High Conviction: Taking On Clean Water in China

| About: Tri-Tech Holding, (TRIT)
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Gregory Skidmore is founder and president of Belray Asset Management in Greenwich, Conn., which aims to use institutional investment methods (whether broadly diversified or niche strategies) to help individual clients. Before founding Belray, Skidmore worked for Advest in New York City and as a financial advisor for Smith Barney.

Seeking Alpha recently got the chance to ask him about his current top stock pick.

What is your highest conviction stock position in your fund - long or short?

Collaboratively, Portfolio Manager David Leute and I believe Tri-Tech Holding (NASDAQ:TRIT) to be a great long opportunity.

Tri-Tech designs and builds systems to assist Chinese government entities with monitoring and managing their natural and municipal water supplies. Essentially, their clients use their software and hardware to monitor and control numerous variables in the sewage treatment and odor control processes.

Can you talk a bit about Tri-Tech's sector? How much is this an "industry pick" as opposed to a pure bottom-up pick?

This is a sector pick and our view is that Tri-Tech is a great infrastructure play in China. Over the past few decades, there has been a rapidly growing issue of water cleanliness in China. Many of the streams, lakes, and freshwater areas have been badly polluted due to lack of regulation. As China's economy continues to expand, so will the demand for water treatment facilities and systems to regulate clean water.

According to the New Agriculturist, "As China's economy booms, the impacts on its environment are becoming more evident. China, for instance, is home to 16 of the 20 most polluted cities in the world. But by far the most serious environmental issue that the Chinese urgently need to resolve is that of water. The country is facing increasingly frequent and desperate shortages, disastrous flooding in some areas, and dangerous levels of pollution. And the problem is not just environmental - insufficient water is already limiting industrial and agricultural output in some areas and threatening to curb China's high economic growth rate and food production if solutions are not found quickly."

Can you describe Tri-Tech's competitive environment?

Tri-Tech admittedly faces fierce competition from local and foreign companies. International competitors have better access to capital, and some of its domestic competitors benefit from stronger brand recognition and connections to Chinese government authorities. Despite these challenges, they are well positioned to take on their international competitors on cost, and compete against domestic companies on technology and wider product offerings.

Fortunately, the barriers to entry in this industry are high and this should provide them with some level of protection against the emergence of new competitors.

Can you give us some detail about some of their domestic and international competitors?

Their most recent 10-K listed the following competitors:

Wastewater and Tail Gas Treatment Segment: Our wastewater treatment competes primarily with products and services from five other local and international companies: Beijing Sound Group (China), HollySys (NASDAQ:HOLI) (China), Nanjing Automation Institute of Water Conservation and Hydrology of Ministry of Water Resources (China), Veolia Water (France) and Degremont (France). Our tail gas treatment competes primarily with products and services from Biorem (Canada), Durr Environmental GmbH (Germany), Kewei Environmental Protection (China), and Kai-Hong (Taiwan).

Water Resource Management Segment:. Our water resources management segment competes primarily with products and services from Motorola (MOT) (USA), HollySys (HOLI) (China) and Nanjing Automation Institute of Water Conservation and Hydrology of Ministry of Water Resources (China).

We’ve identified the following as being potential competitors as well: Pentair (NYSE:PNR), ITT Industries (NYSE:ITT), Veolia Environment (VE), Flowserve (NYSE:FLS), Watts Water Technologies(NYSE:WTS), Calgon Carbon (NYSE:CCC), and Duoyuan Global Water (DGW).

Can you talk about how Tri-Tech's valuation compares with competitors?

The company went public in September of 2009. They recently filed a 10-K for fourth quarter 2009 and reported that full-year revenue essentially doubled to $16.8 million from $8.4 million in 2008. Year-over-year gross margins for their fourth quarter increased to 38% from 27%. EPS came in at $0.24 vs. the $0.12 reported a year ago. They have provided no guidance on future earnings.

With a trailing P/E of 17.8 and sales/net income growth of over 20%, we are excited about its ability to continue to grow earnings. TRIT has a clean balance sheet, and revenue has been increasing by more than 30% for the past two quarters. However, it is still a small company and earnings can be erratic for a company of this size. A few quarterly hiccups aside, we are expecting outstanding growth. Its valuation versus competitors is inconsequential, in our analysis. We believe in the growth story.

What is the current sentiment on Tri-Tech? How does your view differ from the consensus?

Tri-Tech recently filed to issue additional shares. The market viewed this as negative and the stock sold off, but we believe these dilution fears are shortsighted.

What catalysts do you see that could move Tri-Tech stock?

There are 1.6 billion Chinese that make up more than one-fifth of the global population. As China continues to industrialize, the demand for water treatment solutions will intensify. According to the World Bank, 90% of China’s urban groundwater and 75% of rivers and lakes are polluted.

We believe with the growing concern for clean water, the Chinese government will first subsidize programs to treat, clean and manage water in their municipalities.

With extra cash on hand after their equity offering, there is a possibility that Tri-Tech will make an acquisition. However, we view this as unlikely and expect they will use the cash to fund current operations further facilitating strong organic growth. If we’re correct, the stock price should move significantly from where it is trading today.

What could go wrong with this pick?

First, company risk: Many of their customers are cities, counties, and provinces, and historically in China these entities don't pay on time. We think that this may be the reason why their 2009 receivables expanded faster than sales. This problem could limit growth and force them to borrow or issue stock to fund operations.

Second, there's sector risk: We are concerned about increasing competition and whether they can maintain market share and/or pricing in a more competitive environment. In such an environment this growth story gets stunted. We’re looking into their ability to drive down the costs of sales.

Then there is market risk: There has been a lot of debate over a China bubble. If the Chinese stock market drops significantly, Tri-Tech should sell off as well. If at any time we become concerned about a Chinese stock market selloff, we will look to net out the Chinese market risk with a hedge.

Thanks, Gregory, for sharing your pick with us.

Disclosure: The author’s firm has a long position in TRIT.

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