China XD Plastics: Management's Buyout Is Woefully Inadequate

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About: China XD Plastics Company Limited (CXDC), Includes: FXI, HAO
by: Jason Cooper, CFA
Summary

On February 16, 2017, a "Buyers Consortium" consisting of the firm's Chairman and CEO, Mr. Jie Han, and Morgan Stanley Private Equity Asia III submitted a non-binding proposal for acquisition.

The offer of $5.21 per share materially undervalues this security. The offer was also made prior to significant disclosures of investment in new facilities.

Using public releases and statements made over the earnings calls, I attempted to show what the revenue and net income of CXDC could be by 2021 when investment is complete.

I find that the fair value of CXDC could be as high as $58.32 per share using, what I believe to be, conservative assumptions.

China XD Plastics Company (CXDC) engages in the research, development, manufacture, and sale of modified plastics, primarily for automotive applications in China. It currently has three plants in Harbin with a production capacity of 390,000 metric tons, one in Sichuan with a production capacity of 300,000 metric tons, and a plant in Dubai with a nominal production of 3,000 metric tons with production expected to rise to 25,000 metric tons by the second quarter 2018. The aim of the company is to move up the value-added chain of modified plastic products and to diversify into 3-D printing, biodegradable, aerospace, high-speed rail, and medical equipment plastics. They also aim to sell their goods to companies outside of China and are currently in the process of developing relationships with companies in Germany, France, and South Korea. They already have an international customer in South Korea.

Timeline of 2017

Recent events cast a pall over the security. On February 16, 2017, the Board of Directors (the "Board") received a non-binding proposal letter from the "Buyers Consortium", which is comprised of CXDC's Chairman and CEO, Mr. Jie Han, and MSPEA Modified Plastics Holding Limited, an affiliate of Morgan Stanley Private Equity Asia III, to take the firm private at a price of US$5.21 per share. The Buyers Consortium currently beneficially owns approximately 74% of the issued and outstanding shares of common stock of the Company on a fully diluted and as-converted basis, with Mr. Han controlling 33,510,131 outstanding shares (source) and MSPEA controlling 16,000,000 shares that can be converted from the $100M investment that the firm made in 2011 in redeemable convertible Series D preferred shares (source). The "Going Private" transaction would be overseen by an independent special committee established by the Board. The independent special committee was headed by Lawrence W. Leighton, an established American investor and a Board member since 2009. As per the press release, the independent special committee is responsible for, "evaluating, negotiating and recommending to the Board any proposals involving a strategic transaction by the Company with one or more third parties. The Special Committee intends to retain advisors, including an independent financial advisor, to assist in the evaluation of the proposal and any additional proposals that may be made by the Buyer Consortium."

Koneko Research subsequently revealed, on March 9, 2017, that the company did not disclose a, "possibly significant expansion plan negotiated with the Nanchong government," in December of 2016. The disclosure was ultimately made on March 16, 2017, after the research article was disseminated. On March 17, 2017, the firm publicly disclosed the extent of the agreement to build a new plant in Nanchong City, Sichuan which would be capable of producing 300,000 metric tons of biocomposite materials and additive manufacturing and 20,000 metric tons of functional masterbatch, a high-end color additive process in plastics manufacturing (source).

Mr. Lawrence Leighton resigned from the Board and the independent special committee on May 15, 2017. The independent special committee is now comprised of two individuals: Mr. Feng Li and Mr. Linyuan Zha. On June 5, 2017, the Company announced that it retained Duff & Phelps, LLC and Duff & Phelps Securities, LLC as the special committee's independent financial advisor (source).

On July 21, 2017, the Company disclosed that its Heilongjiang subsidiary, Heilongjiang Xinda Enterprise Group Company Limited, signed an investment agreement with the Management Committee of Harbin Economic - Technological Development Zone to construct a 300,000 metric ton biological composite materials factory, a 101,000 metric ton cloud computing factory, and to update 100,000 metric tons of its Harbin facility (390,000 metric ton capacity) to 120,000 metric tons of engineering plastics. Thus, since the "Going Private" offer was announced, the Company further announced that it would transform itself from a company with production capacity of 690,000 metric tons of automotive modified plastics and 25,000 metric tons of premium non-automotive modified plastics to a firm that is capable of producing 590,000 metric tons of modified plastics and 846,000 metric tons of non-automotive premium modified plastics. Its capacity will double by 2021. Due to the significant change in operations, I felt that it would be prudent to examine A) how these changes would impact CXDC's top and bottom lines and B) how the firm could fund such a massive expansion project. While the subsequent analysis attempts to be conservative, management's paltry guidance impacted my ability to forecast when capacity is expected to come online, when capex will be made, and how investors should expect operating expenses to accrue throughout its subsidiaries.

