According to the World Bank, the global economy will contract by 3% in 2009 followed by tepid growth in 2010. For China they forecast full year 2009 growth of 7.2%, ranging from 6.1% (actual) in Q1’09 to over 8% in the second half of the year. Other respectable commentators, including Goldman Sachs and OECD, recently published similar viewpoints.
Notwithstanding that the Chinese economy already contains inherent strengths and is highly competitive, it is gaining further traction from a $586 billion stimulus package announced by the government at the beginning of 2009. Of the $586 billion, $259 billion is allocated towards infrastructure, earthquake and housing with a further $219 billion allocated to transport and power infrastructure.
Whilst the macro-economic picture for China remains unerringly bright, the Beijing government is increasingly aware of the critical importance of preserving national stability in the face of a growing wealth disparity, and unrest, between the rich eastern seaboard and the poorer hinterland.
With this in mind, Beijing set about developing the western region as a top priority within the country’s Plan for Economic Development - dubbed the “Go-West” strategy. The Go West strategy will be of long-term benefit to the entire western region and is proving particularly beneficial to Xi’an city and its surrounds. Xi’an (pop 8 million), situated 600km south west of Beijing, is capital of Shaanxi province (pop 37 million) and is the gateway city to China’s vast hinterland.
As such, Xi’an and Shaanxi are pivotal to the government’s Go West strategy. This note concentrates on two infrastructure plays that generate most of their sales in the Xi’an/Shaanxi vicinity - General Steel Holdings Inc (NYSE: GSI) and China Housing & Land Development Inc (Nasdaq: CHLN). Both are ideally positioned to benefit from China’s enormous infrastructure build-out plans. The remainder of the note deals with China North East Petroleum (AMEX: NEP), a low-cost well run, highly efficient oil driller located north east of Beijing.
All three companies have excellent long-term potential and, following the current sharp pre-Q2 earnings season sell-off, offer compelling value and an opportunity to participate in the China growth story at unusually good entry prices.
GSI is a steel producer in China with four business units; Daqiuzhuang (100% owned), Baotou (51%), Maoming (99%), and Longman (60%).
In order to properly understand GSI, one need only focus on the Longman business – it will generate about 95% of GSI sales in the near-term and it is on the cusp of generating large profits. Longman produces reinforced steel bar (rebar) and other ‘long’ steel products for use in the construction industry. It is located near Xi’an, has no major competitors for 250km and it acquires 15% of its iron ore from its joint-venture partner at a discount to market prices. Longman is the largest steel producer in Shaanxi province and has a 72% market share of all heavy construction and infrastructure projects in Xi’an and the surrounding 15 largest cities.
Via its Longman unit, GSI is particularly well positioned to benefit from; (a) the government’s long-term Go-West strategy as it positively affects the Xi’an gateway city, (b) the $259 billion stimulus earmarked by the government towards earthquake (esp Chengdu), infrastructure and housing, and (c) the $219 billion stimulus allocated by the government to transport and power infrastructure.
At the current share price, $3.47 (July 7, 2009), GSI has a total market cap of $134 million. This pales into insignificance compared to GSI’s projected sales; 2009 $1.53 billion and 2010 $2.24 billion. There are many reasons why GSI’s stock price and market valuation is low:
- On a look-back basis the company has had a low gross margin compared to peers.
- Early 2009 has been a thoroughly difficult period globally for the global steel industry.
- GSI is seen as boosting its balance sheet liquidity in late and/or early 2010 and this acts as an occasional overhang to the stock price.
- There has been a sharp market sell-off in the run-up to Q2 earnings season that has affected all stocks and, whilst GSI’s business is already on a solid business upswing, the process of filtering out winners from losers in the stock market will not get underway until reporting season gains traction in July.
GSI’s long-term strategy is to be a strong consolidator within the disparate Chinese steel industry. It acquires state-owned steel operations at exit PEs of 2-4 and transforms them into efficient producers.
