Description

Summary

Analogue Holdings is a Hong Kong based E&M engineering company that provides building and environmental engineering services to a wide range of sectors (hospitals, hotels, data centers, …) in Hong Kong, Macau and Mainland China. The company trades below the sum of net current asset value and the market value of its minority stake in shanghai listed data center AC manufacturer Nanjing Canatal (reported on the balance sheet at cost). The business has generated returns on equity of 20.9%, 8.0%, 25.4%, 20.6% and 16.5% in the period from 2015 to 2019, all while sitting on a large amount of excess net cash (excluding net cash ROE was 29% in 2019). The company is primarily looking to use its excess capital on opportunistic acquisitions aimed at expanding its international footprint in the lifts and escalators business segment. Despite the negative impacts of COVID on the various business segments, consolidated profits are flat for the first half of 2020 and the value of outstanding contracts stands at a record high of HK$10.77 billion, up 21.4% from first half of 2019. Management is increasingly focusing on the more stable and higher margin maintenance business as well as the more lucrative business segments ICBT and lifts and escalators. The margin expansion resulting from the increased revenue share of the more profitable segments is currently masked by the lumpiness of the large building services segment that is tied to the construction cycle of large contracting projects. The 78-year-old founder and chairman, Dr. Otto Poon, owns 63% of shares and is still very much involved. The company does a good job at investor relations. The reporting is very transparent and results are presented biannually with video presentations in English. Prominent Hong Kong based investor and corporate governance advocate David Webb owns 6% of shares, lending further credence to the company’s board and management. Webb has recently increased his ownership of the company by one percentage point. The company pays out 50% of net earnings, which currently equates to a 6% dividend yield.

Margin Expansion

I believe that the company will increase profit margins and decrease the lumpiness of earnings over time by focusing on growing the higher margin and more stable business segments.

The company’s activities can be differentiated by segment: building services, environmental engineering, information, communication and buildings technologies (ICBT) and lifts and escalators, and nature of work: contracting work, maintenance work and sale of goods. ICBT and lifts and escalators are the most profitable segments with gross profit margins of above 30% and 40% compared to building services and environmental engineering at below 20%. ICBT and lifts and escalators are also the fastest growing business segments with increasing relative share of total revenue. Lifts and escalators have grown from 4.3% of revenue (HK$161 million) in 2016 to 6.1% (HK$274 million) in 2019 and 14.4% in the first half 2020; had the TEI acquisition (more on that later) been completed on the 01.01.2020, Lifts and Escalators would have had a revenue share of 22.3% for the first half of 2020. ICBT has grown from 6.2% (HK$275 million) of revenue in 2015 to 9.9% (HK$444 million) in 2019 and the first half of 2020.

Maintenance work and sale of goods are most profitable by nature of work. The company has stopped reporting gross profit margin by nature of work, but the IPO prospectus shows 32.6% gross profit margin for maintenance work in 2018 and 38.7% for sale of goods compared to just 12.1% for contracting work. Maintenance revenue has been growing in absolute and relative terms. Since 2016 maintenance revenue has grown from 9.8% (HK$431 million) of revenue in 2016 to 15.1% (HK$679 million) in 2019 and 19.5% for the first half of 2020. Meanwhile the lower margin contracting work has decreased from 87.6% of revenues in 2016 to 79.9% in 2019 and 78.5% for the first half 2020 while maintaining a stable level in absolute terms.

Perhaps unsurprisingly, ICBT and lifts and escalators, the highest margin segments, derive a relatively high percentage of their segment revenue from maintenance work. Lifts and escalators generate the biggest percentage of segment revenue from maintenance work at above 40%, followed by environmental engineering at above 25% and ICBT at above 20%. The historical financials by segment and nature of work illustrate the above-mentioned points.

