In this stage of a late bull cycle, plus many predictions of a recession coming in 2020, my intuition is to get into defensive and stable stocks. I have always wanted to add stocks into my portfolio to diversify my asset class. As you can see from my latest portfolio, a crazy 70% of capital invested is in CRYPTO! This is reckless and it’s my first and biggest mistake in investing. There are hard lessons learnt about GREED, capital preservation and risk management. Nevertheless, I am waiting for the next bull-run to come in crypto as it is now, I believe, to be in an accumulation phase. Here is a quick snapshot of the current market in crypto from my previous post. The exit plan is when my crypto portfolio made a 100% on my capital invested, which is $14,000, I would cash out 30%-40% of it and reallocate them to stocks. But that’s the long-term plan.
Anyways, back to the topic of this article, I am thinking of stocks that are stable, defensive and yet pays a decent dividend. My search is not exhaustive, but Sheng Siong came under my radar as I realized their financial performance are pretty solid, surprisingly, and they pay an average dividend yield of 3.5% which is pretty good.
Business Overview of Sheng Siong
Let’s dive right into it. Sheng Siong is established in 1985 and its the third-largest supermarket operator in Singapore after NTUC and Dairy Farm International. Their supermarket stores are mostly located in the heartland of Singapore (our HDB blocks) rather than in big malls or town areas. Their headquarters + warehouse + distribution centre is located in Mandai Link and they have an extensive distribution network in Singapore. The concept of Sheng Siong is to provide both “wet” and “dry” shopping options for customers. Their target customer segment is those price-sensitive or cost-conscious customers as the things Sheng Siong sells are generally cheaper in comparison to NTUC or Cold Storage.
Risks and Downsides of Sheng Siong
Before I go on to talk about the bull case for Sheng Siong, I want to first touch on all the potential risks and things that could go south for this company. This would be my approach for any future stock/REITs analysis as I believe that if you protect on the downside, the upside will take care of itself. In the “52-week low formula”, it is also mentioned that the first thing one should do is to try and kill the company. Find out EVERYTHING that could go wrong with the company and if you can’t make the company go bankrupt, then we are up to something.
1. Low Margin Business
Firstly, the nature of groceries and food in general have a thin gross margin to work with as the product is undifferentiated and and competition is based on pricing. Groceries are commodities and commodities are price-sensitive. This means that a change in price would affect a large change in demand. Furthermore, Sheng Siong competitive advantage is in cost and pricing its products lower would further push down margins. The past 5-year average gross margin is 25% and EBIT margin is 8.5%.
What this means is that Sheng Siong has only 25% of margin to work with for paying rentals, overheads, advertising and other operating expenses. What happens if rentals and labour costs increase over the years? Can Sheng Siong increase its selling price? Very hard. There are many alternatives and substitutes available in NTUC, Cold Storage, Giant and customers would just go to wherever it’s cheaper. The grocery/supermarket business is all about cost control and their EBIT margin of 8.5% could threaten to go lower if they fail to control their operating costs.
2. Saturated Local Market with Limited Growth Catalyst
The revenue of Sheng Siong is largely dependent on the number of stores opened. As of 2018, there are currently 54 stores located in Singapore. The thing about Singapore is we have a small market, a small population and a small land size. Singapore targets to hit a population of 6.9 million by 2030, up from the current 5.8~ million in 2019. How it works is that Sheng Siong would participate in a bidding process whenever HDB opens up commercial units that are intended to be used for supermarkets. It has to compete with NTUC and Dairy Farm (biddings can be aggressive sometimes) and the thing about Sheng Siong is that it has to keep in mind its operating costs to maintain the same selling price and EBIT margin.
The growth in market size for the next 10 years is just that marginal increase in the population of 1 million plus the number of stores it can afford to outbid competitors. Furthermore, if we assume an average household of 4, it means that 1 million would become 250,000 families and if we minus off 20% of foreign expats (they probably don’t buy from Sheng Siong), that is equivalent to only 200,00 potential customers for the next 10 years! This is the reason why their growth rate in Singapore is probably reaching the maturity stage very soon and this is why they are expanding to China.
3. Uncertainty in China
Sheng Siong opened up its first store spanning 54,000 sq.ft in Kunming in Nov 2017. They signed a joint venture (JV) agreement with Kunming LuChen Group to operate supermarkets in China. Interestingly, this supermarket is located in a shopping mall right in the middle of a large residential enclave in the suburbs of Kunming. Sheng Siong holds a 60% equity interest in this JV. As of FY2018, it recorded a loss of $0.4 mil (60% of $0.7 mil), but the effect is immaterial as that only constitutes 0.6% of Sheng Siong’s net income. In Sheng Siong’s latest Q1 2019 report, their China operations broke even (Good news!). They signed a 2nd lease with Kunming LuChen to open a 2nd store which is expected to be operational in Q3 2019.
