CXTI: Solid Business At An Irrationally Low Price

| About: China Expert (CXTI)

Shareholders of China Expert Technology (OTC:CXTI) are feeling great pain lately. From its intraday high of $7.95 on June 25th to yesterday's market close of $2.61, the stock has lost 67.2% of value in about a month and half. In the past three weeks or so, or 17 trading days to be precise, the stock has lost 59.5% of its value.

Sounds like a scary and risky stock, right? That indeed is true if you are a short-term trader who likes to follow the herd and have bought in at around $8, expecting to ride it to $12 in a few months. But if you are a patient investor looking for value, this might just be one of those rare opportunities you have looked out for so long.

Contrary to mainstream Wall Streeters, value investors ruthlessly reject the notion of risk level being increased by volatility associated with depressed stock prices. Quoting investment master Warren Buffett from his 1993 letter to Berkshire Hathaway (NYSE:BRK.A) shareholders:

In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced 'Mr. Market,' an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

The key to investment success obviously lies in finding “irrationally low prices attached to solid businesses.” And in my judgment, CXTI is now really an irrationally priced stock with a solid underlying business.

CXTI is an e-government solution provider and system integrator in China. The company has been in business since 1998. In the past five fiscal years, revenues grew from $1.25M in 2002 to $66.06M in 2006. In the same period, net income has grown from a loss of $951K in 2002 to a net profit of $7.84M.

For the current fiscal year (2007), the company has projected a net income of $20M to $21M (155-168% year-over-year or YoY growth) on revenues of $72M to $74M (9-12% YoY growth). For the next fiscal year (2008), the net income is projected to be between $35M and $36M (67-80% YoY growth), on revenue of $124M to $126M (68-75% YoY growth).

Since 2003, the company has signed e-government contracts with more than a dozen city governments, worth a total of $545.6M after deducting upfront hardware cost and business tax (value added tax). This number ($545.6M) includes both revenues realized in previous quarters and years and revenues to be realized in the future (backlog). Some of the contracts are set to last through end of 2010.

The company reported contract backlog of $39.6M at year end 2005, $227.8M at year end 2006, and $257.3M as of March 31st, 2007. The backlog figure at the end of Q2 will not be available until company’s earnings release in a few days. However, based on my own calculation the company’s latest backlog should now sit at about $384M (which has excluded Q2 projected revenue of $16.3M).

Until this year, CXTI’s market has mainly been in the southeastern province of Fujian. Its main e-government contracts have so far spanned 13 cities and districts within this province. However, this year has seen the company signing four contracts in three provinces other than Fujian, with a total worth of $91M. This is an important milestone for the company and serves to highlight its ability to expand its business into territories outside of Fujian.

CXTI’s business strategy has been to target second-tier Chinese cities, since the first-tier major cities are dominated by multinationals. However, it did manage to secure a contract in Xi’an city in March of the year. Xi’an is one of China’s major cities, tourist attraction and the country’s ancient capital. The city had a population of 8.07M at the end of 2005.

The company’s early e-government projects have turned out to be very successful. Its Jinjiang city e-government project has been selected by Fujian provincial government as a model e-government system for all of its cities. The e-government administration training provided by the company to Jinjiang city officials was made one of the four model programs for the whole nation by the Chinese Ministry of the Information Industry.

CXTI was also the first corporation ever in the Chinese private sector granted authority to provide technology achievement appraisal services for IT companies seeking government funding in China.

One of CXTI’s “secret weapons” against competitors is its access to service by 400 top experts from the Chinese Academy of Sciences and the Chinese Academy of Engineering on a need/contract basis.

For the past four fiscal years, the company’s gross margin has ranged from 46.1% (2004) to 52.6% (2006), operating margin from 24.9% (2004) to 39.9% (2005), and net margin from 11.9% (2006) to 21.3% (2003). Partly contributing to last year’s low net margin were a “liquidated damages” (one-time) charge and interest expenses and finance costs associated with the company’s $6M convertible debentures issued in October 2005. The bond was converted entirely into common shares earlier this year.

The company thinks it will be able to maintain its high gross margin level (it was 56.9% in Q1) through economy of scale and increased utilization of internal work force (instead of contractors). Net margin is expected to improve significantly from last year’s low 11.9%. Based on the management’s midpoint estimate on revenues and net income, the net margin for the current FY (2007) would be 28.1% and that for next FY (2008) would be 28.4%.

