Elevator Pitch

I maintain a Neutral rating on Hong Kong-listed handset casing supplier Tongda Group Holdings Ltd. (OTC:TDGFF) [698:HK].

This is an update of my prior article on Tongda Group published on April 2, 2020. Tongda Group’s share price has declined marginally by -2% from HK$0.44 as of April 1, 2020 to HK$0.43 as of September 21, 2020, since my last update. Tongda Group trades at 5.5 times consensus forward FY 2021 P/E and 0.46 times P/B, and it offers a consensus forward FY 2021 dividend yield of 2.8%.

Tongda Group’s net profit fell -90.8% YoY to HK$29.0 million in 1H 2020 in line with its profit warning, but there are expectations of a sharp 2H 2020 earnings recovery. Tongda Group’s focus on the handset casing products segment of the smartphone value chain and its customer concentration risks are key negatives for the stock. But this has been priced into a large extent, considering Tongda Group’s depressed valuations. As such, I retain my Neutral rating on Tongda Group.

Readers have the option of trading in Tongda Group shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the ticker TDGFF or on the Hong Kong Stock Exchange with the ticker 698:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low and bid/ask spreads are wide.

For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution given that the Hong Kong Stock Exchange is one of the major stock exchanges that are internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $1 million, and market capitalization is above $350 million, which is comparable to the majority of stocks traded on the US stock exchanges.

Institutional investors that own Tongda Group shares listed in Hong Kong include Dimensional Fund Advisors, The Vanguard Group, LSV Asset Management, and BlackRock, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage, such as Interactive Brokers or Fidelity, or international brokers with Asian coverage, like Hong Kong’s Monex Boom Securities and Singapore’s OCBC Securities.

1H 2020 Net Profit Fall In Line With Earlier Profit Warning

Tongda Group announced the company’s 1H 2020 financial results on August 20, 2020, and its poor financial performance was no surprise. The company’s net profit attributable to shareholders fell -90.8% YoY from HK$315.8 million in 1H 2019 to HK$29.0 million in 1H 2020. This was in line with Tongda Group’s earlier profit warning issued on July 10, 2020, where it estimated that its net profit attributable to shareholders is expected to decrease by 85%-95%.

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Notably, Tongda Group’s revenue increased by +2.1% YoY from HK$3,908.9 million in 1H 2019 to HK$3,990.3 million in 1H 2020, despite Covid-19 headwinds.

The company’s core handset casings & high-precision components business, which accounted for 78.9% of its 1H 2020 revenue, saw segment revenue grow by +10% YoY to HK$3,149.3 million in the first half of the year. This was partially offset by a -20% YoY decline in revenue for Tongda Group’s non-handset businesses such as smart electrical appliance casings, household and sports goods, and network communications facilities and others, which suffered from lower demand due to Covid-19. Nevertheless, it is encouraging that Tongda Group’s handset casings business gained market share in 1H 2020, as more of the company’s handset casings solutions were adopted by smartphone manufacturers for their new products.

Tongda Group’s net profit decreased by -90.8% YoY in 1H 2020, notwithstanding a +2.1% YoY increase in its top line over the same period. In other words, the company’s earnings decline in the first half of the year is mainly attributable to a significant deterioration in its profitability. The company’s gross profit margin decreased from 21.1% in 1H 2019 to 15.2% in 1H 2020, and its net profit margin contracted from 8.1% to 0.7% over the same period.

In the company’s 1H 2020 results announcement, Tongda Group attributed the company’s gross margin decline to “the keen competition faced by the Group’s existing products” and “the delay of the Group’s expected product upgrades” due to Covid-19. Unfavorable product sales mix was also another factor that contributed to the company’s gross margin contraction in 1H 2020, which I will discuss in greater detail in a subsequent section of this article.

Tongda Group’s net profit margin contracted by a greater degree as a compared to its gross profit margin decline in 1H 2020. This was mainly due to an increase in research & development expenses-to-revenue ratio from 4.4% in 1H 2019 to 5.1% in 1H 2020, and a foreign exchange loss of HK$11.2 million recorded in the first half of the year (as opposed to a foreign exchange gain of HK$85.6 million in 1H 2019).

Market Expects Sharp Earnings Rebound In 2H 2020

Sell-side analysts see Tongda Group’s net profit attributable to shareholders declining by -36% YoY from HK$402 million in FY 2019 to HK$257 million in FY 2020. This implies a sharp HoH (Half-on-Half) earnings rebound for Tongda Group in the second half of the year, considering the company’s 1H 2020 net profit of HK$29.0 million.

