China Automotive Systems $5.45 Buyout Price May Be Fair

  • Last May China Automotive Systems (CAAS) received a buyout offer of $5.45/share from its Chairman Hanlin Chen
  • The Special Committee of the company’s independent directors hired advisors and Morgan Stanley’s private equity arm joined the Buyer Group, but there has been no other update.
  • Weaker profitability and an unexpected $40mm tax bill have reduced the value of the company.  The $5.45 offer may be fair.
  • Trade protectionism is a risk to US sales, but current proposals would not affect CAAS.
  • The company has ambitious long-term growth plans

This article updates my commentary from June 2017 China Automotive Systems Buyout Price Should be Raised to at least $7.50.  China Automotive Systems has made no comment on the status of Chairman Chen’s offer since it was modified in late August 2017 to add North Haven Private Equity (a unit of Morgan Stanley) to the buyer group (link to revised offer letter).  The company has not held an earnings conference call since 8/10/17.

Topics covered:

  • Company background
  • Global Steering Suppliers
  • Steering Market in China
  • Comparison of CAAS and Nexteer
  • CAAS International Sales & Protectionism
  • CAAS 2020 Goals
  • The $40mm cost of “Tax Cuts”
  • Estimating CAAS 2018 Earnings
  • Buyout Prospects

Company Background

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.

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 $13Bn.  About 10% of sales are in China and about 50% of sales are from Steering systems.  Has #1 global market share in EPS systems.  The company reports an operating profit margin of about 16% from China.
  • ZF Friedrichshafen – a privately held German auto parts group with annual sales of about $45Bn.  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 $97Bn.  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 $10.1Bn of which about $3.8Bn are auto parts, but the company does not break out Steering revenues.
  • Mando – major Korean auto parts company with annual sales of about $5.3Bn from Steering, Braking, and Suspension systems.  About 29% of sales are in China and about 30% of sales are from Steering systems.
  • ThyssenKrupp (TKAMY) – a German industrial conglomerate with annual auto parts sales of about $9.4Bn from Steering, Powertrain, Suspensions, and Chassis components.  About 15% of auto sales are from China.
  • Showa (JP:7274) – a Japanese auto parts maker with annual sales of about $2.4Bn.  About $0.8Bn of sales are from Steering systems
  • 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 and $0.8Bn of sales are from China.

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 and SAIC 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.

Passenger car sales rose slightly in China for 2017 due to the expiration of a temporary reduction in the tax rate  on new vehicles (CAAM sales report).  Commercial vehicle sales grew more quickly with support from a stronger property market and tightened enforcement of regulations against vehicle overloading.

China 2017 Vehicle Sales

The primary domestic steering system suppliers reported relatively weak China sales in 2017.

China Steering Revs

Shibao noted that it achieved higher EPS sales, but earned no profit “due to the relatively high cost of certain projects at the early stage of mass production” (link to 2017 results announcement).  Nexteer attributed lower sales to “decreased customer demand schedules as our major customers in the segment produced at levels
below the industry average” (link to 2017 results announcement).  CAAS brief announcement did not explain its weak China result.

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.

Nexteer vs CAAS China graph

Nexteer vs CAAS

Two adjustments have been made to present 2017 operating 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 17.4%) and reduce net income by current development expense (after tax).
  • “Tax Cuts & Jobs Act” – the US tax deform package passed in December 2017 created a non-recurring benefit to Nexteer through reduction of deferred tax liability and a non-recurring expense to CAAS for deemed repatriation of overseas earnings.

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.

CAAS International Sales & Protectionism

In contrast to its stagnant China sales, CAAS has enjoyed rapid growth in international revenues.

CAAS International

Chrysler North America is CAAS largest customer and accounted for 14.3% of total 2017 sales.  Significant sales to Ford began in late 2016 and CAAS has also established a subsidiary in Brazil.

