China Gerui Advanced Materials Group ( CHOP) is the largest producer of high precision cold-rolled narrow strip steel products in China with a market share of 12.5%. CHOP is trading currently at a trailing 12-months price-to-earnings ratio of about 5, which is incredibly cheap for a company that will be doubling capacity over the next two years. With constant margins at 2012 full capacity, CHOP could be trading at a 2012 P/E of 2.5.

I had the chance recently to interview Edward Meng, chief financial officer of China Gerui.

Can you give me some background on your company?

China Gerui is the largest producer of high precision cold-rolled narrow strip steel products in China, with a market share of 12.5%. We started back in 2000 and over the last 10 years we have continuously been adding to our capacity. Our current production is 250,000 tons of cold-rolled narrow strip steel. We are currently in the process of expanding capacity because we have reached close to full utilization on the existing capacity, which admittedly is a good problem to have. We cannot churn out our product fast enough to meet the high demand.

By the end of 2010 we will add about 150,000 tons of cold rolled wide strip capacity. By the end of 2011 we will be adding another 100,000 tons, achieving a total production capacity of 500,000 tons, which is two times the capacity we have now. This is one of the major reasons we did the latest capital raise of $18.8 million.

What is the price per ton for your product?

The average selling price of our products ranged between $870 to $890 per ton over the last 12 months.

Where do you see the company in five years, 10 years?We will be adding capacity to meet market demand. Now we are focusing on adding to and optimizing our overall product mix. Our high-end products are of the same quality as products that are currently being imported into China except our products are sold at a much more competitive price, so we have had great success in enhancing our growth by replacing products that were until now imported into the country. In the next five-10 years, we will continue to strengthen our market leadership while optimizing our product mix with high-end products.

What are the various segment lines of the company?

Our core business is cold-rolled steel production and we have no other businesses.

Who are your main competitors?

Our competitors are both state-owned and private sector companies. We are the largest player in the cold-rolled narrow steel strip market with about 12.5% market share. The top five players in this segment of the market accounted for about 36% of the market, with the rest of the market consisting of over 200 smaller and private players.

Why do your customers choose you over the competition?

Customers will choose us over our competitors for a number of reasons.
  • 1. We have a strong brand name and reputation in China in our industry. Our products are known for their high quality and precision.
  • 2. We have proven that we are able to customize contracts for our customers based on the specific attributes they required for the intended end-use application.
  • 3. We have strong R&D capabilities and we continue to offer new product offerings that our clients are interested in.
  • 4. We are able to adjust our operations to meet different size orders. Our contract sizes range from over 2,000 metric tons for some companies to as little as 500 tons.

Will the margins stay the same on the new facilities?

Historically, we have been able to continuously improve on our profit margins. Our gross margins are approximately 30% and we expect that to continue.

How is the growth in the overall industry?

We serve over 200 customers from four industries: food and beverage packaging, construction and decoration materials, electrical and home appliances, and telecom. The first three industries are all driven by the increase in the consumption power of the Chinese economy, which we expect to continue to rise. Over the next three years, we expect to see double-digit annual growth in our industry. The telecom industry in particular should continue to benefit from the Chinese government's policy on expanding broadband and 3G networks in both rural and urban areas, which in return, provides for increased demand for China Gerui's product in the manufacturing of fiber optic cables.

What will be the return on capital? What is the output?

We estimate the payback period for this capacity expansion program to be about 2.5 years; this is for both phases combined. The total additional output will be 250,000 tons, 150,000 for phase 1 and 100,000 for phase 2. The expected capex for phase 1 will be 42 million, while the capex for phase 2 is expected to be 12 million.

What will the private placement be used for?

We plan to use the net proceeds from the private placement to finance the previously announced expansion of the company's high-precision cold-rolled steel production capacity, accelerate the build-out of a chromium-plating production line of 200,000 metric tons that was originally scheduled for 2011, as well as for general working capital purposes related to the expanded production capacity.

Zack Buckley is general partner for Buckley Capital Partners Hedge Fund and manages his blog at Uncoveringalpha.com. He developed his investing methodology by synthesizing the ideas from the best investors of all time: Warren Buffett, Peter Lynch, Seth Klarman and Benjamin Graham. Using a value approach, he researched thousands of companies in order to pursue the most undervalued companies, which led primarily to companies in China. Buckley will be spending three months this year in China visiting companies that are exciting investment opportunities. Follow him on his blog, Uncoveringalpha.com, as he travels across China touring factories and interviewing management.

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