Dilemma of Commodity

The price of commodity is dropping against dollar. I have been shorting oil by going long on airlines. I decided to review my position after US government officially took over Fannie and Freddie. The dilemma of commodity lies between worsening supply/demand and high inflation pressure.

There are many forces that will drive commodity price down, at least over the near term. Demand destruction is obvious. In the US, total petroleum and other liquids consumption is projected to decline by 610,000 bbl/d. The sale of gas-guzzler is plummeting. The change of consumer behavior will likely to effect long term demand. Internationally, Asian equity markets are among the worst performers this year. Chinese market is down more than 60%. The weak equity market reflects a gloomy outlook of the region's economy. I also use the chart of Euro-Yen exchange as an indicator for oil supply/demand picture. As Europe is a big oil producer and Asia is a big consumer, when oil demand decreases, Yen will appreciate against Euro. (see the chart)

On the supply side, oil producing countries are increasingly addictive to high oil price.Their expansive fiscal policy depends on exporting oil. Iran's nuclear power project and Chavez's nationalization plan come to mind. If oil price drops further, they might be forced to increase their output to maintain the capital inflow. Thus the downward move is reinforced.

However we can not ignore dollar when analyzing commodity-dollar relationship. After taking over Fannie and Freddie, US government is officially on the hook with the 5.2 trillion mortgage debt. According to some reports, it will likely to cost US government 200 Billion or more. The question is how this bill is going to be paid. With the dismal economy, tax revenue will be down. I doubt that US government will be able to fund this 200+ billion entirely by issuing treasury. Mostly likely big Ben's money printer is running at full speed. Hence I think the recent strength in dollar might be short lived. The inflation pressure will remain high, which will support commodity price.

Wage might become the unexpected force to further drive inflation up. Labor unions are been gaining strength recently. Boeing, GM, Ford just to name a few. In the last 20 years of low inflation and high growth economy, workers do not need to defend their share of cake. During last high inflation era (early 80s), 20% of private sector workers are union members. Today this number is 7%. It will be naive to believe the real way will keep falling. When the real wage is falling at record pace (article), workers will more rely on union to negotiate higher wage. Higher labor cost will further push the inflation higher.

How do I trade this? I have kept my long position in airlines expecting further drop in oil price. The price increase implemented during the days of 150 dollar oil will not go away. Airlines will be the major beneficiary of falling oil. I went long with a small position in Peabody Energy (BTU)yesterday to hedge my oil bear bet. Coal demand is more stable, as the majority of production goes to electricity production.

My gloomy view of the economy

I am not an economist. The market is telling me that US might have dodged a severe recession. According to my humble common sense, I can not believe it.

The 3.3% GDP growth of US in the first half of 2008 was supported by two factors: stimulate checks and strong exporting. The former helped retailers to meet their lowered sales target. But it is gone. We will have a clearer picture of US consumers in the 2nd half of this year, especially the Christmas season, when the shock of high heating bill hits people. The strong export made up most of the "surprise" of the GDP number.What's the picture outside US? Japan just checked in the "Hotel of R" and many Europe countries,such German and UK, have booked their room on priceline.com. As a significant portion of US export are technology, I can not convince myself how it will hold its head above water, when Japan and Europe are drowning. The growth in emerging market might provide some cushion for US export, but slowing US consumer might eventually hit the emerging countries.

So, here is my gloomy outlook. There might the first time in the recent history that all three major economies (US, Europe and Japan)are in the recession at the same time. The slowing global economy will eventually drag on emerging markets. However, as my emerging markets, China and oil producing countries, have sufficient foreign reserve and healthy trade surplus, they might get back to the growth earlier by trading between themselves.

Let me know what do you think!

Brief analysis of Retail Payment Processing Industry

I recently came across ACI worldwide (ACIW), when I was researching Fidelity National (FIS). Since I have been studying Michael Porter’s “Competitive Advantage”, I will try to lay out a detailed business analysis first. ACIW takes cost focus strategy. It dominates in the transaction processing software market serving the large banks. ACIW has built the scale of economy to have cost advantage against its competitors. The high switching cost nature of such products further fortify ACIW’s wide moat.

The largest business for ACI worldwide (60% or Rev) is electronic retail payment processing market. From company 07 annual report:
“The electronic payments market is comprised of financial institutions, retailers, third-party electronic payment processors, payment associations, switch interchanges and a wide range of transactiongenerating endpoints, including automated teller machines (‘‘ATM’’), retail merchant locations, bank branches, mobile phones, corporations and Internet commerce sites. The authentication, authorization, switching, settlement and reconciliation of electronic payments is a complex activity due to the large number of locations and variety of sources from which transactions can be generated, the large number of participants in the market, high transaction volumes, geographically dispersed networks, differing types of authorization, and varied reporting requirements. These activities are typically performed online and are often conducted 24 hours a day, seven days a week.”
ACIW is the leader in retail payments software that facilitates all of the underlying steps involved in processing credit and debit card payments, including (but not limited to):
Channel Management & Enterprise Access: Routing the information along the relevant networks based on the various originations of transaction (ATM, credit, or debit) and geographic locations.
Authentication: Verify the authenticity of POS terminal, network, card, cardholder, and bank.
Authorization: Matching PIN to the account, fraud prevention and etc
The secular growth of Payment processing


Plastic is replacing the paper. Global electronic payment transaction is expected to grow at double-digit pace. Processing capacity and security of the data are major concerns of financial institutions. The old generation mono-line products built for processing single type transaction (e-banking, debit card, ATM service and etc) need to be integrated onto a single platform.

