Friday, June 6, 2014

Texhong Texile Group - Yarns

Background 


This is a gross profit story. I'm going to work backwards from the notional bear case to the opportunity. If you don't know Texhong, this write up is a good place to start. 

Texhong's competitive advantage and earning power are presumed to rest in large part on the difference between international cotton prices (for which "Cotlook A" is a proxy) and domestic Chinese cotton prices ("CC 328"). That spread is narrowing and the market's view -- as reflected in the share price, articulated nowhere -- is that Texhong's earnings and competitiveness will therefore be eviscerated. 

One can see the notional bear case illustrated as follows:
The spread has widened...

 Note: Texhong holds 90 to 100 days of inventory so I have offset the cotton prices above in order to better match cotton prices/costs to Texhong's reporting periods.

Vietnam's share of Texhong capacity has grown...



and therefore earnings have quintupled on a mere doubling of total capacity...



... QED.

I am taking the other side of the argument. I doubt gross margins can fall to anywhere near the level implied by the current market cap and I think they will be higher in 2015 and beyond than they were in 2013.

Texhong Deconstructed: A Simple Model


If one assumes that all of the Vietnam capacity is used to produce cotton yarns that are then sold in PRC -- i.e. that the company has taken maximum possible advantage of the cotton price differential -- everything else falls into place. 


This is what we can surmise/conclude about Texhong's cost structure:


Therefore:


That's the base. I'll emphasize here that there are thousands of grades of cotton and thousands of varieties of cotton yarn, each with their own costs and prices: "Cotlook A", "CC 328", and "ASP" are averages and approximations.

As a reality check, one could go back to 2007 when Vietnam was a mere 2.2% of capacity and compare the consolidated gross margin to the PRC margin presented in this model.  

2014

Using the unit economics illustrated above, and applying consensus ASP and cotton prices expectations to the Texhong's realizable capacity in 2014 gets one to the following:





and therefore:


PRC gross margins expand and Vietnam gross margins shrink.That's not surprising. But if the dominant narrative in one's mind was that Texhong's strength lay in its arbitraging of the cotton price differential, the fact that the consolidated gross margin does not move when the spread is halved is going to seem both counter-intuitive and wrong. (And, if I may be so bold, reading this once is not going to do much to dispel that sense of implausibility; one has to reconstruct the unit economics for oneself to believe in its implications). 

At ~19% consolidated gross margin the equity earns $HK 1.70 and pays $0.50 in dividends in 2014, and $2.33/$0.70 in 2015. This is consistent with management's guidance in April of a 10% earnings margin for 2014.

Margin of safety

The margin of safety is defined by the gross margin that would prevail if the cotton price differential disappeared altogether: 14.7% for cotton yarn, 16.6% for synthetic yarns, 8.8% for fabrics, implying a consolidated gross margin of 15.7%.


This is consistent with HK$0.86 in 2014 in earnings and a $0.26 dividend in 2014. The return on capital at this gross margin is 15% and improving. That's important because it implies that Texhong would grow its way to higher MOS values. 

So anyway


Why this stock? It's volatile, it's cheap, it's well-watched; and I (think I) understand the reason for the sell-off. If I'm right, therefore, the share price will triple in short order, probably upon publication of the 2014 full year results in March 2015.
 
Also, the owner-operators are, upon the available ten year record, as smart, young, entrepreneurial, and honest as one would like them to be. The company pays out 30% of earnings and grows via debt and cash flow rather than by raising equity. The "runway" is long and well-lit – with or without the Trans Pacific Partnership. When things get bad, Texhong buys failed competitors, when things go well it makes lots of dough.


Disclosure: I own Texhong shares. Do your own work.

48 comments:

  1. How did you get volume of yarn sold? Did you just look at spindle numbers in Vietnam and China and total yarn sold and estimate it from there?

    It's kind of funny that the company earned 750M HKD from China alone (okay 500M HKD recurring) and the market hardly assigns a fair multiple to just the China business alone.

    Also take a look at Texhong's competitors like Pacific Textiles and Texwinca Holdings among others. They have operations mainly or entirely in China and they have margins and ROIC/ROEs that are almost equal to or even greater than Texhong. The company is definitely not dependent on the spread between world and Chinese cotton prices.

    Very good piece. Although I'm having a hard time following it, it seems thoroughly researched and analyzed

    ReplyDelete
  2. Hi Cameron,

    For example, on p20 of the 2013 AR you have revenue and ASP by product category and revenue/ASP = volume sold.

