China BAK Battery: Prepare for the Short Squeeze This Week

Apr.10.07 | About: China BAK (CBAK)

Another week of consolidation supports our thesis that China BAK Battery Inc. (NASDAQ:CBAK) increase in selling volume is a direct result of its Form S-1 filing as well as shorts boarding this train for a short ride.

The Highlights

• 20 March 2007, Form S-1 filed offering 4,581,205 shares of CBAK’s common stock for resale by a group of selling stockholders.
• Average Volume 3-months at 286,551. Average Volume 10-days 903,387.
• On 3 April 2007, CBAK files Form 8-K announces dismissal of KPMG. Hires PKF as its principal accountant. Says change of accountants will help reduce costs and maintain same level of service.
• 4 April 2007, stock hits 52-week low of US$ 2.85. Accumulation of the stock accelerates (see Charts below).
• 5 April 2007, stock bounces back to US$ 3.20, up 9% for the day.

Expect short-covering support to further accelerate price increases this week.

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CBAK 5-day performance

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CBAK 10-day performance

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Analysis of past two-week trading volumes

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There is a substantial build up of front month June Call open interest at $ 7.5 (1,019 contracts) and $5 (1,411 contracts). Puts are concentrated at $5 (795 contracts) for June. This is another development worth noting.

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Financial Checklist

Is CBAK a solid investment? We review some financial metrics to identify red flags signaling a troubled stock.

1. Declining Goss Margins: Gross margins are under pressure.

In Q1/2007 gross margins was 19%, down sequentially from 25.62% in Q4/2006 revenues and down as well from 27.1% recorded for the same period last year Q1/2006.

2. Increasing Accounts Receivable [AR] to Sales Ratio [S]: AR/S ratio is decreasing.

When AR/S ratio increases on a Quarter on Quarter basis it is a red flag. Receivables increasing faster than sales suggest customers are taking longer to pay their bills. The primary reason is "channel stuffing." Customers receive longer payment terms to entice them to order products.

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3. Rising Net Income and Declining Operating Cash Flows: CBAK’s net income is rising. Operating cash flows, albeit negative, are also improving.

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4. Consistent EPS Growth: EPS growth has declined.

In Q1/2007 EPS was reported at $0.07, down sequentially from Q4/2006 when the reported EPS was US$ 0.10. Q1/2007 EPS was flat as compared with the same period last year Q1/2006 at US$ 0.07.

5. Are Insiders Net Buyers of Company Stock? Insiders are net buyers of the stock.

In a Form 4 filing, CFO, Han Yongbin, reports acquiring 136, 566 shares, in open market direct transactions, from 26 December 2006. He owns a total of 448,822 shares in the Company.

Zou Yanlong, Liu Hourde, Zhang Shuquan, all Vice Presidents in the company, have each acquired 34,142 shares in open market transactions during the same period.

CEO, Li Xiangqiang, owns 20,143,662, or 41.2% of total common stock outstanding.

Conclusions

The market for Lithium-ion products for use in cell phones and other portable consumer electronics is massive. The market is estimated at $2.5 billion and growing at 15% to 20% annually. CBAK is well positioned to benefit from this growth. There are 416 million cell phone users in China. This user base is expected to grow by another 250 million in the next 5 years. Cell phones in China have a life cycle of 5-7 years as they are sold and resold downstream to consumers with less disposable income. This installed base of cell phone users and their need for replacement batteries is another market that CBAK has harnessed successfully.

Fundamentally, the long-term growth story remains unchanged. Demand for lithium-based batteries is growing rapidly and will continue to do so. Any company servicing this market as an OEM provider, leveraging China’s cheap cost base for low cost skilled labor must experience both revenue and margin expansion.

CBAK shares rallied 9% on 5 April 2007. The pullback in the shares is contained and provides an entry point to begin accumulating a position in CBAK.

Disclosure: The author does not have a position in CBAK at present. This can however change in the near future.