Pink Sheets

This was a suggestion from Alex Harbin in the notes of Faith Based Investing. If I had looked at it sooner, it would have been a lot cheaper.

ShengdaTech (SDTH, sec) I've never looked at this company before. Chinese reverse merger. They make "nano precipitated calcium carbonate": fancy pants lime. They also make other (coal based) chemicals. Q2 results: 54 million shares. Balance sheet is mostly PP&E and cash ($30 million net cash out of $82 million in assets).

Revenue increased 59% yoy, but was flat qoq (the Q1 10-Q says the big increase in NPCC in Q1 was due to capacity expansion, so I wonder if they're capacity limited). 34% gross margins (up from 28%). 29% operating margin. Very low taxes [tax holiday for 2 profitable years, 10-K Note 7] (avoid letting it distort your view of the bottom line). Earned 11 cents diluted for Q2.

Cash flow from operations was somewhat higher than earnings, but capex was larger than operating cash flow! Some cash went to a related party payable/receivable.

The yoy revenue increases were pretty much all due to nano-materials, which has better margins.

The SEC had something to say to them back in April. There are other SEC correspondences.

Ok, so what's the stock selling for? Less than $6? $6.03 (that was on Friday). Will the revenue growth continue into the future? Are they going to disappear [or seem to get in over their heads] like CXTI? Let's dive into this one....


10-K:
Period ending Dec 31, 2006. 54 million shares on Mar 15, 2007.

Two businesses:

1. nano precipitated calcium carbonate ("NPCC")
2. coal-based chemicals (ammonium bicarbonate, liquid ammonia, methanol, melamine)

Direct sales force. Geographical coverage is in northern China, including Shandong Province [an industrious province] where they have good market share.

NPCC is used in paper, paints, rubber, and plastic industries. SDTH sells mostly to tire and PVC industries.

Ammonium bicarbonate is used for fertilizers. Methanol is a common chemical raw material (I've known this since making good money on Methanex, MEOH, which I still consider a reasonable investment for commodities). Melamine is "the intermediate product of environment friendly resin."

We believe the fastest growing area for NPCC will be in the tire and PVC building material market. We believe that our NPCC products provide highly effective fillers and additives for tires and PVC building materials. NPCC products are ultra fine and pure, and its particle size and crystal shape can be controlled effectively in the production process.

They go into detail about how NPCC improves many qualities of PVCs and rubber.

One subject that I think about a lot is how things have changed in the last 100 years. One of the biggest group of changes that never seems to be discussed is the improved qualities of materials. Not that long ago, plastic was a derogatory term to mean phony and cheap. Compare the really awful qualities of 1960s plastic items with consumer products of today. Night and day. And you find big improvements in just about every material (not sure about steel and concrete, however).

According to a report by China Economic Daily dated October 10, 2005, China’s total tire output was 239,000,000 units in 2004 which represents a 18.7% increase from 2003. From 1999 to 2004 the average annual growth in tire output was 15%. Currently, we are the only Chinese manufacturer of NPCC that is able to supply the tire market.

The building boom has pushed the demand for PVC and oil based paints. I wonder if this is sustainable.

They're also targeting new market segments in the future. I have no idea what to think of this other than shooting enough arrows at random could result in hitting a target somewhere.

Our company owns the only exclusive [i.e. there may be others which are non-exclusive] NPCC development and research lab in China. It is located in Pudong, Shanghai and its excellent working environment will attract more intelligent and excellent NPCC researchers and scholars. Currently there are ten staff working in this lab, each having a masters degree in chemical related fields. They engaged primarily in furthering NPCC related technologies. We believe that our development and research team will enable us to obtain more technological improvements, which will allow us to offer cost-effective and high-quality NPCC products. We recently developed new NPCC products for paper, paints, coatings, polypropylene and polyethylene industries. We expect to ship these products to the market gradually in the second half of 2007.

The direct sales force is based in three main cities.