GSI concluded its first big efficiency transformation in January 2009 when it completed an investment of $216 million in two new furnaces at Longman. These two new furnaces, which together represent about 50% of GSI total output, can command sales prices with an 18% gross margin compared to 10% for GSI’s legacy furnaces.
Thus GSI’s overall gross margin target model becomes 14% compared to 10% previously. It will take time and an improved business environment before GSI can ramp-up to maximum efficiency and achieve its full gross margin target model .
During Q1’09, GSI had sales of $323 million and, after stripping out one-time items, generated EPS of 3 cents. Of particular note in Q1’09 is that GSI had a gross margin of only 4.0%.
Looking forward, brokers’ sales estimates are; Q2’09 $372m, Q3’09 $410m, full year 2009 $1.53bn and full year 2010 $2.24bn. Q1’09 to Q2’09 represents consecutive Q on Q growth of 15% (annualised = over 60%) and full year 2009-2010 growth is 46%. Comparing 2010 against annualised Q1’09 represents an increase of 73%.
Demand that is strong enough to boost sales to this degree is inevitably going to exert meaningful upward pressure on GSI’s gross margins. On running our models we conclude however, that the brokers’ EPS forecasts – giving 24 cents for full year 2009 and 57 cents for full year 2010 – show no discernible expansion of GSI’s gross margins from the lowly 4% achieve in Q1’09.
Taking account of the $216 million transformation to GSI’s gross margin target model and recognising that the Chinese stimulus is creating demand pressures sooner than market commentators predicted even two months ago, the following full-year EPS scenarios should be more realistic (still using the brokers’ sales estimates):
Full yr 2009; GM 5.75%, EPS 40 cents (based on 38m shares*), P/e 8.7
Full yr 2010; GM 7.50%, EPS $1.17 (based on 42m shares*), P/e 2.9
* projected share increase recognises that GSI is likely to strengthen its balance for acquisition and strategic reasons during H2 2009 and/or early 2010.
The rationale for using expanded gross margin is further supported by comments from GSI during the May 11th Q1 earnings conference call; (a) the company was at that time about to raise prices above end-Q1’09 levels, and; (b) management confirmed that the new furnaces had not reached optimum efficiency during Q1 and would experience further improvements throughout 2009.
Investors should bear in mind that every 1.0% improvement in GSI’s gross margin equates to 0.51% improvement in net income*.
For 2010, based on sales of $2.24bn, every 1% GM represents $22.4 million and equates to net income of $11.4 million and additional EPS of 27c. Hence, GSI will experience very strong EPS growth as gross margins expand in future. By way of example only GSI would have EPS of $2.00 in 2010 if gross margins reached 11%.
*after deducting tax @15% and minority interest @ 40%.
GSI’s sales for Q2 should in fact be higher than brokers’ estimates. Refer page 39 of GSI’s Q1’09 10Q; In April GSI set a new record in terms of steel output at 10,000 tons per day. GSI runs its operations 24 hours per day and 7 days a week, thus 10k tons per day equates to about 900k tons for 3 months. This is 37% greater than the 655k tons produced in Q1 and should equate to Q2 sales of $400m or more.
As for Q2 gross margin and EPS we must wait and see. Steel prices in China were reported as being soft at the beginning of Q2 followed by healthy and continued price rises during May and June as the government's stimulus took hold. The real story is about gross margin expansion and guidance for Q3 and the longer term future – this is where GSI’s full-year 2009 and 2010 profits potential rests. Investors should anticipate meaningful improvements. GSI reports early August.
China Housing & Land Development Inc (CHLN)
Across China, residential property prices peaked in 2007 and experienced sharp falls in 2008. However, on the back of China’s recent reacceleration in economic growth, allied to incentives introduced by the national government, residential property prices have again been firming in Q2’09. Xi’an, where typical property prices less than half of those of eastern major cities such as Shanghai or Beijing, only experienced mild price softness in late 2008 and early 2009. Commencing March 2009 residential prices started again to move upwards in Xi’an and recent reports suggest demand continues to strengthen.
