EVA Brief: ERAA (PT. Erajaya Swasembada Tbk.)

This stock was once a favorite of mine for wave structure reasons. It was a splendid investment until it hit its peak in 2018. For wave structure reasons as well, I keep a close watch for this stock. Just recently, ERAA took off from around 1000 to 2100 at the moment. Bulls say e-cigar is a fresh wind. I do not subscribe to that point of view. Getting enchanted to stories is easy, but numbers are a more reliable guide. Technically speaking, the recent up-wave looks dangerous to me and should not be viewed as the start of wave 3 of a larger degree. But I am here to talk about EVA perspective.

Let's start with the basics. It is no wonder ERAA stock soared in 2018 if we take a look at EVA. EVA momentum in 2018 was a fantastic 2.2%, a record high at least since 2013. But, as I would explain further later, investors did not quite as excited. Yes, the stock went crazy going from 700/share to 3,120/share, but that still is a low expectation compared to ERAA actual achievement in 2018. One could have a reasonable basis to say that ERAA was still ‘undervalued' back then even when the share price hit 3,120/share.

Let me put it in numbers. Actual EVA momentum (EVA growth scaled by sales) in 2018 was 2.2%. EVA increased quite dramatically from minus IDR 75 Billion in 2017 to positive IDR 311 Billion in 2018 on IDR 24 T revenue base. From a barely wealth waster into a dazzling wealth creator. 5 years in the dark, and finally became a butterfly.

Had investors actually became an optimistic lot and believed that ERAA could continue to generate EVA momentum of 2.2% a year for the next 5 years before going flat, (which would make EVA grows tremendously from IDR 311 Billion in 2018 to IDR 2,978 Billion in 2023) its share price would be fairly priced at IDR 7,780/share – more than double than its recent peak. Of course, that did not happen.

So what drives EVA spectacular growth in 2018? Productivity gains (improvement in EVA margin or ROIC) is largely the source of EVA growth. To be more specific, 2018 productivity gain is for the most part due to an increase in operating margin.

That improvement in productivity is bound to go in the opposite direction. It is pretty easy to see this from the result of Q1 2019. The first on the list is the operating margin in Q1 2019. It is a bit lower than a year before. This might be an indication that the lever to improve EVA margin from jacking up operating margin has been maxed out. Add that to the fact that sales level in Q1 was lower 14% than a year before, and yes, its inventory level spiked in 2018. To increase margin in the middle of troubling demand is just not in the card.

A more concerning aspect is from the capital charge side, namely inventory level. Inventory level has doubled in 2018 from 2017. Q1 2019 saw a bit decline, but it is still at a high level. To add to the fuel, it looks like suppliers are becoming more unwilling to extend credit. These translated into a high working capital number without sales to back it up.

All these tell me to expect a relatively unchanging operating margin, but quite a drastic capital charge which would result in EVA margin to be barely positive. I would say that it is almost certain that at the very least EVA margin would decline which means the lever for EVA growth works backward this year. It means EVA would be lower this year, and there is a good chance that it would turn negative.

This time around, high working capital would break the positive trend in productivity gains....

..which would result in significant EVA decline, possibly to negative territory.

What about investors' expectations?

This is the most interesting part. Historically, since 2013, investors do not put faith that ERAA could grow its EVA. Implied EVA momentum (MIM) has been essentially flat near 0.0% and peaking at 0.5%. Generally, investors basically adjust quickly to EVA development and leave no future growth expectation whether for better or worse. This makes ERAA hard to invest.

Usually, this is not the case. It is very common for investors to be influenced by the cycle of optimism and pessimism: When the stock price is rising, they put high, and often unrealistic EVA growth expectations. When the stock price is declining, they often put unrealistically EVA growth contraction. This behavior makes it easier to invest without looking into the proverbial fortune mirror. Unfortunately, ERAA is an exception. ERAA investors are generally skeptical. They adjust quickly without hoping too much.

So, what now? At the current price of 2,100/share, MIM is only minus 0.1%. Historically speaking, that is a neutral expectation. But, since there is no way I could see a continued EVA growth this year, I would give it a pass. It is very possible EVA momentum would turn out to be much worse than what is being expected currently.