3 companies with red flags and how to react

Investors who have spent enough time in the stock market would know that investing is not smooth sailing all of the time.

As investors, our job is to recognise when things go wrong and proceed to rectify the mistake if the situation calls for it.

With that in mind, I would like to share three companies that are showing red flags at the moment.

Each example describes a specific situation that has occurred within the business. From there, I offer suggestions on how investors should react.

LARGER CONTRACTS, POOR MARGINS 

Boustead Projects Limited, or BPL, is a real estate solutions provider, with expertise in the design and build and development of industrial properties for blue-chip clients.

The group has been taking on projects in key industries such as biotechnology, logistics and aerospace.

Historically, BPL's order book has hovered around the $200 million range.

However, in the fiscal year 2019 (BSL has a 31 March fiscal year-end), the group secured two significant contracts. Each deal was worth well over $200 million, pushing BPL's order book to an all-time high of $747 million in Jan 2019.

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The rapid expansion in order book seemed like great news.

However, when BPL reported its FY2020 second-quarter earnings recently, it was shocking to see that its overall gross margin had fallen from 26 per cent in the prior year to just 14 per cent in the latest quarter.

The decline in gross margin could be a case of aggressive bidding on BPL's part, resulting in higher revenues but with weaker gross margins.

Investors should take note of this red flag and continue to monitor the subsequent quarters' gross margins to determine whether this was a one-off occurrence, or if the group have been sacrificing margins for revenue.

A GROWTH STORY BREAKS DOWN 

Kingsmen Creatives Limited is a leading communication and design group that specialises in serving clients in events and exhibitions, theme parks and corporate interiors.

The group had, in February 2018, announced that it was partnering Hasbro to design and conceptualise a NERF Family Entertainment Centre (FEC) based on the popular NERF brand of blasters, one of Hasbro's best-selling toy brands.

On 1 Oct 2019, Kingsmen made good on its promise by opening its first NERF FEC location at Marina Square mall in Singapore.

Meanwhile, in July 2019, the group also announced that it had partnered Vision High (HK) Limited to bring the NERF FEC concept to Mainland China, Hong Kong, and Macau.

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The news suggested that Kingsmen could benefit from a long runway of growth within the Middle Kingdom.

However, on the eve of the New Year, Kingsmen abruptly announced that this agreement had been terminated.

Needless to say, the announcement throws a spanner into Kingsmen's growth plans for its Intellectual Property (IP) division.

Fortunately, investors can still look forward to Kingsmen bringing NERF FEC to the USA, which it announced in June 2019.

The plan is still in the works and investors need to monitor the news to see if Kingsmen manages to find another partner to expand in Asia.

THE FLYER'S WINGS ARE CLIPPED 

Straco Corporation Limited is a tourism asset operator.

The group owns two aquariums in Shanghai and Xiamen, China, as well as a 90 per cent stake in the iconic Singapore Flyer.

On 19 Nov 2019, the Flyer's operations were halted due to a technical issue, and as of the date of writing, the suspension has lasted nearly two months.

Unfortunately, the latest incident follows a similar suspension of service back in late-2018.

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Back then, the company also cited technical issues as the cause. As it turns out, the suspension lasted for more than 2 months and the Flyer only came back into operation on 1 April 2019.

In light of the suspension, it is worrying to see that a major asset such as the Singapore Flyer has suffered a breakdown two times in as many years.

For me, this situation is a red flag and could be a sign of poor maintenance.

Investors need to be mindful that 2019's earnings will be negatively impacted, and continue to monitor the situation to assess how management rectifies the problem.

GET SMARTS: HICCUPS ALONG THE WAY 

No matter how good your research might be, businesses may throw us curveballs, and we have to react accordingly.

The above three scenarios are hiccups that companies may experience from time to time as they seek growth.

BPL may have snared two large contracts but appears to have sacrificed gross margins in the process.

Kingsmen is trying to break into the China market with its NERF FEC concept but hit a roadblock when the agreement with Vision High was terminated.

Similarly, Straco pursued growth by acquiring the Flyer back in Aug 2014. Until recently, the Flyer has been running smoothly. The last two suspensions call into question whether the maintenance has been sufficient.

The lesson here is that such incidents are part and parcel of investing.

When faced with challenges, investors will need to assess the severity of the incident and decide whether the company may be permanently and adversely affected.

If not, then perhaps it may be time to make use of the pessimism to scoop up more shares at cheap valuations.

This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice.