#7 Investing Ideas – Micro-Mechanics (Holdings) Ltd (SGX:5DD)

We chat with Sudhan, Content Strategist at Seedly. Sudhan shared with us one of his favourite and best investments so far, Micro-Mechanics (Holdings) Ltd. Micro-Mechanics is a small-cap company serving the semi-conductor industry. Find out why the best is yet to come for this company.

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Disclosure: Sudhan owns Micro-Mechanics Holdings at the time of recording.

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The Interview Transcript of Value Invest Asia, on Investing Ideas between

The Interviewer: Stanley Lim from ValueInvestAsia.com

Interviewee: Sudhan _{(Content Strategist from Seedly, and co-author of the book “Invest Lah; An Average Joe’s Guide to Investing)}

Start [02:30]

Stanley:                                 Great! Yeah! we definitely put the link down below for you guys as well, but let’s jump straight into the main core of why we are doing this episode; every week, one of our guests will be sharing one investment idea that they have been thinking about currently, and this week Sudhan, why don’t you share with us which company you’re looking at, and why you like it?

Sudhan:                                 Okay! The company I’m going to share with you Stanley and the audience is Micro Mechanics. So, it’s a company that’s in the semiconductor industry, so they design and manufacture high precision tools and parts used in the semicolon industry, so these parts are consumables, so once you use them you are to discard. So, basically they supply parts that are used in the testing and assembly of the semiconductor value chain, so basically they’re parts; such as rubber tips, or for their semi-conductor value chain and so all these products are one-off use, so we have to whenever use it, and you want to have a new part, you will replace the parts. So, this kind of gives them the recurring revenue.

Stanley:                                 Okay! Okay! why don’t you share with us a little bit more about their business model, so how have they been growing why don’t you share with us what’s the business behind MICRO MECHANICS?

Sudhan:                                 So, Micro Mechanics has a great growth in the business, but in the latest FY we just ended in June 2019, they have slowed down the growth, because due to the slowdown in semiconductor industry, but over the long term they still have potential for this company because as you know, smart phones, Internet of Things, AI are all the raging stuff now right. So, for the long term, semiconductors will still be in demand, but for the short term, there’s always like a … in this industry so short term hit, but long term there is great prospects for this company.

Stanley:                                 Right! Okay! Are they only serving the SEMICON industry or they do serve other industries as well?

Sudhan:                                 I believe they only serve the semiconductor industry right now.

Stanley:                                 Right! Okay! So, that means that their sale is very dependent on the semiconductor volume?

Sudhan:                                 Yeah! That’s right. The semiconductor industry it’s super volatile, super cyclical, so yeah its ups and downs, there are often ups and downs, and if you don’t believe me, you can take a look at Singapore’s Deputy Prime Minister Heng Swee Keat, he recently said that despite the slowdown in industry, the future of the global semiconductor industry remains bright, and the demand looks healthy, so if Minister Heng is… go-to guy then yeah I think this is a great company to invest in the long term.

Stanley:                                 Okay, if that’s the case, if it is in a very cyclical industry, how do we actually predict you know, their sales and demand, how do you actually look at this company, just mainly from the entire industry growth?

Sudhan:                                 Yeah! So, for investing, for myself in general, I don’t really look at short-term demands, so I look at the long-term demands, so even though short-term the company might face head winds, I see it as an opportunity to buy more shares in a company, if the share price would fall, valuation would fall. So, as long as there is long-term growth in the company, I will be prepared to hold on to the company through the cycle also, and especially for micro mechanics, they pay great dividends. So, it’s like you’re paid today while the cycle turns around.

Stanley:                                 Right! Okay, and they supply globally? Or are they only supplying to manufacturers here in Singapore?

Sudhan:                                 So, their main three markets are; China, USA and Malaysia. They also have sales in Singapore, and the Philippines, Thailand, Taiwan, and some of the other countries. So, in Singapore, their sale for 2019 was 75%.

Stanley:                                 I’m just looking at their financials, and Wow! Their profit margin is quite amazing with a gross profit margin of more than 53 percent, and a net profit margin of 21 percent. Why is that the case does this company have a moat? Why are they able to have such a high profit margin?

Sudhan:                                 One of the ways to look at margins, high margins would actually show that the company has pricing power, so that’s the case for Micro Mechanics, like you rightly pointed out, gross margin of fifty four percent, and net profit margin of around twenty two percent, for FY 2019. So, some of the reasons for the high margins is that they they’re always looking to improve the productivity, so they have strategies such as reducing setup time, and having more highly automated machines, and smart factories. So, in the manufacturing industry set up time reduction is a big thing because I’ve experiences in the manufacturing line, so when you can reduce the set-up time, you can do things faster, and you can reduce costs, and stuff, so this gives the company has an advantage over its rivals as well. If you can produce more parts within the set period of time, you will see more output, you’re more efficient, so that’s what is going well for Micro Mechanics, and that shows in its high margins as well.

