Friday, 26 March 2010

KNM Group: Hold, target price 90 sen

HWANGDBS Vickers Research has maintained a "hold" call on oil and gas firm KNM Group (7164), with a price target of 90 sen.

"Although current share price offers a potential 17 per cent upside to the proposed offer price of 90 sen per share, we are keeping the call at this juncture, having taken into consideration several risk factors," the stockbroker said in a March 23 report.

The risks include a potential lower offer price, a higher risk on earnings; and negative investor's sentiment on the stock.

"To the disappointment of many investors, KNM announced to the exchange at market close yesterday that BlueFire Capital Group (Bidco) has yet to conclude its discussion with the firm," it noted.
The brokerage was referring to the offer from Bidco, an entity controlled by KNM Group's founder Lee Swee Eng and two foreign funds, to buy the entire business and undertakings of KNM Group.

The board of directors of KNM has not extended the exclusivity period granted to Bidco to undertake due diligence and satisfy the other conditions of the proposal, but both parties have agreed "to endeavour" to conclude discussions by April 16.

"We view this news negatively and think this could be a sentiment dampener on the already weak share price. The announcement may raise concerns of whether the proposal will materialise.

"In addition, there is also the possibility of a lower revised offer price from Bidco, considering the provision for foreseeable losses and asset write-downs undertaken by the company in its recent fourth quarter 2009 results announcement," the report said.

Two years ago, KNM was riding high.  It was the darling of investors.  Its price was rising at dizzy pace and those who bought the shares gained hugely.  Oil price was high and the industry was bullish.  KNM was well placed to benefit from the industry's good fortune.  It was growing very fast and was actively acquiring companies in related fields.  Though highly profitable with good profit margin, the fast growth required funding with new shareholders' capitals and debt.  Through the many acquisitions, the balance sheet of KNM carries a large non-tangible asset value and debts.  Its biggest acquisition of Borsig was however poorly timed and it coincided with the global financial crisis of 2008.

The oil and gas industry was similarly affected.  The oil price plunged reflecting the supply-demand forces prevailing for this period.  Investment in this industry slowed to a trickle.  Likewise, contracts were canceled, delayed or postponed.   Revenues and earnings in KNM fell substantially.  Though the whole year earning was positive with positive cash flow, the last quarter's earning was a negative; this is worrying.  The management contention that earnings will be positive next year is hardly cast in stone.

There is no doubt that KNM's business fundamentals has deteriorated.  The questions posed:

  • Will this be temporary or will this be permanent?
  • How long will the oil and gas sector take to recover, and with it KNM's fortune?
  • Will KNM be able to service and pay its debts with its present level of earnings?
  • Will KNM survive this trying period to emerge strong again after this period?

At a price of 80 sen per share, KNM's market capitalization was around MR 3 billions.  Its NAV is just below 50 sen.  It's market price is still at a premium to its NAV.  More interestingly, or worrying, its NTA is just about 4.7 sen, reflecting the large amount of goodwill in its balance sheet.

The offer to take KNM private at around 90 sen has introduced another factor into the pricing of KNM shares.  If not for this (still an uncertain) offer, the price of KNM might be much lower in the market.

However, for those looking to buy into KNM, given the large uncertainty and risk, a discount of less than 20% to the 90 sen based on the present price is hardly enticing.   Should you sell then?  The upside is at best capped but there is also significant downside risk if the offer to take it private did not materialise at 90 sen.  Your assessment of the upside reward/downside risk ratio would guide you to make this decision.

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