The Long Case for General Steel Holdings

General Steel Holdings (GSI) is a producer of high quality steel products in China. On October 3, 2007, the stock moved from the OTC bulletin boards to Amex. It has no analyst coverage and, thus far, has almost zero following in the financial press. The stock, which closed on October 5 at $12.73, represents an exciting opportunity to participate in China’s massive infrastructure build-out and economic development. The current stock price represents an estimated 2008 p/e of 5.6. It is only one of two Chinese steel companies quoted on US markets, the other being China Precision Steel (CPSL) which supports a 2008 p/e of 25.

Traditionally the Chinese steel industry has been highly fragmented with over 1,100 separate players, most of which are still state owned enterprises [SOE]. Historically, many of these had low quality output and were uncompetitive compared to large global steel producers. The Chinese Government has declared that the country needs a strong indigenous steel industry capable of competing on a world stage. As such it has afforded Chinese steel companies certain advantages over foreign companies. The Government introduced plans to have the existing industry privatized and consolidated into a handful of efficient companies and also decided that antiquated plants must close. The closing of antiquated plants also ties into China’s plans to cut energy consumption and greenhouse gases by eliminating 55 million tons of inefficient steel making capacity by 2010. To further assist the local Chinese companies in their consolidation efforts the Government prohibited foreign companies from having controlling interests in steel SOEs. In essence, a highly attractive playing field has now been created for a select number of Chinese steel companies.

GSI is at an advanced stage of becoming one of the remaining dominant players in China’s steel industry. In outlining its strategy in February 2007 at Roth Capital Partners*, the company presented its financial expectations as follows (millions, except EPS):

The initial stage of GSI’s consolidation strategy involves a 4-phase M&A program to compliment its original business. After acquisition each company then undergoes a multi-stage expansion and efficiency improvement program using modern Western techniques and business standards. Recall that government-owned industries by their nature, especially in former communist countries, have widespread employment rather than profitability and efficiency as important goals. GSI, with its experienced management, is proving to be well positioned to acquire and manage SOEs on target price earnings ratios ranging from 1.5 to 5.

Original Business

GSI was the first non-government owned steel company in China, then called Tianjin Daqiuzhuang Metal Steel [DQ], founded in 1989 and specializing in steel for agricultural machinery where it has 50% market share nationally. With the cash-rich government now providing strong support to the poorer hinterland the Chinese agricultural vehicle market is anticipated to grow strongly in coming years. DQ’s annual sales are expected to grow from $142m in 2006 to $259m in 2010. DQ is 100% owned by GSI.

M&A #1: Baotou Steel Pipe JV (Baotou)

Based in Inner-Mongolia, Baotou’s products are mostly for the oil and energy sector. GSI owns 80% of the JV, acquired by initially paying Rmb 50m in cash, approx $6.7m. Expected annual sales $26m in 2007 rising to $64m in 2010. The JV commenced business in July 2007.

M&A #2: Shaanxi Long Men Iron & Steel JV (Long Men)

Long Men is located in Shaanxi, a bridgehead province linking Northwest China and the Eastern seaboard. It has fully integrated capabilities; mining, coking, iron making, steel making – fewer than 10% of Chinese steel companies have this capability. Long Men also has mineral rights for an iron ore mine with reserves of 300 million tons and annual production capacity of 3 million tons finished product. It is ideally located to serve the Western Region and has no major competitor within 250 km giving it a significant pricing advantage. Development of the Western Region is a top 5 priority of the Chinese Government in their 2006-2010 Plan for Economic Development. This M&A is a major scale-changing transaction for GSI with anticipated annual sales for Long Men of $1.1bn in 2007 rising to $2bn in 2010. Long Men’s sales and profits are approximately 7 times those of GSI’s original business, DQ. The Long Men JV is 60% owned by GSI, acquired by an initial cash payment of Rmb 300m, approx $40m. The JV commenced June 1, 2007 and one month’s sales & earnings are reflected in GSI’s Q2’07 results.

Note that GSI in this instance has paid $40m for a business expected to produce a net income of $19 million on a full year basis in 2007 ($9.5m for 6 months), equating to a p/e of 2. This is an example of the exceptional deals available to well positioned companies such as GSI in the consolidation of China’s steel industry.

M&A #3: TBA

This is a Coastal Region steel company already in private ownership. Negotiations are well underway. Located in a prime domestic and international transport hub, its existing owners are considered to be inexperienced steel producers. The company sells predominately to the construction industry – an industry with a very bright future in China. GSI believe they can bring major improvements to the business. Expected annual sales of $923m in 2008 rising to $1.17bn in 2010. This is anticipated to be 80% owned by GSI with the acquisition consideration being 10m shares. Expected to be completed late 2007.

M&A #4: TBA

One of China’s leading SOE steel companies and a dominant player in the transport infrastructure product market, it has 30,000 employees, a nationwide sales and distribution network as well as international sales offices. Expected annual sales $3.8bn in 2009 and $4.4bn in 2010. This is assumed to be a share based transaction. Expected completion; late 2008.