Competitive landscape of the industry (Threat of substitution):
There two other products competing against retail payments software in this segment. Small financial institutions generally outsource to third party for transaction processing service, such as First Data or Fidelity National Information Services. Due to the lack of scale of economy, small banks can not justify the cost of housing the processing capacity in house (maintaining IT hardware and licensing software). It typically cost the bank 0.02-0.05 cents per transaction, if using third party service. The second is the in house developed transaction processing software by large banks. Some banks even license their program to smaller banks. ACIW believes that such systems represent at least 34% of the market among large banks.

Retail payments software does not directly competing against the third party service provider, because their customers are typically large banks who have comprehensive in-house IT infrastructure. Using software like ACIW’s, this cost falls to $0.0001 to $0.001 per transaction, significantly less than the third party service.

In-house developed software is the real head-to-head competitor. Theses homegrown software are quite “stone age”, with the newest being 15 years old. The main sources of stress on these systems are from rising payment volumes and new regulatory mandates from bodies such as Visa, MasterCard, and the Office of the Comptroller of Currency. These mandates usually change how transactions have to be processed or encrypted and thus require updating the software. The software update requires much more cash outlay than licensing software from ACIW. ACIW’s software is like an expandable platform where various functional modules can be installed (will discuss later in detail). For big banks, it is much more efficient to have all the functional program built on a single platform. Besides the secular trend of increasing electronic transaction volume, it is critical to watch whether ACIW can take shares from the homegrown program during this update cycle.

High switch cost:
Installing this type of software is like a major organ transplant. You do not want to do it unless the one inside you is failing. It usually takes 9-12 month and can be as much as 24 month to fully install the program. The IT engineers need to be re-trained as well. The switching costs are evident in the fact ACIW’s renewal rates are 98% (5 year term). Winning a new customer almost guarantees a stable cash flow for 100 years.

Rivalry between competitors
The rivalry among the software vendors has been moderate. There two companies competing on the global basis: Mosaic and eFunds. Because the cost of licensing and maintaining software is a small portion of cost of ruining the transaction processing infrastructure, ACIW and its competitors are competing on performance of its product and maintenance service.

Mosaic acquired by S1 in late 2004 sells Windows based products that competed with ACIW in mid-sized banks. S1 has attempted to sell Mosaic’s mid-sized software to large banks, but this strategy proved unsuccessful. ACIW dominates the competition in large banks, because Windows wasn’t perceived as robust enough for datacenters. It confirms that customers are more concerned with the performance and less price sensitive.

eFunds has a division that competed with ACIW for decades, but this division eventually morphed towards a processor type business model. Before it was acquired by Fidelity National, that unit has 50MM of revenue (vs. 370M for ACIW) and installations at 30 of the world’s top 500 global banks (vs. 120 for ACIW). Due to its lack of scale, its profitability is inferior to the rest of Fidelity National’s businesses. As Fidelity National (FIS) focuses on a processor type business model, it is likely that capex will be reduced in this software development division (Management at FIS has mentioned cost cutting at eFunds, but did not breakdown). I think eFunds will not compete aggressively for market share.

Internationally, ACIW competes with various regional players, but a global support infrastructure is proving increasingly important in serving global banks. In addition, ACIW has the scale of economy to offer the most comprehensive solution in the industry. Its competitors, by contrast, only provide pieces of the overall solution.

Bargaining Power of the customers
ACIW’s customers have relatively strong bargaining power mainly due to their ability of backward integration. Historically, they were able to get as much as 40% discount on the renewal license. However ACIW has been able to achieve EBITA margin in the high teens range, comparable to other third party processing companies. Their customers are less price sensitive, which allow ACIW to maintain a desirable margin.

Some Updates on PYI corp

Sorry, readers. I have not posted for last several weeks, as I have been busy applying for UC Berkeley’s HAAS MFE program. I just want to update PYI corp (0498.hk) regarding some recent development since my last post.

Since my last writing, the share of PYI corp has declined significantly from ~HKD 1.00 to ~0.75 a share. PYI issued final dividend in the form of stock warrants, a disappointment to many share holders. Although I think it is a prudent decision for PYI, undeniably the company is tightening its belt on cash. PYI has increased its financial leverage during the Fiscal 08. Debt/Equity ratio increased to 34% from 7%, while the quicken ratio dropped to 0.99 from 1.26. Cash is indeed one of my major concerns for PYI. Yangkou port project rely on land sale to generate cash for capex. A weak economy, particularly weak export industry in Jiangsu, will impair PYI’s ability to execute the plan. The purchase of 12.3% stake in Nantong Port will also burn a significant amount of cash on its balance sheet.

Trading at 30% of this book value, PYI is valued by Mr. Market as a toxic small real estate developer. I believe the market misconception gives a long term investor, like myself, a good entry point to buy a major port operator on Yangtze River at a discount to its book. PYI is not a real estate developer. PYI has very limited exposure to residential and commercial building market, which is in bubble-bursting mode. PYI’s major real estate exposure is its 42 sq km land bank at Yangkou Industry Park. The price of industrial land should not be hit hard, because there is simply no bubble to begin with. Unlike buying a residential or commercial property, one needs to be approved by local government to be eligible for buying industrial property. (Basically you need to have a company which generates tax payment.) It is a much more difficult market than residential property for real estate speculators. As a result, the price of industrial land is relatively stable during past several years I think the value of the land bank depends more on the success of the industrial park. The initial development is promising: Petro China’s 16 Billion LNG project is under construction and RGM international’s 11B project will soon begin construction. The key to watch is the initial land sale to Petro China, which is still under negotiation. The final price will set a bench mark for the value of PYI’s land bank at Yangkou. The industrial land at Suzhou, Yangkou’s neighbor city, is in the range of RMB 250-300/sqm. PYI’s management is hoping to sell their land at similar price, which is higher than my RMB 200-250 estimate. Furthermore, Yangkou port is expected to commence operation by the end of 2008 and Nantong port (discuss below) will be consolidated as a subsidiary. PYI’ share might benefit from the possible upgrade from “real estate developer” to “port operator”. Price to book ratio should be in line with other publically traded ports at 2-3 times.

