Kingold Jewelry: Selling At One-Third Of An Understated NAV Consisting Of Cash, Surplus Gold Inventory And Real Estate

Summary

• Kingold is China's largest independent manufacturer of 24 carat gold jewelry.
• The value proposition is compelling: The stock is selling at 0.35x book value per share and less than 4x prospective earnings.
• Book asset value is understated and the assets consist of cash, gold inventory and real estate, including $160 million of surplus gold inventory.
• Four issues which have been overhanging the stock will be resolved over the coming year, with a series of catalysts along the way.
• The core operating business is efficient, profitable and growing.

Background

Gold jewelry plays an important role in Chinese society as both a traditional gift and a store of value. The Chinese purchase 24 carat investment grade gold jewelry in contrast to the 18 carat gold seen in most Western jewelry. Rising incomes in China have been accompanied by an exponential growth in demand for 24 carat gold jewelry. See this report from the World Gold Council.

Wuhan Kingold was founded in 2002 by Zhihong Jia who had been previously responsible for managing gold mines owned by the PLA. The company surpassed $50 million in sales in 2007, $500 million in sales in 2010 and reached $1 billion in sales in 2014.

The company went public in 2009 and did a further round of financing in 2011 at $3.19 per share. Five years later, the sales and the book value have doubled but the share price has halved.

The shares took a beating in 2015 in response to declining volumes and a falling gold price combined with investor concerns over an opaque real estate development project. The shares have recovered from their 2015 lows but remain well below the levels of the last two rounds of equity financing. We believe that the negative issues surrounding the stock are abating and investors are starting to become intrigued by the prospect of a share price of $1.40 backed by net assets per share in excess of $5.00 consisting primarily of 24 carat gold inventory.

The Value Proposition

The value proposition for Kingold Jewelry (OTC:KGJI) is straightforward. The stated book value per share is $4.03. We will further demonstrate that the book value is understated and that the underlying market value of net assets is somewhere between $5.50 and $6.50 per share. This compares to a stock price of $1.40. Importantly, these assets are fungible, tangible assets consisting of gold, cash and real estate.

Equally intriguing we have calculated that the company has 4 million grams of surplus gold inventory, worth $160 million which compares to the company's market capitalization of $92 million.

The balance sheet is relatively straightforward. The company reports in US GAAP, and a detailed 10-K can be found on the company's website. Gold inventory represents 63% of assets. The real estate development in Wuhan represents 25% of assets. Cash and tax receivables represents 10% of assets.

Based on 65,963,502 shares issued and outstanding at December 31, 2015, book value per share is $4.03.

Surplus Gold Inventory

Historically, much of Kingold's inventory represents gold purchased on behalf of its customers where the delivery price is locked at the time of the order; matched by a purchase by Kingold on the Shanghai Gold Exchange.

During the latter part of 2015, Kingold substantially increased gold inventory above production requirements, buying inventory at levels significantly below today's gold price.

This would not be the first time that Kingold has built up surplus inventory during a period of weak gold prices in order to release those reserves at a later date. In the first quarter of 2014, Kingold announced quarterly earnings per share of 24 cents well in excess of expectations. The company wryly commented that:

"The Company's gross margin was 9.1% for the three months ended March 31, 2014, compared to 2.6% in the prior year period. The increase was primarily due to the Company's purchase of large quantities of gold inventory at year end 2013 and beginning of 2014 at low market prices, resulting in much lower cost of production during the first quarter." (May 15, 2014; Kingold Jewelry Reports Financial Results For the First Quarter)

During the second half of 2015, Kingold was in a relatively unique position to acquire gold (a dollar denominated asset) funded by RMB denominated liabilities (a weakening currency). Gold closed at $1,082 per troy ounce at the end of 2015, and at the time of writing, this note is trading at $1,250.

We took two different approaches to try and estimate how much surplus gold inventory Kingold accumulated during 2015.

Firstly, we looked at the historic inventory turn of Kingold.

Kingold's average inventory turn during 2013 and 2014 ranged between 45 days and 49.5 days. Kingold is currently forecasting 50-60 tons of production. A more optimistic production target of 65 tons (higher production means higher inventory and less surplus gold) would require inventory of between 8.0 and 8.8 million grams.

According to the 2015 10-K, the company held 12,843,308 grams of leased and owned inventory on December 31st, 2015. This implies at least 4 million grams (12.8 million grams - 8.8 million grams) of excess inventory over and above production targets for the next few quarters.

