Titon Holdings - Asset Backed Earnings Play

http://www.titonholdings.com


Titon Holdings (LSE:TON) is a small cap UK based building hardware company presently valued at £7.28m. The company operates in two core geographic markets - the UK and South Korea - where is sells a range of ventilation systems and window hardware to construction companies. Titon has enjoyed a strong share price run over recent months, which has seen the price rise to 69p currently, up from around 22p in late-2012. Despite this, and a less than stellar set of historic financial results, the company still looks attractively priced, even when factoring in the obvious business risks of operating in a country such as South Korea.


The technical position of Titon is positive in that it lends towards there being a continued breakout, even from the current level. There is little resistance at 80p, although there is more meaningful resistance up at 100p. There is strong support around 60p, and support in the form of the blue uptrend shown. The shares are currently oversold as well, which is positive for a continued upward rally. The long-term 'W' formation implied a target of 120p, which could spark further technical buying. The shares are fairly illiquid, but that is not unexpected given that it only has a market cap of circa £7.3m. The spread on the stock is decent though, and is currently around 68p-70p on a bid-offer basis, although that does of course vary dependent upon the size of the trade. Titon has 10.56m shares in issue. There currently aren't any broker forecasts for Titon.

The shareholder structure of the company is fairly simple. Directors hold approximately 3.49 million shares, which amounts to around 33% of the total shares in issue. A further 2.8 million other shares in issue are out of public hands and are held by major shareholders. For that reason, high buying or selling pressure can lead to the shares moving relatively quickly.

So who exactly are Titon? As noted earlier, Titon has sales routes in two core countries; the UK and South Korea. That in itself creates an interesting scenario for investors. It is well-known that there are military tensions in the Korean Peninsula due to the unpredictable nature of the North's actions, so straight away it's important to recognise that Titon will probably always trade at a discount, until it sufficiently diversifies away from that market. Does that completely detract from the investment case? Absolutely not, as will become clear later.

Titon sells both passive and powered ventilation products into the UK market to housebuilders and electrical contractors, but also window hardware (such as handles and trickle vents) to window manufacturers. As is to be expected, the industry is highly competitive, and that has caused Titon to experience margin pressure. The company also sells passive ventilation products to construction companies in South Korea, and a mixture of these products around the world through local distributors. The group manufacturers almost three quarters of the products that it sells. To supplement its UK sells, Titon opened up a new sales channel in early 2014. This new channel was TitonDirect, which is an online sales platform for its products. This strategic move is unlikely to generate material revenues in the short/medium-term, but it's a sensible move.

There is some product risk though, in that ~85% of revenues come from "Trickle ventilation and window hardware products" with only 15% from "mechanical ventilation products". That does pose risks - For example, if there is a change in building codes that scrap the need for trickle vents, then a large slice of Titon's market will have disappeared. However, that is unlikely to happen given that trickle vent integration is still part of law. These risks are all long-term though, so shareholders certainly have sufficient time to react to any regulatory changes, given the consultation process that they typically have to pass through.

As can be seen from the financial results below, Titon's historic financial performance hasn't been attractive.


Since 2006, the company would appear to have made little financial, and therefore operational progress, although this masks the true re-positioning of the business that has happened. Titon now operates on a much more secure footing than in the past. For the sector within the business operates, the gross margin is good at over 20%, and it has been consistently around that level, which suggests a certain amount of pricing power. However, revenues have been disappointing and show that the company hasn't been able to make much headway into growing the top-line of the business. That has largely been because the UK operations have been shackled by increased competition and a deterioration in the housebuilding/construction sector from around 2008 onwards. The result of this is that post-tax group profits have been erratic, fluctuating either side of breakeven. Whilst is is good to see the jump in pre-tax profits over 2013, this basis is insufficient to conclude that the company has turned a corner and stepped up its bottom-line performance.

