HQ Sustainable Maritime Industries (HQS) Analysis

Cash: $43.8M
Receivables: $51.7M

Total Liabilities: $6.5M

Market Cap:…52M?

The thesis is pretty simple here: it’s an old-school net-net. Based on liquid(-ish) assets on hand, the company is dramatically undervalued. It currently sells for about 40% of book with mostly liquid/recoverable assets.

Pessimistically: $43.8M for the cash. Collecting even 60% of the receivables cranks that up to $74.82M as a possible liquidation value. That’s a little less than 10x last year’s earnings – a big step up from the current P/E of 6.41, but not out-of-this-world high either.

The question is: will there be any catalyst to draw investor attention?

No huge/obvious catalyst is present, but there are a few smaller factors that might combine to draw investor attention: previous valuation patterns, unusual seasonality, and a planned partial IPO of a subsidiary.

For 2008 and and 2009 the company’s average annual P/E ratios were 11 and 14.25. It’s not a terribly compelling factor on its own, but it’s somewhat reassuring to see that (at least in the past) investors have valued the company more highly with similar fundamentals.

Another factor is the unusual seasonality of the business. At first glance aquaculture doesn’t seem like a highly seasonal business, but according to management their business gets a substantial boost in the winter from their location. Many of their competitors are located to the north and are forced to shut down in the winter, which sends a lot of business their way. That seemed a little fishy (hah) to me but the sales figures seem to bear it out: earnings double (or more) in the second half of the year. This is pure speculation, but I wonder if investors appreciate that the company needs to be evaluated in terms of yearly cycles rather than quarterly results. There was a lot of institutional selling in the 2Q of 2010 (and presumably 3Q judging by the stock’s steep decline) despite year-over-year revenue increases of around 40% and 25% for the first and second quarters of 2010. Why would investors be bailing unless they didn’t understand the true significance of the quarterly EPS numbers? [snarky answer: because I’m wrong…]

The final factor is the company’s plan for a partial IPO (35%-ish) for their marine pharmaceutical subsidiary on the Hong Kong Stock Exchange. Their healthcare line – if they can actually grow it – seems much more promising than the core business. Gross margin for 2009 was 75.1%, compared to 34.3% for the core aquaculture business (and a truly abysmal .62% gross margin their fish feed division…luckily 2010 margins have improved significantly to take it out of “what were they thinking?” territory). Net margins are about equal in ’09, but that’s mostly due to an atypically large allowance for a doubtful account – previous years saw the pharmaceutical unit outperform the aquaculture on comparative margins.

What kind of multiple will the market accord the pharmaceutical unit’s earnings? The average P/E on the Hong Kong exchange was 15.95x as of September 30, so let’s consider a multiple of 8x earnings. That’s higher than the parent company currently trades, but substantially lower than HQS’s trading level in previous years and only half the average on the exchange where they plan to list it. Breaking it down:

Pharmaceutical net income (2009): $5.2M
Estimated 2010: ~$5M

To be conservative, that estimate subtracts out all recoveries from doubtful accounts and assumes that sales simply hold steady. That feels like a fair assumption since sales for the first six months have been slightly higher and the company has managed to reduce marketing costs (the second largest expense after COGS) by $900,000 over the same period.

If that holds true the pharmaceutical division ought to be worth $40M all by itself at 8x earnings. The rest of the company ought to pull in another $4M net income. That’s substantially more than the other divisions pulled in so far this year, but again that area of the business is highly seasonal. $4M net is simply in line with previous years’ results, which have been roughly mirrored in the first two quarters. Even at a measely 6x earnings, that adds another $24M in value. That totals to a (fairly conservative, I think, since the stock passed the 6x mark while I was in the process of writing this) estimate of $64M market value, which still doesn’t even recognize the full value of the assets.

Together factors these ought to have a positive effect on the stock, but it’s difficult to quantify how much or precisely when without knowing how big a role seasonality has had on the stock price. November 9 (tomorrow) is the 3Q earnings release, so the market’s reaction to that ought to provide some clues (it’s up over 7% today, so perhaps I’m not the only one watching…).

What are the risks?

Well, I think valuation isn’t one – the company sells for a conservative earnings multiple and asset-wise it would fetch a substantial premium over its market value if it went into liquidation. I once read a description of Seth Klarman that said “he prefers for the belt of assets to be supported by the suspenders of earnings.” I think HQS pretty much fits the bill.

Corporate governance is probably a big one. Power is concentrated in three managers/owners/directors who control 20% of the common stock and 90% of the voting power via convertible preferred with enhanced voting power. This means that there is exactly zero chance for any activist investors to agitate for change. Management doesn’t appear to be unusually greedy or incompetent and they do have a substantial stake in the company to keep them focused, but investors who want to have activism as a possible recourse might be discouraged anyway.

A big change in the USD/CNY exchange rate looks like a possible risk, but it’s one that’s moderated by the structure of the company. 30-40% of the company’s net income comes from sales within China, so any increase in the yuan’s value relative to the dollar would in turn raise the converted value of these sales for the company. It doesn’t perfectly hedge out currency risk, but it provides a substantial buffer.

I think the biggest risk is that, for management’s talk about uniqueness and vertical integration, the business doesn’t have any real competitive advantage. The company is making efforts to diversify and add certifications (organic), but there’s nothing to stop potential competitors from joining the party. Luckily, that’s more of a long-term problem since competitors would still take time to make inroads into their market share. And worst-case, the company would still make a profit for investors in liquidation.

Recent Filings:

Latest 10-Q
Latest 10-K

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