A Small-Cap Chinese Stock That's Undervalued

| About: ATA Inc. (ATAI)

Summary

ATA is not effectively utilizing its assets.

The company enjoys moderate barriers to entry and high client switching costs.

Better acquisition integration should unlock value and increase shareholder returns.

Summary

ATA, Inc. (NASDAQ:ATAI) is undervalued due to the ineffective use of its assets and poor returns on strategic partnerships it has invested in. If ATA can unlock value from these strategic partnerships and more effectively utilize its assets, I believe it will see 25% upside from the current share price. The downside risks are limited as the company has stable cash flow and is already undervalued when compared to the present value of its future estimated cash flows.

To show that ATA is an undervalued stock, I start by briefly summarizing the company and the industry that it operates in and use this information to determine its cost of capital. I then value the company in two different ways:

  1. Calculating the value of the net assets, which I refer to as Net Asset Value - NAV.
  2. Calculating the value of the future cash flows, which I refer to as Earnings Power Value - EPV.

I concluded that ATA's NAV is greater than its EPV and calculated the likelihood of the company using its assets more effectively to increase its EPV to be more in line with its NAV. From this, an expected share price was calculated and compared to the current share price of ATA to form the basis of my investment decision.

Company

ATA is a provider of testing technologies based in China. The company's products are used in professional licensing and testing exams in various industries such as IT, accounting, and insurance. As of March 31, 2017, the company is trading at a trailing P/E multiple of 21.4 and a P/BV of 1.4x, which are not initially attractive metrics for a value investor. However, after adjusting for a one-time equity impairment, the trailing P/E multiple is ~14. The company's market capitalization is ~$86M; it is a small-cap stock, not very well known, and has limited analyst coverage.

Industry Analysis

The company operates in an industry where firms compete on technology, price, management experience, established infrastructure, reputation and brand. There are barriers to entry in the industry such as the time and costs associated with establishing a large-scale test center network. Domestic entrants lack the technology and commercial relationships that ATA possesses, and international competitors lack relationships with the Chinese government, industry test sponsors, and local institutions. These factors contribute to a moderate size moat.

Business Risk

ATA, Inc. has seen an improvement in its operating margin since it bottomed at 7.4% in the year-ended March 2013. In addition, the company's clients have high switching costs, which is evidenced by the consistent revenue on a year-to-year basis. This combined with the moderate barriers to entry discussed above suggests the company has medium to low business risk.

Financial Risk

ATA has a current ratio of approximately 2.5 and no long-term debt. It also has stable annual operating cash flows, which suggests the financial risk is very low.

Valuation

WACC

Given that ATA is equity financed, the cost of capital was determined by looking at Chinese companies with similar risk profiles. Similar companies would have a cost of debt of approximately 5%; adding a 5% equity risk premium would result in a cost of capital of 10% for ATA.

Return on Invested Capital - ROIC

Net income is trailing 12-month net income, and invested capital is based on the December 31, 2016, balance sheet

Amounts in RMB

Net Income - A

28,476

Net working capital

223,412

Net Operating Fixed Assets

237,287

Less - Excess Cash

123,855

Invested Capital - B

336,845

ROIC (A/B)

8.5%

ROIC of 8.5%, based on trailing 12 months' net income, is lower than WACC of 10%. Based on this, we expect the Net Asset Value to be greater than Earnings Power Value as the cost to finance the assets of the business (10%) is higher than the return on the assets generate (8.5%).

Net Asset Value: Based on the NAV calculation, ATA is worth $5.22 per share. I considered the costs new entrants to the industry would have to invest to establish a comparable business. All amounts are taken from the Q3 earnings release.

Amounts in $USD (USD/RMB = 6.88)

Assets

Reproduction Value

Current Assets

49,015

Net property, plant and equipment

7,793

Equity and other investments (75% of book value)

11,269

Goodwill

4,727

Intangible assets

1,135

Other long-term assets

5,809

Customer Relations

49,786

Product Portfolio

16,836

Total Assets

146,371

Liabilities

Current Liabilities

18,977

Deferred revenues

201

Operating leases capitalized

6,123

Minority interest

189

Stock Options ($2.32 per option per ADS)

2,209

Total Liabilities

27,699

Net Worth

118,672

# Shares Outstanding

22,733

NAV per Share

$ 5.22

All assets were valued at book value unless otherwise noted. Equity investments were valued at 75% of book value as these investments have been incurring small losses and were recently written down. Customer relations is a hidden asset that I valued at three times annual sales and administrative expenses. I assigned this asset such a high value because any new entrant into this business would have to spend significant resources to attract new clients and due to the high switching costs of customers. Product Portfolio is another hidden asset that was valued at three years of R&D expense. Any new entrant would have to spend significant resources to develop the proprietary software which ATA possesses.

