Despite the nation's rapid economic growth, for a number of years US based investors have been wary about exposing themselves to Chinese stocks. The opacity of the audit system and, in turn, the potential for fraudulent reporting has led many to turn down opportunities that, if subject to US regulation, they would have taken up. This emotional bias has led to a fundamental undervaluation of a large number of Chinese stocks, and over the past three to four months there has been some dramatic upside corrections. One company this is true of is Kingold Jewelry (KGJI), but there could be much more upside to come.
First, a look at the company itself. Kingold Jewelry engages in the design, manufacture, and sale of gold jewelry, ornaments, and investment-oriented products in the People's Republic of China (PRC). Founded in 2002, it has grown to become a leading producer of 24-karat jewelry in China. The company currently supplies large wholesalers, as well as dozens of retailers nationwide. Kingold is well known across the nation, having been named "Famous Brand in China," and "Famous Jewelry Brand" by the General Administration of Quality Supervision and China Top Brand Strategy Promotion Committee in 2007. The company operates from the Hubei Province in the PRC, and has an office in New York.
Kingold generates its revenues primarily from two types of sale. The first type is its branded products. This side of the business involves taking orders from retailers for the delivery of a range of different gold jewelry and ornaments. On receipt of an order, Kingold purchases the required amount of gold directly from the Shanghai Gold Exchange, manufactures the products in its processing facility, and ships the order to the customer.
The second type is custom design products. This side of the business differs slightly in that the customer supplies the company with the raw material and the design of the product. Kingold then manufactures the product according to the customer's specification, and charges the customer a production fee.
During the first half of 2013, branded production accounted for 55.3% of gold processed and customized production for 44.7%.
During Q313, Kingold generated $283.9M in revenues, compared to $220.8M during Q312. The company's gross profit during Q313 was $18.1M, compared to $12.7M during Q312. Net income during Q313 was $10.9M, compared to $8.3M during Q312.
Annual results mirror this quarterly growth. In 2010, the company generated $523.0M in revenues. This grew to $788.9M in 2011, and again to $915.7M in 2012. Management expects revenues to grow again this year, to approximately $1.1B.
Net income during 2010 was $18.1M. This also grew, to $26.1M in 2011 and again to $32.6M in 2012.
Despite year-over-year revenue growth, an estimated $1.1B expected revenues this year, and an almost 50% increase in net income between 2011 and 2012, the market only values Kingold at $124.7M. It is trading at a PE ratio of 4.5 and, at June 30, 2013, the company's book value per diluted share was $2.99.
Why the undervaluation?
The market is valuing Kingold at just over one tenth of its annual revenue. To offer some perspective, consider another company in the jewelry industry, Tiffany & Co. (TIF). Last year Tiffany generated $3.91B in revenues. Its market capitalization is $10B. The only logical conclusion for as to why the market undervalues Kingold is its location. A company generating over $1B in sales with a book value of $2.99 and a PE of 4.5 would not remain valued at a fraction of its quarterly revenues for long in the US.
Readers can see this same sort of undervaluation across a range of Chinese stocks. Take China New Borun Corporation (BORN) for example. China New Borun produces corn based edible alcohol in the PRC. Last year the company generated $341M in revenues. Its market capitalization? $56.6M. Also, consider LDK Solar (LDK). LDK Solar generated $646M in revenues last year. Its market capitalization is less than half of that figure, $274M.
Again, the only logical conclusion is that market participants are building a location bias into their valuations.
Public Company Accounting Oversight Board (PCAOB) proposal
The obvious problem with investing based on an emotional undervaluation is this undervaluation is likely to remain, unless something acts as a catalyst to alter perception. The recent PCAOB proposal regarding the auditing of small companies might prove to be that catalyst. Reports suggest that an amendment to current policy could come before the end of the year that requires a small company to name its auditing partner. The "Audit Transparency: Identification of the Engagement Partner and Other Public Accounting Firms or Persons That Are Not Employed by the Auditor but Participate in the Audit," is reportedly scheduled for adoption or re-proposal before December.
If adopted, this proposal should serve to alleviate many of the transparency issues investors have concerning the validity of the figures of small cap Chinese companies. As faith in the auditing process increases, the location bias investors hold towards Chinese companies should subside. This will likely result in an upside correction of the undervalued stocks.
The PCAOB is not the only near term catalyst that could boost Kingold stock. The company has processed a record amount of gold during the first six months of this year, and expects to process, in total, between 50-55 metric tons before the end of 2013. The increased demand for its products was partly a result of strong demand during the May 1 Chinese Labor Day Holiday. Another public holiday, the "Golden Week" finished recently, and Kingold management expects this to have boosted demand further.
Another catalyst is Kingold CEO Mr. Zhi Hong Jia's recent visit to the US, to host investor meetings and conduct media appearances. These events should serve to improve investor relations between the company and its international stockholders, and reaffirm faith in the company's accounting.
A final catalyst is the management's announcement on the company's recent earnings call transcript that if by the "end of the year the stock price still hasn't seen any change to reflect our company's value; we will consider a dividend." On the same call Mr. Jia stated, "We are planning to issue dividends within this year, and there are no hurdles against doing so, but we cannot disclose when."
Unique gold exposure
Another unique aspect of Kingold's business model is that it offers investors exposure to any increase in the price of gold, while not exposing them to any decrease, as with mining stocks like Barrick (ABX), Newmont (NEM) and Coeur Mining (CDE). If the price of gold falls, demand for Kingold's products will increase, and the associated cost of production will fall. If the price of gold rises, the company passes the extra cost on to the consumer.
Kingold stands to benefit from both scenarios. In increase in demand based on a fall in price will serve to generate increased revenues. An increase in the price of gold will serve to add value to the company's inventory, which mainly consists of gold, currently valued at $169.3M.
Chinese demand for gold
Kingold also stands to benefit from the current record demand for gold in China. China consumed 706.36 tons of gold in the first half of 2013, up 54% from the same period last year. It consumed 832.18 tons during the whole of 2012. The World Gold Council (WGC) estimates Chinese gold demand could reach a record 1,000 tons this year and will overtake India, which the WGC expects will consume approximately 860 tons.
Industrial land acquisition
On October 29, Kingold announced it had entered into an agreement to acquire the operating rights for 66,666 square meters of industrial land for use in the development of Wuhan Kingold Jewelry International Industry Park. The industrial park is located in the Jiangan district of Wuhan, and the rights cost Kingold approximately $164M. Management comments on the acquisition suggest the company intends to develop a major, central operating hub for the jewelry industry in China. Kingold management plans to move part of its existing production facility to this industrial park, which will provide Kingold the opportunity to build upon its current production levels. The company expects to complete construction of this operating hub by mid-2015.
As with any investment, there is risk associated with Kingold stock. Aside from the usual, one considerable risk lies in the upcoming auditory regulations. As part of the new regulations, the company's reported results will be subject to a thorough re-audit. The market is likely to react strongly, perhaps overreact, to any discrepancy. If this occurs, Kingold stock could experience a sharp fall in price, regardless of whether the discrepancy has valuation ramifications.
For a long time investors have placed a disproportionate weight on the checkered history of Chinese stocks when undertaking evaluation. This has led to the fundamental undervaluation of a large number of Chinese stocks. Upcoming regulatory reform should serve to alleviate much of this bias and, in turn, could fuel the upside correction of a number of small cap companies' share price. This upside correction has already started for a number of Chinese companies; Qihoo 360 Technology (QIHU) and Baidu (BIDU) to name just two. Kingold offers investors an opportunity to benefit from this surge in the value of Chinese companies, with both a number of important near term catalysts and fundamental market conditions acting in its favor.