China Ritar Power: Wind At Its Back

China Ritar Power Corporation (CRTP.OB) sells lead-acid batteries where there are an estimated 1,500 manufacturers competing in China alone, it is dependent on end-user markets that are adversely affected by the slowdown in the general economy, it is dependent on volatile lead prices that soared in the past year which depressed margins, and sells today at approximately 29x last years reported earnings.

Sounds terrific, right?

Well, maybe not at first glance. But if the company executes its strategy, today’s stock price is a bargain. The company is already profitable with robust demand and is making a major move to expand its presence in the worldwide marketplace that has not yet attracted the attention of the wider investment community. The company is focused on serving niche markets, expanding capacity, and using vertical integration to lower its input costs. Even better, the valuation is actually more compelling than what it appears on the surface.

Niche Markets

Lead-acid batteries serve the energy storage market, predominantly in the automotive field but also in telecommunications, uninterrupted powers source [UPS] devices, light electric vehicles (scooters, bikes, etc.) and alternative energy production (solar and wind power). While the price of lead soared in 2007 (but has since stabilized somewhat), it is still the cheaper alternative to materials such as lithium and nickel and is expected to remain the dominant secondary source of energy for the foreseeable future. Most lead-acid manufacturers compete in the automotive market on price where differentiation is difficult. China Ritar Power has decided instead to serve the niche markets of telecommunications, uninterrupted powers source (UPS) devices, light electric vehicles [LEV] and alternative energy production (solar and wind power) where they believe margins and growth are more promising.

The company derives most of its revenues from outside China with overseas sales accounting for 78% of total revenue in its latest quarter. It has over 170 customers with no one customer accounting for more than 15% of total sales. Their results have been encouraging to start the year. In the first quarter of 2008, revenues increased approximately 118% compared to the same period in 2007. The company credited this increase mainly to sales of UPS and telecom batteries in overseas markets, where countries like Brazil, India, Thailand, and Vietnam are rapidly expanding their telecom infrastructure.

The company’s decision to enter the solar and wind power market is also showing encouraging early signs. CRTP reported revenue from the solar and wind sector in the 2Q08 increased 90% to approximately $3.8 million compared to last quarter. This is especially encouraging because the solar and wind market provides the highest margins for the company with gross margins of 35%-40% compared to an estimated 18% in the UPS market. These results provide some early validation for management on their decision to focus on these growing markets and should provide increasing growth opportunities for the foreseeable future.

Capacity Expansion

Despite focusing on these smaller niche markets, the company was unable to meet its customer needs in 2007. Per its 2007 annual report, the company was only able to meet about one-third of the demand from their clients during the peak period for their products. To address this shortfall and enable them to meet increasing demand in its markets, the company used the proceeds of roughly $12M from a reverse acquisition to aggressively increase working capital and expand capacity including building an additional manufacturing facility in the Hunan Province. It opened in March of this year and it is expected that this facility will help double capacity in 2008. They hope to quadruple capacity over the next three years and say they have land available at this site to expand even further if it makes sense.

Vertical Integration

The company is also moving upstream in the value chain to help improve margins. In a simple illustration, the value chain of the lead-acid battery market (gross margins in parenthesis) is:Mining (50%) à processing (15%) à lead plate construction (15%) à battery manufacturing (20%) à end customer à battery recycle. In the near-term, China Ritar Power will use their new manufacturing facility in the Hunan Province to enter the lead plate construction segment with a longer-term goal of becoming involved in lead mining. The lead plate production line is expected to have already begun operating in June of this year which the company hopes in three years will provide lead plates for approximately 50%-60% of their batteries. This is noteworthy since the company says lead plate construction comprises approximately 85% of the cost of lead acid batteries and by doing this production in-house it will eventually provide a 3%-5% improvement in gross margins. Longer-term, the company is looking to move further upstream by entering into mining in either a direct role or in a mining alliance which should further increase margins and provide a long-term source of raw materials.

Compelling Price

First, let’s consider how the stock got to trade where it is today. At the time of the reverse acquisition, the company entered into a Lock-Up Agreement with each of the executive officers and stockholders of the Ritar International Group which prevented them from selling any of their shares of the common stock for a 12-month period.

When the twelve-month period ended in February, 2008, this thinly traded stock plummeted from $11 to its current price of approximately $4.00 as the shareholders took their substantial profit in the acquisition. It has failed to generate much interest since this point due to what could be considered general discontent in the marketplace and a non-cash compensation expense that is lowering reported earnings.

This non-cash compensation expense also relates to the February 2007 acquisition in which the company’s CEO entered into a “make-good” escrow agreement with the private placement investors. The CEO, Mr. Jiada Hu, deposited 3.6 million shares in escrow at this time and the agreement stated if the Company meets certain ''make good'' provisions (after tax net income of at least $5.7 million for the fiscal year 2007 and $8.2 million for the fiscal year 2008), the shares are to be released back to Mr. Hu. As a result of reaching the 2007 target, approximately $3.9 million was recognized as a compensation expense in 2007.

In 2008, the company will expense approximately $3.9M for this agreement but it will have no impact on the company after this year. The compensation expense requires no expenditure of cash for the company and it has no effect on the number of shares outstanding. However, it did lower reported earnings in 2007 and will continue to do so for the rest of 2008. But by focusing on niche markets in rapidly growing markets such as solar and wind power, expanding capacity to meet demand and integrating into other areas of the value chain, China Ritar Power is positioning itself as quite a growth story. Removing the temporary non-cash charge to earnings, the company is trading today at 11x previous year’s earnings and 7x expected earnings for 2008.

Given that it trades over-the-counter and can be very volatile, this stock might not be for everybody. However, at its current levels, it offers a solid risk/reward potential for investors interested in gaining exposure to the growing wind and solar markets in China. With their new manufacturing facility starting operations this quarter and the early success of their entry into the alternative markets, things are looking promising. Their story is not out yet, but it may not be a secret for much longer.

Disclosure: Author holds a long position in CRTP.OB