Cogo Group Inc. (Nasdaq: COGO) investors are trying to reconcile the company's apparent strength with a steep drop in stock prices. Although shares of the China-based mobile handset and telecom equipment designer slumped 47% this year, the company is still poised to achieve its seventh consecutive year of growth. Is there an upside here?
As a company, Cogo seems to be doing relatively well. Its primary competitive advantage is designing custom technology component modules that help its clients achieve a quicker time-to-market and a lower production cost.
This is certainly a desirable service for the company's diverse client base, which includes companies such as Huawei, Lenovo (OTC: LNVGF.PK), UTStarcom (Nasdaq: UTSI), and ZTE, because it relies on a short product development cycle to achieve its own sales and profitability goals. Cogo also has supplier relationships with Broadcom (Nasdaq: BRCM), JDS Uniphase (Nasdaq: JDSU), and Panasonic (NYSE: PC).
During the past seven years, we've seen the net margin drop from 10% in 2005 to 3.8% in 2009, leveling off at 4.3%. Some analysts are interpreting that as poor profit margins. The only other negative I've found was the company's free cashflow in the red, caused primarily by a lengthening cash conversion cycle. This creates shrinking (and negative) cash from operations. While that's something investors don't like to see, Cogo managed to turn things positive again this year.
Before I completely lose your interest in Cogo, let's look at the fundamentals. A quick glance at the ratios tells us this stock could be a diamond in the rough. With a forward P/E ratio of 4.2, price-to-earnings ratio of 0.35, and price-to-book ratio of 0.63, we see extraordinary potential for a value pick. The current ratio of 2.8 is healthy, and we see increases across all the major profitability margins and ratios over this quarter last year.
Looking to value this stock independently, we first look at the revenue growth rate and our expectations for the future. I chose a range between 7%, its 2009 low, and 15%, the consensus five-year growth rate. I subtracted the anticipated share buyback remaining from management's repurchase plan, reducing the valuation divisor.
I took a conservative best/worst-case free cashflow range of 2.5% to -1.7%, anticipating circumstances similar to today for at least the near future. I would expect it would err on the top side of this range, as the company has a consistent history of beating analyst estimates (with no reward for its stock performance).
With those factors in place, I arrived at a valuation range of $7.22 to $7.53 per share, which is below the $12 average price target by analysts, but more than 60% higher than the current trading price of $4.45.
Because Cogo is a Chinese company that went public in a reverse merger in 2004, we need to look at the associated risk factors to determine if we can trust the financials at all. KPMG has been the company's auditor since 2006, and Cogo's current CFO has held this office since 2008. Those two factors make Cogo about as low-risk as it gets in this class.
I'm looking for a broader return to Cogo as the Chinese reverse-merger debacle gets sorted out.