China Agri-Business Inc (CHBU.OB) reported another outstanding quarter, driven by the rapid expansion of the company’s direct store sales program.

While the new distribution strategy seems to be working, the stock has appreciated significantly and now trades well above NNWC and book value – CHBU has now transitioned from a pure value stock into a growth story.

Financial Highlights

CHBU’s third quarter revenues were $3.5m, a 471% increase from the same period last year. This follows the 391% increase in second quarter revenues, as the company continues to add new direct stores at a blistering pace.

As of September 30, 2010, CHBU owned 400 direct sales stores, up from 346 direct sales stores in July. Management has set a goal of 500 stores by the end of October so growth should continue into the fourth quarter numbers.

While much of the sales revenue is due to direct store expansion, the company’s traditional network also saw a 120% increase in quarterly revenues, and are now up 22% on the year.

The company’s increased visibility and exposure seems to be helping across all business segments.

This growth is not without cost, as gross margins fell from 70.11% to 42.57% – the direct sales method has much lower margins than the company’s traditional sales network.

Operating margins took a hit as well, falling to 25.3% compared to 40% in the prior year period.

Since sales are increasing at a much higher rate, both operating and net incomes were up despite lower margins. Overall, net income increased 260% to $895k, or $0.07 per share, up from $0.02 per share in the third quarter last year.

Through the first nine months of 2010, CHBU has generated $2.1m in operating income and EPS of $0.15.

The company’s balance sheet remains strong, with almost $0.81 per share in net cash and a book value of $0.88.

Management has also taken steps to improve the stock’s capital structure. During the quarter, the company paid back a $500k convertible note, reducing the risk of share dilution for common shareholders.

The company still has 1.3m warrants outstanding as of September 30 at $1.00, $1.50, and $2.00 per share. However, 758k warrants expired in October.

The last significant chunk (500k) expires in Sept 2011, with a current exercise price of $1.50 per share.

Other Events

As I mentioned in my previous posts on CHBU, management had received approval from the local government for 66-acre land-use purchase costing $4.4m. If completed, this would take a significant chunk out of the company’s cash reserves and the original margin of safety for the investment.

Likely due to these delays, CHBU announced on November 12 that it would be leasing a ~4 acre parcel of land to construct a warehouse and distribution center.

The lease term is for 21 years at $53,800 per year (subject to a 12% increase every three years), with a prepayment of the first ten years in an initial lump sum of $540k.

While I’m not an expert in the going price for Chinese land, this lease agreement seems to come at a high price, especially when compared to the original purchase option.

Valuation

Due to its large cash balance, CHBU trades at very low multiples i.e. EV/EBITDA sits at only 1.73 using an enterprise value of 3.46m.

Looking at it another way, the stock has generated $1.7m in adjusted free cash flow for the year and should produce over $2m for the year – even using this conservative estimate, the stock has a ridiculous FCF yield of 57.8%!

The business should generate EPS of $0.06-$0.07 in the fourth quarter for an annualized EPS number of $0.22, translate into a P/E ratio of only 5.

Both DCF and EPV valuations suggest an intrinsic value of around $1.60.

Conclusion

While the stock has turned in an impressive year, my original thesis was predicated on a discount to tangible asset value.

Now that the stock is trading higher, it has ventured beyond value investing territory and has become even harder to predict. Also, I’ve become even more leery of Chinese small-cap stocks due to major accounting scandals that have recently surfaced.

While I think the stock could run up near $1.50 in the next few months (especially on the back of fourth quarter numbers with easy YoY comparables), I’m going to take the cautious approach.

I’m going to sell CHBU out of the Value Uncovered portfolio based on yesterday’s closing price of $0.99.

The investment gained 80% in 5 months for an annualized return of 314%.

Disclosure

No positions.

Electronic Systems Technology, Inc. (ELST) reported third quarter results last week, with significant improvements in revenue, operating income, and EPS.

2008 and 2009 were rough years for ELST, but recent trends show a return to former operating levels.

Truthfully, the stock is boring, but the company continues to trade at a discount to its net asset or liquidation value, providing a solid margin of safety.

Financial Information

Total revenues for the third quarter improved to $588k compared to $379k in the same quarter last year, an increase of 55%. Surprisingly, most of this growth was generated on the domestic sales side (in the first quarter, growth was seen mostly in the foreign markets).

Domestic sales made up 91% of quarterly revenues. While this sales growth is positive for ELST’s core markets, domestic sales have much lower margins than the international business.

Year-to-date sales of $1.6m are 20% higher than the same time last year, with growth increasing quarter over quarter.

The company reported positive quarterly net income, bringing YTD profits up to $102k or $0.02 per share.

A good portion of this yearly increase can be attributed to mobile data computer systems (MDCS) to public and government entities. For the first time, the company disclosed a material customer, ACL Computers & Software, which is a government subcontractor.

