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DoucSign (NASDAQ: DOCU) is one of the 50-plus companies that’s in my family’s portfolio. I first bought DocuSign shares for the portfolio in December 2018 at a price of US$41 and I’ve not sold any of the shares I’ve bought. 

The purchase has worked out very well for my family’s portfolio thus far, with DocuSign’s share price being around US$79 now. But we’ve not even owned the company’s shares for two years, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to hold DocuSign shares.

Company description

DocuSign provides DocuSign eSignature, currently the world’s leading cloud-based e-signature solution. This software service enables users to sign a document securely using almost any device from virtually anywhere in the world. It is the core part of the broader DocuSign Agreement Cloud, which is a suite of software services – again all delivered over the cloud – that automates and connects the entire agreement process. DocuSign Agreement Cloud includes:

• Automatic generation of an agreement from data in other systems; 
• Support of negotiation-workflow; 
• Collection of payment after signatures;
• Use of artificial intelligence (AI) to analyse agreement-documents for risks and opportunities; and 
• Hundreds of integrations with other systems, so that the agreement process can be seamlessly combined with other business processes and data

At the end of its fiscal year ended 31 January 2020 (FY2020), DocuSign had over 585,000 paying customers and hundreds of millions of users. From its founding in 2003 through to FY2019, the company had processed over 1 billion successful transactions (around 300 million in FY2019 alone). DocuSign defines a successful transaction as the completion of all required actions (such as signing or approving documents) by all relevant parties in an Envelope; an Envelope is, in turn, a digital container used to send one or more documents for signature or approval to the relevant recipients.

DocuSign serves customers of all sizes, from sole proprietorships to the companies that are among the top 2,000 publicly-traded enterprises. The company’s customers also come from many different industries, as the chart below illustrates.

For a geographical perspective of DocuSign’s business, its users are in over 180 countries. But in FY2020, 82% of the company’s revenue came from the US. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for DocuSign.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Has it ever occured to you that the innocuous act of signing documents with pen-and-paper can actually be a significantly wasteful activity for companies? The thought struck me when I was doing research on DocuSign before I bought its shares. Think about it. Signing a paper document requires you to fax, scan, email, snail-mail, courier, and file. DocuSign’s solution can save us both time and money.

There are many use-cases for DocuSign’s software services, ranging from sales contracts to employment contracts, non-disclosure agreements, and more. In fact, DocuSign has a customer that has implemented over 300 use-cases. DocuSign documents are legally accepted and protected with cryptographic technology from tampering. The documents also have a full audit trail, including party names, email addresses, public IP addresses, and a time-stamped record of each individual’s interaction with a document.

DocuSign estimated that it had a total addressable market of US$25 billion in 2017, using (1) the number of companies in its core markets, and (2) its internal estimate of an annual contract value based on each respective company’s size, industry, and location. This estimate remains unchanged (it was mentioned in the company’s FY2020 annual report), though recent business moves may have significantly expanded its addressable market. More on this later. At just US$974.0 million, DocuSign’s revenue in FY2020 is merely a fraction of its estimated market opportunity.

I believe that DocuSign’s addressable market will likely grow over time. There are clear benefits to e-signatures. A 2015 third-party study by Intellicap (commissioned by DocuSign) found that the company’s enterprise customers derived an average incremental value of US$36 per transaction (with a range of US$5 to US$100) when using the company’s software as compared to traditional paper-processes. In FY2020, 82% of all the successful transactions that flowed through DocuSign’s platform were completed in less than 24 hours, while 50% were completed within just 15 minutes. DocuSign’s services help companies save money and time.

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 January 2020, DocuSign held US$895.9 million in cash, short-term investments, and long-term investments. This is nearly twice the company’s total debt of US$465.3 million (all of which are convertible notes). For the sake of conservatism, I also note that DocuSign had US$183.2 million in operating lease liabilities. But the company’s cash, short-term investments and long-term investments still comfortably outweigh the sum of the company’s debt and operating lease liabilities (US$648.5 million). 

