalling or falling. Likely but not yet. 
• Warning Sign #5: The company’s profit margins (and earnings) are shrinking. Nope. Actually, profit growth is better than revenue growth in the recent quarter. (read here)
• Warning Sign #6: The company recently cut its dividend payment. Nope. So far it has outperformed. (read here)

The shrinking pool of cars that are over three years old in the next few years, slow down in the construction and oil & gas sector are facts. There is no disputing about that in Singapore currently (and the small market in which Vicom is in makes it inescapable). The vehicle inspection hike (or other forms of rate hike) is possible but these have not materialize yet (and not sure if it can really counter the drop in earnings). So the possible earnings drop is very real.

I believe Vicom’s coming quarterly reports will be very critical. It would truly test the ability of Vicom’s management (no more sunny Annual Reports, Quarterly Reports, etc). For the moment I do not intend to sell (after all, to sell is only a click away).

Having said that, I must mention that nowadays wild fluctuations of stock prices are not uncommon. I won’t be surprised if there is a violent share price drop in this thinly traded stock if the company revenue or profit shrinks (even by a few %) for the next few quarters or years. Probably akin to a teenage girl’s reaction on discovering her first pimple. Look at what happened to Super Group (after earnings growth first disappeared). Let’s think about Super Group’s Chairman David Teo not too happy expression in this article (read here), and how Vicom’s Chairman Mr Lim Jit Poh would look under the same heading (same heading, same look but different person). This is in addition to the fact that stock price would likely fall once the stock goes ex-dividend on 15 Aug 2015. (read here)

I could sell now and wait for price to drop and  buy again… (that would be ideal; if only I have a crystal ball). However, basically for now (at least), I won’t be chasing the price higher. More reasons to wait and bottom fish. Back in my radar. Frankly, I am more interested to see how Vicom management reacts to the coming situation. I would really be surprised if Vicom management did nothing. For one the management can clearly see the storm coming and is not taken by surprise (we literally have statistics compiled by LTA, and analysts & students estimating the month / year it would happen). This is unlike other catastrophes faced by other companies whereby the management is taken completely off guard.

From another perspective (and looking at a longer time span), it would finally be a chance to pick up more shares of this company, which for a very very very long time did not encounter any significant price dip. (Only a small hiccup in the 2008/09 recession, Oh Come On! Approx. fall in price from $1.95 to $1.45, a drop of only 25%). The incumbent value stock could finally fall below my calculated intrinsic value (and maybe even lower 4++?). I have almost given up hope (obviously not Irving Khan material here) :p

Then again, could it be a similar case of Warren Buffett chasing IBM stocks despite their dismal returns over the last 3 years? (read here)