For the past three years, CXTI’s ROE has ranged from 19.5% (2006) to 69.5% (2004), ROC from 18.6% (2006) to 69.5% (2004), and ROA from 15.2% (2006) to 41.3% (2004). As any seasoned investor would have understood, an ROE in the 60’s is not sustainable. So one should not be concerned about the significant trending down of the investment returns. This trending down was mainly due to the significant increase of asset, equity, and capital base. Moreover, the same factors that have impacted net margin last year have also impacted the investment returns. Even then, an ROE and ROC close to 20% was nothing to be sniffed at.

CXTI has a very solid balance sheet. As of the end of Q1, the company does not have long-term liabilities of any kind. Current ratio stood at 8.07, and the company’s assets consist almost entirely of current assets. It had $21.2M of cash and equivalents, which represented 34% of equity.

Some investors have balked away from this stock because of its relatively long accounts receivables turnover cycle and at times negative cash flow. As of 2006, the accounts receivables turned over roughly every 136 days; and operating cash flow was a negative $1.75M.

This negative cash flow is usually related to upfront hardware acquisition cost on behalf of customers and down payment to contractors. But it is usually small compared to the company’s cash on hand. With a solid balance sheet and sometimes aided by financing, the company has never run into liquidity problems of any kind.

Now with more contracts generating cash for the company, I expect the overall cash flow picture to improve going forward. Indeed, in the first quarter the company has already reported a positive operating cash flow of $10.7M. The company expects its cash reserve together with cash flow generated from the contracts will be able to satisfy its working capital requirement for the remainder of the year. And I believe this would be the case beyond the year also, unless the company is engaged in too many new contracts. In the latter scenario the company’s solid balance sheet should enable it to secure outside financing on favorable terms.

Since CXTI’s customers are city governments in great financial condition, the company has been able to collect all accounts receivables in full. That explains why the company has used a zero allowance for doubtful accounts all along when reporting accounts receivables.

At today’s market close of $2.61, CXTI has a market cap of only $85.223M. The stock was trading at 11.86x FY06 earnings and 1.15x revenues. The P/B ratio against company’s book value at end of Q1 (but using latest share number as of 5/31/07) was a mere 1.44!

Using the management’s midpoint projection for current (2007) and next (2008) fiscal year, it is trading at a meager 4.16x current fiscal year’s earnings and 1.17x sales. The forward (2008) fiscal year P/E and P/S (price/sales) are 2.4 and 0.68, respectively. Even when potential share diluting impact is taken into account using the worst-case scenario (38.7M shares) projected by the management, the forward (2008) P/E and P/S are still merely 2.85 and 0.81, respectively!

What has driven the stock price to such an attractive extreme was the resignation of the company’s CFO, possibly exacerbated by the expiration of former COO’s employment contract without renewal. This led to the intriguing situation where the company CEO is acting as COO and Chairman acting as CFO.

But wait a minute, this is not exactly the first time the company has changed its CFO. The last time CFO was replaced was just a year and four months ago when Ms. Chiang Min Liang was replaced by Mr. Simon Fu on April 19, 2006. The difference this time is that no replacement has been found and announced yet. Furthermore, the fact that the company did not announce the departure of its COO until almost two months later (at the same time as CFO resignation) does indeed appear puzzling to some.

And then there are those who will sell CXTI by following the lead of Mr. Jeff Feinberg’s JLF Offshore Fund, a hedge fund that owned more than 20% of CXTI before it embarked on its position reduction on July 24th. I might discuss this in more detail in a separate post. Suffice it to say here that these sellers are following a buy high, sell low approach and might even be exploited by the hedge fund.

For value investors, this company still quite transparent even with the unpleasant darkness surrounding its recent loss of CFO and COO. As mentioned above, the company likely has a contract backlog of $384.3M as of this writing, which is 4.51x its market cap (as of today’s market close of $2.61/share).

Just tell me how many companies currently trading in U.S. have a backlog that is 4.51x its market cap? And then tell me how many companies that carry a backlog of 4.51x market cap (or more) are trading at a meager 2.85x next year’s earnings and 0.81x next year’s net revenues?

Finally here is another count of visibility. CXTI has revealed its intention to pursue a listing on Nasdaq. Although there is no clear timetable on this, I visualize the present turmoil in this stock as a great buying opportunity for me to get in at a deep discount, well before analysts, mutual funds, and the investing public pile on to seize a piece of the action. For I know Mr. Market is extremely manic-depressive right now!

But for you, you are “totally free to either ignore the market or exploit its folly.”

Disclosure: I own CXTI as of this writing. This writing is not a recommendation to buy or sell CXTI.

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