Should Investors Brake For SORL Auto Parts?

By Stephen D. Simpson, CFA | April 04, 2012 AAA

Although there are a few exceptions here and there, it seems safe to say that American investors' indiscriminate obsession with all things China is long past. A spate of accounting scandals reminded investors of the corporate governance risks, while inconsistent (if not outright disappointing) performance dispelled the fantasy that anything Chinese was synonymous with instant growth.
SORL Auto Parts (Nasdaq:SORL) saw both the rise and fall of that love affair. This Chinese commercial brake company saw the occasional run on its shares on the back of breathless "China will change everything" nonsense, but the stock has since come down significantly, as retail investors got bored and issues within the Chinese economy slowed growth. Here and now, though, this may be the sort of obscure stock that patient investors want to check out more thoroughly.

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A Mixed End to the Year
SORL Auto Parts certainly didn't close the 2011 year on an especially robust note. Revenue was up around 2% overall, with domestic OEM revenue down roughly 10%, domestic aftermarket revenue up almost 14%, and international revenue up nearly 27%. The growth in the aftermarket and international sales is certainly welcome, but the sluggish OEM sales are a direct byproduct of the challenging economic environment in China right now.

Profitability was definitely mixed. Gross margin improved about a half-point, but operating income fell by more than half. First of all, SORL is seeing the same sort of labor cost inflation that is impacting almost every Chinese company these days. Just as important, the company is not stinting on its growth or expansion plans and that's leading to a larger, less leverageable cost base in the near term.

SEE: Investing In China

Opportunity Today Vs Opportunity Tomorrow
I was a little disappointed, but not terribly surprised, to see management give guidance for 2012 that's little better than the results for 2011. Conditions in China are tough now; banks have cut lending activity pretty substantially, and that's filtering down through the economy, as the Chinese government tries to find that happy medium between growth and inflation.

Longer term, I still think there are reasons for optimism. SORL customers like Dongfeng (OTCBB:DNFGY) and Tata (NYSE:TTM) continue to grow and become more viable on the international stage. At the same time, the company likely has to show that it can compete on the international stage against companies like Honeywell (NYSE:HON), TRW (NYSE:TRW) and Federal-Mogul (Nasdaq:FDML) to really work.

Can it be done? Little known Bharat Forge came out of India and has become the second-largest forging company in the world for products like auto and commercial vehicle chassis. Some of this may have come from fortuitous timing and a lucky break here or there, but exceptional leadership played a key role. Now, the fact that Bharat did it does not mean that SORL will. I simply make the point that emerging market companies can become big players in established markets over time, if they are well-run.

SEE: What Is An Emerging Market Economy?

The Bottom Line
The good news is that SORL does not need to supplant Federal-Mogul or TRW to work as a company or a stock. If the company can grow its revenue by about 9% over the next five years, produce mid-single-digit free cash flow margin (which would, admittedly, be quite an improvement over historical performance), and maintain high single-digit free cash flow growth for another five years after that, the stock should be in the double-digits.

That sort of revenue growth doesn't seem so hard to believe, given the expected growth in the Chinese commercial vehicle market (as seen by the likes of Caterpillar (NYSE:CAT) and Cummins (NYSE:CMI)), but by no means is this a sure thing. SORL represents a risky bet on potential, but this is a real company with real customers that arguably should not trade at half its tangible book value.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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