Thursday, October 18, 2012

L&L Energy ( Nasdaq - LLEN )

L&L Energy (LLEN $2.00) is a small but ambitious Chinese coal producer.  The company is managed by American nationals who live in China.  L&L has five coal mines with about 75 million tons of reserves.  Coal production represents approximately 30% of sales (60% of earnings).  It also runs two coal washing plants, three wholesale distribution networks, and a coking facility.  Washing eliminates impurities.  Coking produces higher quality coal used in steel making.  Operations are located in the central part of the country, in Guizhou and Yunnan provinces.  That's a relatively new coal producing region.  L&L Energy invests heavily in capital equipment to boost safety and productivity, similar to the more mature mining regions in China.  A lot of the neighboring mines are owned by small under-capitalized operators.  Many of those mine just a sliver of the reserves they control.  They also tend to rely on manual labor and skimp on safety measures.

The central Chinese government established a new road map for the industry in 2009.  It set a goal of consolidating the coal industry into 300 large scale producers with the capital and expertise to industrialize operations, mine more of the nation's untapped reserves, reduce costs, and improve safety.  That program hit a speed bump in 2010 when a series of deadly accidents occurred.  The government shut down large sections of the industry right away, and proceeded to inspect each mine individually before allowing them to start operating again.  In many cases production limits were implemented after the inspections were finished.  Those delays caused a sharp decline in L&L Energy's results in fiscal 2011 (April).  L&L Energy wasn't hit with any sanctions.  But coal output suffered.  The services it provides to other coal producers experienced substantial blows, as well.

Political uncertainty has created regulatory inertia.  The central Chinese government is establishing a new leadership group.  That transition occurs every ten years.  The final roster will become official next month (November 2012).  A high level murder trial delayed the process.  Bureaucrats in charge of the coal industry have tread lightly during the changeover.  That's put a damper on L&L Energy's expansion efforts.  There still exists some risk that the original road map will be changed.  But the underlying fundamentals indicate the industry should resume its march towards becoming more modernized.  Coal accounts for 80% of the country's electricity.  Reserves are high.  Alternatives like oil and natural gas are in short supply.  Economic growth in China has moderated over the past year to a 4%-5% rate (7%-8% officially).  Coal production has trailed development for the past decade, though, so a substantial opportunity exists to displace imports from Vietnam, Australia, and North America.  If costs can be reduced and output raised GDP and employment could benefit.

Acquisitions promise to leverage results.  If the Chinese government continues its existing plan for the coal industry thousands of small producers will be forced to sell out to larger companies.  The consolidation currently is slated to wind up in 2015.  L&L Energy already has made several deals that were simple business combinations, that weren't related to the government's consolidation rules.  Currency controls in China tend to make L&L Energy's U.S. traded stock attractive to prospective sellers.  It's a convenient and legal tool for getting money out of the country.  Future deals are likely to involve stock, cash, and earnouts in combinations that yield immediate bottom line benefits.

Coal prices have begun to strengthen.  L&L Energy is less vulnerable to import competition than much of the Chinese industry because of its location in the interior of the country.  Still, the surge in imports had exerted indirect pressure on prices earlier in the year.  Industrywide inventories have reverted to normal levels, helping profitability improve in recent months.  Costs remain under control.  And more outside producers have been signed up to use L&L Energy's washing and distribution services. 

The long term outlook is bright.  Organic growth is likely to accelerate once the new government takes over and the regulatory cloud lifts.  Further acquisitions already are being pursued.  And overall energy demand continues to rise.  China is aggressively developing its natural gas fracking industry.  That still accounts for a minor part of the total energy mix but it is likely to expand materially over the coming decade.  Serious thought is being given to using that resource for transportation, though, rather than electricity production.  Hydro-electric output already is at full capacity.  And while some solar installations are being built most of the panels made in China still are exported.

We estimate sales will rise 39% in fiscal 2103 (April) to $200 million.  Income could advance 70% to $.85 a share.  Our 2-3 year projection assumes 15 million more shares outstanding than at present, to finance the company's acquisition program.  Sales could reach $500 million to provide earnings of $1.65 a share.  Our baseline case, excluding acquisitions, puts revenue at $350 million and earnings at $1.50 a share (modest share count increase).  Applying a P/E multiple of 7x to the lower figure suggests a target price of $10 a share, potential appreciation of 400% from the current quote.

