FuYao and RoE
When asked about if there’s only one financial indicator what would Warren Buffett choose, He answered it is ROE.
What is so special about this metric? When talked about fundamental in IN the metrics we use most often is PE but seldom do I see people, even sell side analyst mention about ROE. However, especially for value investor, it is financially the compounding factor of an investment. It is also part of the DuPont analysis that is so useful to check the efficiency of a company.
If a company earns a 100 millions dollar and it has a payout ratio of 20%, it will give out dividend of 20 millions. But ever wonder how would the company use the remaining 80%? It is of course reinvest into its own businesses. But how could we judge the effectiveness of the retained earning? It is RoE. When company report it has x amount of earning. That earning goes to an account which is owner’s equity. The net income divided by owner’s equity is RoE. It is good indicator on how well the management used its resources to generate value for its shareholder.
Over the long run, It is the compounding effect that earns investors most of their money. If a business has capability to maintain its RoE consistently for many years, and also if you could hold it for many years. The PE you paid for the business will be less meaningful over the years. And your return on investment will gradually be identical to the company consistent ROE.
ROE can be manually increase by 2 main ways.(the others are explain by comments below) One way is to use leverage(using debt to generate revenue) and the other way is to return capital to shareholder AKA dividend. The declared dividend will go to a current liability account that is dividend payable. The way to know if the ROE is inflated by leverage is by looking at its ROA if you don’t read financial report(but why?). The higher the RoA, the better the company’s ability to generate income without using debt.
Let’s look a good example- FuYao Glass.
This is best the best automotive glass company in the world. Why? Not because it has the largest market share, but it is because it has 80% profit of the whole industry.
One reason is that they could manage their cost better than all their competitors.
The other reason is that they could sell technologically better products.
The success is due to the laser focus on one product - automotive glass. It is mostly the only thing they do for decades. And they only expand for vertical integration that enhance the two reason above. (although they just bought a glass frame company recently, believing that in the future the most cost-efficient way is to sell the whole door to car manufacturer) unlike its competitor whose automotive glass is just one of their operations. It is the cost advantage and good strategic manufacturing allocation that put the company on top of others.
it has second largest global market share of around 23%
Which consist of
2/3 of domestic market share
10% of foreign market share
TAM is expected to have CAGR of 3%
ASP is expected to have CAGR of 4%
Fuyao and Its main competitors and its percentage of revenue in automotive glass-
Competitors's automotive glass revenue composition
AGC Inc - 28% of their total revenue (largest global market share)
Saint-Gobain - 5% of their total revenue
Nippon Glass - 50% of their total revenue
Fuyao - 97%
Fuyao is the only company that focus solely on automotive glass, Competitors profit margin are miserable at 3.5% or below while Fuyao is at 20% as a result of their focus and expertise. The unusual difference of profitability# could be due to a self-sufficient value added chain. Quartz sand, PVB film, silver, ink, float glass etc are mostly self-supplied. More importantly, they also design and manufacture their own equipments. They have all the technology and expertise to increase the automation and quality of their products.
They take most of the industry’s money and consequently has higher R&D budget and consequently has higher ASP and they take more money. and the cycle continue..
As many business magnet has said, winter is coming. The business in nature is somewhat cyclical. However, the strong foundation of the company is evident just by the fact that they could expand their production while its competitors have no ability to do so. In addition, the company did it while maintaining its healthy balance sheet.
It is obvious to me that they will continue to increase their market share in the future because the company has a good management, excellent vertical integration to further advance their competitive advantage. Time is friend with good company and enemy to mediocre ones.
They have a strong and one of the wisest leader of China- 曹德旺. He is quite outspoken and you can view many of his interview on youtube. I’m sure you can learn something about business from him.
One of the way to judge the quality of the assets of a company is by looking at its accounting policy. In FuYao’s case they are using very aggressive depreciation.
The years of depreciation for the properties is 10-20 years
Equipment is 10-12 years
Transportation is 5 years
Electrical devices and others is 5 years
All with 10% salvage rate.
You can see that since they depreciate their assets at such rapid rate, their assets, as a result, is supposed to be higher in quality.