Stanley:                                 So, you’re basically saying that they are able to research, R&D more into the efficiency of how they do things, that’s why they end up having a better margin than their competitors.

Sudhan:                                 Probably, that’s the case, and also even simple things like putting – for example moving through their production right, for their components, when they put in their capacity, even having things near their machines, makes a lot of difference. For example, you don’t have to travel like one minute to take a new part, to put into their product so if you have it all just inside on your arm’s length right. That makes a big difference in manufacturing, so I think they do a lot of all these lean stigma stuff to reduce the cycle time, and reduction of set-up time.

Stanley:                                 Okay! I’m trying to try and find ways to challenge your ideas right here, when you look at this company, because it’s not a very large cap company, how can you tell how well they are they are basically doing to their industry, or to their competitor, is there a way that you look at it, is there any comparable for this company?

Sudhan:                                 So, Micro Mechanics, there’s no direct rival for them, because of their competitors compete in specific areas of the semiconductor industry, what their company offers, so Micro Mechanic has this whole range of product and services, but his competitors only have certain aspects of those products, so there’s no one direct competitor for them, so that also gives them I think the competitive advantage.

Stanley:                                 Because from my understanding, this kind of companies, when they produce customized tools, or consumable for the SEMICON industry, isn’t it that almost any machine shop should be able to do the same thing?

Sudhan:                                 Yeah! So, from outside it might look like that way, because anyone it seems like anyone can make the parts, but what is hard to replicate is the quality and the cycle time. So, basically if I want parts, I want it in quick time, but let’s say I want I want a thousand parts in within the next few days, if a company can meet my demand at a low cost and high quality, so I would go with that supplier, so for Micro Mechanics, I think it has that advantage, it’s known for its quality and its cost, low cost I think and cycle time as well. So, meeting customer demand is very important in this industry.

Stanley:                                 Yeah! Okay, you sort of feel that they are able to maintain this kind of profit margin even going forward, and able to convince their clientele to stay with them?

Sudhan:                                 Yeah! I believe so, as long as they don’t screw up basically, so I’m sure they can keep their customers happy.

Stanley:                                 Have they screwed up before in the past?

Sudhan:                                 Not that I know of, and hopefully not.

Stanley:                                 Okay! And how long has this company been around?

Sudhan:                                 So, Micro Mechanics has been around for many years, so it was founded in 1983 in Singapore, so that’s like so many years ago, and it was listed in 2003, so they have a long list of history and long existence in the industry, I’m sure they would have been through many cycles, and emerged stronger from each cycle, and one particular thing I like about this business is that, it’s balanced sheet is very strong. So, it is full of cash with no debt, so the last I know that companies without any debt, I don’t think they can go bankrupt. So, they have a lot of cash and no debts. So, they are a strong business.

Stanley:                                 Wow! Okay and so how are you seeing this company? Maybe as a disclaimer, assume you own the stock yourself?

Sudhan:                                 Yes, I do.

Stanley:                                 Okay and you seeing this as a growth company, or as a dividend company, how do you see this company?

Sudhan:                                 I would say this currently can be classified as a dividend company, like I mentioned earlier, its yield is currently around 6%, so strong yield, even if you take away the special dividend so nine cents of total ordinary dividends you have a dividend yield 5%, strong balance sheet and even if you look at their earnings, price to earnings it’s around 18 or 19 times, but I think if you normalize it, I think it’ll be much better.

Stanley:                                 What do you mean by the normalised price to earnings because you just mentioned that they are facing a slowdown you mean the earnings have already slowed or it’s still slowing?

Sudhan:                                 Yeah! So, the FY 2019 have actually slowed down, so it was just reported a few I think last month or two months back. The FY 2019 earnings, so that has already slowed down, so if you use that earnings, reported earnings, the valuation will be around 18 19, but if you were to normalize, I think the valuation would be much better, the Price will be much lower.

Stanley:                                 But if you are seeing this as a dividend counter, okay I’m just looking through their dividend payout right now, it seems that they have been increasing the dividend payout over the past few years from 54% in 2014, all the way now to more than 100%, do you still think that this dividend is sustainable?

Sudhan:                                 Yeah! So, if you look at the dividend valuation itself, like you pointed out is going up, and even above hundred percent, so various companies payout more than what they earn, but the thing is that, if you look at the free cash flow, they are paying much lesser than their free cash flow, and the company also said that they are confident, they are basically maintaining the 10 cent dividend  given out in 2018, because they are confident of their business, and the cycle and that it will do well basically, the company can be much stronger basically.

Stanley:                                 Wow! Oh, you mean that even as they are facing this slowdown, they have no plans to cut their dividend?

Sudhan:                                 Yeah! So, they have no plans; basically maintain the dividend, showing confidence in the business and industry.

Stanley:                                 Okay! if that’s the case, maybe the slowdown is not as bad as we might think, because if we look at the global financial crisis back in 2008, this company actually cut their dividend more than half, from five cents to just two cents. So, you don’t see this as a risk that this would happen again?

