SummaryIntroductionHighway Holdings Limited (HIHO) is a tiny Original Equipment Manufacturer (OEM), which produces metal and plastic parts and electrical sub-assembly for large Japanese, German, and American OEMs. The company is headquartered in Hong Kong and runs manufacturing facilities in Shenzhen in mainland China. Highway Holdings has been in operations since 1990, initially starting its business in Hong Kong as a metal stamping company.In 1991, it decided to move its manufacturing from Hong Kong to a 'free enterprise zone' in Shenzhen set-up by the Communist China with abundant cheap labor. Today, the situation is very different: a much richer China with peaking and increasingly expensive labor force became a real drag on its earnings. Any savings gained from process automation are immediately lost to higher wages. Even at higher wages, HIHO has to fight hard for labor with other, much larger manufacturers such as Foxconn, as well as put up with worker strikes and increasing regulations. Just in 2013, the Shenzhen salaries for low and medium level employees increased between 5.3 and 7.7% year over year while Yuan has strengthened against the dollar by about 10% since mid-2010.Yuan appreciation vs. dollar last 5 yearsHowever, the inflation of the salaries is only part of the story as the Chinese government today mandates many additional expenses. According to HIHO (2013 20f):the Chinese government has during the past few years significantly changed and/or increased the enforcement of a number of laws affecting employees (including regulations regarding their salaries and benefits, labor unions, working conditions and overtime restrictions, and contract duration-in particular, requirements leading to lifelong employment), and safety regulations for buildings and workers. For example, the Shenzhen municipal government recently issued the Interim Measures on the Administration of Housing Funds that require all local businesses to make contributions to a housing fund, which contributions range from 5% to 20% of an employee's salary.Chinese government recently announced another minimum wage increase of approximately 13 percent effective February 1, 2014 for the Shenzhen region, reflecting the difficulty of attracting workers and further contributing to an inflationary environment in China.'While you may applaud the Chinese government's effort to improve working conditions, it's clear that this is a significant drag on the Highway Holding gross margins as its products are labor-intensive.If we look at the company valuation, we see a very-well capitalized company but with no sustainable growth, high dividend of 6.3%, and reasonable trailing P/E ratio of about 13.Fig 2: HIHO valuation based on past operating history (source: YCharts.com, author's calculations)It looks like a reasonable (but not entirely safe) investment for someone who likes dividend income but with only modest price appreciation potential in the absence of a major catalyst. The company has maintained gross margins and profitability throughout the years but the revenue growth has been slow. The major business risk is the customer concentration with three large customers responsible for 57% of the sales in 2013. The revenue has been quite volatile over the years but always bouncing back as the company gained or lost some large customers. For example, the company lost a major (but low margin) customer responsible for 16% of its sales in 2012. It managed to replace some of the lost revenues and recently signed several contracts (Sumar USA, ACI Group GmbH, an unnamed US printer company) indicating that the revenue will probably recover to its historical level (7% growth year over year in 2013).Revenue and Net Income over the years(click to enlarge) (click to enlarge)While the things are 'looking up' in 2013 and 2014 compared to a bad 2012, this is not a reason by itself to rush to buy the stock with little revenue growth unless one can identify specific catalysts to improve the company profitability.I will discuss in this article just such a perfect catalyst: significantly lower labor costs due to relocation manufacturing operations to a Chinese neighbor Myanmar.Manufacturing in MyanmarToday, Myanmar is one of the least developed countries in the world. Its nominal GDP is
only about $915 per person.The country gained its independence in 1948 from the British Empire, was run initially by a succession of incompetent Socialist governments and, finally, a suppressive and brutal military dictatorship from 1962 to 2010. After watching its neighbors China, Thailand, and Vietnam's rapid development, the military-backed Union Solidarity and Development Party decided to embark on a set of political and economic reforms, opening its society and the economy, and drawing the praise of the Western leaders.
