Most people know this: gasoline and diesel are hot, red hot, and people in every part of the world just cannot get enough of them. Most people would also agree that if somebody can get tons of gasoline and diesel from refiners somehow and store them into giant oil storage tanks in any major city in the world, that person will be very very rich because all oil retailers, gas stations, and factories using oil generators in or around the city will rush in to pay the owner a handsome price to buy the gasoline and diesel. What very few people know: there is an oil distributor/wholesaler in China called Longwei Petroleum Investment Holding Limited (LPH), which possess highly sought-after and extremely hard to obtained national licenses of storing, wholesaling, and distributing petroleum products in China, two huge facilities with extremely costly and hard to built giant oil storage tanks, state of the art computer monitoring system, fueling stations, and railways for transporting products directly to factories, straight-forward and stable business model, and highly reliable and easily verifiable national suppliers, trading at a dirt-cheap estimated current-year P/E of about 2.5, estimated forward P/E of less than 1.5, and below book value of equity per share!
In comparison, most comparables of the company all over the world such as PetroChina (PTR), China Petroleum & Chemical Corp (SNP), CNOOK (CEO), Taishan Petro (traded in China), Shen Yang Petro (traded in China), Kinder Morgan Energy (KMP), Energy Transfer Equity (ETE), Southern Union Company (SUG), Regency Energy Partners (RGNC), Enterprise Products Partners LP (EPD), Copano Energy (CPNO), Kinder Morgan (KMI), MarkWest Energy (MWE), El Paso Pipeline (EPB), El Paso Corp (EP), Energy Transfer Partners (ETP), Duncan Energy (DEP), Magellan Midstream Partners (MMP), Chevron (CVX), ConocoPhillips (COP), Exxon Mobil (XOM), Schlumberger (SLB), BP PLC (BP), Petroleo Brasileiro (PBR),Valero (VLO), Tesoro Corporation (TSO), Chesapeake Energy (CHK), Frontier Oil (FTO) are trading a P/E multiples of 10, 15, 20, or even higher.
I believe that the stock has been unduly affected by recent negative sentiment on Chinese stocks and temporarily depressed to this unjustifiably low level. I feel that after the dusts settle in Chinese small cap space, the stock should gradually appreciate to a P/E of 10, about the average P/E level in the industry. I also believe that at current price level the probability of instant arbitrages on the stock — big intuitional buy, hostile takeover, private buyout, due listing, etc — is very real and can hit the wire any time. Some recent examples of valuation arbitration resulting in huge flash price jumps are:
Buyout offer on HRBN at about 200% premium: http://www.bloomberg.com/news/2011-06-20/china-s-harbin-electric-jumps-on-buyout-offer.html?cmpid=yhoo.
The CEO of Puda Coal (PUDA) announcing a cash buyout offer of all PUDA shares for $12 per share, 100% premium over its halted price of $6: (http://finance.yahoo.com/news/Puda-Coal-Receives-BuyOut-prnews-1178582160.html?x=0&.v=1).
Morgan Stanley’s large purchase order on YONG: (http://www.bloomberg.com/news/2011-05-31/morgan-stanley-invests-in-short-sale-target-yongye-international.html?cmpid=yhoo)
Bain Capital Partners’s buyout offer on CFSG: (http://www.reuters.com/article/2011/05/24/us-privequity-orphans-idUSTRE74N0G620110524?feedType=RSS&feedName=innovationNews&rpc=43)
Buyout of CPC: http://finance.yahoo.com/news/Chemspec-International-prnews-407766362.html?x=0&.v=1
Buyout of FTLK: http://finance.yahoo.com/news/Funtalk-China-Holdings-prnews-424194345.html?x=0&.v=1
The happening of just one of the aforementioned outright valuation arbitrations can send the stock price of this extremely undervalued companies up by 50% – 100% in just one day and 300+% in 3 to 6 months when the deal is completed (see later paragraphs for further analysis).
More Background Information:
The company is in the business of oil mass storage, wholesaling, and distribution in Shanxi province and adjacent provinces in China. Longwei has campuses of two big campuses of industry-leading storage facilities in Shanxi province and is in the process of closing the deal on acquiring the third one soon. The company has an extensive distribution network with its own and affiliated gas stations and transportation trucks covering a huge footprint in Shanxi province and the adjacent Shaanxi province.
Shanxi and Shaanxi provinces are in a region that is China government’s primary focus to increase business activities and per capita income under current 5 year plan. Many cities in the two provinces are experiencing above average growth rate right now and transforming from developing cities to developed cities like Shanghai, Beijing, and Guangzhou. The prosperity of the region creates a great backdrop for Longwei to growth its business in a fast speed in the next decade.
More background information for the company is available in the following sites:
The company has delivered a robust compound annual revenue growth rate of over 50% in the past three years and over 70% last year, this of course partly was attributed to the fast increase of total consumption and price of crude oil and gasoline in China. The sentiment toward further growth of gasoline price and consumption in China has recently been dampened as a result of consecutive rate hikes made by China Central Government over the past three months. This worry, however, is at minimum over stretched and probably completely misplaced. Unlike The increase of gasoline price and sale volume in China over the past decade was driven by strong growth in “intrinsic demand” — need for more oil by growing urban populations and corporations, cars, flights, power plants, factories, and production activities from these factories. Even after two decades of fast GDP growth, there are actually about 500 million “middle class and above” population in China. The remaining 900+ million people are at marginally acceptable or poor living standard. The majority in the later group are even short of household essentials such as cell phones, refrigerator, TV, and microwave, letting alone owning cars or taking flights. It is China central government’s goal to bring urbanization and higher per capita income to those under-developed areas, most of them located in western and northern China, over the next 10 years. That’s why despite of the government’s hard effort in trying to prevent the economy from running out of control over the past year, the economy is still growing at over 10% annual rate this past quarter and is expected to still deliver 9% growth rate in 2011. Under this backdrop of general economy, it is certain that demand and consumption for gasoline will continue to be strong and grow steadily, albeit possibly at slightly lower rate than last year, in 2011 and beyond. My view of strong demand for oil are shared by many financial analysts and economists in China. Here are two examples:
Unlike the financial market of U.S., the financial market in China does not offer futures and options on gasoline. Unlike the case for the U.S. before 2008, no speculation or “financial demand” does not have any share in shaping gasoline price in China. So, there is really no “bobble” of gasoline demand and price right now in China. Barring the cases of a complete stale in GDP growth or worse a drop in GDP, it is not rational to expect a disappearance of growth in gasoline demand in China in the foreseeable future.
