China Ceramics Co., Ltd. CCLTF
October 13, 2010 - 3:56pm EST by
2010 2011
Price: 5.50 EPS $2.10 $2.00
Shares Out. (in M): 13 P/E 2.6x 2.3x
Market Cap (in $M): 72 P/FCF 2.6x 2.3x
Net Debt (in $M): 5 EBIT 45 55
TEV ($): 77 TEV/EBIT 1.7x 1.4x

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Investment Thesis

I realize that China Ceramics Co., Ltd. has been written up previously on the VIC, but I think recent events merit another look at this investment opportunity.  In my opinion, the common stock (CCLTF) offers a compelling opportunity to invest in the high secular growth taking place in China in a superior risk-adjusted way.  The company is a leading manufacturer of ceramic tiles used for exterior siding and interior flooring in residential and commercial buildings, primarily in Tier-I and Tier-II Chinese cities.  In spite of its freshly cleaned-up capital structure (details below), clean balance sheet, high growth rates, and profitability, CCLTF stock trades at less than 2x EV/Ebitda, and less than 2.5x EV/FCF.


I believe this investment opportunity exists for a variety reasons, including: i) the way the company became public (a special purpose acquisition company, or SPAC); ii) former capital structure issues that created the perception of a massive overhang; iii) the small size and relative illiquidity in the stock; and iv) general stigmas associated with US-listed, China-based companies.  As I will attempt to demonstrate below, the Board and management have either recently taken steps to fix these issues, or are in the process of implementing strategies to alleviate these problems.  The end result is a clean capital structure, high growth rates, improving liquidity, and a compelling valuation.


Company Background


China Holdings Acquisition Corp. (CHAC) was originally incorporated in Delaware on June 22, 2007, and completed its IPO as a blank check company on Nov. 21, 2007, raising net proceeds of approximately $125 million (including over-allotment options).  The company issued a total of 12.8 million units at $10 per unit in the IPO, each unit consisting of one share of common stock and one warrant to purchase a share at $7.50 with a Nov. 2012 expiration.  In addition, management received 3.2 million shares of founder's stock and 2.75 mm warrants.  Following the completion of the IPO, the company had 16.0 million shares outstanding, 15.55 million warrants outstanding, and approximately $125 million in a trust account.


Almost two years later, in November 2009 CHAC entered into an agreement to acquire 100% of Jinjiang Hengda Ceramics Co., Ltd. (Hengda).  Formed in 1993, Hengda is a leading manufacturer of ceramic tiles.  The terms of the acquisition consisted of $0 cash, 5,743,320 shares of common stock, 5,185,763 shares of "earn-out" common stock held in escrow pending 2009-2011 operating results, and 3,000,000 shares of "earn-out" common stock held in escrow pending minimum stock price achievements.  The escrow shares can be earned by the former owners of Hengda based on the following:




Pursuant to the terms of the SPAC vehicle, the acquisition was voted on by the shareholders of CHAC, with minimum votes "for" the transaction required to consummate the deal.  Shareholders who voted against the transaction had their shares "repurchased/redeemed" by the company for $9.79 per share in cash, but were able to keep the warrant.  As a result of the special shareholders vote, the transaction was approved on Nov. 21, 2009, with 1.6 million management/founder's shares being forfeited, 11.2 million shares being repurchased/redeemed for $9.79 per share in cash, and 5.7 million shares being issued to the owners of Hengda.  Also as part of the deal, the company re-domiciled itself into its wholly-owned subsidiary, China Ceramics Co., Ltd. (a British Virgin Islands limited liability company), and changed its name.  Following the transaction, the company had the following capital structure:




As can be seen, the transaction created a structure where there were very few public shares in the float, and where there was a perception of significant overhang on the shares due to the large number of warrants outstanding with a $7.50 strike price.  As a result, the common shares have traded very little volume since the transaction, and the warrants, which are registered, have been the only publicly traded security that investors could purchase in any size.  Realizing that this capital structure was a significant inhibitor to achieving the true value for the corporation, the Board and management have taken the following steps to increase the float and decrease the number of warrants outstanding:


June 1, 2010 -    Company purchased 996,051 warrants from a third party for $1 per warrant.


Aug. 2010 -         Company initiated an exchange offer for all remaining warrants pursuant to which warrant holders could exchange 4 warrants for 1 share of freely-trading common stock.  As a result, 80.9% of the warrants (11,779,649) were exchanged for 2,944,910 shares of common stock.


Following these transactions, the company now has the following capital structure (note:  I do not know the status of the shares/warrants for Dorset and Hassenfield following the exchange offer, so I assume they are unchanged):




While still not perfect, the existing capital structure is far superior to the structure in place prior to the exchange, with a more reasonable public float approaching 3 million shares, more than likely a far larger number of individual public shareholders who own those shares, and a far smaller number of warrants outstanding.


