Description

Analogue Holdings was written up by zobren in Mar-2021. You should read the write-up; it was good and we agree with many of the conclusions. So why write it up again then? Two reasons: 1. There have been two important new developments 2. We have some additional colour on the different business divisions that may be helpful to members.  

Investment Summary:  Analogue Holdings trades cheapish for a contractor at 7.4x LTM PE/ 3.4x LTM EBIT, but buried in the contractor are two growing, high-quality manufacturing businesses and HKD 2 Bn of assets (cash, securities, and real estate) a little higher than the current market cap. Part of the reason is a recently launched antitrust investigation which we think is priced in (more below). The company is founder-led (owns 63% of the business personally), returns on capital are decent and unlike many small companies in Asia cares about minority shareholders. We believe Analogue as it stands today should be valued at roughly double its current share price and we further believe that its Lifts & Escalators business has significant growth potential and could in five years alone be worth as much as the entire group today. 

New developments

Antitrust Investigation

On 16-Jun-22, the antitrust authority of Hong Kong opened an investigation into Analogue Holdings and a competitor. The allegation is that three individuals (two at Analogue and one at the competitor) rigged tenders by coordinating their submissions from Dec-2015 to Dec-2019.

It is not clear to what extent Analogue is cooperating with the investigation and whether senior management was involved or not. In H1 2022, Analogue has taken a HKD 60 MM provision related to the investigation. Meanwhile the market price of Analogue shares decreased from HKD 1.80 the day before the announcement to HKD 1.28 today. If you attribute the decline solely to the announcement (which is an oversimplification as many real estate related business continued to suffer from negative developments among Chinese developers during that period in addition to the interest rate increases, but we think the antitrust case is responsible for the most of that move) then the market ascribes about HKD 728 MM in lost value. Quite a difference in opinion. 

So, what are the likely consequences of the investigation? First off, the anti-trust regulator in Hong Kong is relatively new – been around for 10 years – and anti competitive behaviour is endemic in Hong Kong, so the fact that the regulator moved on this issue, means that it is very likely that they have solid evidence and that the allegations are likely true. However, Hong Kong is one of the few Asian jurisdictions where one can win a case against the government, so the fact that the allegations are true does not necessarily mean that Analogue won’t get away with it, though it would not be our base case. 

The most likely outcome is a fine coupled with an order to implement procedures to prevent future bad behaviour. The commission follows a formula to determine the fine, which is 15-30% of the sales that had been affected by bad conduct. This base number can be increased or decreased based the existence of a variety of soft factors (did the company cooperate, degree to which senior employees were involved etc.) and compared to a legal limit (10% of the turnover of the group in Hong Kong for each of the years in which bad conduct occurred capped at a maximum of three years; HKD 1.3 Bn in Analogue’s case). The commission did comment that about HKD 2 Bn of contracts were affected by bad behaviour. Logically this number is attributable to both Analogue and its competitor Shun Hing. We don’t know the split, but if you assume the entire number is attributable to Analogue and you assume the highest percentage without any adjustment due to soft factors, you end up with about HKD 600 MM or roughly in line with what the market is assuming. This is probably a bit too conservative but not totally unreasonable if you want to be very cautious. 

So, it seems the fine is captured in the current price, but what about the impact on future business? First, it could lead to Analogue winning less business going forward. It is probably a bit early to tell because the announcement has been recent, but Analogue has continued to win tenders and was invited to new ones. A significant portion of their business is public tenders, and there seems to be no basis for Analogue’s exclusion due to the investigation or even due to a potential conviction. Further, and will get to this in more detail in the discussion of the business unit, there are not that many alternatives to Analogue and Shun Hing, so excluding them is probably not practical in many cases. We therefore do not think it will have an impact on the volume of business. 

