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.