Source: Author’s presentation based on company reports

Source: Author’s presentation based on company reports

Management is well aware of the attractiveness of the higher margin and more stable maintenance work: „During the reporting period, we paid particular attention to growing our maintenance business of providing repair, servicing, operation, and associated minor alteration and fitting out works to customers. We believe that the maintenance market is growing steadily and is less susceptible to fluctuations in economic cycle and construction cycle of large contracting projects and hence will facilitate providing a steadier stream of income. Maintenance business also helps to maintain a continuing and close working relationship with our customers after the completion of a new project. “(Half Year Report 2020)

“Operation and Maintenance (O&M) contracts have become an increasingly important income stream for our environmental engineering segment. With the completion of the organic waste treatment facility in Siu Ho Wan in the end of FY2018, the plant was under our operation and maintenance in FY2019, adding the total number of O&M contracts in this business segment to 13, of which 11 are in Hong Kong, 1 in mainland China and 1 in Nepal. These O&M contracts typically have a duration of 10 to 15 years, together with other maintenance contracts with a typical duration of 3 to 5 years, they can provide steady and recurrent income to the business segment for a relatively long-time span.” (Annual Report 2019)

The international expansion of the attractive lifts and escalators business is another strategic priority, “We actively support our oversea distributors in bidding projects, such as metro/railway tenders in South Korea, Australia and Mexico. During the reporting period, we were awarded our first order in Mexico and Portugal respectively and signed new distributorship agreements in Eurasia and Eastern Europe regions. We will put in extra effort to boost our business growth overseas, targeting on areas with large market size and higher price level, such as the USA and East and South Pacific Rim countries. Moreover, we are looking for ways to work more closely with our oversea partners, and in addition to being a manufacturer and supplier, get ourselves involved in the maintenance business overseas as well as in mainland China.

To cope with the new manufacturing license requirement in mainland China and to meet our anticipated production needs for the next few years, we are working on an expansion plan of our factory in Nanjing.” (Annual Report 2019)

The Chinese market is a particularly large opportunity for lifts and escalators, “The number of elevators produced in mainland China in 2019 is approximately 1 million units according to government statistics, 60% – 70% of which are for local consumption. The total number of elevators registered in use is approximately 6.3 million units. With its continuing urbanization trend coupled with rising safety standards and quality expectation, mainland China is not only the largest manufacturing base of lifts and escalators globally but also the largest market for the supply, installation and maintenance of lifts and escalators in the world that we have started to grow locally since early 2019.“ (Annual Report 2019)

Valuation

At the current share price of HK$ 1.48 and a market cap of HK$ 2,072 million, the company trades below net current asset value (here: current assets – total liabilities) and the market value of its minority stake in shanghai listed data center AC manufacturer Nanjing Canatal (603912.SS), which is reported on the balance sheet at cost. On top of the downside protection provided by the net asset value, you get a good business that generates above 15% return on equity, despite the excess assets on the balance sheet. If you put a peer multiple on the business, you get significant upside from the current share price. Close comperables to the building services and environmental engineering part of the business are Jacobs Engineering and WSP Global. Jacobs trades at around 14.5x EBITDA. WSP Global trades at a 20.1x EBITDA multiple. Kone, Otis and Schindler, comparables for the lifts and escalators segment, trade at 21.6x, 18,4x and 17.6x EBITDA. In the SOTP valuation I take a haircut to those multiples for conservatism and to account for the slightly lower margins Analogue’s currently earning compared to the mentioned peers. I assume a target multiple of 15x EBITDA for ICBT, because I believe it deserve a similar multiple to Lifts and Escalators based on the profitability and growth opportunities of this segment. You can make bigger haircuts to the multiples or the value of the Nanjing Canatal stake, if you want to be even more conservative, but you should still get to above 100% upside under any reasonable scenario, with little downside risk.

Source: Author’s calculation

Source: Author’s presentation based on TIKR Terminal data

Capital Allocation

The company is regularly returning capital to shareholders in the form of dividends. The current dividend policy provides that 50% of net earnings are paid out to shareholders. In addition to the net asset value, the yield provides another floor to the stock price. At the current price the stock yields around 6%. 

Besides returning capital to shareholders, the company is currently looking to expand its international presence through strategic acquisitions, particularly in the lifts and escalators segment, „On top of striving for organic growth by constantly taking its technologies and skills to higher levels, the Group sees merger and acquisition of businesses with strengths complementary to its own as an effective way to quickly grow its business. This together with identifying partners and joint venture opportunities for the different business segments, they will enable the Group to widen the scope and geographical footprint of its business. “(Annual Report 2019)

Dr. Poon has reiterated this strategy during the Q&A portion of the half year 2020 results presentation, where he mentioned to be in talks with one or two lifts and escalators companies in Europe, that are currently not doing well due to the pandemic.

