Warren Buffett Would Love Special Situation Company China Gerui

| About: China Gerui (CHOP)

I am a director and investor in China Gerui Advanced Materials (NASDAQ:CHOP) since inception so I ought to know something about the company. China Gerui, better known in the US by its NASDAQ stock symbol CHOP, is greatly undervalued, perhaps by tenfold. While other stocks may trade at a market value less than revenues and less than cash, few such companies have the growth, operating margins and balance sheet of CHOP. Moreover, CHOP has better comparables than almost all steel companies and is the #1 specialty steel company in China with a rising 12.5% market share in cold-rolled narrow-strip steel. The low valuation accorded CHOP stems from widely publicized accounting irregularities in two dozen Chinese companies, most of which went public through reverse takeovers (RTOs) involving a lower level of SEC scrutiny than IPOs. By way of contrast, CHOP is not an RTO, has filed thorough S4 and F1 Registration Statements, has no accounting irregularities, and has a growing cash trove of $225 million from operations and the exercise of warrants. The company recently completed a $70 million plant expansion which has doubled, yes doubled, capacity. Production from the new plant recently started and will ramp up to full capacity over the next three years.

A sample of what may lie ahead came with the issuance of Q3:1l results versus a year ago: revenues +63%; net income +76%; fully diluted EPS +48% despite a 21% increase in shares outstanding due to the exercise of all outstanding public warrants in March 2011.

In the three years ended 2010, China Gerui increased net income an average of 50% annually even while operating at nearly full capacity of 250,000 metric tons of narrow-strip steel. Many of its 200 customers wanted plated steel and wide-strip in addition to narrow-strip sheets. China Gerui responded by increasing capacity 60% in Q2:11 and 40% at year-end. It will take three years for the new production lines to attain full capacity. Most of the new production will be chromium-plated priced approximately 18% higher than unplated steel. Moreover, gross margins on plated steel will exceed 35% compared to 29% for unplated steel. Net margins averaging 19% will rise accordingly. Hence, a doubling of capacity translates into more than a doubling of revenues and earnings.

Compared to other steel companies, China Gerui’s profit margins are 2x higher, inventory turns are 3x higher and the ratio of receivables to revenues is 1/15. With the many attributes of China Gerui one would think that CHOP would trade at a premium, especially since it tops competitors in most operating and financial comparisons. Instead, CHOP sells at a severe discount compared to steel stocks or even to overall stock market indices. After a three-year period of moderate but steady growth due to capacity constraints, Q3:11 results indicate to me that CHOP may be poised to increase both revenues and earnings by 40% annually through 2013.

China Gerui has a clean balance sheet (9/30/11) featuring zero long term debt, $225 million in cash and an additional $104 million in restricted cash against short-term revolving loans of $176 million. The current ratio is a healthy 1.5. At 12/30/11, CHOP’s market value of under $200 million was less than unrestricted cash and about half the company’s guidance of $345 million in 2011 revenues. An analysis of comparable P/Es is informative. According to an 11/11/11 report on CHOP issued by Global Hunter, the P/E ratio was 1.7 on estimated 2012 earnings of $1.98. An 11/17/11 Oppenheimer report on China Gerui shows average 2012 P/Es for steel companies as follows: China 14.1, Hong Kong 13.8, US 8.6.

A more sophisticated measure of a company’s value is the PEG ratio, or P/E divided by expected growth. Approximately 70% of the companies in the major indices sell at PEG ratios of 1.0 or better compared to my expectation of a ratio of 0.04 for CHOP predicated on a 1.7 P/E and a growth rate of 40%. At a PEG ratio of 1.0, CHOP’s stock would rise 25x. CHOP’s accelerated growth rate due to the plant expansion may create a PEG ratio for CHOP that is far lower than the company with the lowest PEG ratio in the S&P 500 or NASDAQ 100 (0.04/1.4).

Why are the results of CHOP so good? There is a shortage of precision, ultra-thin steel in China leading to high demand that will benefit from China’s determination to transform from an export-oriented to consumption driven economy. Its plant is in one location, Zhengzhou Henan, in the heart of China, midway between Beijing and Shanghai. The GDP growth rate in China far exceeds that of the US and China is the world leader in both the manufacture and consumption of steel with a market share of 50%. CHOP has its pick of steel companies that supply it with commodity rolls of hot-rolled steel. The customer base has grown to over 200 (all domestic) making a variety of products including cans, fiber optic cables, mobile phones, decorative metals and cigarette lighters. Over half of revenues come from consumables. Sales are cost plus, 30% paid on order and 70% on customer pickup 2-4 weeks later. Operating margins are captured in every step of production including the conversion of hot-rolled steel into cold-rolled steel, acid-pickling, stretching and cutting, annealing and plating. China Gerui has fully automated the process of converting rolls of thick steel into steel as thin as .05-.25 millimeters with a tolerance of .003 millimeters.

Management, led by Chairman Lu Mingwang is stable, highly experienced and entirely focused on specialty steel. Major competitors are huge steel companies with specialty steel a very small part of their business. Competitors sell in bulk while CHOP customizes shipments.

Since China Gerui has operating results that are far superior to other steel companies, it is fair to consider China Gerui a special situation company. Steel companies are cyclical in nature. China Gerui has experienced growth through all market cycles. The down side for CHOP appears minimal while the upside is high. For my money, give me a high growth stock with a P/E of 1.7 that is #1 in its market selling at less than cash and revenues instead of a high flying social media stock selling at a P/E of 50. A higher P/E and PEG for CHOP seem inevitable.

Disclosure: I am long CHOP. I am a director and investor in CHOP.