Wednesday, December 8, 2010

HQ Sustainable Martime

The following article is a guest post from Frank Voisin, value investor and blogger at FrankVoisin.com. His articles are chock full of value ideas. You can subscribe to his feed here.

HQ Sustainable Maritime Industries, Inc. (HQS) is a producer of tilapia and nutraceuticals operating in the People’s Republic of China (Hainan Province) and selling predominately to customers in North America, Europe and Asia. HQS is trading at a P/E of <7x for a market capitalization of approximately $82m despite having NCAV of $110m ($100m adjusted for A/R – see below point 3). The company has been growing revenues every year, even throughout the recession. With no debt, positive (and greatly increasing) cash flow from operations, and stable revenues, this company looks like a bargain, so I decided to assess its Tangible Asset Reproduction Value and Earnings Power Value. For Tangible Asset Reproduction Value, I eliminated “Intangible Assets”, included an estimate of the Present Value of Operating Leases, reduced Accounts Receivable by 20% (see below, point 3), and added an asset equal to 2x the 3-year average marketing & advertising expense (in line with Bruce Greenwald’s approach in Value Investing: From Graham to Buffett and Beyond). The resulting value per share is $6.15, a 33% increase over today’s price.

For Earnings Power Value, I used a five year average (though I generally like to use a 10 year average, the company had significant changes in 2004 with respect to the acquisition of Jiahua Marine) of the various operating expenses as a percent of revenue. Surprisingly, HQS has had extremely stable COGS as a percent of revenue (Standard Deviation of just 1.8%) and fair stability amongst its other operating expenses, indicating a fairly variable cost structure. Using a figure less than last year’s revenue and a 12% discount rate for the perpetuity calculations, I came up with a value per share of $7.77, a 69% increase over today’s price.

On both accounts, I have found the company to be undervalued.

A potential catalyst event exists in the near term, as management is committed to spinning off its Jiahua Marine division (which produces healthcare and nutraceutical products) into another company with the goal of the floating up to 35% of the new company’s shares on a public market in Hong Kong. Management believes that the separation of the divisions will allow investors in the new company to assess Jiahua independently of HQS’ seafood division, which will then create a datapoint for valuing the 65% still held by HQS. Separation of the two divisions will, in short, create clarity for the market.

There are a few issues that value investors won’t like about this company:

There is a moderate concentration of sales in that the top five customers account for slightly over 40% of revenues. As detailed in past posts, value investors like a large number of diverse customers, minimizing the likelihood of a single event causing a large amount of revenue to disappear. I don’t find this level to be as worrisome as many of the companies I have looked at, though I would prefer to see this number decline over the coming years as the company continues to grow internationally (in 2005, the top five customers accounted for 62% of revenues, so there is a positive trend).

Management holds 90% of the voting power of the company, despite only owning 22.5% of the economic value of the company. This creates perverse incentives and significant corporate governance issues. If management wishes to unlock value, this seems like the easiest place to do so!

The company’s Accounts Receivable balance has grown substantially in recent quarters, leading some to dismiss the company as a value opportunity. With a few more months’ worth of information available regarding HQS, we can now see that the Accounts Receivable increase, though alarming, was confined to the two quarters comprising the latter half of 2009. So far, 2010 has shown the company reducing its Accounts Receivable. When valuing the company’s assets above, I eliminated 20% of the the Accounts Receivable balance (even though the reported amount is Net of allowance for doubtful accounts!) just to be safe.

Author Disclosure: At publication, the author DOES hold securities of the HQS.

4 comments:

tscott said...

Good Job! I feel I am out my circle of competence investing in Chinese companies. There is lots of talk about the validity of their accounting. Look at China Education Alliance last week. I suppose a diversified portfolio would help though.

Joseph Greiner said...

I have circled back around on this company several times. Even on a stand alone cash basis this company seems exceptionally attractive. The two primary risks that I have identified are as follows:

1. It is assumed that most if not all of the cash balance of HQS is held off shore and repatriating the capital back to the US for dispersal to U.S. may significantly reduce the cash balance.

2. HQ Sustainable Maritime Industries has a concentrated Chinese ownership base.

"The Series A preferred stock and the common stock vote together as one class on all matters to be voted upon by the stockholders. In particular, our three largest stockholders, Mr. Sporns, Ms. Wang Li and Mr. Wang Hua, are family members who share approximately 90.05% of the total voting power of our company. Ms. Wang Li is the wife of Mr. Sporns and Mr. Wang Hua is the brother of Ms. Wang Li. These stockholders will be able to determine the composition of our board of directors, will retain the voting power to approve all matters requiring stockholder approval and will continue to have significant influence over our affairs. This concentration of ownership could have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could have a material and adverse effect on the market price of the common stock or prevent our stockholders from realizing a premium over the market prices for their shares of common stock."

Cheers.

Clark said...

Once a diluter always a diluter. A lesson I learned holding this company.

Anonymous said...

Anyone know why management is keeping so much excess cash on the books? Do they have a stated reason? Why not buy back shares or issue dividends? If they really want to "unlock value", that's the most obvious way to do it.

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