Saturday, 19 January 2019

Invest in water? Citic Envirotech Analysis


The Business
Citic Envirotech (CEE) specialize in providing solution to water treatment and reclamation mainly in china. It has the following segments:
  • Engineering, Procurement and Construction (EPC)
  • Water Treatment
  • Membrane

EPC
EPC provides engineering services which involve the design, fabrication, installation and commissioning of membrane-based water and wastewater treatment systems.

Water Treatment 
CEE invests in wastewater treatment plants under Build-Operate-Transfer (BOT), Transfer-Operate-Transfer(TOT) [Basically take over from the original operator, upgrade and operate and then transfer] and Build, Own and Operate (“BOO”) arrangements A portion of these investment projects are municipal plants backed by off-take agreements from the government.

Others involve industrial water, steam and electricity, wastewater treatment and recycling services to the textile industrial park. It also provides river restoration, sludge treatment services and hazardous treatment services

Membrane
The membrane business Memstar Pte. Ltd. is principally engaged in the business of manufacturing and supplying of membrane, membrane products and integrated membrane system, and operation of water plants. 

Systems
CEE mainly uses Membrane Bio-Reactor (MBR), Continuous Membrane Filtration System (CMF) and Reserve Osmosis System (RO). To read more about the tech like I did, please go to this link.

NOTE: Dollars in Thousands unless stated. 
The EPC segment is the main core business has a good profit margin of >10% however the margin is the lowest of all the segments. Due to the BOT/BOO/TOT agreement, the operation of the water treatment bag in high margins as it cost little CAPEX. EBITA of the water treatment is on par to its EPS. CEE is trying to growing this segment for its recurring income. Membrane segment compliments the operation of the other 2 segments.

Gross margin tell us the pricing power or cost of the business while expenes/revenue tell us how expenses is managed. Cost went up for FY2017 as Material purchased, consumables used and subcontractors’ fees went up higher than the growth in revenue while cost is very well managed at all time low of 14.2% of revenue. (Numbers base on Morningstar, Expenses = Revenue - COGS - Operating Profit)

The Net profit margin are quite lumpy, I am guessing that this is due to the time needed to build up the plants and then recognized the profits and hugely affected by the EPC segment. Average ROE and Net profit margin is above 15% and 10% respectively.

Debt is well managed and has been reduced for the past 5 years at 42% for debt/equity. Interest cover is healthy above 7% but current ratio is below 1 which may affect short term/current liabilities.



Receivables
The receivables made me think hard to try to understands it.  trade receivables, other receivables are the usual types.  Service concession receivables (SCR)  to my best of my understanding is the payment from the PRC government recorded for presumably up to 30 years of the concession arrangement for various BOT/TOT. 

That mean this amount is recurring income that CEE can received yearly during the  'operation' stage. The base on some pricing mechanism which wasn't disclose. From AR2017 note8, we can see how much CEE is being paid yearly and growing. Let's call this Service Concession Fees (SCF).
the Group will receive a yearly minimum amount of RMB635,009,000 (equivalent to $130,436,000) [2016 : RMB524,126,000 (equivalent to $108,887,000)] from
the contracted parties (grantors) in exchange for services performed by the Group.
However the $104.1million of the total SCF of $130.436million in 2017 is recorded as non-current SCR. Judging by the breakdown from the AR2017 note8, this amount is going to be received across the next 30 years. This mean every year, and eventually be larger than the revenue (China Everbright  Water's SCR is 3x its revenue). 

We can see that he current SCR is about $6million, 2nd to 5th year is about $42 million and more than 5 years $631million. If we divide each categories according to total of 30 years, we get $6million, $10million and $25million received per year.



Excluding SCR, we have Receivable/Revenue at above 70% right now. This may not be a concern considering the Cash Conversation Cycle. There is sudden surge for non-current in 2017 though may need to see if this will be a new trend. Stated in AR2017, non-current receivable is due within 3 years and is mainly due to a Build-Transfer projects (Has been changed and recorded as contract assets in 3Q2018).

Cash Conversation Cycle
The Cash Conversation Cycle iin negativelevels. According to AR2017 note7, average credit period is 180 days versus 332 days (according to Morningstar) for CEE to pay its creditors. This mean customers paid CEE twice a year while CEE pay creditors only once a year. Current receivables make up most of the total receivables, thus this is to CEE advantage as current receivables are quickly received.


Receivables exclude CSR
Exclude CSR for Receivable vs Payable
NOTE: Actual FCF = Net profit  - CAPEX - Investing activities + non-cash items + Borrowings

Business Moat, Growth and Risk
The moat here will be their parent company CITIC which is stated owned, thus more government projects will be directed to them. Risk would be government cut in spending and the SCR if that happens. 

Comparing to China Everbright Water
China Everbright Water is also state owned. The modols should be the same have SCR as well, being 3x of its revenue. Apparently China Everbright Water is acquired in the same year as CEE. China Everbright Water bought a small stake in CEE during the placement in 2017 at $0.85.

Looking at some of the metric during selection

CITIC Everbright Which is better?
Profitable for last  5years? Yes Yes -
Positive Operation Cash flow for last 5 years Yes No CITIC
Current Ratio >1 0.81 1.23 Everbright
Debt/Equity 42x 87.4x CITIC
Interest Cover 7.1x 4.54x CITIC

And I was wondering why CSR is not stated in the cash flow statement. So I looked at China Everbright Water. It is there in their statement and oh my god ouch to the operating cash flow. Now I know why they have higher amount of debts than CEE. As for why CEE did not record it in the cash flow statement? I don't know.

 

Latest Results
The above are information I gathered from AR2017. Looking at the latest 3Q financial statement things don't look so rosy. The 3Q2018 operating is at $25million compare to $180million a year ago. FCF from business has drop drastically in 2017, but there was a borrowing(plus issuance of shares) of about $330million injected into the cash flow. In 3Q2018 results, total borrowing(plus issuance of shares) minus total repayment give a net repayment of $53million. Basically CEE refinance most of its loan due with a $53million paid back. There is a reduction in cash flow.


Cash in balance sheet dropped from $631million to $385million. Current ratio is at 0.81x, a drop from 1.8x in 2016, a whooping 50% drop. So did current asset drop or current liabilities ballooned? The current liabilities ballooned 250% from 2016 in 2017. With more projects announced, how will they be financed? Historically CEE did a lot of placements and I think debt will be increase soon. Probably that's why even at such low share price they only did share buyback once in June 2018.

Conclusion
I think I will sit this one out. It prop my interest as its a massive drop and the historical average price to book ratio is above 1x (well most of that is before the acquisition by CITIC). The CSR structure is unknown and its outside my competency. Most important factor is being comfortable in owning a company. And to do so have to erase my doubts. This CSR will definitely bug me. Just as said in his book (for this case is the CSR in the balance sheet):

If you cannot understand a company's income statement put that company into the no-thank-you pile instead of thinking you are not smart enough. - Little Book of Value Investing
CEE is now trading below 0.45x book value of $0.73 with a current yield of 4.54%. I do not think this yield to fluctuate due to cash flow required, $48.3million were paid out last year. Goodwill, intangibles and CSR make up of 33% of assets. If these are excluded from assets, the adjusted book value stands at $0.48. Share price of $0.33 is 0.69x of adjusted book valued. If we do the same for China Everbright Water, book value is negative.

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