The article is up-front about Mr. Buffett's primary investment rules:
- "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.
- You should invest in a business that even a fool can run, because someday a fool will.
- And perhaps most famously, Never invest in a business you cannot understand."
- 'In acquiring a stake in BYD, Buffett broke a couple of his own rules. "I don't know a thing about cellphones or batteries," he admits. "And I don't know how cars work." But, he adds, "Charlie Munger and [MidAmerican Chairman] Dave Sokol are smart guys, and they do understand it. And there's no question that what's been accomplished since 1995 at BYD is extraordinary."'
- "... Buffett and Munger and Sokol think it is a very big deal.... They think BYD has a shot at becoming the world's largest automaker, primarily by selling electric cars, as well as a leader in the fast-growing solar power industry."
- '"This guy ... is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it."
So far, Berkshire Hathaway and Mid-American look like champions based on their entry point of HK$8 per share (16 times 2008 earnings) for 225 million shares. Shares of BYD now trade around HK$42 (a whopping 84 times 2008 earnings) -- up 425% from HK$8 -- rising on the back the Berkshire news, optimism that China's stimulus is working (with local stocks zooming upward), and clean-tech sector momentum.
BYD's two-year stock chart is included below -- we believe shares plunged in February 2008 after plans to raise additional capital were announced. The raise never happened in 2008 because of ensuing market conditions, but BYD announced last week a potential 100 million share offering is now in the works. The planned offering is expected to bring total shares outstanding to 2.4 billion, slightly diluting Mid-American's stake.
Yet, Berkshire Hathaway did not invest in BYD for a quick gain. Rather, we know that Berkshire is on-board for the long-haul. In this case, what matters most are business economics over the long-term and, more specifically, the equity earnings stream that Berkshire/Mid-American will realize from BYD. For us, this is where things get hazy.
From BYD's 2008 annual report, we learn the following:
- Gigantic revenue growth - BYD's 2008 revenue of RMB 26.8 billion increased 26% Y/Y and by a factor of four from RMB 6.4 billion in 2004 (organic and acquisitions).
- But, margin compression - although gross profit increased 23% Y/Y, gross and net margins declined to 19% and 4% in 2008, respectively, from 20% and 8% in 2007 and 27% and 15% in 2004. Total segment operating margin (before interest/finance costs and taxes) was 6.8%, down Y/Y from 9.8%.
- And, low return metrics - 2008 return on average equity and return on invested capital of approximately 9%, and a return on average assets of 3.3%.
- With huge capital consumption to fund growth - cash flow from operations less capital expenditures of negative RMB 3.7 billion in 2008 and negative 2.1 billion in 2007. BYD's net debt increased almost 200% to RMB 7.5 billion, with gearing* increasing to 66% from 24% (*net debt divided by net assets, or shareholder equity).
More on margins - the annual report provides the following explanation for a 100 basis point Y/Y decline in 2008's gross profit margin:
- "(1) income from the handset components and assembly services which had lower gross profit margin, the proportion of which to the overall income increased significantly during the year; (2) decreased gross profit margin of handset component business as a result of unfavorable factors such as high price of raw materials, volatile exchange rates and Renminbi appreciation, which offset the increase in gross profit from the lithium-ion battery business and the automobile business."
- "Mobile handset components" segment revenue increased 30% Y/Y and was 45% of BYD's 2008 revenue and 37% of the company's total segment earnings, with a segment contribution margin of 5.7% compared to 11.7% in 2007. We know from our experience covering the technology sector -- both wireless handset companies and the supply chain -- that competition is consistently fierce. Ever higher volumes are necessary to offset lower average selling prices across virtually all components that feed into finished products and assembly margins are extremely thin (low single digit operating margins). Large handset makers such as Nokia (NOK), which has seen its average selling price decline to the EUR 62 in 2Q09 from EUR 102 just three years ago (2Q06), constantly press suppliers for lower prices in an effort to preserve their own margins. While BYD certainly has scale in this segment, the handset component and assembly is a very competitive business.
- "Battery and other products" segment revenue decreased 13% Y/Y and represented 23% of 2008 revenue and 35% of total segment earnings, with a segment margin of 10.4% compared to 10.6% in 2007. BYD makes rechargeable nickel-cadmium and lithium-ion and batteries for all kinds of electronic devices. According to a January 2009 article in Green Car Congress, BYD is the world's "leading provider of NiCd batteries (65% global market share) and lithium-ion cell phone batteries (30% global market share)". BYD definitely appears to have a scale advantage in this segment based on the company's leading market position and stable margins last year amidst a weaker economy. According to the Fortune article, BYD achieved scale by using low-cost, manual labor for production rather than expensive, automatic machines used in Japan and Korea.
