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TMFMmbop (36.05)

Short Cogo Group

Recs

5

June 04, 2009 – Comments (5) | RELATED TICKERS: COGO , CHL , CHA

It’s Thursday. It’s the morning. This is the CAPS Champion of the World Contest official idea #4. If you’re not signed up to play, do that here. *waiting…waiting*

Signed up? Good. Let’s dive into the pick…

Short Cogo Group

Thesis
Following a 200% rise since November, Cogo Group (Nasdaq: COGO) has gone from woefully undervalued to woefully overvalued thanks to optimism surrounding the rollout of 3G in China and what that means for handset makers. But while Cogo should benefit a little bit, 9.5x EBITDA is far too much to pay in this environment for a middle-man commoditized parts supplier. That premium looks even more absurd given that 3G uptake in China at China Mobile, China Unicom, and China Telecom has by all accounts been much slower than anticipated with consumers citing the high cost of changing handsets (according to survey data from Hong Kong’s Yuanta Securities) as one reason why they’re holding off on making the switch.

Company description
Cogo Group is a China-based company that designs and sells module solutions using established technology (think cameras, Bluetooth accessories, LCD displays, wireless stations, switches) for new electronic products such as cell phones and laptops and for telecom infrastructure primarily in the Chinese market. Cogo is a key parts supplier to Chinese handset manufacturers such as Huawei, ZTE, and Lenovo who are happy to outsource the manufacture of commoditized parts to Cogo so they can focus on designing and manufacturing high-technology and unique value-adds. Cogo’s position in this niche is thanks to company founder/CEO Jeffrey Kang who has the relationships with the Chinese companies that allow Cogo to win business. While this is an ingenious, asset-light business model that helps OEMs speed time to market, it’s also the classic middle-man who will be the first along the value chain to see profit margins squeezed if consumers (as they are today) are feeling pressure on their wallets and pocketbooks.

Valuation
At more than $7 per share, Cogo trades for more than 27x earnings and has an EV/EBITDA ratio of more than 9x. Those multiples are high given the mediocre quality of the business here and have not yet incorporated findings that the rollout of 3G handsets in China has been much slower than expected. Further, while the company’s $108mm in net cash ($2.75 per share) gives shareholders a sense of security, the fact is that this cash will likely never be paid out to shareholders. Rather, it will hoarded until it can be used to make an acquisition at will, I suspect, be at somewhat inflated prices.

But even if we net the $2.75 out of the share price, a $4.25 value per share on the business implies (at a 14% discount rate) 16% annual revenue growth over the next 10 years at 5% EBIT margins. That seems excessive to me, and I don’t expect the company to achieve those expectations. Bulls will argue that we should expect much higher profit margins, but I can’t see that given increasing competition, the rising costs of manufacturing in China, and the company’s middle-man status.

All told, I put fair value here (including cash) at $4.50 to $5.00 per share. That means at least 30% downside from here. Put a red thumb on this one and watch the points roll in.

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5 Comments – Post Your Own

#1) On June 06, 2009 at 3:44 AM, MoneyCraft (34.64) wrote:

Hi,

Obviously you are looking at the half empty of the glass, and have few inaccuracies.

1) According to conf call, company cash position at $3.35/share.

2) Edgar Online had the number of shares at 35,929,788 (and 37,264,100 fully diluted). Not sure if your calculatios are based on 39.58M as indicated in Yahoo/Google (not sure if it's Edgar typo or whatever).

 3) According to Edgar filing,balance sheet shows $108M cash, $17M pledge bank deposit, and $65M accounts receivable. If you add all you'll get over $190 in tangible assets (not including inventories) - should we say cash equivalent?

4) Shareholder equity (book value) = $248M which translates (even assuming 39.58M shares) to $6.25/share. Don't you think it is worth that much at least - I remind you this is a profitable business!

According to company, 15% gross margin and 10% operating margin have bottomed out.

Sales growth unlikely to reach 50% growth (seen in the past years), but it's not it's going to single digit either. In fact according to Conf call, company couldn't capitalized on its potential due to shortage of raw products.