Calculating Potential Revenue and Earnings Power

In order to project potential revenue, I had to determine the selling price per metric ton of each modified plastic product and multiply that number by the estimated utilized capacity at each facility. Management previously guided that sales at the existing Harbin and Sichuan facilities were approximately $3,000 per metric ton and that sales at Dubai were approximately $10,000 per metric ton. They also guided that capacity utilization was 80% at all of its facilities.

In the filings for the new Harbin facilities, management forecast the expected revenue in RMB, capital expenditures, and capacity of each facility (engineering plastics, 3-D printing cloud factory, biodegradable plastics). Using these metrics, I converted the RMB selling price into dollars at an exchange rate of 6.80 RMB/USD to calculate the total sales per facility in USD. I then multiplied each facility's capacity by 0.8 to determine how many metric tons would be produced per facility. Next, I divided annual sales in USD per facility by metric ton production per facility to calculate the USD sales price per metric ton:

Source: Generated by Author

Lastly, I assumed that the biodegradable facility in Sichuan would receive the same selling price for its biodegradable plastics as the Harbin biodegradable plastics facility. I multiplied each plant's potential capacity utilization by the facility's sales price per metric ton to calculate the potential revenue at each facility and in aggregate:

Source: Generated by Author

Based on this analysis, revenue could increase from management's current projection of $1.2-$1.3B for 2017 to $3.65B by the time that the plants are fully operational (80% capacity).

To determine gross profit I used the historic 20% gross margin for the legacy auto plants and the midpoint of management's guidance on the 2Q17 conference call. When asked about margins at the new facilities, Taylor Zhang, CFO of CXDC, stated that:

"In terms of margin -- so we have the breakdown by the different product category. For biodegradable materials, we expect the margin will fall into the range of 22% to 30%. And for the 3D additive manufacturing or 3D printing materials, we expect the margin will be between 50% to 65%. Obviously, this is not a volume business, but a very high -- very [height] business.

And for our Dubai business, the products you focus is alloy plastics, similar to 3D printing. It's a very small volume. But it's a very high value-added and high-margin products. We expect in 2018 we'll be able to produce more locally. And so the total design capacity will be 25K and with margin approximately 40% to 45%."

Source: Seeking Alpha China XD Plastics' CEO Jie Han on Q2 2017 Results - Earnings Call Transcript

Management did not refer to their engineering plastics business, so I used the gross margin midpoint for biodegradable plastics, which may prove to be too conservative. Applying the midpoint of this guidance and the historical gross margin for the legacy plants provides the following calculation of gross profit and gross profit margins:

Source: Generated by Author

Calculating operating expenses was a challenge as management did not provide any guidance as to how expenses might be allocated to the different plastic segments or benefit from increased economies of scale. In order to form a best-estimate, I divided the operating expenses as a percent of sales on a quarterly basis in an attempt to determine a discernible trend. The three operating expenses are Selling Expense, G&A Expense, and R&D Expense. I aggregated data from 1Q12 and added a trend line to determine the trend for each line item. I then projected the trend forward 18 quarters to determine approximately what percent of total sales each expense will be at the end of 2021, the year that the factories will be complete and each plant will be up and running. This provided the following trends:

Source: Generated by Author

Selling Expense has an upward trajectory. Based on projecting this trend into the future, I believe it rational to expect that Selling Expenses will be 0.3% of sales at each facility by year-end 2021.

Source: Generated by Author

R&D Expense is trendless and exhibited a reversion to the mean. As a result, I expect that R&D Expense will be approximately 2.8% as a percent of sales at each facility by year-end 2021. This may be an overly conservative assumption. Firstly, in CXDC's 2015 10-K, the firm noted that it had 10 approved patents and 268 patents pending. Of these patents, approximately 20% had the words "biodegradable" or "3D" in the patent name. This may indicate that the firm will benefit from economies of scale. Secondly, the 10-K notes that they, "develop our products using our proprietary technology through our wholly-owned research laboratory, Heilongjiang Xinda Enterprise Group Macromolecule Material Research Center Company Limited ("HLJ Xinda Group Material Research")". This indicates that the research is performed in Harbin, which has the highest effective tax rate of the geographies in which CXDC operates. My earning's analysis may be too conservative, given that it allocates R&D across all geographies as a percent of total sales. Moreover, in the past, this company has benefited from significant government research subsidies.