The 12.32% stake in Nantong port is priced at RMB 191.46M, which values the whole company at RMB 1.55B. PYI paid RMB 430M in 2005 for its 45% stake, which worth 700M at current valuation (not accounting for controlling premium), 17.5% compound annual return on investment. If PYI is successful buying the stake, it will become the major share holder of the company, which will make Nantong port the first Chinese port ever controlled by “foreign” capital. There is unlikely to be another bidder for the stake. It is unclear at this point how PYI and Nantong Port Group (NPG) will split this stake. Most likely PYI will increase its stake to >50, which will allow it to consolidate Nantong port on this balance sheet.

Growth of Chinese steel production is deaccelerating (finanly)

Association of Chinese Steel Industry just released production data for the first half of 2008. The pig iron production increased 7.9% to 246 M ton compared to 16.9% growth in 2007. Total steel production increased 12.5% to 300 M ton compared to 23.9% growth in 2007. The production growth in the first half of 08 is outpaced by the demand growth. The steel export is 2691.3 ton down 20.35% or 687.8 ton from the same period in 2007. The average export price is $937.38/ton or 41.4% higher than last year.

I predicted the slow down in steel export in the my old post "Chinese steel industry 2008 and beyond". Both tight monetary policy and higher raw material cost are weighting on Chinese steel industry. The average export price is no longer significantly lower than its foreign competitors. As the raw material cost is rising, the labor cost as a percentage of total production cost is much less important than before. On the other hand, the high material cost makes the production efficiency much more valuable today. Thus the cost advantage for Chinese steel companies are diminishing.

This is certainly good news for my POSCO, whose stock has done relatively well compared to its peers recently. Near term, falling oil price will weight on the steel price and the share of steel producers. I am thinking about hedging this position by shorting some other steel makers.

China's shift in its monetary policy

Recent press conference by Hu Jintao, stressing the need for growth,marked an important shift in direction of Chinese monetary policy. Inflation is still a big concern but balanced that with a call for continued growth. He said in this remarks, “We must maintain steady, relatively fast development and control excessive price rises as the priority tasks of macro adjustment.” Some of the policies adopted for fighting inflation will be shifted to support growth.

This shift does not come as a surprise to me, as Central government is facing intensive pressure from the governors from provinces in Eastern and Southern China, where exporting industry accounts for a large share of the economy, have been blaming the currency policy and pressuring central government for a change. Chinese exporting industry, especially those with low value-add industry, has been under pressure due to inflation in raw material,energy and wage, rising RMB and tightened credit market. During the first half of 2008, textile export to United States from Guangdong Provice dropped 31.3% to USD 10.8B (according to Caijing.com). Given the 7% rise in RMB, the export of textile dropped 38% in RMB term. As industries like textile are labor intensive, softness in these sectors put pressure on local employment. The labor markets in Eastern provinces like Jiangsu and Zhejinag are seeing softness the first time since 2002. As the smaller and weaker companies are shutting their doors, a potentially devastating crisis is the corporate debt that is often cross guaranteed. When a company, usually small or financially weak, failed to qualify a loan from bank, they often get a debt guarantee from major buyer or sister companies with same major share holder. Meanwhile the guarantor often obtains debt guarantee from a third company. Because the guarantor and guaranteed company are often financially linked (supplier/customer or business partner), the financial distress of one party might severely damage that of the other. The initiation of default on a small scale could trigger a chain reaction.

The inflation fighting school in the communism party, lead my prime minister Wen Jiabao, is losing their voice in central government, as the rapid rise in RMB and tight lending policy in the first half of this year did not cool the inflation down as effective as some expected. Meanwhile sluggish exporting business in South and East China as the consequence of inflation fighting policy raised enormous pressure from angry and nervous politicians and business people in those area. I believe the central government is forced to adapt the relaxed policy as least for the near term. As the inflation is far from being well-controlled, I doubt such policy will be beneficial to Chinese economy. I predict the RMB will like to appreciate much slower in for short period than it did in the first half of this year, PPI will face upward pressure and stay about 10%. The government will exert more pricing control of key input material (energy, electricity, fertilizer and etc) will be extended. I do not think such price control will survive for a long period, as the supply of these raw material will drop and the price on the black market will rise further (this is already happening in coal market). The government will eventually recognize their failure in fight against the market trend and relaxes or gives up the price control. The raw material sector, coal in particular, and home building sector are likely to benefit from this policy. On the other hand, banks will likely to take more risk and weaken their balance sheet, which makes them extremely dangerous when the government shift back to tight monetary policy if inflation gets out of control.

