China Energy Corp (OTC BB:CHGY)

On July 16, 2010 we issued an alert that CHGY released its 2010 second quarter 10Q.

Points to ponder:

• Working capital deficit increases from the $15.O million figure contained in the 2010 first quarter.

"As of May 31, 2010 we had a working capital deficit of approximately $18,704,013. Please note that although shareholder loans are payable on demand and therefore classified as short-term loans, we may not need to pay back the loan within one year. We do not expect the shareholders to demand payment on such loans this year. We anticipate that the combination of our sales and collection of accounts receivables, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs."

• Debt increased from $19.2 million to $26.2 million.
  
• Debt to equity is 62.9%.
  
• $7.3 million in cash should be hitting the books within six months and dramatically increase operating cash flow.

"Term deposit represents amounts legally held by a bank which are not available for the Company’s general use. These deposits are held as collateral for issuance of notes to vendors for purchase of coal which generally mature between three to six months."

• Operating margins increased sequentially from the 2010 first to second quarter: 31.5% vs. 24.1%.
  
• Sales increased 343.7% to 41.3 million.
  
• EPS came at $0.17 vs. a loss of $0.03 in the prior year.
  
• We found it odd that the company did not include risk disclosures in its quarterly or annual filings.

"We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item."

Our intent over the short-term is to build a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)

-Is the company's auditor ranked in the top 100?
-Is the auditor located in the U.S.A? If located in China the PCAOB (Public Company Oversight Board) may be denied access to investigate the practices of the auditing firm. Short sellers have been using this information as a tool to validate their opinions.
-Are the company's internal controls satisfactory?
-Are their any outstanding legal issues?
-Do the company's top ten customers represent less than 10% of revenues?
-Operating cash flow divided by current liabilities is greater than one. The higher the better.
-Cash divided by current liabilities. This is an the most conservative liquidity ratio. The higher the better
-Is the company buying back stock?
-Chinese filings match respective SEC filings.(In process)

Criteria	Meets Criteria	Notes
Top 100 Auditor	No	Wei, Wei & Co., LLP
Auditor Located U.S.A	Yes	New York, New York
Satisfactory Internal Controls	No	Solely as a result of the significant weaknesses in internal control over financial reporting described in our Annual Report on Form 10-K for the fiscal year ended November 30, 2009, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were ineffective. We believe that the remediation measures we are taking, if effectively implemented and maintained, will remediate the significant deficiency
No Legal issues	No	Risk Factors not included in recent filings
Customer Concentration	n/a	n/a
Cash Flow Ratio is Greater than 1	No	0.16
Cash Ratio is Greater than 1	No	0.17
Buying Back Stock/Insider Buying	No	n/a

GeoTeam® Note:

Please note: On July 6, 2010, the GeoTeam® removed all Chinese stocks that were on GeoBargains and GeoSpecial lists to respective Radar lists as we complete our "quality assessment."

Short term and risk adverse investors should be aware of the quality issues currently present in the ChinaHybrid Space, questioning the validity of what seem like solid fundamental stories. It is beginning to get ugly so be cautious and understand that more pain may have to be endured, as ChinaHybrids are easy prey for short investors. The broad brush that is being applied to theses stocks appears unfair, but we can’t ignore the psychological impact this can have on investors' portfolio decisions. If history is our guide, fear will eventually create an immense opportunity to invest in the companies that prove they can meet quality litmus tests enact shareholder friendly moves. Credibility can also be restored if independent legal/SEC opinions validate accounting practices currently in question. 

***Very Important GeoTeam® note. We have yet to verify if the Chinese filings for ChinaHybrid stocks we monitor match respective SEC filings. We are in the process of completing this task. Although we are not totally convinced that SAIC filings are an accurate represenation of financial statements the issue is impacting stock prices. Conservative investors may want to limit exposure or buy put options on stocks, that have this availability, as insurance against long positions, until we publish our findings. Odds are we will identify some promising companies that will fail this litmus test.

see relevant articles

China Energy Corporation has performed nicely since our alert on March 2, 2010 @ $1.20, giving us a nice boost to our portfolios. (We have now taken some shares off the table). 

