|Shares Out. (in M):||16||P/E||4.9x||4.2x|
|Market Cap (in $M):||70||P/FCF||5.5x||4.7x|
|Net Debt (in $M):||0||EBIT||14||17|
China Advanced Construction Materials Group, Inc. ("CADC" or the "Company") is a provider of ready-mix concrete in the Beijing area. The Company is growing rapidly (40%+ top line last few years), has outstanding margins (30%+ operating margins), strong returns on capital (30%+ ROICs, 50%+ ROEs), and a good competitive position. You can buy it today for 4x forward earnings. I think that it is an easy double, and potentially a good bit better than that. If you're not comfortable with the China investment story then go elsewhere. If you are, read on.
Over the last several years, ready-mix concrete has been grabbing tremendous market share from on-site concrete production in China's major cities. On-site concrete production is dirty and inefficient. With traditional on-site, production is typically made in small batches using outdated, energy-intensive equipment. Ready-mix, on the other hand, is typically produced in fixed facilities, which provides the advantages of greater scale, better quality control, more efficient use of input materials, more advanced technology, greater energy efficiency, and far lower levels of particulate emissions. As a result of these disparities, two years ago the Chinese federal government prohibited on-site production in 127 of its largest cities on a phased basis. Beijing is currently reaching the 100% phase-in level for restriction of on-site production. Country-wide, only about 30% of China's concrete production is currently ready-mix, compared to 80% on average in developed countries. There is clearly still plenty of market share left to be taken. Market share gains for ready-mix are obviously above and beyond growth that will be driven by the underlying high single digit growth rate for the underlying Chinese economy.
CADC is one of a new breed of ready-mix concrete producers that has stepped in to fill this growing need. The Company has worked on many of the highest profile construction projects in and around Beijing including the US Embassy, National Centre for Performing Arts, CCTV Headquarters, Beijing International Airport, National Swimming Centre Water Cube, Olympic Stadium Bird's Nest, and multiple phases of the national railway project. For additional detail, I suggest you visit the Company's website and take a look at one of their IR presentations (http://www.ir-site.com/chinaacm/events.asp).
Demand for the Company's products and services is being driven in the near-term by the $600bn stimulus plan, some 2/3 of which is expected to be invested in basic infrastructure build. Longer-term, demand is being driven by increasing urbanization, as only 25% of the land in and around Beijing is currently developed. CADC is in an enviable competitive position. As one of the larger producers of ready-mix in the Beijing area, it has far more financial flexibility than many of the smaller competitors. This gives it an enhanced ability to devote money to R&D, an important differentiator on the high profile government projects that demand relatively high levels of technical sophistication. In addition, smaller competitors have been falling by the wayside recently (oftentimes selling out to larger competitors) due to their lack of access to the capital necessary to meet stringent new environmental requirements.
From its home base in Beijing, CADC has recently begun expanding into adjacent locales. It has been doing this through the roll-out of two new operating strategies/models, a Manufacturing Services Agreement (MSA) model and a Technical Services Agreement (TSA) model. Under the MSA model, CADC provides some of the necessary equipment but the general contractor provides all of the necessary raw materials. Under the TSA model, CADC effectively franchises out the entirety of its expertise (providing equipment, personnel, and technical expertise). Under both of these new paradigms, margins are greatly enhanced, upfront capital needs are reduced, working capital intensity is brought down, and free cash generation improves. The results of this strategic shift can be seen in the historical financials, with operating margins growing from roughly 18% in fiscal 2008 to 34% in fiscal 2009.
CADC management is very investor-friendly. Gene Hsiao, the CFO, has spent his career in a range of senior financial positions in US companies (Milligan, J&J Snack Foods, RCN, and ARAMARK). He is currently based in the U.S., as a result of the Company's recent going-public transaction and his efforts to establish a credible IR effort. Eventually, he will likely relocate to China. As far as US-listed Chinese companies go, I consider him to be high quality. As an aside, he is very accessible to investors. Has led the Company's recent exchange uplisting, and is in the final stages of getting CADC SarBox compliant.
On the negative side of the ledger, accounts receivable were a major use of cash in the 2009 fiscal year. While this was a clear drag on the year's operating cash generation, I am not overly concerned due to the nature of the receivables. Many of CADC's jobs are large-scale government projects that are 1-2 years in duration. Receivables on these projects may not be collected until final inspection of the projects is complete. The customer on these projects (the Chinese federal government), however, is arguably the world's best sovereign credit. CADC management is acutely aware of the working capital issue, and the negative impact on valuation, and has begun taking steps to lessen working capital intensity. One of these strategies is, as previously described, to move a greater percentage of business to the MSA and TSA models. In addition, management has recently begun some pilot programs to assign receivables to its vendors (effectively using some of its vendors to factor its receivables).
Share price performance has been poor recently. Since hitting a high of $8.50/shr in mid-October, shares have declined steadily to the mid-$4/shr range. Part of this retracement has been a result of the same headwinds that have negatively impacted most US-listed Chinese equities since a brief bout of irrational euphoria in the Fall. In addition, however, there is a more specific phenomenon that has weighed on CADC and several other similar companies. A number of US-listed Chinese companies have issued warrants as sweeteners on financing deals in the last few years. A relatively new accounting pronouncement now requires these companies to book P&L charges under certain conditions to the extent there is a discrepancy between the company's underlying functional currency (in this case, the renminbi), and the currency in which the warrants are denominated (in this case, the US$). While there is absolutely no cash impact, the P&L charges can be enormous. For instance, in the 1st fiscal quarter (ended Sep 30, 2009), CADC booked a $7mm+ "Change in fair value of warrant liability". This charge far outweighed the $2.4mm of operating income that the Company booked in the quarter, leading to a massive reported net loss. Although it's just optics, I think that on the margin there are quant-driven and other non-fundamental investors that read this as a rapid reversal in business fundamentals which thereby leads them to either blow out of positions or avoid the shares to the extent they're not involved. Over the long-term, yes, the market tends to be efficient, but in the short-term I think this peculiarity has been an overhang on CADC (and several other companies).
I expect CADC to do north of $1/shr in EPS this fiscal year (Jun 2010). So, for less than 5x EPS, you're buying a rapidly growing business with strong fundamentals, good management, expanding margins, and an improving IR effort.
Sell side coverage. Increased institutional interest. Market properly discounts non-cash warrant charges.