Giant Interactive’s Industry Leading Position and Competitive Advantages

The secret is out. Online gaming is the most lucrative IT industry in China. That is why new players are keeping on emerging every year. More are set to come into existence and get publicly listed, in mainland, Hong Kong, or U.S., in the next couple of years.

To achieve investment success in this highly competitive industry, investors need to be very selective. Besides financial performance, one needs to pay close attention to the invested company’s competitive advantages and leading positions.

Some investors will want to stick with current industry leaders like Shanda (SNDA) and NetEase (NTES). For those who are looking for emerging industry leaders, however, Giant Interactive is one that cannot be ignored. I have published my overall analysis for this company previously. Here I’m going to concentrate on its industrial leadership and competitive advantages.

Simply put, Giant is reshaping the Chinese online gaming industry. It is rewriting the rules, from business model to the way MMORPGs are played.

It used to be gaming companies follow well-accepted practices to build online games which are then marketed largely through the internet itself. Mr. Shi (Chairman and CEO of Giant Interactive) changed all that.

Mr. Shi himself is an experienced game player. He spends long hours every day playing online games offered by different operators. In building his ZT Online, Mr. Shi interacted with hundreds of game players to collect their ideas and feedbacks. The outcome is a game that combines the best of existing MMORPGs with new features most craved by players.

Players of any taste can expect to find something he/she likes in ZT Online. Mr. Shi has designed his game to be an “encyclopedic” MMORPG. Literally, it includes test questions for different disciplines. It has grandiose wars between nations. It also has peaceful games, races and casual activities like biking, boating, and even hot spring.

And it is certainly full of creative capabilities like automatic location/navigation, automatic medication/healing, automatic attacking/monster killing, programmatic experience level promotion, instantaneous cross-shard migration, virtual asset insurance, in-game lottery, in-game contests, in-game player wage payout (that’s right, some players earn wages), red envelopes, cash awards, special events, and many more.

Some of these “odd” game options have attracted players seeking easy alternatives to play MMORPGs, although they have also been center of criticism from opponents and the media. But to Mr. Shi, game players are the ultimate judges.

Fundamental to Mr. Shi’s gaming success is his deep insight into this industry, even before he started his gaming company. Back then, he observed that there was a huge black market rampant with illicit dealers of game-cheating applications and businesses that sell experience levels and virtual products. These black market dealers, who are now more generally known as “gold farmers”, combined made far more money than game developers and operators.

To Mr. Shi, where there is a black market there is a customer demand. And his answer to this black market is to meet all these player demands in his own game. You can call it “officially assisted cheating,” that is, when the player is willing to pay. Whatever you call it, all the black market revenue is now rerouted back to Mr. Shi’s business, the game developer and operator.

Sounds odd, doesn’t it? Indeed, Mr. Shi’s “officially assisted cheating” did receive certain industrial criticism. Critics have argued that this practice essentially defeated the meaning and fun of game playing because skills or experience levels no longer need to be built through effort. They can now be paid for. To these critics though, I want to tell them that they have missed the big picture totally. Mr. Shi has taught us to pay attention to player needs and demands. Even if the critics cannot see the big picture themselves, can’t they just learn to follow Mr. Shi’s direction?

In MMORPG, the game is the player’s virtual world. Players have vanity deep inside them. They want admiration and envy from fellow players. They want to be heroes, bosses, and kings. Fast, particularly when they cannot afford to spend time to get to their desired virtual status. That is why deep-pocketed players do not blink much when paying for the status.

Mr. Shi grouped players into two, those who have time but not money and those who have money but not time. The first group of players can afford to spend a lot of time practicing and building their skills without spending a penny. The second group, on the other hand, will pay handsomely for higher skill levels. (Inevitably, there will be those who fall in between.)

Mr. Shi positioned his ZT Online to target the second group, the rich players. But rich players alone would not be playing the game without the participation of the first group. So the “non RMB players” (non-paying) players are needed to create and maintain a playable and exciting environment for the “RMB players” (paying). ZT Online turns out to consist of 15% “RMB players” and 85% “non-RMB players”.

Remarkably, the 15% RMB players in this single game (so far virtually the company’s only revenue source) accounted for 13.8% of the Chinese online gaming market as of Q3 in terms of revenue, making Giant Interactive the top 3^rd player in the industry. Even more amazingly, they have put the company on the top spot in terms of net earnings generated in Q3 of 2007. The top three Chinese online game companies in terms of net income for Q3 2007 were ranked as Giant Interactive 290.2M, followed by NetEase 260.2M and Shanda 238.9M.

Not surprisingly, this single game’s heroic deed has also become the reason for many investors to sniff at and dodge the company. I have to agree on the risk that comes with reliance on a single game, for now, that is. But I would also urge you to think, deeply, about why a single game can make the wonder of beating some opponent’s dozen plus games.

Obviously, half of the answer lies in Mr. Shi’s successful business model of “making money from the rich”, recapturing of the black market revenue, and unique ability to include game features desired by his customers, the game players.

The other half of the answer lies in Mr. Shi’s famous and unparalleled marketing talent. Besides marketing through the internet portals, Mr. Shi also leveraged a nationwide marketing network he had built for his previous business. This network has marketed his health product Naobaijin (melatonin) with immense success before.

His national marketing network filled internet cafes with ad posts of ZT Online on every prominent corner, from the wall, the door handle, to the restroom. They even offered a ZT-Online-exclusive incentive to the internet cafes. Those that signed up for this incentive would only operate ZT Online exclusively in the cafés.

This marketing campaign has led to immense success nationwide. But the success is particularly remarkable in tier-II and III cities. These middle and smaller cities were the much-ignored market in this industry before Mr. Shi, who discovered them and made them the focus of his products.

When Mr. Shi first entered the online gaming industry, he found it to be one that was full of rigid rules and one that paid the least attention to marketing efforts and end-user (player) voices. And he has succeeded by addressing all these drawbacks. Some industry observers and analysts believe Mr. Shi has set new rules for the industry and is irreversibly reshaping it into a marketing-oriented and consumer-centered industry.

Mr. Shi’s single-product success is thus clearly not an accident. It is not so by way of his efforts and by way of his design. He believes in focus and argued that enterprises need to have clear focus in terms of both products offered and marketing regions.

His belief in focus has enabled him to re-rise in just a few short years from his now famous fall in 1997. Following his fall, he started with only one product, Naobaijin, after talking to hundreds of consumers in suburban and rural areas. And his marketing initiative started with just one small city (Jiangyin) in Jiangsu Province. Only after his effort turned out to be successful would he begin to duplicate his success in other similar cities, then larger cities like Nanjing and Shanghai, and eventually nationwide.

His focused approach turned out to be so successful that he was able to voluntarily repay in 2001 essentially all the RMB 200M+ debt he owed the “victims” of his failed real estate venture. That was just four years after his fall.

So yes, ZT Online’s success is largely a duplicate of Mr. Shi’s Naobaijin business success. Mr. Shi intentionally focused his company on this single game as a start. His strategy is to strike the market with one missile rather than ten cannons. And not surprisingly, one missile has indeed turned out to be more powerful than ten cannons.

However, a person as ambitious as Mr. Shi will not be satisfied with one single missile. Much like he replicated his Naobaijin success into other health products, he is now beginning to replicate his ZT Online success into new MMORPGs. He has rolled out ZT Online PTP and is rolling out Giant Online and King of Kings III in 2008.

Although Mr. Shi does not have much expectation on ZT Online PTP, it is a venue for him to capture the lower-end market. As NetEase is set to adopt the free-to-play business model, Mr. Shi felt that would leave pay-to-play a blank area in the industry. ZT Online PTP then will serve to capture that blank market area.

Giant Online is a 2.5D, free-to-play MMORPG. This game is completing its double-version beta testing and will begin closed beta testing before the end of this month. Double-version beta testing is Mr. Shi’s yet another invention in which two versions of the same game compete to gain customer acceptance. Eventually the version that wins customer acceptance will be merged with the best features identified from the “lost” version, thus combining the best of both versions.

Mr. Shi has imposed a weekly spending limit on Giant Online players and is promoting it as the least-expensive, free-to-play online game in China. There likely are multiple reasons why Mr. Shi is positioning Giant Online this way.

First, the most obvious one, low price makes great advertisement. Second, ZT Online was criticized as the most expensive online game in China (although Mr. Shi rejected the notion citing higher ARPU from some opponents). Mr. Shi wanted to build a different corporate and brand image. Third, by imposing a spending limit Mr. Shi is preventing existing high-end ZT Online players from switching to Giant Online, thus minimizing the “self-competition” among his own products. Fourth, his three games (ZT Online, ZT Online PTP, and Giant Online) together will serve to capture the low, middle, and high ends of the MMORPG market.

Another likely factor could be that Mr. Shi has looked beyond ARPU and total revenue to the player base. ZT Online has written the PCU record for non-cartoon MMORPG, and its PCU is likely approaching the 1M mark again in Q4. But there is never a player base that is too large. And Giant Online can certainly be designed to perform better in areas like coverage ratio in internet cafes.

Mr. Shi believes Giant Online will become the hottest online game in 2008. He also believes that it can generate similar level of revenue as ZT Online, even though it has been imposed a weekly spending cap. According to him, this is because Giant Online will be able to increase the proportion of RMB players well beyond the level seen in ZT Online.

