Shengkai Innovations (VALV) is a ceramic manufacturing company that designs, manufactures, and distributes ceramic valves for industrial use. Shengkai’s valves 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. It is estimated that Shengkai is responsible for 70% of the Chinese ceramic valve market. Think niche market monopoly.
Shengkai Innovations recently released their 1Q results for their FY2011. Their 10Q is posted here.
It would appear from their most recent results that the growth that I talked about here and here still seems to be a likely scenario. In the quarter ending Sept. 30, 2010 the company announced:
- Revenue: $17.175 million (54.58% growth YOY)
- Operating Income: $6.290 million (24.78% growth YOY)
- GAAP Net Inc.: $28.261 million ($0.76 EPS, fully diluted: $1.16 non-diluted)
Operating income did not experience the same growth that revenues did because of expenses related to the company's 2010 stock compensation plan as well as cash awards/stock compensation paid to new and existing directors. It is possible, and I think likely, to expect these kind of expenses to continue.
For the 1Q Shengkai Innovations received a huge boost of $21.7 million due to fair value adjustments in the value of warrants and options they have outstanding that they account for. Because the price of the stock has fallen over the course of the past quarter, so has their potential "liability" to the company and thus, a non-cash gain of $21.7 million.
You may remember that last quarter Shengkai took a sizeable charge of $50+ million in relation to these same warrants. Obviously, these fluctuations can have very dramatic effects on the reported earnings of the company and they are probably best ignored.
My reasoning for ignoring them thus far:
- The expense taken last year was due to not having accounted for them properly when they occurred in 2008. It was not an expense that the company took on in 2010.
- The most recent gain is due to a reduction of the "liability" that the warrants are to the company, something that will reverse itself it the stock rises as I anticipate.
Because of this, I will consider the company's income from operations: $6.290 million. To this number I will add the $1.316 million that American shareholders receive beneficially through favorable exchange rates. (With bond yields suggesting inflation, the Fed printing money, and economists' estimates of a 40% undervalued renminbi, I think it is fair to consider this a substantial part of the gains in investing in this stock.)
This leaves us with a quarterly return of $7.606 million, or an annualized rate of $30.424 million. This represents estimated "actual earnings" of $0.86 per fully diluted share for FY 2011. This would suggest that the stock should trade at $10.36 with a conservative multiple of 12 or $17.27 with a more growth appropriate multiple of 20.
There are several things to consider about Shengkai Innovations that will further affect the value of the company:
1) Shengkai Innovations just opened a new facility that will triple capacity. This new facility began operating at partial capacity in September and will not be at full capacity until December. This means all the growth that we just witnessed was completely organic and unrelated to the new facility. It also means that it was done despite of the shift of all of their equipment/machines from one factory to the other. Growth should be more impressive starting in the quarter ending in March 2011. Management expects revenues to be around $95 million for the current FY and non-GAAP net income to be $30-32 million. These figures are in line with the analysis above.
2) Shengkai has made impressive growth strides within realms outside of what was once its key market. Reference the table below [click to enlarge]:
In the past the Electric Power Industry has been the primary industry to use Shengkai's services; however, it is apparent that Shengkai is making meaningful strides into the Petrochemical and Chemical industries and growing rapidly there.
3) With a currency that is supposedly undervalued by as much as 40% and the US doing its best to print money, it is possible that investors may achieve gains of 40% simply due to exchange rates.
4) 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.
5) Last, some of the non-cash gains from the fluctuations in warrants and options may be here to stay if we see continued price weakness. 1.9 million options outstanding have strike prices at $7.97 and $8.13, well below current closing prices. These options vest in equal installments of 33% over the next three years. If the 33% of the options expire worthless this coming year, it is possible that shareholders will reap the benefits through less dilution and higher equity values.
All these things considered, it should be easy for Shengkai to obtain a value within the $10-17 price range I have set for it. I estimate that if things continue to go this well for the company, its stock price will eclipse $15 by October 2011. The only things I can see getting in the way of this is continued dilution which didn't appear to be a problem this past quarter and low liquidity levels keeping equity prices artificially low....this may be more of a problem.
I view the low liquidity as an actual benefit to long-term shareholders who can continue to purchase at depressed prices until liquidity picks up. I do not know if this is likely soon: 88% of outstanding shares are owned by insiders and 10% by institutions. This means 2% of its 35 million diluted shares outstanding trade on a regular basis. That is only 700,000 shares. I imagine as the stock price rises, and options are exercised, we will see increased liquidity. In this case, management is more likely to sell, long-term holders are more likely to sell, and options exercised create more shares that are available for trading.
Disclosure: Author is long VALV