Vicom

Vicom provides vehicle and non-vehicle inspection and testing services in sectors including mechanical, biochemical and civil engineering. Vicom is also a subsidiary of ComfortDelgro, a substantial shareholder of Vicom at 67%.

Vehicle inspection and testing services revenue accounts for 30% of Vicom’s total revenue while non-vehicle accounts for 60%. However, both vehicle and non-vehicle inspection and testing services account for 35% of operating profit which implies a higher margin from the vehicle segment, an impressive 37.6%. The operating margin of non-vehicle segment is 19.1%. Do note that the above figures are from 2011 as Vicom stopped reporting segmental results from 2012 onwards. It is however safe to assume that these % should not deviate much in recent years. This means that vehicle inspection is equally strong in contributing to the bottom line even though its revenue share is smaller relative to non-vehicle segments. 

Vicom’s strong margins in the vehicle segment can be attributed to:

1. 74% market share of Singapore vehicle testing and inspection (520,000 inspections out of 702,000 total vehicles inspected.
   
   
2. Most vehicles on the road will have to be inspected at least once every 2 years.
3. Strong growth rate of vehicle population at 2.4% CAGR over the past 10 years, from 754,992 in 2005 to 957,246 in 2015.

At the existing price of $5.85 on 12 Feb 2016, the PE ratio is at 16.26 and PBV ratio is at 3.54. The payout ratio as of the latest dividend is about 75%. It might seem expensive at first glance but it is expensive for reasons. Vicom’s ROE is at 23% and ROIC is at 60%. ROIC has been increasing since 2006 at 20%. This is due to the minimal capital expenditure required once the basic machineries have been in place. Vicom’s net capital expenditure in recent years is mainly to cover its depreciation. Due to its business model, Vicom does not really need to acquire new technology to attract business. Cars will also have to be inspected due to safety regulations. Free Cash Flow to the Firm has also been positive after payment for dividends, averaging $10 million each year over the past 4 years. It also has no debt therefore it is less susceptible to rising interest rates and it has built up a decent sum of cash in recent years standing at $100 million. What are the risks and what price should I buy Vicom at then?

Risk

Vicom’s share price has been down beaten from its high of $6.78 on Apr 2015 to current levels. This could be mainly attributed to the aging profile of Singapore’s car population (accounting for 40% of vehicle inspections in 2015).

As seen in the table above, we can see that Singapore’s car population shot up during 2005-2010 period due to the government stance to encourage car ownership. Growth rate is set at 3% + de-registrations for at least a decade till 2009. From then on it staggered downwards and from Feb 2015 onwards, it is set at 0.25% growth rate + de-registrations. The age profile of 8-10 years is also the bulk, accounting for 51% of car population. By 2018, about half of the car population will most likely be renewed into new cars. Fortunately, with a lower growth rate of COE supply, some people might be considering holding onto their cars longer than 10 years as it is unlikely that COE prices will reach to previous lows. This is evident as you can see that there is a huge jump of cars older than 10 years of age in 2014 and 2015.

For the gloomy years ahead, Vicom has built up cash to prepare for the storm in the vehicle segment over the next 3-5 years as vehicles less than 3 years of age need not be inspected. Although we do not have colour to non-vehicle segment sales in recent years, what I see from recent annual report is that they have started to expand their range of services in Setsco. Hopefully this will mitigate the fall in revenue from vehicle segments even though the management is expecting slowdown in non-vehicle testing services. 

Valuation

I will assume that Vicom will have -5% growth in revenue over the next 3 years and 0% growth from 4th to 5th year. From year 6 to year 10, I will allow it to grow at a decreasing rate from 5% to 2% and the terminal growth rate set at 0.5%. There have to be a cap on growth of vehicles in land-scarce Singapore therefore a 0.5% growth rate is considered appropriate. Operating margins will also be decreased from the current 34.7% to 28% in the terminal year. I have adjusted the regression beta of Vicom’s from 0.5 to 0.72 due to the nature of its higher operating leverage business which has higher fixed cost. After accounting for reinvestment needs, the free cash flow over the next 10 years and the terminal value is discounted at the weighted average cost of capital of 6.93% and 7.8% in the terminal year respectively. Adding back cash and accounting for operating lease as debt, the estimated value per share is $4.83. I have to admit that this is a rather conservative estimate. By assuming 0% growth over the next few years instead, the estimated value per share is $5.35.