Mr. Shi will also be rolling out King of Kings III, a 3D MMORPG he purchased outright from Taiwan Lager Network, in 2008. It appears Mr. Shi is not into licensing games from other than the top online game producers in the world. He wants full control of the game he is operating, thus avoiding unresponsive support and disputes like the ordeals Shanda has gone through with its South Korean partner.

Mr. Shi places a lot of emphasis on R&D. He is willing to pay RMB 10M of salary to hire a top R&D chief. He sees his R&D team double its size by the end of 2008. He also invests heavily on superior server technologies. That enables Giant Online to support 1 million players in a single shard, compared to only thousands in other MMORPGs.

Giant Interactive’s marketing network currently consists of about 3,000 personnel. Mr. Shi has a plan to expand it to 20,000 in three years so that he can maintain his superior market share in tier II and III cities.

With an industry leading position, complementary product portfolio that is set to grow in the next few years, and competitive advantages in terms of superior R&D and marketing muscles, Giant Interactive promises to be a company that will win over the long term!

Disclosure: the author owns GA as of this writing. This post represents only the author's personal opinion. It should not be interpreted as a recommendation to buy or sell GA stock.

Giant Interactive: A Giant Cash Machine

A recipe I like for long-term investment is to look for businesses that operate on high margin, produce high investment return, generate a lot of cash, and trade at attractive valuation. The recently debuted Chinese online gaming company Giant Interactive (GA) is one that I find meet all of these conditions.

GA is a three-year-old company and a new-comer to the Chinese online gaming industry, specializing in MMORPGs (Massively Multiplayer Online Role-Playing Games). Its first MMO game, ZT Online, went into commercialization only in January 2006. However, this game proved the company to be a super-runner. ZT Online was rated the most popular online game in China in the same year by both IDC and game players.

ZT Online’s great start presented itself well in the company’s financial performance. Its first six months (following commercial launch) brought in RMB 82.4M revenue and 43.5M net income. Each of the following two six-month periods recorded three-digit sequential growth. Revenue for the second six-month period (ending December 2006) increased by 296% sequentially to RMB 326.1M and net income increased by 362% sequentially to 201.1M. Then the third six-month period (ending June 2007) saw sequential revenue growth of 111% to RMB 687.5M and sequential net income growth of 155% to RMB 512.3M.

Obviously this type of growth rate is not sustainable. So Q3 began to revert to the more normal sequential growth rates. In the quarter net revenue grew by 9.5% sequentially and net income grew by 9.8% sequentially over Q2 of the year. The abrupt growth deceleration appears related to the life cycle of MOM games which tend to peak roughly 18 months following commercial launch.

The peak out of ZT Online is hardly a secret. But the abruptness of the growth deceleration has caught the street by surprise. Shares of GA plummeted by 25.4% on Nov.20, the day Q3 result was announced. The drop from previous day’s intraday high to the day’s intraday low was even more spectacular, at 41.1%.

The street’s naivete and irrational speculation can mean a great opportunity for rational investors. The challenge is of course to identify true winners. GA appears to be a clear winner by the criteria stated at the beginning of this article.

Being a high-tech service company and in the lucrative online gaming industry, the company enjoyed exceptional profit margins. For 2006, gross margin was 88.9%, operating margin 59.6%, and net margin 59.9%. For the first nine months of 2007, gross margin was 89.7%, operating margin 73.3%, and net margin 73.4%. Net income and margin were helped by the company’s current tax-exemption status (total exemption for 2006 and 2007; 50% reduction from regular tax rate of 15% as a high tech company, or 7.5%, 2008 through 2010).

Since China is implementing a new tax law, starting 2011 the company might be paying either 15% or 25% income tax (not clear yet). At the more stringent regular tax rate of 25%, NOPAT (net operating profit after tax) margin for FY 2006 and first nine months of 2007 were 44.7% and 55.0%, respectively. This means that the company would still have pocketed $0.45 and $0.55 of net profit for each dollar of sales it had made in FY 06 and first nine months of 2007, respectively, had it been taxed at the hypothetical 25% tax rate.

Seasoned investors understand that great earnings do not always translate into great cash flows. A common cash-flow problem is caused by growing accounts receivables. GA certainly does not fall into this category. Game players prepay for virtual products and services offered in its online MMO games (currently mainly ZT Online). Not only are there no accounts receivables to worry about, but also does the company collect deferred revenues (prepayment for game cards and game points) which accumulate to operating cash flow immediately.

As such, GA’s cash flow from operations actually surpasses net income. In addition, the company’s free cash flow has surpassed net earnings as well, due to relatively moderate capital expenditures.

Cash was accumulated so fast that at the end of 2006 and Q3 2007 it significantly surpassed the shareholders’ equity. Cash was so plentiful that about RMB 900M was advanced to finance CEO Mr. Shi Yuzhu’s other business (Shanghai Jiante) in Q1 and Q2. Without such cash advances, Q1 and Q2 07 would also have registered cash and equivalents that significantly surpass total shareholders’ equity. During Q&A session of the Q3 conference call, CFO Mr. Eric He boasted about having plentiful operating cash flow onshore that they can afford to leave the IPO proceeds offshore in a U.S. account for the time being.

That fast-participating cash along with no debt (who needs that with so much cash) makes invested capital (which involves taking away cash and adding debt to equity) appear virtually non-existent. In other words, the ROIC (return on invested capital) appears astronomically high, making the management seem magicians who can turn air into gold.

An alternative measure of investment return is ROE (return on equity). For the one-year period (TTM) ending September 30 2007, I have used the average of year end 2006 and Q3 2007 as an approximation of equity (out of lack of balance sheet data for Q3 06) which is RMB 616.9M. And again I have stripped off the positive impact from the company’s current tax-exemption status by using NOPAT at the hypothetical 25% tax rate, which is $664.9M. These translate into an ROE of 108% for the one-year period ending September 30 2007.

Of course, with the immense IPO cash proceeds the ROE will no longer remain at this level. My estimate for FY 07’s ROE, using average equity for the year and NOPAT at the hypothetical 25% tax rate, is about 23%. The corresponding estimate using FY 07’s net profit (derived from the company’s low revenue projection for Q4) is about 31%. Again note these are the returns when the entire equity is virtually cash. Presently the company has about RMB 6.8B of cash (including both cash generated from operation and the IPO proceeds).

Technically speaking ROE is not as insightful a measure as ROIC. But in GA’s case where ROIC is ridiculously high ROE gives us an alternative way to see the exceptional return the company generated while still virtually hoarding all its equity as cash in the bank. As such, the company is simply in a great position to expand its business and withstand any downturn.

GA's solid cash position also means that, in the intermediate term, it will not have to pursue additional financing (like issuing bonds, secondary public offering, etc.) that could have a negative impact on the share price.

To value this company, I used a DCF model with 16% discount rate. Here are the assumptions I made: (1) the company will be in business for the next 30 years only, (2) free cash flow (FCF) is equal to net earnings, (3) the company will grow FCF or earnings at 27% annual rate for the first five years (starting 08), followed by 15% for the next five years and 7% for the remaining 20 years. I arrived at $12.30 (per share) when I used the hypothetical (25% tax rate) NOPAT for this year, and $16.32 (per share) when I used an estimated net earnings for FY 07. So this model puts the stock at $12.30 to $16.32 per share.

It should be obvious that this model used largely conservative estimates. Particularly, the 16% discount rate used was quite stringent. Moreover, the initial growth rate was assumed to be below some analyst’s forecast of 30 to 40% revenue growth rate for the Chinese online gaming industry as a whole in the next few years. According to iResarch, the industrial revenue in 2006 grew 60% over 2005. And it reached RMB 3.04B in Q3 2007 alone, compared to RMB 7.68B for whole year 2006. As of Q3 GA's market share was third in the industry, at 13.8%, only trailing NetEase's 15.1% and Shanda's 18.4%.

If you have not followed this company, you could be wondering where the growth comes from given ZT Online has likely peaked. The answer is GA certainly is not a one-trick pony. The company's second online game, Giant Online (a 2.5D MMO game) is in closed beta testing and has already attracted thousands of players. Based on data collected from the beta testing, Mr. Shi expects this game to generate at least the same level of revenue as ZT Onlne. Furthermore, the company will be rolling out its licensed 3D game King of Kings III next year. And you can count on more games to be developed and released in the future.

Investing in GA is more or less capitalizing on CEO Mr. Shi Yuzhu’s past success and failure. Mr. Shi is a high-profile entrepreneur in China. As early as 1993, his software company Zhuhai Giant Group was the second largest private enterprise in China. In 1995 he was ranked 8th on Forbe’s first-ever China rich list. In the mid 1990s, Zhuhai Giant even received the attention and visits from China’s top leaders like Li Peng (former Premier), Hu Jintao (current President), and Zhu Rongji (former Premier). Mr. Li Peng (then Premier) was reported to have visited Zhuhai Giant once a year during that period.

Unfortunately, Mr. Shi’s enterprise collapsed around 1997 due to over-ambitious business expansion, real estates speculation, and disregard of fundamental business principles. Mr. Shi’s fall became one of the most famous in China’s modern enterprise history.

