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China Precision Steel (NASDAQ:CPSL) is both a short-term and long-term “must own,” a company that has clearly been overlooked by analysts. Several years ago, the stock had a major sell off, dropping from the $14 level after it made the strategic decision in 2006 to switch its product mix from lower-quality steel products with lower margins to high-precision products with much higher margins.

The company has completely turned around after incurring the associated capital expenditures, including R&D, which caused the stock to drift lower over several years. But now the company is spending only 1% of revenue on R&D, has returned to handsome profitability and is on track to reward investors with rapid and sustained earnings growth. None of these developments have been factored into the stock price.

The stock is extremely undervalued as I will discuss further in this article. I expect the stock to easily break through the $2 mark prior to its upcoming earnings release, and to make a new 52-week high above $2.67 shortly thereafter and reach the $4-$5 range by 2012.

China Precision Steel is a steel processing company engaged in the manufacturing and selling of precision cold-rolled steel products and in the provision of heat treatment and cutting of medium and high carbon hot-rolled steel strips. Its specialty precision products are used in the manufacture of automobile parts and components, steel roofing, plane friction discs, appliances, food packaging materials, saw blades, textile needles and microelectronics.

There are several factors that compel me to buy more of the stock:

1) Increasing Demand/Hyperbolic Market

The company conducts its operations and sells its products in China. Its products are also sold in overseas markets (approximately 19k tons in 2010), such as Thailand, Nigeria and Ethiopia, but the key is China.

In its news release announcing the forecasts, the World Steel Association noted that the country will use 45% more steel in 2011 than it did in 2007, and 3.5% more in 2011 than in 2010. It does not take a rocket scientist to predict that China will continue to enjoy its prominence as the dominant force in global manufacturing and therefore will continue to be a key market for steel. Skeptics may comment about the steel producing capacity of China. And, in fact China has increased its steel exports tremendously over the past several years, making it the number one ranked steel exporter globally.

However, while China is a net exporter of crude steel, it is a net importer of higher value precision cold rolled steel products such as those produced by the company. Manufacturers of products that use specialty precision steel products in China have traditionally imported precision steel products from Japan, Korea, the European Union and the United States. And generally, the quality and standards of China’s high precision steel industry have lagged behind the international norm.

Nonetheless, during the last five years, CPSL has developed and established a nationally recognized brand in China. In fact, the precision steel market in China has been growing at 16% for the past five years, and the company sold over 124k tons of precision steel in China in 2010. This contributed to an increase in sales revenues of 44% over 2009, which is phenomenal by any standards. I expect the demand to increase in China not only due to the factors mentioned above but also due to the cost advantage of sourcing precision steel domestically, which includes a 5% tax credit and reduced transportation costs.

Ultimately, for the company’s customers, this translates into a 5-10% price discount and shorter delivery times over imports.

2) Increasing Capacity and Backlog

The company currently operates three mills, one of which came online in the beginning of 2010 and is running at 25% capacity. It typically takes three years to ramp a mill up to capacity and I expect the company to increase production by 50k tons annually, achieving full capacity of 260k tons by 2013. This is sustainable growth as the company demonstrated a similar increase YOY from 2009 to 2010 from 81k tons to 134k tons. Combined capacity utilization at the three plants is now 75% and the company still has a sizeable backlog of orders. In fact, the backlog doubled between June and September of 2010.

It should be reiterated that the capacity investments are substantially behind the company, as net cash flows used in investing activities for 2010 was $3.7M as compared with $25.3M for 2009. Cash flows used in investing activities decreased as they completed construction of the new 1450mm cold rolling mill, and there was no additional material construction project during the year.

3) Key Customers

In FY2010, the company increased its sales 2 and 3.5 times with its top two customers, respectively. The company also added a key customer, Hangzhou Cogeneration Co, which is has $2 billion in revenue. Hangzhou’s orders now account for 9% of sales and its orders are expected to increase.

4) Rapid Earnings Growth Through Solid Management

In FY2010, the company had earnings of $0.12 per share versus a loss of $0.01 for 2009. The 1470% increase in net income is clear evidence that the company has rounded the corner. The company managed to achieve phenomenal top-line growth during a period of decreasing prices ($748 vs $826 per ton) while also maintaining its margins.

5) Ownership/Insiders

The company has 46M shares of stock outstanding with a float of only 27M. Insiders own 42% of the outstanding shares and have not sold in the past two years. Note, the trading float is only 15M so this stock could move upward very easily on the upcoming earnings news. Also, watch for new institutional money inflows once the stock price stays north of $2 a share for more than 90 days.

The stock trades at a significant discount to sales (P/S of 0.65) and book value of $2.78 per share. The company will announce earnings on February 14th. I expect the numbers will do the talking and drive the stock upward. This could be cupid’s arrow!

Investors in other china stocks such as Qiao Xing Universal Resources (XING) and China GengSheng Minerals (NYSEMKT:CHGS) may want to consider buying CPSL.

Source: China Precision Steel: Ready for a Major Run