PSB Monthly Issue November 2009
November 2009
WITH THIS CHINESE COAL PRODUCER
China’s economy is firmly on the path to higher growth.
Recent data show it grew at a robust 8.9% rate in the third quarter. With growth accelerating, it’s on track to hit the government’s 8% growth target for 2009.
Given the severity of the global economic recession, 8% growth would be a remarkable achievement.
Most economies around the world are expected to shrink in 2009. In fact, the International Monetary Fund is forecasting the world economy will contract by 1.5%.
As we’ve said all year long, China’s fast growing economy offers tremendous investment potential.
In keeping with this theme, our first recommendation is a play on China’s renewed economic expansion. We’ve found a wonderful little Chinese coal producer with our favorite investment traits… a high growth rate and a misvalued stock price.
But before we get into the details, let’s take a closer look at China’s coal industry.
China’s economic growth is driven by development of its infrastructure and heavy industry. These efforts in turn are generating huge demand for steel and power generation.
Coal is key to ensuring steady supplies of both.
Because China has limited oil and natural gas reserves, it relies heavily on its abundant coal resources. China’s recoverable coal reserves are the third largest in the world behind the U.S. and Russia. However, China is the world’s largest producer and consumer of coal.
And, for good reason.
Coal is the lifeblood of China’s economy.
It generates about 70% of China’s electricity. It produces heat required for many industrial processes. And, it’s the basic material used in the production of iron and steel. (China’s the largest steel producer in the world.)
Although China produces more coal than any other nation, domestic supply has not kept up with demand. From 2004 through 2007, China’s coal supply rose 7% a year while demand jumped nearly twice as fast at 13% annually. With China’s economic growth accelerating, we see demand for coal continuing to outpace supply.
Recent monthly coal industry data supports this view.
The data show coal supplies are low, just as China’s economic recovery is starting to drive demand higher. Production levels were cut earlier in the year as demand fell due to the recession. But, inventories have been drawn down to frighteningly low levels.
The coal industry’s biggest customers – electricity generators and industrial plants – are stepping up their coal purchases.
China’s power companies need more coal to boost electricity generation to meet rising demand. Power consumption jumped 10% in September from a year ago. And, demand from other large coal consuming industries – steel, cement, and chemicals – is accelerating as they ramp up production.
Demand for coal is also rising on seasonal factors. With winter fast approaching, industrial plants are buying more coal to ensure a steady supply for heat generation. They don’t want to get caught with inadequate supply just when they need it most.
What’s the effect of all this on coal prices?
They’re starting to move higher of course. Since mid-September, coal prices have increased six weeks straight. They’ve gone up 6.6% a week on average. And, last month they hit a new high for the year.
As a result, Chinese coal producer stocks are poised to move higher.
But, China has over 14,000 small coal producers. How do we find one that has a good chance of providing a huge return?
We’ve identified four qualities that a small coal producer must have to ensure long-term success: (1) Substantial coal reserves, (2) Increasing production capacity, (3) A sound growth strategy, and (4) A strong balance sheet.
One small Chinese coal producer trading on the OTC Bulletin Board has all of these qualities. That company is L&L International Holdings (OTCBB: LLFH).
Name: L&L Int’l Holdings Ticker Symbol: LLFH Market Cap: $118 Million Recent Price: $5.45 PSB Rating System 4.7 Stars Raging Revenue: (5.0 stars) Revenue jumped 19.5% in the most recent quarter to $12.75 million. Management expects revenue to soar 164% in FY 2010 to $108 million. Beautiful Books: (5.0 stars) Earnings rose 7% in the most recent quarter to $0.13 per share. Management is forecasting earnings to double in FY 2010 to $0.94 per share. The balance sheet is solid. Stellar Structure: (4.5 stars) Insider ownership is solid at 45%. Management obviously believes very strongly in the company’s future. There are no institutional holders right now. But, expect that to change if the stock uplists to a major exchange. Valuation Verification: (4.7 stars) The stock is badly mispriced by the market. Based on our valuation analysis, we think the stock is worth at least $11.28 a share. That’s upside potential of 107% or more. Meaningful Milestones: (4.5 stars) The company will present at the Raymond James Coal Investors Conference on November 10th. |
THE COAL PRODUCTION BUSINESS
LLFH is engaged in coal mining, consolidation, and wholesaling in the coal rich Yunnan province of China. While the company’s based in Seattle, Washington, they conduct operations through two Chinese subsidiaries.
