- Specialty chemicals producer China XD Plastics delivered strong operating performance in 2017 with volume +14% and net income +0% in line with guidance
- The company remains over 80% cheaper than comparable China-listed companies
- Rapid capacity expansion is on track to serve growing end markets (bio-plastics and 3D printing materials)
- US Tax changes imposed an unexpected $71mm liability in 2017 and complicate potential corporate actions
- The company has provided no update on the status of management’s unfair $5.21/share buyout offer
China XD Plastics (CXDC) reported satisfactory 2017 results and operating progress which have been largely ignored by investors due to concerns over the fourteen month old preliminary non-binding buyout offer (LINK) from Mr. Jie Han (CXDC’s founder, chairman and CEO) and Morgan Stanley Private Equity Asia (MSPEA). MSPEA has been a strategic investor in the company since 2011.
This report will cover the major developments since my September article (China XD Plastics Midyear Update and No News is Good News Regarding the Unfair Buyout Offer). This article will refer to the US-listed parent company as “CXDC” or “China XD” and the business as “Xinda,” because that is the name used by its Chinese operating units. Topics:
- XINDA’S POSITION IN THE CHINESE CHEMICAL AND PLASTICS INDUSTRY
- CXDC’S PROGRESS OVER THE PAST YEAR
- CXDC’S LIQUIDITY IS ADEQUATE
- A $71MM “TAX CUT” LIABILITY AND FUTURE COMPLICATIONS
- STATUS OF THE UNFAIR BUYOUT OFFER
- NEW STRATEGIC ALTERNATIVES MAY BE AVAILABLE
Growing production and emerging opportunities to list shares in China or Hong Kong could be very rewarding to long-term shareholders. Completion of the current expansion plans has potential to generate over $7/share in annual EPS (see Jason Cooper’s analysis: China XD Plastics: Management’s Buyout Is Woefully Inadequate). The unfair buyout offer has been an unwelcome distraction and should be abandoned or rejected.
XINDA’S POSITION IN THE CHINESE CHEMICAL AND PLASTICS INDUSTRY
CXDC’s Annual Report includes helpful information about the growth of the plastics market in China. 2021 sales volume is projected be 34% higher than 2017 in revenue and 35% higher in tonnes.
The automotive sector accounts for about 20% of the plastics market and is growing at an above average pace due to demand for lighter weight, lower cost and more environmentally friendly materials.
Use of plastics per vehicle produced in China has been growing rapidly, but still lags far behind the US and EU leaving considerable scope for growth.
Xinda rose to #37 on the China Petroleum and Chemical Industry 2017 Ranking of the Top 100 private companies in the industry (from #38 in 2016). The companies on the list produce a very broad range of products, from fertilizers to commodity petrochemicals to specialty compounds. Further insight into Xinda’s business can be obtained through comparison with three major listed companies producing modified plastics (Kingfa appears at #22 in the top 100 industry ranking, while Pret and Silver Age were not included):
Kingfa Science & Technology is China’s largest producer of modified plastic by volume. The company began by serving the appliance industry, and expanded into automotive plastics in 2006. Kingfa operates facilities in Guangzhou (Guangdong), Zhuhai (Guangdong), Qingyuan (Guangdong), Kunshan (Jiangsu), Tianjin, Wuhan (Hubei), and Mianyang (Sichuan). The company’s growth initiatives include biodegradable plastics, supply chain finance and logistics services, and carbon fiber. Significant recent developments:
- 2017 Revenue +29%, Net Income -49% (2017 Annual Report)
- 2017 sales volume of 1.44 million tonnes, including 518,000 tonnes of automotive plastics
- Gross margin fell to 13.6% due to higher raw materials prices. Gross margin from production of different types of plastics ranged from 13-23%. Gross margin from plastics trading was 2%.
- International sales were 15% of total
- biodegradable plastics volume +147% in 2017
- Special engineering plastics volume +38% in 2017
- Carbon fiber polymer materials revenue +332% in 2017
- Current Production capacity of 2.1mm tonnes (including overseas plants) with 0.4mm tonnes of capacity expansion projects underway
Kingfa’s Annual Report has optimistic commentary about demand from many end markets. It mentions that restrictions on non-biodegradable plastics that began in Europe are spreading to China. Leading ecommerce companies like Alibaba and JD are trying to maximize use of environmentally friendly materials while some provincial governments (e.g. Jilin and Jiangsu) have banned some traditional plastics. Kingfa predicts “explosive growth” in demand for biodegradable agricultural membranes (a 1.5mm tonne/year market).