Source: Generated by Author

G&A Expense has a positive trajectory. Based on this trend, I expect that G&A Expense as a percent of sales to be approximately 3.95% at each facility by year-end 2021.

Totaling all of these expenses provides us with a 7.05% operating expense per facility as a percent of sales. Subtracting this expense from the gross profit provides the following potential operating earnings and margins:

Source: Generated by Author

Note: Depreciation expenses are included in the cost of goods sold.

To compute the terminal interest expense I worked to extrapolate whether additional debt would be taken out by the company. Currently, CXDC has $642M in short-term loans and $195M in long-term bank loans (balance sheet as of June 30, 2017). While this may seem over-levered for a company that is projected to earn $85M -$100M in net income this year, the company also has cash and cash equivalents of $279M, restricted cash of $120M, and time deposits of $151M (balance sheet as of June 30, 2017). Thus, net debt currently stands at $286M. This is 3.4x management's 2017 net income lower bound forecast. Moreover, as I will show later in the analysis, with the ramp-up at the companies' Sichuan facility in 2018, I expect the firm to be able to fund remaining capital expenditures from operating cash flow and liquid current assets.

As a result, I project that the annual interest expense in 2021 will be similar to that of 2017. Annualizing the first two-quarter's interest expense gives us an annual interest expense of approximately $50.2M. I allocated this interest expense equally across the companies' operating geographies to get an interest expense of approximately $16.7M per operating geography. This expense was further equally divided per operating facility. The results are shown below:

Source: Generated by Author

The final step was to compute the tax expense. The tax rate in Harbin is 25%; the tax rate in Sichuan is 15%, and the tax rate in Dubai is 0%. Applying these rates to the EBT per each operating facility provides the following net income projections:

Source: Generated by Author

Since there are 65.6M diluted shares outstanding after MSPEA Series D conversion, earnings per diluted share can be calculated as follows:

Source: Generated by Author

Thus, in 2021, potential earnings per share are $7.66, while management's midpoint for EPS in 2017 is $1.41. EPS could increase over five times by 2021. I think that it is important to note that under these conservative assumptions, the Buyer Consortium's takeout price is less than one-times potential earnings in 2021.

Capacity Ramp-Up and Operating Cash Flow

On the conference call that took place on August 9, 2017, Taylor Zhang translated Mr. Jie Han's response as to when to expect capacity at the new plants in Sichuan and Harbin to come online:

"Jie Han just provided a detailed breakdown of capacity on our schedule. So for the biodegradable projects, we have one each in Sichuan and Harbin. Each is 300k. So we anticipate the production will start early 2019. The 1/3 of the capacity will be online and sequentially, in 2020 and 2021, 1/3 in each year will contribute to the capacity. And secondly, for our 3D printing projects, because it's more sophisticated and it takes a little time to develop and build infrastructure, we anticipate that we'll come online in the second half of 2018, little later compared to the biodegradable projects.

So similar capacity on its schedule, we are anticipating 1/3 will be in 2019 and 1/3 in 2020 and the remaining in 2021. For the master batch projects, we expect we'll come online in the second half of 2019. And the last one is the 1,000k engineering plastic [Indiscernible] facility. We expect that will come online, will be completed in the third quarter of 2018."

Source: Seeking Alpha China XD Plastics CEO Jie Han on Q2 2017 Results - Earnings Call Transcript

They also laid out their ramp-up for Dubai:

"Our new facility in Dubai also extends our specialized high-tech products into an important overseas market. We plan to complete the installation of 45 production lines with 12,000 metric tons of annual production capacity by the first quarter of 2018 and to complete the installation of an additional 50 production lines with 13,000 metric tons of annual production capacity by the second quarter of 2018. This will bring the total annual production capacity in our Dubai facility to 25,000 metric tons." -Anna Bin

Source: Seeking Alpha China XD Plastics CEO Jie Han on Q2 2017 Results - Earnings Call Transcript

And Sichuan's automotive plastics facility that has already been constructed:

" [W]e have the capacity currently in production is approximately 80,000. And early next year we're going to see more volume coming on line... so for Sichuan plants, the production capacity in 2018, on an annualized basis, will be 215k"

Source: Seeking Alpha China XD Plastics CEO Jie Han on Q2 2017 Results - Earnings Call Transcript

According to this guidance, I modeled the following capacity ramp-up:

Source: Generated by Author

Assigning the facilities' potential capacity to the earnings model that I developed provides the following net income and EPS trends:

Source: Generated by Author

The capital expenditures for the new plants were disseminated earlier this year in the plant announcements. Importantly, CXDC made a significant capital expenditure in the first three months of this year:

Source: 1Q17 10-Q

It appears that this sum ($328,428,788) was allocated to the Nanchong Biomaterials facility based on CFO Taylor Zhang's vague comments on 2Q17 earnings conference call, "So the CapEx for this year, basically, split between Dubai and our Sichuan company. For Dubai, we budgeted approximately $95 million and for our Sichuan sub, that's for the new project, we anticipate approximately $375 million". As a result, I would expect that this year will require an additional ($375M+$95M-$328M) $142M of cash for investment. This can be covered via the companies' liquid current assets and operating cash flows.