Secondly, we looked at the mix of inventory. We figured that if the company was accumulating surplus gold, it would show up as raw material, (i.e gold bullion stored as bars) not as finished goods.

From Q1 2015 to Q4 2015, gold inventory held as finished goods and work in progress declined (This makes sense as the company reduced production targets as consumer demand declined). In contrast, raw material gold increased substantially from 1.3 million grams to 5.6 million grams. This was partly offset by a decrease in leased gold by 0.3 million grams (Leased gold is used to hedge the raw material requirements of production). Thus, the net increase in gold inventory held as bullion was approximately 4 million grams.

We thus concluded that Kingold has approximately 4 million grams of surplus gold over and above production requirements. This would be worth $160 million at today's gold price.

Hidden value - The value of gold inventory is understated

The company values its owned gold inventory at the lower of cost or market value. Gold acquired above market value at quarter end is written down to market value. (The company took several write downs in inventory between 2013 and 2015 which were charged against the P&L). Gold acquired below market value is left at cost.

In note 3 to the consolidated financial statements in the 2015 10-K, Kingold states the book value of raw materials at $162,766,248.

It also disclosed that raw materials consisted of 5,624,476 grams of gold, implying a book value per gram of gold of $28.94 per gram. The current price of gold is $40.18 per gram ($1,250 per troy ounce). Valued at market, KGJI's raw material gold bullion would be worth $226,038,550, implying an unrealized gain of $63,272,000 or 96 cents per share.

If we made more aggressive assumptions and revalued the entire 10,000,000 grams of inventory owned (not leased) by Kingold, the unrealized gain would be $106,044,435, equivalent to $1.61 per share. We doubt that the company will realize the full gain on its entire inventory any time soon because gains would be subject to Chinese corporation tax, so the inventory used in production will be rotated at the highest cost basis. Nevertheless, it remains an undervalued asset.

Auditing the Gold Inventory

Gold inventory is such a critical component of Kingold's value that it is worth understanding the audit trail for gold in China. We called the company's auditors to ask how they audit the gold inventory. There are four independent checks on Kingold's gold inventory. The first is the annual audit of books and records and physical inventory by the US accounting firm Friedman LLP. Secondly, the auditors can confirm the gold inventory levels through PRC tax records. Gold in China is subject to Value Added Tax such that every ownership transfer of gold creates a record of a tax liability for the purchaser and a tax refund for the seller. It is impossible to create gold ownership without a tax trail. Thirdly, gold in China is a component of monetary policy, and gold transactions are regulated by the central bank, People's Bank of China (PBC), such that all purchases and sales of gold can be verified with a counter party. Fourthly, Kingold's bank loans are secured on Kingold's gold inventory. The loan agreements released on Kingold's 8-K filings describe an independent inspection company called China Shipping Logistics Hubei Company appointed by the banks that inspects and monitors Kingold's inventory on a year round basis. With this intense level of audit trail available to Friedman, we believe that the gold inventory is real.

The Jewelry Park Development (JPD)

In October 2013, Kingold acquired the development rights to 16.5 acres of land in North East Central Wuhan. The transaction provides for the acquisition of the land rights and the construction of 192,149 square meters (approximately 2 million square feet) of mixed commercial space for a total consideration of RMB 1.0 billion (approximately $154 million). The project includes a commercial center for jewelry buyers, two commercial office buildings, a hotel and condominiums, and will be named the Kingold Jewelry Cultural Industry Park.

The JPD has been justifiably criticized by investors; nevertheless, we think the value of the asset is understated in the books and value will be unlocked over the next 18 months.

Activist investment firm Hen Reng Investments aptly summed up shareholder concerns in a public letter on July 20, 2015 where they wrote:

"This industrial park is an initiative that is hard for investors to appreciate. The only thing investors probably hate more than a company investing shareholder cash in projects outside their expertise is Chinese real estate…

Still to be proven by Kingold management is how this industrial park project is a strategic fit. Kingold's stock price indicates the market needs to be convinced…

Kingold has no experience or expertise in property development or marketing. Management has made conflicting statements on the pricing and the total value of the park. Construction has been hit by delays. There is rising uncertainty about the condition of the property market in China, including Wuhan. Company finances are tight. Meanwhile, there are no reports from Kingold's management about tenants actually secured for the industrial park expected to help finance the project… Is this non-core project still worth the risk? We would answer no."

