China Armco Metals (NYSE AMEX:CNAM)

Added to the GeoBargain list on August 18, 2009 @ $2.39

Catalyst: Valuation was compelling; Excitement over the company’s new recycling business.
Peak performance: Reached a high of $11.10 on March 5, 2010
Current Price: $3.26

Current road block: CNAM has yet to put together an impressive string of strong EPS quarters; Issued 2010 net income guidance with no EPS guidance; Down the road, dilution could hamper EPS growth; Capital intensive business, debt to equity ratio is 57.1% which may limit P/E expansion; Investors may have to endure a weak 2010 second quarter before business ramps up in the third quarter and fourth quarters;  Concerns that China's steel industry is faced with oversupply issues.

Of all the ChinaHybrids we monitor, CNAM had one of the wildest rides over the past year. The stock began its big run from the $2.00 area and catapulted to its high of $11.10 on March 5, 2010 as investors became enthused about the imminent launch of CNAM’s recycling venture and new contracts that could dramatically increase revenues. The recycling venture could also help smooth out the lumpy nature of its steel distribution business characterized by unpredictable order patterns from a few companies.

The stock has retraced almost all of gains amidst a weakened stock market and a recent dilutive capital raise completed at $6.50 per share. So what has CNAM done with some of the money thus far? It made an investment in an Australian iron ore exploration company, whose mine is believed to contain quality iron ore, instead of using the money to immediately grow its business. As far as we are concerned, CNAM has enough on its plate and should not embark on a somewhat risky investment that only may pay off in the future...especially when management justified its recent capital raise by claiming it needed to secure sources of supply to fill anticipated demand. Furthermore, the company has a history of reporting sporadic quarterly results.

We would like to gain a better grip on EPS growth which we are not sure will reach our 30% growth requirement on a quarterly basis, especially in the 2010 second quarter, as CNAM reported 2009 second quarter EPS of $0.33. However, based strictly on a P/E analysis CNAM would be considered cheap by most investors and substantial operational gains should start occurring in the 2010 third quarter. Also encouraging is that the fact that the CFO exercised out of the money warrants, maybe a sign of confidence. Investors should keep in mind that as the stock eclipses $5.00 and $7.50 they will have dilution from outstanding warrants to contend with. (see April 23, 2010 research note).

Aggressive long-term investors who are not concerned with quality issues may find CNAM a stock worth betting on with the potential for significant returns. Risk adverse investors may be more comfortable waiting to see how quality issues play out and perhaps paying higher prices before making a substantial investment.

Time line for liquidity needs is uncertain:

"We do not have any commitments for capital expenditures at March 31, 2010. As of March 31, 2010, since inception we have invested a total of $31.0 million for the acquisition of land use rights, construction and equipment purchases for the first phase of our scrap metal recycling facility. While we expect to expand the production capacity of our recycling facility, we have not set a time frame for this expansion. Also, we have not determined how we plan to finance this future expansion and unless we can obtain additional financing, we will be unable to complete construction of additional phases of our scrap steel recycling facility."

Also, consider that as of March 31, 2010 the balance sheet was not that pristine: 

• Current assets to current liabilities was weak at 1.45
• Debt to equity ratio was 37.7% (short-term and long-term debt)

This helps shed some light on why CNAM may have required its April financing deal.

Our intent over the short-term is to build a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)

- Is the company's auditor ranked in the top 100?
- Is the auditor located in the U.S.A? If located in China the PCAOB (Public Company Oversight Board) may be denied access to investigate the practices of the auditing firm. Short sellers have been using this information as a tool to validate their opinions.
- Are the company's internal controls satisfactory?
- Are their any outstanding legal issues?
- Do the company's top ten customers represent less than 10% of revenues?
- Operating cash flow divided by current liabilities is greater than one. The higher the better. (we will use annualized cash flow run rate and eliminate non-cash charges from account liabilities ).
- Cash divided by Current Liabilities is greater than one. This is the most conservative liquidity ratio.
- Is the company buying back stock?

We are extremely pleased to have secured this $12 million credit facility. We see continued evidence that the Chinese economy is on the road to recovery and there has been an increasing demand for commodities coupled with a rising price environment. We believe this additional financial flexibility will enable us to opportunistically grow our distribution business and significantly improve our overall operating results.

China Armco Metals, Inc. is engaged in the sale and distribution of metal ore and non-ferrous metals throughout the PRC.

Please see the full release.