Yuan Flexibility - Big Rally for U.S.-listed China Stocks Coming?

In a surprise move, the People's Bank of China announced yesterday that it will increase the Yuan's exchange-rate flexibility from Monday on, effectively letting the Chinese currency appreciate (and depreciate) against the U.S. dollar. Such a move had been widely expected, though the announcement came as a surprise just one week ahead of the G-20 summit. Experts expect the Yuan to appreciate about 2-5% against the dollar in the next 3-6 months.

Monday morning should be very interesting. We will see how the domestic markets in Shanghai react on the news. I would see anything less than a 2% gain for the Shanghai Composite (SSE) as a disappointment, given that the index tested 2010 lows just last Friday. But what should be even more interesting to see is if market sentiment for Chinese stocks listed on U.S. exchanges will come back strongly. Here are several very good reasons why being invested in China stocks might not be the worst of all ideas when the Chinese currency appreciates:

• U.S.-listed companies report in U.S. dollar, although most of their assets are yuan-denominated. Those will be worth more in U.S. currency.
• Chinese companies with operations primarily in mainland China will generate revenues and earnings almost exclusively in Yuan. Those will be higher now when reported in U.S. dollar.
• Net importers of raw materials from overseas will benefit from lower cost with a stronger local currency.
• Companies will benefit from a higher purchasing power of consumers and to a stronger extent corporate domestic customers.
• U.S.-listed companies often have dollar-denominated debt which will be more manageable.
• International investors will find yuan-denominated businesses more attractive again.

Many, if not most of the U.S.-listed China stocks should get a boost from this weekend's accouncement, however there are some industries where an appreciating Yuan could be seen as negative. Most notably exporters and generally Chinese companies that generate the majority of revenues in U.S. dollar. There is a chain of companies affected with companies supplying parts or services to exporters likely facing margin pressure as well. Personally I would also avoid steel and real estate and focus on consumer stocks, energy, agriculture, food and coal.

Russell Announces Preliminary Index Changes

U.S.-listed China small caps are heavily affected by the preliminary changes that were announced last night for the Russell 2000 and Russell Global indexes. From the 29 China stocks that are currently members of the Russell 2000 Index only one will survive this year's reconstitution. Russell has apparently decided to implement a strict interpretation of the new "Home Country Indicators" and basically all the assumptions I've made in a previous article on the subject have been proven correct now.

The sole survivor of the current China group in the Russell 2000 Index is Advanced Battery Technology (ABAT), but it will be joined after the market closes on June 25 by three new additions: Aoxing Pharmaceutical (AXN), CDC Corporation (CHINA) and L & L Energy (LLEN). I believe a fourth stock, China North East Petroleum (NEP), would have been eligible but it has disqualified itself by getting suspended from trading so the stock couldn't be ranked on the May 28 deadline.

I would expect LLEN and also AXN to benefit from the Russell addition and several of the smaller capitalized deletions to show weakness into the June 25 reconstitution date. Please note that several of the larger cap deletions, stocks like CSFG, SOHU or HOGS will not be deleted from the Russell Indexes completely, instead they will stay on the Russell Global ex-U.S. Index. Those names are not included in the lists that follow as Russell did not announce them explicitly. Others like CHLN, CBAK or HQS will be dropped entirely as the market cap threshold for the Global Index is much higher than for the Russell 2000.

Here is the full list of China Small Caps affected by last night's announcement.

Added to the Russell 2000 Index

AXN   Aoxing Pharmaceutical
CHINA   CDC Corporation
LLEN   L & L Energy

Reconfirmed for the Russell 2000 Index

ABAT   Advanced Battery Technology

Deleted from Russell 2000 Index

ADY   American Dairy
AOB   American Oriental Bioengineering
ASIA   Asiainfo Holdings
CAAS   China Automotive Systems
CAST   ChinaCast Education
CBAK   China BAK Battery
CFSG   China Fire & Security
CGA   China Green Agriculture
CHBT   China-Biotics
CHLN   China Housing & Land Dev
COGO   Cogo Group
CPBY   China Information Security
CPSL   China Precision Steel
CSKI   China Sky One Medical
CSR   China Security & Surveillance
CTFO   China TransInfo Technology
DYP   Duoyuan Printing
FEED   Agfeed Industries
FSIN   Fushi Copperweld
FUQI   Fuqi International
GSI   General Steel Holdings
HEAT   Smartheat
HOGS   Zhongpin
HQS   HQ Sustainable Maritime
HRBN   Harbin Electric
LIWA   Lihua International
NIV   NIVS IntelliMedia Technology
SDTH   ShengdaTech
SOHU   Sohu.com
SUTR   Sutor Technology
UTA   Universal Travel Group
WATG   Wonder Auto Technology

