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  • An Undiscovered Gem in China’s Specialty Chemicals Industry 0 comments
    Jan 6, 2011 3:27 PM | about stocks: TPCG, ACET, SDTH
     Emerging Leader CHCC Projects $16.3M 2010 Net Income

    One of the key characteristics of a great long-term investment is an underlying business with an “economic moat” – something inherent in the company’s core product or service that makes it highly profitable, gives it a permanent edge over and protects it against existing and would-be competitors.  Warren Buffett calls it a “durable competitive advantage,” and it’s a crucial factor the legendary investor looks for when evaluating a company.

    One company that shows signs of being a business with the type of durable competitive advantage that the Oracle of Omaha so firmly espouses is China Chemical Corp. (OTC QB: CHCC), a rising player in China’s specialty chemicals industry.  Yet it remains undiscovered by the market, largely because the opportunity to invest in the company has only been available to U.S. investors since this past October.  The Company is in full SEC reporting compliance, and in November, just weeks after the stock began trading, management had already applied for a NASDAQ listing, for which the company meets all of the requirements.

    Other U.S.-listed peers in the specialty chemicals business, including TPC Group (NasdaqCM: TPCG),Innophos Holdings (NasdaqGS: IPHS), Aceto Corporation (NasdaqGS: ACET), and ShengdaTech(NasdaqGS: SDTH), trade at an average trailing P/E of 21x.  At a similar trailing P/E, which discounts the Company’s tremendous expected near-term growth, CHCC would trade in the $9.00 range, conservatively putting its potential return in excess of 130% from its recent price of $3.80.

    To watch an exclusive interview with China Chemical’s VP of Finance, click here.

    China Chemical is by far the largest supplier of maleic anhydride (MAH) in Shandong Province, with 60,000 tons of annual production capacity, and is also a major producer of phthalic anhydride (PA), of which it can produce 50,000 tons per year.  Both chemicals are key inputs in the production of a broad range of consumer goods components, including PVC pipes, packaging, film, tires, and hoses (all made from PA), as well as fiberglass-reinforced plastics, electrical components, dashboards, and bumpers (all made from MAH and its derivatives).

    While macroeconomic trends have been and will continue to be very favorable for China Chemical, the Company’s true “economic moat” is based in its local geographic market, which is largely limited to Shandong Province.  Shandong is an ideal competitive environment for CHCC for several reasons:

    •    Proximity to raw materials – Unlike its competitors, who use oil-based or natural gas-based raw materials, CHCC uses benzene, a coal-based commodity, to produce its chemicals.  Not only does it cost less than oil and natural gas, but it is also plentiful in Shandong, China’s 5th largest coal producer, giving CHCC a significant long-term cost advantage.
    •    Regulatory limitations on new entrants – Land is an increasingly scarce and important resource in China, and “new chemical industry” land is highly limited by law in an effort to reduce potential pollution and accidents.  Essentially, the government uses land rights as a tool to strongly discourage new industry entrants.
    •    Proximity to clients – As one of China’s wealthiest provinces, Shandong has a large number of factories, which translates to strong industrial demand for MAH and PA – so strong, in fact, that the Company can’t meet existing demand even while operating at full capacity.  In addition, customers all collect their purchases directly from the Company’s plant, eliminating delivery costs for China Chemical.

    In comparison, CHCC’s three largest competitors outside Shandong Province are close either to clients in wealthy areas or to raw materials, but not both.  As a result, they must incur significant transportation costs to either bring in raw materials from distant provinces or to ship the finished chemicals to faraway consumers.

    China Chemical has grown its net income from $5.6 million in 2008 to $10 million in 2009, and 2010 net income, which will be reported in March, is expected to come in at $16.3 million, up more than 60%.  Management forecasts that CHCC’s new 30,000-ton MAH plant, which came online in December 2010 and doubled the firm’s MAH capacity, will boost net income by as much as 70%, putting expected 2011 net income in the range of $25 million to $28 million.  Construction of a new plant for 1,4 Butanediol (BDO), a high-value MAH derivative, has begun and is expected to be completed by the end of 2012.  As a result, gross margin will nearly double to 50% and net income is expected to grow to $80 million in 2013.

    According to Riedel Research’s pre-listing analysis of CHCC, chemical companies in China currently trade at a median P/E of 57x. Adjusting for several overvalued outliers, the report gave a fair P/E in the 15-18x range.  According to the analyst, “at the proposed price of $4 per share we believe the shares could go up 3x to 4x before being fully valued in the near-term.” Now is the time to capitalize on this investment opportunity, before the market catches wind of its tremendous growth potential.

    Disclosure: The subject security is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. For full financial disclosures for all RedChip clients, please visithttp://www.redchip.com/disclosures.asp?src=rcv.

    Themes: China, Chemicals Stocks: TPCG, ACET, SDTH
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