In fact, the most significant progress that the company has made over the period shown, was when it invested £675k in a South Korean joint Venture back in 2008, with distributors Browntech Sales Co. Along with providing further working capital injections along the way, the company established Korean manufacturing operations, and that has turned into a strongly profitable business over the course of the past year. Indeed, just shy of a quarter of all sales are now derived from Browntech, yet it is this venture that is most profitable, contributing £0.69m in pre-tax profits during 2013. In comparison, the UK business incurred a £0.42m loss, which is weak given that the UK trading business booked almost three times as much in revenues. Just before looking at the 2013 results, I'm impressed by the remuneration structure of the company. The annual wages of the CEO are just over £100k, and haven't been rising materially over the past 5 years or so. Combined with the large shareholdings that management possess, they should have their interests aligned well with shareholders.

The 2013 financial results reported for the year ending September 2013 had the following headline figures:
- Revenues of £15.74m
- Operating profit of £230k + £262k profit from associate business
- Profit after tax of £476k after a minimal tax charge of £29k
- Basic and Diluted EPS of 2.87p
- 2.0p in total dividends paid during 2013, up from 1.5p in 2012
These results aren't particularly good at all, for a company exhibiting an erratic trading performance. In fact, with EPS of just 2.87p, the rating is far too high. That isn't helped by the results being flattered by a £225k exceptional profit either. That was generated from a court settlement in which it was concluded that a competitor had breached one of Titon's patents.

So why the interest in Titon? Based on the above, it's trading on a ridiculous PER and is nowhere near a value play. A clue comes from the 33% dividend increase, to 2p, which gives a current, and healthy, yield of 2.90%. The ability to pay this dividend is evidenced in Titon's rock-solid balance sheet. Against a market cap of £7.28m, Titon has:
- £3.30m in property, plant and equipment
- Inventories of £2.86m (albeit it's difficult to tell what proportion of this is 'redundant')
- Net receivables of £0.375m
- Cash and short-term deposits totalling £2.15m

If you factor in the minimal other liabilities of around £180k, the company has circa £8.50m in net tangible assets. An update in January showed that cash was slightly lower at £1.91m, so if you factor that in, net tangible assets are around £8.26m (as a lower-bound estimate). That equates to around 78p/share, so Titon is trading at a ~11.5% discount to its Net Tangible Asset Value (NTAV). Net tangible assets are 2.72x total liabilities and current assets are 2.66x total liabilities, so the balance sheet is excellent for a company of Titon's size, and that gives a lot of comfort, given that Titon's profitable operations are in South Korea. Cash generation in 2013 came to around £870k (admittedly with the flattering exceptional profit). The dividend is not currently well covered, but an anticipated uplift in profitability should mean that it is going forward. The cash pile also secures its payment.

The 2013 profit improvement versus 2012 was derived from its Korean operations, which saw revenues leap 91.7% to £3.7m on the back of increased sales to the private housebuilding sector. That demand was created through the continued introduction of building ventilation regulations, but also an increase quantity of housebuilding as the South Korean economy continued to recover from the recession. It is estimated that dwelling approvals in 2013 had recovered to pre-recession levels of over 500,000 units per annum. That contrasts with the political risk (with North Korea) - you wouldn't expect such a buoyant housing market. The presence of operating facilities in South Korea also reduces profitability risk through currency swings. Given that expenses are incurred in Korean Won (KRW), they track any fall in revenues. The KRW:GBP relation is also fairly stable. Over the last two years the rate has predominantly been between 1700 KRW: 1 GBP and 1800 KRW: 1 GBP, which represents a fairly narrow exchange rate bracket, so currency risk looks to be minimal (as it stands).

As alluded to earlier, the burden of the company does continue to be the UK business, which may seem surprising given the uplift in the economy and the construction sector over the past year. Part of the reason for the sluggish reaction has been because one of Titon's product markets, MVHR, has not been adopted as quickly as anticipated. MVHR stands for Mechanical Ventilation with Heat Recovery. "MVHR systems partially recover the heat that is expelled from a building when it is being ventilated by using that heat to warm incoming air". The technology is becoming increasingly implemented across the housebuilding industry, although competition has increased, and regulations have not been created to make MVHR mandatory. MVHR is meant to help with energy conservation, so it fits in with the government's target to ensure that all new homes are carbon neutral by 2016. Titon have openly admitted that, despite the market growth for MVHR, the scale of market take-up will be directly influenced by whether or not building regulations are adopted. The reason for that is that MVHR implementation can be quite costly, so a large proportion of private sector housing doesn't use it. The building of social housing has been slow, thus reducing the growth from that channel also.