Conclusion

Based on current price, the market is over-valuing Vicom 21% above its intrinsic value. The current yield is at 4.87% (FY 2015 dividend of 28.5 cents) and at the intrinsic value, 5.9%. With the current market sentiment, Vicom will be a conservative play in one’s portfolio with stable dividends and strong economic moat in the long term. The vehicle population is a 10 year cycle and I do not foresee vehicles being displaced from Singaporeans’ life over the next 30 years. Right now, Vicom is nearing the end of the 10-year cycle which many cars will be deregistered. The share price has been affected and the downward pressure will continue to persist in the near term. But be sure to catch it when Vicom offers itself at a discount and you will be in for a ride of decent dividend yield if your investment horizon is at least 10 years.

What to expect of the market in 2016?

Based on 31 Dec 2015 Straits Times Index (STI) closing of 2882.73, I have calculated that the implied equity risk premium (ERP) is 4.98%. This means that for investors whom want to invest in the market, the market must be returning at least 4.98% above the risk free rate. The risk free rate which I used is 2.50% based on the Singapore Government Bond 10 year yield. How did I calculate the ERP? I simply treat the problem as a discounted cash flow model. The price of the index is simply the net present value of future cash flows. Cash flows here is in dividends and share buybacks done by the 30 companies of STI in 2015 and I assume this cash flow will grow at 5% for the next 4 years and a terminal growth rate of 2.5% (equals the risk free rate). Thereafter I apply a discount rate to these cash flows to derive the price i.e. the index level. Deducting the risk free rate out of the discount rate, I will obtain the ERP. 

The cash payout of earnings done by STI companies in 2015 is 60% and I assume that this stays constant. Interesting to note is that for S&P 500, the cash payout in 2015 is 101.5% of earnings, which is unsustainable over the long run. Potentially we could see S&P 500 correcting in the near term. With this information, we will only need to solve for the discount rate. This discount rate is the total return that investors are expecting. Implied ERP is then obtained by deducting the risk free rate. Therefore for investors based on the start of 2016, they are expecting a total return of 7.5% by investing into the stock market.

As of 31 Dec 2015, the trailing twelve months (TTM) price-earnings (PE) ratio of 13.78x and a forward PE ratio of 13.1x, this represents a good opportunity to start accumulating at the market.

Moving two weeks into 2016, the STI ended at 2630 on 15 Jan 2016. ERP at this level has increased to 5.46% and PE ratio has gone to 11.98x. This means that comparing to PE ratios over the past 8 years, a DBS report, the average 12 month forward PE is at 13.74x and as of 15 Jan 2016, the forward PE ratio of 11.98x has crossed 12.2x (-1SD) FY 16F PE. In statistics, this means that we are about 68% confident that the true PE ratio lies between the upper (15.25x) and lower limit (12.2x) of PE ratios. The implied forward ERP of 5.46% is also in the similar statistical range of PE ratio as the earnings are similarly used. This means that STI is getting more undervalued as of 15 Jan 2016. If you are still not convinced, one can compare a longer period by using the historical ERP over the past 20 to 30 years and decide a fair ERP. I do not have the longer history data on hand, probably a Bloomberg terminal might help getting the information easily. Also to note, ERP is a key to calculate the cost of capital thus a higher ERP tends to undervalue stocks.

An interesting insight to note here is that the 2SD away from the average 12-month forward PE is between 16.71x and 10.66x. This means we are 95% confident that the true PE ratio lies in this range. At PE 10.66x, the implied forward ERP is 6.12% and the index will be 2340. This is about 11% drop from 15 Jan 2016 closing of 2630. I do not foresee that we will be heading to this level this time, but if we really do, it will be one of the rare chances to buy stocks at a bargain.

To give you some comparison, the US implied equity risk premium is pretty comparable to Singapore’s due to both countries sharing the same currency sovereign rating of Aaa. Therefore some analysts and practitioners have interchangeably used both ERPs. 

Referencing the above to Prof Damodaran’s compilation of implied ERP on the US equity market posted on his blog, the US ERP as of 2015 is about 6%. S&P 500’s 2015 cash payout is 101.5% of earnings therefore it makes sense that US’ ERP is higher than what I have calculated for Singapore’s.

What I would like to note is that the 75^th percentile of US Equity Market implied ERP from 1960-2015 is 4.93%. This means that Singapore’s current implied forward ERP of 5.46% does signify optimism for STI in the near to medium term and supports my call to start accumulating Singapore stocks.

On a side note, I have also read some recent Howard Marks' memo and on his latest on 19 Jan 2016. I agree with him that the market is a compilation of all investors’ (from your big institutions to men on the street) actions. And these actions are based on predictions going forward and these predictions tend to be swayed by emotions which affect the market strongly in the short term. In the long term, the fundamentals should prevail.

Markets can be right at times and wrong at others. It is always best to take action when the market is wrong. I think now is the time.