Wednesday, June 15, 2011

Economic Commentary: Weak Data and the End of QE2 - Ari Paul

Equities fell about 6% over the past two weeks primarily because of very weak employment data; the nasdaq generated a never before seen series of 9 lower highs and lower lows to start the month.. Some other issues weighing on the markets include continued problems with Greece (they need and will likely receive a comprehensive bailout), a downgrade by Moody's of key Eurozone banks, and tightening credit globally. The ECB suggested they are likely to hike interest rates next month, South Korea hiked rates, and China is tightening credit. QE2 ends this month and has some investors nervous about who will buy US debt now that the Federal Reserve is done buying. Treasury prices have been strong because of the deflationary fears that accompany tightening credit and the weak economic data, but that could change quickly.

High Yield debt has sold off significantly, which is often a precursor of equity weakness. However, the put/call ratio is very high (often a contrarian indicator), and the VIX (a measure of the volatility expected by options markets) has remained low. Overall, this suggests to me that many market participants are pessimistic but are not expecting a wild sell off. Hedge funds are generally bearish, which can have a contrarian effect.

Crude oil has fallen with equities and the strong dollar; OPEC was expected to increase production but could not reach consensus; Saudi Arabia said they may increase production unilaterally.

Chinese equities have been weak for the past 9 months. This is partly because of fears of a Chinese credit or real estate bubble, and partly because many Chinese companies have been uncovered as a frauds, sometimes in very high profile cases. For example, John Paulson, manager of the one of the largest hedge funds in the world, lost $235 million in two days in his investment in Sino-Forest. A shortseller released research that the company was massively overstating assets...and the company neglected to deny the harmful claims. It was primarily this fear of fraud that kept me out of the Chinese market for the past two years. If the Chinese stock market continues to sell off, this will likely reflect more "spring cleaning" of built up problems, and will eventually represent an exceptional opportunity for value investors. I'm starting to hunt for gems.

Overall, I remain relatively flat and patient. If crude oil sells off another 4-8%, I may buy some as a longer term play. I am also likely to buy puts on gold and silver over the next couple of days; if deflationary fears continue to gather over the next couple months, gold and silver could get hit hard.

Monday, June 13, 2011

China XD Plastics - CXDC - A good buy when the world hates Chinese stocks? - Alpha

China XD Plastics (CXDC) is a microcap company selling plastics to car
manufacturers for parts like bumpers, door panels, and dashboards.
While it is traded on NASDAQ and has a legal domicile in Nevada (this
is not an ADR), the company's assets, operations, and sales are mainly
in northeastern China, based out of Harbin. The cheapness and
“growthiness” of the stock are self-evident and easy to quantify
(growing sales/OI/NI at about 40-80%, lots of cash and a healthy
balance sheet, PE of about 3.5); however, like hell and blind dating,
the risks are evident but much harder to quantify (but at this price,
a moderately diversified investor could deal with the uncertainty).

1. Products - CXDC makes specialty plastics for the Chinese automotive industry:
Its plastics are used for exteriors (automobile bumpers, rear- and
side- view mirrors, license plate), interiors (door panels, dashboard,
steering wheel, glove compartment and safety belt components), and
functional components (air conditioner casing, heating and ventilation
casing, engine covers, and air ducts). Over 30 automobile brands
manufactured in China, including Audi, Red Flag, Volkswagen and Mazda,
use CXDC parts.

2. The Chinese car and car plastics industry is booming along with the
Chinese economy:
In 2009, 13.8 million cars were sold in China, which increased by 45%
from the previous year (and from a base of 5.7mn in 2005, for a CAGR
of ~26%). It is estimated that the Chinese car market will grow by 15%
annually in the coming years, and the PRC government has a 5-year plan
to encourage car sales. Each car requires 100 kg to 150 kg of modified
plastic, which means that by 2010 the demand for modified plastic in
the Chinese car industry will be approximately 1.8 million tons (MT)
annually (3.2 MT for 2013). Harbin Xinda’s existing facility has an
annual production capacity of 100,000 MT. Installed annual capacity
of 165,000 MT in 2011, with 80% of the capacity contracted in 2011 and
plans to grow it by 30% for the two years after. However, car sales
growth can't continue forever (see the Risks section). The Chinese
economy (GDP) continues to grow at a 8-9% annualized rate, if you
believe their national statistics (if so, I have some mansions along
the 3 Gorges to sell you).

