Management and consulting company China Direct (AMEX:CDS) has had a full week of news, including the report of strong fourth-quarter and fiscal 2007 results on Monday, raising 2008 guidance on Tuesday and news on Wednesday that the company will now trade on the Nasdaq Stock Exchange. However, the stock is only up 2% this week. To gain some insight into the latest events and their implications for the Deerfield Beach, Fla.-based company, SmallCapInvestor.com spoke with China Direct’s president Marc Siegel. 

I spoke with China Direct’s executive vice president, Rich Galterio, at the Roth Capital Conference in February and he told me that the market would get a clearer picture of what the company has accomplished once fourth-quarter results were disclosed. Do you think the market is beginning to see the real picture now?

“I still don’t think that the value that’s being attributed to China Direct is still a fair value. Here’s the reality of the situation: we did $14 million in revenue in 2006 and we did $174 million in 2007. We did $169,000 in net income in 2006 and we did $11.8 million in earnings in 2007. We earned a penny in 2006 and we earned $0.67 in 2007 per share. Our assets went from $20.8 million to $88.3 million. As the president of this company and as the guy who’s given his blood and guts to doing this, I have a hard time believing the growth rate that we’ve achieved. I can’t even imagine because of what people have seen with the CXTIs [China Expert Technology, Inc.] of the world and other Chinese companies who maybe didn’t do their accounting properly, didn’t report properly, or who didn’t record contracts properly, that people believe that growth is what it really is.”

Why do you think the market is missing this?

“It’s a hard story to understand. We’re still new to the market. The reason Rich told you that the Street would get a better picture at the end of 2007 is that this is the first full year that we’ve owned Lang Chemical, Chang Magnesium and the other Chinese companies. We only raised our money in October and November of 2006 and recently raised $13 million in February of 2007. We really haven’t been around that long.

"I think the value of China Direct will be unlocked when we show that we can monetize one of our investments. We started with Chang Magnesium in December of 2006 and we bought that company for roughly $2.55 million. At the time we bought the company, its audited number was $27 million. They did $94 million under China Direct. If we proved that we were able to buy that one magnesium company and then we’re able (with the wind at our back because we bought it when magnesium prices were $1,850 a ton; today they’re $4,000 a ton) to buy other magnesium manufacturers and build that company into a $200, $300, $400 million company over 18 to 24 months, and we could show that we turned a $25 million investment into a $300 million [investment], then we’ll prove to Wall Street that not only is China Direct a diversified portfolio of Chinese companies, but that we run a diversified portfolio of Chinese companies [in which] we can get at such low valuations that you can get venture capital returns inside a publicly traded company. That will make us a Wall Street darling and then we could get the same kind of multiple as some of the sexier Chinese stocks that we see on Wall Street.

"We grew to $0.67 per share fully diluted in 2007 and we’re trading at 12 times that number. We told the Street that will earn $24 million in 2008. We only have 21 million shares outstanding right now. That translates to about a $1.14 per share, which means I’m trading at less than eight times my current year’s projection. That’s too low for a growing company.” 

Chinese stocks have come under pressure since the United States slipped into a financial crisis. Some say Chinese stocks will remain under pressure until the domestic situation is diffused. Do you feel any of this pressuring your stock?

“The Shanghai exchange is down 34% year-to-date. That cannot help a company whose name begins with China. However, I do believe that as the U.S. becomes more educated as to how business is done in China and people start seeing more as the Olympics come into view, I think people will see it’s not as communistic as people think. It’s much more a capitalistic society.

"I think there will be investors coming into the Chinese market. There’s only about 250/260 Chinese traded companies, so when they do start to buy them, the companies start to move very, very quickly. There’s not that much market cap, so when that kind of money chases that small amount its moves are very dramatic to the upside.”

You raised 2008 guidance pretty substantially this week. What were the major driving factors behind that decision?

“First, we said we’re going from $174 million in 2007 to $320 million in revenue in 2008 and we’re going from $11.8 million in earnings to $24 million in earnings. Most of that comes from the fact that we’ve built capacity at our magnesium operations. Last year we manufactured about five or six tons of magnesium and we resold about 30,000 tons. This year, we will manufacture 40,000 tons.

"The margins on manufacturing are six times that of distribution. Our model will be much more evenly scaled between distribution and manufacturing. Here’s how you come up with the number. If we say we’re going to earn $320 million, if we sell 80,000 tons of magnesium, which would make us about 10% of the worldwide market — the biggest player in the world — that’s $240 million out of the $320 million. Now I haven’t counted my consulting division or my basic materials division, and I’m using $3,000 as my price for the calculation when spot prices today are $4,000 a ton.

"If magnesium stays at four or goes higher we’ll probably have to raise guidance again for Wall Street, but I don’t want to get too far ahead of myself.”  

What were some key performance drivers for the first quarter?

“Magnesium will certainly be our biggest driver in the first quarter. I believe that we will see a good contribution from our consulting division as well.”

You stated in your fourth-quarter earnings press release that you have an internal growth target of 30% in 2008. Has that target changed since your new guidance?

“We’re guiding higher than 30% growth. We target 30%; we hope we can do better.”

China Direct grew at a torrid clip in 2007. Will you grow at the same pace in 2008 and if so how long do you foresee this pace to be sustainable?

“I could not increase my revenues 11-fold like I did last year. I could not go from $169,000 to $11.8 million, but I do believe that with acquisitions and with internal growth we can continue to grow at 50% a year, which is why I believe that whether we were Chinese or not we should have a higher P/E multiple.”

Operating expense as a percentage of gross profit substantially declined in 2007. What enabled you to achieve that and do you expect that trend to continue in 2008?