Speculative ride on fine wine is over

I have been reducing my investment position in fine wines, particularly recent Bordeaux and Burgundy, which turned out to be my best investment in the first half of 08. Fine wine hardly qualifies a value investment and is made to be drunk and enjoyed. Its value is determined by the perceive pleasure, which varies dramatically among people. I have been enjoying fine wines for some years, but I jumped heavily into the market as an investment only after I sensed a self-reinforced upward trend in wine price couple years ago.
My theory was: A rapid wealth accumulation of high net worth class in emerging markets (China, India and some resource rich countries) and their desire of western lifestyle initially created new demand for high end wines (>$100/bottle). As those wines are produced from traditional region, where land designated to produce the wines is fixed, the rising demand drives up the price. In the second stage, as the premium of the marginal quality of the wine rises rapidly, wineries can afford more stringent grape selection to increase their quality to achieve higher pricing, which actually reduce the supply of their wines. Thus drives price even higher. As the demand of wine from emerging markets is based on perceived social status of drinking expensive wines, higher price and increased scarcity of the high end wines in fact attracted more demand. Thus a self-reinforcing cycle is established. The price of ultra premium wines,like Lafite, Latour, or Romanee Conti, went through the roof. The upward trend in price is propelled by another two forces. The ample liquidity in the financial market and rising wine price attracted investment money into the wine market. Several hedge funds specialized in fine wine investing were established during the past several years. This creates "false" demand in the market, because wines bought by the investment fund will eventually appear on the market as new supply. When viewed as an investment rather than consumable, the criteria valuing fine wines is dramatically changed. The price ceiling for the top wines disappeared. The newly released sought after Romanee Conti is priced at $14K or several hundred dollars for every sip. Secondly, not only the wineries that benefited from this trend, wine distributors and wine critics are also enjoying explosive demand for their service. Soon the "must have" "vintage of the century" appeared on every wine relative publication. Just like the hyped 1972 vintage that hit the market at the top of financial market peak, 2005 vintage in both Bordeaux and Burgundy are touted by every major wine critics. The price appreciation of my 2005 Bordeaux purchase is 100-150%. The smaller production burgundy wine is the extreme case of this wine mania. The price of various sought after wines purchased as future jumped several folds when the wine physically hit the market. Due to the asymmetry of information in the wine market, I was able to sell some of my 2005 Romanee Conti wines 2 or 3 times higher right after I made my purchase.
The market is cooling. The fist blow is that Robert Parker, the most influential wine critics, published his assessment of 2005 Bordeaux somewhat below market's inflated expectation. Financial market crisis leads to exit of some institutional players. Although pricing is still firm, as demand from Asia is still firm, the inventory starts to build up in the first and second quarter of 08. The quality of 2006 and 2007 vintages are not praised and the enthusiasm of wine buyers disappears. The self-reinforcing cycle is broken.

An interesting example of bubble and bust for educational purpose.

PYI Corp (0498.HK) deep value investment in growing Chinese Port Industry

Based in Hong Kong, PYI Corporation (0498.HK) Limited focuses on infrastructure investment in and operation of bulk cargo port and logistics facilities in the Yangtze River region in China. It also engages in land and property development in association with port facilities. PYI’s common stock represents an opportunity to invest in Chinese deep water port in the fast growing Yangtze River delta region at 55% discout to its book value, which does not yet fully mark to the market.

2006-2008 is the transition period for PYI. They sold out HK based asset and invested capital to build a portfolio of ports on the Yangtze River. It sold the majority of its real estate and other equity investment for about 922 million HKD (item 47 in their 07 AR) after its flagship, Paul Y center, was divested in 2005 for 780 million HKD (item 56 in 07AR). PYI’s is building a portfolio of ports along the Yangtze River. Yangtze River is largest River and accounts for 80% of the river transportation volume in China. Coal and other raw material are transported from the resource rich west to east and finished products are transported to west to feed western China’s explosive growth. Yangtze River is becoming increasingly important in Chinese transportation system. Chinese government pledged RMB 16 billion to dredge Yangtze River Course by 2020. PYI’s good connection with local Chinese authority allows them to find the favorable deal. The company bought 45% equity in Nantong Port for 435 million CHY at discount to its book value, when other public traded Chinese port assets are valued roughly at 3-6 times book value. It will soon make Nantong port is subsidiary after exercising its option to purchase 12.37% stake in Nantong Port later this year. Nantong port is 10th largest port in China by volume and growing at 30%. Nantong Port will benefit from China’s increasing demand for raw material, as the majority of the bulk goods it handles are coal, ion ore and fertilizer. Yangkou port, the crown of PYI’s portfolio, is also acquired at an extremely low price. After its initial 54% stake in Yangkou port, PYI bought 13.6% interest for 35M HKD in Feb. 2006 (value the whole project at merely 257.4M). Three month later it bought another 7% for 168M HKD, which set the price tag of Yangkou port at 2400M HKD. Yangkou port will become the only deep water seaport that has the capacity to serve trans-pacific ships. PYI is also signing investment agreement with several smaller ports in Suzhou, Chongqin and Yicang. PYI will and Yangkou Port is aiming to service LNG and other clean energy.

Before we break down the parts value of PYI, it worths pointing out that PYI’s excellent share holder friendly management team. The manage team, lead by Tom Lau, focuses on enhancing share holder value. When the company generates excess capital, it returns the capital to share holder in the form of special dividend. This is quite rare in Hong Kong market. It paid 70 cents (30% of its share price) in 2005 after the sale of Dower EDI and then paid 22.2 cents after the sale of China Strategy. Even after such generous pay out, PYI is still able to grown their asset at double digit pace.

