Click to enlarge
The result is $103.4 million in bromine sales in 2010, a 61% increase over 2009, and $120.7 million in 2011. My bromine revenue estimate does not take into consideration additional acquisitions by Gulf Resources. The Company indicated on the call that they are negotiating an additional bromine acquisition that they hope to close in 2010. The Company's criteria for bromine acquisitions are factories that have (i) a land rights agreement with the local government, (ii) proper equipment that is in good shape, and (iii) the ability to produce over 3,000 tons per year in bromine. Management stated that acquisition targets would not exceed 6x earnings. The Company's last acquisition closed in June and management stated that it is expected to add $8.5 million in annual revenues at current bromine prices. Assuming the Company's 35% net income margin on the latest acquisition, you arrive at $3 million in net income, which would imply a 4.6x earnings multiple based on the $13.9 million acquisition price. The Company is able to negotiate favorable acquisition prices of new bromine factories because they are acquiring bromine players that are currently unlicensed due to the Shandong government creating an oligopoly in 2006 by issuing only a few licenses to extract bromine. Management stated that there are 6 bromine targets that they are evaluating for acquisition, representing an additional 20,000 metric tons of bromine.
Disclosure: Long GFRE at the time of this writing
The first step in calculating Gulf Resources's (GFRE) financial estimates for 2010 and 2011 is to create a bottoms-up revenue model for its three business segments: bromine sales, crude salt sales, and chemical sales.
Bromine sales can simply be calculated by multiplying annual bromine production in tonnes by the price of bromine per tonne. Therefore, we need to calculate bromine capacity utilization at each factory in 2010 and 2011. Even though one could expect efficiencies in bromine extraction over time, I am going to assume that all plants acquired prior to 2009 will run at the same utilization rates in 2010 and 2011. For the factory acquired in January 2009, I assume that it reaches the same 79.21% utilization rate as factory #6. For the factory acquired in September 2009, I assume that it reaches 50% capacity in 2010 before reaching the same 79.21% utilization rate as factory #6. For the factory acquired in June 2010, I am using management's estimate of 18% utilization in 2010 and my estimate of 60% in 2011. Based on these assumptions, we can now easily calculate the total bromine available for sale in 2010 and 2011.Click tables to enlarge
We learned on the second quarter conference call that bromine prices have stabilized at $2,800 per tonne. Management also expects that there is a possibility of bromine prices increasing by the end of 2010 as demand continues to outpace supply as China remains a net importer of bromine. Given management's outlook for bromine prices, I am keeping third quarter bromine prices steady at $2,800 per tonne and increasing prices to $2,850 per tonne in the fourth quarter. For the past 10 years, bromine prices have risen at a 9.6% compound annual growth rate (see GFRE investor presentation). I am using the same 9.6% growth rate for the price of bromine for 2011 with price increases gradually occurring throughout 2011.
Crude Salt Sales
Crude salt sales can be calculated by multiplying crude salt production by the price of crude salt. The Company has not broken out individual factory utilization; however, it can be estimated by looking at the company's acquisition history and total crude salt sold. For crude salt, I have assumed the following capacity utilization rates.Click to enlarge
The price of crude salt jumped from $29 per tonne in Q1 to $40 per tonne in Q2. Management indicated on the call that they expect the price of crude salt to continue to increase in 2010. I am estimating that the price increases to $42 in the third quarter and $45 in the fourth quarter of 2010 and continues to grow by $1 per quarter in 2011.
The result is $16.6 million in crude salt sales in 2010, a 65% increase over 2009, and $23.9 million in 2011. My crude salt estimate does not include additional capacity from future acquisitions.
Chemical Product Sales
Chemical sales are not as easy to forecast as bromine and crude salt sales. In the first half of 2010, chemical product sales increased 25.6% over the first half of 2009. I am assuming that sales continue to grow 25.6% in the second half of 2010 over the second half of 2009. In addition, I am assuming management's estimate of $3.2 million in second half 2010 sales from the new water treatment initiative and $9.5 million in 2011 (the midpoint of the $9 to $10 million annual sales estimate). I am not including any future acquisitions in my estimates or new initiatives created through the Gulf's aggressive R&D efforts.
Gross margin increased in the second quarter to 49.3% from 45.3% in the first quarter. Management indicated on the call that gross margins will be the same or improve slightly from the second quarter.
G&A expenses dropped 19% in the second quarter of 2010 over the second quarter of the previous year. Management commented that they have benefitted from controlling costs and streamlining operations. They expect G&A costs to remain the same with a possible slight increase in compensation costs. To be conservative, I estimated a 5% increase in Q3 and another 5% increase in Q4 for G&A expenses due to any increase in labor costs. For 2011, I increased G&A expenses by 10%.
Research and development costs were approximately $125,000 per quarter for 9 straight quarters until Q2 when the company tripled their R&D expense. Management estimated that going forward, R&D expenses will be approximately 1.5% to 2.0% of sales. Management is increasing R&D in order to develop more downstream chemical initiatives with their deep bromine reserves. This is a smart investment given the vast potential in developing chemical products such as water treatment chemicals and pharmaceutical intermediates. I have increased R&D expense to 1% of management's revenue guidance, which is triple the R&D expense of 2009. I also increased R&D expenses by 76% in 2011, or approximately 1.25% of my 2011 sales estimate. I have kept the tax rate at 25%, which is the tax rate in China.
Based on the revenue and cost estimate assumptions described above, here are my projections for the next 6 quarters (note the drivers of the model are highlighted in blue):Click to enlarge
Valuation and Price Target
Based on Tuesday's closing price of $8.75, the stock is deeply undervalued based on all valuation metrics. It is currently trading at 6.8x LTM earnings, 4.6x Enterprise Value / LTM EBITDA, and has a PEG ratio of 0.23. GFRE's most applicable comparable companies are ICL Group, which trades at 20.5x LTM earnings and Albemarle (NYSE:ALB), which trades at 14.9x LTM earnings. I believe that GFRE is comfortably worth 12x to 15x LTM earnings, which would place its current fair value between $15.35 and $19.19 per share. As recently as January 2010, GFRE was trading at $14.94, which was a 14.1x LTM P/E multiple at the time.
Based on forward multiples, GFRE is currently trading at 5.3x 2010 earnings and 4.1x 2011 earnings as well as 3.5x 2010 Enterprise Value/2010 EBITDA and 2.8x 2011 Enterprise Value/2011 EBITDA. Gulf Resources has the potential to get back into its 12x-15x LTM P/E trading range that it was in for most of the first quarter of 2010 from the following catalysts:
I highlighted quarterly price targets based on 12x-15x LTM earnings in the last two rows of my spreadsheet above. My 6 month price target is $20 to $25 per share and my 12 month price target is $24.50 to $30.50 per share.