PSB Monthly Issue October 2010

Huge fortunes have been made in the stocks of companies participating in this multi-trillion dollar endeavor.  In fact, many of you have experienced this first hand with some of our past recommendations.

Most of the companies grabbing the headlines and investment dollars are heavy industrials.

These are companies in industries like iron, steel, cement, construction, and machinery.  They provide the materials needed to build roads, highways, bridges, dams, ports, railways, airports… everything a growing country needs.

And many of these companies have rewarded investors with outsized returns.

However, one particular infrastructure industry has been largely overlooked by many investors.  And it offers huge profit potential going forward.

I’m talking about China’s emerging valve industry.

Valves are an integral part of any modern infrastructure.  They’re needed to regulate the flow of various fluids.  The vast majority of valves are used in water supply, petrochemicals and oil, power generation, and metallurgy.

China’s valve market is large and growing fast…

In 2009, valve sales in China reached $12.3 billion.  That’s a whopping 69% higher than just two years earlier.  And according to the China Valve Industry Association, China’s valve market is expected to grow 31% annually over the next few years.

That’s red hot growth any way you slice it.

The primary drivers are the energy and water industries.  Remember, the Chinese government implemented a $586 billion economic stimulus package in 2009.  A big chunk of those funds is being spent on infrastructure projects for water, electricity, and gas.

Take the thermal power industry for example…

The industry is transitioning from 300 MW units to 1,000 MW supercritical pressure units.  These larger units are more energy efficient and produce far less pollution.  With the smaller, less-efficient units providing 74% of China’s thermal power generation capacity, the growth opportunity in this area is off the chart.

More importantly, only one company in China makes valves used in these units.

Nuclear power also offers terrific growth potential…

China plans on building ten nuclear power generating units with capacity of over one million KW each.  And the Chinese state energy plan calls for 60 more units by 2020.

Demand for valves used in the nuclear power industry is higher than demand in the thermal power industry.  A nuclear power station with two sets of one million KW nuclear generating units typically requires about 30,000 valves.

Based on an increase of 2.5 million KW of nuclear power generating units per year, the average annual demand for valves should hit 38,000.  By any measure, that’s a lot of valves.

Water is yet another industry with skyrocketing demand…

The Chinese government is spending billions on water infrastructure projects connecting the Western and Eastern regions of China.  They’re also spending huge sums building pipe networks in major cities and expanding the wastewater treatment system.

Annual demand for valves by the water industry is expected to top $1.5 billion.

As you can see, China’s valve industry is poised for several years of blistering growth. And one Chinese valve manufacturer in particular is going to grab a large share of this industry.

Introducing, China Valves Technology (NASDAQ: CVVT).

THE VALVE BUSINESS

CVVT is a leading provider of high-quality metal valves in China.  Created as a state-owned enterprise in 1959, they’ve been manufacturing valves for over five decades. As you can imagine, the company has one of the best known brand names in China’s valve industry.

Over the past four years, CVVT’s growth has been out of this world.

Revenue has grown at a compound annual growth rate of 48%.  Sales have soared from just $20 million in 2005 to over $95 million last year.  Best of all, net profits have grown nearly 7-fold from $3.7 million to almost $25 million.

Here’s why…

The company’s product line is extensive to say the least.

They sell over 800 models with more than 10,000 specifications of low, medium, and high-pressure valves.  And they have certifications from national and international organizations, including the American Petroleum Institute, for a number of their valves.

CVVT has also made several strategic acquisitions.

With over 4,000 small companies, the Chinese valve industry is highly fragmented. CVVT has already completed four key acquisitions since 2007.  And they plan on using their brand advantage to consolidate China’s valve market and increase market share.

What’s more, CVVT has several competitive advantages…

The company has the broadest range of valve products in the industry.  They enjoy leading market positions for each of their key products.  And huge investments in research and development as well as manufacturing capacity give them an edge on price.

As you might imagine, customers are flocking to CVVT like flies to honey.

Over 400 large-scale equipment enterprises throughout China buy valves from CVVT. Most of them are state-owned entities in the electricity, petroleum, chemical, water, gas, nuclear power, and metallurgy industries.