In order to value the company, it is difficult to derive from its current consolidated financial reports, because PYI’s Chinese asset has not yet generated significant revenue yet (less than 3% of 2006 revenue). I will breakdown PYI’s major asset to reach a Sum-of-Parts (SOP) valuation for the company.
1. 65.2% stake in Paul Y Engineering (ticker 577 HK), a HK listed engineering services company with projects in HK and China.
2. 57.3% stake in NPG, the first major bulk cargo port along the Yangtze River Delta, and also the largest hub port for iron ore trans-shipment.
3. 75% stake in Yangkou Port, a massive green-field port project covering a land bank of 42 sq km. This is the jewel within PYI and has the biggest hidden intrinsic value. (details below).
4. 100% Mingshen Gas, a market leader in the infrastructure and logistics facilities for LPG, oil and liquid bulk chemicals market in Central China.

1. Paul Y Engineering (ticker 577 HK).
Paul Y Engineering is an engineering services company engaged in construction, project and facilities management. It has 60 years of track record. The company is listed on the HK stock exchange (ticker 577 HK) with a market cap of 661M HKD. implying a LTM P/E multiple of only 5.7x. As the company moves into Chinese infrastructure business, multiple expansion is a possibility. To be conservative, I ignore the premium for PYI’s controlling stake, hence the market value of its 65.2% stake is: 65.2%*661M=431M

2. Nantong Port Group (“NPG”)
Nantong, also known as “Northern Shanghai”, enjoys a unique geographical location. It is located on the northern bank of the Yangtze River near the river mouth, and is a vital river port bordering Yancheng to the north, Taizhou to the west, Suzhou to the south, and the East China Sea to the east. Nantong Port is a major port near the mouth of the Yangtze River and is the first major bulk cargo port along the Yangtze River Delta. Its direct hinterland includes seven provinces: Jiangsu, Anhui, Jiangxi, Hunan, Hubei, Sichuan, Quizhou, and two major cities: Shanghai and Chongqing.

Within this context, NPG is the dominant port group at Nantong Port and accounts for 50% of Nantong Port’s total throughput. It occupies 3,300m of shoreline along the Yangtze River, has 26 productive berths including two berths for vessels over 100k tonnage, and six berths for vessels over 50k tonnage. The main cargoes handled by NPG are iron ore, minerals, cement, steel, coal, fertilizers, grains and edible oil. As the Langshan Phase3 becomes fully operational this year, the capacity will increase 54% to 5000K tonnage. NPG made 54M in 2006 and 76M in 2007 and volume increase 32% in 2007. NPG is expected enjoy double digit top line growth due to its rapid expansion and solid Chinese economic growth. PYI will help to improve their management efficiency and bring NPG’s profitability close to its peers.

As PYI does not break down the cask flow and balance sheet for Nantong Port, it is difficult to use comparable multiples to value Nantong Port. My DCF model assuming 20% earning growth for 5 years and 5% perpetuity growth rate and 15% discount rate yield a 1367M CHY implying 18 PE and 1.2 times book valuee, which at the low end of publicly traded Chinese ports. I believe it will be proved to be a conservative valuation, considering its potential to reach return on asset similar to its peers. Therefore PYI’s 57.3% stake is valued at 783.3M HKD.

3. Yangkou Port
Yangkou Port is special because of its prime geographic location and the natural deep waters surrounding it so that vessels of 100,000 DWT can enter without the need for dredging. Yangkou is located in Jiangsu Province, which harbors a very large exporting industry. For a long time, Jiangsu has only one seaport, Lianyun Port, which does not have the deep water to serve trans-pacific routes. All the exporting goods that are shipped across Pacific Ocean need to be shipped to Shanghai Port or Ningbo Beilun Port, which is very expensive to do. Yangkou Port will have significant cost advantage over its neighbors and will likely to serve the exporting industry in Jiangsu Province, as soon as it develops the capacity.

Yangkou port is also one of few locations approved by the Chinese government for building LNG ports, hence it is likely to benefit from increase import of LNG. It is part of the central governments 11th Five Year plan as a level I seaport, which means strong support from government. In deed billions of fund is already invested by government in the infrastructure, such as rail roads and high ways, to support the port. PYI owns the right to reclaim 42 sq km of land and can lease or sell the land after reclamation. With the completion of a number of milestones, the recent securing of PetroChina’s 7.4 billion LNG project, Yangkou port is on track and land sales can be achieved in the near future.

Yangkou port is a classic low-risk and high profit investment for PYI. PYI put down little capital to acquire 75% interest. (I could not find an official number but it is likely to be little more than 1 billion HKD). This huge project does not require much capital injection from PYI, as it pledge land and sea use for bank loan to initiate the project After the initial development, which is expected to be finished in 2008, PYI will own 42 sq km land. 30 sq Km will be used for industrial purpose, and the rest 11.5 km2 will be developed into a hotel resort and golf course. In the recent filing PYI revalue a piece of 4.16 square km land at RMB 1 Billion, which put per square meter value at RMB ~240. Excluding the development cost at 91 CHY, land will be value at RMB 10.1 billion. PYI expects to sale roughly half of the land to generate cash to fund the port project. Petro China is going to purchase 2 sq km land for this nature gas utility project. Assuming 40% tax rate, it will generate 4 billion cash. Also PYI signed agreement with local government to lease its Yellow Sea Crossing and will sell 2 sq km land to Petro China for about RMB 600M to build a natural gas utility, which will provide a predictable future cash flow.

