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China BAK Battery, Inc. (NASDAQ:CBAK) manufactures a variety of standard and customized lithium ion rechargeable batteries for use in applications including cell phones, laptop computers, power tools, digital cameras, video camcorders, and other devices. CBAK has recently announced a planned new research center in Shenzhen, and a new factory located in the Tianjin Beichen Hi-Tech Industrial Park, to develop a new line of lithium ion batteries. The price chart follows:

click to enlarge
cbak

CBAK has been an interesting stock to follow over the last year. It has gone from a peak of almost 14 in March of last year to the current 4. CBAK has obviously been an excellent short opportunity during this time period. Ironically the decline in stock price has occurred contemporaneously with continued increases in revenues. The revenue chart follows:

cbak

The reasons for the share price decline have sequentially unfolded. As can be seen from the chart revenues in the third quarter of 06 declined. This was accompanied by lower EPS. Soon after the weak third quarter there was the announcement of a federal patent infringement law suit filed by UTSA against CBAK and Black and Decker. The suit is about the high density lithium ion technology. In the fourth quarter CBAK reported record revenues of almost 50 million, however, EPS was only .10 due to $3.7 million ($0.08 per diluted share) in one time ‘non-operating and nonrecurring items’.

Were it not for the one time items, fourth quarter EPS would have been a record .18. Finally, in the first quarter of 07 EPS was down to .07. The reason supplied by CBAK in their press releases and earnings conference for the weak first quarter was decreasing margins. Revenue for the first quarter of 07 was also slightly down at 43 million. The EPS chart follows:

cbak

The crucial issue regarding CBAK is why is EPS on the decline while revenues continue to exponentially increase? I don’t accept the company’s explanation of lower margins and will try to give some reasons.

Let me start with the least substantial: gossip. Several months back there was gossip on the CBAK message board at Yahoo that was subsequently shut down. ‘InsideCBAK’ posted some interesting articles that I skimmed over, not realizing just how important they would be. He claimed that the ‘chairman’ and other insiders wanted the price to go down so they could purchase more shares. He pointed out that these people can purchase shares in other names easily in China.

His timing was a bit off, but it tipped me to a valuable point of view that helps explain why this stock trends in advance of bad news. I follow this stock closely and can say it is my clear impression that it moves in advance of inside news. I wouldn’t put shorting shares past this group. Shorting before bad news and buying back low could be very profitable. All I am saying is don’t assume this would not happen. Some more substantial reasoning tends to confirm this outlook.

First, let’s make an estimate of what first Q1 07 revenues would have been compared to Q4 06 without the ‘decrease in margins’. (Please stay with me on the math here.) Revenues for Q1 07 were 3.1 million less. This should scale rounded up to 0.01 less in EPS. Since there was no 3.7 million charge in the first quarter against income that makes .08 more in EPS. We then have a total increase of .07 for Q1 07 compared to Q4 06. Since the fourth quarter was .10 the first quarter should have had and EPS of .17, but the reported EPS was 0.07 or 0.10 less than it should have been. I do not believe that CBAK’s margins increased drastically enough from one quarter to the next to lower EPS by .10. Let’s take a look at a CBAK image that I got from the SEC site:

cbak

I don’t think it is such a strong balance sheet, but look at the 9 million increase in shareholders’ equity over the last quarter. Net Income first quarter 07 is only supposed to be 3.6 million but somehow shareholders’ equity has gone up by 9 million. Now I apologize for the review it is mostly for myself and anyone else that is not sure about shareholders’ equity. Investopedia says:

Shareholders’ Equity = Total Assets – Total Liabilities

“Also known as "share capital", "net worth" or "stockholders' equity," Shareholders' equity comes from two main sources. The first and original source is the money that was originally invested in the company, along with any additional investments made thereafter. The second comes from retained earnings which the company is able to accumulate over time through its operations. In most cases, the retained earnings portion is the largest component.”

Over the last two quarters, it is the second source that would be relevant: retained earnings. But retained earnings is just the same as net income less dividends and CBAK has no dividends. If shareholders’ equity increased by 9 million then they should have had at least 9 million in net income, but they only reported 3.6. CBAK’s balance sheet is improving by leaps and bounds all the while net income is supposedly very low.

This gives support to the theory that insiders at the company are trying to set up a low share price so they can buy more shares. It appears that the company is disguising it’s net income. If not I invite anyone to please explain how the balance sheet can improve by an amount greater than twice net income. (By the way the fools at Motley fool say money is flying out of CBAK’s corporate windows. Not the case it is mysteriously flying in. They also received 1 million from the local government.)

Another point on margins: If margins are so low for CBAK what is going to happen to companies in Korea, Japan and the US that pay $20.00 an hour for labor instead of .50? If the margins are low that should be to CBAK’s advantage.

Final confirmation of all this would come in the form of insider purchases. But as explained above, don’t assume they will use their own name. I would expect that anytime now there should be or already has been insider purchases, but so far I can’t find any. All that is reported is lots of insider sales that took place prior to this year. Look at the volume at the base of the February price slide. It is interesting to speculate just who it was buying those shares. I personally will not rely on the expectation of reporting. I will buy on a trend, but I will also wait and watch for a report of insider purchases.

My own prediction is that when the company is ready and everyone there has had time to buy the shares that they want then the margins will improve and with increasing revenues EPS will increase five fold. After al,l 5 x .07 is only .35 and they would have had .18 in Q4 06 if it were not for the one time charges. Revenue almost doubles every year and we are already in Q2 07. If the PE ratio also multiplies by say 2, which is where it should be given the growth rate that would lead to a very significant increase in the stock price. One slight hold up could be money required to finance their new operations in Tianjin. The Tianjin facility will not produce until 08 at the earliest.

On the other hand, at some point people will have to recognize the growth potential of this company. After it reaches its final low point things may begin to come together for CBAK all at once: new contracts, improved EPS, price momentum, and continued growth.

Advice on CBAK: Don’t make your mind up about what should happen. This company offers too many surprises for that. Follow the trend.

Disclosure: I am long CBAK

Source: Follow The Trend On China BAK Battery