Sometimes it seems that investing in China is all about finding the "Chinese version" of some successful Western company. Gome is the "Chinese Best Buy (NYSE:BBY)," Lenovo is the "Chinese Dell (Nasdaq:DELL)," Zhongpin (Nasdaq:HOGS) is the "Chinese Smithfield (NYSE:SFD)," etc.
With that in mind, then, is China Yuchai (NYSE:CYD) the "Chinese version" of Cummins (NYSE:CMI), the successful Indiana-based diesel engine manufacturer? More to the point, as the risks of investing in Chinese stocks become more widely-known, is this a name investors can trust as a play on the ongoing growth of China's industrial and transportation sectors? (For more, see Investing In China.)
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A Solid End to the Year
China Yuchai reported that fourth quarter revenue rose almost 24% to about $607 million, largely on the back of a nearly 14% increase in unit sales. While pricing was strong in general, the company also benefited from an going migration towards heavy-duty engines making up a larger portion of the sales mix.
Profitability was also quite good for the quarter. Gross margin improved by nine full points, while operating margin improvement was even stronger. All in all, operating income growth was nearly 130%, and the company posted a strong increase in earnings per share for the quarter and full year. Regrettably, the company did not publish a cash flow statement with the earnings release, but a casual observation suggests working capital increases probably overpowered the earnings momentum.
Unfortunately, there is no easy way to put these results in context, as very few analysts follow China Yuchai and many of their direct Chinese competitors do not report in a comparable fashion. That said, growth for the full year was surprisingly consistent with this fourth quarter result, so it would seem that Yuchai is seeing solid sustained growth in its business.
There is little question that diesel engines are a growth market in China right now. Plenty of engine and truck manufacturers ranging from Caterpillar (NYSE:CAT) to Cummins to MAN SE, Volvo and Tognum have pointed to growth in emerging markets, and China in particular, as significant drivers.
China Yuchai is a somewhat small player currently in light-duty and heavy-duty engines, it has a sizable position in the medium-duty market. That said, context is important. While China Yuchai may well be the largest domestic manufacturer of diesel engines, Cummins' China sales were twice as large in 2010 and the company doubled its growth (while Yuchai grew about 25%). In other words, it will likely be some time before Yuchai elbows its way into the big leagues with customers like Ford (NYSE:F), General Motors (NYSE:GM) or Honda (NYSE:HMC). (For more, see Auto Stocks For 2011.)
Approach with Caution
In some respects, China Yuchai may be an antidote to the spate of recent reports on fraudulent (or at least exaggerated) financials from small Chinese companies. China Yuchai does boast a major auditor (Ernst and Young), has been in operation for quite a while, and boasts major customers like Dongfeng.
That said, it's not a flawless story. The corporate structure of China Yuchai is somewhat confusing and indirect - China Yuchai is a holding company whose major asset is a 76.4% interest in Guanxi Yuchai Machinery (the diesel engine maker). What's more, it is a Bermuda-based subsidiary of Hong Leong Asia, which owns about 28% of the company and a "golden share."
Making matters worse, there have been conflicts before between the holding company and the Chinese diesel engine company. It would take far too much time to recount the problems here, but there were squabbles almost 10 years ago regarding management of the company and distribution of dividends, and there were attempts to declare China Yuchai's ownership stake as invalid, illegal and unenforceable. All of that was more or less settled years ago, but it should be a reminder to investors that investing in situations like these is not just like picking up 100 shares of CAT or CMI. (For more, see ETFs To Hedge China.)
The Bottom Line
The growth potential of the Chinese truck, bus and power generation market is very real, even if some bulls gets a little overheated with their projections. China Yuchai is showing solid growth, good margins and good returns on capital, but the stock's valuation does not seem to fully capture that. While it is entirely appropriate for investors to expect a discount because of the drawbacks of the holding company structure and the risks that go with small companies, very aggressive investors may want to investigate for themselves just whether the discounting here has gotten too severe. (For more, see Long-Term Prospects For China Still Good.)
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