China Automotive Systems: Revving-Up To Move Up

Improving Conditions

We are probably going to make an investment in China Automotive Systems, Inc. (NASDAQ:CAAS) in the near future, again. We deem it a risk outside the bounds of our conservative positions since we are retail value investors. But a little risk-taking can be fun now and then. Our assessment of CAS is a bullish rating.

The company's products are essential and in demand. China's impact on the European and U.S. automotive industries is immense. CAS makes and sells rack and pinion power steering gears and columns for lightweight passenger and heavy-duty commercial vehicles, sensor modules, electronic and hydraulic power steering systems, pumps, and hoses. It designs and sells automotive motors and electromechanical integrated systems, polymer materials, and intelligent automotive technology research and development services. Heavy investments in R&D are making the company a player "in the process of integrating new advanced technologies such as electronic chips in power steering systems into its current production line."

In our opinion, China Automotive is a bullish opportunity because the economies of the West and China are inextricably entwined; we believe trade tensions will ease and barriers begin to fall; the automotive export business is growing but there will be fits and starts. Total vehicle exports are expected to reach 4.4M units in 2023. New energy vehicles (NEVs) will account for more than 30% of them, according to market research firm Canalys.

Partners

China Automotive Systems does business with 60+ OEMs. FAW Group and Dongfeng Auto Group Co., Ltd. are two of the five largest automobile manufacturers in China. Shenyang Brilliance Jinbei Co., Ltd. is the largest light vehicle manufacturer in China. Chery Automobile Co., Ltd., which we drove on a trip in Israel recently, is China's largest state-owned car manufacturer. BYD Auto Co., Ltd. and Zhejiang Geely Automobile Co., Ltd. are the largest privately owned car manufacturers in China. General Motors, Volkswagen, Citroen, and Chrysler North America are all key customers. Starting in 2008, CAS supplied power steering gears to the Sino-foreign joint ventures established by GM, Citroen, and Volkswagen in China. CAS has supplied power steering gear to Fiat Chrysler North America since 2009 and to Ford Motor Company since 2016, according to the CAS website.

China's better vehicle sales are going to trickle down and generate better revenue for CAS. Management is watchful of expenses and with inflation ticking down future earnings might be stronger than forecast. We are impressed that the stock is largely owned by corporate insiders, private corporations, and institutions; that gives decision-makers a bigger stake in planning and execution.

Right Place, Right Price

China Automotive is something of a nexus "under the hood" for the legacy auto industry where it meets the nascent, next generation of electric, self-driving vehicles. Our interest in EVs as the centerpiece of the Green Movement began with a business book; it awakened us to the purposeful and coincidental public policies that led to the implosion of Israel's nascent but vibrant homegrown EV company, Better Place.

We stumbled on CAS in 2017 when the price roamed around $4.50 per share. We wrote about the company in 2020. The volatile share price had popped to $6.99. COVID-19 raged and its economic impact setback China's manufacturing output. By April 2020, the share price was less than $2 each, so we assessed the stock as worth a Hold rating. Two years later we turned bullish when the price climbed to $4 then to over $9 on news about the EV industry.

A number of other factors undergird the last year's rise in the share price (+86%). Last month, China unveiled a $72B tax break for purchasers of EVs and other green cars to spur demand. A report issued about the automotive rack and pinion and electric power steering systems market details the growth. CAS is a key player:

Positive Outlook

Our position about the EV industry and CAS at this time remains positive. Between 2016 and 2020, after China declared its commitment to remove combustible engine vehicles from the roads, EV sales flourished. More production and prices of EVs fell. Other countries and U.S. state governments followed suit. China developed its strategy 360. The government set targets for complete electrification "from sourcing ground materials to production, to distribution, to sales and marketing. It includes incentives for consumers, OEMs and charging providers."

Market share for EVs is growing but slower since the novel COVID virus. The good news about the automotive industry and EVs, in particular, might be the push behind the CAS stock's rise in price. For instance, trade relations might be thawing; the Secretaries of State and Treasury are holding more frequent meetings with China's financial and political leaders where mutual concerns about trade barriers are being discussed. Tariffs might fall away.

We believe price dips under $5 per share are an opportunity for retail value investors with risk tolerance and fortitude to change buying into our moderate buy assessment. Estimated earnings for FY '23 multiplied by the company's 5.95 PE suggest around $5 per share is a fair valuation. But we factor in the industry's inexorable growth and good news. We forecast an average price target of over ~$7 in the next 12 months.