We will expand our sales network by setting new sales offices in Xian, Guangzhou and Dalian, in addition to our existing ones in Shanghai, Tsingdao and Beijing.

They only manufacture 10% of the total NPCC in China. However, they believe they're the only one selling to the tire industry which allows them to have high margins. It would be very bad if some aggressive player invaded that market.

They use a "high gravity precipitation" method [presumably centerfuge based] which has been licensed by Beijing University of Chemical Technology, apparently more correctly Nano Material Technology Pte. Ltd. Four others have a license, but none has "been successful in commercializing this technology."

However, among the five companies, we are the only one that has successfully integrated the ultra-gravity method with a distribution control system, which gives us the ability to maintain high quality NPCC products.

In new facilities in Shaanxi, they've developed another method, the membrane-dispersion technology which was co-developed with Qinghua University and exclusively owned by SDTH. This supposedly allows higher quality at lower cost.

...we jointly own a pending patent developed by Tsinghua University on next generation NPCC particle producing technology based on membrane-dispersion techniques. The pending patent is expected to be officially issued in November, 2007.

and also what is apparently trade secrets:

We also own a proprietary technique for NPCC chemical modification that is applicable to different types of end products critical to adding value to downstream industry plants.

Current NPCC capacity is 90,000 metric tons per year (one of the largest suppliers in China). Biggest customers seem to use 4,000 metric tons per year. They plan to add 40,000 tons capacity in May 2007 and 60,000 tons in Dec 2007 to reach 190,000 tons and be the largest manufacturer in China. Are any other companies planning to add capacity???

The Shaanxi facility is near a limestone mine with the highest quality limestone in China.

Our use of the membrane dispersion technology jointly developed with Tstinghua University has enabled us to save energy in the production process. In addition, we anticipate spending an average of approximately $2 million per year for the next three years to replace our existing chemical equipment in order to reduce energy consumption and pollution. We believe as a result of these and other factors our production costs will be significantly lower.

Despite their claims about the greatness of their research team, their experience seems somewhat short. The director of R&D has been in the NPCC research for "more than six years." However, he did head up the effort to develop proprietary methods for chemical modification of NPCC products for the tire, paint, and PVC industries. So Xukui Chen has done well so far.

In 2006, they completed samples testing of NPCC products with 22 companies in various industries: PVC, rubber, adhesive, latex, coating.

There's more joint development with universities going on. SDTH has exclusive ownership to the technology developed with Tsingdao. With Tsinghua, it's jointly owned but SDTH has exclusive rights to use it. Tsinghua has produced one patent application. The fee to Tsinghua is $130K per year.

There's also "micro-mix reactors" which reduce costs and enable other product lines.

We haven’t fully expensed our budget of $9 million for establishing research and development centers in Beijing, Shanghai and Tsingdao, mainly because we purchased a R&D building with a total investment of $2.5 million. This center is able to meet our current R&D demand.

I'm not sure I understand what that means.

They've completed sampling and testing with 4 foreign companies in the paints, PVC, polyethylene industries in Thailand, Indonesia, Malaysia, and Korea. Products are also being tested in Japan and Netherlands. Expansion is via trade shows and a Chinese B2B website (which doesn't seem very industrial).

Sales team of 41.

Raw materials are nearly 60% of production costs.

There's some significant vendor concentration, as much as 34% in NPCC and 13% in coal based chemicals.
14% customer concentration in tires (Triangle Tire), also a 12% (Zhaoyuan Liao).
20% customer concentration in PVC (Dalian Jinyuan), also a 17% (Qingdao Haiwei).
Not much customer concentration in coal based chemicals.

Competitors' NPCC prices are $161 per metric ton to $620 per metric ton. Perhaps the median might be $300? The segments of competitors is: electrical wire and cable, rubber, adhesive, paints, coatings, plastics, ink.