At micro geographic level, the growth prospect for oil wholesalers and retailers in Shanxi and Shaanxi provinces is even stronger than national average. The region, located just west and north from the central point of China, is right on the border of the “developed portion” and “under developed portion” and at the front line of the next wave of urbanization and GDP growth plan China central government is implementing. Some good articles on the region’s fast economy growth can be find below:
http://www.shanxi.gov.cn/n16/n8319541/n8319612/n8322053/n8324962/n14398382/14623870.html (official 2010 economy review in Chinese on Shanxi Provincial Government website)
http://www.google.com/url?sa=t&source=web&cd=10&ved=0CFIQFjAJ&url=http%3A%2F%2Fwww.seiofbluemountain.com%2Fsearch%2Fdownload-file.php%3Fid%3D4063&ei=k5JRTb-DDIm4sAOxv7XwBg&usg=AFQjCNHsC0daQB5SixOJZ7wpxqpFb2Dhvg (note that this article also mentioned the short of financing sources faced by many enterprises in Shanxi, the reason that Longwei came to U.S. to seek financing from American investors and in return offers this rare investment opportunity to Americans, a win-win situation)
The Industry and Competitions:
The company’s business is very infrastructure and technology intensive, but relatively not labor intensive. As the company stated in its 10K filing, “Barriers to entry in the industry are very high due to stringent licensing requirements and the need for significant storage capacity”, which I completely agree basing on my knowledge of this industry and China regulatory environment. The business requires huge up-front investment in infrastructures and equipments, and requires the facilities and supporting operations to comply to a strict sets of safety and environmental regulations. The financing requirement is daunting under normal times and is daunting currently and in the foreseeable future due to tight monetary environment lenders in China are facing right now. This is one of the reasons the company chose to be listed in the United States — to seek financing from American investors to seize lucrative acquisition and expansion opportunities currently present in the industry (see further discussions below). The safety and environmental requirements are tedious and sophisticated. A small mistake made during construction of the facilities can cause a company a huge financial cost and effort to remedy, and in some cases can be uncorrectable. Both factors give unsurpassable advantage to existing operators in the industry, especially those with an experienced management team, as is the case with LPH. Last but not the least, due to cumbersome application, monitoring, and tedious regulatory conformation procedures, provincial officers always prefer doing business with existing companies that they have been acquainted with over the years and are very reluctant to even consider reviewing applications from start-ups. All of these facts converse to the a single point: almost unsurpassable barriers to entry and secured and profitable lives for established players in the industry.
On the backdrop of recent turmoil in the Chinese small cap group, the management team of LPH has done several things this year in order to assert itself as completely legitimate and robust company. First, on 4/15/2011 CFO of LPH Mr. Michael Toups issued a news release to respond to investors’ concerns: http://finance.yahoo.com/news/Longwei-Petroleum-CFO-prnews-4091296973.html?x=0&.v=1
The most important information provided by Mr. Toups’ answers are:
- The management team will not issue new shares at then current price $1.64 to finance the purchase of the new facility but will instead use cash on hand, working capital, and debt financing to finance the acquisition.
- The board of directors is working on upgrading the auditor to a big 4 or 6 accounting firm and has had preliminary discussions with all of these audit firms.
Next, on 5/19/2011 after its last ER on 5/17/2011 the company hosted a conference call to review Q3 results and answer analysts’ questions. In my opinion, Mr. Toups gave very well-thought and informative answers to key questions such as financing for the new acquisition, how the company can maintain good operating margins, re-assurance of clean financials, and high possibility of auditor upgrade beginning next fiscal year, re-affirmation of fiscal year revenue and non-GAAP net income guidance, etc. Again, the information that the management team will try to finance the new acquisition solely through current working capital, future earnings, and debt financing and will only issue new shares at no less than $3 per share as the last resort to finance no more than 25% of the purchase price is especially encouraging. As a reminder, This last acquisition of a large-scale facility in non-overlapping geographic area confirmed to my research and analytical conclusion BEFORE THE EVENT that northern and southern part of Shanxi province offer huge additional short to long term growth opportunities on top of what the company can find in central part of Shanxi province, the area its two current facilities reside.
The CFO also stressed again that the management is very eager to upgrade its auditor for 2012 to assure to the world that the company is very serious about maintaining a well-controlled internal accounting procedure and processes that completely follow GAAP guidelines. He even went to a point to disagree with a caller’s opinion that upgrading of auditor at this point might not be important in saying that “the CEO and board just want to get a bigger name auditor for 2012 regardless”. I don’t know how other people think but to me this unintentional response from the CFO to a caller tells me clearly that the management team is not just talking but actually walking the talk on auditor upgrade. I surely disagree with the thinking that hiring a big 4 or 6 accounting firm will prove nothing for LPH simply because some Chinese small caps having big 4 firms as their auditors were also alleged of fraud. The argument will be like saying passing a security check point in terminals today says nothing more about the likelihood of a person carrying dangerous articles because many terrorists carrying arms passed security check points with ease before 911. Everybody knows security checking equipments and procedures in terminals have become so much better today after 911. Similarly, after recent allegations on some Chinese small caps, I bet that big accounting firms that care about their images and reputations surely have improved their controlling and auditing processes for Chinese clients from these lessons learned and will not sign up a new Chinese small cap without examining all key titles and transactions that account for at least 90% of the company’s revenue, costs, assets, and liabilities. So, the fact that the management team is not afraid but rather desires to engage and sign a big 4 or 6 auditor have already convinced me that what investors see in their quarterly and annual reports are indeed what they get. It is also possible that the management team is reviewing listing in NYSE, Hong Kong, or mainland China so that the management team would like to have a bigger auditor in place to help the new IPO. Note that the CFO said in responding to another question that the management team will consider some investors suggestions to study the possibility of listing in other markets such as Hong Kong where investors do not have any negative bias toward companies from mainland China. See later sections for further discussions on this topic.
