L&L Energy: A 'China Agnostic' Value Investment

Dec.30.10 | About: L&L Energy, (LLEN)

L & L Energy (NASDAQ:LLEN) is a multi-segment coal producer and refiner that operates and sells within China. The company has four divisions: mining, wholesale, coking, and washing. The primary source of revenue at present is coal mining, with coal washing growing rapidly as the second largest contributor. The company grows primarily by acquiring smaller, less efficient competitors and modernizing their facilities. It currently sells for 6.42x earnings and looks like a good value based on both its current earnings and future potential.

The company is primarily equity-financed. Considering that the acquisition and renovation of under-performing mines is part of the company’s basic business plan, this presents existing shareholders with the problem of dilution as the company issues additional stock to help fund these acquisitions. The acquisitions over the past year and a half have increased the diluted weighted shares outstanding 50%. So far, however, the company has made excellent use of the money. Earnings and revenue growth have vastly outpaced the growth of shares outstanding, with revenue and earnings up substantially year-over-year.

The company presently sells for 2.8x book value. Most of the growth in its assets comes from the steady expansion of its PPE holdings, which makes sense for a mining company. The company’s assets are all valued in RMB, so in the event that China’s currency appreciates against the dollar in the future the assets will rise along with it. Since appreciation seems more likely at this point than depreciation, that seems like a (admittedly minor) point in LLEN’s favor.

An interesting quirk of Chinese law means that the mining assets are somewhat undervalued compared to other comparable operations. Although the machinery and operations are owned by individual companies, the land and its resources are technically the property of the Chinese government and are operated via a licensing agreement with the government. This seems to be halfway between outright ownership and leasing. The licensing fee appears to be a one-time expense, like a land purchase, and it grants right to perpetual exclusive use of the land but the license must be renewed periodically like a lease and a small amount of the proceeds from all products extracted are due to the government as a royalty. LLEN carries the mining rights on their books at a value of $3.8M, which seems like a pretty pessimistic evaluation of their true worth and suggests that LLEN might simply carry it at the cost of the licensing fees. Based on a comparison to recent deals like the recent purchase of new reserves by Natural Resource Partners for $.78/ton (see their 10-K), I can get a sense of the pure ownership value of the land. Known coal reserves on their properties amount to 23.5 million tons, which comes to $18.33M at the NRP deal price. Even if you substantially discount that value to account for the complicated ownership situation, the rights still ought to be worth two or three times their carrying value. Again, it’s a nice but minor addition.

Over the past three years the company has experienced rapid income and earnings growth:

TTM

2010

2009

2008

Revenue

$185M

$109M

$41M

$32M

Net Income

$45M

$33M

$10M

$1M

EPS

$1.55

$1.21

$0.47

$0.05

Click to enlarge

Margins have been extremely high in the past, but they are declining and will continue to do so as revenue increases. This is not indicative of any management or business problems; it comes from the expansion of lower margin business like coal washing and coking. On an individual segment basis margins seem relatively steady. Coal mining net margin was 42% in 2010 and 49% in 2009, with the difference presumably resulting from the differences in the newly-acquired facilities.

Mangement’s projections from earlier can be found here partway through the slideshow. They break down in percentage terms like this:

Management

% Breakdown

Revenue

218.0

100.0%

COGS

(137.0)

-62.8%

Gross Profit

81.0

37.2%

SG&A

(13.0)

-6.0%

Operating Income

68.0

31.2%

Other Expenses

(6.0)

-2.8%

Tax, Minority Int.

(15.3)

-7.0%

Net Income

46.7

21.4%

Click to enlarge

Overall, these numbers seem realistic and the period since they made these estimates has largely seen them achieved. Most of the increases in revenue should be achievable almost solely by the increasing output of the company’s now-modernized facilities. As they noted in the presentation above, many of their recent additions like the washing and coking plants operated at only 50% or less of their full post-renovation capacity as of the end of their last fiscal year. If the output figures are correct – and I’ll give them the benefit of the doubt for estimating something that simple – then the only other factor is demand for their products.