Business Overview


Hengda was founded in 1993, and is based in Jinjiang in the Fujian Province of China.  The company is a leading manufacturer of ceramic tiles which it markets under the "Hengda" or "HD" trademark.  The company has more than 2,000 color and size combinations, with the largest sized tiles measuring 600mm x 600mm (23.6 x 23.6 inches).  Porcelain tiles comprised 79.4% of 2009 revenue, glazed tiles represented 10.0% of 2009 revenue, with the balance coming from styles such as "rustic" or ultra-thin.  The Jinjiang facility has an annual capacity of 28 million square meters, and employs approximately 1,700 employees in 9 manufacturing lines.  This facility has recently been operating at 100% capacity, with the company actually outsourcing some production to third-party manufacturers to fulfill its sales orders.


The company's products are sold to a network of 37 exclusive distributors, as well as directly to large real estate developers.  The distributor network is long-standing (9 of the top 10 clients have worked with the company for over 10 years) and well-diversified (the top 10 clients represented only 43% of 2009 revenue).  Approximately 94% of the company's products are sold within China, with the remaining 6% being exported to countries such as Japan, Russia, Eastern Europe, and South Korea. 


For the periods from 2007 through 2009, Hengda achieved significant growth and profitability.  During this period, revenue grew at a CAGR of 22.8% to reach $122.2 million, and pre-tax income grew at a CAGR of 19.5% to reach $31.0 million.  While the tax rate has been somewhat variable in prior years, the company expects a 25% tax rate going forward.


More recently, in January 2010 the company acquired a state -of-the-art production facility in Gaoan, China.  The total cost of the acquisition was approximately $39.7 million, consisting of $26.9 million in cash and $8.8 million of debt at 5.3% interest.  The facility currently has 3 manufacturing lines running at full capacity (9 million square meters of capacity), and management plans to add another four lines by the end of 2010, and another five lines by the end of 2011.  These capacity upgrades will require approximately $20 million in both 2010 and 2011, but will increase the production capacity of the facility to approximately 42 million square meters.  Combined with the Hengda facility, this will boost the company's capacity to approximately 70 million square meters, or 150% more than the Jinjiang facility alone.  Management has indicated that, barring another acquisition, it intends to pay for these capex upgrades from cash on hand and internally generated funds.


Industry Overview


China Ceramics is benefiting from the massive construction boom going on in China, primarily as a result of Government stimulus, population growth, a fast-growing economy, the modernization of the country, rising living standards, and the urbanization of the population.  For example, the construction material market is anticipated to grow at a CAGR of 8.7% between 2009 and 2013, and the urban population of China is expected to grow from approximately 600 million today to around 1 billion people by 2030.  This massive urban growth is also not just affecting the largest Tier-I coastal mega-cities, as the so-called Tier-II and Tier-III cities are also expected to see incredible growth.  As an example, it has been estimated that there will be upwards of 220 cities in China with more than one million inhabitants, which compares to just 35 such cities in all of Europe today.


While these growth trends are well-known and certainly impressive, it is important to note that China Ceramics had less than 10% exposure to Tier-I cities as measured by 1Q10 revenues.  This could be important given that any sort of construction slow-down, due to economic conditions or over-capacity, is more likely to impact Tier-I cities.  These cities, such as Beijing, Shanghai and Shenzhen, have been far more aggressively developed and, therefore, could be more susceptible to a slowdown.




The following is an analysis of the valuation of China Ceramics common stock, using the net income ranges from the Hengda earn-out transaction as starting points for 2010 and 2011.  For each year, I begin with the minimum and maximum net income figures.  I assume a 25% tax rate, minimal interest expense, and depreciation and maintenance capex that increase slightly next year.  Based on these assumptions, I have estimated the Ebitda and FCF for the company under each scenario.  In the case of the maximum earn-out scenarios, the valuations are impacted by the additional shares that are released from escrow to the former owners of Hengda.




Based on this analysis, at a stock price of $5.50 the enterprise value is around 1.5x next year's Ebitda, and around 2.2x next year's FCF.  These are very attractive multiples given the growth rates that these levels of net income would represent (i.e. 20-30%).  I would point out that these maximum targets appear to be achievable based on the first half numbers for 2010, as the company has already earned net income of $14.9 million (47.5% of target) through the June quarter. 


It is also important to note that I have ignored the dilutive impact of stock price-based earn-out shares as well as the remaining warrants, as these would only begin to make an impact at significantly higher stock prices.  However, if the company were to trade at a conservative multiple of 5x Ebitda, the following is an analysis of the potential valuation for the shares:




This analysis (*) assumes that the warrants are exercised, the share count is increased by the number of warrants outstanding, and the cash proceeds from the exercise reduce the enterprise value.  This analysis demonstrates that there is considerable upside potential in the shares if the company is able to achieve even a conservative 5x multiple of Ebitda.


