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Shengkai Innovations (OTCPK:VALV) is a ceramic manufacturing company that designs, manufactures, and distributes ceramic valves for industrial use. Shengkai’s valve range from 32mm to 1000mm and can withstand pressures of up to 42MPa compared to competitors offerings of up to only 150mm and much lower pressure readings.

Shengkai has pioneered manufacturing techniques that allow it to lower firing temperatures, increase durability, and allow for the valves to operate under higher pressures. These production innovations has allowed Shengkai to increase the number of valves that survive the firing process to over 90%. Shengkia believes that these techniques allow it to provide a higher quality product that distinguishes it from its competitors.

Other ceramic valve manufacturers are said to mainly produce small ball valves able to withstand 2.5 MPa and smaller valves up to 150mm.

It is estimated that Shengkai is responsible for 70% of the Chinese ceramic valve market. In addition, Shengka innovations has patents on many of its techniques adding further value to the company (read monopoly in a small market with large growth potential).

Revenues and Net Income

Positive Developments:

  1. The company relies on the electric power industry for 65% of its revenues. The company is currently the only domestic ceramic valve maker to enter the CPCC and PetroChina (NYSE:PTR) supply system after a six year application process.
  2. Shengkai was also recently awarded contracts in Hong Kong to service Hong Kong’s power generation companies. After a one year testing process the company was selected and has already filled three orders.
  3. Shengkai has also been named a high technology company and will receive preferable tax rates of 15% for the upcoming fiscal year.
  4. Shengkai is currently trying to expand into different markets including the Coal-Chemical market. In August Shengkai attended the “2010 China International Exhibition on Coal Processing & Utilization and Coal Chemicals.” This had attendees such as Shell (NYSE:RDS.A), Total (NYSE:TOT), GE (NYSE:GE), and Dow Chemical (NYSE:DOW).
  5. Economists believe that China's currency is currently undervalued against the US Dollar by as much as 40%. If a free-float currency policy is adopted, US shareholders could realized gains of up to 40% over the next several years due simply to currency exchange rates.

In the FY ended 06/2010 Shengkia was able to increase its revenues from $39.3 million to $54.1 million. This represents growth of 37.66%. Gross profit grew from $24 million to $32.2 million representing growth of 34.2%. This growth is mainly attributable to the increase in revenues.

Pro-forma net income was $19.5 million as compared to $13.6 million in 2009 on a 33% increase in revenue. The company’s GAAP net income was actually a negative $56.4 million due to three things:

  1. A $56.9 million dollar charge to correct for options and warrants issued in 2008 that were improperly accounted for.
  2. A $15.9 million dollar charge in relation to returning stock the Long Sunny Limited in agreement with the financing terms that were laid out in 2008.
  3. A $3.1 million dollar charge in relation to issuing options in the company’s new 2010 employee compensation program.

The first two expenses will not occur again in the FY 2011. I am uncertain as to the regularity of the third expense but I think that it would be fair to say that such practices will continue and may increase in the future.

The $56.9 million dollars is a charge in relation to the offering of preferred stock and warrants in 2008 that will result in an increase of 9,464,843 shares that are later taken into account in my fully diluted figures. These warrants are convertible at $2.5357 by 2013 and the preferred shares are convertible at $3.52 by 2013.

I have few details of the $15.9 million return of shares other than management mentioning that it was part of its agreement in one of the 2008 financing deals that it took part in.

The $3.1 million dollar charge in relations to the employee stock compensation plan is directly resulting from 1,615,125 options set aside for key employees exercisable at $7.97. There were also 310,000 options given to independent directors exercisable at $3.00. 150,000 options were issued to the Chen Wang, the CEO and another 100,215 to his wife who also is in an executive of the company. These options are exercisable at $8.13. The total of all of these options is 2,211,250 with a weighted average exercise price of $7.29. All of these options have a contract life of 5 years in which they can be exercised and vest in three to four equal installments. New shares will be issued to cover these options when they are exercised.

For the year 2010: 900,000 preferred shares were converted to into 900,000 common shares. 284,091 warrants were exercised for 153,154 shares issued on a cashless basis and 25,511 for cash proceeds of $89,799. This may give us a general idea of the minimum amount of the dilution we can expect in coming years.

Cash Flows

The company’s cash flow from operating activities as $21.3 million, an increase of 33.9% from cash flow in 2009. This represents a cash return of 14.3% on its current market cap. On a fully diluted basis with 34 million shares, it would be an 9.8% return.

Further Analysis

In June Shengkai Innovations finished construction on its new production facility. The company has been running at partial capacity and is expected to reach its full capacity on one shift of 24,000 units annually (Shengkai produced 14,376 units total in 2010). The management has said that with the new production facility, the maximum output of the company will be 35,000-38,000 units with additional shifts and investment in equipment.

Management estimates that revenue will increases to $93-95 million in 2011. This would represent growth in revenues of 72%. Operating margins were 59.9% in 2010, similar rates would have operating income growing from $32.2 million to $55.7 million. Management also expects non-GAAP net income to range from $30-32 million. With fully diluted shares around 34 million this would represent earnings of about $0.88 per fully diluted shares. With the current number of shares outstanding this would represent earnings of $1.30.

If we apply a multiple of 15 to this $0.88 earnings we obtain an estimated price of $13.20 (fully diluted, 34 million shares) or $19.50 at current shares outstanding. Clearly this dilution has had a major effect on the estimates of this stock that were not taken into account in my last article found here; however, as of right now the company is capped at having an maximum of 50 million shares. Even at a fully diluted basis, these earnings would be worth $9.00 per share. This is currently 33% above the current stock price and expects the maximum amount of dilution through the issuance of 16 million shares over the next year, an unlikely scenario.

If cash flows continue growing at their present rate, which is probable, it would suggest that in 3 years the operating cash flow would be around $51 million in FY 2013. Discounted back at an 8% rate gives a present value of $40.6 million. This represents cash flows of $1.19 per fully diluted share, or $0.812 per share in the worst case dilution. These would represent returns a return of 18.6% and 12.7% over the risk free rate respectively.

(51)(1.339)^3

(1.08)^3 = 40.6 million Present Value of Future Cash Flows

Keep in mind that an 8% discount is generous given that the current risk free rates are much lower. If we were to apply risk free rates that were equivalent to the current risk-free rate the returns on cash flow would rise to about 23.4% and 15.9% respectively.

*Note: These valuations should be relatively conservative. Typically, companies experiencing 30% growth rates carry P/E multiples higher than 15, not to mention companies looking at 70% growth. Also, if revenues and income are expected to grow at 70+% then it may be reasonable to assume that cash flows from operating activities may exceed the 33.9% growth estimated for the next three years that was used to obtain the valuations used to determine the growth beyond the risk free rate.

*Note: 75% of Shengkai Innovations outstanding stock is owned by the CEO and his wife. This prevents any direct control in management activities by stockholders. As always, individuals should do their own due diligence before making any final decision on purchasing a stock.Please feel free to leave any comments covering anything that you feel has been misrepresented, neglected, or that you have questions about.

Disclosure: Author has been long VALV since January 2010

Source: Shengkai Innovations: A Look at FY 2010