3. A management team with integrity, capability, and an innovative mindset

On integrity

Leading DocuSign as CEO is Daniel Springer, 57, who joined the company in January 2017. Among other key leaders in DocuSign are:

• Scott Olrich, Chief Operating Officer, 48
• Michael Sheridan, Chief Financial Officer, 55
• Loren Alhadeff, Chief Revenue Officer, 41
• Kirsten Wolberg, Chief Technology and Operations Officer, 52

Most of them have relatively short tenure with DocuSign, but have collectively clocked decades in senior leadership roles in other technology companies.

DocuSign has opted not to share details about its compensation structure for senior management because of its status as an “emerging growth company.” And Springer’s total compensation for FY2019 was a princely sum of US$13.4 million. But I take heart in this: 94% of Springer’s total compensation in FY2019 came from stock awards, and around 70% of the stock awards vest over a period of four years. The multi-year vesting of the stock awards means that Springer’s compensation is tied to the long run performance of DocuSign’s stock price, which is in turn governed by its business performance. So I think Springer’s interests are aligned with mine as a shareholder of the company.

Notably, Springer also controlled 2.3 million shares of DocuSign as of 31 March 2019, a stake that’s worth a sizable US$211 million at the current share price.  

On capability

From FY2013 to FY2020, DocuSign has seen its number of customers increase more than 10-fold (41% per year) from 54,000 to 585,000. So the first thing I note is that DocuSign’s management has a terrific track record of growing its customer count.

To win customers, DocuSign’s software service offers over 300 pre-built integrations with widely used business applications from other tech giants such as salesforce.com, Oracle, SAP, Google, and more. These third-party applications are mostly in the areas of CRM (customer relationship management), ERP (enterprise resource planning), and HCM (human capital management). DocuSign also has APIs (application programming interfaces) that allow its software to be easily integrated with its customers’ own apps. 

I also credit DocuSign’s management with the success that the company has found with its land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through other use cases. The success can be illustrated through DocuSign’s strong dollar-based net retention rates (DBNRRs). The metric is a very important gauge for the health of a SaaS (software-as-a-service) company’s business. It measures the change in revenue from all of DocuSign’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more – DocuSign’s DBNRRs have been in the low-teens to mid-teens range in the past few years.

On innovation

I think DocuSign’s management scores well on the innovation front, since the company has been busy with using blockchain technology and AI to improve its services. 

Blockchain technology is the backbone of cryptocurrencies and DocuSign has been experimenting with blockchain-based smart contracts since 2015. In June 2018, DocuSign joined the Enterprise Ethereum Alliance and showed how a DocuSign agreement can be automatically written onto the Ethereum blockchain. Here’s an example of a smart contract  described by DocuSign:

“A smart contract turns a contract into something like a computer program. The Internet-connected program monitors data and triggers actions relevant to the contract’s terms. For example, a crop-insurance smart contract might use a trusted Internet feed of weather data. If the temperature goes above 85 degrees Fahrenheit in April, the smart contract will automatically trigger a crop-insurance payout, again via the Internet. This total automation eliminates ambiguity and promises large savings in time and effort for all parties involved.”

It’s early days for DocuSign’s use of blockchain, but I’m watching its moves here. DocuSign’s management acknowledges that many of the company’s customers don’t yet see the value of blockchain technology in the agreement process. But the company still believes in blockchain’s potential.  

DocuSign has been working with AI since at least 2017 when it acquired machine-learning firm Appuri during the year. In February 2020, DocuSign inked an agreement to acquire Seal Software for US$188 million. The acquisition is expected to close in the first half of DocuSign’s FY2021. Seal Software was founded in 2010 and uses AI to analyse contracts. For example, Seal Software can search for legal concepts (and not just keywords) in large collections of documents, and automatically extract and compare critical clauses and terms. Prior to the acquisition, DocuSign was already tacking Seal Software’s services onto DocuSign Agreement Cloud. The combination of Seal Software and DocuSign’s technologies have helped a “large international information-services company” reduce legal-review time by 75%. Ultimately, DocuSign thinks that Seal Software will be able to strengthen DocuSign Agreement Cloud’s AI foundation.

Speaking of DocuSign Agreement Cloud, it was released in March 2019. As mentioned earlier, it includes multiple software services. DocuSign sees DocuSign Agreement Cloud as a new category of cloud software that connects existing cloud services in the realms of marketing, sales, human resources, enterprise resource planning, and more, into agreement processes. 

