Doubling capacity comes with Working capital challenges
NER was listed in SET on 07-Nov-2018 and the IPO was at 2.58 baht/share. Unfortunately, the capital market in late 2018 wasn’t that good therefore, NER price hit lowest point at 1.7 baht/share at the end of 2018 down -34% from IPO price. After huge dropped since IPO, however, NER was one of the top-performer in 1q19 with return around 47% but sadly its price tumbled again before 1q19 financial statement released due to net profit showed negative growth -15% yoy but what intrigued us is the sale volume increased about 110% yoy. In addition, we found that NER will double capacity from 232,800 tons/year to 465,600 tons/year in 2020. But there are 2 major concerns on NER which are 1) How they will manage the working capital when the capacity is doubled, 2) When will be the right time to put the money in this company because it’s commodity business which Net profit will heavily rely on spread of rubber price and due to its debt burden from inventory hoarding this will significantly jeopardize earning even the superb sale volume growth like 1q19.
Investment thesis and our concerns
- NER will double the capacity from 232,800 tons/year to totaling of 465,600 tons/year. The first phase is RSS capacity improvement which will increase production around 60,000 tons/year with small amount of investment approximately at 40 million baht and it has operated since beginning of 2q19. The second phase is new STR compounds factory, adjacent to current factory, this will increase capacity around 172,800 tons/year with investment cost at 456 mb and expects to complete in 1q19. The management said they have secured the incremental capacity from current customer, who wish to increase order, also grasp other customers in blue ocean market in China. They claimed that the utilization rate of new capacity will be able to reach 100% in 2021.
- Biogas Projects – Management initiated 2 projects of Biogas to save utility cost such as electricity bill and heating expense. Biogas 1st project is now in trial operating period, but it couldn’t run as they expected therefore, the company is likely to postpone project transferring from contractor from ending of 2q19 to Nov-2019. And the 2nd phase will be COD in 3q19 if everything goes accordingly to plan. Total investment of two projects is 560 million baht including interest rate capitalization and raw material used in trial period.
- We personally think that Biogas project might drag performance of the company if they couldn’t run it smoothly and efficiently in the future.
- The market participant was guided by management that actual depreciation of biogas project will be 27.5 million baht each year, but it doesn’t include interest expense and raw material used expense that will be capitalized as investment cost as well. I think depreciation of this project will likely to be around 43.5 million baht higher than originally stated in feasibility study? (If I’m correct)
- Total benefit from cost saving will be 20 mb/year relative to Earning before tax in 2018 around 500 million baht or 4% of EBT which I don’t think it’s worthwhile to do the project relative to associated risks. In case my presumption is correct the total cost saving will be only 4 mb/year if it could run at 80-90% of utilization rate.
- Spread fluctuation will be double-edged sword to company earning due to RSS and STR or compound product is rubber-based product which cost and selling price will depend on world index (SICOM) that governs by demand-supply, oil price, politic and so on. The spread (Selling price – raw material cost) will be the key factor to invest in commodity business. The bottom line can grow 100% or be negative growth as 1q19 even though sale volume increased 100%.
- Working capital will be the problematic issue when they ramp up capacity due to its operating policy that was called “Matching order” which leads them to hoard inventory especially raw material to supply their customer in the next 4-5 months to matching cost when the order is secured. Company needs high working capital to comply with this model.
- Interest expense is one-third of Earning Before Interest and Tax expense (EBIT) came from high level of interest-bearing debt due to nature of the business that requires a lot of working capital. NER is funding its working capital via short-term loan and bank overdraft from financial institution with effective interest rate at 6%. When the earning is volatile from commodity spread but interest expense is fixed, the bottom-line will be roller coaster.
- Northeast Rubber Public Company Limited (Northeast Rubber Public Company Limited) Produces and distributes Ribbed Smoked Sheet (RSS), Standard Rubber (STR) and Mixtures Rubber.
- Main customer will be in the automotive industry and traders both in domestic and foreign market such as China, Singapore, Hong Kong, Malaysia etc.
