SINGAPORE (Apr 9): Water treatment company CITIC Envirotech showed up on our March 19 equity screener via a trailing 12-month EV/Ebitda (earnings before interest, taxes, depreciation and amortisation) ratio versus a five-year Ebitda compounded annual growth rate. EV, or enterprise value, is made up of market capitalisation plus debt, less cash plus minority interests and market value of preferred equity. CITIC Envirotech’s EV/Ebitda multiple was just 11.6 times relative to its five-year Ebitda CAGR at a sterling 55.2%.
Potable water is increasingly viewed as the new gold for this century. More than 80% of China’s underground water is not suitable for drinking, according to a 2016 report from China’s Ministry of Water Resources. Municipalities now have targets to attain higher classifications of water. On a scale of I to X, Type I is the best and Type III is potable water. China wants all its surface water to achieve a Type IV rating by 2030.
Enter CITIC Envirotech, the largest industrial wastewater treatment player in China. The company has invested in more than 60 water plants in China and Asia, with a total capacity of more than 5.5 million cu m a day. The water treatment and resources segment contributed to 21.2% of the group’s total revenue last year. CITIC Envirotech’s largest source of revenue (75.5% in FY2017) is its engineering procurement and construction (EPC) segment. Its smallest segment in terms of revenue (3.3% in FY2017) is its membrane segment.
The EPC segment involves design and construction services in membrane-based water and wastewater treatment for Chinese state-owned enterprises and industrial parks in China. Its clients include large Chinese SOEs such as China Petroleum & Chemical Corp (Sinopec), China National Petroleum Corp (CNPC) and China National Offshore Oil Corp (CNOOC). CITIC Envirotech has also provided EPC solutions to industrial parks such as those in Guangdong, Jiangsu and Tianjin.
The company structures its water treatment plant investments in three ways: Build-Operate-Transfer (BOT), Transfer-Operate-Transfer (TOT) and Build, Own and Operate (BOO). These investments are backed by long-term off-take arrangements by the Chinese government, over a period of 20 to 30 years, which provide CITIC Envirotech with a stable recurring cash flow.
In 2014, CITIC Envirotech completed the acquisition of membrane technology provider Memstar for $293 million. Memstar is a leading manufacturer and supplier of polyvinylidene fluoride (PVDF) hollow-fibre membrane and membrane products. The proposed takeover announcement referred to the company as one of the few manufacturers of high-performance PVDF hollow fibres in the world. The acquisition of Memstar ensures a stable supply of membrane products for the group’s business. Furthermore, Memstar’s R&D centres remain in Singapore, allowing for strong protection of intellectual property and proprietary processes, which are some of CITIC’s key differentiators versus its peers.
High barriers to entry
Chong Weng Chiew, executive vice-president of CITIC Envirotech, says CITIC’s membranes, water treatment design, maintenance and operations processes are unique. One of the beauties of the technology that CITIC Envirotech employs is that its water treatment process, unlike the traditional processes, requires less land area to treat the same volume/quantity of water. This is particularly handy in countries where land is scarce, hence expensive.
Also, as the technology has developed over the years, the process itself has become more cost-effective as long as the operator (like CITIC Envirotech) is able to manage electricity costs, which, to a degree, ties back to the design effectiveness of the treatment facility. In addition, Chong is confident that CITIC Envirotech and its technology are more cost-efficient than its US or Japanese competitors, which employ similar membrane technologies. CITIC Envirotech boasts strong shareholders, which is crucial, given the heavy capital expenditure requirements of the company.
Currently, CITIC Envirotech focuses on ultrafiltration and microfiltration membranes, which are applied in the waste treatment sector. The company has also invested in a Texas-based plant, where it plans to start developing and manufacturing nano-filtration membranes as early as FY2018. Nano-filtration applications include the F&B and pharmaceutical industries. The other angle to this investment is that the company will look to sell these membrane products to third parties as an inroad into those markets. It is worth noting that CITIC Envirotech’s current revenue from the US is derived mainly from selling its OEM membrane to Hydranautics — a world leader in the reverse-osmosis membrane field — which should be a testament to the quality of CITIC Envirotech’s membrane technology. Elsewhere, it is exploring entry into Japan, and has two existing EPC teams in Malaysia.
Who are the strong shareholders?
CITIC, formerly China International Trust Investment Corp, is a state-owned investment company with subsidiaries such as China CITIC Bank, CITIC Securities, CITIC Trust and Shenzhen-listed CITIC Guoan Information Industry. In 2015, a CITIC unit, CITIC Environment Investment Co, became the largest shareholder of what is now CITIC Envirotech, which was known as United Envirotech until July 30, 2015.
In 2016, China Reform Fund became the second-largest shareholder of the company after CITIC. It is a unit of China Reform Holdings Corp, an SOE tasked with pushing forward the central government’s reform programme. Together, CITIC and CRF hold 87% of CITIC Envirotech’s shares outstanding. CRF acquired its stake from Kohlberg Kravis & Co, a strategic investor since August 2011 after injecting a US$113.8 million convertible bond investment. In January 2013, KKR invested a further US$40 million.
CITIC Envirotech’s shareholding enables the company to make long-term strategic plans as it looks to grow the water treatment and membrane segment. Intuitively, the membrane segment is most scalable, and gross profit margins for this segment are as attractive as 50%.
Strong earnings growth despite high gearing
Earnings growth has been strong, with revenue for FY2017 up 67% y-o-y to $908.8 million and net profit up 25% y-o-y to $127.3 million. Free cash flow has been negative for the past five years, but operating cash flow continues to grow (see Chart 1). Gearing is rising, particularly if the perpetual securities are considered (see Charts 2 and 3).
In addition, the company has to redeem $225 million worth of bonds on April 29. Separately, the step-up and reset date of two tranches of perpetual securities is Nov 27. They comprise a US$175 million tranche and a US$180 million tranche, both at a rate of 5.45% a year.
For FY2017, interest expense fell 14% to $33.9 million, and Ebitda and Ebit coverage ratios remain healthy (see Chart 4). The company’s perpetual securities rose 49% to $717.6 million, comprising 39% of total equity (see Chart 5). According to the financial statement, CITIC Envirotech’s net asset value as at Dec 31, 2017 was 80.57 cents. Its fully diluted NAV works out to 78 cents. The company’s total shareholders’ equity of $1.81 billion includes $717.6 million of perpetual securities.
On March 26, the company announced it had completed the placement of 83.2 million shares at 85 cents apiece, or a 21% premium to its current price, to China Innovision Capital, Hong Kong-listed China Everbright and Shandong Hi-speed Group Co. Arguably, this demonstrates upward support for the stock’s valuation even though the company is trading below the placement price at 72 cents. Other possible explanations for the ascribed discount to the current stock price include a tightly held shareholder base with a low free float of around 13%; lower local investor appetite for the stock, given that its current operations are primarily in China; and valuation multiple contraction within the sector. That being said, management has reiterated its intention to address these points and to continue to share the company’s vision with the investing public.
