environmental stock with low downside risk, emerging upside · listed shares 479.3 million ord fp...

Research compiled by Graeme Newing 15 November 2017

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Phoslock Water Solutions Ltd (ASX:PHK)

Listed shares 479.3 million ord fp post forthcoming AGM

Lind 7.1¢ options 2.5 million expiring 20 March 2018

Performance 10.5¢ options 65.0 million, subject to financials, expiring 20 Dec 2019

Total securities 546.8 million

Share price 19.2¢ as at 15 November 2017

Market cap $92m on listed shares, $105m fully diluted

Environmental stock with low downside risk, emerging upside

This is an update on the research notes I published earlier this year on 18 May and 11

September. Please refer to those reports for background – you will find them on

www.newingonstocks.com.

There have been a number of announcements by PHK since my last report. They include

the placement and SPP to raise $7.5m at 17.5¢; updated and expanded revenue and

profit guidance; the report for the September Quarter; the annual report for the year to

30 June 2017; the appointment of Brenda Shanahan to replace retiring director Pam

Allen; and updates on business conditions.

My earnings projections and valuations are little changed despite significant changes in

some of the underlying assumptions. EPS projections for the next three years are 0.9¢,

2.5¢ and 3.4¢, with high growth continuing beyond that. My central valuation is 57¢

within a wide range of probabilities. Importantly, due to the company’s updated and

expanded guidance, my projections are much lower risk than they were.

I would not be surprised to see much higher guidance emerge in due course. For one

thing, the current guidance is bound to be conservative to ensure the projections will be

met. For another, the potential in China is so vast, and PHK is now in the box seat to

benefit.

The potential for the stock has been recognised by investors to some extent with the

shares rising from 15¢ when I wrote the report in May to as high as 24¢ a few weeks

ago.

My view remains that the shares could rise to the 40¢ to 60¢ range over the next year or

two based on my revenue, profit and valuation projections. But, as discussed above, the

risks are probably on the upside.

___________________________________________________________________________

http://www.newingonstocks.com/


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The business

PHK structure in China

The PHK business in China now has two complementary business divisions, being

Contracting and Materials.

Contracting includes the Beijing office, which is engaged in design, engineering and

construction of water projects.

Materials comprises the factory located 150km inland from Shanghai in the city of

Changxing, Zhejiang province, used to manufacture phoslock and other water

treatment products for domestic and export markets.

Phoslock has relationships with a number of Chinese water treatment companies but the

relationship with BHZQ Environmental Engineering Technology Company Ltd (BHZQ) is the

most important, indeed it is crucial. BHZQ is a project manager and solutions provider for

large integrated water remediation projects throughout China and is a 70%-owned

subsidiary of Beijing Enterprises Water Group Limited (BEWG), a large water services

company listed on the Hong Kong stock exchange (stock code 371, price HK$6.35, mkt cap

HK$56bn or about A$9.5bn). BEWG is largely focussed on sewerage projects and water

distribution.

BHZQ is managed and part-owned by water treatment expert Zhigang Zhang, a director and

substantial shareholder of PHK through China Environmental Corporation (CEC). He is

motivated to ensure PHK does well and I note that:

A number of PHK employees are seconded from BHZQ.

PHK will be a sub-contractor to BHZQ on many projects, such as the canal project.

China Contracting

The Beijing office headed by general manager Mr Ting Shan Liu commenced operations in

July. The workforce had built up to include 17 professional employees as at 31 October (the

date of the quarterly report) and this is expected to rise to 25 by the middle of 2018. They

were working on a number of projects with an aggregate value greater than $40m.

China Materials

The factory is headed by plant manager Xhao Peng (Jason) Hai. It commenced production in

August after a commissioning period and had reached a production level of 30-35 tonnes

per day by 31 October and was building towards 40-45 tonnes per day. This will take the

annualised production rate to 15,000tpa, which would equate to annual product revenues

of some $40-50m.

When required a second production line can be added relatively quickly to double annual

capacity to 30,000tpa, while a third line would take capacity to 45,000tpa.


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The factory is completely ‘green’, all discharged water is pollution free and there is no air

pollution discharged. The dryer unit is powered by gas and the remaining power sources

come from the local electricity grid.

Included in the facility are extensive R&D facilities, where work is currently underway on

additional water treatment products, including permeable Phoslock bricks to be used in

running water, rivers and canals.

The potential in China

Like most things in China, the country’s water pollution problem is immense.

According to one article I read1 written in 2013, about one third of industrial waste

water and 90% of household sewerage at that time was released into lakes and

rivers without being treated. Nearly 80% of the cities (278 of them) had no sewerage

facilities and underground water supplies in 90% of cities were contaminated.