Demand should not be a problem. Judging by this index of Chinese coal prices demand is solid and growing. Other reports confirm rising Chinese consumption and, specifically, high demand in the immediate future due to a cold winter. With all that in mind, LLEN should have little trouble selling as much as it can produce.

In addition, the company has already shown indications that it could meet that goal. Trailing twelve month earnings are only a few million below the level expected for 2011, as you can see from the first chart, so the company needs to make only a modest amount of progress to reach the earnings guidance.

The only major threat to the company’s earnings would be taxes. The mining subsidiaries operate as partnerships, which apparently receive excellent tax treatment in under Chinese law. Washing and coking are not, which is presumably one of the reasons for their smaller margins. If Chinese tax laws change the company’s earnings could take a hit, so care would have to be taken to watch for any potential changes in their tax treatment.

The stock seems very overlooked by the market as a whole. Institutional investors hold only about 22% and few hold significant positions. The only sizable position is held by an investment firm called T-Squared that specializes in small-cap companies, particularly in the Chinese market. They hold just under 10%. No analysts at major institutions appear to follow the stock.

I’m guessing that a few factors might be putting off investors. One is uncertainty about the future of the Chinese economy. Investors who worry about a slowdown (or, more pessimistically, a collapse) in China’s housing market might be shying away from the stock for fear that it would likewise see sales decline. Others might be worried about the possibility of questionable accounting, especially in light of the apparent fraud committed by companies like RINO.

Both of those are worthwhile concerns, but I think they’re a bit misplaced here. First, LLEN appears to be “China agnostic” – it seems like at least a decent bargain regardless of your opinion on China’s economic health. Though some of the company’s revenue does come from coal coking (involved in the creation of steel), which would likely be affected by a decline in construction or automotive sales, coal coking is the company’s lowest-margin business. The most profitable division is the pure mining division, whose products seem to be directed towards power generation. Because fossil fuels (mainly coal) are the dominant power source in China this market seems more resistant to a downturn in the Chinese economy. If, on the other hand, the China bulls prove right, then demand for all forms of coal will continue to grow steadily.

Second, LLEN seems to benefit from good corporate governance. Let’s start with a few comparisons to RINO’s corporate governance:

Proxy Fun Fact #1: RINO made an unsecured, interest-free loan in the amount of $3.5M to its CEO and Chairman of the Board. Granted, they later amended it to include interest, but still…

Proxy Fun Fact #2: The RINO Board never actually met in 2009, which is perhaps how it missed evidence of massive fraud.

Proxy Fun Fact #3: The CEO and Chairman of the Board together own 63% of the company.

Proxy Fun Fact #4: The Board has only five members, two of whom (I bet you can guess which ones) control the company. The others have no virtually no stake in the company.

LLEN, in contrast, is a wee bit more investor friendly. The LLEN board has eight members, six of whom are independent (the others are the CEO/owner Mr. Dickson Lee and his brother Richard). Their credentials seem acceptable (even a former Cabinet member among them) and, given that they actually MEET, they seem to take their job more seriously. Mr. Lee holds a large stake in the company, a bit over 25%, but not such a large stake that outsiders would be unable to agitate for change or prevent abusive behavior by management. There also isn’t any weird corporate piggybank behavior.

The lack of attention might also come from its relatively recent listing on the Nasdaq. Until February 2010 the stock traded over the counter, so it might not have been liquid or visible enough for a lot of investors.

The core business seems sound, as do management claims. China’s mining industry is highly fragmented at present, with much of its capacity dispersed among many thousands of small local mines. Current government policy encourages consolidation within the industry by setting minimum quotas of 300,000 tons per mine. Such policies certainly seem to offer opportunities for a company like LLEN to profitably acquire a number of those small local mines. The coal industry in China has a horrific safety record, but that seems to be tied to the dispersal and poor resources of many of the smaller mines. I wonder if this is perhaps a Peter Lynch “ugly business” effect.

