Shengda Tech - A Brief Overview

A couple weeks ago I posted a link to a presentation on Shengda Tech Inc. (NASDAQ: SDTH) (“Shengda” or “the Company”) and I promised I would blog about Shengda in the near future. It took a little longer than I had hoped but I finally got around to writing my blog post. Well, sort of. I actually decided to break-up my post into two parts. In this post, I give a summary of the Company and go through some of the recent news and events. In my next post, I will review Shengda’s financial results along with its performance and valuation metrics.

Summary

Shengda is a China based company engaged in developing, manufacturing and marketing nano precipitated calcium carbonate (“NPCC”) and coal-based chemical products. The Company’s NPCC business and coal-based chemical business operate as two separate business units with their own manufacturing facilities, sales teams, distribution channels, and business plans.

Historically, Shengda’s legacy coal-based chemicals business has accounted for the majority of revenues but the NPCC business is catching up fast and has transformed Shengda into a growth company. NPCC as a percent of total revenue increased from 24.94% in 2005, to 30.31% in 2006, to 46.42% in 2007. The percentage of revenue attributable to the NPCC business has increased significantly despite the steady growth of the chemicals business. While Shengda’s NPCC business has experienced exceptionally strong top-line growth, the high margins associated with this business has resulted in a disproportionate impact on the bottom line.

NPCC

NPCC, manufactured from limestone, is a functional filler or additive with unique chemical and physical properties that make it a valuable ingredient in a wide range of end-products. As a functional filler, NPCC not only reduces material costs but also adds functional benefits that improve upon the overall utility and performance of the end product. The presentation referenced above goes through the costs savings, functional benefits, and potential market size for some of the different NPCC applications developed by Shengda. Currently, Shengda has NPCC applications for automobile tires, plastics (PVC, PE, PP, PET), water-based paints, ink, paper coatings, adhesives, and asphalt. The majority of NPCC sales in 2007 were to tire and PVC manufacturers.

In June, Shengda announced (in this press release) a new application for automobile undercoating paints that it developed with two domestic producers of undercoating paints. The announcement of the NPCC application for automobile undercoating paint was an exciting announcement because this is a high margin application.

Shengda is growing its NPCC business by increasing sales to existing customers, adding new customers, expanding its geographic footprint and expanding the number of NPCC applications.

Coal-Based Chemicals

The coal-based chemicals business manufactures ammonia bicarbonate, liquid ammonia, methanol and melamine. Shengda sells its coal-based chemical products directly to plant operators and farmers. Shengda’s coal-based chemicals are sold as chemical fertilizers and raw materials for the production of other organic and inorganic chemical products, including formaldehyde and pesticides.

The coal-based chemicals business is largely a regional business with the majority of sales coming from customers in the Shandong Province and other nearby provinces.

Convertible Note Offering

Since the end of the first quarter, Shengda has made a number of key announcements that will have a substantial impact on the future of the Company. One week after posting strong first quarter results, Shengda announced a $100 million convertible bond offering with a $15 million note option to the issuer for over-allotments. In the same press release, management said it would utilize $56 million of the proceeds to expand its NPCC capacity and the remaining proceeds would go towards an acquisition of a coal-based chemical company.

Management’s expansion and acquisition plan should not have come as a surprise to investors because this plan was discussed in some detail on the first quarter conference call. Nonetheless, investors may have been caught of guard by the Shengda’s decision to utilize outside financing. In the recent past, Shengda has financed its expansion through internally generated cash flow. Furthermore, Shengda has a strong balance sheet and generates a significant amount of cash from operations. If Shengda was only expanding its NPCC capacity, it probably could have financed its plans internally.

Below is an outline of the pricing & terms of the convertible offering:

* Size: $100 million + $15 million over-allotment
* Rate: 6.00%
* Term: 10 year
* Payments: Semi-annual
* Conversion rate: 100.6036 common shares per $1,000 of principal (approx. 1,143,100 common shares at $9.94/share)
* Conversion provisions: anytime prior to maturity, at option of holder
* Redemption provisions: no conversion prior to June 1, 2011. After June 1, redemption allowed with certain compensation requirements

PR Announcing Pricing of Convertibles

I am no expert on convertibles but I didn’t see anything in the SEC filings that seemed alarming.

Note: It is my understanding that the shares associated with the convertible notes are included in the diluted share count and interest expense is excluded from the calculation of net income available to common (diluted). More on this in my next post.

NPCC Expansion

From the beginning of 2007 to present, Shengda increased its NPCC production capacity over 110% from 90,000 metric tons to 190,000 metric tons. Shengda completed the most recent expansion, which added three new lines with 20,000 metric tons of capacity apiece, in April of 2008. Unlike the previously constructed NPCC lines, which Shengda constructed with carbon steel equipment, Shengda constructed the most recent lines with stainless steel equipment. The stainless steel lines have an expected life of 30 years compared to a life of 10 years for the carbon steel lines. The Company expects the stainless steel equipment to result in lower maintenance costs and higher purity NPCC particles. At the very least, the increased purity of the particles should increase Shengda’s competitive advantage and potentially help boost selling prices. According to the 10K, Shengda’s success with NPCC relative to its competitors has been driven, in part, by its ability to produce higher quality NPCC.