China’s many thousands of lakes are often affected by pollution-induced algae

blooms, causing the surface of the water to turn a bright iridescent green.

The effect of this on human health can only be imagined, with the crisis at catastrophic

levels. Fixing the problem (along with chronic water shortages in the north, and other water

issues) is one of the Chinese government’s key priorities. It allocated rmb 2 trillion (about

A$400bn) in 2015 to tackle water quality issues over the five years to 2020, and has

tightened regulations. That is beginning to help. Some improvements have been made, but

there is a long way to go.

As part of the 2015 plan, in the first half of 2017 China launched nearly 8,000 remediation

projects costing rmb 667 billion (~A$133bn).

The government-funded program is what is driving PHK’s business in China. The first major

project for the company started in October, being the remediation of water quality in a

canal in a major (un-named2) Chinese city. The Stage 1 component will provide revenues of

$5m to PHK by the end of the current half year. Stage 2 will commence in February 2018

and is of a similar size to Stage 1. The project underpins PHK’s estimate that Chinese sales

will total $16m in FY18.

The canal is the largest project ever undertaken by PHK, and in my opinion it is of crucial

importance because when successfully completed it will help to open up the whole vast

market. There are hundreds of projects, canals and other works, identified in China as part

of the remediation effort being advanced by the Chinese government. Many of them will

require PHK’s products and services.

1 http://factsanddetails.com/china/cat10/sub66/item391.html. Written in 2013 by Feffrey Hays.

2 The formal signing ceremony will be held shortly, at which time further details will be released.

http://factsanddetails.com/china/cat10/sub66/item391.html


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In my opinion, if PHK plays its cards right the China business will deliver strong revenue and

profit growth for many years. A growing proportion of sales will be from maintenance

contracts to ensure water quality for 5, 10 and up to 20 years, including an ongoing

requirement for materials such as phoslock.

International Materials

The International Materials division comprises sale and application of product outside of

China, and this has accounted for virtually all revenues to 30 June 2017. In that year sales to

China were just $0.2m, whereas International sales were $3.6m, comprising America (largely

Brazil) $2.9m, Europe/UK $0.6m and Australasia $0.1m.

The company’s estimate of International sales in FY18 is currently $6.4m3, an increase of

77% over the previous year. The company’s guidance for FY19 did not include a divisional

analysis but presumably a further increase in International was included.

3 It was originally stated as $6m but I see in the annual report it was stated as $6.4m.


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Financial projections

Earnings projections

I currently forecast earnings for the next three years (FY18 through FY20) at $4.5m, $10.9m

and $17.2m, which equates to diluted EPS of 0.8¢, 2.0¢ and 3.2¢. Previously my forecasts

were $3.7m, $10.5m and $16.9m, which equated to diluted EPS of 0.7¢, 2.1¢ and 3.4¢. As

can be seen the forecasts have scarcely changed despite the increased capital base.

My sales revenue projections have not changed, being $23m, $44m and $65m, but I have

increased gross margins from 35% to 36.5%, and made some adjustments to overhead

costs, based on the company’s latest guidance4. I should also point out that for FY20 my

earnings projection is stated after a maiden tax expense (at just 4%) as tax losses are

eliminated. I have full tax applying in FY21 which causes EPS to dip to 3.1¢, but profit growth

resumes thereafter with EPS rising to 3.4¢ in FY22, to 3.8¢ in FY23, etc.

In September PHK issued guidance for FY18 revenue (this includes interest income and grant

income, etc.) of $22m. In October the company issued much more detailed guidance not

just for FY18 but also for FY19. For FY18, their forecast for total revenue remained at $22m,

but the guidance also included cost of sales, overheads, net profit and EPS. A projection for

FY19 was also provided for the first time.

Figure 1: Company guidance ($000 unless otherwise indicated)

FY18 FY19

Total revenue 22,000 40,000 Cost of goods sold 13,700 25,000 Gross profit 8,300 15,000 Overheads 4,300 5,650 Net profit 4,000 9,350 EPS 0.9¢ 2.1¢

Total revenue and gross profit includes interest and other income.

Overheads includes interest and depreciation.

EPS based on 455.6 million shares (post placement, pre SPP).

Source: PHK presentation released to ASX on 7 October 2017

To issue such detailed projections would suggest a high degree of confidence by the

company that these will be met, and the corollary is that the projections are conservative.

And the projections mean that my current forecasts are lower risk than the previous ones.

On the basis that the guidance is bound to be conservative, I am quite happy to continue to

forecast revenues a little higher than guidance. Indeed, the risk is that even my forecasts

will prove conservative, particularly beyond the current year.

