Rick Pearson's  Instablog

By contrast, recently uplisted stocks such as Puda Coal(PUDA Quote), China Agritech(CAGC Quote) and Rino International(RINO Quote) are still holding onto double-digit gains following their first-day listing pop. One stock that is providing all of the positive clues of an impending uplisting is Orient Paper(ORPN Quote).

Based on its current attractive valuations and uplist potential, ORPN could provide an IPO-like pop, with even more upside remaining for long-term holders. With a single-digit P/E ratio and plenty of cash, ORPN offers a lot of upside potential with minimal downside risk. (Note that due to its recent reverse split, many financial data sources will have an incorrect share count and thus an incorrect P/E ratio for ORPN. The current P/E is approximately seven).

A recent article on Bloomberg titled "IPOs Unravel as Aviv Shelves Share Sale Amid Record Low Returns" noted that:

"The U.S. company IPOs in the past two months have beaten the benchmark index for American equities by 0.5 percentage points in their first month of trading, the worst performance in Bloomberg data going back to 1995. Thirteen of 18 companies are trading below their initial sale price, Bloomberg data show."

Some IPO highlights are as follows:

Dole Foods(DOLE Quote) recently raised $446 million in its IPO and fell nearly 2% on its first day of trading. It is now trading at $11.63 vs. its IPO price of $12.50.

Shanda Games raised over $1 billion from its ADR IPO and is now down 15% from the offer price. Likewise, RailAmerica(RA Quote) is down by 20%. A summary of recent IPO underperformers is as follows:

For smaller investors, getting allocated shares in an IPO comes with a well known contradiction -- the winner's curse. If the IPO is a hot one, and likely to perform well in the aftermarket, it is almost impossible to get an allocation of shares.

If the IPO is a dud, and likely to underperform in the aftermarket, it is much more likely that retail investors will get their orders filled. I feel that a much safer strategy is to look for underfollowed companies that show all the signs of an imminent uplisting.

An "uplisting" is where an OTC traded stock takes steps to formally list on a major exchange, typically the Nasdaq or Amex, occasionally the NYSE.

Prior to uplisting, companies will typically take some very recognizable steps to meet the exchange criteria, including 1) restructuring their board of directors such that a majority of directors are independent 2) creating the required board committees (audit, compensation and nominations committees) and 3) undergoing a reverse split to meet the minimum share price criteria of the exchanges ($3 minimum for Amex, $5 minimum for Nasdaq).

One great example is Orient Paper. The company is in the business of producing various paper products, including corrugated and photo quality paper. The company trades on a single digit P/E despite very strong revenue growth and huge gross margins. The company recently raised $5 million from institutional investors (including China America and Renaissance Capital) to expand into the photo quality paper business in China -- a business that has 60% gross margins and high barriers to entry (such as government approvals and environmental requirements).

I like the deal because it has a well defined and profitable use of proceeds and included no warrants or convertibles to complicate the capital structure. ORPN shows all the signs of an imminent uplisting including restructuring its board to meet Nasdaq/Amex corporate governance requirements and a just-announced reverse split to meet the senior exchange share-price requirements.

From its Oct. 9 press release regarding board member changes: "Following these changes, Orient Paper's board of directors is now comprised of five directors, three of whom are independent. The Company also established Audit, Nominating, and Compensation Committees."

Having these committees and a majority of independent directors are explicit requirements of both the Nasdaq and the Amex, and the company's choice of wording in the press release reflects these requirements almost verbatim. As a result, the press release seems to be telegraphing this clear objective.

Yesterday, the company effected a 1:4 reverse split, putting the share price well above the required threshold for a Nasdaq or Amex listing, and as a result, the only remaining step is to be approved for listing.

Other things I like are that ORPN has recently ramped up its efforts to attract institutional investors, including attendance at institutional investor conferences (Roth, Rodman&Renshaw, Brean Murray) and appointing CCG as its investor relations agent.

I recently had dinner with Chairman Zhenyong Liu and I have spoken with CFO Winston Yen by phone, and I like what they have to say; it is clear that they have a "big cap mentality." The company is committed to growing the business in a profitable way and committed to expanding its institutional investor base.

I currently own shares of ORPN and my hopes are for an eventual double or triple once it trades on the Nasdaq or Amex. The company has offered to let me tour its facilities, and once I do so, I plan to post a follow-up article here including photos of the facilities and a management interview.