ELST’s products have long been used in patrol cars for police forces, and it appears the company is expanding into the federal space, a positive development.

The balance sheet remains strong, with a current ratio of 23.9. A significant portion of the company’s assets are in cash or short-term certificates of deposits.

Valuation Scenarios

At the latest closing price of $0.54, the stock is still selling at a small discount to NCAV and only slightly above NNWC.

Enterprise value is actually negative, as the company’s cash balance is more than the current market cap.

As a going concern, the company should report full year EPS of approx $0.03, with owner earnings of $200k.

Assuming no growth going forward, this still yields a DCF value of approx. $0.62 per share.

Conclusion

Now that sales are picking up, I’d like to see management return some of the excess cash to shareholders.

The company paid a consistent dividend from 2005-2008 when the business was in similar financial shape, and the resumption of this practice would be a good start.

Although government sales are notoriously unpredictable, another possible catalyst could arise through this new federal government reseller. Even a small federal contract could significantly help a company like ELST.

Overall, this is a pretty boring stock where future gains are limited but with solid downside protection. I’ll be keeping a close eye on an opportunity to sell if the price jumps significantly above the current asset value.

Disclosure

Long ELST

AMCON Distributing, Inc. (DIT) possess a market cap of only $40m, yet just passed the $1B mark in total revenues for fiscal 2010, a significant achievement.

After reporting full year results, the company has significantly improved its financial position and is poised for another solid year in 2011.

2010 Year in Review

DIT hit several key milestones during fiscal 2010:

• Acquired Discount Distributors, a wholesale distributor based out of Arkansas with annual sales of $59.6m. The acquisition occurred in November 2009, so most of this annual run rate is included in 2010 results.

• Opened a new retail food store in Tulsa, Oklahoma. The company is expanding cautiously, and this new store brings the total count to 14.

• Reduced total borrowings under the credit facility by more than $4m, even after the opening of a new store and a decent-sized acquisition.

• Grew net sales, operating profits, earnings per share, and dividends to the highest on company record.

Financial Information

The company operates in two reporting segments, wholesale distribution and retail foods. For the year, total sales increased 11.3% to $1.01B.

Wholesale distribution saw a significant jump in revenues, largely driven by the new acquisition and higher cigarette prices that were passed along to AMCON’s customers – overall cigarette carton sales were down.

Retail foods revenues were basically flat, but gross margins increased from 41.8% in 2009 to 43.8% this year.

As a whole, the higher revenues and lower margins managed to cancel each other out, and operating income remained relatively flat at $15.4M.

However, income from continuing operations increased 5.6% to $9M, due to the lower interest expense (as the company continues to pay down its long-term debt) and tax burden.

On an unadjusted basis, diluted EPS was $11.99 compared to $16.61 last year – however, last year’s numbers were boosted significantly by the sale of AMCON’s water business, a sale classified under discontinued operations.

After normalizing for this one-time event, earnings per share actually rose 10% from the prior year.

Balance Sheet and Efficiency

AMCON continues to generate solid cash flow from operations, and has put the cash to good use – smart acquisitions, cautious store expansion, and debt repayment.

Debt to equity has fallen to 181%, down from a high of 1590% (!) back in 2007. The company’s current ratio now sits at a respectable 2.5.

CROIC is a very solid 16.9%.

Compare these other efficiency ratios to DIT’s key competitor: Core-Mark Holding Company (CORE)

Valuation

The stock has appreciated more than 20% since my original article on this turnaround story, but remains undervalued at current levels.

EV/EBITDA is 4.42 – applying a normal multiple of 6 would translate into a share price of $102.

Conclusion

Management has done a great job of turning around the company over the last several years.

AMCON runs a very lean operation, so net margins probably won’t rise much above 1% overall as long as the majority of the business is driven from the distribution side.

Management has already taken the obvious improvement steps, so growth will be largely from smart acquisitions and well-designed expansion on the retail side.

Last year, the Series C preferred stock was converted into common shares and retired – the majority of the remaining preferred shares are owned by current management so the risk of dilution is small.

Although unglamorous, AMCON’s business is unlikely to go away:

“With over 144,000 locations at the end of the 2009 calendar year, convenience stores outnumbered all other competing sales channels (supermarkets, drug stores, tobacco outlets, and mass merchant/dollar stores) combined, and have become a destination of choice for time-starved customers. Additionally, because convenience stores dominate a number of product categories, they have become an unavoidable part of day-to-day life for many Americans”

Business remains steady throughout the business cycle, in good times and bad:

“our businesses have remained more resilient than many other distribution and retail formats and have performed comparatively well given the challenging operating environment.

While the stock isn’t as cheap as before, it has plenty of upside left.

Disclosure

Long DIT