ShengdaTech (SDTH) - Small Cap Opportunity

I'm increasingly looking at small cap opportunities in this trendless market, dominated by herd behavior - much of it computer generated. The hope is we find some companies that are outside the radar and hence not so reliant on hundreds of hedge funds moving in or out of stock en masse for us to profit. Now, the negative with under covered small caps is they can sit... and sit... and sit... for a long time without any movement. And then suddenly surge out of the blue on a catalyst - much like Fuel Systems Solutions (FSYS) has done [Aug 7: Fuel Systems Solutions - Monster Quarter but Impairment Charge will Confuse]. But this many times requires, months/quarters of no "benefit" (price appreciation) from holding the stock. And in a "what have you done for me" world with investors who always want appreciation, that's a tough road to hoe.

With that said ShengdaTech (SDTH) might be the right company at the right time with the right catalyst to wake up the market to yet another undervalued opportunity that is sitting in purgatory. First, let's look at the most important thing in this market - the chart.

As you can see the stock has had a rough year, dropping from $15 to as low as the $7s. In full disclosure I've been following this company for this entire period and was bullish on it in the $12-$13 range, thankfully we did not buy since we would of been bludgeoned but as time has passed the fundamental story has only improved, while the stock price has only broken down. Typical for this market. With that said we have built a nice 5 month base, mostly between $8 and $10. And that's pretty much all you need to know in today's day and age - the chart.

But since I am old school, I'll give you some background so you can see how people used to invest before computers took over the world. ShengdaTech (SDTH) has 2 business lines; moving into a related 3rd (more on the 3rd later) Per the company' website (note, very cool front page)

1. Nano Precipitated Calcium Carbonate (NPCC) - NPCC refers to ultra-fine precipitated calcium carbonate with an average particle diameter of less than 100 nanometers that is used as an additive in various products. Because of its special physical and chemical properties, NPCC has been widely applied in the paint, paper, plastic and rubber industries. We are targeting the fastest-growing area for NPCC, the tire and PVC building material market. It fills the spatial structure in rubber and enhances the property of rubber products. It can be used solely as a filler, which has a reinforcing effect, and it also can be applied with other fillers such as precipitated calcium carbonate, argil and titanium oxide for reinforcement, filling, improving the process and property of products and reducing rubber content. NPCC can be used to partially substitute some expensive materials such as titanium oxide and silicon dioxide. Currently, we are the only Chinese manufacturer of NPCC that is able to supply the tire market.
2. We are a leader in the coal-based chemical business in northern China, and manufacture ammonium bicarbonate, liquid ammonia, methanol and melamine. Ammonium bicarbonate and liquid ammonia are mainly used for nitrogenous fertilizers and raw materials of chemical products. Methanol is a chemical material and a clean alternative to fossil fuel. It is used in the chemical industry, pharmaceutical industry, light industry and textile industry. Melamine is the intermediate product of environmentally friendly resin.
   

Now on the basis of these 2 products lines, especially the NPCC this would an exciting enough of a company. But in the near term we have an important catalyst which could provide the only thing that seems to be moving these small cap Chinese stocks nowadays - a potential for a large earnings surprise. The company is acquiring a nitrogen fertilizer company.

• (June 20) Today announced that it plans to acquire Jinan Fertilizer Co., Ltd., a nitrogenous fertilizer company based in Jinan, the capital of Shandong Province. The Company intends to relocate its existing coal-based chemical operations to the facilities of the target acquisition, following receipt of a relocation notice for its factory in Tai'an City from the Tai'an City Government on June 16, 2008.
• The Tai'an City Government, as part of China's strengthening of environmental law enforcement reform, issued the relocation notice due to the close proximity of ShengdaTech's coal-based chemical facility to residential and business properties. According to terms of the relocation notice, ShengdaTech must cease operations at its Tai'an City coal-based chemical facility on November 1, 2008 but is permitted to continue operations until October 31, 2008 to ensure a stable transition of its chemical business and employees.
• The transaction will be contingent on the completion of an independent audit and due diligence, and negotiation of the final terms and a definitive agreement, and will be subject to approval by ShengdaTech's board of directors. The Company expects to complete the acquisition of Jinan Fertilizer Co., Ltd. on or before November 1, 2008.
• Jinan Fertilizer and its subsidiaries' were founded in 1958 as the first state-owned, mid-scale nitrogenous fertilizer enterprise in China. Jinan Fertilizer has seven subsidiaries and about 1,800 employees. Its products are sold under the "Quancheng" brand name and include concentrated nitric acid, synthetic ammonia, methanol, fertilizer and carbon dioxide. Jinan Fertilizer also produces compound fertilizer, liquid fertilizer and polywoven sacks. Jinan Fertilizer and its subsidiaries hold a 16% share of the domestic concentrated nitric acid fertilizer market and account for approximately 50% of China's concentrated nitric acid fertilizer exports, making it the second largest in the industry.
• Assuming the current market demand continues, the Company estimates that once Jinan Fertilizer achieves full operations in 2009 it could yield an annual sales of approximately three times the current sales of ShengdaTech's existing chemical business. The gross margin is estimated to be equal or higher than the current chemical business at targeted production levels.

