Thursday, February 08, 2007
China Natural Gas (CHNG)
Q3 10-Q quick check:
period ending Sept 30, 2006
24.2 million shares on Nov 13, 2006. 1.14 million warrants outstanding on Sept 30, 2006 (2.28 years, $3.60 strike... not bad). Assume 27 million totally diluted shares.
period ending Dec 31, 2005
incorp in Delaware
offices in Xi'an, Shaanxi, PRC (same city as CHNG)
24 million shares on Mar 17, 2006
Reverse merger of Xian Xilan Natural Gas Co. and Bullet Environmental Systems and Liquidpure Corp. Some indirect connection with Bodisen Biotech and Amaranth Advisors.
Until late May, Amaranth was also a controlling 5.6 percent shareholder in an affiliated Bodisen company called China Natural Gas Inc., which trades at about $3 per share on the Over The Counter market.
The Chinese company began life as a Canadian penny stock called Bullet Environmental Systems, headed by a man named Ross Wilmot, a longtime investment world associate of a notorious one-time European boiler room operator named Altaf Nazerali.
10-Q Detective notes that Bodisen owns a chunk of CHNG stock.
And 10-Q Detective did a great writeup of CHNG.
CHNG has three main segments.
1) End user residential delivery (50,000 residential customers). CHNG connects to a Shaanxi Natural Gas Company (government operated) high pressure pipeline. This is delivered at lower pressure to residential/commercial/industrial customers [green, purple, and yellow respectively for those familiar with Sim City].
CHNG owns 120 kilometers of high pressure gas pipeline (Their website explains that it's a direct link to a gas field in northern Shaanxi). They're the only private company in Shaanxi to have this type of pipeline. Northern Shaanxi has one of the largest natural gas fields in China.
The natural gas is sourced and transported through 120 Km of proprietary high pressure gas pipelines which are spurred off of the intrastate transport pipeline owned and operated by the state-owned Shaanxi Natural Gas Company. This pipeline supplies natural gas directly from a gas field in the northern region of the province through to the high pressure pipes that then feed into the citygate "let-down" stations at Hongqing and Lantian County. At HongQing and LanTian the pressure is reduced and transported througn a network of low pressure distribution pipes to supply the residential, commercial and industrial customers in Lantian County, Lintong and Baqiao Districts. The spur also feeds a compressor station at Hongqing where compressed natural gas (CNG) is collected by tankers to supply autogas stations.
CHNG is trying to expand into Shangluo and Ankang areas of Shaanxi, attempting government approval to provide gas to residential and commercial. CHNG submitted a project feasibility proposal. Takes 4-6 months for approval/rejection.
2) Wholesale to filling stations. These sell to taxis and buses in Xian (approx 5,000 buses and 20,000 taxis in Xian use natural gas). Note that this is very clean technology. The Chinese government emphasized it in the most recent five year plan.
July 2005, CHNG bought a compressor station near the pipeline to fill gas tanker trucks which then deliver to the filling stations.
CHNG is doing a feasibility study to expand into LNG production (due June 2006): this would require $19 million, to be completed in 2006 and testing in Oct 2007, production Dec 2007. Needs financing and approvals.
3) Retail filling stations. There were an estimated 31 filling stations in Xian. Feb 2006, CHNG finished construction of two filling stations in Xian (each cost about $600K). They purchase gas for 1.16 RMB and sell it for a net of 1.90 RMB. March 2006, constructing a 3rd station. [after the 10-K, they created a lot of these retail filling stations]
For retail filling stations, advertising is focused on taxi drivers. Discount loyalty card. Radio/newspaper ads, etc.
Only one supplier: the government owned Shaanxi Natural Gas Co. Ltd. They've gone from 1 year contracts to 6 month contracts, subject to review prior to renewal, also with a minimum required purchase of natural gas (2.36 million cubic meters for 2005). Prices are strictly controlled by the government and have been stable for three years. What this tells me is that China views Shaanxi Natural Gas Co as a utility, with the usual regulation.50,000 residential customers (apartment blocks, small estates), commercial customers are small businesses such as restaurants and office buildings. Industrial customers include Xiwei Aluminum Company.
Natural gas consumption will increase rapidly in China (expected to double in 5 years). Shaanxi itself has large natural gas reserves.
Several licenses needed: CHNG has them. CHNG includes the license numbers in the 10-K.
Two private competitors. Xinjiang Guanghui LNG Development Corporation (tanker truck transport). Xin'Ao Gas Field Ltd (pipelines in 13 provinces) None of these are currently directly competing with CHNG.
Of the 31 filling stations: 13 state owned. 18 privately owned (mostly single station operators).
243 employees: 6 management, 16 admin, 87 operations, 5 sales, 38 R&D, 16 finance, 75 retail filling station employees.
Jan 2006, CHNG raised $2.8 million by selling PIPE units. 1 million shares plus 275K warrants (3 years, $3.60 strike, with a 10% ownership limitation).
