Willas-Array Electronics (HKG:0854, SGX:BDR)

Willas-Array Electronics Holdings (HKG:0854, SGX:BDR) is a distributor of electronic components. The company distributes more than 10,000 product items that are used in the industrial, audio and video, telecommunications, home appliances, lighting, EMS and automotive segments. Willas Company was established by Mr. Leung Chun Wah in 1981 and Array Electronics by Mr. Kwok Chan Cheung in 1982. The two companies merged in 1992.

Insider ownership

Mr. Leung and Mr. Kwok are still on the Board of Directors today and have a substantial ownership stake in Willas-Array Electronics. Mr. Leung is a beneficial owner through a discretionary trust that owns 24.9% of the outstanding shares (his family members are the other beneficiaries) and Mr. Kwok owns 10.5% of the outstanding shares through an entity called “Global Success”.

The business of Willas-Array operates with razor thin margins. In the last few years their net margin has hovered around 1%. In fiscal 2015 revenue was $3.4 billion HKD or about $440 million in US Dollars. The company describes itself as one of the largest premier distributors of electronic components. They have a network of offices in China and a subsidiary in Taiwan.

Despite their sizable operations, Willas-Array has a very small market cap of just $227 million HKD ($29.3m USD):

Share price: $3.00 HKD
Outstanding shares: 75,505,960
Market cap: $227m HKD
Shareholders’ equity (March 31, 2015): $662m
Cash: $306m
Total liabilities: $1,108m
Trust receipt loans: $506m
Bank loans: $190m
Net income: $30.2m
Fiscal 2015 P/E: 7.5x

Debt / Trust receipt loans

One of the first things I noticed is that Willas-Array has a substantial amount of debt on the balance sheet. And what are those “trust receipt loans” exactly? This quote gave me some idea:

“A trust receipt is a written legal document between a bank and a person borrowing from that bank. It states that the bank will give merchandise to the borrower but the bank will still retain the title to the merchandise and can repossess it if the buyer does not uphold the terms decided upon in the trust receipt. The borrower must keep the merchandise and any profits made from that merchandise separate from normal business expenses and if the bank repossesses the items, the borrower will return the items or the money made from selling the merchandise. Typically, items used in trust receipts are large items with serial numbers that are easy to record and keep track of. For example, automobiles, TVs, large appliances, and trailers can all be given to a borrower by signing a trust receipt. The borrower then promises to pay the loaner back an amount of money worth the property loaned to him.”
Source: http://www.wisegeek.com/what-is-a-trust-receipt.htm

So usually trust receipt loans are used when large items are involved, like cars and TV’s, but in Willas-Array’s case the products are very small in size. I think that the relatively high volumes in this industry basically forces distributors like Willas-Array to take on a substantial amount of debt. I’m not familiar with these types of businesses, but I think a comparable industry might be convenience store distributors like AMCON Distributing (DIT) and Berkshire owned McLane. I have owned AMCON in the past and remember that they also operate with a substantial amount of debt.

The only way to survive in an industry like this is to be consistently profitable. And Willas-Array has been able to deliver on that front. Since 1981 the company has only lost money in one year: 2009. They decided to clear some inventory and dropped their prices in that year. In the last decade profits have mostly been around $30-$40m HKD. Around $20-25m of that was paid out as a dividend to shareholders each year, with the exception of 2009, the year they showed a loss.

Why is it cheap?

Currently Willas-Array is trading at 0.34x the last reported book value and less than 8x earnings. That seems extremely depressed. A chart of the stock price also shows a steep decline this year. What’s going on?

The answer seems pretty clear. In August 2015, the company issued a profit warning. Willas-Array said it expected a loss for the six month period ending September 30, due to losses in an associated company. The associate in question is GW Electronics. In September 2015 the company made another announcement: Toshiba had terminated the distributorship agreements with GW Electronics. Since most of the GW Electronics revenue came from the distribution of Toshiba semiconductor products in mainland China and Hong Kong, this was a very negative development for this associate.

GW Electronics is a joint venture:: Willas-Array owns 49% and the other 51% is owned by G.M.I. Technology, an electronics distributor based in Taiwan and listed on the Taiwan Stock Exchange. GW Electronics began operations in 2012 and Willas-Array made various capital contributions in the next few years. The investment is currently in their books for $82.5m.