Next, on 4/20/2011 the CFO gave a very impressive presentation on RedChip virtual conference: http://www.redchip.com/visibility/conferencePages/virtualconferences/april2011/virtualarchiveapril2011.asp#
Important topics covered by the CFO in the presentation were:
- The company has 12 own tanker trucks used to deliver oil products to its gas stations and customers’ locations. Some customers also send in their own oil tankers to transport oil products.
- Coal production in Shanxi province is growing at 30% annual rate right not, and other industrial activities in Shanxi and adjacent provinces are growing fast too. Two key requirements these industrial customers have on energy supplier are reliability and speed of supply. So, location is key to service industrial customers. That explains the importance of LPH’s newly acquired 3rd facility at the northern part of Shanxi province.
- Each of LPH’s top five suppliers accounts for 10% – 17% of LPH’s total supply. In other words, the concentration risk is low.
- LPH has strong relationship with all suppliers and have ability to lock in the price for future orders in advance with some advance deposit. The company increases advance to suppliers and decreases inventory on hand when price rises quickly; on the other hand the company decreases advance to suppliers and increases inventory on hand when price stagnates or drops.
- The company is able to forecast future gasoline and diesel prices with high accuracy because China government gives 22 days “lock-back” period basing on basket of international prices in its price setting process for wholesale and retail products. Combining this with point 4, the company is able to maintain a very strong gross margin — a wide price differential between the prices it sells to customer and the prices it pays suppliers.
- The company’s strong relationships with suppliers allow it to obtain oil products on a timely manner when there is a sudden surge in demand for its products.
- The management team will use cash on hand, working capital, and debts to finance acquisition of the new facility.
- The management team is foreseeing revenue of $925 million and net income of $125 million for fiscal year 2012 if acquisition of the new facility is completed by the end of this fiscal year.
- In the case that the management team will consider issuing new shares to help financing the new facility, the management team will use equity financing of no more than $25 million and will not sell any new shares below $3 per share. In any case, the management team will keep dilution below 10% of current shares outstanding to deliver maximum accretion to EPS from the new acquisition for existing shareholders.
- The management team has been constantly adding talents to its accounting team and strengthen accounting control and transparency. The company is looking to upgrade its auditor to one of the big-4 auditors for the coming fiscal year.
- The company was re-designing its website, which will include live videos of operations in the facilities (the website is already down; see later paragraph).
- The company welcomes any investor or analyst to visit all its facilities.
- Numbers in the company’s SAIC filing match numbers in its SEC filing after adjusting for time period difference, business transactions in the U.S. that are not included in SAIC filing in China, and other minor adjustments such as currency rates.
- The management team aims at eventually list the company on NYSE (though I suspect the management team might be thinking about other better alternatives of listing than NYSE or Nasdaq, which I’ll go over later).
- The company has done very thorough due diligence when preparing its acquisition of Gujiao and Haujie facilities and have both U.S. and China legal consoles review the acquisition valuations, legal documents, and financing.
Then, on 6/3/2011, Longwei’s IR firm RedChip posted a video online in which Redchip CEO Mr. Gentry visited Longwei’s headquarter and facilities in Taiyuan city and interviewed its CEO Mr. Cai and CFO Mr. Toups. The video can be watched on this page: http://www.redchip.com/testflash.asp
The video contains very good information and visual evidences that in my opinion proves that LPH is everything its management team says it is. The video gives general public a clear view on what’s going on at the facilities including its high capacity storage tanks, pump stations (for fuel tanks), rail spurs connecting to national main rail lines heading to power plants and coal mines, and a cutting edge ERP system, which is integrated with its accounting system to automatically debit an appropriate AR account basing on automatic inputs from the fueling system at the pumps when a customer’s truck is filled up and credit an appropriate AP account when a vendor’s tanker adds gasoline/diesel to the storage tanks. This way, human intervention is prohibited and mistakes in recording business transactions are minimized. Here is Baidu map of LPH’s Taiyuan facility clearly showing national rail ways going through the facility: http://map.baidu.com/?newmap=1&s=inf%26uid%3D81d127560f3bd0acf12d8356%26c%3D176%26it%3D1&fr=10. Here is a list of hotels near LPH’s Taiyuan facility: http://www.17u.com/tag/shanxi-taiyuan-307/longweishihua/. Note that this is a page on a travel portal specifically for visitors to LPH’s Taiyuan facility. Apparently, the facility is probably famous in Shanxi and attracts quite some business and individual visitors every week so that the travel website dedicates a hotel list page just for the facility. By showing this video the company has really raises itself above even the largest global oil giants such as Exxon Mobile, Chevron, or Philips Conoco Phillips in terms of transparency and visibility to investors because I bet very few investors including institutional ones have checked the oil wells, platforms, and other facilities of these oil producers and distributors. In the video, the CFO said that the facility fills up 50-60 oil tanker trucks every day, a throughput clearly supported by just the two fueling stations for oil tankers shown in the video that can fuel at least 8 oil tankers simultaneously. The CFO also explained the usages of various sizes of storage tanks to serve various need of customers and stressed the huge untapped total capacity in these tanks for further inventory expansion. In addition, the CFO confirmed once again that the board has talked to big 6 accounting firms and is aiming at upgrading to one of them for fiscal year 2012 when answering Mr. Gentry’s question regarding eliminating investors’ concern on reliability of accounting reports. Last but not least, the CFO touched on the strategic importance and appeal of its newly acquired facility in northern Shanxi, which echo’s my analysis of where the company should expand to in my coverage initiation and follow-up post on the company’s acquisition of the new facility.