CHLN is the largest private residential real estate developer in Xi’an. In addition to being the gateway city to China’s hinterland, Xi’an has many merits. Briefly these include; ancient capital of China for over 2,000 years until 907 AD, major tourist attractions of the old walled city and terracotta soldiers, universities, strong local economy including hi-tech, aeronautical, military and pharmaceutical industries, and local economic growth of 15% pa. It is an attractive clean-air city with low property prices and it is positioned to enjoy vibrant growth for many years.
An important development instigated by the Xi’an city government is the establishment of a multi-billion dollar satellite suburb – called Baqiao - in the Chan Ba district which, among other, will include a 2,224 acre hi-tech zone encompassing an aerospace research centre, retail and commercial units and mid-to-upper income residential developments for a million people. Companies already attracted to Baqiao include; IBM (IBM), Intel (INTC), Micron (MU), Infineon (IFFNY), Applied Materials (AMAT), Nortel (NT), NEC etc. In March 2007 CHLN acquired 487 acres of ultra-prime land in Baqiao.
When investors look at CHLN they typically note the brokers’ sales and EPS estimates for 2009 and 2010. An outline of brokers estimated sales and EPS for 2009 and 2010 looks like:
Sales by Project
JunJing 11, phase 1
JunJing 11, phase 2
Actual Sales Q1’09
Total Estimate Sales
Net Inc as % of Sales
Based on these estimates alone investors would judge CHLN to be a good value China play; current share price $5.02 (July 7), being a 2010 p/e of 7.2, excellent long-term macro growth prospects and so on.....
However, what investors may not immediately see is that CHLN has contributed 79 acres of its highly prized Baqiao land asset into “Puhua” - an upscale development joint-venture project scheduled for completion from 2011 to 2014. CHLN owns 75% of Pruhua and the JV partner contributed $30 million cash for their 25% share. The project entails 610,000 sq metres of almost entirely residential space. When announcing Puhua, CHLN’s CFO commented:
It is expected to be very profitable, have strong cash flow, it will enhance our balance sheet and increase our net asset value significantly.
Traditionally CHLN has a targeted net income of about 20% of sales. Bearing in mind that this existed when CHLN had to buy-in the related project land, we can assume that Puhua, where CHLN already owns the land, will be a good deal more profitable. Assuming Puhua achieves net income of 25% sales this would translate to net income, for CHLN alone, in the region of $100 million over the 4-year life of the project.
These figures are arrived at by using sales price per sq metre of $850 – being recent sales price per sq metre achieved by CHLN. In reality Puhua is a very upscale project, is situated directly on the Ba river front and it should command selling prices a great deal higher than just $850 per sq metre, or $80 per sq feet.
In addition to the lucrative Puhua project, CHLN owns an additional 390 acres of ultra-prime Baqiao land. The balance from the original 487 acres, 18.4 acres, was sold to an independent property developer in 2008 for $24.4m. The company intends to use this remaining 390 acres for other in-house projects, in conjunction with suitable partners, in order to extract higher profits per acre.
At this early stage it is impossible to estimate what sort of profits this remaining 390 acres may generate. But given that not all of it is river-front it is unlikely to produce profits of $1+m per acre estimated for Puhua.
Prospective investors are advised to read CHLN’s 10K report for year ended December 2008. Among other, it contains excellent information on the residential property market in China and Xi’an.
In summary it seems reasonable to suggest that a comfortably low valuation for CHLN should put it well north of $300 million. Yet at the current share price of $5.02 (July 7, 2009), CHLN has a total market cap of only $155 million. Nor is CHLN likely to do any dilutive share offering – it has been granted local bank facilities of over 1 Billion Yuan (over $150 million) to enable it to perform its required project development work.
Whilst the stock represents compelling value, most of that value play doesn’t start to come on stream until 2010 and especially 2011. In anticipation thereof, CHLN stock should climb strongly into and during 2010. Ahead of this, it may be best to buy the stock on dips between now and y/end 2009.
