Seeking alpha through value investing

PSOF, an undervalued growth stock

2010-03-22T16:03:00.000-07:00

I am a value investor and only like to buy undervalued stocks with enough margin of safety. However, I also like healthy growth companies with sustainable competitive advantages. So, when I see a stock that is undervalued and has strong sustainable growth potential, I do not hesitate - I pull the trigger as soon as I can.

This one is Pansoft Company (Nasdaq: PSOF)

Pansoft is an enterprise resource planning (ERP) software and professional services provider for the oil and gas industry in China. (For those of you who have never heard of “ERP”, please see here.) In short, ERP is a computer system to integrate all segments of a company to efficiently allocate financial, material and human resources.

China ERP market

The ERP concept entered China 10-15 years ago. The market experienced slow adoption and expansion. Since 2005, it developed rapidly and most mid to large size enterprises have adopted ERP systems.

Current major problems for leading global ERP vendors (i.e. SAP and ORCL) are that the Western-style value proposition, operating model, business process design, and supply chain integration model are hard to quickly fit an emerging market like China. Chinese users prefer to use the system to automate current processes rather than change processes to fit in an ERP system. As a result, foreign vendors have limitations to define and understand the real functional and business needs.

Although domestic ERP system developers have started challenging global vendors, foreign ERP developers can still win contracts from the largest state owned enterprises such as PetroChina (PTR) not only for the capability and scale of the systems, but also for the future global expansion ambitions of these companies. An international platform will be necessary to integrate their cross-border operations.

However, for companies like PetroChina, they have big overseas market, but even larger domestic market. As a huge company, PetroChina has thousands of subsidiaries and oil fields in China. So with a mature SAP or Oracle system installed, some localization or customization are definitely necessary to seamlessly integrate domestic operations into a global platform.

PSOF’s niche market

PSOF is not an ERP system developer that directly competes with SAP/Oracle. It actually is good at localizing and customizing the financial module of the SAP system.

Pansoft has been working with oil companies since its inception. Its expertise is to interpret oil companies’ business requirements to IT system, which needs years of accumulated hands-on experiences. In addition, PSOF also understands SAP’s data model, work flow and development tools. Based on all of this expertise and experience, the company’s software offers solutions in accounting, order processing, delivery, invoicing, inventory control, and customer relationship management.

PSOF’s barrier to entry

ERP systems are very expensive. PetroChina spent millions (if not billions) of dollars on the SAP system. The switching cost is huge. PSOF helps PetroChina to further develop the financial module and integrate all of the subsidiaries and oil fields. The switching cost is also tremendous. As long as the software itself doesn’t have a fatal flaw, the user usually has no motivation to switch to other software.

Also, the oil industry in China is dominated by three state owned enterprises: CNOOC (CEO), PetroChina, and Sinopec (SHI). According to the company, PSOF has signed contracts with two of these three. This is a huge barrier to entry.

PSOF’s future growth

PSOF is leveraging its experiences in the oil industry to expand to the coal sector. In the meantime, it has packaged some of its programs that are suitable for general ERP systems. This general application software will be sold customers in other industries.

With PetroChina and Sinopec as customers and fixed long term contracts, this company has stable revenue and strong potential growth.

PSOF valuation

As of March 19, 2010, PSOF has a market cap of 31.2 million, $14.7 million in cash, no debt, and a net asset value of 18.6 million. With 5.78/share, this is actually around $2.7 cash/share. After cash, the PE ratio is only 3.85/0.53 (2009 fully diluted EPS) = 5.8x

We can also use earning power value to value PSOF. This is a process to adjust 2009 operating income. I don’t want to put too much technical stuff here, but the concept is simple: The earning power is not reflected by the operating income only. I believe some part of SG&A and interest income should be added back to operating income because the money spent on SG&A can secure a sustainable barrier to entry. So after taxes, sustainable earning power is around $4 million.

I then use 10%-20% discount rate to calculate perpetuity. The range is $20 million – 40 million. Don’t forget cash. Adding back $14.7 million cash and I get $34.7 million - $54.7 million valuation.

Compared to current valuation of $31.4 million, I think this stock is seriously undervalued. If we can buy this stock under $6, we have a huge margin of safety.

Disclosure: Author holds a long position in PSOF

China Industrial Waste: Strong Foundations for Growth

2010-03-08T17:17:00.000-08:00

Since my last blog of China industrial waste (CIWT.OB), I got numerous emails asking me why trading volume is so low and why the price experienced a pull back from a recent high of $3.45.

Well, Benjamin Graham said: "In the short term, market is a voting machine, but in the long term, it is a weighing machine." As a value investor, I look for undervalued stocks and believe that value will be recognized sooner or later. In the mean time, I also look at my target’s potential growth. I don’t try to forecast growth without solid foundations. I value a stock using earning power based on what I know.

I still believe that China Industrial Waste is a hidden gem and will bring tremendous profits to its shareholders. I recently had a call with CIWT's CEO through its Investor Relationship representative. The call turned out to be very positive and I think it is necessary to share with all my blog readers.

Recently, CIWT signed a new contract with a ship builer with estimated new annual sales of $2million. I treat this as a normal contract and would not spend too much time on it.

The most important and exciting of CIWT's business is its sludge treat business. The following is from its most recent SEC filing:

In accordance with the Company's franchise agreement with the local government, Dongtai Organic is entitled to process all of the sludge generated from the sewage treatment plants in the urban area of Dalian City. The Project generates revenues from two sources: (i) fees which are based on the volume of sludge processed and (ii) fees from the sale of biogas (natural gas) to the Dalian Gas Company. The Project has a designed capacity of 600 tons per day and is currently processing approximately 400 tons per day and supplying approximately 10,000 metric meters of natural gas per day. The Company anticipates the Project will reach 100% utilization within one-to-two years as more sewage treatment plants are constructed in the local area over.