We do not disagree with Heng Ren's sentiments but we believe that, nine months later, there is light at the end of the tunnel. We believe that the news flow has already started to turn positive on the JPD, and future news from the JPD will provide a series of catalysts that could create value for shareholders.

1. In the second half of 2015, Kingold started to pre-sell some space in the JPD. Pre-sales are carried out at a substantial discount to completion prices. Kingold's 2015 10-K reported that it has pre-sold 41,754 square meters (approximately 22% of the project) at an average selling price of 6,000 RMB per square meter (see note 8 10-K). Kingold's cost before interest charges is RMB 1 billion for 192,149 square meters equating to a cost of 5,200 RMB per square meter, so Kingold has already locked in a profit on 22% of the project.

2. After two years in the doldrums, Chinese commercial real estate has started to pick up in 2016. JPMorgan reviewing Chinese NSB commercial real estate data for January and February wrote that: "Sales momentum was very robust at... a 14% Y/Y increase in ASP. The strong sales are driven by further improvement in market sentiment and lower inventory levels, plus more policy support, and are likely to continue into the next six to nine months, in our view. Real estate investment and new starts finally reverted to positive growth after months of deterioration."

3. Construction is due to be completed in April ready for opening the project in July or August. In the conference call following the 2015 results, Kingold provided more detail on the JPD than previous calls including post completion price guidance:

Chairman: "The post-completion sales price... projections... is about MB 7,000 to 8,000, in this range, per square meter."

Also note that in the conference call the CFO confirmed that both the pre-sold and unsold development is held at cost.

So attempting to pull all this together and reconcile the impact on net asset value, we used a price of RMB 6,000 per square meter for the pre-sold portion of the property and a price of RMB 7,000 (the lower end of the companies forecast) to value the remainder of the development.

Proceeds from Pre-Sale	41,754 @ RMB 6000 per square meter	RMB 250,524, 000
Completion Value of Remainder of Project	150,395 @RMB 7000 per square meter	RMB 1,052,765,000
Less Capitalized Interest	Note 5 in 2015 10K	RMB (71,300,000)
Less Consideration		RMB (1,000,000,000)
Book Profit on JPD		RMB 231,989,000
Gain on JPD per share	65.96m shares. USD 1 = RMB 6.475	54 cents

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Based on our conservative assumption of 7,000 RMB per completed square meter, the JPD adds 54 cents per share to the NAV.

We think the assumption is very conservative. Based on the pre-sale prices from September, we think that post construction prices will be closer to 8,000 than 7,000 which would result in the JPD adding 90 cents per share to the NAV.

Value Proposition : Kingold's adjusted NAV

The book value per share at end 2015 was $4.03 per share. We believe we have shown that gold inventory is understated by at least 96 cents per share and that the JPD will add 54 cents or more per share to estimated NAV.

	Base Case	Aggressive Case
Book Value 12/31/15	$4.03	$4.03
Gold Inventory Hidden Asset	+96 cents	+$1.61
Jewelry Park	+54 cents	+0.90 cents
Estimated NAV	$5.53	$6.54

Click to enlarge

Catalysts

Kingold has been negatively impacted by four factors over the last two years. One of these, the Chinese economy, is beyond its control but will eventually get better. We detect that the other three issues that have been depressing the share price (the JPD, debt levels and corporate governance/investor relations) will be addressed over the coming 12 months, resulting in a series of positive catalysts for the stock.

1. The Consumer Slowdown hurt in 2015. Margins will start improving in 2016

China saw a dramatic slowdown in consumer spending especially in luxury items starting in mid-2014. The large publicly quoted jewelry retailers in Hong Kong and Mainland China saw double-digit declines in sales in 2015. This was accompanied by a declining gold price. Kingold rapidly revised down expectations for 2015. Its success in growing market share at the expense of other smaller manufacturers mitigated its volume decline with volumes down only 6% but margins took a hit.

According to retailers, volumes remain weak in the first quarter of 2016, but the gold price has rallied by 15% since year-end. Kingold has issued a production forecast similar to last year's volumes but margins should benefit from low inventory costs and a rising gold price. It is reasonable to expect earnings in excess of last year's earnings of 33 cents. If the company achieved earnings of 40 cents, this would put the stock on 3.6x earnings.

Earnings may not be the key driver to Kingold's stock price in the near term, but the direction should be positive, and the catalyst will be improved margins and further market share gains.