I know what you are thinking - no one needs fertilizer as the world devolves into chaos and growth rates worldwide plummet (ex USA which of course will be immune - did I mention it's time to buy US stocks?) - it would be much more exciting if ShengdaTech was acquiring an US airline or US automaker or some other money losing venture. But regardless of the company, the importance is potential upside to EPS. We'll get into that later.

Now a bit of history - in May the company priced $100M in convertible notes. There was actually an over-allotment of $15M to boot. While this is a positive in terms of raising money, it's usually a death knell to a stock price for the medium term as institutions who buy the debt, short the common to offset their risk. And lo and behold ShengdaTech has their place front and center on the Regulation SHO Threshold Security List. What is that list you ask? Essentially it means "the naked shorting list" - yes naked shorting... something that we have rules on the books to disallow but goes on every day (I mean how else can hedge funds make free money?) Only when it affects our banks do we actually enforce our rules. Many many many small caps with no institutional support are all over this list - so this obviously puts tremendous pressure on the stock price.

In June, the company announced where much of this money was going to, a $56M plant for NPCC expansion.

• Today announced that on June 19, 2008 the Company, through Faith Bloom Limited, its wholly owned subsidiary, entered into an agreement with the local government to invest in the Zibo High-Tech Development Industrial Zone in Zibo, Shandong Province. The local government will provide the Company with sources of supply for limestone with reserves of at least 150 million metric tons, with mining rights to be transferred to the Company within 12 months. In addition, the Company will receive land use rights for the construction of a new NPCC facility and future build out.
• The initial investment in this new location will be approximately $56 million for the purchase of 58 acres of land, the construction of the plant with a capacity of 120,000 MT, and the equipment for the initial 60,000 MT of NPCC production. The first customer shipments are expected by July 2009.
• "We have selected the location for the facility based on its close proximity to a high-quality limestone mine, to our current and prospective customers, and to a shipping port that will serve our growing international customer base more efficiently. We expect to begin construction in August 2008. Our plan is to expand the Company's total annual production capacity of NPCC to 310,000 MT by the end of 2009."

Friday, came the company's latest earnings report - and once again it's impressive. I'll talk about the potential for EPS expansion after the highlights.

• Revenues for the second quarter of 2008 increased to $39.8 million, up 75.7% from $22.7 million in the same quarter of 2007. The strong revenue growth was due to higher selling prices and increased demand for both chemical and NPCC products. The revenue growth was also attributable to the NPCC capacity expansion with three new stainless steel NPCC production lines added in April 2008.
• The NPCC segment contributed 47.9% of total revenue in the quarter and the chemical segment contributed the remaining 52.1%, compared to 47.7% and 52.3%, respectively, in the same period a year ago.
• Gross profit increased to $14.6 million in the second quarter of 2008, up 91.1% from $7.7 million in the second quarter 2007. Gross margin for the quarter was 36.8% compared to 33.8% for the same period in 2007.
  
• Operating income in the second quarter of 2008 was $12.7 million, up 92.9% from $6.6 million in the same period a year ago. Operating margin was 31.9% compared to 29.0% in the second quarter of 2007.
• Net income in the second quarter of 2008 was $10.0 million, up 66.3% from $6.0 million in the same period last year. Fully diluted earnings per share for the second quarter of 2008 were $0.18, compared to fully diluted earnings per share of $0.11 in the second quarter of 2007.

So before we move let's put some of these numbers in perspective. Revenue is up 75%, and the business lines are fairly equal (50/50 distribution) among the NPCC vs chemicals business. Gross margin is up an impressive 3% year over year, as is operating margin. Earnings up 66%. Forward P/E? 15. Granted its a "chemical/industrial" business but...

More details on NPCC

• Revenue from NPCC products increased 76.4% to $19.1 million in the second quarter of 2008 from $10.8 million in the second quarter of 2007.
• The revenue growth was also attributable to the NPCC capacity expansion with three new stainless steel NPCC production lines added in April 2008. At quarter end, total annual NPCC production capacity was 190,000 metric tons compared to 90,000 metric tons a year ago.
• During the second quarter of 2008, we made a significant breakthrough in the development of our new NPCC product, 'NPCCA301,' for use in automobile undercoating paints.
  
• We added six new domestic customers including one new tire manufacturer, three adhesive producers, and a paper manufacturer.
  
