Latitude tree, cyclical and earning power

Rule number one, most things will prove to be cyclical.

Rule number two, some of the greatest opportunities for gain and loss come when people forget rule number one.”               

Howard Marks

[Posted by blank > Jul 18, 2015 11:59 AM | Report Abuse

Definitely this stock is a laggard. The directors are not proactive and zzzzzzzzzzzzzz... collect their directors fees and not think of shareholders. Sickening. Look at all the other furniture counters... Lii Hen, Poh Huat, Hevea have all moved. Lastly they give a miserable div yearly and expect shareholders to be happy.]

Figure 1 below shows its share price performance for the last 5 years. A picture paints a thousand words. Just what else do you and other investors want?

Don’t you think the management has created tremendous shareholder value the last few years by looking at the share price performance as shown in figure 1 above instead of scorning the management as the opening post above?

I first wrote about Latitude Tree just two years ago when its share price was just RM1.26 apiece, together with other furniture stocks as appended in the link below.

http://klse.i3investor.com/blogs/kcchongnz/77997.jsp

All those furniture companies mentioned in the article, including Latitude Tree were performing very well with high return on capitals and selling dirt cheap with low single digit price-earnings ratios and enterprise value (EV) with respect to their earnings before interest and tax (Ebit) at that time.

With its explosive earnings the last couple of years, earnings per share (EPS) has increased by seven folds from 10 sen in 2012 to a trailing twelve months EPS of 69 sen on 31^st March 2015, coupled with the recognition of its value and the subsequent expansion of its valuation, its share price closed at RM6.10 last Friday on 17^th July 2015. The gain is 384% in less than two years.

Less than one and a half year ago on 12th March 2015, I wrote about its excellent cash flows and its good reinvestment opportunities, and did some valuations on it when it was RM2.57. If you have bought it then, the return till now is still very high at 137%.

Just 8 months ago on 21st December 2014, I wrote about it again when its share price was RM3.58, reiterating their high return on capitals:

http://klse.i3investor.com/blogs/kcchongnz/66908.jsp

And still with cheap valuations:

http://klse.i3investor.com/blogs/kcchongnz/67260.jsp

Even if you have bought just 8 month ago, the return of investment is still a whopping 73%.

No, I am not selling medicine here on the road side but just to put things in perspective. That is already history. The pertinent question now is, what is the likelihood of its future financial performance and more importantly for many investors, its share price performance will be? Oh how I wish I have a crystal ball in front of me.

The past financial performance of Latitude Tree

I already knew that some people will say “This time is different”. The past has no relevance about its future. It is already history. But just bear with me with this ranting about its past performance first.

“History doesn’t repeat but it does rhyme”           Mark Twain

Table 1 in the Appendix shows revenue of Latitude has been increasing at a CAGR of about 6.3% from RM412m in 2007 to the all-time high of RM673m as on 31^st March 2015.  Net profit, profit margin and EPS are all at all-time high of RM72.6m, 10.8% 69 sen respectively. We can see that profit margin varies quite substantially over the years with profit margin at a low of just 2.1% during the subprime housing crisis to the recent highest of 10.8%. That is a huge difference of 5 times. The average net profit margin is 5.4%, and that is only half the most recent profit margin.

At the close of RM6.10 on 17^th July 2015, Latitude is trading at a current PE ratio of 8.9 and an enterprise value of 6.7 times its operating profit. Is this price cheap? Should one buy, buy more with margin, hold or sell? But this thinking is just the first level of thinking.

Second level thinking about cyclicals

The opening quote from Howard Marks reminds us about the importance of second‐level thinking about “most things will prove to be cyclical.” It requires us to be very careful in recognizing that equities are not simply a claim on this quarter or next quarter, or even this year, or next year’s forward operating earnings, but are instead a claim on the very long‐term stream of cash flows that will actually be delivered into the hands of investors over time. It would seem to encourage the question

“What is more strongly correlated with actual subsequent market returns? Is it the raw, unadjusted multiple of stock prices to expected earnings to continue to increase or decrease at the same rate, or is it the valuation of stocks after properly adjusting for the predictable cyclicality of earnings or profit margins?”