L&L Coal Partners conducts the mining operations. They own a 60% interest in two operating coal mines. And, they own two other mines currently under development.
The second subsidiary, Kunming Biaoyu Industrial Boiler Co., operates the coal consolidation and wholesaling business. This operation focuses on aggregating and sorting coal from LLFH’s mines and those of other smaller coal producers.
Let’s see how LLFH measures up on the four qualities for success.
The company’s coal reserves are substantial.
Total reserves stand at 86.7 million tons. Reserves at the two operating mines, DaPuAn and SuTsong, are 18.7 million tons. And, the two mines in development, Tian Ri and Laos, have combined coal reserves of 68 million tons.
Using an average price of $130 per ton, the total value of LLFH’s coal reserves is about $11.3 billion.
Production capacity is strong and growing.
The company’s total production capacity is approximately 2.3 million tons per year. LLFH recently obtained approval from the Chinese government to increase production from 240,000 tons to 300,000 tons a year. And, they expect to boost production to 455,000 tons per year when production begins at their third mine.
LLFH is growing through a shrewd acquisition strategy.
By acquiring coal mines, the company’s expanding their coal reserves and production capacity. Right now they’re in the process of acquiring the Ping Yi mine.
This mine would add 31 million tons to reserves and 150,000 tons per year in long term production capacity. Management believes the additional production would add $19 million in revenue per year (using an average price of $130 per ton).
They also have several other mines in their sights.
LLFH is also expanding vertically by entering the lucrative coking business.
Coking is the process of turning coal into coke. Because coke doesn’t give off smoke when burned, it’s used as a fuel for heating stoves and furnaces. Coke is also used as a reducing agent in smelting iron ore to extract the iron. This is an important first step to turning iron into steel.
The best part about coke is… the price per ton is much higher than coal’s.
In October, LLFH acquired the coking facilities of Hon Shen Coal Company. These facilities have annual coke production capacity of 150,000 tons. Management says they’ll add about $18 million in revenue per year (using an average price of $150 per ton).
The company also acquired Hon Shen’s coal washing operation. These operations add 300,000 tons of annual coal washing capacity. LLFH now has capacity to wash 570,000 tons of coal annually.
And, they’re not through expanding by a long shot.
As you can see, LLFH has three of the four qualities we look for in a small coal producer. Now, let’s take a look at their financials to see if they have the fourth quality – a strong balance sheet.
THE NUMBERS
The company’s FY 2009 numbers were nothing short of amazing (their fiscal year ends in April).
Revenue soared 75% to just over $40 million. Net income increased a mind-boggling 610% to $9.95 million. And, earnings per share skyrocketed 820% to $0.46.
A fantastic year all the way around.
The company’s continuing to show profitability in the first quarter of FY 2010 (the most recent quarter). Revenue increased by a solid 19.5% to $12.75 million. Net income increased 4% to $2.69 million. And, earnings per share rose nearly 7% to $0.13.
These results only include one month’s production from the newly acquired coal washing facilities at Hon Shen and DaPuAn. Management expects results to be more impressive in the second quarter when they include a full three months of production.
The outlook for FY 2010 is for more phenomenal growth.
Management just reaffirmed their guidance last month. They forecast revenue of $108 million and earnings per share of $0.94. That’s huge year over year growth of 164% and 104% respectively.
As you probably suspected, LLFH does indeed have a strong balance sheet.
At the end of last quarter, they had $6.4 million in cash and $26.6 million in working capital. Current assets of $42.7 million dwarf current liabilities of just $16 million. And, long term debt of $3 million is reasonable given shareholder equity of $26.4 million.
INVESTMENT RISKS
Now, an investment in LLFH is not completely without risk.
The company’s ability to grow quickly depends on its ability to raise funds in the capital markets. If LLFH is ever unable to raise capital, they’re growth could suffer.
Another risk for shareholders is the potential dilutive effect from the company’s acquisition strategy. LLFH could issue shares of stock to complete future acquisitions that may be dilutive for shareholders.
A third risk is fluctuations in exchange rates between the Chinese Renminbi and the U.S. Dollar. If the Renminbi appreciates against the Dollar, LLFH’s financial results could be negatively impacted.
POTENTIAL RETURNS OF 107% OR MORE
LLFH is poised for big returns in the coming year.
The company continues to boost production capacity across all lines of business. And, prices continue to rise as demand for coal and coke outpaces domestic supplies. These two dynamics should continue driving revenue and earnings at a rapid rate.
Despite the company’s extraordinary growth, the shares are misvalued by the market.
