China Armco Metals Inc (NYSE AMEX:CNAM)

GeoBargain CNAM reported third quarter results this morning. EPS results were not near as strong as expected.

Currently, China Armco derives all of its business by acting as the middle man between suppliers and buyers of steel.  The Company makes its profit on the “brokering margin” it makes when it resells to the buyers of steel products. In our article on November 20, 2009, we postulated that CNAM would report a nice quarter due to pre-announced order bookings for the third quarter and a stabilization in steel prices. As it turns out, sales did beat our expectations and steel prices did remain stable. Unfortunately, the companies “brokering margins” suffered. Apparently there was some give back in margins that were abnormally high associated with a surge in steel prices from the 2009 first to second quarter.  Also, CNAM's distribution business has the tendacy to be fueled by orders from a few customers, so it is possible that unfavorable pricing on a contract to one customer could affect margins. Results also took a hit from a one time tax adjustment that we view as a non-operating factor. 

The good news is the China Armco issued year end guidance that infers a very strong 4th quarter and offered bullish comments about 2010. Otherwise, a decision to keep CNAM as GeoBargain would have been a challenging decision. The stock may take a short-term hit, but it has always been a 2010 story, which is when its new recycling business will kick in.  This should give the Company a new source of revenue and diversify its customer base.

Management is witnessing strong sales momentum in the fourth quarter, traditionally the strongest quarter of its distribution business, and now anticipates:

• Full year 2009 revenue ranging between $90 million and $95 million
• Net income ranging between $4.5 million and $ 5 million.
• Management also anticipates that its metal recycling operation will be completed and tested sometimes in December of 2009 and ramp production starting in the first quarter fueling substantial growth in 2010.

This EPS guidance would imply fourth quarter EPS guidance of $0.19 to $0.24

Commenting on the company's financial performance, Kexuan Yao, CEO and Chairman of Armco Metals stated, "We are pleased with the top line performance we achieved in the first nine months of 2009. Our bottom line was adversely affected by two items which we do not anticipate will recur in the future. More importantly we see strong momentum in the fourth quarter coupling with the launch of our metal recycling business setting the stage for what we believe will be a very prosperous 2010. We are excited to enter this new business line and look forward to providing more information about these operations after they are launched in the near future."

Source: Marketwire (November 24, 2009)

China Armco Contract Momentum Fuels Optimism

In line with our common theme that clues can offer valuable insight into the future performance of a company, we have come across a few promising hints regarding China Armco Metals 2009 third quarter financials yet to be released.

Commenting on the contract, Mr. Kexuan Yao, CEO and Chairman of China Armco Metals, Inc., stated, "We are pleased to deliver larger sized orders to the steel industry as we look to build on the strong sales efforts we are making in the third quarter. We are carrying strong momentum into the busiest sales period of the year for our industry and remain very optimistic about our prospects for the remainder of this year and into 2010. We believe the environment for our customers remains strong and our anticipated metals recycling business launch places the company in a position to experience record performance in the coming years."

In its 2009 second quarter, China Armco reported EPS of $0.33 on sales of $22.5 million.  Thus, we are speculating that 2009 third quarter results will be at least as good as the 2009 second quarter.  

Keep in mind that there are two wild cards that could influence our assumption.  First costs may have been incurred in the third quarter due to the construction of the Company's new recycling facility. Second, although the revenue picture is strong, we do not have concrete information on the change in the price of steel from the 2009 second to third quarter, which varies by region and local demand. 

However there is information that indicates that the overall pricing trend as has at least stayed constant:

Source: www.indexmundi.com
Although iron ore prices have been lower in 2009 as compared to 2008, the general sentiment is that a continued increase in demand will eventually drive steel prices higher in upcoming quarters. While these trends may indicate the direction of raw material costs, China Armco's revenue ultimately depends on its ability to negotiate steel prices with its customers in any environment. Given the continued growth of steel demand in China, coupled with elevated iron ore prices over the longer term, China Armco stands to benefit from the economic recovery taking place domestically. Over the last 10 years, iron ore prices have trended to the upside, demonstrating that the long term pattern will continue in the same direction.
Source: www.indexmundi.com

In the coming months, China will be establishing its own index to price iron-ore, as explained in a recent Xinhua article outlining the need for a national metric for steel prices.

...China's Rizhao International Iron Ore Trade Center in Shandong province signals that the establishment of the country's first iron ore price index...

Jointly invested in by five local private companies pursuing bulk commodity transaction in Shandong, the center mainly provides electronic commerce services for iron ore suppliers and steelmakers. Its registered capital totals 20 million yuan ($2.93 million).

