China Carbon Graphite Group (CHGI.OB): Limitless RMB

Ok, our title is a half truth! There is no such thing as "limitless RMB" but when it comes to investing in China companies listed in the U.S. China Carbon Graphite Group (CHGI) is about as close as it gets. As of today, November 12, 2010 China Vesting is adding CHGI to the undervalued index at a price of $0.94. Conversely, we have decided to remove Songzai International Holding Group, Inc. (SGZH.OB) which recently changed its name to US China Mining Group Inc.

China Carbon Graphite Group has been on our radar for quite some time but not for good reasons. The company seemed to be decent back in early 2009 when the company reported fiscal 2008 net income of $3.98 million or $0.21 per share. 2009 turned out to be just downright terrible with revenues down almost44% and net income turning into a net loss of $1.47 million or $(0.16) per share.

Needless to say investors abandoned ship and now China Carbon is like the hundreds of other China companies listed in the U.S. that are pretty much ignored. Why is China Vesting interested? The stock has been a relative loser but things look to be turning around. We never want to say "never" but we've never seen a company in China obtain a bank loan equal to almost 150% of its market capitalization and it is pure debt with no convertible feature...meaning there is no dilution. Also, the loan is from a REAL bank...China Construction Bank. You can read the company's press release China Carbon Graphite Group, Inc. Announces RMB 180 Million Loan From China Construction Bank here on Yahoo Finance.

So what does this roughly $27 million USD (180 million RMB loan mean? Let's just quote the company:

Each of these loans has a one year term with an interest rate of 5.41% per year and will be renewable at the lender's option after the expiration of the loans. The loan agreement provides for operating and financial covenants typical for loan transactions of this type. Proceeds of the loans will be used by the Company to purchase raw materials, specifically focusing on higher purity graphite and fine grain graphite materials. This loan facility enables China Carbon to significantly reduce the risk of price inflation of raw materials and leverage increased facility capacity, and expand its profit margin, by allowing the Company to buy larger amounts of raw materials in advance in order to receive better pricing.

"We believe the price of raw materials will continue to rise in the coming years, the loans we received from China Construction Bank will allow us to lock in the price of our raw materials by facilitating larger advanced purchase arrangements at better pricing, in order to hedge against the risk of inflation. Furthermore, with the increasing sales and price of our products, we believe we will deliver improved results in next few quarters, showing incremental increases in our top and bottom line," said Donghai Yu, the Chief Executive Officer of China Carbon.

The ability for us to receive these loans on such favorable terms from one of the largest Chinese banks further shows the confidence of our business operation and future industry potential," Donghai Yu continued.

Based on the company's most recent SEC Quarterly Filing as of August 16, 2010 there are 20,160,161 shares of common stock issued and outstanding. Based on Thursday closing price of $0.94 per share the total market capitalization is $18.95 million. With over $8 million or $0.40 per share in cash China Carbon Graphite Group has an excellent balance sheet.

What the company needs to do is increase their top and bottom line. This $27 million USD loan should help take care of that. From looking over the company's 2009 Annual Report China Vesting believes that CHGI should be getting some Chinese Nuclear Plants as clients in the near term (see Overview Of Business section below).

With shares trading at $0.94 per share China Vesting believes that the company is undervalued and will reward shareholders who have a long term...(12-24 months) view. The stock is up 17.38% today making us sick for not introducing China Carbon last week to China Vesting readers. We thought about waiting for the stock to pull back a bit before adding it to the Undervalued index but based on the company's cash position and now 180 million RMB loan, it is worth taking a look at the company now.

Overview Of Business

China Carbon Graphite Group is engaged in the manufacture of graphite based products in the People's Republic of China. The company's products are either used in the manufacturing process for other products, particularly metals, or for incorporation in various types of products or processes. CHGI believes they are the largest wholesale supplier of fine grain graphite and high purity graphite in China and one of China's largest producers and suppliers of graphite products overall. CHGI currently manufactures and sells the following types of graphite products: graphite electrodes; fine grain graphite; and high purity graphite.

Approximately 40% to 50% of CHGI's graphite electrodes are sold directly to end users in China, primarily consisting of steel manufacturers. All other sales are made to over 200 distributors located throughout 22 provinces in China. CHGI's distributors then sell the company's products to end customers both in China and in foreign countries, including Japan, the United States, Spain, England, South Korea and India. In 2010, CHGI's primary strategy is to increase gross profits by better aligning overhead costs with existing levels of sales and pricing and to acquire other businesses within the industry that manufacture products that CHGI does not currently manufacture which CHGI expects to generate significant profits.

