GEO Investing

Since I began publicly disclosing my investigations of Chinese U.S. listed companies last year I have almost entirely focused on short selling. This has been very profitable for me since the sector, with the exception of the largest capitalization issuers, has declined substantially over the past year due to widespread evidence of accounting irregularities and outright fraud conducted by many of the companies.

While I am certain numerous additional negative reports will surface over the next few months, I recently identified three “special situation” long ideas that now deserve attention. In this article I will share the basic reasons why I bought each stock.

Feihe International

Feihe International (NYSE: ADY) is a leading producer and distributor of milk powder, soybean milk powder, and related dairy products in China.ADY’s sales grew from $115 million to $257 million in the past five years. I am long ADY because:

  • Since the acquisition of its production facilities, ADY has considerably invested in remodeling and expansion, greatly increasing production capacity. Replacement cost of these facilitiesis much more than their book value.
  • ADY has substantial excess capacity that can be sold without negatively affecting their production and earnings guidance. One or two asset sales could allow ADY to repay current liabilities in 2011 and eliminate the going concern risk.
  • Furthermore, ADY can raise more cash by selling its dairy farms that are not essential to the core milk powder production business.
  • ADY forecasted $290 million in revenue and $22-24 million in net income for 2011. Based on this guidance, ADY trades at a low 7x 2011 earnings.
  • ADY is one of the largest private companies in Heilongjiang province and has very good relations with local banks. ADY can easily obtain short-term loans and roll over existing debt.
  • ADY retained Deloitte to clean up its internal control issues.
  • Lastly, ADY might be a possible takeover target for multinationals seeking access to ADY’s massive 80,000 retail points of sale.

China Fire & Security Group

China Fire & Security Group (NASDAQ: CFSG) is the leading fire detection and extinguishing equipment provider in China. CFSG’s products are sold to the iron and steel, traditional power generation, nuclear power generation and petrochemical industries. CFSG’s sales grew from $32 million to $80 million in the past five years. I am long CFSG because:

  • CFSG announced a leading global PE fund offered to help management take the company private on March 7th (here)
  • CFSG never raised any capital since it went public in 2006 so it has no use for a continued U.S. listing
  • Management owns 60% of the company
  • Relisting China’s largest fire equipment maker in Hong Kong a few years later would be a huge score for management
  • Roth Capital noted (here) that it has confidence in this buyout offer (especially since heirs of the deceased former Chairman would likely be interested in selling) and raised its rating to a “buy” with a $9 price target
  • 2010 was a bad year, with sales declining from $81 million to $80 million and EPS falling from $0.86 to $0.52, but backlog increased from $20.7 million to $107 million
  • The huge $107 million backlog could make 2011 a banner year
  • China’s steel industry is struggling with overcapacity but is recovering by performing more retrofits boosting fire equipment sales
  • CFSG continues to expand into new verticals including power production and nuclear.
  • Fire safety in nuclear plants should be emphasized in the future

Harbin Electric

Harbin Electric (NASDAQ: HRBN) designs, develops, manufactures, supplies and services a wide range of electric motors including linear motors, specialty micro-motors and industrial rotary motors. HRBN’s sales grew from $121 million to $426 million in the past three years. I am long HRBN because:

  • Baring, one of the largest PE funds in Asia, and Goldman Sachs (GS), the deal advisor, would not have wasted their time looking to buy a fraudulent company.
  • Likewise, short sellers have been unable to show any concrete evidence of fraud at HRBN.
  • Additionally, several domestic Chinese banks including China Development Bank (here) were in discussion with HRBN in the previous round of buyout discussions. CDB agreed to lend HRBN $50 million.
  • HRBN’s valuation is depressed vs HK listed peers
  • The buyout offer is very likely to succeed since the Chairman seems determined to go private.

I bought all three companies in equal dollar amounts, as a “basket,” expecting to make at least 20% on the basket in the next few months. I doubt any one of these companies is subject to serious fraud allegations so I see limited downside risk. I will follow up with further details of my research into each company in future articles.

Disclosure: I am long ADYCFSGHRBN.