Shengtai Pharmaceutical Attractive at Current Levels

Shengtai Pharmaceutical (SGTI.OB) is the largest domestic producer of pharmaceutical grade glucose in China. In 2006 SGTI began the process of bringing production of their primary raw material, corn starch, 'in house' by building a cornstarch manufacturing facility. This serves to increase margins & provide a steady supply of quality raw material required to reliably expand glucose production. SGTI are expanding existing glucose production by 50% to 90000 tons/year by mid 2007. They are also building a new glucose production facility that will have annual capacity of 150000 tons per year. SGTI have make good clauses in place related to a private placement that call for 2007 FDEPS of 0.33 & 2008 FDEPS of 0.43. However, based on their last calendar quarter ASP & margin along with projected capacity expansion they will probably earn 60 cents per share or more over the next 4 quarters. At a modest 10x multiple, that represents >100% total return given the stock's current price of $3.30

The Company

SGTI is based in Changle County, Shangdong, China. Given the business they are in, this is a prime location since Shangdong is one of China's leading corn producing provinces & Changle County is not far from ports. So SGTI have ample access to a primary raw material for starch production & easy access to points of export.

In calendar 4q06 Shengtai commissioned a new internal corn starch plant. This plant replaced third party raw material supply to SGTI glucose manufacturing lines. This means improved supply, increased margin, and better quality control for the company. Ultimately the new starch plant will have 300k tons/year capacity, but as of September of 2007 it had ramped to 240k tons/year.

Currently, SGTI are aggressively expanding glucose production capacity from 60k tons/year today to 90k tons by mid year 08 & 240k tons by EOY 08. This isn't the type of glucose that goes into your favorite sports drink, either. It's pure, sterile, pharmaceutical grade glucose. The type a doctor might inject into your arm or drip into your bloodstream through an IV. Barriers to entry are higher as the production process is more exacting. That's why quality control of the raw material (corn starch) is critical.

The company has about 750 employees. Based on a 28nov07 stock price of $2.85 & 23.57MM shares outstanding SGTI have a market cap of a little more than 67MM. SGTI currently trades at about 1.3x fiscal year 2007 sales & 8.6x fiscal year 2007 net income. That's a little misleading, though, since SGTI turned in sales of 19.4MM & net income of 2.7MM in their first fiscal quarter of 2008. Since their business is 95% non-seasonal, that means the company is currently trading at about 0.87x annualized 1q08 sales & 6.2x annualized 1q08 net income.

The Business

Shengtai primarily manufacture pharmaceutical grade glucose. To the extent that they have excess corn starch production that can't be utilized by their glucose production lines, they also provide raw materials to the food & beverage industry. Also, they are developing sodium gluconate (new product as of June 2007, ~3% of 1q08 sales) & avermectins (their only seasonal product).

Historically, the company has not had enough production capacity to satisfy demand. In an effort to alleviate bottlenecks & improve efficiency SGTI have initiated a two part expansion to increase capacity. The first part of the expansion process brought corn starch production in house to insure ample supply of quality raw material. Their 3rd party supplier was capable of 120k tons/year corn starch production. As of 3q07 SGTI's internal corn starch facility had capacity of 240k tons annually.

Now, the bottleneck has moved to actual glucose production capacity, and this is the second part of Shengtai's expansion plan. Currently, they have 60k tons/year capacity but are expanding existing facilities by 50% to 90k/year capacity. This expansion will take place gradually over the next 6 months, reaching full capacity by the middle of 2008. At the same time, they are also building a brand spanking new glucose facility that will have 150k tons/year capacity. Construction of this facility has been delayed by bad weather but the company hopes to have it on line by 2h08. If they meet that schedule, 2h08 glucose capacity will be 240k tons/year, or 60k tons/quarter...essentially quadrupling capacity.

Currently, starch production exceeds glucose production & excess starch is being sold into the open market. So financial do not yet reflect the margin benefits SGTI will capture from their internal starch production. They produced 37237 tons of starch in their last quarter & sold 11164 tons of it as glucose. ASP was $1194 & $232 per ton of glucose & starch respectively. Gross margin was 30.3% & 9% for glucose & starch respectively.

Potential Acquisitions

In SGTI's form 424 filed with the SEC, they include boilerplate regarding risks associated with failure to integrate any future acquisitions. They also mention regulatory risks that might prevent or complicate acquisition of competitors. That's all standard stuff except when considered in conjunction with SGTI's comments regarding their competitors.

On their recent quarterly conference call, SGTI management mentioned that they are 'friends' with the management of their two largest domestic competitors. In a surprisingly frank admission, they talked about on-going negotiations with these competitors. They also talked about the fact that they might merge with them or buy them. So it's worth remembering that SGTI may acquire some of their domestic competitors in the near future. Any such acquisition is likely to include some exchange of equity.

Valuation

By the middle of next year SGTI will be able to process 22.5k tons of starch per quarter. According to their 10q, at this point 70% of starch production will be used for glucose production. I take that to mean SGTI will produce 22500 tons of glucose per quarter & 7500 tons of starch. Assuming $1100 & $230 ASP at 30% & 9% gross margin for glucose & starch, respectively, that works out to 7.425MM gross profit. About 57% of that has been falling to SGTIs bottom line (actually, more than that but let's be conservative). Using 23.57MM shares outstanding that works out to $0.18 EPS/quarter. That supports a stock price of $7 comfortably.

Longer term SGTI will have capacity to support 240k tons/year glucose production. Using the same basic assumption with a diluted share base of 29.5MM generates annual earnings of $1.50. That supports a stock price of $15 comfortably. In this context, 'longer term' most likely means EOY08 or the first calendar quarter of 2009.

Based on a stock price of $3.30, IRR & total returns are as follows:

Medium Term Model
11/30/2007 3.3
30-Sep-08 -7
IRR 145.94%
Total 112.12%

Long Term Model
11/30/2007 3.3
31-Mar-09 -15
IRR 211.06%
Total 354.55%

Disclosure: Author is long SGTI.OB.

Comments

[firboy4:]

Great article, and one I needed to read since I own a bit of stock in this fairly unknown company.

2008 Jan 06 04:31 PM