2. The Jewelry Park Development will be resolved

Kingold will be commencing the sales and leasing process of the completed JPD this year. This will have a substantial positive effect on the share price. It will have the triple effect of (1) allaying one of the largest concerns of investors, (2) releasing the unrealized gain to the balance sheet, and (3) most important of all, paying down debt.

3. Debt Levels will peak in 2016 and start declining

The acquisition of the JPD caused a rapid expansion of debt level that currently stands at 31% of the balance sheet. This growing leverage worried investors, and it has prevented the company doing anything constructive to unlock value for shareholders. The company cannot contemplate a share buyback until debt is reduced.

Total term debt stood at $147.7 million at year-end. During Q2, there will be a final construction payment of approximately $75 million (see note 5 of 10-K) which investors anticipate could bring total debt up to $223 million ($147.7 million + $75 million).

Kingold has two sources of cash to repay debt. The first is sales from the JPD and the second is the surplus gold inventory that we described earlier in this report. It seems to us that the company can pull either of these levers or both of these levers to reduce debt. The Chairman is highly incentivized to reduce debt because a considerable portion of the recent debt is backed by a personal guarantee from Chairman Jia. In our opinion, the company has the means and the will to start paying down debt once the final JPD payment is made.

Any indications of debt reduction will be taken very positively by the market. Most investors rightly see debt reduction as a prerequisite to a share buyback.

4. Kingold can be distinguished from the fraud scandals that tainted Chinese stocks and investor relations will be improving

Chinese companies quoted on US markets have been tainted by a series of fraud scandals at companies like Sino-Forest, Sino Tech Energy and AutoChina. Unfortunately, investing in China requires an extra layer of due diligence. We submit that Kingold is not a fraud for the following reasons:-

1. Fraudulent companies seek to overstate profits and assets. In contrast, as we have pointed out, Kingold understates its asset values and probably understates profits.
2. Fraudulent companies are less likely to have strong independent audit committees and they certainly don't commission independent reviews of internal accounting controls like Kingold did in 2013. The chair of Kingold's audit committee is David Sherman, an accounting professor from Harvard Business School and NorthEastern.
3. Kingold's single largest asset is 24 carat gold inventory which has a very robust audit trail.
4. On June 28, 2012, Kingold declined to proceed with a secondary offering of stock at $1.30 because the company felt that the discount implied by the underwriting was too dilutive to existing shareholders. It is our experience that fraudulent companies don't turn away money and have little concern for dilution. In contrast, six months later on January 10, 2013, the company placed 7,000,000 shares with three Chinese investors at $1.80, a 38% premium to the current market price at the time. These two transactions do not fit the pattern of a company seeking to defraud US investors.
5. Unlike some Chinese companies that came to NASDAQ, Kingold has a strong Chinese shareholder base which includes sophisticated Chinese investors such as Fortune Capital, the second largest private equity firm in China. Fortune Capital has the skills and means to do detailed due diligence on their Chinese investments and they have a representative on the board of Kingold.

Kingold is not entirely without governance issues. Two issues arose at the end of 2013. The first concerned a loan that was made to a related party without full board approval. The loan was repaid in early 2014 on schedule and the Board passed a resolution requiring management to seek Board approval for any future transaction in excess of $250,000. Secondly, at the end of 2013, shortly after the JPD transaction, the audit committee of Kingold instructed the auditors to review internal controls. The audit of internal controls reported weaknesses in the ability of the company to review and record non-routine, complex transactions (which we assume referred to the JPD transaction). The company recruited additional accounting staff and the auditors gave Kingold an unqualified report in 2014. This is detailed on page 45 of the 2013 10-K available on the company website. In a perverse way, these issues reassure us because they demonstrate a level of board level governance that we do not see in other Chinese companies.

A valid criticism directed at the company's corporate governance is that it has historically had woefully inadequate investor relations.

We are starting to see signs of positive change here as well. During the quarterly results call, we sense a new emphasis on shareholder value and communication with shareholders.

"The company has been working very diligently to form a shareholder value committee to produce - … our top priorities, and …work with third-party consulting firm... to handout some strategies."

"So we took the notice of all the major advice. For example, some shareholders like share corporate buybacks, some like more dividend policy, and some probably prefer the company has more transparency, which we all think is the right direction to move."

"Our number one priority is basically to probably improve the communication with the existing shareholders."

The overall message is that Kingold is talking to its major shareholders and that these shareholders are counselling either a share buyback or introducing a regular dividend policy.