Threatened trade conflict poses a significant risk to CAAS growing export business, however the initial list of products for which the United States Trade Representative has proposed increased tariffs does not include most auto parts.  Various types of vehicles are included (headings 8701-8705), but parts (heading 8708) are not.  Anything everything or nothing in these proposals could end up being implemented.  CAAS seems to be unaffected, but it would be difficult to assess the fair value of the company until US policy is clear.

CAAS 2020 Goals

Despite near-term adversity CAAS Chinese website describes optimistic targets for growth by 2020:

  • 10mm annual unit sales (+63% vs 2017)
  • 1/3 of sales exported (vs 23% in 2017)
  • 1/3 of sales from EPS (vs 24% in 2017)

These goals have not been mentioned in any regulatory filings or shareholder communications.

2020 Target

The $40mm Cost of “Tax Cuts”

China Automotive Systems came public in the US through a 2003 reverse merger with a Delaware Corporation.  The company did not accrue US tax liability on the earnings from its Chinese operating business because it intended that those profits would be permanently reinvested outside the US.  Unfortunately the “Tax Cuts & Jobs Act” now requires payment of a one-time “transition tax” on those past foreign earnings.  The calculation of the liability is subject to publication of IRS guidance, but all of the larger US incorporated Chinese businesses (e.g. YUMC SOHU CXDC and CAAS) with higher quality auditors (KPMG and PWC) each accrued a large estimated liability.  Actual payment can be spread over eight years beginning in April 2018.

It will be difficult determine the fair value of CAAS until there is greater clarity about the final liability for this transition tax.  The IRS has updated guidance several times and it’s possible that the company will know soon whether any revision to its initial estimate is appropriate.  The 10-K also mentions a risk that some future foreign earnings could be subject to US tax:

Subpart F

Estimating CAAS 2018 Earnings

CAAS has provided guidance for 2018 sales of $510mm.  The company has not given an outlook for margins, but they have been fairly steady over time.

CAAS Margins

The company attributed its lower 2017 gross margin to “product mix change”.  If lower gross margins and higher R&D expense continue in 2018 then earnings could drop to $0.54/share

CAAS 2018 Projection

Buyout Prospects

I argued last June that Chairman Chen’s $5.45/share offer significantly undervalued the company (LINK).  Weaker than expected gross margins and higher expenses now make the offer look more reasonable relative to 2018 earnings.  Factors for the Special Committee of Independent Directors and their financial advisors to consider:

  • Was the 2017 decline in gross margin attributable to short-term factors or is it likely to persist?
  • How does the company plan to meet its goal of 10mm unit sales by 2020 and what impact would that have on the fair value of the company?  The Directors should already know whether the company’s capital expenditures have put it on a path to have enough production capacity to reach that goal.
  • How certain is the $40mm liability for the US “Tax Cut”?
  • What impact, if any, will result from proposed US tariffs?

The “transition tax” liability was unwelcome news, but likely increases the motivation of CAAS management to eliminate the US holding company and the related risk of future tax and regulatory surprises.  The addition of an experienced private equity firm to the Buyer Group increases the likelihood that a deal can be steered to completion if the potential return is attractive.  My guess is that discontinuation of quarterly conference calls implies that CAAS does not expect to continue as a public company.

If there are no new significant adverse changes in company performance, tax, or tariffs then my guess is that within 2-3 months the Buyer Group will submit a new preliminary non-binding offer at a lower price.  Then the Special Committee will negotiate a final price at a premium to that revised offer.

Disclosures:

The author is a public shareholder of CAAS.  The author does not make any recommendation regarding any investment in any company mentioned in this article.  Investors are encouraged to check all of the key facts cited here from SEC filings prior to making their own investment decisions.

If any company mentioned in this article can point out any factual errors in the text using public information as of 04/12/18 then corrections will be made as promptly as possible.

Interested parties who wish to communicate privately about CAAS may contact the author at konekoresearch (at) gmail.com

 

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