China XD Plastics (CXDC) recently reported 2Q17 operating results and progress on major strategic initiatives:
- 1H17 net income of $38mm ($0.58/share) and reaffirmed full-year guidance.
- 81% of 1H17 revenues from premium products and rapid sales growth in areas served by the new Nanchong plant.
- Major growth initiatives underway in Nanchong, Harbin, and Dubai with strong support from local governments and blue chip financial institutions.
No news is good news regarding the unfair buyout offer from CXDC Chairman Han and Morgan Stanley Private Equity Asia (MSPEA).
- The price is woefully inadequate as analysed by Jason Cooper of Stuyvesant Capital Management (LINK).
- The timing of the offer raises significant corporate governance concerns.
- A domestic equity placement by CXDC’s main Chinese subsidiary, Heilongjiang Xinda Enterprises, would be a win-win development that strengthens the company and improves shareholder value.
1H17 net income of $38mm ($0.58/share) and reaffirmed full-year guidance
- Revenue +12% yoy due to +14% yoy increase in sales volume.
- Gross Margin dropped to 17.8% from 19.3% in 1H16. Key domestic competitors Kingfa and Pret noted rising raw materials cost as a reason for their weaker 1H17 gross margins.
- SG&A rose to 2.9% of revenue (from 2.4%) and R&D expense rose to 2.8% of revenue (from 2.2%). Higher expenses are being incurred to support expanded production capacity and technical capability.
- Reaffirmed full year guidance for revenues of $1.2-1.3Bn (+0% to +8% yoy) and net income of $85-$100mm (-17% to -1% yoy).
81% of revenues from premium products and rapid sales growth in areas served by the new Nanchong plant
CXDC’s aggressive investment in research and capacity expansion is intended to increase sales of more complex products with lower competition and higher margins. The company has referred to PLA, PPO, PA66, Plastic Alloy, PA6, POM, and PEEK as “premium products.” A detailed review of results by product type shows notably strong results this year from the highest value categories while competition exerted the strongest downward pressure on ASP in the non-premium products:
CXDC continues to enjoy a significant competitive advantage as the only major polymer producer in China’s industrial Northeast. 1H17 results demonstrate that the new Nanchong plant is allowing the company to achieve rapid sales growth in Southwest, South, and Central China:
Major growth initiatives underway in Nanchong, Harbin, and Dubai with strong support from local governments and blue chip financial institutions
Ambitious expansion plans will increase CXDC’s annual production capacity from 450,000 tonnes at 12/31/16 to approximately 1,345,100 tonnes by 2021 and annual revenues from $1.2Bn in 2016 to approximately $3.7Bn. The main objectives are:
Biodegradeable plastics – 600,000 tonnes of new capacity will produce bio-composite materials. CXDC has not explained the market potential of these products, but the mid-year report from competitor Kingfa provided some details of the business opportunities:
台和改性技术的积累，公司开发出质量可靠、价格具优势的生物降解塑料，迅速成为该市场最大的海外供应商。同时，依据 2018 年法国法令要求，公司开发出合规的 40%生物基材料，成为该类材料欧洲以外的唯一供应商。
As mentioned, leading Chinese internet retailers Alibaba and JD have pledged to maximize use of environmentally-friendly shipping materials (articles: Alibaba JD) and France’s Energy Transition For Green Growth plan will curtail use of oil-based plastics for food service cups and plates etc… Such initiatives are expected to become widespread.
Geography – Nanchong is 2400km from Harbin. CXDC traditionally derived all of its sales from customers within reasonable transportation distance from Harbin. New production from Nanchong provides an opportunity to rapidly expand market share in new regions while benefiting from existing high level national corporate relationships such as FAW Group.