Based on my call with Mr. Dong, CEO of CIWT, the sludge treatment business signed a 20 year BOT agreement with the Dalian local government. CIWT now can process 80% of daily generated sludge by the whole city.

Mr. Dong also told me that they charge about RMD 135/ton for the sludge. Although they expect the capacity may increase to 600 ton. I would judge 400 to be conservative.

the sludge treatment revenue=RMB 135/ton x 400ton/day x 30 days/month = 1.62 million RMB/month
The fermentation tanks built by CIWT can generate around 15000 cubic meters of bio gas/day. CIWT also sells bio-gas to local utility company. This part of business will generate 3.9 RMB/cubic meter x 15000 x 30 days/month = RMB 1.76 million.

So the total CONSERVATIVE revenue from the sludge business is RMB 3.38 million, which is approximately $500,000 per month and $ 6 million/year,

CIWT has a 52% stake of the Dalian Dongtai organic waste treatment project. So in the future, this part of revenue will be consolidated into its financial statements.

I am expecting to see a strong revenue growth in 2010. Due to the accounting treatment, net income growth will not be the same as revenue growth because a minority interest should be deducted. But I still believe we will see a nice bottom line growth because the new sludge treatment business net profit margin is expected to be 25%.

The more exciting news is that CIWT's business model has also attracted other city governments. In the coming years, they will go to other major cities to negotiate similar projects.

CIWT uses biotechnology to degrade sludge to generate bio gas. The remnants are harmless and could be used for fertilizer. This is an environmentally friendly method to process sludge as fast urbanization in China, waste water and sludge treatment causes serious environmental damage to large cities. CIWT obviously has the edge in being able to meet the strong demand and grow its business rapidly.

I am positive on this stock and believe it will shine sooner or later.

China Industrial Waste: A Hidden Gem

2010-01-04T16:01:00.001-08:00

China Industrial Waste (CIWT.OB) is the first industrial waste treatment company based in Dalian, a beautiful coastal city in northeast China.

Macro Background

1. China has enacted stricter regulation to enhance ecological and environmental protection.

2. Environmental protection industry is growing 25% per year according official media.

3. High barriers to entry. Companies need to demonstrate their technologies and go through lenghthy license approval process.

4. No more than two direct competitors within a specific region.

Due to the requirements of waste consolidation and mass treatment, as well as possible disastrous results if companies perform industrial waste collection and processing, the government usually only allow no more than two direct competitors to serve a particular region.

5. The region where CIWT serves is the heavy industry center and thus the largest waste producers.

Business Overview

The company mainly engages in three business segments:

1. Industrial waste management

CIWT provides “one-stop” comprehensive solution of industrial and commercial waste treatment. CIWT charges service fees and also makes money from selling scrap materials and recycled products.

This segment contributes around 90% of total revenue and has about 20-30% growth rate.

The expansion plan is in schedule and the management expects the new project to make profit in the second half of 2010. The company expects to double its processing capacity within 1-2 years. Currently, CIWT operates four facilities with a combined 35,300 tons of capacity. After the expansion project, the capacity will increase to 77,000 tons. The company hopes that this expansion will help drive revenues and profitability going forward.

The service fee charged by CIWT is renegotiated annually. As the regulation is stricter and stricter, large clients don’t want to risk their business with the government, so they usually don’t have bargaining power. Usually, service fee makes around 70-75% of total revenue of this segment, and sales of recycled and scrap materials are 25-30%.

Accounts receivable collection is stable, usually at around one month. CIWT collects cash at the end of every month.

2. Municipal BOT projects

This segment contributes about 5% of total revenue. Competition in this field is fierce and profit margin is also low compared to industrial waste management. The company does not plan to invest more in this field. However, this is a stable business with stable cash flow. So CIWT still operates this segment to make some stable profits.

3. Environmental protection engineering.

CIWT has a joint venture with a German company to provide waste water and sludge treatment service. CIWT is not a pure equipment but a comprehensive solution provider.

This segment will be future CIWT’s revenue driver.

Financials

Over the past four years, CIWT has grown its revenues more than 300% from $4.87 million in 2005 to $13.4 million in 2008. Net income grew more than 300% from $1.49 million in 2005 to $4.75 million in 2008. The profit margins were 69% and operating margins were 42.5%. Although the company is involved in big capacity expansion project, it still can generate $4.9 million in cash flow from operations during 2008. 1Q09 was difficult due to economic slowdown but business has since improved.

The company also has enough cash for its debt and construction project payable, which suggests that they don’t need immediate outside financing to finance its projects.

Future Growth

1. China’s environment protection industry is still in its infancy. But with strong government support, the growth will be much faster in the following years.

2. China is moving its manufacturing plants from coastal provinces to inland provinces due to economic development. CIWT has strategically chosen a few sites across the country to meet this change.

3. The central government has enacted favorable tax policies on those environment related industries. There is no value added tax. 70% of corporate tax will be returned and no operations tax. Government also provides favorable interest rate if CIWT wants to borrow loans from national banks.

Conclusion

I believe CIWT is a hidden gem. The value has not been discovered by many investors. I recommend to buy this stock now. If you are patient and can hold this one for one or two years, you may see a very nice return.

A look back of 2009

2009-12-31T09:46:00.001-08:00

Happy New Year to all my followers and seekingalphers.

