Is Lihua International Overvalued?

Includes: FSIN, LIWA
by: Chimin Sang

For momentum trading lovers, they have a new lover these days: Lihua International (NASDAQ:LIWA). This stock soared since its IPO on September 9th. Priced at $4, this stock opened at $5.28 and rose to $10.09 Monday, a whopping 100% plus increase in merely 19 trading days.

Lihua manufactures bimetallic composite conductor wire products, such as copper clad aluminum (CCA) fine wire, CCA magnet wire and CCA tin plated wire. This is a very valid business because physics teaches us that only the outer shell of a wire is really essential in conducting the electric current. CCA products can achieve similar conductivity as pure copper wires with much lower cost in raw materials. Typically aluminum price is a third of that of copper by weight, and ONE TENTH of that of copper by volume.

The income statement of Lihua also reads impressive. The revenue increased 200% for the second quarter of 2009 vs. 2008 and the net income increased 100%. The lower margin was caused by the company entering into scrap copper recycling market which had lower margin. EPS for Q2 2009 was 31 cents.

If we very conservatively assume that LIWA is going to have the same level of operation as of now and counting in the fact that the share count increased to 24 million shares after IPO, the next 4 quarters' earning would be $.28 x 4 = $1.12. The forward looking P/E is a mere 9, with such a conservative estimation. If we assume that the earning is going to increase at the current rate of 100% into the next year, the forward looking P/E is more like 6 now. Given the high growth rate, this stock looks like a screaming buy.

BUT, wait... The business seems to be overly profitable.

For Q2, Lihua had $48 million revenue, $7 million in net income. These were achieved with $45 million current assets, $70 million total assets, and $43 million equity. Its running ROE is 7 x 4 / 43 = 65%.

Two things come into my mind:
1. I want to be in this business
2. This high margin does not last

I have to admit that I don't understand this business too well, but I checked if this company has some technology advantages that other companies do not have. I found some in their SEC filings but none were convincing. Their R&D cost for the whole year 2008 was $60K. They have only one approved patent and three pending patents. A search on Baidu yields numerous companies also in the same business. One of the businesses, Fushi Copperweld (NASDAQ:FSIN), listed here on Nasdaq. Instead of growing business in 2009, FSIN lost revenue.

The current Price over Book ratio of LIWA is a whopping 6. In comparison, Google's P/B is less than 5. So if I were to buy this company today as a sole owner, I would need to classify 5 times its current book value as goodwill. I would find it very hard to justify such a use of capital: There is no brand or technology associated with this huge sum of goodwill.

The current CCA market seems a completely seller's market: LIWA is building up its capacity and exhausting its capacity right away. Its capacity as of June 30 was 6,000 tons, which will increase to 7,500 tons by the end of 2009. Its sales of the first six months is already 2,959 tons, its upper limit. Its revenue is unlikely to explode next year due to the capacity constraint. But then again, it is not clear why LIWA could achieve the high growth but FSIN is losing business.

P/B over 6 is not sustainable for a commodity company. Why LIWA can achieve such a high return seems unfathomable at this point. In any case, if this is true, new enterprises will enter this market and eat away LIWA's profit margin.

Disclosure: No position in LIWA