 Your suggested fair value of $4.50 (with the exception of recent economy turmoil) gets us back to prices not seen for more than 4 years.

You are not serious, right?

 

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#2) On June 06, 2009 at 10:29 AM, TMFMmbop (36.05) wrote:

On the cash per share calculation, I was using the weighted average diluted sharecount for the trailing year, which as you point out, does not give them credit for recent repurchases. So we can increase that to $2.91 (108.7/37.3). I’m skeptical of things like “pledged bank deposits” on Chinese balance sheets, and given the customer base here, I don’t have aggressive expectations about receivables collections, so I will choose to continue to omit them from the equation.

We can disagree on the opportunity here, but I basically see a not-very-profitable business that’s relationship based that will likely go out an spend money on some kind of acquisition. If you expect the company’s book value to generate value at at least a 1:1 ratio, then you need to have confidence in their strategic acquisition team. When it comes to China, I try to be more skeptical. 

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#3) On June 07, 2009 at 3:49 AM, MoneyCraft (34.64) wrote:

1) Read the transcript of their recent earning release. They have $3.35/share in cash. I quote: "...Therefore our total grew by about 8 million sequentially to over 125 million, currently equaling about $3.35 per share..."

2)  Even if they capture 55-60% of their receivables (and I don't see why they can't have it all), it will add another $1/share in cash.

So that's already bring their total cash position at $4.35/share (at the bottom end of it).

3) You pointed out their "middle-man status" as a negative, but  should realize that is what makes them a very agile company. No manufacturing cost, no invenstories. As simple as it is they buy, costomize, and sell based on what customers want.

4) In my opinion, being a middle-man gives them an excellent visibility into market trends (their comment in that regard proves my point). They know exactly what customers want and they provide it to them with added value for a 15-20% cut. With growing market such as china, the economics of scale gives them a potential to become a money generating machin.

5) Their agility allows them to tap into areas they haven't gotten into yet. The Mega Smart purchase gives them an excellent opportunity to tap into the expected mega billion dollar of the Chinese replacement of old electrical meters.

6) I fail to understand how you don't see a very profitable business here, where in fact this is one of the very few Chinese companies which is profitable (even in an economy as bed as we've seen). Remember growth always comes at a cost - so don't  confuse a negative quarter or two for a losing business.

7) One of the great value propositions of a business is the ability to generate recurrent revenues. You can tell they are broadening their customer base - which tells me that Sales & Marketing as percentage of revenues will likely shrink over time, thereby increasing growth & profit margins.

8) From a technical analysis perspective - the stock seemed to establishing a base around the $6.60 area. They've been trading sideway with a moderate uptrend since the beginning of 2009 (hit $6 on begining of Jan 09). Remember many stocks have tripled or more since the lows in March 09. I believe if there's any downside pressure it will sooner rather than later subside.

The EMA 50 line is higher than the 200 average which is viewed as positively for any growth company.

Finally, I think it would be a mistake to short this stock. If at all I would wait another couple of month to make such a determination. They should be able to give a good guidance into Q3.  At the end of the day - I can see the stock trading at $9-10 /share and reaching $13-15/share sometime through the middle of 4Q.

Time will tell.

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#4) On June 08, 2009 at 11:32 AM, TMFMmbop (36.05) wrote:

Good article in China Daily today about the near-term prospects for 3G in China: http://news.xinhuanet.com/english/2009-06/08/content_11508608.htm

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#5) On June 08, 2009 at 6:16 PM, padparadsha (< 20) wrote:

I agree with MoneyCraft;  this is a very solid and profitable company servicing the big Chinese (international) telecoms like ZTE & Huawei; companies showing huge revenue increases so far this year.

Cogo Group's acquisition of the smart meter company will prove to be a very clever move in my opinion.

I think the  heavy emphasis on 3G in your analysis is a mistake, few have really expected any meaningful 3G revenues for COGO this year although they will of course benefit from it later (2010).

I recommend you listen to the conference calls;  management comes across as clever, focussed and maybe most important : trustworthy.

The price can go anywhere in the short term but i think this is going to be one of the winners in China. I will never be short ...

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