Balance Sheet


As of June 30, 2010, the company had a clean balance sheet with $10.0 mm of cash, $15.3 mm of debt, and $34.9 mm of net working capital.  In addition, the company had $88.1 mm of shareholder's equity, and with just $0.5 mm in intangible goodwill, this equates to $6.68 in tangible book value per share.


Management/Corporate Governance


When investing in US-listed, China-based companies, the management team, appropriate corporate governance, and the risk of outright fraud should be given careful consideration.  My primary level of comfort on this front relates to Paul Kelly, one of the company's directors and its non-executive Chairman.  Mr. Kelly was the company's former CEO prior to the Hengda acquisition, and was instrumental in putting together the original CHAC blank check company to focus on acquisition opportunities in China.  In my opinion, Paul Kelly has an impeccable track record in investment banking, merger and acquisition, international financial advisory services, and cross-border business advisory services.  In addition to working with CCLTF, he currently also serves (among other things) as President and CEO of Knox & Co., an international investment banking firm specializing in Asia and the U.S.  Mr. Kelly's complete bio can be found here (, but suffice it to say I believe his involvement lends a great deal of credibility to the China Ceramics opportunity.


In addition to Mr. Kelly, there are several other western-educated individuals involved in the executive management team and on the board of directors.  Edmund Hen, the CFO, graduated from the University of East Anglia, U.K., in 1995, and is an associate of the Institute of Chartered Accountants in England and Wales.  Bill Stulginsky, a director and the Audit Committee Chairman, is a graduate of LaSalle University.  Mr. Stulginsky has over 36 years of public accounting experience, and retired as a Partner from PricewaterhouseCoopers LLP (where he spent 24 years) in September 2009.  Finally, Cheng Davis, who has been a board member since the inception of the company, has been the Vice Dean of International Programs and Development at the University of Pennsylvania since 1993.  This program at the University of Pennsylvania, which she founded and heads, is focused on international training programs for CEOs and executives in the latest theories and practices in the U.S. finance sector.  In my opinion, the involvement of these individuals brings a level of credibility and safety for US investors that is not typically found in similar China-based investment opportunities.  More information on the management and director bios can be found at the company's website:


In addition to the management and board, there are several smaller factors that help lend credibility to the opportunity.  None of these by themselves are significant, but taken together they give additional comfort to US-based investors.  For example, the company uses a global audit firm (Grant Thornton), as opposed to a smaller, less well known firm.  Additionally, the company's SEC counsel is Loeb & Loeb, a well -respected national law firm with an outstanding reputation.  Finally, it is not insignificant that the publicly-traded holding company owns 100% of the stock of the China-based operating company, which provides a small amount of comfort and is not always the case.  Again, while none of these factors by themselves are significant, when taken as a whole I believe they help alleviate some of the stigmas associated with investing in Chinese companies.




The key risks to this investment idea include all of the major ones you would think about when investing in China:


  • - A slowdown in the Chinese construction industry
  • - A slowdown in the general Chinese economy
  • - A "bursting" of the Chinese housing bubble, if there is indeed a bubble
  • - A slowdown for suppliers to the Chinese construction market due to over-supply issues
  • - Fraud. The horror stories one hears about China-based frauds cannot be completely dismissed here (or with any such investment)


In addition to these, there are several company-specific risks that should be considered:


  • - Even with a float that is now around 3 million shares, the stock is still highly illiquid and trades infrequently
  • - While I do not think it will happen, it is possible the company could be talked into a dilutive stock offering by an investment banker in order to 1) increase the float/liquidity, 2) help pay for the Gaoan expansion, and 3) earn the banker some fat fees. Again, in my discussions with Paul Kelly, I think this is unlikely.


The primary catalyst for the shares is the build-out, over the next year and a half, of the company's additional manufacturing capacity at its recently acquired Gaoan facility.  Not only should this allow the company to increase its revenues from current levels, but it may also increase margins as the company is no longer forced to outsource a portion of its production to fulfill its sales orders.


Other potential catalysts for the stock include the additional exposure that could occur now that the significant capital structure issues have been addressed.  Not only is management able to focus on issues other than the capital structure, but now they can focus on growing the business and making sure the company's valuation in the market-place reflects the underlying fundamentals.  For example, I would not be surprised to see the company embark on a series of non-deal roadshows to meet with new potential investors.  I would also not be surprised to see the company attempt to get the shares listed on an exchange other than the pink sheets.  One potential roadblock for such a change in listing, the requirement for 300 individual shareholders, has potentially been eliminated as a result of the warrant exchange.  Essentially, now that the float has been increased and the warrant overhang has been eliminated, the stock is a much more attractive investment opportunity for potential investors.


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