Tuesday, May 22, 2007
Dongfang Electric (1072): a Faithful Buy
This was a company I came to know in late 2005 when Vincent and his team recommended it on Quam, largely because of the cheap valuation (maybe 5x prospective p/e) and the huge order book on hand. I wasn't such a macro guy and couldn't see very far ahead, figuring the good prospect couldn't sustain, so I made a pass on it. And what a miss it turned out. Now I'm looking at it again 18 months later at over $37, and it was less than $10 back then!
Fellow bloggers especially Wing hing have covered DE pretty extensively and you can check out the links to the right for their work. I'll only supplement my thoughts after reading the annual reports and the latest acquisition circular.
Good points
(1) DE has a good clientele serving the power companies. Foremost there's no need to worry about not getting paid. And 2nd in case you're not aware the power industry is constantly under complain for paying out too high a salary to its supposedly civil servants. What's that to do with DE? Well I think you all know it's a lot easier doing business with the rich than the average. How easy? So easy that DE doesn't need working capital.
(2) All 3 DE units have negligible debt. Over the last 3 years, all its working capital requirement was supported by customers and suppliers. If you add up the figures you'll find DE units have what Warren Buffet calls 'float', unbelievable for a construction type company. On the balance sheet the items 'receipt in advance' and 'amount due to customers for contracts' even exceeded the total of a/r and inventory. The trend looked like that DE received huge deposits from customers in 2004 (which maybe the beginning of an order), so much that it had to place it in fixed deposits, for its cash need throughout the order up to 2006.
(3) Why's that? My guess is DE really dictated the terms with the power companies back then. This may be due to its market position and superior engineering capability. Speaking of which, it also means that unlike the heavy industry, DE has relatively little capital requirement. There's no much to reinvest and since working capital is taken care of too, DE is always stuffed with cash.
(4) With the continual growth in power industry, where older equipment is being replaced, and in alternative energies like hydro, wind, and nuclear. The future looks very bright for DE.
Bad points
(5) Are the power companies as generous with new orders? For orders placed in 2004, or even earlier in 2003, the power companies were having a field day (902 and 991 were over $8 and $7 respectively). There was no coal price hike, no restricted tariff increase, and no utilization hour to worry about. Now is a very different climate and the 'float' may go away.
(6) Contrary to popular belief, hydro projects (62% less vs coal-fired) and higher MW coal-fired projects (33% less gross margin YOY vs 2005 for DE boiler) carry substantially lower margin than older less efficient coal-fired projects. Management only cited price competition and did not explain in details. The reason could be there's more foreign competition in these advanced projects, as domestic competition is unlikely. Or (5) could be the reason. But the fact does suggest newer projects have lower margin.
(7) Steel price also was a concern highlighted by the management though it wasn't a contributing factor in the 2006 results. But my speculation is special steel price will more likely rise than fall.
(8) Expect overall margin to decrease over time. In fact management has predicted only increased earnings for the turbine business, flat earnings for DE itself, and decreased earnings for boiler business. As we're nearly midway into 2007 these projections do carry weight. Plus there's no incentive for them to downplay the prospect when seeking approval for a major merger.
For reference the profit forecast is $2.91 a share, or $2.62 to adjust for increased profit tax under reform. I like the business and especially the 'float', but at current price ($36.1) and with a downtrend in margin, it requires faith to think it'll continue to deliver extraordinary return on assets (and to the stock price too). It's a reasonable investment but not spectacular opportunity.
I have more confidence in performance of special steel companies which supply to DE and other equipment manufacturers. Any idea?
DISCLOSURE: I don't hold 1072 at time of writing.
Fellow bloggers especially Wing hing have covered DE pretty extensively and you can check out the links to the right for their work. I'll only supplement my thoughts after reading the annual reports and the latest acquisition circular.
Good points
(1) DE has a good clientele serving the power companies. Foremost there's no need to worry about not getting paid. And 2nd in case you're not aware the power industry is constantly under complain for paying out too high a salary to its supposedly civil servants. What's that to do with DE? Well I think you all know it's a lot easier doing business with the rich than the average. How easy? So easy that DE doesn't need working capital.
(2) All 3 DE units have negligible debt. Over the last 3 years, all its working capital requirement was supported by customers and suppliers. If you add up the figures you'll find DE units have what Warren Buffet calls 'float', unbelievable for a construction type company. On the balance sheet the items 'receipt in advance' and 'amount due to customers for contracts' even exceeded the total of a/r and inventory. The trend looked like that DE received huge deposits from customers in 2004 (which maybe the beginning of an order), so much that it had to place it in fixed deposits, for its cash need throughout the order up to 2006.
(3) Why's that? My guess is DE really dictated the terms with the power companies back then. This may be due to its market position and superior engineering capability. Speaking of which, it also means that unlike the heavy industry, DE has relatively little capital requirement. There's no much to reinvest and since working capital is taken care of too, DE is always stuffed with cash.
(4) With the continual growth in power industry, where older equipment is being replaced, and in alternative energies like hydro, wind, and nuclear. The future looks very bright for DE.
Bad points
(5) Are the power companies as generous with new orders? For orders placed in 2004, or even earlier in 2003, the power companies were having a field day (902 and 991 were over $8 and $7 respectively). There was no coal price hike, no restricted tariff increase, and no utilization hour to worry about. Now is a very different climate and the 'float' may go away.
(6) Contrary to popular belief, hydro projects (62% less vs coal-fired) and higher MW coal-fired projects (33% less gross margin YOY vs 2005 for DE boiler) carry substantially lower margin than older less efficient coal-fired projects. Management only cited price competition and did not explain in details. The reason could be there's more foreign competition in these advanced projects, as domestic competition is unlikely. Or (5) could be the reason. But the fact does suggest newer projects have lower margin.
(7) Steel price also was a concern highlighted by the management though it wasn't a contributing factor in the 2006 results. But my speculation is special steel price will more likely rise than fall.
(8) Expect overall margin to decrease over time. In fact management has predicted only increased earnings for the turbine business, flat earnings for DE itself, and decreased earnings for boiler business. As we're nearly midway into 2007 these projections do carry weight. Plus there's no incentive for them to downplay the prospect when seeking approval for a major merger.
For reference the profit forecast is $2.91 a share, or $2.62 to adjust for increased profit tax under reform. I like the business and especially the 'float', but at current price ($36.1) and with a downtrend in margin, it requires faith to think it'll continue to deliver extraordinary return on assets (and to the stock price too). It's a reasonable investment but not spectacular opportunity.
I have more confidence in performance of special steel companies which supply to DE and other equipment manufacturers. Any idea?
DISCLOSURE: I don't hold 1072 at time of writing.
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