China Chaintek United Co Ltd

China Chaintek United Co Ltd

Headline

• China Chaintek is a deep value opportunity offering limited downside risk with significant upside potential
• The company's share price closed at £16.50p as at 17^th of August 2015; a fall of 82.63% over a year
• The stock has fallen significantly lately, mainly due to the 25% fall in revenues reported in Q2 2015 stemming from the slowdown in China. Although the trend of falling revenues and profitability is likely to continue for the foreseeable future, it appears that degree of fall in the stock price provides a value opportunity with a good margin of safety
• The current stock price equates to a c80% discount on a net-net basis (current assets less total liabilities); and, a discount of c90% on an NAV basis. Broadly, if the company were to be wound up, and proceeds distributed to the shareholders, even assuming only 50% of the liquidation proceeds go to shareholders, this would generate c2.5X – c5X current share price (see Balance Sheet valuation below)
• Even on DCF basis, after allowing for a 50% fall in revenues over the next four years, including significantly reduced operating margins, and, allowing for a high Reinvestment/Capex rate, the Company looks to be priced at a 80% discount (see DCF valuation below) 
• In addition, the fact that the company is largely (c68%) owned by its two (husband & wife) promoters, who have significant skin in the game and experience of the China logistics sector, offers additional margin of safety
  
  
• Therefore, China Chaintek looks to be a deep value opportunity offering significant upside potential, with limited downside risk due to its attractively low stock price. However, the stock is likely to see significant volatility over the short to medium term. This investment thesis is predicated on a long-term hold (at least 1  to 2 year) 

  Brief Background & History

• China Chaintek is a provider of logistics services to manufacturers of consumer goods
• The Company operates through its two business divisions:
  • Logistics Services Division: Provides logistics connections between the Group’s manufacturer customer base and their retail markets in the PRC using a network of eight independent transport agents. The Company aggregates finished goods for third party haulers, to maximise load and reduce per unit transport costs for retailers. The Company claims to achieve efficiencies for both the transport agents and the manufacturers by consolidating the goods of several manufacturers to be delivered to similar destinations at the same time. The Company collects 25% of the delivery fee earned by the transport agents. The Logistics Services division accounts for c85% of the Company’s turnover
  • The Inventory Solutions Services Division: provides inventory storage and management services including sorting, packaging, labelling and short term storage; an activity that began in 2010 in response to customer needs. This division accounts for c15% of the Company’s turnover. The company seems to have started this division with an aim of further entrenching itself into its manufacturing customers’ value chain. Considering the capital intensive nature of this business, it is unlikely to attract good margin’s as compared to the Logistics Services Division. Also, some of the woe’s inflicting the company of late seems to have arisen due to its foray into this business – see below under ‘New Logistics Park mess’

• The Company was formed by Shufang Zhuang and Meijin Xu when they created its operational subsidiary, Xingtai Logistics in 2000, principally to provide domestic logistics services to fast moving consumer goods manufacturers in Jinjiang City, Fujian Province, where the Company’s main business operations are headquartered
• Jinjiang City is a major manufacturing centre where approximately 70% of the entire production volume of sports shoes and apparel in China is produced. The promoters, who are a husband and wife pair with over 40 years’ combined experience in the logistics industry, started the business to tap into the growing need for smarter logistics – with the aim of offering a cost effective outsourced service connecting the manufacturers with transport agents
• All the Group’s logistics’ customer are based in said to be based in the Fujian Province, in close proximity to the Company’s own operations. The Company claims that 7 of the Group’s top ten customers are listed in one or other of the stock exchanges of Hong Kong, Singapore, the PRC and the United States
• The Company was admitted to the AIM market in August 2012 and trades under the ticker CTEK:LSE
• The promoters – Shufang Zhuang and Meijin Xu – hold c67.6% of the company, with the remaining held by other minority shareholders and the public

