Changmao Biochemical Engineering Company Limited

Changmao (‘Company’) manufactures organic acid products. It operates out of mainland China and sells its products in: China (50% of sales in 2019), Europe (22%), Asia Pacific (20%), America (6%), and others (2%).

It is a leading operator in its industry and has benefited from ever-increasing stringency in environmental and safety regulations that have put smaller players out of business and consolidated the industry.

The effects of Covid-19 reduced demand for its products and brought down selling prices and profit margins – it also had to suspend operations in some of its plants during the lockdown period. This resulted in declines of 26% in revenues and 64% in profits in the six months to June 2020 compared to the previous year.

The company reported TTM sales of $462m (2019: $561m), ebitda of $74m (2019: $109m), and net profits of $34m (2019: $66m). Net profits have averaged $44m over the last five years, which incidentally is the target before which management and employee bonuses are initiated.

It reported net cash of $125m along with strong current and liquid asset ratios.

The stock is selling for $308m, which represents 7x average earnings and just 4x after backing out cash.

However, this is a case where simply proceeding based on the reported financials would be misleading.

The company was ordered by the local authorities in Changzhou city where it operates its main factory to relocate - as it now falls foul of environmental regulations, operating just one kilometer away from the Yangtze river. This facility manufactured maleic anhydride, a fundamental raw material for the company, as well as other finished goods.

It has found a new location and expects investment outlays of $770m for purchasing land and equipment. Netting government compensation of $225m, subsidies in the new province of $61m, net cash balance (above) of $125m, and two years of profits of $88m (the expected timeline) would still result in capital requirements of $271m, which is 6x annual earnings (or above 3x average ebitda).

Concurrent with this are management plans to list A-shares in China either in Shenzhen or Shanghai stock exchange to raise further capital – the amount is not determined.

Considering the excessive financial risk involved (either via borrowings or dilution of equity) before the company returns to normal profitability, investors are better off ignoring this stock.