Description

ZhongDe Waste Technology, a Chinese manufacturer of medical and municipal solid waste (MSW) incinerators that recently filed its IPO presents a compelling opportunity to profit from improvements in China’s environmental standards and an increased standard of living in that country.  ZhongDe has experienced tremendous growth over the past few years (revenue growth of 85% and 67% in 2005 and 2006, respectively) and generates 50%+ ebitda margins.  The company has limited awareness among institutional investors:  the stock is covered by only two analysts and is listed in Germany despite the business’s sole focus on the Chinese market (management is considering a dual listing in Hong Kong).  Unlike many public Chinese businesses, ZhongDe is very inexpensive, trading at 11x forecasted 2009 earnings despite having tremendous long-term growth characteristics and an outstanding reputation in markets served.  Additionally, the company is transitioning its business model to winning more long-term contracts to build and operate waste incineration plants which should garner a premium multiple relative to the one time sales associated with its legacy incinerator business.  Given the porous state of waste disposal in China (much of it is dumped in rivers), heightened focus on environmental clean-up due to the upcoming 2008 Beijing Olympics and 2010 World Trade Expo in Shanghai, underlying growth in the MSW industry should accelerate and the market should re-value this security. 

Company

ZhongDe designs, manufactures and installs pyrolytic, grate and rotary kiln waste incinerators for the disposal of solid medical, municipal and industrial (including hazardous) waste. Since 1996 ZhongDe has installed more than 170 waste incinerators in 13 provinces and has installed 112 waste incinerators in the past three years alone.  ZhongDe has a production capacity of at least 40 incinerators per year, and the company plans to build a second production facility in Beijing that should be completed by late 2008 and will double current capacity.  The company’s customers are primarily municipalities and government agencies, and the customer base is broad based with the largest customer representing 13% of 2006 sales.  The stock began trading on the Frankfurt exchange in July 2007.

Medical Waste Incinerators

In the wake of the SARS epidemic, the Chinese government began to require hospitals to collect medical waste at a central location and to properly dispose of it.  As part of this campaign, the government targeted 300 medical waste incinerators in operation in China by mid-2006 and put large government subsidies in place on incinerator purchases (~50% of cost).  By the end of 2006 however, only 150 medical waste incinerators were in use in China, implying that half of the medical waste incinerator market has yet to be built.  ZhongDe estimates that they have 35% market share of the Chinese medical waste incinerator market. 

Municipal Waste Incinerators

While there is ample growth available in the medical waste incinerator sector, the MSW incineration market has significantly greater long term potential.  The Chinese government has mandated that the proportion of trash incinerated be raised from its current level of around 3% to at least 30% by 2030.  This compares to waste incineration levels of approximately 15% in the US, 20% in the EU-15 and 80% in Japan.  In fact, according to government regulation, approximately 1,800 incineration projects will need to be designed and built over the next five years (ZhongDe sold 5 municipal units in the first half of this year).  Currently, the majority of waste is dumped in landfills, which is less costly than incineration but poses severe environment risks and should be more challenging as cities continue to expand in size and population.  The environmental benefits of incineration are significant: a) reduced greenhouse gas emissions (methane) and b) eliminates risk of landfill “leaks” in which waste enters ground water or the environment.  ZhongDe’s strong municipal growth should be driven by the factors listed below:

• ZhongDe’s target markets are small (100,000-200,000 people) and medium-sized (200,000-750,000) Chinese municipalities.  There are currently approximately 500 Chinese cities within these two population bands, and that number should grow as China becomes increasingly urbanized.  Experts estimate that the percentage of people living in China’s cities will increase from its current level of 600 mm people (42% of total population) to more than 900 mm people (60%) by 2030. 

• According to a 2005 World Bank paper on waste management in China, urban residents produce two to three times more waste than their rural counterparts, regardless of income levels, further increasing the size of ZhongDe’s addressable market. 

• Per capita waste consumption has historically tracked GDP, indicating that Chinese consumption should increase dramatically in the next few years as China’s growth continues to outpace that of the developed world, a trend that should create additional solid waste to be incinerated.  China recently surpassed the United States as the world’s largest MSW generator, but its average urban resident generates only 0.95 kg of MSW per day, compared to the 1.65 kg produced by the average OECD inhabitant and 2.05 kg generated by Americans, implying significant per capita growth potential.

BOT Projects

Historically, ZhongDe has been involved strictly in the manufacture and sale of incinerators, which are shipped to incineration plants and operated by other entities.  Recently, however, ZhongDe has expanded its focus to encompass the entire MSW incineration process.  For these projects, dubbed “BOT” (Build, Operate, Transfer), ZhongDe is responsible for building and operating waste incineration plants for its clients (generally local municipalities) over a defined concession period of usually 20 to 30 years.  The recurring revenue nature of this business is attractive, and ZhongDe should receive additional value from the sale of plant by-products such as electricity, steam, and bricks. 

