Dependency on Special Relationships

In this article, we will explore together on the risk of special relationships enjoyed by certain companies.

Special relationships can come in many forms such as support by parent companies or country legislation/government contracts.

This applies to protected industries such as telecommunication operators, water utilities, and power plants where traditionally, governments control the number of operators.

In theory, these companies do enjoy certain monopoly status but we know that these lucrative profits do not last over the long term. Where competitive advantages are derived from legislation or policies, the companies do face huge storms when conditions change.

We should not purchase companies who are on special support by government or certain clients. If we must, we have to deem how sticky the relationships and how long will this kind of set-up last. This is a hidden risk where most investors do not assign the probability of it happening.

We should prefer companies who are able to chart their own destiny and control their fortunes. 

#1 – VICOM

Under Singapore’s Road Traffic Act, vehicles are required to go for inspections in accordance to a schedule.

 (source: http://www.vicom.com.sg/Our-Services/Vehicle-Inspection/Inspection-Price-and-Schedule-List)

Each inspection center needs to be authorised by Singapore’s Land Transport Authority (LTA). Out of 9 inspection centers, VICOM owns 5 and it has shareholdings in JIC inspection centers. The two other centers belong to STA, located in Sin Ming and Boon Lay. Since the regulations dictate regular inspections, it creates recurring demand for VICOM and the other players. However, we need to take note that VICOM is enjoying such monopoly because LTA hasn’t allowed any new operators to enter into the industry. It helps that VICOM is owned by ComfortDelgro, one of Singapore’s largest taxi and public bus provider.

Should LTA decides to introduce competition in this space, VICOM’s fortunes might change. Having said that, one needs to re-evaluate the likelihood of it happening. In my view, in our land scarce environment, it is not going to happen. But who knows?

#2 – Telecommunication Industry

It is known that SingTel was the first telco awarded a license to operate by the then-Infocomm Development Authority of Singapore (IDA). IDA is known as Info-communications Media Development Authority of Singapore (IMDA).

It was almost certain that SingTel would seize the entire market of Singapore until the Government decided to liberalise the sector by 2000. This paved way for newer competitors such as StarHub (awarded the license in 1998) and M1 (formerly known as MobileOne, awarded the license in 1998). In 2001, IDA issued three provisional 3G spectrum rights to SingTel, StarHub and M1.

What was seen as a lucrative industry protected by Government turned out to be a competitive market in a matter of years. Since then, a plethora of competitors swarmed our local market. They are MyRepublic, OMGTel, TPG, Zero1, Circles.Life and other upcoming ones.

Nothing is clearer than the share price performance of the 3 biggest telco operators in Singapore.

In 2001, Energy Market Authority (EMA) decided to introduce more competition by liberalising Singapore’s electricity market. As a result, the dominant player SP Group is being affected.

source: Seedly.SG

Seedly has done a great job listing down the competitors. You can see, in a matter of years, the whole landscape has changed. This is why I am wary of industries that are undergoing huge changes forced upon by government or outside changes.

Companies that are protected by the government may become less competitive over time. When the protection is being lifted off, these companies are exposed to eager competitors who may take away their market share quickly.

#3 – NIC Inc. (Nasdaq: EGOV)

Nic is USA’s premier provider of digital government solutions. It provides over >13,000 digital government services for more than 6,000 federal, state and local government agencies. They own websites that perform functions such as motor vehicles license, registration renewals, corporate filing, document retrieval system, nursing licensing system, tax returns, purchase of hunting and fishing license.

The state governments love NIC because NIC does help them digitalise their services.

Among all of the contracts with different state government, it was estimated that 20% of the revenue comes from a single contract with the Texas Department of Information Resources. In Q4 2017, Texas decided to choose another vendor to perform their portal operations, maintenance and development services.

Imagine losing 20% of your revenue? That would be really painful for the company and its shareholders. It is better to not have customer concentration by serving a wider customer base.

#4 – Adacel Technologies (ASX:ADA)

Adacel is a leading developer of air traffic management software, airport and air traffic control training and airborne vehicle systems. Their software mimics the real-world flight scenarios for trainees. They have two segments: systems (59%) and services (41%). It requires sophistication and know-how to be in this space.

The Company’s products are widely used throughout Europe, North America, the Middle East and the Asia Pacific region. Their clients include aviation colleges, civil aviation authority of various countries, and different air forces of various countries.

For aspiring traffic controller, they are trained by Adacel’s Aurora air traffic management systems.

On 8 November 2019, Adacel reported that their 1H FY2019 will see a 65-70% lower profit than prior corresponding period. This was caused by the loss of the FAA Tower Simulation Support Contract. It was not renewed, instead, US Federal Aviation Authority (FAA) awarded the contract to Adsync Technologies.

#5 – Conclusion

There is another Malaysian company called My E.G. Services. It operates similar services like NIC Inc by providing issue/renewal of driver’s licenses, road tax and foreign workers permit. After the shock election, Malaysia’s Immigration Department decided to end their contracts with MyEG Services.

End of the day, we have to be realistic with what we buy. When I see incredible high margins and super growth in companies, I will check whether there are certain factors that contribute to it. It could be a special form of government support in terms of relationships or legislation or a huge customer, in such instances, I would be cautious about investing in these companies. I rather play safe.

Unless this is a proper marriage, relationships seldom last for a long term. When parties part way from a relationship, there will be damages.