The occurrences in the past two years for Chinese biodiesel and specialty chemicials producer Gushan Environmental Energy Limited (GU) spell disaster for the share price, and indeed it has dropped 96% from all time highs to its current price. Let us take a moment to look at the bigger picture along with GU’s fundamentals, including some detailed analysis of its financial statements. It is this author’s opinion that the current ADS price of GU drastically and unfairly understates the intrinsic value of the company based on current tangible asset values and potential good news of the company going forward.
GU listed its shares on the NYSE at the very end of 2007, during peak oil prices. The shares traded for $9 at the onset, peaked at $17 in 2008, and have since crashed to below $1. GU, a producer of biodiesel and specialty chemicals, boasts on its website that it is China’s largest biodiesel producer by volume, and the company is still building new plants to expand production. A perfect storm of bad news for GU sent its shares plummeting. Initially, the global economic meltdown put pressure on diesel prices. At the same time, raw materials in the form of recycled vegetable oil increased due to inflation in China.
More recently, authorities have levied a consumption tax on biodiesel being sold to the refined oil market in one of the provinces for which those local tax authorities have jurisdiction and in which GU has plants. In response, management challenged the ruling and stopped selling its products to the refined oil market in those affected plants pending resolution on the consumption tax ruling by local tax authorities in order to limit its tax liabilities.
Diesel prices have since recovered to a point where GU would want to produce it, though the company has recently shifted focus to both specialty chemicals and selling biodiesel to the chemicals industry to avoid the consumption tax. Management has vocalized that it can shift back and forth to produce either, and that it intends to produce biodiesel for refined oil once the consumption tax issue is resolved.
Let us do some analysis on GU's financial statements.
Cash balance, as of the latest earnings release in August 2010, was $73.1MN. Total assets were $323MN. For analysis purposes I will include tangible assets only (subtract Land Use Rights of $12.5MN) to arrive at total tangible assets of $310.5MN. There are 83.416MN ADS shares outstanding. GU has no debt. Let’s recap the balance sheet.
Total Tangible Assets of $310.5MN
Total Liabilities of $37.7MN
Total Tangible Shareholders Equity (Tangible Book value) of $272.8MN
Versus $53.4MN of current market capitalization
$3.27 per ADS of tangible book value
$.88 per ADS of cash (with no debt)
Versus $.64 current share price
-- Share price discount to cash balance = 37.5% --
-- Share price discount to tangible book value = 410.9% --
All Figures are quarterly as of latest earnings release:
Cost of Sales: $13.8
Gross Loss: $4.9MN
Let us delve into Cost of Sales. Depreciation in the quarter was $5.4MN. Depreciation is a non-cash expense, meaning GU doesn’t actually pay the money to anyone, but rather they write down the value of the PPE by a pre-determined amount every year. If you remove the non-cash depreciation expense, GU is actually profitable on a gross margin basis (purely net of sales revenue and cost of raw materials). GU is profitable by $500,000 in the last quarter.
This fact may be overlooked by the market. Even in the worst of times, when the ADS price is below $1 (well below cash balance), and the markets and oil prices plummeted, and after temporarily suspending operations at several plants, GU is actually profitable on a pure gross margin basis. This means that GU can still sell its final product for more than it costs to physically produce it. This view is on a cash basis, which is the reason why GU’s cash balance has not decreased all that much, even in the face of large net income losses.
Cash Flow Statement
If any readers are uncomfortable with the logic above, the Cash Flow Statement can provide confirmation. During the last quarter when GU reported a net income loss of $15.9MN, Cash Flow from Operations was only $-3.2MN, reflecting the fact that depreciation and a PPE Impairment Charge, both non-cash expenses, account for the majority of the loss. The cash balance in GU is safe, and will not be coming down alongside net income.
Valuation and Big Picture
Now let us take a look at the bigger picture. GU is in a tussle with local authorities which are punishing all companies that sell biodiesel products to the refined oil industry simply because a handful of companies mix small amounts biodiesel into fossil diesel in order to bypass the consumption tax that they should rightfully pay on diesel sales. Management commented on this and provided the following insight on the situation during a conference call.
“I think what happened was that there are a lot of people who have avoided this consumption tax by just claiming that they are making biodiesel. But really, it's just maybe putting a little bit of so called biodiesel into diesel products and selling it and claiming that they are selling biodiesel, therefore not paying the consumption tax.... I think the government is trying to closeout those players, but not realizing that it will be hurting the real biodiesel producers. That's our reading of it."
In response, GU shut down some of its operations and switched them to produce specialty chemicals, which are exempt from the consumption tax.
Current tangible book value per ADS is $3.27, and current cash balance is $.88 per ADS representing premiums of 410.9% and 37.5% to current ADS price respectively.
The cash balance is fairly stable as the majority of the net income losses are due to non cash expenses such as depreciation. On a pure gross margin, net of sales and raw materials, GU is actually still profitable despite several plants sitting idle.
In this author’s opinion, the current share price of GU is pricing in far beyond a worst case scenario, especially given the fact that GU is not losing its cash balance. The most devastating blow to GU would be if all local tax authorities in all regions decided to tax biodiesel in the same method. Doing this would mean that China is advertising to the world that it is not only refusing to help its Renewable’s businesses, but is actually punishing them more than non-Renewables (chemicals do not pay consumption tax). This of course makes little sense, and in this author’s opinion, this will not happen. In the worst case scenario that this did happen GU would switch all production to chemicals (they have already succesfully done this partially), and would still be valued near its tangible book value of $3.27 per share.
In reality, what may happen is that the local tax authorities side with national sentiments toward assisting Clean-Tech, in which case GU would bring its plants back online to produce biodiesel and at a bare minimum would be very close to breakeven in its P&L. Should this happen, the share price could correct back up to its tangible book value per share of $3.27.
In summary, GU’s valuation is currently 37.5% below cash balance with no debt, and many times below its tangible book value. The market has completely written down the value of GU’s assets as they are currently not producing the products for which they are capable. GU is already beginning to prove that it can use its PPE assets to produce specialty chemicals at a profit, which should be a catalyst for stock price appreciation even with no consumption tax resolution.
At a bare minimum, at this current point in time when many of the plants are sitting idle awaiting resolution from local tax authorities, this author believes the intrinsic value to be roughly $2.50 per ADS which is based on a liquidation perspective of selling its PPE for a discount of 35% to book value. In reality the land and PPE GU owns have probably appreciated during China’s impressive economic growth period, and so this value is somewhat conservative. This intrinsic value represents a premium of 290% to the current ADS price.
In recent developments, GU has purchased a 67% interest in Jin Xin Copper Limited. The transaction involves paying for the company in GU shares valued at $2 per ADS, a premium of 213% to the current ADS price of $.64. Jin Xin agreed to be paid in GU shares that Jin Xin valued at more than three times GU’s current ADS price on the NYSE. These actions would confirm the thesis put forth in this article that GU is being improperly valued at current prices.
Finally, Michael MacPhee, a partner in Baillie Gifford, an $87 Billion Dollar investment advisor, commented on September 28, 2010, that he was adding GU to his Mid Wynd International fund, which is capable of making bets on stocks that are “too small or too specialist to sit comfortably in Baillie Gifford’s two larger investment trusts.” He describes Gushan, along with eight other companies as "...rapidly growing and high potential businesses in out of the way places."
The fund's stock picks have outperformed the S&P500 by 30% so far in 2010, 40% since 2009 and 47% since 2008. This fund has a strong history of making exceptionally good stock picks in the last three years. The fund is now picking GU for price appreciation in September 2010. This author is as well.
Disclosure: Author is long GU