Aviation Related Stock, Revisit (Part II)

In Part I of this series (Read more here), pre-Covid19 Monte Carlo model was compared with actual price range of SAM Engineering (SAM).  The predicted price range correlate well with the actual data.  The author argued that the market might not have incorporated Covid-19 impact thus a post-Covid19 Monte Carlo model is needed to forecast the price.

Several key factors need to be considered in order to build a robust post-Covid19 Monte Carlo model.  They are,

       I.          Earnings impact;

      II.          Volatility (mood and momentum); and

    III.          Economy recovery pattern and duration (V-Shaped, U-Shaped, or L-Shaped).

First, the earnings impact will be assessed using the concept outlined by valuation guru, Prof. Aswath Damodaran (Read more here).  He mentioned three key crisis-specific inputs:

1.      Revenue Change & Operating Margin in 2020;

2.      Expected Revenue Growth in 2021-2025 and Target Operating Margin; and

3.      Failure probability and consequences.

He also posted a very comprehensive spreadsheet for users to do their own valuation (spreadsheet), and a video guide to use the spreadsheet (guide).

Second, the volatility of the price movement will be assessed using the latest five years Price to Earning (PE) ratio with assigned probability.

Third, the shape and duration of the recovery.  Basically, three types of recovery pattern are considered, V-Shaped, U-Shaped, and L-Shaped.  Each type of recovery pattern will be assigned with probability.

Earnings Impact & Recovery Pattern

Now let us examine the earnings impact by first looking at point number 3 in Prof. Damodaran’s key crisis-specific inputs – Failure probability and consequences.  Prof. Damodaran pointed out that smaller, younger and more indebted company are likely to fail in this crisis.  Based on market cap definition, SAM is classified as small cap company in Bursa Malaysia.  It has been in the industry for more than 10 years thus it is not really a young company.  Thus, the key parameters to consider here is indebtedness.

Table 1 shows the liquidity and solvency ratios of SAM Engineering.  The financial position of SAM Engineering is healthy based on the most recent quarter (MRQ) or trailing twelve month (TTM) information as at 31 Dec 2019.  The liquidity and solvency ratios are healthy and their cash in hand is believed to be enough to pay wages and interest in the near term.

Table 1:  Liquidity and Solvency Info

	MRQ/ TTM
D/E	0.27
Quick Ratio	1.43
Current Ratio	1.92
Operating Cash Flow to Debt Ratio	0.88
Interest Coverage	13.3
Interest Expense	RM2.60 mil
Cash	RM20.61 mil

Let us move to point number two – Expected Revenue Growth in 2021-2025 and Target Operating Margin.  This portion can be analysed together with point (III), recovery pattern.  The revenue growth shall follow V-Shaped, U-Shaped or L-Shaped pattern?

The good thing about Monte Carlo model is one can incorporate all recovery patterns into the model, then assigning the probability of occurrence for each pattern.  However, the probability assignment now becomes the main issue.  A poll by Ernst & Young (EY) showed that 38% of the global executives said the recovery will be V-Shaped, 54% said U-Shaped, while 8% said L-Shaped (Read more here).  This Monte Carlo model will use these numbers as input but with different recovery level.  Table 2 shows the recovery assumptions.

Table 2:  Recovery Pattern (Revenue)

Recovery Shape	Back to pre-Covid19 level by	Recovery Path	Probability
V-Shaped	2023	Straight Line	38%
U-Shaped	2025	S-Curve	54%
L-Shaped	2030	Flat-S	8%

Finally, let us look the most difficult parameter - Revenue Change & Operating Margin in 2020.  This is the most important parameter as it serves as the reference point for the model.  Based on rough estimation, if the revenue dropped by 30%, at least 10% work force reduction is needed in order to maintain positive EPS.  Thus, SAM’s 2020 EPS may go negative if the revenue dropped more than 30%.  As such, in accordance with L-Shaped recovery pattern, the minimum price for SAM shall be determined by using discounted tangible book value.  As at 31 Dec 2019, the tangible book value per share of SAM is RM4.11.  Assuming it may trade at 80% of its tangible book value, it will be around RM3.29.  This would serve as the floor value for 2020 till 2023.  (Floor price changed to RM2.0 on 3 May 2020, see Part III for details).

Table 3 shows the assumptions for revenue forecast and the happening rate for 2020.  The EPS is highly dependent on the cost cutting measure and other government support scheme.  For this model, only work force cut is assumed.  Tax rate and other measures are assumed similar to 2019.

Table 3: Revenue Forecast & Probability

Revenue Drop	10%	20%	30%	40%	50%
Work Force Cut	5%	10%	15%	20%	25%
EPS (RM)	0.28	0.18	0.08	-0.03	-0.15
Probability	15%	50%	30%	3%	2%

Figure 1 shows the EPS forecast for various recovery pattern.  (The U-Shaped recovery pattern looks more like a Nike swoosh).

Volatility (Mood & Momentum)

The volatility impact (mood & momentum) is studied using past five years PE range.  Figure 2 shows the daily PE range from Mar 2015 to Mar 2020.  The PE could go as high as 30 and hit the lowest at around 7 but their probability of occurrence is 0.08%.  They only happen once in five years.  About 50% of the occurrence happened between 10 to 23.  See Table 4 for details.

Table 4: PE Range and Occurrence (2015 – 2020)

PE	Occurrence	Percentage of Occurrence	Cumulative Occurrence
13.7	63	5.2%	5.2%
13.8	57	4.7%	9.9%
13.9	34	2.8%	12.7%
13.6	28	2.3%	15.0%
15.1	23	1.9%	16.9%
13.5	21	1.7%	18.6%
15.8	20	1.6%	20.3%
15.9	20	1.6%	21.9%
13.1	18	1.5%	23.4%
14.2	18	1.5%	24.9%
14.3	18	1.5%	26.4%
15.2	18	1.5%	27.9%
15.6	18	1.5%	29.3%
15.5	17	1.4%	30.8%
14.4	16	1.3%	32.1%
14.6	16	1.3%	33.4%
14.8	16	1.3%	34.7%
15.4	16	1.3%	36.0%
23	16	1.3%	37.3%
13.4	15	1.2%	38.6%
14.7	15	1.2%	39.8%
14.1	14	1.2%	41.0%
10.9	13	1.1%	42.0%
13.2	13	1.1%	43.1%
15.3	13	1.1%	44.2%
21.4	13	1.1%	45.3%
22.9	13	1.1%	46.3%
13	12	1.0%	47.3%
14.5	12	1.0%	48.3%
21.8	12	1.0%	49.3%
22.4	12	1.0%	50.3%

The PE range with their probability of occurrence will be fed into the Monte Carlo model, together with the earning estimates and their happening rate in accordance with different recovery pattern.

The simulation results will be reviewed in Part III of this series.

Stay Safe!

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.