Asian Idea Generator Weekly: Follow The Smart Private Equity Money

by: The Value Pendulum

Novo Tellus Capital Partners, a private equity firm with a focus on middle-market industrial technology companies in Asia, recently invested in Singapore-listed Procurri.

ISDN Holdings, another of Novo Tellus' portfolio companies, is a play on the growth of industrial automation.

I screen for Asian stocks which are trading at low enterprise value-to-operating income multiples.

This week's edition of the Asian Idea Generator Weekly profiles and searches for Asian investment opportunities in the following categories: 1) stocks which are either owned by astute investors including private equity firms or experience significant insider buying and share repurchases; 2) stocks that are proxies for secular investment themes; and 3) stocks that pass specific quantitative criteria.

Note that some of the stocks mentioned do not have a U.S. ticker. U.S. investors can invest in most Asia-listed stocks using brokerages with international coverage such as Interactive Brokers, Fidelity, and Charles Schwab.

Piggybacking: Successful Private Equity Firm

Novo Tellus Capital Partners, a private equity firm founded in 2010 focused on middle-market industrial technology companies in Asia, has built a reputation for being a shrewd investor. Its most notable portfolio company is Singapore-listed AEM Holdings, a manufacturer of precision testing and handling equipment for the semiconductor industry.

Novo Tellus became an investor in AEM Holdings in 2011 with a 16.6% stake, and the private equity firm's founder and managing director, Mr Loke Wai San joined AEM Holdings as Chairman. In 2014, Novo Tellus owned as much as 27.1% of AEM Holdings' shares before gradually reducing its interest in the company. In March 2018, Novo Tellus distributed 12.89% of AEM's shares outstanding to its limited partners, while retaining a 4.28% interest through Orion Phoenix, a single purpose vehicle controlled by its fund Novo Tellus PE Fund I. AEM Holdings has been one of the best-performing stocks on the Singapore Stock Exchange in the past decade, boasting year-to-date, 3-year, 5-year, and 10-year annualized total shareholder returns of 47%, 153%, 63%, and 33%, respectively.

On the private equity firm's website, Novo Tellus refers to itself as the "top-performing private equity fund in Asia for the past decade" drawing on data provided by Preqin with respect to all 160 growth, buyout, distressed, turnarounds in Asia between 2009 and 2018 ranked by distributions to paid in capital or by net multiple of capital returned.

In a September 2017 media interview with the Business Times, Novo Tellus managing partner Loke Wai San talked about the firm's investment philosophy and process:

We usually take control of these companies and try to reinvent them...When we invest in a company, it's not just for punting or necessarily just growth. So, we are hands-on investors and usually our transformation takes many years. To be honest, to turn a company around to be where it is today is not just (about the) product - we need to have quality, process control; being manufacturing or field services. It takes a lot to be a very good industrial company because you are providing full services.

Novo Tellus' most recent publicly-listed investment is Singapore-listed Procurri Corporation, an independent provider of information technology distribution and lifecycle services. In March 2019, Novo Tellus became Procurri's largest shareholder with a 29.6% stake. Procurri last traded at S$0.345 on July 29, 2019, which is only approximately 5% above Novo Tellus' acquisition price of S$0.33 per share.

Procurri generated 70.3% and 29.7% of its FY2018 revenue from its Information Technology Distribution and Lifecycle Services business segments respectively. Both business segments are more evenly split when it comes to gross profit, with the IT Distribution and Lifecycle Services business segments accounting for 53.1% and 46.9% of gross profit for FY2018, respectively. In terms of geographic breakdown, Americas, EMEA (Europe, the Middle East and Africa), Singapore, and the rest of Asia Pacific contributed 54.9%, 28.7%, 14.3%, and 2.1%, of the company's FY2018 revenue, respectively.

The IT Distribution business comprises revenue generated from hardware resale involving an independent, vendor-agnostic approach towards buying, selling or consigning data center equipment from all major IT brands, and helping OEMs manage their supply chain management activities like distribution of goods; while the Lifecycle Services business provides independent IT maintenance services leveraging, its multi-vendor expertise for a range of IT systems and networks offers IT Asset Disposition or ITAD services that prolong equipment lifespan through reuse, resale or recycling, and supplies IT hardware as a service on a transaction-based pricing model. Procurri's customer value proposition is compelling as per the table below, which illustrates the value of its products and services to clients.

Procurri's Value Proposition

Source: Procurri FY2018 Annual Report

In the press release issued by Procurri on March 19, 2019, Novo Tellus explained the rationale for investing in Procurri:

We are believers in the capabilities of Southeast Asia's technology and industrials sector, and Procurri possesses many of the qualities we look for in high-potential companies. Sean and his co-founders have built a profitable global company with S$200 Million in turnover in just over 6 years by starting with a clear vision for the future of enterprise IT infrastructure, and then applying their decades of sector experience to build a platform capable of serving the highest valued channels and enterprise customers worldwide. Today, Procurri helps some of the largest IT channels and enterprise customers save IT costs, extend the lifespan of IT investments, and migrate securely to future cloud architectures. The combination of a clear strategic vision, a large global growth market, and a management team with deep sector experience, provides strong fundamentals for us to invest behind long-term equity growth at Procurri. We look forward to working with the management to support Procurri's strong growth momentum, while also providing additional focus on driving operating synergies in the Company's global business infrastructure and a long-term focused investor base