EPV-wise, the stock looks cheap based on reasonable 2011 projections:

Cost of Capital (nearly all equity): 11.13% is average – since this is a small and growing company 12% might be more conservative.

EPV = Net Income / Cost of Capital = 44 / .12 = $366.67M

A current market cap of $302M means that LLEN is selling at almost a 20% discount to its present earning power. When you throw in the company’s recent track record of profitable growth (which passes the return on capital > cost of capital test) and the aforementioned pro-consolidation government policies, that makes for an acceptable margin of safety. The stock is also nicely priced in relative terms. At 6.42x earnings, it’s well below both market and industry averages.

In addition to nice ROIC numbers, recent events show that the company is making intelligent growth decisions. Back on November 29 LLEN announced that it had entered into an agreement with a mine in Colorado (the Bowie Mine) to loan them $3M at 9%, with the option to acquire a 9% stake for a “nominal” price.

If that sounds like a great deal, that’s because it is. I have to guess a little since they only release output figures annually, but LLEN’s total mining output is probably in the 700,000-750,000 ton range. The Bowie Mine’s output is between 4 and 5 million – split the difference and call it 4.5M tons. A 9% share of that comes to 405,000 tons. It’s a bit of an oversimplification to simply add on LLEN’s minority interest to their existing capacity, but from an earnings standpoint it increases their output around 54% for a small price. They haven’t revealed how small that price is, but any amount smaller than the loan itself would be a great deal.

LLEN had to pay several million dollars for each of the mines it currently owns and several million more to renovate them with new equipment. Even if the equity interest in Bowie Mines costs $3M, the full loan amount, it would be far less expensive on a dollars per ton of output basis than any of their present mines. For reference, the Ping Yi Mine (their newest acquisition) cost $3.96M without even including post-acquisition renovation expenses. That price bought an output of 300,000 tons per year once all renovations are complete. LLEN got a pretty good return on that deal: fiscal year 2010 revenues of $22.7M and $8.2M of net profit (the payback period on that one is pretty quick, ain’t it?).

The Bowie Mine deal looks even better. For a lower price – especially once the interest payments are subtracted out of the equity option price – the mine acquires 33% more output. LLEN doesn’t release quality specifications, so it’s impossible to directly compare the output quality of the Bowie Mine with their existing mines. But, since the Bowie Mine produces very high quality coal, it’s probably safe to say that the Bowie coal would sell for at least as much as the coal LLEN is already selling. The deal looks like solid value from every perspective.

I was actually a bit suspicious of how well the deal seems to work out for LLEN until I saw a local newspaper article which mentioned that the mine’s property taxes are currently past due. This explains two things: (a) why the terms seemed so favorable and (b) why the press release emphasizes that the loans are co-senior secured. Bowie seems to have fallen on hard times as a result of reallocating equipment within their mines, which presumably allowed LLEN to dictate terms. The seniority is appealing too, since it guarantees LLEN a bigger piece of the pie if Bowie can’t turn things around. Unless Bowie’s debt burden is truly crushing (and unless all of said debt is owed to GE Energy Financial, the other senior creditor), the value of the Bowie Mine’s reserves should fetch enough in a sale to recover the loan’s full value. It looks like LLEN has great downside protection in addition to its clear upside.

This all sounds too wonderful and gushy, so I’ll close out with some downsides. It’s a Chinese small-cap stock, so the volatility is...interesting. It’s been up and down almost 30% since I first wrote about it on my blog, which was only a fun ride for about half the journey, and it’ll probably continue to be very active. Also, if China sees some Jim Chanos “treadmill to hell” action, the stock will take a monster hit - as will the company, ‘cause that won’t be a normal downturn. There’s also the risk that the proceeds from future stock offerings will not be invested as successfully as before and will dilute earnings faster than their investments grow them. Finally, companies involved in China often do have questions about their accounting, and the same could prove true for LLEN despite its outwardly superior corporate governance and US-based operations. Investors who dislike that kind of uncertainty might want to look elsewhere.

With all that said, however, I do believe that current prices provide enough of a margin of safety to make LLEN a compelling value investment.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.