And thanks to the company’s vast product line and reputation for quality, they do a huge amount of repeat business.  About 50% to 60% of the company’s sales are to existing customers.

However, new business comes rather easily as well.

About 70% of the new, non-repeat business doesn’t require competitive bidding. Customers either trust the company’s brand or know only CVVT can produce the valves they need.

But here’s the best part…

CVVT is perfectly positioned to profit from major industry growth trends.

Earlier I told you about the thermal power industry’s transition to 1,000 MW super-critical pressure units.  Well, CVVT is the only Chinese valve manufacturer with capacity to make valves for these units.  As such, they’re poised to grab a huge share of this lucrative market.

Likewise, the company has an edge in nuclear power.

They’ve been supplying valves to two large nuclear power stations since 2007.  And they were recently certified as a qualified supplier to China Nuclear Power Engineering (CNPE).  CNPE is the first Chinese company focusing on professional nuclear power construction and management.

Petrochemicals also offer huge growth opportunities.

The industry is focusing on building long range oil and gas pipelines throughout China. These projects are boosting demand for ball valves and flat valves.  CVVT has recently completed designs for these valves and added equipment to begin production.

And let’s not forget about water.

The government spending spree on water supply and water treatment will continue driving sales at CVVT.  Large butterfly valves are a key component of these systems. And CVVT makes the largest butterfly valves in China.

No doubt about it, CVVT is poised for huge growth going forward.

They have a strong brand, a broad product line, huge manufacturing capacity, a massive customer base, and robust industry growth trends.  A close look at the company’s numbers and financial projections confirms it.

THE NUMBERS

CVVT’s numbers for the first half of 2010 show amazing growth.

Revenue surged an astonishing 79% to $76 million.  Net income soared an eye-popping 553% to nearly $21 million.  And earnings are up more than five-fold to $0.60 per share.

The company’s clearly firing on all cylinders.

The Chinese economic stimulus and the company’s recent acquisitions are driving this huge growth.  And significant sales gains in petrochemicals and nuclear power show the company’s expansion into new markets is working as planned.

The outlook going forward is for more robust growth…

For all of 2010, revenue is expected to jump more than 75% to $167 million.  And earnings are forecast to surge 55% to $1.24 per share.  Just the kind of growth we need to drive the shares higher.

Next year’s outlook isn’t too shabby either.

Revenue is expected to increase by a solid 17% to $196 million.  And earnings are forecast to jump 16% to $1.44 a share.  Plus, these estimates could easily move higher if the company makes an acquisition or two.

In addition to hefty growth potential, CVVT also sports a solid balance sheet.

They’ve got $13.4 million in the bank and $63 million in working capital.  Short term liquidity is ample with current assets 2.7x current liabilities.  And the company has no long-term debt whatsoever.

INVESTMENT RISKS

Of course, an investment in CVVT is not without risk.

The company’s strong growth outlook depends on continued government investment in infrastructure projects.  A halt in government spending could hurt CVVT’s ability to grow.

Another risk is the company’s ability to grow through acquisitions.  If CVVT is unable to find suitable acquisition targets at reasonable prices, their growth could slow.

A third risk is a potential economic slowdown.  If the company’s customers don’t continue growing, demand for valves could decline.

POTENTIAL RETURNS OF 80% OR MORE

CVVT shares are itching to explode into a major new uptrend.

Massive government investment in China’s energy, water, and petrochemical infrastructure is driving robust demand for valves.  As a major player in China’s emerging valve industry, CVVT is perfectly positioned to cash in on this trend.  And the trend should last for several years to come.

Despite the strong growth outlook, however, CVVT shares are badly misvalued by the market.

At a recent price of $8.01, the shares are trading at just 6.5x the 2010 earnings estimate of $1.24.  And they’re trading at a paltry 5.6x the 2011 estimate of $1.44.

These are both astonishingly low P/E ratios for a company projected to grow earnings 22% a year over the next five years.  In fact, at the recent price, CVVT has a PEG ratio of just 0.30.

In other words, the shares are trading at a 70% discount to the projected earnings growth rate.

This gives us a golden opportunity to snap up shares of CVVT on the cheap.  We can establish our position now and reap terrific profits as the market restores the shares to a fair valuation.