1,355 full-time employees: 433 in Shandong Haize Nano-materials, 346 in Shaanxi Haize Nano-materials, 576 in the chemical devision. 5% management, 3% sales.
45 day to 90 day AR

Notable Risks:
Exhaust gas and wastewater pollution
Raw materials price fluctuations (need moat), especially the price of coal (page 24)
Trade secrets (normal non-disclosure and 5-year non-compete contracts in place)
Possible future chemical supply glut
Potential future tire composition changes to exclude NPCC
Difficulty in attracting good technical people in small city (but this can be a definitely plus, which is why I'll be visiting Visakhapatnam and not Bangalore)
Possible foreign competition

No outstanding SEC issues.
No legal proceedings.

Pages 21 and 22 have excellent long term financial information for the company.

Revenues (each "*" = $1 million, green = gross profit):
2002 chemical  *********
2002 NPCC      ****

2003 chemical  **********************
2003 NPCC      ********

2004 chemical  *************************************
2004 NPCC      *************

2005 chemical  *******************************************
2005 NPCC      ***************

2006 chemical  ***************************************************
2006 NPCC      **********************

Income Before Taxes (the wild tax differences they had distort the picture, in my opinion)
2002: *
2003: ****
2004: ************
2005: ****************
2006: ******************

...return on beginning assets
2003: 17%
2004: 39%
2005: 45%
2006: 58%  (26% return on ending assets, they're expanding fast)
Jumping ahead to Q2 of 2007: an equivalent of about 31% for the half

Looking ahead, depreciation for 2006 was $1.0 million, same as 2005 and similar to 2004. Gross PP&E is around $27 million. In reality, this is not a capital intensive business in the sense of low return on assets with an associated slow depreciation, but I suppose it could be if the competition was bad enough.

G&A way more than doubled in 2006. It had been fairly stable in prior years.

The main reasons were: (1) the $340,771 increase as R&D fee and (2) salary of the employees increased by $86,411 due to the expansion of the production capacity (3) the lease expense of new NPCC facility’s office building increased by $20,718 and (4) production and construction amortization expenses increased by $322,557 and (5) expenses of $750,041 related to becoming a public company and (6) value of warrant granted as the service compensation was $153,619.

Coal price increases: 2004 $70/ton, 2005 $80/ton, 2006 $90/ton.
Seasonality is a slowdown in Dec and Jan.
No allowance for doubtful receivables due to collecting them all before finalizing the report.
No capitalization of internally generated intangibles (e.g. patents).
Land use rights amortize over 50 years. Patents 20 years which is interesting.

Gross margins on chemincal decreased to 25% from 28% (due to mix and materials costs). 2004 was only 24%.
Gross margins on NPCC increased to 40% from 37% (due to increased revenues and lower materials costs at new plant). 2004 was 36%.

Reasons for chemical revenue increase:

(1) additional revenue from new products such as melamine for $3,914,827 and (2) technical improvement (the installation of decarbonators in our chemical plant enabled us to change our product mix to meet seasonal demand) increasing the sales of high profit products, which caused the increase of revenue by $5,811,350 which was offset by the decrease of sales from low profit products by $3,109,859

Reasons for NPCC revenue increase:

(1) additional revenue from new products for $419,075 due to the introduction of new NPCC pulp for tires and (2) revenue increase of $1,453,489 due to increased demand from our customers

Xiangzhi Chen, CEO, 44, owns 45% of the stock. Background is in construction and not the core business.
Anhui Gho, CFO, 36. Came from same background as CEO. Doesn't seem to have a particularly strong accounting background.

All officers and directors own 47% of the stock.

One outside director from Shandong Bangsheng Chemical Co.
One very new outside director from Shandong Chemistry and Chem Eng Assoc and other associations. Seems to have solid connections.
One foreign director, A. Carl Mudd, a financial person. This is good to see:

He has spent the past 14 years consulting with and mentoring CEOs and Boards of Directors major companies on global strategy, business processes and international operations and 27 years as CFO, COO and President of international companies. From 2003 to 2006, he was an advisory director at CIMIC Holdings, Ltd. From 1993 to 1996, he served as director and chairman of the Audit Committee at AM International, Inc. He is a Certified Public Accountant and holds a business degree from St. Edward's University.