I see two huge positives that come with the introduction of multi-product sales. Firstly, it will likely lead to each DocuSign customer using more of the company’s products. This means that DocuSign could be plugged into an increasing number of its customers’ business processes, resulting in stickier customers. Secondly, DocuSign thinks that covering a wider scope of the entire agreement process could roughly double its market opportunity from the current size of US$25 billion to around US$50 billion. 

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

DocuSign’s business is built nearly entirely on subscriptions, which generate recurring revenue for the company. Customers of DocuSign gain access to the company’s software platform through a subscription, which typically ranges from one to three years.  In FY2020, FY2019, and FY2018, more than 93% of DocuSign’s revenue in each fiscal year came from subscriptions to its cloud-based software platform; the rest of the revenue came from services such as helping the company’s customers deploy its software efficiently. 

It’s worth noting too that there is no customer-concentration with DocuSign. There was no customer that accounted for more than 10% of the company’s revenue in FY2020.

5. A proven ability to grow

There isn’t much historical financial data to study for DocuSign, since the company was only listed in April 2018. But I do like what I see:

A few notable points from DocuSign’s financials:

• DocuSign has compounded its revenue at an impressive annual rate of 40.4% from FY2016 to FY2020. The rate of growth has not slowed much, coming in at a still-impressive 38.9% in FY2020.
• DocuSign is still making losses, but the good thing is that it started to generate positive operating cash flow and free cash flow in FY2018.
• Annual growth in operating cash flow from FY2018 to FY2020 was strong, at 45.1%. Free cash flow has increased at a much slower pace, but the company is investing for growth. 
• The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
• At first glance, DocuSign’s diluted share count appeared to increase sharply by 30.7% from FY2019 to FY2020. (I only started counting from FY2019 since DocuSign was listed in April 2018, which is in the first quarter of FY2019.) But the number I’m using is the weighted average diluted share count. Right after DocuSign got listed, it had a share count of around 152 million. Moreover, DocuSign’s weighted average diluted share count showed acceptable year-on-year growth rates (acceptable in the context of the company’s rapid revenue growth) in the first, second, and third quarters of FY2020.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

DocuSign has already started to generate free cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 4.5%.

But over the long run, I think it’s likely that there is plenty of room for DocuSign’s free cash flow margin to expand. I showed in my recently published investment thesis for Alteryx (NYSE: AYX) that there are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems that have much fatter free cash flow margins. Here’s the table I showed in my article on Alteryx:

Valuation

Right now, DocuSign has a market capitalisation of US$14.34 billion against trailing revenue of US$974.0 million. These numbers give rise to a price-to-sales (P/S) ratio of 14.7, which makes the company look pretty darn expensive. For perspective, if I assume that DocuSign has a 30% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 49 based on the current P/S ratio (14.7 divided by 30%). 

But DocuSign also has a few strong positives going for it. The company has: (1) revenue that is low compared to a fast-growing addressable market; (2) a business that solves important pain points for customers; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that DocuSign will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in the years ahead. 

The current high valuation for DocuSign does mean that its share price is likely going to be more volatile than the stock market as a whole. I’m also keeping in mind that stocks have been very volatile of late because of COVID-19 fears. But the potential volatility is something I’m very comfortable with.

The risks involved

DocuSign has a short history in the stock market, given that its IPO was just two years ago in April 2018. I typically stay away from young IPOs. But I’m making an exception for DocuSign because I think its business holds promise for fast-growth for a long period of time. But the company’s young age as a publicly-listed company is still a risk I’m watching.

Adobe is a much larger SaaS company with trailing revenue of US$11.7 billion. Through its Adobe Sign product, Adobe is the primary competitor of DocuSign. So far, DocuSign has defended its turf admirably. This is shown in DocuSign’s strong revenue and customer growth rates. But Adobe’s larger financial might compared to DocuSign means competition is a risk. 

