Graphite: Next Play in China

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING ( TheStreet ) -- Rare earth elements have gone from being an obscure unknown topic to front page news in a very short period of time. There is now an increasing awareness of the fact that China, specifically its Inner Mongolia Autonomous Region, controls roughly 90-99% of the current global supply of certain rare earth elements. China has recently enacted several new policies to increase export taxes and decrease export supply of these rare earth elements, causing shares of many companies who have any connection to rare earths production to soar.

Molycorp ( MCP) went public in July 2010 in an IPO priced at $14 (below its expected range of $15-$17) and then subsequently traded down to as low as $12.10. The latest announcements of export curtailments by China have driven to stock as high as $62.80 -- an increase of 420% in only six months.

Shares of Rare Earth Element Resources ( REE) traded as low as $2.79 in August 2010 and subsequently rose as high as $17.92 in December -- a return of 530% in six months. It should be noted that both of these companies are in the exploration stage with respect to rare earths and neither one of them is yet profitable, making these investments highly speculative. Both of the shares are beginning to sag from their 52-week highs.

One stock, which is actually profitable, that has also soared on the back of the Chinese announcements is Inner Mongolia-based Shenzhou Mining ( SHZ). During the entire month of July, this previously unknown stock traded a total of 146,000 shares at an average closing price of 77 cents. After several gaps up throughout the fourth quarter of 2010, the stock was soon trading in the $4 to $5 range and I viewed it as overpriced based on hype.

Then on Dec. 29, in what is normally quiet trading between Christmas and New Year's, the stock shot up as much as 75% in one day on more than 33 million shares volume. To put that in perspective, the stock traded 226 times more in one day than it did in all of July and at a price which was more than 1,000% higher. The stock currently trades in the $8 to $9 range.

In my opinion, investors who are now jumping into MCP, REE or SHZ are certainly late to the party and there is considerable downside risk in investing here. The shares are all already beginning to show downward momentum. However there is a somewhat related play that has not yet seen the substantial moves of these rare earth plays and where I believe there is still considerable upside.

The related play is graphite and the stock I am (once again) focused on is China Carbon Graphite ( CHGI). The investment story is compelling and the current price leaves it still notably undervalued.

An excellent article in December by Jack Lifton drew considerable attention to graphite and to CHGI, with the stock trading as high as $2.10 on more than 1.4 million shares volume shortly after he published.

Mr. Lifton (who does not own the stock) called CHGI his top graphite pick and suggested the stock had the potential to triple. Other key points from the Lifton article include:
  • China produces 70% of the global supply of graphite
  • Governmental bodies are taking notice of just how crucial secure supplies of graphite are
  • Global supply has remained steady, while global demand has risen due to new applications for graphite, particularly lithium ion batteries
  • There is actually 10 times more graphite than lithium inside a lithium-ion battery
  • While graphite is in high demand for many applications, the greatest potential demand surge (particularly in China) will come from a ramp up in the use of nuclear power. A great write up on China's nuclear future can be found here. Highlights include:
  • Mainland China has 13 nuclear power reactors in operation, 25 under construction, and more about to start construction soon.
  • Additional reactors are planned, including some of the world's most advanced, to give more than a tenfold increase in nuclear capacity to 80 GWe by 2020, 200 GWe by 2030, and 400 GWe by 2050.
  • China is rapidly becoming self-sufficient in reactor design and construction, as well as other aspects of the fuel cycle.
  • Nuclear fuel assemblies are fabricated and supplied indigenously.
  • Domestic manufacturing of plant and equipment will be maximized, with self-reliance in design and project management.
  • (Note: the data above differ from Mr. Lifton's data on the number of nuclear reactors in China, I believe this data is the most up to date)

    The most obvious takeaways from this piece are that China is undertaking a huge expansion in nuclear power, but more importantly is focused on "becoming self sufficient," indigenous" supply, and "domestic" manufacturing. I emphasize this because it means that Chinese companies are poised to benefit substantially from the ramp up as China deliberately favors domestic enterprises.

    CHGI stands to benefit strongly from this as it is currently developing graphite products to be used as reflectors in nuclear reactors. And as a large domestic supplier, it could stand to benefit from China's push to substantially increase the domestic content of materials in nuclear reactors.

    It should be noted that the last time I wrote about China Carbon Graphite in March 2010 , I was extremely optimistic on the stock's potential based on several factors. The company has a top 10 auditor (BDO) and had recently completed a private placement with institutional investors in which it gave an indication of 2010 expected earnings of $5.1 million, which resulted in a forward PE ratio of only 3x. The share price at the time was approximately $1.90 and the stock was basically unknown.

    My high hopes for CHGI were quickly disappointed. Very shortly after I wrote about CHGI, a registration statement became effective, allowing the sale of more than 3 million previously unregistered shares when the share price was now well over $3. These investors had already made several hundred percent in a short period of time and presumably the majority of them sold. The stock price fell on heavy volume, but still remained above $2.

