Biotreat @ 73.5 cts ( Water treatment / China ) 3 comments
Final Poll Results: 6:1
(P.S: Sorry for any disturbances the advertisements above may have caused you)
1. Credibility problems, both in operations and shareholder orientation
2. Possible problems in future fund raising
It is not just highly-priced stocks that one has to be careful of due to the law of reversion to the mean, but also he has to be careful against liberally applying it to stocks that have dropped sharply and which consequently look more attractive than before.
Everybody knows about Biotreat and the disastrous fourth quarter they had that has pulled down share price by ~40% recently. Those willing to bet that the fundamentals have not changed and that it was only one bad quarter caused by bad weather might want to do some bottom-fishing. But the question is: were the fundamentals good in the first place, and do they still remain uncompromised by the bad publicity?
What brought Biotreat to its high of ~$1.20 before its recent collapse was a stream of high-value BOT (Build-Operate-Transfer) municipal contracts whose value the company always declared in its press statements to attract attention. That is a marketing tactic and everybody does it. A brokerage (can't remember which) has discussed the concept of BOT recently and likened a company operating BOT projects as no more than a utility, since it basically invests and owns the infrastructure, and manages water tariff collection thereafter for a certain number of years before transferring ownership to the government. For a brief introduction to the various partnership models check out my writeups on Partnership Models Part 1 and Part 2. It is an increasingly popular model with governments for infrastructure construction financing because they do not need to fork out the capital; the private company does. Some private companies likes it because unlike turnkey projects which are one-time, BOT projects allow them access to a recurring income stream.
If one checks out the cashflow for Biotreat, never mind the profits, over the last two years, the effects of such a model are clear. I am not exactly cognizant of how operating profits are generated for BOT projects (firstly, since the company is building and owning the plant surely the revenue is an internal target; secondly, who is billed? My guess is that it is classified under receivables, to be received from consumers over several decades), but the working model requires heavy initial capital investment and so for FY05 and FY06 the sum of operating cashflow and investment cashflow has been consistently negative--- RMB360M and RMB640M respectively. Obviously they have to be heavily financed: in FY05 the spending was financed by loans and share placements amounting to RMB450M, while in FY06 the company issued convertible bonds amounting to RMB1B.
Now we come to the credibility problem, where, notwithstanding the rather comical explanation on floods washing away its bio-organisms, one wonders at the extent of the negative turnaround in profits in 4Q06. From RMB89M net profit in 3Q06, it collapsed to -RMB66M in 4Q06, a swing of RMB155M or half of FY05 net profit in one single quarter. Note that the rather substantial expenses relating to the convertible bond issue was sustained in 3Q06, and not 4Q. It is rather suggestive that quarterly results are not audited while year-end results are (a problem which appears to be addressed soon by new SGX requirements) and perhaps auditors had certain issues with the company as well, given the previous change of auditors from PWC to Moore Stephens.
The credibility problem is real and poses financing problems long-term. It has already had a run-in with the market earlier in 2004 on the issue of its extravagant employee share option scheme, and the recent earnings shock must surely reinforce the market perception that it is not shareholder-oriented nor transparent. This risk re-rating would probably spill over to the debt financing side as well. Those who are familiar with capital budgeting decisions would know that project rates of return are ultimately decided by the present value of future cash flows, and these are obviously affected by the discounting rate used. The higher the cost of capital, the higher the discounting and hence the lower the net present value. This is a probable scenario with Biotreat, as both avenues of financing --- equity (new placements) and debt --- are likely to become more expensive. Would its initial capital budgeting decisions based on the then-estimated cost of capital be affected? Definitely. That also applies to all future project possibiities. The company has accummulated about RMB1B worth of BOT/TOT projects since the start of 2006, and its strong RMB700M cash kitty, mostly obtained from the convertible bond issue, should be adequate to complete these projects. I also think that the next quarter's results (1Q07) are likely to be better than 4Q06, which included several provisions (cost overrun, forex losses) amounting to ~RMB55M (which only partially explains the RMB155M profit downswing from 3Q06). However, I also believe that Biotreat's fund-raising ability, and hence its ability to bid for future projects, will be heavily hampered, as mentioned above. Given that its BMS wastewater treatment segment accounted for 80-85% of overall revenue and profit (vs its other segment of sales of goods) and that the trend in China is towards BOT private-ownership projects, I would think that its performance in FY07 --- in securing new projects and in securing new capital --- would be crucial in assessing its long-term viability. Any attempt to project income on the basis of past results may be futile, and very risky.
(1) Citigroup 4 Sep report on Biotreat
I agree that Biotreat is a hot-stock-not: Yes/No