Management expects the recently added manufacturing lines to reach full capacity by August. Furthermore, management expects existing customers to utilize 60-70% of the added capacity!

On June 19, 2008, Shengda entered into an agreement with the local government to invest in the Zibo High-Tech Development Industrial Zone in Zibo, Shandong Province. As part of the agreement, the local government will provide Shengda with sources of supply of high quality limestone and land use rights for the construction of an NPCC facility. The proposed facility will have a capacity of 120,000 metric tons that will be constructed and brought on-line in two phases of 60,000 metric tons each. Management expects customer shipments from the first phase to commence in June of 2009. The projected cost of the proposed project, which includes the purchase of 58 acres of land, the construction of the plant with a capacity of 120,000 metric tons, and the procurement of equipment for the first 60,000 metric tons, is $56 million. Shengda plans to construct the NPCC lines with stainless steel equipment.

From the press release:

"We have selected the location for the facility based on its close proximity to a high-quality limestone mine, to our current and prospective customers, and to a shipping port that will serve our growing international customer base more efficiently. We expect to begin construction in August 2008. Our plan is to expand the Company's total annual production capacity of NPCC to 310,000 MT (from 190,000 MT) by the end of 2009."

Note on Capacity: Shengda quotes capacity based on 300 working days a year. Actual capacity has been higher than quoted capacity because the actual number of workings days has run at a higher rate than the 300 days used by management in quoting capacity. Management believes they can achieve 340 working days in a year.

Note on Location: The strategic location of the new facility is very important. The close proximity to quality limestone will reduce transportation costs associated with raw materials and help maintain or improve margins. The other benefits noted in the quote above are self-evident.

Jinan Fertilizer Acquisition

As discussed in the 10K, Shengda’s chemical business is located in close proximity to a number of residential and business properties. Given recent efforts by the Chinese government to tighten environmental laws and the location of Shengda’s chemical plant, management said it was likely that the Chinese government would seek to relocate its chemical plant. In the 10K, management said they were proactively exploring avenues to replace or redeploy the volume of business at risk in the event of a forced relocation. In the most recent conference call and earnings release, management said it was aggressively evaluating acquisition candidates for its coal-based chemicals business. On the call, management made it clear that the acquisition was part of their effort to not only grow the business long-term but also minimize the near-term impact of a relocation.

On June 20, 2008, Shengda issued a press release announcing plans to acquire State-owned nitrogenous fertilizer company Jinan Fertilizer Co., Ltd. (“JFC”). JFC is based in Jinan, the capital of Shandong Province, and is in close proximity to Shengda’s current coal-based chemical plant.

From the recent 10K regarding nitrogenous fertilizer:

“According to a report in China Petro-Chemical Journal, dated February 15, 2006, the agricultural sector in China makes extensive use of chemical fertilizers, consisting of approximately 1/3 of the world’s total consumption. Of this amount, about 70% is nitrogenous fertilizers.”

From the press release regarding the accretiveness of acquisition:

“We expect this transaction to be significantly accretive to our shareholders within the first year of operations," said Mr. Xiangzhi Chen, President and CEO of ShengdaTech.

“Assuming the current market demand continues, the Company estimates that once Jinan Fertilizer achieves full operations in 2009 it could yield an annual sales of approximately three times the current sales of ShengdaTech's existing chemical business. The gross margin is estimated to be equal or higher than the current chemical business at targeted production levels.”

“Significantly accretive” sounds good to me!

In the same release announcing the acquisition, Shengda announce it had received a relocation notice from the Tai’an City Government on June 16, 2008. The relocation notice permits Shengda to operate out of its existing coal-based chemical plant through October 31, 2008. Shengda management plans to relocate its existing chemical operations to the JFC plant. Furthermore, management expects the acquisition to close on or before November 1, 2008. If the acquisition goes as planned, it will significantly minimize or eliminate the near-term impact of the relocation.

In the 10K, management said that the local government might offer some from of financial assistance if it asked Shengda to relocate its plant. As Shengda has opted to execute an acquisition as opposed to simply relocating its existing plant, I am not sure if management still anticipates some financial assistance. I am guessing this will be discussed on the upcoming conference call. Nonetheless, here is the quote from the 10K:

“We also believe that the local government of the Tai'an City, where our coal-based chemical plant is currently located, will offer us some financial assistance or compensation if and when they require us to relocate the plant.”

Research & Development

The success of Shengda’s NPCC business depends largely on Shengda’s ability to: advance its NPCC processing technology; lower its production costs; expand its applications; and, improve upon its existing applications. In order to do these things, Shengda must remain committed to its R&D.