It's been fun to watch and take profit from the strong rally in 2009. I hope all of you have recovered from 2008 and are looking for a better 2010.

I started blogging at SA since this June. I am not an active blogger as I always spend much time on researching my target companies. I may only pick 1 or 2 companies from a long list of candidates. Although it looks not productive, it does produce good profits for my portfolio this year.

Let's take a look:

On July 12, 2009, I recommended RINO
Price on July 13 ( July 12 was weekend): Close at $10.19
Current price: 27.75 ( 12:30 pm of Dec 31, 2009)

return so far: 172%

On August 6, 2009, I recommended YONG
Price on August 6, 2009: $5.98
Current price: $8.24

return so far: 37.8%

On October 8, 2009, I recommended CBPO
Price on October 8: $8.07
Current price: $12.00

Return so far: 48.7%

On October 29, 2009, I recommended GFRE
Price on October 29: $9.47
Current price: $11.68

Return so far: 23.34%

I am satisfied with my picks and recommend you to continue to buy these stocks at dips. I believe these stocks still have very promising future.

As to 2010, I will continue to write recommendations at SA. I hope to recommend one stock a month. I usually don't focus on large cap stocks like C, BAC, GE etc. I personally believe a careful research and disciplined trading of small cap stocks will give you much better profits unless you are retired and want stable income.

I also suggest all of you to buy my recommendations only at dips, never ever chase these stocks at peaks.

Finally, wish everybody a happy new year!

Disclosure: I am still holding yong, gfre, cbpo, and rino

GFRE, Cashing in on Bromine

2009-11-02T08:41:00.001-08:00

Gulf Resources (GFRE.OB) is a leading provider of bromine and specialty chemical products in China, producing bromine, crude salt and other chemical products made from bromine.

Bromine and related chemical products are widely used in oil and gas exploration, papermaking and as industrial refrigeration chemicals, among other uses.

Some Background:

1. Where do you obtain bromine?

Bromine is never naturally found in its elemental form, but rather in compounds with other substances. The element is extracted from natural brine of halogen water.

2. How’s the distribution of global bromine reserves

When we talk about bromine reserves, it is actually about halogen water. Halogen water is not found in normal rivers or lakes. It is actually concentrated in three regions of the world: the U.S., Israel and China. And in China, halogen water concentrates in Shandong province, where GFRE is located.

3. What industries need bromine or its chemical products?

Basically, oil and gas field exploration, drilling, water processing, papermaking chemical agents and inorganic chemicals, agricultural applications and industrial refrigeration.

4. How do you define reserves in terms of available halogen water?

Halogen water is not like iron ore, coal mine or even oil. It flows under the ground in a relative large area. So it is hard to define whether the company really owns the reserve like iron or coal miners. Thus, usually the government would issue license and land use rights to explorers. The company with license and longer land use rights that cover larger areas would be a clear winner.

5. What is the price trend of bromine?

The peak of Bromine price was in August 2008 at 18,000RMB/ton. It dropped to 11,000RMB/ton in January 2009, but jumped back to 15,000RMB/ton in September 2009. The most recent press release from GFRE showed that Bromine price has increased again.

Based on this rudimentary knowledge of bromine, it is clear that bromine is in great demand from diversified industries and users. Then, the special situation of Chinese bromine reserve and government made GFRE more interesting.

China now has only issued six license for bromine exploration in Shandong province. In 2006, the government announced that no additional licenses would be issued and started to close down unlicensed producers. As the largest bromine producer in the market with about 25% share, GFRE has a strong position in the market. And as the largest player in the field, GFRE can leverage the policy to consolidate other smaller players to expand production and production and achieve the economies of scale.

The strong market demand is another positive factor for GFRE. China has remained a net importer of bromine due to strong domestic consumption. In 2008, China produced 170,000 tons of bromine to meet the demand of 200,000 tons. Domestic production is falling short of meeting this growing demand.

Company Highlights

GFRE recently completed an acquisition deal and is ramping up production to begin at the end of November. It now has 50-year mineral and land use rights on 23,109 acres of the richest bromine reserve land in China and access to more than 2.11 million tons of non-reserve mineralized materials.

Currently, bromine production revenue make up about 60% of GFRE’s total revenue. Other bromine chemical products account for 30%, while crude salt, the by-product of bromine production and a basic material in the chemical industry, accounts for a little less than 10%.

GFRE has stable demand from some major state owned companies like PetroChina (PTR) and Sinopec (SHI). These large customers have long term relationship with GFRE and GFRE usually gives them 90 days credit. Transactions with smaller customers, on the other hand, are most often simply cash deals.

The company seeks to grow itself through acquisition and organic growth. The company is looking to acquire smaller explorers to expand its bromine reserves and also to upgrade its older chemical production line to produce more value-added bromine chemical products.

Financials

Strong revenue growth: Revenue grew from $31.7 million in 2006 to $87.5 million in 2008.

Strong profitability: Gross margin increased from 11.2% in 2006 to 35.2% in 2008; Net income margin increased from 3.8% in 2006 to 22.4% in 2008.

Strong balance sheet: $37.96 million cash and only $5.68 current short term/current portion of debt. No long term debt. Accounts payable is just $17,791 million. So, the company can sufficiently self-finance its growth after paying off all its liabilities.

Positive operations cash flow: The company generates positive operations cash flow that, in the past, has been good enough to cover its Capital expenditure.

Finally, let’s do a simple valuation.

Enterprise value = market cap + Debt + Preferred Stock – Cash

It has 31.6 million outstanding shares. Current market cap is around $285 millions.

So the Enterprise Value = 285 + 5.68 – 37.96 = $262.72 millions.

