Recent comments from Alan Greenspan have scared many U.S. investors out of Chinese companies. However, despite the selloff, Harbin Electric (NASDAQ:HRBN) has held up quite well. As one of my new holdings from last week, let’s take a closer look.
Harbin manufactures custom linear motors for industrial applications. Their current products are used in industrial conveyor belts and assembly line systems, oil wells, postal sorting systems, etc. In addition, the company will be expanding into two new areas–automotive electric linear motors (for internal applications) and railcar motors for subway systems over the next year. The company holds 3 Chinese patents protecting broad design features of their linear motors, and HRBN is applying for several more patents.
Review of 2006 Operating Results
HRBN showed impressive revenue growth in 2006, with the top line growing 70% over 2005 to $50 million. The company showed net income growth of 80% ($18.2 million), but this number is deceiving because the company booked a large one time gain of $6 million due to warrant activity. Therefore, net income statistics are not very instructive here, and we would do better to look at operating income as the key metric for 2006 results.
Operating income for the year grew by 40% for the year, indicating that the company’s margins declined significantly from 42% to 34%. Most of this decline can be explained by increased interest costs as the company took out a $60 million loan to finance the construction of a new plant outside of Shanghai, and margins should recover as the company continues to pay down this debt and brings new capacity online. Although the company took a temporary hit in margins due to this financing, it also prevented them from having to dilute shareholder equity in order to finance expansion.
2007 Results and Outlook
Harbin recently announced 1st quarter 2007 results, which continued to show strong revenue growth and a bit of a recovery in operating margins. Total revenues jumped to $13.6 million for the quarter, representing sequential quarterly growth of 13.5% and 54% year over year quarterly revenue growth. Operating margins jumped to 37.6% for the quarter, showing some recovery of operating margins as the company continues to growth the top line. As revenues continue to go higher, operating margins should continue to trend higher and move back toward their former levels.
Harbin also inked an important deal with major North American auto parts supplier in the first quarter, which has validated the company’s decision to expand production in this sphere. As Harbin’s current customers are all based in China, this represents an important step toward diversifying the business and establishing multinational distribution.
Going forward, Harbin is currently constructing a new facility outside of Shanghai which will focus on linear motors for automotive applications, and the plant is expected to come online at some point in Q3. This plant will add $30 million in revenue capacity per year, and the fact that Harbin has already inked a deal with a North American auto parts supplier gives confidence that the plant will be running at full tilt once it is finished.
As well, Harbin is continuing to develop China’s first domestically constructed linear motor powered train, which is due to be tested on a track to Beijing’s airport late in 2007. I don’t expect this project to add anything to earnings in 2007, but this project has the potential to be a major game changer in 2008 as the company moves from the development phase to the production phase.
At present, Harbin believes it is the only producer of linear motors in China, and that substantially all of its competition in the linear motor market comes from higher cost producers in developed nations. Therefore, Harbin’s cost competitiveness should allow them to compete favorably in international markets. As well, HRBN’s Chinese patents provide some protection against domestic competition, so Harbin has only moderate competitive risk.
Perhaps more worrying is the fact that Harbin derives over 80% of its revenues from just 4 customers. Business with two of these customers (Daqing Oil Field and the Chinese postal service) is expected to continue to grow over the near term, but nevertheless, such a high concentration of revenue amongst these clients is something to be aware of. As Harbin continues to branch out internationally, their dependence on any one client should continue to decline, but a failure to diversify over the next few quarters would definitely be a warning sign.
Harbin has reported sequential revenue growth in every quarter since it because a publicly traded company in 2004. I see no reason why that trend should change over the next few quarters, especially with new capacity expected to come online and the company branching into new markets over the next few quarters.
Nevertheless, I am going to make the conservative assumption that quarterly revenues will be flat except for the fourth quarter, which will show an increase of $7.5 million as new capacity from the Shanghai plant comes online. This would yield 2007 revenues of (13.6 x 4) +7.5 = $62 million. Assuming that the company is also unable to increase operating margins (which also appears conservative given Q1 2007 results), then we would expect net income for the year of about $15.5 million (assuming 25% net margins, consistent with Q1). This represents growth of about 30% over 2006 (after subtracting the $6 million gain for warrants in ‘06). Assuming a fully diluted share count of 21 million (which accounts for all warrants and options outstanding…the actual fully diluted share count at March 31, 2007 was just over 18 million), this yields an EPS of about 74 cents per share.
Obviously, these are very conservative estimates, and I believe the company will handily exceed this baseline estimate. I’ve created a more plausible set of estimates below, based on 5% sequential revenue growth, a $10 million impact from new capacity (ie, the new plant runs for half of the 3rd quarter as well), and net margins increasing to 26%.
Revs: $68.5 million (37% increase over 2006)
Net income: $17.8 million (48% increase over 2006 net inc w/o warrant gain)
EPS (21 mill shares): 85 cents
This is my target estimate, although I still believe the company has the chance to exceed this number based on the revenue trend they showed in the first quarter. Be aware, however, that the company tends to show a step function in revenue increases, such that I do not expect a big increase in revenues until new capacity comes online in the 3rd quarter.
Based on my very conservative first estimate of EPS, Harbin is currently trading at less than 18x 2007 earnings. Based on my target estimate, HRBN is trading at a multiple of less than 16x 2007 EPS. Given that my target estimate shows the company growing at over 40%, I believe the company should be valued at a multiple of at least 20. This would yield a target stock price of $17, which represents a 27% premium to today’s stock price. As well, the potential for Harbin to exceed my target estimate provides further upside potential here.
Based on the analysis above, Harbin definitely has some room to run from a valuation standpoint. As well, the technicals are showing some interesting signs here, which makes me believe that investors can realize a nice gain in Harbin over the short term. Back on May 15th, Harbin surged above its 50 day moving average on heavy volume as the company announced the agreement to supply a major North American auto parts manufacturer with linear motors. The stock traded as high as $14.15 on heavier volume over the following days, but has pulled back on below average volume over the past four days amid general market weakness and increasing fears about the Chinese market. However, HRBN has managed to hold its 50 day moving average during the pullback, and the dwindling volume during the pullback suggests that weaker hands have largely been washed out. Going into next week, Harbin looks poised for another bounce off the 50 day moving average, and this is a stock that can move very quickly when it gets some momentum. With a float of just over 5 million shares, it doesn’t take much buying to send the stock higher.
Overall, Harbin continues to post impressive revenue growth, and has a solid balance sheet with $57 million in cash. Nevertheless, net margin contraction in 2006 and recent China fears appear to have held down the stock price to a very reasonable valuation. After trending downward since early April, Harbin is flashing some bullish technical signs, and the current valuation would certainly support a move higher. Keep an eye on Harbin over the next few weeks, as the stock represents an interesting opportunity from both a fundamental and a technical standpoint.
HRBN 1-yr chart