We will try to evaluate the stock of this company which apparently is underestimated by the market. We conclude our work by asking some questions on which we would be interested to know the opinion of others, especially the more contrasting ones.
The procedures used were deliberately made unsophisticated for simplicity of exposition reasons.
About China XD Plastics Company Limited
China XD Plastics Company Limited (CXDC) is one of the leading specialty chemical companies that through its wholly-owned subsidiary Heilongjiang Xinda Enterprise Group Company Limited ("Xinda Group"), is engaged in the research, development, manufacture and sale of modified plastics, primarily for use in the fabrication of automobile parts and components.
Product development takes place through Heilongjiang Xinda Macromolecule Material Research Center Enterprise Group Company Limited ("Xinda Group Material Research"), a wholly-owned CXDC's research laboratory that has 246 certifications from manufacturers in the automobile industry as of December 31, 2012.
CXDC is the only company certified as a National Enterprise Technology Center in modified plastics industry in Heilongjiang Province.
Modified plastic is produced by changing the physical and/or chemical characteristics of ordinary resin materials. In order for plastics to be used to produce automobile parts and components, they must satisfy certain physical criteria in terms of mechanical functionality, stability under light and heat, durability, flame resistance and environmental friendliness.
China XD's primary end-market is the Chinese automotive industry that has been rapidly growing for the past few years where its modified plastics are used by its customers to fabricate the following auto components: exteriors (automobile bumpers, rearview and sideview mirrors, license plate parts), interiors (door panels, dashboard, steering wheel, glove compartment and safety belt components) and functional components (air conditioner casing, heating and ventilation casing, engine covers and air ducts). The company says that its specialized plastics are utilized in more than 23 automobile brands manufactured in China, including leading brands such as AUDI, BMW, Toyota, Buick, Mazda, Volkswagen, Cherry, Geely and Hafei new energy vehicles.
From 2009 to 2011, the current ratio was above the 2:1 rule. In 2012 it fell slightly below the value of 2.
If we look at the trend of the Cash Conversion Cycle we can see that there was a push upward determined by the rise in the trend of the DSO in the last 12 months. Likely what it is getting worse is the ability of the company to convert receivables from customers into cash.
For the company the change of DSO is mainly due to collecting accounts receivable from its customers for a longer period because the auto growth phased into a slower growth mode in China. However, the company believes it is still able to collect well below 90 days, which is its standard credit term and industry average.
The company thinks - from the words spoken by its CFO , Mr. Taylor Zhang - its DSO can be expected to stay at 55 to 75 days throughout the whole year (China XD Plastics' CEO Discusses Q4 2012 Results - Earnings Call Transcript).
The quick ratio got worse in 2012 than that of previous years because of higher levels of inventory accumulated.
The inventory level was proactively increased because demand is expected to increase in the coming quarters.
Inventory to sales ratio has slightly increased from 2010 to 2012 for the reason we have just mentioned, but it is still fairly stable as we can see from the picture below.
The debt/equity ratio got worse in 2012 even though the result of the index itself is still good. The slight degradation is briefly explained by and linked to the increasing in short term loans by 414.6% to fund working capital needs (because accounts receivable increased by 218.1% mainly due to increase in turnover days from 34 days in 2011 to 56 days in 2012 since) and future growth reasons (purchase of property, plant and equipment):
The percentages of annual increase in sales have gradually declined from 2007 to 2011.
We mean that from 2007 to 2011 sales increased every year, but the percentages of annual increases are gradually lower (that is it decreased the speed with which sales increased from 2007 to 2011). Between 2011 and 2012 the speed of sales increasing slightly intensified.
We can represent what we have just said with the following table and its graphical representation.
We can replace the cloud of triangles (each triangle represents the amount (%) of increased sales in one year from the year before), with a linear interpolating equation whose slope is the reduction of speed with which sales are rising from one year to the next.
What is causing this phenomenon? If we exclude that the phenomenon just described is due to variations in exchange rate U.S. Dollar / Renminbi (see chart below), we believe that it is due to a) the changed conditions in the competition and b) the fact that the Chinese economy has recently slowed down.