GFRE currently produces 37,000 tons bromine/year. Considering its 50-year mineral and land use rights, in total it has about 50 x 37,000 ton = 1.85 million tons available in reserve (this is just a rough estimate, not including future acquisition).

So you are paying $262.72 million to purchase 1.85 million tons of bromine, which represents $142/ton of Bromine. If we use 1$ = 6.9 RMB, it is actually around 980 RMB/ton.

At the current price, this is a huge bargain. If we consider future expansion and its monopoly position, it is worth much more than its current price.

YGII, profiting from 1.3 billion people's basic need

2009-08-04T14:09:00.000-07:00

Company Description

Yongye International (YGII) is a fulvic acid based nutrient product manufacturer and developer in China. It is based in Inner Mongolia (actually just one hour drive to Beijing).

The nutrient is mainly used to increase the yield of plants and animals. Its main target is crops, animal only takes no more than 10% of total revenue.

The company likes to call its product as nutrient. However, it is not much different to organic fertilizer. So I would still like to take this company as a fertilizer company.

The product
YGII’s plant nutrients improve a crop’s taste and nutritional value while producing greater yields. When used along with fertilizers, the effectiveness of fertilizers is improved by 10% to 50% (company report), stronger and larger leaves and roots are produced, and typical harvest times are shortened by 10 to
20 days. Yongye animal nutrients help maximize digestion and act as a natural antibiotic for the better overall health of animals.

Financials
Net revenue was $12.4 million in the first quarter of 2009, an increase of 30.5% from $9.5 million in the first quarter of 2008.

Gross profit increased from $5.0 million in the first quarter of 2008 to $6.5 million in the first quarter of 2009. Net income increased 176.6% to $3.1 million in the first three months of 2009, or $0.14 per diluted share, compared to net income of $1.1 million, or $0.10 per diluted share, in the same period of 2008. $9.0 million was raised in a private placement in May 2009. 2009 projected revenue is $82-$84 million; projected net income is $23 to $24 million.

Capacity
To keep up with increasing demand for the Company’s products, the Company is acquiring its contract manufacturer’s existing 2,000 metric tons per annum production facility and land, and completed construction of a new 8,000 metric tons per annum manufacturing facility on the same property.

Distribution Model
At the end of March 2009 the company’s distribution network has a total of 3500 stores selling “Shengmingsu” plant nutrient products.

The sales model is called “community-direct” model. The distributors contract with independently owned agricultural product stores to bring them into the branded store network. Yongye products are featured and prominently displayed in its branded stores. This model creates a network of specialized agricultural product stores which have a local feel and long time recognition in the community.

Before the store is brought into the Branded Store network, it goes through a trials process. After branding, each store has the opportunity to sell a nationally distributed product which attracts attention to the store.

Store owners receive training and promotional assistance. Stores are supplied with a computer that has education and promotional programs that are used to help farmers understand the benefits of Yongye products.

My only concern for this distribution model is that how they handle customer service problems because it is hard to maintain same service quality with independent store owners.

Macro

The amount of arable and productive land in China is declining due to urban encroachment and nonproduction as farmers move to cities for higher paying jobs. China’s increasing affluence
and rising concern about food quality and safety have led to greater demand for organic
plant and animal nutrients.

According to the FAO, China has more than 20% of the world’s population, but only 7% of the world’s arable land. Every hectare of arable farmland in China must support 10.3 people, compared to 5.1 people in the European Union and 1.6 people in the United States. With a population of 1.3 billion people and an estimated average annual growth rate of 0.9% up through 2010, China’s farmland is currently being used at close to capacity levels just to meet domestic demand. The need to use land
efficiently has led to a need to improve productivity. ( From Roth Capital Research Report)Government

The capacity of chemical based fertilizer manufacturing capacity in China is huge. At the end of 2008, China has become the largest producer of nitrogen and phosphate fertilizer. However, this industry is fragmented and actually has problem of over capacity. In order to handle the rising food problem, the Chinese government has made decision to restructure the fertilizer industry.

Recently, the National Development and Reform Commission announced the elimination of outdated chemical based fertilizer production capacity in the following 5 years and will help boost the development of Chinese organic fertilizer industry.

On May 28, 2008, Premier Wen Jiabao reiterated that "guide farmers to apply fertilizer to encourage the growing of organic fertilizer companies" Since then, local governments at all levels have been introducing various organic fertilizer subsidies. 2009 Central Document No. 1 clearly stated "encourage farmers to increase organic fertilizer usage"

Fulvic Acid
Fulvic acid is extracted from humic acids. The Company obtains its humic acids from lignite coal which is also known as Leonardite Coal. China has approximately 12% of the world’s Leonardite Coal reserves (World Energy Council) and 250MM tons much of this is found in Inner Mongolia. ( from company report)

Fulvic acid strengthens the cell walls of plants and animals and acts as a transport mechanism to speed the absorption of essential minerals and nutrients by cells while promoting cell formation. The Company adds to this base its own mixture of macro and micro nutrients to ensure plant growth. These formulas help bind and stabilize the light weight molecules in fulvic acid with the additional components and stabilize it for use on crops.

The Company’s current universal plant nutrient product is a liquid nutrient which is applied via a foliar spray. Yongye now has two patents pending for this mixture and stabilization process in its plant and animal nutrient products.

Competition
China’sfertilizer industry is highly fragmented, with over 2,800 fertilizer products registered with the government in 2007. Yongye competes against 164 other fulvic acid fertilizer products (Chinese Fertilizer Net), however, only four other similar enhanced fulvic acid based products are truly competitors (company report).