Auto-market Growth – Over 90% of CXDC’s current sales are to the automotive industry. Chinese auto sales are expected to grow steadily, use of plastics per vehicle will increase, and domestic plastic suppliers will take market share from imports. CXDC’s 10-K included data from consulting firm Frost & Sullivan, which estimated 48% growth in plastic sales revenue from 2016-2020:
Premium Products – CXDC’s expansions will include significant production capacity in higher-priced higher-margin products. The company has not provided any formal guidance, but described the potential in response to a question during the recent conference call:
Reviewing the status of each facility expansion:
- Nanchong – The first 300,000 tonnes of capacity began development in December 2013. Approximately 60,000 tonnes was available at 12/31/16 and 216,000 tonnes at 6/30/17 and the remainder should be completed in 2H17. The second phase of 300,000 tonnes of biodegradable capacity is scheduled to begin production 2019. Delayed disclosures about this expansion raise serious governance concerns described in more detail below.
- Dubai – the company has been vague about the current status of the Dubai facility. It was referred to as “trial production” in the 10-Q and the conference call mentioned capacity of less than 3000 tonnes and a “product quality issue” that was resolved by the end of 2Q. An additional 12000 tonnes will be available in 1Q18 then 13000 tonnes more in 2Q18. The conference call suggested very favorable progress on developing new customers for this increased capacity:
When the Dubai facility was being planned in 2015, the company mentioned in conference calls that it expected the products to sell at an ASP of $12000/tonne. That would imply annual revenues of $240mm (25000 tonnes * 80% utilization * $12000) and the company expects to earn a gross margin of 40-45% on these sales (conference call excerpt above).
- Harbin – The company has 390000 tonnes of active capacity in Harbin and in July announced plans for a new bioplastics facility, a 3D printing materials production facility, and an upgrade of an existing facility to produce higher margin products (LINK). The new plants are expected to begin operations in 1Q19.
The company believes that it has sufficient cash, cash flow, and credit facilities to fund its capital requirements over the next 12 months. Jason Cooper’s analysis showed that rising operating cash flow from completion of Nanchong Phase 1 and Dubai in 2018 should enable the company to self-fund its expansion plan to 2021.
Development of advanced and environmentally-friendly materials meets China’s long-term national goals. CXDC’s capital expenditures have benefitted from very significant government incentives (10-Q excerpt)
Blue-chip domestic lenders controlled by the government have provided the company with large credit facilities with significant undrawn capacity remaining at 06/30/17:
Notably, the company has zero liabilities to non-bank financial institutions. Such debts would hint that a company’s financial capacity is stretched or that bank lenders have concerns about a company’s trustworthiness.
The price is woefully inadequate as analysed by Jason Cooper of Stuyvesant Capital Management
The company has created uncertainty among investors by announcing very large capital expenditure commitments without any detailed explanation of the long-term benefits. Jason Cooper’s analysis combined a detailed review of the company’s historical financials with conference call comments about future sales volume, prices, and margins to estimate that 2021 earnings would reach $502mm ($7.66/share).
All investors interested in CXDC should read the original text. A few comments:
- Estimating future value based on the average 10.62 average P/E multiple of the Guggenheim Small Cap China ETF is excessively conservative because that ETF has significant exposure to industrial cyclicals and real estate developers that should always trade at lower valuations than a growth business like CXDC. I believe CXDC’s direct competitors provide a more appropriate benchmark and the company would be fairly valued at a 20 P/E multiple:
- Estimating present value of future earnings using a discount rate of 8.675% does not fairly reflect the significant risks in execution of CXDC’s expansion plan. 1) plants may be completed behind schedule, 2) competition may increase and put downward pressure on profit margins, 3) CXDC may fail to develop competitive complex products, 4) end market growth may be below projections, and 5) lower near-term earnings could force the company to raise financing on dilutive terms. I believe a discount rate of 15% would be more appropriate.
Combining these factors (higher valuation multiple and higher discount rate) could have a neutral impact on the present fair value of $58.32/share estimated by Jason Cooper. The fair value is so far above the current share price and non-binding buyout price that a more precise analysis is not necessary at this time.
CXDC’s earnings and value will be rising sharply as expansion plans are completed. There is no apparent reason for shareholders to seek to sell the company. Any potential buyers such as Mr. Han and MSPEA must offer a price that would fairly compensate shareholders for all the company’s future potential.
