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Charles Hicks
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I am a thirty-something manager at a large publicly traded company. Most of my investing focus is on smaller companies offered at a significant discount to intrinsic value, although I frequently short shares I believe are overvalued. In either case I seek to buy and sell based on a compelling... More
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  • Sino Gas International Holdings (OTC: SGAS) - A compelling value
    The market is flush with companies whose shares have dramatically increased in price during recent months. While in many cases these increases were justified by unreasonably low valuations, outstanding bargains still remain. I would like to introduce a small Chinese company which should appeal to value-focused, long-term investors with a bullish outlook on China. 
    Sino Gas (OTCQB:SGAS) is a natural gas service provider whose activities include installation and operation of natural gas systems to residential and industrial customers in eastern China. As of June 30th 2009, Sino Gas owned and operated 37 natural gas systems serving about 100,900 residential customers and five commercial customers. The distribution systems are located in small-to-medium sized cities with populations of between 100,000 and 300,000. Prior to Sino Gas presence, these smaller cities had no access to natural gas and their residents relied on burning coal for heat. With China pursuing reduced coal use to minimize pollution, local governments offer enticing incentives for private companies to provide natural gas. In each of their locations, Sino Gas was granted a minimum of 25 years of exclusive rights to supply gas service. 
    Figure 1. Locations of Sino Gas distribution systems as of 12/31/2008 (SGAS 10-K)
    The company generates sales through fees for installing new residential connections (usually $300 - $400 per connection at over 60% gross margin), and through sales of natural gas (typical prices are $0.30 - $0.40 per cubic meter at about 9% gross margin). Natural gas is supplied to Sino Gas by state-owned oil majors such as SinoPec and PetroChina. While Sino Gas controls the price it charges its customers, the state determines the price of natural gas – a benefit for Sino Gas, since China’s heavy emphasis on reduced pollution should help keep supply prices low for years to come.. 
    In the short-term, a natural result of the company’s profitable connections business is sensitivity to Chinese real estate trends. When conditions are favorable for rapid development of apartments and single-family homes, Sino Gas reaps outstanding benefits as it did in 2007. Similarly, real estate development slowdowns cause sharp drops in Sino Gas profit. Perhaps the worst such case in our lifetime occurred during 2008, when Beijing construction activity was stopped for the summer Olympics just as a financial crisis rippled around the world.    
     In the long term, despite the tough year in 2008, Sino Gas is well positioned to become a  thriving cash cow, offering exclusive provision of a critical clean energy supply in a nation abounding in gas reserves. As one would expect, customers continued purchasing through the winter’s financial crisis, as the company cruised to a 67% increase in annual gas sales vs. 2007. Gas sales continued increasing at a 23% clip as of Q2 2009. With only about 10% residential penetration in its operating areas, Sino Gas revenues are expected to grow for years to come. Growing gas sales should come not only from new customers, but also growing same-customer sales year over year as the Chinese increasingly use natural gas for heating, cooking, and even drying clothes. Average consumption increased from 187 to 344 cubic meters between 2006 and 2008. Estimating 500 cubic meters of annual consumption at $0.50 per cubic meter, with 500,000 households by the year 2020 (about a 50% market penetration), Sino Gas sales would be $125 million annually. The company’s market capitalization stands at $11.4 million today.
    Sino Gas is solidly profitable, and has no long term debt. Shareholder equity is $58.6M, giving it a price-to-book ratio of 0.2, with net tangible assets consisting largely of distribution system equipment, accounts receivables, and minority interests.    Its P/E ratio on estimated current year earnings of $3M is about 4 (P/E = 7 using 2008 earnings), and operating cash flow has been firmly positive year after year, surpassing $4M in 2008 despite the crisis. Why then, one may ask, is the relative valuation so low? 
