Stock Review: China Lesso

Kevin Smith, of API Capital and portfolio manager of the TAMIM Asia Small Companies strategy, highlights one of the more interesting stocks in the Asia Small Companies portfolio, China Lesso (2128.HKG). 

​China Lesso Group Holdings Limited (China Lesso), an investment holding company, manufactures and sells building materials and interior decoration products in the People’s Republic of China and internationally. The company primarily offers plastic pipes and pipe fittings, sanitary ware products, integrated kitchens, systems of doors and windows, decorative plates, fire-fighting equipment, sanitary materials, etc. for use in the fields of interior decoration, water supply, drainage, power supply and telecommunications, gas transmission, agriculture, floor heating, and fire services. It offers its products primarily to independent distributors, civil contractors, property developers, utility companies, and municipalities. The company was formerly known as China Liansu Group Holdings Limited and changed its name to China Lesso Group Holdings Limited in May 2013. China Lesso Group Holdings Limited is headquartered in Foshan, the People’s Republic of China. 

Accounting, Strategy and Governance Comments

Accounting
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1 - Ernst & Young (EY) audit the accounts, use of a big name accounting firm is a positive.

2 - Unqualified accounts over all time periods, no issues raised by EY.

3 - Full compliance with the Hong Kong accounting standards.

Strategy

1 - China Lesso has 22 production facilities across 16 provinces in China. The gives the company a competitive advantage in the urbanization of Central China. In the interim results to 30 June 2018 revenue growth generated in the Central China region was 40.5%, the fastest growth rate recorded for any of the regions. Sales from the Central China region now account for 12% of total sales, this percentage is expected to continue an upward trend. The “core” market of Southern China is showing revenue growth of 9.5% and accounts for 55% of total sales.

2 - Sales are largely generated through 2,172 exclusive distributors which provides a secure distribution platform. The interim result showed revenue growth of 16.4% and earnings per share growth of 9.7%. The company won multiple brand awards in 2018 which underpins demand from additional exclusive distributors to join the China Lesso network.

3 - Government measures to reduce water pollution is providing a demand stimulus for replacement pipelines. Total investment of RMB 4.6 trillion (USD 665 billion) is planned for pollution control in the next five years. Demand for pipes is split across new water supply (23%), new urban rainwater pipelines (28%), centralized heating network (10%), new gas pipelines (33%) drainage and replacement of old pipelines (6%).  

4 - Plastic pipes account for 90% of sales, given to level of ongoing demand for plastic pipes there is no need to aggressively pursue diversification opportunities. The company has a limited international programme and expansion into aluminium products. Production of plastic pipes and fittings will rise to 2.53 million tonnes in 2018 from 2.4 million tonnes in 2017 with capacity utilization of 83%. The company has been building a portfolio of international investment properties in the United States, Canada, Australia and Thailand.
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5 - The balance sheet is geared, 44% debt to  total capital, the debt is largely denominated in USD at rates between 2.83% and 5.32%. Interest cover in excess of 10x is comfortable and the gearing is consistent with the demand profile and strategy of the business.

Governance

1 - Full compliance with the Hong Kong governance standards.

2 - Five independent non-executive directors on the Board. 

3 - The company has adopted the Model Code for securities transactions by Directors. The Chairman Wong Luen Hei and his wife Zuo Xiaoping together control 2,124,793,000 shares equivalent to 68.49% of the share capital. The Chairman has been active buying shares in the Hong Kong market, all transactions have been fully disclosed in the appropriate manner and timing. 

Map showing location of production facilities for China Lesso

Source: China Lesso Interim Report 2018

Conclusion

China Lesso meets our standards for accounting, strategy and governance. China Lesso has a strategy directed towards the development of China, the company has a strong home market in Southern China and is well placed to benefit from urbanization of the interior of China and major infrastructure projects funded by local government bodies and the national government.

Value, Momentum and Quality Comments

1 - Our VMQ score has fallen from top decile to top quintile. The company offers close to the best value available in the market and quality score is top quartile. Momentum has fallen away in recent months, in line with general market sentiment, no specific negative stock news, so we are happy to maintain positions.

2 - There are seven analysts actively covering this stock, all have buy ratings and the median target price is 80% above current levels. Consensus earnings growth remains in double digit percentage growth in 2019 and 2020.

3 - Return on capital employed in excess of 15% helps to underpin strength in the score for quality.

Source: API Capital