Another important risk for DocuSign relates to data breaches. DocuSign handles sensitive information about its customers due to the nature of its business. If there are any serious data breaches in DocuSign’s software services, the company could lose the confidence of customers and the public, leading to growth difficulties. The signing of documents may be highly time-sensitive events. So if there is any significant downtime in DocuSign’s services, it could also lead to an erosion of trust among existing as well as prospective customers. So far, DocuSign has done a great job by providing 99.99% availability in FY2020. 

Valuation is another risk to consider. DocuSign’s high P/S ratio means that the market expects rapid growth from the company. So if the business performance disappoints subsequently, market sentiment could turn quickly on DocuSign, leading to a cratering stock price.

Earlier, I discussed the advantages that the launch of DocuSign Agreement Cloud brought to the company. But there are downsides too. For instance, multi-product sales involves higher complexity and a longer sales cycle; these factors negatively affected DocuSign’s billings growth and net dollar-based retention rate in the first quarter of FY2020. The ongoing COVID-19 pandemic has caused business activity around the world to slow tremendously, with many countries being in various states of lockdown. A lengthy sales cycle could hamper DocuSign’s business in the current environment. For now, DocuSign’s business does not seem to have been impacted by COVID-19. Here’s CEO Dan Springer’s comment on the matter in DocuSign’s FY2020 fourth-quarter earnings call:

“[T]he vast majority of our implementations are done remote. And of course, if you think about the perfect example of that it’s our web and mobile customers, where they never actually have to speak. Not only do they don’t have to have us in person they don’t need to speak to us to onboard. … We do find with some of our larger enterprise customers that they get more value when some of the installation is done on their premises. But we have not had the opportunity in the past to consider doing that completely remotely. And it may be in the new way of business over the next X period of time here then we’ll do more of it.”

And when DocuSign’s management was asked in the same earnings call if its growth would be affected by a recession, Springer answered:

“Yes, I don’t. Because, I think, for most of our customers, at least half of the focus is around efficiency. And people see the incredibly high ROI. And I can’t speak for all-digital transformation programs, of course, but as I think about the ones that are DocuSign-centric people are laser-focused on the ROI they get from getting rid of those manual processes, the wasted labor, getting rid of things like the transportation cost, the shipping, et cetera.

That’s a big focus. So I don’t think in a recession you would see people pull back on that. I would say that any time if you had a significant recession, you expect people to kind of shoot first ask questions later and that could lead to some delays. But, in general, we think the business case just gets stronger when people need to find those efficiencies.”

Lastly, the following are all yellow-to-red flags for me regarding DocuSign: (1) The company’s DBNRR comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.

The Good Investors’ conclusion

Summing up DocuSign, it has:

1. Valuable cloud-based software services in the agreements space that solves customers’ pain-points;
2. high levels of recurring revenue;
3. outstanding revenue growth rates;
4. positive operating cash flow and free cash flow, with the potential for much higher free cash flow margins in the future;
5. a large, growing, and mostly untapped addressable market;
6. an impressive track record of winning customers and increasing their spending; and
7. capable leaders who are in the same boat as the company’s other shareholders

The company does have a premium valuation, so I’m taking on valuation risk. There are also other risks to note, such as strong competition and a longer sales cycle that may not be conducive for a business environment that’s struggling with COVID-19. But after weighing the pros and cons, I have to agree with the idea of having DocuSign continue to stay in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

By now, you might have heard that Singapore Airlines Ltd (SGX: C6L) is being saved by Temasek who promised to inject capital into the debt-ridden company. But our flag carrier is not the only company that may need saving. 

Many local businesses in Singapore face an existential crisis in these challenging times. Companies that (1) have high fixed expenses, (2) have insufficient cash on the balance sheet, and (3) face major disruption to their business, are most at risk.

Here are some Singapore-listed companies that could be fighting for their survival in the coming weeks and months.

Neo Group (SGX: 5UJ)

Singapore’s leading food catering company is high on the list. As of 31 December 2019, Neo Group had S$20.4 million in cash and equivalents but S$34.9 million in short term bank borrowings that need to be repaid within a year. On top of that, it also had $45.7 million in long term debt. 

Neo Group’s food catering business has also likely been heavily disrupted due to the recent restrictions on gatherings of more than 10 people. The extent of the problem is made worse as Neo Group’s catering segment was its most profitable business in the financial year ended 31 March 2019.

