I believe it is time to revisit China Ceramics ("the Company"). An extremely attractive valuation seems to compensate investors very well for the risk taken.
The Company is the leading ceramic tile manufacturer in China.
+ very strong ROIC (~80%)
+ robust balance sheet (net cash after adjusting for recently concluded acquisition)
+ five largest customers (distributors) account for ~25% of revenue
- offers 90-day trade credit to its customers (all current as of 12/31/09 per SEC filings)
- thinly traded (on BB)
+ unlike many Chinese companies traded in the US, Op co is 100% owned by publicly traded Hold co
+ original owner who sold stake to SPAC was paid solely in stock
+ modest management compensation (extremely modest by western standards)
+ large insider ownership (both original owner and SPAC sponsors)
+ potential Yuan appreciation provides additional upside (or downside protection) not reflected on valuation numbers presented
Financials (Rmb million, IFRS)
x m&a exp
x m&a exp
Net debt, adj
Adj fror acq of Gaoan facility
2010(p) = financial projections from the Company's prospectus
The biggest risk in my opinion is potential overcapacity. The acquisition of the Gaoan facility increased the Company's installed capacity from 28 to 38 million m2/yr. Further, it plans to invest an additional US$40 million to bring capacity to 70 million m2 by the end of 2011. It is certainly possible that demand could suffer a contraction just as the company has committed significant resources to its expansion.
For those who are convinced that there is a real estate bubble in China that is about to burst, risk could be mitigated by hedging. To this end, there does not seem to be a shortage of richly valued companies in the Chinese real estate sector. In my opinion, a hedged position has a very attractive risk profile.
The company has a cost structure that would seem to allow it to withstand severe demand contraction without losing money. First, SG&A accounts for about 2% of sales (currently Rmb 17 million/yr). Second, variable costs in the form of raw materials account for ~60% of COGS (with clay 22%). Lastly, D&A adds to about 2% or sales (currently Rmb 16 million/yr).
To illustrate, assume a draconian sales contraction of 50%, and to make it more severe, also assume that the non-variable cost base can not be rationalized (a very unrealistic assumption):
Fixed cogs 200
Variable cogs 175
Gross profit 75
Maint capex 8
Ebitda-m capex 67
One should also consider that the Company's capacity (28 million m2) was not enough to meet demand in 2009. It had to outsource 4.5 million m2. It is logical to assume that its true fixed cost base is lower than that implied by the 2009 numbers, which serve as the basis for the analysis above.
To conclude on the sensitivity analysis, even under quite pessimistic assumptions, the valuation is very undemanding.
Share count and valuation
The share count deserves some attention. As of 12/31/09 there are 8.95m shares outstanding. There are 15.55m warrants (CCLWF) expiring on 11/16/12 with a $7.50 strike price. The Company can redeem these warrants at $0.01 each once the stock reaches $14.25. In addition, there is an earn-out escrow that would increase the share count as follows:
A) Provided certain earnings targets are met the following number of shares will be released once audited financials are issued:
FY09 1.2 million
FY10 1.8 million
FY11 2.2 million
B) Once the stock trades for twenty days (within a thirty-day period prior to 4/30/12) at or above the following levels:
$20/share then 2 million shares will be released, and
$25/share then 1 million shares will be released
Thus, as of today the share count is approximately 10.2m (12/31/09 o/s + FY09 earn-out). Adjusting for the acquisition of the Gaoan facility, China Ceramics is trading at less than 1x (tangible) book, 1.2x fy10 ebitda, and 2.0x fy10 ebitda-total capex (which are far in excess of maintenance).
Given the various moving parts, I find it helpful to look at the share count (and valuation) under different scenarios (with P being the stock price at the completion of the FY10 audit):
FY10 target met, P≤$7.5
FY10 target met, P>$7.5
FY10 target not met, P≤$7.5
FY10 target not met, P>$7.5
Earnings release on June 1st. While I do not necessarily think the release will propel the stock price upward to a large extent, I see it more as a soft catalyst.