“They will not increase as a percentage, but what happens is as you reach economies of scale and as we do more and more revenues we pretty much have the infrastructure in place now to expand our business. I do not expect that to increase as a percentage of our earnings or our sales.”

What will be some key drivers behind the company’s performance in 2008? Which segment of your business will be the major earnings driver in 2008 and why?

“I believe it will be magnesium. The total world wide magnesium market in 2007 was 755,000 metric tons. We distributed somewhere around a little under 30, so we were a little under 5% of the market. This year we think we’ll be 10% of the market. The market will probably be closer to 855,000 metric tons.

"The reason magnesium prices are on such a tear — as other commodity prices are as well, but magnesium in particular — [is that] there’s more and more uses for magnesium today than ever before. The biggest driver is the fact that oil prices are so high. In order for the automobile manufacturers to make cars more fuel efficient, there are only two things they can do: they can either make better, more efficient engines, or they can make lighter cars. The specific quality of magnesium that makes it so desirable is that it’s lighter and stronger than aluminum. The more parts that they could make from automobiles from magnesium, the lighter the cars will be, the more fuel efficient we’ll be.

"The International Magnesium Association estimates that by 2010 and 2011, the average car, which today uses about 5 kg of magnesium, could be using up to 30 kg of magnesium. That’s a six-fold increase just in the automobile industry. Forget about the fact that the back of your iPhone is made out of magnesium alloy and they’re selling iPhones like they’re candy. In addition to that, the new Panasonic tough book that they’re advertising on TV, [is] called a tough book because it’s got a magnesium casing. If you drop it, it won’t break as easily as, lets say, your average ordinary laptop. That’s why I believe the price has substantially increased.”

Are you seriously considering new acquisitions in the near term for your management segment and if so who are you targeting? Are you seeking to enlarge your exposure to the magnesium market or will you dip into other areas with natural resources?

“We’re industry agnostic. We’ll buy any company that we think fits our parameters. We looked at probably 15 acquisition candidates. We’re in various stages of negotiations. We like a few of them very much, but at the present time we haven’t pulled the trigger on anything. We’re always looking for companies that could be accretive to our revenues and our earnings.

"[There’s] a lot of potential in magnesium, because as you grow bigger people migrate to you. So we do have a lot of prospects that we’d like to join our magnesium company, but I don’t necessarily want to be solely a magnesium company. I like to diversify a little bit. So I’m not sure, but we’re seeing companies in a lot of different areas. We really like the natural resources space for one particular reason and it’s that China is one of the largest users of natural resources. Natural resources, by their nature, are a depleting commodity, so supply and demand would dictate that we’re in pretty good shape with the prices going up and the demand as strong as it is.”

Given your success in 2007 on the management side, do you think your strategy/business model is gaining traction in China and will it better enable you to close future acquisitions faster and easier? Why?

“One-hundred percent. Our model has worked so well because every company that has joined the China Direct family has flourished under our umbrella. Also, I think a lot of the Chinese companies that are public today realize that the move from being a Chinese private company to being a U.S. public company is a lot more complicated than they thought when they actually made the jump. We think under our model people can gradually move in and learn, so that when they start to swim with the sharks they fully know how to swim.”

What is your outlook for magnesium prices?

“The estimates are questionable. We’re using 3,000 internally. We think it will be higher, but I cannot give you a number. Our job as a management team is to make sure we’re the lowest cost producer, so that if magnesium prices do go down, everyone else will suffer worse than China Direct.”

How has your position in the magnesium production space changed over the course of 2007 and how will your position change in the coming year?

“Last year, we only produced about 5 or 6,000 tons. This year we’ll produce 40,000 tons. The margin in manufacturing is roughly 24% to 25%. The margin in distribution is roughly 3% to 4%, so you can see the dramatic change in the margins as our business mix continues to migrate towards manufacturing and away from pure brokerage or distribution.”

You said you want to be the global leader in the production and distribution of magnesium. Rich Galterio said ultimately he’d like people to think magnesium when they think China Direct. I know you’ve already made substantial progress in that space, but what future steps will you take to bolster your position in magnesium?

“I’m not sure. There’s a potential that at the right valuation, if it would create additional shareholder value and our company is not receiving the value it should have because we are diversified as opposed to a one product company, then we could actually monetize the magnesium business. Either spinning it off to our shareholders, selling it to a SPAC, doing an IPO or doing a registered distribution.”

The World Bank came out yesterday saying that it is lowering its 2008 GDP forecast for China to 9.4% (2% points from 2007). How will China’s broader economy (macro outlook) affect China Direct’s business?

“I really don’t know at the present time. I would rather be doing business in China than doing business in the United States. Nine-point-four-percent growth is a lot better than the growth we’re having here. We don’t see any risk to our earnings and revenues from the World Bank lowering their growth rate for China for next year.”

What are some potential barriers to continued growth?

“We are seeing more competitors who are trying to buy more companies in our space. Historically in our space targeted companies doing under $100 million in revenue and most of the bigger players — Goldman Sachs, for example — don’t go after those types of companies. We are seeing a lot of small investment banks, a lot of hedge funds starting to come into China to try to do what we’ve done, which is create this arbitrage between where we could buy these companies in China and  where they will actually trade in U.S. capital markets.”

I know you’ve just been listed on the Nasdaq. But are you taking on other greater efforts to augment corporate branding and increase visibility domestically and internationally for your stock?

“We just received research coverage from Dilbert Securities, which is not a household name. We have research now from Global Hunters Securities — also not a household name. We’re anticipating Roth research coverage, but we don’t know when or if it will happen. On our [earnings] call on Monday, we had 112 investors. More and more people are watching us. 

"We hired our first U.S. employee in Shanghai to go out and market the China Direct name. In addition, we’ll be on national TV on May 12 when we ring the bell on the Nasdaq market.”