China Ceramics Co., Ltd. CCLTF
October 13, 2010 - 3:56pm EST by
rasputin998
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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Description

 

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.

 

Valuation

 

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 (http://www.knoxandco.com/paul_kelly.htm), 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: www.cceramics.com.

 

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.

 

Risks

 

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.

Catalyst

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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    Description

     

    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.

     

    Valuation

     

    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 (http://www.knoxandco.com/paul_kelly.htm), 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: www.cceramics.com.

     

    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.

     

    Risks

     

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

     

     

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

     

    Catalyst

    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.

     

    Messages


    SubjectRE: tables didn't paste?
    Entry10/13/2010 11:28 PM
    Memberrasputin998
    Arrgh!  Sorry - I'll try getting them in when I go into the office tomorrow.

    Subjectwriteup with tables
    Entry10/14/2010 12:21 PM
    Memberrasputin998
     Sorry about the tables not posting.  Here's the writeup with the tables, which are critical since I think this fills some critical holes in the previous analyses regarding sharecount.

    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:

     

     

     

     

     

    Earn-out Range ($mm)

     

     Max. Shares

     

     

     

     

    Min

    Max

     

     Released

    2009 Net Income (before tax)*

     

     $           28.0

     $    31.7

     

          1,214,127

    2010 Net Income (after tax)

     

     $           23.8

     $    31.4

     

          1,794,800

    2011 Net Income (after tax)

     

     $           31.4

     $    43.5

     

          2,176,836

    Stock price > $20 by Apr. 2012

     

     

     

     

          2,000,000

    Stock price > $25 for 20 days

     

     

     

     

          1,000,000

     

     

     

     

     

     

     

     

     

     

     

     

     

    Total

     

          8,185,763

     

     

     

     

     

     

     

     

    *Subsequently earned and released from escrow in May 2010

     

     

     

     

    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:

     

     

     

     

    Shares

    %

     

     Warrants

    %

    Management/Founders

            901,450

    10.1%

     

          2,750,000

    17.7%

    Hengda

     

     

          5,743,320

    64.2%

     

                     -  

    0.0%

    Dorset Capital

     

          1,350,000

    15.1%

     

                     -  

    0.0%

    Alan Hassenfield

     

            224,907

    2.5%

     

            495,000

    3.2%

    Estimated Public Float

            730,494

    8.2%

     

        12,305,000

    79.1%

     

     

     

     

     

     

     

     

     

     

     

          8,950,171

     

     

        15,550,000

     

     

    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):

     

     

     

     

    Shares

    %

     

     Warrants

    %

    Management/Founders

          1,588,950

    12.1%

     

                     -  

    0.0%

    Hengda*

     

     

          6,957,447

    53.1%

     

                     -  

    0.0%

    Dorset Capital

     

          1,350,000

    10.3%

     

                     -  

    0.0%

    Alan Hassenfield

     

            224,907

    1.7%

     

            495,000

    17.8%

    Estimated Public Float

          2,987,904

    22.8%

     

          2,279,300

    82.2%

     

     

     

     

     

     

     

     

     

     

     

        13,109,208

     

     

          2,774,300

     

     

     

     

     

     

     

     

     

    *Includes 1,214,171 of the 2009 earn-out shares, released in May 2010

     

     

     

    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.

     

    Valuation

     

    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.

     

     

     

     

    2010

     

     

    2011

     

     

     

     

     

     

     

     

     

     

     

     

    MIN

    MAX

     

    MIN

    MAX

    Net Income ($mm)

     

     $         23.8

     $         31.4

     

     $         31.4

     $         43.5

    Cash Taxes ($mm)

     

     $           7.9

     $         10.5

     

     $         10.5

     $         14.5

    Interest ($mm)

     

     $           0.8

     $           0.8

     

     $           0.8

     $           0.8

    Deprec & Amort ($mm)

     $           6.0

     $           6.0

     

     $           8.0

     $           8.0

    Maintenance Capex ($mm)

     $           4.0

     $           4.0

     

     $           6.0

     $           6.0

     

     

     

     

     

     

     

     

    Ebitda ($mm)

     

     $         38.5

     $         48.7

     

     $         50.7

     $         66.8

    FCF ($mm)

     

     $         25.8

     $         33.4

     

     $         33.4

     $         45.5

     

     

     

     

     

     

     

     

    Current Shares

     

      13,109,208

      13,109,208

     

      13,109,208

      14,904,008

    Escrow Shares

     

                   -  

        1,794,800

     

