Last month I took a substantial swing at UOS. Here is why....

Last month I took a substantial swing at UOS. Here is why.


Character & Track Record

There are many intangible traits about UOS that I like. They are run by people with many years of "sticking too their knitting", with a high financial and emotional stake (they are still run by the founders and are, by far, the largest shareholders). Their reporting is matter-of-fact, to the point, and very much non-promotional. They have a long history of prudence, financial conservatism, and of generating superior returns on their capital (to put it mildly). All of this will be no surprise to the small number of loyal shareholders of the business, some of whom are members of the HC community.

Fund managers Eternal Growth Partners and Harness Asset Management, both of whom have had face-to-face contact with management, have espoused many of these positive attributes in their fund reports, all of which can be accessed from their websites. On the subject of superior returns-on-capital, Eternal Growth, in particular has demonstrated the superior long term returns on invested capital. Inded, the HC gold source for kowledge here is @eternalgrowth.

I also like the fact that UOS is not directly correlated to the Australian economy (the fact that we have not had I recession in over two decades does at times preoccupy me).

However, in the spirit of being dispassionate, I am going to put all of that aside, and just take a fresh look at some numbers.


Returns on Capital

In the last 12 years (the extent of my analysis), returns on equity excluding capital gains (on investment properties) have averaged about 10% annually. Capital gains, over the period, have contributed maybe another 8% in ROE (though these have been diminishing over the last 5 years), giving a total ROE, over the period of about 18%.

However, these returns have been substantially distorted by a large net cash position since FY ending Dec 2011 (thanks to the IPO of its major subsidiary UOA Decelopment Bhd, on the Malaysian exchange). Over the last 5 years, net cash to equity has been running at about 20%. If we allow for this by employing what I call a notional after-tax return-on-capital (0.75xEBIT/capital)[#], excluding capital gains, then a different picture emerges. Here we see that returns on capital (real cash returns, ie excluding investment property capital gains) have actually been trending up in the last 5 years, and are now averaging about 13% per annum.

This is comforting, because If you're like me, you want your investment case to be based on real cash earnings, more than on someone's opinion about what physical assets might be worth. And if you want further evidence that UOS is getting a good bang for it's invested buck (in terms of real cash generation), then consider the following.

In the 5 years ending Dec 2015, the business (consolidated entity) invested $283 m AUD for growth[*]. In that time, after tax operating cash earnings (notional 0.75xEBIT) increased by about $86m.
That's a 30% return on invested capital, in terms of increased (real cash) earnings power. But, should we be misled by one 5-year period, below I repeat the exercise for 5 year periods running as far back as my data allows:

	Column 1	Column 2	Column 3	Column 4
1	5 year period[+]	invested growth capital[*] (AUD m)	increased notional operating cash earnings power[^] (AUD m)	after tax return on invested capital
2	2004 - 2008	208	27	13%
3	2005 - 2009	162	36	22%
4	2006 - 2010	160	39	24%
5	2007 - 2011	284	47	17%
6	2008 - 2012	415	66	16%
7	2009 - 2013	194	66	34%
8	2010 - 2014	371	82	22%
9	2011 - 2015	284	87	31%

Not a bad effort, to put it mildly. It also compares very favourably with annual earnings to operating capital, inclusive of capital gains (ie, 0.75xROC = 0.75xEBIT/[E+D-C]), for the consolidated business. This indicate to me, that property revaluations have not been overly aggressive, by any stretch. Note that I am here defining "operating capital" as: equity + debt - cash (where "cash" refers to that cash that is excess operational requirements).


UOS Ltd after minorities, even better

As attractive as a net cash position of 20% is, the consolidated accounts mask an even more attractive position for the actual shareholders of the parent entity. The somewhat complicated subsidiary structure makes it a little difficult to establish with certainty (and yes, I got a fairly substantial head ache trying to work it out). What I know with certainty is that the consolidated entity owns substantially more cash than what is held by its two largest subsidiaries, both of which account for the bulk of the minority holdings. Additionally, the largest portion of the consolidated debt is held by the subsidiary of which UOS Ltd has only a 46% stake (the REIT) . By my estimates (and yes, I may be wrong) net cash to equity, after minorities, has been averaging about 28% in the last 5 years.


