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Quarz Capital Management, Ltd. Issues Open Letter to the Board of Directors of HG Metal Manufacturing Limited (SGX: BTG)

2017-05-31 16:15 4186

GEORGE TOWN, Cayman Islands, May 31, 2017 /PRNewswire/ --Quarz Capital Management, Ltd. (QCM), an investment manager, today issued a letter urging HG Metal Manufacturing Limited to take immediate steps to address the severe undervaluation of more than 60% which its share price is trading at to its highly liquid and easily valued intrinsic book value despite the commendable efforts of management in steering the company through one of the toughest slumps in steel prices.

QCM proposes that HG Metal conducts a full strategic review on the potential divestment of its non-core but substantial 22.6% stake in BRC Asia with a market value in excess of SGD 30 million (67% of Mkt Cap). Quarz believes that multiple buyers are interested in building up substantial stakes in BRC Asia as evident by the unsolicited bid announced by the company recently. Any of the buyers could establish a near majority control of BRC with the purchase of HG's stake and a proportion of additional market and selective purchases from other less substantial shareholders. Quarz proposes that part of this capital released can be returned to shareholders upon the completion of the sale through dividends or share buyback. Quarz also urges the company to immediately distribute up to SGD 10 million (22% dividend yield) of the excess net cash of SGD 29 million which is currently held by the firm.  

Due to the structural headwinds faced by the Trading Division, QCM recommends the firm to scale back on its Trading Division and to redeploy the capital and human resources released to its Manufacturing Division whose profitability is leveraged to the structural trend of increasing construction productivity and the improving construction sector in Singapore. QCM has delivered the following letter to HG Metal Manufacturing Limited's management team, board of directors and other stakeholders.

ALL RECIPIENTS ARE ADVISED TO READ
"IMPORTANT DISCLOSURE INFORMATION"
AT THE END OF THE ATTACHED LETTER

Quarz Capital Management, Ltd.
Clifton House 75 Fort Street
George Town I KY1-1108 I Grand Cayman
Cayman Islands

                    31 May 2017

TO ENGAGE ON THE PROPOSALS FOR THE RETURN OF EXCESS CAPITAL, REVIEW OF NON-PERFORMING BUSINESS AND NON-CORE STAKES, AND REFOCUSING ON KEY BUSINESS

- POTENTIAL TOTAL UPSIDE OF >40% IN HG'S SHARE PRICE BY 2018 -

Dear Members of the Board,

Quarz Capital together with its affiliates have built up a sizeable position in HG Metal Manufacturing Limited (the "Company", "Firm"," "HGM SP", "HG", or "HG Metal"). We commend HG's management for steering the company through one of the toughest slumps in steel prices and achieving profitability in 2016. We forecast HG's net income to further improve from 2H2017 attributed to a stabilizing and increasing steel price as well as the cost optimization efforts taken by the management.

Despite the turnaround in profitability, HG Metal continues to trade at a market cap of SGD 45 million[1], in our view a fire-sale discount of 60% to its highly liquid and easily valued NAV of SGD 111 million. HG's NAV is mainly made up of its net cash of SGD 29 million, net receivables and inventories of SGD 42 million and a strategic 23% stake in listed BRC Asia[2] with an estimated market value in excess of SGD 30 million. The firm has consistently traded at discounts of 20% and 35% to its listed steel trading/distribution and manufacturing peers. We postulate that HG's intrinsic value is being obscured by 1) the lack of investors' confidence in the long-term profit sustainability and competitiveness of its Trading Division, and 2) the lack of clarity on the allocation of the substantial level of excess liquid assets.

We believe that readily available steps exist for HG's Board to unlock an estimated SGD 20 – 25 million of value for the firm which can potentially yield an attractive >40% total return for shareholders.

