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China Yuchai International Limited (NYSE:CYD) is a dominant diesel engine manufacturer in China. It makes light, mid-sized and heavy-duty diesel engines for a large variety of industries. Its major subsidiary, Guangxi Yuchai Machinery Company Limited (GYMCL), is the market leader in China's diesel engine industry and consistently is ranked No. 1 in unit sales by China Association of Automobile Manufacturers.

Currently CYD is valued at a price to earnings (P/E) ratio of about 5 and a price to book (P/B) ratio of about 0.6. Compared to similar companies in the US such as Cummins Inc. (NYSE:CMI), CYD is extremely undervalued.

Market Leader

CYD is the biggest diesel engine manufacturer in China. It makes a wide array of light-duty, medium-duty and heavy-duty diesel engines for on-road and off-road applications for Chinese and overseas markets. It has 33 regional offices, 2,800 customer service stations and 77 overseas service agents. In 2011, CYD was ranked No. 215 among China's top 500 Enterprises and No. 19 among China's Top 300 Manufacturing Enterprises. It operates the largest single facility for commercial automotive diesel engines in China, with state-of-the-art equipment.

Superior Technology

CYD possesses superior technology in diesel engine manufacturing. It holds over one thousand patents and has developed a large variety of new engines. For example, CYD produced China's first Euro 4 and Euro 6 emission standard diesel engine, China's first Euro 5 electronic-controlled diesel engine and China's first Regenerative Hybrid engine. Recently, one of CYD's engines received the "Engine of the Year" award by China's Association for Internal Combustion Engine Industry.

Decent Dividends

CYD has been paying out dividends since 2006. In September, CYD paid $.50 in ordinary dividends and $.40 in special dividends. This amounts to about 6% in dividend yield.

The following is the history for CYD's dividend payments:

FY 2011

15/06/12

09/07/12

$.50 (ordinary dividend)
$.40 (special dividend)

FY 2010

11/05/11

31/05/11

$.50 (ordinary dividend)
$1.00 (special dividend)

FY 2009

05/03/10

30/03/10

$.25

FY 2008

24/09/09

16/10/09

$.10

FY 2007

25/08/08

19/09/08

$.10

FY 2006

28/09/07

24/10/07

$.10

FY 2006

04/12/06

28/12/06

$.02

If CYD is such a great company, why does its stock price stay so low? I believe the following issues are holding CYD back.

China Discount

CYD owns 76.4% of GYMCL, which is located in Southern China. Because of the recent fraud exposures of US-listed Chinese companies, investors have discounted most Chinese companies. Also, the perception that China's economy may slow down dramatically in the future also helps to depress CYD's stock price, since engine manufacturing is a cyclical industry.

CYD has a long listing history. It listed its share on the NYSE in 1994. Its major subsidiary, GYMCL, was founded in 1951, some 60 years ago. Also, CYD is a market leader in China and has been consistently ranked No. 1 in China's diesel engine market. The likelihood of CYD being a fraud is quite remote.

Gold Share

CYD's biggest shareholder is Hong Leong Asia Ltd (HLA), a Singapore company. HLA currently holds 34.9% of CYD's outstanding ordinary shares as well as one special share. That one special share concerns investors the most because it gives HLA control of CYD's board regardless of share ownership. This means that investors cannot gain control of CYD via ordinary share ownership.

I think this gold share structure is the main culprit for CYD's low stock price. It also helps create tensions between CYD and the management team of GYMCL, its subsidiary. This tension was so severe in the past that at one point it drove the stock price of CYD all the way down to pennies.

The relationship between CYD and GYMCL has since improved and nowadays it's quite stable. But HLA has realized the toxicity of the gold share and has been willing to address the issue. It has tried to negotiate a deal to retire this golden share with Yuchai Group, the minority owner of GYMCL, but failed because of a management change in Yuchai Group.

I believe it's in HLA's best interest to continue to negotiate with Yuchai Group to find a way to retire the gold share. If this can be done, it will provide a huge boost to CYD's stock price.

Valuation

CYD seems to be extremely undervalued when compared to similar companies in the US such as CMI. Several valuation metrics are shown in the following table:

CYD

CMI

Market Cap

594 M

20 B

P/E Ratio

5.20

11.05

P/B Ratio

.67

3.00

P/Sales Ratio

.27

1.08

PEG Ratio

.57

.94

Of course, CMI is a much more stable company with higher profit margins and deserves a higher valuation. But the discount investors have applied to CYD is simply too severe. You can see that the difference is very striking when you look at the P/B ratio and the P/sales ratio of both companies.

The most recent statistics from China seem to indicate that China's economy is picking up some momentum. That will bode well for companies in cyclical industries like CYD. I believe at the current price CYD is extremely undervalued given its market position, its long operating history and its superior technology in engine manufacturing. For investors looking for some exposure in China, CYD may be a good candidate.

Source: China Yuchai International Limited A Great Buy