It is a known fact that macro economic fears can cause stock market declines in which certain stocks can trade at ridiculous valuations. China automotive systems (NASDAQ:CAAS) is a perfect example of this, and even though I am not denying the existence of some real economic problems in China, this company's valuation justifies taking a closer look.
China automotive systems is a supplier of power steering products for primarily the Chinese market (approximately 86% of sales in 2015, with most of the other sales going to the U.S.). Major customers include Fiat Chrysler (NYSE:FCAU) North America and Dongfeng Auto Group (OTCPK:DNFGY). It has grown net sales from about $95 million in 2006 to a height of $466 million in 2014, with net earnings in 2015 of approximately $27 million. Current insider ownership accounts for more than 61% of the outstanding shares, which is (most of the time) a good thing.
Although the company has been able to deliver sustained growth of revenue and shareholder's equity, earnings have been more volatile and have grown not as fast. This company is of course operating in a competitive and cyclical industry, which increases the volatility of its profits and subsequently of its earnings.
The company is currently experiencing a shift from hydraulic power steering (HPS) to electronic power steering (EPS), the EPS percentage of sales was 10,7% in 2014 and 20,1% in 2015, versus and estimated 35% in 2017. The more modern EPS has many clear advantages above the traditional hydraulic power system. The continuing change in product mix will add to the uncertainty about the company's prospects, because in the short term it remains the question if the growth in EPS sales will offset the decline in hydraulic system sales. However the fact that it's subsidiary Hubei Henglong won The 'central government's highest reward for quality', assures us of the quality of the company's products, and the CEO has stated that its not a very big deal to convert the production capacity from HPS to EPS.
"there's quite a bit similarity in the EPS and in the mechanic part of HPS. But you know then with EPS there's still some differences in terms of product structures. There are differences, a clear difference between the high end, the median end and low end product. But we are adjusting our production procedure according to international customers request and these all can be fulfilled. We don't think it's issue in terms of converting the HPS production to the EPS."
Source: Q1 2016 Results - earnings call transcript
And even though the profits and revenue of the company have declined because of the deteriorating growth of the Chinese economy, The CEO already expects a 10% revenue growth in 2017.
I have to admit that considering the industry in which it operates, China automotive systems may not be the most high quality company one can encounter on the stock market exchange. What makes this stock a good investment is it's discrepancy between price and value. I have believe investments should always be made on the grounds of such an discrepancy, may that be estimated future value, or the value of current assets(with a preference for the latter).
China Automotive Systems, Inc. and Subsidiaries
Condensed Unaudited Consolidated Balance Sheets
(In thousands of USD unless otherwise indicated)
|June 30, 2016||December 31, 2015|
|Cash and cash equivalents||$||37,864||$||69,676|
|Accounts and notes receivable, net - unrelated parties||293,135||254,397|
|Accounts and notes receivable, net - related parties||20,947||21,918|
|Advance payments and others - unrelated parties||11,250||4,381|
|Advance payments and others - related parties||386||544|
|Current deferred tax assets||6,500||6,962|
|Total current assets||491,151||476,059|
|Long-term time deposits||4,976||5,082|
|Property, plant and equipment, net||86,695||84,151|
|Intangible assets, net||659||2,793|
|Other receivables, net - unrelated parties||2,148||3,882|
|Other receivables, net - related parties||-||14|
|Advance payment for property, plant and equipment - unrelated parties||14,669||15,192|
|Advance payment for property, plant and equipment - related parties||10,055||8,863|
|Non-current deferred tax assets||4,959||4,899|
|LIABILITIES AND STOCKHOLDERS' EQUITY|
|Bank and government loans||$||42,239||$||40,929|
|Accounts and notes payable - unrelated parties||214,586||197,105|
|Accounts and notes payable - related parties||6,698||6,363|
|Accrued payroll and related costs||6,271||6,332|
|Accrued expenses and other payables||29,828||31,383|
|Accrued pension costs||4,967||4,664|
|Amounts due to shareholders/directors||335||345|
|Advances payable (current portion)||324||-|
|Current deferred tax liabilities||164||194|
|Total current liabilities||315,015||298,212|
|Non-current deferred tax liabilities||-||266|
|Commitments and Contingencies (See Note 29)|
|Common stock, $0.0001 par value - Authorized - 80,000,000 shares; Issued - 32,338,302 and 32,338,302 shares as of June 30, 2016 and December 31, 2015, respectively||$||3||$||3|
|Additional paid-in capital||64,627||64,627|
|Accumulated other comprehensive income||12,352||18,412|
|Treasury stock - 331,992 and 217,283 shares as of June 30, 2016 and December 31, 2015, respectively||(1,454||)||(1,000||)|
|Total parent company stockholders' equity||303,602||299,043|
|Total stockholders' equity||308,991||307,295|
|Total liabilities and stockholders' equity||$||624,606||$||607,695|
Source: China automotive Systems 2015 10-k
When we look at the balance sheet we can see that with its current market cap of 144$ million it trades below the net current asset value (NCAV) of the company, considering the fact that it is still making a profit this is a rare thing to see. Also, the P/E ratio for the past 4 quarters of the stock is around 6, this is quite low considering the company's past P/E ratio. Even higher levels of valuation were seen pre-crisis period. Keeping in mind the company's past performance and the fact that is has got nearly zero debt, I consider it severely undervalued. For example: even though the book value of the stock was in 2010 less than half it is now, the stock was trading many times higher.
Of course investing in this company comes with some risks, and even though I believe risk should by the potential loss of capital instead of the share price volatility, it is easy to see why people are reluctant to invest in Chinese small caps. With Chinese small caps there is always a higher risk that the books are cooked, and there is always the question if the management is really acting in the shareholder's best interest.
China automotive systems has upgraded its auditor in 2010 to PWC, which increases the credibility of its auditing. I believe the management could create more value for shareholders through cash dividends or a expansion of the current $5 million buyback program, the high insider ownership should help to align the interest of stockholders and the management.
Another important risk factor is the foreign currency risk. The lower yuan versus dollar could help the company in penetrating the U.S. market, where the company is already increasing it's sales. The risk however lies in the fact that future volatility of the exchange rate can result in declining financial results for U.S. listed Chinese companies which result their financial reports in dollars. The latest quarterly report shows this:
|Net income attributable to parent company's common shareholders||$||5,364||$||7,659|
|Other comprehensive income:|
|Foreign currency translation (loss)/gain, net of tax||(7,946||)||1,436|
|Comprehensive (loss)/income attributable to non-controlling interests||(164||)||34|
|Comprehensive (loss)/income attributable to parent company||$||(2,267||)||$||9,030|
|Net income attributable to parent company's common shareholders per share|
Source: China automotive systems Q2 2016 10-Q
The most important risk factor to be considered is the possible worsening of the Chinese economy. China automotive systems is a company operating in highly cyclical industry, and even though Chinese domestic car sales have seen improvement in the past months, further economic troubles in china cannot be ruled out. Such a bad scenario however, seems to be already priced in considering the stock's valuation. Everything is a matter of risk reward, and if the company will able to increase it revenues and earnings, and investors are willing to wait before the pendulum swings back, Mr. market will make the stock skyrocket just as it has done before. If not, I believe the downside risk is limited. One has to remind that the greatest profits are made when you go against the grain.
Disclosure: I am/we are long CAAS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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