Eastern Environmental Solutions: Cash From Trash

| About: Eastern Environment (EESC)

On August 16, 2010, we began to consider Eastern Environmental Solutions (OTCPK:EESC) as a bargain. Recall that we have been tracking this story since March 10, 2010. In its March 2010 first quarter, the company reported net income of $1.2 million or $0.07 ($0.06 taxed). While not overly undervalued at the time, aided by capacity expansion and a resumption of operations in late 2009 (a), we surmised that the company might be able to exceed its $4 million 2010 net income run rate and report sequentially higher EPS for its 2010 second quarter.

On August 16, 2010, the company filed its 2010 second quarter 10Q which highlighted the results of what could be a break out quarter. The related press release shed some more light on the quarter:

  • Revenue increased 1071% to $5.2 million.
  • Gross profit increased 706% to $2.9 million Income from operations increased 1173% to $2.8 million.
  • Operating margin increased 385 basis points to 53.3% from 49.5%.
  • Net income increased to $2.4 million from $180,511 in 2009 $7.2 million of working capital.
  • Diluted EPS increased to $0.24 ($0.21 fully taxed) from $$0.02.
  • Shareholders' equity of $16.7 million.

Ms. Feng continued, "The major factor contributing to our strong sequential revenue growth was the shift in our strategy to include recycling polyethylene terephthalate (PET) plastic bottles and plastic bottle caps, which we implemented in the first quarter of this year and began generating substantial revenue in the second quarter. In addition to separating plastic bottles and plastic bottle caps from our own landfill, we have established relationship with local collection points which provide us with much larger and more stable supplies of plastic bottle waste than we had previously collected on our own."

Ms. Feng says, "In addition to providing a valuable new revenue stream, our PET recycling removes waste from our landfill and, in turn, increases our overall disposal capacity at the landfill. Looking ahead, we are focused on further expanding our waste processing operations by implementing additional recycling technologies that will provide new revenue streams from our landfill. At the same time, we are actively seeking new landfills we can either develop or acquire. Given the overwhelming growth of Harbin and other cities within Heilongjiang Province, there is enormous demand and government support for new landfills and recycling technologies."

Simply put, what we have here is a company with:

  • An annuity type revenue stream (via landfill business with the government) that found a way, through its recycling business strategy, to tap into an environmentally friendly growth market.
  • A break out quarter that is likely sustainable.
  • Pre-tax margins of over 50.0%.
  • Cash flow from operations that has turned positive and is tracking at a $2.0 to $3.0 million annual run rate.
  • A Current ratio of 5.24 to 1
  • A top tier auditor (Friedman LLP)
  • Sufficient liquidity to maintain its current business levels. However, at some point, EESC will likely need to raise capital to fully implement its growth strategy, but we are currently not overly concerned about this issue in the near term.
  • A clear intent to up-list to a senior exchange as indicated in our August 9, 2010 research note and by company comments in Monday's press release:

During the quarter, we also enhanced our leadership team with the addition of three new independent directors. These three new board members bring a wealth of industry experience as well as financing and accounting experience that will be instrumental as we prepare for the next phase of our growth. As a result of these board appointments, we believe we meet most of the qualifications to list on a senior exchange.

At near $3.00, EESC is trading at 2.7 times its book value per share of $1.12 and a meager 7.3 P/E times our annualized tax adjusted 2010 EPS expectation of $0.41. If the market sentiment for ChinaHybrids abates and SAIC not matching SEC filings issues fade away, we think investors could flock to EESC shares. Short-term investors may have to exercise patience as EESC is trading at trailing tax adjusted P/E of around 14. (Although a P/E of 25 may be warranted).

(a) On June 13, 2007, the company filed a Form 8-K with the SEC, announcing that in accordance with the PRC National Environment Protection Bureau’s request in relation to landfills and adjustments to their peripheral inhabitants’ well-being, the Harbin municipal government city administrative bureau was carrying out certain adjustments to the original landfill plans of our subsidiary, Harbin Yifeng Eco-environment Co. Ltd. (“Harbin Yifeng”). Such adjustments resulted in the relocation of some peripheral inhabitants of the landfill and its waste water disposal plant. The costs of such adjustments will be borne by the Harbin municipal government city administrative bureau. These measures disrupted Harbin Yifeng’s normal operations. After careful consideration, our Board of Directors decided to temporarily suspend Harbin Yifeng’s operations while the measures were being carried out. However, Harbin Yifeng was still entitled to collect the minimum fixed fees for the Suspension Period as per the “Special Permission Operation Rights Contract”, which Harbin Yifeng had signed with the Harbin municipal government city administrative bureau on September 1, 2003. The bureau was required to compensate and pay Harbin Yifeng a sum equivalent to the fee for disposing 800 tons of waste per day during the Suspension Period.

Disclosure: Long EESC at time of this writing