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We all know that the majority of investors like to follow the herd, and since the shorts sellers got out the cattle prod and told the herd it was time to sell, the cattle stampeded over the last few days.

I am not going to make any assumptions about my audience, but I would hope the average reader of Seeking Alpha is, well, seeking alpha. Yet I acknowledge that most investors would rather crowd into a cozy trade at a high multiple than buy a great Chinese domestic consumption high margin, high return on capital, growth business with a ton of cash trading at only 2.5x current year earnings ex-cash.

We all know that to create alpha you have to be contrarian rather than a lemming, so for those of you with the stomach to handle some volatility, I will explain why the shorts have won the latest battle but the longs will win the war, and why China-Biotics (OTCQB:CHBT) (the "company") could be one of the best investment opportunities in the market.

In order to make my case, I’m going to first debunk the arguments of the short sellers, then tell you why CHBT is not going out of business, and finally I’ll show you ten catalysts that could drive the stock price higher in the next few months.

Short Selling Arguments Debunked

1. China-Biotics is a fraud because the SAIC numbers for 2007and 2008 do not match the SEC filings. The SAIC numbers show a company with almost no cash and $500k of annual revenue.

Counterpoint: Chinese companies must file with the SAIC each year to renew their business license. As we have been finding out, many Chinese companies do not report proper numbers to the SAIC. The reason for this is because the SAIC numbers go into the public domain in China, unlike the numbers filed with the State Administration of Taxation, which remain confidential. China’s entrepreneurs typically do not want their numbers public for several reasons. First, they do not want their competitors, suppliers and customers to know their numbers if they can prevent it. Second, they do not want to be hit up for favors and bribes from officials and others who try to get money from the rich. Everyone knows in China it can be dangerous to show your wealth. Even though their financial statements may be published in the USA with the SEC, most Chinese will not know there is a listed foreign company trading under a different name in the USA and will not speak English well enough to read it.

2. Citron Research could not find the company operated retail outlets on Baidu and what the company had listed as retail outlets appeared in some cases to be shop-in-shops rather than actual independent four wall retail “boxes.”

Counterpoint: Who cares? Retail sales through the company’s own retail outlets, whether these are shop-in-shops or four wall retail stores are only 8% of total sales. Shop-in-shops are uncommon in the US, but actually are very common in large retail chains in China. The company has already indicated that it has decided to scale back its own retail outlets in favor of selling through distributors into the retail channel. This is because it is more efficient to manage distributor relationships rather than a network of retail outlets, and the company also makes higher margins on distributor sales.

How Do You Kill the Company?

The goal of the short smear is to make you think somehow the company is going to be worthless, so you better sell now to get something. Bruce Berkowitz has described that at Fairholme Funds before making an investment they put it through a stress test where they try to “kill the company.” The only way a company goes to zero is if it runs out of money and goes bankrupt. So how do you make the argument to kill China-Biotics? It’s really hard. The company had net cash of $130 million as of the end of June. Operating cash flow for the fiscal year ended March 31, 2010 was $28.2 million. This year operating cash flow will be even higher, conservatively in the $40-$45 million range. I estimate capital expenditures this year of $20 million to finish Phase II of the new plant and expand the old plant. Cash will continue to grow. As far as I can tell, you can't kill the company. If you're a long term buyer of value and can handle the volatility, you are in a great position. At the closing price of $10.40 from Wednesday, the enterprise value is under $100 million. What a deal.

10 Catalysts to Drive the Valuation Higher

Let me give a list of many potential catalysts that could drive the share price higher. I’m not saying they will all happen, but some will, and ultimately they will be the reason why the shorts will lose the war and probably a lot of money, while the longs make a killing.

  1. The company will report strong growth in future quarters as it continues to ramp up production at its new bulk facility.
  2. The investor day on September 20th will be impressive. How do I know? Because I visited the company last year in November and saw their new facility. Investors will see a modern factory full of massive silver tanks producing bacteria and clean rooms for finished products. The scale and quality will blow people away. Investors will quickly forget about all the funny things the shorts wrote on the internet and decide they want to own this business on the cheap.
  3. The company will announce that is has appointed a big 4 auditor for FY2011. This will convince investors that the company has nothing to hide, since the new auditor will by default have to evaluate the prior year financial statements.
  4. The company will amend its SAIC filings.
  5. The company will buy back shares thereby increasing EPS and increasing the risk of a short squeeze.
  6. The company will start paying a dividend. Of the $159.8 million in cash, $75 million is offshore held in USD and $85 million is in China in RMB. Foreign owned companies in China can pay dividends out of retained earnings subject to only a 5% withholding tax. CHBT has $84.3 million of retained earnings as of June 30th, 2010. A lot of dividends could be paid.
  7. After receiving a dividend Mr. Song, the CEO, will use the money to buy more shares.
  8. Management will get fed up with the hassle of being public and dealing with short sellers and decide to go private. Surely there will be firms ready to invest. KKR, Carlyle and Sequoia all made dairy investments in China in 2009 and in July Blackstone invested in an animal vaccine manufacturer. All investments were in publicly traded companies.
  9. Management will decide to move its listing to an exchange like Hong Kong where it will get more appreciation. Many Chinese companies listed in Singapore have recently done the same and have seen their valuations rocket.
  10. The short trade is very crowded. I called Goldman Sachs and there were zero shares available to borrow and the cost of borrowing was 20%. As of August 13th there were 3.56m shares short equal to 32.0% of the free float, but actually given the number of core funds holding positions, the percentage of shares shorted is much higher. If any of the above 9 catalysts occur, they will create a short squeeze which will drive the price higher.

Conclusion

The short campaign has created an excellent investment opportunity for long investors. The short arguments are bunk, the company is not going out of business, and multiple catalysts will appear that will allow you to lock in solid gains. Ignore the message boards and step up to the plate.

Disclosure: Author is long CHBT

Source: China-Biotics: Ten Catalysts for a Higher Stock Price