More details about GW Electronics can be found on pages 139-141 of the 2015 annual report. On March 31 2015, GW Electronics had $97m in cash and $268m in financial liabilities (excluding trade and other payables and provisions). They also had current assets of $650m. I don’t know how much of that amount was inventory and how much were receivables.

GW Electronics will return the Toshiba inventory to Toshiba. From the termination announcement:

“Pursuant to the Agreements and the Termination Notices, GW Electronics will return the existing inventory of “Toshiba” brand of semiconductor products to Toshiba subsequent to the Termination.”

If the company can return the Toshiba inventory and get reimbursed it seems to me that the termination will not be a huge disaster to Willas-Array itself. GW Electronics might not be viable anymore and Willas-Array’s investment of $82.5m will end up being impaired or perhaps even worthless.

GW Electronics plans to downsize and seek other business opportunities:

“As the Termination results in the loss of GW Electronics’ major distribution authorisation, it is intended that GW Electronics will downsize its operation to an optimum level to serve its existing product lines. GW Electronics also intends to continue to seek other business opportunities, such as obtaining authorised distributorship rights from other brands of electronic components.”

Willas-Array has also issued a guarantee to banks that provided loans to GW Electronics. From page 163 of the 2015 annual report:

“At March 31, 2015, the Company had given corporate guarantees (unsecured) of approximately HK$167,340,000 (2014: HK$156,447,000) to its banks in respect of banking facilities granted to its associates, of which HK$131,393,000 (2014: HK$112,342,000) banking facilities have been utilised by its associates.”

So there is the potential for the damage to be a lot greater than an impairment of their investment in GW Electronics.

Important to note is that G.M.I Technology owns the other 51%, so I think they will share in potential losses if the liabilities of GW Electronics end up being greater than their assets. I have only looked at the financials of G.M.I. on FT.com, and their financial position looks pretty weak, so that might become a problem if things turn really sour.

Conclusion

I don’t think there is enough information at this point to get an accurate picture of the precise damage of the GW Electronics situation. That uncertainty is probably also the reason why Willas-Array is trading at just 0.34x of the last reported book value and less than 8x last reported earnings. Obviously that book value is probably inflated somewhat because their investment in GW Electronics is impaired. Even if we write-off the full investment, Willas-Array is still only trading at 0.39x book value.

I don’t think there is a reason at this point to assume that the core business of Willas-Array is affected and that the problems will spread. In the August profit warning the company talks about a positive result for the core business (emphasis mine):

“[…] the Company’s share of loss of its associated companies, which will likely offset the overall positive result of the Group’s core business, this is expected to result in an overall net loss for the Group on a consolidated basis for the six months ending September 30, 2015.”

It is possible that they will break a loan covenant (they are not specified in the annual report), but if they are able to show that this problem is isolated to GW Electronics, I don’t think it should pose a problem.

It could be that the termination of the agreement by Toshiba is a sign of the slowdown of the Chinese economy and that this slowdown will also start to affect Willas-Array’s core business. In that case, if they can’t adjust their business quick enough, they might have a problem. Given the fact that Willas-Array is primarily a distributor I think they should be able to scale back rather quickly.

The long history of profitability and the large ownership of the management does give me some confidence that the business will be able to successfully navigate the ebbs and flows of the business cycle.

Willas-Array is not a high quality compounder by any means and free cash flow has been pretty weak and lumpy at times. Book value hasn’t increased all that much in the last few years if you adjust for a gain in property value and a likely impairment of the GW Electronics investment. But the company has consistently paid dividends. The current valuation does seem very depressed. I think the business can get through the troubles taking place at their associate and live to fight another day. That might be all that is needed to get a good investment outcome here.

A couple of other notes:

• The company did a 1:5 share consolidation (reverse split) in August 2015. Investors received 1 share for every 5 shares he/she had previously. Often share consolidations are done for no good reason, but here it was done to comply with a minimum trading price rule in Singapore. Keep this in mind when looking at annual reports and other filings.
• Willas-Array has a dual listing. The company has been listed in Singapore since 2001 and it has obtained a dual listing in 2013 on the Hong Kong Stock Exchange. That is a bit strange for such a small company, because the IPO cost them around $20m HKD I believe, which is a lot for them. They said the reasons were: greater exposure to potential investors in China and Hong Kong, which has become an important part of their business and ready access to two different equity markets. I do think that it makes more sense for them to be listed in Hong Kong given their operations, but I don’t know if it was worth the cost.

Disclosure: long Willas-Array Electronics (HKG:0854)