AI #8: How Asia's motorists could make you 60% in 2 years

How Asia's motorists could make you 60% in 2 years

Dear Subscriber,

Today, I want to show you the smart way to play the new Asian auto boom.

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I'm not about to recommend you get directly into the treacherous car making industry, though. For me that business is full of potential pitfalls we're better off avoiding.

But there are some businesses that should benefit well from the growing demand for cars in Asia. And I've found a stock that could more than double your money over the next two to three years.

However, first, I'd just like to give you a quick heads-up on my plans for the next few weeks.

I'll be travelling in Asia in October and much of November. The plan is to catch up with a few companies we might well end up investing in. And also just to get a feel for what's happening on the ground in some of our favourite regions. There's going to be a lot to report back on.

But this will be the first time I've tried to write Asia Investor on the road. I'm not quite sure how it's going to work out.

I'll aim to send you each issue as normal, fortnightly on a Tuesday. But because of meetings and flights, it 's possible that the schedule will shift around a bit. It's as well that you know that in advance. Of course, I'll let the team back at HQ in London know. That way, they can keep up to date if I'm facing delays

I aim to travel a few times a year and I'm still working out how best to integrate Asia Investor around those trips. So please bear with me. As ever, if you have any feedback you can drop me a line on asiainvestor@moneyweek.com.

Now, let's get straight into our new recommendation.

The greatest car boom the world has seen

If you want one chart that sums up the difference between emerging markets and the developed world, I think this one from UBS is a pretty good choice. It shows what's happened to car sales in the developed world and the top 25 emerging economies of the global economy over the last few years and what a gulf there is.

To be fair, quite a lot of the incredible growth in emerging markets is down to China, as the next chart makes clearer. Helped by government subsidies, car sales there have been growing at a spectacular pace up 60% year-on-year in August.

But many other markets are also doing pretty well. August sales were up 33% year-on-year in India and 35% in Indonesia, for example. In short, unlike western countries, these markets are by no means saturated. So it's no wonder that so many investors get excited about the potential of hundreds of millions of new consumers being able to afford their own cars in the years and decades to come.

I don't doubt that we're going to see a multi-decade boom in car sales in emerging Asia. And this story fits very well into the Asia consumer theme that is the core of the Asia Investor portfolio. But I have three reservations about trying to cash in on it by investing directly in the automobile industry.

First, cars are the biggest of big-ticket items the second largest purchase most people will make after a house. This makes them highly discretionary and cyclical. Sales boom when times are good and plummet when they're not.

Discretionary items aren't always a bad investment. But carmaking is also capital intensive. And cyclical and capital intensive is a combination I prefer to avoid, except right at the bottom of the cycle.

Second, the auto industry doesn't have a great history of delivering value for shareholders. That's because competition is tough. Everyone remembers that Henry Ford made a fortune from the business. Fewer remember that the US auto industry featured hundreds of manufacturers back then, most of which went bust along the way.

And in this new great auto boom, the competitive situation seems even worse.

The American manufacturers lost a lot of ground to the leaner Japanese firms in the last few decades and at least firms like Toyota were focusing on making some money. Now everyone is betting on China and emerging markets. But these countries want their own national champions in the industry and margins may well take second place to prestige. So the demand may be there but the competition could be brutal and returns much worse than many expect.

Third, I'm unsure about the technological outlook. Quite a lot of money is now going into areas such as electric cars and hybrids, with China playing a major role. It's entirely possible that the car of a decade's time will have changed substantially from what we use today and manufacturers will have to invest a great deal in new technologies to survive.

Some investors would conclude that this is a reason to go into stocks like the Warren Buffett-backed BYD, which is developing an electric car. To me, this is not attractive. We're talking about another capital-intensive scramble to develop a new technology with no certainty about who will come out on top and who might be bankrupted.

So I'd prefer something less cyclical, less capital intensive, less political and with less tied up in any given technology, yet at the same time able to hitch a ride alongside Asia's newly motoring middle class. And that points to businesses such as car service chains or parts distributors.

There aren't many listed firms in this space in Asia yet, either in the retail or the wholesale segments of the market. But after some searching, I think I've turned one up and at a very reasonable valuation too. So let's take a look at Singapore's YHI International

Keeping the car story on the road

YHI is a much simpler business than some of the ones that have featured in Asia Investor, so this week's analysis is going to be unusually short. The firm distributes automotive products such as tyres, batteries and wheels in markets across Asia.

Most of these parts are made by third parties. But the firm has its own manufacturing operation for alloy wheels, with plants in Shanghai and Suzhou in China, Taoyuan in Taiwan and Sepang in Malaysia.

