Why I'm Bullish on China Advanced Construction Materials Group

| About: China Advanced (CADC)

China Advanced Construction Materials Group, (CADC or the “company”) is an undervalued and undiscovered stock which represents an interesting way to capitalize on China’s massive infrastructure build out. CADC is a major provider of concrete for large infrastructure projects.

The company is one of only 10 companies that is certified to provide concrete for national infrastructure projects and the company has long-standing relations with China’s top contractors and construction companies.

As a result, the company is well positioned to capitalize on China’s $586 billion infrastructure stimulus package, which focuses primarily on transportation related projects such as railway, highway, and transportation related infrastructure.

As an example, the company has been active in supplying cement for China’s national rail network, which is scheduled to consume approximately 120 million tons of cement by 2020.

Pro forma for the recent two million share offering, assuming conversion of the outstanding preferred shares and the exercise of all options/warrants, the company has approximately 18.8 million shares outstanding. At $5.35 per share, this would imply a $100.6 million equity market capitalization.

However, under this scenario, the company would have almost $16 million of cash and virtually no debt, implying an enterprise value of only $85.5 million.

Over the past 12 months, the company generated adjusted net income (excluding preferred dividends and warrant valuation) of approximately $15.4 million, which includes an unusually weak q1. This implies an equity cap/LTM net income of 6.5x.

However, since the company will be investing its cash in accretive projects, a more appropriate valuation metric is enterprise value/ LTM net income, which is 5.6x. Regardless of which multiple you use, the stock is very inexpensive for a company which expects to grow organically approximately 30% annually for the next few years.

So why is CADC so undervalued?

  1. Investors have been expecting the company to raise equity and as a result there was downward pressure on the stock. On February 24, 2010 the company completed this much anticipated offering by selling two million shares at $4.60 per share, thereby removing this overhang on the stock price.
  2. Several years ago the company issued convertible preferred to finance its growth. Investors who bought these preferred have a very large paper profit on their investment, and some investors have recently been converting their stock and selling the common. If all the remaining preferred converted, they would convert into an additional 2.2 million common shares, which given the company’s modest float, remains an overhang for the stock.
  3. The company’s September quarterly results (CADC’s Q1) were very disappointing, especially since in the weeks leading up to the release, management had been telling investors (including myself) that their business was doing very well. This created a major credibility problem for the company. Since then, the company has reported a very strong December quarter, replaced its CFO, named an American as its President and hired a new investor relations firm, all of which has improved the company’s credibility in the investment community. However in some investors’ minds, the company is still in the “penalty box” as a result of its Q1 issues. I hope that management will continue to improve the quality and quantity of its communication with the investor community.
  4. Because of the way GAAP requires the company to account for its 1.6 million warrants which expire in 2013, every quarter the company records a non-cash expense (or income) as a warrant valuation. Again, this is a non-cash item, which most investors would exclude from their valuation. However, this quarterly item tends to mask the company’s true profitability and makes valuing the company a bit complicated. In order to make it easier for investors to understand its true profitability, CADC reports GAAP and Non-GAAP (which excludes the impact of the warrant valuation) results. Unfortunately, these warrants may remain outstanding for a few more years, so the warrant valuation issue may exist for sometime.
  5. CADC is relatively unknown among institutional investors. Not many institutions own the stock and currently the company has no sell-side analyst coverage. However, I expect this will change as I believe Roth Capital, who underwrote the recent equity offering, will initiate coverage within 30 days. In addition, CADC is presenting at Rodman’s China conference this week and Roth’s conference later this month.

So what catalysts will make this stock go up?

  1. Initiation of sell-side coverage by Roth.
  2. Increased awareness among investment community, including presentations at Rodman’s and Roth’s conferences.
  3. End of overhang from recent equity offering.
  4. Continued reporting of strong financial results.
  5. Stock trading above $5. Some investors will not buy stocks that trade below $5 and now that the stock is above that level, more investors may consider buying it.

What are the risks in owning this stock?

  1. CADC is a relatively illiquid, microcap stock and stocks like this can often be volatile.
  2. The company has large working capital requirements.
  3. Even though the stock is undervalued, if investors get scared about a slowdown in China, CADC’s stock price may suffer. However, it is important to remember CADC is more dependant on the China government financed infrastructure build out than it is on China’s real estate market (that many investors believe is overheated).
  4. The company benefits from several favorable tax incentives. While these incentives are not scheduled to expire soon (and may in fact be extended prior to expiration), any reduction in these incentives would be negative to the company.

Disclosure: Author holds a long position in CADC