Welling Holding is among the largest companies that manufacture motors for air-conditioner, washing machines, and other home appliances. Its factories are located in China and its products are distributed to many different countries and region. Midea, the world’s largest producer of major home applicances, owns nearly 69% of Welling. Hence, Welling’s stocks are not very liquid.
Midea recently announced its plan to buy the balance shares of Welling that it does not already own at offer price of RMB 1.75 (HKD 2.06). That represents 30% premium to Welling’s price before the announcement. I was lucky enough to buy Welling in August at 1.44. My friend bought after me at 1.43. The offer price is 43% above my purchase price.
Why did I buy Welling?
Let’s go through some simple analysis. Start from looking at Welling’s financial performance over the past 5 years (2012 to present). Revenue and earnings hit the peak in 2013-2014, but since then, declined substantially in 2015-2016. Gross margin fluctuates at the range 12.5-16% while the EBIT margin at 7.8-11%. Net margin ranges between 6.5% and 9%. That’s relatively stable.
The ROE is declining substantially from over 30% to just low teens, but we have to take note of one thing: the excess cash built up in the balance sheet is misleading the ROE figure. At latest balance sheet, Welling was holding net cash, including financial assets, of HKD 3bn or 1.05 cents per share. The cash represented nearly 73% of my purchasing price and is still representing 53% of current price. Welling generates strong free cash flow almost every year and did not distribute all the excess capital out as dividend.
If we look at the valuation over the past 5 years, it rose from the low of 5.2x in 2012 to current high of 10.7x (was around 8.3x before the announcement of full acquisition by its parent company, Midea). Excluding the cash, we are really looking at the adjusted P/E of low single digit. Why is it so cheap?
My friend asked me why Welling was so cheap. I can’t explain either. Given the stability of its margins, earnings, high cash flow, high net cash, the strong growth of its parent, Midea, Welling should have been valued higher, much higher. Is it a value trap? That’s the worry when company is priced too cheap.
If we look at Welling’s history price chart, maybe it could explain little. In 2005, the price crashed by nearly 67% to $0.50 per share. Then, during bull market from the start of 2006 to peak of 2007, the price climbed up by 8x (yes, 800%) to $4.50 per share. During GFC, it crashed by nearly 90% to $0.60. It recovered to $2.3 in early 2011 and crashed by 50% to $1.0 in late 2012. It recovered to $2.60 in mid 2014 but crashed by 50% again to $1.10 in early 2016.
As you see, the price crashed many times by more than 50% in the past decades even when the financial performance has been relatively stable. Its price volatility and performance just did not match with its financial performance. If the price performance has not been matching its financial performance for the past 10 years, why do we think they will become aligned for next 1-2 years?
Perhaps, that’s part of the reason why investors lost confidence or patience with Welling, causing its share price to be depressed. But above reasoning is really trying to find justification for the current low price. So, it’s backfitting and has confirmation bias.
When I was considering to buy Welling, I had this thought. If market continued to value it at low valuation multiple, we could not benefit from the correction to mispricing. We need catalyst to realize the profit from mispricing but don’t see any catalyst coming. What could I get in return?
Assuming that business remains stable and earnings stay at current level, I’m getting earnings yield of 12%, out of which 3.5% is distributed as dividend. The remaining 8.5% will be reinvested or just get accumulated as excess cash. Either way, the retained earnings will increase the book value. If the ratio stays the same, price will appreciate along. 12% return for such company’s profile with lots of net cash, I find it safe to invest despite the volatility of the share price. I am prepared to double my position if the price falls further. Unfortunately, it did not happen.
Can we foresee Midea’s privatization of Welling?
From the start of 2016 until now, Midea’s share price has been rallying strongly. It’s up nearly 200% over the past two years. I bought Midea at 35.15 in May and sold out at 42.54. That’s 21% return in 1.5 month. But, it’s a mistake I made over and over again in past 2 years. I sold out too soon. That’s another day to share on this topic.
The strong rally in Midea’s share price to valuation multiple of 20x P/E might have prompted the management to ask, “why was Welling priced so low?” One yuan of Midea’s earnings is valued by market at 20 yuan, but one yuan of Welling’s earnings is valued at 8-10 yuan only (excluding the excess cash, it’s below 5 yuan only!). Therefore, it will make sense to buy back the remaining shares of Welling. Afterall, in normal valuation exercise, Welling will be easily considered as cheap to buy. When Welling becomes 100% subsidiary of Midea, it will increase the earnings of Midea. If valuation multiple of Midea remains the same, its price will rise accordingly.
Note: Usually when the valuation multiple of a firm is very low, analysts will use high discount rate or low valuation multiple too so that their value estimate is not too far above current price. Sometimes, if their value estimate is far higher than current price, they will take an arbitrary big discount to set a lower target price that is closer to current price. The reason is to protect themselves so that if they are wrong, they will not be wrong too far off.
This acquisition by Midea help unlock the hidden value of Welling. But, I still think the offer price is low. If the market did not sell Welling down in August, they (including me) could get another 30-40% return above current offer price. Now, what’s done is done. We should focus on finding a new company to allocate the capital that we get back from Welling.