I make another re-examination to SRIL. The more attractive it looks, the more I doubt it. I have this mentality to keep the question, 'what if the market is right?' on the back of my mind. A lingering question remains, "How is it possible that the fact is the market has been persistently valued SRIL just close to its adjusted book value?"
The fact is, the market has been valuing SRIL for just its book value without expecting any added-value, which is to say that EV/Capital (think as this like PBV) has been hovering close to one.
Based on this fact, and the sensitivity of SRIL's EVA towards WACC, I adjust WACC accordingly to better reflect market assessment. That is, I now choose WACC of 13% which produces EVA margin to 0%, the definition of no value-added. If you employ CAPM with a 'reasonable' look-back period in estimating beta, you would be likely to find SRIL WACC somewhere around 9-10%. But, why stick to a flawed theory (CAPM) when you could explain your data in a much more meaningful way?
I'll bring up again my previous EVA calculation which assumes WACC to be 11% vs this time around using 13%. There is a slight revision in which now I add forex gains/losses into SRIL's operating profit. This FX revision made the overall performance of Q3 2019 in the last twelve months worse.
This picture says that charged with the cost of capital of 13%, SRIL business tends to just break-even in good days and becomes value destroyer in bad times as it did in 2018 when USD was at its highest relative to IDR.
Thus, it is reasonable that the market usually views SRIL as a wealth neutral company which in number means EV/Capital is close to 1, just like the first chart.
This case reminds me again of why I still reserve a line for ROIC in my spreadsheet.
ROIC is directly tied to EVA, and therefore value, but without the need to estimate WACC. Just by looking at ROIC data above, one could easily tell that SRIL tends to be a wealth neutral company – not great, but not bad either considering most Indonesian public companies face cost of capital in the range between 9%-14%.
Looking at charts is a great way to gain perception, but anyone who employs EVA metrics should be careful not to overinterpret a company when its ROIC is close to its cost of capital. In SRIL case, given the ROIC data above, I would conclude that SRIL is a value-neutral company. Even if EVA turns negative in 2018, that does not change this general view. But certainly, 2018 was the worst year for the past 5 years.
The way I see it, the ongoing downward pressure on SRIL share price is a lagging reaction to a bad condition in 2018. Consider this: in 2018, EVA went down a lot, and if we use WACC of 13%, SRIL's EVA would turn badly that EVA margin would be negative 2%. But the market stood still and kept valuing SRIL as a value-neutral company. This confidence has to be earned by the company.
A fire in the warehouse then happened in mid-2019. That's where the confidence falters. Investors then judged that they were being too lenient on SRIL which then readjust their valuations downward. Then comes coronavirus incidence which possibly made it worse.
The point is, this lack of confidence has its roots in actual SRIL performance in 2018, which is bad. Net income, per usual, missed this picture completely.
But I would argue that investors have taken it too far now. At the current price, investors effectively view SRIL as a wealth waster and expect EVA to crash. I will show you again the implied expected EVA growth that justifies the current share price below. That view is in contrast with the fact that SRIL's real performance bounced back nicely in 2019. The key factor driving this improvement is in the better gross margin which is to be expected when IDR strengthens and made imported raw materials cheaper.
From the Q3 financial statement footnotes, the impact of fire accident has been recorded in Q3 2019. As far as my calculation goes, the impact is negligible to EVA. The impact of weaker dollar far exceeds the bad news from the fire incident. But I'm not sure. Who knows, right? Maybe that was not all there is to it. Maybe the market has already sniffed that something horribly wrong is going on. Knowing this, I'm betting against the market judgment.
One more thing. I'm getting tired of hearing talks that SRIL is in trouble because its debt is huge. I would say that it is far more productive thinking a company's performance in terms of EVA. If EVA falls a lot, it is bad. If EVA is persistently negative, then the company could not generate enough profit to cover its capital cost which is financed by both shareholders and debt holders, and that means the company destroys value. Contrary to what many people believe, EVA does not make things more difficult. It makes things clear, consistent, and simple.
But let me indulge this debt worries a bit. How much debt is too much? The answer to that is relative. Relative to what? There are several ways to answer this. I prefer comparing it to equity portion. It goes like this: Imagine you have IDR 100 Million debt. Is that really big? What if it turns out you own IDR 5 Billion cash in your bank account? That debt does not look so big now. It's a matter of proportion.
A company's capital consists of money from debt holders and equity holders. SRIL's debt portion to its capital has always been high, above 50%. And the fact is, SRIL debt to capital has been declining, especially since 2016. Although debt has been increasing in absolute value, capital from equity rises more quickly. But of course, that alone does not mean anything. I could show you a company or two that has almost no debt, but its EVA is like a black hole. That company, of course, is very risky regardless of its debt level. I firmly believe that investors are much better off looking at how risky a business is in terms of EVA. Think about it like this: A company that is in a lot of trouble because it can't service its debt is a company that has negative EVA, and most likely has been in that condition for years. By the time the debt has become so much trouble, it is too late for its investors. EVA gets it much earlier.
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