In the HG Metal Value Creation Proposal ("Value Creation Proposal") outlined in this letter and the accompanying presentation, we provide actionable steps which the board can take to address HG's severe undervaluation:

  • Recommendation 1: Conduct a full strategic review on the potential divestment of HG's non-core 23% stake in BRC Asia with a market value in excess of SGD 30 million. As evident in the recent announcement by BRC Asia, multiple parties are interested in increasing their stakes in the company
  • Recommendation on 2: Immediate distribution of SGD 10 million (22% dividend yield) of the SGD 29 million excess net cash held by the company to shareholders
  • Recommendation 3: Scale down and/or spin off HG's Trading Division which has consistently generated low rates of return to release initial capital of SGD 10-15 million
  • Recommendation 4: Establish the Manufacturing Division as HG's core business and expedite on investment plans to strengthen the division's capability
  • Recommendation 5: Provide clarity on the allocation of excess capital of SGD 60 million (~135% of Mkt Cap) from the sale of stake in BRC Asia, scale back of Trading Division and existing net cash

HG Metal in Summary

HG is the 4th largest[3] listed steel player in Singapore with Steel Trading/Distribution and Manufacturing as its 2 main divisions. The Trading business focuses on the distribution of steel products for real estate construction, shipping and industrial requirements. HG Manufacturing fabricates customized steel products for its predominantly Singapore construction clientele base. The firm's market cap has slumped by more than 60% and underperformed its sector since 2014 attributed to weak profitability in the Trading/Distribution Division. Falling steel prices have compressed trading margins and led to heavy write-downs of inventory value. Earnings have also been affected by structural changes in the sector.

Uncertainty of the long-term profit sustainability of the Trading Division

We forecast that HG's Trading Division will achieve profit breakeven in 2H 2017 attributed to stabilizing steel prices (driven by stronger global economic growth and curtailment of steel supply in China) and active cost control by HG's management. Similar to other investors, our main concern is the sustainability of the division's profit over the longer term. Our discussions with major end users of steel products in Singapore have concluded that the increasing accessibility and efficiency (shortened lead time from order to delivery) of sourcing from steel mills and distributors in China together with the ease of finding storage areas in Singapore for these products have reduced the amount of orders they place with local steel distributors. This structural trend is well reflected in the falling revenue of listed steel traders in Singapore.

While HG Metal has diversified sales to Myanmar which now accounts for over 50% of its revenue, the increased geographic risk has not been compensated by improved margins. Extensive consultations with physical steel traders reveal the competitive environment of steel distribution in Myanmar where distributors may be able to accept thinner distribution margins through the delivery of substandard and cheaper steel products which do not conform to local building regulations. The ratification of the investment law, increasing stability of the government and stronger global economic growth will potentially improve the business environment in Myanmar. However, we remain skeptical of HG's ability to generate a sufficient rate of risk adjusted return on the capital of SGD ~50 million deployed in this business over the long term. 

Manufacturing business (reinforcing steel products for construction industry) with secular growth trend

Despite being a late entrant, HG has established significant expertise in this area as evidenced by the improving profitability of this segment even in the current weak construction environment. The frontloading of government infrastructure projects and improving construction sentiments from 2018 onwards should provide this division with a clear pathway to profit growth.

The division is also highly leveraged to the Singapore's government ambitious target of increasing construction productivity to lower the reliance on foreign manpower. BCA's (Building Construction Authority) consistent increase in the minimum content for prefabricated steel products[4] in construction projects together with the MOM's (Ministry of Manpower) tightening quota[5] to hire foreign workers will continue to drive the increasing trend of using 'manpower saving' prefabricated construction steel products.

This sector also faces low risk of disruption from foreign competitors due to the difficulties in coordinating the customization and the inefficiencies of transporting pre-fabricated steel products.

We are optimistic that this secular trend will further catalyze HG Metal's profit growth in this segment.

Excess cash and strategic stake in BRC Asia valued in excess of SGD 59 million together

HG Metal retains an excess net cash position of SGD ~29 million (65% of Mkt Cap). It is currently the 2nd largest shareholder in BRC Asia with a 23% stake which has a market value of SGD ~30 million (67% of Mkt Cap).

HG Metal Value Creation Proposal

Our proposed strategic plan provides clear executable steps that the Board can readily undertake to increase shareholder value:

Recommendation 1: Conduct a full strategic review on the potential divestment of the 23% stake in BRC Asia

The stake currently provides no tangible value and/or contribution to HG's operations. We are of the view that the board should deliver clarity to investors on how and when it intends to monetize the stake. As evident by BRC Asia's announcement, multiple parties have indicated interests in building significant stakes in the company as a strategy to further consolidate the reinforcing steel products industry in Singapore or to attain a strong partner with whom they can collaborate, share expertise and introduce the production of high value-added steel products for the construction sector. The implementation of this recommendation can realize more than SGD 30 million of cash (67% of Mkt Cap) for HG Metal.

