|Shares Out. (in M):||54||P/E||3.7x||3.4x|
|Market Cap (in $M):||201||P/FCF||3.7x||3.4x|
|Net Debt (in $M):||-215||EBIT||52||58|
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If you believe that all U.S.-listed Chinese equities are frauds, or if you're taken in with Jim Chanos' thesis that the Chinese economy is about to implode, read no further. You may be right and you certainly have lots of company (Credit Suisse just climbed on this bandwagon), but this writeup will be of no interest to you. On the other hand, if you think opportunity may lay among the low single-digit P/E carnage operating in an economy likely to significantly outpace that of most of the developed world over the next 20 years, we suggest taking a look at China Techfaith (CNTF).
At today's closing price of $3.73, the stock trades for 92% of the net cash on its balance sheet. While we find ourselves dismissing most of the "below cash" names we come across as value traps because their operating businesses are either unprofitable or are insignificant relative to the company's market cap, this is not the case here. For the quarter ending March 31, 2011, CNTF reported 26 cents per share in earnings. Moreover, the company has guided to modestly increased sequential revenues and similar margins for the June quarter. While we don't expect perfectly smooth sailing from here out, these numbers are not a seasonal aberration. Over the next 12 months, CNTF will be exchanging a chunk of declining, low margin revenue for a lesser amount of rising, high margin revenue. While this will likely manifest as a modest decline in Q3 2011 earnings, this decline should be fully offset by Q1 2012.
So we're looking at a company selling for $3.73 with over $4.00 per share in net cash and $1.00 per share of runrate earnings, and there's enough daily volume for trading liquidity to boot! How can an efficient market offer such a bargain? Outside of the widely vetted concerns about China, we think the answer lies in the company's history, rather than in its present state or a rational assessment of its future.
Defu Dong, the company's founder and CEO, left Motorola to set up his own Beijing-based independent handset design house in 2001. A slew of his engineering and executive colleagues followed soon after he established China Techfaith in June 2002.
In China at the time, independent design houses handled all aspects of mobile phone handset design for their brand-name customers up to the point of production. This included industrial, mechanical, software, and hardware design, as well as component selection, testing, pilot production, and production support. The independent design houses described their capabilities as more innovative and technologically advanced than their lower mix, higher volume Original Design Product (ODP) competitors, who catered to smaller brand owners and incorporated manufacturing as part of their services.
China Techfaith completed its first handset design in September 2003. By the end of 2004, it was one of the largest independent design houses in China, managing over 56 different models. Their customers included Chinese brand owners such as Bird, Haier, and Lenovo, as well as the large global brands owned by Kyocera, Mitsubushi, NEC, and UTStarcom. In 2004, operating income was $19mm on $47mm in revenues, with 57% gross margins. The company ended the year with 810 employees.
By 2005, investor sentiment toward China had grown very ebullient and China Techfaith's story had enough pizzazz for Merrill Lynch to do an IPO of their American Depositary Shares (ADSs), despite the company's very limited operating history. They raised $142mm by selling 8.7mm ADS shares at $16.25 each, 6.1mm were sold to raise capital for the company's growth and 2.6mm were sold by existing shareholders. To add to the air of legitimacy, Peter Clarke, the former Chairman of Merrill's Asia Pacific operation from 1992 to 1999, joined the board as Chairman.
In the prospectus, the company boasted that it employed 690 engineers and was set to hire 700 more. It didn't disappoint in this respect - the proceeds were put to work quickly. By the end of 2006, the company's headcount had grown to 2,342 (from 810 pre-IPO) and the year's capital expenditures for facilities expansion ballooned to $24mm from $9mm in 2005.
Unfortunately, CNTF's business peaked just as it completed its hiring and spending ramp. The stock touched over $20.00 before beginning a long, volatile decline set in as concerns grew regarding the ferocity of competition in the handset market, both within China and globally. The concerns were well-founded. CNTF's largest customer, NEC, decided to pull out of the Chinese handset business in 2006. In 2005, NEC's business represented $41mm, or 45%, of CNTF's revenue. Revenues from NEC plummeted to $9mm in 2006 and $3mm in 2007. The other (mostly Japanese) large brand owners followed, and Mr. Dong found himself long a bloated fixed cost base and short over 70% of his anticipated revenue. Operating income plunged from positive $41mm in 2005 to negative $15mm in 2006.
