Gushan Environmental Energy Limited Q2 2009 Earnings Call Transcript

Gushan Environmental Energy Limited (GU)

Q2 2009 Earnings Call

August 12, 2009 8:30 am ET

Executives

Wai Sun Kwong - President

Frank Chan - Principal Financial Officer and Principal Accounting Office

Analysts

JinMing Liu - Ardour Capital Investments

Eric Larson - Somerset Asset Management

Tom Bishop - BI Research

Rodney Hathaway - 1492 Capital

Presentation

Operator

Good morning and thank you for participating in the second quarter 2009 earnings conference call of Gushan Environmental Energy. (Operator Instructions).

I would now like to turn the call over to Wai Sun Kwong, President of Gushan Environmental Energy.

Wai Sun Kwong

Welcome to Gushan's second quarter 2009 earnings call. Joining me on the call is Frank Chan, Principal Financial Officer of Gushan.

Please note that today's discussion may contain forward-looking statements made under the Safe Harbor provision of US federal securities laws. Please see today's press release under the section Safe Harbor statement for a discussion of risks and uncertainties that may affect our results.

Before opening the call to questions, I would like to briefly review our second quarter results.

By any measure, the second quarter of 2009 was an extremely difficult one for Gushan. Total revenues for the quarter dropped 57.2% year-to-year and 37.3% quarter-on-quarter to $25 million. Much of the revenue decline was the result of a sharp drop in the sales volume of our biodiesel product, which was down 33.1% year-to-year and down 36.6% quarter-on-quarter to 40,100 tons.

Sales volume dropped mainly because of the suspension of production at our Fujian plant beginning in mid-April and at our Shanghai plant beginning in mid June. Production remained suspended at Fujian, but will resume at Shanghai at the end of August and I would discuss the status of production at those and other plants a bit later.

Another contributing factor to the drop in revenues was a continued declined in diesel prices in China on a year-to-year basis. The average selling price of our biodiesel declined 33.3% year-to-year in the second quarter but declined only 1.1% quarter-on-quarter from the first quarter of 2009.

The Chinese government actually increased the guidance price for diesel during the quarter, but weak demand as a result of the global economic slowdown and a slow rebound in Chinese industrial production left little leeway for raising prices. However, as China's economy and diesel demand continued to recover we expect our average biodiesel selling prices to begin rising again.

Cost of revenues rose 11.5% year-to-year and 6.9% quarter-to-quarter to $38.3 million. This increase was entirely attributable to a provision of $11.6 million made for potential consumption tax liability for the first two quarter's of 2009. I will explain the consumption tax situation and provision in more detail shortly.

Now excluding the provision our cost of revenues dropped 22.3% year-on-year and 25.5% quarter-on-quarter to $26.7 million in Q2, as a result of lower sales volume. Although selling prices of biodiesel stabilized during the quarter, we were unable to hold the line on raw materials cost as suppliers have demanded higher margin.

As a result the average unit cost for our raw material feedstocks rose 6.4% year-on-year and 4.7% quarter-to-quarter to RMB2,543 per ton in Q2. As a result the company reported its first ever quarterly operating loss of 16.6 million and a negative gross margin of 53.2% of which 46.5% was attributable to the provision for consumption tax. This compares to gross margins of 10.2% during the first quarter of '09 and 41.3% for the second quarter of '08.

We reported a net loss of $16.4 million for the second quarter, representing a basic and diluted loss per ADS of $0.196. Despite the difficult quarter, our balance sheet remains strong with cash on hand of $100.3 million and no bank borrowings as at the end of Q2 '09.

Now, let me explain consumption tax situation, our provision for such tax and its impact on production as this is directly impacting our efforts to address and reverse the deterioration in margin. As previously announced, we suspended production at our Fujian plant on April 19, 2009 because of road work in the area that restricted access to the plant by our customers and suppliers.

Although that road work was scheduled for completion at the end of July, production remained suspended at Fujian because of uncertainty over the plants consumption tax liability.

It remains the company’s view that Gushan should be exempt from consumption tax levied on diesel product. Provincial and municipal tax authorities in Fujian have previously submitted a proposal to the PRC State Administration of Taxation, which we refer to as the SAT, specifically requesting that biodiesel product without petroleum based diesel content be exempted from the consumption tax.