The only concern is the over-capacity of deep water port in the Yangtze delta region. Both Shanghai and Ningbo port are building 1,000 TEU deep water ports. However, Yangkou port will specialize in LNG and other energy/raw material transportation, which hopefully can differentiate them from competition. The local protectionism in Jiangsu Province will likely to direct the exporting volume generated in the province to Yangkou port.

At this point, it is hard to predict future cash follow of Yangkou port. According to the recent comment from PYI’s management, half of the land bank will be sold to fund the project. Recent industry land transaction in the neighborhood is ranging from RMB 200-850/sq. If we assume the first batch will be sold at lower end of the range, RMB 250/ sqm, and the rest will be further developed to enhance value (RMB 350/sqm\\the resort land is valued higher than industry land), the total project will have a book value around RMB11.35 Billion. I will take 20% discount on the valuation to account for the uncertainty. If we look at public traded Chinese port of similar size, most of them are valued north of 10 Billion (excluding land value) indicating a even higher valuation for a successfully developed Yangkou port.

4,Mingshen Gas
Mingshen Gas owns infrastructure and logistics facilities for LPG, oil and liquid bulk chemicals market in Central China. It also operates the largest LPG terminal and storage facilities, as well as a mature logistics network in the region. PYI acquired Mingshen for RMB 467M in 2006 at a slight discount to the book value, which generated 378M in revenue and 8M loss due to government’s price control on LNG. Profit is likely to turn black in the first half of fiscal 09 due to the recent price increase. Mingshen controls 40% of local market. As Chinese government is promote the use of LNG (targeting 10% of total energy consumption), Mingshen is positioned to benefit.
Again, there is no detailed breakdown for Mingshen Gas. As the asset it acquired before the asset bubble in 2007, I will take 30% off the original price paid by PYI (467*70%=327).

Sum-Of-Parts valuation (in million)
Paul Y Engineering 431
NGP 783
Yangkou Port 6800
Mingshen Gas 327
Sum of Parts Valuation 8341
Excess capital (net debt) (238)
Total Valuation (inc cash) 8103
Share count 1508
NAV per share 5.37

PYI is trading at 45% of its book value and 20% of my conservative valuation. Although PYI won’t generate any meaningful positive cash flow until Yangkou port becomes fully operational in 2-3 years, the current market failed to recognize its potential to become one of the major port operators in China.

Chinese steel industry 2008 and beyond

Analysis of Chinese steel industry is critical to understand the macro-economic trend in the steel industry particularly east Asia market, as China accounts for the most of demand and supply increase. The competitive advantage of Chinese steel makers is cost. They have access to cheaper coal, labor and mostly importantly cheap capital. Coking coal still trades $100 per ton cheaper than global market recently. While labor is still cheaper in China, it is a much smaller percentage after recent rise in raw material price. The ion ore deposit in China is lower quality and difficult to mine, hence the majority is still being imported, which mean Chinese steel makers pay the same rate as their global competitors. In sum, Chinese steel makers still have lower cost structure than its competitors but it is much smaller now. The biggest driver of the growth in Chinese steel industry is actually cheap capital. In China, local governors are usually evaluated by local GDP growth and employment rate. Hence they have the incentive to subsidize new steel mill by selling land cheaper than the market rates or/and making loans available at local bank. Chinese banks have been hungry for growth in their loan portfolio due to the high saving rate in China. As a result, steel mills at various scales are burgeoning during and supply soon outstripped fast growing demand. Due to their low cost capital, the steel mills are willing to make modest profit on their products. The small mills often make as little as $10 EBITA/ton.

Chinese steel industry is hitting a tipping point now. The small steel mills in China which accounts for a significant share of Chinese steel production are facing tough headwinds. The critical cheap capital is gone. To fight inflation, Chinese central bank has raised reserve rate to 17.5%., up from 7.5% in 2004. The rising price of raw material effectively raised the requirement for working capital, which caused a capital shortage in smaller mills, which are not able to easily obtain loans from banks now. There is also a biased industry structure working against smaller mills. The small mills can not directly negotiate with foreign raw material supplier and have purchase from the state owned steel maker at a much higher price. As a result their already paper thin margin is now zero to negative. The central government also vowed to improve environment by shutting down high pollution small mills by 2010. There is a nation wide consolidation going on. The state owner integrated steel makers are acquiring the suffering small makers and then shun down the low efficient plants. The new build capacity in 2008 will be around 5100M ton, while at the same time 2400M ton capacity will be shut down (1100M ton was shut down in 2007). So the net capacity increase is 2700M ton, which represent a 5.3% increase. The demand for steel in China is projected to be inline with 10% GDP growth, although certain housing related area is likely to slow. The supply/demand of steel in Chinese local market will move toward balance from overcapacity in 2008

Meanwhile Chinese have raised export tax on steel products. The following chart shows Chinese export raise from less than 10M ton in 2004 to close to70M ton in 2007, while the export tax was reduced from 15% to 0-5% depending on specific products. The export volume reached a tipping point in 2007 when the export tax was raised to 5-10%, which coincide with Chinese government’s move to shut down smaller steel mills. This further puts pressure on Chinese steel export.