We have performed further due diligence to understand CHGY prospects for 2010 and beyond. China Energy's coal business derives revenues fromfour avenues: direct mining, proprietary coal trading activities, transportation coal trading activities and power generation.

China Energy's Revenue Streams

Direct Mining. As many readers may already realize, CHGY owns one mine located in Inner Mongolia. 60 to 70% of direct mining revenues occur in Inner Mongolia. Part of the success of a coal mine depends on the efficiency of what the GeoTeam calls the coal value chain

• Total Reserves: The total amount of coal available in a mine.
• Proven Reserves: Coal that has useful qualities for eventual production.
• Probable Reserves: The amount of coal that may have useful qualities for eventual production. Generally 40% to 70% of probable reserves will exhibit useful qualities.
• Non Mineable Reserves: The amount of coal that cannot be mined.
• Mined Out Reserves: 100% of proven reserves {PLUS} 60% of probable reserves {MINUS} non mineable reserves.
• Recovered Coal: The percentage of the mined out reserves available to sell to the end user (produced).
• Production Capacity- Given a company's equipment/labor position, the total amount of coal that can be produced annually.

Over time the total reserve will be depleted. In the case of CHGY, after going through the value chain, management has determined that it currently has 11 million metric tons of recoverable reserves and an annual production capacity of 800 thousand tons of coal (over a 10 year life span before coal mine is depleted). Recent infrastructure improvement efforts rest efforts have dramatically increased CHGY's recovery rate. This helped CHGY report a surprisingly strong 2009 fourth quarter and should also benefit 2010 results.

Proprietary Coal Trading Activities. China Energy must meet increased demand from its customers outside Inner Mongolia. Since a good chunk of its direct mining operations serve Inner Mongolia China Energy has to purchase from a third party coal operators to meet the demand of customers outside Inner Mongolia.

Transportation Coal Trading Activities. Management indicated to us that China's coal markets can be broadly categorized into supply regions in the south and northwest and consuming regions in the east as well as the southeastern coast. Keep in mind that the supply region still does consume some coal.

Coal is transported by train, ultimately arriving at ports where it is then shipped to eastern/southern coastal regions. The challenge for coal producing/brokerage firms is that China places annual quotas on the amount of coal that companies can transport to consuming regions, leaving them with an excess supply. Consequently, this creates opportunities for firms like China Energy that have high quota limits, such as CHGY. The company transports the coal for the quota deficient client and upon arrival to its destination sells it back to the client with a mark up to cover transportation costs an a small profit

Given the three revenue streams above, China Energy, in a nutshell, can satisfy broad demand coverage; direct mining and proprietary Coal trading activities exist to meet local demand from customers; transportation coal trading operations gives CHGY exposure to regions it would not normally supply. In the case of direct mining operations the end users generally provide their own means of transportation, thus alleviating logistics costs for CHGY. At about 66%, the Gross margins on the direct mining operations are much higher than the trading operations which stand at about 7%.

"This year we expect to see margin improvement on trading since we will do more proprietary trading compared to quote trading."

Power Generation. China Energy also operates a thermoelectric power plant through its Heat Power division (utility) currently serving two purposes:

1. Supplies electricity to the XueJiaWan district in Ordos City, Inner Mongolia.
2. By the use of recycled water from its electric operation, supplies steam heating directly to end users throughout the XueJiaWan district in Ordos City, Inner Mongolia. This is significant as most residential dwellings do not contain boilers. China Energy utilizes twenty-one heat transfer stations and builds out piping infrastructure to transport steam.

In terms of contribution to the company's bottom line, its utility operations are at nearly break even while the coal group currently accounts for all of CHGY's net income.

Due to issues associated with limited coal production capacity and the lack of profitability from its electric utility business, it may be difficult for investors to determine CHGY's potential for EPS growth.

Putting growth aside, we have a company with...

