A China-Based Play On The Global Fracking Boom

| About: Recon Technology, (RCON)
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(Editors' Note: This article covers a small-cap stock. Please be aware of the risks associated with these stocks.)

The technology and energy sectors should benefit from accelerating global economic growth in 2014. The rising tide won't lift all boats, but there's one vessel that appears poised for a promising journey: Recon Technology (RCON). The company is not only a play on increasing technology demand next year but also on the continued prosperity of the energy industry.

Based in Beijing, Recon provides hardware, software, and on-site services to companies in the petroleum mining and extraction industry in China. It also offers equipment necessary for oilfield production, as well as industrial automation control solutions.

Oil and gas engineering applications are a major growth opportunity for Recon, as the booming energy patch in China increasingly relies on the company's leading-edge products.

With a market cap of $21.4 million and 82 full-time employees, this small-cap company is leveraging the growing prevalence of hydraulic fracturing to extract oil and gas from shale formations-a technique known as "fracking" that has exponentially boosted energy production in North America. Now China wants to reap the benefits of fracking and companies like Recon are lining up to help.

Founded in 2007, Recon Technology is the first Chinese non-state-owned oil and gas service company to go public in the US. This year, the company signed several multimillion dollar fracturing projects that should provide long-term growth. Notably in 2013, it inked deals worth RMB 30 million ($4.8 million) with China Petroleum & Chemical (SNP), otherwise known as Sinopec, which is thriving from China's growing need for natural gas.

The second largest of China's national energy companies by market cap, Sinopec is a major producer of both oil and natural gas. The company holds an extensive midstream network and is the county's dominant refiner.

Sinopec is also one of only a handful of companies licensed to engage in exploration and production in China. Recon's partnership with Sinopec should pay off over the long haul, as China increasingly embraces fracturing and the related technologies in which Recon specializes.

Recon also benefits from its tight relationship with the Chinese government, which is implementing policies to promote the exploitation of shale gas by making subsidies available for gas development companies, especially fledgling tech companies such as Recon.

This scrappy China-based technology company is in the frontlines of the Middle Kingdom's budding energy revolution, but it should also get a boost from the improving fortunes of the overall tech sector.

To be sure, domestic political paralysis in the U.S. combined with flagging technology demand in emerging markets has been weighing on the once high-flying technology sector. Year to date, the Technology Select Sector SPDR Fund (NYSEARCA:XLK) has generated a total return of 13.7 percent, compared to 23.3 percent for the S&P 500.

In a year of government indecision and market volatility, corporations are facing difficulty in planning their technology expenditures. JPMorgan's global technology analysts have lowered their IT spending forecast for 2013, down to a gain of 0.3 percent from 0.6 percent. More encouraging, though, is JPMorgan's outlook for a 3.6 percent gain in 2014. This tech tailwind will combine with growing energy demand to make the coming year a promising one for Recon.

The Push for Cleaner Energy

As it combats an increasingly horrific pollution problem while also striving to meet the insatiable energy needs of its industries, the Chinese government is pushing clean energy fuels, primarily natural gas.

November marks the beginning of peak Chinese heating season and already in some Chinese cities, the air density of fine particulate matter is reading well about 600 micrograms per cubic meter. Some readings have even exceeded 1,000. According to the World Health Organization, the safe reading is 25 micrograms. Some highways and schools have been closed this month and flights cancelled due to low visibility caused by smog.

The upshot: As pollution worsens in the Middle Kingdom, natural gas is adopting a starring role in the world's second-largest economy. And that's where Recon comes in. China's leaders believe that existing extraction technology is inefficient in developing domestic shale strata, thereby paving the way for aggressive technology companies such as Recon.

Recon's products include high-efficiency heating furnaces designed to extract impurities and prevent blockage in pipelines carrying crude oil; multipurpose "fissure shapers" that perforate the surface and improve the ability to test for and extract petroleum; and horizontal multistage fracturing.

Recon has benefited from global economic recovery and the increased energy demand that comes with it.

The company's total revenue for the year ended June 30, 2013 was RMB76.6 million ($12.4 million), an increase of RMB1 million or 1.4 percent from RMB75.5 million for the year ended June 30, 2012. This revenue growth was largely driven by demand for the company's fracturing services.

Gross profit in fiscal 2013 jumped to RMB25.1 million ($4 million) from RMB24.3 million in the previous year. Gross profit as a percentage of revenue increased to 32.7 percent from 32.1 percent in the previous year. Net income was RMB39,698 ($6,415) for the year, an improvement of RMB4 million ($0.6 million) from a net loss of RMB3.8 million.

The company has continued its upward trajectory, as reflected by its latest operating results. On Nov. 14, Recon announced increased revenues and improved operations in its fiscal year 2014 first quarter ended September 30.

First quarter revenue came in at RMB11.51 million ($1.9 million), an increase of 27.2 percent from RMB2.4 million in the same quarter a year ago. The robust performance was driven by increased sales of furnaces and centralized "SCADA" systems that monitor and control entire sites.

Gross profits increased year-over-year by 116.4 percent to RMB5.29 million ($0.9 million). Gross margin improved to 46 percent, compared to 27 percent in the same year-ago period. Income before taxes showed strong improvement from a loss of RMB2.31 million in the year-ago quarter to income of RMB414 thousand ($67,000).

Net income (loss) was approximately RMB46,000 ($8,000), an improvement of 102 percent compared to a net loss of RMB2.34 million ($382,000) in the same year-ago quarter.

Diluted earnings per share (EPS) were RMB0.01 ($0.002), compared to EPS of RMB 0.59 in the same year-ago quarter. As of September 30, the company had low debt and cash on hand of RMB6.7 million ($1.1 million). Recon's revenue and earnings should increase in future quarters, as Chinese demand for natural gas continues to grow for the foreseeable future.

Of course, as with any small-cap stock, Recon carries risks. The Chinese economy is not known for its transparency and any China-based company, especially a small one such as Recon, is vulnerable to the vagaries of centralized economic policy. Also, far larger and better-capitalized companies could push Recon aside and take its place if the innovation of its technology ever lags.

That said, this energy services company is well positioned for outsized growth in a technology sector that lately lacks it.

John Persinos is managing director of Investing Daily.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.