Description

With Asian markets in complete chaos, some stocks are getting ridiculously cheap. Among them is Norstar Founders Group (2339 HK), a business that I have followed for several years. Norstar is a healthy, stable, consistently FCF-positive Hong Kong-listed auto-parts manufacturer, trading at 0.2x EV/EBITDA, 0.25x normalized earnings (cash-adjusted), 2.6x FCF, and a 30% discount to net-net value. On top of that, you're getting a 7%+ dividend, which management intends to hike.

Some simple figures (in RMB, FYE 3.31.08):

Market cap: 1.36bn
Net cash: 1.23bn
EV: 121mm

Revenue: 3.9bn
EBITDA: 597mm
EBIT: 525mm
Net income: 510mm
FCF: 518mm
Net-Net Value: 1.9bn

Revenue (24.9% CAGR from 2002-2008)

2002: 1.0bn
2003: 1.4bn
2004: 1.7bn
2005: 2.2bn
2006: 2.7bn
2007: 3.5bn
2008: 3.9bn  

Operating Profit (31.0% CAGR from 2002-2008, operating margin in brackets)

2002: 104mm (10.1%)
2003: 169mm (12.2%)
2004: 200mm (11.7%)
2005: 294mm (13.3%)
2006: 385mm (14.5%)
2007: 441mm (12.6%)
2008: 525mm (13.5%)

Net Income (35.3% CAGR from 2002-2008, net margin in brackets)

2002: 83mm  (8.1%)
2003: 132mm (9.5%)
2004: 164mm (9.6%)
2005: 273mm (12.4%)
2006: 347mm (13.1%)
2007: 404mm (11.6%)
2008: 510mm (13.1%)

ROICs (cash-adjusted)

2002: 35.8%
2003: 35.2%
2004: 23.8%
2005: 18.1%
2006: 19.0%
2007: 20.1%
2008: 23.0%

On the first pass, the valuation and financial results seem hard to believe, and almost do the opposite for the idea -- i.e., there must be something wrong with it. But read on; there are no tricks. This is a clean company: straightforward accounting, aligned and accessible management, very little options issuance, etc. Most importantly, Norstar doesn't have a history of being a value-trap -- at least prior to 2008, the stock consistently traded at 'normal' auto-parts multiples of anywhere between 3-5x EBITDA and 8-10x earnings. The current panic, however, has resulted in investors dumping almost everything in sight, with breathtakingly little regard for fundamentals. Hence, the opportunity at hand...

* Business Overview Part 1 *

Norstar's legacy business -- 75% of sales and 78% of gross profit -- is brake parts production for export into the global aftermarket. They make the brake plates, pads, shoes, etc., that you see at your local auto parts store or when you bring your car in to the shop to get the brakes done. For the uninitiated, brake pads are devices that, when placed in contact with a vehicle’s brake rotors, create friction and slow the vehicle down. Lined brake shoes perform essentially the same friction-generating function, except for a vehicle’s rear wheels. A brake pad/lined brake shoe is made up of a steel portion (the backing ‘plate’ or ‘shoe’) and a composite friction material (the ‘pad’ or ‘lining’). Norstar manufactures both the steel backing plates (without the composite friction material attached) as well as the complete brake pad/lined brake shoe. The ASP for a steel backing plate is between 50-60 cents (USD), vs. 3.00 for a full brake pad, while the ASP for a brake shoe sans lining is 3.50-4.00, vs. 7.00 for a lined brake shoe. Norstar generates 22-26% gross margins on padded and/or lined products, vs. 13-18% gross margins on the steel backing plates alone.

The company's brake part product breakdown is as follows (as a % of overall brake parts revenue):

Brake Plates: 12.7%
Brake Shoes: 37.0%
Disc Brake Pads: 14.0%
Lined Brake Shoes: 36.3%

Norstar is one of the largest and lowest-cost producers of brake parts in China (accounting for 30-40% of the country's export volume), so, while the products seem bland and undifferentiated, the economies of scale here allow for a superbly profitable operation. Returns on capital are 20%+ and net margins are consistently in the low double-digits.

Let me reiterate too that the company is not supplying the Big 3 or anything like that. This is an 80-90% aftermarket product -- i.e. replacement and/or repair. The aftermarket offers a more stable source of demand, as maintenance on a vehicle's brakes, for safety reasons alone, can't be avoided, and replacement is really a function of miles driven.

Norstar's primary customers for brake parts are private integrators and distributors, including Morse Automotive (a top supplier to AutoZone), Satisfied Brake Products, and Nucap. Other customers include Honeywell and Lemforder. As Norstar has expanded, customer concentration has come down a lot – today, the largest customer accounts for only 8.3% of sales. Furthermore, the business is quite diversified geographically – US customers only account for 37% of total auto parts revenue, European customers for 23%, and Canadian customers for 22%. The remaining 17% of the business is in mainland China, which I will cover below.