The company also has a substantial amount of fixed costs. In the last quarter, Neo Group incurred S$14 million in employee expenses and S$1.1 million in finance costs. These are overheads that are unlikely to go away, even as orders dry up. Given Neo Group’s weak balance sheet, it could face difficulty obtaining a loan to bridge it through this challenging period.

Sembcorp Marine (SGX: S51)

Another one of Temasek’s investments, Sembcorp Marine could face a similar fate to Singapore Airlines. Sembcorp Marine is highly dependent on the health of the oil industry and faces major disruptions to its business amid tumbling oil prices (oil prices are near 20-year lows now).

Like Neo Group, Sembcorp Marine has more short-term debt than cash on its balance sheet. That’s extremely worrying given that credit may dry up during this trying times. As of 31 December 2019, Sembcorp Marine had S$389 million in cash and a staggering S$1.42 billion in short-term borrowings. In addition, the company had S$2.98 billion in long-term debt.

And let’s not forget that Sembcorp Marine also has heavy expenses. In the quarter ended 31 December 2019, Sembcorp Marine racked up S$29 million in finance costs alone and also had a negative gross margin. The company also spends heavily on capital expenditures just to maintain its current operations. Sembcorp Marine was free cash flow negative in 2019 after spending S$316 million in capital expenditures.

Sakae Holdings (SGX: 5DO)

Restaurant operator Sakae Holdings has been on the decline in recent years. Even before the COVID-19 pandemic began, revenue and earnings for the company have plunged. In the six months ended 31 December 2019, Sakae’s revenue fell 13.9% and it reported a S$1.56 million loss.

Worryingly, Sakae looks likely to run into cash flow problems in the very near future. As of 31 December 2019, Sakae had S$4.3 million in cash but near-term bank loans amounting to S$45.7 million.

I don’t see how Sakae can pay back its debtors and I doubt it can negotiate to refinance such a large sum over the next 12 months.

The COVID-19 crisis could be the straw that breaks the camel’s back for Sakae Holdings.

My conclusion

Obviously this is not an exhaustive list of companies in Singapore’s stock market that could face a liquidity crisis in these trying times. The pause in the global economy (Singapore’s included) will definitely impact many more companies than those I listed. 

Companies that are not prepared and do not have the resources to ride out this period could be in big trouble. Companies that go broke will see a steep fall in their share prices and shareholders will get very little or nothing back if a company is forced into liquidation.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

A few days ago, I received a text from a friend asking the question that is the title of this article. He knew that Booking Holdings (NASDAQ: BKNG), an online travel agent, is one of the 50-plus companies that’s in my family’s investment portfolio.

Stalled growth

On 18 February 2020, I published my investment thesis on Booking. In it, I wrote that “The world – particularly China – is currently battling COVID-19. If the situation worsens, Booking’s business could be hurt.” Little did I know how badly Booking would suffer. International travel activities have essentially grounded to a halt since the publication of my thesis for Booking, with many countries closing their borders to control the spread of COVID-19.

In particular, the businesses of hotels and airlines across the globe have been crushed. A few days ago, Arne Sorenson, CEO of hotel operator Marriott International, said that the company’s seeing revenue declines of more than 75% in the US. At home, Singapore Airlines cut 96% of its flight capacity last week. Booking, as an online travel agent focusing on accommodations, is also facing a brutal operating environment.

Confidence 

What gives me the confidence that Booking can survive? The company is the largest online travel agent in the world. The entire travel industry is awash in pain at the moment. But this also gives Booking the opportunity to win even more market share if some of its smaller/weaker competitors falter.

I believe that the COVID-19 crisis will blow over eventually (hopefully sooner rather than later, so that the incredible human suffering that’s currently happening can end as soon as possible). This will allow the travel industry to return to strength. When this happens, Booking will be in an even stronger position compared to before.

But Booking has to survive from now till then. I think the chances are very good that the company will. At the end of 2019, Booking held US$8.5 billion in cash, short-term investments, and long-term investments (this sum excludes US$3.3 billion in strategic investments) against total debt of US$8.6 billion.

