Monday, March 16, 2015

Welling Holdings - Mediocre Business At A Great Price

Welling Holding Limited (“威靈控股”, 382.HK) is a manufacturer of motors used in air-conditioners and washing machines. It has 4 manufacturing plants in China, including 3 around the Yangtze River Delta area, and one in Guangdong. In terms of revenue mix, roughly 60%/30%/10% of revenue in 2014 came from air-conditioning (A/C) motors, washing machine motors, and other products, respectively. Although Welling gets almost 40% of its revenue from white goods giant Midea (“美的”, 000333.SZ), it also has a diversified international customer base including Panasonic, Haier, LG, Indesit…etc. As of December 2014, Midea owned 68.7% of Welling.

What Caught My Attention, and Key Questions

What caught my attention? The company trade at about at eye popping 6x LTM P/E, yet it has solid free cash flows, ROIC > 20%, and little debt (in fact, a net cash position). Some cursory research showed that Welling is a global leader in its motor business (albeit a fragmented and commodity one). This is a small/micro-cap with little analyst coverage.

Stock has been beaten down since mid-2014 and approaching its 52 week low. When something trades this cheap, the natural questions are 1) if I’m looking at some peak, non-recurring earning? 2) earnings/cash flows are about to fall off a cliff? 3) the business is facing some existential issues?

After digging through the numbers and filings, my answers to the above questions are “no”, “possible but temporary in any case”, and “no”. The company actually looks ok. Now, the industry is facing some competitive headwinds due to price competition, but I would say this is more cyclical then structural.

Attractiveness of Business and End Market Outlook

I can understand why Welling is cheap (although not THIS cheap). Making motors used in A/C and washing machine is just not a great business. The end market is commoditized, so you got the usual problems of price competition, excess channel inventory…etc. Being a parts supplier is probably even tougher – Welling is steps removed from seeing end user demands, and market signals get through the value chain with some delays. In Welling’s 2014 earnings release, it alluded to some of the industry problems and adopted a negative tone for its 2015 prospects.

Over time though, it comes down to end market demands and industry structure. And it’s not all bad for Welling. It helps that main customer Midea is one of the top players in white goods (along with Gree and Haier). Here I did a quick run through of Welling’s 3 markets: residential A/C commercial A/C, and washing machines.

  • Residential AC is the largest market segment here and has high penetration rate in urban areas, but low penetration in rural areas. Industry unit sales growth was 5% in 2014 (down from 7% in 2013). There’s currently a price war going on, with Gree doing some tough talk and signaling its resolve to retain market share. It seems to me the price war is due to excess inventory in the channels and slower housing market. Once that works though the next year or so, there should still be some runway for slower, but steady growth. The fact that Gree/Midea combines for 2/3 of the market makes it more likely to stabilize eventually. 
  • Commercial A/C market is a growth area. Industry volume grew 12% in 2014 and is expected to continue in the next few years. It has a high presence of foreign players, while the Chinese 3 (Haier, Midea, Gree) only a combined 35% market share. In the next few years I can see Midea, and by extension Welling taking more market shares in a larger market. This is an opportunity.
  • Washing machine competition is another weak spot, and possibly structural. This is under <30% of Welling’s revenue. Industry volume increased less than <1% in 2014. The sector already has a high penetration rate (98.0% in urban and 67.2% in rural in 2012, according to NBS) and suffers from fragmented competition. Amazingly, Welling’s revenues here actually increased 12% in 2014, mostly to higher prices. So perhaps they can mitigate some of the industry headwinds through higher value-added products. 

I would be more worried if this is a situation where the industry 1) is showing no growth and 2) suffers from highly fragmented competition. But that’s not the case for Welling’s sectors (with the exception of washing machines sector where Welling is actually doing fine). The current industry headwinds are real, but not insurmountable - China is still growing after all. Sure, 2015 could be an ugly, but longer term industry outlook and competitive structure is not awful. Looking out 2-5 yrs, Midea and Welling should be able to get through this and survive as one of the top players.

Other Reasons Why the Stock Is Cheap

  • Relationship with Midea. If Midea starts feeling some price pressure, it may be tempted to force some price cuts from Welling. Keep in mind Midea does account for 40% of Welling’s business. Even if transactions between the 2 are true arms-length transactions, Welling would have very weak bargaining power and likely get stuck with disproportionate share of margin pressure.
    • On the other hand, motors are a small part of the cost structure for A/C (average price for an A/C motors is 50-60 HKD, while an AC sells for as low as 2000RMB (~2500HKD)). Midea does not have strong incentive to cheat Welling above and beyond its normal share of pricing cuts.
    • The other potential is if that relationship with Midea prevents Welling from getting other customers. Apparently this has not happened – for example Haier is a customer.
  • Small size and lack of diversification
    • Some better technology for motors could develop that eliminates the need for Welling’s products (or worse, make its plant investment obsolete)
    • Threat of losing clients is a problem (perhaps due to their relationship with Midea)
  • Lower cash flows in near term. Due to rising labor cost, Welling has plans to speed up capital expenditure and install more automation. This would depress cash flows in the next couple years
  • Small market cap, no bulge bracket sell-side coverage. 


Despite all the issues listed above, at 6x P/E it’s not hard to see some upside. If this thing just plod along and survives, and earnings prove to be sustainable (say low single digit EPS growth next 5yrs), at some point this could get revalued to a modest 10x P/E. Johnson Electric (179.HK), another manufacturer of motors, trades at much higher valuations, but that is larger and more diversified so some discount is fair.

Give it a 2-3yr investment time frame, I can see 2017E EPS of 0.26 HKD per share * 10x P/E = 2.6/share. This would be a 70%+ return from today’s 1.47/share.

There’s a high probability this could work out. Survival should not be a problem given Welling’s low debt levels. Low single digit EPS growth is also realistic, as management’s target of 10bn RMB in sales by 2017 would imply 10% revenue CAGR.

Establishing a Position

There is no hurry to establish a full position. There are no near term catalyst and 1H15 could get ugly. Ideally you want the bad news to flush through first.

I got in with a starter position after the full year 2014 earnings came out and stock gapped downward. I want to see how the market reacts after 1H15 before making this a bigger position. The current trading price of 1.47 /share is not that far from the 52 week low of 1.3, a major support level for the past 2 years. If it breaks to say 1.28 (a 12% drop from current price), then I would stop out and wait for another entry point. For a 2% position that's a max loss of ~25bps to the portfolio.

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