By Randy Durig CEO of Durig Capital

Per share values on 02-25-2011:
Market value $9.15
Cash             $6.29
Equity value  $2.86
Shares   24.61 million

Duoyuan Global Water Inc. is a leading China-based water treatment equipment supplier. They have been continuously developing advanced water treatment technologies for multiple end users including municipal, industrial, and residential clients.  Currently, they offer more than 100 water treatment solutions.

We selected Duoyuan Global Water Inc. because it is one of the select few that fit our model. Our goal is to select, purchase and continually monitor companies in an effort to obtain outstanding performing investments while minimizing risk by finding low values for our clients. We will cover part of our review and selection process as well as explain why Duoyuan Global Water made the cut and is the latest addition to our High Cash Stock Review.

Introduction

Duoyuan Global Water is seen as an innovator in the low cost Chinese clean water services.  They are focusing their efforts on developing advanced technologies, increasing production capacity, exploring potential markets and expanding their market opportunities.  They provide customers with SO9001 Quality Certification, ISO 14001 Environmental Certification, and Six Sigma methodology. Duoyuan is focusing on both their internal efficiencies and further enhancing customer satisfaction.   Products regarding technology, quality, service and innovation have become a focus as they aspire to become China’s leading supplier in the water industry.

Duoyuan Global Water is extremely well positioned in a desirable and infinitely growing industry.  Demand from both society and industry for water in China is expected to develop exponentially.  According to the Joint Monitoring Program for Water and Sanitation of WHO and UNICEF, about 100 million Chinese still do not have access to an improved water source as of 2008 and about 460 million did not have access to improved sanitation services.  Progress in rural areas appears to lag behind what has been achieved in urban areas.  Some parties have claimed that water in China may be even more valuable than petroleum.

60% of China’s 661 cities face seasonal water shortage.  Over 100 cities have severe water constraints, such as contamination of drinking water from upstream sewer and feces flow. This is a critical health problem that could and does causes serious illnesses.  A study by UNICEF in 11 provinces found that over half of all drinking water samples contained unacceptably high levels of bacteria.

Shanghai, like many other Chinese cities, depends on surface water that is heavily polluted, such as the Huagpu River shown here whose water comes through Suzhou Creek from the heavily polluted Tai Lake.

Step 1 – We first search for companies with pristine balance sheets.

Duoyuan Global Water has $6.29 million in cash with no debt on the balance sheet. They had sales of $51.5 million last quarter meaning an annual run rate of about $200 million or $8.13 per share annually.  The stock price minus the cash on hand gives them an enterprise value of about $2.86 per share.  This is a strong balance sheet and $2.86 per share is a very low enterprise value especially when they earned $0.55 per share in the last quarter alone.  This is an amazingly low level considering the growth potential and required infrastructure that Duoyuan Global Water caters to as China may be one of the unhealthiest and largest population center in the world.  The enterprise value trades at only 5.5x last quarter’s profit.  Annualized, the last quarter’s earnings illustrate a 1.3x to enterprise value which is one of the lower we have seen.  The enterprise is earning about an 18% rate of return after tax, again based only on the last quarter.  The enterprise value is very low considering they have an average earnings forecast for 2011 of $1.67 per share.   Based on the average analyst forecast, Duoyuan Global Water has an enterprise value after tax return of over 50%.

As a secondary note: Having a mountain of cash and no debt is considered a very conserve business model, especially when one considers this has been a very high growth company in a rapidly expanding industry.

Step 2 – We like extremely low values.

After reviewing hundreds of companies for the rare strategic position of growth and value, if not thousands, Duoyuan Global Water is one of the lower valued companies that we could identify. The enterprise value per share is a mear $2.86. Sales last quarter were $51.5 million up 35 percent year over year.  Profits were $0.55 per share which were up an amazing 121% year over year.  During the last nine months of 2010, sales were $119 million.  Their $51.5 million single quarter sales were close to the entire enterprise value of $70.3 million. These are very low valuations for a high margin sector.

Step 3 – Is the operation or enterprise driving value to their shareholders?