So what do you get for your money?

Well, at a purchase price of 60c (I started buying at a smidgeon below this), you are getting about 84c of book value. But if my estimates are correct, that book value includes over 20c of net cash. So if you buy the enterprise and pocket the cash, then you are left with over 60c of net assets which you paid less than 40c for (and what's more, they are net assets with a demonstrated ability to earn superior returns). Of said differently, you are buying at an EV to operating-capital of about 0.61 (ie a discount of 39% to operating capital). This compares with a price to book ratio of 0.7 (ie a discount of 29% to book).

But at the end of the day, what really matters to me, is cashflow.

By my estimates, notional after tax returns on capital (0.75xEBIT to operating capital, as previously defined) have averaged about 12.0% per annum of operating cash earnings (plus a little over 4% of annual capital gains) over the last 5 years, and over 13% (plus nearly 2% of annual capital gains) over the last 3 years. My numbers here are similar whether determined for the consolidated entity or for the shareholder interests of UOS (per my estimates). Over the last 12 years, the returns have averaged about 11.6% of real cash returns, and nearly 7% of property revaluation gains (for a total average return on capital, over the lat 12 years, of about 18.5%).

So, if we buy the business for 60c, we can pocket the net cash of over 20c, such that we are effectively paying under 40c (EV) for net assets of over 60c (current operating capital). These assets are generating cash earnings to the tune of about 12%, after tax. This means we will be getting a retrospective cashflow yield (0.75xEBIT/EV) of nearly 20%.

Lets assume that the Malaysian property market becomes permanently depressed, and that after tax returns on operating capital fall to 8%, and never recover, and that property prices stagnate for ever (no more capital gains). Well, at the 60c purchase price, your still going to be getting a yield (as previosuly calculated) of about 13%.

But in truth, an assessment such as this (based on EV), probably under estimates the value of the business. It implies that you pocket the net cash. But if history is anything to go by, this is a business that can deploy its cash at high rates of return, which means that cash is very likely to be of more value retained by the business than in my pocket.


The blemish

No investment is perfect. Here, the biggest irritant to me, is the DRP, which has been a feature of the business for a long time (perhaps since the initial float, though I haven't checked). This has caused the shares on issue to grow at about 5% annual rates (almost all shares have historically participated in the DRP). Whilst 5% growth in shares sounds horrendous, what must be remembered as that the main reason for this degree of dilution, is that the shares are cheap, and have been for long time. A low share price means a large number of shares need to be issued to match the dollar value of the declare dividend. But on the other hand, the main reason that the business is an attractive investment, is that it is cheap!

So let's have a closer look.

If I purchase at 60c:
At the 60c purchase price, if I choose to take my dividend as cash, I will be receiving a dividend yield (unfranked) of about 7% (on EV). As almost all shares have been participating in the DRP (and assuming this continues) the earnings and dividends, can be expected to grow at about 13% (see footnote [&]) annual rates. But, of course, if I take my dividend I will suffer that dreaded dilution. I estimate that at a price-to-book ratio of 0.7 (currently the case, and assuming it continues), at a return of 12% on capital (and conservatively ignoring any capital gains [see footnnote @]) that the annual dilution will be running at about 5.5%.

So, the pie will be growing at 13% annual rates, but my share will be growing at a little under 7% [1.13*(1-0.055) - 1]. So at a 60c purchase price, I will receive a 7% yield (on EV) growing at nearly 7%. That's nearly a 14% annual return (on EV) even if we ignore any future capital gains.

On the other hand, if I was to participate fully in the DRP, then I will be growing my share of book value to the tune of 13% per year, even if we ignore any future capital gains. And remember, that you already acquired, at purchase, more book value than you paid for (you acquired at an EV to operating-capital of just a little over 0.6).

If I purchase at 70c:
Given the lack of liquidity with UOS, and depending on how the market winds blow, it may be difficult to acquire further shares at 60c in the near future (who knows?).