I would prefer Booking to have significantly more cash than debt. But Booking’s debt is mostly long-term in nature (88.5% comes due on or after 31 December 2020). Moreover, the company’s debt has well-staggered maturities as shown in the table below. The earliest due-date for Booking’s long-term debt is September 2021 and it involves a manageable sum of US$1 billion. So there’s plenty of time for Booking to maneuver, and to wait for the travel industry’s health to improve.

No guarantee

But there’s no guarantee that Booking will survive. It could eventually crumble should the travel market undergo a long winter if COVID-19 proves to be a particularly tricky disease to combat. This is where diversification is important. 

I mentioned earlier that Booking is one of the 50-plus companies in my family’s investment portfolio. Even if Booking fails to survive, my family’s portfolio will. Diversification is how I guard the portfolio against specific-company risks. With diversification, my family and I are able to stay invested in Booking and participate in its potential recovery without having to worry about a significant hit to the portfolio. 

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Singapore Airlines (SGX: C6L) recently announced a massive round of fundraising. In all, Singapore’s national carrier is looking to raise S$15 billion. The first slice of the fundraising involves a S$5.3 billion rights shares issue, and a S$3.5 billion tranche of mandatory convertible bonds (MCBs).

Temasek Holdings is one of the Singapore government’s investment arms and the current major shareholder of Singapore Airlines (SIA) with a 55% stake. It has committed to mop up all the rights shares issue and MCBs that other SIA shareholders do not want.

My blogging partner Jeremy Chia published a wonderful article yesterday. He shared his thoughts on why he’s not interested in investing in SIA despite Temasek’s promise to provide up to S$15 billion in capital. I’m not here to share my thoughts on investing in SIA. Instead, I’m here to provide you with a factual breakdown of the numbers behind SIA’s rights shares issue and MCBs.

I recognise that SIA’s latest fundraising activity is complex, and there’s a lot of confusion about it. I want to help clear the air, to the best of my abilities. The Good Investors exists to demystify investing for you – so here I am!

Details of the rights shares issue of Singapore Airlines

Here are the important numbers concerning SIA’s rights shares issue:

• Total sum: S$5.3 billion.
• Number of rights shares to be issued: Up to 1.778 billion rights shares to be issued, on the basis of 3 rights shares for every 2 shares of SIA that currently exist. There are 1.185 billion SIA shares that exist right now.
• Price per rights share: S$3.00.
• Renounceable? Yes, this rights shares issue is renounceable, so you will get to trade the rights.
• Changes in SIA’s book value per share (BVPS) and earnings per share (EPS) because of the rights issue: As of 31 December 2019, SIA’s BVPS and trailing-12-months EPS were S$10.25 and S$0.67, respectively. After the rights shares issue, the BVPS will fall to around S$5.89 while the EPS will decline to S$0.27, assuming everything else stays constant.
• What you have to effectively pay for SIA’s shares: At the time of writing (11:20 am, 30 March 2020), SIA’s share price is S$5.82. If you subscribe for your full allotment of rights shares, you’re effectively paying a price of S$4.13 per share for SIA’s shares. The math works this way: Effective price per share = [S$5.82 + (S$3.00 x 1.5)] / 2.5.
• The effective valuations you’re getting: At an effective share price of S$4.13, SIA will have a price-to-book ratio of 0.7 and a price-to-earnings ratio of 15.

Details of the MCBs of Singapore Airlines

For the MCBs, do note that the total sum SIA is looking for is S$9.7 billion. But the current tranche involves just S$3.5 billion. The key financial numbers for the current tranche of MCBs are as follows:

