Orient Paper: Investors Ought to Lower Expectations

Apr.14.10 | About: Orient Paper (ONP)

An article was published on Seeking Alpha this morning, presenting Orient Paper as a high conviction buy. The author, Eric Jackson from Ironfire Capital LLC, believes that Orient Paper (NYSEMKT:ONP) has the potential to double or triple its current price this year. I happen to have conducted some research on Orient Paper a while back and have a different opinion. I believe Orient Paper’s near term upside is limited, given Tuesday’s close price of $10. Any expectation that the stock price may double or triple near term seems to fall in the area of speculation.

My belief is based on the following arguments.

Commodity Business

Orient paper (ONP) operates a commodity business, in a highly competitive and fragmented industry. It produces offset printing paper, corrugating medium paper, writing paper, and most recently digital photo paper. The 2009 gross margin is 19.6%, and net margin 12.4%. Orient paper appears to be well managed, generating an impressive ROE of more than 20% in the past several years. However, it is less likely that a commodity business without much differentiating power will continue to generate high ROE in the long run.

Long-term Potential

In 2009, Orient Paper grew its net income by 45% from 2008. The company projects its 2010 net income to be $18M, a 50% growth from 2009. What multiple should investors assign to it? People tend to assign a high multiple to a stock based on recent earnings growth. Such a valuation risks double punishment. When the company didn’t hit the expected growth target, the stock price is impacted negatively due to the lower earnings; at the same time, the multiple will contract, giving the stock price another hit.

Although Orient Paper has experienced impressive earnings growth in the recent past, there is no guarantee that it can grow at a similar speed in the future. More over, part of its growth was funded by additional share issues and came at the price of dilution. Without external capital and dilution, Orient Paper can grow its capacity at most 20% annually, assuming it continues to enjoy the 20% ROE, and re-invests all cash it earns.

The long term growth potential of Orient Paper should be close to that of the Chinese paper industry, somewhere between high single-digit to low double-digit.

In summary, I’m willing to assign a multiple of 10x-12x 2010 earnings to Orient Paper, given its long-term growth potential, management and corporate governance. Post the public offering, total shares outstanding is about 18M. That gives a fair valuation of $10-$12 per share. This also prices Orient Paper comfortably at 2.3x-2.7x its book value. Expectation that Orient Paper stock price will trade 20x 2010 earnings appears to be a far stretch.

Disclosure: No positions