M&As: Other

GSI’s participation in China’s steel industry consolidation does not end with M&As 1-4 listed above. Items 1-4 only represent M&A’s that are either already completed or at advanced stages of completion. Over the next couple of years progress is expected to be made with regard to further acquisitions.

General Comment Regarding M&A Transactions in China

M&A deals in China are very long arduous processes, taking 1-2 years or longer from start to finish. GSI management understand that a more inclusive approach to M&A is a better solution for all concerned. It has found that the joint-venture solution provides the best advantages in terms of swiftness in gaining official approval and ultimately consummating the respective M&A transaction, whilst also retaining the possibility that GSI may ultimately gain 100% ownership at a later date.

Overall Picture

It is insightful to view how all these M&A units add together in tabular form, both in terms of sales and profits, in order to appreciate the magnitude of the positive change that GSI is undergoing. The net profits figures are “profits after tax and after minority interest”. All figures in millions.

Update to Projections

All the above projections are as provided by GSI in February 2007. Since then, the Baotou and Long Men transactions were both completed for cash ($46.7m) whereas they had been expected to be share deals (15m shares). Additionally since February, the company published Q1’07 and Q2’07 financial results, these being:

• Q1’07: Sales $37.6m Vs $26.6m in Q1’06. Net Income $0.7m Vs $0.37m in Q1’06
• Q2’07: Sales $121m Vs $29m in Q2’06. Net Income $2.3m Vs $0.15m in Q2’06

The Q2’07 results deserve further attention. In Feb‘07 the Long Men JV was anticipated to be on an annual net profits basis for 2007 of $19.0 million (after tax and after minority interest). It was also assumed this JV would take place on July 1, 2007, hence the inclusion of $9.5m net income for 2007 from Long Men in the presentation. In fact the JV became effective early, June 1, 2007 and GSI’s Q2’07 results included one month’s sales and income from it. For that month, June 2007, the Long Men entity alone produced a net income for GSI of $2.4 million (after tax and after minority interest). This JV was expected to produce net income for GSI of about $1.6 million per month, implying the June results for Long Men were an earnings ‘beat’ of 50%. In September 2007 GSI again participated in an investor presentation where this 50% ‘beat’ was confirmed (presentation not publicly available on the internet but a copy may be obtained from GSI, refer slide 16). Whilst this ‘beat’ is a positive development, steel businesses are not always linear and it may be imprudent to assume that Long Men profits will be 50% ahead of the expectations for all the remaining months of 2007.

In updating GSI's forecast EPS assume the following:

• Profits per entity unchanged from the Feb‘07 presentation
• Interest cost of 10% per annum on acquisition costs for Baotou and Long Men, being $2.7m for 2007 and $4.67m annually thereafter, ignore tax effect thereon
• For 2007 use 32.4m total share base, same as actual as of end Q2’07
• M&A #3 occurs at end 2007, effected with 10m shares
• Ignore M&A #3 in late 2008 for the moment as this is not on immediate horizon
• Ignore possibility of Long Men JV profits being ahead of expectations

Management

GSI has a high quality management team. Of particular note;

• Henry Yu, founder and Chairman. Amongst others, he is a representative for China on Asia Pacific Economic Cooperation (APEC) Development Council, a person well connected in China and highly respected outside.
• Zhang Dan Li is President & Chairman of Long Men.
• Du Quing Hai is General Engineer at Beijing Industrial Design and Research Design Institute with 40 years industry experience and holds 4 patents for elements of blast furnace design.
• Fred Hsu is Managing Director of Sagem Communications, part of Safran Inc, a global 500 company based in Paris, France.
• Ross Warner, 18 years management experience with companies working in Asia.
• John Chen, CFO, holds a California CPA license.

Events to Watch

1. Q3’07 earnings release

These will be due about November 20, 2007. The Feb’07 presentation indicated full-year 2007 EPS of 35 cents. In the preceding table the Revised Forecast suggests that on a like for like basis EPS should be 41 cents for the year. Given that YTD Q2’07 EPS were 7.5 cents this leaves 33.5 cents to be earned in the second half of the year, equivalent to $10.9 million net income, or about 17 cents / $5.4 million net income for each of Q3 and Q4. Bearing in mind that the Long Men JV alone produced net income of $2.4 million for the month of June the company ought to have little problem in achieving net income of $5.4 million in Q3 and again in Q4. Investors should expect the company to match or beat its earnings expectations of 17 cents EPS in Q3.

2. M&A #3, due late 2007

This JV transaction has been in the pipeline for a long time and is an event highly likely to occur soon. Whether or not all the various approvals, Government and otherwise, are obtained by end Q4’07 is not yet known publicly. Either way this M&A transaction is set to have a major and positive effect on the company’s sales, earnings and EPS in coming years. Refer to Net Profit section in table under paragraph ‘Overall Picture’ above. The announcement of this successful M&A transaction is likely to have a positive effect on GSI’s stock price.

