PSB Monthly Issue April 2010

Air pollution is a huge problem in China.

According to the Chinese government, the air over two-thirds of the country’s cities is considered polluted.  (Air quality is measured in 338 cities.)

Here’s another stat… only 1% of China’s 560 million city dwellers breathe air considered safe by the European Union.

This horrendous air pollution is causing a health crisis among the Chinese people.

Respiratory problems, cancer, and heart diseases related to air pollution are now the leading causes of death.  And, the World Health Organization has found an eye-popping 750,000 Chinese die prematurely every year from respiratory problems.

Why is China’s air quality so poor?

The main reason is coal burning furnaces.

China is the largest consumer of coal in the world.  They use it to generate electricity and power their many factories.

Of course, burning coal releases harmful toxins into the air.

China is now the biggest emitter of greenhouse gases in the world. (They surpassed the U.S. for this dubious honor back in 2006.)

The Chinese government recognizes the problem.

In their 11th Five-Year Program (released in 2005), the government called for greater energy conservation.  They mandated a move away from coal toward cleaner energy solutions.  One of the solutions is greater consumption of natural gas.

Natural gas is the cleanest fossil fuel.  It produces less than half as much carbon pollution as coal.  And, although gas does emit some carbon pollution, it is seen as the bridge fuel to “green” alternative energy sources.

As a result, demand for natural gas is growing rapidly in China.

From 2000 to 2008, China’s annual consumption of natural gas increased 16.2% on average.  Believe it or not, that’s a much higher growth rate than oil and coal consumption.

And, China’s natural gas consumption is expected to keep growing.

A senior energy researcher for the government recently made the following prediction. He expects China’s demand for natural gas will reach 200 billion cubic meters in 2015.That’s double the 2008 level!

A number of Chinese companies are benefiting from the growth in natural gas consumption.  The most obvious ones are the huge natural gas producers. Unfortunately, these companies are not penny stocks.

However, through my research, I’ve uncovered a penny-sized company with a unique niche in China’s natural gas sector.  The company is none other than China Natural Gas (NASDAQ: CHNG).

Let’s take a closer look at this amazing company.

THE NATURAL GAS DISTRIBUTION BUSINESS IN CHINA

CHNG is a leading provider of natural gas in China’s Shaanxi and Henan provinces.  The company currently supplies compressed natural gas (CNG) and pipeline natural gas. And once their new plant is finished, they plan on supplying liquefied natural gas as well.

The company doesn’t produce any natural gas.  Instead, they purchase natural gas and supply it to their customers.  They profit by capturing the spread between what they pay for natural gas and what they sell it for.

The company’s primary business is providing compressed natural gas (CNG) as a vehicular fuel.  Company-owned fueling stations sell CNG to taxis, buses, and private cars operating with CNG technology.

What exactly is CNG?

CNG is a fossil fuel substitute for gasoline, diesel, and propane fuel.  As a much cleaner burning fuel, CNG is an environmentally friendly alternative fuel source for vehicles.

CNG is used in traditional gasoline powered vehicles converted into bi-fuel vehicles (gasoline/CNG).  These hybrid vehicles need to refuel at special fueling stations.

That’s where CHNG comes in.

They’re building a CNG fueling station empire.

They currently own and operate 36 CNG fueling stations (24 in Shaanxi and 12 in Henan).  But, they’ve barely scratched the surface of this market.  There’s still plenty of room for growth.

And, CHNG is expanding rapidly.

They just received approval to build a new compressor station and six more fueling stations in Henan.  And, through a joint venture with China’s largest supplier of CNG, they’re building 10 new fueling stations along the West/East Pipeline this year.

These new stations will provide a big boost to revenue and earnings going forward.

CNG isn’t the only thing the company sells.

In late 2007, CHNG began selling gasoline at their CNG fueling stations.  Not only do gasoline sales add to revenue, they’re also helping to increase CNG sales.  By offering one-stop refueling convenience, CHNG is attracting more hybrid car owners to their stations.

