I published an article entitled “Shanghaied by Shengkai?” at the end of March, where I suggested that auditors, underwriters, original investors, and PR firms could not be trusted to have done their due diligence. Preceding that article, I had found encouragement in the positions and verbal affirmations of Shengkai Innovations (VALV) from these individuals and organizations. The realization that I could no longer count on these opinions and supposed due diligence came with the alleged frauds involving China Media Express (CCME) and China Integrated Energy (CBEH).
Since that time, I have been working with another investor, Rich Molpus, who was able to point me in the direction of several individuals who could assist me in my search for the truth on Shengkai Innovations. I still feel exactly the same in regards to not being able to trust the finance professionals, but I do feel that we can trust the customers and distributors of the company’s products.
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As can be seen from the chart above, VALV’s value has fallen precipitously as fraud exposure increased and uncertainty within the sector grew to new heights. On top of all of this, it is my belief that the above average volume in May, June, and July resulted from the liquidation of several millions of shares from Vision Opportunity of China Fund (VNOPF.PK), which is returning funds to shareholders.
I can tell you with some certainty that VALV produces ceramic valves that perform the way they are advertised. I have spoken with two U.S. based distributors of SK ceramic valves who distribute them to power, industrial, and petrochemical companies in the Midwestern, Northern, and Northeastern parts of the country. The first distributor, John Petrick, stumbled upon Shengkai while during a web search through the American Petroleum Institute looking for something new. He notes that VALV’s products are “unique” and said “there is nothing like them in the world.” According to John, ceramic valves have been a long time coming in industries where steel and other types of valves wear out so quickly that they are effectively useless after a few months.
John mentioned a power plant in Ohio that had been searching for valves that would not wear out after a month or two in operation. This plant had tried several alternatives, most recently rubber-seated valves, and was having to replace the valves every two months or so. John installed SK ceramic valves at the end of 2009 and those valves are still in use today. I tried to ascertain the identity of this company, but because of competitive issues, John was not comfortable releasing such information to me.
John mentioned that he does not believe Shengkai has proper quality inspections before its products are installed in the field. He hopes for quality inspections to reach a higher standard. John also mentioned that there have been instances of careless mistakes that were made with basic issues during the installation process in the past, but he is happy with the product overall.
Morad Cheriki is another supplier of SK valves in the United States. Morad speaks very highly of SK valves and has not experienced the same quality/installation issues that John had mentioned. Through his network of distributors, Morad has sold valves to Republic Engineered Products, a U.S. steel company that has been in operation since 1886. Republic had tried several SK valves as a trial and, according to my contacts, then ordered eight more once it was satisfied with the performance. I have contacted the plant manager in Lorraine, OH to verify the installation of these valves, but he has not returned the calls.
Midwest Valve Parts is another company in the U.S. that distributes SK valves. I called it to discuss its feelings towards SK valves. Citing a new relationship with Shengkai, it would not give me any information about whether it or its customers were satisfied with SK valves, though it did confirm carrying the valves.
For further evidence of the valves' existence, I have included pictures of the valves and of the manufacturing facilities. These pictures come from walkthroughs done by investors as well as ones that were provided to me by Morad Cheriki.
Now that we have confirmed that Shengkai’s products are real, we have to determine if its revenues and margins are believable. Shengkai boasts gross margins of 60%, which are far higher than its competitors that sell steel valves. I spoke with John about the relative pricing of each unit and he told me Shengkai’s products are substantially more expensive. For instance, a metal-seated ball valve might sell for $1,000. A comparable ceramic valve might sell for $2,000. An 8-10 in. knife gate valve might sell for $1,000-1,500. SK knife gate valves might sell for $5,000-7,000.
As you can see, SK has significant pricing power due to the longevity of its products. SK can charge several multiples over steel valves for its products because they are far more durable, but I do not believe the production process requires several multiples of expenses to produce the valves. While I cannot definitively say that this would produce margins of 60%, it sure makes sense why its margins are substantially higher than those of its steel valve competitors.
So why has the stock price fallen from a high of $10 down to the $1.30-1.50 range? As mentioned above, fear of fraud certainly placed huge downward pressure on all Chinese reverse mergers. A portion of Shengkai's fall could possibly be explained by supply and demand. When supply of a company's shares exceeds the demand, prices fall. This will happen regardless of the company's fundamentals.
