(Nov 13): Shares in Mainboard-listed conglomerate Hong Leong Asia (HLA) have already rallied 76.5% this year. But they may still be undervalued, especially since the company’s management appears to be taking a better look at the businesses within the group.

On Oct 30, HLA announced that it would be restructuring its consumer goods unit Xinfei. The latter manufactures white goods in China, including refrigerators, freezers and air-conditioners. Xinfei will be ceasing its manufacturing and production activities. Instead, it will explore strategic participation with potential partners using Xinfei’s trademark and intellectual property.

HLA’s shares opened 5% higher on Oct 31, following the announcement, rising to $1.26, from $1.20 at close on Oct 30. They have since slipped slightly, closing at $1.225 on Nov 7. That gives the company a market capitalisation of $433.73 million.

A restructuring of Xinfei could help HLA return to profitability. Xinfei is among HLA’s smaller business units. In FY2016 ended Dec 31, it made up just 10% of HLA’s revenue. HLA also has a 40.2% stake in New York-listed engine manufacturer China Yuchai International, which accounted for 75.7% of revenue. HLA consolidates CYI’s revenue as it would a subsidiary because HLA also owns a special share in CYI that entitles HLA to elect a majority of directors in CYI. Meanwhile, HLA’s building materials business accounted for 12.4% of revenue. The remaining 11.9% of revenue came from the group’s air conditioning systems, industrial packaging and other business segments.

For FY2016, revenue declined 8.8% y-o-y to $3.7 billion while losses deepened 17.3% to $71.2 million. Most of the weakness in HLA’s financials can be attributed to Xinfei, which reported a 1.1% increase in losses after income tax to $128.5 million. Its revenue declined 12.8% to $370.6 million. In commentary accompanying the results, HLA says Xinfei’s earnings were affected by weakening demand for freezers and fridges as well as intense price competition.

In fact, if Xinfei’s numbers were excluded, HLA would probably have reported a profit. For FY2016, CYI announced a 51.2% increase in total earnings to RMB515.7 million ($106 million). This puts HLA’s share of the earnings at RMB207.31 million. HLA’s building materials business, which includes a 74.3% stake in Malaysia-listed building materials company Tasek Corp, reported a profit after income tax of $33.9 million. Losses after income tax from the industrial packaging, airconditioning systems and other business segments totalled $32.8 million.

The poor outlook for Xinfei has extended into this year. For 2QFY2017, HLA reported a 0.7% y-o-y decrease in its losses to $18.2 million on a 3.5% rise in revenue to $1 billion. Xinfei’s revenue for the quarter fell 2.6%. HLA does not break down the operating profits and losses of its various units in its quarterly statement. It reports its results for 3QFY2017 on Nov 14.

Value in CYI Without the losses from Xinfei weighing the group down, HLA could be revalued on the basis of its other units. Shares in CYI closed on Nov 6 at US$22.49 each, giving the stock a market cap of US$911.6 million ($1.2 billion). HLA’s 40.2% stake is equal to US$366.5 million, or $498.5 million. That is more than HLA’s current market cap, which means shareholders are getting HLA’s other assets for nothing. HLA’s stake in Tasek is worth $365.7 million. As at end-June, HLA also had net cash of $195.6 million.

Founded in 1993, CYI serves the engine market in China via a 76.4% stake in Guangxi Yuchai Machinery Co. The latter is a 66-year-old Chinaheadquartered company that manufactures light-, medium- and heavy-duty engines for vehicles, construction equipment, and marine and agriculture applications. CYI also owns a 48.9% stake in hospitality and property development group HL Global Enterprises (HLGE).

CYI has reported some strong numbers this year. For 1QFY2017 ended March, the company’s revenue increased 34.9% y-o-y to RMB4.6 billion. Earnings increased 179.2% to RMB249 million. However, growth slowed in the second quarter. For 2QFY2017, CYI’s revenue rose a smaller 11.7% to RMB4.1 billion while earnings increased 6.3% to RMB131.5 million. Shares in CYI plunged 22.5% to US$17.13 after the numbers were released.

The stock has since rebounded and is up 62.9% year-to-date. On Oct 20, CIMB Research initiated coverage on CYI in a report paid for by CYI. Analyst Ngoh Yi Sin rates CYI an “add”, with a price target of US$30.53, describing the company as a “laggard play on China’s manufacturing upcycle”. Ngoh also expresses optimism about its ability to ride China’s Belt and Road Initiative and other government moves.

“A recent slew of government measures kicked off a cyclical upturn for the engine-manufacturing industry in China, underpinning the results and share price outperformance of its peers. These include more stringent emission standards, reduction of electric vehicle incentives and stricter enforcement of anti-overloading policy in China,” she says in the report. “We believe [Guangxi Yuchai Machinery] would continue to benefit from some of these regulatory tailwinds, hence driving the near-term demand for its engines.”

Ngoh also highlights the company’s “robust financial position”, with net cash per share of US$11.14 as at end-2016 and a cash conversion cycle of 90 to 120 days on average. “It has consistently recorded positive free cash flow in the past, and sees little need for intensive capex in the near term,” she writes.

While Ngoh says CYI still faces risks from intensifying competition, rising component prices and the growing use of electric vehicles, she expects the company will continue to grow as it pursues new product lines and forms more joint ventures. This year, the company entered into a JV with German engine manufacturer MTU Friedrichshafen, a wholly-owned subsidiary of Rolls-Royce Power Systems. Under the JV, CYI will produce MTU engines in China. Production is expected to start in 2018, with a total investment of RMB150 million for the first phase.

Active restructuring On Oct 25, the Singapore Exchange queried HLA about its unusual trading activity. That day, shares in HLA had gained as much as 14.6% on significant volumes. In its response, HLA’s board pointed to Ngoh’s report as well as to a recent deal by HLGE. On Oct 19, HLGE announced the completion of the disposal of an indirect 60% stake in Copthorne Hotel Qingdao Co. This was done via a public tender on the Shanghai United Assets and Equity Exchange. The consideration of RMB214.35 million will be remitted to HLGE after clearances.

HLA also said it “continues to explore other strategic options and potential alliance opportunities”, as announced in its 2QFY2017 results release on Aug 11.

Could there be more deals for HLA underway? After reporting two consecutive years of losses, HLA has some disappointed shareholders. But if market sentiment holds up, more opportunities could arise for the group to realise some value.

Can shareholders look forward to more activity at Hong Leong Asia?

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Can shareholders look forward to more activity at Hong Leong Asia?

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