In some news that i’ve read it is known that they generally have major upgrade for their factories every few years in order to automate their facilities more. You could see that some factory’s productivity has been rising but the workers remain around the same.
Let’s do some DuPont
If you want to invest in company in China one thing you need to be careful is the account receivable. Because in China there are too many companies that don’t pay their debts. Your money is usually gone if you can’t retrieve it after certain amount of time. Receivables turnover is a good ratio as it is an accounting measure used to quantify a company's effectiveness in collecting its cash owed by its customers. So pay extra attention to this if you own an China’s stock.
In FuYao’s case, on average, Its customer’s used around 80 days to pay back its debt, it is not an impressive number compared to other industry but every industry has different standard ratio. In addition, majority of its clients are major car maker which reduce the likelihood of bad debt. Furthermore, it is better than 88 days last years. Indicate that it is regaining upper hand in the supply chain.
And the one of the most impressive about this business is that its operating cash flow is actually consistently higher than its earning. Not only the assets, but they also have a high quality of earnings.
While the above mentioned accounting policy and receivable turnover have something to do with the earning quality, the inventory turnover helped as well.
It is important to look for swelling inventory, it is one of the account that company can manipulate their earning when they move inventory’s number to the cost of goods sold(COGS). There are certain methods regarding this expense realization, FIFO, LIFO, Weighted Average. I will cover these maybe the other day. But it is important to notice that business could intentionally reduce their cost so that they get higher earning artificially. Over the time, it bloated the numbers on inventory. The inventory turnover days was reduced from 108 in 2015 to 96 in 2018. Indicate not only the quality of the inventory’s number but also the management ability to improve the operation.
ROE of Fuyao is 21%
The ability of the company to consistently maintain its above average software-company-like ROE is due to dividend distribution. It slim down the owner’s equity by giving out around 45% profit(?) over the years. Fuyao is a rare growth company nowadays that giving out cash to investors more than it takes from investors. Now wouldn’t it better if they could just keep more of the earning and reinvest into assets that compound? Of course it would be better! But that excessive money will bring them into field that they are not familiar with. One of the core culture of this company is to focus on the things they do best. And not mindlessly invest into thing that they’re not capable just to increase revenue and market share of other industry. If they cannot achieve decent ROIA, the right thing to do is to give the money back to investor.
RoA of 11.91% indicate that it earned its money without too much leverage. Fuyao y-o-y profit increase is largely due to currency difference and turnover of its acquired US factory otherwise it will be less than its 2017’s eps. Their TianJin factory and float glass factory just started operate. Suzhou factory will probably start operate in year. Russia’s factory is approaching breakeven, and there’s still potential productivity in its US factory.
Productivity is expected to surge in 3 years but profitability is not guaranteed since China and the world is approaching down cycle.
The valuation of the company is not high, and it is not without a reason. The whole car sales suffered their first decline in decades falling 4.1% from 2017. According to China Association of Auto Manufacturers(CAAM), Car sales suffered ninth straight month of decline. According to China passenger Car Association, 39.9% of the car dealers suffered loss in 2018. To make matters worse, chinese automakers’ debts and liability have increased. 13 listed auto manufacturers have the average debt ratio of 66.1%. It is highly probable that some of the car makers are going to go down if the trouble get worse. On the other hand, US’s market is also slowing down. Major automakers reported weak US sales of the first quarter and vehicle sales is expected to decline in 2019.
In the nutshell, profit growth will not be guaranteed in the near future. And I’d like to avoid making any projection. So I won’t touch on Forward PE and try to avoid too much valuation. Because I’m fully aware that something in business is knowable, and some are unknowable. I hope to improve the quality of my article by reducing as much unknowable information as possible especially those that will misled people. I’m certain that I do not know how the company will do in next earning report. I’m not even sure how the company will do in this or next year.
What I know with confidence is that Fuyao, whose industry is in downcycle now, is a great company with good corporate culture and demonstrated excellent fiduciary duty. Time is good friend for great company.
Some fundamentalist will says about this PB or that PE. But I somehow feel most of them are laser focus only on next quarter earning. As a investor, distance myself from the behaviour perhaps will give me advantage against the crowd.