How do you get excess supply? You have institutional shareholders trying to sell millions of shares of an illiquid stock. I believe that Vision Opportunity of China Fund is selling its block of over 10 million shares. Volume has been 3-5x higher than the volume in January-March for the months of April, May, June, and much higher than that for the month of July.
There were 1.4 million traded on April 11 and 1.8 million again on June 8. There were 1.4 million shares traded on July 7. Lastly, another 2.3 million shares traded on July 13 and an astounding 5+ million shares traded on July 14 as the stock rallied after GeoInvesting's report. Somebody large was selling and now it looks as if someone large is buying. These volume amounts are huge for a company with a float of 8 million shares.
So why do I think that VOC is selling? VOC stated that it's given the investment advisor its 12 months notice for discontinuation of its services and also mentioned that it will begin returning capital to shareholders. The letter also mentions that VOC had built up cash of $11.5 as of March 31, and that this cash position had increased to nearly $23.4 million as of May 23, when the letter was written. The company discloses an NAV of $74 million near the end of March. This suggests that 32% of its portfolio was in cash by May 23. Shengkai represented about 37% of the firm's NAV.
It's possible for VOC to have moved into having 32% cash without selling Shengkai, but it was unlikely. Especially when you consider that there was a lawsuit filed against the company for $380 million (look under "contingent liabilities where it states the directors believe that not all the claims will be dismissed"). A company with net assets of $74 million being sued for $380 million with an open SEC investigation and directors who borrowed heavily to increase their personal stakes means that they would have huge pressure to sell and preserve what cash they had regardless of how they felt the portfolio companies would perform.
Regardless if VOC was selling or not, there has been huge volume recently and most of it has been to the downside. I would like to be building investor confidence in Shengkai once again. The Sequoia fund is the largest institutional shareholder according to 13-Fs that were filed for the quarter ending March 31. The Sequoia fund has an excellent track record and was essentially started to absorb the partners who were invested with Warren Buffett’s partnership after he stopped managing money. A lot could have happened over the last three months, and the fund's positions could be larger or even non-existant today, but the very fact that it held a position is a bright spot amidst all of the negative surrounding the sector. In about another month, the new 13-F will come out and we can see what it's done with its position over the past three months.
Also, on July 13 I became aware of a newsletter sent out by GeoInvesting.com that reads:
Based on preliminary information, The GeoTeam has begun to initiate a long position in Shengkai Innovations (NASDAQ: VALV). We intend to provide details of our reasoning behind this move, but right now we are electing to be nimble and to take advantage of the current price.
VALV spiked nearly 40% within hours of having received the notification and 15% the following day. I have found the evidence towards Shengkai compelling and have been buying more and more shares over the past couple of months.
With all of that out of the way, let's look at the compelling value that we have in Shengkai Innovations. In the four quarters that had ended March 31, I estimate that Shengkai made about $23.3 million in profits after excluding extraordinary items that are largely attributed to the fluctuations in its outstanding warrants. With 37 million shares outstanding, this would result in ordinary earnings per share of $0.63 per share. Management expects earnings of $31-34 million for the fiscal year that ended June 30. This would represent earnings of about $0.88 per share.
I expect Shengkai to maintain its double digit growth. Growth could slow from recent quarters, as there is not currently another facility under construction that will triple capacity again; however, additional machines and additional shifts can improve output in the near term. In the company’s last conference call, there was a hint that the company may consider adding another factory in the near future after the current factory’s output is maximized.
Shengkai currently trades at less than 4x its current adjusted earnings per share or at 66% of its tangible book value. The company reports having $50.5 million in cash but the total market capitalization has been fluctuating around $40-60 million. All of this while it has been growing at double digit rates.
This article intended to build confidence in Shengkai by displaying definitive proof that the valves do exist, and that they do behave as advertised. I also sought to provide evidence that could justify its gross margins while supporting its reported revenues. Global Hunter Securities also affirmed the management’s revenue guidance after touring the facility in April and seeing the production capacity. By itself, Global Hunter’s affirmation means little given the recent events; however, when considered with all of the other evidence that I have been able to compile, it provides for a very compelling buy.
Assuming that the VIE structure is legally enforcable in China, which I believe it is, then I feel that $10 per share is a very conservative estimate of potential value achievable over the next year.
Disclosure: I am long VALV.