The PRC SAT has not yet responded to that proposal. However, based on notices received from the Fuzhou local SAT, the company believes that it will be asked to pay the consumption tax on a contingent basis for any sales by the Fujian plant pending a decision by PRC SAT on the consumption tax exemption.

With the plants all ready now, gross margins because of market condition, the company determined that paying the contingent consumption tax would result in negative operating cash flows at the plant.

In light of that, the company had decided that it would be prudent to continue to suspend production at the plant to minimize operating cash outflows until a determination on the tax matter is received.

In July 2009, our Sichuan plant received similar notices from a local SAT in Sichuan province and the company is currently in discussions with the local SAT.

If the Sichuan plant is eventually required to pay the consumption tax Gushan may have the suspend production there as well. To-date no other plants have received consumption tax assessment but there is no assurance that it would not happened elsewhere.

At this time we also do not have any indication of when we can expect a determination from the PRC SAT on the consumption tax exemption. While, we are hopeful that the PRC SAT will make a determination in our favor, there is no guarantee of this. Should they determine that we are subject to the consumption tax on all sales from January to first ’09 onward, the amount would be substantial and may even necessitate suspending production at all plants until diesel prices rise sufficiently to restore positive operating cash flow.

As a contingency, we are preparing to expand sales to the chemical industry and such sales are not subject to consumption tax. We are also stepping up our research efforts to develop new products for the chemical industry.

Now, given the uncertainly over the consumption tax situation, we are making a provision for the amount of potential consumption tax owed on actual biodiesel sales through the first two quarters of 2009.

This provision amount of RMB79.4 million or US$11.6 million is based on a consumption tax rate of RMB0.8 per liter or 99.2 million liters of biodiesel products sold as refined oil products during Q1 and Q2.

The company has not actually paid or been asked pay the consumption tax and this provision was made as a contingency. If as we hope that the PRC SAT determines that our biodiesel is not subject to the consumption tax, the provision will be reversed in our subsequent financial statement.

Obviously, the unresolved consumption tax situation and current market conditions create a high degree of short-term uncertainty in terms of our outlook for the rest of 2009. Nevertheless, we remain confident in the long-term outlook for China's biodiesel market and for Gushan.

Our strong financial position and balance sheet will help ensure that we have the resources to ride out the current downturn and position us for future growth.

Our average biodiesel selling prices began to stabilize during the second quarter and we expect that prices should resume an upward trend as China's economy and diesel demand continue to recover. We are also continuing to negotiate with our supplier to keep our raw materials cost under control, while accelerating efforts to secure alternative feedstock such as jatropha and castor bean oil.

Over the medium to long-term, China's economic growth, rising energy demand, and the governments commitment to developing alternative energy sources provide a very strong underpinning for growth of the biodiesel market; because of that Gushan is continuing to proceed with a production expansion plan.

Construction of our new plant in Chongqing and Hunan is complete and those plants each with an annual production capacity of 30,000 tons are ready to commence production as and when we receive clarification from local tax authorities on the consumption tax issue.

We also expect the expansion of your Shanghai plant to add another 50,000 tons of capacity to be completed during the third quarter. A new second plant in Sichuan with an annual capacity of 50,000 tons using entirely inedible oils as raw materials remains on track to commence production in the first half of 2010.

These expansions in plants will raise Gushan's total annual production capacity to 450,000 tons or 135 million gallons by the end of 2009 and 500,000 tons or 150 million gallons by the middle of 2010.

We will of course continue to closely monitor the situation and adjust our plans accordingly. We will also keep you informed of any material development with regard to resolution of the consumption tax issue.

At this time, we will be pleased to answer any questions that you may have and I would now turn the call back over the operator to begin the Q&A session. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of JinMing Liu of [Gushan Environmental]. Please proceed.

JinMing Liu - Ardour Capital Investments

Yeah. I have first, are your Sichuan, Hebei, province facilities in production right now?

Wai Sun Kwong

Yes.