Added to the Russell Global Index

AUTC   AutoChina International
CAGC   China Agritech
CBEH   China Integrated Energy
CBPO   China Biologic Products
CCME   China MediaExpress
CHOP   China Gerui Advanced Materials
CO   China Cord Blood
CTEL   City Telecom (H.K.)
CVVT   China Valves Technology
CXDC   China XD Plastics
DEER   Deer Consumer Products
GFRE   Gulf Resources
HTHT   China Lodging Group
JKS   JinkoSolar
RINO   RINO International
SCOK   SinoCoking Coal
SORL   SORL Auto Parts
YONG   Yongye International

Deleted from the Russell Global Index

CHNR   China Natural Resources
CSUN   China Sunergy
DL   China Distance Education
GIGM   GigaMedia Limited
GRO   Agria
GU   Gushan Environmental Energy
JRJC   China Finance Online
NED   Noah Education Holdings
NCTY   The9 Limited
QXM   Qiao Xing Mobile Communication

Excessive Shareholder Dilution

The following is a screen of Chinese reverse merger stocks, listed on senior U.S. exchanges, and their year-to-date performance, where shareholders had to face massive dilution over the past two years. The first number shows the percentage of new shares issued over the past twelve months (MRQ data, fully diluted shares). The second number shows the dilution since December 31, 2008. And in the third column you can see the performance of the stock between January 1 and June 3, 2011.

Ticker	Company	12 M	30 M	P YTD	Comment
SBAY	Subaye	79.22%	479.55%	-78.42%	Trading Halted
YONG	Yongye International	10.46%	181.37%	-40.96%	Hit Piece (Absaroka)
SCEI	Sino Clean Energy	116.14%	166.01%	-71.41%	Hit Piece (Alfred Little)
NEWN	New Energy Systems	15.33%	134.68%	-51.62%	Problems (GeoInvesting)
CNAM	China Armco Metals	54.17%	111.60%	-56.71%
CSR	China Security & Surveillance	31.23%	98.13%	-12.95%
DEER	Deer Consumer Products	-0.52%	97.77%	-40.29%	Hit Piece (Alfred Little)
PUDA	Puda Coal	92.54%	97.14%	-57.90%	Trading Halted
SKBI	Skystar Bio-Pharmaceutical	0.55%	96.73%	-58.48%
TPI	Tianyin Pharmaceutical	0.28%	94.53%	-36.77%
FEED	Agfeed Industries	28.25%	82.84%	-61.98%
HEAT	SmartHeat	44.98%	73.84%	-71.97%
CJJD	China Jo-Jo Drugstores	35.19%	71.13%	-48.73%
ONP	Orient Paper	23.21%	70.38%	-43.56%	Hit Piece (Muddy Waters)
GPRC	Guanwei Recycling	50.95%	66.67%	-46.79%
ABAT	Advanced Battery Technology	21.23%	61.17%	-62.08%	Hit Piece (Kerrisdale)
SCOK	SinoCoking Coal	36.57%	60.75%	-52.39%	Hit Piece (Citron Research)
UTA	Universal Travel Group	31.91%	58.50%	-35.30%	Trading Halted
NEP	China North East Petroleum	0.17%	57.38%	-42.02%
GSI	General Steel Holdings	6.64%	55.68%	-40.07%
CVVT	China Valves Technology	3.40%	55.21%	-68.80%	Hit Piece (Citron Research)
CNET	ChinaNet Online	40.95%	51.52%	-58.50%
KGJI	Kingold Jewelry	49.55%	50.45%	-61.28%
CDII	China Direct Industries	21.53%	50.31%	-29.81%
SPU	SkyPeople Fruit Juice	29.19%	49.05%	-52.48%	Hit Piece (Absaroka)
HRBN	Harbin Electric	0.03%	47.09%	-17.30%	Hit Piece (Citron Research)
CHNG	China Natural Gas	27.33%	46.34%	-41.93%
CGA	China Green Agriculture	9.91%	46.05%	-46.00%	Hit Piece (Alfred Little)
CALI	China Auto Logistics	0.98%	44.72%	-42.86%
GFRE	Gulf Resources	2.38%	42.84%	-71.85%	Hit Piece (Glaucus Research)
YUII	Yuhe International	27.46%	41.37%	-44.47%

Update on China Sun Group (CSGH)

It's been a rough ride for investors of China Sun Group (CSGH). The stock is down 44% this year and currently fighting with the $1 mark. However, there are new developments which might bring the stock back on the screens of value investors, so it's time for an update.

