Analysts Folly Spells Opportunity

05/30/2012 10:45 am EST

Focus: STOCKS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

What has happened to this stock is indicative of a market so hypersensitive to the appearance of negative news that it can take good companies down for the wrong reasons, observes Marc Gerstein of Forbes Low-Priced Stock Report.

It’s hard to buy low and sell high, because it can be scary to truly buy low, something more easily said than done.

But for those hardy enough to brave cyclical issues, China questions, and a four-day 46% stock pounding (just after the stock was formally priced for purposes of publication) in response to an mild earnings disappointment, combined with caution regarding the near-term future, Guanwei Recycling (GPRC) presents an interesting opportunity.

The company imports plastic byproducts, mainly from Europe—particularly Germany—and uses it to make Low-Density Polyethylene (LDPE) pellets in China, which are in turn used in such products as packaging, industrial equipment, architectural products, shoe manufacturing, etc. So end markets are plain-vanilla cyclical.

Going forward, there are two near-term concerns.

First, the latest sales disappointment is not troublesome. The Chinese New Year holiday (which considerably slows the pace of work in that country) came early this year, causing some customers to accelerate buying in last year’s fourth quarter, thereby leading to less activity in the first quarter of 2012. But although China’s economy is still developing, things look challenging near term given the government’s effort to combat overheating.

Many products using LDPE are exported, which is no panacea now given ongoing concerns in Europe. But business cycles do turn, and as we’ve seen with other selections we’ve made in housing and banking, upturns, when they come, can cause stocks to rally far faster than many anticipate and often make it quite worthwhile to sit for a time with so-called “dead money.”

The other concern involves raw-materials costs, which could keep gross margins under pressure probably until oil prices moderate and/or the company benefits from planned cost-cutting initiatives.

When the near term looks bad, investors need to look at two factors: valuation and special characteristics of the company itself. GPRC looks strong in both respects.

As to the latter, GPRC is one of few Chinese plastics manufacturers to meet environmental standards necessary to be cleared by German regulators to acquire raw materials from manufacturers there. This is important relative to other recyclers, since the German firms with which GPRC deals do not use plastic that has already been recycled, this being the only kind GPRC uses.

Use of virgin plastic makes GPRC better able to produce product for the high end of the LDPE market. In fact, GPRC has no trouble finding customers. It sells all it produces, has recently raised capacity from 65,000 to 80,000 tons, and is planning for future increases (although it need not rush, since annual production is now at 52,000 tons). The Chinese government also limits how much raw material firms can import; presently, GPRC is authorized to import more than it can presently use.

As to valuation, this debt-free company has about 50 cents per share in cash, which is now more than half the stock price in light of the post-May 14 pounding. The company is profitable and usually cash flow-positive (in the first quarter, it boosted raw-material inventory in anticipation of production in the months ahead).

Some may have been put off by management’s failure to bite when conference call participants fished for hints of dividend or share buybacks (GPRC wants to hold cash for future capacity additions, which is fine by me since the company sells what it produces).

Given where the stock is now, even assuming cost pressures persist for a while, as I expect they will, and the company earns, say 30 cents per share (below the run rate implied by the weak first quarter), the forward P/E would only be around three.

Sometimes, it pays to look past an earnings disappointment, and even negative sentiment toward China. Guanwei Recycling is a buy.

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