The company announced the creation of a Shareholder Value Committee in January 2015. Since then, there has not been much news on value creation, but it is a reasonable guess that the company cannot embark on either a dividend or share buyback strategy until the JPD is complete and debt reduced. Once again, we think that an early signal for further shareholder value creation will be declining debt levels and further sales or leases from the JPD.

Share Buyback and Debt Pay Down

In light of the company contemplating a share buyback, we have created a model of the impact of a combined share buyback and debt pay down.

In this model, we take the more conservative of our NAV estimates and assess the impact of two buyback scenarios. The conservative scenario assumes that the company raises $75 million from a combination of real estate asset sales and sales of surplus gold inventory. The aggressive scenario assumes that the company raises $150 million from real estate and surplus inventory. Neither assumption is unrealistic because the company intends to sell at least 50% of the JPD which would amount to $100 million of proceeds, and the company owns at least $160 million of surplus gold inventory.

In the first scenario, we assume that $55 million is used to pay down debt and $20 million to buy back shares at an average price of $1.80. In the second scenario, we assume that $110 million is used to pay down debt and $40 million is used to buy back shares at an average price of $2.00. We assume the more expensive debt is paid down first and the less expensive debt is paid down last.

	Before Transaction	Conservative Case	Aggressive Case
# of shares	65,963,502	54,852,391	45,963,502
Debt	$200 million	$145 million	$80 million
Interest Savings		$4.95 million	$8.8 million
Net Income	$26,385,000	$31,335,401	$35,185,401
Book Value	$265,680,172	$245,680,172	$225,680,172
NAV base case	$364,780,000	$344,780,000	$324,780,000
Book Value per share	$4.03	$4.48	$4.91
Adjusted NAV per share	$5.53	$6.29	$7.07
EPS	40 cents	57 cents	77 cents

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Under our conservative assumptions, a share buyback could increase the net asset value per share to $6.29 and increase recurring earnings per share by over 40%. If the company gives any indication that it is contemplating a share buyback and paying down debt, then this will be a very powerful catalyst for the stock price.

Outlook for the core operating business

The core operating business of gold jewelry manufacturing is well managed and consistently profitable. Chinese consumer spending has faltered for the last 18 months but it will eventually recover, and over the next 5 years, the consumer sector including jewelry will grow faster than the consumer sector in developed markets. Kingold will grow faster than industry averages as market share continues to accrue to KGJI at the expense of small family workshops.

Conclusion and Price Targets

After recovering from the trough of bad news in 2015, the share price is on the verge of an important breakout above $1.45.

We believe that the positive news flow in the short term will take the stock through $1.45 and the next resistance level is $1.90.

$1.80 is an important share price target for the company because its cornerstone Chinese shareholders invested at an average price of $1.80 per share. There is an important element of "face" involved in getting the share price back above this level. It is why we picked $1.80 as the buyback price for our conservative buyback model. We predict that the Chairman will do what it takes to restore these shareholders to profit, and over the coming months, it will have the means to accomplish that goal.

Thus, our short-term technical target for the stock is $1.90 for an upside of 60%.

We also have a longer term "blue sky" price target of $6 for the stock based on a combination of normalized earnings power and asset value.

Normalized Earnings:- We estimated normalized earnings power by analyzing average margins over the complete cycle. In early 2014, prior to the cyclical slowdown in luxury spending, Chairman Jia stated a medium-term target volume of 70-80 million tons of production. We use 70 million tons as a production target with an average gross profit per gram of $1.15 per gram to forecast earnings power of 86 cents per share (we have an earnings model but this article is long enough!). Applying a 7.5X earnings multiple to normal cycle earnings would imply a target price of $6.45.

Net Asset Value:- Our base case NAV without a share buyback is $5.53. Our base case with a share buyback is $6.29. If we place a 25% probability on a share buyback, then a probability weighted base NAV would be $5.68. (We note that our base NAV calculations are overly conservative on the JPD and include nothing for retained earnings in 2016).

Our target price is based on the average of the Earnings Power target price and a Price/probability weighted NAV of 1 = $6.06.

The catalysts we would need to give the blue sky price target credibility are clear indications from the company that:- 1) Margins are improving and consumer spending is recovering, 2) the company is paying down debt and on a route to shareholder value creation through a share buyback, and 3) the company is committed to shareholder friendly values accompanied by better communication with investors. We will monitor longer term indicators carefully over the course of 2016 but in the meantime, we believe we will be paid while we wait by a positive short-term news trend.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long KGJI. 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.