China Automotive Systems: Revenue And Profitability Growth Not Converting To Cash Flows

seekingalpha10-19

Consistent revenue growth since 2021, but a 700% YoY drop in Q2 free cash flow raises concerns about operational inefficiencies. Net income fell in Q2, mainly due to a $4.7 million loss from ...

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(NASDAQ:CAAS) has seen its share price recover in 2024, following the sharp decline last year.  Despite the steady revenue growth since 2021, the company hasn’t been able to turn this improvement into stronger cash flows, which naturally, raised some eyebrows.  Therefore, in this article, I considered reviewing the recent financial performance of the company, with an emphasis on the headwinds, challenges, and risks that the company is facing.  In the outlook section, I will provide the rationale behind my Hold rating, including a deep dive into valuation and the fundamentals of the company.  For now, I would like to start with a brief company overview section for those readers new to this stock.  Company Overview China Automotive, as its name suggests, is a Chinese based supplier of power steering systems for the automotive industry. Their power gears are used in passenger vehicles and commercial trucks.  Their major customers include large automotive manufacturers in China (BYD Auto, Geely, and Chery) and international companies like Stellantis and Ford. The company operates mainly in China through several subsidiaries that specialize in different areas of the automotive steering market. I considered including a breakdown of revenue per business segment below.    Q2 2024 10QOwnership-wise, the latest 14A shows 65% ownership of common stock across all 9 directors and executive officers. In my view, a very respectable amount of skin in the game.    14AHeadwinds  I'd like to start with dessert.  One of the factors that raised my eyebrow in their last earnings results was the disconnection between their strong revenue growth and the decline in net income. Net sales were up by 15.4% YoY, operating income was up by 28%, however, net income declined by 32% in the same period, falling from $10.5 million to $7.1 million.  By looking at the income statement, it seems that this decline was driven by unfavorable foreign exchange rates.    seeking alphaThe company reported a net financial expense of $0.7 million, a big contrast to the net financial income of $4.0 million in Q2 2023. In other words, we are talking about a $4.7 million negative swing in the company’s financial results due to foreign exchange volatility, which is quite concerning, in my view.  The company has substantial exposure to foreign currencies, due to its revenue from export markets like North America and Brazil.  Looking at the charts of the Brazilian Real vs the Chinese Yuan Renminbi and the US Dollar vs Chinese Yuan Renminbi the company's foreign exchange loss in Q2 makes sense.  Despite this high volatility, I remain highly disappointed that the company has no foreign exchange forward contracts to hedge against foreign exchange risks. Back in 2023, the company entered into foreign exchange forward contracts to mitigate the impact of exchange rate fluctuations between the RMB and USD. However, this strategy has not been extended to 2024, leaving the company exposed to exchange rate fluctuations. Moving on to other pressures, operating expenses increased by 40.7% YoY. I am not overly concerned about this increase considering that operating income saw a decent improvement in the last quarter of 28.9%.  However, I am slightly more concerned about the risks associated with their transition towards electric power systems. As of today, the traditional steering product market is still a large portion of the company's revenue, accounting for over 65% of net sales.  However, as the industry gradually moves towards more electrified and autonomous vehicles, the demand for traditional steering components may stagnate or decline, particularly in more advanced markets like North America and Europe.  That's not the situation today, since sales of the traditional systems grew by 7.5% compared to last year. However, in the next 5-10 years, the company may need to shift its focus from traditional power systems to electric ones. Otherwise, their revenue could take a significant hit. Outlook I'd like to start with price action. If we look at the share price over the last 2 years, there is a mixed performance, with a significant increase in Q1 2023, followed by a decline in the same year.    stock roverFrom a technical analysis perspective, there is an upward trend line that seems to be quite reliable.    trading viewFrom a valuation perspective, most of the valuation ratios seem to be trading close to the 5-year minimum, except for P/CF and P/FCF.   stock roverSo, let's have a closer look at the cash flow statement and try to understand why these two ratios look so bad.  Operating cash flow dropped by 200% in the second quarter, but what's even more worrying is that free cash flow plunged by 700%.   trading viewAs mentioned in the previous section, the increase in operating expenses and the decline in financial income due to unfavorable forex rates played a big role in this decline.  In addition, accounts and notes receivable saw a significant increase of $20.5 million. I am concerned about this increase in receivables, as the revenue growth is not leading to an increase in cash, indicating either extended credit terms to customers or delays in collecting payments. On top of that, income taxes paid went up by $600k compared to last year, adding to the overall decline. If we zoom out, and we consider a yearly timeframe, the trend in operating and free cash flow does not look favorable, despite the revenue growth.  My investment style doesn't align with this trend since I put more emphasis on cash flow than revenue, except for companies in their early growth phase. Moving on to the balance sheet, the company has negative net debt, with cash & equivalents sitting at $148.4 million.  The liquidity ratios look ok. Nothing spectacular, but no major red flags.    Ratio Value    Current Ratio 1.5   Quick Ratio 1.2   Cash Ratio 0.4    Click to enlarge The cash ratio is low, mainly due to the $162 million in accounts payable. Moving on to insider buying activity, over the past 12 months there was only one transaction made by the CFO, Li Jie, totaling $19k in November 2023.  Considering the small amount purchased by the CFO, and the lack of recent insider buying, I remain disappointed. On the bright side, there were no insider selling transactions.  The activist activity has been silent since 2018, and the amount of shares owned by institutional investors has not changed drastically in the last quarter. However, the put/call ratio increased by 36% in Q2, indicating some pessimism among 13F filers.  Conclusion To wrap up, I find that China Automotive presents a mixed outlook.  On the bright side, the company has shown solid revenue growth consistently since 2021. Operating income followed this trend, however, the net income of the company seems to be quite volatile due to foreign exchange rates.  I appreciate the fact that management has a significant ownership stake in the company, but I disagree with their decision not to hedge against foreign exchange fluctuations in 2024. On the negative side, the 700% YoY drop in free cash flow, despite revenue growth, points out to operational inefficiencies, particularly with increasing accounts receivable. Additionally, their transition to electric power systems remains a concern, especially if the company fails to pivot toward electrification as the automotive industry moves in that direction. On top of that, the lack of insider buying and the increasing put/call ratio shows that both management and institutional investors are being cautious.  To conclude, while I see decent revenue growth, I don’t see the same improvement in their cash flow statement. Therefore, I’m keeping a Hold rating until their cash flows improve and, ideally, insiders start buying shares.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2476766529"}