JinMing Liu - Ardour Capital Investments

Okay. And on the VAT refund in the plant and I mean I noticed while you peers in Fujian province announced they received that certificates for both their facilities, why you didn’t received the certificates for your Fujian province facility.

Wai Sun Kwong

Well we have if you just refer to the announcement we made. We have already got the certificate for processing the VAT rebate for Shanghai and also Beijing, so we are moving step-by-step on that front.

JinMing Liu - Ardour Capital Investments

Okay. Another thing is can you help, what is your current selling price for your biodiesel?

Wai Sun Kwong

It is around RMB4,100 per ton.

JinMing Liu - Ardour Capital Investments

On that front can you help me understand the difference between the gross fuel price of diesel and your reported selling price, because I noticed the average diesel selling price in China right now is about RMB5,000 per ton or maybe a little bit less?

Wai Sun Kwong

Firstly the different, I guess your price would probably be inclusive of VAT.

JinMing Liu - Ardour Capital Investments

Yes.

Wai Sun Kwong

VAT is 17%. Now if you take that away, I think it will come to roughly RMB5100 or something like that and then of course because of -- this is a price where you would find probably the big companies like SINOPEC and PetroChina are able to charge, but we are actually pricing our biodiesel products, due to weak demand of diesel in general, at a significant discount to that. If you look at it will be RMB1000.

JinMing Liu - Ardour Capital Investments

Okay. So your discount through the leading big oil company over there is about RMB1000?

Wai Sun Kwong

Yes. It’s a quite a significant discount, in fact we have operated for many years in this industry and we have not faced a situation like this before.

JinMing Liu - Ardour Capital Investments

Then what is your relation with your customers.

Wai Sun Kwong

What do you mean?

JinMing Liu - Ardour Capital Investments

My question is what's the regional deep discount, whether your customers are …?

Wai Sun Kwong

Our customers are not -- as you know we have not been [selective] of SINOPEC or PetroChina, so our customers are really the independent or the privately-owned gas station. In fact, they are also selling at a discount to SINOPEC and PetroChina. So, currently the situation is only the very large deal enterprise were able to sell at so called near the guidance price and that is in fact quite a significant discount.

The difference between what selling price is selling and also what the independent i.e. our customers are selling and of course we also sell at a discount to our customers selling price to sell. So altogether adding up to what you see is what I said before which is the RMB1000 of discount currently.

JinMing Liu - Ardour Capital Investments

You mentioned that you may sell your biodiesel into the chemical market. What is your assessment of the size of that market and also you can covert all your sales at…?

Wai Sun Kwong

Yes. I think the size; it is actually a very large-sized market. However, as you know we have only been selling a small portion, if I could mention, but we are already improving on, expanding on those sales. I think in quarter one, we sold roughly 14% into the chemical industry and then in Q2 that percentage has jumped up to around 27%. So we are making some progress on that front, but obviously we are still vary of the fact that if we try too hard, too quickly that may also depress the prices.

Operator

(Operator Instructions) Your next question comes from the line of Eric Larson of Somerset Asset Management.

Eric Larson - Somerset Asset Management

Give me a quick background, this contingent tax issue you said that you have to have a petroleum based blend in that, in order to be exempt from that contingent tax, is that correct?

Wai Sun Kwong

No, in fact the contrary, because the law is actually not very clear.

Eric Larson - Somerset Asset Management

Okay.

Wai Sun Kwong

And that's why we believe that, in our business the way we made our biodiesel should not be charge for this consumption tax.

Eric Larson - Somerset Asset Management

I see.

Wai Sun Kwong

In fact the Fujian provisional government in a way supported that view because they actually made a proposal for us to the central government tax bureau for our case and so we're still waiting for the time.

Eric Larson - Somerset Asset Management

Okay. And then I joined the call just a few minutes late, and you may have talked about this. Your byproducts selling prices on a quarter-to-quarter basis, sequential quarter from March to June quarter continue to fall pretty sharply.

Can you help me a little bit with your byproduct selling prices and what may begin to firm those up a little bit?

Wai Sun Kwong

I think the main reason for the drop is because we are not able to produce and sell the higher margin byproducts, which was erucic acid and erucic amide during the quarter.

Eric Larson - Somerset Asset Management

Okay.

