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BYD, Counting Sheets and Buffett - Part 1
Posted by: Seattle Ethan (IP Logged)
Date: October 30, 2012 04:56PM
Shortly after Warren Buffett took a 9.9% stake in BYD, a Chinese company that makes batteries, hybrid and electric vehicles (EV) and solar panels, in September of 2008, his business partner Charlie Munger commented, “I will be surprised if BYD doesn’t become the best-known company in China.” Since the unusually strong endorsement, the buzz about EV (electric vehicle) and energy revolution has died down as oil prices have moderated below $100 per barrel, conventional vehicles improved competitiveness by increasing fuel efficiency, the U.S. Commerce Department slapped anti-subsidy duties of up to 250% on Chinese solar products, and demand for solar panels from Europe has dropped off a cliff due to its economic woes.
Berkshire Hathaway (BRK.A)(BRK.B) could have sold its stake in BYD at roughly 945% return in 2009 — only one year after it invested — but Buffett and Munger held on to BYD as a long-term holding. Now BYD has dropped some 84% from the 2009 peak and its OTC ADR under symbol BYDDF now trades below $2 per share. At $2 per share, BYD is trading at 1.2 times my calculation of book value and 1.4 times tangible book value. Challenges BYD face are well documented in this Wall Street Journal article, which is referenced later. So why did Buffett and Munger make this unusual bet on a technology company and hold on to it as a long-term bet?
Bet on the Man
Ben Rosner, a CEO of a grocery chain, struck up a conversation with the manager of a competing grocery chain at a black tie event. Rosner asked how much the other chain was paying for different items in the inventory and found peculiar how much the competing chain was paying for one particular item — toilet paper. Rosner wondered, am I paying too much for toilet paper? He then immediately left, still dressed for the black tie event, drove some distance to the warehouse, and counted the sheets on a toilet paper roll. He found that his supplier had been lying to him about 500 sheets being in a toilet paper roll. Of this Buffett thought, “Intensity is the price of excellence,” and made sure Rosner stayed on as the manager of the chain after Berkshire acquired it.
Though the degree of managerial difficulty is significantly higher for a trail-blazing technology company like BYD, Bill Gates and Warren Buffett have both said that investment in BYD is a bet on its CEO — Wang Chuan-Fu. David Sokol, who was once Buffett’s lieutenant, described Wang as an unusually purposeful executive. Munger thought Wang “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.”
Wang reportedly works until 11 p.m. most days, doesn’t have many vices or indulgences other than owning a Lexus and Mercedes that he likes to take apart to learn how they work, and felt disgusted when an American auto company threw an extravagant holiday party while losing billions in the middle of 2008-09 financial crisis. Buffett has said that he likes to collect companies and people, and BYD and Wang fit the mold.
In the Wall Street article, perhaps the most alarming problem listed is the huge total debt of about $2.9 billion (using translation ratio of RMB6.3 to $1), although the most recent figure after the third quarter filing is closer to 15.5 billion yuan ($2.46 billion) in net debt, compared to about $766 million in cash and cash equivalents at the end of the second quarter. The following is the debt payment schedule from end of June 2012.
*millions in USD. Conversion at RMB 6.3 = $1.
Considering the shrinking revenue and the following table showing direction of net income and free cash flow, it is easy to see why the article questioned BYD’s financial health and solvency.
*millions. Conversion used RMB 6.3 =$1 for simplicity.
BYD had positive net income and operating cash flow in the periods examined, but heavy capital spending caused free cash flow to be negative in 2010 and 2011. BYD is known for cost control, so why then is capital spending ballooning? BYD has done a poor job of forecasting. In 2010, its initial projection was to sell 800,000 cars, which was slashed to 600,000 cars by September, but it ended up selling only about 520,000 cars in 2010. BYD has acknowledged the problem and pledged to do a better job of forecasting.
