Tongda Group: Cheap Valuations Justified By Margin Pressure (OTCMKTS:TDGFF)

Elevator Pitch

I maintain my “Neutral” rating on Hong Kong-listed handset casing supplier Tongda Group Holdings Ltd. (OTC:TDGFF, 698:HK). Smartphone sales are likely to decline as a result of the current coronavirus outbreak, but Tongda Group is still guiding for a 14% YoY increase in handset casing shipments to 160 million units this year. Tongda Group’s FY2020 profitability is dependent on its ability to increase the sales mix of higher-margin 3D and uni-body Glastic casings, to offset the margin pressure for 2.5D Glastic casings.

While Tongda Group is trading below half of its book value, margin pressure and a reduction in dividend payout ratio last year are key concerns, which warrants a “Neutral” rating.

This is an update of my initiation article on Tongda Group published on July 17, 2019. The share price has declined by -28% from HK$0.61 as of July 16, 2019 to HK$0.44 as of April 1, 2020 since my initiation. It trades at 5.1 times consensus forward next twelve months’ P/E, which represents a discount to its stock’s historical five-year and 10-year mean consensus forward next twelve months’ P/E multiples of 8.3 times and 7.5 times respectively. The stock is also valued by the market at 0.48 times P/B, versus its historical five-year and 10-year average P/B multiples of 1.87 times and 1.52 times respectively. Tongda Group offers a trailing twelve months’ dividend yield of 2.4% and a consensus forward next twelve months’ dividend yield of 3.6%.

Readers are advised to trade in Tongda Group shares listed on the Hong Kong Stock Exchange with the ticker 698:HK, where average daily trading value for the past three months exceeds $3 million and market capitalization is above $350 million. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage, such as Interactive Brokers, Fidelity, or Charles Schwab, or local brokers operating in their respective domestic markets.

Impact Of Coronavirus Outbreak

According to a research report published by Taiwan’s TrendForce Corp. on March 30, 2020, global smartphone shipments are expected to decline by -7.8% YoY to 1.29 billion units in 2020, and the market research firm revised its forecast for 1Q2020 global smartphone shipments from 307 million units earlier to 274 million units. The weak outlook is largely attributable to disruption to manufacturing and supply chain activities as a result of the coronavirus outbreak. On the positive side of things, Tongda Group highlighted that the “major operating plants under our Group has substantially restored to their normal operation” as of March 17, 2020 in the company’s FY2019 results announcement.

At its FY2019 earnings call on March 18, 2020 (audio recording and transcript not publicly available), Tongda Group disclosed that its production activities have been restored to 80% of normalized levels (prior to the coronavirus outbreak) by mid-March.

The company also guided for a 14% YoY increase in handset casing shipments from 140 million units in FY2019 to 160 million units at the recent earnings call, notwithstanding production disruptions in February due to the coronavirus. Tongda Group remains positive on handset casing shipments in FY2020 because of new clients recently secured such as Chinese smartphone company Vivo, an increase in adoption rate of “Glastic” casing (a term used to refer to glass-like plastic casing), and the 5G smartphone replacement cycle.

On the flip side, smartphone demand could be adversely impacted by the current coronavirus outbreak. Tongda Group’s major clients are Xiaomi Corporation (OTCPK:XIACF, OTCPK:XIACY, 1810:HK), Apple (AAPL) and Samsung Electronics (OTC:SSNLF, OTC:SSNNF), and these customers have indicated recently that their smartphone sales have been affected by the coronavirus. South China Morning Post reported on March 31, 2020 that Xiaomi “warned of a short-term decline in sales during the first quarter,” while “the coronavirus outbreak halved demand for smartphones” in China in February 2020, according to a Reuters article published on March 9, 2020. Samsung Electronics highlighted at its annual general meeting on March 18, 2020 that “the smartphone market is contracting.”

The outlook for global smartphone shipments and sales, and Tongda Group’s handset casing shipments in 2020, is heavily dependent on how the coronavirus situation evolves over the next few months.

Intense Margin Pressure In FY2019

Tongda Group’s revenue increased by +3.2% YoY, from HK$8,899.3 million in FY2018 to HK$9,185.9 million in FY2019, but the company’s net profit attributable to shareholders decreased by -26.0% YoY, from HK$542.8 million to HK$401.5 million over the same period. This was largely attributable to intense margin pressure in FY2019.