Procurri is an interesting investment opportunity in the sense that it operates in high-growth, fragmented markets. Based on industry forecasts quoted by the company in its 1Q2019 investor presentation, the markets that Procurri is exposed to are expected to double in the next four to eight years. These include the global cloud infrastructure market which MarketsandMarkets predicts to grow from $101 billion in 2016 to $210 billion in 2022; and the IT asset disposition market which Verified Market Intelligence forecasts to double from $12 billion in 2017 to $25 billion in 2025. Goldstein Research expects the global IT maintenance market to grow at a 9.4% CAGR from $145 billion in 2016 to $249 billion in 2024.

Procurri serves specific niches within the markets mentioned above, such as the hardware resale (sub-segment of the global cloud infrastructure market) and the independent IT maintenance (sub-segment of the global IT maintenance market) segments. According to Frost & Sullivan research, Procurri is one of four global market leaders in these niche segments, but none of them have a market share in excess of 2%.

Aside from organic growth, Procurri is adding channel partners and acquiring companies to be an eventual consolidator of the niche markets it operates in. Procurri formed new partnerships with PureWRX and Nutanix (NASDAQ:NTNX) in February 2019 and December 2018, respectively. PureWRX is a leading OEM-certified pre-owned IT hardware platform, whose partnership with Procurri will allow the company to offer Juniper (JNPR)-certified pre-owned routing, switching and security products to qualified Juniper channel partners. Procurri's partnership with cloud computing firm Nutanix will make Procurri become Nutanix's official preferred global partner for ITAD services.

Procurri also recently acquired a 49% stake in Rockland Congruity in April 2019. Rockland Congruity was a 51:49 joint venture set up in January 2017 between Procurri US and Congruity LLC, providing independent IT maintenance services leveraging on Congruity's global network of 1,000 partners and 12,000 service professionals and engineers. Post-acquisition, Procurri has full control of Rockland Congruity, which is rebranded as Procurri.

Procurri currently trades at trailing 12 months EV/EBITDA of 5.0 times and EV/Revenue of 0.44 times, based on its share price of S$0.345 as of July 29, 2019. The key risk factors include a failure to integrate acquisitions well and higher-than-expected costs (spending more to drive market share gains) impacting profitability.

Thematics: Industrial Automation Play

Another of Novo Tellus' portfolio companies is ISDN Holdings [ISDN:SP] [1656:HK], which is dual-listed in Singapore and Hong Kong. I will focus on ISDN Holdings' Singapore-listed shares for the purpose of this article, as ISDN Holdings is headquartered in Singapore, and the Hong Kong listing (2017) is much later than the initial Singapore listing (2005).

Novo Tellus invested in a 6.4% stake in ISDN Holdings at S$0.20 per share that was announced in February 2019. ISDN Holdings last traded at S$0.23 on July 29, 2019, which represented a 15% premium to Novo Tellus' acquisition price. Novo Tellus has relevant knowledge of ISDN Holdings, given that AEM is a key client of ISDN.

ISDN Holdings is an integrated engineering solutions provider focusing on motion control, industrial computing solutions and other specialized engineering solutions. ISDN generated 76.6% of its FY2018 revenue from the motion control business segment, with the remaining revenue derived from other specialized engineering solutions and industrial computing solutions. ISDN Holdings is a designer and assembler of customized motion control systems used for factory automation that helps its customers improved operating efficiency and save costs. China and Singapore are ISDN Holdings' largest geographic markets, contributing 71.1% and 15.5% of its top line in FY2018, respectively.

In ISDN Holdings' February 2019 press release announcing Novo Tellus' investment, Novo Tellus elaborated on the reasons for investing in ISDN Holdings:

Our Fund invests in rising stars in Southeast Asia's manufacturing and industrial economy and ISDN presents a compelling opportunity to invest behind the transformation underway in Asia's factories. It's clear that Asia's industrial producers are embracing greater levels of automation and increasingly moving towards Industry 4.0 manufacturing practices. Indeed, the industrial automation market in Asia is estimated to exceed S$40 billion by 2020. ISDN is uniquely positioned to capitalize on this vast market opportunity: it has already delivered automation solutions to over 10,000 industrial customers to date, and its deep customer relationships, advanced engineering capabilities, and strategic market presence in key manufacturing markets like China, Thailand, Vietnam, Singapore, Hong Kong and Malaysia should enable the Company serve the increasingly sophisticated automation needs of Asia's manufacturing industry.

The global factory automation market is expected to expand from $203.98 billion in 2018 to $368.37 billion in 2025, based on a report by Allied Market Research. Factory automation is a secular growth trend driven by the scarcity of labor (ageing population) and rising inflation (need to keep fixed costs low to reduce operating leverage in an environment of rising costs). This should drive demand for ISDN's motion control products over time.

