Guest Post: Duoyuan Global Water (DGW): Chinese Water (Long idea)

Duoyuan Global Water (DGW): Despite concerns, a cheap pure play on water and Chinese urbanization

By Josh Rowe

Introduction

On September 13, American depository shares of Duoyuan Global Water (DGW) were cut in half on worries over an accounting scandal at DGW’s sister company, Duoyuan Printing (DYP). Duoyuan Water and Printing share a chairman, Wenhua Guo, but have separate management teams; the CEO and CFO of DYP have been replaced. DYP also fired its auditor, Deloitte, and instituted an internal review of possible irregularities in its filings to the SEC. At the time of writing, it was not clear which numbers were in question, or whether, as some have speculated, DPY withheld information such as bank statements, distributor contracts, or expense accounts from its auditor. Notwithstanding the meltdown in the stock, there is nothing to link the controversy at DPY to Duoyuan Global Water, apart from Mr. Guo’s role as chairman of both companies. DGW is undertaking a preemptive third-party review of accounting standards, which may entail future headline risk. Regardless, with its market cap cut in half, fears are likely overblown.

The scandal is the third shock to weigh on investor sentiment regarding DGW since its listing in 2009. The first was of its own making; following a run up to $45, the company announced a secondary offering of 3.5 million shares (increasing the float some 11%), to which investors reacted negatively. The second was the slowdown in Chinese stocks as the PBOC raised deposit reserve requirements for lenders, putting the brakes on the credit-fueled bull market of 2009. I believe that neither of these first two negatives poses a serious obstacle to the long-term performance of DGW’s shares. Water is a secular bull market in China, dependent less on the global business cycle than on internal demographics. DGW’s secondary was not as dilutive as the subsequent share price drop would suggest, and is not necessarily a token of future dilution. $211 million in cash ($8.50 share diluted) lends ample room for expansion of capacity without tapping the equity market.

The third concern represents an “unknown unknown.” Due to Western investors’ persistent uncertainty about standards of transparency and corporate governance in the People’s Republic, the mere whiff of an accounting scandal is sufficient to seriously impact the credibility of a Chinese firm’s financial reports. Because DGW is listed in America and subject to the reporting requirements of the Securities Exchange Act of 1934, and because its relationship with its auditor, Grant Thornton, appears to remain solid, these sorts of risks should be less worrisome than in stocks traded only on Mainland Chinese exchanges. If the accounting irregularities are confined to Duoyuan Printing, and if a prospective investor is willing to accept the increased volatility of a Chinese-originated ADR, DGW represents compelling value over a several year horizon. Though we must acknowledge concerns over slowing growth in China and DGW’s potentially dilutive capital markets strategy, my conclusion is that these risks should not greatly affect long-term holders of the stock. The following paragraphs present the bull case for shares of DGW, predicated on its highly competitive market position in an area of secular and state-supported growth.

Reasons for optimism

Above all, market dynamics support a rising demand for DGW’s products, both within the PRC, and potentially outside. As a rapidly industrializing, urbanizing economy, China’s water needs should grow far in excess of cheap, reusable supply. According to a recent series of reports in The Economist, China has 21% of the world’s population yet only 6% of its renewable fresh water. In the water-poor North and West, conditions are particularly problematic—80% of the country’s water is in the more developed South, and the North China Plain that sustains much of the country’s agriculture is currently in drought. 67% of Chinese cities are in deficit; this is a large and growing problem, as China currently has over 150 cities with greater than 1 million in population. The average Chinese citizen subsists on only one quarter of the water per person of the world average.

Market research cited by DGW indicates that demand for water treatment products is expected to grow 15.5% per annum to 2012, and faster thereafter. DGW should benefit from increases in demand for water for personal consumption, industrial use, agriculture, and municipal water treatment alike. At present, 38% of the company’s revenues come from circulating water treatment products used in cooling and refrigeration, 22% from water purification (drinking water, food processing, the electronics and pharmaceutical industries), and 41% from wastewater treatment and reuse (municipal sewage, petroleum, paper).

This last segment should see the most robust growth. The company itself projects 45.5% increases in sales due to increased urban demand, government regulations mandating water treatment, and tougher enforcement of environmental protection laws. The latter are becoming a higher priority in state policy as newly wealthy Chinese consumers awake (as did Americans in the 1950s and 1960s) to aesthetic and health consequences of environmental laxity. DGW’s ambitious projections are supported by a number of political considerations and by the secular dynamic of urbanization. The current national budget allocates more than ¥150 billion for mandatory water conservation. This number should form a minimum baseline in future years. DGW’s expanded production capacity reflects its anticipation of at least a robust upgrade cycle.

