On October 5, 2010, I wrote an article about Gushan Environmental Energy (GU). At the time, the stock was trading at 64 cents, and I highlighted some fundamental information that led to my investment thesis that the stock is worth $2.50 per share. GU last closed at 99 cents, which represents a 55% increase, due in my opinion to the acquisition of Jin Xin and the announcement of the share repurchase program. In this follow-up article, I will outline management’s answers to some tough questions, surrounding what I believe to be key issues affecting the share price.
The main driver in valuation I believe are GU's production facilities (PPE) being heavily discounted by the market, evident by its market capitalization equalizing approximately 30% of its tangible shareholder’s equity. See my last article that provides links to SEC filings to support this statement. My investment thesis is strengthened by some of the words from GU management below. Particularly, management expressed the belief that both the government and private corporations will have a strategic interest in GU's production facilities if and when China follows the lead of other countries and mandates a blend of biofuels in transportation fuels production. This has been talked about in China for several years and management believes a similar mandate will take place in China. This same mandate is already taking place around the world, including in some states in the U.S.
Additionally, management believes that GU can return to profitability given today’s diesel prices, should they be able to operate at full capacity.
In another recent development, GU announced Wednesday that it is enacting a change in ADR ratio (effectively, a reverse split), which will bring its share price to roughly $5. This act essentially takes delisting off the table, with a share price 400% higher than the $1 NYSE minimum. News of a reverse split can sometimes be taken negatively, though in my opinion, in this case it is extremely good news because the company was facing delisting as its only other option. Remaining NYSE listed will provide for better valuations through more exposure and liquidity. Ceasing to be a "penny stock" would also provide an opportunity for institutional investors to buy, whereas before, many mutual fund by-laws prevent the purchase of stocks under certain price benchmarks. By the same token, it may also pave the way for sell-side analysts to pick up coverage, which I think they should given that Gushan is China's largest producer of biodiesel.
What follows will be an outline of my questions with management’s response copied in verbatim with no editing. I have communicated to President Wai Sun Kwong my intentions to post his responses through this form of media and he has provided his consent.
Q) What is your feeling on whether the consumption tax issue will have a resolution in your favor? If it is ruled in your favor, would you immediately switch back to biodiesel production for the refined oil industry? And how close to profitability would you be given today's diesel prices and raw materials prices?
A) We remain confident that the consumption tax ruling will be in our favor. However, we do not know when such ruling will be determined as we understand that this issues is being handled at the highest authority within the Chinese Government. If the ruling is in our favor, we expect to focus back to biodiesel production and we should be profitable under current market conditions if we can produce at or close to full capacity.
Q) What is the progress on sourcing Castor Bean oil from Indonesia?
A) The progress of the sourcing of castor bean from Indonesia has been slower than expected. This is mainly due to quality and quantity issues faced by our suppliers/farmers which we are trying to help to resolve. Once we are able to resolve such issues then we would be able to move on to sign up additional contracts. We require a large quantity of castor bean oil and the cheapest way for us to purchase is to sign up contracts with supplier/farmers who manage/grow the crop.
Q) Is the chemical business profitable? If you stripped out biodiesel sales altogether, could your chemicals business including sales of biodiesel to the chemicals industry be profitable standing alone? How long would it take to ramp up production to produce the chemicals business at 100% of your plant's capacity, and would this be profitable on a net income basis?
A) As mentioned in our latest results release, we are planning to develop products to sell into the chemical industry which we believe would be profitable for us. However, it is still in the early stage and as such we are unable to provide the exact ramp up timing. We believe 100% chemical production would be profitable on a net income basis for us although we have not planned to have 100% chemical production as we hope the biodiesel business would return before we get there.
Q) Why did you buy Jin Xin? Do you feel that its industry is expanding in China? Do you feel you got a good price, and what is your holding period for this investment? Are there any synergies operationally or is this purely a financial investment?
A) We bought Jin Xin because we believe in its management and it is in an attractive sector where the demand is very strong. Copper recycling as well as other metal recycling is certainly a sector which is expanding in China. We felt that we have purchased it at an attractive price: issuing Gushan shares at US$1 (ie US$2 per ADS) shows that Gushan’s current share price is substantially undervalued. Also, Jin Xin’s owner/management has given a 3 year of guaranteed profits which would contribute meaningfully to the overall financial performance of Gushan. There is however no synergy between Jin Xin’s business and Gushan’s business. We see the acquisition of Jin Xin as a strategic investment for Gushan in that Jin Xin’s owners/management are like partners with us and if Jin Xin proves to be successful we will expand its business together by either expanding production facilities or acquiring companies in the same business.
Q) Given that the market is pricing GU's assets at a small fraction of your book value (shares trade even below cash right now), what is your feeling on the actual market value of your PPE that is sitting idle? Can you give you a range to what you think the PPE is worth on the open market right now?
A) It is difficult to put a market value on our PPEs as they are purposed built and involve proprietary technology. However, how we would see the value of our PPEs (and Gushan) is that as you know currently there is no government mandate to blend biodiesel into diesel in China despite being discussed for a few years. In the last few years whilst China has been discussing the biodiesel mandate, many countries around the world like Argentina, Malaysia, Indonesia etc. have moved forward and issued biodiesel mandates. Even in the US, where it has been far behind in the development of biodiesel, quite a number of States now have biodiesel blending mandates. As such, we believe a biodiesel mandate in China will happen at some point in time (again timing is always uncertain in China) and when it happens, our PPEs (or Gushan) will have strategic value to government/corporations which wish to or need to go into the biodiesel business as we have the largest capacity in China.
Q) How does management look at GU as a profitable entity going forward? Do you feel as if the long term outlook is bright? If so, any chance of share repurchases? Is management buying shares personally?
A) Our management remains confident in the long term prospects of Gushan although there are short term issues to be resolved. For Gushan to return to profitability is the highest priority of our management and we believe the acquisition of Jin Xin is one step towards the right direction. Our confidence is shown by the recently announced US$5m share repurchase program.
Disclosure: Long GU