4 I had first to back out from total revenues, and from gross profit, my estimates of interest and other income.

Also note that in the summary sheet on page 2, the gross profit margin is shown as 37% but only because it is rounded to save on space. The underlying profit margin is 36.5%.


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Financial position

PHK is now debt free for the first time in years and has a reasonable cash and receivables

balance.

I had not anticipated the placement and SPP which together will raise about $8.1m cash. On

my previous forecasts the company’s cash position at 30 June 2018 would have been quite

tight at $1.1m, but I thought it manageable. However, my forecast is annual and if I had

done a half yearly forecast I might have been closer to the mark because it is probably this

half year that will be the tightest. For one thing the cash position at 30 September 2017 was

$3.3m but that was after receipt of $3.4m from the placement. Also the $1.0m short term

loan from Link Traders (Aust) Pty Ltd (used to help fund the new production facility) was

repaid on 1 November. Moreover, I had not thought that payment terms for Chinese sales

would be so onerous at 90 to 120 days (as disclosed in the September quarterly).

My current financial projections are that FY18 will finish with a cash position of $6.2m.

Dividend projections

My financial projections allow for dividends to be declared and paid from FY21, after

accumulated losses are eliminated. However, there will be no shortage of cash well before

that point, and upon reflection the company would be in a position to undertake a tax-free

capital return to shareholders, perhaps as early as FY19 if enough of the performance

options are exercised early, and certainly in the following year which otherwise based on my

projections would close with a cash position of $27m.

Valuation

My current central valuation as at 30 June 2017 is 57¢ fully diluted, based on future cash

flows over a 30 year period, discounted at 10% pa. The valuation is lower than the 62¢

estimated in my September note due largely to the dilution from the recent placement and

SPP. But that is using just one scenario and I do recognise it could vary substantially from

the central case.

Refer to the summary table on page 2 to view alternative valuations based on a range of

other assumptions on revenue growth and discount rate.

By 30 June 2018 my valuation would increase to 62¢ and one year beyond that, to 70¢.

My assumptions through FY21 are shown in the summary table on page 2 of this report.

They include sales revenue growth of 25% in FY21. Beyond that the key assumptions

comprise:

Sales revenue growth 10% pa.

Gross profit margin continuing at 36.5%.

Discount rate of 10% pa.


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Corporate

Capital base

The number of shares issued has increased by 50.6 million since my 11 September report

following the issue of:

7.5 million shares upon exercise of the remaining employee options at 9¢, in

September, raising $0.7m.

23.0 million shares from a placement at 17.5¢, in September, raising $4.0m.

20.2 million shares from a SPP at 17.5¢, in October, raising $3.5m.

An additional 3.5m shares will be issued to two directors subscribing to the placement,

being Zhigang Zhang (up to) 2.5 million and Brenda Shanahan 1.0 million, following approval

at the forthcoming AGM scheduled for 23 November. This would raise a further $0.6m.

It is encouraging that the placement was done at a discount of only 1.5¢ from the price prior

to the trading halt, and that six institutional investors took up meaningful allocations.

Investors based in China (including Zhigang Zhang), Hong Kong and Singapore subscribed for

nearly half of the total.

I would again remind you that the 65 million 10.5¢ performance options will be issued if

certain criteria are met within the qualifying period between 10 April 2017 and 30 June

2019, as to 30 million options to CEC, 20 million options to Chinese employees and 15

million options to Australian executives. For CEC and Chinese employees the criteria are

aggregate Chinese sales of RMD100m (being $19.6m at the current rate of 5.08) or

aggregate Chinese pretax profits of RMD16m ($3.1m). For Australian executives the criteria

are aggregate group sales of $25m or aggregate pretax profits of $4m. If vested, the options

would expire on 20 December 2019.

I have left unchanged my assumption that the performance options will be exercised to

raise $6.5m cash in the half year ending 31 December 2019. However, the criteria for

vesting will almost certainly be met well before the qualifying period ends – probably at

some point during the quarter ending 31 October 2018 (based on monthly management

accounts). And once vested, the 50 million options held by the Chinese are likely to be

exercised soon thereafter. The cash would be more useful to the company in October 2018

than December 2019.

Shareholders

None of the substantial shareholders, nor any of the PHK directors bar Zhigang Zhang and

Brenda Shanahan, participated in the placement. But Laurence Freedman (who added 5,714

shares for $1,000) and Robert Schuitema (he added 87,714 shares for $15,000) participated

in the SPP. The latter also converted his 2 million employee options at 9.0¢ in September


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prior to expiry. Of course, they have all been diluted down to some extent. For example

Laurence Freedman has been diluted to 18.4% from 20.7%.