The reality is that the government are actually moving in the opposite direction in that they are planning to scrap the "Code for Sustainable Homes" later this year, and merge certain rules on energy efficiency into building codes. That won't help the MVHR code, but that is ultimately only a segment of Titon's business. MVHR sales are being targeted in other Western European countries in the interim. The company's key performance objective for 2013/14 was to further improve UK profitability, but given tough UK trading conditions, it will probably book a similar revenue performance to that last year. Sales into other countries rose by 7%. Overall demand in the Rest of the World (ROW) was 'sluggish', but there were positive signs notes in Denmark and the US. Ultimately, Titon operates within a very cyclical sector. When economies are performing well, housebuilding and construction rises, and that typically should lead to increased demand for Titon's products, along with retrofitting sales, even if at a slow pace in Europe. Further ahead, Triton plans to increase its sales to Original Equipment Manufacturers (OEM).

Up until now, it almost certainly comes across that Titon is an asset play in that the company is trading a discount to its NTAV, which is the basement price that a company would have to pay to launch a takeover. 99% of the time, the company would have to pay a material premium to the NTAV. However, I'm not suggesting that a takeover is likely - it's not.

The attractiveness of Titon is two-fold, the second attraction being that it's also now an earnings play. In late January the company announced its interim management statement in which it noted that group revenues were up 17% Y.O.Y in Q1 alone. UK sales were flat (due to increased competition), but sales to the ROW were up by 56%. That contributed to a massive rise in pre-tax profits to £329k in Q1 alone. It appears that Titon is becoming less of a UK centric investment proposition, but one that's also reliant on a strong performance in South Korea. Of course, that does have downsides, but the profit figure speaks for itself. Furthermore, the statement read:

"The contribution from our associate company, Browntech Sales Ltd has also improved significantly in the period against last year. We expect the positive results from Korea to continue for the rest of the financial year."

That's important as if suggests Q1 was not a 'blip', but rather the underlying performance of the company now that it has increased exposure to South Korea. Assuming a slow-down in profits such that Titon generates £1m in profit over 2014, and applying an effective 10% tax rate (Titon has various R&D credits and tax losses that it can use to offset the tax charge), and the post-tax profit comes out at £900k. Those figures would generates pre-non controlling EPS this year or 8.5p, which would put the company on a prospective PER of just 8. There is scalable upside to that profit figure depending upon how Korea operates over the rest of the year [in March South Korean house prices rose for the 7th month in a row]. It is no surprise that the share price has been trending upwards over the course of the last 6 months.

That is the essence of the investment proposition that Titon presents. The company's operations are far from superb (especially in the UK), but this is a company valued at just £7.28m, so the business is hardly going to be completely top-notch. The management have well-aligned interests and the technical picture continues to look positive. Given the operations in South Korea, Titon will trade at a discount, but there should be meaningful progress in diversifying the overall revenue structure of the group over the course of this year. Most importantly, the company is heavily asset backed and trading at a discount to its NTAV. Combined with the company entering a phase of increased profitability, there looks to be appreciable upside from the current level, even when factoring in the operating risks. Titon should release its half-year results in May, and these should show much improved profitability compared to the corresponding period last year. The asset backing should provide a downside buffer for investors. I have therefore put a Buy tag on Titon Holdings at 69.00p with an initial target price between 90p and 100p.

UPDATE (09/05/14) - Moved it off a buy tag this morning. As expected, it's on target to make £1m pre-tax profit this year, but the EPS figures appear low because around half of the profits are filed under 'non controlling interests' for accounting reasons. Therefore, the EPS figure doesn't tally with overall profitability and actually gives off the impression that Titon is pretty expensive in terms of earnings. For that reason alone, I've ditched the holding short of the 90p-100p target. The market will probably look at the high PER and probably won't bother to look at underlying profitability. 13% profit captured.

3 comments:

  1. Thanks el1te. Can I just ask. what is the difference between net asset value and net tangible asset value? I see that net tangible asset value for TON is lower than the net asset value so what is excluded?

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    1. net tangible asset value excludes assets which are not touchable, so things like software systems or goodwill.

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  2. Excellent write as usual El1te :0).

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