Shanghai Pret Composites operates facilities in Shanghai, Chongqing, and Jiaxing (Zhejiang). The company’s growth initiatives include increased sales of high-end automotive products and integration of its acquisition of US-based Wellman Plastics Recycling. Significant recent developments:
- 2017 Revenue +7.6%, Net Income -37%
- Higher raw materials prices pressured gross margins
- 9% of 2017 revenues from non-automotive applications
- Target 2020 capacity of 500,000 tonnes/year
Guangdong Silver Age operates facilities in Dongguan (Guangdong) and Suzhou (Jiangsu). The company supplies makers of electronics, wires and cables, appliances, lighting, transportation, and household goods. It does not provide any breakdown of sales by end-market, but is not regarded as a significant competitor to Xinda, Kingfa, and Pret in the automotive sector. The company’s growth initiatives include supplying materials for 3D printing, investment in a business that makes sophisticated metal parts for mobile phones and other applications, and investment in cobalt mining and processing in the DRC. The company has not yet filed a 2017 Annual Report.
China XD Plastics has 3 facilities in Harbin (Heilongjiang) and newly opened facilities in Nanchong and Dubai described in more detail in the next section. One of the company’s competitive advantages is that its Harbin facilities are the only major modified plastics producers in China’s industrial Northeast. About 90% of Xinda’s output is used by the automotive sector, but the company has a long-term goal of achieving 50% of total sales from electronics, aerospace, high-speed rail, and other applications. The company’s growth initiatives include biodegradable plastics, 3D printing materials, and specialty engineering plastics.
All of the major plastics makers benefit from significant government support under the Made in China 2025 plan (LINK) which encourages domestic production and innovation of new materials.
As a leading company in the sector Xinda would be fairly valued at a P/E multiple at least in line with peers. Using the $100mm midpoint of 2018 guidance and 25 multiple would generate a share price of $38, but Jason Cooper’s analysis of the earnings growth that will result from current expansion plans suggests a higher price may be appropriate (see China XD Plastics: Management’s Buyout Is Woefully Inadequate).
CXDC’S PROGRESS OVER THE PAST YEAR
- 2017 Revenue +7.3%, Net income +0.1% (excluding the $71mm accrual for US tax expense)
- 2017 sales volume of 457,385 tonnes +14% vs 2016
- 2017 Gross margin declined to 18.3% due to increased volume of lower margin plastics marketed as a way to develop new customers.
Xinda has a long-term goal of raising sales volumes of more specialized higher priced and higher margin materials. 2017 results show success in higher sales of PLA and PPO, weaker results from intermediate products (plastic alloy, PA6 and POM), and a surge in volume of lower value products (ABS PP PE) which management described as a short-term strategy to develop new customer relationships.
Xinda made progress at raising sales in regions (Southwest, South, and Central) served from the new Nanchong production base.
Xinda added 156000 tonnes of production capacity in Nanchong during 2017 and began major capacity expansion projects in both Nanchong and Harbin.
Much of the new capacity (300,000 tonnes each in Nanchong and Harbin) will produce biodegradable plastics. These environmentally friendly materials serve new markets where the company should earn attractive margins.
The 10-K includes a new disclosure on page 50: “We anticipate continuous expansion in our business by entering into new markets serving different industries and geographic regions.”
XInda was not able to increase international sales in 2017. Revenues recorded in Dubai declined to $83mm in 2017 from $110mm in 2016. Shipments to the problematic “Korean customer” were suspended again after year-end due to an overdue receivable of $37.7mm. A portion of this had been received by the time the 10-K was filed. During conference calls management has expressed optimism about potential customer relationships in Europe and Russia. Activation of new capacity in Dubai will soon test whether there has been progress. The company will participate next week in the NPE2018 convention in Orlando.
