China Gerui Advanced (NASDAQ:CHOP)

Last week, GeoInvesting Contributor Zack Buckley had the chance to interview Mr. Edward Meng, CFO of China Gerui Advanced Materials Group (CHOP). Here is the full transcript, the abbreviated transcripts can also be found on thestreet.com and seekingalpha.com.

Zack: Can you give me some background on your company?

Edward: China Gerui is the largest producer of high precision cold-rolled narrow strip steel products in China, with a market share of 12.5%. We started back in 2000 and over the last 10 years we have continuously been adding to our capacity to meet the increasing demand from the China market for the high-end cold rolled steel products that we produce. We are in the sweet spot where there is limited supply of the high-end products that we produce, which puts us in a great position. The company came from a SPAC background. The SPAC merger was completed in March 2009. In November 2009, we completed a follow-on offering and were upgraded to NASDAQ. Our current production is 250,000 tons of cold rolled narrow strip steel. In view of the long-term cold-rolled steel market growth in China, which is primarily driven by rising domestic consumption, we are currently in the process of expanding capacity because we have reached close to full utilization on the existing capacity, which admittedly is a good problem to have. We cannot churn out our product fast enough to meet the high demand. By the end of 2010 we will add about 150,000 tons of cold rolled wide strip capacity. By end of 2011 we will be adding another 100,000 tons, achieving a total production capacity of 500,000 tons, which is two times the capacity we have now. This is one of the major reasons we did the latest capital raise of $18.8 million.

Zack: What is the price per ton for your product?

Edward: The average selling price of our products ranged between $870 to $890 per ton over the last 12 months, depending on the then prevailing price of commodity hot-rolled steel. Due to our cost-plus pricing strategy, we have been able to pass on any increase in raw material prices to our customers.

Zack: Where do you see the company in 5 years? 10 years?

Edward: From 2004-2008, we added capacity year on year and funded this all through our own internally generated cash flow. Going forward, we will be adding capacity to meet market demand. We have always been able to stay one step ahead of our competitors. When everyone got into hot rolled coil, we got into cold rolled steel. When cold rolled steel got competitive, we went to high-end steel. Now we are focusing on adding to and optimizing our overall product mix. Our high-end products are of the same quality as products that are currently being imported into China except our products are sold at a much more competitive price, so we have had great success in enhancing our growth by replacing products that were until now imported into the country. In the next 5-10 years, we will continue to strengthen our market leadership while optimizing our product mix with high end products.

Zack: What are the various segment lines of the company?

Edward: Our core business is cold-rolled steel production and we have no other businesses. High precision cold rolled narrow strip steel is the primary business of the company for now. With the additional expanded capacity of 250,000 tons before the end of 2011, we will start serving the cold-rolled wide strip steel market with high-end, higher margin products.

Zack: Can you explain the different steel products?

Edward: Cold rolled steel – Cold rolled sheet products are used in a wide variety of end applications such as food & beverage packaging, construction and decoration materials, electrical and home appliances and fiber optic cable. Cold rolled sheet products are used in these and many other areas of manufacturing. To meet the various end user requirements, cold-rolled sheet products are metallurgically designed to provide specific attributes such as high formability, deep drawability, high strength, high dent resistance, good magnetic properties, enamel ability, and paintable. These are the types of products that we make. They are specialized, high-end, high-margin, non-commodity products.

Hot rolled steel – Hot-rolled steel is the commodity raw material that goes into our production process of cold-rolled steel. Hot-rolled steel cost is impacted primarily by the cost of iron ore. China Gerui purchases hot-rolled steel from the open, commodity market, and then turns this steel into high-end cold-rolled steel products by leveraging our proprietary production process and advanced high-precision machines. We do not make hot rolled steel. We are not a commodity steel producer.

Zack: Who are your main competitors?

Edward: The cold-rolled steel market in China is highly segmented. Our competitors are both state-owned and private sector companies. We are the largest player in the cold-rolled narrow steel strip market with about 12.5% market share. The top five players in this segment of the market accounted for about 36% of the market, with the rest of the market consisting of over 200 smaller and private players.

Zack: Why do your customers choose you over the competition?

Edward: Customers will choose us over our competitors for a number of reasons

1. We have a strong brand name and reputation in China in our industry. Our products are known for their high quality and precision. We have strong technical capabilities.
2. We have proven that we are able to customize contracts for our customers based on the specific attributes they required for the intended end-use application. As such, they have seen us do it successfully before, so they keep coming back since they know we are reliable and can meet their specifications.
3. We have strong R&D capabilities and we continue to offer new product offerings that our clients are interested in.
4. We are able to adjust our operations to meet different size orders. Our contract sizes range from over 2,000 metric tons for some companies to as little as 500 tons.