Secondly, it could reduce the profitability of the Building Services segment as some of its history was flattered by illegal conduct. This seems likely. The pre pandemic average operating margin was high for a contractor at 5-6%. So, what is a good assumption going forward? That is a tough question as both the extent of anti-competitive conduct and its impact are unknown. However, we believe that Building Services is structurally a better business than Environmental Engineering (more on the reasoning below). Environmental Engineering averages about 3% operating margin which seems more consistent with general contracting and that is our assumption for Building Services going forward which we believe to be conservative. You might argue that this is only slightly below the H1 2022 run rate, which is true, but H1 2022 is still impacted by Covid restrictions which hopefully one day will fade out. 

Note that we owned Analogue before the announcement of the investigation.   

Toppy tower 

Analogue bought a building in the northwest of the New Territories for HKD 580 MM. The building is called “Toppy Tower” and is a 12-storey industrial building. The group will refurbish the building and once done, will use it to consolidate its all offices in that one location. A recent change in the building code allows them to increase the area by up to 20% and assuming they fully utilize this opportunity they will have paid around HKD 3,600 per square foot exclusive of whatever they are spending on the refurbishment. It is not clear how much Analogue is currently spending on rent nor is it easy to figure out what the right rent comparable for “Toppy Tower” is. Average office rents in Kwun Tong which is on the other side of the bay in what we would consider to be an unfashionable location are about HKD 350 per year. Though admittedly the average building in Kwun Tong is better located than Toppy Tower. Bottom-line is that while the purchase does not look like an obvious mistake or an unnecessary extravagance, there is just not enough information to judge whether it is a good use of capital. 

Business Segments 

Building Services 

What do they do? Most of the business is fabrication and installation of air conditioning, fire systems, plumbing and electrical systems on a fixed price basis almost exclusively in Hong Kong and Macau. While contracting is generally a bad business the focus areas of Analogue are a touch better for several reasons: 

• work starts when a fair chunk of the construction has been completed meaning the work occurs indoors and is less exposed to the vagaries of the weather

• work occurs towards the end of construction when major delays are less likely and when a lot of money has been spent meaning the probability that the project will be finished and the client has the funds to pay are a bit higher

• project length is much shorter than general construction which means there is less room for things to go wrong

• Like most jurisdictions Hong Kong has rules in place making it harder for foreign companies to compete for fire systems and electrical systems than for general construction 

• One of their specialities are the air conditioning systems for data centres and hospitals, which are critical to their operation and where price sensitivity is a bit lower

• A fair proportion of the work can be done in a factory setting with only final assembly at the construction site increasing predictability 

The market is very fragmented with the top 5 players accounting for only about 21% with Analogue being the largest player at 9% (according to a Frost & Sullivan market study the company commissioned for their 2019 prospectus). That sounds competitive, but the majority of the value of contracts in Hong Kong are high rises and these contracts are very difficult to split amongst several contractors. This means in practice that only the largest firms qualify for this type of work meaning you only have a handful of companies competing for most high-profile projects. This is somewhat confirmed by the recent investigation of the anti-trust regulator, because if this segment was subject to textbook ‘perfect competition’ two firms colluding could hardly change the outcome of any tender and would be pointless. In summary, we are not advocating that the business quality is comparable to Google, but it is a bit better than the admittedly very low business quality of a general contractor. It is also worth noting that Hong Kong is very densely populated, and several initiatives are under way to build more housing. The largest of the schemes being discussed is “Lantau Tomorrow Vision” which entails 260,000-400,000 newly built homes for a total cost of around USD 60 Bn in addition to several much smaller plans by private developers and initiatives to integrate Hong Kong, Macau as well as the Guangdong province through several large-scale infrastructure projects. We don’t know whether these plans will come to fruition or over what timeframe, but it seems likely that there will be a decent pipeline of work over the coming years. 

Environmental Services

This segment builds and operates sewage treatment facilities mostly in Hong Kong. The segment looks much more like a typical contracting business. Large scale, fixed price projects that take a long time to finish with all the risks that this entails, and the most recent financial year excluded, margins have been modest. We think this is the worst segment, but we understand that this is the historical nucleus of the group, so there may be some emotional attachment to keeping and growing it. That said, Analogue is moving in the right direction. For example, they developed a mini sewage plant of the size of a container that can be produced in their plant in China and has in theory some appeal for rural applications or where a temporary solution is required. The product is new and only time will tell if they get any traction. 

