China Petrotech @ 53.5 cts ( Oil services / China ) 5 comments

Final Poll Results: 7:0

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Main issues

1.Shift of focus away from software towards direct oilfield services implies execution risk

The evolution of China Petrotech's business model since its IPO is an interesting study in itself and I shall speculate here on the reasons for its evolution. Of course, the independent investor can take this with a pinch of salt but this is my reading of the situation. Here I can say that I am practising the technique of developing the story for the stock.

The stock IPOed in mid-2004 and its business was the provision of IT productivity software for the oil exploration/production industry, from data collection to management to analysis. The business provided great pre-tax margins of >60% and things looked good as FY04 turnover grew 50% year-on-year while net profit advanced ~30%. However, the nature of its business was that the products (software systems) tended to be one-off and non-recurring (except perhaps for upgrades and maintenance), and this coupled with the company's lack of critical mass (only RMB60M revenue) meant that it was a constant uphill battle to come up with new innovative software solutions that would be wanted by the China oil majors (Petrochina, Sinopec, CNOOC) which China Petrotech served (one can look at the post-IPO difficulties faced by another IT systems provider, Sinobest, to realise the struggle with revenue and margins). It was indicative of the long-term viability of the company's software business that out of its 20-30 software product offerings, only one --- the Logging Data Organisation System --- was actually a standard software adopted by the China oil majors (and this software product was trumpeted by the company in a description of its competitive strengths).

Nowadays, software is actually used as part of a total solution offering for the customer, tightly integrated with the hardware and sold as a package --- this is what offers a long-lasting competitive advantage and binds the customer to the supplier. Standalone software like what China Petrotech was offering were simply inadequate in anchoring this supplier advantage, and it was for this reason that the company began sale of specialised hardware, beginning with spectrometers, that complemented the company's IT solutions; however this was insignificant enough that by FY05 there was still only one business segment --- software solutions.

At the same time the company sought to expand its breadth of software offerings by acquiring SLTT (Shaanxi Long Top Technology), an ERP (enterprise resource planning) software solutions provider, in mid-2005. Although it provides a new software capability (resource planning) previously missing, SLTT's net profit was RMB 1.2M on a turnover of RMB2.6M for the first nine months of 2004, below 5% of China Petrotech's overall profit and revenue respectively. The sum of the parts might well be greater than the individual components, but it is too early to tell whether this strategic acquisition would work out well.

Simultaneously, the company sought to move closer to the customer, by providing direct oilfield services (sample scanning, well logging, data digitisation) since 2H05 through its newly acquired oil services subsidiary Ba Zhou. From a standing start, the two initial contracts provided RMB11M in 1Q06, more than half the total revenue for that quarter. The oil services contracts provided a source of recurring revenue and also a more likely source of competitive advantage through close relations to the oilfield operators. At the same time the company sought oilfield services contracts elsewhere, securing one in Cambodia and pursuing possibilities in Indonesia. This last point is interesting because why should it go overseas if it has acclaimed close relations with the China oil majors which should facilitate oil services contacts on the mainland (its home base) itself?

The point I am bringing through the above discussion of the company's business model evolution is to point out the probable difficulty in maintaining a constant pipeline of software solution orders from the customers post-IPO, which has led the company to build other growth engines despite the fact that the best margins are with the software solutions. Up to FY05 when software solutions have been the main driver, pre-tax margins have been 70-80%; however in 1Q06 margins went down to <50%; the main reason was that the majority was contributed by oil services which yielded lower margins (a secondary point to note was that year-on-year software solutions revenue had actually fallen from RMB11M to RMB8M, if one strips away the oilfield services contribution). This means that the paradigm shift is going to give a quantum drop in margins straightaway, meaning the company must work hard to increase revenue more than proportionately. Investors considering this stock must be aware that they cannot now base the company's performance on past track record, because the model has changed. Are they willing to bet on the new model, which has only just started to take shape post-IPO? Put in this perspective, the company offers one of the shortest track records around based on its current business model. Execution risk is a factor; receivables risk is another (the group post all acquisitions has receivables equal to its entire FY05 revenue!). And at 12.2X trailing PE and 3XNTA such risks may not be worth assuming; another oil services provider Sky China for example, trades at <10X trailing PE and 2XNTA (although they offer a different range of oil services, strictly speaking).

Perhaps it is best to look at this stock one year down the road to have a clearer view of its execution. Sometimes, it's better to watch the action from a distance until there is enough evidence to show that a clear business uptrend is established.