China Automotive Systems, Inc. (CAAS) Q3 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the China Automotive Systems Third Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kevin Theiss, Investor Relations. Thank you, Mr. Theiss. You may begin.

Thank you, everyone, for joining us today. Welcome to China Automotive Systems 2018 third quarter conference call. Joining us today is Mr. Jie Li, Chief Financial Officer of China Automotive Systems. He will be available to answer questions later in the conference call with the assistance of translation. Before we begin, I would remind all listeners that throughout this call we may make statements that may contain forward-looking statements. Forward-looking statements represent the company's estimates and assumptions only as of the date of this call. As a result, the company's actual results could differ materially from those contained in these forward-looking statements due to a number of factors including those described under the heading Risk Factors in the company's Form 10-K Annual Report, for the year ended December 31, 2016 as filed with the Securities and Exchange Commission, and in other documents filed by the company from time-to-time with the Securities Exchange Commission. The company expressly disclaims any duty to provide updates to any forward-looking statements made in this call whether as a result of new information, future events or otherwise. On this call, I will provide a brief overview and summary of financial results for the 2018 third quarter and nine month period. Management will then conduct a question-and-answer session. The following 2018 third quarter financial results are unaudited and the fiscal year results are audited. These results are reported under U.S. GAAP, and for the purposes of our call today, I will review the financial results in U.S. dollars. We will begin with a review of the recent dynamics of the automobile industry and China Automotive's market position. For the third quarter 2018, China's GDP grew slow to 6.5% from 6.7% in the second quarter and 6.8% in the first quarter of 2018. This number represents the weakest growth since the first quarter of 2009. Industrial production in the month of September grew 5.8%, but was below Reuter's expectation of 6%. According to the China Association of Automobile Manufacturers, China's vehicle sales fell 11.6% year-over-year in September 2018, the steepest decline in nearly 7 years. That drop followed a year-over-year sales decline of 3.8% in August and a drop of 4% in July. Passenger car sales fell 12% year-over-year to $2.1 million in September, resulting in a third quarter sales decline of 7.6% year-over-year. Commercial vehicle declined approximately 2.2% year-over-year with both bus and truck sales down in the third quarter of 2018. With the nine months period ended September 30, 2018, vehicle sales in China rose 1.5%. Passenger vehicle sales totaled $17.6 million for a 0.6% year-over-year gain. Commercial vehicle sales were $3.2 million, up 6.3% year-over-year. In the first nine months of 2018, sedan sales were up 1.29% year-over-year, SUV sales were up 3.9% year-over-year, and MPV sales were down 13.16% year-over-year. Credit curbs will make car loans more difficult and falling stock prices on Chinese exchanges have impacted consumer confidence. In addition, in 2018, vehicle tax levy was raised from 7.5% to its former standard of 10%. Slower economic growth combined with these specific actions affected passenger vehicle sales in the third quarter and nine months of 2018. Net sales of our traditional hydraulic steering products continued to anchor our sales in the third quarter of 2018. Hydraulic steering products sales declined by 1.7% due primarily the softness in the domestic brand passenger vehicle market. Net sales of our electric power steering products for the third quarter of 2018 declined to $21 million from $25.7 million in the same period last year and accounted for 18.7% of total sales revenue. To more quickly penetrate the domestic Chinese and export markets for electric power steering systems, we established a new joint venture, Hubei Henglong KYB Automobile Electric Steering System Company Limited or known as Hubei KYB with a subsidiary of Japan KYB company limited for the development and production of EPS systems. Specific product categories include column type electric power steering systems, geared type electric power steering systems, and rack type electric power steering systems and other automotive EPS products. CAAS and Japan KYB are transferring all