Most of the products provided by local fertilizer companies are low quality, liquid compound fertilizers, many of which are not licensed for sale. These products do not provide plants with a full range of nutrients and International producers are comparatively expensive.

The Market for Plant Nutrients
China Market has the overall fertilizer market is estimated to be a $50B industry in China, which is estimated to grow about 30% a year from 2005 to 2009.
Yongye is marketing in ten Provinces and is estimated to grow appproximatly 70% to 75% in 2009. So far, its main product: “Shengmingsu” plant nutrient product has about 2% market share.

Management
Organic fertilizer companies are still in early stage and mostly tiny compared to major Chinese fertilizer companies. Management plays an essential role.

I had chance to talk to a few management team members of various Chinese organic fertilizer companies, I would say that the management team of YGII impressed me most. The CEO has a clear goal of future development and is very committed to this business. Additionally, the company has recently engaged KPMG as its auditor. This is clear a positive move by the company to improve its internal controls and
financial reporting. The hiring of a big four auditor reflects management's commitment to enhance shareholders' value and will further increase investors' confidence.

In order to communicate well with global investors, YGII also hired a few America educated Chinese as senior executives and Americans to be strategy VP. As its target so far is Chinese market, they hired a a Chinese marketing guru to direct its branding and marketing.

Valuation

Macro level, I will look at its industry and government support. Especially in China, government support is really really important. If the Chinese government is committed to something, they will do it without tedious process. Secondly, considering the population and food requirement, organic fertilizer absolutely has a huge market.

Micro level, valuation of this kind of small cap firm is very hard to do. I don’t think DCF could be a good way to value the business at this stage.

Price/sales and price/earnings may be better but we should also take future growth into consideration. I don’t think trailing P/E & P/S ratios are meaningful but may be good references. Forward ratios have uncertainties also.

Current trailing P/E and P/S ratios are around 11x and 2.6x. It seems a little expensive. However, if we consider a 70% top and bottom line growth, the forward P/E and P/S will be 6.5x and 1.53x. Based on its fundamentals, I believe 70% growth for 2010 is sort of conservative.

If we allow some margin of safety, I would say below $6 is absolutely a buy. If it is above $6 and below $8, you may have some risks but still strong growth potential.

Other financial ratios

Risks

The limited operating history and the early stage of development make it difficult to evaluate the business and future prospects.

The company is subject to high customer concentration risk. A limited number of major distributors represent a majority of the company's total sales.

Adverse weather could reduce demand for the company's nutrient products and consequently have an
unfavorable impact on its financial performance.

The market in which the company operates is highly competitive and fragmented. The company may not be able to compete effectively with existing or new competitors with greater resources.

Rino, a company worth watching

2009-07-13T10:10:00.000-07:00

Company Description

Rino, headquartered in Dalian, capital of Liaoning province, is a provider of environmental protection equipment for the iron and steel industry in China. Partnering with the China academy of sciences, Rino designs, manufactures, installs, and services wastewater treatment, flue gas desulfurization equipment, and high temperature anti-oxidation systems to reduce industrial pollution and/or improve energy utilization. The company was founded in 2003 and now hires 300 employees.

Positive and challenging macro and industry conditions

*The alarming pollution level has made Chinese government commit to investing more than 1.5% GDP or US$ 200 billion during 11th five year period (2006-2010), compared to USD$ 100 billion during last five year period.

*In steel and iron industry, China has mandated that all blast furnaces and converters in iron and steel factories must have wastewater treatment facilities in place within five years. Energy consumption is required to reduce by 20% during the 11th five-year period. Furthermore, the government provides various tax incentives to certain state-owned steel makers to push for the adoption. Penalties will be imposed if companies continue to dispose pollutants after newly enacted policies.

*Squeezed by both rising raw material costs and falling steel demand, China’s iron and steel industry is facing significant challenges in the near term. However, China’s economic stimulus package will largely increase domestic demand.

Business Breakdown

Rino’s product portfolio consists of:

* Sinter flue gas defulfurization equipment

* Wastewater treatment equipment

* Anti-oxidation systems

In November 2008, the company announced that a new sludge treatment system has been successfully developed. The new system, which can be applied to municipal and oil industry, is expected to put to commercial use in the 2^nd half of 2009.

Flue Gas Desulfurization

Background

Sulfur dioxide (SO2)has become a major environmental concern in China as China is becoming the largest steel producer in the world. There are about 400 sinters in the iron and steel industry in China. The government has mandated that the coal fired sinters and other similar furnaces must install desulfurization facilities or will be imposed with monthly penalties, or even be forced to shut down. According to company 10K, Rino’s desulfurization system is the only equipment that is specifically designed for sinters larger than 90 square meters, which account about 50% of existing sinters in China. It is projected that the growth would be about 11 sinters larger than 90 square meters per year in China till 2015. The market average sales price is around $7.74 million, with total market value of $1.6 billion in 2009 and $2.06 billion in 2015.

Technology

Most desulfurization equipment suppliers in China concentrate on power generation with little experience in the iron and steel industry because the sintering process needs special design skills and manufacturing technologies.

However, there are also a few technologies on the iron and steel desulfurization process. No particular technology has dominated the market yet.

Flue Gas Desulfurization (FGD) technology is used to remove SO2 from the exhaust flue gases when burning iron ore, coal, or oil. This technology is mainly used in the sintering process.

There are three categories of FGD technology:

*Wet FGD: Use limestone/gypsum, ammonia, dual-alkali, and citrate

*Semi-dry: Use spray dry absorption, circulating fluidized bed (CFB) technology

*Dry FGD: Dense flow absorber and Nid dry-desulfurization

Rino’s technology is semi-dry CFA FGD jointly developed with the Chinese Academy of Sciences.

