Predicting China's Next 'Skyrocket Stock'

by: Richard Pearson

New Energy Systems (OTC:NEWN), SinoCoking (NASDAQ:SCOK) and Sinoclean Energy were all stocks that traded at a significant discounts to their fair value and subsequently skyrocketed. China Carbon Graphite (OTCPK:CHGI) has the potential to be the next skyrocket stock.

In August 2009 I received an email from a New York based hedge fund manager who was holding a very large position in a small cap Chinese maker of lithium ion batteries based in Shenzhen. He was concerned that this opportunity was “too good to be true.” He told me that the stock was trading so cheaply (at $2.00 and only 2x earnings) that there could only be two conclusions. Either (a) the company was a total fraud, or (b) this was the buying opportunity of a lifetime. I arranged a meeting with management and booked a flight to Shenzhen where I toured the factory and met with the CFO, the CEO and the head of sales. As it turned out, I was very impressed by the company and by management. The factory was clean, well organized and production was humming along at a busy clip. I told the hedge fund manager my conclusions and subsequently “loaded the boat” myself, buying all the stock I could get my hands on. In subsequent months I continued to provide suggestions to management on how they could improve their capital markets profile and I introduced them to a number of other investors and investment banks who could hopefully provide research coverage in the future.

Since then, they have completed 2 major acquisitions, publicly announced their intention to uplist, begun a proactive IR campaign and just presented at the Rodman & Renshaw (RODM) conference in Beijing. That company, New Energy Systems, subsequently traded from $2.00 to $10.00 and now trades at around $8.00. This stock wasn’t “too good to be true” but rather was “too good to pass up!”

Just a few weeks ago, a Chinese friend in Beijing told me that I really should take a serious look at Sinocoking, which had just come to market via a reverse merger on February 5th. The reverse merger came with a concurrent PIPE where SCOK raised $7 million at $6.00 per share and investors received additional warrants at $12.00 per share. On February 9th the stock traded as low as $3.50 and looked cheap, but I assumed I would have plenty of time to get into the stock because it was not yet NASDAQ listed and there was no catalyst to move the stock. Within 2 weeks (amazingly fast) the company announced its approval to uplist to the NASDAQ and the stock skyrocketed to over $45.00. From my evaluation price of $3.50 that is a return of over 1,100% in less than 1 month! Sadly on this one, I didn’t “load the boat” but rather “missed the boat completely.” But I did learn a valuable lesson, which is that when a stock is massively under valued, it can move fast so it pays to get in quick and not be stingy about the price.

Still feeling the sting from missing out on SCOK, I came across Sinoclean energy, also on the recommendation from a friend. The company, which makes a type of “clean coal,” was trading at only 2x operating cash flow and only 4 times projected earnings and was clearly overlooked and underfollowed. Accounting treatment of warrants and convertibles resulted in a huge Q4 accounting loss making the company look like a money loser, when actually results were quite positive. The market was clearly missing this. I’m glad I jumped in when I did because this one has gapped up substantially, up 100% for the week on tremendous volume.

Based on these experiences, I believe that the next “skyrocket stock” could be China Carbon Graphite Group (OTCPK:CHGI), which was brought to my attention by the same savvy friend who told me about SCLX.OB as well as China Energy Corp., which is up by over 200% in the past 2 weeks. Unfortunately I missed out on China Energy.

CHGI manufactures high purity graphite from coal. According to a March 4th S&P report, the company has over 50 customers in 22 provinces in China and the company's strategy includes efforts to double capacity from 15,000 tons to 30,000 tons annually and to develop nuclear graphite capabilities and capacity for new nuclear power plants. The stock trades at around $1.90 despite having book value of around $2.50. That’s worth repeating: this stock trades at a 25% discount to book value ! It is also trading at a multiple of only around 2.5x operating cash flow (about the same as where SCLX was before it skyrocketed up). The company has already given guidance for 2009 that indicated that both revenues and net income would increase 15-25% vs. last year. If so, that means that, based on reported market cap, CHGI is trading at only around 4x 2009 earnings, despite 15-25% growth. If management can continue growth at this rate for 2010, then we are looking at only 3x 2010 earnings.

Ordinarily, if a company is trading at 75% of book value and only 2x cash flow there is a strong risk of it being “too good to be true.” However, there are a few other things that give me comfort. First, the company just raised nearly $3 million in a private placement in December which would (hopefully!) indicate that institutional investors (including Silver Rock, Jayhawk Capital and Taylor A.M.) have recently done their due diligence. Second, the company recently appointed BDO as their independent auditor. BDO is a world class international auditor with extensive China experience and I have worked with their affiliates before. Finally, in October the company announced that it had a majority of independent directors, including the audit committee, which is chaired by Yizhao Zhang, who also happens to be CFO of Universal Travel Group (UTA). In short, I trust the numbers.

In terms of uplist potential, CHGI is more obvious than most. In October 2009 CHGI put out an 8K which contained the following language:

“With the election of Mr. Chen and Mr. Zhang, the Company now has a majority of independent directors. Effective October 28, 2009, the Company created audit, compensation and corporate governance/nominating committees and adopted a code of conduct.”

This language is verbatim what is required for an uplisting to NASDAQ or AMEX and the only reason to pursue this course is to prepare for an uplisting. Also in October 2009 and right around the time of appointing the directors, CHGI upgraded their auditor to BDO. Orient Paper (NYSEMKT:ONP) also upgraded to BDO right before their uplisting in 2009 and released a nearly identical 8K.

As far as I can see, the only thing holding CHGI back from an uplisting is the share price, which needs to be above $3.00 for the AMEX and above $5.00 for the NASDAQ. Ordinarily I would recommend that a company in this situation reverse split its stock to achieve the uplisting, however in CHGI’s case I wouldn’t take this route. First, a reverse split would exacerbate already low liquidity. Second, and more importantly, the stock currently trades at such a huge discount to its fair value that it will likely find its way to the $3.00 to $5.00 range without any reverse split necessary. Assuming this stock trades on the NASDAQ and earns $6.0 million in 2010, a PE multiple of 15 would result in a share price of around $6.00 which is a 3 bagger vs. the current price of $1.90. I’m not suggesting that the stock should gap to $6.00 all at once, however based on the discount to its fair value I think that a 50-100% gain in the short term would not be unwarranted and with very little downside risk vs. the fundamentals.

Disclosure: The author holds long positions in SCLX.OB and CHGI.OB