BYD Company Limited (“BYD” or the “company”) is a joint stock company listed on the Hong Kong Stock Exchange (SEHK:1211) and the American pink sheets (OTCPK:BYDDF).
BYD, along with its subsidiaries, is engaged in the research, development, manufacture and sale of (1) rechargeable batteries, (2) handset components and assembly service, and (3) automobiles and related products.
The company entered the rechargeable batteries market in 1995 to compete against Japanese rechargeable batteries and, within ten years, became responsible for over half the rechargeable batteries market. The company then used its position in the rechargeable batteries market to create a leading position in the handset components and assembly service market. The company has recently, through a 2003 purchase of a defunct Chinese automaker, begun to build its automobile division, and, by 2008, had the best selling sedan in China. Most recently, BYD has partnered with the Los Angeles Department of Water and Power to develop a grid-scale battery project for renewable energy storage.
I feel a little bit like I’ve wandered into uncharted territory. (Well, uncharted for me anyway.) Most of my investments come in the form of a quantitatively undervalued company. It’s easy to show a discount to net asset value or a discount to previous years’ earning power. BYD, on the other hand, does not easily succumb to quantitative analysis. Instead, in order to see the value inherent in BYD, you have to rely on Charlie Munger’s Lollapalooza Effect or Phil Fisher’s Fifteen Points.
*The Lollapalooza Effect (“LE”)
Charlie’s Lollapalooza Effect describes a situation where multiple factors greatly reinforce and amplify one another. In these situations, the factors are not simply additive in their combination; they are often multiplicative or exponential. It’s much like reaching critical mass or a tipping point, where the combination of factors provide for an explosive result. In this case, the culmination of the five LE factors below provides BYD with a very good chance for not only dominating the Chinese internal combustion engine (ICE) car market, but the global electric vehicle market and renewable energy storage market as well.
(1) Low-Cost Operator
The first LE factor is that BYD is, by far, the low-cost operator in all its divisions.
When starting the rechargeable battery business, the CEO, Wang Chuanfu, decided to substitute migrant workers for the expensive automated robotic arms used on the Japanese assembly lines. Since the automated arms cost about $100,000 a piece and depreciated at a rate of $20,000 a year, Wang Chuanfu calculated that migrant workers would be more cost-effective given China’s low-cost labor environment. Additionally, BYD’s location in China helps the company recruit engineers from China’s best schools for the low price of about $600 to $700 a month -- though this amount is slightly understated given that BYD provides subsidized housing in company-owned apartment complexes and low-cost meals in BYD canteens.
And, of course, let’s not forget that BYD does not have to deal with unionized labor. (If you take a look at the margin breakdown by segment in BYD’s annual and interim reports, you can see that BYD’s automobile segment makes profit before taxes of roughly 15%. That’s astounding when compared to other automakers.)
The benefits of being a low-cost operator can be seen when comparing the final value proposition presented to automobile consumers.
The most visible plug-in hybrids right now are the Toyota Plug-In Prius (NYSE:TM) and the Chevy Volt. The retail price for the Toyota Plug-In Prius is roughly $35,000 to $40,000 when it enters production at the end of 2011 or the beginning of 2012. The Chevy Volt started production this year and retails for $41,000. BYD’s plug-in hybrid, the F3DM, went into production at the end of 2008 (commercial sales started in March 2010) and retails for $22,000. That’s a pretty big difference.
I should point out here that, on the all-electric vehicle front, the Nissan LEAF and BYD’s E6 sell for roughly the same price of $32,000 and will be rolling out at about the same time. BYD’s edge in this part of the market is that the Nissan LEAF has a range of 100 miles whereas the BYD E6 has a range of 186 miles.
(2) Vertical Integration
The second LE factor is that BYD is vertically integrated.
As we all know, vertical integration helps keep costs low and quality high. Since BYD’s rechargeable batteries have never been recalled, in contrast to its Japanese competitors, this makes it very easy for BYD to market the battery technology underlying the automobile and renewable energy business. BYD’s reputation for quality control can also be seen in the fact that every piece of equipment in a BYD automobile, except the windshield and tires, is made by BYD.
BYD’s starting point in rechargeable batteries has allowed the company to vertically expand upwards into the hybrid/all-electric automobile and renewable energy markets. This is very similar to what the company did when it expanded into the handset component and assembly service market. Normally, this would be worrisome, since a vertically integrated company has the ability to monopolize markets, and the United States would never stand for that. Of course, BYD is located in China...
(3) China’s Central Planning
The third LE factor is that BYD benefits from being located in China.
Now, this is more than just a low-cost worker argument. Ten years ago, I did not think that I would ever utter the words that China has a friendlier business atmosphere than the United States, but for batteries, hybrid/electric cars and clean energy, it’s true. Although China no longer has a strict planned economy, the country is still able to exert some direction and influence through its series of Five-Year Plans. In fact, the country’s twelfth five-year plan decrees that China will have 5 million electric cars traveling on the nation’s roads by 2020. (They currently have almost none.) Notably, this is on the back of China’s enormous growth in its consumer car market. Additionally, China has been pouring money into clean energy technologies whereas, in comparison, the United States is merely trickling money into the sector. (After all, the U.S. Congress can’t even come together and agree to give 9/11 rescue workers health benefits, so how can anyone expect them to fend off the energy lobby?)
(4) Leading Technology
The fourth LE factor is that BYD has the best technology.
BYD has a commanding lead in the rechargeable battery market stemming from its early success of crowding out the Japanese rechargeable battery makers. Very few companies have comparable experience and expertise to go up against BYD in the rechargeable battery market.
In the automobile division, the company has leveraged this expertise to partner up with Daimler AG (DAI). Although there are some other companies, Tesla Motors (NASDAQ:TSLA) comes to mind, that have also been able to leverage their technology to partner up with big automakers, it seems to me that there’s a fundamental difference. Tesla Motors is a high-cost operator partnering up with Toyota in hopes that the latter can help the former bring costs under control. BYD is already a low-cost operator partnering up with Daimler AG to bring Daimler’s design expertise to the table.
In the renewable energy storage division, the company has leveraged the exact same battery technology to partner up with KB Homes and the China Southern Power Grid. This is key. The lithium-ion ferrous phosphate battery packs will be the same type used in plug-in vehicles that BYD expects to roll out in Los Angeles in the near future. In other words, with every incremental improvement in BYD’s battery technology, three separate divisions of the company stand to benefit. (The rechargeable battery division, the automobile division and the renewable energy storage pack division.)
(5) The CEO
The fifth LE factor is BYD’s CEO.
Charlie Munger calls Wang Chuanfu a “combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.” Additionally, Wang Chuanfu’s frugality is the stuff of legends. The CEO is worth somewhere between $4 billion and $5 billion, but he only pays himself about $265,000 a year and lives in a BYD-owned apartment complex with the other engineers. His only indulgences are a Mercedes and Lexus that he took apart to see how their engines worked. It’s been reported that the last time the BYD team went to Detroit, they shared a townhouse to save on hotel costs. Finally, when Warren Buffett asked how BYD planned to keep its lead, Wang Chuanfu replied “We’ll never, never rest.”
*The Fifteen Points
- Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- How effective are the company’s research and development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have depth to its management?
- How good are the company’s cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
- Does management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
- Does the company have a management of unquestionable integrity?
A company doesn’t have to pass all of the fifteen points, but a company should pass enough of the points to make an investment worthwhile. A lot of these points have been covered as a result of our exposition of the Lollapalooza Effect factors. The only three issues that I see with BYD concerning Fisher’s Fifteen Points are numbers 4, 7 and 9. I’m not particularly sure whether BYD’s sales organization is above-average, and it’s hard to tell whether sales increases are due to secular growth in the underlying industry or something peculiar to BYD.
It’s also hard for me to tell whether the company has outstanding labor and personnel relations -- the mere fact that BYD does not have Foxconn-like problems is not enough to come to a conclusion on this matter. Finally, BYD suffers a bit from the key man risk that Wang Chuanfu is the drive behind the company. (Thankfully, he’s only 44 years old, and they’re trying to build a deeper bench.)
As of November 12, 2010, shares in BYD traded at HK$47.40 or US$6.13. Since there are 2,275,100,000 shares outstanding, BYD is currently trading for about HK$107.84 billion or US$13.95 billion. The recent ~25% slide in valuation in the last month has been attributed to problems with building facilities on land slated for agricultural development (the facilities have been confiscated) and a 99% decline in year-over-year profits in 3Q 2010 (largely attributable to an increase in COGS and sales/distribution costs).
In 2009, the company made HK$3.8 billion in earnings (though free cash flow was about HK$6 billion). On that basis, the company would be trading for a fairly rich valuation of 28x P/E. I expect that, with a revised 2010 automobile guidance of 600,000 units rather than 800,000 units, the company will earn roughly HK$4 billion in earnings this year for a 27x P/E. (If the free cash flow comes out to around HK$6 billion again this year, that will drop the P/FCF to between 17x to 18x.)
So, how can we determine whether HK$107.39 billion is a fair price to pay for the company?