The overarching point I'd make here is that there is nothing glaring (like 90% customer concentration, or huge exposure to the North American OEMs) that explains the enormous discrepancy in valuation between Norstar and any other run-of-the-mill auto parts supplier (most of which, even after the market's recent meltdown, still trade at 2-4x EBITDA). The company's factories are operating at 95%+ utilization, so, yes, growth will be limited without further capacity expansion. BUT, it's not like the business is dropping off of a cliff by any means. In fact, in the first fiscal quarter ended 6.30.08, the company revenue's were up 23% year-over-year.

The brake parts division alone should generate a stable 300-400mm annual EBIT going forward (remember, compared to an EV of 121mm and a market cap of 1.36bn). So while I can appreciate the argument that, given the macro environment, auto parts companies should be worth less, are they really only worth 0.2x EBITDA? Or 0.3x EBIT of ONE (healthy) division? Or 70% of net-net value? That I'll leave for you to decide.

* Business Overview Part 2 *

As we have established, brake parts account for 75% of Norstar's auto parts business. Of the remaining 25%, 18.4% is a fast-growing mainland Chinese operation. The company also runs small trading and construction hardware businesses, both of which are barely material to the overall valuation.

The Mainland China opportunity:

Norstar’s approach to business China is very different from its approach to the global export market. The export market is fairly regulated -- in order to supply companies like Honeywell, you need to get licensed and pass a variety of quality benchmarks. The Chinese aftermarket, on the other hand, is relatively under-developed, with fewer safety/quality standards and a ton of low-cost competition. Hence, Norstar is sidestepping it for now. The company is instead focused on building relationships with Chinese OEM auto makers, supplying these companies (at the point of production) with higher value-added components such as suspension systems/axle modules and shock absorbers. The company primarily serves as an assembler of these components for now, but is making the necessary investments to vertically integrate into manufacturing. Current customers include Beijing Benz-Daimler Chrysler Automotive, Shanghai General Motors, Beijing Automotive Industrial Holdings, and at least 8 other local manufacturers.

It's important to note that Norstar only started selling into the Chinese market in October of 2005, and finished 2005 with China sales accounting for a mere 23.4mm RMB, or 1% of overall revenue. By the end of 2006, however, China sales increased to 441.8mm, up nearly 19x, and accounted for 12.6% of overall revenue. By 3.31.08, China sales accounted for 643mm in sales and 98mm in gross profit -- a 15.2% margin that is similar to the margins that Norstar achieves in its export business. This is a fast-growing, profitable division that management hopes will account for as much as 50% of company-wide sales in 3-5 years. You're getting it basically for free.

* Management *

Norstar was founded in the mid-1990s by two entrepreneurs, Lilly Huang and Zhou Tian Bao, who are both still with the company today and who collectively own 51% of the stock. Throughout the years, Huang and Zhou have been quite prudent in terms of both share issuance and capital allocation. The company has only issued options twice in its history, once in 2006 and once last year. Total options outstanding = 3% of basic shares outstanding. The company has also only made one relatively small acquisition since coming public, a 40% minority stake in Profound Global Group in 2004. Profound is a small Chinese manufacturer/distributor of auto parts and metal hardware products; Norstar paid 181.7mm HKD for its stake, which, at the time, equated to less than 7x Profound’s trailing earnings.

* Risks *

1. RMB appreciation: Like many export-oriented companies, Norstar’s costs (42% steel, 19% friction materials, 16% chemicals) are primarily denominated in RMB, while its revenues are in USD. The RMB has appreciated from 8.3 per USD in January of 2005 to 6.8 today, which is quite a macro headwind for the company. They have offset this headwind so far by passing on price increases to customers. They also benefit from the fact that steel is largely transacted in USD. But, certainly, further appreciation does not help gross margins (which have remained quite stable, nonetheless).

2. The US economy: Norstar US business saw sales fall by 4% in the second half of last year. However, the company only generates 37% of its overall auto parts revenue from American customers. 

3. Acquisition risk: there is the chance that management does something dumb with Norstar's (recently generated) big cash balance. History and incentives would indicate otherwise, but it is still a risk.

* Conclusion *

The thesis here is pretty straightforward – you have a Chinese auto parts company with a stable, high FCF export business, significant growth opportunities in its homeland market, a strong balance sheet, and admirable returns on capital, trading at 0.25x earnings and a discount to net net value. Management is aligned with shareholders through significant equity ownership and pays out a significant dividend.

I've done a lot more work on this and can follow-up in greater detail for those who are interested. But so as not to make the writeup too long, I'll stop here. At these kind of valuations, once you're relatively confident that the business is not falling off a cliff (sales grew 23% last quarter), the other stuff doesn't matter as much.

Catalyst

1. Dividend hike.
2. Continued good results.
3. Calming of the current financial panic.
4. Agitation by several large, value-oriented hedge funds (Sansar, Tosca, etc., who haven't sold a share even though they are otherwise suffering greatly in the current environment).