Tuesday, April 13, 2010

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

April 13, 2010 | about: FXI / HAO / ONP / PGJ

From SeekingAlpha.com

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

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