Not Just Paper Profits

04/29/2010 11:33 am EST

Focus: STOCKS

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, finds a reasonably priced Chinese paper producer he thinks will meet China’s growing demand as consumer spending grows.

As China becomes more prosperous and the standard of living increases, the demand for paper products is growing rapidly.

The Chinese paper industry grew by 162% in just the past eight years, with a projected average annual growth of 12% in the next five years. According to the China Paper Industry Association, the country will become the world's largest producer and consumer of paper by 2015—even as paper demand flattens out in the US and Europe.

Because a wide variety of consumer products require paper packaging, investing in China's corrugated paper industry is a smart way to profit from the country's rising domestic consumption.

Orient Paper (Amex: ONP) is the leading supplier of corrugated paper products in Beijing and other nearby cities in northern China. Currently, corrugated paper and white paper each make up roughly half of the company's sales.

Aware of the strong growth in Chinese domestic consumption, the company just started construction of a new manufacturing facility to triple its production of corrugated paper products from 150,000 to 450,000 tons per year. The entire plant is planned to be completed in early 2011.

The stock has sold off from a high of $15 in January to [above $10 now] as a result of a dilutive secondary offering to finance the new production lines in March. The company raised $24.7 million. Although the offering caused a 20% dilution in share equity, the production line will increase the company's earnings by at least 80%—a great deal, in my book.

In fact, due to the shortage of corrugated paper in China, the company expects to make back its investment on this product line in less than three years. Earnings per share, even after the dilution, will increase by 50% to $1.55 next year. So, thanks to the strong demand for its products and a highly efficient management team, it's not surprising that Orient Paper has strong financials:

  • The company's revenue for 2009 was up a whopping 56.7% to $102.1 million. Net income was up 45% in 2009 to $18 million.
  • The company also has a healthy balance sheet, with $6.9 million in cash, $7 million in working capital, [and] only $4.3 million short-term debt.
  • I expect the company to earn $1.03 per share in 2010, post dilution. When the new production facility goes in effect next year, the company will likely make $1.55 per share.

Overall, Orient Paper is another high-growth, undervalued Chinese company. Its average three-year annual revenue growth of 42.2% and net profit margin of 12.5% are more than twice as high as most major US paper companies. Yet the company's stock is trading at less than ten times this year's projected earnings, which is 40% cheaper than the average valuation of listed US paper companies, selling at 17x their [projected] 2010 earnings.

I recommend that you buy ONP below $11.50. My six- to nine-month price target for the stock is $15.50, based on ten times next year's [estimated earnings per share]—a 50% gain from today's price.

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