Duoyuan Global Water has been executing at high levels over the last year.  On virtually every valuation metric, they have generated strong growth and profitability.  They are trading below some benchmarks that turned out to be very strong recommends such as our review on Adam’s Energy (AE), and Universal Health Insurance (UVE) such as realizing higher returns on their enterprise.  But Duoyuan Global Water is in a far more exciting industry, growing substantially faster in sales all while making the top tier of profit growth for companies we review.  Understanding that they have close to $2 of earning potential per year per share, we find it difficult to identify firms in the current climate that have the ability to generate a 66% return after tax relative to the enterprise. In the last reported quarter, they generated $0.55 in profits with the average analyst estimating a profit of $0.48.  The 14% earnings surprise was attained in part by solid growth, believing short term orders might have peaked and also permanent cost reductions due to decreased advertising.  After analysing Duoyuan, their structure and industry position reminded us of another Chinesse firm we reviewed called China Yuchai International know as (CYD) which has performed very well since inclusion into the High Cash Stock Review.

Management believes the reduction in marketing cost will not affect their on going business as they still are forecasting 29% growth rate which is quite strong.  Mr. Wenhua Guo, the Chairman and Chief Executive Officer, stated,

“This quarter’s revenue increased due to strong demand from all three product segments, which was partially due to a change in the timing of sales as some customers shifted fourth quarter purchases to the third quarter in order to meet the completion deadlines of China’s 11th Five Year Plan”

Step 4 – Is this a good business?

This is an extremely well positioned business in an intriguing industry. There are numerous competitors in the Water and Sewer pollution control business.  As China’s demand increases, we believe that being an organically developed Chinese company selling to the Chinese municipal and federal governments may be a competitive advantage.  Most of their competitors are global firms with few being based in China.  We believe this may allow them to have a true advantage in the semi closed socialist economy.

Step 5 – Is the Train Wreck and then the fog from the Wreck clearing?

With this case a very low enterprise value, often a “Train Wreck” is needed to drive value close to cash. We’ve identified six major issues that in part have driven the value so low:

1. Accounting irregularities
2. Law suit on accounting
3. Business built on a distribution model
4. China is their only market place
5. World class competition try to gain access
6. Additional risk and issues.

Step 5 – Is the Train Wreck and then the fog from the Wreck clearing?

With this case a very low enterprise value, often a “Train Wreck” is needed to drive value close to cash. We’ve identified six major risk and issues that in part have driven the value so low:

1. Accounting irregularities
2. Law suits on accounting
3. Business built on a distribution model
4. China is their only market place
5. World class competition tries to gain access
6. Additional risk and issues

1. Accounting irregularities

This is the 800 pound gorilla.  They have a sister company called Duoyuan Printing Inc (DYP). With similarities in the name and having the same Chairman, Duoyuan Printing Inc is being accuses using poor accounting policies leading many to assume that these possible irregularities may be issues with both firms.  Investors amicably assumed both companies are guilty.  This report is focused on Duoyuan Global Water and we will not go into Duoyuan Printing Inc issues here.

Looking into the accounting at length, first they have and had different accounting firms in the recent past.  That Duoyuan Global Water used a major accounting firm (our CPA clients believe that Grant Thornton is well respected) should give legitimacy.  They claimed that Grant Thornton Hong Kong was purchased by BDO and this BDO announcement confirms the statements.

Many companies we follow due to mergers or acquisitions have had this occur. For example, if BDO audits a major distributor of Duoyuan Global Water equipment, then the can not do a fiduciary audit based on both the distributor and Duoyuan Global Water when a large part of revenue for one is from the other.  In this instance, BDO needs to owe its loyalty to just one and usually the larger revenue provider is chosen as possibly the case here.

With that, Duoyuan Global Water submitted a SEC 6-k in December, 2010 that said:

DUOYUAN GLOBAL WATER INC.

Form 6-K

On December 24, 2010, Duoyuan Global Water Inc.’s (the “Company”) public accounting firm, JBPB & Co. (formerly Grant Thornton (“GT Hong Kong”)), resigned as the Company’s accountants due to its merger of business with BDO Limited.

GT Hong Kong was engaged to audit the Company’s financial statements for the financial years ended December 31, 2008 and December 31, 2009. GT Hong Kong’s reports for such years did not contain any adverse opinion or disclaimer of opinion, and were not qualified or modified as to uncertainty, audit scope or accounting principle. Additionally, during the Company’s two most recent fiscal years and any subsequent interim period, there were no disagreements with GT Hong Kong on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements if not resolved to the satisfaction of GT Hong Kong.”

