Lihua International: A Growing Business With At Least 50% Upside

| About: Lihua International (LIWA)
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Introduction

At its current market quotation, China-based Lihua International (NASDAQ:LIWA) is a value investor's dream. Despite a market cap of ~$150 million, growing earnings and cash flows, and an unlevered balance sheet, the company is trading at far less than its net current assets-an extreme rarity in today's markets. At the moment, there is significant concern about the recent slowdown in China's economic growth, as investors are unsure about the long-term consequences of China's recent transition of power and how it will affect economic policies and laws regarding treatment of non-state-owned enterprises. This uncertainty over the Chinese government's potential economic reforms has caused many institutional investors to remain cautious, keeping their money out of China until the new leadership provides a clearer indication of any future economic reforms. Once this happens, large investors will start investing more money into China, causing unique market inefficiencies such as Lihua to disappear.

Business Overview

Lihua International is a company that develops, manufactures, markets and distributes refined copper products in the People's Republic of China. Among the copper products the company produces are copper anode, copper rod, fine and superfine pure copper wire, and copper-clad aluminum fine and superfine wires. Lihua sells its wire-based copper products directly to small electronic motor manufacturers, who then in turn sell to companies in the consumer electronics, automotive, utility and telecommunications industries. Lihua sells copper anode to a few large cathode producers in China, which convert the copper anode into copper cathode, the fundamental building block for most pure copper products. The company was founded in 1999 and is based out of Danyang, the Peoples Republic of China.

Since going public in 2009, Lihua has expanded its line of products. Prior to 2009, the company had primarily focused on the copper-clad aluminum fine and superfine wires. In the first quarter of 2009, the company began production of copper rods from recycled scrap copper; in August 2010, the company began production and sale of copper anode and increased refined copper smelting capacity to 50,000 tons per annum. In October 2011, Lihua completed capacity efficiency improvements to two copper smelters, and in 2012 the company focused on copper anode expansion, completing construction of two new copper anode smelters.

Steep Discount

My goal is to demonstrate that the company is priced at a steep bargain by at least ~50% based purely on the company's fundamentals. To do this I will use Benjamin Graham's "net net" investing approach that he created to identify undervalued stocks based on their net current asset value. As Graham described in The Intelligent Investor, the purchase of a stock at a price below current assets less total liabilities is a "golden opportunity," as the investor is essentially acquiring plant, property and equipment and all other assets for free. Further, because the stock is trading at less than its current assets, there is no growth whatsoever priced into the stock. If management were to liquidate a company and distribute the liquidated assets to the shareholders, the company's liquidation value would be at least the value of its working capital. Thus, buying a "net net" stock is as close to a sure thing as you can find in the market-you are paying a price less than the company's liquidation value and acquiring capitalized assets and any future growth for free. At the very least, the market is expected to correct the company's quotation to net current asset value, and any growth in the business is merely an added bonus for the shareholder.

As of March 31, 2013, Lihua had current assets of $247,368,779. With total liabilities of $19,812,898 (comprised as all current liabilities), the company has a net current asset value of $227,555,898. Dividing by the number of shares outstanding, the company's net current asset value per share is ~$7.66. With a current market price per share of ~$5.02, the company is trading at about two-thirds of its net current asset value. To reiterate, the company's share price could increase by over 50% and would still only be trading at its working capital value, with no growth prospects whatsoever priced in.

Discussion

This extremely low valuation would be plausible if Lihua was a declining business with a bleak future, but by all accounts the business is growing at a rapid pace. As described in the business overview, the company has made significant capital expenditure investments in its copper production capabilities, demonstrated by its increased net revenue growth from ~$370 million in 2010 to ~$854 million in 2012, an increase of ~130%. Gross profits and net income have increased by ~44% and ~51%, respectively, since 2010. Diluted net income per share was $1.34 in 2010, $1.77 in 2011 and $1.93 in 2012, an average annual growth of ~22%. At its current price of ~$5.02, the company is trading at a miniscule ttm P/E ratio of ~2.60, an absurdly low multiple for a company with such high recent earnings growth that is still in its expansion phase. Operating cash flows have also shown stellar growth, increasing from ~$30 million in 2010 to ~$49 million in 2012, an average annual increase of ~32%.

State of the Chinese Economy and Future Policy Questions

Given the preceding discussion, a skeptical investor should wonder why such a seemingly glaring inefficiency has not yet been corrected. A potential factor leading to Lihua's undervaluation is the fear and uncertainty weighing on the Chinese economy.

Since the Asian financial crisis of 1998, China's economy has consistently exceeded the government's annual economic growth target. This year, however, China's economy is projected to grow exactly on pace with the 7.5% goal it has set for itself. Going forward, economists fear that China's spectacular rate of growth over the past decade will not be sustained, and China's growth will gradually slow down. Since a credit crunch in June in which China's central bank withheld liquidity to control the behavior of irresponsible lenders, China's stock market is down ~13%, reflecting fears of an economic downturn in the region.

A Reuters poll showed that activity in China's normally robust manufacturing sector may have declined in July for the first time in ten months, signaling a reduction in domestic and international demand for manufactured goods. If China's manufacturing activity continues to contract, the basic materials industry could suffer. The iPath DJ-UBS Copper ETF (NYSEARCA:JJC) is down ~14% year-to-date, and there are fears that continued manufacturing slowdown may drive copper prices even lower.

Much of the uncertainty surrounding the future of China's economy will be cleared up when the government's new leadership unveils reforms at the next meeting of the Central Committee of the Communist Party of China, expected to be held in October. President Xi Jinping has reportedly "taken charge of sweeping economic reform plans to revitalize the economy." Some potentially hopeful news for Lihua is that the government has indicated it may encourage private enterprise through increased lending to non-state-owned enterprises and tax breaks for small businesses. Once investors get a better idea of the direction of China's economy, increased institutional funds will pour into China. Currently trading at ~50% below net current assets and almost a dollar below cash per share with only ~22% institutional ownership, Lihua can not be expected to trade at such attractive valuations for much longer.

The current environment of uncertainty and caution provides an interesting opportunity for contrarian investors to gain exposure to the Chinese market at a depressed price. Even if manufacturing continues to slow down and copper prices drop in the near future, the extreme price discount of Lihua's stock provides more than an adequate margin of safety to protect against more negative economic data.

Word of Caution

Any investor considering an investment in a Chinese company must take extreme caution, as there is always an underlying concern of fraudulent activity. There have been many instances of Chinese companies with accounting policies that are not in accordance with American GAAP, thus misleading investors who took financial reports at face value. In the case of Lihua, the financial statements were audited by Crowe Horwath, a prominent international accounting firm. According to Accounting Today, in the United States Crowe Horwath ranked ninth in net revenue among the top 100 public accounting and consulting firms in 2013. In Lihua's 10-K report, Crowe Horwath wrote, "In our opinion, the consolidated financial statements referred to above present fairly, in all materials respects, the consolidated financial position…and the consolidated results of their operations and cash flows." While this affirmation of the company's financial exhibits is a reassuring sign to potential investors, it by no means guarantees the authenticity and accuracy of the reported numbers.

Conclusion

Lihua's uniquely cheap valuation provides investors with an opportunity to purchase a stake in a growing, debt-free business at less than its net current asset value. In the next few months, China's new leadership is expected to reveal significant economic reform to stimulate the Chinese economy, which will increase demand for basic materials such as copper and encourage increased foreign investment from many large institutional investors. In today's markets, stocks trading at below net current assets are few and far between, and investors should-at the very least-give serious consideration to any such opportunities that arise.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.