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Paper business in China?

April 13th, 2010 · 1 Comment

Yes, we like this one as well. Additional reassurance that this guy went over and kicked the tires, and is a corporate governance specialist..
We still think China is the place to be for smallcap growth companies. However, especially after the Fuqi disaster (we’re still waiting what really caused the problems there), we’re all too aware of possible corporate governance issues.

That’s why it’s reassuring that Eric Jackson from the Ironfire Capital Fund is a corporate governance specialist and has gone over there to kick some tires (the same holds for China Fire & Security Group CFSG). Although one could say that this only removes some of the trust we normally have to place in the published data to trusting Eric, but we think it still is something of a reassurance, as we have the data (which all look good apart from the dilution) and Eric.

In any case, the way to play these Chinese smallcap companies is to take small positions in many of them. They can’t all be scams (and most of them really are cheap and in growing businesses). And these companies could easily multiply over a 5 year period while the worst they can do is go bankrupt.

The Top Pick From Our China Trip

,
On Thursday April 1, 2010, 1:40 pm EDT

Over the last two weeks, I have traveled
through China
, meeting with the management teams of eight companies
that my proprietary model at Ironfire Capital has flagged as having the
potential to double or triple in the next two years. No model is
perfect, and they all require additional due diligence. As the saying
goes, trust but verify.

Chinese companies in particular draw Western
investors because we hear stories of stocks shooting up in value over a
relatively short period of time. However, many people are still
justifiably afraid of holding these stocks. One hedge-fund manager asked
me to tell him, when I returned, which of the companies were frauds. He
suspected many firms in China of cooking the books.

That’s why
I’m here for the trip
with my colleagues from Hong Kong and Shenzhen : We want to
separate the real undiscovered gems from the names built on hype.

My
top long pick of all the companies I met with is Orient PaperNYSE” PRIMARY=”NO”/>
which trades on the New York Stock Exchange. The company sells
fine writing paper and corrugated paper for boxes, and three weeks ago
it started production of paper for digital photographs. Earlier this
week, Orient Paper released its full-year 2009 numbers. Revenue grew 57%
to $102 million for the year and 98% for the fourth quarter to $31
million.

Investors did not like the decrease in gross margins
from 22% to 18% in the recent quarter and the increase in SG&A
expenses by over $1 million from last year. However, the margins were
affected by increased coal costs in the fourth quarter that were due to
the colder winter near Beijing .
The company uplisted to the NYSE in December and was required to take on more
consultant costs in preparing for that. It also announced yesterday that
it was selling 3 million shares at $8.25, taking the stock down 13%. My
firm was a big buyer on the news, and ONP is now one of our top long
positions.

I believe that
the stock is now at a low point and will rise significantly in the year
ahead. A doubling in the stock price from here in the next year seems
very achievable. A better return than that over that time period is not
unreasonable. The downside risk appears to be very low.

Orient
Paper has its headquarters in the city of Baoding, about two hours to
the southwest of Beijing .
It would be considered a third- or fourth-tier city in China and is
more agriculturally oriented — think Bakersfield, Calif., but smaller
and more rural.

We met with the company on Saturday afternoon for
about three hours. Orient Paper has two plants operating at
three-shifts-a-day capacity, churning out its paper products. We went to
the older plant first, which was literally in the middle of a field
outside of Baoding. To get to the plant, we traveled down a long gravel
road, past rubble, cats licking through garbage and moms taking their
babies home strapped on their backs, on beat-up old scooters.

We
immediately were ushered into the office of the CEO, Zhenyong Liu, where
we exchanged cards with him and about a dozen other members of
management. Liu founded the company in 1996 and has slowly built it up.
He still owns 35%. As of yesterday, Orient Paper has a $120 million
valuation, $30 million in cash and $4 million in debt (and it did $102
million in revenue last year).

Liu took us through a plant tour.
Every parent loves his child, and every founder is proud of his
operating plant. Eight lines were running when we were there, taking in
recycled paper at one end, melting it down and churning out the finished
rolls at the end of the line.

We saw the records, in Chinese, of what tonnage was being churned out
for each of the shifts. We waded through the hip-high mounds of recycled
paper waiting to be turned into fine writing paper, and a field of $2
million worth of inventory in recycled boxes waiting to be turned into
the corrugated paper.

The new digital photography paper is made
from recycled textbooks. Baoding is close to many book publishers in Beijing and Tianjin
which have long-term contracts for paper supplies. They are also buyers
of the fine paper. Orient Paper can sell its fine paper and corrugated
paper for roughly double what it pays. It can sell its digital
photography paper for roughly triple its cost.

