Description

Value with a catalyst. Texhong is the world’s largest producer of stretchable yarn, and is the best business in a bad industry. The company is run by the excellent owner-operator Tianzhu Hong, who has steered it to a 20 year record of 15% post-tax returns on tangible capital. Hong has also been building out Texhong’s downstream business, which will bring strategic benefits that investors underappreciate. 

Hong has treated minority shareholders well over two decades and the stock is not a value-trap. Yet it trades on 4x trailing EV/EBIT and 2x our three year estimate. It’s historic average is 8x.

This opportunity exists because the stock trades US$1mm/day and is mostly owned by Hong Kong retail investors. Sentiment typically swings with the macro environment and is still recovering from being hit badly two years ago by the US/China trade war, falling cotton prices and RMB, and then Covid. With macro headwinds now reversing to become tailwinds, we expect Texhong to report record profits this year. That should act as a catalyst for the stock, and given today’s valuation we see limited downside if we are wrong and multi-bagger upside if we are right. 

The stock has previously been written up on VIC in 2013 and 2018 and those writeups provide useful background. This one will focus more on the situation today and why the opportunity exists.

Business model

Texhong is the largest producer of stretchable yarn in the world with a 40% market share. It sells to companies who make fabrics like spandex, also sells non-stretchable yarns, and is expanding downstream into fabrics itself. 

The textile industry has few barriers to entry; most yarn manufacturers are based in China and earn returns below their cost of capital. In contrast, Texhong generates an acceptable 15% post-tax return on tangible capital because of the excellent management of its owner-operator, Mr. Tianzhu Hong. 

Hong owns 52% of the company and is Executive Chairman, while his Co-Founder Zhu owns 15% and is CEO. They have high integrity, customer focus, and capital allocation skills. Minority shareholders are treated well, with no unscrupulous behavior in over 20 years and an average dividend payout ratio of 30% pre-Covid. The remaining cash is reinvested into growing the business. We are therefore comfortable that with Hong in charge the stock is not a typical HK listed value-trap. At 53, he continues to have a good runway ahead of him.

Hong has made three key decisions in his 20+ years that shape the company’s business model.

The first was to expand from China to Vietnam in 2006. Vietnam now accounts for over half of production and has access to cheaper cotton. This is because China places tariffs on cotton imports to keep its domestic cotton producers - primarily located in Xinjiang - price competitive and operating. The tariffs mean cotton in Vietnam costs 15-20% less, which is an advantage as cotton accounts for more than half the cost of making yarn.

Texhong’s yarn is typically sold to Chinese customers, at the price of Chinese domestic cotton prices plus a markup. Since the company has lower international cotton, labor, and utility costs, the company is able to earn a 15% EBIT margin in Vietnam when Chinese competitors barely break-even.

With roughly half of Texhong’s production in each of Vietnam and China, the company earns a 10% EBIT margin through the cycle. It is also worth noting that competitors typically earn a RMB 500-1,000/mt lower markup due to having inferior yarn quality, service or delivery speed.

Nevertheless, the company’s sophisticated competitors such as Shandong Dai Yin have increasingly followed the company in expanding outside China.

To stay ahead, Hong made a second key decision a couple years ago to build factories in Nicaragua and Mexico to supply North America and in Turkey to supply Europe. While the expansion has been slowed by Covid, once complete it will give Texhong lower costs and protect the company from trade wars by supplying customers in each region ‘locally’. 

Hong’s final key decision is likely the most underappreciated by investors. Five years ago, the company began investing heavily to build its own downstream facilities in Vietnam. These factories use Texhong’s yarn to produce fabrics and jeans. This is a major transformation that will increase returns and bring strategic advantages.

We estimate that around HK$5bn has been invested in capex and acquisitions to date - equal to 50% of the company’s market cap today or 35% of its EV - and expect another HK$5bn over the next five years. That should grow the downstream business from just over 20% of revenues today to 40%. 

Hong thinks downstream will eventually be a higher margin and return business, and we agree. We expect the company will generate HK$50bn in revenues in five years, assuming a slightly lower growth rate than the 5 and 10 year averages of 13% despite the major investment and rebound from Covid. If downstream’s share is 40% (HK$20bn) and EBIT margins are 10-15% (vs 10% for yarn), then EBIT is HK$2-3bn. On HK$10bn of capex, that results in returns of 20-30% pre-tax and 16-24% post-tax.