Prior to 2005, this technology was not incorporated in Chinese iron and steel industry. As the government has enacted stricter regulation policies, the FGD began booming. So far, no major desulfurization technology has become dominant in the market, but Rino’s technology has advantages as following:

*Small space required

*Low water consumption*

Low processing cost*

90% SO2 removed

Other major technologies used in China are:

*Limestone/Gypsum: Low cost but high water consumption, pipes are easy to corrode, process is complicated, 90% SO2 removed;

*Ammonia: High cost, 90% SO2 removed

*Dense flow absorber: Low cost but low reliability in processing, 90% SO2 removed;

Given current macro economy, low cost and low water consumption technology should be more competitive in the market.

Based on revenue, Rino had about 6.8% market share in current iron and steel desulfurization market. The company expected that the market share could be 20% in 5 years. In order to be conservative, the market share in financial model is estimated to be:

*Base case: 12% within 5 years

*Bear case: 9.7% within 5 years

*Bull case: 15% within 5 years

Wastewater Treatment

Background

In the iron and steel industry, water cooling is used in the whole production process. The cooled wastewater is thus contaminated with gasification products, organic compounds, and large amount of rough solids.

According to company 10K, there are a total of 730 blast furnaces of 300+ cubic meters in size operating in China. 470 have adopted wastewater treatment facilities, but most of these facilities are out of dated. 260 have no wastewater treatment equipment installed.

Except blast furnaces, there are also 670 steel making converters with a capacity of 75 tons in China. Among these converters, 340 have old wastewater treatment facilities, while the other 330 do not.

Similar as desulfurization, wastewater treatment is also manadated by the Chinese government within the following five-year period.

Based on company 10K, the treatment facility for a blast furnace costs $2 million per unit, and for a converter costs $1.7 million per unit. Following is the calculation of total market value:

Technology

Current major technologies are:

*Membrane separation technology to remove soluble oil and grease

*Flocculation to remove fine solids

*Sedimentation techniques to remove rough solids

*Biotechnology to remove organic compounds

The sedimentation is the necessary step in the industry water treatment process from blast furnaces and converters.

Rino’s Lamella Inclined Tube Settler system is one type of sedimentation equipment. This equipment’s advantages are:

*Low installation cost

*Increased throughput

*Low maintenance cost

According to company 10K, there is no comparable technology currently available in China.

Rino’s Lamella system current has around 4% of market share. The management expects the market share could be 18-20% at 2015. In order to be conservative, the market share in financial model is estimated to be:

*Base case: 12% within 5 years

*Bear case: 9.1% within 5 years

*Bull case: 15% within 5 years

Anti-Oxidation

Background

During the hot rolling steel heating process, a thick layer of oxidized iron will form on the surface of the steel. The oxidization reduces steel output, adds pollution, and increases energy/water consumption. The production costs will then be much higher. The anti-oxidation is designed to prevent or reduce the oxidation process by putting a protective coating on the steel.

In order to reduce the energy loss caused by oxidation, the government has required the iron and steel industry to use advanced anti-oxidation technology to reduce annual energy consumption by 20% within 5 years.

The production capacity of hot rolling steel is 613 million tons in 2008. The annual growth till 2015 is expected to be 5%.

Technology

There are three technologies adopted:

*Vacuum furnace: expensive and can not be applied to all types of steel

*Inert-gases protection: fast but expensive

*Protective coating: Simple and low cost

Protective coating is common in Chinese iron and steel industry. Rino’s technology is called inorganic coating glass, which can be applied to higher temperature than organic coating glass.

Rino’s technology has following advantages:

*Applicable to a wider range of temperatures for most hot rolling lines. The comparable technologies developed in the US and Europe are mainly used in common steel and alloy steel under normal temperature.

*Convenient to use. Just directly spray onto the surface of steel, while other products are applied after the steel is cooled.

The production capacity of hot rolling steel is 613 million tons in 2008. The annual growth till 2015 is expected to be 5%. Each ton of heat rolling steel needs 1.26K ton of paint. Based on ASP of $1265/ton, the market value of 2009 is expected to be $1025.91 million and $1309.35 million in 2015.

Current market share of Rino is less than 1%. Because of the advantages of its technology, the growth of market share is expected to be high.

In order to be conservative, considering the production capacity constraints, the market share in financial model is estimated to be:

*Base case: 2.2% within 5 years

*Bear case: 1.5% within 5 years

*Bull case: 3% within 5 years

Financial

Balance Sheet

*Liquidity ratios improve

*A/R improves

*Debt increases

*Margins improve

*Expense growth higher than revenue growth but acceptable

*Accrual ratio improves

Valuation

It is expected that the company will consistently deliver around 30% top line growth, with sustainable profit margins, plus 2-year no-tax for environment protection company policy, FY2009 EPS is expected to be ranging from $2.00 to $2.18, which implies around 4.2x PE ratio. Similar Chinese company within same sector and growth profile, such as DGW, have around 10x-12x forward PE multiple.

Considering conservative assumptions on sales amount, current market price is a little undervalued. Because Rino is applying to move from OTC to Nasdaq, more investors such as large mutual funds can start to purchase, the price then may reflect similar multiples other Chinese firms have. So the target price, considering the discount of small cap company, could be ranging from $12 to $15.

Risks

Corporate governance

CEO and Chairman are husband and wife. Not enough independent board directors.

Concentration of major customers

Revenue is generated from a limited number of customers. Top-five customers account for more than 80% of total revenue. Company management said they would expand its sales and distribution throughout China.