Mr. Dong then rather remarkably pulled the company out of this deep hole by redeploying its assets to serve smaller brand owners globally. Because these smaller customers lacked the manufacturing capabilities of the Japanese giants they replaced, CNTF interfaced with the Electronic Manufacturing Service (EMS) providers to contract and oversee production as well. The company had transitioned from a design house to an ODP. Revenues grew to $143mm in 2007 from their $81mm trough in 2006. By 2008, revenues reached $209mm, and the company eeked out a small operating profit. The ODP business has much lower gross margins than the design business, and all through this transition Mr. Dong continued to chop away at operating expenses. Headcount declined to 1,363 by the end of 2007, and further to 522 by the end of 2008.
In 2009, gross margins were a measly 18%, but the company was able to earn $13mm in operating income on $211mm of revenue thanks to continued expense management. With the business apparently stabilized (though the market didn't believe it - the company's shares repeatedly traded below $1.00 throughout the beginning of 2009 despite holding over $1.50 in net cash), Mr. Dong sought out better margins by utilizing the company's technological capabilities to expand into the gaming business and build its own handset brands. In June 2009, Infiniti Capital (a Hong Kong based venture capital fund) and IDG Capital Partners (a $2.5B China-focused fund that was an early investor in Baidu, Sohu and CTRIP, among others) each put in $10mm to fund a JV (now called 798 Entertainment) with CNTF to develop and market motion gaming technologies. IDG funded its interest through a convertible note, which it has since, per the indenture, converted into 5.25mm ADSs of CNTF (these are already included in the 54mm fully diluted ADS sharecount) and an interest in 798 Entertainment. Net of these transactions, CNTF owns 68% of the 798 Entertainment JV. The motion gaming segment has clearly gained some traction, generating $10mm in revenue in Q1 2011 with a 58% gross margin.
In February 2010, the company acquired QIGI Technology, a higher-end smartphone brand owner in China, and launched its own branded smartphone line. The acquisition was amazingly cheap, as CNTF paid only $13mm in consideration for a company that had $11mm in cash and $8mm in annual operating income (though admittedly $12.5mm of that consideration was with CNTF's own cheap currency - 4.4mm ADSs valued at $2.85 at the time). In addition to the acquired QIGI brand, CNTF's branded phone lineup now includes Jungle, Barbie, and Disney. Their target market appears to be the pre-teen and teenage female demographic. In Q1 2011, the branded phone business generated $15mm in revenue with 40% gross margins. The business has been growing fairly steadily at a high single digit annual rate.
The Company Today
The company currently operates in three segments: ODP, Branded Phones, and Gaming. Of the $272mm in total revenue generated in 2010, ODP represented 82% or $223mm, Branded Phones represented 14% or $38mm, and Gaming represented 4% or $11mm. The company's strategy has been to move the mix away from the lower growth, lower margin, short product cycle ODP business into the higher growth, higher margin, longer product cycle Branded Phones and Gaming segments.
Quarterly trends confirm that this strategy is being executed. In the first quarter of 2011, the mix had migrated to 68% ODP, 19% Branded Phones, and 13% Gaming. Gross margins in Q1 2011 were 25% for ODP, 40% for Branded Phones, and 59% for Gaming. Total revenues grew 29% year over year, and operating income increased 149%, from $6mm to $16mm.
Recently some complications that had been embedded in CNTF's capital structure have been cleaned up. As mentioned above, a $10mm convertible note issued to IDG has been redeemed for a combination of CNTF equity and an equity interest in 798 Entertainment. Also, a prior agreement for the company to issue a $30mm convertible note to Beijing E-town International Investment and Development Company Ltd (BEID), a Chinese state-owned investment company, has been amended so that BEID will contribute $30mm and CNTF will contribute $45mm into a 40/60 owned joint venture that will develop a 10 million-unit capacity smart phone production line in Beijing. The company closed Q1 2011 with $215mm of cash, or $4.00 per share using a diluted share count of 54mm that no longer has confusing convertible note obligations.