Next, the company has created a totally re-designed, re-engineered new website on 6/14/2011 (http://finance.yahoo.com/news/Longwei-Petroleum-Announces-prnews-1716385882.html?x=0&.v=1). The new website can be seen here: http://www.longweipetroleum.com/. It is apparent that the company has spent a lot of time and money designing the new website. The layout and appearance of the new website look very professional and cutting edge than the old website. It fits perfectly to the management team’s mandate of bringing Longwei to the next level — in the management’s term the “major league” of the energy industry and publicly traded companies.
The new website contains a lot of well organized and valuable information such as:
- The home page and Overview page in Corporate Info section (http://www.longweipetroleum.com/corporate-info/overview) clearly list all facilities and assets (oil tanks, railroads, owned by the company and their capacities and key licenses awarded by China central government.
- The Management and Board of Director page in Corporate Info section list detailed background and qualifications of key executives and directors. In my opinion, the executives and board of directors have strong experience in business administration, corporate governance, accounting control, financial markets, and the oil industry.
- The page in Petroleum Projects section (http://www.longweipetroleum.com/petroleum-products) lists all current major products the company is selling with exact product numbers used in China.
- The home page and Competitive Advantage (http://www.longweipetroleum.com/operations/competitive-advantage), Sales & Marketing (http://www.longweipetroleum.com/operations/sales-marketing), Growth Strategy (http://www.longweipetroleum.com/operations/growth-strategy), and China’s Energy Market (http://www.longweipetroleum.com/operations/chinas-energy-market) pages in Operations section provide detailed descriptions and explanations of the industry, the market, and the company’s strategy of expansion, growth prospect, and competitive advantages that the management team went over in conference calls and presentations.
- The Storage & Operations (http://www.longweipetroleum.com/operations/storage-operations), Railroad System (http://www.longweipetroleum.com/operations/railroad-system), and Quality Control (http://www.longweipetroleum.com/operations/quality-control) pages in Operations section provide detailed descriptions and explanations of these key aspects of operations and show photos of various parts of the facility for investors to see in their own eyes. Many of the equipments, people, and fixtures shown here are also shown in the onsite interview video mentioned earlier (http://www.redchip.com/visibility/investor.asp?symbol=lph)
- There is a Facility Web Cams page (http://www.longweipetroleum.com/operations/facility-web-cams), which is going to show daily operations in the facilities so that all investors can see and feel daily lives of the staff employees and workers in the site (and hopefully appreciate what they work on diligently every day for the society and the shareholders). Per formal response I got from the management team, the implementation of the live videos has been delayed due to firewall issues that are technically more difficult to overcome than the IT team’s original estimate. As a person with hands-on system development experience, I can certainly sympathize with the challenge the IT team is facing. I also think that live streaming may not provide good viewing experience for investors in the U.S. because cross-pacific bandwidth is limited (granted, some investors might be ok viewing lagged videos). I have suggested using timely updated video recordings as an alternative. It would .like daily “transaction logs” of a database that can be used to show what happens in a database every day and recover the database to any date and time. This way, the quality of the video can be higher than real-time streaming and viewers can cache for a while before start viewing to make watching a video a more pleasant experience. The management team said that they have taken my suggestion seriously and will adopt it if the firewall issue cannot be solved soon. So, I think the videos, live or recorded, will be shown in this page very soon. For now, the onsite interview video mentioned earlier has served the purpose of showing many parts of the operations to the public.
- The pages in Investor Relations section make all SEC and other public financial, conference calls, and other business information easily accessible for the public. The design and functions of pages in this section is very impressive and match those on the websites of fortune 100 companies in my opinion. The easily customizable spreadsheet view of historical prices (http://ir.stockpr.com/longweipetroleum/historical-quotes) and financial data (http://ir.stockpr.com/longweipetroleum/financials) is especially convenient for investors and analysts.
- The FAQ page under Shareholder Resources (http://ir.stockpr.com/longweipetroleum/faq) answers many key questions that investors care the most. Notice that the question about the company’s independent auditor is left blank, possibly because an announcement of a new auditor is coming soon and the management team doesn’t want to confuse investors now.
- The FAQ page, IR contacts page (http://ir.stockpr.com/longweipetroleum/ir-contacts) and Contact Us page (http://www.longweipetroleum.com/contact-us) make detailed address and phone numbers to the company’s offices, CFO, Investors’ Relations, Transfer Agent, and Legal Counsel openly available to the public. Again, the contents and designs of these pages match the biggest and best known companies of the world in my opinion (many small caps do not openly and willing show a lot of contact information to their executives and offices).