their current Chinese EPS business, including KYB Japanese customers in China to Hubei KYB. Japan KYB has been engaged in development and manufacture of EPS system for 30 years. The rights to the EPS technologies of both parties are being transferred to the new joint venture with full technical support. We have already conducted a groundbreaking ceremony with the new facility at our production headquarters in Jinzhou City. We are highly optimistic that our new joint venture will quickly develop the market EPS products to enhance our market share in China and build stronger export sales and become a larger supplier for the world's automotive market. Our net export product sales to North America rose by 22.2% to $30.3 million as sales to both Fiat Chrysler North America and Ford remain robust in the third quarter of 2018. The products sold to our North American customers are advanced hydraulic steering. We believe we may be able to introduce new products using more advanced hydraulic features or products based on other technologies as well. In addition, we continue to believe that our Brazilian assembly operation would serve our global tier 1 customer in Brazil and Chinese OEM operating in the region has a bright future. Our gross margin was 13.7%, compared with 19% in the same quarter of 2017. This decline was mainly due to higher raw material cost and a change in the product mix. As part of our drive to control and improve efficiency, we lowered our selling, general and administrative, and R&D expenses by 22.6%. Our income from operations was $1.8 million in the third quarter of 2018, compared to $4.9 million in the same quarter of 2017. The decrease was mainly due to lower gross profit. Our diluted net income attributable to the parent company's common shareholders per share was $0.01 from $0.16 in the quarter of 2017. We continue to invest in research and development with almost $7 million invested in the third quarter of 2018 compared to $9.2 million in the third quarter of 2017. The lower R&D expenses were mainly related to more strict cost controls and transfer of our electronic powered steering research projects to our new joint venture for electronic power steering. In addition to our EPS technology, our R&D is also developing other new products such as our Advanced Driver Assistance Systems, ADAS for the future. At September 30, 2018 we had cash, cash equivalents, pledged cash and short-term investment of $144.1 million. During the third quarter, cash flow from operations was $9 million with capital expenditures of $24.3 million mainly to enhance our EPS production capabilities. Providing incentive to buy new vehicles, China's top economic planning body has proposed cutting the tax levied on car purchases by half to 5% with vehicles that have engines no bigger than 1.6 liters. No decision has been made on the proposal or implementation, but the automotive industry is one of the most important in China employing many people. The Chinese government has cut the tax in the past and successfully spurred the purchase of new vehicles. We announced that the Special Committee of the Board of Directors received a letter dated August 16, 2018 from the Buyer withdrawing its non-binding going-private proposal. In the withdrawal letter, the Buyer stated that considering the recent market conditions, it decided to withdraw the proposal and immediately terminated any further discussions with the company regarding going private. As such, China Automotive Systems will remain a public company going forward. We are well positioned with our broad product portfolio, hydraulic steering price as we supply into more than 60 customers, our prestigious customer list is clear evidence of the high quality performance and reliability of our steering products. International operations in North and South America are growing. We believe our new EPS joint venture will bear significant returns, and increase our market share in China as well as open new doors internationally in the future. Let me review the financial results for the third quarter of 2018. Our net sales were $112.1 million compared to $118.4 million in the same quarter of 2017. The decrease in net product sales was mainly due to a change in the product mix and lower domestic sales volume due to softer demand in the Chinese domestic brand automobile market. Net product sales to North America grew 22.2% to $30.3 million compared to $24.8 million for the same quarter in 2017. The increase in export sales to North America was mainly due to higher sales of the company's more advanced