1. A strong market position that will virtually stifle the likelihood of harmful competition in all its business lines.
   
   Coal Group
   
   
   • The Coal Group does not have competition [as is experienced by other businesses]. Although there are approximately 30,000 coal mining companies throughout China, because demand currently exceeds supply, competition is not a concern in the operation of our business."
   • CHGY favorable standing with the government enables it obtain high coal quotas.
   • In its efforts to improve the efficiencies in the coal mining industry, China is taking the approach of shutting down smaller mines or any mine which does not meet its specified basic production Coal Group requirements."
   
   Heat Power
   
   
   • "Heat Power does not have competition as it holds an exclusive license to supply heating and electricity to serviced areas. Competition in obtaining such license are largely mitigated by a good review of operating history by the PRC government."
   
   In essence, it could be argued that CHGY's role to supply electricity and heat, motivates the government to look upon the company somewhat favorably.
   
   
2. Predictable & Sustainable Revenue Streams...

• China Energy's direct coal mining business should be able to generate consistent annual revenue for over 10 years before resources are exhausted.
• As CHGY's electric supply business is one the only show in town ,it should also generate predictable revenue streams. However, the power plant operates at maximum capacity and adequately meets the electricity needs of its served market, so CHGY may not see much growth from this business. 

Validating China Energy's Growth

Can China Energy develop a plan to convince investors that it can aggressively grow its business beyond its current structure? Management indicated to us that there are at least three ways the company can pursue long-term growth.

Coal Business Demand Driven Growth. As the economies of Inner Mongolia and China expand so too should the need for the coal.

"The demand/supply imbalances should be intact for years to come."

With its current mining production capacity fixed at 800k tons, CHGY would have to utilize its coal trading operations to benefit from increased coal demand and/or experience an increase in coal prices. Business could also be enhanced from favorable increases in quotas limits. However, the challenge from this scenario is that the trading business carries low gross margins which would require extreme increases in revenue to drive EPS growth.

Coal Mine Acquisition. The obvious second opportunity would be to acquire another coal mine to add to its direct mining business. This strategy would carry the best margins. We estimate this tact would require from $50 to $60 million in funding. Not including the capex for mining equipment after the acquisition, funding requirements may be less.

In light of this potential need, dilution becomes the issue. Management is very aware of this and would like to minimize the likelihood of such an event. With regards to dilution, we would assume that acquiring a revenue generating mining operation could be immediately accretive to EPS, unless the coal mine does not have mining equipment installed, in which case it would take about 1.5 years or longer to have full production. Still, we suggested that the company consider ways to reduce it shares outstanding before taking on more capital and possibly waiting until the end of the year to make such a move, at which time the stock may be trading at higher levels. In doing this, CHGY could end 2010 on a positive note while entering 2011 with a new source of growth and a loaded gun.

Keep in mind that increasing coal trading activities and acquiring another mine are not mutually exclusive events. Elevated coal trading revenues are inevitable. Acquiring a mine could ultimately shift some proprietary trading revenues to direct mining operations and result in improved margins.

On an interesting side note, the government has the authority to assign coal mines to entities. If CHGY was the beneficiary of such an act, acquisition costs would be substantially reduced.

Heat transfer. As real estate expands so should the coverage area that CHGY serves. We will surmise that this segment can grow by another 20 to 30% in 2010. The good news for this division is that it seems to be close to contributing to the bottom line. However, we need to gain a better understanding of the cost equation of this business. We assume that the need for the construction of heat transfer plants and piping infrastructure will increase as area coverage expands.

To sum it up, CHGY must find a way to generate consistent EPS growth. Couple this with an enviable monopolistic like market position and investors may be inclined to assign its stock a premium multiple. It may be too early in the game to make a definitive conclusion, but the story is certainly worth following.

Concluding Thoughts:

Like many Chinese firms, CHGY likely loses two weeks worth of revenue during the March quarter. We estimate that CHGY will produce about 167 thousand tons of coal from its direct mining operations during its first quarter (vs. 300 thousand tons in the 2009 fourth quarter) and will produce about 211 thousand tons per quarter for the remainder of 2010 ($32 annually). Our coal trading revenue assumptions have a wide range (from $57 million to $92 million).

