Two Promising China Microcaps

Huifeng Bio-Pharmaceutical (HFGB) is currently trading at $0.70, down 24.74% for the year and down 50.00% from its May 4 high at $1.40. The Trading China Tracker Score is 9 (Buy).

Huifeng is a leading Chinese producer of diosmin and rutin, raw materials for the pharmaceutical industry. Huifeng products are sold in China, France, Japan, Hong Kong, Russia, India, Germany and the U.S. and the company has a five-year $56 million diosmin supply contract in place with a leading French distributor. For FY 2009 the company reported earnings per share of $0.15 on 25% higher revenues and significantly improved net margins.

The company sees strong growth ahead for 2010 and the years to come. Official guidance calls for revenues to rise by 60% this year and for net margins to improve further to the 22%-23% range. 2010 EPS should come in around $0.20 due to a higher share count. There is a high risk of further dilution in 2011/12 as the company plans to make several strategic acquisitions and to aggressively pursue the patent drug market. Entering this market will transform the company from an input supplier to a patent drug developer.

Huifeng plans to raise $15-20 million dollar to acquire patent medicine factories and for the construction of a new diosmin plant. With this funding the company expects revenues and net income to more than triple in the next three years. However, I would not expect such an equity raise before Huifeng has successfully uplisted to a senior exchange - the company is actively progressing this plan and a reverse split will likely precede execution.

At the current price of $0.70 Huifeng shares are valued at 3.5x this year's earnings. In a normalized market for China small caps a P/E multiple of 7 should be easily achievable, which leads me to believe that the stock will revisit its May high of $1.40 within the next 12 months.

Jade Art Group (JADA) is currently trading at $0.36, down 47.06% for the year and down 66.98% from its April 5 high at $1.09. The Trading China Tracker Score is 15 (Strong Buy).

Now this is an interesting story. Back in 2008 this stock was trading safely in the $2-$7 range, just to collapse in early 2009 and stay below $0.30 for most of the year. Last fall trading in JADA shares became highly erratic with huge price swings to both sides, culminating in a massive run up from $0.36 to $1.09 within just two weeks this April. And now for the past 3 weeks we find JADA below $0.40 again, trading on low volume and having lost all momentum.

However, Jade Art Group finds itself in a much improved financial position now. With a current market capitalization of $28.8 million, the company is sitting on $14.5 million pure cash, if we add account receivables we even get to $20.5 million. The company posted earnings of $0.09 for the past two quarters and operating cash flow looks even better with $0.16 per share for the past six months. The company has no debt and a 50-year contract to access a huge mountain of jade on favorable terms.

The company tries to put some of its cash to work by searching for a complementary acquisition. Last November it transfered $8.8 million to a Shenzen-based investment group to identify a possible target company, the results of this endeavour are expected to become clear by August 14 this year. The strategy of diversifying its business seems crucial for JADA as right now the company has only one supplier and five customers, the risks associated with such a fragile business structure should not be underestimated (government regulation, natural disasters, weather conditions, competition, jade market).

Acknowledging those risks, I don't believe JADA's business should be valued with a multiple higher than 5x this year's earnings. If I assume no growth in jade sales for the remaining quarters this year, the company should be able to generate $12 million net income in FY 2010. As operations are high margin and provide strong cash flow we should add the company's current pile of cash to our projections (5x $12m plus $20m cash) which gives JADA a fair value of $1.00 at this time.

I would be a buyer in the low $0.30's, a level that provided strong support in the past nine months. It seems very likely that the stock will regain momentum later this year on the next earnings release, the announcement of an acquisition, a recommendation focusing on the strong balance sheet, or just the company breaking their months-long silence again. This is a very speculative idea, high risk and low visibility, but with potentially huge rewards and that's why I am recommending it here.