Long Shot: Wired for Value

 | Jul 10, 2013 | 10:00 AM EDT  | Comments
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Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.

When a huge rally has investors nervous about the market, I increase my "sleep factor" by focusing on deep-value stocks that will offer a substantial downside cushion during a correction or an extended bear market. I regularly write about trolling in down-and-out sectors, such as U.S.-traded Chinese stocks or coal miners. One category of stocks that can represent exceptional value is those trading at or below net cash, which means the business is valued at zero.

Of course, these can be risky, as the market could be correct that the business is worthless -- such as a biotech firm burning cash that never gets a drug approved. But if the business is not worthless, you can capture rapid appreciation as the market rerates the stock to reflect going-concern value. 

I recently stumbled on an interesting company trading at net cash that has a strong balance sheet and exceptional growth: Lihua International (LIWA). The company is based in China, about 100 miles from Shanghai, and the stock has traded on the NYSE since 2009. Because it is Chinese, it has paid the penalty created by the frauds and blow-ups that infiltrated the U.S. markets in 2010 and 2011: The stock is quoted at $5, equal to its cash holdings of $5 a share (net of its very minimal debt of $5 million). 

Lihua has a singular focus: it makes copper wire for a variety of markets in China, such as residential and commercial construction, electronics and utilities. The company uses recycled copper, so there is a "green" element to the story, as well. It has grown rapidly, as you would expect, given the breakneck pace of economic expansion in that country.

The firm generated $370 million in revenue in 2010, a figure that grew to 2012's sales of $853 million. Gross margin is thin, at around 10%, but operating expenses are de minimis. Of last year's $853 million in revenue, Linhua cleared $90 million in gross profit -- and $78 million in operating profit! Net income totaled $58 million, with the only below-the-line expense being income taxes. Importantly, cash flow tracks the net income, so you know there are no games going on in the income statement. Operating cash flow was $48.7 million in 2012. 

First-quarter results showed equally strong growth, and the company was capacity-constrained in important markets, most notably in copper anode. The company is installing a fourth smelter in order to increase capacity and serve this market. Additional growth in the second half and beyond could be driven by the introduction of a new copper-clad aluminum wire (CCA), which reduces the weight of the wire. This should hold great appeal for those dealing in long-distance power transmission.

Clearly one risk in the stock is the direct exposure to the Chinese economy. If the economy does slow, Lihua's growth could also slow substantially. An additional risk is the capital requirement to launch CCA, which could approach $100 million for plant and working capital. 

Many U.S. investors -- if not most -- will not touch a Chinese stock. I understand the sentiment, as I have several zeroes in my personal account that I bought back in 2010. But, at this point, I don't believe you can "fool me twice." U.S. investors have ferreted out the frauds, and the names that remain are legitimate companies with real businesses. (Even Muddy Waters Research has moved on from China and is investigating Silicon Valley tech companies!)

Lihua has been around for quite some time and it has never had an issue with its reported GAAP-based numbers. It reconciles with the SAIC numbers reported to the Chinese government, and it has a U.S.-trained chief financial officer that understands the importance of credibility and transparency. One Seeking Alpha analyst has been pointing out discrepancies between the Lihua's sales and stated capacity, but I think measuring capacity is tricky and that there are probably translation issues, rather than anything of real intrigue. 

I believe the distrust of Chinese stocks is creating a great opportunity in Lihua. Unless the cash is simply not there, which I feel is unlikely, there is a cushion under the valuation. If the company can expand to meet insatiable demand and sustain its high growth rate, the stock could ultimately be a multi-bagger as the cash rises and the valuation expands to reflect the company's growth rate.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider LIWA to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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