Share Price

The only Chinese steel stock quoted in US markets other than GSI is China Precision Steel (CPSL). It recently issued earnings guidance of $14m net income for 2008. CPSL stock currently trades at $10.00 giving the company a market capitalisation of $348 million and puts it on a 2008 p/e of 25. When GSI concludes M&A #3, its EPS estimate for 2008 becomes $2.29. For reference, applying the same 25 p/e multiple to GSI equates to a stock price of $57.

Summary

GSI is at an advanced stage of becoming a dominant player in China’s huge steel industry. Its stock is very much undiscovered at this point with no analyst coverage and, as yet, virtually no following in the investment press except for the briefest mention by Barrons on July 2, 2007. The company presented at Roth Capital Partners in February 2007 and again in September. It appears the GSI story was not well understood and was met with some disbelief by a number of would-be investors. Given the enormous upside on offer this is understandable in a sense, especially considering that the stock was only listed on the OTC market at that time. However, because the company has already taken a major step forward via the large-sized Long Men JV effective June 1, 2007, the financial results over the coming quarters will clearly demonstrate the credibility of the lofty financial projections issued in February. Most likely the share price will move up in spurts from time to time as significant events occur and are made public. On October 3, 2007, GSI stock moved from the bulletin boards (GSHO.OB) and traded for the first time on Amex (GSI). On Friday, October 5, the stock closed at $12.73. This equates to a 2008 p/e of 5.6. I believe within a few months from now, by which time M&A #3 is completed, it should easily trade at $35 or more, being 15 times 2008 earnings. As we progress further into 2008 GSI stock is likely to trade closer to $45 or $50, being 20 times 2008 earnings or 15 times 2009 earnings. Or it may trade higher on the back of China receiving favorable media exposure during Olympic year. In either event I consider GSI stock to be exceptionally good value at current levels and is an excellent infrastructure play on China’s economic development.

References

• General Steel Holdings Inc web site
• Roth Capital Partners presentation, February 2007
• Q1’07 earnings announcement
• Q2’07 Earnings Announcement
• Q2’07 Earnings SEC filing
• Barron’s

Disclosure: Author owns shares in GSI which he holds as a long-term investment.

Comments

[HH99]

A superb analysis from a true expert on Chinese companies.

[HH99]

A superb analysis from a true expert on Chinese companies.

[J.D]

I've never seen a Chinese industry plan for the steel sector which includes privitization. Any reference? Generally, plans for consolidation will favour major state-controlled players, while inefficient plants are being retooled and re-opened (not simply closed) which does nothing for the prospects of reasonable steel production growth (which is astronomical). How GSI fares could depend on the guanxi of its controlling shareholder. Generally, steel in China seems to be a real estate play, with 50% of output going to construction. If that sector slows (no talk of bubble there, right?) the market will be flooded with supply, which I take it would be back for margins.

[MasterP]

GSI does have coverage. Roth recently initiated coverage

[Amine]

Thanks for the presentation. If your numbers are accurate, the stock is indeed ridiculously underpriced. My only concern is industry specific. While the cycle hasn't turned yet for the Steel industry, we're close to its fifth-year run. When you look at X, NUE and other Steel players, their stocks haven't recovered as much as the indices that comprise them. That said, you can't really apply these caveats to this particular name :
- First of all, this is a solid Chinese Steel player that's playing a major role into a consolidation phase.
- The management is highly regarded and well connected.
- China's demand for Steel isn't waning anytime soon
- The name is comparing very cheap to US and European comps
- The prospects for future growth through acquisitions are promising

All in, I agree with you that this is an unbelievable bargain right here (~ $13.5) and that the mispricing will gradually disappear as this name gets more coverage from the Street.

[jjah]

great report Kevin. However, on page 4 in your price tgt you apply a 25 multiple to 08 eps of $2.29. However, on page 1, GSIs '08 est is only $1.81, implying a tgt of 45.20 - still not to bad for a $12 stock!!!

[CaboRick]

Who is Kevin Brennan ? I googled him and could not find anything , except this well written article. I like the GSI story, but got a tad concerned he wrote it with the intention on creating some momo today for the stock sold off pretty darn hard 15 after the article was written ? I don't mean to be negative, but remain a tad leary based on todays action...

[synergyzhan]

does this company's organization structure seems complicated to anyone else? feels like they are making money thru series of M&A but normal operation.

GSI Inc owns GS invsetment and Victory new Holding, they joint ventured the Daqiu Zhuang metal; Daqui Zhuang metal owned some other investment firm, and those investment firm owns part of Long Men....... Daqiu Zhuang owns 32% of Long Men, and 80% of Baotou......

[microman]

Nice article and analysis on GSI. I would append to the article by noting that there are several more interesting Chinese steel companies that trade on US exchanges, albeit the OTCBB. These are SUOT.OB, PUDC.OB, and TNRO.OB. Of these three, SUOT seems to be the most deeply discounted based on EPS and growth rate.

[richandmer]

GSI just reported their 1st quarter earnings. Very Disappointing. Price has dropped down to $8.26 and looks to drop further.

Just curious what your thought are now on GSI. Their sales appear to be doing fine, but earnings is much more elusive. Love to hear your comments.

[User 213238]

excellent article; thank you very much.