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Why business models matter

10 July 17 | The Business Times

STEEL, a processed, durable form of iron, has been used through the ages to make a variety of things: weapons, armour and farm equipment; and now the railways, cars, ships and buildings of modern life. Around the world, millions of tonnes of steel is produced a month, with about half of production going into the construction industry.

The structural steel industry in Singapore, which uses steel made elsewhere for infrastructure projects here and in the region, has been in the doldrums. Are there opportunities within it, if we think things will improve from a cyclical perspective?

We commence our investigation by zooming in on two listed structural steel firms here.

We see how different business models might lead to stark differences in financial performance and valuations.

The first company, Yongnam Holdings, fabricates steel for buildings and also provides steel struts as temporary supports whenever any sort of excavation work is needed.

It is one of the largest structural steel companies in the region, supplying international main contractors for projects such as metro lines, integrated developments and airports.

But there's something curious. Even though revenues amount to the hundreds of millions of dollars a year, the company has made three consecutive years of losses.

Even from 2007 to 2012, where it reported substantial net profit numbers, high capital expenditures meant weak free cash flows relative to net profit.

Contrast Yongnam to another smaller steel player, TTJ Holdings.

TTJ fabricates steel for commercial buildings, offshore oil and gas plants, as well as museums, bridges, tourist attractions and condos. It also used to have a dormitory business. Unlike Yongnam, it currently isn't in the steel strutting business.

Its revenues are far lower than Yongnam's, hovering at around S$100 million a year. Yet it is far less capital intensive.

It has just over S$20 million worth of property, plant and equipment. Cash flows have been positive and growing in the last seven years, resulting in a large cash pile of almost S$80 million by end-April with barely any leverage.

Even though TTJ generates a fraction of the topline revenue of Yongnam, its market valuation is 50 per cent more, at S$150 million. At 43 cents, it is also trading above its book value of 37 cents a share.

By contrast, Yongnam is trading at a huge discount to book. Net asset value at end-March was 62.3 cents, but the company barely trades above 20 cents, giving it a total market capitalisation of just under S$100 million.

How can two companies in the same industry experience such a discrepancy in fortunes?

Look closer at Yongnam's balance sheet, and one might have the beginnings of an answer.

Clearly, the market doubts that Yongnam's steel beams and columns, which it had worth over S$200 million of by end-2016, are worth that much.

The problem is that these beams and columns, used for supporting excavations in the steel strutting business, are hugely capital intensive.

Many years ago, it seemed like a good idea for Yongnam to bet big on them. Huge investments have to be made on importing the steel beams and columns, and storing them somewhere before providing them for major projects. Yongnam grew to become a major player in the business.

Most struts can be reused but the waiting time for projects is unpredictable. As projects dried up, their utilisation rate dropped. Meanwhile, they are incurring very high maintenance costs. We are talking about tens of thousands of tonnes of struts that needed to be stored.

They can be disposed of, but with China flooding the market with steel, what kind of price can they get?

Meanwhile, the construction industry has also been hit by high labour costs due to government policies restricting foreign labour.

Yongnam was also hit by high borrowing costs and specific situations around project execution that led to cost overruns.

Through all that, it continued spending on capital expenditures, notably on steel beams and columns.

TTJ, meanwhile, operated on an asset-light model. The steel fabrication business is one where you purchase steel only as and when needed. The firm has avoided providing steel strutting in the last three years.

Fabrication operations have been shifted to Malaysia, where costs are lower. The company has also been very selective in taking on niche projects which have higher margins.

As such, TTJ steel business Ebitda (earnings before interest, taxes, depreciation and amortisation) ranged from 8.8 per cent to 17.6 per cent in the last five financial years.

Versus Yongnam, without the burden of holding on to large piles of steel struts sitting around unused, TTJ was able to build up its cash pile.

This is not to say Yongnam cannot do well again. While 2017 is a tough year, there are potential mega projects it is bidding for which might contribute substantially to the firm's revenues in the years ahead.

It is also cutting costs and headcounts, and has also reorganised its engineering department.

In Yongnam versus TTJ, we have a classic case of a potential turnaround story with a shaky business model trading at justifiably weak valuations, versus another firm with a cash flow-generating business model. Both are operating in a construction industry going through a downturn.

It makes more sense for the conservative investor to examine the smaller firm with the sustainable business model and the strong free cash flows.

Turnaround plays such as Yongnam are far tougher to figure out. The rewards are always tempting should one get it right but, for now, all we have is a cautionary tale.