Texhong – secular growth story, 6x - 8x P/E with sustainable annual EPS growth >20% a year and ROE >25% for the next many years

TEXHONG EQUITY STORY

Texhong (CMP HKD 12.28, ticker 2678.HK, market cap US$ 1.4bn) is Hong Kong-listed textile company, specifically a yarn manufacturer. For those who are not familiar with textile, the textile chain is: raw materials cotton or chemical fibers, out of which you make yarn, which goes into fabrics, and then into garments. Texhong is predominantly a yarn manufacturer, however it also has a small fabrics business. Whilst garments are all about labour, yarn is the most capital intensive part of the textile chain. By far and large, Texhong focusses on cotton yarn, so cotton is its key raw material. Texhong is not in garments, i.e. doesn’t make clothes: it purchases cotton and chemical fibers and turn them into yarn, which sells to the hundreds of fabrics manufacturers, primarily in China. Currently the company has a capacity of 1 million spindles, of which 400k in one giant plant in Southern Vietnam, and 600k scattered across smaller plants in China. The company was founded in the ‘90s by Mr Tianzhu Hong (45 years old, self-made), still Chairman/CEO and controlling shareholder. Mr Hong started by acquiring for a penny and then successfully restructuring bankrupt state-owned textile mills in China. In the early ‘00s he understood well before anyone else that the heady days of textile in China were about to end, so he relocated for two years to Vietnam to set up a plant there. The company’s track record is nothing short than spectacular. Out of a sleepy industry, over the past 10 years (2003 – 2012) Texhong has managed to increase revenues by over 7x, and EPS by over 4.5x, generating an average ROE of 25%, never raising a penny of equity (bar for the 2005 IPO in HK), and since its listing consistently (bar one year) paying out in dividends ~1/3 of net profits.

Texhong’ first competitive advantage lies in its Vietnam plant, which last year generated some 80% to 90% of the company’s net profits, on our estimates. In Vietnam labour costs are about 30% cheaper than in China, however this is offset by higher logistics costs, plus labour is not so important to yarn manufacturing, typically making up only about 15% of production costs. The reason why the Vietnam plant is so profitable is that in Vietnam yarn manufacturers can purchase international (basically US) cotton free of duties, process it and then ship the yarn back to China (where most of the fabrics manufacturers are still based) also free of duty, thanks to the China-ASEAN free trade area. Such option is not open in China, where about half of all the global yarn manufacturing capacity is still located. In China cotton prices are basically administered. Every year the government sets a fixed price at which the government would buy for its state reserve any cotton that the farmers would not manage to sell to the traders or mills. This naturally becomes the benchmark price at which every textile mill has to buy cotton domestically. Domestically grown cotton makes up about 2/3 of total cotton supply in China. Another 1/3 comes from imports, primarily from the US. However, prices for imported cotton are also administered, as the government makes the purchases and then allocates quotas to the mills at a fixed, modestly discounted (single-digit) price vis-à-vis domestic cotton. Historically, US cotton has almost always been significantly cheaper than China cotton, by an average of 24% over the past decade (after accounting for 13% VAT and 1% customs duty into China). This is basically Texhong’ Vietnam competitive advantage, which explains why in Vietnam Texhong manages to earn net margins in excess of 20%, whilst the vast majority of China’s textile mills have been struggling for survival for years now. Such advantage has never been so large, as since the summer of 2011 China government has basically kept domestic cotton price largely stable at around Rmb 19,000 – 20,000 per ton, which resulted in a discount US/China cotton over the past two years of about 30%.

Texhong’ Vietnam competitive advantage is entirely sustainable. As a rule of thumb, it takes about $0.5m to set up a 1,000 spindle capacity, so the replacement cost of Texhong’ Vietnam plant is about $200m. This is a huge amount for an industry that has been making razor-thin margins for years, is cash starved, highly fragmented in thousands of small enterprises with precious few large-size profitable companies having access to the capital markets. Besides, even if more Chinese yarn manufacturers set up shop in Vietnam, Texhong’ margins would yet not erode as long as China’s cotton price policy doesn’t change; simply, Vietnam capacity would replace China capacity, which is already partially shutting down and migrating. Is China’s cotton policy sustainable? Based on extensive industry channel checks, we believe it is. China government has recently announced the cotton price for next year at Rmb 20,400/t, implying (at current US cotton price of US$ 87c/lb) a US/China cotton price discount of 34%. As China communist party is still largely a rural organization, China government priority is first and foremost to protect the farmers. About half of China’s cotton farms are located in the remote and backward Western province of Xinjiang, where cotton farms are small-sized and not mechanized like in the US or Australia; cotton there is still largely handpicked. Clearly those farms are inefficient. Even at the current price of Rmb 19,000-20,000/t, their margins are thin, lower than for most other crops. Besides, the Xinjiang cotton industry is dominated by traders, who are largely influential former Red Army military officers. Last but not least, China government has quite clearly shown to care very little about its textile industry, which creates little value but consumes a lot of energy, an increasingly scarce resource in China. China government wants manufacturing to move higher-end, towards value accretion. If the mills complain, they tell them: why don’t you create a brand, where you can make double-digit margins, rather than producing for the foreign brands at virtually no profit? China government is very conscious that, as the country becomes more affluent, low-value added, polluting and highly energy-consuming industries (the likes of steel and textile) may gradually move out of China, just like they moved out of the Western countries in the ‘80s and ‘90s; this is precisely what the government wants, so sorry guys no support. For Texhong, this is a boon. Whilst the current discount US/China cotton is probably an aberration, even if the discount were to revert to the historical average of about 20%-25%, still there’s no way that virtually any mill in China can compete with Texhong’ Vietnam plant, by far the largest in the country. Besides, having still 60% of its capacity in China, Texhong is fairly hedged in the short term; even a sudden drastic change in China’s cotton policy (unlikely) would not really affect its consolidated profits, as any margin erosion in Vietnam would be offset by a broadly equivalent margin boost in the China operations.