The Heat transfer business is seasonal, from October to April. This means that the revenues from the heat transfer group will be strongest in the first quarter and see no revenue in the third quarter. Overall, in 2009 the utility business grew 38.6% to $9.7 million. This growth rate is skewed somewhat as the power plant was shut down for the 2008 Olympics. We will assume a more modest growth rate of 25% for the heating transfer business for 2010 and estimate revenue of close to $12 million with no growth from the electric supply business. But in the end, since the heat power operation does not contribute to profits in will not play a big role in driving EPS.

For a rudimentary EPS forecast we analyzed the cost relationships over the past three years as a predictor of future revenues.

For our first group of EPS estimates we,

• Applied 2009 pre tax margins (minus government subsidies) to consolidated revenues.
• Used a 25% tax rate

For our second group of EPS estimates we,

• Applied 2009 segmented pre tax margins (minus government subsidies) to segmented revenues.
• Used a 25% tax rate  

Full Year 2010	3year Historical average cost assumption	2yr Historical average cost from 2007and 2008	Highest cost year of last three years
GAAP Revenue avg.	$135.5 million	$110.2 million	$99.5
GAAP EPS group 1	$0.31	$0.26	0.23
GAAP EPS group 2	$0.41	$0.39	$0.38

Adjusting the 2009 fourth quarter for a more normalized coal production would have resulted in EPS of $0.10 vs. $0.11 (minus government subsidies). Annualizing this number, assuming no growth in its business, gives us a full year estimate of $0.40. Of all these scenarios we feel that the 99.5 revenue figure is most plausible with EPS falling in a range of $0.23 to $0.40. If investors choose to apply a P/E multiple of 15 to 25 they would arrive at potential valuation scenario range of $5.70 to $9.50, We will code CHGY as a GeoSpecial on the Radar as we await the first quarter release.

Potential Upside scenarios:

• Accretive acquisition
• Increased quotas
• Heat Power business turns profitable
• Margins Improve due to 2009 mining upgrade program
• Capital restructuring

We were just about to publish this article yesterday afternoon when we noticed that China Energy reported its 2010 first quarter. The company came in with fantastic numbers in its seasonally weakest quarter, giving us some confidence that 2010 EPS may approach the high end of our estimated range.

Please note that:

'As of February 28, 2010 we had a working capital deficit of approximately $15,000,000. We anticipate that the combination of our sales and collection of accounts receivables, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs. However we may require other sources of capital."

Other coal stocks include: Sinocoking Coal & Coke (NASDAQ:SCOK), L&L Energy (NASDAQ:LLEN),Songzai Intl Holdings (OTC BB:SGZH)

Other heat transfers stocks: Smartheat (NASDAQ:HEAT)

On March 2, 2009 we initiated a trading position in China Energy shares in the mid $1.00 area. The company reported it 2009 financial results via a 10K filing:  

December Yr.	Full Year 2009	Full Year 2008	Period Change
GAAP Revenue	$41.7 million	$19.9million	109.5%
GAAP EPS	$0.11	$0.09	22.2%
Reported Tax rate	30.0%	28.0%	7.1%
Tax-Adjusted GEO Supplied Non-GAAP EPS a	$0.11	$0.04	175.0%
Fully Diluted Shares	45.0M	45.0M	0.0%

-----------------------------------------------------------------------------------------------------------------

December Qtr.	4th Qtr. 2009	4th Qtr. 2008	Period Change
GAAP Revenue	$21.9 million	$5.5 million	109.5%
GAAP EPS	$0.15	$0.09	66.4%
Reported Tax Rate	Benefit	Benefit	n/a
Tax-Adjusted GEO Supplied Non-GAAP EPS a	$0.09	$0.05	80.0%
Fully Diluted Shares	45.0M	45.0M	0.0%

There a couple of issues investor should be mindful of that could influence performance and P/E expansion:

• Net-working capital is negative which is reflected in a current ratio that is less than one.  Ideally, investors would probably prefer to see a current ratio of at least 2 to 1. 
• The Debt to equity ratio is 66.0%. Ideally, investors would probably prefer to see this ratio at less than 20%. 

