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There is much in the news lately regarding the abundance of steel in the market and excess manufacturing capacity putting pressure on pricing around the world, especially in China where exports have been off as well. This has been reflected in industry performance year-to-date. According to the China Iron & Steel Association (CISA), 44 of its 80 registered large and medium-scale iron and steel companies suffered losses for the first 8 month of 2012. While this is not good news, I don't believe the situation is as dire as some would say, and there are already indications that the tide is turning.

As I have written before, I expect China will work through its backlog relatively quickly, supplying steel for organic growth and subsidized infrastructure projects, and those companies that survive the turbulence may be better for it. There are not a lot of public options for investors looking to participate in China's next cycle of growth, but China Industrial Steel, Inc. (OTCPK:CDNN) is one of them.

China's Fragmented Steel Market

By virtue of China's size, geography and differing regional stages of development, its steel industry grew to be highly fragmented. As provinces moved from agricultural to industrial economies and communities shift from rural to urban, small steel mills cropped up to service local demand. The majority of these smaller mills turned out basic commodity products which were initially sufficient to meet market needs. Over time, savvy private and state-run operations harnessed China's growing infrastructure, low cost labor supply, technological improvements, economies of scale, and developing transportation network to build efficient national operations. Leveraged further by strong government subsidies, companies such as Baosteel Group Corporation (state-owned) and Jiangsu Shagang Group, (privately held) consistently demonstrated China's ability to produce cheap steel, eventually making it the leading supplier to the world.

Things were humming along nicely until about 2009, when a unique confluence of events changed the landscape of China's steel sector. A raw material squeeze play and labor demands upped the costs of production while global economic conditions resulted in a sudden and precipitous decline in demand, forcing a dramatic cut in selling prices and, in turn, operating margins.

The fallout from this was as would be expected. Stock prices fell substantially as investor concerns were compounded by overall market conditions. Within the industry, companies with a sound business model, strong customer relationships and appropriate resources continued operating, recalibrating their businesses to accommodate changed circumstances. Those without staying power went by the wayside.

On the policy side, China's 12th Five Year Plan (covering 2011 - 2015) includes specific tactics for the steel industry. Fiscal and tax policies, as well as capacity and export regulations were collectively designed to encourage consolidation and business improvements. Beijing did make reference to consolidation of the industry in its 11th Five Year Plan, but typical of any government, intervention tends to be light when everyone is making money. In the aftermath of recent market frailties, Beijing's renewed earnestness on this front is evident; in a speech this past summer, CISA's Secretary General commented that "conditions are ripe for the industry to turn itself from being "large" in terms of size to "strong" in terms of quality and competitiveness."

It looks like these policies are starting to take effect. During an industry forum this November, CISA Vice Chairman Wang Xiaoqi stated that most large and medium-sized steel companies have shaken off losses since October, and may be able to offset the losses by the end of the year. I expect this momentum to continue as Xi Jinping takes the helm and endeavors to establish a sustainable growth model for China's economy.

I have mentioned several smaller steel companies that I believe are positioned to profit as the market turns, including General Steel Holdings, Inc.(NYSE:GSI), Sutor Technology Group Limited (NASDAQ:SUTR), and China Gerui Advanced Materials Group Limited (NASDAQ:CHOP). Right now I am focused on China Industrial Steel, as I believe it is particularly undervalued.

China Industrial Steel - a Brief History

China Industrial Steel currently operates four production lines with an aggregate annual production capacity of 2.3 million metric tons of steel from its headquarters on approximately 1,000 acres in Handan City in Hebei Province. CDNN products include steel plate, bar, and wire which are primarily used in building construction and large scale infrastructure projects, such as roads, bridges and railway lines. The Company also manufactures and sells steel billet, a semi-finished product, which is utilized as a raw material by other manufacturers.

CDNN began operation with a 1.4 million ton facility in 2007, through a strategic relationship with Wu'an Yuanbaoshan Industrial Group Co., Ltd., a multi-industrial conglomerate with over 4 billion RMB in assets. As demand for the Company's products grew, utilization rates maxed out and management decided to add capacity. The self-funded construction was completed in 2009, increasing capacity to 2.3 million tons. The Company also added 2 million metric tons of steel rolling production capacity, enabling CDNN to produce higher quality finished products.

Profitable Operation

CDNN operated profitability well into the global financial crisis. The Company reported record results in 2011. Revenues for the year were $823 million, up 43% from 2010, and earnings per share were $0.62, up from $0.39 in 2010. The Company remains profitable year to date, despite reporting its first quarterly loss for the period ended September 30, 2012. According to its most recent 10-Q, revenues for the first nine months of this year were $475 million, with net income of $2.8 million. There is evidence that operating losses will be short-lived; the Company's capacity utilization rate was approximately 61% for the quarter ended September 30, 2012, as compared to 52% for the nine month period, indicating an increase in production.

Flexible Management Team

China Industrial Steel began producing steel bars in 2010 in response to market demand, however, when demand for steel bars, and in turn its pricing had fallen off, the Company shifted the facility to the production of steel wire. That move proved wise, and wire sales are now the largest contributor to CDNN revenue. The Company sold 195,417 metric tons of wire, generating $120 million of revenue in 2011 and 345,902 metric tons of wire generating $184 million for the first nine months of 2012.

Clean Public History

In order to expedite the implementation of its expansion strategy, management elected to go public, and did so through a registration statement on Form S-1 rather than through a shell. The SEC declared the S-1 effective on September 28, 2011. Today CDNN is a fully-reporting company providing transparency for shareholders and potential investors. With access to public capital markets and the ability to use its stock as currency, CDNN has the resources it needs to grow organically and through acquisition.

Forward Looking Strategic Plan

CDNN is constantly seeking ways to expand and diversify its production and processing capabilities to take advantage of market demand. Management is currently evaluating financing alternatives to supplement the funding of a production line for a coated steel product called Galvalume™, a specialty steel primarily used in the automotive and home appliance industries. The planned facility will have an annual capacity of 400,000 tons per year.

CONCLUSION

After a rather tumultuous year, China's steel industry appears poised for recovery. Government actions combined with organic growth are likely to result in visible improvements in 2013 and CDNN is well positioned to benefit from this turnaround. The Company remains profitable for the year, unit sales have been consistent, and management has the flexibility to adjust its product mix to maximize profitability.

Investors with a mid- or long-term horizon should strongly consider CDNN.OB. Selling at just over $1.00, the stock is trading at a PE of 7 on trailing 12 months earnings, which is relatively low compared to steel companies here in the U.S. such as Nucor Corp. (NYSE:NUE). The stock has garnered little notice in the market. Volume has been thin, but it is beginning to trade, so even if the Company only returns to its 2011 levels, the potential for the stock to move up is substantial.

Caution

There is no question that investing in smaller-capitalization companies, as well as investing in companies in emerging markets, is not suitable for all investors, and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risk.

China Industrial Steel is definitely a smaller-capitalization company with operations based in an emerging market, specifically in China. But the company is a U.S. reporting issuer, and subject to the reporting requirements of the U.S. Securities and Exchange Commission, so U.S. transparency and disclosure is available to investors.

Source: China Industrial Steel: An Undervalued Orphan In China's Steel Sector