Gross Undervaluation And Multiple Strategies Will Catalyze SORL Auto Parts

| About: SORL Auto (SORL)
This article is now exclusive for PRO subscribers.


SORL is significantly undervalued as compared to its main competitor.

SORL has a strong strategy to catalyze the company’s growth.

Given the gross undervaluation and expected growth, the stock is likely to gain 20%-38% over the next year.

SORL Auto Parts (NASDAQ:SORL) is the largest commercial vehicle air brake system manufacturer in China. The company derived 81% of its 2013 revenue from commercial vehicle brake systems, with 19% coming from passenger vehicle brake systems. The mix changed to 80% commercial and 20% passenger in Q1 2014. SORL has a strong strategy to drive future revenue and earnings growth. When combining the significant undervaluation with numerous growth catalysts, SORL has a large upside potential.

Significant Undervaluation

SORL is trading at only 5X analysts expected EPS of $0.70 for 2015. The company's main publicly traded competitor, Westinghouse Air Brake Technologies (NYSE:WAB) is trading with a much higher valuation at 20X expected 2015 EPS. Please note that SORL also competes with the following non-public entities: Knorr-Bremse, China VIE Group, and CAFF Automotive Braking. Since those companies are not publicly traded, I will use WAB for the valuation comparisons. SORL is also undervalued when taking tax implications out of the equation with an EV/EBITDA of only 2.41, while WAB is trading with an EV/EBITDA of 15. It is rare to see a company trade with SORL's low EV/EBITDA ratio. In terms of these metrics, SORL is undervalued by 75% in terms of expected 2015 earnings and undervalued by 83% in terms of EV/EBITDA.

SORL is also undervalued in terms of its balance sheet since the stock trades at 63% below its book value per share of $9.66. WAB trades with a much higher valuation at 4.6X its book value per share. SORL has 4.6X more total assets than total liabilities, while WAB has 2.3X more total assets than total liabilities. With a price to book ratio of 0.37, SORL is undervalued by 92% as compared to WAB in terms of the balance sheet.

SORL's undervaluation resulted from the slowing GDP growth in China back in 2010. Since SORL is highly levered to China, the stock sold off significantly. The GDP growth rate fell from the double-digits back in 2010 to between 7% and 8% currently. The growth rate has remained in the 7% to 8% range throughout 2013 and thus far in 2014. Therefore, it appears that China's growth rate has stabilized, and is still above the expected global growth rate of 3.7% for 2014 and 3.9% for 2015. Therefore, I think that the fear of China's slowing growth has already been priced in to SORL's stock. Investors have reason to be concerned with China's economic health as about 78% of SORL's revenue is derived from China (57% from the China OEM market and 21% from the China aftermarket). That leaves only 22% of revenue coming from outside of China. With that in mind, I think that SORL's valuation will increase as various catalysts materialize.

Strategies to Catalyze Future Growth

Conditions have improved for SORL in 2013 and thus far in 2014. China's commercial vehicles market experienced increased growth last year after declining in 2011 and 2012. China has become the largest market for commercial vehicles. There is plenty of pre-buying before China's stricter stage IV emission standards go into effect. SORL plans to capitalize on these conditions through various strategies.

SORL has a plan to increase sales to OEM customers. It plans to do this by improving customer service and by increasing sales of integrated systems and modular supplies. The company is also working to increase sales in the bus market by enhancing relationships with major bus clients. SORL developed a team that is dedicated to bus product development. SORL is also working on increasing sales in the rail transportation market by expanding the product line. These strategies will allow SORL to better respond to its customer's needs and to increase revenue. Since the new brake products have higher margins, the strategies will help SORL to increase its profitability.

SORL has an eye for the future as it is developing new products. These include automotive electronics and energy saving products. The traditional air-brake drive products are being upgraded to electronically controlled products, which have higher profit margins. The energy saving products will produce more environmentally-friendly results not only in use but also during manufacturing.

Another important strategy is to improve the manufacturing process. SORL is looking to improve its manufacturing technology. This will be done to enhance product quality, reduce human error, increase efficiency, and to lower production costs. Ultimately those efforts will lead to higher earnings for SORL as production costs are lowered.

The company is also open to acquisitions or strategic alliances. SORL is looking to expand its international sales outside of China. The company is targeting acquisitions that can be integrated effectively and looking at possible joint-ventures with companies that would become major customers. SORL hasn't yet announced any new acquisitions or joint ventures, but this is something for investors to keep an eye on.

This is a comprehensive set of strategies that gives SORL a pathway for future growth. From increasing sales, improving products, improving manufacturing, and lower costs, SORL has a vision for the future that goes beyond one year. The company's strategies paint a picture that shows SORL is striving to drive growth for the long-term. The strategy to increase OEM and bus sales are likely to contribute to earnings over the next year, while the new product development and manufacturing improvements may take more time to materialize.

Defining the Downside

The stock is more volatile than average with a beta of 1.25. Typically, the stock will rise 25% higher than the market during a bull run and fall 25% more than the market during a market sell-off. The stock experienced periodic drops of 20% to 25% in short periods of time over the past few years. Negative economic news from China is likely to trigger a sell-off in the stock.

SORL does face downward pricing pressure from customers and competitors. However, if the company executes well on its strategies, it can lower costs to maintain its margins in the face of downward price pressure. The company does have the advantage of having low production costs since it operates in China.

With the stock already valued so low, I wouldn't expect it to fall too far from current levels. However, I wouldn't count out another 20% to 25% drop after a terrible quarterly report and negative outlook, or if we get new significant negative news from China. The stock appears to have formed a new uptrend which would be consistent with investors recognizing the low valuation and future growth potential.

Defining the Upside

Even a conservative price estimation of taking the expected 2015 EPS of $0.70 and dividing it by the current price of $3.55 gives us a potential 19.7% price appreciation over the next year. This represents the inverse of the forward PE, or earnings yield. The earnings yield suggests that the stock price can rise 19.7% based on the expected EPS in relation to the current price. That would give the stock a trailing PE of 6 if the EPS of $0.70 was achieved for 2015. I think that SORL could achieve this by meeting its earnings expectations in three out of four quarters. If SORL exceeds its estimates in three out of four quarters, the results could be even better. If investors awarded SORL with a PE of 7, which is less than half of WAB's forward PE of 20, the stock could reach $4.90 within a year. That would represent an increase of 38%. At this level, the stock would still be trading significantly below its book value per share of $9.66.

If SORL executes its strategies well, the company is likely to achieve strong increases in revenue (increased OEM and bus-related sales) and maintain or increase its gross margin (due to lower production costs and higher margin products). This is likely to lead the company to meet/exceed its earnings expectations going forward and hit the price targets given above.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.