But Mr. Shi proved that he can learn and benefit from failure, even a major one. In early 2000s Mr. Shi reemerged with great strength through successful healthcare and nutrition businesses (Shanghai Jiante, etc.) and equity investment (Giant Investment, etc.). That enabled him to venture into the lucrative online gaming industry in late 2004. In just a year, his first MMO product ZT Online hit the market with great success.

Other than Mr. Shi’s well known marketing acumen, it appears there are two other key elements that have helped Mr. Shi to reemerge and will empower him for a lasting success. One element Mr. Shi learned from his Zhuhai Giant collapse, i.e., cash position and liquidity is the life of enterprise. The other element he discovered in his previous success and it is called high margin businesses. Mr. Shi does not believe in low-margin high-volume businesses. He thinks the way to business success is to focus on high-margin areas.

And so far we have seen GA’s enormous cash-generating power and high profit margins to be well aligned with Mr. Shi’s philosophy.

Mr. Shi understands the online gaming industry by being a regular game player himself. Even before he founded Shanghai Zhengtu, he had acquired unique insight into virtual products, absentee role-experience-level boost, external game-cheating programs, etc. Some credited him with being the first to introduce the free-to-play business model into China, even though Shanda was officially the first to announce it. It was said that one of Zhengtu's vice presidents had accidentally let out Mr. Shi's idea to Shanda. Mr. Shi's gaming industry insight will continue to be a key contributor to GA's success.

Mr. Shi is also a close friend of China's business heavy-weights like Mr. Duan Youngji (Co-founder, CEO and Chairman of Stone Group) and Liu Chuanzhi (Co-founder, former CEO and Chairman of Lenovo). Mr. Duan and Liu were Mr. Shi's coaches even during his most difficult times.

Most of GA’s current senior management (President Liu Wei, COO Zhang Lu, and vice presidents) has at least worked with Mr. Shi either since Zhuhai Giant or Shanghai Jiante. Mr. Shi thinks the great fall that he and his team have been through together is his most precious asset. Along with the lessons learned from the previous notorious failure, this loyal management team has full knowledge and thorough understanding of Mr. Shi’s unique marketing methodology and operational philosophy.

GA’s CFO Mr. Eric He is a Wharton School MBA and CPA and Chartered Financial Analyst in the U.S. He has quite extensive financial career background. It is clear from Q3 conference call that Mr. He stands out among the CFOs of young Chinese companies in terms of communication with U.S. analysts.

Enough good has been said about this company. Now I do want to throw in a few chilling words of caution.

Firstly, the lucrative online gaming industry is also where the best young Chinese entrepreneurs are. Mr. Shi is competing with the likes of Mr. Ding Lei (NetEase) and Mr. Chen Tianqiao (Shanda). GA still has a great catch-up to do to capture the top spot. We have seen a great start. But whether Mr. Shi and his team can keep the momentum going remains to be seen. If Mr. Chen Tianqiao is right, however, the online gaming industry is growing fast and has room for multiple players to coexist and grow together.

Secondly, the insiders have too much power by owning the majority stake of the company. Following the IPO, the senior officers own 57.22% of the company. Forgive me for not mentioning the benefit of insider ownership.

Thirdly, the prepayment business gives the management a lot of room to manipulate the deferred revenues. Quarters can be easily made stronger or weaker than they actually are. For example, given the precipitous drop in sequential growth in Q3, could Q1 and Q2 have been dressed up at the expense of Q3 and Q4 to boost IPO performance?

No, I’m not suggesting they have done that. It is my hope the management has not taken and will never take advantage of the deferred revenues to dress up or down quarterly or annual financial performance. A truly smart management will never do that. After all, they are supposed to follow GAAP. But if they are truly brilliant, they should have learned from the recent class action lawsuits filed against them.

GA's prospectus disclosed (p.1) PCU and ACU of 888,146 and 481,054, respectively, for Q3 2007. It also included a chart (p.94, click here to view) that plots monthly ACU and PCU versus time through September 07. PCU and ACU decline can be seen starting in June and lasting into Q3. The prospectus also attributed the decline to game rule changes. Still, it has not prevented law firms from alleging failure of disclosure on declining ACU and PCU in Q3.

The management should understand that cash-rich companies make perfect target for class action suits. So it has no choice other than remaining fully honest and transparent when it comes to financial disclosure. After all, it is quite dramatic for a company to be in class action suits less than a month after going public.

Disclosure: the author owns GA as of this writing. This post represents only the author's personal opinion. It should not be interpreted as a recommendation to buy or sell GA stock.

Wall Street's No Confidence Vote on TCM’s Management

The market is a voting machine in the short run and a weighing machine in the long run. That was how Benjamin Graham, the Father of modern security analysis, characterized it. Today, shareholders of Tongjitang Chinese Medicines (TCM) overwhelmingly voted “no confidence” on TCM’s management team. Shares of TCM closed down 25.87% on heavy volume.

Before the market opened CIBC World Markets analyst Elliot Wilbur downgraded Tongjitang to "Sector Perform" from "Sector Outperform”, citing disappointing revenue growth from the company’s flagship product XLGB (Xianling Gubao). Following her lead, investors run for exit in great panic, in a day when S&P 500 lost 2.94% and FXI lost 4.77%.

In the third quarter XLGB sales grew only a paltry 2% year over year. The management attributed the slow growth to a combination of three factors. First, TCM obtained the national trade secret status for XLGB which provided for manufacturing exclusivity and pricing protection. As a result, the company was ready to raise its selling price and accordingly scaled back sales and marketing effort. Second, unusually warm weather in certain regions has served to reduce its sales since warmer temperature tends to lessen symptom of osteoporosis, particularly among senior patients. Third, flooding in certain areas served to reduce the number of trips patients made to hospitals and retail pharmacies.

Apparently shareholders did not want to listen to excuses. But is this (paltry XLGB growth) the sole factor behind CIBC’s downgrade and investors’ panic exodus? It does not appear so simple to me. The 26% single-day drop is essentially a loud “no confidence” vote on TCM’s management. And it is not all about XLGB.

If you are like me, what appears the most worrisome is actually the management’s asset management strategy. Since Q2 (although I just found out from Q3 conference call) the company has invested a fraction of its cash reserve in Chinese IPOs listed in Hong Kong or mainland exchanges. In Q3, TCM recorded a RMB 4M gain from these short-term investments. As of end of Q3, the company has RMB 41.4M (about 5.1% of company’s total cash reserve) invested in these junior Chinese securities.

In the Q&A session of the Q3 conference call, management revealed the IPO investment program will continue through at least the end of Q4. Whether they will continue this program into 2008 depends on cash reserve available and market condition ("extent of market activity," to use the management's original words) then. The management intends to allocate 10-15% of cash for investment in Chinese IPOs.

Moreover, the company’s IPO proceeds were still mostly deposited in US$. Management explained that this was due to the stringent foreign currency regulation in China that limits conversion into RMB. It also partly justified its IPO investment program as a way to hedge the loss incurred by the depreciation of US$ against RMB.

From management’s remarks, it appears the IPO investments are mostly short-term oriented. There was no mentioning of valuation considerations, only market condition. It seems the hotter the market is, the more likely the company is going to stay in this game. Given today’s frothy Chinese stock market, it makes me wonder if the management’s vocabulary contains the word “risk” at all.

Secondary to the cash management, analysts were concerned about the rise of accounts receivables (A/R). Based on my calculation, A/R turnover increased to about 131 days at end of Q3 compared to 118.5 days as of end of 2006. Management indicated they are aware of this problem and is working to improve it significantly in Q4. Let’s follow up on how well they keep their words three months later.

Obviously, these are more than enough for investors to scream “enough is enough.”

I also noted a significant increase in inventories. Inventories turnover increased to about 134 days from 78.5 days as of end of 2006. I do not know if this inventories build up was on finished goods or on raw materials (I intended to ask about this during the conference call; but operator cut me off). If it was due to stock-up of barrenwort or other raw materials this would be a non-issue, since it could be a great strategy to lock down raw materials cost in an inflationary environment. The price of barrenwort has skyrocketed in the past couple of years until recently.

Then, wasn’t there anything encouraging out of the quarter? Sure yes.

Sales of other core products excluding XLGB (Moisturizing and anti-itching capsules, Zaoren Anshen capsules, and Daibaizhu Syrup) increased 723% to RMB 25.5M. The company’s OTC strategy seems to have worked pretty well, particularly the Moisturizing and anti-itching capsules which have registered more sales to the OTC market (retail pharmacies) than to the prescription market (hospitals). To understand why OTC strategy is important, please read my previous post.

And although Q3 is the seasonally weakest quarter, it also has grown significantly faster than the other quarters so far this year. Net revenue has grown 28.7% YoY in the quarter compared to growth YoY of 24.9% for the first nine months of the year. Gross profit has grown 34.1% in the quarter compared to growth of 22.5% for the first nine months. Operating income has grown 147.1% in the quarter vs. growth of 15.6% for the first nine months. Net income has grown 464.7% in the quarter vs. 52% for the first nine months. Net income in the quarter was greatly helped (and skewed) by interest income (mainly from the IPO proceeds), investment gain, government grant and a gain associated with disposal of Guizhou LLF’s liabilities. Acquisition of Guizhou LLF is expected to complete by the end of year. LLF will contribute an estimated RMB 10M of revenue in Q4.