Fluctuating raw material prices

Rino’s raw materials make up the majority of its cost of sales. Rino does not have long term contracts with suppliers. Steel and steel products account for a significant part of Rino’s raw material costs. However, the material price is usually factored into the contract value at the time of signing. So most of the time, the raw material price is passed to customers.

Impact on Chinese iron and steel industry due to global economy slow down

Rino solely services Chinese iron and steel industry, which is typically cyclical. Recently, the Chinese iron and steel industry has big problem of overcapacity and climbing iron ore price. However, this may also stimulate the demand for low cost domestic technologies that Rino provides. Furthermore, the large economy stimulus package focuses on infrastructure, so there may have strong domestic demand for steel and steel products.

Conclusion

Rino is uniquely positioned to service Chinese iron and steel industry. Benefiting from the stricter environment protection mandates, huge production capacity of Chinese iron and steel industry, and low cost, Rino is expected to have 30%+ top line growth and 40%+ gross margin.

Because it is still traded on OTCBB, this company has not been identified by most institutional investors. As it is moving from OTC to Nasdaq, its value will be realized. However, consider its small cap and existing risks, current $8.75 price may not provide enough margin of safety.

So ideal entry point maybe below $8/share and the expected return in the following 6 months is 50% ($8 to $12).

Notes: This article was written about 10 days ago. Rino has been listed on Nasdaq since July 13, 2009. The price went to $9.80 when I am posting this blog. I will continue to watch this stock and hopefully get more info about this firm. I am always ready to buy but need to make sure I have enough safety margin.

Water Investment - Part I

2009-07-01T08:24:00.001-07:00

Investment Thesis

Water: A Defensive growth sector

The global water sector, which is estimated to be a $425 billion market, remains at the forefront of industrial, geopolitical, and social agendas because of worsening supply/demand imbalances at regional and national levels and the heightened megatrend catalysts of water scarcity, quality, and safety issues. We are bullish on the global water sector’s defensive long term growth potential.

The Next Oil
The demand for water – the life-sustaining natural resource that has no substitute – continues to escalate at an unsustainable rate, fueled by population growth and industrial expansion. The world’s fresh water supply is also shrinking due to pollution, draining of underground aquifers, and climate change. As a result, we expect to see a sustained focus and investment in the global water sector for years to come.

Above Average Growth Outlook
The US has an estimated backlog of $300 billion-$1 trillion of infrastructure replacement/upgrade that should have 3%-5% growth potential, which is slightly above expected long term GDP growth. Developing countries, especially China and India, should continue to see 10%+ growth as they build out basic water and wastewater systems.

Investment Outlook

Potential M&A targets
Several of the top Multi-Industry companies, including GE, Danaher, ITT, and Siemens, have market-leading water equipment businesses, but revenue is only small part of its total revenues. As the sector is growing, some sole play maybe potential takeout candidates.

Surging in new equipment & services
As the demand for cleaner water and the fact of water shortage, new technologies and equipments are being developed in recent years aiming to increase the efficiency of water usage and water treatment. These technologies not only focus on fresh water but also on sea water, which comprises of 97% of total water body on the planet.

Risks
Water businesses are predominantly less cyclical and product cycles are relatively modest and incremental; the key risks would be mostly execution, M&A-related, and regulatory compliance.

Scope
The water market is composed of at least ten distinct subsectors, including the equipment, and
services for pumps, valves, water test, filtration/desalination, drinking water, wastewater,
industrial water treatment, infrastructure, automation, and consulting/engineering services.
Each of these subsectors has its own demand drivers, embedded technology, competitive dynamics, etc. In developed countries, such as the United States, the estimates for the backlog associated with upgrading the US water infrastructure range widely from $300 billion to $1 trillion (and two-thirds of that spending is for distribution network/pipes/pumps). For developing countries, the expected 10%+ growth is driven mostly by installing water infrastructure for the first time. Many sectors of China’s water system should see 20%+ growth over the next several years.

Investment Strategies

Focus on the higher growth, higher technology segments of water
With regard to what areas of the water sector are especially attractive, we suggest investors to focus on the higher-technology segments of water equipment and services, including filtration, ultrafiltration, desalination, reuse, and water test. These businesses should see the highest growth with stronger pricing and higher barriers to entry.

These technologies include desalination, filtration, water treatment, waste water treatment, and consulting firms providing solution to water usage. As it might be hard to find firms that have similar technologies for a specific field, these firms can usually charge high prices to maintain high profit margins.

In contrast, the lower-tech, more commodity products, such as pipes, pumps, and valves are becoming commoditized.

Focus on vertically integrated companies
Although water is not replaceable, it is very hard for utility companies to raise water prices in reality. So water industry does not strictly follow the basic supply/demand rule. Most utility companies need government subsidy to be profitable, which squeezes profit margins of utility companies. Water infrastructure contractors are usually those traditional infrastructure firms. Because of low profitability of project owners, it is hard for them to increase their profit margins. Although the stimulus package will generate revenues for them, most value will be captured by other players on the value chain.

As it is expected to see further investment and consolidation in the water sector over the next
five to ten years to where a global water oligopoly should emerge. Importantly, the consolidation has started first among the traditional leading equipment manufacturers, including GE and Siemens, but we are now increasingly seeing more of a presence by the top service companies, such as Veolia and Suez. Large firms like Veolia and Suez are vertically integrated, they provide solution, service, financing, and engineering to end customers by partnering with equipment manufacturers to build desalination plants. These firms will have economies of scale, capture value along the value chain, and reduce costs along the life cycle of water projects.

