China Power Equipment (OTC BB:CPQQ)

As a follow-up to the same line of thinking relayed in our November 2nd article, Hidden Clues Yield Opportunities, the GeoTeam® is speculating that one of our GeoSpecials, China Power Equipment, may continue its growth trend established in the 2009 second quarter.  We are basing this on a press release issued on October 5, 2009.  The Company announced it was in discussions with Advanced Technology & Materials Co., Ltd. to supply China Power Equipment with an amorphous alloy used to produce its new generation of energy saving transformers and transformer cores.

The key phrase in the press release was:

"The possible sourcing collaboration would not reduce the volume we buy from our current amorphous alloy supplier."

This may imply that demand for the company's products remains strong and is accelerating.

One of our GeoMembers has made a an insightful observation regarding the recent weakness in CPQQ shares. He has inferred that the recent price action could be the result of investors exercising their warrants. If this scenario is true it will be bring additional capital to the CPQQ, possibly minimizing future fund raising needs.

The GeoTeam® is coding China Power Equipment (OTCBB:CPQQ) as a Special Situation based on its break-out 2009 second quarter:

• China Power recently reported $0.09 ($0.07 fully taxed) in its 2009 second quarter. For all of 2008, the Company reported operating earnings per share of $0.13 ($0.10 fully taxed).
• Second quarter sales increased 164% to 5.9 million.
• The Company produces a new generation of energy saving transformers and transformer cores which fit into China's efforts to curtail greenhouse gas emissions and reduce energy consumption.
• China Power Plans to increase capacity

"Mr. Song went on to say, "China Power Equipment intends to increase its manufacturing and distribution of amorphous transformers and cores by at least 200 percent for 2010 over 2009. This will be accomplished by both increasing production at the Company's existing facilities as well as hopefully adding additional production facilities during the first or second quarters of 2010."Source: PR Newswire (September 1, 2009)

Relevant questions investors should consider regarding capacity expansion:

• What capacity is China Power Equipment currently operating at?
• How much money will the Company need to raise to fund its capacity expansion plans?
• How does the company plan to fund its capacity needs?
• Will a funding transaction result in short-term dilution?
• How long will it take China Power to generate revenues from new capacity?
• How long will it take the Company to exhaust its new capacity?

The GeoTeam® is somewhat concerned about potential short-term dilution issues. Warrants with a an exercise price of $1.00 per share are already in the money and will result in an additional $4.5 million outstanding shares. If the warrants are exercised, CPQQ will receive $4.5 million which should significantly help fund capacity expansion initiatives, possibly with no dilution. If the warrants are not exercised, China Power would have to tap the financial markets for funding which, together with its warrants, could result in a significant increase in its diluted shares count. Of course, it is quite possible that the stock is at a higher price six months from now which would result in less shares being issued to fund its needs. Debt financing would also be an alternative. In any event, it seems realistic to assume that a 200% increase in capacity should eventually lead to much higher revenues.

Based on the current revenue run rate and assuming CPQQ is near full capacity, the Company could end the year with revenues of $20 million.

Lets assume the following:

• 2009 revenues will reach $20 million. ($11 million for the last six months).
• Raw material costs will remain stable.
• Sales prices of products will remain stable.
• Current pre-tax margins will remain at 26%.
• Outstanding shares for the next six months will increase to 19.4 million (14.9M + 4.5M)
• Capacity expansion will be complete in first half of 2010.
• Company will raise $5 million by issuing 3.3 million shares to fund capacity expansion.
• 2010 Outstanding shares will increase to 22.7 million
• Revenues will eventually reach $60 million with new capacity. (200% increase)

These assumptions would translate into a 2009 tax-adjusted EPS figure of approximately $0.20 and an eventual EPS figure of $0.44 at full capacity.

Using a stable revenue run rate may be conservative as CPQQ has seen a sequential increase in revenues for the last several quarters. To calculate a more realistic revenue assumption we need at the very least need to know:

• What capacity is China Power currently operating at?
• Can the Company out source production if operating at full capacity?
• What are raw material cost trends?
• The GeoTeam® would like to gain a better understanding of the Company's ability to raise prices in response to raw material price increases.

Management commented, "Gross profit decreased $194,896 or 26% during the three months ended March 31, 2009, compared to the same period of 2008. This was primarily due to the increase in the average unit cost without a proportionate increase in average unit price as a result of the increase in the raw materials cost."(Source: First Qrtr 10Q)

If China Power does not have pricing flexibility, this situation must be mitigated via an increase in the volume of product sold,  which could be facilitated by an increase in capacity.

To derive a 2010 EPS estimate we need to know when capacity expansion will be completed and how much of this capacity will be utilized in 2010.

Why is CPQQ on the GeoSpecial list and not a GeoBargain?

We still require confirmation to confirm that the 2009 second quarter "break-out" quarter was not an aberration. With fully taxed earnings per share of $0.15, the stock is selling at a P/E of 10 and may offer some investors an attractive risk/reward opportunity. Please note that CPQQ shares have risen substantially over the past few weeks.