If I buy shares at 70c, then on an EV basis, I will be effectively paying under 50c for over 60c in operating capital (ratio of EV to operating capital of about 0.78). If I elect to take the dividend in cash, I will now be receiving a dividend yield (on EV) of about 5.5% growing at nearly 7% annual rates, for a total return of nearly 12.5% (on EV), even if we ignore any future capital gains.

If I was to participate fully in the DRP, then I will still be growing my share of book value to the tune of 13% per year, (ignoring any future capital gains), but this time, instead of starting out with a little over $1.60 in operating capital for every dollar (on an EV basis), you will be starting out with a little under $1.30 in operating capital for each dollar of EV (you will now have acquired at an EV to operating-capital of about 0.78). Still nothing to scoff at!


If the Malaysian property market becomes permamenty depressed

Lets assume the property market in Kuala Lumpur heads decidedly south, for an extended period, such that cash returns on capital fall to 8% and capital valuation gains stagnate to zero.

Under such a scenario, the 60 odd cents (per share) of operating capital can be expected to earn a little over 5c, in the first year. Continuing to assume a 35% payout to cash earnings (for the declared dividend), this will represent a dividend of about 1.8c, which on an EV of under 40c (assuming you purchased the shares at 60c) represents a yield (on EV) of over 4.5% (unfranked).
Now under such conditions, there is a good chance that the share price will fall further, relative to book value. This will can cause DRP dilution to accelerate savagely, if the company maintains its DRP policy. Lets make the very dour assumption (I think) that the price drops to 30% of book. If this were to happen shortly after making your purchase at current prices, and then stay there for a protracted period, then you suffer the double indignity of suffering the dilution of the much lower price, without the benefit of the extra book value that the lower price would have bought you.

My estimates indicate that under such a scenario of returns-on-capital and price-to-book, dilution will result in an annual loss of ownership to the tune of about 8% (ouch!). So whilst the pie can be expected to be growing at over 8% annual rates (assuming the vast majority of shareholders continue to participate in the DRP) , if you choose to take our dividend in cash, your dividend will never grow. You will be stuck with a 4.5% yield (to current EV) that never grows. I guess that's still better than prevailing interest rates, but it's hardly enticing. The silver lining is that at current prices (about 60c) you got over $1.60 of operating assets in the dollar at the time of your purchase (EV to operating-assets ratio of about 0.61, as sated previously). So after 10 years you will have book value of $1.60 in the dollar (per EV) and you will have acquired total dividends of 18c in the dollar (per EV), giving you an annualised return of about 6%. No too exciting, but substantially better than any current long dated securities.

On the other hand, if you choose to participate fully in the DRP, then you will have your share of operating assets in the business growing at over 8% annual rates, (which, as stated previously, is $1.60 of operating assets in the dollar). So after 10 years, your share of operating assets will have grown to $3.45 (1.6x1.08^10) for each dollar purchased (on an EV basis), giving an annualised gain of 13%. That's not exactly insignificant (though you will have been paying annual taxes on the dividends that you never received).


In conclusion
This looks like a case of "heads, I win big, tails I don't do too badly". But I welcome any feedback that may throw some light on where I may have got it wrong.

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Footnotes
[#]: Here I am assuming a 25% tax rate, which is the Malaysain corporate rate. Here "capital" means operating capital and as such I am subtracting the net cash position (capital = equity + debt - cash).
This, I believe, is the best way to compare the actual ROE against what would be achieved if all cash was returned to shareholders (or conversely, if all debt was paid off by shareholders).

[*]: Here I am referring to all investment cashflows + increases in working capital, less depreciation (note that depreciation is fairly insignificant here, and is generally not substantially larger than capex on PPE).

[^]: 0.75xEBIT, excluding investment propery capital gains.
And yes, in case you're asking, the company's earnings are well matched by operating cashflows per the cashflow statement (adjusted for changes in working capital), over time.

[+]: Financial years ending December.

[&]: A 12% return on average capital, with essentailly all earnings retained, equates to about a 13% growth rate

[@]: Ridiculously conservative considering that investment properties amount to nearly 60% of the operating capital in the business for the consolidated entity (though closer to 50% of operating capital, for shareholders of UOS, by my estimates).