Sales are roughly equally divided between Northeast Asia (mostly China, Hong Kong and Taiwan), ASEAN (with Singapore and Malaysia being the largest markets) and Oceania & Others (which is Australia and New Zealand, although with a growing European business). Northeast Asian sales come mostly from the manufacturing division, while those elsewhere are mostly distribution.

YHI's sales and profits were not immune to the global recession But they held up fairly well, as the charts below show. In particular, profits in the distribution business were down just 6.25% from 2007 to 2009. Manufacturing suffered more, although profits began to rebound somewhat in 2009. And the firm now looks to be back on the growth track: First half results showed a 24% recovery in sales and a 32% rise in profits.

Overall, the group has managed a 12% compound annual growth rate in sales and a 19% rate in profits during 2000-2009. Generally, it seems to be a solid business in a good niche, covering a wide range of markets and not being over exposed to any single one.

One thing that particularly appeals to me is that the management appears to understand the importance of branding. As well as distributing leading brands like Pirelli and Hitachi, the firm is also trying to establish its own house marque in wheels (Advanti Racing), tyres (Neuton Tyres) and batteries (Neuton Power). Too many Asian firms in this kind of business focus on trying to maximise sales at low prices, ignoring the extra margin that can be eked out of distinguishing your product from the low-cost competition.

The main weakness of YHI recently has been falling margins. The net profit margin has fallen to 5.45% in 2009 from around 7% in 2006 and before. Its return on equity is similarly down from around 20% to 12%. This reflected higher raw material and other operating costs in manufacturing and some unfavourable foreign exchange movements, as well as investment in new capacity.

For this reason, the distribution business, with its greater stability, lower capital requirements and lower vulnerability to raw material costs, is always likely to be the more attractive side of the business to my mind.

However, there is considerable growth potential in the manufacturing side and margins should improve substantially as new capacity comes into use increases and productivity improves. So we should see margins pick up again in the next couple of years.

Overall, I would expect that YHI will be able to grow earnings at double digit rates for many years to come if it gets its strategy right, albeit with a bit of volatility in the manufacturing side of the business. On a current price/earnings ratio of 7.1 times last year's earnings, that strikes me as attractive. And if all goes well, I think it could make us 60%-120% over the next 2-3 years

A 60-year history, but little outside interest

YHI dates back to a tyre retailer set up in Singapore in 1948 by the father of chief executive Richard Tay Tian Hoe. From the 1970s onwards, the firm began securing import and distribution rights for major Japanese brands and expanding into distribution in other Asian markets. In 2003, the Tay family grouped together the different distribution and manufacturing businesses and floated the combined group on the Singapore stock exchange.

Tay and his family remain the group's largest shareholder, as the following table shows. Investing in a firm with a controlling shareholder carries certain risks, as I'll discuss in the following section.

YHI has a market cap of only around $160m. And it operates in a line of work that's about as unglamorous as it gets. So it's not attracting a lot of institutional interest these days. Having said that, Singaporean sovereign wealth fund Temasek was a shareholder for a while after the float.

The largest outside shareholder is the NT Asian Discovery fund, a small cap-focused value fund based in Bangkok. If you have an exceptional memory for details, you may recall that this fund is also the largest outside shareholder in Silverlake Axis, our banking software play. That's not too surprising: with a relatively limited number of funds focused on small and medium sized Asian firms, a handful of names tend to crop up a good deal among the stocks I look at for Asia Investor.

Unsurprisingly, liquidity is not high in this stock but I don't anticipate you should have trouble taking a reasonably sized position. Average daily volume over the past year has been just over 200,000 shares.

A few of the potential risks

In addition to the usual Asia Investor risk warnings I'd stress the following for YHI:

First, this is a family company, as are many firms in the portfolio. As I always say, there can be major advantages to investing in a well-run family business; with their personal wealth tied in the business, the family will hopefully take a long-term, prudent approach to managing the company.

However, the presence of a single controlling shareholder can lead to the minority shareholders being disadvantaged by related party transactions or restructurings that benefit the controlling interest rather than them. This is always a risk; however, thus far YHI shows no history of doing so. Indeed, it seems to have followed a policy of rewarding shareholders well through dividend payments since listing, as we'll see below.

Second, there are no enormous technical or regulatory barriers to entry in YHI's industry. Neither does the firm have the kind of powerful consumer brands that we see with firms such as Hsu Fu Chi. Its main strength is the experience, expertise, network and customer and supplier relationships that come with having been operating in its markets for many decades. These can be overcome by determined competitors, but their value shouldn't be underestimated.