                   -  

        2,176,836

    Pro-Forma Shares

     

      13,109,208

      14,904,008

     

      13,109,208

      17,080,844

    Stock Price

     

     $         5.50

     $         5.50

     

     $         5.50

     $         5.50

     

     

     

     

     

     

     

     

    Market Cap. ($mm)

     

     $         72.1

     $         82.0

     

     $         72.1

     $         93.9

    Net Debt ($mm)

     

     $           5.0

     $           5.0

     

     $           5.0

     $           5.0

    Enterprise Value ($mm)

     $         77.1

     $         87.0

     

     $         77.1

     $         98.9

     

     

     

     

     

     

     

     

    EV/Ebitda

     

     

    2.0x

    1.8x

     

    1.5x

    1.5x

    EV/FCF

     

     

    3.0x

    2.6x

     

    2.2x

    2.1x

     

     

    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:

     

    2011 MAX Ebitda ($mm)

     

     $         66.8

    EV at a 5x Ebitda Multiple ($mm)

     $       334.0

    Plus: Net Cash ($mm)*

     

     $         15.8

     

     

     

     

     

    Equity Value ($mm)

     

     

     $       349.8

     

     

     

     

     

    Shares Outstanding*

     

     

      19,855,144

     

     

     

     

     

    Value per Share

     

     

     $       17.62

     

     

    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 (http://www.knoxandco.com/paul_kelly.htm), 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: www.cceramics.com.

     

    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.

     

    Catalysts

     

    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.

     

    Risks

     

    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.

    SubjectRE: Visit
    Entry10/14/2010 12:39 PM
    Memberrasputin998
    They have been in a quiet period for the last few weeks.  From our immediately prior conversations, we've gleened that they have been working on an uplisting and that they were also exploring a capital raise for plant expansion and to increase the trading liquidity of the stock.  When we voiced our concerns about raising equity at anything close to the current share price, management's response suggested they strongly shared our view - i.e., we are fairly confident they won't be issuing stock at these depressed levels.

    SubjectRE: RE: RE: Visit
    Entry10/16/2010 04:25 PM
    Memberrjm59
    The warrants are basically already eliminated, there are only 3M left after they did the exchange, so it's hardly an overhang vs the 20M total shares or so...  I was also very perplexed why there was such tiny volume in the common after the warrant exchange, I expected the common to start having more volume than the warrants but until just this last week the volume hadn't increased and was just a few hundred shares a day.  I suppose the holders of the warrants didn't feel like selling and there wasn't much awareness.  At the rate of this week, I'd definitely expect that the churn (and the help of screeners) would get the # of stockholders above 400 to get back on the nasdaq.
     
    I also got the impression from management that they'd not consider a capital raise.  I spoke with them before the warrant conversion and asked - based on the original assumption they'd do a capital raise because the float was so tiny (600k shares I think after the spac), but they exceeded my expectations on that by doing a warrant conversion which is an order of magnitude better long term than if they just did a pipe or public offering to boost the float.  Now the float is at 3.6M or so which is definitely high enough for free trading, just have to get the word out there, they haven't presented at any of these conferences as far as I know?

    SubjectDilution
    Entry11/01/2010 04:58 PM
    Memberef901
    I guess we now know why they were in a quite period. Rasputin, what do you make of the offering and associated dilution at these prices? It seems like taking out debt at 5-6% is a much better way to raise capital...

    SubjectRE: Dilution
    Entry11/01/2010 09:59 PM
    Memberrasputin998
    I've been clear that I thought they intended to raise equity, but not in the context of the current price ($5.50 per share at the time of writing).  I also stated that I'd be disappointed if they issued stock with a 7 handle or below.  By implication I was ok if they sold shares above that level.  There is no price listed on the F-1 and I am not aware of any price talk out of Roth (please let me know if this is incorrect). 
    They are averse to debt and they want to increase the trading liquidity of their shares and they want to raise capital for growth.  In most deep value situations, I am of course strongly in the camp that the company in question should be buying their cheap stock instead of selling it.  However, this is a growth company that just happens to have a low P/E - it is not a 50-cent dollar cigar butt.  They want to (and arguably need to) expand and consolidate this industry using their brand and their relative size.  In this instance if they go on the road, market it up to a "fairer" price (even though still not anywhere close to a "fair" price) and do a deal above $8 (not that I have any insight on their ability to accomplish this) and have growth capital, more trading liquidity, and a wider audience of "real" investors (i.e., mutual funds as opposed to hedge funds) for a stock that will still be wildly undervalued despite the dilution, I think it's an acceptable outcome.  It even might be the better outcome for current shareholders from an IRR perspective.
    I've been in many ultracheap illiquid situations, and I know these are common in VIC portfolios.  The fact is, most of these "ultracheap illiquids" stay cheap for a long, long, long time.  Let's say they raise the $35mm (after slippage) by selling 5mm shares at $8 to investors outside of the "wise guy" or "vulture" variety.  They then have some net cash and can make additional growth acquisitions with 25% IRRs and some modest synergistic upside (yes, even if still abhorrently dilutive to their current 3 P/E).  So then we're looking at a company with 20mm shares outstanding that can conservatively do $60mm in EBITDA and $40mm in free cash after taxes and maintenance capex.  At $8 per share, instead of owning something excruciatingly illiquid at a 3 P/E and waiting and waiting and waiting and waiting for a 5 P/E, we own something reasonably liquid with a rock-solid balance sheet and much higher trading liquidity and investor awareness at a 4 P/E with a clear trajectory to an 8 P/E over then next 12- 18 months.  I know this can be philosophically problematic for many of us here, but is it really so terrible?  Is it even the wrong thing for them to do?

