SORL Auto Parts: Little Downside Risk

Summary

• SORL is a legitimate company that provides high-value products to a diverse and growing customer base, at a reasonable profit.
• But the stock trades at a 50% discount to book value, which basically implies that the business is worthless.
• SORL is a China-based company, and we understand the skepticism given that Chinese companies have a history of corporate governance scandals.
• But the downside to investors is limited at the current valuation.

SORL Auto Parts (NASDAQ:SORL) is China's leading manufacturer of air brake systems for commercial, passenger, and railway transportation vehicles. Its shares are trading about 20% lower since the company reported Q4 results last week, but aside from some cost inflation, the results were actually pretty good. With a P/B of 0.5, SORL is incredibly cheap for a company that sells high-value products at a reasonable profit (with a healthy balance sheet to boot), and while business risk has increased, it seems that SORL's status as a China-based company is what's ultimately responsible for the low valuation. We certainly understand the concerns here, but SORL appears to be a legitimate company and we think there's little downside risk at these levels.

Strength Continues

Revenues increased 43% in Q4 and 40% for the year as the company increased market share and expanded its global customer base. SORL reported strong growth across each of its three segments, but the core China OEM business was the highlight, growing 73% for the quarter and 52% for the year. China's auto-parts industry is in an upswing thanks to the government's infrastructure and property investments and tightening of emissions standards, which has raised demand for new trucks. Automobile output in China expanded to an all-time high of 29 million units last year, and commercial vehicles led the way with volume growth of 14%.

If SORL's increased investments in PP&E are any indication, the strength should continue. Last year the company invested $26M (14.2% of sales) in PP&E "to prepare for growing product demand", and management expects revenues to increase 15% to $450M in FY18. This is a huge investment compared to historical levels (SORL's capex averaged just 3.6% of sales over the previous ten years), and it follows up on 2016's relatively large outlay of 6%. These investments were a major drag on cash flow over the last two years, but with these investments out of the way FCF should return to more normalized levels next year.

Figure 1: Capex vs. Free Cash Flow

Source: Madison Investment Research

SORL did see some cost inflation in Q4 but it wasn't as bad as it looked. The collection of a large sum of receivables in the prior year quarter (a one-time occurrence) was responsible for most of the opex increase, and while freight, packaging, sales compensation, and R&D costs all increased on a percentage of sales basis in Q4, these items decreased 100 bps for the year. The company's margin profile hasn't materially changed, and any concerns here are overblown. Next year the company expects to generate a net profit margin of 6.2%, which is the same as last year's and is consistent with SORL's average margin of 6% over the previous 5 years.

Valuation

SORL currently trades at a P/B of 0.5, a P/S of 0.2, and a P/CF of 2.6, which more-or-less implies that the business is worthless. But SORL is far from a worthless company: SORL provides essential vehicle components that help ensure driver safety, and counts all the major truck manufacturers among its customers.

The company is also reasonably profitable, with a 10-year average "mid-cycle" ROIC of 10.2% that puts it in the same category as Continental (OTCPK:CTTAY) and Denso (OTCPK:DNZOF). In other words, SORL's business creates shareholder value by generating a higher return on capital than what it costs to obtain it. So often you see managers waste investor resources in low-margin or money-losing operations, but this isn't the case at all with SORL.

There doesn't appear to be any issues with the balance sheet or leverage (D/E is 0.2 and interest coverage is 11x), so let's investigate the risk factors to see what's really holding back the valuation.

Risks

It does appear as though business risk has increased. SORL's sizeable (and growing) international customer base exposes the company to protectionist trade policies, and there is a risk that Trump's tariffs could set off retaliatory measures from other countries. But SORL's geographic diversity reduces this risk. The company exports to more than 104 countries and US customers account for less than 5% of sales. The negative impact from higher trade barriers in any single market appears to be minimal.

Weak pricing is another concern. Short lead times and SORL's lack of long-term contracts with customers requiring minimum purchase amounts increases the level of price competition the company faces, and SORL continues to face downward pricing pressures from customers and competitors. That being said, SORL has managed to keep gross margins relatively stable over the past ten years (total volatility is less than 350 bps), and many competitors are dealing with the same issue. We actually think gross margin is primed for a rebound due to all the recent growth in OEM, which should lead to subsequent increases in higher-margin aftermarket business.

Given that SORL doesn't face any unusual operating risks, SORL's Chinese roots and ownership structure appear to be the main areas of concern. Most investors are familiar with the many risks that come with investing in China, and Chinese companies are notorious for their transparency issues, weak corporate governance practices, and even outright fraud. SORL may be listed on an American exchange, but the stigma associated with Chinese companies doesn't do it any favors.

Chairman and CEO Xiao Ping Zhang, along with his wife and brother (all of whom are directors on the board) collectively hold 58.9% of the shares outstanding. While we do like it when managers have a stake in the game, too much control can stifle shareholder influence and prevent investors from having a say in various matters, including the election of directors and other corporate transactions and business combinations.

Conclusion

Even after a strong year that saw the company increase market share and expand its global customer base, SORL is cheaper than ever. Strong industry conditions should persist through next year at least, and free cash flow should improve significantly now that the company's large capex projects are finished. We understand the investor skepticism given China's history of corporate governance abuses, and SORL's lack of an independent board and centralized ownership structure are hallmarks of fraudulent companies. But SORL appears to be a legitimate company with legitimate products and customers, and the downside to investors is limited at the current valuation.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.