products. Gross profit was $15.4 million in the third quarter of 2018, compared to $22.5 million in the third quarter of 2017. Gross margin was 13.7% compared to 19% for the same period of 2017, mainly due to an increase in the cost of raw materials and the changes in the product mix. Selling expenses were $3.4 million in the third quarter of 2018, compared to $4.5 million in the third quarter of 2017. Lower selling expenses were mainly due to lower unit sales as well as utilizing the lower cost shippers. Selling expenses represented 3% of net sales in the third quarter of 2018, compared to 3.8% in the third quarter of 2017. General and administrative expenses were $3.7 million in the third quarter of 2018, compared to $4.4 million in the same quarter of 2017. The decline was primarily due to lower personnel expenses. G&A expenses represented 3.3% of net sales in the third quarter of 2018 compared with 3.7% in the third quarter of 2017. Research and development expenses were $7 million in the third quarter of 2018, compared to $9.2 million in the third quarter of 2017. R&D expenses represented 6.2% of net sales in the third quarter of 2018 compared with 7.8% in the third quarter last year. The lower R&D expenses were mainly due to greater cost controls over R&D expenditures and the transfer of some research projects to our new joint venture, Hubei KYB for electronic power steering. Net financial income was $0.8 million in the third quarter of 2018 compared to net financial income of $1 million in the third quarter of 2017. Income from operations was $1.8 million in the third quarter of 2018, compared to $4.9 million in the same quarter of 2017. The decrease was mainly due to lower gross profit and lower gross margin. Income before income tax expenses and equity in earnings of affiliated companies was $1.8 million in the third quarter of 2018, compared to $5.7 million in the third quarter of 2017. The decrease in income before income tax expenses and equity in earnings of affiliated companies was mainly due to lower operating income in the third quarter of 2018 compared with the third quarter of 2017. Net income attributable to parent company's common shareholders was $0.4 million in the third quarter of 2018, compared to net income attributable to parent company's common shareholders of $5.1 million in the third quarter last year. Diluted earnings per share were $0.01 in the third quarter of 2018, compared to diluted earnings per share of $0.16 in the third quarter of 2017. The weighted average number of diluted common shares outstanding was 31,645,556 in the third quarter of 2018, compared to 31,644,271 in the third quarter of 2017. Let me go over the results for the first nine months of 2018. Our net sales for the first nine months of 2018 were $371.9 million, compared to $355.3 million in the first nine months of 2017. Nine-month gross profit was $54 million, compared to $68.2 million in the corresponding period last year. Nine-month gross margin was 14.5%, compared to 19.2% for the corresponding period in 2017. For the nine months ended September 30, 2018, gain on other sales amounted to $3 million, compared to $5.9 million for the corresponding period in 2017. Income from operations was $7 million compared to $23.2 million in the first nine months of 2017. The operating margin was 1.9%, compared to 6.5% for the corresponding period of 2017. Net income attributable to parent company's common shareholders was $5.5 million compared with $19.7 million in the corresponding period last year. Diluted earnings per share were $0.17 in the first nine months of 2018, compared to diluted earnings per share of $0.62 for the corresponding period in 2017. Our balance sheet highlights. As of September 30, 2018, total cash and cash equivalents, pledged cash deposits and short-term investments were $144.1 million, total accounts receivable including notes receivable were $249.6 million, accounts payable including notes payable were $196.6 million, and short-term loans were $70.9 million. Total parent company stockholders' equity was $309.5 million as of September 30, compared to $306.1 million as of December 31, 2017. Net cash flow from operating activities was $9 million in the first nine months of 2018. Management - the business outlook, management has reduced its revenue guidance for the full year 2018 to $510 million from $520 million. This target is based on the company's current views on operating and market conditions, which are subject to change. With that, operator, we're ready to begin the Q&A session. Operator?

