China Agri-Business Inc. (CHBU) has been holding in my Value Uncovered model portfolio since June, when the company was selling at a discount to its NNWC.

The company reported outstanding second quarter earnings 10 days ago, with the stock jumping over 20% on the news, before falling back over the last week.

CHBU remains in solid financial shape and is growing like crazy, and yet is trading for less than NNWC.

Financial Highlights

CHBU reported a huge increase in sales for the first half of the year on strength of the company’s “New Agriculture-Generator” initiative. Net revenues jumped an outstanding 325% to $4.99M compared to revenues of $1.17M in the prior year period.

For the second quarter, net income increased 206%, increasing quarterly earnings per share to $0.06.

Gross margin has dropped significantly compared to last year, from 73% to 35%, as the company undergoes a transformation to the new direct store sales model.

Despite the change in gross margin, both operating and net margin levels remain extremely high at 23% and 21.8% respectively (the company pays no taxes).

The company’s balance sheet is extremely solid, with a current ratio of 13.9 – with most of these assets being liquid.

Despite significant investments in equipment this year, CHBU continues to throw off cash, generating 757k in FCF for the year so far, more than doubling the amount from a year ago.

New Sales Model

Based on these results, the company is moving to an entirely new sales model going forward. Direct store sales now make up over 80% of the CHBU’s total revenues, as the traditional sales network becomes less of a focus.

Growth was largely driven by an expansion in the number of total stores, increasing from 250 to 346 in a single quarter. The company expects 500 stores by October 2010, several months earlier than previously forecasted.

Although the new model has much lower margins than the traditional network, the rapid growth like this is hard to ignore. Despite the impressive steps China has taken as a country overall, there remains a huge rural population that could benefit from the company’s products.

According to the press release,

“At the Company’s direct sales stores, farmers can purchase fertilizer products, including organic fertilizers made by China Agri, have access to the Company’s sales staff who are knowledgeable about the products offered, and receive services that include technical support. This will help farmers to increase their crop yields and productivity and, in turn, should encourage them to be loyal long-term customers for China Agri.”

Valuation

My original investment thesis was based on the fact that the stock was a Net/Net trading at less than net cash. Here are updated numbers for the past few quarters:

Based on the most recent closing price, the stock is currently selling at a 22% discount to NNWC.

Conclusion

It is not often that the market provides a growing, cash flow positive stock with a market cap less than the cash on the balance sheet. CHBU is a capital-light business with little debt and obvious growth potential.

As with many Chinese stocks, management and disclosure is always a concern. The company has limited experience running a retail operation and will assuredly run into growing pains as the torrid expansion eventually slows.

The company is also in line to purchase a large parcel of land to expand capacity, a transaction that will cut into the margin of safety on a NNWC basis.

However, if CHBU continues to report operating results like this quarter, the stock might be worth holding on to as an earnings/growth play, rather than just a value investment based on assets.

Disclosure

Long CHBU

Here are a few interesting value investment ideas from the past two weeks:

KHDHF.PK

Investment Analysis: KHD Humboldt Wedag International Ltd. (KHDHF.PK) – Purchase A Pile of Cash And Get A Competitively Entrenched, High Quality Cash Cow With Good Growth Prospects For Free

This is a thoroughly research post from AboveAverageOdds regarding a spin-off business, one of the special situations investment scenarios that has historically provided outstanding returns.

KHDFHF is an industrial business specializing in proprietary technologies for cement and mineral processing.

The company is obscure, and other factors (including only reporting financial results twice a year, located in Germany, etc) might serve to deter investors.  Despite the obscurity, the company appears to have a strong competitive position and a solid cash position to take advantage of future growth opportunities.

FURX

Furiex Pharma: Spinoff Trading at Net Cash – Continuing the spin-off theme with an analysis of Furiex Pharmaceuticals (FURX) over at OozingAlpha. FURX is a company in the drug discovery business and was recently spun-off from PPDI back in June.

Within weeks of the spin-off, the stock dropped from $18 to below $10, and has traded around there since.  Although the stock is currently trading around net cash, the business requires a high rate of cash burn while researching new drugs.

Several promising drugs in the pipeline could lead to future gains.

STRL

When All Problems Are Short-Term – Barel Karsan has a post on small-cap infrastructure company called Sterling Construction (STRL).  The company is in a very cyclical business, and appears it depends on budgets of state governments (many are struggling with tax & budget issues), resulting in margin pressure and revenue swings.

STRL doesn’t have the typical ‘value-oriented’ balance sheet, but has earnings potential for investors unconcerned with short-term results.

Net/Net List

Top Net/Net’s By Market Cap – In the spirit of Graham and other deep value investors, net/net investing has proven profitable over many years. Several recent investments here at Value Uncovered, including CHBU & ELST, were based on this methodology.