Tongda Group is equally optimistic with regards to the company’s outlook for 2H 2020. In the “Prospects” section of its 1H 2020 interim report, the company cited 5G smartphone penetration growth, product upgrades, and market share gains as its key growth drivers in 2H 2020 and beyond.

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Product Sales Mix Has A Significant Impact On Profitability

As highlighted above, Tongda Group’s gross profit margin contracted from 21.1% in 1H 2019 to 15.2% in 1H 2020, which was one of the key factors that contributed to the company’s -90.8% YoY drop in net profit in the first half of the year.

The company’s product sales mix has a significant impact on its gross profit margin and overall profitability. As per the chart below, higher-priced premium and flagship smartphones tend to use more expensive casing solutions, and vice-versa.

Tongda Group’s Range Of Handset Casing Solutions

Source: Tongda Group’s 1H 2020 Results Presentation Slides

Due to the economic fallout brought on by Covid-19, there has been a shift in consumer preferences towards cheaper budget smartphones, and this in turn led to greater demand for cheaper casing solutions. Tongda Group’s main products are Glastic (a term used to refer to glass-like plastic casing) handset casings, and it is likely that the company generated a higher proportion of sales from lower-margin 2.5D (two-and-a-half-dimensional) Glastic casings (versus the higher-margin 3D and uni-body Glastic casings), which resulted in gross margin compression.

Looking ahead, Tongda Group guided in its 1H 2020 interim report that “potential upgrades of conceptual design for the Group’s casings from 2.5D Glastic casings to the 3D and uni-body Glastic casings” will result in a more favorable product mix and drive higher profit margins for the company in 2H 2020. Market consensus expects Tongda Group’s gross profit margin to decrease from 18.3% in FY 2019 to 17.0% in FY 2020, but this still represents an improvement from the company’s gross profit margin of 15.2% in 1H 2020.

Focus On Handset Casing Products And Customer Concentration Are Key Negatives

Despite expectations of a sharp earnings recovery for Tongda Group in 2H 2020, I am still negative on Tongda Group for two key reasons.

Firstly, Tongda Group is focused on the handset casing products segment of the smartphone value chain, which is not a favorable segment as compared to optics as an example. This is because smartphone casing is not exactly the most important factor (e.g. camera specifications) that consumers assess and evaluate in their purchase of smartphones. As a result, handset casing manufacturers like Tongda Group have relatively less bargaining power with smartphone manufacturers, which implies downward pressure on average selling prices and lower profit margins.

Secondly, Tongda Group has relatively high customer concentration risks. In 1H 2020, two of the company’s clients, referred to as Customer A and Customer C in its interim 1H 2020 report, accounted for approximately 40% and 10% of Tongda Group’s 1H 2020 revenue, respectively. While Tongda Group does not disclose the names of its customers publicly, Customer A or Tongda’s largest customer in terms of revenue is speculated to be Apple (AAPL). The potential ban of WeChat and TikTok apps could possibly have a negative impact on the sales of Apple’s iPhones, and Tongda Group’s significant revenue exposure to Apple could hurt the company.

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Valuations And Dividends

Tongda Group trades at consensus forward FY 2020 and FY 2021 P/E multiples of 8.8 times and 5.5 times, respectively based on its share price of HK$0.43 as of September 21, 2020. In comparison, the stock’s five-year and 10-year average consensus forward next 12 months’ P/E multiples were 7.9 times and 7.5 times, respectively. The stock is also valued by the market at 0.46 times P/B, versus its five-year and 10-year mean P/B multiples of 1.7 times and 1.5 times, respectively.

Tongda Group offers consensus forward FY 2020 and FY 2021 dividend yields of 2.5% and 2.8%, respectively. The company chose to omit interim dividends for 1H 2020, as compared to 1H 2019 dividends per share of HK$0.01. But market consensus still expects Tongda Group to increase its dividends per share from HK$0.01050 in FY 2019 to HK$0.01066 and HK$0.01193 in FY 2020 and FY 2021, respectively.

Risk Factors

The key risk factors for Tongda Group are a weaker-than-expected sales recovery in 2H 2020, unfavorable product sales mix resulting in lower-than-expected profit margins for the company, and a suspension of the company’s dividend payout for a longer-than-expected period of time.

Note that readers who choose to trade in Tongda Group shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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