Wednesday, January 31, 2007
A Couple of Glass Makers from Heaven and Hell Part II
From hell - ZJ Glass (739)
JZG is almost the exact opposite of Xinyi, though it's only one step up in the value chain. It's the 4th largest float glass manufacturer in China but with a capitalization (domestic + H shares) of $1.25b or only 1/5 of Xinyi's.
First, it's been operating in a severely over-supplied domestic float glass market (since 2004), which at one point last year forced some firms to close production as the selling price was so low at $50 per weight case (JZG's unit cost was $64). All major players had to sit down and agreed on a joint price hike as the whole industry was losing money (which nevertheless could suggest a bottoming-out). The price stabilized at around $70 per weight case (JZG's avg. selling price was $66). The other contributing factor was the surge in heavy oil price (73% YOY for 2006 1st half), which might come down in 2nd half with the drop in crude oil prce (or not because of the price fixing mechanism).
JZG managed to lessen the impact by focusing on higher quality automotive grade glass and recently ultra-thin glass for electronics, but it still reported 66% decline in profit in 2005 and a net loss in 2006 interim (EBIT was close to breakeven though). The loss was a 1st since listing. Like Xinyi it also pursued vertical integration by building an upstream soda ash plant in Qinghai and breaking into the downstream processed glass market. But both fronts are not showing success so far.
Qinghai soda ash plant started production last year and contributed 18% to the 2006 interim turnover of $580m. 70% of output (in volume) was light ash for non-glass applications and 30% was dense ash for glass production, which was said to increase in the future. Segmental information showed 37% of output (in RMB) was consumed by JZG and the rest was sold to the market. The business reported a loss before interest and tax but management told things would improve when capacity is better utilized (2006 expected utilization: 66%). They also cited that the building of the Qinghai-Tibet railway had disrupted deliveries. However, it appears that JZG has simply moved from one over-supplied market to another! Even management quoted the national supply of soda ash would reach 15.5m tonnes in 2006, outgrowing the national demand of 13m tonnes. Selling price dropped by 28% to RMB1,350 per tonne in 2006 1st half compared to that of 2005, though the price didn't change much within the 6 months. The only bright spot is there's 5-year profit tax exemption followed by 50% reduction for the following 5 years. This may not last under profit tax reform though.
Processed glass business performed worse with production volume, selling price, and turnover all declined in 2006 1st half. Total sales was only 7% of turnover.
Unlike Xinyi's management who are wary of debt financing, ZJG loaded up the balance sheet with debt pretty hard, so hard that total debt was $3.3b at 2006 interim. NAV was only $1.3b. Current ratio was 0.4 and net gearing was 186%. In typical Chinese fashion 2/3 of the debt was short term and management claimed they would have no problem renewing it, which might have some grounds as ZJG still managed to borrow $125m more in 2006 1st half to finance the working capital of the soda ash plant! However I don't expect this can continue for long as capacity expansion is the prime target under austerity measures. Finance cost was a high $76m in 2006 1st half.
$1.6b was spent on the soda ash plant and there's planning for a second phase of it which will cost another $1.6b ($385m was spent already). In the interim account ZJG reported a total capital commitment of $7.3b, of which $6.3b is for more float glass production lines! This makes ZJG look more like a builder than a glass factory. Of course all these expansions were planned in 2004 and now everything is put on hold indefinitely.
For as demon as ZJG can be it has attracted funding from the IFC, who together with a fund put in $800m, $260m by equity (1/4 of the then capital) and $540m by loan. Proceeds would go into retiring short term debt and the new loan would be long term with semi-annual repayment starting July 2008. Proforma net gearing would come down to 124% and current ratio would improve to 0.52. I guess maybe the soda ash plant project fits into the IFC agenda of developing the rural China.
After injection Chairman Feng's stake would be diluted to 55% (400m shares out of 721m). This is another bright spot as ZJG has avoided equity financing until now. Corporate governance is supposed to improve gradually marked first by the step down of the Chairman's wife and daughter from the board replaced by two management staff. Chairman Feng has also provided personal guarantee and pledged 120m domestic shares as security for the loan.
With IFC's involvement ZJG becomes an interesting turnaround bet. For one I think ZJG is not heading into big troubles any time soon as bankers (not Chinese bankers) are conservative and should have done their math before lending. IFC was impartial and wasn't throwing good money after bad one. As the placing was completed after June 2006 they should've known better about the float glass and soda ash business. And second with IFC as the chief lender I think ZJG will focus on debt repayment over the next few years (read: no more senseless expansion). This will cut down interest expense as debts are repaid gradually, which will increase future profits.
Over the last 5 years (up to 2005), ZJG made about $200m in 3 years and $80m in 2 years. In 2005, it made $74m on an avg. price of $70 per weight case of float glass. Let's assume conservatively that with the soda ash plant 2007 profit is $100m. Depreciation is about $300m a year which together with profit will go into retiring debt. Interest savings (assume 6.5% on debt) after tax will be $17m a year, and $51m in 3 years. This will give a 15% annualized profit growth, which may be higher if ZJG has a break from the profit tax reform. Against a $1.26b capitalization, prospective p/e will become 10.8x, 9.4x, and 8.3x. There's also upside from the recovery of the float glass market and increase in efficiency of the soda plant. But equally things could get uglier than already is and IFC may not be the lender of last resort for the second time.
ZJG is a speculation, which means there's considerable upside but also real risk of losing one's capital. But what more can you expect from a company from hell.
DISCLOSURE: I don't hold 739 at time of writing.
JZG is almost the exact opposite of Xinyi, though it's only one step up in the value chain. It's the 4th largest float glass manufacturer in China but with a capitalization (domestic + H shares) of $1.25b or only 1/5 of Xinyi's.
First, it's been operating in a severely over-supplied domestic float glass market (since 2004), which at one point last year forced some firms to close production as the selling price was so low at $50 per weight case (JZG's unit cost was $64). All major players had to sit down and agreed on a joint price hike as the whole industry was losing money (which nevertheless could suggest a bottoming-out). The price stabilized at around $70 per weight case (JZG's avg. selling price was $66). The other contributing factor was the surge in heavy oil price (73% YOY for 2006 1st half), which might come down in 2nd half with the drop in crude oil prce (or not because of the price fixing mechanism).
JZG managed to lessen the impact by focusing on higher quality automotive grade glass and recently ultra-thin glass for electronics, but it still reported 66% decline in profit in 2005 and a net loss in 2006 interim (EBIT was close to breakeven though). The loss was a 1st since listing. Like Xinyi it also pursued vertical integration by building an upstream soda ash plant in Qinghai and breaking into the downstream processed glass market. But both fronts are not showing success so far.
Qinghai soda ash plant started production last year and contributed 18% to the 2006 interim turnover of $580m. 70% of output (in volume) was light ash for non-glass applications and 30% was dense ash for glass production, which was said to increase in the future. Segmental information showed 37% of output (in RMB) was consumed by JZG and the rest was sold to the market. The business reported a loss before interest and tax but management told things would improve when capacity is better utilized (2006 expected utilization: 66%). They also cited that the building of the Qinghai-Tibet railway had disrupted deliveries. However, it appears that JZG has simply moved from one over-supplied market to another! Even management quoted the national supply of soda ash would reach 15.5m tonnes in 2006, outgrowing the national demand of 13m tonnes. Selling price dropped by 28% to RMB1,350 per tonne in 2006 1st half compared to that of 2005, though the price didn't change much within the 6 months. The only bright spot is there's 5-year profit tax exemption followed by 50% reduction for the following 5 years. This may not last under profit tax reform though.
Processed glass business performed worse with production volume, selling price, and turnover all declined in 2006 1st half. Total sales was only 7% of turnover.
Unlike Xinyi's management who are wary of debt financing, ZJG loaded up the balance sheet with debt pretty hard, so hard that total debt was $3.3b at 2006 interim. NAV was only $1.3b. Current ratio was 0.4 and net gearing was 186%. In typical Chinese fashion 2/3 of the debt was short term and management claimed they would have no problem renewing it, which might have some grounds as ZJG still managed to borrow $125m more in 2006 1st half to finance the working capital of the soda ash plant! However I don't expect this can continue for long as capacity expansion is the prime target under austerity measures. Finance cost was a high $76m in 2006 1st half.
$1.6b was spent on the soda ash plant and there's planning for a second phase of it which will cost another $1.6b ($385m was spent already). In the interim account ZJG reported a total capital commitment of $7.3b, of which $6.3b is for more float glass production lines! This makes ZJG look more like a builder than a glass factory. Of course all these expansions were planned in 2004 and now everything is put on hold indefinitely.
For as demon as ZJG can be it has attracted funding from the IFC, who together with a fund put in $800m, $260m by equity (1/4 of the then capital) and $540m by loan. Proceeds would go into retiring short term debt and the new loan would be long term with semi-annual repayment starting July 2008. Proforma net gearing would come down to 124% and current ratio would improve to 0.52. I guess maybe the soda ash plant project fits into the IFC agenda of developing the rural China.
After injection Chairman Feng's stake would be diluted to 55% (400m shares out of 721m). This is another bright spot as ZJG has avoided equity financing until now. Corporate governance is supposed to improve gradually marked first by the step down of the Chairman's wife and daughter from the board replaced by two management staff. Chairman Feng has also provided personal guarantee and pledged 120m domestic shares as security for the loan.
With IFC's involvement ZJG becomes an interesting turnaround bet. For one I think ZJG is not heading into big troubles any time soon as bankers (not Chinese bankers) are conservative and should have done their math before lending. IFC was impartial and wasn't throwing good money after bad one. As the placing was completed after June 2006 they should've known better about the float glass and soda ash business. And second with IFC as the chief lender I think ZJG will focus on debt repayment over the next few years (read: no more senseless expansion). This will cut down interest expense as debts are repaid gradually, which will increase future profits.
Over the last 5 years (up to 2005), ZJG made about $200m in 3 years and $80m in 2 years. In 2005, it made $74m on an avg. price of $70 per weight case of float glass. Let's assume conservatively that with the soda ash plant 2007 profit is $100m. Depreciation is about $300m a year which together with profit will go into retiring debt. Interest savings (assume 6.5% on debt) after tax will be $17m a year, and $51m in 3 years. This will give a 15% annualized profit growth, which may be higher if ZJG has a break from the profit tax reform. Against a $1.26b capitalization, prospective p/e will become 10.8x, 9.4x, and 8.3x. There's also upside from the recovery of the float glass market and increase in efficiency of the soda plant. But equally things could get uglier than already is and IFC may not be the lender of last resort for the second time.
ZJG is a speculation, which means there's considerable upside but also real risk of losing one's capital. But what more can you expect from a company from hell.
DISCLOSURE: I don't hold 739 at time of writing.
Monday, January 29, 2007
A Couple of Glass Makers from Heaven and Hell
From heaven - Xinyi Glass (868)
Xinyi was listed in Jan 2005 and is the largest exporter of auto glass in China. It sells mostly to the replacement market worldwide but is qualified to supply auto glass to all 3 major US carmakers, a proof of its product quality. Auto glass is not a flashy business but an essential one with consistent demand. You're not gonna change your windshield unless it's broken; and you're gonna have to change your windshield to stay on the road if it's broken. Auto glass took up 3/4 of the turnover and the remaining 1/4 is from construction glass, coated one which is said to be more environmental friendly and energy saving. Local and overseas sales mix is 60/40.