By my calculation, ROE and ROC for the past twelve months were roughly 23.7% and 19.8%, respectively. Admittedly these numbers were helped by the tax exemption status, and also slightly by the unusual gains mentioned above. But they were also diluted by a greatly expanded equity and capital base associated with the huge and non-productive cash reserve generated from the IPO earlier this year.

Another encouraging piece of news is that the company has obtained a legal “nationally well-known brand” for its Tongjitang name. This marked an important victory for the company in its brand protection endeavors. It allows the company to weigh its legal options against Hubei Tongjitang, Sanjin Group’s Tongjitang subsidiaries, and any other company that attempts to steal the Tongjitang brand. You can read more about this in this post. As a follow up and clarification to that post, company CEO Mr. Wu Xiaochun is a major shareholder in Shanghai Tongjitang and use of the word Tongjitang there was by an agreement with Guizhou Tongjitang, TCM’s major operating company.

On top of these, you can also add the 11 potential new products on company's pipeline, encouraging clinical result from Synarc, and the active acquisition efforts being undertaken. Not counting Guizhou LLF, the company's current products include 15 modernized traditional Chinese medicines, 38 western medicines, and 4 nutritional products.

Coming back to XLGB, management expects its normalized growth rate to be in the vicinity of 20%. On a TTM basis, XLGB has generated a net revenue of RMB 437.3M as of end of Q3, compared to RMB 374.6M for FY 2006. This means that if XLGB proves to bring in zero growth in Q4, we will be looking at 16.7% growth for XLGB in FY 07. For XLGB sales to reach the 20% ball mark in FY 07, Q4 growth on XLGB has to be about 9.5%. This looks an achievable target for Q4.

In fact if you assume XLGB grows 20% and non-XLGB products grow 40.8% in FY 07, you would arrive at RMB 605M total revenue for the year. And this is precisely the midpoint of the managment's projection (RMB 590-620M) for the year. What's to be ashamed of these growth numbers (20% flagship product and double that rate for other products)?

To the management, XLGB’s long-term potential can be seen from its room to grow in China. At this stage, XLGB is only carried in 2400+ out of more than 20,000 hospitals and 34,000+ out of 250,000 retail pharmacies.

All in all, management’s execution does not look all that bad so far this year. Management has demonstrated ability to execute in OTC market, product diversification (non-XLGB and new products), brand protection, acquisition initiatives, and more. (Investors might like to see a faster pace of acquisition than is already achieved though.) Long-term investors will look beyond the quarter and the year to get at the whole picture. They will not be part of the voting machine.

However, I’m very concerned about management’s cash management strategy going forward. The Wall Street has voted out loud in protest against the management’s reckless way of asset management. This is a critical test on the management’s willingness to listen to shareholder voices, sincerity in enhancing shareholder value, and overall wisdom and intelligence. Unless the company has a long-term plan to Chinese equity investment and imparts adequate valuation considerations, the obvious smart choice is to stop this reckless practice before it is too late. Meanwhile I urge my fellow investors to open dialog with the management to find out more about this.

How the market will weigh TCM in the long run rests on the management completely.

Disclosure: the author owns TCM as of this writing. This post represents only the author's personal view which can be biased or incorrect. It should not be interpreted as a recommendation to buy or sell TCM stock.

Brand Protection Key to TCM’s Long-Term Success

My kind reader Rick posted a comment on my blog asking for one or two negatives on Tongjitang Chinese Medicines (TCM). In response I have posted a few risks associated with investing in this stock. For most part, they are either uncertainties in the Chinese pharma industry or minor issues common to small caps. But I do want to single out the brand protection issue and discuss it a little more here.

Although not as famous as Tongrentang (which dates back to 1669 and is probably the best-known “senior” medical brand in China), Tongjitang is still a well respected brand in China. The brand dates back to 1888 when once-governor of Yungui (Yunnan and Guizhou provinces) Mr. Tang Jiong and his friend invested 2000-liang (2025 ounces) of silver to open Tongjitang Drugstore.

Gradually Tongjitang was renowned for its highly proficient physicians, quality drugs, genuine ingredients, fair pricing, and business ethics. The reputation even spread overseas. So there was a legend about an overseas Chinese (in serious illness) traveling from Southeast Asia to Guiyang to seek medical treatment from Tonjitang around 1940. There he recovered from his illness in just one month. To express his gratitude he offered to pay a huge sum to Tongjitang. But the drugstore firmly declined his offer based on its business principle. This legend was said to have made the brand famous in various regions of the country.

Like many other senior brands, in the past half-century or so Tongjitang has gone through chaotic times. But the brand managed to survive and was revigorated following the buy-out by Mr. Wang Xiaochun’s Guizhou Xianling. TCM’s heavy advertising and marketing spending in recent years has helped to strengthen the brand.

Naturally what come with a great brand are not just praises and flowers. There also come infringement and plagiarizers. In the Chinese market, not only are there counterfeit XLGB medicines there are also related and unrelated medicines sold on plagiarized Tongjitang brand. In the past, the company has worked with several provinces to crack down counterfeit XLGB products with some success. But by briefly browsing the customer questions section of Guizhou Tongjitang Pharmaceutical’s (TCM’s major operating company) web site, there still appears to be some customer concerns regarding counterfeit XLGB products. Furthermore, in the service complaints as well as the customer questions sections there were two or three reports of skin-related medicines sold on counterfeit Tongjitang brand.

Several enterprises have also competed to take a share of the Tongjitang brand. I have knowledge of three companies (other than TCM) that use the word “Tongjitang” in their company names. They are Shanghai Tongjitang, Hubei Tongjitang, and Sanjin Pharma’s Tongjitang subsidiary. All these companies seem to have been endorsed by their respective local governments. Their Tongjitang brands have all been claimed to date back to the 1888-founded Guiyang Tongjitang. Yet none of them has provided a convincing story of how it is related to Guizhou Tongjitang.

The most striking example would be Shanghai Tongjitang. It owns the www.tongjitang.net domain and was founded only in August 2002. Without explaining how it is related to the genuine brand, it mysteriously boasts about Tongjitang’s more than century-old history on its web site. Now you have seen the enterprise version of a five-year-old kid bragging about having five or six generations of descendants. Unless it is a subsidiary of Guizhou Tongjitang (which I do not believe so), this is brand infringement at its most blatant extreme. Shanghai Tongjitang claimed it was GMP certified in March 2005.

TCM management is aware of the existence of Hubei Tongjitang and Sanjin’s Tongjitang subsidiary (but I do not know if it is aware of Shanghai Tongjitang). Due to China’s inadequate regulatory and legal system, TCM will be fighting an uphill battle with these infringers. The company thinks it might need to live with these companies in the end. A thorny issue is that Tongjitang is not actually legalized as a well-known trademark in China. But I believe it would be a big mistake for the company to leave at that.

After all, Tongjitang was recognized as a “National Senior Brand” in 1994 by the then Ministry of Domestic Trade. And partly based on this recognition, the company has won a lawsuit in July on a domain-name infringement case in Changsha City, Hunan Province, according to a Guizhou Daily report. Another key point mentioned in the report was the company’s winning history in legal battles related to its Tongjitang brand. (Oh sure, this is a proof that the company has not really sat still when it comes to brand protection. Good news for shareholders.)

In my humble opinion, the company should have dedicated personnel working just to protect its brand. The top priority for this team should be to earn a legalized “well-known trademark,” using as basis its 1994 “National Senior Brand” recognition, its “Guizhou Province Well-Known Brand” recognition, and the history of legal judgments in favor of the company. Depending on the outcome of this legal battle, the company should confront the infringing businesses mentioned above and resort to legal means when necessary. Understandably, due to the various local stakes involved and China’s inadequate legal system, this legal battle is most likely a much tougher one than the domain-name case where the defendant was only an individual.

Meanwhile the company should immediately work to differentiate its Tongjitang brand from the plagiarized brands (if it has not started doing so yet). It should clearly state that Guizhou Tongjitang is the only genuine Tongjitang brand, in its various advertisements, marketing campaigns, seminars and other consumer education initiatives. Those plagiarized Tongjitang brands should also be clearly named and stated to be unrelated to the genuine “National Senior Brand.”

In the event the company cannot legalize Tongjitang as a national "well-known trademark", it should think about the possibility to acquire these infringers. Collectively (with the infringers) they should work together to guarantee the quality of their products and use a single “Tongjitang” brand. In alliance they would be powerful enough to secure a legal “well-known trademark” in China, thus preventing new comers from stealing the brand again. If this is infeasible or does not work out, the only solution would be to strengthen the brand differentiation effort described above. And that is why brand differentiation is important from the very beginning.

Successful brand protection will contribute to TCM’s long-term success, in a big way. And management’s skill, commitment, wisdom and creativity will be put to test in its brand-protection endeavor.

Disclosure: the author owns TCM as of this writing. This post represents only the author's personal view which can be biased or incorrect. It should not be interpreted as a recommendation to buy or sell TCM stock.

A Dozen Reasons Why I'm Bullish on TCM

At this late stage of the China bubble, I’m looking around for great Chinese names with fair valuation. One such name is Tongjitang Chinese Medicines (TCM). Here are some of the reasons I think it will be a winner in the next decade.