• Total sum: S$3.5 billion.
• Number of rights MCBs to be issued: Up to S$3.5 billion, in the denomination of S$1.00 per rights MCB, on the basis of 295 rights MCBs for every 100 shares of SIA that currently exist. As mentioned earlier, there are 1.185 billion SIA shares that exist right now.
• Issue price per rights MCB: S$1.00, meaning you’ll pay S$1.00 to purchase each rights MCB.
• Renounceable? Yes, this rights MCB issue is renounceable, so you will get to trade the rights.
• Maturity date of MCB: 10 years from the date of issue of the rights MCBs.
• Conversion terms of MCB: SIA is obliged to convert the rights MCBs into SIA shares when the MCBs mature. The conversion price is S$4.84 per SIA share. When the MCBs are converted at the maturity date (10 years from the date of issue), every S$1,000 worth of the MCBs will “grow” to S$1,806.11. This S$1,806.11 will then be converted into SIA shares at a price of S$4.84 each, giving us 373 SIA shares. The math works this way: Number of shares obtained upon conversion = S$1,806.11 / S$4.84
• Redemption terms of the MCB: SIA has the right – but not the obligation – to redeem the MCBs every six months from the date of issue at a certain price, giving you a certain yield. If the MCBs have yet to be redeemed when we hit the 10-year mark from the date of issue, SIA is obliged to convert the MCBs into SIA shares, as mentioned earlier. The redemption prices and yields are given in the table below. Note that you cannot ask for the redemption – it is entirely up to SIA to decide.

• What you’re effectively paying for SIA’s shares under the MCB, assuming it is converted: As mentioned earlier, if the MCBs are converted, every S$1,000 in MCBs will be converted into 373 shares. This gives rise to an effective price of S$2.68 per SIA share under the MCB. The math works this way: Effective price paid = S$1,000 / 373 shares. 
• What you’re effectively paying for SIA’s shares, in all, under the MCB, assuming it is converted: But to get hold of the MCBs, you’ll have to own SIA shares. Every 100 shares has a full allotment of 295 rights MCBs. At the time of writing, SIA’s share price is S$5.82. This works out to an overall effective price of S$3.47 per share. Here’s the math: Overall effective price paid = ([100 x S$5.82) + (295 x S$2.68)] / (100 +295). 
• Circumstances where you’ll make money on the MCBs alone (ignoring what happens to your SIA stake): There are a few scenarios where you’ll make a profit: (1) SIA redeems the MCBs before they are converted; (2) SIA allows the MCBs to convert into shares 10 years later and SIA’s share price is significantly higher than S$2.68 at that point in time. To be clear, the price of S$2.68 is the price you’re effectively paying for SIA’s shares in the event of the MCBs’ conversion. If SIA’s share price is around S$2.68 at the point of conversion, it’s very likely you’ll be losing money on the MCBs;  if SIA’s share price is lower than S$2.68 at the point of conversion, you’ll be losing money on the MCBs.
• When is it beneficial for SIA to redeem the MCBs? Redemption of the MCBs will require SIA to fork out cash, which negatively impacts SIA’s financial health. On the other hand, the conversion of the MCBs does not require SIA to dole out any cash. So from this perspective, it’s beneficial for SIA to not redeem the MCBs at all. This is important to note for the MCB holders for cash-flow-planning purposes, since SIA could very well choose not to redeem the MCBs.

Other important points to note

Shareholders of Singapore Airlines can choose to participate in the company’s fundraising activity in one of the following ways:

1. Subscribe for both the rights issue and rights MCBs
2. Subscribe for just the rights issue but not the rights MCBs
3. Subscribe for the rights MCBs but not the rights issue
4. Do not subscribe for both the rights issue and rights MCBs

If you’re a Singapore Airlines shareholder and you choose the fourth option, you can still recover some capital by selling the rights issues and rights MCBs (both are renounceable, so the rights can be actively traded). But you will face massive dilution, since the airline’s share count will increase significantly.

I hope laying out all these numbers will help you – if you’re a Singapore Airlines shareholder or are interested in its shares and/or MCBs – to make a better-informed decision.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Much ink has been spilt on the whole Singapore Airlines Ltd (SGX: C6L) fiasco. 

The latest news now is that Temasek, one of the Singapore government’s investment arms, has stepped in to provide our country’s flag carrier with much-needed capital. 

This comes as Singapore Airlines (SIA) is confronting liquidity problems due to its high debt load and fixed costs, and the disruption to its business because of the COVID-19 pandemic.

The rescue

In essence, Temasek, which currently owns around 55% of SIA, has underwritten a S$5.3 billion equity fundraising by the airline. Temasek has also underwritten a $9.7 billion issuance of mandatory convertible bonds (MCBs) by SIA; the MCBs will either be converted to shares in 10 years or redeemed before then. What this means is that Temasek will not only subscribe to all the rights and relevant bonds that it’s entitled to; it will also purchase any of the rights or bonds that other SIA shareholders do not want.