Xinyi fits into the growth story of both auto parts outsourcing and booming property market in China. The storyline is further enriched by the growing China automobile industry and the huge infrastructure spending under the eleventh-5-year plan. Xinyi's capitalization has doubled to about $6b in two years since the IPO. Profits were $260m in 2005 and $236m in 2004. 2006 interim profit was $140m. Turnover too grew from $1b in 2004 to $1.4b in 2005; 6-month turnover grew from $600m in 2005 to $700m in 2006.
Xinyi has production facilities in HK, Shenzhen, Donguan, and Wuhu. In the prospectus it said it'd spend $700m in installing two float glass production lines in its DG plant with maximum capacities of 269k tonnes and 157k tonnes. Float glass is the single largest cost component which takes up 1/2 of production cost. This backward integration is supposed to create substantial cost savings to Xinyi, first in terms of procurement and second in transportation. As I could tell this was the largest selling point of the IPO - no need to find customers to fill up this capacity and a 10% return on assets would produce $70m profit. However, no estimate of savings were made in the prospectus and it got few mentioning in the 2005 annual report. These float glass production lines were to begin commercial production in end of 2005 but according to the 2006 interim report, there's only trial production run and float glass sales was only 2% of turnover. I'd soon learnt about the over-supply problem in float glass from studying the glass company from hell, though some recent press reported that float glass price is finally rebounding. My concern is whether this delay is caused by teething problem, which will go away soon, or a larger quality issue (otherwise why not produce as much as possible since Xinyi needs float glass and has sunk in so much cost?). It remains to be seen how much benefit this $700m investment will yield.
Separately, Xinyi chose to expand into alternative energy (there's no previous mentioning in the prospectus) and announced in May last year it'd build a $290m solar glass plant in DG. Trial production would begin in 4Q 2007, sounds familiar? Two weeks later, Xinyi placed 220m shares via its sponsor Kingsway and raised $186m. Its ability and expertise in producing solar glass aside, Xinyi certainly seems to know how the keep the market's hope alive.
Xinyi's gearing has been decreasing and is now at <20%, which contrasts with the rapid expansion which saw it assets grew from $1.6b pre-IPO to $2.8b. Is it a lack of confidence in the expansion (therefore relying on OPM) or is the management just being conservative? Dividend policy is also puzzling. It paid out $190m dividends since the IPO but had to raise $186m from placing. It paid out 46% of earnings in 2005 but capax was 3x the earnings. Effective tax rate is unusually low at only ~5%.
Xinyi is run by Lee, a Fukienese, and family members - brothers, brothers-in-law, and sons. They hold some 50% shares in total. Market rumours had it that Kingboard bought some shares from the Lees who reported a sell down of 54m shares off the exchange in last November. This may add some credibillity to Xinyi but there's no way to confirm the news.
I like the auto glass business and the backward integration. I'm not sure about the solar glass part and hesitant about the management as they seem opportunistic and not very forefront in their presentation of the business. But it may just be my own suspicion. Say if Xinyi earned $300m in 2006 then the p/e would be 20x. Assuming $100m cost savings in 2007, the p/e will become more affordable though still not a bargain at 15x. The current price has probably taken into account of the savings from the float glass production as the existing plants are operating near full capacity and profit growth in 2005 already slowed down to 10%. But this area is also the biggest uncertainty.
I don't think Xinyi is my saving angel yet.
DISCLOSURE: I don't hold 868 at time of writing.
Xinyi was listed in Jan 2005 and is the largest exporter of auto glass in China. It sells mostly to the replacement market worldwide but is qualified to supply auto glass to all 3 major US carmakers, a proof of its product quality. Auto glass is not a flashy business but an essential one with consistent demand. You're not gonna change your windshield unless it's broken; and you're gonna have to change your windshield to stay on the road if it's broken. Auto glass took up 3/4 of the turnover and the remaining 1/4 is from construction glass, coated one which is said to be more environmental friendly and energy saving. Local and overseas sales mix is 60/40.
Xinyi fits into the growth story of both auto parts outsourcing and booming property market in China. The storyline is further enriched by the growing China automobile industry and the huge infrastructure spending under the eleventh-5-year plan. Xinyi's capitalization has doubled to about $6b in two years since the IPO. Profits were $260m in 2005 and $236m in 2004. 2006 interim profit was $140m. Turnover too grew from $1b in 2004 to $1.4b in 2005; 6-month turnover grew from $600m in 2005 to $700m in 2006.
Xinyi has production facilities in HK, Shenzhen, Donguan, and Wuhu. In the prospectus it said it'd spend $700m in installing two float glass production lines in its DG plant with maximum capacities of 269k tonnes and 157k tonnes. Float glass is the single largest cost component which takes up 1/2 of production cost. This backward integration is supposed to create substantial cost savings to Xinyi, first in terms of procurement and second in transportation. As I could tell this was the largest selling point of the IPO - no need to find customers to fill up this capacity and a 10% return on assets would produce $70m profit. However, no estimate of savings were made in the prospectus and it got few mentioning in the 2005 annual report. These float glass production lines were to begin commercial production in end of 2005 but according to the 2006 interim report, there's only trial production run and float glass sales was only 2% of turnover. I'd soon learnt about the over-supply problem in float glass from studying the glass company from hell, though some recent press reported that float glass price is finally rebounding. My concern is whether this delay is caused by teething problem, which will go away soon, or a larger quality issue (otherwise why not produce as much as possible since Xinyi needs float glass and has sunk in so much cost?). It remains to be seen how much benefit this $700m investment will yield.
Separately, Xinyi chose to expand into alternative energy (there's no previous mentioning in the prospectus) and announced in May last year it'd build a $290m solar glass plant in DG. Trial production would begin in 4Q 2007, sounds familiar? Two weeks later, Xinyi placed 220m shares via its sponsor Kingsway and raised $186m. Its ability and expertise in producing solar glass aside, Xinyi certainly seems to know how the keep the market's hope alive.
Xinyi's gearing has been decreasing and is now at <20%, which contrasts with the rapid expansion which saw it assets grew from $1.6b pre-IPO to $2.8b. Is it a lack of confidence in the expansion (therefore relying on OPM) or is the management just being conservative? Dividend policy is also puzzling. It paid out $190m dividends since the IPO but had to raise $186m from placing. It paid out 46% of earnings in 2005 but capax was 3x the earnings. Effective tax rate is unusually low at only ~5%.
Xinyi is run by Lee, a Fukienese, and family members - brothers, brothers-in-law, and sons. They hold some 50% shares in total. Market rumours had it that Kingboard bought some shares from the Lees who reported a sell down of 54m shares off the exchange in last November. This may add some credibillity to Xinyi but there's no way to confirm the news.
I like the auto glass business and the backward integration. I'm not sure about the solar glass part and hesitant about the management as they seem opportunistic and not very forefront in their presentation of the business. But it may just be my own suspicion. Say if Xinyi earned $300m in 2006 then the p/e would be 20x. Assuming $100m cost savings in 2007, the p/e will become more affordable though still not a bargain at 15x. The current price has probably taken into account of the savings from the float glass production as the existing plants are operating near full capacity and profit growth in 2005 already slowed down to 10%. But this area is also the biggest uncertainty.
I don't think Xinyi is my saving angel yet.
DISCLOSURE: I don't hold 868 at time of writing.
Thursday, January 25, 2007
Investment Ideas for 2007 Invited
Yesterday I went to an investment seminar held by Quam. It was a slight disappointment that it lasted only an hour or maybe less, while it took me 1 hour of commuting time back and forth and some 20 minutes of waiting. Having said this, just one good investment idea would make all these troubles worthwhile.
The four sectors they have picked for 2007 are banks, automobiles, infrastructure construction, and ports/shipping. Banks are no longer bargains though they may still be good long term investments. I've mentioned some shipping plays already and ports are more expensive though consistent. So today I'd focus on the automobiles and infrastructure construction sectors. I'm only starting on these sectors so if you have any good ideas as to where or what to look, let me know.
Everyone knows about the China automobiles growth story so there's no repeating here. It's another battlefield over-crowded with domestic and foreign producers all trying to get a bigger slice of this growing pie. I used to like Denway despite I could not understand its accounts at all. All important financial information is condensed in one line as 'investment in an associate', although I think this structure had nothing to do with the management but rather the government's policy that forbids foreign majority ownership. I like the chance of Honda in China because of its success in North America and here in HK. However Denway is only a manufacturer so there's a cap in profit potential. Then I found out Dongfeng also produces automobiles for Honda, hence making Denway's identity confusing. That of Dongfeng is even more confusing as it also produces cars for Nissans, Peugeot, and now there's talks with Volvo too. The market though seems to like this blurred identity and has rewarded it with a higher valuation. Brilliance should have a good future with its JV with BMW but that is offset by its problems with its own brand luxury sedans. I don't know much about Qingling nor Isuzu other than that its profit is on a declining trend. Other the other hand there are pure domestic brands like Geely and Greatwall but I'm doubtful of their cars' quality and low price strategy over the long run. 'When the tide comes all boats shall rise', it may be the case here but I'd rather be waiting on the shore at the moment.
Take a step step and look at some ancillary companies. I think there's a listed company running Benz dealerships in China and Hong Kong. It may be a good proxy bet after further study. Norstar makes car brakes and has proven itself in the US replacement market. It's starting to develop the domestic market too. But it seems to have too much dealings with its owners. IPE claims itself to be an autopart supplier but the numbers suggest it's at least one or two years away. Weichai makes heavy truck engines and is technologically advanced with its cooperation with German counterparts in developing Euro IV environmental standard compliant engines. But it's price has advanced too far ahead. There may be some good companies in making windshields, tires, electronics, die casting moulds, or other autoparts, lying out there waiting to be uncovered. I'll just have to keep looking.
Infrastructure construction sector is heavily favored as under the latest China 5-year plan the transportation/logistics network is the focus of development. We'll see more roads, railways, bridges, ports, airports get built over the next 5 years. However it's hard find any bargain here. For constructors we have China Communication Construction and for traders we have CNBM. Both seem fully priced in right now but the Quam team still prefers CCC for its irreplaceable leader status. CIMH the infrastructure machinery maker is just as richly priced. China State Construction sounds similar to CCC but actually derives most businesses from HK and the international market. PYI is more a landlord than constructor with heavy investments in the Yangtze River Delta. There are numerous HK construction plays but I doubt they can make it successfully into the China market. I like Shui On Construction for its cement plants are in around Sichuan and the southwest which should benefit from the development of the neighbour 2nd tier cities. Anhui on the other hand is a bit pricey which according to Quam has a prospective p/e of over 20x. Guangshen Railway, pricey, Zhuzhou CSR Times, crazy.
This post is not very organized and coherent, but it's intended as a brainstorming session to invite views from readers.
The four sectors they have picked for 2007 are banks, automobiles, infrastructure construction, and ports/shipping. Banks are no longer bargains though they may still be good long term investments. I've mentioned some shipping plays already and ports are more expensive though consistent. So today I'd focus on the automobiles and infrastructure construction sectors. I'm only starting on these sectors so if you have any good ideas as to where or what to look, let me know.