• We successfully expanded our international customers by adding four new clients, a Korean tire manufacturer, Vietnamese and Israeli polyethylene manufacturers, and an automobile undercoating company in Singapore.
  
• In addition, our new NPCC lines, with a total capacity of 60,000 metric tons, reached 70% operating capacity this quarter.
• Total volume of NPCC sold during the second quarter of 2008 was 44,744 metric tons, up 16,714 metric tons, or 59.6%, from 28,030 metric tons in the second quarter of 2007. NPCC for use in tires and PVC represented the majority of the NPCC sales at 44.9% and 32.6% of total NPCC revenue, respectively. NPCC for use in latex increased 59.7% sequentially, representing 11.9% of total NPCC revenue. Sales from NPCC used in the production of printing ink, paint, paper, PE, and the Company's newest NPCC application, automobile undercoating paints, combined to generate 10.6% of NPCC revenue.

More details on chemical business

• Revenue from the chemical segment for the second quarter of 2008 was $20.7 million, up 75.0% from $11.9 million in the second quarter of 2007.
  
• Sales of liquid ammonia, which represented 37.5% of the chemical segment's revenue, increased 53.8% as a result of increased selling prices. Ammonium bicarbonate and methanol represented 29.5% and 18.7%, respectively of the chemical segment's revenue, and melamine contributed the remaining 14.3% of chemical segment revenue during the quarter.

Details on gross margins

• The chemical segment benefited from the increase of average selling price of liquid ammonia, methanol, melamine, ammonia bicarbonate and ammonia resulting in gross margin of 33.1%, up 7.4 percentage points from 25.7% in the same period in 2007.
  
• Gross margin for the NPCC segment was 40.8% in the second quarter, a decrease of 1.9 percentage points from 42.7% in the same quarter last year as a result of higher average raw coal prices, which were not fully offset by increases in NPCC average selling price.

NPCC Outlook

• ShengdaTech began production at its three new stainless steel NPCC lines in Shaanxi province in April 2008. This facility, which has a total production capacity of 60,000 metric tons, ramped up to 70% capacity through the first half of 2008 and is currently producing at 100% utilization.
• The Company expects to expand its total annual production capacity of NPCC to 310,000 metric tons by the end of 2009.

So to put in perspective - a year ago NPCC volume capability was 90K tons, by the end of this past quarter it has been raised to 190K (not fully utilized during the quarter) and by end of 2009 it will be up to 310K.

Jinan Fertilizer Update

• The Company estimates that once Jinan Fertilizer achieves full operations in 2008, it could yield annual sales of approximately three times the current sales of ShengdaTech's existing chemical business. The gross margin is estimated to be equal to or higher than the current chemical business at targeted production levels.
  
• The Company is expected to disclose more detailed financial information on the acquisition upon completion of a financial audit, a business case analysis, and Board of Director approval, all of which is expected to be completed in August or September 2008.

So we have nothing "new" that was not disclosed in the June announcement in terms of financials for the fertilizer business, but now we see more detailed financials will emerge within weeks. This is important because you appear to have to beat investors over the head with information for them to notice. My personal opinion is if you have don't give the average American investors a clearly stated EPS increase no one will notice. Why do I say that? The stock price tells you that.

Just using a very rough back of envelope figure - we know about half the company's current business is chemicals so let's call it $65M for 2008. This fertilizer business, in which they have already "paid for" will generate 3x that level of sales or approximately $200M in sales. That's more than the entire company has this year (let's call it $135M in sales). At an equal or higher gross margin to the chemical business - which just shot up in the past year from 25% range to 33% range. While this is lower than the NPCC business this is a huge increase. $200M @ 33% gross margin = $66M in additional annualized gross profit or (again very simplistic assumption) $16.5M PER quarter. To put that in perspective the company as positioned today just did $14.6M of gross profit this quarter. So in plain English this deal will more than double their gross profit. How that translates through the rest of the profit & loss statement I am unclear at this moment until we get more information (i.e. what will operating margins be?) but we should have an update soon. And if the company plainly states it in "dumbed down" language that Briefing.com can scream about we should get our catalyst. But what is apparent is that 2009 estimate of $0.79 is going to be obliterated and without going into my initial projections (pending more detail from the company) it should be beat by a few country miles.

Now with that said, ShengdaTech is the victim of naked shorting - and as a small cap in a country that is clearly out of favor we don't know when the stock will pop. But in a 1-2 year time frame this should be one of the most promising opportunities in our stock universe. So with that I will be initiating a position this morning, and if the stock can break above recent highs of $10.60s we'll add to it on a show of strength.

We'll begin this with a 1.4% stake in the $10 range.

I'll update this post with any additional insights from the conference call going on this morning when I get a chance to listen later in the week.

Long ShengdaTech in fund and personal account