    SubjectRE:RE: Dilution
    Entry11/11/2010 06:50 PM
    Memberef901
    Raputin, thanks for the response...I agree that if they can re-invest at those rates it would be attractive. In looking at the EBIT margins for the business they seem high, especially when you look at other similar types of businesses in EM. I wasn't able to find any public comps in China but found a few companies in India, Phillipines (Nitco, Somany Ceramics, Mariwasa Siam Holdings) with EBIT margins which were significantly lower. Do you know why such a gap exists and how do you get comfortable these margins can be sustained?

    SubjectMargins
    Entry11/12/2010 05:52 PM
    Memberrasputin998

    ef -

     

    Thanks very much for your question.  I agree that getting comps for this one is difficult and I'm not sure it makes sense to compare industry participants across countries.  Further, there are substantial differences between the comps you cite and China Ceramics' business.  Nitco and Somany are distributors as well as manufacturers.  They operate showrooms and cater to customers to some extent at the retail level.  They also import tiles and market them to their customers.  Their business seems to be primarily indoor tiles rather than outdoor construction material. 

     

    I also think gross margin would be the relevant test of an industry's normalized margin rather than EBIT margins, which would be more company-specific.  From their latest financials, I get gross margin (outside of store costs) of 22% for Nitco and 32% for Somany, versus 32% for China Ceramics.  Mariwasa has a negligible gross margin and seems to be a former joint venture that went through a restructuring.  I only glanced at this one but I know many JVs operate with low or no margins and directly pass on their economic benefits to their sponsors by purchasing inputs from them at above market prices or selling output to them at cost.

     

    Aside from the country/local competitive differences, there are a number of reasons why China Ceramics would operate at higher margins than producers that also market to retail customers.  China Ceramics sells its output directly to its 38 exclusive distributors.  It does not sell retail or operate stores at all and it does not resell tile (other than outsourcing to meet demand that currently exceeds their capacity levels).  Their distributors typically pick up orders directly from the company's warehouse.  Their product is highly customized and specifically designed for each project.  Their business does not really involve off-the-shelf product.  This level of customization allows them to pass on virtually any cost to the customer plus a markup based on the complexity of the design.  They have proprietary technologies that allow for unique combinations of appearance, weight, thickness, and durability.  They've shown us highly durable tiles that are also very thin and light enough to float on water.  They went over their gross margins with us by tile sample, which ranged from high-20% for their lower end product (which is still well above the average quality level in their marketplace) to over 60% for highly specified tiles designed for the Japanese end-market.

     

    Within their market, they are the largest manufacturer, with about 6% market share.  There is one other large competitor, with about 4% share, and the rest of the market is split up between 1,000 mom and pop producers.  The Hengda brand is considered the premium brand within their market.  They have spent much more on R&D than their competitors and thus can offer tiles that noone else in their market can produce.  For example, they offer an 800mm x 800mm tile whereas the competition's largest size is 200mm x 300mm.  The larger size is obviously very advantageous to the contractor who wants to improve efficiency with fewer applications per coverage area.

     

    I hope this helps.

     

    - R.

     


    SubjectRE: update?
    Entry04/04/2011 01:37 PM
    Memberrjm59
    Still haven't found any red flags yet, they just released the SAIC filings that list 30+ customers and suppliers - has anyone tried to contact to verify them?  This is definitely not a DGW (just posted today by Muddy Waters), I visited unannounced in sept to Jinjiang and there is definitely a lot of production at the factory, but margins can be hard to verify.  Haven't seen their new facility in Gaoan but have heard from a colleague that it is much more modern than the Jinjiang facilities.
     
