Saturday, May 9, 2009

Bear Market Rally

The equity markets have decided to ignore any bad news on the economy and rejoice at the “second derivative” turning positive, meaning things are getting worse at a lower rate than when the economy was in the equivalent of cardiac arrest in late 2008. If you believe the market is undervalued right now, you have to be thinking that the economy is returning to 2006 levels and this whole crisis was just an inconvenient blip. I don’t think anyone actually believes that, but who can pass up a good rally? Besides some key holdings, I’d rather sit primarily in cash and wait for valuations to improve.

At this point, there is significant systematic risk in the market right now and I think the market is due for at least a 20% correction in the next six months. There are just not enough jobs right now for the consumer to pay off debt to heal the banking sector. Our solution for the banking sector is to keep current management in place, let them earn excess income by keeping interest rates artificially low so the banks can earn higher net interest margins on loans, bide time by mocking the public’s intelligence with “stress tests”, try to get toxic assets off their balance sheet by manipulating the price through leverage and non-recourse loans, and hope the economy can improve enough so they can earn enough to heal its balance sheets. It’s a nice deal for current management and the creditors, it gives them all the upside. Hopefully it works, because the taxpayer is on the hook for any downside. It’s kind of like taking the worst things about capitalism and socialism and mixing them together. I really don’t care if it “works” or not, this too-big-to-fail policy by the government is just wrong.

Now that I got that rant out of the way, I will highlight a tiny company that I believe is a good long-term play. I have begun a position in Oriental Paper (OPAI.OB), a small manufacturer for the mid- to high-end paper market focusing on the northern Chinese region. The stock can be bought at around $0.26 per share right now even though it had 2008 earnings of $0.20 per share with healthy growth rates and solid operating cash flows. In fact, it is forecasting revenue growth of 30% in 2009. As comparison, they had guidance for 20% revenue growth in 2008 and delivered a 64% increase. Hopefully they will continue this practice of under-promising and over-delivering.

Competitive Advantages:
While it is a small player and I admit they do not have an unfair competitive advantage, there are aspects that show why this company has been successful. The company believes it has a regional advantage in the Hebei province. The CEO states, “[Hebei] has been our focus not only because the region provides growing demand for our products in the urban centers of Beijing and Tianjin, but because we also enjoy a price advantage in the region over competitors from other locales in China. We are approximately 75 miles (120 kilometers) from Beijing, the cultural center of China and our largest target market. Tianjin, another large urban center, is also approximately 75 miles from our facilities. We continue to see the benefits of our regional advantage, and believe that Orient Paper, Inc. is well-positioned to capture additional market share in 2009.” The company is the only paper manufacturer in Hebei province that has obtained Pollution Discharge Permit, and the company's sewage processing system of 30,000 tons capacity allows for production and operation in accordance with environmental protection regulations. Due to environmental regulations, many small paper mills have been shut down.

Business Model
The company has over 140 customers and none of them represent more than 10% of sales (The top ten customers comprise about 40% of sales). The company has shown to be good at collecting on revenues, as evidenced by a 64% increase of sales in 2008 but only having a 28% increase in Accounts Receivable. I listened to the Heckmann Corporation (HEK) quarterly conference call this Friday and they mentioned a difficulty from small-to-mid sized companies in China to get access to cash. So cash collection will be a major issue to monitor and I will look to make sure OPAI continues to manage this effectively but I do like how this company does seem to collect cash for its sales.

A major upside to this stock is a new production facility that would add production to its current 170,000 ton capacity. The company believes this increased capacity will allow it to meet domestic demand for paper, which is currently exceeding domestic supply. They announced in May, 2008 that they are building a new facility which will have an annual production totaling 1.2 million tons by 2010. The company predicted this increased production would add sales between $800M-$1.3B, with net income in the range of $160M to $230M. For a company with 45 million shares outstanding, that is pretty significant. Although completion of the facility has been delayed, I have confirmed with their company spokesperson that they are still actively preparing it for production. This new facility would change the dynamic of the company as it would have to compete in Southern and Eastern China where it may not have the cost advantages it enjoys in the Northern region.

Besides the obvious risk of being a Chinese microcap selling on the over-the-counter market, the company has some sizable debt but they should be able to pay off all the short-term debt with existing cash and upcoming operating cash flows. The company needs to do a better job with investor relations (they have told me they plan to hire an investor relations firm, for what that is worth) and there is low liquidity in this stock.

At current prices, I'll take the risk on OPAI.OB and hope it drops from here to add more on weakness.

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