The trade center offers services including electronic transaction, information exchange, quality inspection, storage, transportation, insurance, and settlement for the two parties in iron ore trading, according to Wang Lei, head of the preparation team for this program.

"As the biggest iron ore importer, China has not set an iron ore price index to date. The iron ore trade center will promote orderly iron ore imports and standardize activities of trading parties, and gradually facilitate China to launch its own iron ore price index in the future..."

Data from China Customs shows that the country imported 443.7 million tons of iron ore in 2008, half of the world's overall iron ore exports volume over the year, and the imports in January-April period in 2009 hit 188 million tons.

(Xinhua, May 22, 2009)

China Armco's 2009 investor presentation documents the potential of the Company's metal recycling leg, Armet Renewable Resource Co., Ltd.

Source: China Armco

The GeoTeam is left to infer that current and future events are encouraging for China Armco, a company that is in the right industry at the right time.

Disclosure: Long CNAM

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.

Our sales efforts in the second quarter benefited from a strong rebound in several key metal markets. We believe this momentum will continue in the coming quarters and we intend to make every effort to improve our operating results further. We believe our expanded credit lines, coupled with the anticipated launch of our scrap metal recycling facility later this year places the company in the strongest financial position in its history and poised for an extended period of exceptional growth for the benefit of our shareholders.

• Price = $2.95
• Trailing GAAP EPS = $0.40
• Geo calculated Fully-Taxed Trailing non-GAAP EPS = $0.28
• Geo 2009 fully taxed EPS Estimate= $0.64 ^b
• P/E based on Fully-Taxed Trailing non-GAAP EPS = 10.54
• P/E based on Geo 2009 fully taxed EPS Estimate= 4.61

1. CNAM meets 9 out of 10 GeoBargain® Requirements
   
   

   	Requirement	Comments
   	Recent 52-week High (generally within 3 months)	Must Reach $7.00
   	30% EPS Growth Rate a	2nd Qtr. 2009 EPS increased 250% Full year 2009 Geo estimate implies an EPS growth rate of 125%
   	10% Revenue Growth	2nd Qtr. 2009 revenue increased 71.8%
   	Strong Balance Sheet	As of 2nd Qtr 2009
   YES	Positive Cash Flow	$ 17.1 Million as of 2nd Qtr. 2009
   YES	Debt to Equity Ratio less than 20%	0.0% (We still need to verify)
   NO	Current Ratio is at least 2:1	1.3:1
   	Return on Equity is at least 15%	6 Months Trailing 18.6%
   	Minimum Pre-tax Operating Margins of 8%	15% as of 2nd Qtr. 2009
   	Preferably Under 50 Million Shares	10.1 Million shares as of 2nd Qtr. 2009
   	High Insider Ownership (generally greater than 15%)	>15%
   	Limited Institutional Ownership (generally less than 20%)	<20%
   	P/E Divided by Growth Rate (PEG Ratio) is Less Than 1. a	0.063

   
   

2. Recently reported a substantial increase in revenues and net income for its 2009 second quarter.

   • Revenues increased 71.8% to $22.5 million
   • GAAP EPS increased 38% to $0.33
   • Geo calculated tax-adjusted non-GAAP EPS increased 250% to $0.21
   
   
3. China Armco should directly benefit from the China stimulus plan.  On July 16, 2009 China released figures stating that GDP growth for the 2009 second quarter came in at 7.9%, easily surpassing expectations and giving some indication that the government's quick and aggressive response to the global recession is taking hold. (Source: GeoTeam report, Capitalizing on China's Stimulus Plan - Part I)
   
   
4. Favorable industry trends as discussed in the China Armco's filings:
   
   
   • Steel- We believe that domestic steel production will continue to witness significant growth as China continues to grow. The steel industry is an important basic industry of the national economy of China, and plays a vital role in the recent industrialization efforts of the country. Production volume in China has more than doubled within the past five years. China’s share of the world's steel production continued to grow in 2008 representing 38% of the world's total crude steel production.
   • Recycling- The energy saved by recycling reduces the annual energy consumption of the industry by approximately 75%, which supports the government's energy conservation goals. The PRC identified the scrap metal recycling industry as a way to minimize the use of scarce natural resources and reduce energy consumption and emissions in the steel manufacturing industry.  In China, the scrap metal recycling industry is highly fragmented with no dominant player.
   