The reason I like to pursue the uplist strategy is that it is achievable and profitable. Unlike trying to claw one's way into an IPO allocation, shares of ORPN can be purchased in the open market today.

Unlike an IPO issuance, there is no phenomenon of insiders and VCs trying to time a hot market to unload shares at an inflated price. Instead, the uplisting represents the beginning of the institutions just getting into a newly available stock.

I currently track a number of potential uplist candidates, but ORPN is what appears to be the most likely and most imminent. Once the uplist occurs, it is typically too late to get the pre-list valuations.

Looking back to September, China Agritech rose nearly 12% on the day of its uplisting and currently trades at a level 20% above that. Puda Coal rose by over 20% on the day of its uplisting and still trades at a substantial premium. While the timing and execution for an uplisting by ORPN is not certain, I think it offers enough downside protection that the smart move is to get in sooner rather than later.

At the time of publication, the author was long ORPN.

Apple Computer (AAPL) soared nearly 8% in after hours trading on Monday following its release of revenue and earnings that easily topped analyst estimates.   This performance bodes very well for makers of lithium ion batteries such as China Bak Battery (CBAK), Advanced Battery Technologies (ABAT) Hong Kong Highpower Technology (HPJ) and China Digital Communication Group (CMTP.OB), none of whom has yet released quarterly results.  All of these stocks are public and liquid, however they trade on very different multiples so investors should select carefully.  CBAK is one to avoid for now, while CMTP.OB could be the next home run.  ABAT and HPJ look fairly

valued, but could benefit further if there are any positive earnings surprises.

Inside every ipod, iphone and Apple laptop is a lithium ion battery.   The lithium ion battery has become smaller, more energy efficient and longer lasting, effectively replacing the previous generation of Nickel Metal Hydride batteries.  CBAK, ABAT, HPJ and CMTP.OB are all competitors in this market and are currently enjoying high margins as demand for products such as those made by Apple continues to soar.  Apple’s strong results provide a great barometer for what to expect from upcoming earnings reports by these battery makers, all of whom should enjoy a strong pick-up in revenue. 

Following the IPO of A123 Systems (AONE), CBAK’s stock price is up by over 50% as enthusiasm has grown  for next generation battery makers.  But like A123, CBAK is a money losing company.    I would expect to see significant revenue growth from CBAK this quarter, but  unless CBAK can effectively double sales from the previous quarter, it is unlikely to breakeven in the coming quarter.  Following its recent run-up from below $3.00 to nearly $5.00, the company is currently valued at a $260 million market cap despite only making a small profit in one out of the past 8 quarters.  Despite the hype for batteries, this is a stock that should be avoided by investors who focus on fundamentals. 

HPJ has also enjoyed a spectacular run-up due in large part to the A123 IPO.   The stock was trading at $1.38 in August and now trades in the $4.00-5.00 range.  The stock looks intimidating based on its ttm PE multiple of 30x, but this doesn’t factor in HPJ’s huge  growth potential.  The company recently signed a contract with Siemens Gigaset Communications GmbH to supply batteries under the Gigaset name in Europe.  This demonstrates some concrete progress in HPJ’s transition from being a supplier of Nickel Metal Hydride batteries into a producer of higher margin Lithium-ion batteries.   The current wave of good news is already factored into the share price, but there could still be room for more upside if HPJ reports very positive quarterly results.  The company already put out an interim report saying that sales for July and August are up 8% vs the comparable period one year ago.

These positive results for Apple and HPJ bode extremely well for China Digital Communication Group (CMTP.OB).  The company derives 68% of its revenues from lithium ion batteries for hand held consumer devices such as MP3, MP4 players, cell phones and cameras.  Despite significant revenue growth, the company still trades at around $9-10, a ttm PE of only 7x earnings.  As a result, any positive surprise in earnings could put this stock up close to the $20-25 mark, in line with HPJ .   The company has gross margins in excess of 30% and over $10 million of cash with no debt. 