Information, Communications & Building Technologies (ICBT)

This segment buys electronic components and puts them together into systems to control buildings. Their flagship project is the automated passport clearance system in the Hong Kong airport, but they also offer camera systems for malls to analyse footfall or systems to track and optimize energy consumption in large buildings (for example Two IFC tower in the financial district which some members will be familiar with). This segment occupies a few good niches, has consistently generated very good margins and some products like the automated passport clearance system could be sold in other jurisdictions in Asia. 

Lifts & Escalators 

This segment manufactures lifts, escalators, and walkways in a manufacturing facility in Mainland China. It is one of the key reasons why we own Analogue as we believe that it has real potential to grow, and you are not paying much for it. It seems to us that they have been successful by a combination of cost control, offering very good value for money, accepting a lower margin than some competitors and focusing on niche products where there is less competition from large players (such as vehicle lifts or automated ramps for people with limited mobility etc.).

We think it is useful to think about lifts and escalators as two separate businesses as the dynamics and regional focus are quite different. 

Escalators is a much weaker business than elevators as breakdowns are much less painful for customers, there is no security concern, there is limited brand awareness and maintenance tends to be much more straightforward. Not coincidentally a lot of the work the group has done outside Hong Kong were escalators and walkways rather than elevators. Analogue has been able to win projects in many different jurisdictions (Germany, Canada, Brazil, UK, the list goes on), we believe with the help of distributors that deal with some of the aftersales. There are four reasons why we are optimistic that they can sustain and perhaps even accelerate their growth. 

The first is that building distributor relationships in foreign jurisdictions and winning projects that can serve as a reference is much harder than winning follow-on business that builds on this success. 

Secondly, Analogue recently completed the renovation of Midlevel Escalator in Hong Kong, which is one of the longest escalators globally and one of the most photographed tourism sites in Asia and should make for a nice calling card to win business going forward. 

Thirdly, Analogue is still growing from a small base. Their largest market is Hong Kong where public safety records allow you to infer market shares for the installed base of c9,000 escalators and where they have a share of about 1% or about 80 escalators compared to the market leader Schindler who has a 31% share with about 2,800 installed units. 

Finally, management has commented that one of the biggest obstacles to growth of the elevator and escalator business is additional manufacturing capacity which they are currently expanding, and which should increase capacity by 3-5x sometime next year.

Elevators on the other hand seems to be a very Hong Kong focused business. And as discussed even there a lot of the elevators seem to have been niche products (vehicle lifts, service lifts etc.) as opposed to ordinary passenger lifts most of us think of when they hear “elevator”. Where they have won passenger elevator projects, they tended to be from the public sector in Hong Kong which is very price focused. Analogue’s market share seems to be around 2% or about 1,000 installed units. Over the coming years there should be an opportunity to grow that installed base as about 50% of the installed base of elevators in Hong Kong is over 20 years old with programs in place to renew the fleet across public housing (which accounts for about three quarters of the population) and the private sector. 

In addition, the company wants to expand elevators internationally and has acquired a 49% share in a New York based elevator service company and recently established a UK subsidiary. If you are wondering why they have not expanded more into China, we believe the answer is that the Chinese market is one of the most competitive in the world with a lot of very price aggressive players in addition to the current problems amongst its developers. Longer-term China could be an interesting opportunity for Analogue though as China aims for “industrial self-sufficiency”. If you want to get a better sense of the opportunity and issues of the Chinese market, we recommend the recent earnings calls of Otis and Kone which feature extensive discussions. 

Whether Analogue will be successful with its international expansion plans for elevators outside China remains to be seen and we would love for them to shoot the lights out, but we are a little bit sceptical. We find the example of local competitor Chevalier Limited instructive, which is a business with some similarities. It was also founded in Hong Kong, started out in construction, and seems to have branched out into elevators in the 70s and has as a result a much larger presence in elevators than Analogue with a c.12% share which puts them among the largest non-international players. Chevalier too had pursued an international expansion strategy and while they did secure some projects abroad it seems to remain a largely Hong Kong focused business. 

