Financial Engineering – From 1.5m to 40m in 11 months

This post traces a sequence of buy and sell transactions to show you how an initial investment of 1.53m became 40m worth in just 11 months.

I came across this company, 8I Holdings Ltd, that provides training to the public in Value Investing in Singapore. The Company went IPO in December 2014 with opening price of AUD $0.25 per share. At today’s share price of $0.88 per share, the return is 252% in 1.5 years. Its market cap is AUD 314m, not a tiny company.

It just released its Annual Report 2016 today with FY16 revenue SGD 22.2m, other income 10.6m, and net profit 18.8m. With AUD-SGD exchange rate nearly at 1.0 now, it makes comparison much easier.At today’s share price, the P/E is 16.7x, not a ridiculous multiple. But, when you read the report in details, you will raise more questions, BIG questions.

Extraordinary Gains in FY16 results

8I - Financials FY16

8I - Revenue details FY16

Source: 8I Holdings’ FY16 Accounts

From FY16 accounts above, out of the 22.2m revenue, 9.44m came from sale of associate’s shares. Out of the 10.6m other income, 9.16m came from gain on re-measurement of investment retained in former associates to fair value after partial disposal. Both of these gains are from the same associate, CPA Academy Pte Ltd (CPA). That’s a total of 18.6m that we are talking about, against net profit of 18.8m. If we subtract this extraordinary gains of 18.6m from the profit before tax of 20.26m, it’s left with 1.66m profit before tax. Therefore, it’s very important to understand what these gains are about.

 

Transactions (or Financial Engineering?)

This is the sequence of transactions by 8I Holdings to buy part of CPA and sell part of it for higher and higher prices in less than 12 months.We are not talking about 50% higher prices. We are talking about 21x higher prices in 4 months difference.

Date Company

 

Txn of
Shares
Txn
Amt $
Total
Value $
Notes
23-Jan-15 CPA 51.00%  1.53m  3m Bought 51% of CPA for SGD $1.53m.
This values CPA at $3m (P/E 5.77x).
CPA FY2014 revenue 1.9m, net profit 520k.
31-Mar-15 CPA 20.00%  4.5m  22.5m Sold 20% from 51% of CPA for SGD $4.5m to Champion Star United Inc.
This values CPA at $22.5m (P/E 43.27x).
The value of CPA increased from 3m to 22.5m (7.5x) in 2 months.
The remaining 31% of CPA is valued at $6.975m now.
25-May-15 Digimatic 14.31%  10m  69.9m Swapped 31% of CPA with 28.18% of Digimatic (134.571m shares).
Digimatic’s total number of share is around 477,540,809 shares (subject to rounding error).Sold 68.320m shares of Digimatic for S$10m to Champion Star United Inc.
This values Digimatic’s share at 0.14637 per share.
Total value of Digimatic = S$69.897m.
Total value of initial holding of 134.571m shares of Digimatic = 19.697m.
The remaining 66.251m shares of Digimatic is valued at S$9.697m.This values 31% of CPA at 19.697m, implying total value of 63.54m (P/E 122x).
The value of CPA increased from 22.5m to 63.54m (2.8x) in 2 months or from 3m to 63.54m (21x) in 4 months.
CPA 31%  19.7m  63.5m
16-Dec-15 Digimatic 80m
shares
@
0.395 per share
 31.6m  270m Digimatic proposed to offer 80m shares at AUD $0.20/share to raise AUD $16m at IPO.
FY2015 revenue SGD $5.894m, net profit 718k (excluding waive of loan of 520k).
IPO on 16 Dec 2015 with opening price 0.33 and closing price 0.395 per share.
Total number of shares after IPO is 683,664,000.
Total value of Digimatic at closing price 0.395/share = AUD $270m.
The value of Digimatic increased from S$69.897m to A$270m in 7 months. The remaining 66.251m shares of Digimatic is valued at AUD $26.169m, increased from S$9.697m 7 months ago.

In summary, 8I Holdings bought 51% of CPA for 1.53m, valuing CPA at 3m. Two months later, it sold 20% from the 51% of CPA for 4.5m cash, valuing CPA at 22.5m. Two months later, the remaining 31% was swapped with 28.18% of Digimatic, worth 19.697m, implying value of 63.54m for CPA. It sold 14.3% from this 28.18% of Digimatic for 10m cash. When Digimatic went IPO in December 2015, the value of remaining shares in Digimatic rose from 9.697m to 26.169m.