3. The competition is mostly one big German company:
BASF, the German company, has 65% of the market share (by sales) and a
local competitor has 16%. CXDC has a 6% market share. CXDC claims
that its edge over BASF is greater design flexibility for customer’s
individual requirements and that on average its formulation cost of
the products is 10-30% lower. For the local competitors, CXDC claims
it has the largest inventory of products certifications and the
largest number of variety of products to be offered to customers. I
haven't been able to verify this and so am treating the company like a
commodity manufacturer with a slight price edge against BASF.

1. CXDC is a growth company by sales, OI/NI, and FCF measures:
Like the Chinese car industry, CXDC's financials look like
radioactive, supergrowth mushrooms. From 2008 to 2009, sales went
from $75.8mn to $135.7mn, operating income from $9mn to $17.6mn, and
net income from $8.2mn to $4.1mn. Why the NI drop? The company
issued some warrants with preferred stock and revalued the warrants to
create a $12.2mn one-time non-cash “loss” (see Note 15 in the 10-K).
So annual sales were up 79% and OI about 100%. FCF went from -$16.9mn
to $3.3 mn. The Q1 2011 10-Q paints a similar picture. First quarter
2011 sales were $76.1mn ($50mn the year before), with OI and NI coming
in at $14.6mn and $11.9mn (compared to $8.4 mn and $13.1 mn). The NI
fell because CXDC started paying a standard Chinese tax rate of about
20%, whereas it had an exemption before to pay basically no taxes
(management in a conference call estimate that 20% would be the rate
going forward) – also the derivatives the previous year added to NI.
The operation margin went up from 17% to 19% from Q1 2010 to 2011
(gross margins have consistently been between 24-26%). 2011 revenue
guidance is $280-310mn with non-GAAP net income guidance of $48-51mn.
But can you eat it?

2. CXDC has a healthy balance sheet and healthy ROE:
CXDC has total assets of $184.5 with total liabilities of $66.9mn
($27.5 are ST loans from banks, with ~$20mn being deferred tax
liabilities). Current assets are at $135.8mn, with ~$31mn in cash and
~$27mn in accounts receivable. The Q1 ROE was 10.1% (the 2009 ROE
would be complicated due to the derivatives transaction and a
preferred dividend). Also total stockholders equity has grown the
last 8 quarters (from $104mn to $118mn just from Q1 2010 to 2011), so
it's a healthy check that the earnings are real (just as cash on hand
is the other check).

3. This growth stock is cheap... deep value cheap:
The expected 2011 and 2012 EPS is $1.01 and $1.18 respectively. The
6/9/2011 price is $3.59. So the 2011 and 2012 PE are 3.6 and 3.0.
Put another way, the enterprise value (EV = equity market cap + ST
debt FV + preferred & warrants - cash) now is ~$175mn and the non-GAAP
net income guidance is $48-51mn. The 2011 FCF I estimate to be about
$37-40mn, given a continuation of the Q1 earnings rate and historical
D&A and capex figures (keep in mind that capex is high at about $13mn
as management spends to grow capacity-maintenance capex is harder to
calculate). So the current FCF yield is about 23%. Auto suppliers
(when solvent) generally trade at 11-13x earnings. However I give a
2/3 discount to Chinese companies (my rule of thumb – see Risks
below). So 11 x $1.18 x 0.67 = $8.7 per share expected intrinsic
value for a 1-year hold (a range of $6 to $12).

A two-stage DCF for the company gives it a value of $8 to $14.50, given
my assumptions of ke = (11% to 15%) and g = (15% to 25%) - the model
has many other conservative assumptions.

1) It's a one man show but his team seems solid:
CXDC has 396 employees with 87 as temps. It's basically the Jie Han
show, as he co-founded it in 2004 and is now the CEO and Chairman. He
was previously in the nylon business, associated with the Harbin Xinda
Nylon Factory, which he founded in 1985. He has some political clout
as a deputy to the Harbin Municipal People’s Congress (prob. a bad
thing for foreign investors, but it depends on his probity).
Han has three lieutenants: Taylor Zhang as CFO, American educated,
former CFO of Advanced Battery Technologies, Inc (Nasdaq: ABAT);
Qingwei Ma as General Manager of Harbin Xinda since it was founded in
2004; and Junjie Ma as CTO (a polymer materials engineer with a few

2) The board is sterling and should be a good check:
The board includes: Yong Jin, a professor at Tsinghua University and
an academician of the Chinese Academy of Engineering; he knows the
ChemE and has more than 30 patent applications; Lawrence W. Leighton,
an international investment banker (Princeton and HBS, positions at
Bear Sterns, JPMorgan Chase Bank and recently as the CEO of the U.S.
investment bank of Credit Agricole, the major French Bank) – he is the
independent director on the audit committee and has his reputation on
the line for their veracity; and Cosimo J. Patti, a former banker who
is now an Arbitrator for the SEC and National Association of
Securities Dealers.
The 2 Westerners on the board and the Western-educated CFO should be
a decent fraud antidote as their reputations are on the hook; but this
is still a Chinese company so fraud is always a risk (see Risks).