Sudhan:                                 Yeah! I don’t see that as a risk, I don’t believe we will go back and face the same issues we faced in 2008-2009, this slowdown is just I think it’s short-lived, won’t be as painful as what we faced in 2008-2009, and if you look at a dividend payout ratio in 2009 it was 100 percent, so it was really not sustainable, so they had to cut dividends.

Stanley:                                 Right! Okay, how would this company be affected by the current macro environment that we look at, the trade war and we look at you know just everything that’s happening right now, what’s your view on that, and how would this company be affected?

Sudhan:                                 Yes, their sales from China’s for 2019 was 29 percent you know, so the trade war between China and US might be on investors’ minds, but in fact during the 2018 AGM, the company said that there’s no direct impact on the company’s business from China, because they only supply to the manufacturers within the country, so maybe Chinese companies or multinational companies based in China, so they don’t really export out of China.

Stanley:                                 Right! Okay! So, whatever business that they serve, they actually have a local machine shop right there?

Sudhan:                                 Yeah! That’s right, and they serve within the country.

Stanley:                                 Wow! That’s pretty interesting, what’s in your own opinion might be the risk for this company then?

Sudhan:                                 So, the risk basically is that the business cycle, I mean the semiconductor industry doesn’t turn around, so it’s a protracted downturn, structural decline, but I don’t see that happening, yeah like I mentioned, we still use the smartphones, and there’s still growth in this tech industry, so all these smartphones and all the machines still need all the chips that goes into all these equipment; and valuation wise, it’s kind of low risk, I think if investors will look into this company, so from income perspective, they’ve got great dividend yield from this company, valuation wise I don’t think it’s demanding.

Stanley:                                 Okay! How would you look at the valuation, what is a fair price for this company in your opinion?

Sudhan:                                 I just look at the earnings, and the dividend yield, because it’s the price to earnings rate, the earnings is much lower, and you know that the Price is higher, I’ve not looked at the normalized earnings, its price and normalized earnings, but I believe it’s still decent around this price.

Stanley:                                 Maybe, just on the last point I’m trying to challenge your idea here, because I look at their past performance right, and this company right now has a market cap of roughly S$240 million market cap, and I just look at their past performance. Over the past 10 years, it hasn’t really grown in terms of revenue, it hasn’t really grown dramatically fast, and if they have already been in the business for say 30 odd years, almost coming to 40 years, and they’re still at this size, do you feel that this is just how big the market is going to be for them, they might just become a non-growing company in the next few years?

Sudhan:                                 I think the company can grow with the demand in the semiconductor industry, like I think many years back, the industry was still much smaller, SEMICON for smartphones were not there, I mean not that prevalent compared to now, and but it’s always talked about this AI, IOT and variables, so I think the next few years might see different kind of growth phase compared to the past many decades.

Stanley:                                 Before I let you go, if an investor is looking at this stock, how would you see this stock on your whole portfolio, in terms of sizing, how do you size such a position in your portfolio?

Sudhan:                                 Okay! first for myself, I understand this is a cyclical industry, the companies in, so when I started buying the company, I bought very slowly, I didn’t like go all in, so I bought it even slower than the other companies that I have, compared to more stable companies. So, I try to buy only like twice a year, so I really was deliberately slow in purchasing more shares in this company, and also because I kind of knew that the industry was going to slow down, so I purposely pace my investments slower, and kind of take advantage of the decrease in share price.

Stanley:                                 Oh! Wow! You only invest in it twice a year, that’s very disciplined. How many people can do that?

Sudhan:                                 Yeah! So, even for the overall portfolio position, I think I don’t want this company to be too huge compared to my whole portfolio, so yeah there’s a reason also I pace myself.

Stanley:                                 Yeah! I see. Okay, maybe just go give all the audience a little bit more context, why don’t you share a little bit more about how you actually invest, what type of investor do you categorize yourself as?

Sudhan:                                 I wouldn’t say I’m like a strict value or growth or dividend investor, basically I invest in companies that can grow for the long term, and pay decent dividend, and there’s a huge market that they can tap into, so I think that’s me, probably like Motley kind of investor.

Stanley:                                 Yeah, and how many stocks do you own personally?

Sudhan:                                 Currently, I have around 20 to 30 stocks.

Stanley:                                 Okay! Well, very diversified, and so a stock Like Micro Mechanics will take up maybe like 2 to 3 percent in your portfolio. I see, this is pretty fascinating, and thank you so much for sharing so much detail, not just on the company, but also on how we should actually think about, when we are investing, and sizing up our position, and so once again this is a Sudhan, contributor at Seedly, we will provide the link down to the Seedly blog, so you can read some of Sudhan’s blogposts as well. thank you so much for your time Sudhan, I think this has been an extremely interesting company, and I think many of our audience will definitely be checking it out very soon.

Sudhan:                                 Thanks Stanley, thank you for having me here, and I hope that your audience like Micro Mechanics as well.

Stanley:                                 Definitely! I hope to chat with you very soon.

Sudhan:                                 Ok Stanley.

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[End 23:12]

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