China Yuchai

A high quality net-net stock

Thesis

CYD is a holding company and its main business is a 76.4% stake in Yuchai, China’s No.2 (mainly diesel) engine manufacturer for trucks, buses, construction, and agricultural machinery. Yuchai is a Sino-foreign business meaning the rest 23.6% shares are state-owned. CYD also has a 48.9% stake in a hotel operation in Malaysia, which will be ignored in this write-up due to its negligible (0.2%) revenue contribution.

Currently, CYD has net current assets of $611 million, and its stock trades for $339 million. This is a Ben Graham net-net stock with a large margin of safety. If the stock trades up to the net current asset value, the total return will be 78%.

Many net-net stocks today are problematic: either they are heavily in debt, or their businesses are unprofitable and declining. Neither of these issues apply here. Founded in 1951, Yuchai has built a reputation for high product performance and excellent customer service in China. It has generated profits and distributed dividends for the past 20 years. Its long-term debt ratio is merely 3.5%, which is very healthy for a capital-intensive manufacturing business. In fact, CYD’s cash is twice its total debt.

Over the past 10 years, CYD’s PB ratio never surpassed 0.5 — a figure that is too putative even for a cyclic business. I believe the main reason behind such suppressing multiple are two fold: 1) it’s Sino-Foreign structuremakes it unlikely to actively return value to shareholders, and 2) Chinese investors, who are familiar with Yuchai's business, are unable to invest due to its listing on the US stock exchange.

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What happened for the past three years

In 2021 and 2022, Yuchai’s net income shrank by 50%, and CYD’s stock price dropped to $7 per share from its 2020 peak of $16. However, as I will detail below, Yuchai’s poor performance was a result of a series of industry-wide one-time event and national macroeconomic difficulties, not a fundamental deterioration of its business. In fact, Yuchai maintained its No.2 market share during this challenging time.

National VI(a) emission standards were enforced in July 2021. A pre-buy of cheaper and less strict National V vehicles in the first half of the year led to significant inventory build-up and much lower demand for National VI trucks in the second half of 2021. National VI engines not attaining economy-of-scale production contributed to a lower gross margin. To make things worse, in the second half of 2021, commercial vehicle unit sales declined by 36.5% nationwide. Meanwhile, Yuchai’s R&D spending kept increasing, preparing for the implementation of National VI(b) standards in 2023. As a result, Yuchai’s net income dropped by 47.6% in 2021.

In 2022, although the gross margin recovered to its 2020 level, national sales of diesel engines declined by 26%, back to its 2016 level. More strict area lockdowns and travel restrictions led to supply chain interruptions, construction declines, and weakened consumer confidence. Yuchai recorded a negative operating cash flow for the first time in 20 years, as did all other competitors. Things are slowly recovering: in 2023, national diesel engine sales increased by 23%, and Yuchai’s CFO was almost back to its 2020 level.

2013-2023 National diesel engine sales and yoy change.

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Yuchai’s industrial position is stable

Construction and agriculture are essential components of China’s economy, leading to a high demand for trucks, tractors, cranes, and other machinery, all of which run on diesel engines. The EV transition has had little impact on the heavy-duty engine market, at least for the foreseeable future. Additionally, there is further growth potential in exporting to new emerging markets. Overall, I believe it’s safe to assume that the demand for diesel engines in China will remain stable, if not grow, in the near future.

Based on the market share data from the past five years, Weichai (2338) has significantly outpaced its competitors and firmly held the top position in the market. On average, Yuchai has maintained the second position with a slight advantage. Weichai and Yuchai are the only two companies that have consistently remained in the top three in the market over the past six years.

Figure 2. 2018-2023 market share for the top 3 diesel manufactures. Notice that company 3 is not necessary the same company.

With its brand name, financial prudence, 50 years of R&D investment, and rising technical barriers due to increasingly strict national emission standards, I have little concern that Yuchai’s can maintain its around 10% market share.