Last but not the least, the company presented again in RedChip’s virtual conference on 6/23/2011 – http://www.redchip.com/visibility/video/displayClientpre.asp?symbol=LPH&confID=12&fileloc=mms://wm.vitalstreamcdn.com/aurelius_vitalstream_com/RC/VCJUN2011/LPH_VCJUN2011_pres.wmv&descr=RedChip Virtual Conference VIII
The company even went so far as to file a formal SEC form 8-K registration to make its presentation an official legal document in SEC’s record – http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001013762%2D11%2D001806%2Etxt&FilePath=%5C2011%5C06%5C23%5C&CoName=LONGWEI+PETROLEUM+INVESTMENT+HOLDING+LTD&FormType=8%2DK&RcvdDate=6%2F23%2F2011&pdf=
LPH seems to be the only presenting company in the conference to make this extra effort to marking its management team’s words on a stone. Because other presenting companies did not do that, it is reasonable to assume that LPH’s management team did this by their own judgment and was not advised by RedChip team. Small things like this truly set the confidence and integrity of LPH’s management team apart from those of most other Chinese small caps. By registering the presentation to SEC the management team essentially hard bind themselves legally on every information and numbers they have in the presentation. This is yet one more evidence supporting that what investors have seen and heard from the company’s official communication channels (websites, presentations, videos) are what the company really is.
Some new pieces of information provided in this last conference presentation (including the Q&A section) are:
- 1. The management team is seeing revenue of $925 million, adjusted net income of $123 million, and adjusted EPS of $1.09 (adjusted net income and EPS exclude potential non-cash derivative revaluation charges for the remaining not yet exercised warrants issued in 2009, which is about 9% of current shares outstanding).
- 2. The CFO answered in the Q&A section that the board is aware of the huge valuation gap between LPH and its comparables trading in Hong Kong and is working with its legal counsel in reviewing the possibility of listing in Hong Kong.
- 3. The CFO also said that the board would consider a buyout offer of $4 – $5 if that’s the best for all shareholders even though the CEO’s original vision is to grow the company into a big cap. I was called out by an important meeting later of the day and thus did not get a chance to sit in LLEN’s presentation, but I am sure LLEN management team would probably give similar answers.
Information about the Company’s Major Suppliers
To dig further to understand the supply side of the company’s operations, which is the second most important piece of running the business after the key assets, I did some extensive research of LPH’s top 5 suppliers that together account for 72% of the company’s cost of sales in 2010. Here is what I found:
Guangzhou Tenghao Company, LPH No.1 supplier (17%) in 2010:
Headquarter Location: Guangzhou city in Guangdon province (http://en.wikipedia.org/wiki/Guangzhou) — one of the biggest harbors in China importing all kinds of goods including petroleum products. Also the biggest city in the most populated province in China.
Corporate website: http://www.tnho.com.cn/intro/gsjs.html
Corporate profile on a job posting site: http://gz.oiljob.cn/jobseeker/company_message_1_0_937_1.html
My Note: Tenghao is a very large national refiner and supplier of petroleum products that was formed as a joint venture by several top universities in China, China Petroleum & Chemical Corp. (SNP), CNOOC Ltd. (CEO), and other national oil producers. It has branches/subsidiaries in southern and north-central China and sells products mostly to mid-size+ oil distributors and wholesalers in China.
Lanxin Petroleum Co., Ltd., LPH No.2 supplier (16%) in 2010:
Headquarter Location: Beijing City (http://en.wikipedia.org/wiki/Beijing) — capital of China and one of the top 3 most populated city in China.
Corporate website: http://www.china-bluestar.com/cn/zyyw/index.asp?producttypeid=69&MenuOn=5
Baidu Search: http://www.baidu.com/s?bs=Lanxin+Petroleum&f=8&wd=%C0%B6%D0%C7%CA%AF%D3%CD%D3%D0%CF%DE%B9%AB%CB%BE&n=2&inputT=889
Shanxi province random product quality examination in 2010, which specifically called out Lanxin Petroleum gasoline used by Longwei passed the test: http://wenku.baidu.com/view/fb98f2f7ba0d4a7302763a72.html
My Note: Lanxin Group is one of the biggest conglomerates in China with public traded and private subsidiary doing a wide range of businesses. It’s public traded subsidiary Shen Yang Petroleum, which I used as a comparable to LPH in my valuation, is a large petroleum and chemical importer and refiner in northern China. It also has at least three large scale private independent subsidiaries supplying petroleum in central and northern China that have “Lanxin Petroleum” as part of their company names (which locale specific prefix).
Panjin Jinjiang Oil Company, LPH No.3 supplier (14%) in 2010:
Headquarter Location: Panjin City (http://en.wikipedia.org/wiki/Panjin) — a harbor and major oil-producing city in Liaoning Province at north-east corner of China.
Corporate profile on a yellow page site: http://nengyuan.qincai.net/corp-8012.html
My Note: Panjin Jinjiang Oil Company is a large-size regional provider of petroleum products in northeast China.
Yan Lian Industrial Group (a fully-owned subsidiary of Shaanxi Province Yan Chang Petroleum Industrial Group), LPH No.4 supplier (13%) in 2010:
Headquarter Location: Yan’an City (http://en.wikipedia.org/wiki/Yan%27an) — A major city in Shaanxi province, adjacent with Shanxi province to the west. Shaanxi province is the trading center for many goods coming from Mongolia, western part of China, Russia, and countries adjacent to the west border of China. All these areas are major oil-production areas.
Corporate profile on Baidu Pedia: http://baike.baidu.com/view/4724023.htm
Corporate website: http://yanlianshiyejituan.cn.gongchang.com/
Parent company (Shaanxi Province Yan Chang Petroleum Industrial Group, top 500 companies in China) website: http://www.yanlian.com/gsjj.asp
My Note: Yan Lian Industrial Group is a super-sized oil refiner in Shaanxi province. Its parent company Yan Chang Petroleum Industrial Group is a national petroleum giant and one of the top 500 companies in China that is partially own by Shaanxi provincial government (100% owned by provincial government before until being partially privatized).
Tianjin Dagang Jinyu Industrial Co., Ltd., LPH No.5 supplier (12%) in 2010:
Headquarter Location: Tianjin City (http://en.wikipedia.org/wiki/Tianjin) — one of the biggest harbors in China importing all kinds of goods including petroleum products and a center of heavy industrial activities.
