CNAM: 1Q2010

The Chinese recycler and metal distributor China Armco (Ticker:CNAM) recently announced its results for the first quarter of the year. CNAM is another case in which ascertaining the enterprise value requires looking at more than the SEC-reported earnings, and snooping into the sources of reported income and expense.

CNAM's 1Q2010 revenues were up 59% from $5.4 million to $8.6 million compared to 1Q2009. Good, right? CNAM reports non-GAAP earnings of $670,000 or $0.06/sh, well ahead of its non-GAAP earnings of $185,000 or $0.02 per share in the year-ago quarter.

The GAAP earnings (the ones the SEC requires be reported) were only $53,000, or $0.01 per share, down from GAAP earnings of $0.03 per share in the year-ago quarter.

The difference is stark: up a third or down a third? And from how much?

So, what's behind this?

FAS 157.

When CNAM issued stock at $3 in a private offering in 2008 to raise funds to build its new recycling plant, it also issued warrants that could be exercised for shares at $5. As the price dropped in 2009, the value of the warrants under FAS 157 declined, and under GAAP, CNAM recognized "income" from the change in paper value of warrants that CNAM could not exit at a profit but seemed less likely to be exercised. As the price rose in the first quarter of 2010, CNAM was required by FAS 157 to book "losses" associated with value recovery in the same warrants. As CNAM went past $10, investors exercised at $5 and CNAM gained valuable capital with which to increase the size of its business deals.

What investors buy isn't the paper value of warrants a company can't exit, though. Investors buy a future income stream on a diluted-share basis. On that basis – the basis on which investors actually evaluate businesses – CNAM has shone. Net revenues increased 59% – in a quarter in which its recycling plant wasn't fully up and running. Net income (ignoring the warrants) increased 262% over the year-ago quarter. CNAM ended the quarter with over $4m cash, up from less than $750k in the year-ago quarter.

The best news? This growing income stream is in undervalued Chinese currency, the value of which will pop when prices normalize. CNAM is a buy at its current $4 because nobody is bothering to read the details.