HSBCGlobal ResearchEquitiesDiscovery ResearchBy: Shuo Han Tan and York PunDecember 2019SPOTLIGHTDiscovery ResearchMalaysia small- and mid-caps: Best ideas for 2Discovery Research launches coverage of our Malaysia small- and mid-cap universe with six initiations and one assumption of coverageSmall-caps。什en operate in niche businessesz enabling them to prosper irrespective of the macro environment. Their low correlations to the broader market offer valuable portfolio diversification to the investorOur short list of stocks that we think have the potential to compound capital at high rates of return over multiple decades includejn order of preference, Heineken, Kossan, Carlsberg, and Mynews, all rated BuyDisclosures & Disclaimer： This report must be read with thedisclosuresand theanalyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it.Diversification benefits. The correlation of small-caps to large-caps has fallen from an average of 90% throughout the 2000s to approximately 50% now. We suspect that this reduction may have been caused by the emergence of index funds and ETFs that increasingly determine a large amount of flows in the large-cap space. In contrast, the small-cap arena is still primarily driven by idiosyncratic and stock-specific factors. Small-caps often operate in niche businesses, allowing them to prosper irrespective of the macro environment. Low correlations to the broader market thus offer valuable portfolio diversification to investors.Exhibit 3: Correlation of small-cap index vs large-cap index since 2006100%90%80%70%60%50%40%30%Mar-01Mar-03Mar-05Mar-07Mar-09Mar-11Mar-13Mar-15Mar-17Mar-19 Correlation of FTSE Malaysia Small Cap to KLCISource: BloombergAlpha opportunities due to a presence in niche sectors. The KLCI, Malaysias main index, is dominated by financials, utilities and conglomerates. In contrast, the domestic small-cap universe is more evenly spread across sectors. As shown in the chart below, there is a significant number of small-cap companies in the industrials, consumer discretionary, materials, real estate, technology and consumer staples sectors. As above, small-cap investing offers the opportunity to access niche sectors and companies not present in the large-cap space that potentially provide better long-term returns. As price discovery is less efficient, there are many opportunities for active small-cap investors to tap into these unique exposures and add value.Financials CommunicationsTechnology 12%Exhibit 4: Sector breakdown of Malaysian small-capsConsumer Discretionary14%laterials 13%Real Esta 12%Source: BloombergExhibit 116: Revenue and profit trends, FY08-18Exhibit 117: Margin trends, FY13-18Revenue (MYRm)Profit (MYRm)Gross margin Operating Margin Net MarginSource: Company reportsSource: Company reportsExhibit 118: Cost structure, FY18Exhibit 119: Balance sheet structure, FY18 COGS SG&A Impairments100% 90% -80% -70% -60% -50% -40% -30% -20%10% -0% -37.6943.俨OthersCash Investment in associates/JVsPPEReceivables _J-Asset6.0% Others27.3%Long-term borrowings58.0% Short-term borrowings8.78PayablesLiabilitySource: Company reportsSource: Company reportsFY13FY14FY15FY16FY17FY18Exhibit 120: Cash conversion cycle, FY13-18 (MYRm)400200 0-200-400-600-800FY13 FY14 FY15 FY16 FY17 FY18Receivable DaysInventory DaysPayable DaysCCCSource: Company reportsExhibit 121: Cash flow composite, FY13-18 (MYRm, %)CFO CFI CFF CFO/Net ProfitSource: Company reportsForecasts and valuationRevenue and earnings outlook. In our forecasts, revenue growth may stagnate. As revenues from current contracts are largely fixed, growth in the FPSO segment depends on new projects. However, a stretched balance sheet may limit the ability of the company to bid for new contracts. The offshore marine services (OMS) segment, which is currently unprofitable, may provide the biggest delta to earnings forecasts. Bumi Armada is aggressively cutting costs and selling vessels in this segment, while trying to maximise the utilisation rates of the remaining vessels on its book. However, oversupply still plagues the OMS market, limiting Bumis ability to turnaround this business significantly. In our forecast, we expect this segment to be broadly stable, as potential new wins in the subsea construction vessels negate lower revenue contribution from its sold offshore marine services vessels.Margins. Bumis margins have improved significantly over the past few quarters. This has been a result of the operational improvements in Kraken and the OSV segment as well as an aggressive cost