Wai Sun Kwong

We believe that this trend which has been happening and if you look back one or two quarter, will continue on that basis and because the byproducts are been sold into the chemical industry.

I think it’s also a reflection of a generally weak market out there until we see full economic recovery on all front with prices, the returning to normal in a sense.

Eric Larson - Somerset Asset Management

So kind of looking forward at least in the near term, we should remain conservative on our pricing assumptions?

Wai Sun Kwong

Yes. I mean, we believe that prices will be soft.

Eric Larson - Somerset Asset Management

Okay. Then you talked about the various facilities that you have geared ready to come up etcetera. I sure want to sure understand this relative clearly, you would not open those facilities until you have a more clarity on the contingent tax or would you -- how are you looking at that just from a strictly from an opening point of view?

Wai Sun Kwong

Yeah. For the new plant in Chongqing and Hunan, as I mentioned they are already complete and ready to start reduction. We definitely will not open or start production at those plants until we get more clarification from the local government on the consumption tax issue.

JinMing Liu - Ardour Capital Investments

Okay, good. We will catch up offline. I’ve got a bunch of other questions. But thanks, it's good to hear your voice, I guess.

Operator

(Operator Instruction) Your next question comes through the line of Tom Bishop from BI Research.

Tom Bishop - BI Research

I understood the discussion of RMB1000 discount. As far as it went, it wasn’t quite clear to me why it exists, has the 1000 RMB discount on diesel prices always existed or is this something new and the one thing, one reason I can't quite get my mind around it, is that, I mean surely at the gas pumps, the independents are selling for a RMB1000 less than the majors, right. So, I have a little confusion?

Wai Sun Kwong

Yeah, the independent gas pump they are, but they are still selling at a discount to the big boys the SINOPEC and PetroChina. Exactly, how much, that will be somewhere in the middle. But you see our customers are independent so we have traditionally sold our product at a very small discount to the independents.

I think over the past number of years, in China definitely, it was a market where demands far outstrip supply and therefore we have always been able in the past to price our product pretty close to whatever the guidance price was, but I think the situation has changed quite dramatically since the fourth quarter of '08.

I think one of the primary reasons is that exports have slumped quite substantially in China and as a result, the use of diesel or the demand for diesel have come down dramatically.

Tom Bishop - BI Research

China will have us believe that GDP was up 6% in the first half and that would be smoking hot in the United States.

Wai Sun Kwong

Yes.

Tom Bishop - BI Research

That's quite very strong and so it's little hard for me to understand that you can have GDP growth of 6% in China and yet people are worried about a slowdown and diesel prices are really weak and I just don't get that?

Wai Sun Kwong

It's a difficult one. We operate in the real market i.e. the commercial market and what we are seeing is what has been presented in these results and of course I do not want to comment on sort of GDP numbers in China, but certainly what the government has done is to increase a lot of bank lending.

Of course I don’t have a clue where those lending have gone, but as you probably have read, property market has come back and also consumption has also increased in China. Maybe that's one of the factors that have driven the GDP growth to balance out the deficit in slump in export.

Tom Bishop - BI Research

Yes, perhaps the entire sales or GDP in the construction and car sales area, though you would think that car sales even truck sales are up I believe and that should help your diesel demand I would think but perhaps it's a little strange?

Operator

You have a next question from the line of Eric Larson.

Eric Larson - Somerset Asset Management

Quick question on the support price for -- the government support price, where does that sit right now and directionally where do you think that goes in the next quarter or two or three??

Wai Sun Kwong

You mean the guidance price?

Eric Larson - Somerset Asset Management

Yes, the guidance price.

Wai Sun Kwong

As I have just mentioned it would be roughly 5100 excluding VAT.

Eric Larson - Somerset Asset Management

Okay.

Wai Sun Kwong

That's on an average basis.

Eric Larson - Somerset Asset Management

Okay.

Wai Sun Kwong

Where it will go now, the government has got a mechanism to adjust the -- and in fact there is a formula to adjust the guidance price and they can adjust it.

If I remember correctly if there is a significant deviation in the world oil prices in the past 20 days, something of that nature, but there is actually a formula, which they can adjust the price, but in fact the older day, it would be discretionary but there is a formula for that.