- Product Application: use in tire industry.
- Sale breakdown
- Sale volume and Sale volume growth
(Note: NER and other rubber companies are confined export volume in 1q18 and in 2019 from International rubber council (ITRC) which comprises of 3 countries – Thailand, Malaysia and Indonesia to lift world rubber price and stabilize demand and supply which I think it didn’t work as it supposed to !!!.)
- Total capacity and Expansion plan.
- Company has communicated their operating policy “Matching Order” since IPO which is the process of buying raw material prompts with secured selling order that will be delivered in next 4-5 month. Order matching will make sure that they will have supply to deliver but it doesn’t guarantee the spread. On the other hand, they need a huge working capital to hoard raw material particularly in growing capacity phase. We worried about vulnerable financial position of this company.
Our main concerns toward this company
- It is undeniable that the first question after every company has expanded their capacity will be “Does it have order to fill up the capacity?”. NER answered that they have already secured the orders from current customer which consistently asking for increasing their quota order, but the company has denied because they want to balance concentration risk. Therefore, the new capacity 60,000 tons/year of RSS and 172,800 tons/year of STR compound will take this previous opportunity loss. However, we don’t even know whether it could fill up capacity for 100% or not? We only have to believe in the management.
- Doubling Capacity, Doubling Debt?
- The current situation, where there is no expansion capacity, NER had total asset around 6,900 million baht in 1q19 which 78% was inventory (90% of inventory was raw material) while it had total liability of 4,211 million baht that composed of interest-bearing debt around 3,550 million baht or 84%. DE ratio and IBD/E ratio in 1q19 were 1.49 times and 1.28 times, respectively.
- NER has cash cycle around 170-175 days which mainly came from slow inventory turnover (inventory turnover day in 1q19 was 167 days) due to “Matching order” process while AR day and AP day are totally offset. This means that by every increasing of inventory will be funded by interest-bearing debt or equity.
- Then let’s imagine that if the capacity and sale are double, which amount of inventory will be the proper level? And How will they find another credit line from other financial institution? What is the cost from balance sheet expanding through debt?
- We assume that inventory will reach 8 billion baht in 2024.
- As you can see the table above, interest expense is accounted for around 30% of EBIT (earning before interest and tax) and the fluctuation of this number varies on spread of each period.
- When the earning is volatile from commodity spread but interest expense is fixed, the bottom-line will be roller coaster.
When will be the right time for this investment?
- Spread and sale volume will be the key factors for net profit growth. We have no choice to believe that they can fill up new capacity as management expects, the only factor left on the table will be spread prediction.
- Due to spread figures below, we assume that the spread will be in company favor when rubber price (SICOM) sharply and continuously drops because the weighted average of cost of inventory method will lower COGS along the declining while selling price was fixed in 4-5 months ago. The mismatch between accounting number and operating number since the auditor commands company to use weighted average cost method to recognize in income statement rather than FIFO to prevent accounting manipulation. (Company may selectively choose low cost of raw material to manufacture and deliver to customer.). In addition, another period that company claimed that they will have a favorable spread is when rubber price is stable.
- We use gross profit margin exc. Depreciation as a proxy of spread. Spread varies from 9.6 baht/kg in 1q17 to 3.88 baht/kg in 1q19. We surmise that the breakeven point of spread will be around 2.5-2.8 baht/kg.
- In order to determine the magnitude of spread changing, we did the sensitivity analysis and found that every 1 baht/kg of spread change will significantly affect net profit in 2018 around 40% given that all other factors are equal to actual operating figures in 2018.
- As the investor, we have to evaluate when will be the right time to speculate in the company to enjoy the great spread and if we were about to be wrong, at which price level will be justified with associated risks.
Risks: Vulnerable financial position, High debt level, unable to fill up new capacity as expect, unpredictable of rubber price, unsuccessful of biogas projects.
Ticker: NER TB equity
Market cap: 4,158 million baht (USD 134 million)