Misdirection at China Natural Gas?

Despite year-on-year revenue growth of 91 percent to $66.7 million and comparable net income gains of 67 percent in 2008, the share price of China Natural Gas (CHNG-$2.45) tumbled more than 60 percent last year. Now that crude oil prices are trending higher again, is this the time to step in and purchase stock of the owner/operator of 35 compressed natural gas (CNG) fueling stations for hybrid (natural gas/gasoline) powered vehicles in Shaanxi and Henan provinces?

Chinese Demand for Natural Gas

Currently, natural gas consumption accounts for less than three percent of total energy consumption in the People's Republic of China (PRC). Driven by environmental pressures, improvements in social infrastructure fueled by economic growth, and a stable energy supply, natural gas consumption is anticipated to grow at 15 percent annually for the next 20 years, according to China’s Ministry of Science and Technology.

The company estimates that currently there are approximately 50,000 vehicles using CNG in the Xi'an metropolitan area (where it owns 23 fueling stations), with some 6,000 buses and 20,000 taxis using CNG. The PRC government projects that current total demand for CNG as a vehicular fuel in Xi'an (capital of the Shaanxi province) is approximately 1,070,000 cubic meters per day—more than the approximately 940,500 cubic meters of CNG pumped per day. As a result, management believes that there is significant unmet demand for CNG as vehicular fuel.

Construction and Related Costs

The major market risk exposure is the pricing applicable to purchases and value-added reselling of condensed natural gas, which are regulated and fixed by the PRC central and local governments. Ergo, revenues and profitability depend substantially upon the end-user demand for natural gas. In 2008, sales of CNG increases year-over-year 82 percent to 149.4 million cubic meters, due to the addition of 11 new filling stations. Growth will likely slow in 2009 as management anticipates adding only five new fueling stations.

Average construction costs per fueling station and construction period are $900,000 - $1.0 million and two – three months, respectively. If the future is so bright—with demand allegedly outpacing supply—why is the company only building out capacity by five gas stations this year?

Could it be a looming cash shortage? The company added $42 million in long-term debt to the balance sheet in 2008, due to a liquefied natural gas terminal being constructing in Jingbian, Shaanxi province. Management opines that transportation savings from the processing plant will result in lower transportation costs and improved margins. What about the interest expenses and fixed, operational costs associated with the debt and facility servicing? The plant is expected to start operation by late 2009. Once completed, the plant has LNG processing capacity of 500,000 cubic meters per day, or approximately 150 million cubic meters on an annual basis.

Construction of the LNG facility has not helped the share price of CHNG. The company issued senior notes to Abaxis Lotus Ltd. in exchange for $40 million in funding. In connection with the purchase agreement, CHNG issued seven-year warrants exercisable for up to 2.9 million shares of the company’s common stock at an initial exercise price equal to $7.3652 per share. The exercise price was reset to $3.69 a share on January 29, 2009.

The indenture also required CHNG to pay additional interest at the rate of 3.0% per annum if the company had not obtained a listing of its common stock on the Nasdaq Global Market, the Nasdaq Capital Market or the New York Stock Exchange by January 29, 2009. To date, CHNG has not obtained a listing of its common stock on any of the markets stated in the agreement. In the opinion of the 10Q Detective, it is unlikely that CHNG will get the required stock listing. If the Company fails to get waiver from Abax, the interest rate on the debt will jump to eight percent.

Sleight of Hand

"The magician and the politician have much in common: they both have to draw our attention away from what they are really doing." ~ Nigerian writer Ben Okri

Is CNHG management practicing sleight of hand, too? In an April 2008 Investor Presentation, management said it would have 42 fueling stations in operation by January 2009 and was "working with the Thai government to evaluate opening retail CNG filling stations throughout Thailand." As of March 2009, CHNG had no CNG operations in Thailand.

The company purportedly owns property and equipment worth $76 million, up from $32 million in fiscal 2007. However, the 10Q Detective observes that at December 31, 2008, one consultant based in California served as CHNG’s accountant—she being the one engaged to prepare the financial statements! In a related concern, according to the 2008 FORM 10-K filed with the SEC:

• The Company did not have sufficient and skilled accounting personnel with an appropriate level of technical accounting knowledge and experience in the application of generally accepted accounting principles accepted in the United States of America commensurate with the Company’s financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant. The Company’s management believes that the number and nature of these significant deficiencies, when aggregated, was determined to be a material weakness.
  
  The Company is lacking qualified resources to perform the internal audit functions properly. In addition, the scope and effectiveness of the Company's internal audit function are yet to be developed…. due to limited qualified resources in the region, we were not able to hire sufficient internal audit resources before the end of 2008.

Give me your secrets
Bring me a sign
Give me a reason
To walk the fire – "The Unit" TV Theme Song

CHNG is not a new story for us. The 10-Q Detective owned/sold 2,000 shares of the stock for an 18 percent short-term gain in early 2007. The profitability of the LNG terminal aside, we still believe that the company’s original business model—acquiring and operating CNG fueling stations—is an attractive growth opportunity. We just need some credible reasons to believe that CHNG—with its current management—can become a leading CNG player in Shaanxi, Hunan, and other provinces in Western China.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.