1. “Tongjitang” is a Chinese name brand with more than a century old history. The brand dates back to 1888, is known by many Chinese households, and was officially honored by the central government. Company CEO Mr. Wang Xiaochun was a career lawyer until 1997, when he bought Xianling Pharmaceutical. He clearly understood what’s in the name and merged Xianling with Tongjitang in the early 2000s under the encouragement form Guiyang city government.

2. Tongjitang’s flagship product Xianling Gubao (XLGB) has become a leading traditional Chinese medicine for treating osteoporosis as measured by revenue, according to a report by the SFDA-affiliated China Southern Medicine Economy Research Institute (SMERI). SMERI estimated XLGB to have accounted for 70% of sales of traditional Chinese medicines for the treatment of osteoporosis from 2003 to 2005. SMERI also ranked XLGB No. 10 in terms of market share, at 0.74%, among all modernized Chinese medicines in seven leading Chinese cities’ hospital prescription market for the first half of 2006. That is, 0.74% of market for the thousands of all modernized Chinese medicines.

3. According to a recent report by China’s Xinhua news agency, over 11% of Chinese above age 20 suffer from osteoporosis and there are about 35M to 40M osteoporosis patients nationwide. (Read this Seeking Alpha post also.) An earlier report from the same agency on 2003’s World Osteoporosis Day indicated that osteoporosis related fracture rate exceeded 9% and was on a trend to increase year after year. Interestingly, back then it put the osteoporosis patient population at an even more alarming 90M, or 7% of the entire Chinese population, making the world’s most populous county also the largest in terms of osteoporosis patients.

4. China's aging population translates into increasing number of osteoporosis patients and more medical spending.

5. China’s phenomenal GDP growth is set to continue and every 1% of GDP growth is accompanied by approximately 1.7% growth of the medical and health care market.

6. Tongjitang’s XLGB, Zaoren Anshen Capsules, Moisturizing and Anti-itching Capsules and Dianbaizhu Syrup are in the national and provincial medicine catalogs of the National Medical Insurance Program. Participants in this program get 80 to 100% reimbursement for purchases of these medicines (from either hospitals or OTC stores). The Chinese government expects the enrollment in the National Medical Insurance Program to almost double to 300M by 2010 from 157M as of end of 2006.

7. Although XLGB is the company’s main revenue source (77% of total revenue as of FY 2006, 78% as of Q2 2007), TCM is not exactly a one-trick pony. It also has ten other SFDA-approved Chinese medicines in its portfolio. In Q2, sales from other core products (Zaoren Anshen Capsules, Moisturizing and Anti-itching Capsules and Dianbaizhu Syrup) increased 193% vs. XLGB’s 11%. Similar trend should continue in the future. There are also a couple of other traditional Chinese medicines (for treating depression, menstrual pain and anxiety) in different stages of clinical trial.

8. One of the key reasons Chinese pharmaceutical stocks remain attractively priced is due to the 20+ large-scale, drug-price-cutting campaigns mandated by the central government since 1997. However, the main targets of these price cuts have mostly been low-quality copycats. Government has consistently indicated willingness to protect high quality name brands, particularly top traditional Chinese medicines. The price cuts have not affected TCM’s products, while in July 2005 the 50-pack XLGB capsules actually got 11.1% boost on price ceiling. I’m cautiously optimistic about the continuation of this discriminative policy in the future.

9. The company has a good OTC strategy. The Chinese OTC market has grown at an annual rate of over 20% in recent years. By 2010, its market size is expected to reach that of the United States in 1995. Compared to the hospital market, OTC market is also much less susceptible to the government’s price-cutting initiatives. Government actually encourages patients to purchase medicines from the OTC market as a way to decrease the medical insurance cost. Therefore, to a great extent OTC market serves as a safe harbor for pharmaceutical producers. TCM has a strong sales force (of 500 as of March) targeting the OTC market. Revenues from the OTC market have brought in a higher gross margin to the company, compared to those generated from hospitals. So far OTC market has made a significant contribution to TCM’s total revenue and its contribution is expected to increase further in the future.

10. XLGB promises to become the first ever FDA-approved traditional Chinese medicine, thus entering the U.S. market. TCM contracted Synarc to perform clinical study of XLGB as a drug for the treatment of osteoporosis in late 2005. Synarc co-founder, Chairman Emeritus and renowned authority in osteoporosis Mr. Harry K. Genant also serves on TCM’s board as an independent director. On Thursday, Oct. 25, China’s official newspaper People’s Daily republished a report by Health Times on a positive result from XLGB's efficacy and safety verification study by Synarc, in which centralized imaging and biochemical marker techniques were used. The randomized, double-blind, multi-center study lasted two years and has proved XLGB’s efficacy and safety for the treatment of post-menopause osteoporosis. XLGB has been found to inhibit bone resorption and increase bone density significantly. The study also found that simply taking calcium and vitamin D supplements does not have the beneficial effect of improving bone density. With this encouraging result, TCM can now begin the FDA regulatory submission process. According to U.S. National Osteoporosis Foundation osteoporosis is a major public health threat for an estimated 44 million Americans. Based on the positive efficacy and safety result, I feel the company might also begin regulatory processes in Europe and other regions as well sometime in the future.

11. China’s strong economy has created a great soil for consolidation in fragmented industries like pharmaceuticals. TCM sees itself as a leading consolidator in its industry. In September it entered into a purchase agreement to acquire 100% registered capital of Guizhou LLF Pharmaceutical for RMB 42.2M. Guizhou LLF is a profitable company with about RMB 50M of revenue in 2006 and will add more than 10 OTC and prescription traditional Chinese medicines to TCM’s product portfolio once the acquisition is complete. This acquisition should help to reduce the company’s dependency on XLGB. Combining with other existing products, it promises to bring down XLGB’s revenue contribution from 77% in 06 to the 70% level. Thanks to its IPO earlier this year, TCM had RMB 772M of cash as of the end of Q2. So one can expect to see more deals announced going forward.

12. The company also manufactures 37 western medicines. One such medicine is in clinical trial for the treatment of post-surgical acute pain. Although revenue contribution from these products is insignificant at present, they appear to be paving the way for a more diversified product portfolio. Given proper execution, these insignificant products could just be on their way to ride on the reputation of the Tongjitang brand and be significant one day.

Although Q3 earnings release is right around the corner, you want to keep your excitement at bay since this is seasonally the weakest quarter of the year. XLGB’s positive clinical result on efficacy and safety and FDA application might serve to cheer up traders and investors a bit. But the three-day spike earlier this week likely has discounted the news somewhat. Moreover, the actual FDA approval is still years away. If you are a long-term investor, however, you would not need to be concerned with the quarterly fluctuations or any event-driven price movements. And you want to buy when price goes down instead of when it goes up.

Disclosure: the author is long TCM as of this writing. This post is not a recommendation to buy or sell TCM stock.

Critical Moment for China Expert Technology

When I first wrote about China Expert Technology (CXTIE) on Aug. 13 there appeared to be still hope (though not likely) that it would file its 10-Q report for Q2 on time. The second day, however, the company filed for the five-day extension, citing the following reason:

"The review of the financial statements has not yet been completed."

Then a new CFO (Mr. Qiyou Li, or Jeff Li) was nominated on Aug. 15. Today, three more weeks have gone by and the 10-Q is still up in the air. That, under a new CFO who was the company's former financial controller and has managed the company's financial matters from accounting to internal auditing for two whole years!

Is it really "the review of the financial statements" that is at issue? Did former CFO Mr. Simon Fu’s resignation cause the filing turmoil or was there a financial chaos that caused Mr. Fu to resign?

Honestly I do not have an answer. But some investors have begun to question the quality of the company's previous financial statements.

It is hard to blame them. I called five Chinese cities (including one district and one county) CXTIE claimed to have signed e-government contracts with in recent months. None of the cities confirmed the contract.

A few words of caution: I might not have spoken to the right official in all of the cases. But at least for the city of Xi'an, I was sure I have spoken with a key official responsible for the planning, assessment, and monitoring of the city's e-government projects. Moreover, for the district and county mentioned, I also had reason to believe I have spoken with reliable sources.

Still, it is possible that the company's contracts were signed with third-party management companies. But it really worries me when the local governments (particularly in Xi'an's case) had no knowledge at all of such management companies who were supposed to be doing e-government businesses with them. And the “management companies” were recognized neither by the local Departments of Commerce nor by the directory services.

Furthermore, all of the contracts were major ones mostly in excess of RMB 100M. It is very disturbing none of them was covered in the Chinese media.

All of a sudden, I felt I did not understand the company's business which I had once thought I did. And my natural reaction was to turn to the management for help.

With much persistence, I did finally get to talk with Mr. Michael Huang, Chairman of the company. Although he did mention management companies as a possible reason, he told me he was not involved in the company's day-to-day operation so he could not help me on questions regarding the contracts. He said he has forwarded my email inquiry to Mr. Xiao Xin Zhu, the company's CEO who should be answering my concerns. Mr. Zhu, as you might have guessed however, never responded to my inquiry and follow-up email I sent him.

