Description

Summary

FPT Corp is Vietnam’s leading technology company with a long runway of double-digit growth, a sustainable ROE of more than 20%, and excellent corporate governance. With the stock currently trading at 10.6x trailing P/E and an estimated 9x 2019e P/E with a projected dividend yield of 5.5%, the stock offers exceptional value and long-term compounding potential. Readers should be advised that like many stocks in Vietnam, FPT has a foreign ownership limit (“FOL”) of 49%, and the FOL for FPT is always full. This makes it somewhat difficult, although not impossible for foreigners to buy (more details below).

Background

FPT was founded in 1988 as a private enterprise (i.e. not state-owned) and then listed on the Ho Chi Minh Stock Exchange in 2006. The Chairman, Mr. Gia Binh Truong, and the CEO, Mr. Quang Ngoc Bui, were two of the co-founders and they collectively own 10.5% of the company.

FPT currently has three core businesses: Software Outsourcing, Telecom, and Education, which together accounted for 77% of consolidated profits in FY18. This write-up will focus on these three divisions as they are expected to drive the majority of the group’s growth and profitability.

FPT also has divisions focused on systems integration and online advertising, as well as associate (equity-method) subsidiaries in retail, distribution, and securities brokerage. In 2017, FPT undertook a significant corporate restructuring by selling majority stakes in the retail and distribution businesses. Financial investors bought a majority stake in FPT Retail, which was subsequently listed on the stock market as FPT Digital Retail (FRT VN). Taiwan’s Synnex Technology purchased a majority stake in FPT Distribution. These two divisions, which historically accounted for more than 50% of sales, were deconsolidated in 2018. Management undertook the restructuring to focus the company on higher margin businesses with better growth prospects and lower working capital requirements. FY18 results are not directly comparable to FY17 results due to the restructuring. FPT’s reported net profit declined -11% y/y in FY18 but pro forma net profit increased by +35% y/y.

The Telecom division (FPT Telecom – FOX VN), Online Advertising division (FOC VN), and securities associate company (FPT Securities - FTS VN) are also listed on the stock exchange. However, due to very limited free floats and liquidity, the market capitalizations and valuations of these listings may not be very meaningful.

Software Outsourcing (35% of FY18 sales and 44% of net profit)

FPT Software (“FPTSoft”) is the largest provider of software outsourcing services in Vietnam. FPTSoft has approximately 15,000 employees compared to around 2,000 employees at the next largest domestic competitor. FPTSoft services international clients in Japan (56% of divisional sales), North America (22%), Europe (9%), and the rest of Asia (14%). The large percent of revenue from Japan is because it was the first region targeted by FPTSoft and the strong client relationships have driven continued growth in the region.

FPTSoft’s business model is similar to many Indian IT service companies although FPTSoft is still relatively small in scale. For example, FPTSoft’s FY18 revenue was just $367m compared to $20.6b for Tata Consultancy and $11.6b for Infosys.  FPT Software has grown revenue at a 5-year CAGR of 31% including 35% in FY18, which is much faster than the overall industry. Management attributes this outperformance to more attractive pricing and lower labor costs, which are about 20% cheaper than India and 30% cheaper than China. This labor cost advantage has been stable with India in recent years and has been widening with China, so we think FPTSoft can continue to grow much faster than the overall industry. Additionally, some international clients prefer to have some geographic diversification from their IT service vendors, instead of relying solely on India or China.

FPTSoft’s top five customers account for approximately 30% of revenue and the top 10 account for around 45%. Key industry verticals are auto, finance, logistics, and healthcare. The strategy is to increase penetration with top customers as well as adding new customers. Additionally, FPTSoft is using bolt-on M&A to establish new client relationships and move into higher value-add consulting services. FPTSoft acquired RWE IT Slovakia in 2014 and US-based Intellinet in July 2018 for $30m. We expect FPT to conduct additional bolt-on acquisitions to further bolster its international presence. Management is targeting acquisitions less than $50m in size.

FPTSoft has consistently achieved mid-teens operating margins and we expect this to continue. One of the key challenges for the business is recruiting new talent but FPT’s education business, discussed more below, is a key advantage in training and recruiting new software engineers.

Telecom (36% of FY18 sales and 17% of net profit)

FPT Telecom is the third largest provider of broadband services and Pay TV in Vietnam with approximately 23% market share and 2.3 million subscribers. Viettel is the dominant player and VNPT is similar in size to FPT Telecom. Both are state-owned competitors. FPT Telecom is 45.7% owned by FPT Corp and 50.2% owned by the Vietnam State Capital Investment Corp (SCIC), an investment arm of the Vietnam government. FPT Telecom is consolidated into FPT Corp’s financial statements. The government’s large minority interest explains why the division accounts for a much higher percent of consolidated revenue than of net profit.