- "Automobiles and related products" segment revenue increased 77% Y/Y and represented 32% of 2008 revenue and 28% of total segment earnings, with a segment margin of 5.8% compared to 5.3% in 2007. BYD sold 170,000 automobiles in 2008, double the number in 2007, but still small relative to both the Chinese and global markets. BYD is rolling out new models this year, including a hybrid called F3DM. To put 2008 unit sales in perspective, we highlight several items:
- Domestic market size, from annual report - "According to the China Association of Automobile Manufactures, in 2008, aggregate production and sales volumes of the automobile market in China were approximately 9.345 million vehicles and approximately 9.38 million vehicles respectively, representing a year-on-year increase of approximately 5.2% and 6.7% respectively, a significant slowdown in growth rate. Of these, sales of sedans exceeded approximately 5.047 million units, representing a year-on-year increase of approximately 6.8%. Domestic brands accounted for approximately 26% of the total sales volume of sedans and continued to occupy a major position in the market."
- Chinese competitor Chery Automotive sold 356,000 vehicles in 2008, down 7% Y/Y.
- Global market size - according to consulting company CSM Worldwide, projected 2009 global sales will decline 8% to 56.8 million units, while 2010 sales might rebound 7% to 60.8 million units. GM and Toyota (TM) are the world's largest automakers, and both sold approximately 9 million units in 2008.
- Technology and competition - the Green Car Congress article referenced above also says that BYD's auto "battery packs retain 80% of initial capacity through 2,000 full charge and discharge cycles, and have a 10-year lifetime." Berkshire Hathaway is enthusiastic about BYD's technology and track record of success with batteries. Still, we know that -- as in the electronic device battery market -- Sanyo Electric, Sony, Samsung SDI, LG Chem, and NEC are aggressively angling for market share in the electric car battery market.
- Low barriers to entry - a 1/12/09 WSJ article entitled Technology Levels Playing Field in Race to Market Electric Car summarizes Mr. Wang's strategy as the following (emphasis added):
- "capitalizing on the electric car's low barriers to entry. Few products are as complex to develop and produce as gasoline-powered automobiles, which are assembled with thousands of precisely engineered parts. But electric cars use only basic motors and gearboxes, and have relatively few parts. Aside from perfecting the battery itself, they're far easier and cheaper to build -- and that makes for a level playing field."
- Margins/metrics for leading, mature players - we know last year was horrendous for automakers, but what about five year average operating margins, ROE, and ROI? Based on Thomson Reuters data, Toyota's five-year average operating margin, ROE, and ROI were 6.9%, 10.4%, and 5.5%, respectively, with an effective tax rate of 40%. Honda's were 6.8%, 12.1%, and 5.8%, with an effective tax rate of 41%. The industry averages were 6.0%, 9.1%, and 4.9% with an effective tax rate of 38%.
- BYD is an insurgent player with arguably* strong battery technology and no legacy cost structure tied to a very large, complex supply chain in major developed markets (we put an asterisk next to arguably because we've heard different views from clean-tech investors).
- The company is trailblazing to establish market share in a large, global market. However, incumbent players are not going to close up shop and go home. BYD will need to work overtime to achieve the quality and reliability for which Toyota and Honda are well known.
- Despite not having a legacy cost structure, BYD's automobile segment margin of 5.8% is only in-line with average margins for mature, traditional high cost competitors. BYD's ROE of 9% is in-line with the five-year industry average.
- Although BYD's auto sales are growing rapidly and the company will benefit from significantly lower tax rates (16.5% in 2008), the company has no established brand or distribution outside China unlike mature players . As a result, these areas will no doubt require meaningful investment on top of continued investment in physical plant.
For sure, given increased global environmental concerns, the world will move toward more clean-tech solutions. Why not try to reduce dependency on fossil fuels by promoting electric cars that can be recharged overnight when electric grid usage is low? Assuming concerns surrounding batteries (heat, efficiency, recycling) and car safety (small size, fear of "electric" accidents, increased pedestrian accidents + silent engine perils) can be addressed, seems very plausible that a growing portion of the population will drive hybrid vehicles over time.
We are certain that Berkshire Hathaway and MidAmerican performed extensive due diligence on BYD and understand that they think the world of Mr. Wang. Other smart, long-term oriented investors are also buying into the BYD story, surprisingly even at now elevated P/E multiples. According to a 7/21/09 report from China Knowledge Online sourcing information from the Hong Kong exchange, The Capital Group Companies recently increased its stake to 7.02% from 6.93%.
Still, even with great management and a potential technology advantage, we can't help but scratch our head over the economics of the business. We have no problem believing that BYD will be around in ten years and quite possibly be bigger, better, stronger in each of the company's key markets. After all, the low-cost provider in a given market can be a big winner with a durable competitive advantage. Plus, perhaps MidAmerican will benefit from access to BYD's battery know-how. However, with low margins and large capital requirements, we are less confident in the company's ability to "generate cash and consistently earn above-average returns on capital" (Berkshire Hathaway's #4 Owner-Related Business Principle, "preference for companies that...."). As a Berkshire Hathaway shareholder with great respect for Messrs. Buffet and Munger, we're curious to see how things develop at BYD.
As an aside, Berkshire's confidence in BYD gives us confidence in our position in American Oriental Bioengineering (AOB, $5.28). AOB also has a motivated, hard-charging CEO with a successful track record and long-term vision, yet has the benefit of business model with high margins and excess cash generation.
Disclosure: long BRK-B, AOB.
© 2009 Jeffrey Walkenhorst
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