    Heavy capital expenditures prior to market crash. Sino Gas made approximately $54 million in capital investments during 2006-2008 associated with pipeline construction and acquisition of smaller gas distributors. These investments were funded largely by over $30 million in equity offerings in 2006 and 2007 at average pricing of about $2.50 per share, as well as cash from operations and some loans.   In 2008, total net income was $1.6 million on a $70 million asset base, representing a return on investment much lower than typical costs of capital. Since pipelines are depreciated using a constant rate, depreciation cost as a percent to sales is likely to remain high per new connection and per cubic meter during the coming 2-4 years as the customer base grows in each city. Consequently, although the company enjoys guaranteed revenue, Sino Gas will find it difficult to finance expansion into new cities until net earnings are increased without new loans or equity issues – unless they find a liberal loan officer! It is worth noting, however, that as recently as September 2009 the CFO reiterated the company’s ambitions to expand into 60 cities in coming years ( interview)
    A series of unpleasant surprises and temporary loss of investor confidence. Regardless of cause, the period from mid-2007 through all of 2008 was a frustrating time for Sino Gas shareholders. The Company had repeated financing gaffes, including missed make good targets causing shareholder dilution, a failed acquisition attempt in a fairly large city (Baoding) during which time nearly $2 million of cash was tied up as a deposit, a CFO replacement, and fines due to failed registration of privately placed shares for sale. On top of the disappointing earnings, all this proved too much for shareholders as the market collapsed.  As recently as March, shares traded hands at a stunning price of $0.06, valuing Sino Gas at $1.5 million.
    Sino Gas offers enduring shareholder value. Hopefully it is clear from the above that while the decrease in share price since 2007 has been catalyzed by events that justify concern, the underlying enterprise value of Sino Gas remains quite intact. A web search of cities where Sino Gas operates (i.e., Qujing, Nandong, Zhangjiakou and etc.), will give a quick intuitive sense of the scale of operations in the company’s future. Urbanization and increased Chinese residential use of natural gas are firmly entrenched economic trends, and Sino Gas has already deployed the capital to service millions of residents for years to come without further financing. Below, using a discount rate of 20%, I calculate the net present value of Sino Gas at $91.8 million, or about $3.06 per share. This is well above the requirements for listing on a major stock exchange, where valuations are frequently higher.
    The valuation model assumes 37,000 customers added per year between 2010 and 2020, with a flat rate of $350 per connection. The annual gas use per customer is projected to trend upwards at 3% per year from 358m3 to 500m3, reflecting increased domestic use as Chinese consumers become more accustomed to natural gas. Per unit gas prices also trend upwards at 2% per year, although the benefit of this price increase would likely be offset somewhat by higher gas prices from state-owned enterprises.    Gross margin from gas sales doubles from 8% to 16% as depreciation costs decrease as a percent to sales. Gross margin from connections is held flat at a lower-than-average 60%, partly as a buffer against overestimating profit from connection fees due to inevitable volatility in real estate markets. 
    Sales, general and administration expenses are modeled with gradual increases at a rate lower than sales growth, reflecting significant opportunity to leverage sales growth to bottom-line earnings as Sino Gas grows its customer base in existing territories. There should be minimal incremental expense in maintaining customers with gas connections, and low-cost recurring business with real estate developers paying gas connection fees as they construct apartments in each city. As natural gas penetration plateaus in the coming years, operating expenses could even decrease with no need to manage a large connections business. Nevertheless, the model conservatively includes sales and operating expense increases from about $5M in 2009 to over $10M in 2020. Note:Taxes are included in general expenses for simplicity.
    Based on these projections, earnings are estimated in the tables below, with annual earnings after 2020 being flat at about $15.3M. 
    Sales and profit values in millions
    Sino Gas Distribution Business Model   
    YearGas customersGas consumption (m3)Gas priceGas salesGas sales gross marginGas Sales Gross profit
    2010150000368$0.40 $22.098.00%$1.77
    2011190000379$0.41 $29.407.00%$2.06
    2012230000391$0.42 $37.398.00%$2.99
    2013270000402$0.42 $46.129.00%$4.15
    2014310000414$0.43 $55.6310.00%$5.56
    2015350000427$0.44 $65.9811.00%$7.26
    2016390000440$0.45 $77.2412.00%$9.27
    2017430000453$0.46 $89.4813.00%$11.63
    2018470000466$0.47 $102.7514.00%$14.38
    2019510000480$0.48 $117.1315.00%$17.57
    2020550000500$0.50 $137.5016.00%$22.00
    Sales and profit values in millions

