China Precision Steel an attractive niche play

Shannon Roxborough | Aug 21, 2008 6:20am EDT | Comment

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To keep up with its impressive growth story, China is devouring more raw materials than any other nation. Its use of commodities is remarkable: China consumes nearly 30% of the global aluminum and zinc supply, a quarter of its copper and it produces and consumes one-third of the world's steel.

Steel is as valuable as gold to the Chinese, who require huge amounts of the material to feed booming demand from its unprecedented infrastructure build-out and manufacturing, automotive and shipbuilding sectors. Steelmakers and steel product producers in China have aggressively expanded their operations and stepped up production in recent years to meet these needs.

One company cashing in on this ever-growing demand is China Precision Steel, Inc. (Nasdaq:CPSL), formerly OraLabs Holding Corp, a value-added steel processing company that manufactures and sells high-precision, cold-rolled steel products. Its roughly 40 specialty products are mainly used in the manufacture of automobile parts and components, appliances, kitchen tools, microelectronics, saw blades, textile needles, and food packing and containers. It also provides the heat treatment and cutting of medium- and high-carbon hot-rolled steel strips. Though the company primarily does business in mainland China through its wholly owned subsidiary, Shanghai Chengtong Precision Strip Co., Ltd., last year CPSL began exporting products to Thailand, Indonesia, the Philippines and Nigeria.

The company had a solid third quarter for the period ended March 31. Revenue grew 61% year over year to $18.7 million. Net income came in at $4.6 million, or $0.10 per diluted share, a 231% increase over the year-ago quarter. Gross profit rose 58% to $5.3 million. Exports accounted for 19% of revenue a 2.3% increase from the previous year. In a move to secure a stable supply of raw material, the company advanced suppliers $26.8 million during the quarter, reducing its amount of cash on hand to $14.3 million. With investment and new construction expenditures expected to reach $20 million, CPSL may need to access capital markets (the company plans to invest in a new production line for high-quality stainless steel and a new cold roll mill at its Shanghai facilities).

The picture for steel in China is mixed. According to Luo Bingsheng, vice chairman of the China Iron and Steel Association, the country's steel consumption rose about 16.3% in the first six months of 2008 but is expected to slow to 13% growth in the second half of the year. He also pointed out that China's steel exports are expected to drop 23% from last year's level. China exported 7.21 million tons of steel products in July, a 21.4% increase over the same month last year, while steel product exports for the first seven months of 2008 were down 14%, the General Administration of Customs said.

Chinese steelmakers are facing serious concerns about weakening steel prices and rising production costs, which could put pressure on their profits.

The prices for iron ore and coking coal, the two key raw materials for steel making, have soared by 85% and 300%, respectively, over the past several months (global prices of iron ore has quadrupled in the last five years, fueled primarily by China's almost insatiable hunger for steel). Some analysts are expecting slower demand for Chinese steel and steel products due to producers passing along costs in the form of higher prices.

Despite these concerns, analysts at Merriman Curhan Ford initiated coverage of CPSL last month with a "buy" rating, citing the company's expanding profit margins and 20% annual growth in China's precision steel market. The firm said the company has been able to undercut its competition and still grow margins. The analysts also noted that CPSL "has added significant capacity which should gradually come online over the next few years, potentially allowing the company to grow its revenue by over 20% annually." They added: "We believe the stock can trade 12 to 15 times our FY10 EPS estimate of $0.50 or a range of $6 to $7.50."

Several large Chinese steel companies acquire iron ore from resource-rich Brazil (specifically, Vale do Rio Doce, a Brazilian company that is the world's largest supplier of iron ore). Others have been courting Australian mining interests in order to gain access to the island nation's vast iron ore reserves. CPSL, on the other hand, has looked closer to home for crucial raw materials, tapping the resources of domestic suppliers.

CPSL has two primary strengths in the market: a strong competitive niche and a cost advantage over competitors who rely on foreign imports (CPSL's products cost less to manufacture, and have shorter delivery times and with less freight expenses). Moreover, the company's efforts to ramp up production capacity should fuel top-line growth over the next several years.

That said, CPSL appears to be an attractive niche play on the Chinese steel market, which is expected to realize continued growth as China moves forward with its plans for economic expansion.

CPSL, which closed at $4.79 on Wednesday, has a 52-week trading range of $2.81 and $12.65.