Today A123 Systems (AONE) reached $28.20, implying a market cap of approximately $2.0 billion.  This is more than double its IPO price, and triple the low end of the initial IPO offering range.  Investors are clearly placing a lot of hope in A123’s technology, but are also clearly ignoring the company’s fundamentals and playing the stock for its momentum.  At the other end of the spectrum, other lithium ion battery plays such as China Digital Communications (CMTP) are also trading out of line with their fundamentals, but are undervalued rather than over valued. 

In my last article on A123 I questioned the valuation of A123 when it was trading around $18 per share and I received massive amounts of feedback suggesting I didn’t understand the potential for A123’s lithium iron phosphate technology.  I responded to many of these emails with a  simple question:  “What revenue and margin forecasts are required to justify the current valuation of A123 ?”.   I received zero responses which actually answered the question, so I decided to construct an analysis of my own.

From the IPO prospectus, one can see that A123 has 2 business lines, battery products as well as R&D services.  The majority of revenue and presumably the basis for growth expectations is derived from product sales, so I will confine my analysis to this part of the business.

Historical financials are as follows:

All numbers in US$ millions except %s

A few key things to note here.  First, A123 has negative gross margins.  Every time it sells another product, it loses a bit more money, although in 1H 2009 it did start coming close to being able to sell its products for above what they cost, coming only 7% short.  Second, even if A123 were selling its products at a profit, its operating expenses are still greater that 100% of revenues.  Clearly numbers like this make it impossible to value A123 in a traditional way and assumptions are necessary to make any kind of a forecast.  To do this, I created a few very generous hypothetical scenarios and tried to answer my original question: “What revenue and margin forecasts are required to justify the current valuation of A123 ?”.   I assume a generous full year hypothetical 2009 and then compare it to a very generous hypothetical 2011, making assumptions for revenue growth and margin improvement.  My analysis looks like this.

All numbers in US$ millions except %s

From the table above, it can be seen that in order to justify a P/E multiple of 100x, it will have to do the following things:

-          quadruple revenues

-          transform from negative gross margins to margins of 25%

-          maintain operating expenses at current levels with no increase

-          pay no income taxes due to tax loss carry forwards

If A123 does all of those things, net income should be around $20 million and the current valuation of $2.0 billion will represent a P/E ratio of 100x.  With the exception of the tax losses, none of this seems particularly likely.

Compare this to a different lithium ion battery maker, China Digital Communications (CMTP).  CMTP makes standard lithium ion batteries for portable devices and has a direct comparable company, Hong Kong High Tech Power Co (HPJ).   CMTP is highly profitable, with gross margins in excess of 30% and net margins of over 20%.  The company has no long term debt and the market cap consists of 30% cash.  CMTP is in the same business as its Shenzhen neighbor HPJ, but while HPJ trades at a P/E of 21x ttm earnings, CMTP trades at only 5x earnings.  

For CMTP, I can see 2 reasons why the stock trades at a discount its fundamentals and close peer.  First, CMTP is not nasdaq listed.  Second, CMTP has no research analyst coverage.  To the extent that these factors change, CMTP is easy to benchmark against HPJ and should be trading at a price in the low $20’s, up from its current level of only $6-7.  This would place it on a P/E similar to that of HPJ in the low 20’s. It is notable that as recently as August, HPJ was an under-followed company as well and traded at $1.38 (a  P/E of 9x) when coverage was initiated by Rodman & Renshaw.  Less than 3 weeks later it traded as high as $3.89.

With A123 on the other hand, I can still see no reason to award a $2.0 billion valuation.  But if anyone can better answer my question above, I would be eager to hear an informed opinion.

The author can be reached at comments@pearsoninvestment.com

Disclosure:  The author holds a long position in CMTP

Battery maker A123 Systems (AONE) priced its $378 million IPO last night, selling 28.1 million shares at $13.50 each.  The stock will begin trading today. The Company increased the deal size by almost 10% even after raising the offering price by 50% from the initially indicated range.  Even if this IPO soars in the aftermarket, don’t feel too bad about being left out of the party because there are much smarter ways to play the lithium-ion battery market.  Like China Bak Battery (CBAK), A123 is a money losing company trading on an excessively high valuation.  Profitable alternatives such as Advanced Battery Technologies (ABAT), China Sun Group (CSGH.OB), Hong Kong Highpower Technology (HPJ) and China Digital Communication Group (CMTP.OB) all make for a better fundamental investment. 

