A Great Value Play: Lihua International, Inc. (LIWA)

Just took a position in Lihua International (NASDAQ: LIWA) and I usually like to do some sort of writeup so I can remember in the future why I took particular positions. Lihua International is a Chinese reverse-merger company that is in the copper wiring/electrical arena. They're currently trading at about $5.07 per share ($158M market capitalization).

Asset Valuation

First thing that jumped out to me about this company is that while the market is valuing them at $158M, they have $144M in cash equivalents alone in the bank. Ignoring the $854M in revenue in 2012, this at first glance seemed to be a complete misvaluation by the market because if you divided up the cash alone, each share outstanding would receive about $4.80. In fact if you look back to 2011, if all assets were liquidated and debt paid off, net current assets per share alone are worth $11.69, and that was over two years ago:

Lihua's Net Current Asset Value/Share (2011)

(click to enlarge)

Attractive Margins

Another thing worth noting is Lihua's supply chain management. Unlike its competitors, Lihua isn't making its wiring from virgin copper, but instead scrap copper. The benefit of this is that its margins are not compressed like it's competition's because its costs are not as high, so its management of scrap copper suppliers has given it a competitive advantage:

Chinese Copper Suppliers

(click to enlarge)

Product Mix

Besides it's supply chain management, Lihua also has the benefit of focusing on one of its core product innovations, copper-clad aluminum wiring (CCA). Their high-quality pure copper wiring alternative is priced much cheaper than pure copper wiring (almost 1/3) which provides significant cost advantages in larger projects from the lower commodity price of aluminum.

Copper-Clad Aluminum (CCA) Wiring Structure

Why is this important? Because the PRC government just approved $240B to be invested in the development of China's Smart Grid infrastructure over the next five years so all of its citizens are able to receive affordable power. Along with this comes miles and miles of necessary wiring and cable running, and what better use of CCA wiring/cables than for large projects over thousands of miles. Why is Lihua set up best to benefit from this? Because they currently are the only company that has the proper license in place to import scrap copper to China from places like the United States, which makes them the only company currently able to even approach filling such large orders. Besides CCA wiring, its product mix does still include pure copper wiring, in addition to copper anodes, rods, and magnetic wiring.

In addition to China's investment in its infrastructure, China is the number one consumer and importer of copper:

Copper Demand By Region

(click to enlarge)

The trend is in no way slowing down either, current predictions are that given the trend, China's consumption and utilization of copper could soon exceed world supply, which means scrap copper suppliers are going to become vital, and Lihua is already in position to benefit from this. As far as copper commodity fluctuations go, even though copper pricing is expected to remain stable with the growing demand, Lihua's products are all priced on a cost-plus basis, which means any movement of commodity prices would not erode its profit margins.

Risk

So why does this price of $5.07/share seem too good to be true? Well, its China, which means shady business practices, and its a Chinese reverse-merger, which means potentially even shadier accounting practices. However, due to the fate of its fellow reverse-merger companies such as China MediaExpress Holdings (CCME), all Chinese reverse-mergers are being painted with the same brush by institutional investors.

In 2011, Absaroka Capital, who had taken a short position on Lihua, released a study it commissioned on Lihua trashing the company's practices and accounting methods. Among things claimed in the study included doubt regarding Lihua's financial statements, its executives' backgrounds, supplier relations, and its auditor's track record. In response to this allegations, Lihua's CFO directly addressed all claims (seen here) made by Absaroka, which in my opinion rendered them moot. In addition to that, Lihua has made strides over the past year to be as transparent as possible to the market regarding its accounting methods, even going so far as to having forensic accounting firms such as John Lees Associates do a full investigative confirmation of its cash balances. Besides this, its auditor is Crowe Horwath. While technically using Crowe Horwath's Hong Kong division, Crowe Horwath has a reputation here as one of the top ten auditing firms in the US.

Also, since these allegations were made two years ago in 2011, I'd presume Absaroka has already left its short position by now after the stock tumbled 22% from its study. In other words, they made their money, and now with Lihua's transparency of accounting practices, there's little more to gain for Absaroka or any other institution with a short interest.

Conclusion

Taking a long position in LIWA, committed half my capital allocated to this position for now in case of a dip in the price, this will allow me to average down a bit for a bigger return later. My estimated fair value of the stock is about $15, with a hedge of at least $11.69 from a net asset valuation. Expected time for value manifestation is about 2-3 years, with a option for future review of fundamentals at the $12/share mark.

Benjamin Graham Was Wrong

I was doing some equities research and I ran across this from Benjamin Graham's classic 1934 edition of Security Analysis:

This was one of Ben Graham's examples of calculating the Net Current Asset value for a stock, by using a discount rate to calculate the true liquidation value of various types of assets on the balance sheet. The only thing is that Ben Graham's White Motor Company example was actually incorrect.

If you look at the liquidation value of the Total Current Assets, he only subtracts Current Liabilities to arrive at the Net Current Assets Result of $16,300 when in fact he should of subtracted Total Liabilities.

In practice, if a company goes bankrupt, all creditors go to the front of the line because the assets are collateralized by debt. That would mean that ALL creditors go to the front of the line, not just the ones who are due in one year or less. If long term creditors were left out, how would they receive their repayment if the shareholders got what's left way before the creditor's debt needed to be serviced?

The answer is it would never happen. That would be the equivalent of the owners of a house in foreclosure receiving the rest of the sale price of the house after only the first year of debt had been paid for on a 30 year mortgage. What about the other 29 years worth of money the bank forked up so the owners could buy the house? The same is true for a company. The long term creditors are due their piece of the pie and will always get theirs well before the shareholder even see the leftovers.

The funny thing is that Benjamin Graham knew this and stated on the page before this example:

"The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score."

However, its clear in the example that he only deducted current liabilities. Perhaps this was just a flub up, but the conclusions he derives are based upon the erroneous fact of subtracting current liabilities. The funny thing is that people like Buffet, Ruane, and Graham himself based the majority of their investing decisions on this calculation when it is in fact wrong. Talk about luck!