The average P/E ratio in the industrial goods industry is 16.8x trailing earnings.  With a more conservative P/E of just 10x the 2011 estimate, CVVT shares are worth $14.40 a share.

That’s upside potential of 80%!

Based on our analysis, we see CVVT trading up to at least $14.40.  Buy CVVT shares now for potential gains of 80% or more.

ACTION RECOMMENDATION

BUY China Valves Technology (NASDAQ: CVVT) up to $8.80 per share.

Chip equipment stocks have been volatile lately.

We’ve seen it first hand with a few of our previous chip equipment stock recommendations.  But I’m not worried.  Generally speaking, pullbacks in these stocks offer great buying opportunities.

Here’s why…

Recent data show the industry’s still growing rapidly…

According to SEMI, the global chip equipment industry association, second quarter 2010 billings worldwide hit $9.1 billion.  That’s a smart 22% increase over the first quarter.  And a whopping 240% surge over the year ago period.

Bookings jumped as well.

SEMI reports global second quarter bookings reached $11.7 billion.  That’s 22% higher than the first quarter.  And it’s a stunning 296% year over year increase.

SEMI also gave us great news for 2011…

Semiconductor fabs are expected to increase production capacity by 8% next year. This will involve spending $39 billion on new chip manufacturing equipment. That’s an increase of 18% over 2010 spending levels.

Best of all, spending will top the pre-recession spending peak hit in 2007.

This sure doesn’t sound like bad news for chip equipment makers.

With fabs spending billions on new equipment, one industry niche is sure to prosper. I’m talking about gas-delivery systems.  These systems control the flow, pressure, sequencing, and mixing of specialty gases used in chip manufacturing tools.

Gas delivery systems are critical components throughout the manufacturing process.

You see, various specialty gases are used in many of the key steps in the chip manufacturing process.  Steps like deposition, etch, cleaning and annealing to name a few.  Without proper gas delivery systems, the manufacturing process would come to a screeching halt.

Through my research, I’ve found a penny-sized company specializing in this field. They’re knocking the cover off the ball this year… and they look ready to do the same next year.

The company is none other than, Ultra Clean Holdings (NASDAQ: UCTT).  Let’s take a look under the hood.

Key Investment Data Name:  Ultra Clean Holdings Ticker Symbol:  UCTT Market Cap:  $197 million Recent Price:  $9.00 PSB Rating System 4.6 Stars Raging Revenue:  (4.7 stars) Revenue is expected to jump 181% in 2010 and 17% in 2011.  The ongoing semiconductor capital investment cycle should drive growth through next year at least. Beautiful Books:  (4.7 stars) Earnings are expected to turn positive in 2010 and surge 35% in 2011.  Plus the company has a strong balance sheet with $23 million in cash and $19.8 million in long term debt. Stellar Structure:  (4.5 stars) Insider ownership is a bit lower than we’d like at 3%.  However, institutional ownership of 84% is very robust.  The smart money clearly loves this company. Valuation Verification:  (4.5 stars) The stock is mispriced by the market.  Based on our valuation analysis, we think the stock is worth at least $15.23 a share.  That’s upside potential of 69% or more. Meaningful Milestones:  (4.7 stars) The company has strung together three straight quarters with positive earnings.  And they’ve posted upside surprises in each of the last four quarters.

THE CHIP EQUIPMENT BUSINESS

UCTT is a leading supplier of critical subsystems for the semiconductor manufacturing industry.  They design, develop, and manufacture highly specialized subsystems tailored for specific steps in the chip making process.

Their primary products are gas delivery systems and chemical mechanical planarization subsystems.

The company’s customers are some of the biggest manufacturers of chip equipment. These include Applied Materials (AMAT),Lam Research (LRCX), and Novellus Systems (NVLS).

In order to reduce manufacturing costs and product delivery times, chip equipment makers now outsource certain functions.  One of these functions is the manufacture of gas delivery systems.

UCTT has established themselves as one of the leading providers of these critical subsystems.  How did they do it?  By focusing on efficient manufacturing, reducing design-to-delivery cycle times, and by ensuring high product quality and reliability.

The company’s now focusing on boosting growth.

One way is by increasing market share with chip equipment makers.