   
5. Comments suggest that China Armco Metals can continue to show dramatic growth in coming quarters.
   
   
   • 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.
   • Our sales efforts in the second quarter benefited from a strong rebound in several key metal markets. We believe this momentum will continue in the coming quarters and we intend to make every effort to improve our operating results further. We believe our expanded credit lines, coupled with the anticipated launch of our scrap metal recycling facility later this year places the company in the strongest financial position in its history and poised for an extended period of exceptional growth for the benefit of our shareholders.

Short-Term Potential value based on fully taxed adjusted trailing non-GAAP EPS

P/E 25 * $0.28 = $7.00
P/E 20 * $0.28 = $5.60

Short-term Potential value based on 2009 fully taxed adjusted Geo non-GAAP EPS Estimate

P/E 15 * $0.64 = $9.60

^a CNAM is not paying a full U.S. tax rate. Therefore, all EPS numbers have been adjusted by the GeoTeam to reflect a tax rate of 36%.

^b The GeoTeam is still investigating the possibly of dilution due to outstanding warrants. It initially appears that this becomes an issue if the stock reaches $5.00 per share.

These scenarios are not intended to be investment advice, but are scenarios based on some commonly used investment guidelines. They are provided to aid investors in making their own investment decisions.

Valuation Scenarios

Added to Geo Bargain list on August 18, 2009. ($2.39). 

Data Inputs:

Fiscal Year Ends in December
2008 Tax-Adjusted non-GAAP EPS: $0.28

^a CNAM is not paying a full U.S. tax rate.  Therefore, all EPS numbers have been adjusted by the GeoTeam® to reflect a tax rate of 36%.

^b EPS numbers are non-GAAP.  Non-GAAP EPS Figures exclude certain non-operating gains and losses as well as certain non-cash items. Non-GAAP information should not be viewed in isolation or as a substitute for reported, or GAAP information . For a more complete explanation of the company's definition of non-GAAP please refer to its financial press releases. The GeoTeam® non-GAAP figures may, from time to time,  differ from company supplied figures.

^c The GeoTeam® is still ivestigating the possibly of dilution due to outstanding warrants.  It initially appears that this becomes an issue if the stock reaches $5.00 per share.


Short-Term Valuation Scenarios

Peg Ratio Analysis - Common rule of thumb that PEG ratio should be less than 1.0

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.

Commenting on this financial performance for 2008, Kexuan Yao, China Armco's Chairman and CEO, stated, "Commodities and metal production experienced a dramatic slowdown across all sectors which peaked in the fourth quarter of 2008. These declines impacted our ability to maintain and grow our revenues in that period. The costs of shipping ores as compared to the price of shipments increased dramatically, having a strong negative impact on operating margins, especially in the fourth quarter. Though we were not immune from this downturn and results were below our earlier expectations, we are encouraged by improvements in a number of metal prices in the first few months of 2009. We intend to work diligently to keep our cost structure low enough to weather this economic downturn and position the company for growth as metal markets rebound. We remain committed to entering a new market segment in steel recycling where there is a huge void in production capabilities and strong governmental support for the recycling metals industry in China."

The company did not provide 2009 financial guidance.

Source: Marketwire (March 26, 2009)

The Company now anticipates its full year net income for the year ended December 31, 2008 will range between $4.4 and $4.7 million. This revised guidance from the previous estimate of $6 million reflects lower than expected revenues due to a global economic slowdown which softened aggregate demand, and created an oversupply of ore in the market. Estimated fourth quarter 2008 net income is now estimated to be approximately $400,000 to $700,000. Based on 8.2 million shares outstanding, full year EPS estimates for 2008 are $0.54 to $0.57 per share.

Source: Marketwire (January 30, 2009)

"The company signed a Non-Binding Letter of Intent on May 22, 2008 to acquire 100 percent of Shanghai Armco & Metawise (HK) Limited ("Armco"), a privately held company based in Hong Kong, China. Armco imports, exports and distributes metal ores, and non-ferrous metal and is planning to expand its operations into the steel scrap metal recycling business.

Source: Marketwire (May 28, 2008)

The GeoTeam has verified that the reverse merger has been consummated.

Cox Distributing, Inc. (formerly trading under the symbol "COXD" on the OTC Bulletin Board) acquired 100 percent of Armco & Metawise (HK) Ltd, a privately held company based in Hong Kong and China, in June of 2008 through a share purchase agreement. Armco intends to expand its import and export activity within China as well as construct a steel recycling facility initially capable of recycling 1 million metric tons of scrap metal annually.

Source: Marketwire (July 16, 2008)