The company’s gross profit margin declined by -190 basis points, from 20.2% in FY2018 to 18.3% in FY2019. There was rising competition in the lower-end segment of Glastic casing – 2.5D (two-and-a-half-dimensional) Glastic casings (as opposed to the higher-end 3D and uni-body Glastic casings) – last year. At the same time, Tongda Group’s average selling price and profit margins for the tri-proof and high-precision components segment also fell, given that “the smartphone components for the new models supplied by the Group were not a significant upgrade,” as per the company’s FY2019 results announcement.

This implies that even if Tongda Group does achieve its FY2020 handset casing shipments target of 160 million units, the higher revenue growth might come at the expense of lower profit margins. 2.5D Glastic casings and Glastic casings as a whole (including 3D and uni-body Glastic casings) accounted for 35% and 70% respectively of Tongda Group’s 140 million handset casing shipments in FY2019, as disclosed at the company’s FY2019 earnings call on March 18, 2020. The company is guiding for Glastic casings as a whole to account for an even larger 80% of its total handset casing shipments this year, with metal and glass casings accounting for the remaining 20%. Assuming a rise in the sales contribution of 2.5D Glastic casings, Tongda Group’s profit margins could be under further pressure this year.

Product Mix Optimization To Partially Offset Margin Pressure In FY2020

As highlighted in the preceding section, there is intense price competition in the lower-end 2.5D Glastic casings segments. In contrast, the higher-end 3D and uni-body Glastic casings command higher average selling prices, as per the chart below.

Comparison Of Different Types Of Casing And Their Prices

(Source: Tongda Group’s FY2019 Results Presentation Slides)

Tongda Group has a technological edge in the 3D and uni-body Glastic casings segment, which means that these products are more immune to price competition. In its FY2019 results announcement, Tongda Group emphasized that its 3D and uni-body Glastic casings involve “high-entry barrier technologies such as development of high precision molds, color printing and film processing,” which the company claims “are ahead of the domestic industry and help enhancing the gross profit margin of its products.”

Another driver of margin expansion could be Tongda Group’s entry into the Internet of Things or IoT products space. The company highlighted in its FY2019 results announcement that it has “allocated resources to the R&D of innovative products in IoT” with expectations that IoT “will become a popular trend in the coming years.”

Seeking Opportunities In The IoT Products Space

(Source: Tongda Group’s FY2019 Results Presentation Slides)

Market consensus expects Tongda Group to increase its gross profit margin from 18.3% in FY2019 to 18.6% in FY2020, which is still below its FY2018 gross profit margin of 20.2%. There could be a potential surprise on the upside if the company manages to improve its profitability with product mix optimization.

Valuations Undemanding But Dividend Payout Was Reduced

Tongda Group trades at 7.1 times trailing twelve months’ P/E and 5.1 times consensus forward next twelve months’ P/E based on its share price of HK$0.44 as of April 1, 2020. As a comparison, the stock’s historical five-year and 10-year mean consensus forward next twelve months’ P/E multiples were 8.3 times and 7.5 times respectively. The company has traded as low as 1.5 times trailing twelve months’ P/E and 1.0 times consensus forward next twelve months’ P/E during the 2008-2009 Global Financial Crisis.

Tongda Group is valued by the market at 0.48 times P/B. In contrast, the company’s historical five-year and 10-year average P/B multiples were 1.87 times and 1.52 times respectively. During the 2008-2009 Global Financial Crisis, the stock’s trough P/B multiple was 0.17 times.

Tongda Group offers a trailing twelve months’ dividend yield of 2.4% and a consensus forward next twelve months’ dividend yield of 3.6%. The company’s full-year dividends per share dropped by -62.5% YoY, from HK$0.028 in FY2018 to HK$0.0105 in FY2019, despite the fact that its net profit declined by only -26.0% YoY. In other words, Tongda Group’s dividend payout ratio was reduced from 31% in FY2018 to 17% in FY2019, which was a disappointment.

On the positive side of things, there was an improvement in its balance sheet strength, which could help to support future dividend payouts. The company’s debt-to-total equity ratio decreased from 48.4% in FY2018 to 37.8% in FY2019.

Risk Factors

The key risk factors for Tongda include a larger-than-expected decrease in smartphone shipments and sales as a result of the current coronavirus outbreak, weaker-than-expected profit margins, and a further cut in the dividend payout ratio going forward.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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