When I first wrote about Texhong I suggested that the low-end run rate gross margin would approximate 15.7%. The full year 2014 results seem to bear this out.
Remember that the company holds 30 days of inventory so that as prices fall last month's more expensive cotton is sold on at today's lower prices. It is the direction -- and not the level -- of cotton prices that matter.
This is what happened:
and this is the impact that it had on Texhong's gross margin:
One can also see its imprint in the balance sheet:
Now that cotton prices appear to have stopped falling, adding that back get us to this:
The next issue is that of the appropriate multiple to apply to these estimated forward earnings (or dividends).
First, Texhong will de-lever despite continued substantial growth capital expenditure:
Its bonds are publicly traded and rated by, inter alia, Moody's. An upgrade of the bonds ought also to improve the market ratings of the equity.
Second, this is a company with a history of domination, ambition, and profitable growth, and whose long-term outlook is no worse now than it has been in the past.
Third, I have excluded a number of free options: cyclical recovery in the PRC end markets, the Trans Pacific Partnership, lower operating costs (labor, utilities, taxes, distribution) in Vietnam, etc.
If 10x earnings is conservative then $15 is at the low end of fair value.
Disclosure: I own some of these shares
Thanks for the update. I saw that you had OPRX in your portfolio. It seems there are some interesting developments there, and some interesting stuff in latest Q call and 10k. In case your not following that stock anymore :) .
ReplyDeleteI'll catch up on it. Thanks!
ReplyDeleteThank you for the opdate. I followed you into Texhong a few weeks after reading your first post on it.
ReplyDeleteWhat i liked about Texhong - and still do - is the low risk this upside potential comes with.
thx for the update. a question or two. first, where are you getting avg. cotton prices? ive seen charts but not daily data.
ReplyDeletesecond, on the inventory effect chart: can you explain it in a bit more detail, how you get from the change in cotton price to the value of inventory to the ultimate RMB impact on gross profit? i cant seem to recreate the chart..
third, it looks like u are adding back 700 and 775m in cotton mismatches for the next 2 years. but if cotton prices are stable, why would there be an addback? shouldn't it be no major movements? or are you forecasting that prices increase and the mismatch goes in the opposite direction (i.e. positive)?
Latest daily data is behind a subscription pay wall.
ReplyDeleteBut daily data is unnecessary -- you can just eyeball the chart, make rough estimates and still come to some firm conclusions.
80% cotton content per tonne of yarn.
(Q-on-Q change in cotton price) X (tonnes of yarn sold)= financial impact. Do this for each Q, sum them and you have the financial impact for the year (i.e. ~617 million RMB).
617/(tonnes of yarn sold during the year) = financial impact per yarn tonne of falling prices in 2014 = 1400
Multiply 1400 by the number of MTs to be produced and sold in 2015 --> 500 X 1400 = 700.
That's the amount to be added back to normalize 2015 gross margins if you believe as I do that cotton prices have stopped falling.
very helpful.
ReplyDeleteany thought on the 3rd point - why cotton mismatches would boost margins in the next 2 years if cotton prices stay flat?
Sure -- it's the very heart of the thesis.
ReplyDeleteThe argument is as follows:
1. Texhong operates on a "cost plus mark up" business model
2. The default gross margin is in the 17% range
3. FALLING prices create a TEMPORARY mismatch between inventory cost and yarn prices
4. When yarn prices STOP FALLING the temporary mismatch (between historical inventory cost and current yarn prices) goes away
5. When the temporary mismatch goes away, the company earns its default gross margin of ~17% to ~18%
That's it.
Bonus (i.e. apart from the thesis laid out here):
If cotton prices RISE, then there is a reverse mismatch: temporarily lower cotton inventory is matched with now higher yarn selling prices and gross margin temporarily shoots up into the 20%s. (From memory,this happened in 2010-2011).
In which case the company earns a windfall profit until such time as yarn prices stop RISING.
Hope that's somewhat clearer than the earlier explanation that I offered.
ps.
ReplyDeleteSo what I've done in the blog post/chart is to add back the TEMPORARY mismatch of 1,400 RMB/MT (while cotton prices have been falling) to get a normalized set of numbers.
I've got a question regarding E. I cannot open their website www.enterprisegrp.ca (for weeks on end already). Even differents location / machines and proxy servers do not work. Can you open the website?
ReplyDeleteIt works for me, yes. See if this works better
ReplyDeletehttp://www.enterprisegrp.ca/financial-statements.php
Doesn't work either. I am now using archive.org as a workaround. I do not understand why I cannot open their site though.
ReplyDeleteI have the same problem. Im in the netherlands. Friends in various countries can open the website though, so Im not too worried.
ReplyDeleteHi Red, I am curious to hear your thoughts on Texhong's Xinjiang JV. The business rational makes sense to me, but I am wary of these types of arrangements...
