China Growth Plays: Aluminum and Water

Sham Gad

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

With China's benchmark Shanghai Composite Index down over 50% from its highs, everyone seems to believe that all the "hot money" has left China. As a value investor, I don't deal with hypes, fads or momentum. I look at cold, hard economic facts. And the facts are these: China's stock market is down over 50% from its high, the country continues to dominate as the low-cost producer, and 1.3 billion Chinese want everything we have.

Investors, both domestic and foreign, are gloomy on Chinese stocks. When events like this occur, I start digging around.

Almost everyone believed the Olympics would be a boon to Chinese equities. It wasn't, but the Olympics displayed to the world that China is certainly no hype and is here for the long haul. Let's look at some businesses that will surely benefit from China's long-term growth and enrich patient investors in the process.

Aluminum Remains Sturdy

Like all commodities, aluminum has had across-the-board price increases, from about $1,800 a ton in 2005 to nearly $3,000 a ton today. But recently, equity prices in aluminum companies across the globe have fallen to levels not seen for quite a while.

Energy is a major input in aluminum production, and the high cost of oil has hurt margins. In the U.S., aluminum titan Alcoa(AA) is off 30%, while the smaller Century Aluminum(CENX) is off more than 40%.

In China, however, Aluminum Corp of China(ACH), commonly known as Chalco, is down nearly 70% from its high. Clearly, the rapid rise in Chinese equity prices a couple of years ago fueled Chalco's sharp rise, and subsequently the stock got clobbered with the similar rapid fall in equity prices.

But the long-term economic case for aluminum is favorable. Since energy accounts for as much as half the cost of making aluminum, the recent $30 drop in crude oil and $4 to $5 drop in natural gas bodes very well for aluminum producers. Additionally, aluminum supplies are tight. The global days of inventory of aluminum sits at about 29 days today, vs. 48 days in 2002 and 85 days in 1994.

It bodes even better for China, as the country continues to gobble up commodities to fuel its economic growth. Like most large enterprises in China, the government owns a large chunk of Chalco. While such an ownership structure lends itself to a bit of uncertainty, it's clear from the Chinese government's past actions that it favors a market-oriented policy, albeit a controlled one.

At its current price of $23 a share, Chalco currently trades at a current P/E of 2.5, a forward P/E of 7 and an enterprise value/EBITDA of 2. Net margins are 11%, and return on equity exceeds 17%. And you get over 4% in dividends while you wait.

Precious Water

China is currently the world's fastest-growing consumer of bottled water, with a 17.5% compounded annual growth rate from 2002-2007, double the rate of the next-fastest-growing country, the U.S. China's high growth in bottled water consumption is easy to understand: Drinking water quality is poor, and no one trusts water from the tap. According to estimates by the State Environment Protection Administration of China, one-half of China's major cities have polluted tap water.

Enter China Water and Drinks, a licensed water producer in China that trades over the counter in the U.S. The way to participate in this company is through Heckmann(HEK), a special-purpose acquisition company (SPAC) that finally used its cash to buy China Water. Although both stocks still trade, the deal will close later this year, and an overwhelming majority has already voted in favor of it.

China Water is the largest supplier of water to Coca-Cola(KO) in China. China's four top bottled water producers (Coca-Cola China being one of them) control over 50% of the market in China. On its own, China Water produced 844 million liters of water in 2007, or 6.3% of total bottled water consumed in China.

The potential growth of the Chinese water industry has not gone unnoticed: Heckmann agreed to purchase China Water for about $625 million in cash and stock. In 2007 China Water had sales of $56.7 million and net income of $19.5 million. Heckman's price suggests an ultra-rich 31 times earnings.

Or does it? In 2006, net income was $6.2 million, representing a growth rate of over 300%. With Chinese bottled water consumption on a high growth trajectory, this business could turn out to have great growth at a reasonable price investment, a favorite setup of many a value investor. While I've yet to pull the trigger on this one, it would be wise to keep a very close eye here.

This was originally published on RealMoney on August 29, 2008. For more information about subscribing to RealMoney, please click here.

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