ZhongDe recently signed two BOT contracts and has four non-binding LOIs for additional projects that are currently being awarded in the near-term.  The capacity of these projects will range from 100-600 t/day.  Management believes that unlevered returns for these projects should range from 13-16%. 

Competitive Landscape

ZhongDe’s primary competitors are domestic firms, as the smaller incinerators built by ZhongDe can be manufactured much more inexpensively domestically.  There are a handful of other Chinese players in both the medical and municipal waste markets, and while each presents a threat to ZhongDe, the companies are geographically dispersed and the market served is both large and growing.  Leading international competitors such as Veolia-Onyx, Alstom and Mitsubishi are generally focused on large scale facilities in tier 1 cities and have not overlapped significantly in ZhongDe’s target markets.

Management believes that technological barriers to entry are sufficient enough to dissuade additional competition from entering the market.  ZhongDe’s technology is generally regarded as cutting edge, as it produced the first small trash incinerator to meet China’s initial standard for dioxin discharge established in 2003.  The emission of dioxins from ZhongDe’s current group of incinerators was independently calibrated at one-fiftieth of the current national standard, and one-tenth of the standards of the European Economic Area.  Additionally, ZhongDe uses pyrolytic technology in many of its incinerators which generally require significantly less energy input during the incineration process than rotary kiln technologies typically used by large international waste businesses.  Chinese waste has a higher degree of organic substance when compared with waste from Western countries, and therefore has a much lower heat value giving pyrolytic technology a significant cost advantage.

Management

ZhongDe’s Founder and CEO, Chen Zefeng, owns more than half of the business.  Zefeng appears to be extraordinarily well-connected and influential within many leading government and environmental agencies.  Zefeng serves the Deputy Director of the China National Association of Environmental Protection Industry (CAEPI), a trade group managed by the State Environmental Protection Administration.

Valuation

ZhongDe has grown revenue by more than 50% in each of the past two years.  In the first half of 2007, revenues and net profit grew by 99% and 196%, respectively.  Our projections through 2009 are shown below.  We have included earnings from the six previously mentioned BOT projects into our forecasts, but have not assumed any further contract wins.  Additionally, we have not included any benefit from the early stage aviation waste market (aircraft overhaul and maintenance waste) despite its sizeable market potential.  ZhongDe trades at 11x 2009 forecasted earnings, a very compelling valuation given its established market presence, its unlevered balance sheet, and the strong growth profile of the MSW industry in China.  Our valuation does not exclude the current cash balance which will be used to fund capacity expansions and BOT projects, but we believe that the cash generation of the business will be able to fund the majority of these outlays. 

The main constraint on ZhongDe’s growth is plant capacity.  The company’s current plant capacity allows for the manufacture of approximately 40 incinerators per year (depending on size and throughput), and ZhongDe’s unit production figures have been near that total for the past three years.  In order to address this issue, the company is constructing a new plant that will double current capacity when the plant opens at the end of 2008. 

The primary advantage to ZhongDe’s foreign listing is the significant Chinese tax savings afforded to foreign-invested companies.  As a German company, ZhongDe is entitled to a full tax exemption for its first two years and a 50% reduction for the next three years, commencing from its first profit-making year.  We have estimated ZhongDe’s tax liability at zero in 2007 and 2008 and half of China’s 25% corporate tax rate in 2009-11.  This incentive was recently abolished, but ZhongDe was grandfathered in.  Additionally, ZhongDe might continue to receive tax incentives beyond 2011, as Chinese tax laws afford reduced rates to “incomes generated from engaging in environmental protection,” a condition ZhongDe believes that it meets.

Risks

Chinese business ventures are invariably risky, as the terms under which contracts are awarded are often murky, and the competitive landscape is difficult to assess.  ZhongDe’s management team seems to be both competent and well-connected, but the level of local and federal government involvement in contract awards creates a degree of risk.  Further, the degree to which China will actually commit to meeting its incineration targets is uncertain.  ZhongDe’s latest 150 ton/day MSW incinerators cost upwards of $2 million each, a substantial expense for Chinese municipalities.

ZhongDe has not manufactured a waste-to-energy incinerator, and some of the economics built into the BOT projects assume success in generating power from incinerator operation.  It is worth noting that Chinese MSW composition differs materially from the MSW of more developed nations, reducing the amount of energy by-products that can be generated.  Approximately 50% of Chinese MSW is food waste and only 6-7% is comprised of paper and plastic.  By comparison, 40% of New York MSW is paper and plastic and only 13% is food waste, resulting in much lower humidity and higher heat generation than that of Chinese MSW. 

DISCLOSURE:  We and our affiliates are long ZhongDe Technology (ZEF), and may long additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of ZEF.  This is not a recommendation to buy or sell shares.

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