Regarding the first point a), if we analyze the evolution of the competitive framework from 2009 to 2012 (just read the financial statements of the company with reference to the article ''competition''), you can see two things: the first is that now foreign companies control at least 78.6% of the market and secondly that CXDC has a new domestic competitor, where 21.4% is not controlled anymore only by two companies, but by three (including CXDC). So while in the past - according to 2009 data - CXDC shared with its competitor 40% of the market, it now has to divide the 21.4% of the market (46.5% less) with two other competitors. This means that the other two companies that directly compete with CXDC (Guangzhou Kingfa Science & Technology Co., Ltd. and Shanghai Pret Composites Co., Ltd.) are sharing the remaining part of the market that was 9% up to 2010, 14.1% up to 2011 and it is 14.2% as of 2012.
The fact that imported automotive plastics decreased from 65% in 2005 to 45% in 2012 of the total China-automotive modified plastic supply, can be explained by the fact that foreign manufacturers have delocalized production in China, where the labour cost is lower compared to that of the countries of origin. Consequently domestic production has increased which is now able to meet a higher percentage of domestic demand than in the past.
What we want to do now is to establish a relationship of dependency between sales and operating income (EBITs) for the past 5 years and once we have estimated the slope of the line, we're going to replace the value of the sales expected for 2013 and then we will evaluate the 'reliability' of the guidance on company's income provided by the company's CEO in the earnings call in which the 2012 financial results were presented and discussed. In the evaluation we assume that the total operating expenses (including COGS), considered as a percentage of sales, will remain at the same level also in 2013, let's say around 84.3% of sales. It is a geometric mean computed over the past 5 years' data.
As you can see from the figure below, we have replaced the difference quotients (green delta symbols), with a straight line whose slope is equal to about 0,034 (positive). This value represents the slope of the function ΔEBIT=f(Δsales) compared to x-axis.That is the speed with which the operating profit range increases when the sales range increases.
The mathematical equation of our line is:
Where f(X)=Ebit(t)-Ebit(t-1) and x=sales(t)-sales(t-1). Each green delta in the picture above is ΔF(Sales)/Δ(Sales).
Finally, as a result of our solid year of performance in 2012, we announced our guidance for fiscal year 2013. We expect revenues to range between $935 million and $1 billion (China XD Plastics' CEO Discusses Q4 2012 Results - Earnings Call Transcript)
Then we will replace the expected sales values for 2013 in our equation of the line. We obtain the following range of expected Ebit's values for fiscal year 2013:
Ebit 2013 (MIN)=[0.0341645374 * ($935 - $599.82) + 0.0341394307] + $111.88 = $123.37
Ebit 2013 (max)=[0.0341645374 * ($1,000 - $599.82) + 0.0341394307] + $111.88 = $125.59
Net income for fiscal year 2013 to range between $100 million and $132 million, excluding any non-cash charges related to stock-based compensation and changing fair value of existing derivative liabilities. The current wide net income guidance is a function of the expected sales from our subsidiaries in Sichuan Province (China XD Plastics' CEO Discusses Q4 2012 Results - Earnings Call Transcript).
Can we trust the guidance provided by the company's CEO on projected sales for 2013? Because it is the initial assumption which all our assessment depends on ..
What we can do is to assess the predictive ability of the CEO. That is we can compare the predictions made with the final results of previous years to assess whether and how the CEO has been good with predictions. From this we can also see how deep CEO's knowledge is of CXDC's business dynamics. If we want it can also be considered as a measurement to evaluate the efficiency of management.
(click to enlarge)
We will add to the company's sales expectation for 2013, the geomean error's value of $25.25. So let's assume that CXDC will make sales of $ 1,025.25 for 2013.
Ebit 2013 (max)=[0.0341645374 * ($1,025.25 - $599.82) + 0.0341394307] + $111.88 = $126.45
As we can see from the table above, CXDC management has always been able to exceed sales forecasted the year before the final results. So we can consider sales forecasts made for fiscal year 2013 having a very high degree of reliability. Therefore, as a starting point of our evaluation, based on the DCF method, we can start from a value of EBIT being equal to $126.45 (see above on how we calculated this value).