NEP is a low cost oil producer in North East China. It can drill new wells at a cost of $320k versus a cost of $2.5 million for similar wells in the USA. Similarly, it enjoys labor costs that are less than one tenth of those in the USA. The company sells all its production locally to PetroChina at “Platts” Singapore daily average rate – typically $2/$3 under WTI.
During Q1’09, NEP had sales of $8.9 million and generated net income of $2.3 million, equivalent to a respectable 25.5% of sales. This Q1 performance was achieved with an average oil price of $40.04/bbl – illustrating that NEP has a highly profitable business model even during a period of low oil prices.
Because net income is a high % of sales, this generates strong cash flow which NEP uses to drill more wells. Having started 2008 with 247 production wells, the company froze its drilling program in Q1’09 as the global oil price crashed into the mid $30s. In May’09 NEP reactivated its drilling program and announced intentions to drill 5 new wells per month. This should bring well numbers to 282 by end 2009 and 342 by end 2009, or more subject to oil remaining above $60/bbl.
The company has leased oil acreage from PetroChina with total reserves of 75m barrels. They anticipate extracting up to 35%, being approx 26m bbls, over the useful life of the leases ending in 2022 and 2023.
On this acreage, NEP envisages being able to establish a total of 675 wells from 247 at present – thus giving NEP lots of potential to expansion production for several years. The PetroChina lease terms stipulate that NEP must pay PetroChina an oil royalty based on production – this PetroChina royalty has already been deducted from data used in this note and, as such, any NEP sales figures used herein are net of the royalty.
In addition to NEP leases, PetroChina has also leased acreage to 36 small independent local producers. NEP is actively seeking acquisition opportunities amongst these local producers. If/when a suitable target is found NEP may issue additional shares but it is believed that such a transaction, if and when it occurs, would be highly beneficial to NEP.
To assess the likely total value of oil-in-the-ground at NEP, take total potential oil to be extracted 26m barrels, deduct production to date since leases were awarded in 2002 and 2003 – about 1.5m bbls – deduct lifetime oil royalties to PetroChina at 40%, balance = 15m barrels.
At its current share price of $4.03 (July 7, 2009), NEP has a total market cap of $84 million, implying a value of extractable oil in the ground of $5.60/bbl. This is a measure of the sort of acquisition opportunity that is understood to be available locally to NEP.
NEP is an under-discovered stock. It graduated from bulletin board (CNEH.ob) to full Amex status only in June 2009 and many financial web sites, e.g. Yahoo, do not have continuity of news releases and information from NEP’s pre-Amex life. The remaining target price provided by one broker requires updating and earnings per share estimates do not seem to have been provided, or were withdrawn presumably being obsolete. Prospective investors can refer to the Investor Relations section of NEP’s web page for a full list of publications in recent years. The web page also contains a lot of useful information about NEP, its assets and plans.
And so to EPS forecasts: In Q1’09, when oil averaged $40/bbl, NEP had sales of $8.9 million and EPS of 11 cents. The oil price in Q2’09 for NEP averaged about $60/bbl. Ignoring any upside for increased oil production from new wells, this would equate to Q2 sales of $13.35 million and EPS of 20 cents. Similar EPS for Q3 and Q4 would produce full year 2009 EPS of 70 cents. Looking to 2010, and adopting Goldman Sachs recent prediction of $85-$95 oil, sees earnings per share of $1.20 i.e. a forward p/e of 3.4 at the current $4.03 share price.
Warning: All three of these stocks are fairly thinly traded and, because they are cheap with outstanding long-term potential, they are likely to experience price surges in the last couple of weeks before earnings release. This trend is usually pronounced when day-traders become involved. After earnings the stock prices can often fall back, especially with the departure of the day-traders. Buyers should either buy the shares ahead of the pre-earnings surge or after the post-earnings drop but probably not in the days immediately before earnings by which time the price may be peaking. Calmer heads should prevail.
Disclosure: Long all three shares.