At its recent price of $5.45, LLFH is trading at just 5.8 times management’s FY 2010 earnings forecast of $0.94 a share. This is well below the industry average P/E ratio of 16.4.
Using the industry average P/E, LLFH is worth about $15 a share. That’s upside potential of 175%.
Based on our analysis, we see the stock trading up to at least $11.28. Buy LLFH now for potential gains of 107% or more.
ACTION RECOMMENDATION
BUY L&L International Holdings (OTCBB: LLFH) up to $6.81 per share.
Recent price is $5.45.
Use a stop-loss of $2.73 on this position.
Don’t forget your position sizing and stop-loss rules.
WITH THIS SOFTWARE PROVIDER
The wireless communications industry is undergoing a monumental change. Older and slower analog wireless networks are being replaced by high speed broadband networks.
High speed networks are critical to the industry’s future.
They make it possible for mobile customers to surf the web, send email, download music, watch TV, see video, and play video games. These applications now account for about 25% of all wireless service revenues.
Demand for wireless data services is skyrocketing.
The number of wireless data subscribers is expected to grow from 41 million in 2008 to 757 million by 2013. And, worldwide mobile data revenue is forecast to expand from $102.4 billion in 2006 to $251.9 billion by the end of 2012.
A combination of faster networks and cool new mobile devices is just too appealing for consumers to pass up. Smartphones have become the new must have gadget thanks to the iPhone.
And, the new netbooks are a big hit with consumers too. Sales of the tiny computers are expected to hit 20 million units in 2009 and 75 million units by 2014.
The migration to wireless data services is creating a huge opportunity for the likes of Apple, Research In Motion, AT&T, and Verizon. But, the big boys aren’t the only ones benefiting from this trend.
We’ve discovered a quality microcap software company right in the middle of this transition. The company’s software is used by both wireless service providers and mobile device manufacturers. As you can imagine, the company is poised for solid growth as wireless services expand.
That company is Smith Micro Software (NasdaqGS: SMSI).
Name: Smith Micro Software Ticker Symbol: SMSI Market Cap: $294 million Recent Price: $9.08 PSB Rating System 4.5 Stars Raging Revenue: (4.2 stars) Revenue is up 10% to $49.8 million for the first half of 2009. Management expects revenue for the full year to come in between $110 to $115 million. That’s 12% to 17% year over year growth. Beautiful Books: (4.7 stars) Analysts expect earnings to grow an impressive 20% a year over the next five years. The company’s balance sheet is rock solid with $14 million in cash and no long-term debt. Stellar Structure: (4.8 stars) Insider ownership is decent at 11%. Institutional ownership is a solid 56%. There’s plenty of room for institutions to increase their holdings and drive the stock higher. Valuation Verification: (4.5 stars) The stock is badly mispriced by the market. Based on our valuation analysis, we think the stock is worth at least $15 a share. That’s upside potential of 65% or more. Meaningful Milestones: (4.5 stars) The company won its first contract from a cable operator. This could pave the way for contracts with other cable operators. |
SOFTWARE FOR THE MOBILE COMMUNICATIONS INDUSTRY
SMSI is a leading provider of software products and services for the mobile communications industry. Their software enables seamless broadband connectivity and next-generation media and mobile convergence products over wireless networks.
The company sells its products to many of the world’s leading wireless service providers, original equipment manufacturers, PC and device makers, and large businesses. They also sell retail software products directly to consumers.
SMSI operates through two different business segments.
The Wireless Group focuses on developing mobile connectivity, mobile information management, and mobile security solutions. QuickLink Mobile, the group’s leading product, provides mobile users the ability to easily connect a notebook or wireless device to wireless wide area networks (WWANs) and Wi-Fi hotspots.
Many of the largest wireless carriers worldwide use QuickLink Mobile technology to help subscribers easily connect to their wireless networks every day. Companies like AT&T, Sprint, T-Mobile USA, Verizon, Vodafone, and others employ QuickLink technology.
Enterprise businesses also use QuickLink Mobility products. With more employees working outside the office, companies are depending on remote access to their wireless networks.
QuickLink Mobility is preferred for several reasons.
It works across various kinds of networks, including WWANs, local area networks, and Wi-Fi networks. The applications support most IP services. And, it interoperates with over 200 carriers worldwide and hundreds of the popular mobile broadband mobile devices and embedded WWAN PC notebooks.
The Wireless Group also provides innovative applications for multimedia and personal information management. If you have Verizon or Sprint wireless, you’ve probably used this application to download music to your mobile phone.