Information we need to digest in order to gain insight into the near term growth potential of China Energy Corp:

China Energy has the rights to operate the LaiYeGou coal mine in Inner Mongolia.

China Energy Corp recently completed a two year infrastructure improvement project to its mine and now has the capacity to produce approximately up to 800,000 metric tons per year by the end of 2010.

"The expansion included the installation of “longwall” mining equipment, the construction of wider laneways for access to the mine and from mine to coal field, construction of seven work stations and emergency exits and improvements to the draught system."

2009 mining operations were temporarily hurt as these improvements were implemented. We found it interesting that  the LaiYe Gou mine has established proven and probable reserves of 26.09 million metric tons.

"China Energy does not expect to encounter further interruptions in its business operations."

It appears that China Energy Corp produced 453,430k metric tons of coal in 2009 of which about 300k metric tons were produced in the fourth quarter. (still need confirmation on this, as this seems large). What we need to know is how fast operations will reach full capacity.

We will provide more details if warranted.  Any input is appreciated.

Maj

Disclosure: Long

2009 10K Excerpts:

• China’s coal industry is growing and its customer base is chronically under-supplied. There are pressures from the government to use clean or alternative energies instead of coal due to environmental concerns; however, coal reserves in China are abundant and less expensive than switching to clean or alternative energies.
  
• Given the increase in demand for coal production for electricity and heating in China, the Central government is encouraging local governments to build more power stations, coking factories, calcium carbide factories and silicon iron factories across the country.
  
• For the Coal Group, we attempt to obtain contracts granted by the government, because in such cases transportation would be guaranteed from LaiYeGou coal mine to the final destination. Where contracts are privately arranged, transportation is arranged through the hire of third party transporters by customers. In some instances, coal is purchased by third parties in close proximity to train stations where transportation to customer destinations is more efficiently arranged. However, transportation to destinations is limited to those for which routes are in place.

• The Coal Group does not have competition in the usual sense of the term that most other businesses experience. Although there are approximately 30,000 coal mining companies throughout China, because demand currently exceeds supply, competition is not a concern in the operation of our business. The electricity and heating supply industry is also growing; however, the government is taking steps to monitor and control economic growth in the rural areas to ensure that the economy is developing at a stable rate.
  
• The NDRC, in its efforts to improve the efficiencies in the coal mining industry, is taking the approach of shutting down smaller mines or any mine which does not meet its specified basic production requirements. The LaiYeGou mine is considered one of the larger mines in the area, and, therefore, we do not believe it will be subject to such potential closure. Our production levels are determined by market demand.
  
• Our business of buying and selling coal on a proprietary basis expanded in 2009 as a result of our receipt of additional quota from the local railway bureau to transport coal by train. We were able to trade more coal as a result of our ability to deliver more coal to trading partners by rail. Quota is awarded by the local railway bureau based on an application prepared by us each year. Parties are awarded additional quota based on their successful use of quota in the previous year. We have received a larger amount of quota for 2010 than we held in 2009; however, our ability to use any or all of this quota in 2010 is not guaranteed and will vary with market conditions, and our ability to source commercially acceptable coal purchases and subsequent trades.
  
• Heat Power has two distinct operations: supplies steam heating directly to end users throughout the XueJiaWan district in Ordos City, Inner Mongolia: and it also supplies electricity through Electric Power Group. Revenues generated by Heat Power were $9,748,301 in 2009 compared to $7,008,528 in 2008. The $2,739,773 change was a result of an increase in sales volume resulting from an over 50% increase in the coverage area of Heat Power’s operations, and a 31% increase in megawatts sold by the electric Power Group. In addition, sales in 2008 were artificially low due to a temporary shutdown of electricity power plant operations for air quality control purposes in connection with the 2008 Beijing Olympics.
  
• We believe that cash flow from collection of accounts receivables, customer deposits and bank and shareholder loans will be sufficient to sustain our working capital needs.