The company also
has a homegrown water-treatment process to reuse 80% of the water for
running the presses.

We asked about a recent incident at the Roth
Conference in California, where it was reported that Orient Paper was
supposed to present but then canceled at the last minute. This was the
day after Fuqi International’s announcement of an accounting restatement. Investors
dumped the stock. Liu was not at the conference and told us that Orient
Paper was never supposed to present. Liu told us that Roth had made a
mistake in putting the company on the speaker list. He said that if he
had been there, he would have told his CFO, Winston Yen, who is based in
Los Angeles, to get up and present even if Orient Paper wasn’t
expecting to do so. Such are the hazards of investing in smaller Chinese
stocks, where miscommunication with shareholders is possible.

We
ended the tour by seeing the operations of the new plant pumping out
the digital photography paper, which was also humming. This new business
is the big opportunity for Orient Paper shareholders. Only three to
five China-based companies are producing this paper, and Orient Paper
gets 30%-plus margins on it, vs. its 20%-plus margins on its other
business. All paper lines are growing and appear to have much room to
run.

Digital photography printing is in its early stages of
development in China, with a rising middle class buying up cameras and
snapping pics with abandon. Wedding photography and wedding packages are
just starting to grow in popularity here. Walking around Beijing , I counted at
least 10 shops and studios dedicated to taking photos for weddings.
Orient Paper is looking at how it can provide its paper to this growing
area (which also enjoys high margins).

I really liked Mr. Liu.
“I’m a slave to this business,” he told me in Chinese. “I can’t leave. I
must make it successful.” He owns 35% of the company, and I believe
him. He was very open and engaging and had clearly thought about some of
our suggestions to add some large company paper industry directors to
the board. From everything I saw, business is strong, and the company
should have a great 2010.

With a trailing price-to-earnings ratio
of 7 and a trailing enterprise-value-to-EBITDA ratio of 6.6, the stock
is cheap, and the company has no further financing needs. Of all the
Chinese companies I met with, Orient Paper has the biggest upside with
lowest risk.

High Conviction: A Well-Managed Chinese Small Cap in High Growth Mode

Eric M. Jackson, Ph.D., is Founder and Managing Member of Ironfire Capital LLC, based in Naples, FL. Ironfire is an equity long-biased and corporate governance-focused investment firm.

Jackson completed his Ph.D. in the Management Department at the Columbia University Graduate School of Business, with a specialization in Strategic Management and Corporate Governance, and holds a B.A. from McGill University. He was previously Vice President of Strategy and Business Development at VoiceGenie Technologies, a software firm now owned by Alcatel-Lucent.

Seeking Alpha recently had the opportuntity to ask Jackson about his single highest conviction holding in his fund.

For starters, would you tell us a bit about your fund and your investment approach?

I founded Ironfire in 2007. We look for undervalued companies with the potential to double or triple in value over the next few years. We pay particular attention to China-based, U.S.-listed companies that operate in large growing markets, with strong corporate governance and management.

We use proprietary analytics to identify possible investments, perform rigorous research and invest. We seek to have an ongoing and positive relationship with our investee companies. Our local presence in China, through our Hong Kong and Shenzhen offices, gives us direct access to meet with our investee companies in this important market.

What is your highest conviction stock position in your fund right now, long or short?

It is a small-cap company called Orient Paper which is ONP on the AMEX. It is one of our largest long positions.

Two weeks ago I visited Orient Paper in Baoding, China – about 2 hours southwest of Beijing. The company makes fine writing paper, corrugated paper, and digital photography paper. It was started in 1994 and now operates 6 presses at 3 shifts a day. They just started producing the digital photography paper last month and therefore you won’t see this new product meaningfully contribute to the company’s results until Q2.

However, what impressed us most is how well the company has performed over the last few years in its core business. It’s a boring business that just keeps churning out the strong results.

Revenues increased from $40m in 2007 to $102m last year, with margins increasing from 16% to 20%. Management has already projected that 2010 will see its net income increase 50%. To do this, given historical trends, they would have to see an almost doubling of revenues to $200m. However, we don’t know what management’s assuming to come from the digital photography business. That’s a business in which there are only 3 – 5 other Chinese players. The margins should be noticeably higher on this business too.

Take it all together and we estimate you can buy ONP today for about 2.3x its forward multiple. Throw in the fact that they just completed a private placement (which means future financings are unlikely) and we think ONP could double or triple from here before the end of 2010.

Can you talk a bit about the industry/sector? To what extent is this an industry pick as opposed to a pure bottom-up pick?

