Building Asia ex-Japan’s largest maker of the “nervous system” in smart cars with Responsibility – Bamboo Innovator Monthly Riddle

 “Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”
BAMBOO LETTER UPDATE | June 30, 2015
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Dear Friends,

Can You Guess This Asian Wide-Moat Company?

Building Asia ex-Japan’s largest maker of the “nervous system” in smart cars with Responsibility

How would you respond when you lose your finger in a workplace accident? We will be depressed, the inevitable and natural response which paralyzes and robs us of the ability to respond to our troubles and setbacks.

For Leonardo Del Vecchio who severed part of his finger in a mold-making factory while working as an apprentice to put himself through design school, he went on to build Luxottica (LUX), the world’s largest eyewear company with a market cap of $32.7 billion and became Italy’s second richest man. Luxottica is one of the world’s most respected companies that is responsible for revolutionizing and dominating the entire eyewear industry, creating a fashion concept out of a functional item and putting luxury glasses on the world.

For Mr. C who lost two of his fingers while manually operating a stamping machine, he went on to build Asia ex-Japan’s largest maker of [Flagship product’s name] in automobiles and motorcycles, a mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. The painful accident made Mr. C “swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line.” Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. “As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.” Mr. C also set his mind to build a sustainable, scalable, wide-moat business model with an “organizational-wide competitive ability and an organizational-wide management information system”.

This month of July, we highlight this Asian wide-moat innovator behind “the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts.” Without this “nervous system”, the auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

Our earlier highlight for the month of May about Asia’s #1 maker of a patented automotive electronics part that is part of the fast-growing multi-billion Advanced Driver Assistance System (ADAS) market and the race towards the autonomous car is up >25% in <2 months.

Read the story of Mr. C below and be inspired about the values of Responsibility – the ability to respond in times of hardship and adversity..

Q: “Chairman C, [Company’s name] has an illustrious business history since its establishment more than 38 years ago in 1977. Can you share with us how it all started, the philosophy and thought process underlying the evolution of the business model, the lessons learnt, and the ups and downs in your personal journey building [Company’s name]?”

Mr. C: “My personal journey in building [Company’s name]? I was poor when I was young and I always wanted to venture into business to give a better life to my family. After my middle school, I wanted to go straight to work but my father insisted that I must continue to study in the night school. So I work in the daytime in the metal stamping division of lighting company.

At that time, metal stamping is still operated manually by hand, with the operator using one hand to hold the metal, another hand to step on the machine’s pedal, stamping the metal piece by piece. However, an incorrect rhythm or a slight neglect will result in a workplace accident. An accident happened to me and I lost two of my fingers as a result. As a result, I swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line. Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.”

Q: “Thank you for sharing such a moving and inspiring personal story behind the impressive production automation commitment at [Company’s name]. Our curiosity is piqued, can you share with us what is so difficult about making these [Flagship product’s name] beyond having more capital and money?”

Mr. C: “Computer and smartphones can malfunction, but can cars afford to malfunction? When consumer electronics products break down, they will cause inconvenience, but they will not cause our lives. When a car is moving and it suddenly malfunctions, what would be the consequences? In terms of safety standards, automakers have far higher requirements for components and parts than those for consumer electronics products. Safety is of paramount importance. When there is an incident of a car engine on fire, a big reason is because of the breakdown of the [Flagship product’s name]. [Flagship product’s name] are first used during the World War II in fighter planes. The [Flagship product’s name] is small and not eye-catching, but it is the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts. Without them, the auto parts cannot start and work. Now, [Flagship product’s name] need to be even smaller and precise than ever before and the supplier has to produce customized parts according to the customer’s diverse requirements. Each car requires around 600 to 3,000 to 6,000 [Flagship product’s name], depending on the ‘smartness’ or electronic content of the model. So the demand is rather sizable in terms of volume and value.

Yet in the early days, no one is interested in this business. The reason is simple. Besides the high barriers to entry and extremely high standards set by the customer, the supplier would have to produce small-lots and multi-items, and this does not make any economic sense from a cost perspective. The time period of investment is long and the payback even longer and uncertain. [Company’s name] has grasped the technical complexity of the functioning of the various auto parts and foresee the change in the shifting profits in the value chain towards high value-add electronic parts.

Hence [Company’s name] focuses on mission-critical [Flagship product’s name] in the safety area. The technical expertise required is much higher and the design and development of the molds requires deep know-how, but the margins are also much higher. There are other auto parts companies who also tried to break into this business but they started in producing the products that will not affect the safety and engine of the car, thinking that it will be a starting point to win more business. However, these companies underestimated the barriers to entry and they have all exited.

Thus, not anyone can enter this business. Because of the extremely high standards for safety and reliability, car makers are very strict in selecting their suppliers. Once the supplier is connected to the automakers’ supply chain, that’s ten-year worth of business at least. With mutual trust as the foundation, this relationship is not easily changed. However, this also means it is very difficult to break into the supply chain of an automaker.”

Q: “We understand the high barriers to entry and stringent quality standards required by the car makers. Still, we are curious – are there any specific production technique or know-how or secret to success that [Company’s name] has mastered over the 38 years that gives it a sustainable wide-moat competitive advantage to generate a relatively high ROE of 20.5% and to keep growing?”

Mr. C: “…. <SNIPPED>”

Q: “Do you have any words of advice for entrepreneurs? What is the best advice you have received that has guided your thinking?”

Mr. C: “I always remember what my parents have taught me since young, ‘Be kind to others’. My mother would also remind me, ‘If you manage to make money, you must treat your workers better.’ Our principles of management include: ‘Co-sharing of fruits reaped through teamwork’, ‘Human-friendly management’, ‘Whole-hearted trust and support’..

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

Who is Mr. C and this wide-moat Bamboo Innovator?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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