After leaving Douyuan Global Wate, and upon review the above SEC filings, BDO claimed in a SEC filing:

“in relation to the changes of accounting client Dougyaun Global Water Inc. We agree with the statements made in response to the form 6-k insofar as they relate to our firm”

With that said BDO has signed off, giving Duoyuan Global Water a clean bill of accounting health for 2008 and 2009:

1. In the second SEC filing listed above, BDO has nor had anything to gain.  Duoyuan was no longer their client.
2. BDO could lose greatly in a post Arther Anderson world where fraudulent accounting can kill the account auditing firms.  After such an announcement, if fraud truly did occur, both BDO and Grant Thornton have introduced themselves to the possibility of a very large liability.
3. Grant Thorton and BDO are considered top notch accounting firms.
4. Anyone including BDO monitoring the stock knew there were accounting rumors prior to the BDO letter filed with SEC.

On a lessor note, as Douyaun was asked to leave Grant Thornton Hong Kong (Now BDO) they accepted Grant Thornton (China).  Grant Thornton International claims it’s global accounting organization has combined global revenues of $3.7 billion from its 96 member firms last year – while staying each member firm within Grant Thornton International is a separate national firm.

Duoyuan Global Water audited 2010 earning will come under Sarbanes–Oxley Act of 2002 rules, and their annual report expected March 23, 2011 if containing fraud, would possibly be considered a serious criminal act, both for the involved parties at Grant Thornton and Duoyuan Global Water.

What this indicates is that Duoyuan Global Water is staying within the Grant Thornton global accounting organization and possibly sharing many of their you say the “franchise” services:  Global accounting firms must have compliance officers, and obvious with this said, Grant Thorton International did not “RED FLAG” this inter-organizational transfer, what would be a compliance officers duty if illicit accounting was at all suspected.

2. Lawsuits

The lawsuits are based on their accounting.  If Duoyuan Global Water, BDO and Grand Thornton are incorrect regarding their accounting and fraud is discovered, the attorneys have already lined up and the costs could increase dramatically. Worst case scenario, this could be the end of all three especially after they claimed in their SEC filing to have achieve acceptable accounting in 2008 and 2009.

3. Business built on a distribution model

Duoyuan Global Water depend on distributors for all of their revenue. They have no long-term distribution agreements and most agreements have terms of one year.  As existing distribution     agreements expire, they may be unable to renew or possibly with un-favorable terms. They compete for quality distributors with both international conglomerates and local companies with many listed below.  Their competitors often enter into long-term exclusive distribution agreements that effectively prevent their distributors from selling their products.

3.  China is currently the only market Duoyuan Global Water operates in

Even though the demand and growth in China is quite high, the lack of global diversification could limit growth if the Chinese economy has an recession or the municipalities become underfunded.

The Chinese government may change overnight how or with whom they do business.  Cronyism could lead to changes with whom government officials favor and/or dislike.

4. Competitors

Duoyuan Global Water has many competitors both from China and abroad.  Part of their growth plan is to offer a wide variety of products and solution to obtain a higher degree of market penetration with add on solutions to each possible client and issue that may arise.  Even though there are numerous competitors, Duoyuan Global Water has few if any that compete across all product lines. The cradle to grave approach, one stop shopping, to product and service offerings, that competition has yet to achieve, tends to allow firms to outperform competition.

Circulating Water Treatment Equipment:

Zhejiang De’an New Technology Development Co. Ltd. (China)

Jiangyin Jialong Environment Technology Co.Ltd. (China)

Beijing Kejingyuan Technology Co. Ltd. (China).

Automatic filter competes with:

Claude Laval Co. (USA),

Amiad Filtration Systems (Israel) (LSE: AFS.L )

Beijing Luolun Filtration Equipment Technology Co. Ltd. (China)

Water Purification Equipment and ozone generator competes with:

Ozonia Ltd. (Switzerland)

ITT (Sweden)

Jiangsu Koner Ozone Co., Ltd.(China).