Another foreign director, Sheldon Saidman, a marketing person.

From May 2001 to October 2005, he served as president and chief operating officer of Liberty Wire & Cable, Inc. He holds a bachelor’s degree in journalism and public relations from The University of Maryland.

Unlike so many Chinese reverse mergers, they have a true audit committee. Carl Mudd (chairman), Dongquan Zhang, and Sheldon Saidman.

The Audit Committee has established as a separately-designated standing committee in accordance with section 3(a)(58)(A) of the Exchange Act. The Audit Committee has at least one member, Mr. Carl Mudd, who meets the definition of an “audit committee financial expert” under SEC rulesand whom the Board has determined to be “independent”.

Compensation committee: Dongquan Zhang (chairman), Carl Mudd, Sheldon Saidman. The highest compensation is $250K total. CFO got $100K total.

No employee stock options granted in 2006. No options exercised, nothing vested in 2006.

Some related party stuff. March 2006, SDTH leases Shaanxi plant and land from Shangdon Shengda: the SDTH CEO is controlling shareholder of it.

Audit fees $165K for 2006, $84K for 2005. No other fees paid to auditors.

Auditors:
Hansen, Barnett & Maxwell
5 Triad Center, Suite 750
Salt Lake City, UT 84180
(801) 532-2200
40 years of experience. They audit 38 public companies.

Non-qualified opinion.

Equity statement:
In 2006, there were 5.8 million shares issued for cash at $2.29.
3.1 million shares issued "recorded as a purchase". What's up with that?
$971K was distributed to shareholders. What's up with that?
154K warrants issued
$907K of the net income for the year was recorded as statutory reserves. What's up with that?

Operating Cash Flow:
cash flow exceeded net income by $4 million due to $4 million receivables decrease, plus payables increase, and depreciation, partly offset by trade AR and advances and inventory.

Investing Cash Flow:
Capex was huge at $15 million, not surprising.

Financing Cash Flow:
$2.9 million cash added due to AP of related parties. $952K added due to AR of related parties.
$971K distributed to shareholders (no addition info here, wait for the notes).
$14 million cash generated from stock issue.

So the stock issue effectively financed the plant expansion while operations generated $21 million.


HISTORY:
In 1998, 19 investors (with Chen Xiangzhi having a controlling interest) formed Shandong Shengda Nano Co. Ltd. ("Shengda Nano") in PRC, which makes NPCC for tires.

Nov 13, 2001, those same investors formed Shandong Shengda Chemical Co. Ltd ("Shengda Chemical") in PRC, which makes ammonium bicarbonate, liquid ammonia, and methanol in PRC.

Sept 2004, those same investors formed Dongfang Nano-Materials Pte Ltd, a Singapore private limited company. The name changed to Eastern Nano-Materials Holdings Pte. Ltd ("Eastern Nano"), and two subsidiaries of it: Shandong Haize Nano Co Ltd ("Haize Nano") and Shandong Bangsheng Chemical Co Ltd ("Bangsheng Chemical"), both in PRC: ("Eastern Nano Subsidiaries").

Nov 2004, the investors transferred all of Shengda Nano and Shengda Chemical, with the exception of $7.8 million in cash and $301K receivables, land, land use rights, buildings, to the Eastern Nano Subsidaries, which also assumed $1.3 million in liabilities from the investors.

June 2005, Eastern Nano Subsidiaries acquired this stuff for $5.2 million. Chen Xiangzhi, the controlling shareholder, personally borrowed $5.3 million and paid $5.2 to the investors as a capital distribution. The net assets transferred were also considered a capital distribution. This was done to follow PRC rules. After this, the investors repaid the loan which was considered a non-cash(?) investment into Eastern Nano parent by the investors. This also included a $3.4 million receivable from a shareholder. Wow, is that silly or what?