On 31.03.2020, the company established its first footprint in the US by acquiring a 51% equity stake in Transel Elevator & Electric Inc. (TEI) at an aggregate consideration of US$35.70 million. The purchase price corresponds to 0.6 times FY2019 revenue of US$118.7 million (up 24.8% compared to 2018) and 6.7 times FY2019 profit before tax of US$10.5 million (up 228.1% compared to 2018). TEI has been operating in New York City since 1989 and its primary activities are modernization, installation, repair and maintenance for elevators and escalators in residential and commercial properties in New York metropolitan area. The acquisition will establish local presence, knowledge and experience in the US lifts and escalators market. New York City in particular offers an attractive opportunity for maintenance work, “According to the Elevator Report 2017 issued by the New York City Department of Buildings, New York has approximately 84,000 elevators, claiming to be the largest stock in North America and with the oldest stock in the world. In view of such potential demand and leverage on its successful business model, the Group considers the acquisition as a strategic move which will provide huge opportunity to gain presence in the New York markets while gradually tapping the USA market.” (Analogue Holdings Press Release, 31.03.2020)

Subsequently the company has reduced its equity interest in TEI to 49% due to concerns about tensions between Hong Kong and the US, “In August 2020, the Company has reassessed the regulatory, operating and business environment in the U.S. and has determined with the board of TEI that it is in the best interest for TEI to have TEI’s local management increase their equity stakes in TEI due to latest changing China – U.S. tension. Accordingly, the Group has disposed of 2% equity interests in TEI on 10 August 2020.” (Half Year 2020 Report)

This is a direct reaction to the sanctions imposed on Hong Kong Justice Secretary, Teresa Cheng, spouse of Analogue’s chairman, Dr. Otto Poon, “Washington imposed sanctions on Hong Kong Chief Executive Carrie Lam and 10 other top officials including Cheng, for what it called their role in curtailing political freedoms in the territory, prompting a sharp rebuke from Beijing.” (Reuters, 09.08.2020)
Technically the company has reduced its equity stake in TEI to a non-controlling interest, but I believe this to be a temporary circumstance. An ambilateral call/put option agreement for the remaining stake will eventually result in a complete takeover, once the concerns about impact of sanctions on the business activities of Analogue Holdings in the US are clarified/subside.   

On 23.02.2021, the company established its first European lifts and escalators subsidiary in the UK to capture opportunities in Europe.

(Some of the) Risks

The international expansion of the lifts and escalators segment, which is a major priority for the company, might not be successful or the best use of capital.

I believe that the company is mitigating this risk by strategically and opportunistically acquiring established players to gain a foothold in target geographies.

With no hard catalyst in place the market might take a while to appreciate the quality of the business and its strategy and might never appreciate it fully.

I view this as rather unlikely, primarily due to management’s focus on creating shareholder value and the capital they currently have available to them. As long as earnings are growing, which I believe will – both organically (especially through organic growth of higher margin business segments) and inorganically (through acquisitions in the lifts and escalators segment) – the dividend alone will provide ample returns to shareholders and/or be a catalyst for a higher share price.

The building services segment in particular has high working capital requirements. In view of the high order book, there might not be as much excess capital available for acquisitions and shareholder returns as I’m suggesting.
Management is alluding to this point in the half year 2020 results presentation, when asked about the use of the large cash amount on the balance sheet. This is somewhat of a luxury problem; the high order book proves that there’s high demand for the company’s services and the company has more than enough capital to support this growth, return capital to shareholders and look for strategic acquisitions.

US Sanctions on Hong Kong Justice Secretary, Teresa Cheng, spouse of Analogue’s chairman, Dr. Otto Poon, might inhibit Analogue’s expansion into the US market.
I have no insight on this point, but I’m not sure that this is an actual challenge or just perceived to be one by the company. Regardless, the US market is just one of the target geographies for the lifts and escalators expansion. The Chinese market is possibly an even bigger opportunity.

Catalyst

Growing Earnings

Growing Dividend

Acquisitions