    Pacific Textiles and Texwinca are imperfect comps, imho. In fact, part of the charm of Texhong is that it has no listed comps.

    ReplyDelete
  3. If you were asking about the China/VN distribution, I used capacity numbers (i.e.) spindles and 240 tonnes per spindle.Texhong operates at full capacity and its capacity expansion has been demand driven.

    In order to maximize the cotton price arb effect, I assumed that all the VN volume was sold into China.

    ReplyDelete
  4. Thoughts:
    What if the RMB appreciates dramatically?
    What if there is a drought in China?
    What is the Indian rupee (competition) or Pakistani Rupee depreciate more?

    This thesis reminds me of Dexter Shoes, and Indian textile guys as they got wiped out by a massive appreciation in INR and fall in global demand and rise in Chinese production ~3-5 years ago.

    ReplyDelete
  5. I think part of their edge comes from the fact that Chinese textile industry is very outdated and fragmented. I think profit margins in China were almost twice as high as the general textile industry.

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  6. Tirath,

    Some people are philatelists and others spot trains. I collect references so Dexter Shoe Co so I'm especially pleased that you chose that over the more obvious Berkshire Hathaway analogy.

    ReplyDelete
  7. When I compared it to the buffett Dexter and berkshire story, one thing springs to my mind. These guys have operations in already the cheapest parts of the world, they are very low cost.

    They are also very well managed. So other low cost competition has either lower scale, worse management or is not as well capitalized to keep up with new cheaper manufacturing technology.

    So I dont think they are very comparable.

    Plus it seems the bigger guys can buy up smaller guys in bad times for a bargain. Reading all the AR's it seems like mr Hong watches what he pays for equipment.

    ReplyDelete
  8. John, forget about Dexter & Berkshire. This is how message boards deteriorate into nonsense: someone who's done no work throws out a non sequitur and that red herring prevents useful information sharing.

    Each company should be evaluated on its own terms. Texhong is not for everyone but it's worth spending more time on than Tirath has.

    Your comments accord with the evidence I have seen.

    ReplyDelete
  9. Hehe yeah your right. What do you mean by 'not for everyone'? I never get that comment. An investment either fullfills certain requirements or not. It seems with valueinvesting you tick boxes, and this one ticks a LOT of boxes right.

    If this investment is not for a certain person, then that person has some biases to clear up right?

    But what gets you comfortable enough to put 25% of your money in it? It is my largest position, but I am always too afraid I am missing something to put in more then 10-15%.

    According to kelly betting strategy this one should be a v large position tho. But I guess you also have to sleep at night?

    ReplyDelete
  10. Thanks for the post on Texhong, Red. I'm also curious to hear the Lanesborough story. It's balance sheet looks juicy and it's trading at an unusually low market-cap.

    ReplyDelete
  11. "Not for everyone" -

    Well, Texhong is a bit of a jigsaw and putting a puzzle together is not everyone's idea of a good time.

    As long as one has a process that's safe and works reliably to beat the market, the important thing is to keep investing -- i.e. the important thing is to enjoy oneself.

    Plus, knowing what one needs to know about a business like Texhong is more important than what one knows about it. So a post that reduces everything to one variable -- the cotton price differential -- is going to seem naive. (even more naive, paradoxically, than a post which says it trades at P/B of X when its ROE as always been 3X and therefore it's cheap". Knowing what one needs to know is not easy and probably requires some experience.

    --

    I'd rather not have 20% of my PA in one stock. There are probably hundreds of stock out there that will double over the next year and, if 90% of them are lotto tix, that still leaves dozens that are are proper value investments.

    I don't work hard enough and am not smart enough to spot or recognize more than a one or two in an ordinary year so I try to make the most of the ones that I do spot.

    ReplyDelete
  12. I saw you own Emeco. You might want to check out ACW. It is a similar story: cyclical, similar debt, but more upside and less risk imo. And a better company. Cycle is replacement driven instead of macro driven. And replacement is very due. And insiders own more.

    ReplyDelete
  13. Nice,I'll have a look. Thanks

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  14. Had a quick look: cycle average revenue 900 x 17% EBITDA margin = ~150 @ 5x multiple => 765 EV less debt & pensions = > $7.70 stock.

    Is that more or less the idea? Or do you have a higher cycle average revenue number in mind?

