China Automotive Systems Buyout Price Should be Raised to at least $7.50

• China Automotive Systems, a major supplier of steering gear to the Chinese auto industry, received a buyout offer of $5.45/share from Chairman Hanlin Chen.  (LINK)
• The offer values the company at 7.8X reported 2016 earnings and just 0.6X 12/31 book value, multiples well below comparable companies trading in Hong Kong and China
• Increasing technological sophistication of steering systems brings opportunity for higher future unit prices and margins
• CAAS has lagged the growth in sales and innovation of competitor Nexteer
• Fair value for a buyout would be at least $7.50share, 10X estimated 2017 earnings

China Automotive Systems (CAAS) has a long public company history following its US listing in 2003.  It was formed through merger of suppliers to domestic Chinese automakers and has maintained good corporate relationships with these key customers.  A 2014 Geoinvesting article  provides a nice introduction to the group.

Steering systems have undergone several major transitions from manual to hydraulic power (HPS) to electric power (EPS) and will play a key role in future Advanced Driver Assistance Systems (ADAS).   Each new generation improves safety and fuel efficiency, but at higher upfront cost per unit.  Each new generation of more sophisticated components increases the competitive importance of technology.  ADAS will bring higher margin and profit potential, but will require large R&D expenditure and could be disruptive to existing suppliers.

As a small player in global markets CAAS has a significant opportunity to gain market share, but faces a significant challenge in keeping up with product development ability of larger competitors.  Chairman Chen’s offer (LINK) does not fairly compensate public shareholders for the company consistent profitability and future potential.  A 10 P/E would still value the company below all listed competitors, but reflect the uncertainty over industry developments.

Global Steering Suppliers

The global steering market has a limited number of major participants:

• JTEKT Corporation (JTEKY) – Japanese maker of auto parts and machine tools with annual sales of about $12Bn, about 50% from Steering parts
• ZF Friedrichshafen – a privately held German auto parts group with annual sales of about $39Bn.  ZF acquired TRW Automotive Holdings in 2015.  TRW’s annual steering sales were about $2.5Bn prior to the merger.
• Bosch Group – a privately held German conglomerate with annual sales of about $82Bn.  The company does not disclose total Steering revenue, but did report 2016 revenue of about $1.1Bn for its China steering joint venture.
• NSK (NPSKY) – a Japanese producer of precision bearings and some automotive and industrial products incorporating bearings.  Annual sales are about $8.5Bn of which about $3.2Bn are auto parts, but the company does not break out Steering revenues.
• Mando – major Korean auto parts company which produces Steering, Braking, and Suspension systems.
• ThyssenKrupp (TKAMY) – a German industrial conglomerate with annual auto parts sales of about $7.7Bn from Steering, Powertrain, Suspensions, and Chassis components.
• Nexteer (NTXVF) – the steering business of Delphi Automotive which was acquired by Aviation Industries of China (AVIC) in 2011 and then listed on the HKEX in 2013.  Annual sales of about $3.8Bn include about $2.5Bn of steering systems.

 

Steering Market in China

China’s passenger vehicle sales are approximately 45% domestic brands, 45% foreign brands produced by joint ventures with major Chinese auto makers, and 10% imports (LINK).

• The domestic vehicle brands like Geely, Great Wall, and JAC which have been CAAS main customers compete with lower prices for more basic vehicles using less advanced components.  For steering systems this has meant a slow transition from HPS to EPS.
• The joint venture vehicle brands have primarily purchased steering components from affiliates of their home country steering suppliers.  Japanese brands favor JTEKT and NSK, Germans favor ZF, Bosch, and TK, American brands favor TRW (acquired by ZF Freidrichsen) and Nexteer (formerly  Delphi), and Korean brands favor Mando and Hyundai Mobis.

In addition to CAAS, there are several smaller domestic Chinese suppliers including Zhejiang Shibao and Xinhang Yubei.

Comparison of CAAS and Nexteer

Nexteer’s rapid growth since it came under Chinese control makes it the most useful benchmark for CAAS performance and valuation.

Two adjustments have been made to present 2016 results on a comparable basis.

• Development Expense.  CAAS charges all R&D expense on its income statement.  Nexteer records Research as a current expense but capitalizes internal Development expense and then amortizes it as part of Cost of Sales.  Nexteer’s approach generates higher current earnings while CAAS presentation is more conservative.  In the above comparison Nexteer’s results have been adjusted to remove amortization of past development from cost of sales (reported gross margin was 17.2%) and reduce net income by current development expense (after tax).
• Warranty expense.  CAAS recorded a $5mm charge in 4Q16 Cost of Sales related to recall of EPS systems sold in 2012-2015.    A more informative presentation of 2016 performance removes this amount (and an assumed tax effect at 25%).

Nexteer’s rapid growth has eroded the advantage CAAS once held as the leading domestic producer of steering systems.  Nexteer has a higher annual R&D budget and more advanced product line (almost all sales from EPS).  CAAS margins show that it continues to operate successfully at the lower end of the market.

