Prosperity Minerals cement operations should benefit from China’s continued growth

Considering the latest large-scale infrastructure investments by the Chinese Government across the entire country as well as the potential of Chinese economy to continue on its growth path, Prosperity Minerals seems to be fortunate to be in the right place at the right time.  

The company specialises in two lines of business, production and sale of cement, as well as trading of iron ore, all within The People’s Republic.

Prosperity’s cement business is operated via six wholly or partly owned production facilities across Southern and South Eastern China. The gross yearly tonnage of these is some 23 million. The company employs modern suspension pre-heater dry processing technology to achieve production efficiency in its plants.

The iron ore trading business is operated as a back-to-back business model. Prosperity sources ore from its suppliers in America, Africa and Asia and sells to mainly large scale steel manufacturers in China, as an agent without ever taking ownership of inventory.

The cement market in China is forecast to expand by 10% a year in the medium term, just as the Chinese government is in the midst of its drive to clean up the industry by eliminating “outdated cement production facilities”. This, coupled with likely future trend towards industry consolidation is likely to ensure acceptable operating margins for the main players in the industry. Why consolidation? For the reason that the cement market is highly competitive in the People’s Republic and given its commodity-like nature the unit price proves a deciding competitive edge, hence acute need for scale.

The dynamics of ore market in China are also favourable for Prosperity Minerals; the country accounts for over a third of world demand, it is unable to produce enough ore locally to meet this demand and hence depends heavily on imports; additionally to this there is a limit imposed by the government on the numbers of importers allowed a licence. The current number of active importers in the country is officially put at around 100.

So the market for the company’s wares is obviously there, the question is can Prosperity make itself prosperous? In six months to 30th September ’08 the company achieved an impressive revenue acceleration of 77% (revenue from cement up by 26.4% and from ore trading by 102%), however gross profits have collapsed from 12% of revenue to 6.7%. The net margin has also seen a dramatic decline from 10% of revenue to 3.6%.   

The cement business was negatively affected by increased coal prices as coal remains the primary source of energy for the production facilities. The management acknowledges the problem and is experimenting with residual heat electricity generation; this carries a potential annual savings bill of some $8m. Prosperity’s ore business was bleeding due to a significant drop in the spot price of iron ore.

The cost base was further damaged by administrative expenses going up 68% to manage the on-going and planned expansions, share of profits of associates has almost halved and finance expenses have almost doubled in line with addition of $100m worth of debt in the form of redeemable notes. The EPS for the period has thus declined 37.5%.

Given the above it is no surprise that management has given up on the idea of an interim dividend.

Total Assets of Prosperity are 37% up on last reporting period and now amount to just over $600m. The Asset base has been boosted by acquisition of plant and equipment for a combined sum of almost $6m, interest in newly acquired businesses of $19.7m has been added, interest in associates increased from $74.7m to $140m. Prosperity held $43.9m of cash on its books.

Total debt amounts to just under $199m with $46m of it being current. Debt to Equity Ratio is 69.4% making Prosperity a pretty leveraged operation.

Although the company has delivered a slightly improved cash flow from operations of $19.7m compared to $16.8m in previous reporting period, the Capital Expenditure remains high; Free Cash Flow to Equity is therefore negative.

Return on Capital hovers between 8% and 10% during regular economic conditions, this is somewhat lower than is desirable for a fast growth company such as Prosperity Minerals.

Prosperity is undoubtedly a growth company, considering the compounded annual growth of some 33% over the last five years it is obvious the potential is there. The growth trajectory is reinforced by the management who state that the capacity will likely increase to 31m tonnes by 2010 from the current 23m tonnes, then up to 50m tonnes in the medium term.

Assuming the forecasted growth in capacity materialises over the medium term, the Capital Expenditure is kept at same levels as current (as percentage of revenue), Return on Capital improves to 11% and Return on Equity does not deteriorate from current 17%, the current intrinsic worth of the stock is a minimum of £1.50 a share.

However, Prosperity Minerals is a commodity business at the mercy of energy and transportation costs for its costs of sales. Finally, the company is making and will likely continue to make acquisitions which carry execution risks. These, as always, can either add to or distract from value.

Alec Hajinoff is a full time investor, freelance writer and operates www.onlyprofitable.co.uk