1) Concentration risk (suppliers and a distributor):
Raw materials such as polypropylene, ABS and nylon come from 2
petrochemical suppliers (each providing about 50%). While management
claims they can get these from many suppliers, they claim to only have
chosen 2 to increase volume buying discounts. No way to verify this.
Also a rise in oil prices will cause these input prices to rise, but
again I have not found a way to model this on COGS. Sales through one
major distributor was 83% and 81% for 2008 and 2009, but the company
had no single customer above 10% of sales. CXDC has been getting
better, as the 2011 10-Q notes that “sales to three major distributors
accounted for approximately 60% of the Company’s sales for the three
months ended March 31, 2011, with each distributor individually
accounting for 33%, 14% and 13%, respectively” (it was 90% for Q1

2) Macro risks of China:
The PRC government could confiscate all assets, war or civil unrest
could break out, the management could perpetrate fraud or transfer
assets to itself (weak foreign investor protection and high agency
costs), etc. This isn't boilerplate – these are real risks in China.
Because of them, I have a rule of thumb that Chinese stocks should be
valued at 2/3 to ½ their American counterparts. See my general
discussion here:

3) Real estate bubble knock-off risks:
China is probably at some stage of a RE bubble, though Jim Chanos
thinks it's deep and late while Willem Buiter at Citi thinks it's very
early and “rational” because RE is a better place for Chinese savers
to store consumer savings than in banks that give them interest rates
much lower than inflation (you can refer to numerous reports on this
bubble). If the Chinese economy and home prices stumble, car sales
are bound to fall (and hence CXDC's sales). Past correlations between
house and auto sales are probably not reliable (both markets are so
new), so quantifying revenue impacts in a worst-case scenario is hard
(but that nasty tail risk still exists). See here for more
information and links:

4) Internal control risks and an auditor tiff:
In November 2009 CXDC fired its auditor Bagell Joseph Levine &
Company, LLC and hired Moore Stephens in Hong Kong. I investigated
this smoke and couldn't find any fire behind it (See the consolidated
2008 statements, with the auditor's opinion, and the company's
response and in the November 4, 2009 Current Report on Form 8-K). In
the 2009 10-K, CXDC admits its internal controls are weak and its
trying to strengthen them by hiring E&Y to bump up controls through
2010. I have no insight into how strong or weak the controls are (put
this into the “China fraud risk” box). Even 10-Ks are just marketing
documents that have been put under some scrutiny of human (not divine)
auditors and lawyers; each investor should be vigilant and exercise
her own judgment.

5) Current expansion could pose growth risks:
The company plans to grow capacity at about 30% annually for the next
few years. So capex is high and growth expansion always poses margin
and sales risks. Capacity growth doesn't mean sales or profits growth
will inevitably follow.

6) Micro-cap, illiquid float, penny stock risks, and high price volatility:
Since management/insiders own about 68% of the company, only about 32%
floats and the 10-day average volume is about 1.6% (250K out of a 15mn
float, with 48mn shares outstanding). Because the share price is
currently below $5, the SEC could subject the company to its penny
stock regs, and some institutional investors may not be able to buy
it. Also the stock's price volatility is very high over the last 2
years, from a $2 low in mid-2009 to a $11.15 high later that year.
Few investors can deal with this sort of roller coaster.

Recent 10-K:
Recent 10-Q:
Last Investor Conference Call:
Last Investor Presentation:

1) Corporate buyback plan - On April 7, 2011, the Company’s board of
directors approved the repurchase by the Company of up to $10 million
of its shares of common stock through May 31, 2012.

2) Completion of new capacity upgrade and continued high sales and
profit growth.

3) Management incentive agreement – if you read it closely, it seems
that management has an incentive to keep the stock price low in 2011
and then have it rise over the next three years (perverse).

4) Mr. Market sorts through “China Frauds” and revalues “China
Bargains” (one quick survey I took of other investors is that Chinese
stock prices, for ADRs and listed in the US, are hitting bottoms as
investors shy away from fraud and China macro risk... so a few pearls
are being sold as beads). Sino-Forest Corp. is just one example of a
potential China fraud, with high uncertainty:

5) The best catalyst would be for a value investor to take a $10-20mn
position and then sit on the board or be a board observer; either a
proactive activist or a PE investor may end up doing this.

UPDATE - Summer 2011: Morgan Stanley Private Equity Asia took a large position in CXDC - this should be a credible outside party to monitor management and control agency costs.