Historic financial performance

Strong historic operating performance

• The Company’s historic income statement for the four years, FY2011 to FY2014, is shown in Appendix 1. The key highlights are as follows:
• The Company grew turnover by 8.47% CAGR over the period;
• Of particular interest is the strong Gross Profit Margin (in the mid 80%) and Operating Margin (in the mid/high 70% range) shown by the Company

Healthy balance sheet

• A brief overview of the Company’s 2013/14 balance sheet is provided below
• During this period, the Company was also generating significant free cash flows, growing its cash pile from RMB 98m in FY2011, to RMB 472m in FY2014. The company, in its H1 2015 earnings, reported a cash position of RMB 514.1m as at June 2015
• The company has no external borrowings

Current and future forecast

The China downturn

• The company gave an indication of the difficult trading conditions in its Q1 2015. This has continued to Q2 2015, where the Company has announced a 25% fall in revenues year to date. The operating margins have fallen by c6% to c75%.
• Management has sounded a cautionary note about market conditions, which have significantly worsened during the period under review.  The effect of downturn in retail sales in the shoes and apparel sector is now starting to bite.  Many of the Company's key suppliers have been particularly hard hit by these conditions, with lower volumes combining with higher fuel prices to create the worsening trading conditions which have led them to seek better terms from the Company, resulting in the payment of the rebates.  Management are of the view that these challenging conditions are likely to continue for some time, with the corresponding effect on trading and margins.  
• However, the Group continues to be highly cash-generative, resulting in a cash position at the half year of RMB514.1 million (H1-2014: RMB411.6 million).
• In addition, the Company maintained customer levels in its logistics services business (covering sectors including shoes and apparel, food, building materials, textile and trading) with 10 out of the top 20 customers being listed companies. 
• The management team also stated that it remains focused on expanding capacity and growing its customer base despite the slowdown in the growth of the Chinese economy.

The New Logistics Park mess

With a view to significantly increasing its warehousing capacity, the Company in 2010 entered into a letter of intent with the People’s Government of Cizao Town, Jinjiang City for purchasing a Land User Right (LUR) on a piece of land of approximately 145,600m2. The LUR fee was RMB 273 million in total which the Company has fully paid for in December 2013 but is yet to obtain the LUR certificate to commence use of the parcel of land due to structural government changes in China, the formation of new government bodies and their effect on provincial policy. Consequent to the delay in the issue of the formal LUR Certificate, the Group has signed a supplementary agreement with the LDC dated 6 March 2015. This agreement confirms that the LUR in respect of the parcel of land specified in the initial purchase agreement is not now able to be obtained from the LDC, that the LDC is seeking to locate an acceptable alternate parcel of land for the Company and that the Group has the right to request full payment of RMB273 million from the LDC at any time up to the date that a formal LUR Certificate is issued by the LDC. In its Q2 trading update, the Company stated that it is pursuing a full refund of the RMB 273 million from the LDC.

However, despite the delays with the New Logistics Park, the Company’s healthy cash-generating financial position, has allowed it to continue expansion of capacity by signing leases on couple of warehouses/distribution centers over the last year. Based on forecast, the Company should be able to meet its capital expenditure with internally generated cash.

Valuation

Balance Sheet Valuation

As can be seen below, the Company’s current stock price equates to 21% of its net-net value (using only cash as the current asset). If one accounts for the LUR receivable from the LDC, and the other fixed assets that the company owns, there is a significant margin of safety on offer.