Management has explicitly stated that its expansion into China is just a trial. If it succeeds, they will expand further but if it fails, the sunk cost would be limited up to USD 6 million. Big Foreign brands such as Walmart and Tesco have struggled to make an entry into China’s supermarket industry, what more Sheng Siong. Furthermore, the branding of Sheng Siong’s products and the brand of Sheng Siong itself is not strong yet. There is no economic moat in branding and it can get wiped out easily by a highly fragmented grocery retail industry in China.
4. Tough Competition
The supermarket business is a highly competitive one as products are homogeneous and the only areas to compete on is pricing and probably customer experience. Sheng Siong is not the first-mover advantage and they are the SMALLER player in comparison to NTUC and Dairy Farm. NTUC has 230 outlets including (FairPrice supermarkets, FairPrice Finest, FairPrice Xtra, FairPrice Xpress and Cheers). Dairy Farm has 62 Giant Outlets and 50 Cold Storage Outlets. Meanwhile, Sheng Siong has only 55 outlets (including China) as of 2018. NTUC and Dairy Farm has the financials and resources to bid aggressively or expand their businesses but Sheng Siong can’t.
In this business, it’s all about cost competitiveness, market presence, market share, customer experience and customer convenience. As a smaller player to its competitors in terms of the number of outlets and economic resources, it’s not going to be easy for Sheng Siong to grow or expand as fast as the others. Furthermore, Sheng Siong has zero market share in town areas and shopping malls, their only territory is within HDBs. This means that they have already given up a large portion of the supermarket pie to its other two competitors.
5. E-Commerce (Online Grocery)
Next, change in consumer habits such as online grocery shopping is also an emerging trend that we should watch out for. However, I am not too concern on this as the online sales of NTUC, Dairy Farm and Red Mart only contribute to 11.7% of total online sales and 0.6% of total retail sales in Singapore. Furthermore, it is hard for online grocery start-ups to take off as it takes a large volume of purchases to cover the high fixed costs of labour and delivery transports. I think people still prefer the experience of visiting a physical grocery store to see, smell and touch the produces rather than buying online.
6. Sustainability of Dividend Payout
Next, is their dividend payout sustainable? It is definitely not sustainable from 2013 to 2016. This is because their free cash flow per share is lower than dividends per share. It means that they are paying dividends to shareholders NOT from their operation earnings but from their cash reserves. This can last for a few years, but it is definitely not sustainable over the long-run. Fortunately, Management has lowered the dividend payout ratio from 105% in 2013 to 72% in 2018. This explains the reason why there is a sharp drop in dividends for Sheng Siong. But at least we know the payout ratio in 2017 and 2018 is sustainable.
7. Negative Free Cash Flow due to High CAPEX
Sheng Siong Free cash flow is not as strong as I thought. Warren Buffet pointed out a good point during one of the AGM in 1994. He mentioned that there is a huge difference between a business that grows and requires huge capital and a business that grows and doesn’t require huge capital. Most financial analysts do not give adequate weight to that difference and it surprises him how so little attention is paid to that. Sheng Siong requires a significant amount of CAPEX for bidding leasing space, equipment upgrades, fitting out new stores and doing renovations. There are years that Sheng Siong can’t pay up for capital expenditures from operating cash flow and this is something to keep in mind. *If you want to find out more about his speech on Business & CAPEX, the video is available on our FB page.
The Bull-case and Upsides for Sheng Siong
Now that we have outlay all the potential risks ahead, you can decide for yourself the required margin of safety that you feel comfortable with, or to stay away from Sheng Siong completely. The next section would talk about what I like about Sheng Siong and why I am putting this under my watch list.
1. Steady Financial Performance
One of the first and simplest way to identifying solid companies is to simply check their revenue, gross profit, net profit and operating cash flow over the past few years. It should be increasing consistently and steadily. Let’s have a quick look at Sheng Siong’s financial performance.
It looks pretty solid to me. Very consistent growth, increasing steadily over the past 5 years and their financials seems rosy. Increasing revenue tells us that demand is strong, the company is expanding and they are making more money. Gross profit tells us that the cost of goods sold have been managed well. Net income tells us that operating expenses have been manged well. Cash flow from operations tell us that cash flow liquidity is strong. Basic earnings per share have also grown very steadily and this is one of the main filters that Warren Buffet looks for in a company.
2. Solid Cost Management
In the earlier section of this article, I mentioned that cost management is a critical component to look at for a grocery business. This is because they can’t increase the selling price easily and they have to compete on cost. Gross margin is also thin and operating costs have to be managed well to protect their operating profit (EBIT) margins. Despite increasing raw prices, you can see that Sheng Siong has done a pretty good job in pushing COGs margins down from 77% in 2013 to 73% in 2018. This is probably due to shifting towards fresh produce which has a higher margin, bulk buying, attractive discounts from supplier relationships, more efficient logistics network and economies of scales.
Next, labour costs and rental costs have increased in Singapore, but yet you see that Sheng Siong’s operating expenses as a % of revenue has been maintained tightly under control at around 16-17% from 2013 to 2018. As a result, their EBIT margin, a measure of operating profits, has increased very steadily and consistently from 6.5% to 9.4%.