But despite Temasek coming in to save the day, I’m not interested in investing in SIA, even at these seemingly low prices.

How did it get into this situation in the first place?

Much like other airline companies, SIA is heavily leveraged due to the capital-intensive nature of its business. The high cost of replacing and upgrading SIA’s fleet has also led to negative free cash flow in four of the last five years.

To keep itself afloat, our flag carrier has been increasingly making use of the debt markets for its cash flow requirements. In fact, the company issued bonds to the public just last year to raise more capital. At the end of 2019, the airline had S$1.6 billion in cash, but S$7.7 billion in total debt.

The aviation industry is highly competitive too and the emergence of low-cost carriers have led to thinner margins for airlines.

The COVID-19 pandemic was the straw that broke the camel’s back as the significant loss of revenue (SIA recently cut 96% of its flight capacity) finally led to severe cash flow problems for the company and Temasek ultimately had to step in to save the day.

Temasek saving the day but shareholders will be diluted

Let’s be clear, this is not a government bailout. It is nothing like what the American airlines got from the US government, which included a massive grant. 

SIA’s situation is simply a major shareholder promising to back the company when it sells new shares to raise capital.

The new shares will dilute existing shareholders if they don’t take up the rights issue. On top of that, the mandatory convertible bonds will also dilute shareholders in 10 years when they are converted, unless they are redeemed before then.

SIA shares seem cheap but it really is not

Under the rights issue portion of SIA’s latest fundraising exercise, existing shareholders of the airline will be given the opportunity to buy three new shares at S$3 per share for every two shares they own.

Based on SIA’s current share price of S$6.03, I will get shares for an average price of S$4.21 each if I buy in today and subscribe to the rights issue. That seems cheap – but it really is not.

As of 31 December 2019, SIA had a net asset value per share of S$10.25. But that will drop substantially after the rights issue.

The rights issue will increase shareholders’ equity from S$12.1 billion to S$17.4 billion, or an increase of 43% from 31 December 2019. At the same time, the number of shares will increase from 1.2 billion to 3 billion. After the dilution, the net asset value per share will fall to around S$5.80 per share based on SIA’s last reported financials.

I also expect SIA’s net asset value per share to fall even more than that because of the heavy losses suffered as a result of the COVID-19 pandemic.

In the quarter ended 31 December 2019, Singapore Airlines incurred about S$800 million in staff costs, S$210 million in aircraft maintenance expenses, and S$522 million in depreciation. Most of these fixed costs will likely still need to be accounted for during the period of near-zero flights, despite SIA grounding its planes. These costs add up to around S$0.50 per share per quarter.

Together with the upcoming dilution and the heavy losses, Singapore Airlines’ shares could have a net asset value of close to or even less than S$5.30 per share in the future, depending on how long the pandemic lasts.

Earnings per share dilution

Earnings per share will also fall after the issuance of new shares because of the rights issue. SIA reported trailing 12 months profit of S$765 million.

Even if our flag carrier can achieve similar profit after the whole pandemic passes, its earnings per share will drop substantially because of the larger number of outstanding shares.

By my calculation, normalised earnings per share will decline from S$0.63 to just S$0.25 after the rights issue.

I’m not buying shares just yet…

The injection of cash will put SIA in a much better financial position but I’m still not convinced. 

Even if I buy shares today and subscribe to all my allotted shares in the rights issue, I don’t think I’ll be getting that great of a deal. I’ll be paying an average price of around S$4.21 per share, which translates to only a small discount to my calculated adjusted net asset value per share. It is also slightly more than 16 times SIA’s normalised earnings post-rights issue, which is not that cheap.

Moreover, if SIA is unable to redeem the mandatory convertible bonds before they get converted in 10 years time, they will potentially lead to further dilution to shareholders.

Let’s not forget too that our flag carrier (1) has a history of inconsistent free cash flow, (2) operates in an industry that is a slave to fuel prices, and (3) has strong competition from low-cost carriers. 

Given all these, despite the seemingly low share price, I still don’t think Singapore Airlines shares are cheap enough for my liking.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.