Waste to energy: where there’s muck, there’s brass

WHERE THERE’S MUCK, THERE’S BRASS¹

For ethical investors like Morphic the quest is to find the limited number of companies on offer that trade at low prices, have good growth prospects, are well governed and are actively engaged in trying to make the world a better place.

Hong Kong listed China Everbright International (CEI) is a pioneer in providing waste to energy solutions for urban and agricultural waste. It is now one of the top five investments in both the Morphic Ethical Equities Fund and the Morphic Global Opportunities Fund.

Figure 1 – Morphic’s Investment Analyst met with China Everbright’s IR team in Hong Kong

Although it has gone up more than 10% since we first bought the stock late in 2017, we believe CEI is cheap and should have years of growth. Meantime, unlike other energy generators, it is not exposed to rising feedstock prices: it actually gets paid per tonne of fuel input (garbage) it uses to produce energy. It also gets a subsidized higher price for the power it generates.

Traditional Chinese landfill solutions are no longer viable as pressure on peri-urban land for housing development intensifies. China’s urbanization has risen from 26% of the population in 1990 to 56% in 2015², and is tipped to reach 60% by 2020. Municipal waste has increased even faster as China has gotten richer, and uses more packaging.

The pressure on land was evident on a recent visit to Buluo, a city of 1.2mn people outside Shenzhen in China’s south, to inspect CEI’s waste-to-energy plant. Freeways in construction and newly built skyscrapers make it clear that as people flock from the countryside to the city, there are better uses, and more money to be made by local governments, for land than to fill it with rubbish.

When Morphicians Claudia Kwan and Eva Trabaud visited the plant, which will soon handle 83% of the city’s municipal waste, they didn’t smell even a waft of rubbish. One of the highest priorities for the plant is to eliminate any smell of rubbish, so as to head off “not in my back yard” concerns. Complete odor control is also a vital marketing goal to build credibility for future CEI project bids.

Figure 2 – Visit of the waste-to-energy plant in Bulou

As frequently happens when the Chinese Communist Party decides change is needed, Beijing has set aggressive targets. The current 13^th five-year plan requires 54% of all municipal waste to be incinerated by 2020 (151% increase over the period). In China’s 4^th largest urban city, Tianjin, incineration is tipped to grow 300%, taking landfill to zero by 2020. These are growth numbers rarely associated with defensive industries with predictable and stable cash-flow streams.

For China’s growing urban population, CEI is the solution to household waste, while subsidiaries also offer solutions in agricultural waste and disposal of water treatment solids.  Adhering to tough environmental standards, CEI produces enough electricity to support the annual electricity consumption for over 3 million households. Part of CEI’s edge against foreign companies and a host of smaller competitors is its proprietary grid furnace technology specially designed for disposing of China’s unique waste stream to the highest environmental standards.

Waste-to-energy projects are developed under 25-30 year Build-Own-Transfer agreements (BOT), a concept we believe is poorly understood by the market. The mandatory IFRIC 12 accounting standard for BOT projects is complex and does result in reported profits for each project in their first year being much higher than cash flows. On the other hand, in later years the reverse is true: reported profits fall, but cash flows grow steadily.

IFRIC 12 means investors need to have faith in CEI’s judgment in booking revenue and leaves the company open to earnings gapping in future years if construction revenue growth wanes because it can’t find new projects. However, we believe concerns about this are misplaced. When company cash flows are analyzed thoroughly, project by project, we believe they point to a valuation of at least HK$18 a share for CEI – against the average market price we bought at which was below HK$11 and the current price above HK$12 a share. We also note that CEI has taken steps to increase shareholder confidence by increasing dividend payments in recent interim results. It also demonstrates a high level of transparency in terms of publishing its project pipeline.

Finally a word about governance. CEI is a subsidiary of a finance-based Chinese State Owned Enterprise (SOE), China Everbright. A point of concern is that SOEs vary in terms of getting the balance right between government objectives and shareholder interests. More positively, SOEs can also sometimes have an edge over private sector firms when entering regulated industries or ones that require permits from other levels of government – although CEI believes it never needs to rely on this for tenders.

In any case, CEI appears to us to be a relative jewel among SOE subsidiaries. In its present form, CEI owes almost wholly to the entrepreneurial leadership of its former CEO, Chen Xiaoping, who retired recently. Mr. Chen took what was essentially a moribund HK shell and identified the looming environmental crisis in urban waste management as a growth opportunity for a new business. We believe he has created a solid management transition process – proving that, investment in people is the critical determinant of long-term success.

1 Oxford Dictionary: (English proverb) Dirty or unpleasant activities are also lucrative.

2 National Bureau of Statistics of China