Tuesday, October 21, 2008

Is Gulf Resources Really Undervalued?

It seems a fair question, probably one that is being asked by every shareholder in the company during the midst of its current steep decline in share price. Gulf Resources (GFRE.OB), the largest bromine producer in China and fourth largest in the world, is expected to earn $0.20-$0.23 per share this year despite a temporary 3Q disruption in demand due to the Olympics. The company just announced that 4Q revenue demand is strong as customers have renewed orders following the restriction of certain industrial activities during the Olympics. Despite no obvious impairments to its future earning capabilities specific to the company, the current price of the stock is still just $0.23. Is it just the fact that Chinese companies are currently out-of-favor, especially over-the-counter stocks with low liquidity, coupled with the drop in commodity prices which is causing this stock to trade at slightly over 1x 2008 earnings? Despite the pessimism in the marketplace and the de-leveraging of the investment community, this seems like an extremely depressed price even at today’s standards. What is the investment community seeing? First, here are some questions for consideration.

Does the company have any competitive advantages?
Yes, it has gained 20% market share in Chinese bromine industry as one of only six companies in the country with a bromine exploration license. China has stated they will no longer issue any future licenses and are shutting down unlicensed production facilities giving Gulf Resources a significant barrier to entry. Gulf Resources is taking advantage of this opportunity by investigating potential acquisitions of unlicensed bromine production facilities to expand its market share. The company also has a profitable subsidiary specializing in chemical products to the oil & gas industry and paper making industry offering some growth potential.

Is bromine an element that is in demand?
Yes, China is a net importer of bromine as only 160,000 tons were produced within the PRC to meet the country’s demand of 190,000 tons.

Does the company have a sustainable source of bromine?
Yes, the company maintains 50-year mineral rights with reserves of approximately 2 million tons and annual production of just over 30,000 tons per year, giving it over 60 years worth of production potential.

Is the company in financial trouble?
The company currently has about $6.3M in cash and $21M in debt. The first installment of the $21M debt is due May, 2009. This $3M payment is interest-free and can be covered with existing cash. The other $18.2M is due no earlier than December, 2009. The company generated about $20M in cash flow from operations in the trailing twelve months and should be able to service this debt with cash flow from operations.

So why is it selling so low?
In June of this year, the price per share of Gulf Resources was over $2 per share. The main reason for the recent free-fall in share price cited by the company is a sell-off by a large stakeholder, presumably China Finance which owns 3.3M shares as of 6/30/2008. These shares were received as payment for surety guarantee services provided by China Finance for Gulf Resources’ 2006 merger and it is largely speculated (largely being a relative term since only a few people seem to follow this stock) that China Finance is selling its 3.3M shares now that the shares are qualified for sale. It is now anyone’s guess if the sell-off is being caused by a large shareholder and when the sell-off will be done.

Latest statistics show China has slowed to 9% growth. While many people are focused on a slowdown in the global economy, this is one stock that seems to have been battered down way too much. This company possesses clear barriers to entry, generates solid cash flow from operations, and has appealing growth potential in a domestic marketplace that has greater demand than supply. Trading at 1x 2008 earnings and 0.60 P/BV, there is enough margin of safety at this price to counter the risks in this micro-cap.