Lastly, its manufacturing segment will be vulnerable to any rise in raw material costs in particular aluminium and upward pressure on wages. And with the firm focusing on increasing the amount of production that it does for car manufacturers (OEM business) as opposed to sales that go to retail outlets, sales will probably become somewhat more cyclical in the years ahead.

Good value on every measure

The table below shows recent results and my base case for the next two years: as you can see, YHI currently trades on a trailing price/earnings ratio of 7.1 for FY2009, and on 6.1 times my base case for FY2010. It also sports a fairly attractive dividend, on a trailing yield of 4.25%.

The balance sheet is pretty solid. Net debt to equity stood at 14% at end June, with a healthy current ratio of 1.9. In some respects, YHI looks like a classic value play, trading at below the value of its assets: the net asset value per share is S$0.34, putting it on a price/book ratio of 0.8 times.

The big disadvantage of a stock like YHI is that while I think it has good long-term earnings potential, it doesn't have many obvious catalysts for rerating. It's unlikely that the business will ever be high profile enough to be rewarded with a high Asia consumer' valuation like some of the stocks in the Asia Investor portfolio.

However, it traded on a trailing p/e in the 8-12 range for the three years before the global financial crisis. And I don't think it's a stretch to suggest that it might get into that territory again in a couple of years. Add that to the potential of some strong earnings growth, and I think this stock could deliver us a surprisingly good gain.

For my base case, I'm going to assume a p/e of around 8.5 times my FY2011E in two years time, or S$0.46. That would be a potential gain of around 67% on the current offer price. Discounting back at my minimum target rate of return of 15% a year gives a current buy limit of S$0.35. In a bullish scenario, I think we could see FY2011 EPS of around S$0.06 and a p/e back to 10, giving the potential for a 2-3 year gain of up 120%.

Recommendation

Buy: YHI International

Ticker: YHI (Bloomberg), YHII (Reuters), Y08 (SGX and many brokers)

Exchange: Singapore (mainboard)

Market cap: S$158m

Bid/mid/offer prices: S$0.27/S$0.27/S$0.275

Buy limit: S$0.35

52-week low/high: S$0.19/S$0.29

YHI is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

Five-year performance history: 2005 +11.72%; 2006 -4.94%; 2007 -6.49%; 2008 -51.39%; 2009 +34.29%; 2010 +14.89% (to date)

That's all from me this week. I'll be back in a couple of weeks, when I should be writing to you from Singapore and Jakarta. As ever, if you have any queries in the meantime, please email me on asiainvestor@moneyweek.com. You can also access the ASIA Investor archive on the MoneyWeek website by clicking here. The password for the next fortnight is Dollar

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report:

Chart of the Day: Whoops - A Better Car Chart - UBS 30/06/10

The Auto Theory of Everything Revisited - UBS 03/09/10

China Aug car sales surprisingly robust, policy helps - Reuters.com 01/09/10

Car sales in India rise 33% to record on Nissan, Volkswagen's new models - Bloomberg.com 09/09/10

Indonesia's car sales up 35 pct in Aug frm yr ago - Reuters.com 24/09/10

YHI International annual reports 2003-2009

YHI International listing prospectus June 2003

YHI International second quarter earnings announcement 2010

Temasek Holdings to take up 6.16% stake in YHI International - SGX regulatory announcement 02/03/04

NTAsian Discovery Fund investments update July 2010

Data from Bloomberg

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I'd stress the following for YHI:First, this is a family company, as are many firms in the portfolio. As I always say, there can be major advantages to investing in a well-run family business; with their personal wealth tied in the business, the family will hopefully take a long-term, prudent approach to managing the company.However, the presence of a single controlling shareholder can lead to the minority shareholders being disadvantaged by related party transactions or restructurings that benefit the controlling interest rather than them. This is always a risk; however, thus far YHI shows no history of doing so. Indeed, it seems to have followed a policy of rewarding shareholders well through dividend payments since listing, as we'll see below.Second, there are no enormous technical or regulatory barriers to entry in YHI's industry. Neither does the firm have the kind of powerful consumer brands that we see with firms such as Hsu Fu Chi. Its main strength is the experience, expertise, network and customer and supplier relationships that come with having been operating in its markets for many decades. These can be overcome by determined competitors, but their value shouldn't be underestimated.Lastly, its manufacturing segment will be vulnerable to any rise in raw material costs in particular aluminium and upward pressure on wages. And with the firm focusing on increasing the amount of production that it does for car manufacturers (OEM business) as opposed to sales that go to retail outlets, sales will probably become somewhat more cyclical in the years ahead.