That said, Vietnam doesn’t make the whole Texhong story. Still youthful Mr Hong has clearly proven to be two steps ahead of anyone else in the industry. His story reminds very much of the story of Lakshmi Mittal in the steel industry. In fact, we believe Mr Hong could become the Mittal of textile, a visionary and a consolidator. Even in its smallish China plants, Texhong still manages to be profitable, by saving aggressively on capex (only the finishing is done with Japanese machinery, the bulk of production with Chinese equipment which is about 2/3 cheaper), and by focussing more on higher-end niche products which do not compete with imports.

Texhong is on a roll. Over the next 12-18 months, capacity in Vietnam is being expanded from 400k spindles to effectively 900k, by adding a second giant plant in North Vietnam, close to the China border. Further 330k splindles are being added in China, focussing on niche higher-end yarns. All in, just about a year from now Texhong will have expanded capacity by over 80%. Besides, the company is mulling greenfield projects in Turkey and in Uruguay, the latter to cater for the vast Brazilian market, replicating (thanks to a favourable duty arbitrage) the Vietnam-China business model, thus projecting the company from an Asian to a truly global scale/footprint. Having recently placed a $200m HY straight bond (good terms: Jan 2019, 6.5%), Texhong is comfortably funded for such aggressive expansion plan, without the need to raise any equity.

SHARE PRICE VOLATILITY EXPLAINED

Texhong share price has been hugely volatile in recent years – for the wrong reasons. Texhong share price went from less than HKD 1 in late 2009 to over HKD 7 in April ’11, fell back to less than HKD 2 in early 2012, and has since then recovered to over HKD 12. By far and large, the share price volatility came from the unprecedented volatility in cotton price over the period, coupled with uninformed investors wrongly extrapolating one-off cotton inventory gains and losses. Like every yarn manufacturer in Asia, Texhong stocks up months of cotton inventory, typically 2 to 8 months depending on the tightness of the global cotton market. Driven largely by financial speculation, international (US) cotton prices surged from less than US$ 50c/lb in early 2009 to >$2/lb in March-April 2011, to then quickly collapse to a range of $70-90c where they have stabilized since about a year. Due to cotton inventory gains/losses, Texhong’ reported unusually high margins in 2010, to then slip even into headline net losses by H2 2011. In reality, stripping out the cotton stock gains/losses, we estimate that Texhong’ yarn gross margin in 2010-11 averaged about 16%, only modestly below its long-term average (high teens) to reflect the tough macro environment and demand destruction for cotton textiles that the cotton price boom produced. If Texhong were to be properly covered by the Street (the stock has currently no brokers coverage) such a basic fact would have been discounted, and the share price volatility would have likely been significantly lower. But as there’s no large cap listed company on any exchange in the textile industry, financial markets’ understanding of these businesses is very limited.

VALUATION

As cotton prices have stabilized, in H2 2012 Texhong reported > HKD 1 annualized EPS. This was the first clean interim result which was not biased by any significant cotton inventory gain/loss (even in H1 2012, for the first three months Texhong still suffered from cotton stock losses, as it still had to clear the last portion of the high-cost inventory accumulated during the cotton price bubble). As capacity is being expanded by >80%, particularly by >100% in Vietnam where most of the profits are generated, all of which should be fully operational by the middle of next year, by 2014-15 EPS should realistically increase to somewhere in the range of HKD 1.5 – 2, resulting in 6x to 8x P/E at current share price of HKD 12 – all this assuming margins remain around the historical average (net margin high single-digit) and conservatively not incorporating any impact from the Turkey and Uruguay projects, which are yet to be finalized. Shenzhou International, another HK-listed textile company of comparable size, generating ROEs broadly comparable to Texhong (>20%), and yet having in our view a significantly less attractive growth profile, trades on some 11x 2014e consensus, suggesting (despite the recent run) some further 40% to 80% near-term upside potential for Texhong share price. This could be quickly realized if the stock manages to attract some brokers coverage, highly likely as the market cap has now stably crossed US$ 1bn. Longer term, once the stock will have settled on the double-digit P/E it deserves – given its impressive track record, 25%+ ROE and tremendous growth story – equity returns should henceforth broadly mirror earnings growth, which in our view should easily exceed 20% per annum for the next several years. Worth remembering, textile is a massive industry worth hundreds of billions of dollars, half of which is in China – all ripe for migration to more efficient locations. In this context, Texhong is still a minnow, even when it will have reached ~US$ 2bn top line, as we believe it will by 2015 once all the capacity expansion will be up and running. Capacity in Vietnam could be then very realistically further expanded by a factor of 10x over the next decade or so, and as in Vietnam Texhong enjoys pay back periods of only around 4 years in our estimates, all this growth could be very realistically self-funded, as the company always has self-funded its tremendous expansion without ever diluting shareholders, a rarity for Hong Kong-listed growth companies.