FPT Telecom has grown at a 5-year revenue CAGR of 21% including 16% in FY18. We think the division can continue to grow at a mid- to high-teens revenue CAGR due to still relatively low broadband penetration levels of around 45% in Vietnam. FPT is largely finished with converting connections from copper to fiber, with 82% of subscribers on fiber as of the end of 2017.

Operating margins came under some pressure in the last several years, mainly due to increased provisioning for government fees and higher depreciation from fiber optic investments. However, operating margins improved modestly in FY18 to 14% and management expects this level of profitability to be sustainable going forward.

FPT Telecom has also entered the data center business with data centers in Ho Chi Minh City, Hanoi, and Da Nang. Currently data centers only account for 4% of divisional sales but the new cyber security laws which require foreign companies to use local data centers could drive strong growth in the future. Management estimates that they have over 30% market share in data centers.

One potential positive catalyst for the stock is a buyout of the SCIC’s stake in FPT Telecom. The Vietnamese government (Ministry of Finance) has a publicly announced goal of reducing investments in Vietnamese companies and the FPT Telecom stake has been slated for disposal. Management has expressed interest in buying SCIC’s stake when it is put up for sale. This could be very earnings accretive if it is acquired at the right price. However, SCIC has been reluctant to sell the stake and the timeline depends on intragovernmental politics.

Education (6% of revenue and 16% of net profit)

FPT Education is the largest private education company in Vietnam and primarily focused on IT vocational education. This division has significant synergies with the core Software Outsourcing business, as 40% of graduates take jobs with FPT upon graduation. Additionally, it is a very profitable standalone business with operating margins of more than 50%.

They have four vocational campuses in Hanoi, Ho Chi Minh City, Can Tho, and Da Nang as well as a new campus under construction in Da Nang. FPT Education also has a k-12 campus in Hanoi, but vocational education is expected to continue to contribute the majority of divisional revenue in the medium-term. Education revenue has grown at a 5-year CAGR of 20% including 32% in FY18. Enrollment jumped 48% y/y to 36,635 at the end of 2018, suggesting strong revenue growth is likely to continue in the coming years.

Shareholder Friendly Management / Strong Balance Sheet

FPT management is widely regarded as one of the best and most shareholder friendly management teams in Vietnam. Since listing, FPT has maintained an average dividend payout ratio of around 40% and management has guided for this policy to continue. Furthermore, the company has not raised new equity since listing in 2006 and we expect the company can continue to fund growth, capex, and modest M&A with operating cash flow. The balance sheet is in a net cash position of VND 2.5 trillion ($108m / 9% of market cap). The company has good financial disclosure with monthly revenue and profit updates and English annual reports.

The company recently announced that the current CEO and co-founder will be retiring later this year. He is 62 years old and will remain on the board after stepping down as CEO. We believe succession planning has been under way for the past few years and the new CEO will probably be one of the current division heads of the core businesses. Therefore, we don’t expect any major changes in strategy under the new CEO.

Financial Forecasts

Management has guided for FY19 revenue and profit growth of 15%. We think guidance may be conservative and growth of 15-25% p.a. can be achieved over the medium-term based on the historical growth and structural drivers of the Software Outsourcing, Telecom, and Education divisions discussed above.

Valuation

FPT is cheap in both absolute and relative terms. The stock is trading at 9x forward P/E compared to 16x for the Vietnamese market. IT comps in India trade at 15-25x P/E and Education comps in emerging markets trade at 15x-30x P/E or more.

At the current price, we think FPT offers around 25% annualized return potential just from earnings growth and the dividend yield. The stock offers multi-bagger potential over the next few years if it were to rerate to 20x P/E, which doesn’t seem outlandish based on emerging market comps and the average valuation of the Vietnam stock market.

One factor that has depressed FPT’s valuation is the full FOL, discussed more below.

Investing in Vietnam / Foreign Ownership Limit (FOL)

Foreign investors can invest in Vietnamese equities by setting up a domestic cash custody account. This can be done through several international banks (HSBC, Deutsche Bank, Standard Chartered, Citibank) as well as a number of domestic brokerage firms. Many prime broker ISDA counterparties will also offer access to Vietnamese equities via swap.