Thank you. We will now start to get Q&A, our question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of [Robert Polawich] [ph] a private investor. Please proceed with your question.

Oh, yes. Good morning. Thanks for taking the call. I have a couple of questions here. And, of course, with your - the gross margins really have come down and, I guess, that's - as you indicated, higher cost of raw materials. I'm just wondering, what's the timeframe for getting price increases on new contracts to cover the cost of raw materials? Do you think that's something that can be passed on without too much difficulty? And will that be the plan as we move into 2019?

Okay. Thank you. [Foreign Language]

[Interpreted] Okay. Basically, raw material cost increase is only one of the factors affecting the gross margin depreciation - gross margin decline. The other two factors are basically the product mix. During the third quarter 2018, we were increasing the sales of lower margin mechanic steering products. So due to the increase of those products are affecting our blended gross margin. And also, the last factor is the increase of warranty expenses. And so, combining raw material and product mix and warranty expenses, those three factors are - and then we see a pressure of the gross margin. In the past, we were able - for instance, the gross margin, the raw material challenges, increase is not the first time. In the past, we were able to pass some of the pressure to our suppliers. Some of the raw material suppliers, we're able to negotiate with them. This year, because they're going through some challenges as well, so we're not able to do it during this quarter. But in the longer run, we believe we are able to renegotiate with them of the raw material procurement cost as we are a large volume buyer.

Okay.

[Interpreted] Go ahead, Robert.

Okay. Thanks, let's see. I see that the joint venture, I guess, is signing - the startup was in September. And I was looking at KYB's reports and it looks like the startup volume is about US$175 million combined. And as we move into 2020, the projection is for about US$307 million from the combined joint venture, which is an increase of about US$130 million. I'm assuming that the ramp up of this new business will - is happening now. And what can you say about the projections for growth over the next year to two years?

Okay. [Foreign Language]

[Interpreted] So Robert, the projection you mentioned for joint venture is the - after the discussion on both sides we've come to those numbers. We think it's achievable given the size of Chinese market. And also as you can tell the EPS products are really catching up in China market. Our - at the moment, our EPS products - our market share for the EPS product in China is still relatively modest. We believe with the partnership with KYB, we're able to build out a major force and we can expand from there. So from that point on, we can grow 10% to 15% a year and increase our market share.

Okay. I also see now to that - it looks like Brazil is picking up, they had their vehicle sales, I think, were up 25%, last month. Do you think that will help the situation with what China Automotive is doing in Brazil?

[Foreign Language]

[Interpreted] Yes. You are right, Robert. In the first nine months of 2018, our sales in Brazil also experienced a very strong growth. On a year-over-year basis, we grew 30% in Brazil.

Okay. I guess, I have, I can say, a last quick question or two. As minority shareholders regarding status of China Automotive, we know that for about 1.5 year almost we were dealing with the potential for a buyout from Chairman Chen, and I know that that's been canceled. Are we now at a point, where we can feel confident that China Automotive will remain a public company, traded I guess in the U.S. markets? And in light of everything that's transpired, is there any possibility that we could see even some level of the share buyback in light of the share price now being as low as it is, as a vote of confidence for existing shareholders as well as potential new shareholders. I mean, personally, I've owned China Automotive stock for a long time. And we held it in good faith, but it sure would be nice to see some vote of confidence that we could feel comfortable continuing to hold the shares. Thank you.

Okay. [Foreign Language]

[Interpreted] Okay. So back to your comment, first comment. In terms of the Chairman's and his party's withdrawing the go-private proposal, that decision is final. And CAS will remain a U.S.-listed or NASDAQ-listed public company into the long run. And so we want you to know, CAS are very committed to maintain a U.S. listing status. In terms of a buyback, and your points are well taken. The challenge right now is the Chinese government implemented a very strict and stringent capital control policies. As you know the U.S. China situation at the moment, and so the capital transfer from China to outside of China has been difficult in getting through the Chinese government's approval. However, we are working out some solutions and trying to be able to achieve that goal.

In terms of a buyback, personally the CFO, Jie Li, he think, it's something worth looking at it. And he's in - he agrees with you that the company is undervalued.

Okay. I appreciate you're answering my questions. I mean, that sounds good to me. I just wanted to say that, I know the joint venture with KYB that is a significant development and I'm familiar with that company. They're over 100 years old. And you will have great success with this joint venture, I have no doubt. Thank you. Thanks a lot for taking the call.

Thank you.

Thank you. Our next question comes from the line of [John Sheehe] [ph], a private investor. Please proceed with your question.

