Posted by: donmihaihai | February 8, 2008

Another big fat Ass.

SP Chems announced a “bad” 4Q2007 results in an uncertain market where its NPAT slumped a huge 52% to reach RMB38.2 million compared to RMB79.3million in 4Q2006. The share price slump as well and now trade at $0.675 and from various reports, SP Chems is currently trading at fair value.

Since SP Chems is in a capital intensive industry where huge infrastructure must be build up 1st cum in a cyclical basic chemical industry with no pricing power, using Book Value to value SP Chems is a good choice. Now at $0.675, SP Chems is valued at 1.1 X book Value, back to the valuation where I made my initial purchase in May 2006 which was also just above Book Value at around $0.46.

What so special about trading just above BV since many Value investors learnt from Ben Graham about purchasing stock below BV or even net-net stock (below working capital). Going by that way, SP Chems haven’t met the target unless it drops another 30 to 50%. Well, who know, it may happen. 1st of all, Ben Graham did not care about the business as long as it is a going concern. Even if it is a bad business, as long as it is still be around, the chances are value investor can sell them away at BV or higher sometime in the future. This buying below BV provided a margin of safety for them.

Valued at just above BV also mean that SP Chem cannot and unable to generate satisfactory return going forward or their book is fake. Is that the case? In the almost 2 years since I own SP Chems, its BV jumped $0.20, close to 50% from around $0.40-0.45 to $0.62. In fact, SP Chems BV or shareholder equity grow extraordinary from $0.23(with $0.04 from IPO proceeds) in 2003 when SP Chems IPO to current $0.62 for 2007. After getting a $0.04 per share($14.1 million) from investor in 2003, SP Chems has never raise any money from investor or thru option despite the huge amount of capital required. This is the best single indicator that SP Chems is generating good return. And it doesn’t matter if NPAT drop this quarter or next quarter as long as profit is not going back negative for long, growing of BV depend more on ROE than earning growth.

Well there are negative concerns such as 1) profitability of Aniline, 2) profitability of VCM, 3) freak snow storm in China and 4) high debts.

1) Profitability of Aniline is actually not a concern at all. Like all basic chemical, Aniline goes thru cycle. Over production lead to soft pricing and under production lead to super profit and in the previous cycle at 2003/2004, Aniline made losses at gross level but SP Chems overall profitability was supported by the super profit of Caustic soda and Chlorine. Then the cycle turned, with Aniline generating super profit while Caustic Soda at breakeven level but Chlorine making huge losses. At that point of time, Aniline profit was sweetened by extra imbalance in benzene and Aniline output. Currently, there is nothing much to do except to wait for the cycle to turn and it can take abit longer as greater profit earlier can lead to greater/longer losses this time round.

2) The profitability of VCM is a tough call as VCM is usually being produced inhouse by downstream PVC chemical producer. As the management said, there are no/little independent producer out there. With high ethylene price, raw material for VCM, it seem like profitability is a concern. But well, as a cyclical product(hard to believe it is not), it is always subject to demand and supply and if it is not profitable for SP Chems to produce VCM, the producer of PVC will not be that profitable(or making losses) as well. The diff between SP Chems and these downstream producers are separate by transportation expenses. High raw material costs usually pass thru the value chain. It is just a matter of time when the profitability turn.

3) Freak snowstorm is out of control and just for a short period. The worse? Making losses in 1Q2008 which is nothing to fear about.

4) The level of debts for SP Chems is not high at all even though the sum may look huge at around RMB1.1 billion. The debt/equity ratio of 1X is not much especially taking into consideration of SP Chems owning about RMB2 billion of hard assets. And more than 1/2 of them are less than 5 yrs in operation and operate strategically at CFCITP. SP Chems has no problem about paying the interests of the debt as the cashflow is usually higher than NPAT due to the capital intensive natural of the business. The latest prove is despite reporting a bad quarter, cashflow cover 5X interest payment on whole year basis.

In fact, SP Chems actually cut dividend in 2007. The feeling is not good when dividend is cut but when SP Chems is facing some short term uncertainty with interest rate going up in China, it is much better to pay down debts than paying dividend. And with wonderful outlook cum MTSBP 2 going forward, being at a strong financial position is much better than paying dividend but weaker their financial position.

A comparison between SP Chems and Stamford Tyres.

A comparison is make between SP Chems and Stamford Tyres and it is make not because they are in the same industry but mainly because on factors like 1) dividend, 2) different perception from investor as Stamford Tyres is seem as a stable business with dividend paying quality while SP Chems is not 3) Currently facing short term problems, and lastly 4)The only 2 companies I know of that fit those categories.

At the 1st look, SP Chems is much better than Stamford Tyres in every year in ROE and ROA except in 2003 where SP Chems lost out in ROE(due IPO proceeds) but was still better in ROA . In fact, generating ROA of 9 to 12% in consider good as that is return on assets deploy without any liabilities. But the main point is at cashflow and dividend, despite having a low dividend payout ratio, SP Chems showed that they are ready to cut dividend when the debt level goes up as in 2005 and debt/equity remain stable at 1X after that. But for Stamford Tyres, the decision to keep paying increasing dividend yearly start to back fire in 2007 and despite cutting dividend payout during FY2007 results, dividend payout ratio should goes up rather than down in FY2008. Investor had been enjoying first and paying later with rather high dividend yield due to low share price. In fact, Stamford Tyres was generating negative cashflow for past 4 yrs after interests payments.

With debt/equity moving up every year to 1.47X for Stamford Tyres, if it does not start to generate cashflow to at least cover interests payment, Stamford Tyres should start to reduce dividend downward(already started), stop expansion and sell inventories (tyre and rim).

In fact, Stamford Tyres look more like a Ben Graham stock than SP Chems and it is actually trading at a slight discount to it BV currently.

SP Chems for past 5 years

ROE : 2007 : 23.05%, 2006 : 28.68%, 2005 : 26.56%, 2004 : 24.37%, 2003 : 15.76%.

ROA : 2007 : 9.69%, 2006 : 12.17%, 2005 : 10.53%, 2004 : 12.36%, 2003 : 9.47%.

Debt/equity : 2007 : 0.99, 2006 : 1.00, 2005 : 1.01, 2005 : 0.74, 2004 : 0.40.

Dividend payout ratio (NPAT) : 2007 : 15.16%, 2006 : 17.39%, 2005 : 7.10%, 2004 : 15.41%, 2003 : 0%

Dividend payout ratio (cashflow) : 2007 : 11.86%, 2006 : 11.64%, 2005 : 4.87%, 2004 : 11.16%, 2003 : 0%

Stamford Tyres for the past 5 years.

ROE : 2007 : 13.04%, 2006 : 19.30%, 2005 : 12.67%, 2004 : 18.17%, 2003 : 16.55%.

ROA : 2007 : 5.56%, 2006 : 8.46%, 2005 : 5.98%, 2004 : 8.64%, 2003 : 7.87%.

Debt/equity : 2007 : 1.47, 2006 : 1.40, 2005 : 1.33, 2004 : 1.31, 2003 : 1.31.

Dividend payout ratio (NPAT) : 2007 : 38.94%, 2006 : 21.85%, 2005 : 38.13%, 2004 : 18.25%, 2003 : 14.32%.

Dividend payout ratio (cashflow) : 2007 : negative, 2006 : negative, 2005 : negative, 2004 : negative, 2003 : 12.33%

There the biggest question I been cracking my head on, can SP Chems generate free cashflow? It is generating lot of free cashflow presently but in the future? I am betting a big yes right now.


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