The company reiterated its Q2 guidance of $82mm to $84mm in revenues with gross margins similar to Q1 on June 6, so there appears to be little risk that the Q2 print will be less than 25 cents. Based on our discussions with management, growth is likely to continue in the Branded Phones and Gaming segments after Q2, but the company plans to make adjustments in its ODP business that could sacrifice revenues and raise gross margin percentage, but will likely lower the dollar amount of gross margin in the short term.
About half of the company's ODP business is currently sub-10% gross margin design and manufacturing contracting with smaller handset brand owners. The other half is 30%+ gross margin specialized designs for industrial customers. Going forward, the company plans to deemphasize the low-margin ODP business and grow the higher margin opportunities within this segment. Note that while this low margin ODP business represents $27mm of quarterly revenues, it also only contributes $2.7mm of gross margin each quarter. While this should be at least partially offset during the transition period, we're looking at an up to 5 cent risk to quarterly earnings for a couple of quarters before growth in the higher margin ODP, Branded Phone, and Gaming businesses take up the slack.
As mentioned above, the company has made $45mm in cash commitments to the BEID JV. This investment will be made over several years and we expect any outflows for this will be more than offset by CNTF's current operating cashflow. We believe it is also likely that CNTF will invest aggressively in its Gaming segment based on management's enthusiasm and conviction regarding the growth potential there. Depending on how this is timed and structured, there will be some draw on the company's cash balances before the return on investment replenishes it. We do think both of these investment initiatives will have relatively short payback periods (i.e., less than 5 years) but have little insight on the actual IRRs. The planned sale of some of the company's property holdings will partially offset these cash claims. The company completed the sale of one floor of an owned six story building for $4mm in the first quarter and we understand it is about to sell another floor for $5mm.
The company is currently available in the market for a negative enterprise value. This is true despite the fact that it has generated consistently growing profits since 2008. Even ignoring the fact that balance cash exceeds its current market cap, we conservatively expect that the company will earn its entire market cap again over the next four years.
Business transitions are always delicate. However, potential profit impact of this seems very modest. We have other well established and rapidly growing segments and only $2.7mm in quarterly gross margin to offset. It helps that Mr. Dong has successfully navigated a much larger and more dire transition in the recent past.
It is uncertain that the company will earn an adequate return on the cash it intends to deploy.
Fraud risk is of course the pink elephant in the room. While not impossible, we think the fact patterns here strongly indicate against fraud:
1. Deloitte Touche Tohmatsu is the company's auditor. While Deloitte has posted notice about weaknesses in the company's internal controls (primarily regarding the company's GAAP expertise, which it is currently addressing), it offered an unqualified opinion that CNTF's financial statements adequately represented its financial position. As most of us know, Deloitte was initially fooled by such high-profile Chinese frauds as China MediaExpress and LongTop Financial. However, as a result they have clearly stepped up their scrutiny and skepticism in their audits of U.S.-listed Chinese companies. Consequently, we think it is far less likely that a company that received an unqualified opinion from Deloitte this year will turn out to be fraudulent.
2. CNTF came to market via a traditional IPO process rather than through a SPAC purchase or an RTO. While this doesn't inoculate against fraud, the presumed level of due diligence supporting an underwritten IPO is much higher than that of an RTO and probably higher than that of a SPAC purchase.
3. Two large, well-respected venture capital firms with extensive experience in China, Infiniti Capital and IDG Capital, coinvested with CNTF in a CNTF-controlled joint venture. IDG Capital converted the majority of its convertible note position in the entity into the common stock of CNTF. Presumably both of these investors did extensive due diligence before putting their up their capital and their reputations.
4. BEID, a Chinese state-owned investment company, is investing a significant amount of money in a CNTF-controlled joint venture. We think that there was extensive due diligence prior to BEID's commitment and, further, that it's unlikely that the managers of CNTF would risk running afoul of BEID if they were running a fraudulent operation.
5. The company's history and the CEO's actions are inconsistent with fraud. Why would the company represent that it had lost much of its customer base and embark upon rebuilding its business if it was making up what was actually happening? Why did Mr. Dong buy 120,000 ADSs for himself in the open market during March 2011? Why did he buy 143,000 ADSs in December 2010?
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