Everyone knows about the China automobiles growth story so there's no repeating here. It's another battlefield over-crowded with domestic and foreign producers all trying to get a bigger slice of this growing pie. I used to like Denway despite I could not understand its accounts at all. All important financial information is condensed in one line as 'investment in an associate', although I think this structure had nothing to do with the management but rather the government's policy that forbids foreign majority ownership. I like the chance of Honda in China because of its success in North America and here in HK. However Denway is only a manufacturer so there's a cap in profit potential. Then I found out Dongfeng also produces automobiles for Honda, hence making Denway's identity confusing. That of Dongfeng is even more confusing as it also produces cars for Nissans, Peugeot, and now there's talks with Volvo too. The market though seems to like this blurred identity and has rewarded it with a higher valuation. Brilliance should have a good future with its JV with BMW but that is offset by its problems with its own brand luxury sedans. I don't know much about Qingling nor Isuzu other than that its profit is on a declining trend. Other the other hand there are pure domestic brands like Geely and Greatwall but I'm doubtful of their cars' quality and low price strategy over the long run. 'When the tide comes all boats shall rise', it may be the case here but I'd rather be waiting on the shore at the moment.
Take a step step and look at some ancillary companies. I think there's a listed company running Benz dealerships in China and Hong Kong. It may be a good proxy bet after further study. Norstar makes car brakes and has proven itself in the US replacement market. It's starting to develop the domestic market too. But it seems to have too much dealings with its owners. IPE claims itself to be an autopart supplier but the numbers suggest it's at least one or two years away. Weichai makes heavy truck engines and is technologically advanced with its cooperation with German counterparts in developing Euro IV environmental standard compliant engines. But it's price has advanced too far ahead. There may be some good companies in making windshields, tires, electronics, die casting moulds, or other autoparts, lying out there waiting to be uncovered. I'll just have to keep looking.
Infrastructure construction sector is heavily favored as under the latest China 5-year plan the transportation/logistics network is the focus of development. We'll see more roads, railways, bridges, ports, airports get built over the next 5 years. However it's hard find any bargain here. For constructors we have China Communication Construction and for traders we have CNBM. Both seem fully priced in right now but the Quam team still prefers CCC for its irreplaceable leader status. CIMH the infrastructure machinery maker is just as richly priced. China State Construction sounds similar to CCC but actually derives most businesses from HK and the international market. PYI is more a landlord than constructor with heavy investments in the Yangtze River Delta. There are numerous HK construction plays but I doubt they can make it successfully into the China market. I like Shui On Construction for its cement plants are in around Sichuan and the southwest which should benefit from the development of the neighbour 2nd tier cities. Anhui on the other hand is a bit pricey which according to Quam has a prospective p/e of over 20x. Guangshen Railway, pricey, Zhuzhou CSR Times, crazy.
This post is not very organized and coherent, but it's intended as a brainstorming session to invite views from readers.
Wednesday, January 24, 2007
More Layers in my PCBs please, Mr. Financial Secretary
Of course our Financial Secretary IQT (such named in a column of HKEJ) isn't moonlighting in a PCB factory. Rather it's his family's company Meadville, a PCB manufacturer, which is going through an IPO now. Upon initial read of the prospectus, it seems to be an interesting prospect.
More layers = higher technology = higher margin. This is the rule of thumb for PCBs I learnt from my past clients. But even multi layer PCBs are getting common in China and so we have HDI, high density interconnect, which squeezes in more 'electronic path' than a standard PCB. With denser and multi-layer PCBs, electronics can be made increasingly compact, as we have witnessed the rapid shrinking in weight and size of computers, phones, digital cameras and other electronics over the last few years. The next step is IC substrates which is even smaller in a micron state. As the trend of miniaturisation in consumer electronics isn't changing soon, demand for these high end PCBs is predicted to be much stronger than the overall market.
Manufacturing PCBs is a bloody competitive business and one way to come up ahead is to be the forerunners. In China where there's little proprietary technology this means being the first to adopt foreign technologies in local production. But for this to happen one needs to earn enough reputation and trust among customers before they are willing to transfer their technologies and outsource production. This appears to be the growth story of Meadville who has successfully collaborated with Hitachi and TNCsi, two Japanese firms with more advanced production technologies, and managed to stay in the top end of the market and avoided excessive price competition.
Looking at the breakdown of the latest turnover, about 2/3 was derived from higher-end PCBs (>8 layers), HDI, and IC subtrates. Conventional lower-end PCBs (<8 layers) constituted about 20% and has been on a decreasing trend (down from 48% in 2003). Meadville serves customers in communications equipment (Huawei, ZTE), computer and peripherals (ATI), consumer electronics (Pioneer), mobile phones, automotive, medical and industrial equipment. It's comforting to know many of its customers require 2 years before fully admitting any new supplier. Local/export ratio is about 70/30. Pricing is said to follow a cost-plus model meaning any rise in material cost can be passed on to customers - I'll wait and see.
Capital expenditure is gonna be substantial at $1.2b, $1b, and $650m over the next 3 years. Comparing to the pre-IPO net assets of $1.5b, we're talking about a super expansion phase here! Meadville is gonna be ~3 times as big as it is now. I certainly hope the management is right in their forecast. The IPO proceeds are only enough to cover the first year so I'd expect a lot more gearing or even fund raising in the future. And initial production expenses and depreciation is gonna hurt profit too. Debt is already running high at $1.1b and $700m was paid out as part of pre-IPO reorganization. Financial strength is one key concern, although I don't quite believe the Tangs will risk ruining its reputation with Meadville. (K.S. Lee on the other hand does this trick more and more often now)
I also don't quite grasp the accounting treatment on the giving out of shares by the controlling shareholder to the management and staff. This is supposed to be a transfer of existing shares but it'll nevertheless be expensed off by the company in the 2007 accounts. And the amount will be substantial at $250m.
Profit, as usual in any prospectus, is rising rapidly and Meadville is estimated to have earned $310m in 2006. Capitalization based on the top end price of $2.4 will be $4.8b or $5.0b with over allotment, giving a 2006 p/e of 15.5-16.1x. This is not cheap at all for an industrial and certainly the Tang family name is sold at a premium. P/B at IPO will be around 1.8x. Valuation is built upon success in future expansion and management quality. I'm gonna have a dip in this IPO (I won't receive a lot of shares anyway) and see my luck, just for excitement in this boring market when only China Mobile and a few are rising. Meadville is certainly worth another look at should its price becomes more affordable down the road.
Similar companies listed on market are Daisho Microline and Hannstar but they are not as diversified in customer base. DM is focused on mobile phones and Hannstar is on notebook computers. But they are selling at much cheaper valuation at maybe 6x and 10x respectively. Or WKK the PCB machinery trader is even cheaper. These may be more interesting bets.
DISCLOSURE: I have applied for 3313 and hold 532 at time of writing. I don't hold 567 or 667 at time of writing.
More layers = higher technology = higher margin. This is the rule of thumb for PCBs I learnt from my past clients. But even multi layer PCBs are getting common in China and so we have HDI, high density interconnect, which squeezes in more 'electronic path' than a standard PCB. With denser and multi-layer PCBs, electronics can be made increasingly compact, as we have witnessed the rapid shrinking in weight and size of computers, phones, digital cameras and other electronics over the last few years. The next step is IC substrates which is even smaller in a micron state. As the trend of miniaturisation in consumer electronics isn't changing soon, demand for these high end PCBs is predicted to be much stronger than the overall market.
Manufacturing PCBs is a bloody competitive business and one way to come up ahead is to be the forerunners. In China where there's little proprietary technology this means being the first to adopt foreign technologies in local production. But for this to happen one needs to earn enough reputation and trust among customers before they are willing to transfer their technologies and outsource production. This appears to be the growth story of Meadville who has successfully collaborated with Hitachi and TNCsi, two Japanese firms with more advanced production technologies, and managed to stay in the top end of the market and avoided excessive price competition.
Looking at the breakdown of the latest turnover, about 2/3 was derived from higher-end PCBs (>8 layers), HDI, and IC subtrates. Conventional lower-end PCBs (<8 layers) constituted about 20% and has been on a decreasing trend (down from 48% in 2003). Meadville serves customers in communications equipment (Huawei, ZTE), computer and peripherals (ATI), consumer electronics (Pioneer), mobile phones, automotive, medical and industrial equipment. It's comforting to know many of its customers require 2 years before fully admitting any new supplier. Local/export ratio is about 70/30. Pricing is said to follow a cost-plus model meaning any rise in material cost can be passed on to customers - I'll wait and see.
Capital expenditure is gonna be substantial at $1.2b, $1b, and $650m over the next 3 years. Comparing to the pre-IPO net assets of $1.5b, we're talking about a super expansion phase here! Meadville is gonna be ~3 times as big as it is now. I certainly hope the management is right in their forecast. The IPO proceeds are only enough to cover the first year so I'd expect a lot more gearing or even fund raising in the future. And initial production expenses and depreciation is gonna hurt profit too. Debt is already running high at $1.1b and $700m was paid out as part of pre-IPO reorganization. Financial strength is one key concern, although I don't quite believe the Tangs will risk ruining its reputation with Meadville. (K.S. Lee on the other hand does this trick more and more often now)
I also don't quite grasp the accounting treatment on the giving out of shares by the controlling shareholder to the management and staff. This is supposed to be a transfer of existing shares but it'll nevertheless be expensed off by the company in the 2007 accounts. And the amount will be substantial at $250m.
Profit, as usual in any prospectus, is rising rapidly and Meadville is estimated to have earned $310m in 2006. Capitalization based on the top end price of $2.4 will be $4.8b or $5.0b with over allotment, giving a 2006 p/e of 15.5-16.1x. This is not cheap at all for an industrial and certainly the Tang family name is sold at a premium. P/B at IPO will be around 1.8x. Valuation is built upon success in future expansion and management quality. I'm gonna have a dip in this IPO (I won't receive a lot of shares anyway) and see my luck, just for excitement in this boring market when only China Mobile and a few are rising. Meadville is certainly worth another look at should its price becomes more affordable down the road.
Similar companies listed on market are Daisho Microline and Hannstar but they are not as diversified in customer base. DM is focused on mobile phones and Hannstar is on notebook computers. But they are selling at much cheaper valuation at maybe 6x and 10x respectively. Or WKK the PCB machinery trader is even cheaper. These may be more interesting bets.
DISCLOSURE: I have applied for 3313 and hold 532 at time of writing. I don't hold 567 or 667 at time of writing.
Sunday, January 21, 2007
Land VAT and Tomson (258)
Albert Tong was quoted saying that Tomson will not be affected by the land VAT at all as most of its projects have been completed and are for rental, and that it is a debt-free company. This reply shows his immaturity and maybe lack of in-depth understanding of the matter. But he's only 22/23 and I remember what I was like when at his age.
I don't see how his reasoning can lead to his conclusion (especially that rental properties are required to be taxed too). Tomson Riviera being such a focal point of the Shanghai property boom would surely attract attention from the public and may even become a precedent setting case of enforcement. This can be a good or bad thing. I wishfully think there may be some leeway as after all Tomson helped build Pudong from nothing years ago when no body else was interested. If I don't misread the guidelines Tomson should have about 2 years to cut a deal with the local tax bureau, assuming it'll not liquidate the units. It may require a cash call at that time to pay for the tax. I'll be more comfortable if units are sold progressively from now till then as there should still be money left on the table after tax.
