Cogo Group (COGO), a Chinese company operating in the communications equipment industry, is interesting as a value play based on price/book, a strong balance sheet, and ample cash. A former high flyer, it has traded from a high of 22.50 in 2007 to a low of 2.46 in November last year.
At Monday's closing price of 5.57, it is a prospect for accumulation, based on the possibility that it will participate in the renewed growth of the Chinese telecommunications industry. I got the idea from an article by Mark Gerstein here on Seeking Alpha and did my own homework before buying.
From a recent press release:
Cogo Group, Inc. is a leading provider of customized module and subsystem design solutions in China. The Company believes it acts as a proxy to China's technology industry as it works with virtually all the major ODMs and OEMs in China. Cogo leverages these relationships and combines their IP to create designs that Cogo then sells to electronic manufacturers. These designs allow manufacturers to reduce their time to market for new products and ultimately increase sales. Cogo focuses on the mobile handset, telecommunications equipment, digital media and industrial applications end-markets for their customized design modules while also offering business and engineering services to their large telecommunications equipment vendor customers.
Growth has been stellar, about 40% per year from 2004 to 2008: however, margins have grown thin over the past 3 quarters, pushing share prices down. The balance sheet is very strong, including 3.35 per share of cash, which provides margin of security. Management is planning to deploy the extra cash for acquisitions in order to increase revenues, and seems to appreciate the potential of buying businesses that have complementary technical expertise. The issue of margins has their attention: their goal is 15% gross margin and 10% operating margin.
For a company where future business depends on customized design solutions, it is tempting to speculate that R&D spending is indicative of potential future sales, as they will tend to increase proportionate to the amount of collaborative development work being undertaken on behalf of customers. Noting that R&D has been increasing both in absolute terms and as a percentage of evenue; if this money is being spent successfully, it bodes well for future sales.
Sources of Potential Growth
3G is expected to grow rapidly in China, and COGO plans to participate. Richard Davenport suggested the stock in an article on SA back in March, based on the 3G potential. The stimulus will make funds available for infrastructure, and COGO is working to get in front of this by going into smart grid and railroad, expanding what they call their industrial segment. They are working on an acquisition, the so called Mega Smart deal, which was discussed on the latest conference call. Mega Smart is the entity they have created to receive the acquisition. Details of who they are actually buying were not forthcoming.
The Mega Smart deal is not being present transparently and has not been consummated. A read of the 10-K reveals a subsidiary headed by the CEO's mother. Taxes have been nominal but will be phased in to 25% over the next few years. The business model, as far as I can interpret it, relies on developing modules and sub-assemblies and getting them designed in. As a middleman margins can be squeezed in difficult economic times. Currency fluctuations between the RMB and USD can affect profits.
Assuming growth at 7% a year, a reduction from historical levels, and margins similar to past averages, EPS of .60 x P/E of 17 seems possible, yielding a target of 10 in two years. Downside risk is moderated by the strong balance sheet – no long term debt – the 3.35 per share of cash. Upside potential is kind of diffuse, there was that 22.50 several years ago, but a return to that level would require 30% growth to fuel it. The World Bank recently raised its growth estimate for China to 7.2%, so 7% seems like a good growth estimate for COGO.
Long term the company has good prospects, due to the expectation that China will recover rapidly from the global recession and become a larger factor in the manufacture of communications equipment. As of this moment, the market, the sector and the stock are showing signs of heading south. After the 3/9 bottom I had a lot of success buying value type tech stocks and selling into the rally, a process I would like to repeat if conditions permit.
With that in mind, I have taken up a starter position with the intention of adding to it systematically if the stock continues to decline. Otherwise, the plan would be to hold and monitor quarterly earnings and conference calls, focusing on growth, R&D expense (as a possible tell for growth), and margins.
Disclosure: Long COGO