THIS COLUMN observed in December that the initial public offering of Aluminium Corp of China (Chalco) was a profoundly unappealing proposition based on its prospectus. Chalco's global share offering went on to be 11 times subscribed and its shares have since performed handsomely, rising 23 per cent from their HK$1.37 issue price to HK$1.69 yesterday. There are two conclusions to be drawn from this: 1. Don't look to this column for investment advice; and 2. Don't stand in the path of an oncoming freight train. When the world's investment banks decide to hitch their formidable engines to the wagons of the latest investment theme, stand back. Better still, hitch a ride in the caboose. Chalco's story was all about state-sector restructuring, but the China investment fad has a parallel and potentially more exciting theme: the privately owned enterprise (POE). Unencumbered by the inefficient and bureaucratic structures, redundant workers and unfunded social welfare liabilities of state firms, POEs are taking an increasing share of the Chinese economy. They are fresh shoots bursting through the compost of the command-and-control economy - in theory, at least. Increasing numbers of POEs can be expected to list in Hong Kong in the coming years. At the start of the year, UBS Warburg even launched an index of 'private chips', 12 Chinese private companies listed overseas. It includes stocks such as Greencool Technology, Euro-Asia Agricultural, Chaoda Modern Agriculture and China Rare Earth. An object of beauty for the brokerage community has been Wah Sang Gas Holdings, which has attracted a flurry of positive coverage in recent weeks. Wah Sang's core business is building gas pipelines and selling piped and bottled gas to consumers and companies. It is a play on the huge potential growth in the gas market as Beijing steers the country away from its dependence on coal to more environmentally friendly energy sources. Listed on the Growth Enterprise Market in 2000, Wah Sang has reported impressive growth in profits in its past three quarters (its financial year ends this month). The company is not shy about blowing its own trumpet. Its results for the nine months to December 31, which showed a 76.8 per cent growth in net profit, were 'remarkable and encouraging', Wah Sang's announcement declares. Outlining its future prospects, the company says: 'The urbanisation process . . . will continue to create enormous market potentials for the group.' Just in case you failed to get the message, it adds: 'Given China's favourable market conditions with boundless potential, the group is poised to benefit enormously from the tremendous business opportunities ahead.' Brokers certainly have got the message. Three research reports released last month - by Merrill Lynch, UBS Warburg and SG Securities - all placed a 'strong buy' on the company. What could be the fly in the ointment of this boundless vision of future prosperity? Merrill Lynch identifies it in last month's report. After noting that Wah Sang Gas is a niche player in an 'extremely underpenetrated' market, it observes that 'the key investment risk lies with cash flow' (and human resource management). Wah Sang builds pipelines which it hooks up to housing estates in small and medium-sized cities, mainly in Tianjin and surrounding areas. The company states that its accounting policy is to recognise revenue from pipeline construction 'on the percentage of completion method, which is measured by reference to the proportion of costs incurred to date to the estimated total cost of the relevant contract'. In other words, if the company has a contract to build a pipeline that it estimates will cost $10 million to fulfil, and it has spent $7 million so far, then it books 70 per cent of the contract value as revenue - whether or not it has received the money. This might be no reason for concern, were up-to-date balance sheets and cash flow statements available. But quarterly Growth Enterprise Market reports require only a profit and loss account. In fact, Wah Sang Gas's last full set of accounts, for the year to March 31 last year, show a divergence between profit booked and cash received. Operating profit was HK$74.06 million, but cash and equivalents declined from HK$32.4 million to HK$31.7 million. Trade receivables - money owed by customers - nearly doubled, to HK$89.46 million from HK$47.16 million. The firm's cash ratio, a measure of liquidity, deteriorated to 0.29 from 0.5. A precise comparison between profit and cash flow is difficult. Companies can choose to construct the cash flow statement using the 'direct' method, which lists all cash inflows and outflows, or the 'indirect' method, which provides a reconciliation of reported profit to movements in cash. Wah Sang, like most companies, uses the less-transparent indirect method. Notably, Merrill reports operating cash flow for the year to March 31, last year, at a negative HK$21 million, but forecasts this to reverse to a positive HK$163 million for this year. Cash flow is particularly important for fast-growing companies, since growth can place strain on liquid resources. It is perfectly possible for a company to grow too fast for its own good. Yet there is an additional reason why investors should place close attention to the cash-flow characteristics of this company. The largest portion of Wah Sang Gas's operations are in the Tianjin area, a region that gained some notoriety during China's 'itic' crisis. The near default last year by Tianjin International Trust and Investment Corp on a Japanese samurai bond provoked a diplomatic incident, with repayment coming only after protests by Japanese officials. Japan threatened to cut off development aid to the Tianjin area over the issue, a Japanese foreign ministry official told Business Post last year. Tianjin officials complained that the itic had been unable to raise the funds to honour its commitments due to the failure of state-run firms to repay their debts. These same state firms may now be among Wah Sang Gas's customers - its contracts are with property developers that are associated with local authorities. Merrill's report states: 'As Wah Sang does not collect household fees directly but rather through property developers or property management companies, the risk comes from default from latter parties.' The temptation to default may not be inconsiderable, given that Wah Sang Gas reportedly charges a connection fee of up to 3,000 yuan (about HK$2,800) per household. That seems like a lot, even for a newly urbanised peasant. Given the huge profitability of Wah Sang Gas's pipeline business, the fees are a bit of a mystery. In the year to March 31 last year, gas pipeline construction contributed HK$100.54 million to Wah Sang's operating profit, on turnover of HK$131.36 million - a margin of 76.5 per cent. Why would a hard-pressed mainland local authority allow a private contractor to make such large profits for the benefit of foreign shareholders? Of course, the GEM board is full of weird and wonderful stories of fantastic profit-making machines. This one may even be true. But be sure to scrutinise this year's cash-flow statement. Wah Sang Gas shares have risen 21.4 per cent to 85 HK cents so far this year. There could still be time to catch the caboose. But for this writer, it's time to get off the track. Wah Sang reportedly charges a connection fee of up to 3,000 yuan Graphic: btl19gbz