    ReplyDelete
  15. gross margins will be 20-30% (depending on segment). If they get back up to 1 billion$ in revenue if average age ticks down (over 10 years for medium trucks and 6.5 years in 2013 for class 8 trucks), then they could do around 200 million$ in FCF.

    Their wheels segment has a new product with coating that makes em last almost twice as long. They have 7 year exclusivity on it.

    average age of class 5-8 trucks are at all time highs. I recommend reading presentation, and reading several quarterly calls. And there is also about to be a supply shortage of new trucks.

    Plus new medium trucks are almost 20% more fuel efficient then 10 years ago (the average age on the road right now).

    And they also have some cost cuts left to do, so if they pay off debt, they could do 50 million in FCF if the fleets arent aging.

    2 Hedgefund have large stakes in this, and insiders have been increasing their stakes over the years. And the replacement cycle is really due.

    http://www.cornerofberkshireandfairfax.ca/forum/investment-ideas/acw-accuride/

    and also recommend reading the VIC write ups on it.

    You dont have downside protection from assets, but I kinda doubt that is the case with EHL either after the recent 50% write off.

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  16. Hi John,

    May I know where you obtained the information for Cotlook A Index and CC 329 from?

    Tried searching but only seems to find those monthly information.

    Thanks

    ReplyDelete
  17. Thomas,

    I'm not John but you can find what you need here:
    http://www.china-cotton.org/english/ccindex_more.php?offset=1440

    and
    http://www.indexmundi.com/commodities/?commodity=cotton


    --

    John, I appreciate the heads up & I'll look into it.

    ReplyDelete
  18. Red,

    I'm so sorry! Thanks.

    Thomas

    ReplyDelete
  19. Hi Red,
    Thanks for your interesting piece. I tend to agree with your analysis that 2014 numbers will be good (and most probably 2015 and beyond as long s the price differentials diminish slowly).

    However, in the case of the elimination of the price differential there is much less margin of safety than you estimate. Specifically I think that an ASP of 21,442 for the “Margin of Safety” scenario appears to be overly optimistic. A Chinese producer would then earn 21,442 – 13917 = 7525 ( 35% margin) versus 25,859 – 19,144 = 6,728 (26% margin) currently.

    In a highly competitive commodity business with falling material costs one would expect constant margins or constant unit profits at best. This implies to ASPs in the range of 18,811 (constant margin of 26%) to 20,645 (constant unit profit of 6,728) with the low end of the range being more likely. Gross profits in your case would drop to 688 (7% gross margin) to 1337 (13% gross margin) with values at the low end being more likely.

    In my view the investment case comes down to one’s opinion on how quickly (if at all) the price differentials will vanish.

    Interested in your response
    Cheers
    Max

    ReplyDelete
  20. If you look at the stockpiles of cotton in China, they are still very large, so it is unlikely it will dissapear within the next year.

    Secondly, part of the cotton is imported from outside China. The tariff on this is still in place. China needs to protect the farming population (for obvious reasons).

    So I think there will always (or at least in the next years) be a price difference, it will just be smaller then the past several years.

    They are now going from buying the cotton from farmers to subsidizing the farmers instead. But still, part of the cotton has to be imported, and the import tax still exists, up to 40%.

    ReplyDelete
  21. Hi red,
    don't you think the market view is also incorporating the current dispute between China and Vietnam over the oil rig, and the fact that many chinese factories in Vietnam were targeted by riots, some of them damaged, and some of them stopped...
    G.

    ReplyDelete
  22. the company just issued a profit warning for this years interim results , citing lower yarn price and depreciating rmb

    ReplyDelete
  23. Max,

    Thanks for the thoughtful feedback.

    If a reduced spread doesn't improve the margins of domestic producers,the implication is that a wide spread didn't crimp their margins in the first place. That can't be right (and it isn't right).

    Important to distinguish between falling prices and narrowing spreads, imo.

    I also don't think it useful or accurate to characterize yarn as a commodity business but that's a side issue.

    ReplyDelete
  24. G,

    Maybe. Insurance and tax concessions from the VN government should make up for any losses. Yarn/Textiles is a privileged industry in Vietnam.

    ReplyDelete
  25. Hi red.

    Yesterday a profit warning came out by management, today the stock is up over 5%.

    Can you make any sense out of this? Does the profit warning contradict your hypothesis (which I found very well constructed by the way)?

