Wednesday, September 24, 2014

5 things you need to know about Starburst

When I first heard about Starburst IPO, I thought this business is unique. Starburst specialises in the design and engineering of firearms-training facilities. Starburst designs, fabricates, installs and maintains anti-ricochet ballistic protection systems for firearm shooting ranges and tactical training mock-ups. Their clients include law enforcement, military and security agencies, as well as civil authorities in Southeast Asia and Middle East.

There are several positive takeaways why one should consider Starburst. The industry has high barriers of entry that many can’t imitate due to the intricate technical expertise. Starburst has the patented “Searls” trademark – anti-ricochet ballistic protection materials protect military lives during peacetime firearms training.

I shan’t talk about the advantages but focus on risks and challenges:

1) Operating cash flow is lumpy

Project fee is based on “percentage of-completion” recognition. The contracting party is able to retain 10%-20% of the contract sum upon completion of works in order to assess any shoddy work or outstanding work that yet to be completed fully. That leaves us 90% of earnings which I believe may split in 2 stages – one is design and the other is fabricate and install. Therefore, its three stages before the full payment are received. This does not sound appealing to me. This is probably why Starburst is focusing on increasing their maintenance services (after one year warranty), so that the business is able to earn recurring income. Currently, this portion amounts to 14% of group revenue as according to FY2013. Whether Starburst is able to expand tremendously (in terms of revenue splits) for the maintenance service over the years remain to be seen.

We also have to take into account that winning a contract is often a lengthy, time-consuming and complex process. As of now, the firearms training and tactical mock up service offerings is non-income recurring. So, this will create an uncertainty in revenue streams, unless there is a continuous pipeline of order book to provide the earning visibility.

2) Cost management

Starburst will estimate and buffer in any additional costs for their contracts. However, there is a possibility that the itemised costs may rise above the management estimate. For example, additional foreign workers are hired to meet the timely delivery of the project. Or there is an unforeseen increase in the cost of materials, components and equipment. Or there are under-par performances of sub-contractors and suppliers that result in project delay. (hopefully, the work is not stalled) These are issues that contribute to cost overruns which will cause a dent in the profitability of Starburst.

Another point to note is the possibility of rising raw materials cost such as steel and anti-ricochet materials under the “Searls” trademark. It’s done by third party manufacturers based on client specifications and this cost is passed on to Starburst. At the moment, I don’t see this happening as the working capital is healthy. But I can’t foresee the future in Middle East where contractual agreements (with terms and conditions) with agencies could be volatile at times. If there is a cost dispute during the project execution period due to sub-contractor/leasing of equipment problem in foreign markets, this will result in project delays and cost constraints. As a result, Starburst should have a solid cost management structure and cost contingency plan in place.

And for this reason, I also won’t expect Starburst to pay off any huge dividends in the future since the business is new in Middle East. If so, I will be hugely worried. Cash needs to be maintained for any of the unforeseen cost-based issue mentioned above. If you buy Starburst, you are aiming for capital gains. However, to attract retail investors and I think it’s attractive - Starburst agrees to pay 20% of the Group’s PAT (profit after tax) for the financial year ended 31 December 2014.

More on the costing part…. the nature of this business is working capital-intensive. Majority of the project expenses are upfront costs, meaning the past project earnings have to be received on time to pay off any short-term liabilities. The challenge is that the payment from clients is paid progressively (percentage-of-completion method). Alternatively, a cheap loan taken to pay for the overriding expenses but this means interest expenses incurred. Should interest rates rise; I am not sure how this will affect their repayment period.

According to the CIMB analyst report dated August 20, 2014, the analyst reports that there will be a Guarantor for Starburst, per project undertaken. The Guarantor is usually the Financial Institution who issues the performance bonds. This can mitigate the risks of the contracting party gone bust (in the worst-case scenario) or does not pay up over a long period of time (you are dealing with foreign agencies). I think this protect Starburst interest.

I am a little skeptical. Resolutions and legal recourse takes a great deal of time and effort.

3) Payment delay

There is a risk where the client may drag on the payment. I understand some feel the payment is prompt because the contracting parties are government bodies. Think again. Starburst is entering into new markets of Middle East that include Qatar, United Arab Emirates and Saudi Arabia. Not to forget any bureaucracy that stifles prompt payment. Starburst needs time to establish their trust, reputation and network. Especially strong business relationships.

Therefore, there is a chance of ballooning receivables when credit terms lapses. If this gets out of hand, your cash is locked up and your cash flow will encounter problems when other project costs escalate because of higher material cost.(the overall project and production cost split is found in the prospectus) Do remember to monitor the costing and accounts receivables of Starburst.

I just hope more clients of Starburst will take up their maintenance services in the near future since income is recurring.

4) Government regulation and permit changes

There is a risk of government and state-owned agencies not renewing the permit for Starburst to operate in Middle Eastern countries. I think they may be some level of regulatory approvals required. In this industry, the project bidding process is highly opaque. It’s best to check with Starburst directly. I am not in an expert on this but I do wonder why the Qatarians not choose the local Defence Contractors to work closely. There will be, of course, some level of competition amongst contractors in Middle East. Maybe the “Searls” technology is a unique selling point for Starburst, apart from their extensive experiences and track record.

5) Founder risk

I read from the recent CIMB analyst report dated August 20, 2014 that the business is highly dependable on two founders – Messers Edward Lin and Yap Tin Foo, who manage the technical and marketing aspects of the business respectively. Maybe this explains why the management owns 80% of Starburst shares, leaving limited free float to the public tranche. It can be seen as a positive sign because both will manage the business diligently. On the other hand, it can be viewed as a risk of not having a talent contingency plan and structured organization flow chart in place due to limited talent capacity. You are buying into a scalable business which has the potential for growth, but one that may operate like an SME.

Conclusion

I will put Starburst on my watchlist for now till valuations are compelling. If I buy, I will accept the risks and challenges highlighted and capitalize on the demand for firearms training facilities in Middle East. I also do note the competitive strengths of Starburst such as their track record and economic moat (Searls trademark). Starburst is in a high EBIT business with few competing players, an area where defence budget in Qatar, UAE are increasing.

The main challenge, in my humble opinion, is the revenue recognition process and the cost structure which may need some monitoring in place. No doubt Starburst sounds attractive from the external perspective but one need to look beyond the ringing sound of current and forecasted order book. Don’t get blown away. Stand on guard and focus beneath Starburst mode of earnings and expenses.

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