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Increasing operating margin is expected

With increasingly strict national emission standard, diesel engine production is a difficult business. To meet the National VI(b) standard, Yuchai’s R&D increased at a CAGR of 37.4% from 2019 to 2021 . Since 2022, Yuchai may final be able to take a break:

Total research and development (R&D) expenditures, including capitalized costs, were lowered to RMB 1.0 billion (US$ 146.4 million) in 2022 from RMB 1.2 billion in 2021, as most National VI and Tier-4 engine development programs reached commercial production. — from 2022 Annual Report

In 2023, Yuchai's R&D expenses increased by only 1.9%. To predict how long this trend can continue, we need to consider the potential requirements of the National VII standards.

The China VI emission standards have already surpassed the Euro 6 standards in many aspects. Meanwhile, the development of the Euro 7 standards remains controversial. Under the current Euro 6 standards, vehicle emissions have been reduced to negligible levels. Many research institutions argue that Euro 7 is not the right approach: its environmental impact is minimal while the costs are extremely high. As a result, some experts predict that when China sets its National VII emission standards, it will take a more cautious and moderate approach. Therefore, I expect Yuchai will not need to significantly increase its R&D to meet the National VII emission standards, which are expected to be announced around 2026.

Lastly, Yuchai's gross margin increased by 20% in 2022 and by 3.7% in 2023. This improvement is due to achieving economies of scale and the reduction in unit production costs as National VI engines became widely adopted in China. Overall, with increasing revenue, stable R&D expenses, and further cost reductions, I expect to see a promising upward trend in Yuchai's operating margin.

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Valuation

Balance sheet analysis

As I mentioned at the beginning, CYD is trading at a large discount to its net current asset value (NCAV). If the stock trades up to the net current asset value, the total return will be 78%. Below is the calculation with a bit of more details:

2025 forecast

Putting together my analysis of Yuchai’s industrial position and operating margin, I project Yuchai’s 2025 earning based upon following assumptions:

• Assuming its revenue recovers at a CAGR of 9.4%, the same rate as in 2023, Yuchai's revenue is expected to return to its FY'20 level by 2025.

• Using 10y average of 4.8% for operating margin. As analyzed above, Yuchai’s operating margin is expected to improve.

• Tax rate of 15%. Yuchai has been enjoying this reduced corporate tax rate under the Western Development Tax Incentive Scheme or the High Technology Incentive Scheme since 2008.

• Using a EV/NOPAT multiple of 8, which I think it’s fair for a cyclic business. (The median PE ratio for CYD for the past 10 years is 7.6x)

• Applying an 80% discount to its cash, as it seems unlikely it will be distributed.

Here is how the business would look at 2025 by using above assumptions:

At current market cap of $339 M, the upside is 173%. Of course, whether CYD’s stock will trade to its fair value or not is a big question mark, considering its depressing multiples over the past decade.

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Conclusion

In summary, I think Yuchai's recent poor performance is largely due to several one-time events, such as the adoption of National VI standards, the impact of COVID-19, and the slowdown of China's economy. With Yuchai's stable industrial position and the large R&D expenses for National VI standards coming to an end, I expect Yuchai's profits to continue improving as the Chinese economy recovers.

A quick note on insider ownership: Hong Leong Asia Ltd holds 44.7% of the shares, and the Guangxi Government holds 18.2% (effectively 37% of Yuchai is state-owned). I didn’t find any directors or executives with significant ownership, so I don’t expect management to actively address the undervalued stock price. CYD has consistently paid high dividends, with an average payout ratio of 63% over the past five years, as this is how Hong Leong Asia collect cash from the company.

Since only 37.8% of the shares are publicly held, the stock is quite illiquid. Being a US-listed local Chinese business certainly doesn’t help, as Chinese investors who are familiar with Yuchai's business cannot invest. The illiquidity leads to significant volatility in its stock price. Looking at CYD's historical price, returns have been quite substantial (over 100%) as Yuchai's performance recovers each time.

Finally, I’d like to point out that value investing funds such as Brandes Investment Partners and Chou Associates are among the institutional investors.

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The author of this write-up owns shares in the company mentioned and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.