Corporate profile on Alibaba: http://tjjysy.cn.alibaba.com/athena/companyprofile/tjjysy.html
My Note: This is a more regional, rather than national, supplier. However, it has been doing the business for 20 years and has a very complete list of petroleum and chemical products. So, it still looks like a very reputed and reliable mid-size supplier to me.
Looking at the information on the top 5 suppliers shown above, I have the following observations:
Three of them are super big national petroleum producers in China, and the remaining two are well known mid-size+ regional petroleum producers. All of them have advanced oil refining and processing facilities and are very reliable suppliers. From all the information I see, although they these companies are big and sell products to many places in China, they are not based in Shanxi province and don’t have any major facility or distribution network in Taiyuan metro or other places in Shanxi province. So, they have use a wholesaler in the province to store their products and distribute the products to retailers.
It does not look possible that Cai can have substantial ownership in any of these big suppliers and can influence their management team. Remember that these companies are big, and most of Cai’s capital is still tied to LPH. So, it is extremely unlikely that any of these suppliers will do any cover up for LPH.
It is almost impossible that any of these big and well-regarded suppliers would take customers’ deposit and run away or eat it own words written in contracts to supply a valuable customer like LPH petroleum products at deeply discounted, very competitive prices in a timely matter. The implication: LPH’s advances to suppliers are safe and well spent for a good purpose.
By law of statistical distribution and regression (notice how slowly the percentage decreases from No.1 to No.2, it is likely that the next 2 to 5 biggest suppliers probably account for 20% – 25% of LPH’s 2010 cost of sales, and they are also big national or regional petroleum suppliers. In other words, the top 7 to 10 suppliers together likely account for 95% of LPH’s annual material purchases. So, to audit 95% of LPH’s cost of sales, its auditor only needs to send inquiry letters to no more than 10 companies to ask them how much their 2010 sales to LPH was. Of course this kind of information is confidential, but any supplier will have no problem releasing it as long as the requesting party has a written consent from its customer. It is not an exaggeration to say that doing this is really a walk in a park for any auditor. The simplicity and sheer small number of suppliers and major assets is the critical factor that differentiates LPH from the majority of other Chinese small caps in terms of likelihood of manipulating accounting numbers and fooling the auditor.
One point I’d like to mention here is that by staying strictly with storing and distributing products (in LPH’s case petroleum products) and away from the task of actually discovering and producing products — e.g. exploring and/or refining oils — LPH faces much smaller risk than PTR, SNP, or CBEH (because a huge chunk of CBEH’s business is producing bio-diesel fuel). Any company that is in the business of production faces the risk of disruption in production due to all kinds of problems every day. The risk is especially high for oil/bio-diesel producers (look no further than BP’s huge disaster last year for example). On the other hand, the risk on cost side that LPH faces is much smaller and manageable.
The aforementioned events and developments together with all additional data and information from other sources have given me enough confidence to once again feel confident that there is no material misrepresentation in any of the company’s past financial reports and that the management team has not mis-informed the public intentionally regarding the company’s assets and operations.
Again, I recognize that there is no sure guarantee that no serious problem can happen in the company, and as I say in my disclaimers that investors always need to do their own due diligent and control their investment and trading risks (managing risk for short-term trading is especially important for short-term traders on Chinese small caps because of current still distorted sentiment and manipulations by shorts and some others). However, basing on strong surrounding evidences suggesting an honest, integral, and investor-friendly management team, auditor, and business operations, I see no reason not to give the benefit of doubts to the management team. Think about this: if I am a CEO who is seriously cooking the book and just want to get more money from the public, why would I committed to use cash, working capital, and debt financing to expand my business to give existing shareholders biggest bang for their bucks and use limited equity financing only as the absolute last resort? Why would I work so hard to upgrade to a big 4 or 6 auditor in coming months, who I know very likely will scrutinize my books hard before willing to sign up? Why would I produced a detailed site video with the CEO of a well-known PR and analytical house? Why would I openly let all people watch recordings of my operations on my website? Why would I openly put key legal documents on my website for all investors to view? If any part of my business operation or financial reports is bogus, I wouldn’t do any one of these actions, letting alone all of them.
In my opinion nowadays some demand on the management team of Chinese small caps to prove everything just go too far beyond the line. By the standards Chinese companies are required to prove themselves, Exxon Mobile, Chevron, or Philips Conoco Phillips all may be frauds and all are all not worth investing because I bet very few investors including institutional ones have checked their oil wells, platforms, and other facilities. So, should I value all these stocks at a forward P/E of less than 1.5? Nothing is 100% in this world, but I do not think it is an adviceable or statistically proven profitable strategy to base investment decision on a slim probability — say 1% — of something being true. If you ask me I would say I am pretty certain but not 100% certain either that even the most well known companies out there such as Google, Berkshire Hathaway, and Boeing are 100% clean. Thus, I do not think that it is fair and reasonable for an analyst to excessively punish a stock and shy away from it simply because he/she has not seen all internal accounting or business records (if he/she does he/she probably has violated SEC’s rule on insider trading anyway).
The stock has been depressed at current underground dirt cheap level over the past few months under last rounds of allegations of frauds on several Chinese small caps, among them CCME, RINO, and LPH’s not so similar peer CBEH. Even for those who have very negative feeling toward Chinese small caps for RTOs, they need to recognize that there is no specific accusation or allegation of fraud or financial misreporting of any sort by the company. In addition, although the management is working diligently to upgrade to a big 4 or 6 accounting firm under general pressure from investors on Chinese small caps, there is no reason to think that its current auditor is not doing its job. The fact that LPH’s business model is so straight forward and it is so easy to audit the titles of their key assets and transactions that constitute the majority on their balance sheet and income statement is another thing that dramatically decrease the likelihood of the company manipulating its numbers without being caught for years. I think the stock has been depressed to this level solely because of general “doubt” being applied to all Chinese small caps lately and many investors adopting an approach of assuming guilty until proven innocent and sell first and ask question later to all Chinese small caps.
