7/30/08

ShengdaTech Inc, A Small Cap Gem from China?

Formerly Faith Bloom, then Zeolite, and now called ShengdaTech (SDTH), the company was founded in 1993, went public in late March 2006, and has traded on the NASDAQ since mid 2007. Based in Tai'an City, China, ShengdaTech operates in two segments. It is a leading producer of nano precipitated calcium carbonate products (around 46% of sales) and also manufactures coal based chemicals (around 54% of sales) for fertilizers and other products.

Nano precipitated calcium carbonate (NPCC) is derived from limestone and has a variety of applications as an additive. NPCC improves and lowers costs on epoxy resin, oil based inks and paints, paper products, plastics, PVC building materials, and tires. Demand for NPCC is growing briskly, at double digit rates. ShengdaTech says that it has about a 10% share of its current market.

There is plenty of room for growth both domestically in China and abroad. In 2007, international sales of NPCC were about 1% of the total. With a larger international sales team this year, the company expects its international NPCC sales to account for around 15%.

Because of growing demand, SDTH will start building a new NPCC factory in August of this year. The facility should increase capacity by over 60% (from March 2008) and is expected to come on line by January 2010.

ShengdaTech's patented technology (membrane dispersion) gives it an edge over competitors. It results in around 5% lower costs than ordinary NPCC manufacturing. Moreover, ShengdaTech's NPCC production is situated close to limestone mines, lowering transportation costs. Its new factory will also have easy access to limestone.

Gross margins at the NPCC segment are around 40%, with revenue growth expected to be around 50%.

The chemicals segment is growing too, though slower (revenue growth was around 7% in 2007), and provides SDTH with some cash flow. Gross margins in the chemical segment run at around 25%. Faster growth may be achieved through acquisitions.

Overall margins were around 34% in 2007. Because of stronger growth in the higher margin NPCC segment, these are expected to increase to 36% in 2008, and may top 37% in 2009.

ShengdaTech is led by 46 year old Xiangzhi Chen. He has been with the company since its creation and has proven himself a capable leader. Chen owns over 40% of SDTH stock.

These positives come with risks.

1. NPCC sales growth may slow if the company does not keep its competitive edge. Less expensive or better products by competitors may take away customers.

2. The company has negative cash flow. It may have to take on more debt (SDTH recently sold $115 million worth of 6% notes, convertible at around $9.94 a share and due in 2018) or make a secondary share offering.

3. There is a key man risk associated with the CEO, Chen. While his very significant stake in the company can bode well for shareholders, his interests may not always align with them. Should he decide to leave the company or reduce his stake, the stock price can be hurt.

4. Because of governmental regulations, SDTH is moving its chemicals facility to a different city. It has to close shop by November 2008. The company says that it will be compensated for the move, but this is not certain. If the move is delayed or runs into problems, profits at the chemical segment may be hurt.

5. The chemical segment's sales are highly cyclical, with potentially wide profit swings. There is less demand in the winter months. The Chinese government sets fertilizer prices, which may not always be to SDTH's benefit.

6. ShengdaTech's supply chain is very concentrated. For example, around 4/5 of its raw materials were bought from just 10 suppliers in 2007. On top of this, raw materials costs are rising.

7. The company deals with dangerous materials. Accidents can occur, which can result in loss of life and production stoppages. Added to this inherent risk is where ShengdaTech's facilities are located. China has had earthquakes recently. Severe weather is also not rare. A snowstorm closed a factory for a short time earlier this year.

8. While the company estimates that its highest NPCC growth will come from PVC materials, demand has been softening. If China's economy continues to slow, demand for tires may also weaken, reducing NPCC demand.

9. There is always political risk associated with China.

Some or all of these risks are probably priced into the stock's price already. Despite a significant rise in recent weeks, it is still considerably off its 52 week high. The low analyst earnings estimate for 2009 is $0.71 a share. At a recent price of $9.46 a share, SDTH is trading at around 13.3 times 2009 earnings.

Disclosure: I do not own any ShengdaTech shares, but may buy some in the future (at least 3 days from when this is posted).

I am grateful to the reader who mentioned this stock in an email.