The last interim report showed the book cost of properties under development, which I assumed to be Tomson Riviera, at ~$1.2b. Tomson hasn't made any provision for land VAT and gave an estimate of $150m as contingent liability in the last annual report. I think this figure probably has excluded Tomson Riviera in the calculation as it was under construction. I also found out from the company's circular that the land was acquired in year 2000 at $450m. I'm waiting to see how DTT the auditor will deal with this potential timebomb when the 2006 final results are due in April. But now I'll assume the worst.
The estimated market value of Tomson Riviera in my last analysis is $5.9b @5000 per sq.ft.. I don't think the local tax bureau will use the asking price of $10,000 per sq.ft. in the calculation as there is no turnover at that price and Tomson can simply hire a bunch of valuers to appeal. If the tax was levied today, the ball park exposure* would be ($5.9b x 95% - $1.2b) x 60% = $2.6b! And Tomson's gain would shrink to only $1.8b, and to $1.5b after a further 15% profit tax! In other words, a little more than 2/3 of the profits will be taken away for the society's good! If this does become reality I think all land developers will think twice before erecting another building! To continue, net proceeds from Tomson Riviera will be $5.9b x 95% - $2.6b - $0.3b = $2.7b. This is about the market capitalization of Tomson now so I'm still getting my money's worth, although not much more (indeed there's some $2.8b net assets but I'm not counting on them in my analysis).
Hope for the best but be prepared for the worst.
* readers interested in the exact calculation can go to http://www.ctaxnews.com.cn/sydjch/t20061219_1441042.html. thanks accountboy hing for providing the link. i did not apply it here as the cost of the project was so low that the end result wouldn't be much affected. btw, it's funny that the numeral example in the link was actually set up in a way to demonstrate developers could earn more by lowering the price(!), explaining there is a tax advantage (no VAT) for mass housing projects with a <20% gross margin. however whoever wrote this is probably clueless as to how market functions. i wonder how many commercial developers will be interested in earning 20% on a property which they have to buy, borrow, build, and sell and which will take at least 3 years' time, unless they can borrow like hell!
DISCLOSURE: I hold 258 at time of writing.
I don't see how his reasoning can lead to his conclusion (especially that rental properties are required to be taxed too). Tomson Riviera being such a focal point of the Shanghai property boom would surely attract attention from the public and may even become a precedent setting case of enforcement. This can be a good or bad thing. I wishfully think there may be some leeway as after all Tomson helped build Pudong from nothing years ago when no body else was interested. If I don't misread the guidelines Tomson should have about 2 years to cut a deal with the local tax bureau, assuming it'll not liquidate the units. It may require a cash call at that time to pay for the tax. I'll be more comfortable if units are sold progressively from now till then as there should still be money left on the table after tax.
The last interim report showed the book cost of properties under development, which I assumed to be Tomson Riviera, at ~$1.2b. Tomson hasn't made any provision for land VAT and gave an estimate of $150m as contingent liability in the last annual report. I think this figure probably has excluded Tomson Riviera in the calculation as it was under construction. I also found out from the company's circular that the land was acquired in year 2000 at $450m. I'm waiting to see how DTT the auditor will deal with this potential timebomb when the 2006 final results are due in April. But now I'll assume the worst.
The estimated market value of Tomson Riviera in my last analysis is $5.9b @5000 per sq.ft.. I don't think the local tax bureau will use the asking price of $10,000 per sq.ft. in the calculation as there is no turnover at that price and Tomson can simply hire a bunch of valuers to appeal. If the tax was levied today, the ball park exposure* would be ($5.9b x 95% - $1.2b) x 60% = $2.6b! And Tomson's gain would shrink to only $1.8b, and to $1.5b after a further 15% profit tax! In other words, a little more than 2/3 of the profits will be taken away for the society's good! If this does become reality I think all land developers will think twice before erecting another building! To continue, net proceeds from Tomson Riviera will be $5.9b x 95% - $2.6b - $0.3b = $2.7b. This is about the market capitalization of Tomson now so I'm still getting my money's worth, although not much more (indeed there's some $2.8b net assets but I'm not counting on them in my analysis).
Hope for the best but be prepared for the worst.
* readers interested in the exact calculation can go to http://www.ctaxnews.com.cn/sydjch/t20061219_1441042.html. thanks accountboy hing for providing the link. i did not apply it here as the cost of the project was so low that the end result wouldn't be much affected. btw, it's funny that the numeral example in the link was actually set up in a way to demonstrate developers could earn more by lowering the price(!), explaining there is a tax advantage (no VAT) for mass housing projects with a <20% gross margin. however whoever wrote this is probably clueless as to how market functions. i wonder how many commercial developers will be interested in earning 20% on a property which they have to buy, borrow, build, and sell and which will take at least 3 years' time, unless they can borrow like hell!
DISCLOSURE: I hold 258 at time of writing.
Something Else
Rocky Balboa is a 'buy'. It's good to watch an inspiring movie every once in a while. I felt good afterward (and it's not just me in the middle age, I found out that the movie is a sensation among Britian youngsters). The story is also a timely one for HK and suits today's sentiments well, that of reminiscence of the past. HK is like a grown up man in his middle age, and many of us share signs of middle age syndrome, having become too comfortable or worse lost and cynical. So it's good to have the mindset freshened up.
The movie could've been made a bit longer, say 15-20 mins, to allow more depth and portrait of the characters. But this is only a minor complaint and doesn't affect the delivery of the main message. I found the best bit to be the dialogue between Rocky and his manager Larry (also the same guy as before!) during the opening 10 minutes or so. Trust me, this one is quite different from other Rocky movies and worth the while.
It's creepy your heart still gets pumped up after so many years when you hear the familiar Rocky tune "Dadada, Dadada, dadadadada....".
The movie could've been made a bit longer, say 15-20 mins, to allow more depth and portrait of the characters. But this is only a minor complaint and doesn't affect the delivery of the main message. I found the best bit to be the dialogue between Rocky and his manager Larry (also the same guy as before!) during the opening 10 minutes or so. Trust me, this one is quite different from other Rocky movies and worth the while.
It's creepy your heart still gets pumped up after so many years when you hear the familiar Rocky tune "Dadada, Dadada, dadadadada....".
Saturday, January 20, 2007
More Thoughts on Land VAT
In a free housing market when demand drives up property prices, supply will pile in and eventually catch up (as land development takes time) with the demand and the market will resume to a normal but higher level (assume low inflation). Just like when the stock market is really heated we'll see all kinds of IPOs and placings to absorb the buying power, but only happening in a much quicker fashion. Sometimes overshooting occurs in both ways and with a little human intervention we have booms & busts.
China housing demand is on an upward slope, but no one quite knows whether the slope is a gentle or steep one. As the government has allowed some part of the population to come ahead of others (e.g. urban and coastal cities), a surge in demand for quality housing is natural progression. Afterall improvement in quality of living is what drives people forward. It's also natural that developers ignore the mass market, i.e. low income families who have little spending power. This together with the lack of a formal public housing programme by the government has created a vacuum in the property market, a cause for social unrest or 'deep level contradiction'. But China's problem is more complicated.
Another contributing factor is the slow RMB appreciation (it actually depreciated against most currencies last year!). It has attracted a massive sum of foreign speculative money in stocks and properties. Exchange reserves continue to pile up everyday and consumption keeps falling behind. Local citizens and companies have limited access to foreign markets due to capital control. Investments in resources and fixed assets are no longer welcome. So where do these monies go? Stocks and properties again! Unless RMB is appreciated sufficiently this excess liquidity will not go away and neither will property speculators. I think Jim Rogers once said he has found the surest bet to be those against central bankers who try to act against the market. Many are following his advice now.
My question once again is: why deter property development when you know demand is going to stay strong in the long run? I think the outcome will be one of the following scenario.
(1) The government has analysed enough data to conclude that future supply is gonna outstrip demand by so much that a severe crash will be a certainty, like we HK and our neighbour Japan experienced. Therefore it properly introduces drastic measures to smooth out the 'boom & bust' pattern and the society is saved from any adverse impact.
(2) The government has analysed enough data but under-estimated future demand for housing or RMB, and by controlling supply now, future property prices will escalate further and the eventual bust will be worse.
(3) The government has analysed enough data to properly estimate future demand but by intervening the supply side too much, property prices will still rise in the future and will follow a similar path as in scenario 1.
What's your guess? As I don't believe in central planning I think either (2) or (3) is more likely. So I'm sticking to property plays, selectively of course! Profits will be lower because of the new tax. Consolidation will accelerate and eliminate less efficient players. However I don't see the general direction of the market will be altered. As for impact on individual companies, it's too early to tell before we see how the local government and bureau actually enforce the guidelines. Are they gonna scrutinize every single property projects in China sold over the last 10 years? Or will it work on a self-declaration basis like how the VAT investigation was handled before? No one has an answer right now. But I do know there's no way the governement can turn private developers into providing low-income housing projects with land VAT. If it tries really hard it'll more likely find everybody is out and itself alone in the housing market!
I have no clue how the hyper valuation of most land developers came from at the first place, therefore I can't comment how they will be affected now. In my view they are already too expensive, with or without the land VAT!
China housing demand is on an upward slope, but no one quite knows whether the slope is a gentle or steep one. As the government has allowed some part of the population to come ahead of others (e.g. urban and coastal cities), a surge in demand for quality housing is natural progression. Afterall improvement in quality of living is what drives people forward. It's also natural that developers ignore the mass market, i.e. low income families who have little spending power. This together with the lack of a formal public housing programme by the government has created a vacuum in the property market, a cause for social unrest or 'deep level contradiction'. But China's problem is more complicated.
Another contributing factor is the slow RMB appreciation (it actually depreciated against most currencies last year!). It has attracted a massive sum of foreign speculative money in stocks and properties. Exchange reserves continue to pile up everyday and consumption keeps falling behind. Local citizens and companies have limited access to foreign markets due to capital control. Investments in resources and fixed assets are no longer welcome. So where do these monies go? Stocks and properties again! Unless RMB is appreciated sufficiently this excess liquidity will not go away and neither will property speculators. I think Jim Rogers once said he has found the surest bet to be those against central bankers who try to act against the market. Many are following his advice now.
My question once again is: why deter property development when you know demand is going to stay strong in the long run? I think the outcome will be one of the following scenario.
(1) The government has analysed enough data to conclude that future supply is gonna outstrip demand by so much that a severe crash will be a certainty, like we HK and our neighbour Japan experienced. Therefore it properly introduces drastic measures to smooth out the 'boom & bust' pattern and the society is saved from any adverse impact.
(2) The government has analysed enough data but under-estimated future demand for housing or RMB, and by controlling supply now, future property prices will escalate further and the eventual bust will be worse.
(3) The government has analysed enough data to properly estimate future demand but by intervening the supply side too much, property prices will still rise in the future and will follow a similar path as in scenario 1.
What's your guess? As I don't believe in central planning I think either (2) or (3) is more likely. So I'm sticking to property plays, selectively of course! Profits will be lower because of the new tax. Consolidation will accelerate and eliminate less efficient players. However I don't see the general direction of the market will be altered. As for impact on individual companies, it's too early to tell before we see how the local government and bureau actually enforce the guidelines. Are they gonna scrutinize every single property projects in China sold over the last 10 years? Or will it work on a self-declaration basis like how the VAT investigation was handled before? No one has an answer right now. But I do know there's no way the governement can turn private developers into providing low-income housing projects with land VAT. If it tries really hard it'll more likely find everybody is out and itself alone in the housing market!
