Megan's loan default highlights the important of credit analysis

Megan is one of the stocks recommended by me (go here) as well as a few research houses. While we understand that Megan operates in a very competitive environment, we were attracted to the undemanding valuation of the stock (which trades at a PE of 3-4 times for much of last 1 year). We are aware of its high gearing but we thought the management could find the funds, when needed, to meet its financial commitments. Yesterday's announcement (go here) proves that we were wrong.

From the chart below, we can see that Megan has been range-bound between RM0.55-0.85 for the last 15 months. To some, that should have raised some questions. But, then again, we have seen similar trendless trading for that period in semiconductor stocks, such as MPI & Unisem as well as KESM (which provides burn-in testing for semi-conductor assemblers). So, the question was not raised.


Chart: Megan's daily chart as at May 7 (courtesy of Tradesignum.com)

A careful study of Megan's Balance Sheet for the last 4 quarters (see the table below) could have raised some serious doubts about its ability to meet its current liabilities from normal liquidation of its current assets. While its current ratio remains more than adequate at 1.8-2.0 times, what's worrying is the deterioration of its trade receivables & inventory turnover. Megan's debtors' collection period has increased from 108 days as at 30th April 2006 to 144 days as at 31st January 2007, while its inventory turnover has worsened from 17 days to 49 days during the same periods. At the same time, the current portion of its borrowings has jumped from 35% as at 31st October 2006 to 46% as at 31st January 2007. In the end, Megan's short-term borrowings were too huge to be settled via funds generated from its normal asset conversion cycle. Since there were no new funds from fresh borrowings or through the issuance of new share capital, Megan's fate was sealed.



The interesting question to ask is why did the majority shareholder allow such a default to happen. Why did they not push through the earlier proposed Right Issue or abandoned its earlier proposed private placement? It is not acceptable to blame the depressed stock price. If need be, Megan could have structured a 2-call Right Issue, utilizing some of its reserves to cheapen the Right Issue shares. Why was it not done? Could it be because the majority shareholder does not want to invest more money into Megan for reasons only known to them?

The same shareholder is now faced with the difficulty choice- to pump in more money now, or to sell off the stake in Megan, or to allow a white knight to come in. Any of these options would result in a loss to him as well as to the other shareholders of Megan.

The Megan default has highlighted the important of analyzing a company's financial position i.e. its liquidity position as well as its gearing position. I will re-examine the format of my stock recommendation with the view of incorporating some ratios that would help in the reader coming to an informed decision on a stock.