    Still waiting for their audit (they're a foreign issuer so have til june 30 for 20F).  Grant Thornton Shanghai (vs HK which audited DGW) is the auditor, not aware of any frauds that have come out of that office yet? It used to be a BDO office but not the really sketchy one that audits ONP, ZSTN.  This one along with EDS are the only SPACs I can think of that haven't seen any fraud issues yet that I'm aware of?

    Subjectmajic
    Entry04/08/2011 09:56 PM
    Memberrasputin998
    We've been adding steadily into this weakness.  We are currently buyers of both the shares and the warrants, depending on relative price and which is more liquid on a given day.
    The company is currently trading at a 2 P/E despite 20+% growth into the foreseeable future.
    I see only two ways we could possibly lose from current prices - either the company is a fraud, or their capital management is so atrocious that they can figure out a way to set up a bonfire that will totally destroy the tremendous cashflows they are going to garner.
    We keep in regular contact with Paul Kelly and Edmund Hen, the CFO.  While we haven't yet visited their facilities ourselves, two sets of friends of ours have independently.  Their estimates reasonably confirm the capacity levels and runrates reported by the company.  We have seen stepped up local due diligence from Roth and Global Hunter, and most recently the 20-F signoff from Grant Thornton.   There are some high profile US-citizen board members whose reputations are too valuable to stick around here if something were fishy.  There is so much scrutiny on these US-listed Chinese names that fraud becomes less likely each day for those still standing in my opinion.  I am very confident that there is no fraud here (though obviously 100% certainty is impossible).
    We have discussed capital management at length on several occasions with Mssrs Kelly and Hen.  While we of course want to see some significant buyback or dividend, they are committed to completing the current expansion.  With just over a two year payback on these investments, their decision seems reasonable and may actually be the correct one.  I do think though, as the share price continues to decline, the decision tips further and further into the "do something visible for shareholders" camp as a tangible boost to their credibility is more and more necessary.  We will continue to bring up this perspective.  Though most value purists would say that buybacks are better when the shares are so depressed, we favor dividends since the float is so limited and we want to maintain what little trading liquidity there is.
    There is a large seller of the shares that seems to prefer dribbling them out at lower and lower prices over offering the block out at a discount.  I think the seller is doing his investors a disservice, but we're content to add in pieces as the shares trade down.  I also think the company would consider another warrant for share exchange if holders a significant number of the warrants approached them.
    The negativity is of course across the entire China space as more frauds seem to be revealed on an almost daily basis.  We think there is opportunity in the sector and have selected six names for investment out of about three dozen that we've looked into.  I would be very, very surprised if more that one of the names we've selected turns out to be a fraud.  If we're right, a number of these will end up being two, three, or four+ baggers over the next couple years.
    China Ceramics is currently the largest exposure we have under this strategy and it is also by far the largest position in my p.a., which is an account that tends to be very concentrated in any case.

    SubjectRE: majic
    Entry04/08/2011 11:14 PM
    Memberrjm59
    Rasputin,
    Do you mind sharing your other 5 names you still think are legitimate in the us-listed china space?  Also I visited a number of companies including CCCL last Sept and would be happy to share offline, we also seem to overlap on a number of ideas (rmorris@mesoncapital.com).
     
    To share, I still would be quite surprised (which I think would have meant 90% sure a year ago, 50% now, ha!) if the following are significant frauds: CCCL, EDS, IDI (with restated #s not original overstated ones - this is the only one I know of that seems to have actually have turned around), TXIC (though we will see if the business actually benefits the shareholders vs insiders), and EMDY.
    Thanks

    SubjectRE: re: majic - types of fraud
    Entry04/09/2011 05:30 PM
    Memberrjm59
    Sorry - I should be more clear what I meant by "fraud".  I was referring to the "existential" fraud like CCME, RINO, CBEH, CAGC, DGW, DYP where the business is a small fraction of what is publicly represented is much bigger than the actual business (ex they say they have 100M revs but only 10M revs are really there).  It seems like 90% of Chinese RTOs are something like this or some variation like PUDA where there is an external lien or ownership that makes the US shares worthless.
     
    I think there has definitely been fraud at TXIC but it's not an existential thing, more like TYCO where the business is there but the insiders were diverting value.  The question is whether value goes to shareholders is still up in the air there.
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