Last week, Fool.com published a story on L&L Energy that guest contributor Joseph Kruse believes was misreading the company's future. After an email exchange, we asked Kruse, a money management professional with staff in China, to put his rebuttal in writing.
Signs of continued growth and infrastructure expansion
Indeed, China is the world's fastest-growing economy and has witnessed exponential growth in recent years in industries such as real estate, infrastructure, and manufacturing. More important, this extreme growth looks to continue over the next decade and will further perpetuate demand for L&L's product. The company fits perfectly into the mold of a growth business as its compounded revenue growth rate over the past five years is more than 70%.
L&L continues to pursue its vertical integration strategy by expanding its coal washing and coking businesses through the acquisitions of the Hong Xing and Ping Yi washing plants and the Zone Lin coking operations. Capital is required to expand and ensure infrastructure of operations are properly maintained or expanded. L&L has been one of the few Chinese companies we've seen that has focused on using capital generated internally from operations versus consistently accessing the capital markets to pad its balance sheet (e.g., Puda Coal
Determining appropriate valuation
Within the investment community, there are a number of techniques used to assist in determining the appropriate value of a company. One of the most common techniques is a discounted cash flow analysis. When deciding which technique to use, it is imperative to understand the mechanics of each methodology and to know when and how to tailor each method in various circumstances. There are many investors and writers out there who would falsely lead you to believe that a standard application of the valuation techniques is suitable for any situation and may be applied in most circumstances.
For instance, last week Fool contributor Isac Simon and energy editor Dan Dzombak published an article commenting on L&L's free cash flows. In the article, they claimed to have utilized a basic methodology for calculating FCFs, yet failed to incorporate the correct inputs (e.g., the correct effective tax rate) as well as failed to adjust their calculations to incorporate the fact that L&L is a growth company. This "growth company" adjustment is one that discounts the amount of cash spent on capital expenditures.
If one is attempting to uncover true FCFs for a growth company, rather than applying a technique learned from a textbook, it is imperative to only incorporate so-called maintenance capex (cash used to maintain the business), rather than "growth" capex (cash used to grow the business) so as to avoid penalizing a growth company for expanding its business.
As such, by failing in these two regards, they determined that L&L had FCFs of almost -$36 million. However, by incorporating the correct techniques outlined above, you'd be able to see the hidden value in such a company. Such a procedure would reveal to the astute investor a "truer" FCF number of almost $29 million.
Long-term value appreciation
As mentioned, it takes an intelligent and perceptive investor to be able to see true value where others do not. And such ability leads to investment success. The key is to be able to remain steadfast and confident in one's methodology and have the fortitude to weather market turmoil. For those shrewd and diligent investors, there remains great potential in the current marketplace to uncover great amounts of hidden value in gems such as L&L Energy.
Click here for more detailed discussion on "maintenance" capex and the most appropriate method for calculation.
Guest contributor Joseph Kruse is not subject to The Motley Fool's trading rules, and thus he may or may not have a beneficial stake in any company mentioned in this article. Read about the Fool's disclosure policy here.