DCF valuation

 For the DCF valuation, I have assumed what I believe to be a highly conservative scenario:

1. Revenue falls by 50% for 4 years from FY15-FY18; thereafter, revenue starts raising, but only at a marginal rate of 3% from FY20-FY24; and, a terminal year revenue growth rate of 2% (the company's own estimate for FY15 is a revenue decline of 25%, and the Company looks to be on course for this based on its Q2 trading update)
2. Operating margin falls to 50% for FY15, and by 10% each year to 20% by FY18; thereafter, Operating margin stabilizes at 15%
3. The Company reinvest’ 50% of its cash flow in pursing capacity expansion and other growth initiative. In addition, I have assumed no value for the RMB 273m receivable from the LDC, assuming that all of any cash it receives back will be reinvested in capacity growth
4. Finally, I have assumed a significantly high cost of capital of 20%

The results of the DCF valuation is as follows

 

This conservative DCF valuation show the stock being priced at over 80% discount to value.

Conclusion

• At its current price, China Chaintek offers limited downside risk, with a significant upside potential. However, the stock is likely to see significant volatility over the medium term, and any upside is only likely to crystallise over one to two year horizon
• The fact that the company is largely owned by its two promoters, who have significant skin in the game and experience of the China logistics sector, offers additional margin of safety

Appendix 1 – Income statement from FY2011 to FY2014

China Chaintek
Income Statement	31/12/2014	31/12/2013	31/12/2012	31/12/2011
	RMB	RMB	RMB	RMB
Total Revenue	363,665,980	350,625,538	340,585,459	262,736,832
Logistics Services	313,277,490	303,685,617	293,758,400	238,735,518
Inventory solutions	50,388,490	46,939,921	46,827,059	24,001,314
COGS	(51,861,544)	(44,702,868)	(57,026,047)	(44,985,958)
Gross Profit	311,804,436	305,922,670	283,559,412	217,750,874
Gross Profit Margin	85.74%	87.25%	83.26%	82.88%
Operating expenses
Distribution expenses	(1,133,985)	(642,892)	(736,408)	(1,225,047)
G&A (admin expenses)	(24,629,064)	(21,327,814)	(32,532,210)	(17,573,673)
Total Operation expenses	(25,763,049)	(21,970,706)	(33,268,618)	(18,798,720)
Operating profit	286,041,387	283,951,964	250,290,794	198,952,154
Operating Margin	78.65%	80.98%	73.49%	75.72%
Other income / (exp)
Int exp
Int inc	1,333,460	886,954	617,125	257,419
FX gain/(loss)			1,063,550	386,408
Government Grant			1,550,000	0
Gain on sale of property		68,975
Profit before tax	287,374,847	284,907,893	253,521,469	199,595,981
PBT margin	79.02%	81.26%	74.44%	75.97%
Tax	(73,299,898)	(72,518,637)	(66,939,720)	(50,578,254)
Effective tax rate	25.51%	25.45%	26.40%	25.34%
Net income after tax	214,074,949	212,389,256	186,581,749	149,017,727
Net income margin	58.87%	60.57%	54.78%	56.72%

Appendix 2 – Balance Sheet (FY2014 & FY2013)

China Chaintek
Balance Sheet	31/12/2014	31/12/2013
	RMB	RMB
Assets
Non-current assets
Land use right prepayments	360,337,726	302,436,208
Property, plant and equipment	75,965,619	80,407,090
	436,303,345	382,843,298
Current Assets
Land use right prepayments	2,098,482	669,911
Trade and other receivables	95,098,771	97,188,052
Cash and cash equivalents	472,166,608	319,283,433
	569,363,861	417,141,396
Total Assets	1,005,667,206	799,984,694
Equity and Liabilities
Current Liabilities
Trade and other payables	11,477,171	11,733,085
Current tax payable	13,312,971	15,069,918
Total Liabilities	24,790,142	26,803,003
Capital and reserves
Share capital	382,249	357,254
Share premium	105,291,900	66,838,371
Merger reserve	(204,100)	(204,100)
Statutory common reserve	5,000,000	5,000,000
capital reserve	9,821,903	9,821,903
Warrant reserve	13,184,433	13,184,433
Retained Earnings	847,400,679	678,183,830
Total Shareholders' funds	980,877,064	773,181,691
Total Equity and liabilities	1,005,667,206	799,984,694