Recycling Opportunities in China

Amid the recent SEC warnings about investing in companies that have gone public by reverse merger or reverse take-over (RTO) with a dormant shell company, my inner-contrarian perked up at the chance to find an exploitable outlier. Reverse mergers are 100% legal and occasionally used for business unit spinoffs even with reputable companies.

Just consider Frederick's of Hollywood Inc. (AMEX: FOH), which merged with New York City sleepwear manufacturer Movie Star in 2006; Clearwire Corp. (Nasdaq: CLWR), which merged with Sprint Nextel's wireless broadband unit, Xohm, in 2008; and even NYSE Euronext Inc. (NYSE: NYX), parent company of the New York Stock Exchange, which merged with Archipelago in 2006.

The problem for investors is the lack of financial disclosure and scrutiny that would normally be necessary for a successful IPO. Essentially, quite a bit of due diligence is left up to the investor. And the investors that get in trouble are ones who take these companies involved in the reverse merger at face value and compare apples-to-apples without digging deeper. For this case study, I present to you Guanwei Recycling Corp. (Nasdaq: GPRC).

Guanwei is based in Fuqing City and recycles plastic waste from Europe into polyethylene for use by Chinese manufacturers. It went public through a reverse merger last year.

A major risk factor for investors is the financial statement auditor. After all, we depend on the accuracy of the financial statements to make accurate valuations. Guanwei is audited by BDO Limited, the Hong Kong-based member of BDO International. BDO Limited has been in business for 30 years and, through recent mergers, employs more than 1,000 people with 50 partners. BDO Limited's chairman and CEO, Albert Au, is clear that, "All BDO Limited's audits of the financial statements of our SEC registrant clients are conducted in accordance with the standards" of the Public Company Accounting Oversight Board.

It also helps to know that an expert in the field recommends it (in a segment that sees very little mainstream coverage). Joe Giamichael, the managing director and head of China research at Global Hunter Securities, said he stands behind it.

Analysts have just recently visited Guanwei in China and are reporting that all is well with the company. In fact, the firm's business could triple beginning next month if the Chinese government approves a quota increase (as it is expected to) and the company is able to source more raw recyclables. There are other factors, too, including back-to-back positive earnings releases for FY 2010 and Q1 2011, and support and licensing by the Chinese government.

In light of these external factors, let's dive into the financials to see what we're working with. In the past 12 months, Guanwei has generated $53 million in revenues with a 20.8% net margin. Its sales growth from 2009 to 2010 was nonexistent, but gross margin improved from 22% to 32%. For my valuation, I'm using a growth rate range of zero to 30% to allow for both the possibility of another flat year, and increased sales through the additional capacity pending approval.

Discounting back expected future cashflows at 18% (higher than normal because of Chinese monetary policy), and applying a scaled-down book value at $0.20/share, I arrived at a target price range of $6.52 to $7.21, well above the current trading price of $1.57. Guanwei's trailing P/E of 3 and a price-to-book of 1.4 can also make a value investor start to drool.

One of the major risk factors for Guanwei's stock price increase right now is the broad skepticism of, and borderline libelous attacks on, the integrity of small-cap Chinese companies, specifically those that went public via an RTO. The Chinese government's monetary policy is another significant risk factor because it suffocates business growth. It does this by increasing interest rates and limiting access to credit because it fears inflation, and it is artificially repressing the Renminbi (the official currency of the People's Republic of China) to increase exports.

All things considered, there is risk in these small companies, but GPRC passes the litmus test for a legitimate business with a great outlook. I believe this downward trend is nearing exhaustion, and GPRC is a long-term buy opportunity currently trading at a highly discounted market price.

Tomorrow: more about the reverse merger mess.