The timing of the offer raises significant corporate governance concerns
Mr. Han and MSPEA submitted their preliminary non-binding proposal on February 16, 2017. At that time, they had material non-public information about the company’s expansion plans. It appears that the offer was intended to deprive public shareholders of the significant future value that would be realized from those plans. The company eventually disclosed the Nanchong expansion plan in March 2017 and the Harbin expansion plan in July 2017, but the evidence below shows that Mr. Han and MSPEA were fully aware of those plans in December 2016, two months prior to submission of their offer:
December 12, 2016 – China XD Plastics signs an agreement about the Phase 2 development with the Nanchong City Government at a public ceremony reported in Chinese media (example)
In March, CXDC disclosed that its Board of Directors and MSPEA gave their initial approval to the expansion on December 8, 2016. Presumably the company had been working on the details of the plan for many preceding months or years.
It was also disclosed much later that the Board of Directors and MSPEA gave initial approval to the Harbin expansion in December 2016, but in that case, an official agreement was not signed until July 2017.
January 3, 2017 – CXDC placed orders for RMB 1.44Bn (about US$211mm) of equipment for the Nanchong expansion (see Bio Composite equipment contract and 3D Printing Materials equipment contract) with advance payments of 0.9Bn RMB (about US$132mm) due within 10 days.
February 16, 2017 – Mr. Han and MSPEA deliver their preliminary non-binding buyout offer to the CXDC Board of Directors. It appears shameful for the letter to describe the offer as a “very attractive opportunity to the company’s stockholders” when they were aware of the above developments, which had not yet been disclosed to shareholders.
March 9, 2017 – Koneko Research publishes CXDC Receives An Unfair Buyout Offer When It Is Over 80% Cheaper Than Comparable China-Listed Companies, which includes details of the Nanchong plan from Chinese media.
March 16, 2017 – CXDC provides its first disclosure to shareholders about the Nanchong expansion as part of its year-end earnings report. The company claims that no prior disclosure was appropriate “due to the uncertainty of securing the necessary land use rights for the project.” Considering that equipment had already been ordered and construction had already begun, this explanation may have been a weak attempt to cover up the failure to make timely disclosures.
The signing of the Land Use Rights Transfer agreement provided a pretext for the overdue announcement, but it seems hard to believe that there was any real uncertainty about this agreement following the local government’s participation in the public ceremony in December.
July 17, 2017 – CXDC signs agreements for the Harbin expansion plan (see CXDC wechat post)
July 21,2017 – CXDC issues a press release disclosing the Harbin expansion plan to shareholders. The release mentions: ”Encouraged by the strong demand and market potential for biological composite materials, additive manufacturing used composite materials and functional masterbatch materials, the Company’s Board of Directors preliminarily approved the Company’s strategic investment in these initiatives in December 2016 and on June 1, 2017, respectively.” This acknowledges that Mr. Han and MSPEA were aware of the expansion plan prior to submission of their privatization offer in February.
It appears obvious from this sequence of events that Mr. Han and MSPEA made their buyout offer with the benefit of valuable non-public information about the company’s expansion plans. Prior to consideration of the privatization offer, I believe the independent Directors should investigate whether management followed a policy of minimal and misleading disclosures in order to depress investor interest in CXDC shares and facilitate the buyout offer.
If disclosures have been poor then CXDC management and MSPEA bear some responsibility for the problem of CXDC’s low stock valuation for which they have offered the solution of a buyout on terms enormously advantageous to themselves.
Unfortunately, the backgrounds of CXDC’s independent Directors do not include any training in international public company corporate governance. Director Feng Li works for a Plastics industry research group:
Director Linyuan Zhai is a retired executive of FAW Group, a major state-owned enterprise with many divisions producing vehicles and parts. The FAW Group has been the most important end customer for CXDC products.
These Directors bring valuable connections and experience to CXDC, but do not appear to have any expertise in the governance issues relevant to the buyout. Inexperience does not excuse them from their legal responsibilities so I believe they must engage an external legal advisor to investigate these issues.