    Sino Gas Connections Business Model  
    YearNew ConnectionsPrice per new connectionConnection salesConnections Gross margin percentConnection gross profit
    200624500$294 $7.20 78.53%$5.66
    200739306$330 $12.97 75.77%$9.83
    200826770$347 $9.29 68.71%$6.38
    200936268$350 $12.69 60.00%$7.62
    201037000$350 $12.95 60.00%$7.77
    201137000$350 $12.95 60.00%$7.77
    201237000$350 $12.95 60.00%$7.77
    201337000$350 $12.95 60.00%$7.77
    201437000$350 $12.95 60.00%$7.77
    201537000$350 $12.95 60.00%$7.77
    201637000$350 $12.95 60.00%$7.77
    201737000$350 $12.95 60.00%$7.77
    201837000$350 $12.95 60.00%$7.77
    201937000$350 $12.95 60.00%$7.77
    202037000$350 $12.95 60.00%$7.77

    As mentioned above, earnings are projected to be flat at $15.3M from 2021 onwards as connection business decreases are offset by growing gas sales and reduced administration costs. Net income is estimated by subtracting sales & admin expenses (which include taxes for simplicity) from total gross profit. For example, in 2013, estimated total gross profit is equal to $4.15 + $7.77, or about $11.92. Sales, admin, and tax expense is estimated at $6.50, yielding $11.92 – $6.50 = $5.42 in net income, having a discounted value of $5.42/[(1+0.2)^(2013 – 2009)] = $2.62
    Sales and profit values in millions
    Sino Gas Earnings Forecast    
    YearTotal salesSales and Admin as a percent to salesTotal gross profitSales and admin expenseNet incomeDiscounted earnings using 20% rate
    2006$10.85 12.87%$6.47$1.40$5.07N/A
    2007$22.11 14.83%$10.98$3.28$7.70N/A
    2008$21.49 27.28%$7.46$5.86$1.60N/A
    2009$27.90 17.00%$8.88$4.74$4.14$4.14
    2010$35.04 15.25%$9.54$5.34$4.19$3.49
    2011$42.35 13.00%$9.83$5.51$4.32$3.00
    2012$50.34 12.00%$10.76$6.04$4.72$2.73
    2013$59.07 11.00%$11.92$6.50$5.42$2.62
    2014$68.58 10.00%$13.33$6.86$6.48$2.60
    2015$78.93 10.00%$15.03$7.89$7.13$2.39
    2016$90.19 9.50%$17.04$8.57$8.47$2.36
    2017$102.43 9.00%$19.40$9.22$10.18$2.37
    2018$115.70 8.50%$22.15$9.83$12.32$2.39
    2019$130.08 7.75%$25.34$10.08$15.26$2.46
    2020$150.45 7.00%$29.77$10.53$19.24$2.59

    Summing discounted earnings from 2009 through 2020 gives the following enterprise value for Sino Gas:

     Dollars in millions excluding price per share
    Discounted earnings$33.15
    book value$58.60
    enterprise value$91.75
    price per share (using 30M shares)$3.06
    Rapidly increasing average trade volumesIf the above is insufficient motive to purchase shares, it is worth mentioning that the trading activity for Sino Gas stock has been quite favorable in recent weeks. Shares are at the middle-to-low end of the trading range in the last three months, with strong volumes and consistent buying occurring in the $0.40 - $0.45 price range. Investors buying at this price point would appear to have minimal downside and tremendous upside potential. See charts below.

    Disclosure:  Long SGAS
    Sep 17 9:35 AM | Link | 5 Comments
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