( Click on Table to Enlarge )

Wednesday, October 17, 2012

Computer Modelling Group ( Toronto CMG ) -- Market Share Expands

Computer Modelling Group ( $20.00) appears on track to report excellent on target Q2 (September) results.  Energy prices remain at elevated levels, providing the cash flow to support new development.  And most of the reserves that are being identified these days are difficult to extract.  Computer Modelling is the leading provider of simulation software used by energy companies to maximize production of tar sands, heavy oil, shale, and other challenging targets.Competition is provided by Schlumberger and Halliburton.  Those companies have a large installed base of customers who use their software for so-called "black oil" deposits, which are relatively straightforward to extract.  Both also offer high end solutions.  Those products are less powerful and comprehensive than Computer Modelling's.  As a result, users often spend enormous sums on consultants to muscle the work through.  A growing number of oil and gas developers are switching to Computer Modelling while maintaining their other business relationships with Schlumberger and Halliburton.

At a recent trade show Schlumberger and Halliburton didn't advertise their high end simulators.  Both products remain on the market.  The two giants are becoming resigned to working with Computer Modelling in high end applications, though.  That trend promises to boost financial performance in upcoming periods, particularly in international markets where large national oil companies typically have relied on the majors for one stop shopping.

Our estimates are unchanged.  Future growth could be amplified by a next generation system that is slated for commercial release in late 2013.  Shell and Petrobas are sharing the development cost.  Those companies will obtain first crack at the technology.  But Computer Modelling will retain 100% of the marketing rights with no obligation to pay royalties or any other reimbursement.

( Click on Table to Enlarge )

Points International ( Nasdaq - PCOM ) -- Slower Deal Flow

Points International (PCOM $10.00) appears on track to report somewhat reduced growth in upcoming periods.  We have reduced our financial estimates, accordingly.  The company is the leading provider of loyalty programs for airlines, retailers, banks, and other consumer oriented companies.  Growth has been explosive over the past several years.  Further gains are likely as more companies implement the technology and additional features are introduced. 

Competition is becoming more intense.  Points has several potential deals in the pipeline.  Most of the prospects are large corporations that run their own loyalty programs.  In many cases they employ large consulting companies to help out.  Points's technology is superior.  But it's getting more difficult to dislodge the entrenched consulting companies.  Those firms provide a wide range of services beyond loyalty programs and are using discounts and bundled pricing to retain the business.

Organic growth is being sustained at a 15%-20% pace.  Existing customers are broadening their programs.  And smaller accounts continue to be added.  Growth is poised to moderate somewhat, though, due to the slowdown in landing larger accounts.  The long term outlook remains positive.  Gains are likely to be maintained in the near term but at a reduced rate.

( Click on Table to Enlarge )

3-S Bio ( Nasdaq - SSRX ) -- Receives Buy-Out Offer

3-S Bio (SSRX $13.50) appears on track to produce excellent Q3 results.  The long term outlook remains favorable, as well.  Finances are robust, moreover.  The company holds approximately $7.00 a share in cash.  3-S Bio's chief executive in combination with a local private equity firm recently submitted an offer to purchase the entire company for $15.00 a share in cash.  Several other U.S. listed Chinese companies recently have made plans to go private, as well.  Numerous China based companies have blown up during the past three years due to accounting fraud and other irregularities.  That's caused the value of Chinese shares in general to trade at reduced valuations. 

The American short selling community has investigated 3-S Bio on several occasions.  Nothing out of the ordinary has ever been discovered.  The company is run by U.S. trained scientists.  It's products compete on the world stage.  A major American dialysis company, Davita, recently formed a joint venture with 3-S Bio to take advantage of the high potential Chinese health care market. 

The price being offered appears low.  After the company's cash is backed out the deal values the ongoing business at 8x earnings.  In light of 3-S Bio's growth potential and high likelihood of success a significantly higher multiple appears justified.  Since the company's CEO is part of the buy-out group it's unlikely competing offers will emerge.  Existing shareholders might insist on a higher price.  It's uncertain if the buyers will agree to that, however. 

Financing appears to be in place.  The transaction looks like it has a high probably of going through.  Current holders might want to wait and see if a better price emerges.  The stock still has 10% to go to reach the stated buy-out price.  Investors realistically can hold off to earn that arbitrage income, as well.  More aggressive investors can sell the shares now and reinvest in another Special Situation.

( Click on Table to Enlarge )