I have no clue how the hyper valuation of most land developers came from at the first place, therefore I can't comment how they will be affected now. In my view they are already too expensive, with or without the land VAT!
Thursday, January 18, 2007
Thoughts on Land VAT
I recall K.S. Li once said in the press that in the good old days before 1997, a land developer could easily earn profit from three sources for every dollar it puts in a project.
1. Increasing demand for housing as people become more affluent
2. Inflation created by negative interest rate environment
3. Profit on construction and finance costs
And profits from 1 and 2 was often multiples of 3. Of course we all know what happened after the good old days when profits from 1 and 2 disappeared.
China property market is in a similar environment. But China doesn't have an inflation problem, quite the contrary its problem is too many people are producing too many stuff too quickly. This factor is nevertheless replaced by the speculation on RMB appreciation, which has created an even greater impact. So we can understand why HK developers, big and small, are all rushing into China to rekindle the long lost romance.
Land VAT was said to be in place since 1993 but has never strictly been enforced. The collapse of the property market soon afterward played a pivotal role in 'vetoing' this policy. Another reason cited was the lack of clear guidelines. Many local governments eager to grow and develop their cities simply charge 1-2% on sales proceeds as land VAT.
Valuing land like stocks is not science, and often a property valuer sounds no different from a stock analyst who will beat yesterday's self in no time. Take One Silver Sea in HK as an example, a mid-market residential land acquired at the bottom of the property cycle and then repackaged and sold successfully as an ultra luxury property project like those on the peak. How are we to divide up the profit between (i) that due to the appreciation of land during the time of development and (ii) that due rightfully to the competence of Sino Land. Or when Thomas Lau reaped a huge profit from breaking up a Wanchai shopping mall into 100 or so smaller shops and then selling them out successfully, was there land appreciation involved? You can argue yes because that's exactly what's in Mr. Lau's pocket, but you can also argue no since most, if not all, buyers lost money afterward. Money was made timely from the sentiments of the buyers but not the land.
Now the guidelines have been set and it's passed on to the local government and tax bureau to enforce it. From what I read from the paper the land VAT appears to be a profit tax but done on individual project level (I'm waiting for details as to how this 'profit' is calculated). Luxury property sector is predicted to be hit the hardest as the profit is the highest. On every dollar of profit made from land development now the government wants a bigger slice. (It's like 'oh! the land I sold you last year was sold too cheap and now you are rich and I want compensation!'). In communist fashion the rates charged are progressive too, starting at 30% and topping out at 60%. Together with a 25% unified profit tax rate, the effective tax rate will be from 47.5% to as high as 70%! Just imagine what this'll do to the supply equation.
I know Canada (many say it's the most communist non-communist country) has a progressive personal income tax that also tops out at around 60% or maybe slightly less. The natural result, intended or not, is nobody would want to work that hard when the government is receiving more than they do on the marginal income, i.e. putting up 1 dollar effort but getting only 40 cents. Some even deny promotion as it'd make them earn 'less' overall! In the end there's more harmony than prosperity.
The intent of the government is clearly to curb speculation and rises in property prices, but the foreseeable result is also that there will be lesser supply in the future, especially in the luxury sector where developers are 'encouraged' to move away from. How contradictory this is? Or does the China government believe it has the right prescription for this overheating property market?
(To be continued)
1. Increasing demand for housing as people become more affluent
2. Inflation created by negative interest rate environment
3. Profit on construction and finance costs
And profits from 1 and 2 was often multiples of 3. Of course we all know what happened after the good old days when profits from 1 and 2 disappeared.
China property market is in a similar environment. But China doesn't have an inflation problem, quite the contrary its problem is too many people are producing too many stuff too quickly. This factor is nevertheless replaced by the speculation on RMB appreciation, which has created an even greater impact. So we can understand why HK developers, big and small, are all rushing into China to rekindle the long lost romance.
Land VAT was said to be in place since 1993 but has never strictly been enforced. The collapse of the property market soon afterward played a pivotal role in 'vetoing' this policy. Another reason cited was the lack of clear guidelines. Many local governments eager to grow and develop their cities simply charge 1-2% on sales proceeds as land VAT.
Valuing land like stocks is not science, and often a property valuer sounds no different from a stock analyst who will beat yesterday's self in no time. Take One Silver Sea in HK as an example, a mid-market residential land acquired at the bottom of the property cycle and then repackaged and sold successfully as an ultra luxury property project like those on the peak. How are we to divide up the profit between (i) that due to the appreciation of land during the time of development and (ii) that due rightfully to the competence of Sino Land. Or when Thomas Lau reaped a huge profit from breaking up a Wanchai shopping mall into 100 or so smaller shops and then selling them out successfully, was there land appreciation involved? You can argue yes because that's exactly what's in Mr. Lau's pocket, but you can also argue no since most, if not all, buyers lost money afterward. Money was made timely from the sentiments of the buyers but not the land.
Now the guidelines have been set and it's passed on to the local government and tax bureau to enforce it. From what I read from the paper the land VAT appears to be a profit tax but done on individual project level (I'm waiting for details as to how this 'profit' is calculated). Luxury property sector is predicted to be hit the hardest as the profit is the highest. On every dollar of profit made from land development now the government wants a bigger slice. (It's like 'oh! the land I sold you last year was sold too cheap and now you are rich and I want compensation!'). In communist fashion the rates charged are progressive too, starting at 30% and topping out at 60%. Together with a 25% unified profit tax rate, the effective tax rate will be from 47.5% to as high as 70%! Just imagine what this'll do to the supply equation.
I know Canada (many say it's the most communist non-communist country) has a progressive personal income tax that also tops out at around 60% or maybe slightly less. The natural result, intended or not, is nobody would want to work that hard when the government is receiving more than they do on the marginal income, i.e. putting up 1 dollar effort but getting only 40 cents. Some even deny promotion as it'd make them earn 'less' overall! In the end there's more harmony than prosperity.
The intent of the government is clearly to curb speculation and rises in property prices, but the foreseeable result is also that there will be lesser supply in the future, especially in the luxury sector where developers are 'encouraged' to move away from. How contradictory this is? Or does the China government believe it has the right prescription for this overheating property market?
(To be continued)
Tuesday, January 16, 2007
DISCLAIMER AND SIMPLE RULES (UPDATED)
DISCLAIMER
This blog is not meant to provide any form of investment advisory services, for which you should consult your own brokers and advisers.
SIMPLE RULES (to which I will probably add more in time)
1. Any feedback and discussions are definitely welcome. However, this blog is not a Q&A forum and hence please do not ask "what should I do" type of questions which will not be answered.
2. If you have extensive comments you can send it to abacimailbox@gmail.com. I'll post it upon receipt (I know it's extremely hard to work with the little comment window that has little functionality). Chinese is definitly fine but I can only reply in English for now, until my Chinese typing is up to speed.
This blog is not meant to provide any form of investment advisory services, for which you should consult your own brokers and advisers.
SIMPLE RULES (to which I will probably add more in time)
1. Any feedback and discussions are definitely welcome. However, this blog is not a Q&A forum and hence please do not ask "what should I do" type of questions which will not be answered.
2. If you have extensive comments you can send it to abacimailbox@gmail.com. I'll post it upon receipt (I know it's extremely hard to work with the little comment window that has little functionality). Chinese is definitly fine but I can only reply in English for now, until my Chinese typing is up to speed.
Failed Speculation??? Then What???
Below is pure speculation, which has failed so far too, written for the sake of experience sharing.
During the correction last June when I was looking for bargains, one of the choices was between Sinopec (386) and Shanghai Petrochemicals (386), its 55% owned H-share subsidiary. The odds looked favorable after the prices of both had dropped some 30%, from $5.5 to $3.8 for Sinopec and from $5 to $3.4 for SP, in less than a month or so.
I had come to like refineries that time because I saw the bottleneck on their profitability (or should I say non-profitability), i.e. the arbitrary cap set on product price and consequently the share price, would ease in time. This odd example of 'Chinese characteristic capitalism' (the more you sell, the less money you make?) could not exist forever, as the government knew very well that over-investment and over-production in the economy could not be effectively curbed if energy costs were not fully reflected in the system.
China was obliged to open up the wholesale and retail market for petrochemicals under the WTO, so it's certain a reform in the pricing mechanism would happen. My guess was refineries would be entitled to earn a 'normal' profit, irrespective of crude oil price. This would be somewhat similar to the power industry where the tariff must eventually go up to reflect the coal price, making power plants a good buy too (note: at that time).
The crude oil price wasn't such a big concern to me as Sinopec had enough downstream operations to make use of that oil to lessen the impact.
For SP, I took comfort that it was the largest refinery group and had the most gas stations in Shanghai, two important strategic assets to all petrochemical players, local or foreign.
Now came the speculative part. It had long been rumoured that SP would be privatized as part of the Sinopec reorganization, and that the offer price would be around $5 and involve a share swap (to lessen the financial burden on Sinopec). My wishing thinking was that I'd buy SP and then wait for the privatization to happen, then I'd exchange it for Sinopec shares. That way I could earn both the takeover premium and then the appreciation from Sinopec.
And how wrong I was!
7 months later, Sinopec went up by 70% (against a drop in crude oil price), and SP, only 20%...and no privatization...need to say more?
Actually quite the opposite happened as SP announced in October it would instead undergo A-share reform, floating all domestic shares in Shanghai. I had no idea which egghead came up with the idea (that was 100% against market anticipation) but naturally it was voted down by the A-share minority shareholders, for most of them had bought the shares waiting for a buyout, not a receipt of more shares.
Then what?
It's anybody's guess. Sinopec still needs to simplify its group structure and do away multiple listings of its subsidiaries/associates (btw, the other usual suspects are Yizheng Chemicals (1033) and Sinopec Kantons (934), and especially the latter). The divergence in share price performance of Sinopec and SP has now made the share swap option more appealing to Sinopec and acceptable to its minority shareholders (lesser dilution). A much lower crude oil price may suggest timing is about right, which is more urgent now than 7 months ago, as any positive development in the pricing reform (which nevertheless will lift the price of Sinopec too) will lead to a higher offer. But again nothing may happen or the egghead may think of something ingenious again.
Meanwhile I can only wait. Speculation sometimes can be long and boring.
DISCLOSURE: Unfortunate or not, I still hold 338 at time of writing. I don't hold any 386, 1033, or 934 at time of writing.
During the correction last June when I was looking for bargains, one of the choices was between Sinopec (386) and Shanghai Petrochemicals (386), its 55% owned H-share subsidiary. The odds looked favorable after the prices of both had dropped some 30%, from $5.5 to $3.8 for Sinopec and from $5 to $3.4 for SP, in less than a month or so.
I had come to like refineries that time because I saw the bottleneck on their profitability (or should I say non-profitability), i.e. the arbitrary cap set on product price and consequently the share price, would ease in time. This odd example of 'Chinese characteristic capitalism' (the more you sell, the less money you make?) could not exist forever, as the government knew very well that over-investment and over-production in the economy could not be effectively curbed if energy costs were not fully reflected in the system.