    Shortly thereafter, the company reported an unexpected fourth-quarter loss and the stock tanked. Next the company reported a first-quarter 2010 loss and investors completely abandoned ship, driving the share price down to below 50cents. At this point, the company was being valued not even for its assets but simply for the value of the cash it had in the bank.

    There was basically no news on the stock for the next six months and the share price languished until the fourth quarter of 2010. Since that time, there has been substantial news, all of it good, and the share price has rebounded sharply from a low of 45 cents to a high of $2.10 on Jan. 3.

    The positive news on the stock has been as follows:

    First, CHGI announced that it had received a loan of 180 million RMB ($27 million) from China Construction Bank, one of China's leading commercial lenders, explicitly to be used for the purchase of raw materials. Based on CHGI's historical gross margin, a $27 million loan implies expectations (by both CHGI and the Bank) of over $40 million in sales in the next 12 months. The company also announced that: ""We believe we have sufficient cash on hand and from operations, together with our bank facility, to expand our factory capacity and continue to support our business," alleviating concerns about future dilutive financings.

    Second, on Nov. 16, the company announced record financial results, with sales of approximately $10 million for the quarter. During the course of 2010, CHGI doubled production capacity from 15,000 tons to 30,000 tons, driving revenues higher in the third quarter. The company has also announced that it will double capacity again by June 2011 to 60,000 tons.

    Next, the company announced the appointment of Grace King as its new vice president of finance. I viewed this as a strong positive given that she is a Columbia-educated American with more 20 years of Wall St. experience including Merrill Lynch, APEC Investment and Great Eastern Capital. In the past, hires like this have typically been made in advance of an uplisting to the Nasdaq, Amex or NYSE and it therefore caught my attention in a significant way.

    At this point in time in December 2010, the share price still hovered around $1 and I was tempted to write about my renewed optimism on the stock. However, given my past disappointment, I decided that it would be worth visiting the company in Inner Mongolia and first conducting a thorough tour of the facilities and a detailed interview with management. Despite the fact that Inner Mongolia is a remote destination and particularly unpleasant in January, I am glad I made the trip because it provided me with a great first hand view of China Carbon Graphite . I am currently long the stock. A link to the video of my tour of CHGI can be found below.

    VIDEO: The Upside in China Carbon Graphite

    The key takeaways from my visit were that CHGI is now operating at 100% capacity, in stark contrast to its previous loss making fourth quarter of last year. As a result, I expect fourth-quarter 2010 results to either meet or beat third-quarter results of $10 million in revenue and $1.9 million net income. The reason for the loss in the fourth quarter of 2009 was that CHGI had just upgraded to a top auditor, BDO, and BDO insisted on an immediate write down of older past due accounts receivable.

    This is the most conservative and appropriate treatment, but the sudden unexpected accounting loss did cause investors to panic and dump the stock. Sales were previously overly dependent on lower margin graphite electrodes sold to the steel industry, but in 2010 this has shifted to the point where these low margin products now represent less than 15% of sales volume. So I view last year's fourth-quarter surprise as a one-time negative event that is not going to be repeated.

    Typically if a company is operating at 100% of capacity I would be concerned about the potential for constrained future growth. However, in the case of CHGI this is clearly not cause for concern, given the planned expansion to 60,000 tons by June 2011. In addition, despite the 100% current utilization, the company can now begin to emphasize higher margin products such as high purity graphite and fine grain graphite which are used in a variety of high-tech applications including aerospace, defense, automotive and clean tech end products. So in addition to higher revenues, I also expect stronger profitability.

    Assuming the company can maintain its quarterly sales at the third-quarter level of $10 million, and net income of 9 cents per share per quarter, a share price of $3.50 still puts CHGI on a single digit PE ratio. That is 85% above the current share price of $1.90. As I previously mentioned, the $27 million in loans from CCB is consistent with expectations of approximately $40 million in annual sales based on CHGI's historical gross margin. Note that this valuation is conservative and completely ignores the potential for margin expansion with higher margin products and it also completely ignores the capacity expansion to 60,000 tons which will be complete in June and it assumes only a single digit PE ratio.

    To the extent the market values CHGI with an expanded capacity at 60,000 tons, an expanded margin or an expanded PE above the single digits, this valuation should be in the $5 to $6 range, which is well above the required thresholds to list on the Nasdaq or Amex. I note, however, that I don't expect to see a $5 to $6 share price until after earnings are released, the stock is uplisted and the company announces planned sales of nuclear graphite.

    As for the uplisting, during my visit the company informed me that they have already begun the uplisting process and intend to uplist to the Amex exchange as soon as possible. The company has currently put in place all of the necessary independent directors and committees required by the Amex, and now only needs to meet the share price threshold required by the Amex.

    In addition to the uplisting, CHGI is planning a non-deal road show in February to get in front of institutional investors which, combined with an uplisting, could provide a strong catalyst for the stock since it is currently quite unknown to most investors.

    Disclosure: The author holds a long position in CHGI.

    The author can be reached at comments@pearsoninvestment.com

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    This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

    Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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