If that summary sounds complicated to you, then this is a shorter summary: 8I Holdings bought 51% of CPA for 1.53m, sold 20% for 4.5m cash, sold 15.74% for 10m cash and balance 15.26% was worth 26.169m. The 1.53m investment became 40.669m (13.5x) in 11 months.

Initial investment: 1.53m cash

Gains: $4.5 (cash) + $10m (cash) + $26.169m (quoted shares) = 40.669m.

The value of CPA increased from 3m in January 2015 to 22.5m in March, and to 63.54m in May, in which it was swapped with Digimatic’s shares. In December, on Digimatic’s IPO, the value of Digimatic’s shares equivalent to CPA would have been worth ~170m. From 3m initial valuation to 170m valuation, that’s 57x in 11 months!

The report said CPA and Digimatic did some restructuring, but no amount of restructuring could increase the value by 21x in 4 months (and 57x in 11 months) when the fundamental business model remains the same. I don’t know what kind of restructuring they did apart from changing the Company’s name. This whole deal looks to me more like financial engineering and gross overvaluation in subsequent transactions.

One could argue that CPA was undervalued at 3m at the first transaction as it generated a net profit of 520k in previous year, for a low P/E of 5.77x. Ok, let’s assume that it’s undervalued at 3m. Two months later, it’s valued at 22.5m for P/E of 43.27x, certainly a high valuation multiple. Two months later again, it’s valued at 63.54m for P/E of 122x, a ridiculous valuation multiple.

In the second transaction, why would the buyer pay 4.5m for 20% shares of CPA after knowing that the seller bought that 20% for just 600k two months earlier?

In the third transaction, why would the same buyer from second transaction buy additional shares of CPA at the price that is 2.8x the price it paid just two months earlier?

Who is this buyer? Champion Star United Inc. I can’t find any public information about this Company. A quick Google search points to a Bloomberg page that states Champion Star United Inc was incorporated in 1982 and is headquartered in British Virgin Islands.

Perhaps, they have anticipated the subsequent IPO of the restructured company, Digimatic, that could be priced at very high valuation. But, when the restructuring took place in May 2015, Digimatic was already valued at $69.9m. From Digimatic’s IPO prospectus (see the table at the end of this post), FY14 net profit was 501k and FY15 net profit was 192k, a sharp drop from the previous year. That makes the P/E way above 100x. Did they expect FY16 to achieve super exponential growth in net profit or that the public was willing to pay even higher valuation multiple when it’s listed? Unfortunately, the latter happened.

What is CPA Academy Pte Ltd?

It was established in July 2013 by one man team to provide digital marketing seminars and workshops to teach the public how to do digital marketing. Attendees at the workshop could be charged S$3,888 per person for a three day course.

You can find more about this Company at their website’s about us page. At the point of restructuring in May 2015, it was just a two-year old Company with a team size of fewer than 10 people.

In 8I Holdings’ press release on the acquisition of 51% stake in CPA, it mentioned that CPA’s net profit after tax was 520k with revenue of 1.95m for 2014 financial year. In Digimatic’s IPO prospectus, CPA was renamed to Digimatic Media Private Ltd (DMPL). Its audited financials for FY14 and FY15 are shown in the table below, extracted from the IPO Prospectus. FY14 net profit was 501k on revenue of 981k, and FY15 net profit was 192k on revenue of 1.8m. This is very small amount of revenue and profit.

Digital Marketing Business

Digital marketing is getting popular worldwide in the past few years with the rise of social media as people spend more and more time online. Many companies are setup to ride on this bandwagon and provide digital marketing services. I attended a few short workshops before to understand how they work. At every workshop, the trainer would self-proclaim as the best in the market. This is not a surprise, considering that the trainers are marketers themselves.

One bad thing about digital marketing business is that it has extremely low entry of barrier. Everyone can attend the competitor’s workshop, learn the skills and setup a company to conduct training to the public at a lower rate. CPA Academy was started that way by only one guy and expanded to a bigger team later. There are many others that started in the same way. The startup capital is also very low. With less than $50k (probably even lower), one can start this business.

In digital marketing, the online advertising platforms are those big giants, like Google, Youtube, Facebook, etc. These platforms earn advertising fees when online users click or see the ads. The digital marketers provide services to increase the click-through rates of the ads or increase the conversion rates of visitors to paying customers. They do not own the advertising platforms. Thus, the fees they earn are after paying those platforms the advertising fees. They earn based on the performance of the ads in generating additional sales.