The trouble in CBEH, which many consider a comparable to LPH, added doubts and fears to this stock too. What many people fail to recognize is that although the two companies’ operations have some similarities, comparing CBEH to LPH is still comparing apple to orange. One critical difference is that CBEH is in the business of producing something, in this case bio fuels. Any company that produces/manufactures something naturally can potentially run into problems of not being able to produce as much as the company would like to sell due to all sort of reasons — supply shortage, technology problem, labor problem, quality control problem, etc. Another key difference is that bio diesel has much smaller customer base and distribution channel than regular gasoline and diesel. In other words, CBHE faces much higher operational difficulties and risks than LPH on both production and sales sides. LPH is in the business of purely getting a highly standard product from source producers, store them, and then sell and distribute them to customers. As I said in my coverage initiation, for a commodity with high demand like gasoline, there is really no question if LLEN will be able to sell all inventory it has got any time it wants, and with many not-so-sophisticated oil wells and refineries sitting in the oil-rich part of western and northern China, southern Russia, and some other adjacent countries, it is not difficult for the company to find rich supplies of the products. The only difficulty is that it has to have national level one license to store oil and buy directly from refineries, a license that is enormously difficult to get in China (think about national communication license that AT&T and Verizon need in order to operate telecom in the U.S. as an analogy) and huge capital and technical requirements to build these huge oil storage tanks, fueling stations, pipes, railways, and advanced monitoring systems. Many people probably are not aware of how daunting the engineering specifications of these oil tanks and other equipments are. Building these facilities are not like building a single house in Texas! It is extremely expensive, and it is very hard to pass government inspections on safety, quality control, and environmental control, to start operating. However, once the company has pass all these obstacles and have had all required arsenal in place, the business operations become a stable and low risk profit generating machine that is very easy to manage because the product sells for itself and barrier to entry is extremely high.
Notice that a couple funds increased their stake in LPH big time last quarter (http://www.nasdaq.com/asp/holdings.asp?symbol=LPH&selected=LPH&FormType=Institutional), $3 million of money is not a small amount by any standard, if I were the fund manager of these funds I would not have put such a huge investment in a small cap unless I had known exactly what I were getting and were confident that I would be able to get an abnormal return like 100% in my investment (rather than cents or dimes). Rochdale and Fidelity (through its subsidiary FIL LTD) are not tier-one funds, but they still have more than enough arsenal to make a big bang on a small cap like LPH. I feel that what happened to YONG (http://www.bloomberg.com/news/2011-05-31/morgan-stanley-invests-in-short-sale-target-yongye-international.html?cmpid=yhoo) or CFSG (http://www.reuters.com/article/2011/05/24/us-privequity-orphans-idUSTRE74N0G620110524?feedType=RSS&feedName=innovationNews&rpc=43) might happen on LPH too. The stock hasn’t get a tier one institutional buyer yet, but for now tier 2 or even tier 3 buyers are more than enough. Also,
Also, short interest has decreased to a meager 285k, or about 0.26% of shares outstanding in May (http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol=LPH&selected=LPH), short interest in LPH had never been material to begin with (about 0.8% at the height) but nevertheless has decreased by about 1/4 over the past 4 months. So, it seems that even the few daring shorts that took advantage on the stock’s price drop in the short term have concluded after several months “due diligence” that this company is for real and that they have exhausted their ability to temporarily fool and frighten the market by their fabricated doom story.
Barring any serious, major misrepresentation of the company’s assets shown on its balance sheet, if I were a big angel fund, VC, pure speculative hedge fund, or industry buyer with enough capital to deploy right now, I would be willing to buy out LPH for at least $4 per share as long as Mr. Cai agrees to remain as my consultant for 3 years (because I need his existing connection to Shanxi government officials). I would be willing to pay $5 as long as I know that I’ll own existing two huge facilities (and all existing equipments and systems in it), the national tier 1 oil storage and distribution license (which is very difficult to obtain in China), and contracts with top 5 existing suppliers. Think about this, even if fiscal year 2012 EPS comes in only $0.50, about half of my extremely conservative estimate (see next section for details) and half of current book value of equity per share is wiped out, this will still be a good investment for me just from the view of real return on private equity. $0.50 on $5.00 investment is still 10% return in the first year, and that return will keep on growing even under the worst possible scenario under the wildest imagination I can possibly compose. Comparing this to investment in real estate that many Americans are familiar with, which is a completely private equity with liquidity that is lower than the smallest cap stocks and significant operating expenses and hassle, 10% return on an oil distributor with very visible growth trend, looks pretty good to me. So, in my opinion the market is currently valuing LPH not at its full potential (good case scenario), not at probability weighted average scenario, or not even at very bad scenario for a going concern. Current price of $1.5 or so can only be justified if this company is going to bankruptcy court immediately and has to sell its valuable storage facilities and tanker trucks at significant discount to their book values (even if the company needs to sell them in a not to disorder manner, LPH should be able to sell these assets for more than their book value because land use right, real estate price, and construction costs have gone up dramatically over the last two years)! I think at this moment I need to find a high-definition microscope to see the chance of that happening on LPH.
