EVA Brief: GGRM (Gudang Garam)

What I expected in prior Elliott Wave analysis turns out to be true. I expected we would see elevated, unrealistic expectations during ending diagonal. That’s what we have here.

Market expectation is too excessive during the entire last up-leg (wave iii-v during ending diagonal)

The implication of ending diagonal is massive. It needs further investigation. I have observed that most major downturn in stocks start with overvaluation. Hence, it is futile to seek ‘bad news’ when a stock starts to turn down after some long period of bull market. However, a sustained prolonged In GGRM case, we now have the ingredient of wishful expectation from 2016-2018 in the background.

The expectation gap is narrow currently because GGRM recent performance in the last 12 months of Q2 2019 rose considerably

If this Q2 performance could be sustained throughout the year, then there is a doubt to the wave interpretation, especially if GGRM could maintain this kind of EVA growth next year.

Hence, it is important to understand the nature of Q2 improvement. Let’s see here...

The major source of EVA improvement in Q2 came from a significant increase in productivity compared to Q4 2018

So, part of the answer why the improvement is significant in Q2 was because 2018 was suck.

Remember, a gain in productivity means an increase in EVA margin (or ROIC), not just maintaining it.

What is notable in Q2 was GGRM reached an unprecedented EVA Margin / ROIC level

If we look at the changes since 2016, a further look into details shows two major developments here:

First, operating margin has been lower since 2018. Competition and taxes add the pressure here.

Second, GGRM has notably better inventory management here. This is a real progress. Days inventory (calculated with sales) fasten up from 180 days in 2016 to 130 days in Q2 LTM 2019. This inventory improvement alone contributed to an increase of 1.36% EVA margin during that period.

In short, EVA margin deterioration from declining operating margin has been offset by improvement in inventory management.

This is all nice and dandy, but it shows me that maybe the lever to improve EVA margin further has been exhausted. I mean, the key so far has been faster inventory cycle which has been sped up almost 30% over 2 years. From NOPAT margin, it is unlikely the situation would change anytime soon (VAT regulation and competition). There is a potential from fixed asset charge to be the value driver if GGRM could drive sales growth. This is because I believe GGRM could satisfy more demands without needing to add significant machinary investments. But that is a stretch.

That was the outlook from 2 years perspective. What is of particular issue now is the fact that EVA margin has increased quite a lot in Q2 compared to Q4 2018. This is why EVA momentum is big enough to offset high market expectation which you saw in the first chart. The major source of this EVA improvement came from working capital too, but not nearly for the same reason I explained earlier.

Yes, inventory cycle has been speeding up, going faster from 147 days in Q4 2018 to 130 days in Q2 2018. That translated into almost 0.5% EVA margin improvement. FYI, total improvement in EVA margin from Q4 2018 to Q2 2019 is 1.0%. So that makes half of the improvement comes from faster inventory management. The other half, however, comes from deferring excise duty payment. Paying excise duty later is a big game for GGRM that does not make into the news, but it is a significant source of value.

The problem is, deferred excise duty payment is a very volatile number. What is most likely though, it could not be deferred for a long time. It’s even very likely that we would see a very different number in Q4.

Bottom Line

So, what does it all mean to me? Like I said, IF I find good reason that GGRM at least could maintain this tremendous EVA throughout the year AND there is a good chance that GGRM could make another major EVA growth next year like it did in Q2 2019, then I would really question my Elliott Wave interpretation. But after looking deeper into the source of EVA improvement, what I find was the source is unreliable, to say the least.

Deferring VAT could not be expected to be a reliable source of value as I have also shown you and I would bet that inventory cycle could not be sped up significantly further. I suspect this progress inventory cycle in Q2 is due to Ramadhan, which means it would start to normalize throughout this year to slower level. But even if GGRM could maintain its inventory cycle, EVA margin would soon decline, possibly by next year when GGRM finally pay its deferred excise duty. That almost assuredly will contract EVA. If that were to happen, the expected fundamental factors are in place for the wave interpretation: excessive expectation in the background, and absolute decline in EVA in the future.