Adding to this problem, BYD is vertically integrated and makes most of its own auto parts, except for tires. Vertical integration, though it's possibly an advantage for BYD in the long-term and it's strange to flag a company for being farsighted, is one of the reasons for huge capital expenditure compared to revenue.
Another managerial mistake was when BYD missed ample opportune moments to raise more funds in the stock market when its stock price peaked at $10.8 per share in 2009 but instead, it ended up issuing 79 million new shares at $2.78 per share to raise $219 million in 2011. The 2011 offering was lackluster, so public offering may not be a very good option to raise money in the immediate future, unless BYD doesn’t mind massive dilution at a stock price close to book value.
Have We Seen This Movie Before?
The transformation of China’s economy is reminiscent of the way the South Korean economy evolved over the last 60 years except everything is bigger and happens much faster. In the beginning, the South Korean government also protected its fledgling domestic auto companies from foreign competition by requiring joint ventures to gain access to the market.
It also provided other support like cheap loans to fuel growth and development for the eventual goal of Korean domestic companies exporting overseas. Korean consumers, for a long time, shunned Korean brands due to either inferiority or perceived inferiority and preferred foreign brand vehicles, which were considered status symbols. It’s doubtful if South Korea’s Hyundai could have become the company it is today without government support through the years, especially after exporting in the late 80s Hyundai Excels — voted one of the “Cars That Deserves to Die” by Popular Mechanics.
It is unclear whether BYD has access to the kind of cheap loans that were once available to Korean auto companies. To quote the article: “Industry officials said BYD is at little risk of insolvency because Chinese officials and banks often prop up major companies, and it enjoys the backing of major state-run banks.”
BYD does employ more than 160,000 workers. However, according to Zachariah’s summary of G.E. Anderson’s book, "Designated Drivers: How China Plans to Dominate the Global Auto Industry," only State-owned-enterprises (SOEs) owned by Chinese state such as Shanghai Auto enjoy debt implicitly guaranteed by the central government while companies like BYD that are not SOEs receive less preferential advantages.
Now the world believes that Japanese and Korean auto companies make great cars, but they too started by copying Western designs in the beginning just as BYD now “draws inspiration from” (read, "copies") Toyota designs. One side note of interest: BYD S6, which is sold in China, looks exactly like the Lexus Rx 350 (though performance is another story) except for logos and the emblem on the grill. In fact, after purchasing a BYD S6, for $90, one can buy a Lexus logo, grill and emblem right from a BYD dealership and transform a BYD S6 into a Lexus Rx350 in about 20 minutes. There’s even a Youtube video on this.
Ironically, due to China’s territorial dispute with Japan over an island, angry Chinese protesters have been flipping over Japanese cars on the streets lately. In order to protect their vehicles, Chinese owners of Lexus Rx350s are now starting to replace Lexus emblems with BYD ones.
BYD is trying to do big and difficult things: revolutionize energy industry; usurp conventional vehicles with EVs and hybrids; close the quality gap with leading companies; overcome the image of Chinese inferior quality. The last two obstacles should be achievable in time since Japanese and Korean companies have overcome similar problems. But the first two goals have obstacles that may make investment in BYD a curve ball, or the opposite of a fat pitch Buffett likes to look for, and it isn’t clear if the man with the right intensity can overcome them.
In part 2 of this article, we explore more of Charlie Munger’s investment thesis in BYD, which may explain why China is so interested in alternative fuel vehicles and what Jeremy Grantham has to say about that.
Disclosure: Long BYD, long BRK.B. I also have open buy orders for BYD. Nothing in this presentation should be taken as a recommendation to anyone to buy, hold or sell certain securities or any other investment mentioned herein. This article is for educational purpose only.
Guru Discussed: Warren Buffett: Current Portfolio, Stock Picks
Jeremy Grantham: Current Portfolio, Stock Picks
Stocks Discussed: BYD, BYDDF, BYDDY, BRK.B, HYUNDAI, TM,