Just as importantly, being vertically integrated will improve Texhong’s existing yarn business. ‘Fast fashion’ has resulted in the company’s order book shrinking to just three weeks long and so the company has kept half of its yarn production in China to remain close to downstream customers. Building out its own downstream business in Vietnam will free up all future investments to be allocated to the higher margin geography and further reduce the group’s vulnerability to US/China tariffs.

Valuation

Texhong has traded at an average of 8x EBIT over the last decade, and we don’t think it should trade lower than that today - if anything, the business is getting better. A back of the envelope valuation shows that you have a very large margin of safety even on conservative assumptions. While the stock often swings on macro news, we think the downside is limited over three years if we are wrong and the upside is high if we are right.

We look at tangible book to estimate downside. This was HK$12/shr as of June 2021 and increased during both 2008-9 and 2020. Even assuming a macro downturn, we expect it to be HK$15/shr in three years. The stock bottomed at 0.3x and 0.5x in 2008 and 2020 respectively, but has always traded above 1x at some point over three years, and averaged 1.5x over time. At today’s HK$10/shr stock price, that suggests very limited downside for a patient investor.

One thing worth discussing is the ‘China risk’. We think the biggest risk to our thesis is a ‘new paradigm’ where Chinese stocks are simply ignored and fundamentals don’t matter. Yet while there may be changes in investor sentiment, we see the underlying risk for this stock as low over time. Texhong has most of its production outside of China, those operations inside serve Chinese clients, the company is building out a global network to mitigate the impact of potential tariffs, and the stock is listed in Hong Kong rather than Shanghai. Since the float is mostly owned by local investors, even an extreme scenario where US investors are banned from owning HK stocks should have relatively little impact beyond an initial drop from sentiment and some forced selling.

Why this opportunity exists

Texhong shares trade US$1mm/day and are mostly owned by Hong Kong retail investors. That has historically resulted in overreactions to changes in the macro environment, and often with a lag.

For context, virtually every macro variable was providing a severe headwind to the stock just 18-24 months ago: The US/China trade war was in full swing, cotton prices had declined, the USD was strong vs the RMB, and then Covid hit. To make matters worse, this all happened when the company had increased debt to fund its downstream investments. That sent the stock down from HK$12.5/shr in April 2019 to HK$5.5/shr in October 2020.

The underlying economics of the business remained unchanged throughout this period and management continued to reinvest downstream. Yet despite demand rebounding, cotton prices at highs, the RMB strengthened, and trade war rhetoric cooled, the sentiment on the stock has yet to fully recover. Indeed, investors should be buoyant. 

The most important of these macro variables historically has been changes in cotton prices, because they significantly impact profits in the short term. Texhong is likely earning record profits right now, boosted by cotton prices that have risen since March 2020 to their second highest level in 20 years.

To see the benefit of rising cotton prices, imagine a hypothetical scenario where Chinese domestic cotton prices are RMB 14,000/mt. After adding a RMB 10,000/mt markup, yarn is sold for RMB 24,000/mt. Suppose that Texhong’s cotton cost in Q1 is lower at RMB 12,375/mt because over half the company’s production is in Vietnam, which has access to cheaper international cotton. That allows the company to earn a 9% EBIT margin.

In Q2, cotton prices rise 30% to RMB 18,200/mt, which adding the RMB 10,000/mt markup results in a RMB 28,200/mt price of yarn. Yet Texhong’s cotton costs initially stay the same because it holds 100 days of cotton inventories. The company therefore sees a spike in profits, which has historically sent the stock higher.

Some sophisticated investors have argued that rising cotton prices do not benefit Texhong beyond this temporary blip because prices of yarn are set using a cost-plus formula. But counter-intuitively, this is not strictly correct. While Texhong’s cotton costs do eventually rise 30% in Q3, the company has access to cheaper cotton and so even though the percentage increase is the same as the increase in prices, the absolute increase is lower. (Prices have increased by RMB 14,000/mt x 30% = RMB 4,200/mt whereas Texhong’s costs have increased by only RMB 12,375/mt x 30% = RMB 3,713/mt). In the end, Texhong does retain some of the benefit, although this typically gets eroded further over time as cost changes filter through the supply-chain.

The stock, however, has typically been driven by retail investors who overreact to short term changes in profits. The table below compares how the stock has behaved every time international cotton prices have moved +/- 30% over the last decade. 

Texhong is not only fundamentally undervalued and experiencing underlying strategic improvements, it is benefiting from the incredibly strong macro conditions of near record cotton prices, an economic rebound, and strengthened RMB. 

We expect that record profits in March will act as the catalyst for the stock to catch up to the company’s short term and long term results.

Catalyst

Record profits this year.