Andri Capital Letter To Gulf Resources
To the Board of Directors of Gulf Resources, Inc.:
As a shareholder in Gulf Resources, Inc. (“Gulf Resources”, “GURE” or the “Company”) we are writing to you now to encourage you to take decisive action to enhance shareholder value.
Today the concerning situation is as follows:
Poor shareholder return
In recent years the company has fared well. Revenues have grown by approximately 50% since 2012, profits more than doubled and earnings per share increased by roughly 80%. However, shareholders of GURE – the owners of the company – have not benefited accordingly.
Since the beginning of 2012 the Company’s shares have mostly seesawed between $1-$2.5/share and delivered a negative return of approximately -6%. At the time of writing the shares trade at $1.61/share, which is also 83% below the IPO price in 2009. Since the company does not pay dividends or engage in share repurchases the shareholders have not reaped the rewards of the business’ success.
Also, we believe the shares of GURE to be significantly undervalued and trading well below liquidation (net current asset) value. On March 31, 2017 the Company’s book value was $7.68/share, net current asset value (current assets net of total liabilities) $4.71/share and net cash value (cash net of total liabilities) approximately $3.29/share. At the current market price of $1.61/share the Company’s stock is trading at a roughly 79% discount to book value.
As of March 31, 2017 the Company held $172.8 million in cash. That amounts to 46% of total assets and 48% of book value. We believe this to significantly exceed the required amount to operate and grow the business.
According to our estimates the Company’s cash requirements for operations are as follows:
1) Working capital:
On March 31, 2017 the company had approximately $5.2 million in inventories, $60.6 million in accounts receivables and $10.4 million in accounts payable and accrued expenses. Assuming annual sales and cost of sales (according to reported annual results on December 31, 2016) of $149.3 million and $94.8 million, respectively, the Company’s cash conversion cycle is approximately 128.1 days. As a result, the Company needs a minimum cash balance of $33.3 million to finance this investment in working capital.
2) Operating expenses:
Assuming unchanged annual operating expenses as of December 31, 2016 this amounts to nearly $6.8 million.
With the addition of $174 thousand in interest expense the total stands at roughly $6.9 million.
3) Other current liabilities:
On March 31, 2017 the Company had outstanding current liabilities (excluding accounts payable) of $6.1 million.
4) Capital expenditures:
The Company expects to spend $10 million on drilling 2-3 new wells in Sichuan. It will also spend on improving bromine and chemical production facilities.
Overall, the sum of the above (1) – (5) results in a total cash requirement for GURE of approximately $56 million. This leaves nearly $117 million of excess cash.
What is the purpose of all this cash? The board has stated that it is “continuing to look for vertical and horizontal acquisitions”. That would justify such a large cash position if there was a definite acquisition coming up in the next few months. However, the Company has been hoarding cash for over four years. This cash account – consisting of “highly liquid current deposits which earn no or little interest” – results in lower return on equity, drives down the share price, raises cost of capital, causes inefficiency and may lead to bad investment decisions. It also means that nearly half of the Company’s assets deliver no returns to shareholders. Overall, the Company enjoys a strong debt-free balance sheet and cash-flow positive operations, which alone is sufficient to both ensure continuing operations and finance future growth. As a result, the Company does not need to sit on such large piles of cash to finance a potential acquisition that might or might not happen sometime in the future.
Based on the above, we believe GURE has the opportunity to improve its capital structure and unlock significant shareholder value. By properly allocating the $117 million of excess cash, or at least part of it, the Company can enhance shareholder returns and still pursue its acquisition strategy at minimal cost. Specifically, we propose the following:
Share repurchases and debt issuance
We believe that the optimal strategy for the Company is to take advantage of the great undervaluation of its shares by authorizing a share repurchase program and subsequently adjust its capital structure by issuing debt to finance potential future acquisitions. This will lower the firm’s long-term cost of capital, increase efficiency, provide tax benefits and reward long-term shareholders through capital appreciation and greater returns on equity.
Returning some of the excess cash to shareholders through share repurchases will also send a clear signal to the market that here is a management that has shareholders’ interests at heart. Engaging in share repurchases will then further produce a more proper market price for the stock, increase credibility and enable the Company, if it so pleases, to gradually reissue shares over time at a significantly higher price. Authorizing repurchases of up to 15 million shares, for as long as the market price is below book value of $7.68/share, will benefit long-term shareholders greatly and most likely do so quite quickly without significantly affecting the capital structure or cash position of the Company, due to the low market price and average daily trading volume.
Since the Company is unlikely to be able to return all the excess cash to shareholders through open-market repurchases (due to the low market price and trading volume) we believe that the board should not entirely dismiss the idea of returning cash to shareholders by paying a (one-time special) dividend. Such an action is always preferred to letting the cash burn a hole in shareholders’ pockets or forcefully engaging in sub-optimal, non-core acquisitions.
Lastly, we believe that the Company can continue to pursue its growth strategy at minimal cost by issuing debt to finance any potential future acquisition. Issuing debt is both less expensive than using equity and more value enhancing for shareholders. At an effective tax rate of approximately 25% the Company’s after-tax cost of debt is only 5.7% whereas the cost of equity is roughly 48% (using current earnings yield as an estimate, based on 2016 EPS of $0.78 and share price of $1.61). Since the Company is practically debt-free and cash-flow positive the issuance of debt will be beneficial both in terms of tax savings and increasing return on equity.
As a guardian of shareholder interests it is the duty of the board to take appropriate action to maximize shareholder value. Allowing the Company to sit on idle cash for over four years – cash that exceeds the operating requirements of the business and is unnecessary to finance the acquisition of new businesses – is an act that is not in the best interest of shareholders. Furthermore, the great undervaluation of the Company’s shares coupled with a large cash account, debt-free balance sheet and positive cash flow puts GURE at the risk of being an easy takeover target. We therefore urge the board to reverse the long-lasting trend of depressed shareholder return by returning this excess cash to shareholders through aggressive stock buybacks and value-enhancing capital restructuring.
We hope you review our suggestions closely and start immediately to take those decisive actions in the best interest of shareholders of Gulf Resources, Inc.
We further welcome all discussions regarding the matter at any time.
Stefan A. Stefansson