Description

Qingling Motors Co. Ltd. (1122 HK)

HKD/RMB: 1.13

Price:  0.77 HKD/shr

Shares Outstanding: 2,482.27m

Market Cap: 1.9bn HKD (1.7bn RMB)

Cash and ST investments:  4.1bn HKD (3.6bn RMB)

Debt: 0

Minority Interest: 0.33bn HKD (0.29bn HKD)

Enterprise Value:  -1.87bn HKD (-1.61bn RMB)

Thesis

It is rare to come across classic net-net investment as advocated by Benjamin Graham, and Qingling Motors seems to be one of these elusive gems.

Qingling Motors is a best-in-class manufacturer and distributor of commercial trucks in China trading at 0.77 HKD/shr while net cash on balance sheet alone is 1.50 HKD/shr.  The stock has come off dramatically along with the Hong Kong market.  However, the company is a solid cash flow generator, pushing out at least 250m HKD in CF per year ex-growth on a normalized basis.  The current negative enterprise value is pricing in an extremely heavy discount on the company's current cash balance and future cash flow generation. We believe the discount is unjustified. 

We’ve spoken to numerous sell-side analysts  who we believe are too focused on Qingling's higher P/E ratio and lower ROE compared to peers (ie they largely do not take the cash balance into account). While some readily admit that the company is trading below cash with a good business and good management, many cite lack of catalysts and high P/E as a reason to remain neutral or even negative on the stock.  

The company recently came out with great interim results, but there is obviously fear surrounding the overall health of the trucking industry in China due to declining industrial activity.  However, we believe that Qingling should remain profitable during an industry downturn due to the superior quality of its products and advantageous balance sheet vs. many competitors that levered up over the past few years.  In terms of growth, Qingling is expected to be able to push out at least another 125m RMB from a diesel engine JV with Isuzu (after Capital expenditure of around 600m RMB spread out over the next 3 years).  Products of the JV will be used by Qingling internally (we estimate 60%) and the rest sold to Isuzu (one of the world's largest diesel engine and truck producers). 

The stock’s price level seems to be pricing in a complete destruction of cash on the company’s balance sheet and no profitability going forward.  

Business Description

Qingling Motors manufactures and sells light-duty trucks (62% of revenue), pick-up trucks (24% of revenue), multipurpose vehicles, heavy-duty trucks, and truck parts and accessories in China.  The company was part of a manufacturing arm owned by the Chongqing government in the 1990s, and enjoyed high returns on capital due to the state-owned nature of the truck making industry.  During the early 2000s, however, Qingling ran into issues when the majority of the truck market was open to private investment and competition.  The company has since rationalized its business model to compete effectively with the help of Isuzu, and has successfully turned crowded inventory and a highly levered balance sheet into a lean operation with a massive net cash position. 

The company is now planning to use their cash to expand its product offering into heavy-trucks and diesel engines.  Currently, Qingling is 50.1% owned by the Chinese government (in the form of A-shares, the rest is H-shares), and 20% owned by Isuzu.  The 30% free-float is mainly small institutions and retail investors which could allude to why the stock as performed poorly along with the rest of the Hong Kong/China markets as liquidity kept exiting over the last year or so.  Management of the company is comprised of professional managers from both Isuzu and Chongqing, and seems to be well respected in the industry according to our channel checks.

Industry

The truck-making business itself is very competitive, with sales split among many players in China.  The industry, however, is seeing phenomenal secular long-term growth?albeit not without an occasional hiccup as can be seen in recent times.  The long term economic growth of China (and the government's recent hefty investments plans in road infrastructure) and the replacement of worn out and old trucks that are less environmentally acceptable has increased the demand for new products such as those provided by Qingling.  Heavy trucks are experiencing the most volume growth as a result of increasing domestic trade, while light trucks are expected to see the same as rural area commerce picks up.  The former is also the one subject to the most competition which Qingling has up until now mostly stayed out of while focusing on their specialty premium light truck offering.  The JV with Isuzu, however, aims to expand outside of light trucks and should provide Qingling with enough brand name and technological advantages to compete (Isuzu technology, from our contacts with industry experts, is the preferred technology among customers although the higher price point makes these trucks attractive mostly to mid to large enterprises willing to pay up for the quality).  The company should continue to benefit from government policies to open up western china (where the company is based) and improve rural roads.   It is also possible that Qingling Motors will become a consolidator and use their heavy net cash position to gobble up many small/flailing competitors mired in debt.

The Engine JV

The Engine JV is an offshoot of an equity alliance with Isuzu.  This JV is expected to provide Qingling with the capability to produce around 100,000 modern diesel engine units by the end of 2008, 175,000 by 2010 and 200,000 by 2011.  The entire capital cost of this JV is around 1.5b RMB, of which Qingling would be responsible for half minus the injection of its existing engine manufacturing assets.  I estimate the cash expenditure to be around 600m RMB for Qingling over the course of the next 3 years which is more than covered by internal cash-flows.  The expected ASP from these engines is around 45,000 RMB/unit, and gross margin is expected to be around 20%.  Assuming capacity utilization of 70% and incremental SG&A of around 150mRMB, a pre-tax cash-flow of 300m RMB can be reached by 2011 (150mRMB of which is Qingling).  This JV will also serve to provide Qingling's existing truck manufacturing base with newly designed, more modern/environmentally friendly engines while selling the excess into the world market (no specific offtake agreement with Isuzu exists as of yet, although it's assumed most would go to them).

Risks
The first risk that comes to mind is corporate governance and management issues, but we’ve followed this company for a while and they’ve always been honest and good with managing expectations. So we don’t believe there’s much risk here.  Although one should always be cognizant that as a public H-shares investor you will be the minority —with the Chongqing government and Isuzu having the most say.

Management intentions with cash (currently to sit on it waiting for good acquisitions or investments, when asked management seems to have a very conservative attitude on their future plans with this cash and want to guarantee a good return when its used)

Excess competition and the cyclical nature of truck-making

Increasing raw material costs to company, such as steel, although recent events have rendered this risk moot for a while.

Catalyst