Some of my readers were asking if the great buying opportunity has finally arrived. As you know, I do not make buy or sell recommendations. But this much I can say. If all of the e-government contracts prove to be real and solid, this stock can be picked up at $3 a share and still be a great value. On the other hand, this stock is worth little if the management cannot prove the contracts’ validity down to the RMB amount.

I have played enough hide and seek with this company. Before I quit this game, though, I would like to give this advice to the management: it is time to prove the company’s financial integrity and restore shareholder confidence. Face the shareholders and address their concerns. Concerns as basic as the validity and soundness of the e-government contracts! A no-nonsense approach to address their concern would be to publish contact information (in both English and Chinese) for them to verify the validity and progress of your outstanding e-government contracts.

Do that, before their patience runs out.

Disclaimer: the above represents only my personal view, which could be right or wrong. It is not a recommendation to buy or sell CXTIE. I do not have a position in CXTIE as of this writing.

CGG Veritas, a Veritable Bargain

CGG Veritas (Compagnie Générale de Géophysique-Veritas, CGV) strikes many as a low P/B (Price/Book) stock. This France-based company is a leading global geophysical service provider to the oil and gas industry. Using Friday June 8’s market close of $44.04 and Euro to US$ exchange rate of 1.3372, CGV was trading at a P/B of merely 0.37!

That certainly sounds exciting; but this unfortunately is not the end of story. You could be greatly disappointed when you find out that its goodwill stands at $102.20/share out of its book value of $118.11. In other words, 86.5% of its book value is goodwill.

Much (90%) of this monstrous goodwill was originated from the recent acquisition of the former Houston based Veritas DGC to form CGG Veritas. However, the purpose of this article is not to assess the quality of the goodwill. Rather, my major intention is to figure out the worth of the entire CGV enterprise from a value investor’s perspective.

CGV’s debt-equity ratio stood at 0.65 as of end of first quarter (March 31 2007). Using another measure, the debt is 175% of market cap as of Friday’s close. Due to this high degree of leverage, some value investors would simply stay away from this stock. I happen to be a value investor who believes in the added benefit of flexibility (now that it is not overdone). So I would take a shot at valuing this stock.

I will apply Greenwald’s valuation approach to this stock. The Greenwald approach values stocks using three elements, the reproduction cost, earnings power value, and the growth value. Let’s assess each element for CGV now.

I. CGV’s Reproduction Cost

The reproduction cost is simply the cost a competitor would need to incur in order to reproduce CGV’s business in a (hypothetical) level playing field, i.e., when there is no barrier of entry to new competitors or no competitive advantage on CGV’s side.

To come up with reproduction cost for CGV, we would mainly adjust for the CGV’s goodwill and the value of R&D and marketing investments, which are off the balance sheet.

As mentioned above, 90% of the goodwill is attributable to the recent acquisition of Veritas DGC. The $3,513M cash/stock combination paid to Veritas shareholders represents a 67% premium to Veritas’ market value of $2,099M back in August 2006. Based on Veritas’ reported book value on Oct. 31 2006, CGV has paid at a P/B ratio of 4.34, which was pricey yet likely a typical valuation for acquisition in the energy sector.

To have a built-in margin of safety, however, a value investor should not take the management’s valuation doctrine at face value. Instead, one should make major adjustment downward in this type of expensive business acquisition. The right approach is one that values the business being acquired at a discount to its market value instead of premium. That means valuing the acquired business as if we the value investors were buying the business ourselves.

In valuing the acquisition, we will take clue from Veritas DGC’s historical financial performance and the industrial business cycle.

The seismic or geophysical industry was stuck in a cyclical trough from 1999 to early 2004. The second half of 2004 through 2006 has seen robust recovery. And the robust growth appears likely to continue going forward.

For a cyclical business, it appears reasonable to approximate long-term ROC using the ROC achieved in the first two recovering years following a trough. Since Veritas’ fiscal year (before being acquired) ended July 31 and the recovery started from the second half of 2004, this means that we can use the ROC achieved in FY 2005 and FY 2006. Veritas achieved ROC of 12.01% and 11.36% for FY 2005 and 2006, respectively. So we would take a conservative round number of 11%.

The other elements needed for evaluating the worth of a firm’s long-term growth are the growth rate itself and cost of capital. Veritas’ revenue growth from FY 2003 through 2006 was 10.98%, 12.48%, 12.32%, and 29.68%, respectively. But since we are looking for a sustainable long-term growth rate, we would use a conservative, mid single-digit rate of 6%.

Regarding cost of capital, one can use either practical estimate or the WACC (weighted average cost of capital) derived from CAPM (Capital Asset Pricing Model). Good enough for us, CGV’s management has made public the WACC numbers they use in valuing goodwill. Depending on business segment, the company uses WACC in the range 8.29% (for multi-client library) to 9.06% (for products). For Veritas, it appears reasonable to use 8.5%, which is the mid value between multi-client library business (8.29%) and processing business (8.67%).

Finally we need to know the initial invested capital, which we take the average of FY 05 and FY 06, or $724.046M.

Simple math then places Veritas’ worth at $1,448M or €1,114M at the rate of $1.3 per euro. Remember this is the result of valuing Veritas based on initial capital outlay of about $724M, long-term growth rate of 6% at an ROC of 11%, and a capital cost of 8.5%.

Compare this to the purchase price €2,725M ($3,513M) the company paid, this is a 59.1% discount. With this, we have essentially written €1,611M (or 85.9%) off the estimated total €1,878M of goodwill. Had we the value investors bought Veritas at $1,448M or €1,114M, we would have received a 31% discount relative to Veritas’ market value in last August (at $56.16 per share). And we would have paid only 1.93x Veritas’ book value ($749.8M) as of Oct. 31, or 1.79x its book value ($810M) at the completion of merger in early January. Since Veritas had a high quality balance sheet (with zero goodwill and reasonable amount of intangibles) we can feel really happy to have paid only 1.79x book.

With Veritas’ value adjusted to our satisfaction, the only thing that remains is the valuation of CGV’s other subsidiary, CGG. The company’s account on CGG seems to be largely fair. But we do want to add the values of R&D and marketing, which are not reflected in the balance sheet.

For the value of R&D, we follow Greenwald’s simple 5-year (FY 2002 through FY 2006) straight-line depreciation approach, which gives €96.04M. For marketing value adjustment, we first find the SG&A expense per revenue euro during the last six fiscal years (FY 2001 through FY2006). Then we calculate the smoothed-out SG&A expenses incurred in the last three fiscal years (FY 2004 through 2006). We take 50% of the smoothed-out SG&A expense as the marketing value adjustment. This gives €157.68M . The R&D and marketing value adjustment together amount to €253.72M.

After our immense goodwill “write-off” and R&D/marketing value adjustment on the CGG unit, we arrive at an adjusted book value of €1,049.83M, which also approximates the reproduction cost of CGV’s asset at the end of first quarter ended March 31 2007.

Again using €/US$ ratio of 1.3, this translates to a per-share adjusted book value of $50.08. CGV was trading at 88% of the adjusted book value (adjusted P/B=0.88) as of Friday’s close. Although this does not look as exciting as a P/B of 0.37, it certainly still represents a good bargain.

II. The Earnings Power Value

The reproduction cost represents the cost a new entrant needs to incur in order to mimic CGV’s business when there is no barrier of entry. According to our estimate above, CGV is worth about $50 a share under this free-entry business environment. However, for a well-respected leading global provider of geophysical services and equipment manufacturer that has been in existence since 1931, one would be tempted to ask if this reproduction cost has reflected CGV’s franchise value.

The answer is clearly no. And that is why there are two other elements in Greenwald’s valuation approach.

The first elements reflective of the franchise value is the earnings power value, which evaluates the present value of a firm’s future distributable cash flow assuming a zero growth rate.

We are to assume that CGV maintains earnings forever at the level of FY 2006 (zero growth) for both the CGG and the Veritas subsidiaries. Note again that (the old) Veritas’ FY ended July 31 while CGG’s FY ended Dec. 31.

To determine the present value of future cash flow, we adjust the FY06 earnings of each subsidiary to arrive at a base cash flow. Greenwald calls this base number adjusted earnings.

Because we are assuming no growth, the firm will only need to invest at a level that can maintain its current (FY 06) earnings. That means the capital expenditures, R&D and SG&A expenses need to be adjusted downward to a “maintenance level.” Following Greenwald, we can call these maintenance capital expenditures, maintenance R&D expenses, and maintenance SG&A expenses.

For all three maintenance costs, we find respective cost per revenue euro (or dollar) for the past few (6 for CGG and 5 for Veritas) fiscal years and use this to determine the investment level for prior year’s revenue, which means FY 05’s revenue. This way we are stripping out the growth component out of the FY 06 result.

For amortization and depreciation, we simply add the reported numbers back. For acquisition we simply account for it euro for euro. This is because “current” (FY 06) year’s revenue contains the acquired businesses’ full contribution. For one-time charges, we average them out over the past five (Veritas) or six (CGG) fiscal years.

After going through all these, we arrive at a combined adjusted earnings figure of €314.31M, which consists of €228.12M contributed by CGG with the balance from Veritas.