Hello, everybody. Thank you for taking my call, and thank you for the detailed answers you provided to all the questions so far. Can you share some expectations about how much of capital expenditure will be required for the KYB joint venture over the next year?

Okay. [Foreign Language]

[Interpreted] Okay. So the formation of the joint venture is based upon the contribution from CAS side and we'll have - we'll contribute the equipment and the production line, because we have the existing production line equipment and the KYB will contribute the cash to the joint venture. So they were probably putting in about $10 million with our equipment, we're able to increase the production for the EPS product - increase in production capacity for EPS product.

So from the China Automotive Systems side, you will not make a large capital expenditure over the next year for the joint venture. Is that correct?

Correct.

Okay. That's great. And can you comment on the impact of U.S. tariffs on export sales to North America?

[Foreign Language]

[Interpreted] So since the announcement, the State Department's announcement on the increase of the tariff imports, we have gone through a series of evaluations, the potential impact to our business in North America. The short answer is, it's controllable, it's manageable, so yeah. So our projected sales to the North America is about $120 million, one-third of that is currently facing about 10% tariff. And with that potential - we've still not announced and finalized, but it's the U.S. government, who has the potential to increase to 25% at the end of the year. Okay. So after the discussion, after our discussion with our customers in North America, we come to a mutual agreement to share some of the impact on both sides. And also combining - also we'll receive some of the government subsidy and along we're seeing appreciation of US dollars which is in favor to us. And so, these three things together we believe will help us mitigate the impact of the increase of tariff. And so, we believe the potential negative impact to our North America business will be manageable and minimal.

That's great. Thank you very much for that detail. That's all my questions.

Thank you.

Thank you. Our next question comes from the line of Peter Halesworth with Heng Ren. Please proceed with your question.

Yes, so my first question is was there any sense if there was an acceleration of orders, is there pull-through in this quarter in order to avert or mitigate tariff on the part of U.S. customers? That's my first question.

Peter, can you repeat your question? Your voice is low.

Yes, is there any evidence that there was an acceleration of orders from U.S. customers to beat the tariff? Is there any evidence of that? That's my first question.

Okay. [Foreign Language]

[Interpreted] Our order book from the U.S. customer has been relatively stable. So there is no accelerating growth for that chapter, that area.

Okay. And then my second question is, what was the valuation of the company provided by Houlihan Lokey, which was the advisor to the Special Committee that was representing shareholders during the failed buyout from the Chairman? What was the value of the company that Houlihan Lokey arrived at?

[Foreign Language]

[Interpreted] To answer your question, Houlihan Lokey was retained by Special Committee, which is formed by some of the Board members. So the senior management has never - has no access to that report. So the whole evaluation was done by the Special Committee.

Okay. And just my last question relates to what Mr. [Polawich] [ph] mentioned before, this loss of confidence on behalf of shareholders. It's very concerning to not see the Chairman on this call, who we haven't heard from directly for over 15 months. Also the CEO is not on the call. Shareholders want positive change in corporate governance and IR. And the $2 stock price is a high penalty that we're suffering because of this poor corporate governance and IR. And in fact, shareholders have given ideas about how China Automotive can improve their corporate governance and IR, and it's been ignored. And it's a matter of fact that China Automotive is an American corporation in Delaware, listed on NASDAQ and it needs to start to act like it. You need to meet investors. You need to communicate directly and regularly. You have to have a Board that's qualified and represents…

Thank you.

[Foreign Language]

[Interpreted] Okay. So before the earnings conference call, I mean, the Chairman actually called to CFO. His flight was delayed. So at the time of the conference call he was - he's actually up in the air. So he has tried to attend the call. So that's - but he's on his way to meet one of the largest customer of CAS, discussing a 2019 order. I think lot of those shareholders of CAS will appreciate those efforts, especially in a year there have been some difficulties.

Thank you. There are no further questions at this time. I'd like to turn the floor back over to management for closing comments.

Well, we thank everybody for joining us today. And we look forward to speaking with you in the future.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.