After valuing all the assets, the value of ATA's liabilities were subtracted to arrive at the value of the company's equity. Liabilities were valued at book value. Outstanding stock options (Exhibit 1) and the capitalized value of operating leases (Exhibit 2) were also subtracted to arrive at ATA's Net Asset Value of $5.22 per share.

Earnings Power Value

Based on my EPV valuation, ATA is worth 3.95 USD per share. Amounts used are trailing 12-month income statement values:

Amounts in $USD (USD/RMB = 6.88)

Operating Profit (TTM * TTM operating margin)

11,762

+

Operating Lease interest (Cost of debt * PV Operating Lease)

306

+

Stock Option Expenses

1,332

=

Normalized EBIT

13,400

-

Taxes on EBIT (Tax at 41.7%)

5,588

=

Normalized Cash flow

7,812

+

Depreciation

1,252

=

Gross Cash Flows

9,063

-

Zero Growth CAPEX (avg. CAPEX last 5 years)

1,029

=

Zero Growth Free Cash flows

8,034

/

WACC

10.0%

=

PV Zero Growth Free Cash flow

80,340

+

Excess Cash & Marketable Securities

17,999

=

TOTAL VALUE

98,340

-

Debt (no debt)

-

-

Minority Interest

189

-

Stock Options ($2.32 per option per ADS)

2,209

-

Operating Leases

6,123

=

Equity Value

89,819

/

Number of Shares

22,733

EPV per share

$ 3.95

To calculate the present value of ATA's zero growth earnings, I began by taking the trailing 12-month (TTM) earnings and multiplying by the TTM operating margin of 16.9%. To this, I added an adjustment for operating lease interest, which is the interest that would be paid if operating leases were capitalized. I also added an adjustment for stock-based compensation as this amount is non-cash. These amounts were adjusted for taxes to arrive at normalized cash flow. Normalized cash flow was then adjusted by adding depreciation, as this expense is non-cash, and, then subtracting average capital expenditure to arrive at zero growth free cash flow. This amount was then divided by the WACC of 10% to arrive at the Present Value of Zero Growth Free Cash Flow.

The Present Value of Zero Growth Free Cash Flow was adjusted and excess cash was added to arrive at Total Value. Excess cash was calculated by taking 50% of the December 2016 cash balance, which would leave ATA with a ~1.6 current ratio. From this Minority Interest (Book Value), the value of outstanding Stock Options (Exhibit 1), and the capitalized amount of capitalized operating leases (Exhibit 2) were subtracted to arrive at Equity Value.

Decision

ATA has a share price that is 70% of its NAV. The question is can the company use its assets more effectively to increase its cash flow? Management has increased operating margin in recent years, which is a positive development. However, it has made a poor equity investment, which was recently written down and is incurring continued losses. Management needs to unlock value out of these investments to increase cash flow and create value for shareholders. I believe there is approximately a 50% chance of this occurring. Since the value of the company's zero growth earnings is already greater than the current share price, downside protection exists.

I recommend purchasing ATA with a target price of ~$4.60 per ADS (Exhibit 3).

Disclosure: I am long ATAI.

Exhibit 1: Value of outstanding stock options

The value of outstanding stock options was calculated by using an online Black-Scholes model with the following assumptions: Stock price - $3.7; exercise price - $2.61; time to maturity - 7.1 years; risk-free - 0.72%; and expected volatility - 50%. These amounts were taken from Note 12 of the company's 2016 annual report and resulted in a cost per option of $2.32 per ADS. There were 1.9 million outstanding options, which was divided by 2, because 1 ADS is 2 shares.

Exhibit 2: Value of capitalized operating leases

Taken from Note 17 of the 2016 annual report. Operating leases were included as debt, because although this amount is off-balance sheet, it represents amounts that must be paid in the future.

Year

Commitment $USD

PV of Commitment

2017

1,673,816

1,594,110

2018

1,934,885

1,754,998

2019

1,513,089

1,307,063

2020

1,588,072

1,306,511

2021

204,926

160,565

6,123,247

Exhibit 3: Value per Share

NAV per share

$5.22

NAV (ex cash)

A

$3.64

EPV per Share

$3.95

EPV (ex cash)

B

$2.37

Cash per Share

C

$1.58

Catalyst

D

50%

Intrinsic Value

B+((A-B)*D)+C

$4.59

Disclosure: I am/we are long ATAI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have 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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Education & Training Services, China
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here