Management 

The Hong Kong market trades cheaply as most members will know. We think though that while there are some real bargains, many businesses deserve their low valuations for four reasons. First, there is a high amount of fraud esp. for businesses that are based in Mainland China and only listed in Hong Kong as there is no extradition to Hong Kong for financial crimes. Second, many controlled businesses like Analogue do not care about minority shareholders. Third, disclosures tend to be very poor, boilerplate documents without any attempt to explain what is going on in the business. Fourth, capital allocation is poorer on average than say in the United States with many companies hoarding cash or investing in unrelated assets rather than returning capital to shareholders. Long wounded way of saying management is extra important. 

On the first point, we naturally do not believe that there are signs of fraud, but it is worth highlighting some personal misconduct of the founder in this context. The founder, Otto Poon, is married to former Hong Kong Secretary for Justice Teresa Cheng. In the run up to her appointment in 2018, local press discovered that she made unauthorised changes to her house for which she apologized. The whole thing became a bit of a local scandal which led to a lot of press scrutiny and to the discovery that the house next door belonged to her husband, Otto Poon, who also had an unauthorised structure (a swimming pool). He was prosecuted, at some point claiming somewhat incredibly that he was not aware the building code demanded a permit and ultimately found guilty and fined HKD 20,000. We usually take a dim view on any kind of legal issues, reasoning that if you break the law in private you probably also break it in your professional life. However, this case seems more like a traffic violation to us. A lot of the facts surrounding the case are public, so you can come to your own conclusions. One other thing that is probably worth noting is that Otto Poon seems to have excellent government contacts through his marriage which should be helpful in competing for government work. 

The second and third points happen to be an area where Analogue really shines esp. for a sub USD 300 MM market cap company in Asia. They are one of the few small companies who do detailed presentations on their business every half year. They are not great presenters, but we think it shows that they at least try to explain their business to shareholders. Better yet, these presentations are live and both analysts and shareholders can call in to ask questions that management answers live. The questions are as a result not quite as softball as the typical analyst call. The whole thing is recorded and on their website. Really wish more companies in Asia did that and we think it shows that they care about minority shareholders. 

On the fourth point, the jury is still out. Analogue does have excess capital, but that is largely the result of its 2019 IPO. The rationale of the IPO was according to the company to help it win business as customers would regard a listed business as more credible; an explanation we find plausible enough. So far there have been two significant deployments of capital. The acquisition of 49% of an elevator service business in March 2020 for HKD 279 MM and the acquisition of a new headquarter for HKD 580 MM. Zobren covered elevator service business acquisition very well and we won’t rehash it here. Only thing to add is that the first half of 2022 has been much worse and would imply that they paid a high double-digit PE if annualised. That said, given how abnormal the last few years have been we feel it’s a bit too early to judge and only time will tell if this was a smart move. 

The acquisition of a new headquarter on the other hand is in our experience a time-tested red flag. As discussed above in this case there could be business justification, but so far there is just not enough information to come to a view.

On the positive side management started selling down Analogue’s stake in Mainland listed Nanjing Canatal, which we view as positive though the pace of the disposals is admittedly slow. Analogue also returns capital in the form of dividends (share buybacks are for technical reasons not possible btw) and LTM dividend yield runs at about 9%.

In summary, this is an area of concern, but we would give Analogue the benefit of the doubt for the moment (famous last words ;) ). 

Valuation 

Downside case

Net cash, the recently acquired Toppy Tower and the market value of its listed Canatal stake equal HKD 2.0 Bn. Assume a fine from the current investigation of HKD 600 MM equals HKD 1.4 Bn or about HKD 1 per share. Assumes of course that the operating businesses turn out worthless, but also assumes that management, which owns c.68% of the business, does squander the cash doing something stupid. 

Base case

We think about the valuation in three buckets. The mediocre contracting businesses Building Services and Environmental Engineering, the high-quality manufacturing businesses ICBT and Lifts & Escalators and the other assets namely Toppy Tower, cash and the Canatal stake. 