The company's long-term strategy is to expand product offerings by manufacturing nuclear graphite used as a reflector or moderator in nuclear reactors in China. The profit margin on these products would be significantly higher than the profit margin on the company's current line of products. There are currently 11 nuclear power plants in China, with 15 more plants currently under construction. These power plants currently purchase their nuclear graphite from manufacturers in foreign countries, including Japan, Germany and the United States, which involves greater costs than purchasing from local Chinese companies. CHGI knows of only one graphite manufacturer in China that currently produces nuclear graphite that meets the specifications of these power plants. Only graphite rods with a diameter of more than 840 millimeters and a purity of more than 99.9999% may be used in nuclear power reactors. To date, CHGI has produced only samples that meet these standards. The largest graphite that we currently produce in large quantities that contains such a high level of purity has a diameter of 600 millimeters.

Financial Highlights

In connection with the private placement offering in December 2009 and January 2010, the Company agreed to certain covenants in the event that the Company did not meet the performance target for fiscal year ended December 31, 2010 of net income of at least $5.1 million ("Make Good"). It looks highly unlikely that the company will achieve its "make good" numbers unless the next two quarters are just blockbuster.

Here is what the company had to say for the first six months of 2010,

Sales. During the six months ended June 30, 2010, we had sales of $8,095,000 as compared to sales of $6,551,000 for the six months ended June 30, 2009, an increase of $1,544,000 or approximately 23.57%. The low sales revenue in the first two quarters 2009 was primarily due to weak demand of graphite products, graphite electrode in particular in 2009, as well as the residual effect of the closedown of our facility in anticipation of the 2008 Olympics. Our revenue for the six months ended June 30, 2010 was mainly from sales of fine grain graphite, graphite blanks and semi-processed graphite products. We experienced a significant decrease in the demand of graphite electrodes and high purity graphite during the six months ended June 30, 2010 resulting from the global economic slow down.

For the six months ended June 30, 2010, two customers accounted for 10% or more of sales revenues, representing 32.9% and 18.8%, respectively of the total sales. As of June 30, 2010, there were three customers that constitute 23.3%, 16.9% and 10.8%, respectively of the accounts receivable. As of December 31, 2009, there were three customers that accounted for 17.6%, 15.4%, and 14% respectively of the accounts receivable.

Cost of sales; gross margin. During the six months ended June 30, 2010, our cost of sales was $6,842,000 as compared to $4,857,000 during the six months ended June 30, 2009, an increase of $1,985,000 or 40.87%. As a result, our gross profit decreased $441 or 26.03%, for the six months ended June 30, 2010. Our gross margin decreased from 25.86% for the six months ended June 30, 2009 to 15.48% for the six months ended June 30, 2010. The decrease reflects the variance in production mix. We increased sales of graphite blanks and semi-processed graphite products due to the significant decrease in demand of high purity graphite and graphite electrodes. These products have much lower gross margin.

Net income. As a result of the factors described above, our net loss for the six months ended June 30, 2010 was $(138,000) as compared to net income of $1,000,000 for the six months ended June 30, 2009, a decrease of $1,138, or 113.8%. At June 30, 2010, cash and cash equivalents were $8,059,541.

Conclusion

As you can see from the chart below, CHGI traded in the range $1.25-$3.25 late April of 2010. The stock went on a crazy run in March of this year for no apparent reason. The company issued guidance for $5.1 million net or $0.25 per share on April 19, 2010 but the stock started taking off a month earlier. The only other news/events at that time was the announcement on March 3, 2010 with China Carbon Signing a Letter of Intent to Acquire Chiyu Carbon Graphite Limited. The point we wanted to illustrate is that CHGI can move quickly on the upside and the downside.

The 200 day moving average (DMA) is currently at $1.09 per share. If CHGI breaks through this resistance line we believe there is not much to hold back the stock until the $1.40-$1.50 levels. Based on Thursday closing price of $0.94 per share the total market capitalization is $18.95 million. With over $8 million or $0.40 per share in cash and a 180 million RMB loan from China Construction Bank....China Vesting believes CHGI is undervalued and will begin to see improving fundamentals.