Ben Graham was aware of just this kind of problem, arguing that stocks should be evaluated on long-term average earnings over a cycle of 5 to 10 years, rather than on one or two quarters, or even a year or two of current earnings as propagated most analysts, investment bankers and many other market players.

This behavior of all these players accounts in good part for the wide fluctuations in stock prices, which largely parallel the changes in their earnings between good years and bad. Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in its reported quarterly profits. A private business might easily earn a few times more in a boom year as in poor times, but nobody will be willing to pay a few times more for a business in a boom year than in poor time. Will you? I know there are investors who are prepared to pay a few times more for the stock during the boom time than the bust time. That to me is more of a speculative endeavor. I also know big money is made speculating on quarterly results, but research has also shown more money has been lost hoping that trees growing to sky.

Cyclical Valuation of Latitude Tree

Rather  than  rely  upon  current  earnings  Graham  had  a  simple  yet  powerful  alternative Normalized Earnings Power, or average earnings, or average profit margin. As Graham opined:

“The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.”

As Latitude Tree is in the furniture industry which has been historically cyclical, fluctuating with general economic cycles, we will apply this principle here to check if the price is reasonable.

Over a cycle of 9 years as shown in Table 1 in the appendix, the net profit margin averages at 5.4%. With this profit margin and the trailing twelve month (TTM) revenue of RM673m, the normalized earnings is RM36.4m. At RM6.10, the normalized P/E ratio is 16.3. Is the price reasonable?

Latitude Tree with its latest financial performance, its return on equity and return on invested capital are excellent at 17% and 21% respectively. These ratios will be somewhat lower if there is a mean reversion of its earnings. But still these ratios are quite good for me. This PE ratio of 16.3 also meets the maximum price he is willing to pay is 16 times earnings, but just. So in this respect, it appears that it is okay to hold Latitude Tree at this price.

A check with the Stock Performance Guide by Dynaquest shows the historical PE ratio of Latitude Tree over a cycle of 12 years, with my update for 2015, as shown in Table 2 in appendix. The PE ratios of Latitude Tree varies from a low of 2.9 in 2013 to the highest of 12.4 in 2007 when earnings was depressed due to the subprime housing crisis. The market historically seems not willing to accord too high a PE ratio of this type of cyclical stocks.

So with a current PE ratio of 8.9, a normalized PE ratio of 16.3, is Latitude Tree cheap? Should you buy more, buy more on margin, hold or sell? Your opinions with rationales are highly appreciated.

Oh yeah, also bear in mind the shares are quite illiquid and its share price can easily be manipulated.

K C Chong (19^th July 2015)

Appendix

 Table 1: Past financial performance of Latitude Tree

Year	2015ttm	2014	2013	2012	2011	2010	2009	2008	2007
Revenue, 000	673210	651025	493687	517863	500664	506866	397378	404176	411706
Net Profit, 000	72609	64333	32046	14847	19741	36483	13213	8485	8793
Net Profit margin	10.8%	9.9%	6.5%	2.9%	3.9%	7.2%	3.3%	2.1%	2.1%
EPS, sen	68.8	56.6	25.1	10.2	12.8	42.8	21.6	16.7	15.8

Table 2: Historical price range and P/E ratio of Latitude

Year	Price Range		PER Range
2004	0.80	1.33	6.9	11.4
2005	1.15	1.37	7.6	9.1
2006	1.11	1.32	5.4	6.5
2007	0.79	1.31	7.5	12.4
2008	0.49	0.86	4.4	7.7
2009	0.50	1.25	3.5	8.7
2010	1.01	1.77	3.5	6.2
2011	0.60	1.32	4.7	10.3
2012	0.57	0.78	5.6	7.7
2013	0.70	2.50	2.9	10.2
2014	2.04	3.93	3.6	6.9
2015	3.63	6.50	5.3	9.4