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For short sellers of Chinese RTO equities, the last few months have been a harvest of epic proportions. In fact, if you have been short Chinese reverse mergers lately, stock selection has been of secondary concern as the group has fallen together in lockstep with its biggest losers.

However, when an entire sector sells down in a rushed panic with disregard to the fundamentals of the individual equities, it creates peril for the overzealous shorts that arrive late to the party. In the game of investing, attempting to short the baby that was thrown out with the bathwater is not wise.

One potential shorting landmine in the Chinese RTO space is Lihua International (LIWA,) a China-based manufacturer of alternative copper wire, rod, and anode products.

Currently, 3.28 million shares of LIWA (over 20% of the float) are short, making this a popular downside bet.

Today, I would like to present 5 reasons why shorting Lihua now is a terrible strategic bet.

1) The Risk-Reward Ratio Now Favors Longs

Lihua closed last Friday (7/1) with a share price of $6.00. Six dollars flat coincidentally happens to be a nice round number for us to demonstrate the current asymmetric risk-reward ratio.

At a share price of $6.00, Lihua is trading at just about double its current cash and cash equivalents position of $90.7 million ($2.99 per diluted share).

$6.00 per share also implies an exact 200% upside between current levels and the $18.00 analyst targets given in May by both Rodman and Renshaw and Chardan Capital Markets.

Working off these two facts, we can compare two theoretical strategies.

a) Going long Lihua at $6.00 until the analyst target of $18.00 is reached.
b) Going short Lihua at $6.00 until Lihua trades at cash.

Under normal market conditions, equities reach and exceed consensus analyst targets fairly regularly, whereas trading at cash is considered a black swan event reserved for only the most dire of circumstances.

However, at Lihua’s $6.00 per share price, the long “a” bet provides new longs exactly four times as much upside as the “b” short bet. (200% vs 50% upside)

If you are not already versed in the fundamentals of Lihua, you may now be wondering if $18.00 is a well-set target. Let’s take a closer look.

2) The Fundamentals

Lihua is currently trading at a price to earnings ratio of 4.2, a forward P/E of 3.17 and a cash-adjusted P/E ratio of just over 2. This compares to a broad copper industry P/E average of 18.5 and forward P/E of 13.70 (see here.)

A triple from current levels to the analyst target of 18 would put Lihua closer in-line with peers, but still leave Lihua relatively undervalued from a pure P/E comparison standpoint.

Looking at P/E ratios without considering balance sheet and growth is a largely futile exercise. We therefore need to add into the equation Lihua’s balance sheet of 90.7 million in cash, lack of debt, and recently announced increased guidance of 53-55 million in net income for 2011 (a 32.2-37.2% year over year growth rate.)

Once we dig further, we find that while Lihua is successfully outgrowing the vast majority of its copper peers, the market simply has not yet given it fair credit for doing so.

One direct comparison that can be made to demonstrate this would be to look at Lihua vs Encore Wire (WIRE), a Texas-based manufacturer of copper wire and metal products.

Encore Wire (NASDAQ:WIRE) Lihua International (NASDAQ:LIWA)
Revenue 1.04B 444.24M
Net Income 28.41M 42.12M
Total Cash 75.23M 90.70M
Gross Margin 10.17% 15.12%
EBITA 55.99M 61.07M
Operating Margin 4.08% 13.29%
EPS 1.23 1.41
P/E 20.96 4.25
Market Cap 597.24M 180.19M

Using a head-to-head comparison, both companies appear quite healthy with heavy cash positions and solid margins. However, Encore Wire required twice the revenue as Lihua to produce about 67% of the net income.

Usually, the market favors efficiency and growth over scale. However, if you were to consider Encore Wire’s larger revenue as a positive offset and value the two companies equally, you would have to increase Lihua’s share price by a multiple of 3.31 times to achieve market cap parity.

This would result in a Lihua share price of 19.89, which happens to be very close to the Global Hunter Securities’ analyst target of 20.

We could go on with fundamentals, but I believe it is fair to say that using any form of traditional valuation, Lihua International is currently grossly undervalued. The current analyst targets of 18 and 20 also appear to be set at a fairly conservative level considering Lihua's rapid growth profile and profitability.

3) Growing Demand in the Chinese Copper Sector

Lihua is unique in that its copper and bimetallic products are produced from smelted scrap copper instead of newly mined “virgin” copper. The resulting products are 99.97 pure, exceeding industry and government regulations. If you are at all familiar with the cost-control obsessed culture of China, it should not come as a surprise that Lihua’s customers are attracted to the savings these environmentally friendly products provide.

All signs point to the demand for basic metallic products in China remaining high for years to come.