CXDC’S LIQUIDITY IS ADEQUATE
The major expansion plans have stretched CXDC’s balance sheet. Liabilities net of cash grew by $186mm in 2017 and on the 4Q17 conference call the company estimated $400mm of capex for 2018. Guidance is for net income of about $100mm and I estimate depreciation of about $50mm (compared to $43mm in 2017). That leaves about $250mm of net financing required. The company held $479mm of cash + time deposits at 12/31/17 and had $350mm of remaining borrowing capacity under existing lines of credit from an impressive group of major Chinese lenders.
Those lines include a syndicated loan of $156mm led by Standard Chartered which must be repaid in three installments during 2018. Last Fall the company sought commitments for a $295mm replacement loan that would have included funding for a potential buyout, but has not yet announced any completed agreement. International lenders may be cautious about a new facility because they cannot assess the company’s capital structure while the status of the buyout is unclear. The 10-K disclosure of “continuous expansion” suggests that it would be prudent for CXDC to issue longer-term debt and possibly equity if it could be done at attractive pricing.
The company has received 697mm RMB (about US$109mm) of government grants and incentives to support its plant construction and research projects (see “deferred income” on 10-K pages F-28-29).
A $71MM “TAX CUT” LIABILITY AND FUTURE COMPLICATIONS
China XD Plastics came public in 2008 through a reverse merger with a Nevada Corporation. The company has had no operations in the US and did not accrue any US tax liability based on the assumption that all of its earnings would be permanently reinvested outside the country. The “Tax Cuts & Jobs Act” passed in December 2017 removed the option to make that permanent deferral and requires payment of a one-time “transition tax” on previously untaxed overseas earnings. CXDC accrued a $71mm estimated liability in 2017, but the actual amount payable may be adjusted as the IRS issues guidance on implementation of the law.
CXDC now faces the risk that all future foreign income could be subject to changing US tax rules, including profits in Dubai that were previously expected to be tax free. Any significant corporate actions could also carry US tax implications. Sohu.com, another Chinese business with a US parent company explained in its 10-K:
In order to escape from future US tax obligations Sohu proposes to liquidate its US parent company and distribute shares of a new Cayman Islands holding company that would hold all of the company’s operating assets. Sohu explains in its proxy statement that the liquidation will require payment of the entire transition tax this year and additional tax may be applied to the extent that the fair value of the Sohu Cayman shares distributed exceeds their “adjusted basis”.
It appears highly desirable for CXDC to eliminate its US holding company as Sohu is doing, but covering the tax liability in 2018 might be difficult when the company also has heavy capital expenditure commitments. CXDC might also incur tax on the excess of the “fair market value” of its business over the adjusted basis, however there might never be a time when the market value is lower.
STATUS OF THE UNFAIR BUYOUT OFFER
Chairman Han and MSPEA submitted their preliminary non-binding offer to acquire the company for $5.21/share on 02/16/17 and the Board of Directors appointed a Special Committee to evaluate the offer. Three months later the head of the committee (Lawrence Leighton) resigned. The remaining members soon engaged legal and financial advisors. There is no evidence of any progress since that time.
Previous Koneko articles showed that the offer was made at a time when Chairman Han and MSPEA knew the company had significant expansion plans underway that had not yet been disclosed to public shareholders. Agreements had been signed with local governments, equipment had been ordered, and construction commenced during the same month as the offer was made.
On 11/16/17 the company appointed Joseph Chow as a new independent Director. He appears highly qualified to serve as a Director, but curiously has not yet been included on the Special Committee evaluating the buyout offer. It’s possible that the Special Committee has been inactive. If a buyout agreement were approved only by the two existing Special Committee members then their independence could be challenged in court. The backgrounds of those Directors suggest that they can make valuable contributions to CXDC, but also suggest that they may have connections with CXDC management that compromise their ability to independently evaluate a transaction proposed by Chairman Han. A Winston & Strawn presentation included these guidelines for independence of Special Committee members:
Participants in CXDC’s 4Q17 conference call expressed frustration about the buyout. To clarify some misunderstandings, there is no deadline for action and the company has no obligation to disclose the current status of negotiations, if any negotiations are taking place. For comparison, JA Solar received a buyout offer in June 2015, a revised offer in June 2017, announced a definitive agreement in November 2017, received shareholder approval in March 2018, and the merger still has not closed due to a high number of dissents. CXDC is not setting any records.
