CADC: Don't slip into these cement shoes
A great company but it will drown investors
A popular caricature of the Italian-American mafia's method of settling a score is placing the feet of the transgressor in cement until it dries and then throwing him into a lake or river to drown - cement shoes. China Advanced Construction Materials Group, Inc. (CADC:NASDAQ), a Chinese ready mix concrete producer may be cement shoes for investors. This Delaware holding company for a Beijing, China based cement manufacturer enjoys great fundamentals and is benefiting from extensive railway infrastructure spending by the PRC. As a bullish long, value investor and analyst, fundamentals are my life-blood. But economic policies in China and massive insider ownership may sink this stock and drown retail investors in losses.
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The latest issue of Business Week magazine warns of a potential bubble occurring in commodities in China. Easy credit policies by the government to maintain China's phenomenal GDP growth has fueled over production of commodities related to the government's infrastructure build out. Author, Dexter Roberts, reports that overcapacity in the cement industry has added 600 million tons of cement to an existing 1.9 billion tons. This already exceeds the projected needs of 1.8 billion tons by 2012. CADC's 2009 revenues reflect this potential overcapacity. While revenues grew 31%, concrete sales increased by only $500,000 or 2% even after resumption of pre-Olympic construction activity in CADC's primary locality, Beijing.. This contrasts with a 44% increase in fiscal 2008. Fortunately, CADC's patented processes have created revenue streams by providing manufacturing and technical services to other concrete providers. Mixer rentals have also generated new income sources. Despite profit margins of 61-92% for these services, future revenue is still ultimately dependent on the supply/demand dynamics in the Chinese market place for concrete.
To evaluate investment opportunities in Chinese equities, I score companies on 10 criterion; P/E, P/CF, Sales and earnings growth, cash ratio, D/E, ROE (DuPont Calculation), ROIC, Insider ownership, and float. By all fundamental measures this company is a a 4-out-of-5 star investment. Its problem is insider ownership and float. Chinese companies listed on American stock exchanges tend to maintain significant insider ownership in order to protect company leadership. Unfortunately, these owners do not understand the dynamics of American stock markets. Stock price movement requires a large enough float so that aroused institutional interest can create demand. CADC is too tightly held. Two officers control 83% of the common shares. Preferred warrants to 27 investors are convertible to 4 shares of common stock and an option for 2 more shares at a purchase price of $2.40/share. Inside ownership and convertible options total more than the number of share outstanding. There is no available float for this stock. This means there is no room for institutional interest to move stock prices. An interested retail investor cannot make money with this stock despite the fundamentals of the company and the potential for long term concrete demand in China.
Furthermore, management has failed to show any progress toward vertical integration, streamlining its supply chain, or geographical expansion over the last two years.
Presently the stock price of CADC is falling. The severe winter months in China slow construction activity. This will heavily impact earnings for Q4 2009 and Q1 2010 for CADC and put further downward pressure on stock prices. If subcontracting income maintains momentum in this slow environment, CADC's P/E may still be extremely attractive to value investors. Don't be fooled. The upside is too limited for the above reasons. Chinese infrastructure growth is an appealing investment, but don't waste your time and money on CADC until management makes three moves.
1) Retires the 7 million dollar debt to 27 investors that represent an over 3.5 million share conversion so that these shares can be offered on the open market.
2) Slowly unwinds insider ownership to increase the available float3) Expands CADC's geographical footprint beyond Beijing (one city cannot grow forever), especially through its high margin subcontracting activities.
Any progress in these areas will certainly arouse my interest in CADC as a play on infrastructure growth in China. China, today, is where America was in the fifties. There are many decades ahead for growth and prosperity. Long term investment in well run Chinese companies is a formula for financial success. CADC is very well managed. Management just needs to understand American markets and everyone will prosper.
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