China was obliged to open up the wholesale and retail market for petrochemicals under the WTO, so it's certain a reform in the pricing mechanism would happen. My guess was refineries would be entitled to earn a 'normal' profit, irrespective of crude oil price. This would be somewhat similar to the power industry where the tariff must eventually go up to reflect the coal price, making power plants a good buy too (note: at that time).
The crude oil price wasn't such a big concern to me as Sinopec had enough downstream operations to make use of that oil to lessen the impact.
For SP, I took comfort that it was the largest refinery group and had the most gas stations in Shanghai, two important strategic assets to all petrochemical players, local or foreign.
Now came the speculative part. It had long been rumoured that SP would be privatized as part of the Sinopec reorganization, and that the offer price would be around $5 and involve a share swap (to lessen the financial burden on Sinopec). My wishing thinking was that I'd buy SP and then wait for the privatization to happen, then I'd exchange it for Sinopec shares. That way I could earn both the takeover premium and then the appreciation from Sinopec.
And how wrong I was!
7 months later, Sinopec went up by 70% (against a drop in crude oil price), and SP, only 20%...and no privatization...need to say more?
Actually quite the opposite happened as SP announced in October it would instead undergo A-share reform, floating all domestic shares in Shanghai. I had no idea which egghead came up with the idea (that was 100% against market anticipation) but naturally it was voted down by the A-share minority shareholders, for most of them had bought the shares waiting for a buyout, not a receipt of more shares.
Then what?
It's anybody's guess. Sinopec still needs to simplify its group structure and do away multiple listings of its subsidiaries/associates (btw, the other usual suspects are Yizheng Chemicals (1033) and Sinopec Kantons (934), and especially the latter). The divergence in share price performance of Sinopec and SP has now made the share swap option more appealing to Sinopec and acceptable to its minority shareholders (lesser dilution). A much lower crude oil price may suggest timing is about right, which is more urgent now than 7 months ago, as any positive development in the pricing reform (which nevertheless will lift the price of Sinopec too) will lead to a higher offer. But again nothing may happen or the egghead may think of something ingenious again.
Meanwhile I can only wait. Speculation sometimes can be long and boring.
DISCLOSURE: Unfortunate or not, I still hold 338 at time of writing. I don't hold any 386, 1033, or 934 at time of writing.
Sunday, January 14, 2007
Something Else
Today I started reading a book called "Chasing Daylight" by Eugene O' Kelly and am now more than 1/3 finished. It's not a difficult read at all, though I'm sure it will lead to a lot of thinking afterward. The book is a 'death diary' which chronicled the last three and a half months of O' Kelly's life after being diagnosed with terminal brain cancer in May 2005. It also caught my attention that O' Kelly was the CEO of KPMG (US) and was at the peak of this career when the death sentence came (though it doesn't necessarily mean he was as much accomplished in other aspects of life, and he probably wasn't).
I'm always interested in reading a 'death diary' as it is not fiction but first hand account of a human being and his life, or the approaching end of it. There ain't many offerings in the market. Since a time unknown, death has become a forebidden subject in our society rarely discussed. I wonder if this book would get published if the author weren't a heavyweight.
This is not a book review and I'm not giving moral judgement on the author's life either. But I'd would like to share with you the opening of the book which began with a quote.
For anything that men can tell, death may be the greatest good that can happen to them: but they fear it as if they know quite well that it was the greatest evils. And what is this but that shameful ignorance of thinking that we know what we do not know?
-Socrates
Note: I intend to write something non-stock every once in a while and the next episode will definitely be lighter in tone. Incidentally, "Something Else" is a great tune played by Cannonball Adderley and Miles Davis, my two favorite jazz musicians.
I'm always interested in reading a 'death diary' as it is not fiction but first hand account of a human being and his life, or the approaching end of it. There ain't many offerings in the market. Since a time unknown, death has become a forebidden subject in our society rarely discussed. I wonder if this book would get published if the author weren't a heavyweight.
This is not a book review and I'm not giving moral judgement on the author's life either. But I'd would like to share with you the opening of the book which began with a quote.
For anything that men can tell, death may be the greatest good that can happen to them: but they fear it as if they know quite well that it was the greatest evils. And what is this but that shameful ignorance of thinking that we know what we do not know?
-Socrates
Note: I intend to write something non-stock every once in a while and the next episode will definitely be lighter in tone. Incidentally, "Something Else" is a great tune played by Cannonball Adderley and Miles Davis, my two favorite jazz musicians.
Friday, January 12, 2007
China COSCO (1919) & OOIL (316) (Reload)
OOIL announced today that it had proceeded to initial completion of the disposal of the 4 North American ports. The Vancouver part of the deal was done while the NY part is still pending approval from the Port Authority. This means OOIL is certain to receive HK$14.66b out of the HK$18.33b total considertaion. Since the deal in terms of consideration is now 80% completed, it's time to re-run the valuation formula we had last time.
Valuation of OOIL shipping business: 30.6b - 14.66b cash - NY ports 0.38b* - remaining ports 1.98b - properties 9.5b = only 4b!!!
* conservatively restated at 1.5x p/b assuming no completion.
The updated figures of CSCL and China COSCO (shipping business) was HK$14.4b and HK$12.7b respectively.
China COSCO has risen some 20% due mostly to the A-share hype so it's no longer a sector bargain, which now goes to OOIL which is now about 30% cheaper than its peers.
My sector preference now is OOIL -> China COSCO -> CSCL. Keep in mind the revived industry prospect is not yet reflected. The shipping plays should still have a long way to go.
DISCLOSURE: I hold 1919 and 316 at time of writing.
Valuation of OOIL shipping business: 30.6b - 14.66b cash - NY ports 0.38b* - remaining ports 1.98b - properties 9.5b = only 4b!!!
* conservatively restated at 1.5x p/b assuming no completion.
The updated figures of CSCL and China COSCO (shipping business) was HK$14.4b and HK$12.7b respectively.
China COSCO has risen some 20% due mostly to the A-share hype so it's no longer a sector bargain, which now goes to OOIL which is now about 30% cheaper than its peers.
My sector preference now is OOIL -> China COSCO -> CSCL. Keep in mind the revived industry prospect is not yet reflected. The shipping plays should still have a long way to go.
DISCLOSURE: I hold 1919 and 316 at time of writing.
Wednesday, January 10, 2007
Shanghai Home At RMB10,000 per square feet??? Part II
Thanks Anonymous for his extensive comments (can be found under my original post) which is exactly what I hope for when starting this blog, no flame but healthy discussions on stock picks. (If you can please leave a name next time as it's easier to communicate. I don't believe this is your last post rite?)
In response, I'm starting a part II because there's quite some information I want to supplement.
The Repulse Bay project of 'Aunt Sweetie' is really a disaster but she is either already too rich or too busy going to courts to care about that. Albert Tong on the other hand should have more aspiration at his age, I hope.
In HK, while many wealthy families choose to live on the Island South and the Peak, some opt for large expensive apartments on the mid-level like Albany and Regence Royale (by Hendersen). Lee Shau Kee for one still lives on Macdonald Road. I don't have supporting facts but I guess there are also large and expensive apartments in Manhattan. I think convenience is a factor and the city view has an allure to some.
The asking price of RMB10k per sqft. is definitely too high for now, as already proven by the poor sales. This is not debatable. But one can't dispute either that the company is very cheap right now. At the current share price it's like buying the whole Tomson Riviera at only RMB2.3k per sqft., and the remaining assets of Tomson come free. If you assume a fair price of RMB5k per sqft., then Tomson is at least 50% undervalued. Although we don't know how long it'll take Tomson to clear its stock, in any case it has no financial pressure to do so, the value of the property while unsold will still appreciate over time, as a result of improving market conditions or RMB appreciation or both. I can't predict the extent of the rise of the market (i'm of course a bull in property!) but my guess is it will more than compensate for my waiting. Take a conservative guess, say Tomson sells out all units exactly 3 years later and at only RMB5k per sqft., this will be 100% return over 3 years or 25% annualized return.
There are many who share your skepticism and are waiting on the sideline. Opportunity cost is high in a bull market so it's natural people adopt a wait and see approach. After all, Tomson has done a CB to institutional investors before and its property was once put on a global tender, so the stock can't be called an undiscovered gem. So whoever wants in should have gotten in already.
I never go all offensive in investments and tend to keep some asset plays in my portfolio. Since I'm long on China properties, I need some exposure and am much more comfortable holding Tomson with its ready-to-deliver property and discount-to-NAV valuation, than those property counters with a land bank which takes years to develop but already trading at multiple times book value.
DISCLOSURE: I hold 258 at time of writing.
In response, I'm starting a part II because there's quite some information I want to supplement.
The Repulse Bay project of 'Aunt Sweetie' is really a disaster but she is either already too rich or too busy going to courts to care about that. Albert Tong on the other hand should have more aspiration at his age, I hope.
In HK, while many wealthy families choose to live on the Island South and the Peak, some opt for large expensive apartments on the mid-level like Albany and Regence Royale (by Hendersen). Lee Shau Kee for one still lives on Macdonald Road. I don't have supporting facts but I guess there are also large and expensive apartments in Manhattan. I think convenience is a factor and the city view has an allure to some.
The asking price of RMB10k per sqft. is definitely too high for now, as already proven by the poor sales. This is not debatable. But one can't dispute either that the company is very cheap right now. At the current share price it's like buying the whole Tomson Riviera at only RMB2.3k per sqft., and the remaining assets of Tomson come free. If you assume a fair price of RMB5k per sqft., then Tomson is at least 50% undervalued. Although we don't know how long it'll take Tomson to clear its stock, in any case it has no financial pressure to do so, the value of the property while unsold will still appreciate over time, as a result of improving market conditions or RMB appreciation or both. I can't predict the extent of the rise of the market (i'm of course a bull in property!) but my guess is it will more than compensate for my waiting. Take a conservative guess, say Tomson sells out all units exactly 3 years later and at only RMB5k per sqft., this will be 100% return over 3 years or 25% annualized return.
There are many who share your skepticism and are waiting on the sideline. Opportunity cost is high in a bull market so it's natural people adopt a wait and see approach. After all, Tomson has done a CB to institutional investors before and its property was once put on a global tender, so the stock can't be called an undiscovered gem. So whoever wants in should have gotten in already.
I never go all offensive in investments and tend to keep some asset plays in my portfolio. Since I'm long on China properties, I need some exposure and am much more comfortable holding Tomson with its ready-to-deliver property and discount-to-NAV valuation, than those property counters with a land bank which takes years to develop but already trading at multiple times book value.
DISCLOSURE: I hold 258 at time of writing.
Tuesday, January 09, 2007
Buy China, Buy Chalco (2600)
Price of Chalco (2600) has fell to HK$6.88 (as I'm writing now) from as high as HK$8 only a few days ago, a fall of comparable extent to the Chinese property and financial counters. Maybe it's profit taking from the proposed A-share listing hype or maybe it's early bird selling on proprietary information. But I'm gonna stick my neck out and defend Chalco, as the current retreat of price has made the share less speculative and attractive again.
Chalco is one of Tony Measor's top picks for 2007 and he started recommending it as far as in last June. I quickly came to agree to him after some fact finding and yesterday I looked at my email to him back then.