56% of China’s population still lives in rural communities, often constrained by a hereditary registration laws that define residency as rural or urban, and determine land allotments. These laws are likely to be further liberalized, and the standards of living and social mobility offered by urban life continue to attract young Chinese to the many fast-growing cities. The Ministry of Housing estimates that between 2010 and 2025 some 300 million Chinese will move from rural areas to urban. Residential property markets in Hong Kong and Shanghai have recently come under scrutiny as high-end properties have traded at spectacularly high valuations. In second and third-tier cities, however, property price rises continue unabated, driven on by a strong fundamental demand dynamic. Most China watchers believe that urban migration is a process that has not approached its peak; as it grows, demands for water treatment and reuse will as well. This is not a bubble; it is a powerful, sustainable trend.

Appealingly, municipal water treatment is also a high-margin business for DGW. All of its products in this segment earn over 40% gross (frequently more) and technological developments in quality and efficiency drive pricing power. DGW’s microporous aerator, a new product in 2009 that has seen high rates of adoption, is one example. Using oxygenation to kill more than 98% of germs in wastewater, the microporous aerator competes at the high-end of the market. One of the beneficiaries of DGW’s equity offering, projected 50% sales growth rates in this product should provide adequate returns on capital. In recent years, R&D has shrunk somewhat as a share of revenue, but has grown significantly in absolute terms (net sales have increased by more than 32% each of the past three years). Particularly among its domestic competitors, the company is a technology innovator, and links its future strategy to remaining such. In the medium term, DGW is exploring licensing agreements with Israeli and American firms to bring highly efficient drip irrigation and membrane-based desalinization technology to its product portfolio. Though it is not discounted in the stock price, management recognizes that agriculture represents an enormous untapped growth market. There has also been some preliminary talk of partnerships with distributors in India. I would adopt a “wait and see” approach.

DGW has several competitive advantages in all of its business segments. Compared to international offerings from Veolia, Suez, or Thames, DGW (thanks to cheap labor) is the low cost producer. Domestic competitors cannot offer the same diversity and complementarity of product offerings. RINO, which provides water to the iron and steel industries, was a popular name with Western smart money in 2009. By contrast, the wide range of DGW’s businesses make it a less cyclical, more secular play. Unlike niche manufacturers leveraged to growth in particular industries, DGW is a WalMart-like “one-stop shop.”

DGW evidently believes its U.S. listing give it better access to capital and more brand prestige than its Chinese rivals. One of its largest expenses is a 12 million RMB CCTV 4 advertising campaign to convince distributors of its superior product quality. Selling costs have risen slowly and steadily on the back of this and other campaigns. DGW operates with a network of over 80 regionally diverse independent distributors; international competitors are often limited to one. By agreeing with distributors to yearly contracts, DGW is highly flexible to regional demand shifts, and maintains tighter control over working capital. Like an industrial company, DGW’s vertical integration permits volume discounts on raw material, and improved workflow from standardized practices across segments. Like a high-tech company, its relative small size and investments in R&D give it an edge in energy efficient and non-chemical water treatment technologies.

Financial analysis

An analysis of DGW’s financial position (if it can be believed) reveals a pristine balance sheet, a strong platform for growth, and an excellent cash flow yield. I have attached a discounted cash flows model, with conservative assumptions, that can easily generate valuations at a 50 to 100% premium to the current price. The model is fairly rough and unconventional in places, but fairly self-explanatory. Thus, here, I will merely highlight some of DGW’s financial results that speak its compelling value at current levels. Full financial data are only available from 2009, at the time of DGW’s New York listing; still, this business is steady enough that a reliable picture can be drawn. As of Q2 2010, DGW carried no debt on its balance sheet. It has financed itself entirely through equity, which it has redeployed as capital expenditure, primarily to bring online a new manufacturing facility at Langfang, where many of its higher-margin products are made. This significant investment should reduce mandatory CAPEX in the near future. Elsewhere, the balance sheet has expanded at a rate above 50% for the last several years, though without significant growth in working capital. Inventory turn came down from 96 to 78 days over the previous FY. The company has weathered the rise in raw material costs since 2006 admirably, increasing gross margin from 35% in 2005 to 48% in 2009. Operating margin improved from 14% to 24% over the same time, and is on track to hit 32% for FY2010. A 2008 change in PRC corporate tax policy eliminated DGW’s privileged status and applied a standard rate of 25%, equity-financed CAPEX, reflected in long term asset growth, appears to be in the neighborhood of 10% of revenue. These charges have not materially harmed the bottom line; free cash flow is on track to grow 70% in 2010.

From a cash flow perspective, the company is doing even better than its statement of operations might indicate. In June 2009, in accordance with FASB rule 123r, DGW expensed the award of $12.6m in ordinary shares (2 are redeemable for 1 ADS) at par to its employees, making up a significant proportion of SG&A cost. This share-based compensation was a sub-CFO level award for services already rendered. Rather than an ongoing compensation expense, shareholders should view the award as a one-off, a reward made possible by the company’s American listing. Management claims, “Going forward, we anticipate employee share-based compensation expense to be minimal.” The effect was a large, non-cash hit to net income. The award was not tax deductible; excluding the impact of share-based compensation, net income would have risen pro forma 55.7% in 2009. Instead it declined 12.5%. Cash flow growth in 2009 was in excess of 30%.

