MVSTW - Microvast Has Got A China Problem

2023-05-24 09:36:23 ET

Summary

• Microvast Holdings lost ~40% of its market value overnight after the U.S. DOE has reportedly cancelled a $200 million grant for the company due to its alleged links to the CCP.
• The latest development has nearly wiped out optimism from earlier this month, when Microvast reported stellar first quarter results with an upward-adjusted full-year guidance.
• Despite it being an American company, MVST's substantial China exposure remains an acute overhang and immediate risk on both its fundamental and valuation prospects ahead.

It has been a whirlwind for the Microvast Holdings, Inc. ( MVST ) stock over the past two weeks. The stock had its biggest intraday squeeze after the company reported upbeat earnings earlier this month that also included an upward-revised guidance for the full year. Management also expressed optimism over increased visibility into its roadmap for scaling newly introduced commercial vehicle battery cell and storage offerings in the year ahead and beyond across core growth regions spanning Europe and the U.S. Much of the stock’s post-earning gains have been durable, as tangible and consistent fundamental improvements at MVST during the past two quarters helped to recoup some of investors’ lost confidence.

Yet, multiple compression risks are back in focus after the U.S. Department of Energy retracted a $200 million grant that was previously intended to support MVST’s expansion efforts at its Clarksville, Tennessee facility, alleging “ties to the Chinese Communist Party.” Despite management’s optimism expressed not too long ago for an improved fundamental roadmap going forward, the latest development underscores how MVST’s China exposure remains a sensitive subject for which the risk-off market climate continues to trade at an incremental discount on.

Microvast Has Got Risks Pertaining To China Investments

Despite being a U.S.-headquartered company, MVST’s operations exhibits substantial exposure to risks pertaining to China investments – a cohort that has been shunned by U.S. investors due to mounting regulatory, geopolitical, macroeconomic and other risks. This is consistent with the onset of MVST’s decline to levels below its SPAC merger price, which gained pace in late 2021, when the broad-based market selloff at the time due to heightened pandemic fears was exacerbated by the SEC’s finalization on rules pertaining to the “Holding Foreign Companies Accountable Act” (“HFCAA”).

Holding Foreign Companies Accountable Act

Under the HFCAA, all publicly-listed companies in the U.S. that have engaged an auditor in jurisdictions non-compliant with SEC-mandated PCAOB inspections – primarily Hong Kong and mainland China – will be subject to risks of being delisted. The SEC requires all PCAOB-registered audit firms be subject to annual PCAOB inspection requests – non-compliance for three years from the request date will subject the firm’s clients to delisting risk. Despite MVST’s nature as an American company, with its core Chinese operations held under a subsidiary that is considered a “wholly foreign owned enterprise” in the region, the company’s engagement of an auditor based in China – namely, Deloitte Touche Tohmatsu Beijing – has subjected the stock to related delisting risks.

Although Chinese regulators and China-based PCAOB-registered audit firms have since agreed to opening their books for full PCAOB inspections in late 2022 , markets have yet to fully remove the valuation discount attributable to delisting risks from relevant stocks, underscoring the lingering concerns over HFCAA. In the latest development, completed PCAOB inspections on eight audit engagements in 2022 performed by PWC Hong Kong and KPMG Huazhen in mainland China – which were together responsible for “40% of the total market share of U.S.-listed companies audited by Hong Kong and mainland China firms” – found substantial deficiencies . This included findings that point to a lack of “appropriate audit evidence” obtained to support the inspected audit engagements’ conclusions, which the PCAOB has given PWC Hong Kong and KPMG Huazhen one year to remediate – or fix – before they are publicly disclosed.

Although it is not unusual for first-time inspections to result in significant findings, the conclusion of the PCAOB’s inaugural inspection of Chinese audit firm engagements foreshadow similar results ahead as the agency moves on to review the work performed by remaining Hong Kong and mainland audit firms responsible for U.S.-listed companies – including MVST’s auditor, Deloitte Beijing. With much work left to do to validate the transparency and integrity of financial information disclosed by U.S.-listed firms that have engaged auditors from Hong Kong and/or mainland China, it is without doubt that related delisting risks have yet to completely dissociate from involved stocks, underscoring dour market confidence for MVST.

While the company had previously been providing updates on how it plans to work with its auditors to “determine a path forward and a timeline for compliance,” related information have since been reduced to standard SEC filing risk disclosures in recent quarters.

On December 16 2021, the PCAOB published a list of the accounting firms in Mainland China and Hong Kong that it determined it is unable to inspect. That list does include Microvast auditor, a Mainland China office of Deloitte...Microvast does anticipate that it will be designated as a commission identified issuer following the filing of its 10-K earlier today, but we've also begun discussions with our auditors to determine a path forward and a timeline for compliance as we expand and diversify our global operations.

Source: MVST 4Q21 Earnings Call Transcript .

And it is unlikely for MVST to switch out of engaging a Chinese audit firm within the foreseeable future, as a similar process would not only be costly and time-consuming to execute, but also face the reality of rejection. The engagement of a new auditor would typically involve a review of audit files conducted by the previous auditor, and any substantial findings – a highly probable risk considering the recent PCAOB inspection results in Hong Kong and mainland China – could result in an outright rejection of the new engagement request by the company, or a retrospective audit which would be costly.