The remaining capital required for investment is depicted below based on the press releases that I previously highlighted:

Source: Generated by Author

Since management was vague about the timing of these expenditures, I assumed that the total would be invested in equal increments of approximately $196M over the next three years, meaning that there is no expected capital investment in 2021. Using a 5% depreciation rate, I calculated projected operating cash flows for CXDC by adding projected depreciation to the projected net income:

Source: Generated by Author

Based on this analysis, CXDC should be able to fund all of its capital expenditures out of operating cash flow and its liquid current assets. In fact, they should have additional cash to pay down all of their debt by year end 2021, which would further bolster earnings and shareholder equity by decreasing the interest expense.

Valuation:

We can calculate the present value of this security based on projected earnings per share in 2021. China XD Plastics is a small cap Chinese stock. Its cohort, Chinese Small cap stocks, currently trade at 10.62x earnings (HAO P/E multiple). Assigning a similar multiple to CXDC would yield a future value of:

$7.66 (2021 EPS) x 10.62 (P/E Multiple) = $81.35 per share in 2021

We then need to discount the 2021 value back to 2017. In order to do this, we need to calculate the Beta of the security. We calculated that the 5 year Beta prior to the offer being made is 0.57. However, we believe that this Beta is inadequate and does not accurately reflect the risk of the security. We believe that management did not make an adequate effort over that time period to promote the stock to institutional investors. From our time following the stock (since 2013), we can only recall one or two investor conferences that the firm attended. As a result, the share price has essentially been flat for five years, with the 200 WMA trending perfectly sideways at $5.00 on the stock chart. Instead, we chose to use the Value Line Investor Survey average Beta for Chemical (Basic) Companies with market caps of less than $10.0 billion. This provided us with a Beta of 1.14. In order to get our discount rate we used the following formula:

Req=Beta(ERP)+RFR

Req=1.14(5.75%)+2.12%

Req=8.675%

Note - the equity risk premium was calculated by dividing the 12-month forward earnings of the S&P500 as projected by FactSet by the price level of the S&P500. The risk-free rate (10 yr US Treasury) was subsequently subtracted from this number (the market's earnings yield) to calculate the ERP.

Discounting future earnings back to the present value:

PV=FV/(1+Req)T

PV=81.35/(1.08675)4

PV= $58.32

Thus, if my projections are correct and management is able to execute, CXDC would be fully valued at $58.32 per share.

Conclusion

China XD Plastics is an extremely undervalued security. It currently trades at less than 4x this years' earnings estimate and less than 0.5x book value on a fully diluted basis. However, if management is able to execute on its plan, then the securities' fair value is $58.32 per share, which is more than 10x today's price.

The primary factor that has inhibited CXDC from trading in-line with its fundamental valuation is its management. The current level of communication makes it difficult to forecast earnings and capital expenditure intentions. They did not publicly announce when they booked international customers and they do not attend investment seminars to attract institutional investors. The most concerning factor occurred when management joined the Buyer Consortium with MSPEA and offered investor's $5.21 per share, which is less than 4x this year's earnings estimate. They did so after assuring investors that 2017 would be the year in which the company focused on building value for the shareholder base. They also made this move prior to disclosing significant investments that would, as I demonstrated above, transform the company and be significantly accretive to the bottom-line.

Since the "Going Private" offer is contingent on the majority of the minority shareholders acceptance, investors should vote against the paltry valuation. If the woefully inadequate offer is revoked, management should immediately force conversion of the Series D preferred shares to put MSPEA on an equal playing field with the rest of the minority shareholders. Management should then clarify how it intends to grow its business and what it will do to reward the shareholder base. My projections of FCF and the firm's liquid current assets should allow China XD Plastics to initiate a small dividend, which could be increased as high-margin operations begin production in 2019.

Disclosure: I am/we are long CXDC. 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.

Additional disclosure: My firm, Stuyvesant Capital Management Corporation, has invested funds for our-self and our clients in this security.