    ReplyDelete
  26. AndreS,

    There are two things going on:

    1) Texhong carries 90-100 days of cotton inventory so cotton bought at higher prices three months ago is not going to fare well when ASPS fall today. The interim results won't look pretty and deserves a profit warning. (You can see this play out in extreme form in 2011. And the opposite was happening in 2010: ASPs rising because the spot price of cotton was rising while Texhong still had "old" lower price cotton inventory).

    2) in the longer-term, what one would call "run-rate", lower ASPs will correspond with lower cotton prices and I believe my thesis will play out as expected.

    So I suspect that the price action may have something to do with the interplay between year ahead performance money and patient capital.

    ReplyDelete
  27. Thanks for taking the time to spell out the case Red.

    I've a question about ASPs. I presume these historically look something like the Chinese cotton price plus a relatively constant premium, but haven't been able to find any yarn pricing data to confirm or deny this theory.

    Secondly, what is the source of the undisclosed ASPs that you used to determine revenue in the second table in the 2014 section?

    Similarly how did you arrive at an ASP of 21,442 in the final table?

    Thanks in advance.

    ReplyDelete
  28. Fraser,

    I've linked to the data that I have found for Texhong's ASPs going back to 2007.

    The 2014 ASPs are 1-for-1 reductions wrt to the price of cotton. So, for example, if cotton prices* fall by 1000 RMB/tonne, I assume that cotton yarn ASPs also fall by 1000 RMB/tonne. (i.e. the savings are passed on to the customer).

    *Bearing in mind that Texhong's domestic operations use both yarn priced at domestic spot and yarn imported via their allocated quota. So Texhong PRC's effective cost of cotton is an average of those two different prices.

    ReplyDelete
  29. Oops, Link here:
    https://docs.google.com/spreadsheets/d/1OzqP8RbEcndv6nf6kw8ETL0w-KoZSBDE3aYtZqolLm4/edit?usp=sharing

    ReplyDelete
  30. Great thanks Red. Really appreciate you taking the effort. 6000RMB looks like a reasonable assumption to use as a cotton-yard spread.

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  31. Where did you pull the capacity (in tons per year) going back to 2007?

    The company only seems to list capacity in # of spindles, with only a brief mention in the AR about capacity reaching "32,000 tons per month on average" by end of 2013.

    But your numbers are exact, including the breakdown between Vietnam & China. Source document?

    ReplyDelete
  32. There are various analyst reports out there that list capacity and location.

    Or you could reconstruct it from the various statements about capacity in the ARs and the debt prospectus

    Revenue/ASP = production,which at full capacity = capacity

    Let me know if you can't get hold of an analyst report and I'll place one in the cloud.

    ReplyDelete
  33. Hi Red,

    Very nice model and analysis.

    (1). I was trying to calculate the valuation of this stock by looking at the long-term average ROE. Looks like the asset turnover ratio has dropped in last year, the financial leverage is more constant. The net profit margin varies a huge lot over the past years due to the volatile gross margin. Since this company has relatively low cost structure in the industry and by looking at its historical performance with/without the production outside China, I assume a base case can be 15% gross margin which translates to about 7% net profit margin. The long term ROE can be around 20%. Does this make sense to you?

    (2). The industry is quite fragmented. With 2 million+ spindles in the near future, it will become one of the largest companies in the industry, but still a small percentage of the whole market. Due to the volatile nature of this industry, I guess it may be wise to expand prudently instead of aggressively. What do you think its growth potential in the next several years?

    (3). One major risk is that it is still a commodity industry. The performance of the company depends a lot on the cotton price trend which is hard to predict and to hedge. Companies in the industry have little bargain power over the upstream cotton suppliers and downstream fabrics/clothes makers. I guess it may be a good idea for it to extend the industry chain, e.g., enter the downstream business to enjoy better margins and to make the profits more stable. What do you think?

    Thanks,
    Sam

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  34. Sam,

    1) 15 and 7 makes sense

    2) The owner-operator is targeting 10 million spindles by the end of the decade

    3) I have my doubts about whether this is in fact a commodity industry but the company's next step in Vietnam seems to be vertical integration, just as you suggest.

    Also, the production facility in Turkey (start 2016) is a JV with a customer.

    ReplyDelete
  35. Hey red.

    any chance you could upload one of those analyst reports? Seems I'm having a hard time finding a good one on Bloomberg.

    Andre

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  36. Sure

    https://www.dropbox.com/s/c7rii1vvpzkhzjj/Texhong%20Materials%20-%20for%20Web.zip

    ReplyDelete
  37. thanks for posting. How do you have access to these reports? Through bloomberg or something?