POSCO (PKX) is the fourth largest integrated steel maker in the world. The shares of most of its competitors have done quite well in the past 6 month, while the shares of POSCO have been under pressure. Why? Pricing! Investors have been criticizing POSCO’s hesitance to raise their price. Weak pricing power usually turns me down especially when the cost inflation is high. In the case of POSCO, this is not because of weak pricing power. In fact, major domestic and Asian competitors have aggressively raised price. POSCO choose to sacrifice near term profit to keep a good long term customer relationship. The market took this strategy negatively which is reflected in POSCO’s stock price. I do not have a value for the intangible customer relationship. As POSCO trades in line with its global competitors at 11 times earning, the market apparently gives no value for the improved customer relationship, which I believe will pay off in the long run.

POSCO’s management team is best of the breed in the steel business. POSCO operates its steel business in a tough environment. 1, rapidly growing Chinese steel producing capacity intensifies price competition in east Asian market. 2, POSCO is heavily exposed to stainless steel, which has been very volatile in the recent years. 3, POSCO has less internally supplied raw material. POSCO also prices their products below domestic competition. Yet they generate better gross margin (21% in the most recent quanter vs Mittal’s 12%, and US steel’s 7%). This is achieved after POSCO exprense its massive R&D in COGS. The ROE of POSCO has been in low 20s and high teens in spite of lower than average financial leverage and massive cash and equity investment on its balance sheet (15% of Equity is in Cash and equivalent and 32.2% in equity investment). Its long term debt to equity ration is 23.7% vs Mittal’s 74.5% and US steel’s 121%

POSCO’s strategy is to leverage its technology innovation to achieve lower cost and product differentiation. Due to its scale, POSCO has successfully leveraged its R&D spending. An interesting figure to look at is 2005-2007 average capex per ton of major steel maker, which I pulled from US steel’s presentation. POSCO spends almost twice the average to improve efficiency of their steel mill and invest in better technology.

Result? POSCO has decreased their coal ratio from 850kg/THM to 700kg/THM. (chart is cited from POSCO’s 1Q 2008 presentation). Given the fact that coal price has increase almost five folds during last 4 years, the value of such efficiency improvement worth a lot more now.

POSCO also leads the industry in production efficiency. (adopted from 1Q 2008 presentation.)

POSCO also invest heavily to produce high value added products to defend its margin from Chinese competition. Although this strategy backfired in 2006 when its stainless steel business recorded a negative margin, product innovation will help them to sustain higher-than-average gross margin.

The competitive advantage of POSCO

The biggest hidden value of POSCO is its leadership in FINEX technology. FINEX is designed to produce molten iron directly using iron ore fines and non-coking coal, eliminating the costly preliminary process of sintering and coke making. Thanks to the reduced iron making process, the overall construction cost will be slashed by 8 percent compared to that of conventional furnaces. The $1.1bn furnace is expected to produce steel about 17 percent cheaper than the conventional ones since it can use cheaper and more abundant coal fines instead of the previously used high-quality sticky coal lumps. As the skyrocketing coking coal price, the cost advantage of new steel mills build with FINEX technology will be even wider.



In the $140 barrel of oil world, being close to customer is a significant advantage. The undergoing urbanization in India and China will sustain the growth in steel demand for the near future. POSCO is well positioned to ride this trend. Chinese government has ordered to close low efficient and high polluting steel mills by 2010, which effectively reduce supply. POSCO will build a 12M ton steel mill in Orissa, India using the FINEX technology. FINEX technology + low cost ion ore will ensure the cost leader status of POSCO India giving a boost to their bottom line. The new steel mill will serve as a significant base for POSCO to expand into India and Middle East market.

POSCO have good long term relationship with its customers and often hold equity investment in their customers. Although POSCO has more pressure to raise their price in a strong market, it will benefit from the customer relationship during tough time. This is evidenced by the 100% utilization rate in its two major mills from 2002-2006, when other domestic producers suffered influx of steel imports..





The disadvantage of POSCO

Both Korean and Japanese steel makers do not have as much cheap self-supplied raw material as their global competitors (Mittal, US steel). The Chinese competitors have access to lower cost coal, while the Indian Competitors have access to cheaper ion ore. Steel price in Asia is lower than those in North America or Europe, while high shipping rates make it more expensive to sell products in US.

Disclosure: I currently have long position in PKX.

Recent weakness in MCOs present an good entry point for long term investors

Whenever I am attracted to a business that is trashed by the market and trades at a dirt cheap valuation, the first question is to be answered is why it is cheap...

Same applies to the MCOs. They are trading at 7-10 times P/E over their already lowered earning forecast. Why are they cheap? After I listened to 4Q 07 and 1Q 08 of most of the major MCOs (UNH, WLP, AET, CI, HUM and CVH), the most popular questions from the street analysts is the rising medical cost in the form of both unit cost inflation and utilization rate. UNH and WLP have been quite honest on this issue, while others deny. I have no doubt about the higher than expected cost trend. People tend to use more health care service before they lose their job. It is not unexpected that the utilization rate is lagging the economy. The street seems to equal higher cost to lower profits. This view is supported by the rising Medical Loss Ratio (MLR) from the first quarter earning report from the major MCOs.Thus the theory of underwriting downturn is spreading.

It is rather the lack of pricing discipline than the higher cost that leads to an underwriting downturn. As long as the insurers pass the cost onto consumers, higher cost means higher revenue. The managements of the major public MCOs have acknowledged their willingness to protect the margin, even if they are to sacrifice membership growth. I would take managements comment with a grain of salt. Since healthcare insurance is priced annually on a rolling basis, the expected higher trend will certain eat into margin until it is repriced. A positive note from several 1Q 08 call is that the major not-for-profit players who have been driving the price competition are backing off, because these players more heavily rely on investment income and have more exposure to equity investment. Their balance sheets are certainly worsened in the current environment. Hence I expect the pricing discipline will come back as the underwriting capacity of not-for-profit is limited by their balance sheet.