"I ended up buying some Chalco at $5.3, at which price it looked to be a safer bet...I know it's the largest alumina supplier in PRC (representing over 90% of domestic supply) and PRC has to satisfy 50% of its alumina demand from overseas. That two factors alone will gurantee buyers for Chalco for a long time...Chalco is also expanding both forward to smelters and -backward to mines with the surplus cash. And it appears smelters are turning around after almost two tough years, judging from the segmental figures of Chalco and the [timing of] Asia Aluminum privatisation. I'm however uncertain about global supply of alumina which can depress the domestic supply price, although Chalco should has the logistics advantage.
Even a 6b profit (2004 level) will give a p/e of ~10x [at current price is ~12.5x], and future profits will go up because of acquisitions and expansions."
Later I found out Chalco actually is the second largest player in the world after Alcoa of US, which holds a 8% stake in Chalco. The management was quoted yesterday saying accordingly to plan 2007 capacity of primiary aluminium could reach 3.4m tons (~30-35% share in domestic market) whilst that of alumina will be close to 10m (my guess is 2/3 of domestic market). As it takes 2 tons of alumina to produce a ton of aluminium, logistics aside, Chalco can utilize up to ~70% of its alumina output internally. This should ease concerns about the continual drop in Alumina price due to an increase in domestic supply which went up by some 50% in 2006 alone! Aluminium price (LME) on the other hand rose 18% in 2006. The PRC government has made its goal clear in its latest 5-yr policy address for a clean and efficient economy. That means curbing any further investments in capacity and consolidating existing ones. I believe it's a matter of time before Chalco will emerge as a winner.
We are taking about the biggest player in a major construction and industrial material and in perhaps the biggest consuming nation, and with government blessing! How risky can it be? Well very much so according to the market.
Starting from 2006 and up to yesterday, Chalco (up by 17.8%) has underperformed other constuction material plays like steel (angang up by 164%), copper (jiangxi up by 100%), and even cement (anhui up by 170%)! 2-year performances (in the same order) were 50%, 150%, 90%, and 200%. As far as I know those industries also face similar issues of rising energy prices, over capacity, and are in consolidation phase too. Maybe the market thinks Chalco only just started to go downhill while the rest is already in recovery. But this also serves to illustrate the extent of a rebound should the market changes it perception. Of course I don't expect Chalco to repeat its peers' performances in 2007 as market sentiments are hard to predict, but I do think it's a very reasonable buy into the China long term growth story.
DISCLOSURE: I hold 2600 at time of writing.
Chalco is one of Tony Measor's top picks for 2007 and he started recommending it as far as in last June. I quickly came to agree to him after some fact finding and yesterday I looked at my email to him back then.
"I ended up buying some Chalco at $5.3, at which price it looked to be a safer bet...I know it's the largest alumina supplier in PRC (representing over 90% of domestic supply) and PRC has to satisfy 50% of its alumina demand from overseas. That two factors alone will gurantee buyers for Chalco for a long time...Chalco is also expanding both forward to smelters and -backward to mines with the surplus cash. And it appears smelters are turning around after almost two tough years, judging from the segmental figures of Chalco and the [timing of] Asia Aluminum privatisation. I'm however uncertain about global supply of alumina which can depress the domestic supply price, although Chalco should has the logistics advantage.
Even a 6b profit (2004 level) will give a p/e of ~10x [at current price is ~12.5x], and future profits will go up because of acquisitions and expansions."
Later I found out Chalco actually is the second largest player in the world after Alcoa of US, which holds a 8% stake in Chalco. The management was quoted yesterday saying accordingly to plan 2007 capacity of primiary aluminium could reach 3.4m tons (~30-35% share in domestic market) whilst that of alumina will be close to 10m (my guess is 2/3 of domestic market). As it takes 2 tons of alumina to produce a ton of aluminium, logistics aside, Chalco can utilize up to ~70% of its alumina output internally. This should ease concerns about the continual drop in Alumina price due to an increase in domestic supply which went up by some 50% in 2006 alone! Aluminium price (LME) on the other hand rose 18% in 2006. The PRC government has made its goal clear in its latest 5-yr policy address for a clean and efficient economy. That means curbing any further investments in capacity and consolidating existing ones. I believe it's a matter of time before Chalco will emerge as a winner.
We are taking about the biggest player in a major construction and industrial material and in perhaps the biggest consuming nation, and with government blessing! How risky can it be? Well very much so according to the market.
Starting from 2006 and up to yesterday, Chalco (up by 17.8%) has underperformed other constuction material plays like steel (angang up by 164%), copper (jiangxi up by 100%), and even cement (anhui up by 170%)! 2-year performances (in the same order) were 50%, 150%, 90%, and 200%. As far as I know those industries also face similar issues of rising energy prices, over capacity, and are in consolidation phase too. Maybe the market thinks Chalco only just started to go downhill while the rest is already in recovery. But this also serves to illustrate the extent of a rebound should the market changes it perception. Of course I don't expect Chalco to repeat its peers' performances in 2007 as market sentiments are hard to predict, but I do think it's a very reasonable buy into the China long term growth story.
DISCLOSURE: I hold 2600 at time of writing.
Monday, January 08, 2007
Every Dog has its Day? My Industrial Picks for 2007
Industrials have taken up so much beating over the past two/three years. Some say rightfully so but I say 2007 may be a year of turnaround for the underdog, mainly because of the huge liquidity in the market. When most have their hands full of Chinese financials and H-shares, sooner or later people will move on to something else. Just a tiny drop of this liquidity will give a huge boast to the industrials as they have been ignored for so long which pretty much exhausted all selling. Also I'm seeing some positive trends developing.
(1) Prices of oil and other resources have come down and seem stabilised.
(2) Industrials have adapted to become more efficient.
(3) RMB has depreciated against most currencies in 2006 thanks to weakening USD, so export has become more competitive especially for those serving non-US markets.
(4) Valuation has come down to a level unseen since 2001 with most now trading at low single digit p/e.
Some negative factors remain though.
(1) Government's stance to fade out most small-size, low tech, labor intensive type manufacturing.
(2) Coming profit tax reform which will hurt most industrials which are foreign enterprises.
(3) Rising labor cost, environmental standard, and competition from uprising local factories.
One needs to be selective as not all will rise like in the last small cap boom. Following Peter Lynch's rule of 5, that out of 5 small caps one will become a star, one will become a dog, and 3 will be average, I'm listing out 5 of my choices for 2007. All five have a prospective p/e of 4-8x, are financially strong, pay dividends, and won't give you many sleepless nights.
Man Yue (894)
It produces capacitors of all kinds and sizes used inside every electronics. A capacitor works like an internal battery storing and supplying power, save that it discharges itself completely when powered off. Man Yue is ranked 7th in the world in sales and its products are found in all major brands of electronics. As a capacity is used in the power supply section where safety (as opposed to cost) is most important, customers are less likely to switch suppliers often. Product liability lawsuit is the last thing they want. Just imagine those China made applicances in the past which tend to lit up themselves after a while and you'll get the picture. So entry barrier is high for new comers and MY enjoys lesser competition. Profit has been up for 5 straight years and I expect 2006 results will continue the trend.
Arts Optical (1120)
It's a ODM of eyeglasses frames and has been a steady performer earning more or less HK$100m for the past 5 years, quite remarkable already considering the worsening operating environment. Latest interim result showed a 30% increase in profit as a result of capacity expansion. Management was cautious in their tone in the interim report but I expect it will do well in the second half, since most of its customers are in Europe and its competitors Sun Hing and Elegance also reported excellent result last month. Fashion never dies and the strong Euro should bring in more business.
Fujikon (927)
It is a ODM for headphones used for mobile phones (Nokia and the like), game consoles (X-box), and mp3 players (ipod and the like). It's a direct beneficary of the mobile phone and digital gadget boom which is still going strong. As more and more mobile phones are turned into personal entertainment center, demand for higher audio grade and wireless headphones will grow stronger. It recently completed its expansion programme and the latest interim result already showed 50% increase in profit. I expect the momentum to remain strong in the second half.
Yip's (408)
It's a downstream petrochemicals player which produces solvents, coatings, and lubricants, serving the PRC market under multiple brands. Solvents and coatings have all kinds of applications, e.g. in tannery, medicine, adhesives, toy, electronics, printing, furniture, paint, ink, varnishes, and you name it. I figure it's a supporting player for the construction and manufacturing industry, which both will grow over time. Despite of the rise in oil price, its profit has been up for 3 straight years and the latest interim showed another 36% increase in profit. Petrochemicals are more complex than other businesses but I'm buying Yip's management. It's also comforting that Forbes Magazine voted Yip's as one of the 200 best small enterprises in Asia.
VSC (1001)
It's a long time construction steel supplier in HK and the PRC. Under the 2nd generation leadership of Andrew Yao, VSC expanded into steel coil processing in the PRC supporting the industrial sector. VSC suffered last two years as its contruction supply contracts were for muti-year but at fixed price, a deadly combination in a boom market. Now variable costing is built into new contracts and we saw much improved figures in the latest interim report with doubling of profit and resumption of dividend payment. Recent joint venture in steel coil processing with Ryerson, a large Amercian steel player, should help VSC move up the value chain and access to bigger customers over time. It's also a vote of confidence on VSC and its management. 2006 should be a turnaround year for VSC.
p.s. financial performance of a small cap is by definition less predictable and reliable, so one should always diversify and vary his bet accordingly.
DISCLOSURE: I hold all 5 stocks at time of writing.
(1) Prices of oil and other resources have come down and seem stabilised.
(2) Industrials have adapted to become more efficient.
(3) RMB has depreciated against most currencies in 2006 thanks to weakening USD, so export has become more competitive especially for those serving non-US markets.
(4) Valuation has come down to a level unseen since 2001 with most now trading at low single digit p/e.
Some negative factors remain though.
(1) Government's stance to fade out most small-size, low tech, labor intensive type manufacturing.
(2) Coming profit tax reform which will hurt most industrials which are foreign enterprises.
(3) Rising labor cost, environmental standard, and competition from uprising local factories.
One needs to be selective as not all will rise like in the last small cap boom. Following Peter Lynch's rule of 5, that out of 5 small caps one will become a star, one will become a dog, and 3 will be average, I'm listing out 5 of my choices for 2007. All five have a prospective p/e of 4-8x, are financially strong, pay dividends, and won't give you many sleepless nights.
Man Yue (894)
It produces capacitors of all kinds and sizes used inside every electronics. A capacitor works like an internal battery storing and supplying power, save that it discharges itself completely when powered off. Man Yue is ranked 7th in the world in sales and its products are found in all major brands of electronics. As a capacity is used in the power supply section where safety (as opposed to cost) is most important, customers are less likely to switch suppliers often. Product liability lawsuit is the last thing they want. Just imagine those China made applicances in the past which tend to lit up themselves after a while and you'll get the picture. So entry barrier is high for new comers and MY enjoys lesser competition. Profit has been up for 5 straight years and I expect 2006 results will continue the trend.
Arts Optical (1120)
It's a ODM of eyeglasses frames and has been a steady performer earning more or less HK$100m for the past 5 years, quite remarkable already considering the worsening operating environment. Latest interim result showed a 30% increase in profit as a result of capacity expansion. Management was cautious in their tone in the interim report but I expect it will do well in the second half, since most of its customers are in Europe and its competitors Sun Hing and Elegance also reported excellent result last month. Fashion never dies and the strong Euro should bring in more business.