    One thing I dont understand about this one is how does the TPP affect this one positively? There is no price spread in cotton between vietnam and the west right? Do they get a much bigger premium for value added products in the west or something?

    ReplyDelete
  38. Sorry for the delayed response - i was traveling.

    I don't have a Bloomberg. Embarrassed to say that I don't know enough about its features to evaluate its cost effectiveness. I googled for those materials, starting from last summer when i was intrigued by the contradictions in the VIC writeup.

    TPP - it's not about cooton prices but about tariffs on garments.

    When VN joins, it can export to the US & other members free of tariffs, which increased its addressable market. Also, if the yarn forwarding rule is included, as VN wants it to be,PRC yarn will essentially be classed as VN yarn. US textile industry association estimates that VN share of US textile consumption would grow from ~7% to ~30%.

    Both developments would benefit Texhong since fabric/garment production in VN would explode and Texhong is best placed to supply yarn to satisfy this increased demand.

    ReplyDelete
  39. Thanks for the interesting blog and idea, always good to read posts that are thought-out.

    Just a quick question that relates to other similar situations as well, where the stock is listed in currency X and reports in currency Y. I'm wondering if there's a reason you decided to convert to HKD (stock's currency) instead of just converting the stock price to renminbi/CNY (which I feel is a lot more simple)? Is there any reason why converting the stock price is not a good idea? I appreciate the help on this small question.

    ReplyDelete
  40. Hi red,

    Thanks for your reply.

    I have read your article again and have a few questions about your model:
    (1).It seems you set cotton to yarn conversion rate to be 1:1, i.e., it takes 1 ton cotton to produce 1 ton yarn. Is it accurate? I haven't found the exact numbers but some articles say it takes around 1.1 ton cotton to produce 1 ton yarn; the conversion ratio depends on the types of yarn and cotton. This may change your cost and gross margin estimates.
    (2).How did you get the non-cotton cogs? Did you just use the average cost multiplied by the percentage of non-raw-material costs shown in annual reports? However, raw materials are not just cotton, which makes it hard to calculate a more detailed cost structure.
    (3).You have set the cotton sourcing of domestic and imported via allocated quota to be 50% each. How did you get this number? Some industry news reported 3:1 ratio in industry, but I can't find the exact percentages used by the company. Again, this number may change your model results.

    Btw, in your reply, you mentioned the long term 10 million spindles target. Where do you find this number?

    This is a nice article. Thanks.

    Sam

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  41. Eepi - buying the stock "entitles" you to a dividend stream denominated in HKD so the share price is going to be pegged to that. If HKD/CNY moves, your present value of that stream will move with it.It's worth doing a sensitivity analysis at different exchange rates.

    Sam - the debt prospectuses in the dropbox materials above give cotton cost as a % of gross profit and one then can calculate cotton cost per per tonne of yarn and things (non-cotton COGS etc) play out from there.

    Sorry for the brief replies but I'm on vacation

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  42. Hi Sam,

    Let me try answering question no. 3. While there is a quota for imported cotton(raw material form), 4:1 ratio as imposed by the Chinese government recently. There is, however, no quota imposed on imported cotton yarn(value-added cotton).

    Red's cotton sourcing datafor 50% of imported cotton for China might be referring to cotton yarn.

    Thomas

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  43. Red,

    Could yo please comment a little bit these news:

    http://www.texhong.com/Public/Uploads/539694df75674.pdf.

    They are expecting a drop in their results because of the decline in the cotton price.

    Sorry for my english, I´m writting you from Spain.

    ReplyDelete
  44. David,
    See the discussion of Texhong in my newest post.
    http://quinzedix.blogspot.com/2014/06/ordem-e-progresso-half-time-report-part.html

    -- 90 days of cotton inventory
    -- Cotton bought 3 months ago is being sold at lower ASP
    --> Temporary compression in gross margin

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  45. Hi Red.

    Have you exited (part of) your Texhong positions @ $6.4?

    Is it because you anticapite better entry prices after the interim results?

    Jeff

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  46. Jeff,

    Yah, I think it goes down before it goes up. I've been trying to move into high beta stocks so that I can take advantage of that volatility. H1 will look terrible and low float plus weak hands could see this thing trade down to $5.

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  47. Congratulations, Texhong really seems to be playing out so far.

    -Andre

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  48. Lucky to have worked on it before the events played out. Here's to H2.

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