Editor's note: Following is part 2 of an article that looks at China stocks focused on the newly emergent Chinese consumer. Here is part 1.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) -- Aside from travel, another promising China consumer play is the food and beverage sector. I carefully evaluated China Nutrifruit Group ( CNGL), SkyPeople Fruit Juice ( SPU) and Country Style Cooking Restaurant ( CCSC). Of these three China stocks, I like SkyPeople the best and recently have been buying its shares. I also like Country Style Cooking Restaurant, but its shares are simply too high for my criteria, so I am holding off for now on that name. SkyPeople Fruit Juice is a small-cap China stock with a top 10 auditor and a booming high-margin business that caters directly to consumers with a rising disposable income. The stock is not widely followed and trades with a price-to-earnings ratio of only about 5, so it has the potential to easily double this year. I recently toured the company's two factories in Xi'an. I also met with its distributors and purchased its products from WalMart ( WMT) in Beijing as well as from several retail locations in Xi'an. In total I spent four days on the ground to get a better feel for the company and its prospects. I was so impressed that after my visit I went back to my hotel and started buying shares as soon as the U.S. markets opened. SkyPeople has a net margin of nearly 25% and has cash of roughly one-third of its market cap. The reason the stock trades so cheaply is that investors still don't seem to understand the seasonality of the company's business, something that is dictated by the seasonal fruits that it processes. By the end of the second quarter, the company effectively runs out of inventory, putting a cap on sales potential. The December quarter is the strongest quarter and will show the strongest financial performance -- sometimes as much as 50% of annual net income. Despite the obvious seasonality, investors have sold off in the past after weak quarterly results in the slow season and then started buying again in stronger quarters.
The company has already reaffirmed 2010 net income guidance at approximately $20 million, and this implies a very strong fourth quarter. As a result, I am buying the stock while others have been selling. There will be two key drivers for the business and the stock going forward. First is the mitigation of seasonality. Management has made clear to me that it is making solid progress here. SkyPeople is beginning to offer new products with complementary harvesting and squeezing seasons. Historically, the company has offered pear, apple and kiwifruit products. Going forward, it is adding jujube, mulberry and pomegranate, because these fruits have complementary harvesting seasons that will boost inventory into the second quarter. In addition, the company is currently expanding capacity in its juice concentrate business. The shelf life of juice concentrate is very long, and SkyPeople can use it to produce and sell retail fruit juice in all seasons under its own label. Once the seasonality is smoothed out, the opportunity to buy the stock on the seasonal dips will disappear. The second key driver of the business will be distribution. SkyPeople already distributes products through all of the WalMarts in Beijing, as well as in other retail outlets in cities across China. The company is currently looking to distribute products through WalMarts in Shanghai as well. In addition, SkyPeople is focused on exports, and already exports via distributors to the U.S., Europe and the Middle East as well as other countries in Asia. The company is approved by the U.S. Food and Drug Administration and is Kosher certified, which is beneficial for its exports. I visited the company's key distributor in Beijing and noted that in addition to WalMart, the distributor has access to 7-Eleven, Carrefour and other major retail outlets in China, so I am optimistic that distribution will expand to these retailers. From a financial standpoint, SkyPeople looks solid. The company has gross margins of 30%-50%, depending on the season, and net margins that are consistently in the 20%-25% range. As of the third quarter, the company had $46 million in cash, which is currently being used to finance a significant expansion of capacity and broadening of product ranges. The company generated more than $9 million in operating cash flow during the first three quarters, and as a result does not need additional financing in the foreseeable future.
The expansion will result in a 40% increase in capacity, primarily in the higher-margin products. The company hopes to complete it in time for the peak season in 2011. As a result, I am expecting that 2011 financial results will show very substantial growth over 2010, which itself was a record year for the company, according to already released guidance. Based on already released guidance, net income in 2010 grew by more than 50% from 2009. Based on the capacity expansion, it should grow by up to 40% in 2011. This would give SkyPeople a forward P/E of only 3 or 4. The stock's 52-week high was $8.10, but I believe the stock could easily break through this during 2011 once full-year 2010 results are released and the capacity expansion begins to produce results. In addition, the company is currently planning to act as a sponsor at the China investor conferences of Roth Capital and Rodman & Renshaw by providing thousands of bottles of juice for investors to drink between meetings. This struck me as a very novel way for the company to put itself on the map with investors and maximize attendance at its company presentations. The near-term catalysts for the stock price will be the release of full-year 2010 results, which I expect to meet or beat guidance, as well as the company's sponsorship and presentations at the upcoming China conferences. All of these catalysts will happen in March, so I expect it will not take long to see a significant jump in the share price. The first barrier I am watching for it to break is the old high of $8.10. Once it does this, I think the stock has the potential to be in the $10-12 range in 2011. This share price estimate is slightly lower than existing Wall Street estimates, which put a target price of $13 on SkyPeople. I view $13 as being slightly high based on my visit to the company and its current business prospects. At the time of publication, Pearson was long SPU.