In December of 2007, Shengda issued a press release announcing it had received patent approval for its membrane dispersion technology used to manufacture NPCC. Shengda’s membrane dispersion technology, co-developed by Shengda and Tsinghua University, produces more consistent and higher quality NPCC particles at a lower cost. The success of Shengda’s membrane dispersion technology and the higher quality NPCC produced from this technology has enabled Shengda to increase its market penetration and target higher-end applications. Shengda is one of only one of a few companies that utilize this technology.

All but the original 30,000 metric tons of Shengda’s NPCC capacity employs Shengda’s membrane dispersion technology. The original 30,000 metric tons of capacity utilizes the ultra-gravity method of manufacturing NPCC. While there are five other Chineses manufacturers using the ultra-gravity method, Shengda is the only manufacturer that has integrated the ultra-gravity technology with a distribution control system that enables Shengda to maintain higher quality NPCC products.

R&D not only plays an important role in improving the quality and manufacturing process of NPCC but also in developing new and improving upon existing NPCC applications. In cooperation with Qingdao University, Shengda developed its NPCC application for tires. With this formula, Shengda believes it is the only NPCC manufacturer that has successfully penetrated the tire industry. While Shengda’s tire and PVC applications have been significant contributors to revenue, Shengda is rapidly expanding its application portfolio.

In 2007, Shengda spent $2.5 million to purchase a new R&D center in Shanghai. There are 13 employees, including six PhDs, employed at the facility. Shengda management believes the new facility will help attract senior research personnel at a reasonable cost. With the new research center, Shengda terminated its R&D cooperation agreements with Tsinghua University and Qingdao University of Technology.

Competition

NPCC

Shengda is the largest Chinese manufacturer of NPCC. Jilin Tianze, Shengda’s largest domestic competitor, has about half the capacity of Shengda. The next two largest competitors have about a quarter of the capacity of Shengda. There are several other domestic manufacturers of NPCC that are significantly smaller.

Shiraishi Calcium Kaisha (“Shiraishi”), headquartered in Japan, is the only international competitor identified by Shengda. While Shengda has other international competitors, I believe Shiraishi was singled out because it competes in the domestic market. According to Shengda’s 2007 10K, Shiraishi’s selling price per metric ton in 2007 ranged between $496 and $620, significantly higher than other manufacturers. The higher price per metric ton was probably the result of Shiraishi selling its NPCC particles to manufacturers of auto paint and ink. On Shengda’s Q1 2008 conference call, Shengda management said that the auto-ink market was a high-end market.

As the largest manufacturer of NPCC in China, Shengda is in a position to recognize economies of scale when purchasing from its suppliers and selling to its customers. Limestone is the primary raw material in manufacturing NPCC. Shengda’s capacity gives it the necessary leverage to negotiate volume discounts and favorable terms with its limestone suppliers. When selling to existing and potential customers, Shengda is in a position to sell its capacity and ability to meet customer volume requirements.

While having economies of scale is good an all, Shengda’s competitive advantage truly lies in its research and development efforts. As discussed above, Shengda recognizes the importance of committing to its R&D program.

Coal-Based Chemicals

Shengda sells all of its coal-based chemical products to customers in the Shandong Province and several other provinces in northern China. In its 10K, Shengda identifies five competitors selling into the same region, along with their respective capacity. I have not seen any information detailing the production capacity (other than actual production numbers in 10Ks and 10Qs) of Shengda’s coal-based chemicals business but Shengda describes itself as the regional leader in coal-based chemicals.

Risks

Investors should read through all of the risks identified in the 10K. Particular attention should be paid to risks associated with being a China based company selling into the Chinese market.

See pages 13 to 23.

Both the NPCC business and the coal-based chemicals business rely on coal as a raw material (coal is a key fuel in the calcification of limestone). Substantial increases in coal prices will likely depress profit margins. It will be interesting to see and hear how higher coal prices have impacted margins, if at all.

From the 10K:

“Over the last two years, the price for raw materials such as coal has undergone a great deal of fluctuation in China, which has affected our profit margin. We have adopted measures to reduce risks in raw material supply, including establishing long term relationships with suppliers, diversifying suppliers and supply sources, and seeking long-term contracts with suppliers.”


Up Next

With the construction of the new NPCC plant and the acquisition of JFC, Shengda managemetn is going to be busy over the next year. If management is successful in working through these challenges, Shengda will be well positioned for future growth.

In my next blog, I will review Shengda’s financial results along its performance and valuation metrics. I promise you will be pretty impressed with some of the numbers.

Best regards,
Tuff

Disclosure I: I have a long position in SDTH and might be a little biased. As always, do your own due diligence. I am just some shmuck blogging about stocks in my free time.


Shengda Tech Website

Shengda Tech Inc. - A Primer

I have been meaning to blog about Shengda Tech Inc. (Symbol SDTH) for a couple months now but I just haven't gotten around to it. I am hoping to write about Shengda sometime within the next week or so. Until then, here is a good primer...

http://www.shengdatechinc.com/files/pdf/06-30-08-SDTH-profile.pdf

Shengda is currently trading at $8.41. I managed to add to my existing position earlier today at $8.07.