So, I surely am not joking in mentioning pure speculative hedge funds, VCs, or even early seed angle funds here. Using a five year investment time frame, a VC can probably expect to get as good return from LPH right now as they can get from a home-run start-up yet at significantly lower risk than even the start-ups with the most promising and guaranteed business. This is just my opinion, but I think Rochdale and Fidelity probably feel the same too. The fact that nobody has stepped over the 5% ownership line yet doesn’t mean that nobody will. Again, look no further than YONG and CFSG for examples (see valuation section for my estimate of fair value for the stock). Again, at current price level, the ultimate value arbitration — LBO of the company’s current stocks trading on AMEX and/or relisting the company on HongKong or Shanghai exchange, where many of LPH’s comparables are trading at P/Es of 20+ (see valuation section for details), is very real. I would not be surprised if the management team has already engaged investment banks in Hong Kong or China to sketch out a plan for listing there. Again, a buyout of even $5 per share and relist for $15 – $20 per share (P/E of 20 with FTM EPS of just $1) in a year should be satisfactory to even the greediest arbitragers. Sure, it involves a lot of legal work to buyout and relist a company, but for a potential 300% return in a year (or two) if I can summon $500M I’ll definitely do it. Now, as a standard check for any arbitrager, even if EPS for next fiscal year turns out to be only $0.65 per share, almost no growth from this year, and I am only able to sell the stock at 10x EPS in Hong Kong, which is close to the lowest among all oil operators listed there, I will still be able to sell each share at $6.5 and earn 30% profit (excluding legal costs and transaction fees). So, my range of arbitrage gain is 30% – 300%! To execute a LBO the two biggest current shareholders of course have the upper hand because they control majority stake. However, even an outside suitor is surely not out of competition because at $5 or even $4 per share offer of immediate “cash out” for the big shareholders should be tempting to them after being baffled for so long by the undue depression of the stock in the financial market here even if they had a vision of making this a billion dollar company and a well-known global energy operator in the long term.
Another possibility of arbitrage that most market participants are not aware of yet is the reverse execution of the above scheme — listing on Hong Kong, ShengZhen, or Shanghai exchange first and then buyout all shares currently trading on Amex. Think about this: if the company issues 10M more shares for $20 per share to go public in Hong Kong, the company will get $200M capital and only increase share base by less than 10% to just over 110M and fiscal year 2012 projected EPS of still over $1 (including all shares trading in the U.S. as a base for calculation pan-company EPS). Not only will LPH gets all additional capital it needs to pay the last acquisition immediately but will also have enough spared capital to buy all 30M or so floating shares on Amex for $4 or even $5 per share and again earn 300% return for any shares it buys from Amex and resell in Hong Kong. Same as with previous scheme, my estimated profit under the close to worst case scenario is 30% excluding expenses. Again, at current price this kind of arbitrage plan is no longer just a theory, casual thought, or talk. It is an easily executable scheme for anybody with enough capital and legal expertise in corporate reorganization and stock listing. I am not saying that this will definitely happen; I am just saying that this surely CAN HAPPEN any time and that it is possible some serious institutional or private investors are already making the plan going without being detected by public yet. Redchip President David Gentry’s Twit last week that Redchip is talking to investment banks in Hong Kong for listing [of its clients I suppose] (see the twit on 6/9/2011 here: http://twitter.com/RedChipNation) is in my eyes a strong hint of what to come for LPH.
Valuation and Target Price
While LPH is in similar business with other well-known oil distributors like KMP, its TTM P/E is only about 5.1% of KMP. Its FTM P/E is only about 3.7% of KMP. Note that KMP’s gross margin and net margin for the last three quarters were 35.8% and 14.5% respectively, while LPH’s gross margin and net margin for the last three quarters were 19.7% and 11.6% respectively. So, I think a rational investor should be able to easily see the flaw of the allegation that LPH’s financial results are too good to be true (or maybe it’s just a general allegation to the Chinese small caps spectrum that spills over to LPH). If 19.7% gross margin and 11.6% net margin are too good to be true for an oil distributor, then what are 35.8% gross margin and 14.5% net margin? It is not hard to understand why I think the market is totally misjudging LPH. I do recognize that it is not unreasonable to expect LPH to trade at a discount to these peers within foreseeable future, and the extent of the discount might remain substantial in the next couple quarters due unfortunately to the still sour sentiment on Chinese small caps. Still, in my opinion the discount to its peers is too huge by any rational reason. Multiplying a very low target P/E of just 5 by the projected EPS of $1.09 for fiscal year 2012 produces a price of $5.45, which I think is a very conservative and reasonable target price for the stock within next 12 months.
One last note: as shown in the table, LPH’s YOY revenue and net income growth rates are in line with many comparables in the U.S. and China in general. Just by looking at the increase in crude and gasoline prices over the past two years and the increase in consumption all over the world particularly in China, one can easily apprehend the high revenue and net profit growths oil operators have enjoyed. So, contrary to the general theme of attack shorts are throwing on to all Chinese small caps, there is nothing unbelievable or “too good to be true” in LPH’s financial results. In fact, because LPH is in early stage of its corporate life, the company should be able to grow faster than those bigger competitors with ease, and that’s what the company is doing for shareholders’ in its last acquisition for fiscal year 2012.
About the Author:
Kevin Chen is an independent stock analyst covering selected stocks as a hobby. He holds Chartered Financial Analyst credential, a MBA degree from a top 20 business school majoring in Investment Management and Financial Markets, General Financial Management, and Corporate Finance, a M.S. MIS degree, and a M.S. International Administration degree. He has work or personal experiences in IT/high tech, real estate, wholesale/retail, manufacturing, designing, education, and entertainment industries in China, Taiwan, Hong Kong, Canada, and USA. He has years of experience in financial planning and investment management/consultation for corporations and individual investors, financial analysis, strategic planning, budgeting, risk management, cost control, accounting, data mining, trend forecasting, pattern recognition, behavioral study, and statistical modeling..
The author has a long position on LPH at the time of publishing this article. The article only represents the author’s personal assessment and opinion on the stock. It is by no means a guarantee of performance on any long or short trades on the stock and should not be relied upon solely for buying or selling the stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences, needs, tax status, and other factors when making an investment or a trading decision. Information was obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.