Recommendation 2: Immediate distribution of SGD 10 million (22% dividend yield) 

HG will continue to retain a net cash balance in excess of SGD 19 million which can potentially increase to > SGD 50 million with the execution of Recommendation 2 and 3 of the Value Creation Proposal. We believe that the remaining excess cash is more than sufficient to execute on strategic and opportunistic plans. 

Recommendation 3: Scale down and/spin-off - of the Trading Division

We are of the view that this business should be further scaled down to focus on products which are complementary to HG's Manufacturing Division offerings and/or generate sufficient risk adjusted return to capital employed. We believe that SGD 10-15 million of capital can be released from the initial reduction in activities of this business. Talent, capital and management's focus can be redeployed to strengthen the Manufacturing Business.

Recommendation 4: Establish Manufacturing Division as HG's core business

Despite the slowdown in construction activities in Singapore, we are highly optimistic about the long-term prospect of this business due to its secular drivers. We advocate the board to expedite on investing and strengthening the capabilities of this division with the ambitious goal of HG Metal becoming a major business in this industry.

Recommendation 5: Provide clarity on the allocation of excess capital of SGD 60m

The implementation of our recommendations has the potential to increase the net cash position to ~SGD 60 million (135% of Mkt Cap). We request the board to provide investors with a clear and coherent strategy on the allocation of this excess capital such as on the strengthening of the HG Manufacturing Division and other projects which provide sufficient risk adjusted return. We are of the view that HG can return part of the excess capital over a 2-3 year period in the form of special dividends and share buybacks. The strategy while allowing the board and management to continually assess value accretive opportunities, also provides a strong signal to investors about their clear commitment on the effective allocation of shareholders' capital.

Conclusion

We firmly believe that our Value Creation Proposal can provide a clear pathway to deliver a significant return of at least 40% for all HG's shareholders in the mid-term. Post capital distribution, HG continues to retain substantial levels of cash which can be further deployed into higher value creation businesses or progressively returned to shareholders. The execution of HG's well planned strategy of expanding in the steel manufacturing sector and stronger industry dynamics will potentially deliver further sustainable shareholder returns in the long-term. We look forward to working collaboratively with the board and management team and share our thoughts on the significant opportunity which can be realized at HG Metal.

Sincerely yours,

Mr. Jan F. Moermann
Chief Investment Officer, Quarz Capital Management, Ltd.

Mr. Havard Chi, CFA
Portfolio Manager, Quarz Capital Management, Ltd.

For further information, please contact:
Havard Chi, CFA (hch@quarzcapital.com , +65 9433 3898)

[1] As of 30th May 2017

[2] BRC Asia has a market cap of SGD130m (30th May 2017) and is one of the top 3 manufacturers of prefabricated construction steel in Singapore

[3] Ranked by revenue

[4] In Nov 14, BCA implemented minimum prefabrication level, adoption rate of Prefabricated Bathroom unit & PPVC for specific GLS (Government Land Sales) sites. The min level for the usage of prefabricated products was raised again in Nov 2015. In Feb 2017, BCA mandated that buildings constructed for office usage on selected land parcels under the GLS programme will require a minimum level of 80% of the total office area to be undertaken with structural steel construction (which needs to be prefabricated).

[5] MOM has decreased the sector dependency ratio (no of foreign workers per 1 Singapore worker) and increased the foreign worker levy annually since 2015. In Jan 2017, it mandated that construction firms are required to have least 10% of their work permit holders to be qualified as 'Higher Skilled' R1 workers with higher base salaries.