The share price might move up on better-than-expected revenue and earnings forecast by the CEO in his May address to shareholders and analysts. The notion might also be driving the share price before the next earnings announcement is scheduled for August 11, 2023. The consensus is Q2 '23 EPS will be less than half that of last year's EPS of $0.31 but the actual EPS numbers beat estimates in 7 of the last 9 quarters.

Other technical numbers can be adding impetus to our forecast for a higher share price:

Q1 '23 Added Momentum

China Automotive's share price is +81% over the past 12 months on all the news including better revenue and earnings expected to be reported in May for Q1 '23. Shares climbed to over $9 each but then tumbled (-12% YTD). At about $5.12 per share, the price is closer today to its June '23 settlement of ~$4.90 per share than to the stock's 52-week high of $9.70 despite 3 consecutive years of revenue growth and positive earnings. Q1 '23 highlights reported in May included:

• Net sales increased by 4.3% to $142.2M compared to $136.4M in Q1 '22.
• Gross profit and gross margin were higher, +46.9% and about 31%, respectively.
• Income from operations was $7.7M in Q1 '23 versus a loss from operations of $1.5M in the first quarter of 2022.
• Selling expenses declined attributable to lower transportation costs that seem to still be dropping in 2023, and lower marketing and administrative costs.
• The net financial loss of $400K in Q1 '23 is tied to foreign exchange volatility.
• The capital structure is comparatively stable: the market cap is $153M, debt is $45.68M, and cash and equivalents including pledged cash and short-term investments are $164.3M.
• The Enterprise Value is $116.55M, the PE is 5.95, and the short interest is just 1.42%.

Risks

China's manufacturers still face headwinds from ongoing intergovernmental political and trade tensions. U.S. tariffs imposed on goods from China in 2018 remain in force including vehicle parts imports. Reuters reported that in May a bipartisan group of U.S. lawmakers met corporate leaders in the automotive industry to persuade them to "shrink reliance" on parts manufactured in China. Concomitantly, CAS faces headwinds to domestic sales as China's imports of auto parts and accessories increased to $2.25B in May from $1.97 in April of 2023.

The good news for CAS is that demand and production in the U.S. and China for new cars continue to strengthen and defy domestic economic issues like inflation.

A second risk stems from the seasonality of the auto parts business affecting sales, and cash flow, making for a bumpy quarterly share price ride during the year. In March '23 the actual Q4 EPS was $0.23, $0.14 in December '22, $0.24 in September '22, and $0.31 in June '22.

Another risk to CAS investors is due to the fast rise of the automotive industry in China between 2009 and 2018 and through to 2023. Competition might affect earnings; the plethora of relatively young OEMs in China's automotive industry are scrambling to capture market share resulting in a domestic and overseas EV price war. OEMs are leaning on suppliers like CAS to lower prices for products and systems; lower margins shrink in the drive for greater revenue.

Other risks exist, too, especially in a highly regulated society like China. Businesses face financial regulations and laws as a core priority to reduce financial risk to the government. There are frequent claims the U.S. and China's economies face debt crises and the economies are sinking; there is an ever-present crisis looming over consumer spending that will hurt companies like China Automotive Systems. We believe China's economy is on track for a 5% growth in GDP.

International trade exposes society to international travelers and ideas that can be seen as a threat to the government. Think Jack Ma and the unraveling of his empire when one gets too big for their britches. Finally, CAS faces competition from others in the auto parts and equipment business.

The Drive Away

China Automotive Systems, Inc operates in a growing industry. It has a hearty list of customers at home and worldwide; they offer a bulwark to vagaries and disparities among national economies. The company's cash flow from operations reassures us for the future:

Easing inflation rates, stabilizing interest rates, better consumer spending on automobiles, and the continued backing of the government to improve vehicle sales and exports, put CAS in a healthy growth position. At the current share price, and especially on any dip, we are bullish about the stock. A few hedge funds own shares of CAS; it appears they usually buy on price dips.

This is in our opinion a risky investment; supply chain issues still plague the automotive industry forcing some OEMs to establish their own production and supply chains. But they are also strengthening partnerships with suppliers like CAS and pursuing acquisitions. Further cutbacks in R&D spending by CAS might be a signal that it is time for the company to engage China's bubbling M&A automotive stewpot.

Investing in moderation is still best advised. Also, consult a tax attorney or financial advisor about the implications of owning shares in a foreign-based holding company. The narrative about the who, what, where, when, and how of CAS's beginnings are interesting but the most memorable reason for owning the stock focuses on the 'why' i.e., to make a profit.