Assuming flattening growth across all four business segments (circulating water treatment, purification, wastewater treatment, and spare parts), with wastewater gradually increasing its share of operations, it is reasonable to expect total sales growth over the next decade to range between 15% and 35% per annum. If we also assume that the company can maintain its recent operating averages both on the cost side and in stewarding its capital, it is likely that we will see consistent double-digit cash flow growth for the foreseeable future. There is a risk that management will find, as technology leaps forward, or as competitors enter the market, that this level of performance is more capital intensive than it has currently estimated. Duoyuan may take on debt; more likely there may be further dilution of existing shareholders. Further, the cost of being a market leader is increased competition. DGW may lose pricing power, or may be forced to invest more of the proceeds of growth in marketing. Fluctuating raw material costs pose another challenge; the company targets 40% or greater gross margin on all new products, but with most hard commodities in secular bull markets, this may be unattainable. Nevertheless, DGW has a number of structural advantages in sourcing, distribution, technology, and in its (so far) cozy relationship with the state. Economies of scale should mitigate some of the headwinds to profitability.

All told, assuming historical operating averages remain intact or decline somewhat (a fairly conservative assumption, in my view), a discounted cash flows analysis generates a ADR value of $28.55, more than a 100% premium to mid-September 2010 levels. If current growth and profitability trends persist, the value could be much higher. I have used a 10% (marginally below DGW’s WACC) discount rate that I believe is at least a fair opportunity cost of owning equities in a global slump. Chinese equities may deserve a higher discount rate; if so they probably deserve a perpetual growth rate above the 2% I have employed.

Catalysts

Besides being substantially oversold, there are a number of catalysts that make DGW an attractive play into the end of 2010. Firstly, because of the impact of 2009’s share-based compensation, net income for 2010 will have a relatively easy comp. The stock is not heavily covered; thus when the December 31 10K reports earnings growth of 120%, some heads on the Street may turn. DGW has beaten the EPS consensus three of the last five quarters. If there is to be any material appreciation in the renminbi (which looks unlikely at present), input costs at PPP will come down and the dollar value of American-listed shares will increase. At minimum DGW is insulated from adverse currency fluctuation. Finally, water is a theme that is attracting more and more institutional money managers as global shortages (this summer’s Russian fires being a key illustration) become more acute. Duoyuan is the clearest pure play on water in the PRC.

More compellingly, it is likely that the heft of political mandates for investment in wastewater treatment will increase in late 2010. Wastewater, now the largest revenue driver for DGW is the most important variable in cities’ water conservation efforts, and is an important health consideration. China’s 12th five-year-plan, to be released this year, is expected to heighten focus on efficient water use and environmentally sensitive development. Environmental protection occupies a new significance in the minds of China’s planners, who see leadership on environmental issues as critical to China’s economic development, the quality of life of a growing middle-class, and to its diplomatic position in the world. DGW stands to benefit from any explicit mention of water use in the forthcoming plan.

Conclusion

My bull position on DGW rests on the view that the market has mispriced the risk of owning a Chinese ADR listing, and views DGW as a higher beta play on the Chinese business cycle than it actually is. Its balance sheet is clean, its finances are conservative, and ROIC on the development of the manufacturing facility in Langfang (as well as R&D facilities planned near the Daxing headquarters) funded by IPO should be positive. Investors scared by the surprise and relative opacity of management’s share-based compensation award should not expect a repeat. The stock shows a cash flow yield of greater than 6% with respect to enterprise value, and FCF multiple of only 15 times based on my 2010 projections. Compare this to a 130x multiple for the Shanghai Composite, per Bloomberg in August 2010. Its enterprise multiple is below 3, while the Shanghai Composite averages near 7. If Duoyuan Global Water were not tarred by the brush of scandal at DPY, or by the froth of what Jim Chanos calls “the greatest credit excess of all time,” I believe value investors would be taking heed. The risk of an unknown unknown in Chinese stocks is always great. The perception of that risk, however, represents much of the downside, as rumors lead investors to fly to the exits. This has already happened in DGW. I would explore a small, non-core position, occupying no more than a few percentage points of my portfolio, at an entry below $14. It seems unlikely that a question over expense accounts at a separate company could shave 50% of the value off a name that was already cheaply valued. If the scandal blows over, and DGW’s numbers can be believed, the stock could trade in high twenties by early 2011.

DCF Model:
https://docs.google.com/leaf?id=0B_ipU5WJf9sJNGE1Yjc4NmUtYTg3Mi00YjZlLWFhYzQtZTc5NGQwODQ1MDc3&hl=en&authkey=CLOxhv8B

Disclosures and Disclaimers: This long idea should not be taken as a recommendation to buy or sell any security. This is an informational posting only. Both the author and the proprietor of this site have been and will cotinue to be invested in DGW at various points in time.

About the author: Josh Rowe is currently in the final stages of earning his PhD from Princeton University and will soon be looking for buyside employment in San Francisco.