PYI corp (“PYI”) is a misunderstood and under-covered stock, which currently trades at 40% below intrinsic value. 

 

PYI formerly known as Paul Y-ITC started its roots as an engineering, building and construction service provider in Hong Kong with ownership stakes in various disparate construction-related assets.  However, in the past two years, the Company has started a transformation process to become an important player in China’s ports and infrastructure development industry.   To date, PYI has made two significant investments in bulk-cargo port facilities along the Yangtze River; a 45% stake in Nantong Port Group (“NPG”) and a 75% stake in Yangkou Port (both in Jiangsu Province).  The Company has also been divesting non-core assets and returning the proceeds to shareholders by way of special dividends. The current PYI comprises of three key components, with its two port assets being the largest contributors of intrinsic value.

 

PYI’s transformation has largely been ignored by the market so far, but if one follows the recent announcements by the Company, and bothers to read the footnotes in the Company’s filings, it is evident that the business transformation is real and there is significant “hidden” value in the Company’s ports assets and land bank.

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 HK$554 mil (US$ 71.2 mil), implying a LTM P/E multiple of only 5.1x.  Key financials are shown below:

 

Key Financials For the Fiscal Period Ending In Currency	12 months Mar-31-2004A HKD	12 months Mar-31-2005A HKD	12 months Mar-31-2006A HKD	LTM 12 months Sep-30-2006A HKD
Total Revenue	3,334.0	3,247.7	3,109.9	3,226.1
Growth Over Prior Year	NA	(2.6%)	(4.2%)	5.9%
Gross Profit	68.1	192.3	230.1	214.5
Margin %	2.0%	5.9%	7.4%	6.6%
EBITDA	(15.8)	112.3	111.8	105.6
Margin %	(0.5%)	3.5%	3.6%	3.3%
EBIT	(69.5)	78.9	97.5	98.4
Margin %	(2.1%)	2.4%	3.1%	3.1%
Net Income	(61.7)	80.0	100.9	109.3
Margin %	(1.8%)	2.5%	3.2%	3.4%

  

Paul Y Engineering has net income margins of 3.4% which is not high, but is consistent with other engineering services company.  In fact, Paul Y Engineering has been increasing its margins and should continue to see margin expansion through the provision of higher margin business (e.g. facilities management).  One can argue that a 5.1x LTM P/E multiple for this company is low, and this company deserves to trade at 8-10x P/E (as implied from a DCF assuming meager 3% p.a. growth, no margin expansion and 11-13% discount rate).  However, to be very conservative, I’ll use the lower current market cap of Paul Y Engineering in my sum-of-parts valuation.   Therefore, PYI’s 65.2% stake in Paul Y Engineering is worth HK$361 mil.

 

 

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.

 

Volume throughput grew 18% and 16% respectively in 2005 and 2006 with similar growth rates for its revenue.  However, due to significant operational leverage, net income grew 31% in 2005.  No numbers are released yet for 2006 but it is expected that the growth in bottom line will also be in the high double digits, due to the operational leverage. Further, NPG started a cost reduction program that is expected to reduce labor costs by a third in the next three years, hence further margin expansion is expected.

 

My DCF valuation of Nantong Port using discount rate of 12% and 4% perpetuity growth rate yields a valuation of HK$2,115 billion (US$272 mil).   Taking an arbitrary 30% haircut on this value to reflect the current sub-optimal margins gives a valuation of HK$1,480 mil (US$190mil).  The implied LTM P/E multiples based on the valuation (after 30% haircut) is 17.9x but forward multiple is only 13.5x 2007P/E.  For comparison, other Chinese ports are trading at an average of 21x P/E due to their high growth prospects and operational leverage.  Again, for conservatism, I will use my lower DCF valuation of Nantong Port including 30% haircut in my Sum-of-Parts valuation. Hence, PYI’s stake in Nantong Port Group is worth HK$666mil (45% *HK$1,480mil).

 

This is the jewel within PYI.  PYI owns the right to reclaim 42 sq km of land and can lease or sell the land after reclamation. Two years ago when this green-field project first commenced, the project was just a vision. However, with the completion of a number of milestones, the recent securing of PetroChina as an anchor tenant, and the joining of a high-profile Chinese minister on the Board of PYI are testaments that this project is on track and land sales within Yangkou Port can be achieved in the near future.  Phase 1 of the project which consists of 10 sq km of an Industrial Zone and a 1.44 sq km man-made island will be completed by 3Q2008 and land sales are expected starting this year.

 

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.  It is one of a few locations in China that can be used as a deep-water port, and it is one of few locations approved by the Chinese government for building LNG ports. 

 

PYI intends to realize value through land sales of the land it owns at Yangkou post reclamation and development.  From the Company’s filings at the time it acquired its stake in Yangkou, it can be inferred that PYI only paid a mere RMB 23 psm (US$2.96 psm) for approximately 30sq km of land, and paid RMB 54 psm (US$ 6.9 psm) for the remaining 12 sq km, with blended price of RMB 32 psm.  Based on recent comparable land sale prices paid for industrial land, Yangkou’s land bank, once reclaimed and developed, should easily be worth between RMB 150 – RMB 800 psm (US$19.2.-US$102.8 psm).  Subtracting unit reclamation costs of RMB 30 psm gives a profit of RMB 120 psm, if one assumed land was sold at the low end of RMB 150 psm.  Assuming PYI sells its first parcels of land at RMB 160 psm in 2008 (to be conservative instead of this year) and increases the selling price over 5 years to reach RMB 430 psm in year 5 (which is still lower than what comparable industrial land is going for currently in some places), I derive a NAV of HK$5,786 (US$743 mil) for Yangkou Port assuming a 15% discount rate.  Therefore, PYI’s 75% stake in Yangkou is worth HK$4,339 mil (US$557 mil).

 

In HK$mil		PYI's stake	Valuation	Value to	Implied	Method
				PYI	2007/PE
Paul Y Engineering		65.2%	554	361	5.1x	Market Cap of Paul Y Engineering
Nantong Port Group		45.0%	1,478	665	13.5	Based on 4% perpetuity growth and 12 % discount rate followed by a 30% discount to reflect current sub-optimal margins
Yangkou Port		75.0%	5,786	4,339		Using 15% discount rate and assuming land sales start in 2008 at RMB 160 psm rising to RMB 430psm in year 5.
Sum of Parts Valuation				5,365
+	Cash on hand at PYI level			1,561
Total Valuation (inc cash)				6,926
	Number of PYI shares			1,463
NAV per share				HKD 4.74
	Current share price			HKD 2.84
	Premium/(discount to share price)			-40.0%

 

 Note that the above is a conservative case.  If we exclude the 30% discount applied on Nantong Port, and assume that the selling price of land for Yangkou starts at RMB 180 psm and increases to RMB 690 psm in year 5 (instead of RMB 430 psm), then the intrinsic value per share of PYI rises to HK$6.31 per share implying a current discount of 55% to intrinsic value.

 

·        In the footnotes of PYI’s 2005 annual report, they have a huge HK$900 million tax provision for “revaluation of land under development”.  This shows Management truly believes it can sell its Yangkou landbank at a significant profit.

·        Management’s compensation is highly skewed to certain profit thresholds being achieved, clearly aligning Management’s interest with shareholders