Under the zero-growth condition, the present value of the future cash flow is simply the adjusted earnings divided by cost of capital. Again, for weighted average cost of capital the maximum value used by the management was 9.06% (for its products business). But we will settle on a more conservative 10% instead. This leads to €3,143.1M in the present value of future cash flow.

To arrive at the earnings power value, we need to account for debt and excess cash (beyond 1% revenue). After subtracting the debt (as of March 31 2007) of €1,573.5M and excess cash (relative to FY06’s revenue) of 363.18M, we finally arrive at the earnings power value of €1,932.82M. This translates into €70.92 per share or $92.2 per share (at $1.3 per euro), which is more than double Friday’s market close of $44.04!

We have not made any adjustment for the business cycle. As pointed out above, FY 2006 was about the second year into the seismic industrial recovery. So we take that as the midpoint of business cycle, which sounds reasonable if not conservative.

CGV’s franchise value can be found by simply subtracting reproduction cost from its earnings power value. The result is €882.99M or $1,148 M. So the franchise value alone is €32.50 or $42.12 per share, close to CGV’s current market value.

Since the adjusted book value is about $50 (13.7% above current market value), at current market price we are getting the franchise value for free! This is precisely the type of margin of safety a value investor seeks.

III. Value of Growth

A firm’s growth creates shareholder value only if it can maintain an ROC that is greater than its cost of capital, a condition achieved only by firms that enjoy competitive advantage (or franchise value). As in II, we are still going to use 10% as cost of capital. Referring to CGG and Veritas’ historical data and factoring in seismic industry’s business cycle, it appears 11% is a sustainable ROC for the combined firm (CGV). For a sustainable long-term growth rate, we are going to use 6%.

For initially invested capital, since we are already aware of the excessive goodwill in the corporate balance sheet we will use our adjusted book value (€1,049.83M, see I) for the equity portion. After debt is added, we come up with an initial capital outlay of €2,633.13M.

Using this set of parameters, the present value of CGV’s assumed growth amounts to €3,291.42M. This translates into €120.77 or $157 per share. Obviously this extra $64.81 per share franchise value of growth (beyond zero-growth value of $92.2/share) serves as yet another level of safety protection for value investors. The total franchise value under the growth assumption is $106.93 (beyond the firm’s reproduction cost of $50.08).

IV. A Brief Note on Business Environment

Although the seismic industry will remain cyclical in nature, the industry has been greatly strengthened in recent years mainly for two reasons.

First, the strong long-term global demand on energy has resulted in a negative net reserve replacement rate in the oil and gas industry. This means reserve replacement has not been able to catch up with consumption. To alleviate this problem, oil and gas companies will need to maintain a high level of exploration expenditures going forward. And this will benefit both drilling and seismic companies.

Second, technological advances in recent years have increased fidelity, reliability and scope of the seismic technologies. These technologies are now not only used in exploration, but can also be used in development and production by oil and gas companies. This means new revenue opportunities for the industry.

CGG Veritas’ commitment in R&D has enabled it to capitalize on the recent technological advances. It has firmly secured competitive advantage in high-end growth markets such as data acquisition in transition zones and difficult terrain or deepwater sub-salt reservoir delineation and discovery.

Overall, CGV’s business is going strong. As of May 1, 2007, the company’s backlog was €1,213M (or US$1,650M). This represents about 62% of the combined CGG – Veritas revenue in FY 2006 (although the two units had quite different FY end dates).

Given CGV’s franchise position and overall industrial strength, its high leverage level and aggressive expansion strategy is likely not a cause for alarm. And if management proves the monstrous goodwill’s worth one day (which is likely), investors will be hugely rewarded.

V. Conclusion

CGG Veritas’ current market value is below our adjusted book value of $50.08. Its earnings power value (based on FY 06 result) puts its worth at $92.2 per share. When long-term growth is also taken into account, the stock is likely to be worth well above $100 a share. So its current stock price ($44.04 as of Friday’s market close) represents a bargain with huge margin of safety. At the mid-40 price level, one is paying for less than its adjusted net worth and getting franchise value (as a leading global geophysical player) for free. The franchise value is worth some $40 to $100, depending on how much of CGV’s future growth is taken into account.

Disclosure: the author owns CGV as of this writing.

Erratum and Update on CIWT’s Valuation Ratios

Yesterday I wrote about CIWT's (China Industrial Waste Management) valuation and growth prospects. In particular, I stressed that this is a cash cow with a Cash/Equity ratio of 57.9% as of 12/31/2006.

That is all good. However, the Price/Cash ratio listed in the Valuation Ratios table (Table 3) was wrong. The value listed was 10.98, when correct value should be 3.46 (based on May 4’s close of $1.48). Essentially the cash content in each share was incorrectly understated by a factor of 3.17.

Here is the corrected table.



And here are the same ratios computed based on today’s (5/8/07) close ($2.40).



Happy investing to everyone!

Disclosure: the author owns CIWT as of this writing.

A Cute Little Cash Cow in China's Industrial Trash Mounds

Small investors often hunt for spectacular return in microcaps. But more often than not they end up losing their precious capital. That does not mean there are no treasures in microcaps. The problem is that few microcaps have a sound underlying business. So small investors often buy into hot trends, cool but empty business concepts, hypes, or even worse, outright scams. And this is the root cause of the incredibly high failure rate associated with microcap investment.

The key to success in microcap investment is to select value stocks with a liquid and profitable business, solid investment returns, and high growth rate. Stocks that satisfy these criteria are what I call two-in-one stocks, i.e., a value stock and a growth stock in one.

A two-in-one microcap stock I recently found and invested in is China Industrial Waste Management Inc. (CIWT). This stock is listed on OTC Bulletin Board and has a market cap of about $19.6M as of Friday’s (5/4/07) close.

1. Financial Highlights

As can be seen from Table 1, CIWT has a quite profitable business with net margin in the thirties or forties 2004 through 2006, the period over which financial data is available publicly. The gross margin falls somewhere around 70%. And it improved significantly in 2006 to 72.08% (from 68.02% in 2005) due to expansion of customer base and increase in sales volume.



In the past two fiscal years revenue growth has been quite robust (17.5% in 2005 and 31.1% in 2006), although net income growth was a little uneven. However, the negative net income growth in 2005 was mainly due to (a) an increase in legal and corporate expenses, and (b) the company was no longer eligible for income tax exemption it had enjoyed in 2004 (and 2003). With the tax difference excluded, EBITDA in 2005 did show a 7.1% growth. (I marked EPS for FY04 and EPS growth rate for FY05 as “N/A” due to the massive share issuance associated with the reverse merger in FY05, which has rendered EPS comparison between FY04 and FY05 meaningless.)

To even out the result, I have also listed the CAGR (Compound Annual Growth Rate) during the entire period (the last row marked “GR 04-06”). The CAGR was 24.1% for revenue, 17.9% for net income and 23.9% for EBITDA. The CAGR values for revenue and EBITDA (which are both about 24%) are likely to be a more objective indication of this company’s long term growth rate.

With the robust growth you would probably have figured that this small company has tapped some sort of debt or equity financing for growth. Not so. This company has no debt (Table 2). It has been able to finance its growth entirely through its operating cash flow! The last column in Table 1 lists free cash flow as a percentage of operating cash flow. For the entire period (2004-2006) not only was the company able to generate positive free cash flow, but also the free cash flow was consistently a huge percentage (72.1% to 84.8%) of its operating cash flow!



That left CIWT with plenty of room to pursue business acquisitions. In 2006, CIWT’s 90% owned subsidiary Dalian Dongtai Industrial Waste Treatment Co. Ltd acquired 60% interest in Liaoyang Dongtai and 18% interest in Dongtai Water Recycling Company. And even after both capital expenditures and acquisitions are taken into account, CIWT still recorded $2.56M in net free cash flow.

CIWT indeed looks like a cute little cash cow. It added $2.72M of cash to its balance sheet in FY06. As of year end 2006, the company has $5.661M of cash, which is an amazing 57.9% of its total equity!

As cash-rich as CIWT is, it is not too surprising to see its current ratio and quick ratio of 9.1 and 7.7, respectively, in 2006. That, along with the exceptionally fast accounts receivable turnover (DSO 12.4 days) and reasonable inventory turnover (103.7 days), makes it obvious that CIWT is operating a highly liquid business.

It is interesting to observe that the current and quick ratios reached double digits in 2005 (Table 2). Meanwhile FCF scored the highest percentage of OCF (Table 1) in the same year. This indicates that the management scaled back on capital expenditures in the year to conserve cash, likely in anticipation of the slower growth (17.5% revenue growth) in the year.

And here comes yet another indicator of a great business in CIWT. From table 2 you can see that CIWT’s investment returns were quite impressive. In 2006 ROA was 25.96%, while ROE and ROC were both 30.47%. (For 2005 there was not enough financial data to compute the various ratios. That was why there were blank cells in Table 2.)

2. Valuation Ratios

Table 2 lists five valuation ratios based on Friday’s (5/4/07) market close and CIWT’s FY06 financial result. For a company that is growing revenue at 31% and EPS at 64% in 2006 and long-term growth likely to be in the twenties, it is quite obvious to me it is grossly undervalued.



Taking everything into perspective, CIWT is a highly liquid, profitable, efficient, and fast-growing small company that is traded at deep discount.