Eric Larson - Somerset Asset Management

Okay. So they will now move prices much more quickly and aggressively relative to world oil prices versus traditional behavior, I would assume, correct?

Wai Sun Kwong

No, I don't know. That's not going to happen. In fact what the government have been is trying to do is, in a way correlate its own refined product prices through the world pricing, so that’s more likely.

Eric Larson - Somerset Asset Management

I see.

Wai Sun Kwong

On par.

Eric Larson - Somerset Asset Management

Okay. That’s make sense. That was good clarification. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Rodney Hathaway of 1492 Capital.

Rodney Hathaway - 1492 Capital

I had a follow up on the consumption tax. Is this tax been levied at the provincial level or the central government level and the reason I asked that is, why would certain of your plants be potentially subject to the tax while others are not?

Wai Sun Kwong

This is actually from the central government but because how its written was rather vague and therefore it is subject to interpretation and different local governments have taken different type of interpretation and that is why we are trying to clarify through local government to the central government, but as I have said if when the central government determine, if they determine that we have to pay this tax than of course it will happen to every single of our subsidiary or operating plant.

Rodney Hathaway - 1492 Capital

Okay. So the manufacturing process is the same at all of your plants?

Wai Sun Kwong

Yes.

Rodney Hathaway - 1492 Capital

Okay. I guess the other question I have in a terms of the biodiesel, relative to the petroleum based diesel. Is there a difference in your energy rating on the biodiesel versus the petroleum diesel that will make it either inferior that would cause the large discount in price?

Wai Sun Kwong

Yes. I would say that our biodiesel firstly, has all ready met the European standard. And secondly, as a high quality biodiesel product, it has got similar characteristics to diesel and therefore it represents a very good substitute for diesel.

Having said that, biodiesel have got it own problems. For example, it doesn’t work too well in very cold weather and also normal engines, the old engines, vehicle engines cannot take 100% of biodiesel, because it will have some of the rubber content of the vessel would not be worn away.

So there are some characteristics which are not -- have to be adjusted for and that's why we have suggested our clients or our customers to blend our biodiesel. But of course on the other side is that our biodiesel product provides a very clean energy and have far less emissions that diesel.

Rodney Hathaway - 1492 Capital

Is there are general perception amongst consumers that the biodiesel is a slightly inferior product? Would you say is that a fair comment?

Wai Sun Kwong

We have not actually investigated that area, I guess because previously, historically we have never faced the current type of situation before and our products have selling very well previously. I mean it still sells well, but of course the price is now a bit lower.

Rodney Hathaway - 1492 Capital

I guess just a last question is, kind of a follow-up from the previous caller that, I too have a little bit of a difficulty in understanding why there are such weakness in diesel demand when there is still growth out there. The growth may be have slowed this year, but it's till growing in a fairly robust pace.

Do you have a sense on what's your primary customer end market is? Is there a specific industry that your biodiesel is being been sold to that is showing extraordinary weakness relative to the overall economy? Do you have a sense of where you diesel is being sold?

Wai Sun Kwong

No. our customers are all local, very close to our plant and they are on average, mainly the independent privately-owned gas stations and typically they sell the diesel to mainly trucks, I would imagine for transportation of goods. Those sort of things.

I don't think there is any sort of specific area, but I do believe that the drop in export is a factor, which effect the current situation, but there again if the Chinese economy continue to recover at this sort of pace, we certainly still believe that it may be a timing difference in a sense of -- generally the real economy takes a bit of time for the pricing to return to normality.

Rodney Hathaway - 1492 Capital

Your share has -- have you seen any improvements in your local markets sense since the end of the quarter?

Wai Sun Kwong

I would put it, we are still not able to raise our price, but at least it's sort of stabilized. This situation is better than what happened at close to the end of the first quarter where prices were still dropping.

Rodney Hathaway - 1492 Capital

So, you've seen a stabilization in prices then?

Wai Sun Kwong

Yes, I would tell.

Operator

There are no further questions. I would now like to turn the call back over to management.

Wai Sun Kwong

Thank you again for joining our second quarter earnings call and we very much look forward to speaking to you again on our next call. Thank you.

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