how to get plays on soundcloud One of the key practical reasons was to open a natural and human resource rich country to foreign direct investment as the country sorely lacked capital.Myanmar has proposed of the most progressive pro-business laws in the Southeast Asia, where foreigners will be allowed to lease land and directly invest into business as long as at least 25% of the workforce are Burmese. While foreign experts are optimistic, they are also cautious, as the military is still the real powerbroker and may decide to reverse the reforms.While the country still lacks much of basic infrastructure (visitors are advised to bring a handful $100 bills due to a scarcity of ATMs), the country made a heavy bet on manufacturing as it possesses a 32 million labor force willing to work only for as little as $1 or $2 a day (by far the lowest in the region).Comparison of labor costs between Myanmar and its neighbors (Source: Forbes, CIA):Myanmar has by the most attractive demographics profiles for next 30 years compared to its peers. The prime working age population of 25-54 will be growing helping the wages to stay low, which will give it a competitive advantage over China whose working age population already has peaked.'Age pyramid' for Myanmar and China (Source: Indexmundi.com)(click to enlarge)(click to enlarge)It's not likely that Burma will truly become 'the factory of the world' as its overall population is not that large, but the early movers into Burmese manufacturing will be able to reap the fruits of their labor in a few years once the infrastructure has caught up.Labor costs savingsAs of June 25, 2013, the Company had a total of 447 employees who were working on a full-time basis for the Company. All of the Company's employees are employed by the Company's various subsidiaries. According to 2013 20f, as of June 25, 2013, 115 employees were engaged in the administration of the Company while 332 employees, were engaged in manufacturing, quality assurance, warehousing and other supporting functions.China briefing on salaries in Shenzhen (source: China-briefing.com):Assuming high school or technical school education level for factory workers and 6% yearly increases and a small enterprise, I estimate that an average factory worker makes about 3,100 RMB a month (about $500 USD).This number also check out against the most well-known Shenzhen employer Foxconn, which agreed to lift the salary to 4,400 ($700) per month by the end of 2013, from current RMB 2,200 ($350) per month in 2012. According to the table, the giant Foxconn should be able to pay 65% more than its small and 35% more than medium competitors.If we assume another 20% overhead mandated for benefits, an average HIHO factory employee should be costing 3,720 RMB ($600 USD a month.) If we multiply this number by the number of the factory employees and annualize it, we get about $2.4 million spent on salaries.Now let's consider how much the same workers would cost in Myanmar. According to the table above,
the factory in Myanmar worker gets paid monthly about $64 in 2013. It would be fair to say that a worker in Myanmar may not be as well trained as China worker and once their training improves, the corresponding salaries would increase. Even if we double the average salary (to account for higher qualification and benefits), at most it would cost $128 to hire a factory worker. Annualizing this salary and multiplying by the number of workers, we get only $0.5 million in total salaries or $1.9 million savings. With everything being equal, but assuming a 30% effective tax rate, this will result in $1.3 million in net earnings.
soundcloud followers If we apply a reasonable P/E of 10 just to this number, the company is worth $13.3 million, 30% more than its current market value but I will not make such a drastic assumption that HIHO will be able to move all its manufacturing out of China.How much will the move save?It would be naïve to try to project the exact earning or a cash flow for a company with a very volatile revenue which is also undergoing a major change. Instead, I'd like to estimate how much the saving from moving manufacturing to Myanmar can contribute to its existing value. I realize that the savings from moving the work abroad would be somewhat offset by the restructuring one-time costs. I will also assume that only half of the work will be moved to Myanmar as the company was clear that they want to start with the most labor-intensive assembly work but haven't made plans yet to move all work out of China, most likely because of some dependence on the supply-chain. The company, however, would incur very little fixed costs associated with the move as its lease is year-to-year.Fortunately, HIHO has almost no lease obligations past this year:(click to enlarge)While the lease was probably extended for another year in February 2014, the lease needs to be extended every year, increasing the operating risk in China and an incentive to move.However, the new labor laws pose a significant risk of inability to terminate long-term employees (2013 20f):employees who have worked for the Company for 10 years or more or who have had two consecutive fixed-term contracts must be given an 'open-ended employment contract' that, in effect, constitutes a lifetime, permanent contract, which is terminable only in the event the employee materially breaches the Company's rules and regulations…Such non-cancelable employment contracts will substantially increase its employment related risks and limit the Company's ability to downsize its workforce..To the best of my research, this rule will not apply if the company decides to close the facility and move out of the country as many of its peers already have done. Nevertheless, I will assume some costs with the training new employed and probably paying some severance to laid-off ones.All in all, it appears that there would be relatively low cost to abandon Shenzhen manufacturing facilities and move production to Myanmar where HIHO already subcontracting some of its work.Interestingly enough, HIHO already mentioned its move costs in its earnings press release. It said that in 2014, the savings from the move would be roughly offset by restructuring costs and the real benefits will only start to accrue in 2015. If we assume it will move 25% of its production in 2014 and then another 25% in 2015, the cost of the move should be about $325 thousand if we take as base prior estimated $1.3 million labor cost saving.Contribution to bottom line from labor cost savings in thousands $USD (source: author's calculations)Applying a 10% cost of equity discount rate (beta=1.4, Rf =3%, ERP = 5%), the move to Myanmar should produce $4.9 million of extra value (growth rate 2%, the contribution stays the same past 2016).ConclusionHighway Holdings Limited seems fairly priced at a first glance. While the company holds a lot of net cash and pays a solid dividend, it also shows few signs of growth. Once we consider the impact of savings of its planned move of manufacturing to Myanmar, the equation drastically changes. The move should produce an additional $4.9 of value based on projected cash flow. This implies an about 50% undervaluation.Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.Disclosure: I am long HIHO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.
