Opportunities in Cleantech Stocks Amidst the Bear Market in China

While many in the U.S. are wondering when this long bull market in stocks will run out of steam, those following the Chinese market are living out a rough material pullback over the last year. Concerns about the slowing Chinese economy and debt burdens had existed for a while, but then the trade war that was long threatened went fully aflame this year, hitting the major Chinese indices hard:

·        Shanghai Composite Index down 24% since Jan 24 2018

·        SZSE (Shenzhen Stock Exchange – 500 stocks) down 30% since Nov 2017

·        Hang Seng Index (Hong Kong) down 18% since Jan 2018

These indices have bounced off of their lows in the past couple weeks, but their performance over the last year essentially fits the traditional definition of a bear market: a 20% downturn from top to bottom.

A bear market opens up opportunities for patient investors who are ready to deploy capital. Patience is key because there is no way to pinpoint the bottom; you may invest in a stock and appear to have “caught a falling knife” if the downturn continues. However, if you have bought a stock that is truly worth significantly more than what you paid for it, further decreases actually open up the opportunity to double down on your conviction. Then the investment should pay off in spades once the correction is over and the market turns, as it always does.

As Warren Buffet recently said: “I know whether to buy stocks; I don’t know when to buy stocks.” For those who are interested in finding long-term buy-and-hold positions in China at this juncture, here are high-level overviews of two companies that are involved in cleantech and for which I have high conviction of superior risk-adjusted returns over the long run (disclosure: I am long both).

Daqo New Energy Corp (NYSE: DQ)

Daqo has a market capitalization of approximately $343 million at a share price of $25.57, down 63% from highs around $68/share that was reached twice within the last year. The stock is trading at a P/E of just 2.86x while profitability continues to expand.

Daqo is a Chinese polysilicon manufacturer currently with 18,000 metric tons (MT) of production capacity. That is relatively small compared to the largest global manufacturers, as evidenced by this chart produced by one competitor:

However, Daqo is the low-cost leader:

* The competitors do not explicitly state their production costs or delivery volumes, so these figures are approximations based on available disclosed information.

** In addition to raw polysilicon, GCL-Poly produces and sells wafers (the next step in the process of turning polysilicon into solar modules), so this comparison is likely not apples-to-apples. They do not break out their cost of producing wafers vs polysilicon.

One of Daqo’s key advantages is its location of production in Xinjiang province in the far west of China. The factory in Xinjiang benefits from a low cost of electricity as compared to the industrialized eastern section of the country (electricity is the largest cost component in manufacturing polysilicon). Also, Daqo has performed well in applying new technologies to gain incremental efficiency improvements in production, such as hydrochlorination and thermal energy recycling.

Even from this starting point, Daqo expects further significant cost reduction of $1.70/kg (or almost 20% off of its already industry-leading production cost) by increasing production scale to as high as 65,000 MT by 2020. Given the much higher current throughputs of the competitors, it is reasonable to believe that Daqo does have more room to run in terms of increasing economies of scale.

China has experienced a long and fast expansion of polysilicon production capacity in China (see my previous post). However, and not by coincidence, current polysilicon prices are in historically low territory in the $ mid-teen/kg range. Over the long term, this is undoubtedly going to be a problem for manufacturers who cannot compete on price. Daqo estimates there is approximately 300k metric tons of capacity in China, and that 30-35% of that capacity is currently idle to due low prices. This would strongly indicate an upcoming painful period where weaker competitors with higher cost structures will be weeded out. Given its already strong position, Daqo can remain profitable before, during and after this transition.

In a commodity business, cost isn’t everything – it’s the only thing that matters.