11 September

Now (post AGM)

Fully diluted

Shareholder Shares

(mill) %

shares (mill)

% shares

(mill) %

Link Traders (Aust) Pty Ltd 88.2 20.7% 88.2 18.4% 88.2 16.1% China Environmental Corporation 30.0 7.0% 32.5 6.8% 62.5 11.4% Evan Lucas & Leanne Weston 19.4 4.6% 19.4 4.0% 19.4 3.5% Sail Ahead Pty Ltd 14.5 3.4% 16.6 3.5% 19.5 3.6% Hongmen Pty Ltd 15.1 3.6% 15.1 3.2% 17.1 3.1% Other China-based employees >1.9 >1.2 >20.0 3.7%

Total issued shares 425.2 100% 479.3 100% 546.8 100%

Lumps Zhigng Zhang’s holding with CEC’s.

The position for other China-based employees will exceed 20 million to the extent of current holdings.

Source: Company reports

Hongman is controlled by China-based employee Zhongming (Dennis) Hong. I see from the

annual report that he sold 865,000 shares during FY17, taking his position to 11.4 million

shares at 30 June. On 25 August he exercised his 5 million 6¢ options, which would have

taken him to 16.4 million shares. However according to the annual report, on 25 September

he held 15.1 million shares so must have sold 1.4 million to fund the exercise. In addition to

the 5 million 6¢ options at 30 June Hong also held 2 million unexercisable options.

The only other senior employee to have sold shares during FY17 was China-based Xingyuan

Wang who sold 700,000 shares net of purchases to leave him with 1.2 million shares at the

close of the year (plus 1 million unexercisable options).

The other senior employees, being Nigel Traill, Sarah Groves and Andrew Winks, held

positions of between 0.5 million shares (Groves) and 3.8 million shares (Traill) at 30 June

2017. Subsequently they all exercised their 9¢ options prior to expiry and in fact Nigel Traill

appears in the list of top 20 shareholders as at 24 September with 5.5 million shares.

Directors

On 15 September it was announced that Brenda Shanahan has been appointed a non-

executive director, and that the Hon. Pam Allen is retiring at the forthcoming AGM after

some 10 years on the board. Thus after the AGM the directors will comprise:

Laurence Freedman AO (non-executive chairman).

Robert Schuitema (managing director and company secretary).

Zhigang Zhang (non-executive).

Brenda Shanahan (non-executive).

Laurence Freedman of course needs no introduction, being a wealthy entrepreneurial

investor with an exceptional background in finance and charitable works. Robert Schuitema


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also needs no introduction having been in his role at PHK for many years. Zhigang Zhang,

while a non-executive director of PHK, is general manager of BHZQ, PHK’s strategic partner

in China, and he is the key to PHK’s success going forward, as covered in my previous

research notes. But I thought I would expand upon the background of Brenda Shanahan,

because she is new to the company.

Ms Shanahan has a background in stockbroking, funds management and investment

consulting. She is a former member of the ASX, partner of May Mellor Laing and

Cruickshank and principal of investment consulting and worldwide partner at WM Mercer.

She is also a former director of Equilink Ltd and thus has that connection with Laurence

Freedman. In October 2017 she retired from the board of Challenger Ltd (ASX:CGF, $13.69,

$8.4bn) where she had served as a non-executive director since 2011.

She is currently a non-executive director of two other ASX-listed companies, being Bell

Financial Group Ltd (ASX:BFG, 71.5¢, $191m) and Clinuvel Pharmaceuticals Ltd (ASX:CUV,

$8.79, $420m). She is also a director of DMP Asset Management and of Kimberley

Foundation of Australia Ltd, chair of St Vincent’s Medical Research Institute and chair of the

Aitkenhead Centre for Medical Discovery. In August 2017 she awarded an honorary

doctorate from the Swinburne University of Technology.

She had no PHK shares when appointed but after the AGM she will be injecting $175,000

cash into the company by subscribing to 1 million placement shares at 17.5¢.

I congratulate the directors for attracting someone of her calibre to the board. It goes the

other way too – I would think an ordinary company could not have attracted such a person

to their board.

Disclaimer

This analysis is cursory in nature and is not intended to be relied upon by third parties, who

should make their own enquiries. The report does not does not contain investment advice.

Any views expressed in this report are purely my own unless otherwise indicated.

Disclosure

I have not received any remuneration from any person for this report.

Associated entities own 9.5 million shares in PHK at the time of writing.

This report was published on www.newingonstocks.com

© 15 November 2017, Graeme Newing

http://www.newingonstocks.com/

environmental stock with low downside risk, emerging upside · listed shares 479.3 million ord fp...

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