Silverlake Axis Ltd (My thoughts)

A reader asked me about my view on Silverlake Axis Ltd (SGX: 5CP). Actually, if you read The Motley Fool articles, it is not hard to come across articles about this company. Fundamentally it is a very strong company.

1. Why Have Silverlake Axis Ltd’s Shares Fallen by Nearly 30% In 2 Months? (read here)
2. Silverlake Axis Ltd’s Latest Earnings: What Investors Should Know (read here)
3. Is Silverlake Axis Ltd Good Enough to Buy? (read here)
4. Rock-Solid Shares to Start 2015 With (read here)
5. 3 Companies with Explosive Growth over the Past Decade (read here)

Corporate Presentation (read here)

According to The Motley Fool, it is one of the four rock solid shares to start 2015 with (up there with Raffles Medical, Kingsmen Creatives & Vicom).

To quote from The Motley Fool:

It is a software outfit that has been thriving in Southeast Asia – over the decade in review, the company has seen its revenue and net income grow at impressive compounded annual rates of 32.4% and 31.2% respectively.

40% of leading SE Asian banks use Silverlake’s software and services.

My only bugbear about this company is that its business of providing IT software and services is beyond my circle of competence. Similarly I have the same issues with business model of NeraTel and Global Testing Corporation Limited.

I am curious as to what is the business moat of Silverlake, and what customers and its competitors think of their services. I don’t even get to use their products (at least I do in a little way with NeraTel).

“Never invest in any idea you can’t illustrate with a crayon.” Peter Lynch

A brief take on its business model below.

Its business model can be divided into 6 portions:

1. Software licensing
2. Software Project Services
3. Maintenance and Enhancement Services
4. Sale of Software and Hardware Products
5. Credit and Card processing
6. Insurance Processing

The 2 main revenue drivers are Maintenance and Enhancement Services (42%) & Software Licensing (30%).

Financial statistics

Let’s do a quick study on its financial statistics.

At first glance, Silverlake’s history of Revenue, Gross Profit, Net Profit, ROE, Net Assets Per Share, EPS and Dividend seems near perfect. Except for a dip in ROE in 2013 & 2014, and dividend payout in 2011.

When I look at the above statistics. A few items jumped at me:

1. Share price is too expensive. At a P/E of 30.96 (from POEMS), Price / Sales at 20.25, Price / Book at 16.89 and EV/EBITDA at 35.8, it is ridiculously over-valued.
2. Its profitability and management effectiveness seem too good to be true. With a profit margin of 53.75% & operating margin of 54.89%, ROE at 45.69%, I wonder if this is sustainable. I would take approx. 20 to 25% ROE as good. Beyond which would raise suspicion. From another angle, if their future performance pales in comparison to what they have now, what value would speculators / analysts give this company? Eg. if they achieve 20% ROE – still good, but worse then before.
3. It has a strong balance sheet. Almost SGD85 mil in cash after deducting debt. Very low Total Debt/Equity. It has way too much current assets as compared to current liabilities (current ratio at 4.58).
4. Dividend Yield(%) is relatively high at 3.4.

“Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’. Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out the forces that could cause those results to stop occurring.”  Charlie Munger

This stock has not gone un-noticed in our small market. No doubt it is a great company (perhaps too good), and has caught many’s attention. Which explains the extremely high valuation. It is quite similar to Raffles Medical. Ultimately what makes a good investment is the stock price.

“The actual risk of a particular investment cannot be determined from historical data. It depends on the price paid. ” Seth Klarman

“The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters.”  Seth Klarman

Maybe to think deeper like what Charlie Munger said – what could cause the good earnings results to stop.

I found this post by Investment Moat (read here): “What sets Silverlake apart is that they operate in a niche segment. Maintenance is a recurring revenue and predictable business to be in. Unfortunately, the systems lifecycle is getting shorter and shorter, which means shorter maintenance cycle making it perhaps not as lucrative as in the past.”

In another post by What’s behind the numbers (read here): “In software licensing and Maintenance enhancement services (2 biggest revenue contributors), it seems that Silverlake needs to constantly secure contracts (for software licensing) and continually acquiring companies.

For the Software Project Services: Despite implementing new project services such as card system projects ,the revenue and profit for this segment has been declining over the years due to banks preference in reliance on internal resources to minimize costs. ” 

There seems to be elements which Silverlake might not be able to control.

In addition, if we look back further in history, this company is not immune to the financial crisis in 2008/2009. Its EPS and Free Cash Flow dropped drastically in 2009 – see table below from Morningstar (and so did its share price).

Point being that there is a chance to pick up this stock in market crashes or corrections. Also there are more resilient companies in the market whose EPS & free cash flow (FCF) did not really dip as much during the GFC, companies such as Vicom and Raffles Medical (in fact their EPS and FCF increased). And these are companies with simpler and more transparent business models.

“Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky.” Seth Klarman

I think the predictably of earnings is very important – this is coming from a guy who has bought a few cyclical counters (and have yet to see to any paper gains after many years). eg. Golden Agri, SIA. Consistent increasing EPS and FCF really show whether the company has a business moat (be it Franchise, patent, economic scale, etc). Esp. when the business is beyond your circle of competence.

 

Let’s do a quick study on the trailing PEG and intrinsic value of Silverlake Axis Ltd.

1) Trailing PEG

• P/E: 30.96 (from POEMS)
• Dividend Yield (%): 3.4
• EPS compound growth rate: 23.76%

The trailing PEG will be 27.5/(23.76 + 3.4) = 1.14. Which is not good (>1).

2) Intrinsic Value

First let’s look at the estimated 5 years earning growth which is 23.76%. Let’s assume a 20% discount, the figure will be 19%.

Given EPS and a PE ratio, stock price can easily be calculated for any company. Using the below formula.

F = P(1+R)^N where:

• F = the future EPS
• P = the starting (present) EPS (0.04)
• R = compound growth rate (19)
• N = number of years in the future (5)

Estimated future EPS: 0.0955

I will be estimating the future PE of Silverlake Axis Ltd to be 21.7 (See data from Morningstar below) Average of the PE from 2008 to 2014.

Future Stock Price

P=EPSxPE

• P = future stock price
• EPS = future EPS
• PE = future PE

Hence future stock price of Silverlake Axis Ltd is 21.7  x 0.0955 = 2.07235

Intrinsic Value

P=F/(1+R)N

• P = present (intrinsic) value
• F = future stock price (2.07235)
• R = MARR (15% or 0.15)
• N = Number of years (5)

Hence, the intrinsic value of Silverlake Axis Ltd is 1.03.

Stock price of Silverlake Axis Ltd on 29 July 2015 is 1.03.  There is no margin of safety.

 

In summary:

Silverlake Axis Ltd has consistently performed well over the past few years. However, even then there are a few years whereby EPS and Free Cash Flow dipped.

Its business is not within my circle of competence and I would need a bigger margin of safety before I purchase its shares.

“Know what you own, and know why you own it.” Peter Lynch

The share price and calculated intrinsic value shows no slight margin of safety. Likewise, the trailing PEG shows none.

With the recent dip in the Singapore Market, the share prices of a no. of companies have also dropped (some by a lot). Even fundamentally strong companies with good historical track records, such as Boustead, Japan Foods Holding Ltd, Osim, NeraTelecommunications Ltd, etc.

“Don’t bottom fish.” Peter Lynch

Having a low buy price is a great starting point, but I think one must really know the company inside out, so that he/she will have conviction if the price turns south (or worsen). There are many reasons why share prices drop, some rational, some irrational.

The reader who bought Silverlake at the recent selling would be sitting on substantial paper gain by now. In fact, I am of the opinion that the blog post questioning Silverlake’s accounting practices in relation to some of its mergers and acquisitions over the past few years is quite unjustified (read here), and created a good buy entry. The speculative public, motivated by fear, oversold the stock and forced the stock’s price downward. (Isn’t the stock market just great)

However, if price is to continue dropping instead of rising, what would prevent he/she from selling? (anytime in the next 3, 5 or 10 yrs) That is the key.

I have tried reading Silverlake Axis’s annual report, and I can’t relate to what they are talking about, probably because I am not in the banking sector and neither have I used their products. (Probably because the software caters to banks, which explains the confidentiality). I think part of the reason why the public makes such adverse reactions (causing stock price to plunge) when they read the blog post questioning its accounting practice, is the fact that most people cannot relate to what actually is going on. I think only a few like Warren Buffett, have the patience in reading IBM’s Annual Report for 15 yrs before buying its stocks.

“A real-life analogy would be if Graham went to the discount store to shop for a bargain, any bargain, as long as it’s a bargain. You have to know the feeling. You are walking through the store and there before you are snowblowers marked down from $259 to $25. Even though you live in Florida and will probably never use a snowblower, the price is so low that you can’t pass it up. That is the essence of who Graham was and how he chose his investments. 

Warren’s approach is to determine what he wants to buy in advance and then wait for it to go on sale. Thus, the only time he can be found in a discount store is when he’s checking it out to see if anything he needs is selling cheap. Warren functions in the securities market the same way. He already knows what companies he would like to own. All he is waiting for is the right price. With Warren the what-to-buy question is separate from the at-what-price question. He answers the what-to-buy question first, then determines if it is selling at the right price.”                Extract from the book, Buffettology

Personally, for me I can safely say I know to a certain degree the business model / products / services of the companies whereby I have a stake in. Eg. Super Group, Colex, IsoTeam, Riverstone, Vicom, SMRT, CapitaLand, Golden Agri, SIA, etc. Even Sarine Tech (which I bought when its share price plunge). With Silverlake Axis – I am clueless.