The platforms, such as Google Search and Facebook, could change their algorithms to display the ads and they do so every now and then. So, one effective digital marketing strategy that worked well last year may not work this year. The digital marketers have to always keep up with the latest trend and update their strategy from time to time.

So, this is a business that has very low barrier of entry, many competitors, subject to price war, and has to constantly update their strategy. It’s very hard to build a competitive advantage when the strategy has to keep changing every year, and the competitors can easily imitate your strategy. High competition also bid up the advertising fees that those platforms charge, leaving less for the digital marketers to earn.

On the flip side, the advantage is that this business is easy to setup with low capital, and when it secures a big contract with the advertisers, it can scale up without much additional capital investment.

However, don’t expect this business to have a super growth potential, like Google’s and Facebook’s. These technology giants were priced at very high valuation at their IPO because they could scale to multi-billion dollar business and they already had a very recognizable brands and large number of users. Digital marketers are earning portion of the advertising dollars after paying these giants and could be replaced by the competitors in the following year. Therefore, it’s hard to set high valuation multiple, e.g. > 100x, for digital marketers, expecting them to have exponential growth for the next several years.

Aftermath of Digimatic’s IPO

Digimatic’s share price has fallen from 0.395 at IPO to 0.14 today, suffering 65% fall in 6 months. At current price of 0.14, the market cap is $95.7m. Based on FY2015 net profit of 718k, that’s P/E of 133x, still a ridiculous multiple after 65% fall!

It will release its preliminary FY16 results on 31 May 2016. I don’t know this business well and can’t forecast the earnings. I suppose the operating income could rise and fall substantially from year to year. If it does report a super growth in earnings, do check its financial statement to see if there is any extraordinary gains from the sale of business or revaluation of the subsidiaries, like what 8I Holdings did with its transactions in CPA.

Even if Digimatic more than quadruples its net profit from 718k to 3m (core operating profit, excluding any one-off gain, etc) this year or next year (I doubt they could), this won’t justify market value of $95m. This is not a business where Digimatic has a clear leadership position and possesses a network effect, in which the winner takes all.

Existing shareholders should expect a very rough ride with the share price. They might see the Company announcing exciting transactions or restructuring deals here and there, like what Digimatic has been doing in the past 6 months. Whether or not these transactions could create value for shareholders is very questionable.

This is Digimatic’s financials, extracted from the IPO Prospectus.

Digimatic - Financials FY15

Digimatic - Segmental Financials FY15

Source: Digimatic Group’s IPO Prospectus

Who are the winners in this whole deal?

The founders of CPA sold 51% stake for 1.53m. The remaining 49% was transferred to Digimatic, which was listed subsequently. They received cash for the first sales and then quoted securities worth many millions. The main founder, Ivan Ong, holds 60.83m shares of Digimatic, as stated in its IPO Prospectus. At current price of 0.14, this stake is worth 8.5m. In less than 3 years since founding the Company, the founders created more than 10m for themselves.

8I Holdings paid just 1.53m for 51% stake in CPA. It received 4.5m and 10m cash for subsequent sales of part of that stake. The remaining stake, swapped with Digimatic’s shares, is worth nearly 10m at current Digimatic’s share price of 0.14 (was worth 26.1m at the time of IPO price of 0.395). In 1.5 year, they turned 1.53m to nearly 24.5m.

Champion Star United Inc (CSUI) paid 4.5m cash for 20% stake in CPA. It paid another 10m cash for 68.32m shares of Digimatic, or equivalent to 15.74% of CPA. Digimatic’s IPO Prospectus shows that CSUI owns 155.14m shares of Digimatic, which is worth 21.7m at today’s share price of 0.14 (was worth 61.3m at the time of IPO price of 0.395). In less than 1.5 year, they turned 14.5m to 21.7m.

Shareholders who bought Digimatic’s shares at IPO. They could have bought at anything between the opening price of 0.33 and the closing price of 0.395. At current price of 0.14, they are sitting on the loss of 55% to 65%.

So, everyone wins except the public investors who bought Digimatic’s share. In this whole financial engineering, money was created and transferred to the hands of the financial engineers, paid by the ignorant public, who bought at IPO or some time after that.

 

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4 thoughts on “Financial Engineering – From 1.5m to 40m in 11 months

  1. Likely Champion Star United Inc (CSUI), is formed by pool of students. They are using an offshore company to go around the MAS CIS code, collective investment scheme.

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