However the uncertainty may be damaging the company:
- Loan refinancing may be problematic when lenders don’t know what the company’s ownership structure will be
- Growth capital may be unavailable because the reputation of the company has been damaged and interest in CXDC shares has fallen to extremely low levels
- The company may not be able to plan for new US tax rules
- The company may not be able to plan for conversion of MSPEA’s preferred shares and MSPEA’s exit from that position due to expiration of the fund which held the investment
NEW STRATEGIC ALTERNATIVES MAY BE AVAILABLE
Evolution of Chinese capital markets may provide new opportunities for CXDC to raise capital for growth and deliver attractive returns to current and future investors:
- China Depository Receipts – Internationally listed Chinese companies in favored industries (including new materials) will have the opportunity to issue shares in China’s domestic market without changing their corporate structure. Initial guidelines suggest a minimum market capitalization of 200Bn RMB which means very few companies qualify, but this restriction is likely to be eased over time.
- Hong Kong dual listing – the Hong Kong Stock Exchange has eased rules for secondary listings of companies from other international exchanges. The HKEX notes that few companies will not meet the initial criteria for CDRs, but that a Hong Kong listing could provide an attractive alternative because Mainland investors can easily trade HKEX listings through the Connect programs.
Dual listing of China XD shares in Hong Kong or Shanghai could be an ideal outcome for CXDC and all of its shareholders. Without any significant changes to its corporate structure the company could achieve better visibility, better liquidity, better access to capital, and a higher valuation for shareholders.
A previous Koneko article suggested that CXDC could raise capital by placement of a minority interest in its China operating subsidiary (Heilongjiang Xinda Enterprise) with an eventual listing of that company on a domestic exchange. That still appears viable from an equity market perspective, however the company would also need to determine whether such a transaction would generate US tax liability based on a deemed disposal of part of its ownership in Heilongjiang Xinda. Issuance of parent company shares dual-listed in Shanghai or Hong Kong would not carry the same tax risk.
China XD’s new independent director, Joseph Chow, may be able to share insights about building shareholder value based on his experience at China Lodging Group (+1012% return since 2010 IPO) and China Biologic Products (+2424% 10-year return).
China XD has a valuable and growing business. The buyout offer has been an unwelcome distraction that damaged the company’s reputation and delayed evaluation of alternatives that would be more likely to provide mutual benefit to all interested parties. If negotiations are not close to a fair price (>$30) then they should be terminated and the Board of Directors should initiate a new study of strategic alternatives to address:
- Corporate Structure and Tax
- Opportunities for Dual-listing
- Improving value for company shareholders
- Access to Capital for growth
- Ensuring a smooth exit of Morgan Stanley Private Equity
- Opportunities to introduce new strategic investors
At the time of publication the author is a public shareholder of China XD Plastics. The author believes that it would be in his best interest if the facts in this article were widely understood. The author does not make any recommendation to any other person about investment in China XD Plastics shares. The author may adjust his own investment in China XD Plastics at any time.
Conditional terms used in the article such as “may” “could” “seem” and “appear” indicate the author’s subjective opinion based on the facts presented. Readers are encouraged to check the facts themselves rather than relying on the author’s opinion. Descriptive terms such as “unfair” indicate the author’s subjective judgment based on the facts presented. These descriptions are made according to the common usage of these words rather than any specific legal standard of unfairness that may be applied in any legal jurisdiction.
The author has made his best effort to accurately summarize facts publicly available as of the date of publication (05/04/18). The author does not want to spread errors or misinformation. A link to this article has been sent to CXDC CFO Taylor Zhang using his email address in company press releases firstname.lastname@example.org. If CXDC, or anybody else, can provide public information as of 05/03/18 which shows there are errors in the text then corrections will be made as promptly as possible.
Aside from corrections to any errors discovered in this article, the author may not release new public commentary about China XD Plastics. His willingness to do so will depend on future developments which cannot currently be predicted.
Interested parties who wish to communicate privately about China XD Plastics may contact the author at konekoresearch (at) gmail.com
A copy of this text has been sent to CXDC’s independent Directors at the communication address provided in the 10-K: