HARVEST- a riddle wrapped up in an enigma?

A reader, Coypond has commented on my post entitled "Speculators, Be Smart!". He wrote a very lengthy comment which I reproduced below. I have prepared my equally lengthy reply and I'm wondering whether I should post it as a simple reply to his comment or as a separate post. If I post it separately, it may appear I am making a big thing out of a simple comment. Then again, I believe that Coypond may welcome a civil discourse. For the benefit of all readers, I will post it here and I would welcome your comment.

*************************************************************************************

CoyPond commented:

Alex Lu, I refer to your article “Speculators, be smart!” dated 26Dec 2011. You may have a point there, but in Malaysia vis-à-vis the KLSE it’s difficult to do so.

First & Foremost, I don't want you and the readers to think that I am a big time shareholder, and neither am I defending the management of HARVEST. I am just a small time investor who thinks that there is prospective value in this company from the recent newspaper reports and announcements.

I see that you have a lot of doubts about HARVEST. I doubted AIRASIA too when it first came on the scene. That was an opportunity missed – big time!

You have also said much in the article – much too much. You remarked, you insinuated – mostly bad, about HARVEST and about Raymond Chan. A good many of your remarks were based on assumptions, and when you “assume” all the time you know what that means – I rest my case. No! I must go on.

In the first place it’s quite unkind of you to say that Raymond Chan would be silly from all the newspaper reports of his mega projects, completed and ongoing ones. His flagship SAGAJUTA is a cash-rich company – you should feel free to check this out. So surely a man who has built up such a successful business conglomerate must know what he’s doing when he decided to use a listed vehicle which happens to be HARVEST in this case to expand his business further.

You asked “whether Harvest can carry out any construction contract?” Good question. Why not? You don’t need much to be a main contractor. All you need is good management, ample finances for operational expenses and many good sub-contractors – to put it simply. Now I ask you, did Tony Fernandez have any airlines business experience before he started AIRASIA? Does he know how to fly an airplane? Is AIRASIA a success story today?

You claimed HARVEST is a weak company, again on assumption and without basis. But surely you would agree that to spot multi-baggers we would have to see the potential beyond historical data. And, in this instance, changes happening in HARVEST currently are significant. They have secured new core business - a new direction, a new and meaningful beginning sort of. Not just that. This will turn the company around, profitably for sure.

You also talked about rumours… well, you of all people should know better than to give credence to rumours as far as the stock market is concerned. Let's base our arguments on facts.

If you say HARVEST is grossly over-valued, then what do you make of the report by TA SECURITIES as the Principal Adviser and COVENANT EQUITY as the Independent Adviser on BURSA’s website on 19 & 20 Dec 2011? Was BURSA abetting TA SECURITIES and COVENANT EQUITY in cooking up the report on HARVEST’s new businesses? Somehow you inadvertently seem to be saying so!

Now on to the fundamental side, HARVEST has already been awarded RM199M worth of contracts and another RM609M by April 2012, refer to BURSA’s announcement on 19 Dec 2011. The total contract value over a 30 months period is therefore RM808M. Hence if we take an expected net profit margin of 10%, we get RM80m. On yearly basis, we get RM32M with an EPS of 17.7 cents based on paid up of 180m shares. And taking a PE of 10, it would give HARVEST’s share a fair value of RM1.77. Even at RM2.0, the PE is still in the teens. Not excessive at all!

In concluding, I hope you would give HARVEST another look based on BURSA’s report on 19 & 20 Dec 2011. We are just trying to justify why BURSA should not prolong the designation of HARVEST any further, let justice prevail. You have put up many good articles of stocks in your blog and I hope you will continue to do so.

*************************************************************************************

My reply:

Hi Coypond, Thank you for your long & thorough comment. Let me start by stating our area of agreement. There are:

1) Raymond Chan has built up successful businesses and one of his companies, SAGAJUTA is a big property investment company. I believe it owned 1Borneo, the biggest shopping complex in Kota Kinabalu.

2) If HARVEST can secure multi-million ringgit contracts, whether from Raymond Chan’s group of companies or third parties, it could be a profitable company. Its net profit would depend on turnover & profit margin.

3) If HARVEST can make good profit, then its current share price may not be overvalued.

You said that I have made assumptions about Raymond Chan that are mostly unfavorable. That’s not quite correct. I merely assumed that Raymond Chan is a smart businessman, who looks after his own interest. If you are such a person, you would not do the following:

1) You would not accept an exchange of something that you owned worth RM1 million for something worth less than RM1 million. Example: You would not swap an asset worth RM1 million in return for 1 million shares of HARVEST unless you think that HARVEST is worth at least RM1.00 apiece.

2) If you owned less than 100% of HARVEST, you would treat it less favorably than your 100%-owned private company. Implication: If you are developing a property, you would not hand the construction job to HARVEST at a hefty profit margin. To do so would mean that you are giving preferential treatment to HARVEST at the expense of your own company. Smart businessmen achieved their success by counting every ringgit & sen.

The above statements or assumptions are fairly straight forward. If you agreed on these, let’s move to the areas which we may disagree. I believe in the following:

1) HARVEST is a weak company. It is a loss-making concern, with accumulated losses of RM19.7 million (here). As at 30/6/2011, HARVEST's shareholders' funds stood at RM30.5 million (or NTA per share of 17.4 sen). Its outstanding shares are 174.3 million units of RM0.25 each plus 70.7 million warrants (known as HARVEST-WA).

2) Despite securing a few sizeable contracts from Raymond Chan’s private companies, I do not believe that HARVEST will make big profit for the following reasons. The reasons are:

• The current profit margin for construction work is about 10%. If you are in doubt, check out the account of Binapuri and Fajar.
• To carry out big contracts, you need a big team of personnel. HARVEST does not have that. It can rely on SAGAJUTA but that would not free. It can build up its own team but that would have a similar effect on its bottom-line.

All in all, I would be very generous if I were to assume that HARVEST can achieve a profit margin of 5%. In my opinion, it could be even less than that. Why?

I will give you an example. If I were to renovate my house by engaging a contractor, it would cost me RM100k. Now, I decided to help out my unemployed brother-in-law who has no experience in renovation work. I would pay him RM100k and he would in turn engage the same contractor at a cost of RM90k; thus he would pocket RM10k. It looks like a win-win situation for all, except the contractor. Do you think I would get the same level of workmanship from the contractor since he is getting RM10k less for the same work? I believe not. So, the real winner is my brother-in-law and the real loser is me.

Let’s go back to the case of HARVEST & SAGAJUTA. Raymond Chan cannot create profit for HARVEST out of the thin air. It has to come from somewhere. It will most likely come from SAGAJUTA. Do you think Raymond Chan would let HARVEST, a company which he has less than 50% shareholding, makes profit at the expense of his 100%-owned SAGAJUTA? If you accept this analysis, you can ignore the TA’s report.

Finally, I like to elaborate on my statement: “As a seller, Raymond Chan would be silly to accept Harvest shares after the share has been played up”. Again, we have to go back on basic human instinct. Would you allow a stock to be played up (HARVEST rose from RM0.08 to now RM1.00 while its warrant rose from RM0.04 to RM0.80) and then accept these securities as a currency in exchange for something that you owned. Before the rally, HARVEST and the warrant are worth about a total of RM21 million. Today, the shares & warrants are valued by the market for a total of RM230 million. Raymond Chan pumped in contracts into HARVEST and in the process boosted up the value of the securities. Would he now accept these securities in exchange for his assets for which the value remained stagnant? I have higher regards for Raymond Chan than to assume that he would do such a silly thing.

Based on the above, I cannot buy the HARVEST story. It just doesn't make sense.