We observed the relationship between sales and EBITS, from 2007 to 2013E, which can then be expressed by a function in order to better analyze the phenomenon.
Starting from these pairs of data (x=sales, y=EBITS), we can therefore determine the function y = f that is Ebit = f(Sales) that describes the phenomenon from 2007 to 2013E. But which function?
First of all the observed points will be arranged on a dispersion diagram:
Now we can determine the function that comes close as much as possible to the points (sales, EBITS) observed (statistical interpolation).
The function that comes close as much as possible to the observations is the power function which mathematical equation is f = 0.1304711641 X^ 1.0241278098. That is:
EBIT= f(Sales) = 0.1304711641 Sales^ 1.0241278098 where R^2 (coefficient of determination) is 0.97. R^2 varies between 0 and 1: when it is 0 the model used does not at all explain the data, when it is 1, the model explains the data perfectly.
How will sales grow during the period from 2013 to 2017? We can use the regression to obtain a function that expresses the growth trend of the sales. The trend, determined on the ground of sales historical data can be represented by an exponential function which mathematical equation is f = exp (-1098.3115569753 + 0.5490934999 x). R^2 is 0.99 so the method used explains all the data set very well.
We can use the function f = exp (-1098.3115569753 + 0.5490934999 x), where x=fiscal years (2007, 2008, …, 2017) and y=f=Sales, to forecast sales for years 2014, 2015, 2016 and 2017.
Now that we know sales for the years 2014, 2015, 2016 and 2017, we can use the function f = 0.1304711641 X^ 1.0241278098 to compute Ebits.
We set a yearly net investment calculated as a 10% on yearly sales and we assume that working capital will yearly increase at the same rate as sales do. So we ended up to the following prospect of FCFs for the next 5 years:
Why? The answer is that the operating profit margin is not enough. That is the company should make more profit considering the volume of sales that it produces.
As a matter of fact the percentage of total operating cost on sales is around 84%. It is a geometric mean computed on the past 6 years (from 2007 to 2012). Let's say every 1$ of sales is costing 0.84$ for total operating costs. This means that on 1$ of sales the company is able to get 16 $cents, excluding the financing and one time costs.
The company is now focused on growth and developing its business. As a matter of fact the company is incurring more costs mainly in order to penetrate in North and East markets by giving more incentives to its distributors and customers, by reducing post-sales service fee and by investing more resources in R&D to create higher value-added products to offset any decline from lower margin products. The fruits of incurring more operating costs for growth purposes and investment in research and development for high value-added products cannot be picked up right away because it will take some time before new high value-added products will be accepted by new customers. At that point, the sacrifices of so many of CXDC's efforts will pay off in terms of higher profit margins (China XD Plastics' CEO Discusses Q4 2012 Results - Earnings Call Transcript).
If we examine the past, the company has never achieved positive free cash flows. Only in a year it was positive, then during the remaining four years it was below zero and in some cases even far below zero. So one could argue that it is so because the company is in a phase of growth and development of the business. But then we ask how long does this growth take? How can you sustain growth if the free cash flows were negative and the prediction on future ones is negative too? And we forecasted that revenues will increase exponentially and operating profits increase according to a power function.
We mean that we went even beyond the most optimistic expectations of growth but if we need to estimate operating profits taking into account the speed with which operating profit increases with increasing sales, we would have to estimate operating profits more low due to operating costs. Operating expenses for the last 5 years represent, on average, about 84% of sales.
The company believes that it holds ''unique proprietary formulas and processing techniques that enable it to produce low-cost high-quality modified plastic materials.'' But if the company cannot control operating costs in a country like China, where the cost of labour is among the lowest in the world, what kind of expectations an investor can have about the profit margin. Furthermore can we be ''sure'' that after all the efforts that have been sustained for the growth, the company has finally achieved the position that will ensure high enough margins to pursue opportunities to enhance shareholder value? By analyzing the information taken from the company's financial statements of the past years, it doesn't seem to us that the company is gaining market share at the expense of the competition.
When an operating margin target to be achieved, for example, within the next 2, 3 or even 5 years can't be set, then an investor askes himself/herself: what can I base my investment expectations upon?