Pure water equipment with EDI functions compete with:

GE Water & Process Technologies (USA) (NYSE:GE)

CANPURE Corporation (Canada)

Zhejiang Omex Environmental Engineering Ltd. (a subsidiary of Dow Chemical) (USA)(NYSE:DOW)

Microporous aerator competes primarily with:

REHAU (Germany),

ITT (Sweden)

Yixing Nopon Environment Co. Ltd. (China).

Belt-type thickener-filter press mono-block machine competes with:

Wuxi Tongyong Machinery Co. Ltd. (China),

DWT Project Co. Ltd.(Finland)

Passavant-Roediger GmbH (Germany).
Many of the competitors, especially the international arena, posses stronger brand names, has greater access to capital, longer operating histories, established relation ships with customers, stronger research and development capabilities and greater marketing and other resources than Duoyuan Global Water.

5. Additional risks and issues

A.  Even though BDO signed off that accounting was acceptable, this is not guarantee that there were no incorrectly or intentionally misstated entries.  This is still a possibility, although the risk of have something terminally wrong is now very slim, in our opinion.  This risk is not unique to just Duoyuan Global Water as all entities may potentially have the same issues.

B.  Knowing they have a great balance sheet, most companies that we have reviewed postmortem are loaded with debt and can’t pay the current accounts due.  This is completely the inverse.  With no debt and high levels of cash, there are no debt covenants management must meet to stay liquid, as is often the case with heavily leveraged firms

C. Chinese companies are notorious for accounting irregularities.  Some of these companies currently have higher valuation, even after accounting issues were recently exposed than Duoyuan Global Water has; keeping in mind no wrong doing has been exposed just rumored. We believe Duoyuan Global Water has a superior balance sheet and is positioned well in a high growth environment.

D. There is a very high level of short positions and they possibly could identify additional risk other than accounting that we are not aware of.
In Summary

We enjoy companies that can provide outstanding short term execution— positioned with possibly a superior business model driving their future success.  We believe Duoyuan Global Water has a great value, business execution, and has a conservative balance sheet that fits our model. We are optimistic that Duoyuan Global Water will outperform their higher valued peers. They have completed excellent quarters and have already attained growth of assets.

1. PE Benchmark Review

Based on the 2X price to enterprise metric, Duoyuan Global Water is currently receiving an average earning estimate of $1.49.  If they achieved the lower, more conservative, S&P 500 average of 17.80 times the $1.49 estimate, it would equate to a $26.52 plus the cash of $6.28 giving it a stock market value of $32.8 or over three times the current market value.

2. Sales Benchmark Review

Based on revenue models, knowing Duoyuan Global Water stock price is about 66% cash, the underlying enterprise value disparity between them and their bench marked peers is materially significant.  Comparing Duoyuan Global Water to their peers in the pollution control industry for sales values, assuming they will achieve about $151.34 million in revenues which is the consensus analyst estimate, one arrives at a per share value of $28.90 (their current estimate for 2010 times the industry quoted peer, price to sales for the industry) — plus the $6.28 cash meaning a combined value of $ 35.18.

3. Profit Growth

souce Zacks Research

Duoyuan Global Water has out preformed in profits last year against both their pollution control peers and the S & P 500 and is forecasted to grow at an annual rate of twenty percent.  This is a higher projected growth rate than their competitors coupled with a conservative balance sheet.  Duoyuan Global Water could and possibly should attain a stock value premium to their slower growing peers.
Addition Duoyuan Global Water information such as Financial ratios, charts and news are available here.

Conclusion

We believe that Duoyuan Global Water’s enterprise is trading at about a 70% discount to many of their peers and well below most companies in the in the pollution control industry. It is even trading at a lower value than Chinese based companies who have recently been exposed to having accounting irregularities. We find their valuation surprisingly low, especially considering that they have consistently out preformed their peers in this superior business environment and a major CPA firm giving them the O.K. on their accounting along with proving high level of Quality Certification such as SO9001 verification. This, coupled with the established solid business franchise that the average forecast is that Duoyuan Global Water will out grow their peers over time, is why we have included Duoyuan Global Water in our High Cash Stock Review.

Disclosure

Durig Capital owns Duoyuan Global Water (DGW) for itself, clients and related client accounts.

Sincerely,

Randy Durig

Financial Investment Advisor
DIR 971-732-5119

A+ Rating
with the BBB!

Durig.com | Investment-Income.net

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