3. ZERO Debt
Debt works as a financial leverage. It could boost earnings and expand a business much faster, but it comes with a risk and that is liquidity risk. Sheng Siong has zero debt and that tells us that the management is pretty conservative in managing financial risks. We do not have to worry so much about interest coverage risks and they seldom do equity financing. Since they do not borrow debts or raise equity, it means that their expansion of new stores or into China is largely funded by cash sitting in their bank accounts and cash flow from its operations. This bring us to the next point which is Sheng Siong’s cash conversion cycle.
4. Negative Cash Conversion Cycle
Cash is the lifeblood of a company and a grocery business typically have a negative cash conversion cycle. This means that money is collected FIRST even before paying out to suppliers. The reason is simply you don’t buy a chicken or apple on credit. That is also the reason why the accounts receivables of Sheng Siong is extremely low (<1%). The pattern of a negative cash conversion cycle applies to Dairy Farm and NTUC as well and this is one of the main reasons why I like supermarket stocks. They don’t have to worry so much about cash collection. Sheng Siong has 87 million worth of cash in its bank as of FY 2018 and I am quite comfortable with that buffer for any future expansion plans or economic crisis.
5. Latest Results of Sheng Siong Q1 2019 Report
The thing that I would probably look out for is finding out their expansion plan, in particular, whether they are opening up new stores. As of now, I believe Sheng Siong has a solid track record of managing both operating costs and COGs, so I am not too worried about expenses at the moment. If revenue is driven by new stores opening and they can maintain the same % of COGs as well as operating expenses, we can expect net profits to go up by the end of 2019.
In their latest results, Sheng Siong mentioned that 3 new stores would be opening in May thus adding a total of 15,780 square feet to its total retail space. If we use a conservative estimate of 1,700 sales per square feet, that would be $26.8 million. Assuming a 9% EBIT margin, their operating income from these 3 stores would translate to a gain of approximately $2.4 million in operating income. Earnings after tax would be $2 million (assuming 17% corporate tax rate) and dividends would be $1.4 million (assuming 70% payout ratio). That is a pretty good number and I think that both EPS and dividends per share would continue to increase steadily at this current rate of expansion. But of course, this is just a simplified assumption. In reality, it will probably take a few months or years for the stores to gain traction.
6. Price-to-Earnings Valuation
Over the past 5 years, Sheng Siong has an average P/E ratio of 22.76x. The last closed price is 22.09x. I guess the current market price is fairly valued and I would probably wait until their P/E ratio drops to 20 before getting in.
7. High-Quality Management
How do we evaluate the quality of a company’s management team? Very simply, just look at their actions, look at what they are doing and observe whether any of their actions translate into positive financial results. To illustrate, I have summarised 8 things that Sheng Siong management did.
- Financials are very consistent and they are increasing steadily
- Knowing that Singapore has a limited market, they venture into China
- They shy away from aggressive biddings by competitors
- They managed to contain the costs of running a business very well
- They have zero debt and are conservative in risk management
- They cut their dividend payout ratio to make it more sustainable
- They have a very clear plan: to target HDB heartland areas & cost-conscious customers
- Lastly, and this is my favourite, The Verge and Woodlands 6A (2 of their BIGGEST stores got shut down permanently in 2017). Both stores contribute to a total of 20%~ to the group revenue and the closure of these 2 stores have a significant impact on Sheng Siong’s financials. Under such circumstances, most businesses would suffer a temporary decline in net profits and put a note under their annual report to explain for the fall. What did the management of Sheng Siong do? They immediately open up 10 new stores in 2018 and revenue and net income increased by 7.4% and 1.4% respectively in 2018!
These are the kinds of actions and results you want to see in a company. Based on the above reasons, I am quite convinced about the quality of Sheng Siong’s management and I have confidence in them. It is important to note that while some business’s financials improved, it is because they leveraged heavily on debt and that is a red flag sign. Sheng Siong’s financial improvement is fueled by ZERO DEBT. It is purely based on organic growth, cash balance and operating cash flow.
8. Closing Thoughts
In summary, I like Sheng Siong for the simple reason that they are a defensive and stable business, their financial performance is relatively strong, management is solid and their dividend yield is pretty decent. Whether the economy is in a bull market or a downturn, people would always visit supermarkets to buy food and groceries and I don’t think that is going to change for the next 5 or 10 years. Their business model is simple to understand and it’s not a complicated business. Furthermore, their alternative growth catalyst, China, has broken even in Q1 2019 and they are expanding a second store which is going to open up in Q3 2019.
However, not every business and company is perfect. The biggest risk to me ahead is still a perceived weak branding, intense competition and a saturated local market. But I felt that the fundamentals of Sheng Siong still outweighs the risks to me. Nevertheless, I would want the safety of margin and I am waiting for prices to fall below $1 (or when P/E <20) to scoop up Sheng Siong and add it into my portfolio. Feel free to comment and let me know what you think about Sheng Siong.