Return on Incremental Equity
Well, one thing that we can do is take a look at the return on incremental equity for the company. In other words, we can see how much each retained dollar in the company grows earnings.
Since the company’s near-term and intermediate-term growth will most likely be driven by its automobile segment, we can try to screen out the other segments and isolate just the automobile part of the company. After all, the CEO has repeatedly talked about the great economics and economies of scale in their automobile segment, so let’s try to quantify that a little bit. (Sidenote: Bless you BYD CFO for breaking out the assets by segment.)
We can see that for the period from 2006 to 2009, the company’s equity for the automobile division increased by HK$4.5 billion. The company’s net income increased by about HK$3 billion for the same period for an eye-popping incremental return on equity of roughly 67%. So every dollar that the company sinks back into the automobile division results in value of about $1.67. That’s pretty incredible. (The incremental return on equity for the company as a whole rests at around 21%, which is still pretty good.)
Implied Growth Rate - Reverse DCF
Now, if we assume that the company can continue to reinvest earnings from the automobile division back into the automobile division, the company should be able to grow overall earnings at something close to a 35% to 45% clip (assuming that the other divisions stay roughly at the same level of earnings) for at least the medium-term. Compared to a reverse DCF of the BYD share price (using earnings and not free cash flow), assuming a long-term 4% growth rate and an 11% discount rate, the current price assumes earnings growth between 20% and 30%.
Implied Growth Rate - Reverse Graham Valuation Formula
If you use Ben Graham’s valuation formula of EPS * (8 + 2 * (growth)) * (4.4 / AAA corporate bond yield), then you can reverse engineer an implied growth rate as well. The average Moody’s AAA yield for the last 10 years is 5.98%, and the EPS for 2009 was HK$1.77. On this basis, the implied growth rate is only about 14%. Since Graham’s formula generally overstates value a little, we can use a modified (7 + 1.5 * (growth)) to get a slightly higher implied growth rate of about 20%.
Implied Growth Rate - Greenwald’s NPV/EPV
If we use Greenwald’s NPV/EPV calculation, we get a nice little formula of (1 - (growth / return on capital)) / (1 - (growth / cost of capital)) for the multiple we should pay on EPV. Since EPV is just the steady-state EPS * (1 / return on capital), we can calculate the EPV to be roughly HK$17.70 per share. This assumes that there’s no growth on the HK$1.77 of EPS and that the cost of capital is roughly 10%. Since the return on invested capital is about 25%, we can see that the implied growth rate is roughly 7.4%. (Notably, Greenwald’s formula suffers slightly from an inability to deal with companies that can achieve growth rates exceeding their cost of capital. Or, stated another way, Greenwald’s formula overstates value the more growth rates approach the cost of capital.)
It’s always hard to value a growth company. Assets are easy to value, and the resulting valuation is fairly reliable. Historical earnings are also easy to value, and the resulting valuation is still pretty reliable (though less reliable than asset valuations). On growth companies, though, we wander into slightly dangerous territory. The best we can do here is take a view on the implied growth rates and see whether they are reasonable.
The company is probably not wildly undervalued, but I would posit that the company is at least fairly valued to moderately undervalued at prevailing prices. Notably, the analysis thus far has neglected to price in any recovery in the two non-automobile divisions or attribute any value from the nascent renewable energy storage pack business, which can be thought of as free options.
Additionally, I’d add that the growth in the automobile industry has thus far been based primarily off sales of ICE vehicles. Even though the qualitative analysis has focused on BYD’s competitive edge in batteries and hybrid/electric vehicles, we need not rely on that edge for the investment to work out.
Growth company volatility.
- The problem with a lot of growth companies is that when they run into a bit of trouble, such as BYD did recently, the market capitulates and the shares will trade much lower than is warranted. Of course, volatility isn’t risk, so the long-term investor need not worry too much about this.
The auto industry is terrible.
- Well, sort of. The barrier to entry is not high for most of the auto industry. ICE cars are very easy to produce. However, the barrier to entry for hybrid and electrical vehicles is not as low. BYD has the most advanced technology in the field, and because of its previous business lines, its economy of scale is huge. These provide a real moat for the company.
The technology industry is tough.
- Well, that’s certainly true. It’s possible that some upstart in California or Mumbai could develop a better battery based on technology that doesn’t infringe BYD’s patents. However, there’s a bit of a first mover advantage here, and I think BYD understands that. Once you start to integrate your product into other people’s developed products (individual household and grid-scale renewable energy storage packs, etc.), the switching costs provide for a nice competitive advantage. Also, let’s not forget that BYD has a head start in battery technology already, so any upstart would have a ways to catch up.
Disclosure: Author is long BYDDF.PK