Focus on emerging markets companies

Most large scale infrastructure projects are more or less invested by government, which means a country with such a low government spending on capital investment as India is not likely to provide too many opportunities. China, Malaysia, Singapore, Brazil and South Africa, provides the best opportunity with high capital investment growth as well as high government spending on capital investment, these markets show a promising future with high growth potential.

China
Due to rapid growth in population, urbanization and industrialization in China, the country faces severe
water shortages and water resource pollution. The average annual water resource volume in China is estimated to be approximately 2.8 trillion cubic meters, which is the fourth largest source of water in the world. However, only 2,200 cubic meters of water is available per person in China compared with the average global water availability of 8,800 cubic meters per person, ranking China 88th in the world.

It is estimated that China’s population will grow to 1.6 billion the mid-21st century, the per capita water resource is expected to decrease to 1,760 cubic meters.

The water utilization rate is approximately 60% in 2007 for five major rivers in China. By comparison, international average utilization rate is between 30% and 40%.

To address those issues, the Chinese government has enacted stricter environmental standards and invested significantly in water treatment projects to promote sustainable economic growth and to provide its population with affordable, purified water. Accordingly, the demand for water treatment equipment has experienced and is expected to continue to experience rapid growth.

Brazil
Brazil’s major and medium size metropolitan areas face increasing problems of water pollution. Coastal cities such as Rio de Janeiro, São Paulo and Recife suffer effects of upstream residential and industrial sewage contaminating feeder rivers, lakes, and the ocean. In 2000, only 35% of collected wastewater received any treatment.
For example, according to the environmental sanitation company of the state of São Paulo,Cetesb, the Tietê River, which runs through the São Paulo metropolitan area (17 million inhabitants), has returned to its 1990 pollution levels. Despite the support from the IDB and Caixa Economica Federalin a US$400 million clean up effort, the level of dissolved oxygen has returned to the critical level of 1990 at 0 mg per liter due to increased levels of unregulated sewerage, phosphorus, and ammonia nitrogen discharged into the river. Although the city of São Paulo treats 63.9% of the collected sewerage, the surrounding cities of Sao Bernardo (19.7%), Diadema (11.3%), and Guarulhos (0%) treat much less. The state water company Sabesp projects that a minimum of R$3 billion would be necessary to despollute the river.

Singapore & Australia
Both countries have some strong water companies and the most advanced water treatment technologies in Asia-Pacific regions. However, major companies of these two countries are being traded at pink sheet market.
So emerging markets, we can focus on China and Brazil.

Next Big Things in water
The key issues on the water sector horizon for investors to monitor range from supply/demand imbalances, to regulatory shifts, further market consolidation, and emerging companies and technologies. Following are a few next big things in this sector.

Water reuse
The practice of pumping the treated wastewater back into the ground or into rivers is becoming increasingly attractive of new water supply for many inland and coastal regions for irrigation ,heating, cooling and other non-direct potable uses.

New technologies such as membrane, filtration will further convert water into potable water. Although most of these technologies are still in its infancy stage, we can keep these on our radar screen.

Desalination systems
Given continuing trends in emerging market urbanization and industrialization, desalination (“desal”) is gaining recognition as an economically justified solution to address growing water scarcity in coastal regions globally.

Desal operating costs are 3X-4X lower than 30 years ago. While desal has traditionally been focused in water-scarce regions like the Middle East, North Africa, and Spain, we have noted increased investment in new desal capacity in nontraditional markets like the United States (15 new plants under construction), China, and India.

Filtration technologies displacing chemicals
Filtration and ultrafiltration technologies have been displacing chemical treatment,
especially in industrial applications. Advances in material sciences and nanotechnology
are being used to filter more complex contaminants.

Measuring industrial water efficiency
Regulators and non-government organizations such as the United Nations Environmental
Program Finance Initiative (UN EPFI), are exploring ways for companies to calculate
water use and efficiency. This could pave the way for industry water efficiency, conservation, and investment. Many companies in oil-producing markets, which are high consumers of water, already disclose their water usage. This should help apply more pressure on demand-side conservation initiatives.

Water testing
Today, the EPA requires the 54,000 US water utilities to test for nearly 100 known
contaminants. The present water treatment systems were never intended to filter these new micro-pollutants aspirin, caffeine, and even animal growth hormones from farmland water runoff but changes need to be made. This trend directly benefits the companies providing test equipment and services.

Integrated solutions are becoming the focus for multinational water companies, like GE, Veolia, and Suez
Vertical integration can offer a customer a complete solution: plant design, planning, financing, equipment and service.

Water conservation/water-friendly products
I expect to see a proliferation of water-friendly products and services emerge addressing their conservation advantages. These products include water-free toilets, efficient irrigation systems, and try cooling technology for power plants.

Companies & Sectors to Consider

Highest growth subsectors of global water market
• Desalination :Energy recovery (ERII) is the global leader. Total operates costs today in desal are 3X-4X lower than 30 years ago. New desal facilities are becoming cost competitive with traditional water sources, typically operating at less than $1 per cubic meter, on par with conventional water sources.
• Membrane manufacturers include GE, Pall
• Water reuse: Danaher’s Trojan business is considered the market leader, followed
by ITT’s Wedeco business. The market is growing 15%-20% and potentially faster.
• Water test: Danaher is the number-one manufacturer of the equipment and consumables used to test the quality and safety of water. Danaher’s Hach business commands the leading share, estimated at about 25% globally and is about five times larger than its next closest competitor. In a razor-and-razor-blade model, Danaher’s high margin consumables drive attractive returns.
• Automated water meters: The leaders are Badger and Itron.