Although I do not have clear view of the profit margin of the MCOs in 08, the valuation is compelling enough to take a hard look. When stock price is depressed by short-term uncertainty not the long term change in fundamental of the business, it often present an attractive investment opportunity.The big picture is still bright for the MCOs. 1, the population in US is growing and getting older; 2,longer life expectancy increases the total medical service to be consumed over one's entire life; 3, advancing in medical technology increase cost; 4,consolidation in the space will continue, especially in the current environment where smaller MCOs are squeezed. If we think the MCOs as a retailer of medical service (as I mentioned in my previous post), these predictable trends are all working for their benefit.

Coventry Health Care lowers its guidance

Another shoe dropped in the managed healthcare space. Coventry(CVH) lowered its full year guidance to $3.65 to $3.75 from $ 4.39-$4.49. Higher than expected MLR is cited. The revision of Private Fee For Service (PFFS) seems to be firm specific driven by a negative development of its reserve (delayed claim submission is cited as the cause.). While the higher than expected MLR of its commercial business is quite a concern. Looking back to its 2008 1Q call, CFO, Shawn M. Guertin, confirmed a "stable trend at the neighborhood of 7.5%", after many of its major competitors (UNH, WLP) reported higher than expected inpatient unit cost. The management also backed its original guidance given the fact that most of its competitors lowered theirs. Management's credibility aside, this revision come barely as a surprise. It is merely a catch up with its competitors......

managed care organization (MCO) is getting interesting

I always like to take a careful look at business that possess a strong balance sheet and yet experienced significant drop in share price....MCOs apparently qualify....I will post a series review of MCO industry on this blog...

Industry Overview

The managed care organization (MCO) is basically a retail business (purchasing medical service in bulk and sell to individual customer) and an insurance business (additional compensation is rewarded for the risk assumed). It creates value for its customers by purchasing medical service in bulk at a lower price and by helping customers using their healthcare service more efficiently. The market divides into three major categories: Commercial Risk Management, Individual market and government sponsored program (Medicare, State Children's Health Insurance Program and Medicaid).The government and large corporations in the commercial risk management segment have a strong bargaining power and more price-sensitive. The individual and small businesses are generally price-taker and have very low bargaining power.

There are usually two or three major MCOs competing in a local market. The high market concentration renders the big firms strong bargaining power when negotiating reimbursement rates for healthcare providers. The rivalry in the industry is decreasing because of the on-going consolidation. I expect the consolidation to continue into the future, as the smaller players can not compete against the low cost large MCOs, especially in this tough economic environment. Due to the slower economy, commercial business is under pressure (both on pricing and membership growth). Higher unemployment rate will result in lower membership enrollment. As corporation customers trying to cut their medical cost, the smaller and high cost MCOs will take a harder hit. Healthcare insurance is largely a commodity business, therefore being a low cost producer is critical to the success of the company. The market share leader can always attract more doctors and negotiating for better rate by committing volume to the doctors. In turn more membership is attracted by low price and larger doctor network. The moat of the market share leader grows by widening gap in the membership counts. Due to such economics of scale in the MCO industry, the entry barrier is high.

In addition to favorable industry characteristics, the demand outlook is bright. The demographic trend driven growth is highly predictable. Healthcare cost is increasing at 7.5%-8% annually, driven by higher unit cost (more expensive new therapy, as medical technology advances) and utilization rate (more frequently using healthcare service). This rate will likely to increase because as the boomers get older, the utilization rate will be higher. Higher cost will be translated to higher revenue for the MCOs given their ability to pass cost inflation onto the end consumers. As people will live longer life, the total medical cost during one’s life will be certainly higher. Secondly 18% of the population are still uninsured, which represents a growth opportunity for individual market. Individual business is more profitable for the insurers since the consumers have less bargaining power, but the selling cost is also higher than dealing with big custromers. Companies who can achieve low selling cost, such as online direct sale, will likely to benefit the most from this opportunity. The fix cost (G&A) is pretty scalable in this business. There is more cost leverage as the topline keeps growing. Hence the bottom line should grow even faster.

The biggest concern in the industry is increased government regulation and uncertainty regarding universal converge policy. I believe universal coverage could be slightly positive for the industry. Although margin is likely to be depressed, it is likely to be compensated by greater volume influx from currently uninsured. Low cost provider will be likely to benefit. Massachusetts already operates under a universal coverage policy, under which insurers have demonstrated their ability to operate profitably. Auto Insurance industry has proven profitability under universal coverage model. Guaranteed issuance will certainly increase the premium, because those with pre-existing conditions that are not able to obtain coverage will be covered. Essentially healthy people are paying to cover the sick. If you think MCO as medical service retailer, larger volume is actually a good thing. Credit Suisse has a nice state-by-state analysis showing a strong positive correlation between government regulation and insurance premium. Given the market power of the insurance companies the higher regulation cost will be eventually passed on to consumer in the form of high revenue.

To be continued….

Please tell me want do you think.

Durian Investing

Finally decide to restart my investing blog.....Many have been leaned from years of successful and unsuccessful trades....

Durian is a fruit with formidable thorn-covered husk and terrible smell...Only people who really what's underneath the appearance and have the gut to take a bite will be rewarded with its sweet and tasty fresh.... Just like value investing....hunting treasures covered by unappealing looks....

So...I call my new blog...Durian Investing