About Quarz Capital Management

Quarz Capital Management, Ltd. is a value oriented and research driven investment advisory firm that seeks to earn above average, long-term returns by identifying value investments across the globe.

www.quarzcapital.com

Important Disclosure Information

SPECIAL NOTE REGARDING THIS LETTER

THIS LETTER CONTAINS OUR CURRENT VIEWS ON THE VALUE OF HG METAL MANUFACTURING LIMITED'S SECURITIES AND ACTION THAT HG METAL MANUFACTURING LIMITED'S BOARD MAY TAKE TO ENHANCE THE VALUE OF ITS SECURITIES. OUR VIEWS ARE BASED ON OUR ANALYSIS OF PUBLICLY AVAILABLE INFORMATION AND ASSUMPTIONS WE BELIEVE TO BE REASONABLE. THERE CAN BE NO ASSURANCE THAT THE INFORMATION WE CONSIDERED IS ACCURATE OR COMPLETE, NOR CAN THERE BE ANY ASSURANCE THAT OUR ASSUMPTIONS ARE CORRECT. HG METAL MANUFACTURING LIMITED ACTUAL PERFORMANCE AND RESULTS MAY DIFFER MATERIALLY FROM OUR ASSUMPTIONS AND ANALYSIS. WE HAVE NOT SOUGHT, NOR HAVE WE RECEIVED, PERMISSION FROM ANY THIRD-PARTY TO INCLUDE THEIR INFORMATION IN THIS LETTER. ANY SUCH INFORMATION SHOULD NOT BE VIEWED AS INDICATING THE SUPPORT OF SUCH THIRD PARTY FOR THE VIEWS EXPRESSED HEREIN. WE DO NOT RECOMMEND OR ADVISE, NOR DO WE INTEND TO RECOMMEND OR ADVISE, ANY PERSON TO PURCHASE OR SELL SECURITIES AND NO ONE SHOULD RELY ON THIS LETTER OR ANY ASPECT OF THIS LETTER TO PURCHASE OR SELL SECURITIES OR CONSIDER PURCHASING OR SELLING SECURITIES. ALTHOUGH WE STATE IN THIS LETTER WHAT WE BELIEVE SHOULD BE THE VALUE OF HG METAL MANUFACTURING LIMITED'S SECURITIES, THIS LETTER DOES NOT PURPORT TO BE, NOR SHOULD IT BE READ, AS AN EXPRESSION OF ANY OPINION OR PREDICTION AS TO THE PRICE AT WHICH HG METAL MANUFACTURING LIMITED's SECURITIES MAY TRADE AT ANY TIME. AS NOTED, THIS LETTER EXPRESSES OUR CURRENT VIEWS ON HG METAL MANUFACTURING LIMITED. IT ALSO DISCLOSES OUR CURRENT HOLDINGS OF HG METAL MANUFACTURING LIMITED SECURITIES. OUR VIEWS AND OUR HOLDINGS COULD CHANGE AT ANY TIME. WE MAY SELL ANY OR ALL OF OUR HOLDINGS OR INCREASE OUR HOLDINGS BY PURCHASING ADDITIONAL SECURITIES. WE MAY TAKE ANY OF THESE OR OTHER ACTIONS REGARDING HG METAL MANUFACTURING LIMITED WITHOUT UPDATING THIS LETTER OR PROVIDING ANY NOTICE WHATSOEVER OF ANY SUCH CHANGES. INVESTORS SHOULD MAKE THEIR OWN DECISIONS REGARDING HG METAL MANUFACTURING LIMITED AND ITS PROSPECTS WITHOUT RELYING ON, OR EVEN CONSIDERING, ANY OF THE INFORMATION CONTAINED IN THIS LETTER.

FORWARD-LOOKING STATEMENTS

Certain statements contained in this letter are forward-looking statements including, but not limited to, statements that are predications of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Forward-looking statements are not guarantees of future performance or activities and are subject to many risks and uncertainties. Due to such risks and uncertainties, actual events or results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Forward-looking statements can be identified by the use of the future tense or other forward-looking words such as "view," "believe," "convinced," "expect," "anticipate," "intend," "plan," "estimate," "should," "may," "will," "objective," "project," "forecast," "management believes," "continue," "strategy," "promising," "potential," "position" or the negative of those terms or other variations of them or by comparable terminology.

Important factors that could cause actual results to differ materially from the expectations set forth in this letter include, among other things, the factors identified in the risk sections in HG METAL MANUFACTURING LIMITED Annual Report for the year ended Dec, 2015, prospectus AND INFORMATION MEMORANDUM FOR ITS MULTICURRENCY MEDIUM TERM NOTE PROGRAMME DATED JAN 2015. Such forward-looking statements should therefore be constructed in light of such factors, and Quarz Capital Management is under no obligation, and expressly disclaims any intention or obligation, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

Source: Quarz Capital Management, Ltd.
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