Transparency on Foreign Investments

And building on the topic of transparency, MVST’s substantial China exposure – more than half of Q1 2023 revenues were generated from sales in the region, with the majority of its production capacity stationed in Huzhou – also subjects it to incremental risks related to recent considerations by the Biden administration to tighten limitations on foreign investments. Specifically, the U.S. government has recently stepped-up efforts in restraining investments abroad on the grounds of national security, further exacerbating the risk sentiment over Chinese-affiliated investments. In addition to the existing Committee of Foreign Direct Investment in the United States, or "CFIUS," which reviews "foreign investments in or acquisitions of U.S. businesses," the Biden administration has been contemplating the enactment of a " reverse CFIUS ," which would review outbound American investments – particularly in China given escalating national security concerns.

In reports provided to lawmakers Friday on Capitol Hill, the Treasury and Commerce departments said they were considering a new regulatory system to address U.S. investment in advanced technologies abroad that could pose national security risks...People familiar with the work on the new program expect it to cover private-equity and venture-capital investments in advanced semiconductors, quantum computing and some forms of artificial intelligence. U.S. officials want to prevent American investors from providing funding and expertise to Chinese companies that could improve the speed and accuracy of Beijing's military decisions, for example.

Source: The Wall Street Journal .

DOE Grant

Related developments would likely further exacerbate an already battered valuation outlook for the MVST stock due to incremental regulatory and geopolitical risks. The recent reports regarding the retraction of a $200 million DOE grant to MVST, previously intended to support the build-out of its operations in Tennessee, also corroborates how the company has been stuck in the thick of an intensifying U.S.-China crossfire. MVST’s Clarksville, Tennessee facility currently under construction is slated for start of productions by the fourth quarter with annual output capacity of 2 gigawatt hour (or about 2,000 electric heavy-duty rigs based on an average 500 kWh battery pack size), and will serve as a key link to bolstering capitalization of opportunities in the U.S. market. The DOE’s speculated decision on retracting the $200 million grant due to alleged findings over the company’s association with the Chinese government could potentially weigh on the return on invested capital prospects pertaining to the Clarksville facility, and also dent its ambitions in gaining share within the expanding total addressable market, or TAM, for electric heavy-duty vehicle battery solutions.

The cancelled DOE grant is also a harbinger of more regulatory tightening to come pertaining to American business ties and investments in China. In addition to risks of derailing its U.S. roadmap as discussed in the earlier section, MVST’s China exposure also threatens to thwart its budding growth momentum in Europe.

During the first quarter, much of MVST’s outperformance was driven by growth in sales and backlog for its European customer, with the related share mix expanding at a rapid clip comparable to the U.S.

Our European revenue almost tripled year-over-year in the first quarter and accounted to 22% of our total revenue up from 7% of revenue a year ago. This growth was driven by the initial ramp of several customer projects, some of which I mentioned earlier and added by an improving supply chain. Going forward, we expect government led initiatives such as European Green Deal U.S. planned to ban combustion engine vehicle sales by 2035, along with U.S. IRA initiatives, continuing to be a significant driver of electrification initiatives…As we outlined last quarter, a large percentage of our commercial vehicle backlog is from European customers who are launching the electrified models for the first time. We continue to expect volume growth in our European segment, especially for the 53.5Ah cell as customers expand production…

For the second quarter, we expect the revenue to be in the range of $63 million to $67 million, up slightly from Q2 a year ago at the midpoint, driving by the continue ramp of our European commercial vehicle projects, as well as orders from customers in Asia Pacific. With a strong and growing backlog, we continue to have good visibility into 2023 driving by European commercial vehicle projects, entering the production phase and the ramp up for our energy storage business.

Source: MVST 1Q23 Earnings Call Transcript .

However, the “good visibility” management had alluded to earlier this month on MVST’s growth roadmap in the U.S. and Europe going forward is likely becoming increasingly murky instead, proving their previous optimism as premature. The U.S. and EU have been bolstering the alignment of their joint approach in “screening outbound investments to prevent companies’ capital, expertise and knowledge from supporting the technological advances of strategic rivals in ways that could threaten national security.” This could potentially drive new challenges to MVST’s core production capacity coming out of Huzhou, given tightening regulations over the kind of R&D that American entities can ferry overseas, especially China, and impact its ability in addressing global customer demands.

The Bottom Line

In addition to acute risks pertaining to MVST’s China exposure, the recent retraction of the $200 million DOE grant also threatens to add pressure on its already burdened balance sheet. The company currently operates at a cash burn run-rate of about $50 million per quarter. With management expecting full year 2023 capex spend of $210 million at the upper range and ongoing operating losses, the company’s current cash on hand balance of just under $300 million potentially foreshadows a need to tap incremental fundraising from public markets – either through equity or debt – soon, especially considering its nominal access to revolving credit facilities in double-digit millions, which comes at an inopportune time given unfavorable market conditions.

Admittedly, much of the outflows will stem from investments toward the Clarksville facility build-out, which is slated to complete this year, suggesting a reduction in cash burn going forward. However, ongoing operating losses, which considering the immediate fundamental risks brought forth by its China exposure, are likely to remain a recurring theme and pressure MVST’s liquidity within the foreseeable future. Microvast Holdings, Inc.'s unprofitable nature is likely to further compound multiple compression risks attributable to the stock due to its China exposure, especially amid the risk-off market climate.

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