This week will see two more US listed China “up-listings”, both of which enjoyed a substantial run-up in price. China Agritech (CAGC) will begin trading on the NASDAQ on Monday and Puda Coal (PUDZ) which will begin trading on the AMEX on Tuesday. CAGC was up as much as 10% on Friday and PUDZ actually closed up 22%.  Other China stocks which have up-listed this year have also been top performers.   As detailed below, the top 3 stocks on my up-list watch list are:  China Biologic Products, Inc. (CBPO.OB),  China Digital Communications (CMTP.OB) and L&L International Holdings (LLFH.OB).

To get a better feel for the upside potential of up-listings, I teamed up with Maj Soueidan, President of GeoInvesting, LLC.   Geoinvesting.com has one of the most comprehensive databases which specifically follow US listed China small caps.  As a result, it is one of my favorites.  Some of the findings from Geo:

-          RINO International (RINO) up-listed to the Nasdaq in July and initially saw its price jump 10% from $9.10 to over $10.00.  Since up-listing, the stock has traded as high as $17.75 – almost double its pre-Nasdaq price.

-          Deer Consumer Products (DEER) was trading at $8.00 in July when its NASDAQ approval was announced. The stock traded up over 50% in 1 week, to over $12.00 and currently trades at $12.74.  It reached a high of $14.00 in August.

-          China Bio Energy (CBEH) was trading at $5.00 in July and then rose 10% on the day of its NASDAQ approval.  It now trades at $6.42, almost 30% above its pre-Nasdaq levels.

Tracking potential up-listing candidates is well worth the effort because up-listings typically result in a significant inflow of new investor demand to a previously underfollowed stock.  There are many institutional investors who may be very interested in a specific sector or company but who will simply not invest in an OTC stock.  As soon as the stock becomes Nasdaq or Amex listed those funds will jump in immediately, giving the stock a boost.  Due to the lack of institutional following, many research analysts are reluctant to initiate coverage on OTC stocks, which in itself contributes to a lack of investment by institution funds. 

In order to identify and track potential up-listing candidates, it is important to understand the criteria for an up-listing and watch for OTC traded companies that are actively looking to fulfill these criteria.

The most obvious criteria which issuers seek to satisfy are stock price thresholds and corporate governance requirements.  The Amex requires a minimum share price of $3.00 and the Nasdaq requires $4.00. As a result, small cap companies who intend to up-list will typically undergo a reverse split in order to meet the minimum share price level.  DEER, RINO, CBEH, PUDZ and CAGC all underwent this identical process.

A second tip off is a ticker change or other corporate governance changes which are done to accommodate the listing.  For example, Puda re-incorporated in Delaware just prior to the up-listing.  Another change to watch is changes to the composition of the board of directors.  These are done to satisfy listing requirements at the Nasdaq and Amex which require a certain minimum number of independent directors on audit and compensation committees. 

A third tip off is when institutional investors are already taking an interest in an OTC stock.  This was the case for both CAGC and PUDZ, who both presented at Rodman & Renshaw (RODM).  It is also the case for potential up-listers LLFH and CBPO, both of which still trade OTC. 

China Biologic Products, Inc. (CBPO.OB),  China Digital Communications (CMTP.OB) and L&L International Holdings (LLFH.OB) all show signs of being in the next round of up-listings.

-          CBPO recently presented at the Rodman & Renshaw conference in New York and recently raised over $9 million in a private placement. The company completed its reverse split in 2008 and currently trades at $5.80, well above the threshold for Nasdaq or Amex

-          L&L also attended the Rodman & Renshaw conference.  Last year the company conducted reverse split and changed their accounting firm to Kabani & Company, a well known US listed small cap firm. The stock is currently trading at $4.75.

-          China Digital has publicly stated that they are looking into an up-listing and the company is currently looking to hire an international CFO.  Following its 10:1 split in July, the company now trades at $4.30.

Many investors had accurately predicted the up-listing of Puda and China Agritech for much of this year, and yet when the up-listing occurred, there was still a significant run-up in the stock price.  Why does this profit opportunity persist ?  I believe it is simply because institutional funds and research providers avoid OTC stocks, leaving that category of investing to the individual investor.  For those of us willing to play this corner of the market, this seems like one case where the individual investor might have an actual advantage over the institutions.

Disclosure:  The author is long shares of CAGC and CMTP.OB