In China, the vast majority of polysilicon is currently sold into the solar PV supply chain. However, the industry has a longer term play in selling polysilicon to computer chip manufacturers. As evidenced by the “Made in China 2025” strategy, China is determined to gain a dominant position in many advanced industries, and semiconductors are seen as a vital core technology. China aims to achieve a self-sufficiency rate of 40% in semiconductors by 2020 and 75% by 2025, versus 16% today. If the policymakers follow through, the opportunity for local industry seems tremendous. Daqo and GCL-Poly have already made references to this potential opportunity. The switch from supplying to solar PV over to chip manufacturers may not be perfectly seamless as there would certainly need to be some retooling of existing production lines or building out of new capacity, but much of the IP is similar and so the existing Chinese polysilicon suppliers would have a great head start and are well-placed to jump on this trend.

I project a return on invested capital (ROIC) of 11.6% for Daqo. Generally, a double-digit ROIC implies a very good business.

Key risks to the bullish thesis:

·        Daqo’s cost advantage isn’t necessarily an impenetrable “moat”; others can set up manufacturing in Xinjiang as well. In fact GCL-Poly is working on such an expansion.

·        The abrupt cut to solar subsidies by the Chinese government in May of this year is an overall negative for the industry.

Geely Automobile Holdings Ltd (ADR: GELYY; OTC: GELYF)

Geely has a market cap of approximately $17.8 billion, down 45% from its high last November. It trades at a very reasonable P/E of 10.2x for a company that has exhibited compounding growth with plenty of runway ahead of it.

Geely is the #2 domestic brand of passenger vehicles in China. Geely is a subsidiary of the holding company, Zhejiang Geely Holding Group, which was founded by Li Shu Fu in 1986. He remains the chairman and controlling shareholder of the holdco and is essentially the final decision-maker for Geely.

In addition to the company’s impressive performance and outlook discussed below, Mr. Li’s leadership is a key reason to invest in Geely. He proved his worth as an auto company executive when his holdco acquired Volvo Car Group from Ford in 2010 when it was a struggling brand. He invested $10 billion into Volvo and turned it back to operating profit. This past summer, Volvo considered an IPO and the market valued the company in the mid-teen $ billions. Volvo did not follow through, as Mr. Li likely believes the company could fetch a significantly higher valuation when the uncertainty surrounding auto tariffs has settled down.

Mr. Li is one of the richest men in China and is reported to have close ties to China’s political leadership. Recently it was disclosed that he amassed a 9.7% personal stake in Daimler AG. Daimler rejected a more direct proposal for an equity stake or technology-sharing deal with Geely. Despite the initial rebuff, it is possible that Mr. Li is in the early stages of executing a masterstroke involving a tie-up of Daimler and Geely.

Geely is executing impressive organic growth driven by both volume and pricing. The company sold 1.24 million vehicles in 2017, representing 63% volume growth over the prior year. Gross margin has been improving since 2014 and is above 19%, which is in step with the global automakers: Ford (16%), Toyota (19%), and GM (21%). The company has very little debt outstanding and has increased its dividend significantly since 2015. I calculate a projected ROIC of nearly 18% for Geely, which is spectacular if it can be maintained.

The runway of future growth comes from the EV market in China. China has prioritized this market by calling for the production of 2 million EVs per year by 2020 and 7 million per year by 2025. At the beginning of 2017, China implemented an updated subsidy program for EVs and hybrids which, among other things, sets minimum EV production quotas on the automakers. This benefits the larger players over the startups.

Geely targets 90% of total sales volume from EVs and hybrids by 2020. Its first EV brand was launched in 2015 and sold 25,000 units in 2017. The company is in the midst of launching fully electric and hybrid versions of all of its major existing models and some new models.

The trade war should not be a material headwind for Geely as it does not export cars to the U.S.

Key risk to the bullish thesis:

·        Competition in EV manufacturing. The Wall Street Journal reports that there are now 487 EV manufacturers in China, including startups. Year to date, Geely only has one car among the top 20 best-selling EVs. Competitors BYD and SAIC have several each.

Sources:

https://nationalinterest.org/feature/heres-how-china-achieving-global-semiconductor-dominance-26402

https://cleantechnica.com/2018/08/26/chinas-electric-car-sales-up-64-in-july/