H1 22 annualised seems like a decent run rate for Building Services earnings. They currently suffer from somewhat lower profitability due to Covid vs. history, but history was flattered by illegal conduct, so we expect an operating margin of 3% going forward roughly in line with the current margin or HKD 122 MM. For Environmental Engineering we think H1 22 annualized operating profit is an OK guess of what the run rate looks like and implies HKD 34 MM. We use 8.25x EBIT which is equivalent to a PE of about 7x for an enterprise value of HKD 1.3 Bn. We don’t give credit to growth even though these businesses should grow roughly in line with GDP to be extra cautious considering the mediocre business quality. 

H1 2022 annualized operating profit for ICBT and Lifts & Escalators together was about HKD 127 MM.  As raised by Churchill in the discussion to the previous post, we agree that Fujitec is a better comp than Kone et al as there are some similarities in strategy and regional exposure. You can argue that Fujitec has much more name recognition and scale so should be valued at premium to an obscure Hong Kong small cap and you would have a point. However, Fujitec has not grown very much over the past few years while Analogue has, Fujitec is subject to much higher taxes and Fujitec has a significant net cash balance which Japanese investors tend to ignore (and usually for good reason) and if you followed their example would lead to 20-30% higher multiples. Taken together these points are roughly a wash in our view. Fujitec’s current NTM EBIT multiple is 12x and that is what we use for an enterprise value of HKD 1,520 MM. To sense check, this implies a PE of about 15x. 

Add the Canatal stake (HKD 740 MM), a HKD 300 MM fine and the value of Toppy Tower of HKD 580 MM and you get to an equity value of HKD 3.8 Bn or about HKD 2.70 per share. 

You can argue that the market will never give credit to the Canatal stake and Toppy Tower. However, management started disposing of Canatal which should help recognition and at a minimum Analogue should get partial credit for Toppy Tower through rent savings and potential rental income (admittedly at a lower valuation when viewed through this lens). 

Note that we ignore the net cash balance as we view a portion of it as necessary working capital for a growing contractor and trying to split operating from excess cash feels arbitrary, but there is probably another cushion of value in there. 

Upside case

Same as the base case, but with EBIT from Lifts & Escalators roughly tripling to HKD 180 MM. Why? Because management commented that they believe the factory expansion will allow them over the mid-term (we think 5 years) to triple their business and we buy that. Tripling sounds like crazy talk? Keep in mind that the Lifts & Escalators business currently is quite small (less than USD 50 MM in sales), so it takes less to grow that at a high rate esp. without the manufacturing bottlenecks that held them back in the past. 

Assuming that management is correct that the current provision of HKD 60 MM is sufficient to cover the fine (yes, a big if, but this is also the upside case) you get to HKD 5.5 Bn equity value or about HKD 3.90 per share.  

Risks

Culture: We don’t believe the antitrust violation was an isolated one-off by two rogue employees, but we also don’t think illegal behaviour is widespread throughout the organization and at the heart of everything they do. That said there is no real way of knowing for certain and something which is difficult to assess outside-in. 

Scale: Analogue is small. Makes growing easier but puts them at disadvantage in maintenance and development of new products (somewhat offset by access to relatively cheap talent). 

Management: Otto Poon, the founder, is in his late 70s and if something happened to him it would probably be time to exit this investment. 

Construction business: fixed price contracts are naturally risky, and the list of bankrupted contractors is long. Building Services has some mitigants as outlined above, but Environmental Engineering has all the typical contracting risks.

Safety incident: Lifts & Escalators brand is nascent. A high-profile safety incident could potentially kill that business.  

Capital allocation: not clear how good management is in this regard. M&A is one of the uses of capital they often highlight.

Politics: trade between China and the rest of world is becoming a more contentious topic leading to tariffs and other trade obstacles that impact Analogue’s international expansion. 

Disclaimer 

We own this (surprise!). 

We have tried to take care in preparing this write-up, but you know, it could be all wrong.

We may sell or change our mind and we won’t tell you about it.

Catalyst

Earnings growth 

Resolution of the antitrust investigation