Zack: Will the margins stay the same on the new facilities?

Edward: Historically we have been able to continuously improve on our profit margins. Our gross margins are approximately 30%. With the new 250,000 ton capacity that will be released from the expansion program by 2011, we expect to improve on this profitability level going forward. Our ability to enhance our margin performance is primarily due to our cost-plus method of pricing, our ability to optimize our product mix (with higher margin chromium-plating accounting for an increasing percentage of total capacity going forward), and our ability to continuously offer new products to the market.

Zack: How is the growth in the overall industry? In China?

Edward: We serve over 200 customers and they primarily come from 4 industries. Food and beverage packaging, construction and decoration materials, electrical and home appliances as well as telecom. The first three industries are all driven by the increase in the consumption power of the Chinese economy, which we expect to continue to rise. Over the next three years, we expect to see double digit annual growth in our industry. The telecom industry in particular should continue to benefit from the Chinese government's policy on expanding broadband and 3G networks in both rural and urban areas, which in return, provides for increased demand for China Gerui's product in the manufacturing of fiber optic cables.

Zack: Who are your main customers? May I speak with them?

Edward: Our main customers come from those industries mentioned above. For example, one customer is a producer for telecom operators in China. Other customers are food and beverage packaging and home appliance producers in China.

Zack: Do you expect your revenue by industry to stay stable in the next few years? Where will your additional capacity go to?

Edward: The food and beverage packaging industry contributes almost 50% of the revenue for our company. Going forward, we see increasing revenue contribution from the telecom industry and construction decoration materials, along with growth in revenue from food & beverage packing.

Edward: Our additional capacity will go toward more coated products and wide strip products.

Zack: What will be the return on capital? What is the output?

Edward: We estimate the payback period for this capacity expansion program to be about 2.5 years. This is for both phases combined. The total additional output will be 250,000 tons, 150,000 for phase 1 and 100,000 for phase 2. The expected capex for phase 1 will be 42 million, while the capex for phase 2 is expected to be 12 million.

Zack: How will you finance both phases?

Edward: The capacity expansion program has been financed with internally generated cash, proceeds from the conversion of warrants, and accessing the capital markets. We are confident the expansion program will be executed successfully and production will start as per the original schedule. Our business generates strong free cash flow. We currently have approximately 16 million warrants outstanding and the majority of the warrants get converted by March of next year. We anticipate this warrant conversion can yield an additional $75 million plus to finance our expansion and future business and capacity expansion All of these resources together will help finance Phase 2 of our expansion, serve us well in terms of our overall working capital needs and put us in a competitive position for future business development.

Zack: What will the private placement be used for?

Edward: We plan to use the net proceeds from the private placement to finance the previously announced expansion of the Company's high-precision cold-rolled steel production capacity, accelerate the build-out of a chromium-plating production line of 200,000 metric tons that was originally scheduled for 2011, as well as for general working capital purposes related to the expanded production capacity.

Zack: If you had to invest in a small cap US listed publicly traded Chinese company other than your own, what would it be?

Edward: Looking at the overall spectrum of Chinese companies that trade in the U.S., I would encourage investors to look at companies that will benefit, the way China Gerui has and expects to continue to benefit, from the growing purchasing power of the Chinese consumer and middle class.

Zack: If you had a golden bullet, where you could eliminate one competitor, who would it be?

Edward: We don't think we need a golden bullet to compete in our market. We believe we will continue succeed in penetrating China's cold-rolled steel market as well as replacing high-end imports. We are focused on maximizing our operating efficiency and optimizing our product mix. We expect to continue to increase our market share in China. Overall we are optimistic about our business prospects. We expect continued growth in both our top and bottom line for the rest of the year.

Disclosure: No Position

Profile

GeoTeam Contributor Zack Buckley is CEO of Uncoveringalpha.com and a research analyst at Geoinvesting.com. He developed his investing methodology by synthesizing the ideas from the best investors of all time, based on their track record. This led him to closely follow Warren Buffett, Peter Lynch, Seth Klarman and Benjamin Graham. Using a value approach, he pursued the most undervalued companies he could find, which led primarily to companies in China. Buckley will be spending three months this year in China visiting companies that are exciting investment opportunities.

****Follow him on his blog, Uncoveringalpha.com, , as he travels across China touring factories and interviewing management.**