Via valueblockbusters.blogspot.com/:
Traders have punished shares of Eastern Environment Solutions (EESC) harshly in recent weeks. In about three weeks from June 26th to July 16th, the stock imploded from a high of $2.65 to a low of $0.66 (on an intraday basis). Since then it has been dangling wildly within the $0.80 to $1.50 range on light volume.
The light volume suggests the end of the heavy sell-off. But as you can see from the price range, the volatility is probably going to hang on for a while.
Typical price behavior for a microcap stock (or call it a nanocap if you are an investment pundit)! You said. As a bargain hunter in quality microcaps, however, I have closely watched it and pulled the trigger recently.
Why the sell off? Most keen investors would be quick to ask. If I have to give you a single contributing factor it would be the nine-month suspension of the company’s core business operation that started in mid June (effective June 13, 2007).
That surely sounds awful. But in reality things are far from as bad as they have appeared. Why? The short answer is that revenue from EESC’s core business is actually only going to be slightly impacted during this nine-month suspension period. The long answer would go all the way down to the nature of its operation.
EESC’s core business as of this writing is a 17-year BOT (Build-Operate-Transfer) contract to process and dispose non-hazardous municipal solid wastes (MSW) for the city of Harbin, the capital of China’s northeastern Heilongjiang Province. The city has a population of almost 10 million and the 17-year BOT contract started from September 1, 2003 and lasts until September 1, 2020.
The MSW disposal and processing operation is conducted through a landfill facility constructed through 60% investment from EESC and 40% from the municipal government. During the 17-year operation EESC is entitled to 100% of the revenue. When the BOT contract expires the ownership of the facility is returned to the government.
The MSW processing business turned out to be highly profitable to EESC, which turned a profit on its second year of operation (2005). For 2006 EESC reported revenues and net income of $3.20M and $2.65M respectively, on gross margin of 86.7%, operating margin of 78.6% and net margin of 82.8%. ROE and ROC were an impressive 45.0% and 28.6%, respectively.
Although the net margin and investment returns were helped by tax credit, they would still have stood at quite respectable levels without that. Without the tax credit, the net margin, ROE, and ROC would still have been 51.5%, 28.0% and 17.8% respectively.
Cash flow from operations was a strong $3,127M (118% net income) in 2006. After equipment and construction spending, the company recorded a free cash flow of $2.137M (80.6% net income).
Backing EESC’s high margin, high return business is a set of well-defined financial parameters on the BOT project. Here are the main ones:
1) Landfill investment: EESC RMB 120M, city government RMB 80M
2) Total landfill capacity: 7.8 million tons
3) Daily processing capacity: 1200 tons
4) Revenue to EESC: RMB 42 per ton of MSW processed
The nine-month suspension of the landfill operation was due to the need to relocate nearby inhabitants and a waste-water-disposal plant. According to the terms of the BOT project, not only will the municipal government bear all the cost of relocation but also is EESC guaranteed revenue equivalent to processing 800 tons of MSW per day, which is two thirds of the daily processing capacity. On an annual basis this is about $1.62M of revenue (using exchange rate of RMB 7.564 per US$ as of Friday, 7/27/07), about 69% of the 2006 revenue from the landfill business.
69% of regular BOT revenue for doing nothing in the nine-month period! Not bad at all.
These well-defined financial terms make revenue and investment returns from the BOT project highly predictable while the risk is reduced to a very low level.
Yet at Monday’s market close of $0.83, the stock was trading at a P/E (against FY06 EPS) of 2.93, P/S (against FY06 revenue) of 2.43, and P/B (against end-of-Q1 book value) of 1.06! Note that I have not used the reported diluted EPS of $5.96, which would have resulted in a P/E of 0.14. Rather, I have calculated EPS using the year-end share number, instead of the weighted approach, to adequately account for the impact of share dilution. P/S was calculated using a similar approach.
Why do the investors fizzle then? The easy answer is that microcaps and nanocaps are inherently more volatile and investors and traders alike are almost never rational. But are there any catches beyond that?
Very likely yes. In my opinion, investors might have also been discouraged by the low-growth and finite-potential nature of the BOT business. In a BOT operation like the MSW landfill business EESC is engaged in, earnings eventually ramp up to its capacity and remain more or less stable for much of the later stage of the BOT contracting period. Following that the contract expires. Investors are seeing no further earnings potential beyond that.
Indeed the prudent investor should always see through the fantastic earnings, margins, investment returns and valuation ratios to get at the whole picture. To certain extent, businesses that have limited potential do deserve the low valuation ratios they are trading at. Cases in mind are miners that possess limited reserve and manufacturers or service providers with limited businesses life span. EESC’s BOT business roughly fits into the latter category.
With this in mind, I used an adapted CAPM (Capital Asset Pricing Model) to value the present worth of EESC’s BOT business at $1.28 to $1.33 per share.
But an important question to ask is if this is really the whole picture of EESC’s business. The answer is no. Besides the BOT business, EESC also provides environment engineering consulting services. As of FY 2006, its consulting business contributes to 26.7% of revenue.
Relative to its finite and more or less stable Harbin BOT operation, EESC’s consulting business might grow over time and contribute a higher proportion of revenue. However, since it is still young and less quantifiable compared to the BOT operation, I would not attempt to put a price tag on it.
The company just filed its Q2 report with SEC yesterday morning. For the first half of 2007, the company has not succeeded in expanding its customer base for this part of business. And mainly due to the weakness in this area, revenue for the first six months decreased by 36% year over year. (Since the BOT operation was suspended on June 13th, that likely also had a little impact on the operation result.) Luckily net income from continuing operation fared much better and decreased by only 1.7% year over year, thanks to the exemption of income taxes.
Nevertheless, this is still not the end of story. The company will be extracting natural gas from the solid wastes in its landfill and sell it to local utility companies. Gas collection tubes have already been installed in the landfill. When solid wastes add up to enough quantity, natural gas production will commence. The company originally estimated that this would occur by 2008. But the nine-month suspension of landfill operation apparently has delayed this a bit.
Behind the scene, the company is partnering with other waste processing companies in Heilongjiang and Jilin provinces. It is also on the look out for additional BOT opportunities. The downside of these pursuits would be more capital requirements from both potential acquisitions and PP&E investments. But if future projects can bring in similar level of profitability and investment returns as the Harbin BOT project, long-term investors should have little to worry about.
Caution: EESC is a very thinly traded stock. Any market order is surely a recipe for catastrophe. Limit order is the only plausible way to play this stock.
Disclosure: I own EESC as of this writing. Investment in microcaps involves special risks and is not suitable for everyone. This writing is not a recommendation to buy or sell the EESC stock.
$0.81 (08/16/07)