All those assets, including the stuff withheld, had a carrying value of $28.2 million.

The stuff that Shengda Nano and Shengda Chemical withheld was then leased to Eastern Nano Subsidiaries.

The stuff, excluding the stuff withheld, had a carrying value of $23 million.

Nov 15, 2005, the investors formed Faith Bloom Ltd in British Virgin Islands (you can see the reverse merger coming here). Dec 31, 2005, Eastern Nano parent transferred the Eastern Nano Subsidiaries to Faith Bloom in exchange for 10 million Faith Bloom common shares to the investors. This was considered a reorg into Faith Bloom.

March 31, 2006, Faith Bloom issued 1.3 million shares to some institutional investors and accredited investors for $15 million, less $1 million in costs. On the same day, Faith Bloom did a reverse merger into Zeolite Exploration Company (Nevada), exchanging all 11.3 million Faith Bloom shares for 50,957,603 shares of Zeolite common, giving Faith Bloom investors 94.2% of the company. In Jan 2007, the company name changed to Shengdatech, Inc.

All financial statements are stated as if this reorg had been in place the whole time.

END OF HISTORY


In Sept 2006, they realized that 2004 and 2005 needed to be restated: revenues were overstated due to incorrectly accounting for rebates to customers of $513K and $723K. It took 40% off the selling expenses and 1% off revenues of 2004.

Land use rights, buildings, and some equipment are not consolidated into the financials as SDTH is not the primary beneficiary due to significant other operations and equity of lessors. Remaining future leases are:
2007: $887K
2008: $277K
2009: $184K

In the agreement between Eastern Nano parent and Shengda Nano and Shengda Chemical in Nov 2004, some assets were deemed impaired by $231K.

Revenue recognition seems ok. No post-delivery obligations.

R&D costs:
2004: $2.4K (yes, you read that correctly)
2005: $104K
2006: $341K

The 2005 non-trade receivable as mostly an income tax refund of about $4 million.

PP&E is almost entirely plant, machinery, and eqipment of $25 million. The building is $1.9 million.
$3.7 million depreciation against $27 million in PP&E.

$818K of replacement equipment was purchased from a related party.

Depreciation schedule (straight line):
Building: 15-25 years
Plant, machinery, equipment: 10-17 years (is this too long?)
Motor Vehicle: 5-10 years (10 years is pushing it)
Office equipment: 3-5 years

Other Payables is mostly utilities payments, plus payroll and "other".

SDTH was granted a tax holiday for the first two profitable years.
Only 50% taxes during years 3 to 5, which is 15% federal and 1.5% for local.

Tax for 2006 would normally have been $5.78 million. This would have lowered net income to $11.75 million (from $17.53 million) resulting in 19.6 cents per currently fully diluted share (assuming 60 million shares).



Wendy Fu joins as VP of finance (press release).
2005-2007: worked in Deloitte & Touche as a SOX senior consultant.
1999-2004: assistant controller, Wal*Mart China
1997-1999: regional finance mgr at Asia Pulp & Paper
1995-1999: auditor with BDO Binder
licensed CPA and holds a masters in accountancy from U Texas, Austin.... a Longhorn!

Here's the Q2 press release which has a lot more good stuff. The coal based revenue dropped qoq due to a 15 day factory shutdown and upgrade in April. The equipment should reduce raw material cost. The NPCC production is at full capacity, as I had wondered above.

Moreover, we successfully added seven new domestic clients and one Malaysian client, which marks our expansion into the international markets for NPCC.

Latex and adhesives had strong growth, up 264% qoq to 8.5% of NPCC revenue.

The higher gross margins at the Xi’an factory were due to the use of the company’s proprietary membrane dispersion technology combined with lower raw materials and labor costs, which together lowered the overall cost of goods sold at the Xi’an factory by 30% compared to the original factory.