Their plan is to capture new outsourcing opportunities for other kinds of critical subsystems.  This is a smart way to leverage existing customer relationships.  And it’s a clever strategy for increasing productivity.

UCTT is also expanding into other technologically similar markets.

For example, they’re making large subsystems for use in the flat panel, energy, and medical equipment industries.  In fact, Intuitive Surgical (ISRG), a major medical equipment manufacturer, became one of the company’s biggest customers last year.

And finally, the company’s keeping a lid on manufacturing costs.

UCTT has two manufacturing facilities in China and one in Singapore.  These are both lower cost manufacturing regions compared to the U.S.  And the company employs stringent cost containment and capacity enhancement initiatives.

UCTT clearly has a sound growth strategy and an efficient operating model.  A quick glance at their financial numbers shows you both are working beautifully.

THE NUMBERS

UCTT has been on fire through the first half of 2010.

Revenue soared 338% to just over $204 million.  After posting a net loss of ($21 million) in the first half of 2009, the company rang up a big net profit of $9.5 million. And earnings shot up from a loss of ($0.99) to a profit of $0.41 per share.

Quite a turnaround in a challenging economy…

Even better, UCTT revenue and earnings beat management’s guidance and analysts’ estimates in both quarters.  Remember, nothing drives a stock price like upside surprises.

And, the best is yet to come…

Management’s forecasting record revenue and earnings for the third quarter.  Full year 2010 revenue is expected to soar 181% to nearly $450 million.  And 2010 earnings are expected to hit $1.05 per share.

But it doesn’t end there…

Full year 2011 revenue is expected to jump more than 17% to $527 million.  And 2011 earnings are forecast to surge 35% to $1.42 per share.  With growth like this, the shares are sure to move higher.

What’s more, strong growth isn’t the only thing going right for UCTT.  The company also has a solid balance sheet.

They’re sitting on $23 million in cash.  With current assets 2.5x current liabilities, short-term liquidity is no problem.  And the company has just $19.8 million in long-term debt.  A very manageable amount for a company with over $73 million in shareholder equity.

INVESTMENT RISKS

Like any investment, UCTT does involve some risks.

The positive outlook for UCTT depends on the continued recovery of the global economy and the chip industry.  A slip back into recession would likely hurt future results.

Another risk is the lack of patent protection for the company’s intellectual property.  If UCTT fails to adequately protect their intellectual property, the company could lose their competitive position.

A third risk is the company’s reliance on a small number of large customers for a big portion of sales.  The loss of one or more of these customers could cause business to suffer.

POTENTIAL RETURNS OF 69% OR MORE

UCTT is primed to deliver outstanding gains going forward.

The company has a unique niche in a fast growing industry.  They’re expanding market share within existing markets.  And they’re expanding into new markets.  All the while, management’s keeping a tight grip on costs.

The semiconductor capital investment cycle is in full gear.  And with fab spending on equipment poised to hit $39 billion next year, the cycle shows no signs of slowing down.

This is a perfect environment for UCTT to show consistent quarterly gains in revenue and earnings.  And you know what that means… higher share prices ahead.

Despite the bullish outlook, UCTT shares are misvalued by the market.

At a recent price of $9.00, UCTT is trading at just 8.6x the 2010 earnings estimate of $1.05 a share.  And, the shares are trading at a mere 6.3x the 2011 estimate of $1.44.

These are meager P/E ratios for a company expected to grow earnings 20% annually over the next five years.  In fact, the company’s PEG ratio works out to just 0.43.

In other words, UCTT is trading at a 57% discount to their projected earnings growth rate.

The average P/E ratio for companies in the chip equipment industry is 14.5x trailing earnings.  Using this metric, UCTT is worth somewhere between $15.23 and $20.88 a share.

That’s potential upside of 69% to 132%!

Based on our analysis, we see the stock trading up to at least $15.23.  Buy
UCTT now for potential gains of 69% or more.

ACTION RECOMMENDATION

BUY Ultra Clean Holdings (NASDAQ: UCTT) up to $9.90 per share.

Recent price is $9.00.

Use a stop-loss of $4.50 on this position.

Don’t forget your position sizing and stop-loss rules.

Portfolio Update

• None at this time.

 

Category: PSB Monthly Issues