Cheap Stocks has a nice list of stocks trading at less then NCAV.  Several names on the list, such as VOXX, have been on these lists for awhile, so it is important to find those with some sort of catalyst.

Disclosure

Long CHBU & ELST

As I’ve analyzed on Value Uncovered before with the UBET/CHDN deal, merger arbitrage (along with other special situations investments like going private transactions and tender offers) can provide solid returns during periods of market uncertainty.

Over the past several months, I’ve kept my eye on a merger opportunity between two small community banks in Pennsylvania, Tower Bankcorp (TOBC) and First Chester County Corporation (FCEC).

If structured correctly, these special situations investments can provide ‘risk-free’ profits, but investors must read the deal terms very closely or find their ‘risk-free’ position is exposed or incorrect.

Merger Background

On December 12, 2009, Tower Bankcorp, a community bank with a market cap of 134M, agreed to purchase First Chester National Bank with an all-stock transaction valued at $65M.

The stock transaction was structured using a floating exchange ratio based on FCEC’s performance until closing – at announcement, the deal was valued at $10.22 per FCEC share.

Together, the two banks would have a combined size of $2.7B in assets, with a strong presence in key markets around Philadelphia and Harrisburg, PA.

As originally planned, the merger was supposed to close in Q2 2010, subject to the necessary shareholder and regulatory approvals.

Merger Complications

During the second and third quarter of 2009, FCEC suffered from a sharp increase in the number of impaired loans, with non-performing loans jumping to 2.84% in Q3 2009.

Two days after the merger announcement, FCEC sold $52.5M in residential loans to TOBC in order to ensure the bank complied with minimum regulatory capital requirements.

Also, as part of an amendment to the merger agreement in early March, FCEC agreed to sell off its American Home Bank mortgage division, with TOBC provided a $2M line of credit as needed, once again to stay above capital requirements.

To further complicate matters, after a review by the bank’s audit committee in early March, FCEC found material weaknesses in its internal control procedures for identifying problem loans, forcing the bank to restate financials for all of 2009.

Finally, due to First Chester’s inability to file reports in a timely fashion, the NASDAQ put the stock on notice of delisting.

These complications pushed out the timeframe for closing the deal, and caused further uncertainty in the markets on whether the transaction would be finalized at all.

On the Road to Recovery

Despite the struggles at FCEC during the first quarter, the banks seemed to have made significant strides towards completing the merger:

May 24 – The banks received a first round of regulatory approvals from the FDIC and PA Department of Banking.

June 30 – Federal Reserve of Philadelphia approves the transaction, satisfying all regulatory requirements

July 27 – FCEC files restated quarterly reports for 2009, along with its annual 10-K

August 11 – FCEC catches up on its quarterly report for Q1 2010

August 18 – FCEC files a quarterly report for Q2 2010, announcing that the bank’s financials are up-to-date

Terms of the Merger Agreement

According to the merger announcement, the shareholders of First Chester would receive 0.453 shares of TOBC stock for each share of FCEC. The exchange ratio was variable, using the following table:

Delinquencies were calculated for purposes of the merger as follows:

Inflated Exchange Ratio?

At first glance, the merger had a ridiculously high spread, leading to more investigation for a possible arbitrage opportunity.

As recently as two weeks ago, FCEC stock was trading over $8. With TOBC trading around $19, the market was implying an exchange ratio of approx. 0.420, signifying delinquencies in the $55 – $60M range.

After digging through FCEC’s latest 10-Q, as well as detail from the bank’s FDIC call reports, my calculations show a different scenario:

Apparently, other savvy investors have caught on, as FCEC’s stock price has fallen almost 35% in the last month, with a sharp drop occurring this past week.

However, even with the lower prices and revised exchange ratio, the stocks still appear to be mispriced:

A purchase of FCEC’s shares will result in a loss of almost 15% post-merger (assuming no change in the stock price of TOBC), a significant difference.

Additional Risks

Outside of the exchange ratio issues, there remains significant hurdles to the completion of the deal.  The transaction must still be approved by the bank’s shareholders – at current pricing levels, it would seem illogical for FCEC’s shareholders to approve the deal.

FCEC also announced that the outside date of the merger would be revised to November 20, 2010, potentially pushing out the completion even further.

Conclusion

As I mentioned at the beginning of this post, merger arbitrage can offer attractive annualized returns, but there remains definite risk for investors who aren’t diligent in their analysis.

In this case, a too-good-to-be-true return scenario led to a need for further digging, and revealed a transaction that the market continues to misprice.

*Hat tip to Cale Smith over at Islamorada Investment Management for sparking the discussion. And stealing my limelight with his post! 🙂

Disclosure

No positions at the time of this writing.