Sino-Environment @ 80 cts ( Environmental / China ) 2 comments
Final Poll Results: 9:7
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2.Single product risk
3.Questionable competitive advantage
Investors can always expect a stupendous set of post-IPO results from new IPOs and this is exactly what Sino-Environment gave them recently, where it announced a 50% growth in FY05 profit over FY04; however what really got investors excited was the 1Q06 results which showed a tripling of revenue and profit over the corresponding FY05 quarter. The idea of waste gas treatment also appeals to investors, given the China government's emphasis on "sustainable development" ie. environmental protection. However, the stock itself has risen to a level that looks unsustainable to me. Below I list six key risks/food for thought to attentuate the enthusiasm for this stock (Why six? See the end of the article for the answer).
1. IPO risk: Sino-Environment IPOed at $0.33 in late April, at the peak of the China stock boom. That indicates insider and probably underwriter valuation of this stock. So it is now more than double that price one month after the IPO, in a significantly more sober market. What gives?
2. Single product risk: I am reminded of Sun East which I reviewed earlier, which also relied on breast cream to drive its expansion. Sino-Environment relies almost entirely on sales and installation of its VOC Automatic Recycling Device which is used to treat and recover toluene which can be used in various industries in China. Although the company has shown the marketability of this device by a track record of rising sales and ability to charge higher rates per device over the last 2-3 years, it is simply too few to make a judgment. How scaleable and sustainable is the business model? If the demand for this device drops unexpectedly, there will be no second segment to cushion the bottomline, because the China wastewater treatment segment is still in flux.
3. What competitive advantage?: The company claims that one of the key competitive strengths of the VOC device is a relatively high recovery rate of toluene (up to 98%) which places it at the forefront of technology. I hardly believe that this qualifies as a key objective for a mainstream customer in China: surely their prerogative would be to control gas emissions to the minimum rather than to maximise money that can be made out of it? Re-cast in this manner, there would be multitudes of companies, local and foreign, which should be able to provide a more comprehensive range of environmental control services both in breadth and depth. Note that the nature of this business hardly provides a chance for repeat orders from the same customer, so they will have to continue sourcing for new customers domestically within China and hope to achieve a critical mass and reputation.
4. Historical perspective: Elaborating on the above point on competitive advantages and strengths of the business model, think back to the enthusiasm surrounding previous similar IPOs like Devotion Ecothermal (heat recovery systems), Zhonghui (solid waste management systems), Sunpower (energy-saving & environmental products for the oil industry!) to consider how any acclaimed competitive advantages can suddenly disappear one year post-IPO. I generally feel scale of operation is one of the most important factors to consider for an IPO stock, because it at least gives an assurance of economies of scale and a consequent cost advantage, the primary attraction for China stocks ---- Sino-Environment's revenue base is merely ~S$20M-odd for FY05.
5. Receivables risk: For those investors enamoured of the huge 1Q06 revenue growth, check out the balance sheet --- total receivables (trade + others) form about half the current assets, about two quarters of FY06 revenue (assuming 2Q06 is similar to 1Q06), and about 90% of FY05 full-year revenue. Some China systems integration company just had trouble with its receivables earlier this week, if I remember correctly. High receivables always make me nervous.
6. Valuation risk: Finally, some numbers for the quantitatively-inclined investors. If we take the liberty of annualising the 1Q06 profit we get RMB95M net profit which divided by 300M post-IPO shares gives S$0.067 earnings per share ie. 12X forward PE. That is being generous; the number of contracts per quarter tends to fluctuate (though the value per contract increases): in 1Q05 there were only 6 contracts (hence explaining the huge growth of 1Q06 in comparison), in 2Q05 it jumped to 10, then in 2H05 there was a combined total of 16. The total for full-year FY05 in turn was slightly less than that for FY04, 32 compared to 33 previously. It is likely that 1Q06's contracts are on the high side compared to other quarters, in which case full-year earnings might well be lower than our annualisation method. Some analysts are even more generous with the forward PE: UOB gives a price target based on 20X forward PE. For an IPO stock with no track record, that is plain ridiculous.
Well there goes the six issues I have with the stock. Enjoy this week, in particular, 06/06/06!