The company is also working to increase the number of hybrid vehicles on the road.

In late 2007, CHNG began an automobile conversion business.  At their auto conversion sites, the company converts gasoline-fueled vehicles into natural gas/gasoline powered hybrids.  More bi-fuel vehicles on the road mean more customers for the company’s fueling stations.

In addition to the CNG businesses, CHNG supplies pipeline natural gas to industrial, commercial, and residential customers.

Each of the company’s 108,000 customers is connected to CHNG’s pipeline network. They purchase natural gas by inserting prepaid cards into the connection equipment. This action pays for the gas and initiates gas flow.

CHNG generates revenue two different ways.  They make money from the sale of natural gas.  And, they get paid for installation and maintenance of the pipeline.

This business offers significant growth potential for the company.

They’re constantly expanding into newly developed commercial and residential areas. And, they’re in negotiations to supply natural gas to a new tourist site under development in Tangyu.  This project alone could add 50,000 new pipeline gas customers.

The company’s newest business segment is liquefied natural gas (LNG).

CHNG plans on entering the LNG business later this year.  Construction of their new LNG processing and distribution plant should be finished by the end of June.  We’ll delve into this new line of business in future updates.

Let’s go ahead and move on to the company’s financials.

THE NUMBERS

CHNG knocked the cover off the ball in 2009.

Revenue jumped 20% to $81 million.  New fueling stations, more pipeline gas customers, and higher gasoline sales drove the increase.

Despite a rise in operating expenses, net income surged 24% to $18.9 million.  And, earnings increased 9% to $1.13 per share.

I’m expecting more strong growth in 2010.

The company’s adding more fueling stations.  They’re expanding their pipeline gas customer base.  And, they’re entering the lucrative LNG business in the second half of 2010.

These growth initiatives should provide a significant boost to revenue and earnings this year.

CHNG also has a strong balance sheet.

They’re sitting on over $48 million in cash.  Short-term liquidity is excellent with current assets 8x current liabilities.  And, long term debt is manageable with a debt to equity ratio of just 0.19.

INVESTMENT RISKS

Of course, an investment in CHNG does involve some risks.

CHNG’s business depends on a steady supply of natural gas.  If the company is unable to obtain natural gas, their business could suffer.

Another risk is the company’s expansion into the LNG business.  If it’s not successful, CHNG’s growth could slow.

A third risk is advances in other alternative fuel technologies.  Advances in technology that reduce demand for CNG could hurt CHNG’s business.

POTENTIAL RETURNS OF 71% OR MORE

CHNG shares are poised for big gains this year.

The company is building more CNG fueling stations.  They’re growing the pipeline gas business.  And, they’re entering the LNG business later this year.

All of these growth initiatives are happening while the stock’s trading at an attractive valuation.  The shares are 45% below the 52-week high of $18.  And, they’re trading at just 9x earnings.

That’s well below the 21x average of industry peers.

Given the company’s strong growth outlook, I think the shares deserve a P/E of at least 15x.  At this multiple, the shares are worth $16.95.  That’s potential upside of 71%!

Based on our analysis, we see the stock trading up to at least $16.95.  Buy CHGN now for potential gains of 71% or more.

ACTION RECOMMENDATION

BUY China Natural Gas (NASDAQ: CHNG) up to $11.00 per share.

• Sell half your shares of L&L Energy (LLEN) to capture gains of 124% or more.
• We issued sell recommendations in our last Portfolio Update for Hi Tech Pharmacal (HITK), ChinaCast Education (CAST), Overhill Farms (OFI), DRI(TBUS), and Great Lakes Dock & Dredge (GLDD).  If you haven’t already, exit these positions now.
• We adjusted our Buy Price for Tianyin Pharmaceuticals (TPI) to reflect a dividend of $0.025 per share paid on March 10, 2010.

Category: PSB Monthly Issues