Short Cogo Group
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
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.
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.
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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