China Direct: Star on the Horizon

China has the fastest growing major economy in the world, with an average growth rate of 10% per year for more than two decades. Its basic materials sector has been particularly strong, given the almost insatiable demands of industry. China Direct, Inc. (AMEX: CDS) provides a unique way to participate in this phenomenal growth.

China Direct invests in China by taking majority stakes in small-to-medium enterprises (SMEs), which as a whole represent 75% of the growth in the Chinese economy. The China Direct model seeks out well-managed, profitable companies that are capital constrained. In general, these companies have a hard time accessing capital through traditional channels and, therefore, are unable to realize their potential.

Through its China-based CDI Shanghai Management division, China Direct meets with many promising SMEs every week. They are able to choose from among the best opportunities at compelling valuations. With limited options for expansion, SMEs are more receptive to China Direct’s acquisition model requirements. Invested capital is staged based on performance and is only a small multiple of the acquired net tangible assets. Existing management is kept in place and western-style efficiencies are implemented to improve profitability, thus creating a win-win situation for the partners.

Acquisitions to date have been concentrated in the basic materials sector, allowing China Direct to take advantage of the massive increase in demand within the Chinese economy. Magnesium, in particular, has been the primary area of growth for China Direct. In fact, industry observers predict that, within the next few years, China Direct will be the number one producer of magnesium in the world. Zinc and lead will be net income generators in the coming years as China Direct expands its metal operations. Yet another division, CDI Wanda, holds great promise in the area of tire recycling, but has yet to contribute much in the way of net income.

The sheer volume of acquisition candidates that CDI Shanghai Management sees allows the company to leverage this division by providing consulting services via CDI Consulting to other companies seeking to participate in the fast-growing Chinese economy. CDI Consulting is a highly profitable division of China Direct, yielding net margins in the 60%+ range over the last year.

At the time of its 3rd quarter 2007 earnings release on 11/14/2007, the company provided 2008 guidance of at least $20 million net income on revenues exceeding $270 million. The fully diluted share count at the time of this writing is approximately 21 million, thus indicating guidance of $0.95 earnings per share for 2008. Considering this guidance, the stock represents a substantial value at a price of $6.80 as of the close on 2/1/2008. This represents a forward price/earnings ratio of 7.15 in an industry where it is common to value stocks at 18 to 20 times earnings per share. The midpoint of this valuation range implies fair value at approximately $18.

According to management, this guidance is not inclusive of any additional acquisitions. However, since the 11/14/2007 earnings release, there have been two important acquisition announcements. The first announcement, Jixiang Mining on 11/29/2007, gives the company sole mining rights to a parcel of land in the Yongshun Kaxi Lake Mining area. The Ministry of Land and Resources has approved the annual mining of 10,000 metric tons of zinc and lead. Reserves are estimated to be worth $54 million at current prices and management expects the operation to yield 30% net margins. The second announcement, letters of intent to acquire Baotou Xinjin Magnesium Co. Ltd. and Baotou Sanhe Magnesium Co. Ltd. on 12/19/2007, is even more significant. While this deal has not been finalized as of this writing, the company estimates total annualized revenues of $80 million and net margins of 10% associated with these two entities for 2008.

The forward price/earnings ratio, coupled with the additional acquisition announcements, makes this a compelling buy. Nevertheless, existing shareholder dilution is a concern, as China Direct currently has approximately 2 million outstanding Class B warrants with an exercise price of $10. The proceeds from the exercise of these warrants will be used to make more accretive acquisitions, thus enhancing shareholder value; however, the supply may dampen any upward move in the stock as the warrant holders exercise. Despite this, China Direct enables investors to capitalize on the exciting growth prospects of the world’s fastest growing economy in one of its fastest growing sectors.

Sentiment: Strong buy

12-month price target: $20

Disclosure: Author has a long position in CDS

Comments

[J.D:]

SMEs make up 75% of the growth in China? Such a claim puts the credibility of the piece in serious question. Let's see some specific evidence before CDS starts investing in Chinese ant farming.

2008 Feb 04 07:09 PM