According to its 2016 Hong Kong listing prospectus, ISDN is ranked first and fourth in terms of revenue in 2015 in the Singapore (10% market share) and the China (5.1%) motion control solution markets, respectively. Both motion control markets in China and Singapore are fragmented with the five largest players in both markets having under 30% market share.

There are common characteristics that both Procurri and ISDN share; specifically, both of them are market leaders in growing, fragmented markets.

ISDN currently trades at 9.0 times trailing 12 months P/E and 7.8 times forward FY2019 P/E based on its share price of S$0.23 as of July 29, 2019. The bear case for ISDN includes order delays or cancellations by clients which might prefer to adopt a "wait-and-see" approach in the current uncertain global economic environment, and further diversification into renewable energy. ISDN has stakes in hydropower plants. While renewable energy is also a growing market, it could possibly distract ISDN from its core business in motion control.

Screens: The Favored Valuation Multiple Of Private Equity Firms And Deal Makers

In his book "Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations," Tobias Carlisle, founder and managing partner of Carbon Beach Asset Management LLC, and best known for his blog, introduced the enterprise value-to-operating earnings valuation multiple, calculated as revenues net of cost of goods sold and selling, general & administrative expenses. Investing in U.S. stocks based on this valuation multiple would have delivered a CAGR of 15.95% between 1974 and 2011, according to a 2012 study conducted by Carlisle and his co-author of his first book "Quantitative Value," Wesley Gray.

This enterprise value-to-operating earnings valuation multiple is likely to be favored as private equity firms and deal makers for two key factors. Firstly, Enterprise Value-to-Operating Earnings adjusts for leverage to present a pure operating performance for companies independent of financing decisions (which is relevant for private equity firms which can choose to gear up their portfolio companies later if needed), unlike equity multiples like P/E and P/B. Debt is included in the numerator (enterprise value), while interest expenses are added back to the denominator (operating earnings). Secondly, operating earnings are calculated in a top-down approach deducting cost of goods sold and selling, general & administrative expenses from revenue. Unlike net profit in the P/E multiple, non-core and non-recurring gains are less likely to be included in operating earnings.

There are 18 stocks (excluding banks and financial stocks whose cash balances would obscure the multiple) listed in Asia ex-Japan with a market capitalization in excess of $1 billion trading at a trailing 12 months Enterprise Value-to-Operating Earnings multiple below 4 times. The list of the stocks is presented below, in order of cheapness:

Stock Trailing Enterprise Value-to-Operating Earnings Trailing EV/EBITDA
China Railway Signal & Communication Limited (OTCPK:CRYCY) (OTCPK:CRYYF) [3969:HK] 0.35 0.32
China Oriental Group Co. Ltd. (OTCPK:CUGCY) (OTCPK:CUGCF) [581:HK] 1.12 0.98
Hyundai Development Company [294870:KS] 1.52 1.47
Taekwang Industrial Co. Ltd. [003240:KS] 1.65 1.18
China BlueChemical Ltd. (OTC:CBLUF) (OTCPK:CBLUY) [3983:HK] 1.67 1.46
BAIC Motor Corp Ltd. (OTC:BCCMY) (OTCPK:BMCLF) [1958:HK] 2.26 1.67
TCL Electronics Holdings Ltd. (OTC:TCLHF)[1070:HK] 2.38 2.38
Dongyue Group Limited (OTC:DNGYF) (OTCPK:DNGYY) [189:HK] 2.42 1.99
Road King Infrastructure Limited (OTC:RKGXF) (OTC:RKGXY) [1098:HK] 2.59 2.78
Pt Indo Tambangraya Megah Tbk (OTC:PTIZF) (OTCPK:ITAYY) [IMTG:IJ] 2.89 2.73
Sinotruk (Hong Kong) Limited (OTCPK:SHKLY) [3808:HK] 3.21 2.56
SK Hynix Inc (OTC:HXSCF) (OTC:HXSCL)[000660:KS] 3.28 2.35
Dynam Japan Holdings Co. Ltd. (OTC:DJPHF) [6889:HK] 3.34 2.12
Sinopec Engineering Group Co. Ltd. [2386:HK] 3.48 1.72
China Longyuan Power Group Corp. Ltd. (OTCPK:CLPXF) (OTCPK:CLPXY) [916:HK] 3.59 3.59
China Overseas Grand Oceans Group Ltd. (OTCPK:CSVGY) [81:HK] 3.67 3.88
Shougang Fushan Resources Group Ltd. (OTC:SHOUY) [639:HK] 3.70 3.20
Hebei Construction Group Corp. Ltd. [1727:HK] 3.75 3.60

Closing Thoughts

Following the smart money is one potential source of idea generation. Novo Tellus, a private equity firm with an impressive investment track record, recently invested in Singapore-listed Procurri Corporation and ISDN Holdings this year. Both of them are market leaders in growing, fragmented markets, which makes them interesting investment opportunities.

The Enterprise Value-to-Operating Earnings valuation multiple can be a good alternative to the more commonly-used P/E multiple, as it is independent of financing decisions and excludes one-offs and non-recurring gains. A list of 18 Asia ex-Japan billion-dollar market capitalization stocks trading at a trailing 12 months Enterprise Value-to-Operating Earnings multiple below 4 times is presented above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.