The privatization offer demonstrates a significant conflict of interest between CXDC’s public shareholders and MSPEA, which has a 24% interest in the company through its ownership of convertible preferred shares. Investor uncertainty over MSPEA’s intentions and the possible redemption liability of those preferred shares appears to have been one factor depressing demand for CXDC stock. I believe it would improve investor sentiment, demonstrate closer alignment of interests between CXDC/MSPEA, and strengthen the company’s balance sheet if CXDC exercised its right to convert those shares:
A domestic equity placement by CXDC’s main Chinese subsidiary Heilongjiang Xinda Enterprises would be a win-win development that strengthens the company and improves shareholder value.
If the privatization offer was made at an unfair price using an unfair advantage of material non-public information then it’s good news that it has made no apparent progress. The offer is so far from the $58.32/share fair value calculated by Jason Cooper that it seems unlikely that negotiation with the buyer group could result in an offer deserving shareholder approval.
A superior strategic alternative is available to CXDC that would strengthen the company and deliver improved value to all current investors including Mr. Han and MSPEA. I believe that CXDC should sell a minority interest in Heilongjiang Xinda Enterprises (HLJ Xinda) to carefully selected strategic investors and work towards a future domestic Chinese exchange listing of this entity.
The company’s corporate structure as of 12/31/16 (10-K excerpt)
The possible structure after a private placement of HLJ Xinda:
The possible structure after a domestic public listing. This could take 2-4 years through a traditional IPO or about 1-2 years through a reverse merger with an already listed company:
Sale to strategic investors could strengthen corporate relationships with major domestic financial and operating partners. I estimate a fair price for this equity placement would be 15-20 X earnings of the HLJ Xinda Group. In 2016, HLJ Xinda had pretax earnings of $104mm. At a tax rate of 15% that would mean net income of $88mm. Sale of a 20% stake could bring $265-$352mm in new equity.
This timely infusion of new equity would greatly reduce the company’s financial risk during its aggressive expansion plan. The company would be better able to cope with unexpected delays in bringing capacity online, a slowdown in customer demand, or increased competition.
I believe that there would be significant investment interest in CXDC from strategic investors and future HLJ Xinda IPO buyers because the company has taken many steps to raise its public profile in China. CXDC has introduced an attractive Chinese corporate website www.xdholding.com and has an active wechat channel with 19 items posted since 7/1/17. The company has also raised its visibility in China through increased participation in research conferences, trade shows, and through media coverage.
Maintaining the parent company listing in the US and the subsidiary listing in China would give CXDC superior flexibility in long-term financing of its global operations.
The sale of equity at a fair valuation multiple would greatly increase CXDC investor confidence in the visibility and value of the business and would likely lead to significant appreciation of CXDC shares. The pending reorganization of China Evergrande Group is an example of a foreign parent company, which is going to list its largest domestic Chinese subsidiary through a reverse merger. The Hong Kong listed shares of the Evergrande parent company have risen 375% since the reorganization plan was announced in October 2016.
At the time of publication the author is a public shareholder of China XD Plastics. The author believes that it would be in his best interest if the facts in this article were widely understood. The author does not make any recommendation to any other person about investment in China XD Plastics shares. The author may adjust his own investment in China XD Plastics at any time.
Conditional terms used in the article such as “may” “could” “seem” and “appear” indicate the author’s subjective opinion based on the facts presented. Readers are encouraged to check the facts themselves rather than relying on the author’s opinion. Descriptive terms such as “unfair” and “shameful” indicate the author’s subjective judgment based on the facts presented. These descriptions are made according to the common usage of these words rather than any specific legal standard of unfairness or shamefulness that may be applied in any legal jurisdiction.
The author has made his best effort to accurately summarize facts publicly available as of the date of publication (09/11/17). The author does not want to spread errors or misinformation. A link to this article has been sent to CXDC CFO Taylor Zhang using his email address in company press releases. If CXDC, or anybody else, can provide public information as of 09/10/17, which shows there are errors in the text then corrections will be made as promptly as possible.
Aside from corrections to any errors discovered in this article, the author may not release new public commentary about China XD Plastics. His willingness to do so will depend on future developments, which cannot currently be predicted.
A copy of this text has been sent to CXDC’s independent Directors at the communication address provided in the 10-K:
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. I have no business relationship with any company whose stock is mentioned in this article.