Fujikon (927)
It is a ODM for headphones used for mobile phones (Nokia and the like), game consoles (X-box), and mp3 players (ipod and the like). It's a direct beneficary of the mobile phone and digital gadget boom which is still going strong. As more and more mobile phones are turned into personal entertainment center, demand for higher audio grade and wireless headphones will grow stronger. It recently completed its expansion programme and the latest interim result already showed 50% increase in profit. I expect the momentum to remain strong in the second half.
Yip's (408)
It's a downstream petrochemicals player which produces solvents, coatings, and lubricants, serving the PRC market under multiple brands. Solvents and coatings have all kinds of applications, e.g. in tannery, medicine, adhesives, toy, electronics, printing, furniture, paint, ink, varnishes, and you name it. I figure it's a supporting player for the construction and manufacturing industry, which both will grow over time. Despite of the rise in oil price, its profit has been up for 3 straight years and the latest interim showed another 36% increase in profit. Petrochemicals are more complex than other businesses but I'm buying Yip's management. It's also comforting that Forbes Magazine voted Yip's as one of the 200 best small enterprises in Asia.
VSC (1001)
It's a long time construction steel supplier in HK and the PRC. Under the 2nd generation leadership of Andrew Yao, VSC expanded into steel coil processing in the PRC supporting the industrial sector. VSC suffered last two years as its contruction supply contracts were for muti-year but at fixed price, a deadly combination in a boom market. Now variable costing is built into new contracts and we saw much improved figures in the latest interim report with doubling of profit and resumption of dividend payment. Recent joint venture in steel coil processing with Ryerson, a large Amercian steel player, should help VSC move up the value chain and access to bigger customers over time. It's also a vote of confidence on VSC and its management. 2006 should be a turnaround year for VSC.
p.s. financial performance of a small cap is by definition less predictable and reliable, so one should always diversify and vary his bet accordingly.
DISCLOSURE: I hold all 5 stocks at time of writing.
Wednesday, January 03, 2007
End of Era of Chinese Tourists in HK? Part II
In my search for beneficiaries of the growing China luxury retailing market, one company I think worth keeping an eye on is Dickson (113).
Dickson is an experienced and established player with a long history in luxury retail. It operated two Seibu and one Havey Nichols department stores in HK. It also runs smaller shops under licensed brands like Rauph Lauren, Tod's, Brook Brothers, S.T. Dupont, and separately Dickson Watch & Jewellery. There are 490 shops in total with 225 in China, 171 in Taiwan, 60 in HK, and the rest in Singapore, Malaysia, and the Philippines.
This level of experience and size should give one confidence of Dickson's China expansion, where it will have two Seibu stores open in Shenyang and Chengdu by end of first quarter of 2007. Seibu also opened its TST store just before the last Christmas season and 48 brand shops throughout Asia. First half results suffered a 15% drop as a result of the associated pre-operating expenses. FY2007 is a year in transition for Dickson and hence profit is likely to be down or flat at best.
Going forward in FY2008 though, earnings should increase by some HK$60-70m* with all the new stores and shops. Starting from last year's number of HK$210m, potential earnings can be HK$270-280m or as much as HK$300m if one factors in the improved local retail market and contribution from the recently acquired Tommy Hilfiger business. This would give a prospective FY2008 p/e as low as 7-8x p/e, very reasonable for pan Asian retail play with China concept.
I'm neutral on the TH acquisition. Although the consideration is acceptable and the business will partially fill the earnings gap left by the closure of Seibu CWB, the brand license will expire at 2014. There's no certainty an extension can be obtained and Dickson Poon the vendor did not provide any idemnity on this. I roughly calculated Dickson would need 6 years (out of 7.6 years of the remaining license) to get back its net investment of HK$360m, if the TH business performance at least maintains at the same level. The operating cashflow of TH however can be applied to continuing China expansions and will strengthen the already solid financial position of Dickson (zero net gearing).
The share price has dropped quite a bit since the flat results last year failed to excite the market. A drop in interim figures didn't help the price either. So further downside is limited and any earnings surprise in China could lead to a re-rating. Take Lifestyle (SOGO) as a benchmark and we're talking very pleasant surprise here (trading over 30x p/e). However it takes time for new stores to become profitable and opportunity cost is a concern in this hot market right now. So bear this in mind and keep an eye on the progress in the coming results announcements.
* The latest 2 Kunming stores injected into Parkson earned about RMB14m each. Take into account Parkson mostly does concession sales which have a lower margin and that Dickson's stores are in bigger cities, I expect each Seibu to earn RMB20m profit. I also expect Seibu TST to earn about HK$15m, taking SOGO TST numbers as a reference and applying a 10% net margin. The rest is contribution from new brand shops.
p.s. financial performance of a small cap is by definition less predictable and reliable, so one should always diversify and vary his bet accordingly.
DISCLOSURE: I don't hold 113 at time of writing.
Dickson is an experienced and established player with a long history in luxury retail. It operated two Seibu and one Havey Nichols department stores in HK. It also runs smaller shops under licensed brands like Rauph Lauren, Tod's, Brook Brothers, S.T. Dupont, and separately Dickson Watch & Jewellery. There are 490 shops in total with 225 in China, 171 in Taiwan, 60 in HK, and the rest in Singapore, Malaysia, and the Philippines.
This level of experience and size should give one confidence of Dickson's China expansion, where it will have two Seibu stores open in Shenyang and Chengdu by end of first quarter of 2007. Seibu also opened its TST store just before the last Christmas season and 48 brand shops throughout Asia. First half results suffered a 15% drop as a result of the associated pre-operating expenses. FY2007 is a year in transition for Dickson and hence profit is likely to be down or flat at best.
Going forward in FY2008 though, earnings should increase by some HK$60-70m* with all the new stores and shops. Starting from last year's number of HK$210m, potential earnings can be HK$270-280m or as much as HK$300m if one factors in the improved local retail market and contribution from the recently acquired Tommy Hilfiger business. This would give a prospective FY2008 p/e as low as 7-8x p/e, very reasonable for pan Asian retail play with China concept.
I'm neutral on the TH acquisition. Although the consideration is acceptable and the business will partially fill the earnings gap left by the closure of Seibu CWB, the brand license will expire at 2014. There's no certainty an extension can be obtained and Dickson Poon the vendor did not provide any idemnity on this. I roughly calculated Dickson would need 6 years (out of 7.6 years of the remaining license) to get back its net investment of HK$360m, if the TH business performance at least maintains at the same level. The operating cashflow of TH however can be applied to continuing China expansions and will strengthen the already solid financial position of Dickson (zero net gearing).
The share price has dropped quite a bit since the flat results last year failed to excite the market. A drop in interim figures didn't help the price either. So further downside is limited and any earnings surprise in China could lead to a re-rating. Take Lifestyle (SOGO) as a benchmark and we're talking very pleasant surprise here (trading over 30x p/e). However it takes time for new stores to become profitable and opportunity cost is a concern in this hot market right now. So bear this in mind and keep an eye on the progress in the coming results announcements.
* The latest 2 Kunming stores injected into Parkson earned about RMB14m each. Take into account Parkson mostly does concession sales which have a lower margin and that Dickson's stores are in bigger cities, I expect each Seibu to earn RMB20m profit. I also expect Seibu TST to earn about HK$15m, taking SOGO TST numbers as a reference and applying a 10% net margin. The rest is contribution from new brand shops.
p.s. financial performance of a small cap is by definition less predictable and reliable, so one should always diversify and vary his bet accordingly.
DISCLOSURE: I don't hold 113 at time of writing.
Tuesday, January 02, 2007
End of Era of Chinese Tourists in HK?
Starting from Jan 1 2007, custom duties on luxury watches, golf equipment, and cosmetics brought into China by citizens and visitors will be raised by as much as 30% of the value of goods. This is the 1st rate adjustment since the duty was introduced last July, which also covered electronics and clothing (unadjusted for this time).
The government's goal is to boast internal consumption by leveling the after-tax cost of luxury items sold in China vs. bought overseas by Chinese travellers especially in HK. From my Canadian experience this sort of regulations are very hard to enforce because almost everybody will cheat, as long as they see a cheaper price elsewhere. I doubt the last round of regulation in July has deterred the Chinese shoppers, if the past Chirstmas holiday is of any indication. The obvious solution is to lower or do away import taxes on luxury items and let people buy as much as they want, after all personal enjoyment is no longer a sin or label for greed and evil capitalism. I think China is moving toward this direction as it too needs internal consumption to balance out its trade surplus.
I think 2007 will mark the start of the end of era of 'freedom shoppers' in Hong Kong. These shoppers have accomplished their historic mission by giving a lift to us when HK economy was at its post SARS bottom. Now sentiments in HK have turned much better and the economy driver has been passed on to the financial sector. So the golden days of HK retailers are numbered and long live the China ones.
Most China consumption and retail plays are incredibly expensive and hence not very good investments now. As good as a brand like Li Ning and Ports, for example, their share prices (over 40x p/e) have fully, if not more than, reflected their prospects. Any disappointment will likely have a drastic effect on share price. Department stores like Parkson and Golden Eagle are traded even more expensively despite not owning any brand. On the other hand, most HK based retailers are trading at single digit or low teen p/e only. So the logical move is to look for those HK sizable players with a China plan.
Pay special attention to luxury retail as demand is less dependent on price. There's this funny perception that the pricier the good the better the quality. Imagine the profit potential when the land, rental, staff and other operating costs are so much cheaper in China but the selling price is the same as in HK!!
The government's goal is to boast internal consumption by leveling the after-tax cost of luxury items sold in China vs. bought overseas by Chinese travellers especially in HK. From my Canadian experience this sort of regulations are very hard to enforce because almost everybody will cheat, as long as they see a cheaper price elsewhere. I doubt the last round of regulation in July has deterred the Chinese shoppers, if the past Chirstmas holiday is of any indication. The obvious solution is to lower or do away import taxes on luxury items and let people buy as much as they want, after all personal enjoyment is no longer a sin or label for greed and evil capitalism. I think China is moving toward this direction as it too needs internal consumption to balance out its trade surplus.
I think 2007 will mark the start of the end of era of 'freedom shoppers' in Hong Kong. These shoppers have accomplished their historic mission by giving a lift to us when HK economy was at its post SARS bottom. Now sentiments in HK have turned much better and the economy driver has been passed on to the financial sector. So the golden days of HK retailers are numbered and long live the China ones.
Most China consumption and retail plays are incredibly expensive and hence not very good investments now. As good as a brand like Li Ning and Ports, for example, their share prices (over 40x p/e) have fully, if not more than, reflected their prospects. Any disappointment will likely have a drastic effect on share price. Department stores like Parkson and Golden Eagle are traded even more expensively despite not owning any brand. On the other hand, most HK based retailers are trading at single digit or low teen p/e only. So the logical move is to look for those HK sizable players with a China plan.
Pay special attention to luxury retail as demand is less dependent on price. There's this funny perception that the pricier the good the better the quality. Imagine the profit potential when the land, rental, staff and other operating costs are so much cheaper in China but the selling price is the same as in HK!!
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