For one, the Chinese Ministry of Industry and Information Technology has publicly stated China has set a goal to nearly double its production of recycled metals by 2015 to a total of 12 million tons. (from 7.75 million tons last year)

Tao YongHe, an executive with Yunnan Copper group, China’s fourth largest Copper producer, stated in a recent article that the Chinese government is supporting development of recycled metal products and he expects urbanization and industrialization to keep scrap-copper demand high for the next 5 years.

The management of Lihua themselves have reiterated in their last 2 quarterly conference calls that demand for their products is robust and growing. Their challenge lies only in continuing to increase their manufacturing capacity to meet this demand. Lihua is in the process of doubling its smelting capacity from 50,000 tons to 100,000 tons in the second half of 2011. Current 2011 estimates only take into account a few months of operations at the doubled capacity. This essentially guarantees continued revenue and income growth through 2012.

In February, Lihua, which was trading at $10.29 at the time, was mentioned along with Chinese Internet portal Sohu.com (SOHU) by David Riedel of Riedel research as a recommendation to play the inflation taking place in China. Riedel postulated that the demand for Chinese consumer durables may increase as the growing middle class hedges inflation by choosing to buy electronics and other products now instead of risking them rising in price later.

4) Chinese Government Support

In China, it is no secret that companies can be made or broken based on their ability to co-operate with the Chinese government.

2 weeks ago, the Ministry of Environmental Protection of the People's Republic of China awarded Lihua a scrap metal import license. This allows Lihua to further improve its margins by now importing scrap copper directly instead of buying it at a premium through a licensed importer.

The awarding of Lihua’s import license is just the latest in a string of events showing Lihua’s good-standing and co-operation with the Chinese government. Four months ago in March, Lihua was awarded a “Best Internal Audit Practice Award” by the auditing bureau of Danyang. A month later, Lihua announced a partnership with one of China’s top non-profit research institutes, RIORE, in developing low-carbon recycling opportunities.

5) The Perfect Set-Up for a Short Squeeze

Since the allegations of fraud in several Chinese RTOs including China Media Express (CCME) and Longtop Financial (LFT), there has been a virtual gold-rush to find the next big short winners. Both professional and amateur investment researchers alike have combed the space with gusto in an effort to expose the next Chinese flop.

In doing so, they have utilized the strategy of going after the most suspicious offenders with clear red flags first and then working their way down. Using a gold mining analogy, it is logical to conclude the easiest to find "surface gold," or in this case, the Chinese equities with the most signs of potential impropriety, have already been uncovered.

As the smoke clears and Chinese sector-wide panic subsides, while the bad apples will stay justly depressed, we can expect equities like Lihua that were simply in the wrong sector at the wrong time to revalue up dramatically.

Recently, a pair of Chinese RTO equities with business operations far more controversial than Lihua had events that triggered sizable one-day rallies that would be genocidal to late-arriving shorts. Yongye International (YONG) rose ~50% on the day it was announced Morgan Stanley was making a significant investment. A few days later, Harbin Electric (HRBN) was up 59% in a single day on the announcement of the potential advancement of a buy out offer to go private.

Day by day, the game is getting increasingly dangerous for those betting on the short-side of Lihua.

  • There are currently 3.28 million LIWA shorts, representing over 20% of the float (16.5 days to cover).
  • The company is buying back its own stock. Over $2 million has already been utilized, which leaves over $12 million already booked for the buy-side.
  • With 90 million in cash and growing net profits, the buyback can easily be increased if management decides to do so.
  • With 3.28 million shares needing to be bought back, it is unlikely the short-exit will occur in an orderly fashion. It is more likely that one of many possible events will trigger a scramble.
  • It is quite possible that even a technical non-news event such as a sizable buyer entering the market could cause a downside-pattern break which could start this chain reaction.
  • It is likely only a matter of time until Asian equity funds like Morgan Stanley’s Asian Equities arm that purchased a stake in YONG, move to capitalize on Lihua’s current pro-long risk-return ratio.
  • A short squeeze could potentially be triggered if Lihua annouces it is taking steps to pursue a dual listing on the Hang Seng (Hong Kong) exchange, where there is a much lower level of skepticism in Chinese Equities and similar equities trade at a P/E ratio of 12-20.
  • With Lihua's quarterly earnings report coming within weeks, shorts have more reason to book profits ahead of a potential momentum-changing event.
  • The management of Lihua could also decide it’s more practical to operate as a private company and simply buy out the existing shares at a premium that is attractive enough to be accepted.

Conclusion

It is said there is a time for everything. There was a time where shorting Lihua as a sector momentum play worked and could be considered strategically justifiable. That time has now gone.

Source: Lihua International: A Chinese RTO Equity You Should Not Be Shorting