Jan 2006, CHNG raised another $2.2 million by selling PIPE units. 784K shares plus 213K warrants (3 years, $3.60 strike, 10% ownership limitation).
Jan 2006, CHNG raised yet another $5.4 million by selling PIPE units. 1.9 million shares plus 523K warrants, same terms and restrictions.
AR includes reserves based on historic bad debts, customer concentration, etc. recorded mostly on a specific identification basis.
Inventory is FIFO, with allowances for writedowns if prices drop. "Inventory consists of material used in the construction of pipelines." Wouldn't it also be natural gas itself? [no, also construction, see below]
Depreciation schedule is good. Cars are 5 years, buildings 30 years.
Contracts in progress relates to constructing and selling pipelines (typically 2 month duration).
Revenue recognition is as expected with sufficient detail.
Tax rate is only 15% (instead of 33%) due to being in a favored industry (natural gas industry).
The huge increase in revenues is due to one-time construction and installation as well as increased sales of natural gas. It's not clear to me what the sustainable revenues are. Construction revenues have high gross margins. Natural gas sales increased by 396% over the prior year.
Skipping ahead to the numbers...
Natural gas revenue: $1.69 million (recurring) 23% gross margins
Construction/installation revenue: $3.16 million (one-time) 65% gross margins
Natural gas revenue: $306K (recurring) 26% gross margins
Construction/installation revenue: $578K (one-time) 50% gross margins
Looking at the amended Q3 2006 10-Q:
Natural gas revenue Q3 2006: $5.21 million (recurring) 47% gross margins
Construction/installation revenue Q3 2006: $1.30 million (one-time) 60% gross margins
One customer accounted for 36.1% of revenue for Q1-Q3 of 2006 (87.0% for 2005!).
As CHNG keeps doing construction, it results in a one-time big profit, but adds to a recurring smaller profit. You can see that the recurring revenues are ramping up very fast. Let's say that quarterly gas revenues ramp up to around $8 million (I tend to think it will be more than that) and construction/installation falls off to a steady $300K. Assume the same gross margins. This would result in a gross quarterly profit of $3.94 million. We'll say that operating expenses increase to $800K (which seems pessimistic since they're scaling slowly). We would then see a quarterly net income of $2.67 million and the stock might be worth $5.93, assuming no seasonality [see below]. It's currently trading around $2.80, which would be an acceptable discount for an investment.
New households pay approximately 60% of the construction costs of the pipelineOk then, let's say they hit-the-wall right now and stop growing as of Q3 2006. What would that look like in terms of free cash flow? Revenues for a typical Q3 would be $5.2 million and gross profit would be around $2.46 million. Operating income might be $1.82 million and net income $1.55 million for a typical Q3.
that supplies their homes with natural gas up front and the balance is paid as
part of the monthly natural gas bill.
As far as seaonality goes, I have no idea. CHNG has been growing too fast to see any seasonality in the results. According to TravelChinaGuide, average high / low temperatures are:
Jan: 39 / 22 degrees F
Mar: 56 / 36 degrees F
May: 78 / 55 degrees F
July: 89 /70 degrees F
Sept: 75 / 58 degrees F
Nov: 52 / 35 degrees F
Q3 goes from July to Sept. Between the two of them, I have to think that natural gas is going to be used more for heating than air conditioning.
Looking at 2005 and 2006 results for each quarter:
Q1 05 gas/construction revenue: $233K / $10K
Q2 05 gas/construction revenue: $426K / $653K
Q3 05 gas/construction revenue: $406K / $986K
Q4 05 gas/construction revenue: $620K / $1.51 million
Q1 06 gas/construction revenue: $865K / $922K
Q2 06 gas/construction revenue: $2.50 million / $1.22 million
Q3 06 gas/construction revenue: $5.21 million / $1.30 million
Far from being an abnormally high revenue quarter, Q3 2005 was the only time in the last 6 quarters that gas revenue actually declined.
A big important question is whether the 40% portion of the construction that is not paid up front is lumped in with the construction revenues (as it should) or gas revenues (which would be very wrong). The revenue recognition section says:
Revenue from construction and installation of pipelines is recorded when the contract is completed and accepted by the customers. The construction contracts are usually completed within one to two months time.So if I understand this correctly, they recognize the full revenue when construction is done (and accepted) and the 40% paid along with the gas bill is essentially accounts receivable and already recognized as revenue. This would be good from the standpoint of making sense of the gas vs construction numbers above.
Ok, I now go back to the 10-K again...
The increased operating expenses are due to increased sales and marketing costs to sign up new customers during 2005. Also, they entered the filling station segment. They mentioned applying for permits and such. Kickbacks? This is China, after all.
Liquidity: They raised all that money in Jan 2006 to start up the filling stations. They ended up starting up a lot of them (four in Q3 of 2006 alone). There were 17 filling stations on Nov 10, 2006 and they planned to build or buy at least 4 more (Q3). They then built two stations in Henan Province (population 100 million) and ended the year with 23 stations (ten in Henan).
