New Energy Systems: Hidden Gem With Strong Foundations for Growth

| About: New Energy (NEWN)

As a value investor, I am always looking for companies with great fundamentals and growth potential. By running my daily screen, a long candidate has attracted my eyes.

It is New Energy Systems Group (Amex: NEWN). NEWN is a leading provider of lithium-ion batteries for portable electronic devices in China with headquarters in Shenzhen, Guangdong Province, which is China's first—and arguably one of the most successful—Special Economic Zones. This company has recently been uplisted to Amex from OTCBB and trades in the range of $6-7.

In recent years, the global output of lithium-ion batteries has soared more than 50% annually and the demand is expected to maintain its upward momentum till 2018. At present, the global supply of Li-ion batteries is monopolized by three giants in Asia, i.e. China, Japan and South Korea, and all three have a total market share surpassing 95%.

The first use of lithium batteries was in laptops, but now they are widely used in cell phones, video machines, digital cameras, MP3 players, hybrid cars and other electronic products. The batteries are becoming more environment-friendly with a longer life, smaller size and lighter weight. Chinese Li-ion battery manufacturers are not only seizing market share for Li-ion batteries for portable products like 3G mobiles and laptops from South Korea and Japanese competitors, but also are actively developing the Li-ion battery market for electric cars and E-bicycles.

In China, the fastest-growing auto market in the world, the development of Li-ion batteries has become a core part of the development of hybrid cars. The Chinese government has recently handed out policy incentives to encourage more electric cars on the road and the demand for Li-ion batteries will increase. Investments into companies in the battery business will reward investors generously. In fact, this is already reflected in the Shanghai A-share market. Most Chinese battery companies listed in the A-share market have advanced more than 20% since August 1, 2010, with an incredible 100% net income increase in the first six months of 2010.

Products from NEWN now support iPhones, iPads (NASDAQ:AAPL), Blackberrys (RIMM) and all major-brand cell phones, laptops, digital cameras, MP3s, etc. Currently, NEWN only operates at around 50% of manufacturing capacity and has begun to expand internationally. On August 26th, 2010, NEWN announced its plan to launch MeePower™, a new brand of advanced battery backup systems expected to be available to distributors in the U.S. beginning in the fall of 2010. MeePower generates 4–7 times more power than an original OEM battery’s capacity and can recharge the OEM battery more quickly and last longer.

In the past, the company only dealt in the low-margin battery shell & cap and battery-distribution businesses. But acquisitions in 2009 transformed NEWN into a rapidly-growing, high-margin, integrated manufacturer with an established brand name.

The first acquisition was of Anytone, a manufacturer and seller of lithium-ion battery finished products and was acquired by NEWN with both stock shares and cash payments. The acquisition not only enhances NEWN’s ability to rapidly innovate with quick-turn capabilities, over 30 patents and deep R&D capabilities, but also broadens product offering and allows NEWN to touch end-user customers.

Another acquisition was with NewPower, a China-based manufacturer of lithium-ion batteries. NewPower has extensive manufacturing expertise and capabilities. It only operates at 50% of production capacity and can triple its production with minimal additional capital expenditures. Both acquisitions are strategically important to vertical integration and increase profitability of the existing battery distribution business with added margins by internally sourcing lithium-ion batteries.

Although the company’s cash positions are influenced by its payments for the acquisitions, NEWN still shows strong second-quarter earnings. The company’s revenue has increased 335.2% to ~23.4 million and gross profit increased 280.1% to ~$6.1 million year over year. A final payment of $4.0 million is related to the Anytone acquisition and reduced account payable and accrued expenses on its balance sheet. Its adjusted EPS has increased 59.1% to $0.35 per diluted share and the company has affirmed its goal to earn at least $1.23 per diluted share in 2010. A conservative 10X P/E valuation gives an intrinsic value of $12.3 for NEWN, which is well beyond the current price level. Lastly, the company is still expanding and operating only at 50% of its capacity.

The latest 10-Q also shows that the stock value of NEWN paying for both acquisitions is ~6.4 dollars. NEWN has only 35,000 outstanding stock options with an exercise price of 6.19 and outstanding shares of ~11.86 million. The current price of $6.17 for NEWN is extremely cheap, with a trailing 12 month P/E of 5.6.

What worries most investors of small cap Chinese companies is dilution, especially when the companies are eager to raise capital with a secondary offering. However, as NEWN has just completed two acquisitions with a healthy balance sheet, the chance of a secondary offering is very slim.

NEWN has now completed its acquisitions and integrated its business lines. The company has transformed into a fully-integrated manufacturer with a brand name, and is focused on growing its business in both China and overseas markets. The company will continue to introduce new products to meet changing market demand and increase higher margin direct sales to OEM customers and retail partners. NEWN is on its way to expand into large, higher-margin international markets such as North America, Europe and Japan. The management teams of NEWN have accumulated abundant knowledge about the battery industry and built a strong distribution network for years.

I believe that NEWN will continue to experience organic growth in the years ahead and will generate value for shareholders while maintaining high corporate governance standards.

Disclosure: Author is long NEWN