Let us first look at current valuation. CSGH has a very irregular fiscal year that ends on May 31, so we are already in FY 2011 at the time of writing. For the first nine months of their 2010 fiscal year, the company posted a net income of $6.28 million or $0.12 in EPS, both numbers are flat year-over-year so there is no income growth. Although revenues were up 10% from 2009, a decline in selling prices of cobalt-based products led to lower gross margins.

For the fourth quarter of FY 2010 (March to May 2010) China Sun Group guided for stable revenues and net income so we can expect the company to close FY 2010 with $0.16 in EPS. The stock is currently valued with a trailing P/E of 6.5, based on yesterday's close at $1.04. That is not unreasonable for a stock with no EPS growth, but here are some facts that indicate significant growth for the years to come.

Government Support

On April 15, the company announced that their new Lithium iron phosphate (LIP) power batteries passed all 32 tests required by the Chinese government. The company stated that "this is a strong endorsement of China Sun as a key component vendor for a new energy-saving vehicle."

On April 29, the company announced that their LIP project has been selected by the government of Liaoning province as a "key" industrial project and CSGH will benefit "through the award of subsidies which will help insure a successful and timely ramp up of LIP production."

LIP Growth and Electric Vehicle Batteries

LIP is used in 100Ah's automobile power batteries, which have been certified by the National Automobile New Product Quality Supervision and Test Center. China Sun Group introduced the new product in October 2009 and recently announced that by the end of 2012, it expects to achieve a manufacturing capacity of 2,000 tons. This requires investment in 12 production lines in addition to state of the art equipment.

An excellent interview by Zack Buckley with China Sun Group COO Fu Guosheng (read the full interview at uncoveringalpha.com) sheds some more light into projected LIP growth:

The company has already upgraded 3 production lines to produce LIP and is currently working on upgrading the next 3 lines. According to the interview, CSGH expects to produce 160 tons of LIP in 2010, 700 tons in 2011 and 1,400 tons in 2012. Again, please note that CSGH's fiscal year ends in May so these 1,400 tons for FY 2012 do actually match the 2,000 tons manufacturing capacity by the end of 2012 from the press release. The average price for raw LIP is about $23,000 per ton with a profit margin of 30% - 31%, so we are talking about possible 2012 LIP revenue in the $32 million range with gross profit of about $10 million.

Keep in mind that this is additional to the current cobalt oxide business as "in the future, 6 production lines will focus on LIP and 6 production lines will focus on the old raw material products." (Source: Zack Buckley interview). The company generated about $42 million revenue in FY 2010 with mostly cobalt based raw materials for batteries.

Another driver for growth is coming from the plans to fully vertically integrate the business by producing their own electric vehicle batteries.

We are on pace to create a manufacturing chain which ranges from raw material procurement to final battery production. We expect to produce batteries in August 2010. ... We are planning to build up a unique model to not only supply the raw material for the lithium batteries, but also produce our own lithium batteries, which is one of the major components of battery-powered automobiles. We will be a holistic provider of the raw materials for auto batteries as well as the finished product for automobiles and electronics. (Source: Zack Buckley interview)

Cobalt Mine Project Postponed

CSGH seems to have abandoned the idea of constructing their own cobalt mine in the central African Congo region. That was always a very questionable move in my opinion, due to the unmanageable risks of investing in and operating such a big project in a politically unstable region. China Sun Group, a small company sitting on the other side of the world, shouldn't engage in such risky endeavours. The plans have been postponed as COO Mr. Fu stated:

The transportation from Congo would take too long, as we sometimes need very quick delivery of our raw materials to supply customers’ needs. Also due to the uncertainty in the global economy, we postponed the Congo project and changed our business strategy accordingly. We can get cobalt in China, not only because it is cheaper in China, but also it saves lots of time for us because of the geographic proximity of shipping. Especially when we see the rapidly emerging requirements in the market, it is an advantage that we can get raw materials shipped to us immediately if our suppliers are in China. (Source: Zack Buckley interview)

Bottomline for value investors: even though the company did not achieve EPS growth in their most recent fiscal year, the prospects for the company seem to be much better now. CSGH is trading at a discount to most other players in the lithium-ion batteries group and I wouldn't be surprised if that changes in the next few months. The company also promised that they will "significantly improve their corporate governance and communications with the investment community going forward and look forward to listing their shares on a senior stock exchange soon."