The Consumer Group focuses on developing software for the Mac and PC productivity, utility, and graphics market. These products are sold through the company’s website, partner websites, and traditional retail outlets.
The group’s leading product line is StuffIt, which provides superior compression, encryption, and archive capability. The group also sells popular diagnostic and utility software which helps protect against spam, spyware, and hackers.
SMSI has a broad product portfolio, strong brand recognition, and an experienced management team. This gives the company a strong advantage over its competitors. As a leader in its markets, SMSI is positioned perfectly to profit from the huge growth in wireless data transmission.
Now, let’s take a peek at the company’s financials.
THE NUMBERS
Despite the global economic recession, SMSI is showing impressive growth this year. Strong growth in the wireless industry is helping SMSI prosper in an otherwise difficult economic environment.
Here’s a quick summary of the company’s numbers for the first half of 2009.
Revenue is up a solid 10% to $49.8 million.
Strong growth in the wireless business segment is leading the way. And, several new key customer contracts should drive growth in the second half as these new services launch.
The really big news was the company’s signing its first contract with a cable operator. Comcast has enlisted SMSI to help it offer mobile services in its markets. This should pave the way to contracts with other cable operators in the months ahead.
The company also saw its wireless carrier customers launch the first wave of Netbooks. These small computers which are designed for mobile connectivity could really boost sales if they catch on with consumers.
Thanks to rising sales, SMSI is showing strong profitability so far this year.
Net income surged 42% to $9.6 million. Earnings per share jumped 36% to $0.30. And, the company beat the consensus quarterly estimates in both the first and second quarters.
The outlook for full year 2009 is pretty good.
Management is forecasting revenue of $110 million to $115 million. That’s anywhere from 12% to 17% higher than 2008. Pretty impressive growth for an economic recession.
Analysts are projecting a slight 4% increase in earnings per share to $0.72. Not bad when you consider so many companies are expected to post year over year declines in 2009.
We should see earnings growth pick up substantially in 2010.
Analysts are forecasting 18% growth to $0.85 per share. That’s more in keeping with the five year projected earnings growth rate of 20% annually.
In addition to strong fundamental growth, SMSI sports a rock solid balance sheet.
At the close of the second quarter, SMSI was sitting on a cash hoard of $14 million. Current assets were more than five times current liabilities. Cash flow from operations for the first six months is a healthy $9.8 million. And, the company carries no long-term debt.
INVESTMENT RISKS
Of course, an investment in SMSI does involve some risk.
Most of the company’s revenue is derived from a small number of products. If demand shifts away from these products, the company’s business could suffer.
Another risk is competition from Microsoft in the retail software segment. If consumers are satisfied relying on capabilities included with Microsoft operating systems, SMSI’s retail software sales could decline.
SMSI’s success depends on its ability to anticipate and adapt to changes in technology and industry standards. If they don’t stay ahead of the technology curve, their products could become obsolete.
POTENTIAL RETURNS OF 65% OR MORE
SMSI has been a strong performer during the market’s rally off the March low. After hitting a low of $3.64 in March, the stock soared 254% to a high of $12.87 in September.
The stock’s now drifting lower as investors who bought near the lows take profits off the table. Short term profit taking is to be expected after such a big upward move.
This is great for us.
We now have a perfect opportunity to buy SMSI on a dip. Given the company’s strong growth outlook, we see this as nothing more than a temporary pullback. We fully expect the shares to resume their upward move and set new highs in the months ahead.
At its recent price, SMSI is misvalued by the market.
The company is expected to grow earnings at 20% a year over the next five years. Right now, the shares are trading at a P/E ratio of just 12.6. This yields a PEG ratio of 0.63.
In other words, SMSI is trading at a 37% discount to its long term growth rate.
We believe the market will eventually factor in the company’s growth rate to its stock price entirely. Using a P/E ratio of 20 times the 2009 consensus earnings estimate of $0.72, the shares are worth $14.40. And, if we apply that same P/E to the 2010 estimate of $0.85, the shares are worth $17.00.
Based on our analysis, we see the stock trading up to at least $15 a share in the next 12 months. Buy SMSI now for potential gains of 65% or more.
ACTION RECOMMENDATION
BUY Smith Micro Software (SMSI) up to $10 per share.
Recent price is $9.08.
Use a stop-loss of $6.93 on this position.
Don’t forget your position sizing and stop-loss rules.
Category: PSB Monthly Issues