Auditors are Kabani & Company. I've run into them before. Kabani had what appeared to be a fraud perpetrated against them by Genex who posted a fake letter supposedly from Kabani on Kabani letterhead in an SEC filing! Kabani audited Harbin Electric, a fine upstanding company that recently switched to NASDAQ. I had noted here that Kabani handled 28 accounts in 2005. From their website:
Member: American Institute of Certified Public Accountants, California Society of CPAs , MEMBER AICPA Center for Public Company Audit Firms (formerly, SEC practice Section ), Registered with PCAOB.Kabani gave CHNG an unqualified opinion for 2004 and 2005.
Visual display of financial statements:
All other stuff *
Total current assets **
Property, Plant, Equip ****************
Construction in progress ***
Total assets *********************
Liabilities (all current) ***
Natural gas revenue ********
Cost of natural gas -------
Construct/Install revenue ****************
Cost of construct revenue ------
Total revenue ************************
Cost of revenue ------------
Selling expenses --
G&A expenses ---
Operating income *******
Net income ******
Cash Flow Statement:
Net income ******
Contract in progress ++
Other payables +++
Unearned revenue ---
Property & equipment ----------------
Stock issued for cash *****************
Net increase in cash ***
"Insignificant" allowance for uncollectable accounts.
Interest-free advances to suppliers.
Reasonable depreciation schedule (cars are 5 years).
PP&E is nearly all operating equipment, as expected, with some buildings, cars. Modest depreciation at this point.
Construction costs are material, labor, overhead.
Construction projects normally completed in 1 to 2 months.
Revenue from gas sales is recognized when gas is pumped through pipelines to end users.
"Insignificant" advertising costs for 2005 and 2004.
Taxes are low because of the 15% tax incentives for natural gas.
The usual PRC welfare stuff is in there.
All natural gas is purchased from one vendor (see above), with a required minimum purchase (2.36 million cubic meters for 2005, 1.6 million for 2004).
Two suppliers accounted for 51.5% and 13.3% of equipment purchased.
Customer 1: ***********Customer concentration is very high, but will decrease going forward. By now, I expected it to be more diversified from the filling stations.
Customer 2: *******
Customer 3: *****
Customer 4: ***
All others: ******
The customer concentration is high in construction/installation (40%, 17%, 17%).
In 2004, construction concentration was 36% and 37% (seems like the same customers).
Jumping ahead to Q3, for 9 months: supplier concentration was 42.2% and 17%. Customer concentration was 36.1% of total revenues.
$350K payable to a stockholder.
Management / Insiders
Qinan Ji, 48, Chairman. Founded Anxian Hotel in Weinan City, Shaanxi. Formed Xian Sunway Technology and Industry Co. Founded Sunway Technology Industries (which now owns a big chunk of CHNG stock). 1990 represented Weinan City at the People's Political Consultative Conference. Chairman of Weinan Anxian Petrolium and Chemical Co. Long ago founded and ran Weinan Anxian Trade & Industry Co. BS in economic mgmt, Northwest U (Shaanxi).
Bo Chen, Vice Chairman (Oct 2005). President and a founder of Bodisen Biotech (BBC). 1997-2001 COO and CTO of Shaanxi Bodisen Chemical Co (which is essentially Bodisen Biotech). 1994-1997 CEO of Yang Ling Shikanglu Chemical Technology Development Co (nothing googles). BS Shaanxi Normal College 1984.
Patrick McManus (board member) has ties to Bodisen Biotech. Bad news. Possible fraud. Herb Greenberg has been all over them, mentioning the investment in CHNG.
Bodisen Biotech sec page.
Yangling Bodisen Biotech Development Co. owns 516K shares.
Minqing Lu, 43, CEO.
People selling shares in the recent prospectus (3 amendments)
Amaranth LLC 1,363,096
SovGem Limited (Peter Charles St. George) 454,365
MidSouth Investor Fund LP (Lyman O. Heidtke) 181,889
Jayhawk China Fund (Kent C. McCarthy) 445,278
T2 Capital Management (Richard Taney) 36,349
Broadlawn Master Fund (Jon Bloom) 22,718
Jon D. Gruber and Linda Gruber Trust 68,152
Gruber & McBaine International 77,243
J. Patterson McBaine 22,721
Lagunitas Partners (McBaine) 286,250
Primarius China Fund (Patrick Lin) 227,182
Nite Capital (Keith Goodman) 68,154
Antoine de Sejournet 63,611
Philippe de Cock de Rameye 11,450
Vision Opportunity Master Fund (Adam Benowtiz) 90,874
Citizens Security Life Insurance (Darrell Wells) 22,718
Peijian Sun 636,111
Jiakuan Wang 647,379
New York Global Securities (Scott Morrison) 420,843
I really hate to rule out a company because it has links to what might be a fraud (Bodisen Biotech), but I just can't invest in this company. It's too bad because the price has been getting better and better.