So the claims in the 10-K are being realized this year. That's good to see.

In July 2007, ShengdaTech completed the addition of 40,000 metric tons of NPCC capacity. The new lines are expected to be at full capacity by November, 2007. The Company also plans on completing instillation of an additional 60,000 metric tons of capacity by year end 2007. Total NPCC capacity, once all lines are completed, will be 190,000 metric tons.

Wonderful, they put the conference call transcript in the SEC filing.

...we have successfully won seven new domestic customers and one overseas customer in the past quarter, and we expect to add four or five new NPCC customers in the third quarter.

and the Q&A.
The ASP for NPCC is around $390/MT without VAT.

Our cash on hand and cash generated by operation activity can support the capacity expansion of 60,000 metric tons capacity.

The big players like Michelin use their own technologies. The 2nd tier players have shown interest. Their targets are Kumho tire (Korea) and Bridgestone in Japan.

NPCC is used in the coating for manufacturing coating paper which usually requires about 12 -15 parts of NPCC, equivalent 8-10% of total weight. For latex, NPCC is mainly filled into silicone adhesive, which has high demand of NPCC which usually requires 30% of total weight. Regarding paint, NPCC can partially replace titanium dioxide (20%) and other materials which usually require 5-8% of total weight. For PVC, the proportion is about 5% of total weight.

However, this statement seems odd given how incredibly common limestone is in the world

Limestone is the main raw material for producing NPCC. Because China has large reserves, we are able to produce NPCC at a reasonable cost while in many other countries where limestone is not widely available the cost is relatively higher.

Here's the 40K metric ton capacity completion press release. New membrane method lowers cost by 5-7%. Also better quality particles. Overall, production costs are lowered by 30%.

Carl Mudd acquired 5,000 shares at $5.40.

Modified articles of incorporation. 110 million authorized shares.

Q1 conference call
$460 per metric ton ASP before VAT.

In order to continue to consolidate our market share, we plan to begin adjusting our NPCC average selling prices in the second quarter. Given the strong cost efficiencies in our Xi’an facility, we have the ability to offer lower price to our customers without compromising our blended gross margin.

Going into detail about the Xi'an facility lower costs:

Our cost on the limestone is 14% lower, electricity is 7% lower and consumption of anthracite is 8% lower, soft coal is 45% lower.

Q1 results

SEC commenting on rebate issue and a purchase obligation issue

Q&A info
These are good questions and the answers seem fine. A $199K "other expense" was bank fees and disposing of equipment. Expect 60 sales people by the end of 2007.

Can you explain why purchases of property and equipment on the cash flow statement were negative in the fourth quarter?

A: As of September 30, 2006, the Company had recorded, as fixed asset additions, the construction of the new 60,000/mt plant. During the fourth quarter 2007, it was determined that a portion ($971,496) of the amount paid to related parties for the construction of the new plant was a capital distribution. During the 4th quarter, this amount was reclassified from fixed assets to a charge to stockholders equity and exceeded the amount of additions and advances paid for the 40,000/mt plant thereby resulting in a negative addition to fixed assets for the quarter.

I guess...

Carl Mudd buys 3,000 shares for $4.00 each.

Q4 results

Feb 23, 2007: A. Carl Mudd, Sheldon B. Saidman, Dongquan Zhang added to the board.



I like this company. The business seems to have very good characteristics. They seem serious about a good set of goals. They've demonstrated an ability to deliver by setting up the new factory and getting the anticipated results. They've brought in appropriate outsiders.

The price per shares is/was around $6.00. This is a case where it's worth asking whether this is something worth more than a cigar butt valuation.

I'm going to assume 60 million totally diluted shares. I think the stock is worth around ten dollars a share, which might be a bit high compared to my valuation of other stocks (the tax holiday for SDTH doesn't last forever). Maybe I'm relying too much on a gut feeling.

I bought some with some cash that I added into one of my accounts. It's not much. If some opportunity arises, I might buy some significant amount.