Up until 2015, all Vietnamese listed equities had an FOL of 49% for non-banks and 30% for banks. In 2016, the regulator relaxed the FOL rule to allow companies to voluntarily eliminate the FOL entirely if they are not in “restricted” sectors. Around 16 companies have elected to eliminate the FOL since the rule was relaxed. One of the first companies to eliminate the FOL is Vietnam Dairy Products (VNM VN). The chart of Vietnam Dairy Products in the second half of 2016 shows an example of the potential positive impact that FOL removal could have on FPT and other Vietnam equities that always have a full FOL. Unfortunately, the telecom sector is still regarded as a “restricted” sector so FPT is not allowed to eliminate the FOL unless further regulatory reforms are made.

It’s important to understand the trading dynamics for a Vietnam stock that has a full FOL. For a foreigner to buy the stock, another foreigner must be willing to sell. This transaction can take place on the exchange, but the Ho Chi Minh Stock Exchange has maximum/minimum daily price change limits of +/-7%. In the case of FPT and some other blue-chip stocks that are highly regarded by foreigners, there is a large discrepancy between how domestic investors and foreign investors value the stocks. And because the FOL is always full for these stocks, nearly all of the trading of the stock on the exchange is locals trading with other locals.

When the premium foreigners are willing to pay compared to locals exceeds 7% from the previous day’s closing price, then the foreigner transactions must occur off-market. Off-market transactions require copious amounts of paperwork and approval by the State Securities Commission (SSC) and Vietnam Securities Depository (VSD). This process can take a month or more.

Furthermore, since the transaction does not occur on the stock exchange, foreign investors who are required to mark-to-market their portfolios typically will take an immediate loss on the value of their portfolio after purchasing stock in an off-market transaction. This is just a paper loss since it is likely that the stock can be resold to another foreign investor at a similar premium, but this is a short-term issue many foreign investors are not willing to deal with.

We have been able to build a sizeable position in FPT over a number of years by periodically buying small blocks of stock that become available on-market at limit-up (+7% from the previous days close) and also by purchasing a few larger off-market blocks at premiums of 10-20%. FPT has been easier to buy than some other full FOL names like Mobile World (MWG VN), which typically require paying a 30%+ premium.

FOL reform in Vietnam would be a major catalyst for FPT. We think this is likely to occur eventually, although the timing is difficult to predict and dependent on the Vietnamese regulators. One avenue the regulators could take is to eliminate the “restricted” sector status for most industries including telecom. Another avenue would be to create a Non-Voting Depository Receipt (NVDR), similar to the system that exists in Thailand, which would allow foreign investors to purchase shares in the pool of local shares with all benefits excluding voting rights. The inefficiencies created by the FOL issue might restrict Vietnam from being upgraded to MSCI Emerging Market status. We think the government is aware of this and it could provide motivation for FOL reform.

Risks

Currency: The Vietnamese Dong is a managed currency, which has gradually depreciated over time. In the last five years the currency has depreciated an average of 1.9% p.a. The Vietnamese central bank is thought to watch the Chinese Renminbi closely and depreciate the Dong at a similar pace over time, in order to maintain a labor cost advantage to continue attracting FDI. There is a risk of Dong depreciation if the Renminbi depreciates significantly, but this risk is hedged by the fact that 39% of FPT’s revenue is from overseas. The overseas revenue is primarily denominated in JPY, USD, and EUR.

Wage Inflation: FPT has experienced wage inflation of 7-8% in recent years. This level of inflation has been manageable and allowed for steady profit margins, but if wage inflation increased dramatically it could pressure margins or reduce FPTSoft’s international competitiveness.

Telecom Price Competition: The broadband industry in Vietnam is fairly competitive with two large SOE competitors. FPT has managed to keep ARPU broadly flat in recent years but only by offering higher bandwidth at a similar price. If industry subscriber growth were to slow dramatically, price competition could worsen.

Government Regulation: The Telecom division margins suffered from increases in the Vietnam public-utility telecommunication service fund and franchise fee during 2017. Additional increases in fees or other negative regulatory developments could impact fundamentals. We see the highest regulatory risks in the telecom business.

Vietnam Retail Investor Flows: Because FPT’s FOL is full, the price on the stock exchange is set almost exclusively by domestic investors, who are overwhelming retail investors. Retail investors tend to be less fundamentally inclined and short-term oriented, which could lead to temporary disconnects between the stock price and fundamentals.

Catalyst

Earnings growth

FOL reform

Buyout of SCIC’s stake in FPT Telecom