Friday, April 16, 2010

Leveraging Net-Nets

Hanwei Energy (HE) is a Canadian-headquartered company that operates in the industrial pipe business (for oil, gas and water transmission) primarily in Asia. The company trades at about a 30% discount to its net current assets, but has seen its revenue decline as a result of a combination of factors (more competition in one of its major markets, the global recession, transformation of one unit into a joint venture, etc.).

Unlike most net-nets, however, the company is mostly breaking even, and therefore may appear to be an attractive investment for value investors. Further investigation, however, reveals some caveats to look out for even for profitable companies trading at discounts to their net current assets.

First of all, the company's accounts receivable constitutes a large part of its current assets. While the company believes strongly in its ability to collect on it, the size of the receivables equate to over a year's worth of sales, meaning many customers are likely significantly overdue on their payments.

Adding to the risk of the receivables situation is the company's debt. Indeed, two companies with differing debt loads can have the same level of net current assets, but one is still more risky than the other. Consider two companies, each with net current assets of $50 million, but where Company A has $50 million of current assets and no liabilities, while Company B has current assets of $200 million against $150 million of debt. If half of both company's current assets become in doubt, Company A is still in a position to survive; Company B, however, becomes underwater, with shareholders at serious risk of losing their entire principal.

Furthermore, it appears Hanwei is intent on adding to its debt load and continuing to grow, thus increasing the risk for the investor. From the company's latest quarterly report:

"The Company’s 2010 growth plan requires additional working capital of Renminbi (“RMB”) 150 million ($23 million). This mainly includes working capital to support the growth in the pipe business. Management plans to finance these working capital and investment needs with cash on hand, cash from operations and debt facilities which have been arranged with Chinese banks. Management also believes that it has the ability to access additional equity financing if needed..."

So rather than reduce risk by paying down debt where possible, the company is actually planning to continue to lever. If business operations are indeed successful, the reward to shareholders at this price could be handsome. Unfortunately, the risk of principal loss (which value investors seek to avoid) also appears high.

Where possible, value investors should try to determine a company's plans going forward, and should be wary of investments with too much or increasing leverage, as the risk of principal loss increases in such situations.

Disclosure: None

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