Valuation Benchmarks

The limited number of major producers of steering systems leaves few good benchmarks for CAAS valuation.  Using a broader pool of auto parts makers:

CAAS valuation is much lower than other HK and China listed auto suppliers.  But leading global competitors like JTEKT and Mando are also cheaper than China listed companies.  It would be hard to argue that CAAS deserves a higher valuation than a Japanese or Korean company which has bigger scale and a more advanced product line.

CAAS investors have to balance the opportunity for growth in unit prices and market share against the risks of competing with larger players.  In my opinion a 10 P/E would provide fair compensation in a buyout of CAAS public shareholders.

Estimating CAAS 2017 Earnings

CAAS has provided guidance for 2017 sales of $485mm.  The company has not given an outlook for margins, but they have been fairly steady over time.

Buyout Prospects and Alternatives

Chairman Chen’s letter stated: “I am interested only in pursuing this Acquisition and am not interested in selling my shares of Common Stock of the Company in connection with any other transaction.”  A competing offer is therefore unlikely.  The following alternatives are available to shareholders and the company:

• No action.  The buyout price does not provide for compensation for the CAAS consistent profitability, history of dividends and share repurchase, and significant market presence.  Several Chinese companies have seen sharp appreciation in their share prices after withdrawal of lowball buyout offers.  Momo (MOMO) is currently over $37 after withdrawal last August (LINK) of an $18.90 buyout offer.  SORL Auto Parts (SORL) is currently over $8 after withdrawal in January 2016 (LINK) of a $2.84 buyout offer.  China Cord Blood (CO) is currently over $8 after withdrawal in April 2017 (LINK) of a $6.40 buyout offer.  It may be that Chairman Chen’s buyout offer has been made with knowledge of favorable developments not disclosed to the public and that shareholders would earn a much higher return by rejecting the offer.
• Corporate Alliance.  Major international competitors offer broader product lines and may be better positioned for research and development of ADAS steering systems.  Nexteer recently addressed this issue by forming a joint venture (LINK) with Continental AG (a major German producer of powertrains, braking systems and other auto parts).  China’s technology giants,  vehicle OEMs, and parts makers are moving aggressively into ADAS development and new partnership opportunities may be available to CAAS.
• China Listing.  Most of CAAS business is operated by Hubei Henglong Automotive Systems Group.  CAAS could begin working towards a Shanghai/Shenzhen listing of a minority interest in this entity.  If successful then it would enable the group to raise capital at a higher valuation and provide parent company investors with improved visibility into the value of the China business.  I previously suggested that such a structure would be the most attractive outcome for China XD Plastics (see 03/09/17 article).  I think the argument is stronger at CXDC because that company is larger, has more significant international operations, and has a business which should draw greater investor interest.  Zhejiang Shibao, a smaller Chinese producer of steering systems, has H-shares listed in Hong Kong and A-shares in Shenzhen, but that option is only available to a Chinese incorporated company.

Chairman Chen’s letter did not mention the support of any financial partners for his buyout offer.  This might increase the risk that it lapses due to the absence of a private equity firm with experience in all the legal, regulatory, and financial steps required for completing a deal.  On the other hand, CAAS has positive working capital ($168mm at 3/31), substantial annual earnings (over $20mm/year) and no long-term corporate debt.  I believe a buyout could be completed with bank financing and no significant equity partner would be required.

I assume that all shares held by insiders would be rolled over in the buyout rather than acquired for cash.  It is likely that a substantial number of additional shares are held by parties with personal or business connections to Chairman Chen and CAAS and these shares may also be rolled over.  For example, in 2014 CAAS issued 4,078,000 shares to nominee holders specified by Jiulong Machinery Electricity in compensation for acquisitions of the minority interests in two joint ventures (LINK).  If those shares were not sold then the owners may wish to maintain their interest after the buyout.  At a buyout price of $7.50/share, $90mm would be required to buy all non-insider shares, but additional rollover participation could reduce the financing requirement.

Key Risks

Chairman Chen may not be willing to offer a fair price to public shareholders.

The China passenger vehicle market may weaken.  Car sales rose 14.9% in 2016 helped by a temporary reduction in the sales tax rate on small vehicles (see 01/13/17 article).  In the first 4 months of 2017 car sales are up only 1.5% compared to last year (LINK).  Lower sales could reduce Chairman Chen’s willingness to complete a buyout.  Or Chairman Chen could attempt to take advantage of a temporary cyclical slowdown in sales by acquiring the company at a lower price.

CAAS may lose market share if its EPS and future ADAS products do not offer competitive pricing and performance.

Disclosure: The author is a public shareholder of CAAS seeking the maximum possible return from his investment.  Interested parties who wish to communicate privately about CAAS may contact the author at konekoresearch (at) gmail.com