Thursday, February 28, 2008

How Bright Is China Solar's Future?



China Solar & Clean Energy Solutions, Inc. (CSOL-$2.70) provides solar hot water heaters and coal fired residential boilers in the People’s Republic of China (PRC), primarily in rural areas.

Going forward, given prospects for alternative energy solutions in the PRC and existing demand for China Solar’s products, the Company believes that a CAGR of 70% per annum is attainable for the next several years.

According to statistics from the Chinese Energy Research Association, there are currently over 3,500 solar hot water heater manufacturers producing products under more than 3,000 brands. The top three solar hot water heater companies (by market share) are government-owned companies.

Positioning China Solar for accelerated growth in such a fragmented—but highly competitive--industry will require that management successfully execute on a
multi-prong marketing strategy that expands and differentiates the China Solar footprint, including the pursuit of opportunities in foreign markets, extending its product offerings into additional clean product alternatives, and making accretive acquisitions.

Albeit China Solar has a
sexy alternative energy story, investors ought to note the intrinsic risks related with buying into a thinly traded, Beijing-based company—in constant need of financing to fuel its growth.

The development and marketing of new products and the expansion of distribution channels and associated support personnel requires a significant commitment of resources.

Financing Issues

As of September 30, 2007, China Solar had only $3.31 million in cash on its balance sheet.

On January 9, 2008, the Company entered into a $2.76 million cash Purchase Agreement to acquire Shenzhen PengSangPu Solar Industrial Products Corporation (SZPSP), which is principally engaged in the re-sale of energy-saving heating products (such as pressure water boilers, solar energy water heaters, and radiators) in southern China. Part of the consideration of the transaction contains future incentive-earning payouts to the three principal stockholders of SZPSP, too.

How to pay for this acquisition?

On February 25, China Solar announced that it would raise approximately $11.3 million from the sale of up to an aggregate of approximately 4.7 million shares of the Company’s common stock.

Unfortunately for existing shareholders, the financing contains "last-resort" dilutive terms on the part of China Solar, including an indemnification by the Company to deliver up to 1.0 million additional shares of common stock to the investors (for no additional consideration) in the event that the Company’s after-tax net income for the fiscal year ending December 31, 2008 is less than $4.8 million.

The Company is also required to deliver 1.0 million additional shares of common stock if the Company’s after-tax net income for the fiscal year ending December 31, 2009, is less than $8 million.

The terms of a $2.75 million Securities Purchase Agreement entered into on June 13, 2007, indemnify investors involved in this private financing, too. China Solar issued a promissory note that these prior investors could convert Class A and Class B Warrants at potentially very high discounts (up to 75%) to the market price of the common stock (arising from the failure by the Company to perform with respect to its financial performance). These 'death-spiral' convertibles reset—under the terms of the warrants—if the "pre-tax income" for the year ended December 31, 2007, is less than $3.0 million, then the exercise price will be reduced by the percentage shortfall, up to a maximum of 75 percent.

If reported pre-tax income for FY ’07 comes in below $0.75 million, the exercise price per share of the Class A and Class B Warrants is reset from $1.90 a share and $2.40 a share to $0.48 per share and $0.60 per share, respectively.

In the event the pre-tax income for the year ended December 31, 2008, is less than $5.5 million, the exercise price will be reduced by the percentage shortfall, again up to a maximum of 75 percent, too.

Operating Review

Revenue growth for the quarter ended September 30, 2007, increased 92% to $12.6 million, driven by higher unit sales of solar water heaters and residential boilers. However, gross margin fell 70 basis points to 20.2%, caused by pricing competition in the solar water heating market and rising raw material prices.

Operating income increased 41% to $782,685 from the prior year. However, net income declined 9.2% to $499,074, pressured by operating expenses.

Management emphasized product awareness in the quarter, resulting in higher advertising, branding, and sales costs.

Net cash provided by operating activities was $324,013 for the nine months ended September 30, 2007, a decrease of $624,854, or approximately 66.5 percent, from $966,867 for the same period of 2006. Of concern, accounts receivable and inventories soared, up $6.3 million and $4.9 million, respectively. The increases were both due to the consolidation of the May 2007 Tianjin Huaneng acquisition.

Investors will need to keep an eye on days of sales outstanding and inventory turnover numbers in FY 2008.

Business Outlook

Looking out to FY 2008, estimated pre-tax income is $5.5 million, which assumes a recovery in gross margin to 22% (due to the successfully integration of recent acquisitions, higher unit sales, and the bringing 30%-40% of peak season manufacturing production in-house). Eliminate duplicate overhead, coupled with effective management in the growth of the distribution network, operating margins could improve to 7.5%, yielding share-net income of 39 cents.

Water source heating provider WFI Industries Ltd (TOR:WFI) is the closest publicly traded peer comparable to China Solar and fetches a 35 multiple to trailing-twelve-month earnings. China Sunergy (CSUN-$7.20), a manufacturer of solar cell products in the People’s Republic of China, with no earnings, commands a market capitalization of $284.8 million; and, JA Solar Holdings Co., Ltd (JASO-$15.90), a manufacturer of solar cells based in China, yields 37.1 times earnings.

One could easily assign this 35 multiple to China Solar, given its above-average prospects for growth, and plans to expand its photovoltaic solar products.

Capital spending/financing issues, continued pricing/margin concerns, and limited visibility on management’s ability to execute on its business strategy, however, lends us to conservatively estimate that the stock be priced—at best—15 times earnings, generating a 12-month price target of $5.85 a share.

Other Investment Risks & Considerations

With growth comes existing shareholder dilution. As of January 9, 2008, there were 6.2 million shares of common stock outstanding. Assuming the exercise and conversion of all Preferred Stock and warrants there would be about 15.9 million shares of common stock outstanding!

Similar to other Chinese stocks traded on U.S. equity exchanges, China Solar is in non-compliance with Section 404 of the Sarbanes-Oxley Act of 2002, which requires an annual assessment of internal control over financial reporting, and attestation of this assessment by the company's independent registered public accountants.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

1 comment:

ZenHomeEnergy said...

When building a new home, or when refinancing, the economic aspect of this becomes even more interesting.

Solar Hot Water