3. Business Description

CIWT is a holding company that has a 90% interest (and 98% voting right) in Dongtai Industrial Waste Treatment Co. Ltd. (Dongtai for short), a company that specializes in the collection, treatment, disposal and recycling of industrial wastes primarily in Dalian City of China’s northeastern province of Liaoning.

As of March 31, 2007 Dongtai has 308 full-time employees, including 55 management and supervisory personnel, 18 technicians and 235 assembly line workers.

According to CIWT’s Chairman and CEO Mr. Jinqing Dong (in his letter to investors), Dongtai has experienced a 600 time increase in asset value in the first 15 years since its inception, from RMB 0.1M (at 1991) to 60M (at year end 2005). That represents a CAGR of 53.18%. Mr. Dong also believes that such rapid growth is most likely to continue based on the management’s analysis on various internal and external conditions.

CIWT’s FY06 financial result seems to agree with Mr. Dong’s projection, with total asset still expanding by 45.79% in the year even after the first fifteen-year’s spectacular growth.

In 2006 about 53% of Dongtai’s revenue was from waste collection, treatment and disposal services and 47% from recycling operations. Table 4 lists the waste tonnage collected by Dontai in the past six years along with growth rate. It can be seen that although the growth rate was uneven over the years, there was significant growth every year. And the CAGR is 27.2% over the entire period.



The management estimates that the annual growth rate for the company’s waste collection business in the next ten years will be 20%.

Combining actual CAGR of about 24% for revenue and EBITDA (see Section 1) from 2004 to 2006, Dongtai’s CAGR of 27.2% in waste collection volume from 2001 to 2006, Mr. Dong’s comments on future asset growth, and management’s projection of 20% annual growth for the waste collection business in the next ten years, it leads me to believe that this company is very likely to experience a sustainable long-term growth in revenue and earnings of 20+%.

Part of the reason behind the management’s optimistic outlook is due to the highly regulated nature of the Chinese industrial waste treatment industry. To be in business, companies have to meet stringent license requirements both from SEPA (State Environmental Protection Administration) and local governments. The license requirements cover staff qualification, technological and management processes. This creates a high barrier of entry into this industry.

Furthermore, the central government usually grants exclusive rights to qualified companies for operation in certain regions. Dongtai is granted exclusive rights to engage in industrial waste treatment business in Dalian and surrounding areas. As a result, Dongtai is essentially guaranteed a basic market in the Dalian area to some extent.

Since last year, Dongtai has begun investing in BOT (Build-Operate-Transfer) projects in Dalian. In such projects, the winning bidder is allowed to invest in the construction of the BOT facility and operate it for 20 to 25 years. During this 20-25 year period the municipal government pays the operator a steady and recurring stream of revenue.

Dongtai currently invest in two BOT projects through taking 18% interest in Dongtai Water Recycling Company and 49% interest in Dongtai Organic Waste Treatment Company. Through Dongtai Water Recycling, Dongtai is participating in a municipal sewage treatment BOT project. Through Dongtai Organic Waste Treatment Company, Dongtai is participating in a BOT sludge treatment and disposal project. The sewage treatment BOT project is projected to generate $985,000 revenue and $150,000 profit in 2008. And the Sludge BOT project is projected to generate $4.95 million revenue and $515,000 profit in 2008.

In terms of intellectual properties, Dongtai holds 4 approved patents and 2 additional pending patents. The expiration date for the four approved patents varies from 2015 to 2027. Besides, Dongtai’s technologies have won awards from local governments or were listed as key environmental technologies by SEPA or the Ministry of Science and Technology. As a comprehensive industrial waste treatment company, Dongtai has ten different processing systems that span electronic garbage dismantling, organic solvent distillation recycling, precious metal recycling from catalysts, comprehensive industrial waste water treatment, incineration and landfill for hazardous and solid wastes, and so on.

Dongtai is also beginning to expand its business into areas outside of Dalian. In March 2006, it co-founded Liaoyang Dongtai Industrial Waste Treatment Co. Ltd and is now holding 60% interest in this company. Liaoyang Dongtai engages in the collection, disposal and recycling of industrial wastes in Liaoyang City, in the central part of Liaoning Province.

The company’s 16-year operating experience along with the reliably profitable nature of its business has enabled Dongtai and CIWT to finance its business expansion entirely with its own operating cash flow. And this financing capability is likely to continue, according to CIWT’s recent 10-K report:

“We believe that our primary sources of liquidity are cash flows from operations and existing cash. We intend to use our available funds as working capital and to develop our current lines of business. We anticipate that cash flow provided by operating activities will provide the necessary funds on a short- and long-term basis to meet our operating cash requirements.”

4. Macroeconomic Environment

China’s industrial waste treatment industry is still in its infancy. Only coastal cities and major inland industrial cities have built comprehensive industrial waste treatment facilities like Dongtai. Most companies in this nascent industry are small, like Dongtai or even smaller. However, the economic and regulatory environments are well aligned to benefit these small players.

To prevent environmental problems from becoming the Achilles’ heel of China’s unprecedented economic expansion, the nation is committed to investing over 1.5% of GDP, or RMB 1.4 trillion, during its eleventh five-year plan period (2006-2010) on environmental protection. In the solid-waste-processing category (which is one of Dongtai’s business area), total investment is planned to be RBM 65B. In another area Dongtai has business in, the industrial waste-water treatment, the total investment is projected to be about RMB 200B.

Dongtai is doing business in the northeastern Liaoning Province, which is one of the country’s largest industrial centers and waste producers. Liaoning ranked No. 4 nationally in annual production of hazardous wastes and No. 1 when historical reserves were also taken into account. In 2005, the province reported hazardous waste tonnage of 7.87M (including reserve), far beyond its licensed processing capability of only 601.1 thousand tons.

And that is why the province has no choice but to take effective measures to alleviate the problem. In LNEPB’s (Liaoning Environment Protection Bureau) 11th 5-year plan, one important focus is to build a provincial network for hazardous waste and medical waste treatment. This provincial network will have two major regional centers, the central region center in Shenyang (Liaoning's capital), and the southern center in Dalian. And you have guessed it: the southern center is essentially the Dongtai treatment facility. Yes, LNEPB has made explicit that construction focus will be on the Dongtai hazardous waste treatment facility expansion project (along with a provincial treatment center).

This undertaking is related to the central government’s initiative to invest RMB 15B in the construction of 31 centralized provincial hazardous waste treatment centers, part of the RMB 65B to be invested in the solid-waste-processing category. So it is no surprise that CIWT mentioned in its recent 10-K filing that the Dongtai expansion project is one of the 31 projects approved under SEPA’s Hazardous Waste and Medical Waste Treatment Facility Construction Program. Likely the Dongtai facility is perceived as part or extension of Liaoning’s provincial treatment center as far as this national initiative is concerned.

In recent years Liaoning has also invested in other regional treatment centers, like those mentioned in this link. However, Shenyang and Dalian are the two major regional centers.

Why is Dalian made one of the two major regional centers in the province? This is simply because of its size and geographical and economic importance. Dalian is a major port, industrial and trade center, and tourist destination in China’s northeast. It has an area of 12,574 square kilometers and a population of 5.721M (as of 2006). It also has a huge and fast-growing economy. Table 5 lists Dalian city's 2006 GDP and Industry Value Added along with growth rate. The city’s investment in environmental protection stood at RMB 520M in 2006.



Dalian’s prosperity has attracted businesses from major Chinese companies and multinationals. Here are some of the major companies with facilities in Dalian that are also Dongtai’s major customers: Canon, Pfizer, Toshiba, Toto, Posco-CFM Coated Steel, Fuji, Wepec, Ryobi, TDK, YKK, Panasonic, and PetroChina.

And, owing to Dongtai’s position as a well-established industrial waste treatment specialist with mature technologies, it does not have to confine itself to Dalian. It can leverage its success in Dalian along with its financial strength to gradually expand its footprint into other areas. And we have indeed seen the company inching into the territory of Liaoyang.

5. Cautionary Remarks

This article represents only my personal opinion on CIWT. It should not be used as the sole basis for taking positions in this stock. In no way should this article be interpreted as a solicitation to buy or sell securities.

For your protection, I also want to point out that although CIWT’s business is highly liquid (as indicated in section 1), CIWT stock is quite to the contrary. There are usually not more than a few buyers and sellers in this stock on any given day. Any prudent investor should refrain from using market orders to avoid unpleasant surprises.

6. Concluding Remarks

CIWT is a grossly undervalued stock with great growth potential. It is a company that is able to grow revenue and earnings north of 20% over the long term while only trading at a P/E of 7.7 recently.

Through sixteen years of operation, CIWT’s 90% owned subsidiary Dongtai has established itself solidly as a leading industrial waste treatment center in China’s northeastern Liaoning Province. Dongtai’s expansion and growth are strongly supported by a favorable regulatory and macroeconomic environment that dictates a somewhat guaranteed market and revenue.

What is truly unique about this microcap is that it is a cash cow. Call it "a little cash cow in China's industrial trash mounds!" This cute, little cash cow is capable of financing its remarkable growth through existing cash reserve and ongoing operating cash flow. Therefore, it looks like a rare microcap that can truly reward its investors over the long run.

Disclosure: the author owns CIWT as of this writing.