We are bottom-pickers at heart. Obviously, the last few years suggest that anyone who ignores industry or macro trends does so at their own peril. Smaller publicly traded China-based companies are almost always in industries that are growing rapidly because of the rising purchase power of the emerging middle class. That trend benefits ONP specifically with respect to its corrugated paper business (which is a proxy for manufacturing health) and its digital photography business.

The Chinese are much crazier about taking photos than North Americans. However, they’re just starting to get into digital photography and printing out their photos. All this said, if I didn’t visit ONP, walk around the plants, see the three shift a day presses, see the stockpile of recycled paper waiting to be turned into product, and meet the CEO/founder, Mr. Liu, and his team, I wouldn’t be as comfortable with the investment.

Can you describe Orient Paper’s competitive environment?

Boading, where the company is located, in an unremarkable agricultural town. It reminded me of a smaller and more rural version of Bakersfield, CA. Its older plant is literally in the middle of a field. However, Baoding is strategically close to Beijing and Tianjin. That’s important because those towns have heavy student, manufacturing, and publishing populations. ONP has strategic relationships with nearby long-term suppliers of text books and boxes which they turn into their fine paper and corrugated paper respectively.

There are also many buyers of their paper lines nearby. This gives them an edge in their traditional businesses.

With respect to their digital photography business, there are only 3 to 5 Chinese printer competitors serving a market of nearly 1.5 billion.

Can you talk about valuation? How does valuation compare to the competitors?

ONP is the only Chinese company of its kind that trades in the U.S. Therefore, it’s difficult to compare it to others on an apples-to-apples basis.

On an absolute basis, the company is cheap. Its trailing P/E is 8x. Its trailing Enterprise Value to EBITDA is 6x.

However, as mentioned above, assuming the company hits its earnings numbers it’s committed to for 2010 or beyond, we get to a forward P/E of 2+x.

Does the company export at all? How would they handle revaluing of the yuan if so?

I am pretty sure they only supply the Chinese market, so a Rmb revaluation would lower their year-over-year U.S. dollar comps.

Labor, power and raw materials costs are rising in the Chinese supply chain. How will the company deal with this?

They have a stable and local supply of recycled paper which they turn into their end use paper. They don’t use wood pulp. Their supply contracts go out a year and then get rolled over. So far, these have been stable. They also reuse 80% of their water through a purification process.

Last year, the winter was colder than usual and so electricity costs were higher than usual, so they are open to that. If there were to be rolling blackouts due to power grid issues, they are at the mercy of that.

They are in a rural area 2 hours southwest of Beijing, so the labor is plentiful and inexpensive.

What is the current sentiment on the stock? How does your view differ from the consensus?

This is a small company, so part of the reason why this stock is so cheap is that there is no consensus. People don’t know about it yet. We’ve seen a pattern with smaller Chinese-based companies listed in the U.S. that they can grow very quickly — especially after raising money through a private placement to help fund growth.

Puda Coal (PUDA) raised some money in February, which took its stock down to below $5. However, the market quickly reassessed its growth and, with some good results and recent analyst coverage, the stock is now north of $11. We suspect a similar path this year for ONP.

Although many Western investors crave the yield they see coming out of smaller Chinese companies, they worry about the risk of fraud. Fuqi International (FUQI) recently stumbled with a delay in filing their 10K and their stock dropped almost 50%.

That’s why we are big believers in looking at the corporate governance of a company and using our people on the ground in China to go out and meet these companies. You have to separate the real from the frauds, but it can be done.

Does the company’s management play a role in your position?

Absolutely. The CEO, Mr. Liu, really impressed me. He founded this company in 1994 and has grown conservatively. They have only $10m in debt and he still owns 35% of the company. “I’m married to the company,” he told me in Chinese. “I cannot leave this company without making it a success.” He’s someone who doesn’t install marble fountains out front of the company. It’s all about growing the business.

What catalysts do you see that could move the stock?

Earnings. Watch for Q1 earnings next month and Q2 earnings, which will be the first with a full quarter’s worth of digital photography paper included, in August.

What could go wrong with this stock pick?

I don’t see company-specific risks. I think management has a handle on all relevant issues and they’ll perform. I think the big risk is a correction in the U.S. When U.S. stocks correct, these smaller cap Chinese companies can go down even more (just as they rise faster in up markets). I suspect the U.S. markets will pull back or go flat later this year. When they do, I hope we’ll see the ONP numbers start to move the stock up on its own.

Thank you very much, Eric.

Disclosure: Eric Jackson’s Ironfire Capital is long ONP and PUDA

Tags: ONP

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