ReplyDeleteThe debt covenant reason makes sense to me. Frankly, everything this fellow does makes sense to me.
ReplyDeleteTrue, I have been impressed with their ability to deliver the Vietnam expansion project, and also the fact they were able to stop the other expansion plans (Turkey?, Uruguay?) without incurring significant costs. On that basis, there's no reason to think they will not be able to handle a JV on the mainland.
ReplyDeleteVery pleasing to see the positive profit alert today - I was hoping for it, but great in any case!
Hi red,
ReplyDeleteAny particular outlook on the current market panic in China and how it might relate to Texhong? I guess it makes for a good buying opportunity assuming there is no spillover from the stock market stuff into the 'real economy'?
The real economy is what matters obvs; and sentiment is a gift. Texhong is a competitively advantaged, delevering, growth business that pays 1/3 of earnings out as dividends. : the longer we are made to wait for our payoff the higher that payoff will be.
ReplyDeleteHey Red.
ReplyDeleteI'm not sure that 10x is a reasonable multiple to give to this given the potential for the stockpile supported price floor risk inherent in Texhong. I'm disappointed that Max didn't see the need to comment back on the initial post in regards to his comments on your assumptions for margin of safety.
I would argue that in the short run your assessment of the affect on PRC producers would be correct, and you would see margin expansion in the case of a liberation of the chinese market. In the long run however, you should see increasing capacity investments in an uncoordinated and competitive market when producers are achieving supernormal profits, therefore erasing the margin expansion.
What do you think?
Cheers,
Trevor
what is your assessment on latest earnings release ? Seems a bigger pricing pressure on yarns then we thought? 11% lower then your estimate. You think there is a recovery in there somewhere? Im thinking of selling the whole batch, but maybe you got better info. I dont like to hold this now, as it basically seems like a gamble on the TPP, and that can still take a while.
ReplyDeleteHmm ok, it seems they were still holding a sizable amount of more expensive inventory? Inventory costs were 3.1 billion RMB. on 216k tonnes produced. But if you assume 13k or 9k (for US cotton) then I get raw material costs closer to 2.6-2.6b RMB. That would mean 22-23% GM. Is that right?
ReplyDeleteI'll be back from vacation & in front of a computer on Thur/Fr and I'll comment on this set of results then. In the meantime,
ReplyDelete(1) you can probably see from my model above that ASP pressure is not "the issue" (in fact ASPs are a little better than I expected) -- instead it is product mix;
(2) the earlier comment/thought that Texhong at this price is nothing more than a binary option on TPP passage is false in my view. There is enough information on additional capacity in H2 and in 2016, both 100% owned and via the new JV, to support EPS in excess of $1.60/share. Texhong's multiples outside of perceived crises ranges from 9x to 13x.
(3) The move toward vertical integration should not, I think, be taken too lightly: you can see what multiples vertically integrated textile cos can command and you'll remember that this fellow Tianzhu Hong both thinks things through and follows through as long as the EVA is there.
Finally, when the spurt of growth capex is over toward the tail end of 2016, this company should be producing quite a lot of FCF -- more than HK$1,200 per year -- thereby undergoing a material delevering.
Seems to me more interesting and productive to think about what a (proper) devaluation of the CNY does to debt service, export price of yarn, the pressure on HKD/CNY (or HKD/USD), Texhong'strategy, etc.
The gross margin issue is yesterday's narrative and sell side analysts should catch up and re-work their models & PTs in the next few days. Price may follow later rather than sooner, of course, esp in view of the turbulence in the HK equities market,.
Hi red, how concerned are u about the depreciation of the CNY? Couldn't this squeeze margins (i.e. with higher input costs on the Vietnam side but unchanged ASPs in RMB) while at the same time making the USD-denominated debt more expensive to payback?
ReplyDeleteiF China actually lets market forces price the CNY, a larger devalue (10%?) would have a very material impact on EPS...how do you think about this risk and do u see any mitigating factors?
Looking forward to your post reviewing the situation
Hi AVI -- I have put up a new post re: Texhong. Specifically wrt to your concerns, I think RMB devaluation is a wash on the operating side of things: yes, Vienam margins will be crimped a little but Vietnam is 60% of capacity and only ~30% of that VN capacity is sold on to China. On the other hand, the translation of operating results from RMB to HKD -- earnings and dividends -- will be proprtioately affected. I thnk that gets overwhelmed by the other developments listed in Texhong's outlook.
ReplyDeleteRe: the debt service. Obviously Moody's has stated that it wants Texhong to delever to 3x EBITDA and I think it will do that this year but I don't think its ability to actually service its debt is in question. Virtually all of its capex is discretionary/growth and it can de-lever quite quickly if it wants or needs to.