Sinotel Technologies

Stock Name : SINOTEL
Stock Code : D3W
Listed in Singapore Stock Exchange

Sinotel is a mobile telecommunication infrastructure turnkey solution provider that link buildings to telco backbone infrastructure. Sinotel is operating in 6 provinces in northern People Republic of China ("PRC").

Investment Highlights:

1. 
   
   Sinotel operates in PRC, which is the largest telco market with 700 mil mobile subscribers as at end of CY2008 and this number is increasing by 10mil monthly. China's 700 mil 2G mobile subscribers is 3x the size of USA (250Mil mobile subscribers). China current mobile penetration rate of 47.3% is low as compare to its asian peers (80%-174%).




2. 
   
   The 3 Telco companies in PRC will collectively spend a total of RMB280bil for the next three years to bring 3G coverage to at least 200 tier 2 cities. The growth in spending is primarily coming from 6 areas:- (a) the growth in urbanisation, (b) the growth in property square meter / capita, both commercial and residential properties (c) the migration of 2G to 3G, (d) the fierce competition on coverage by the 3 telcos and (e) the free-for-all competition (both geographically and mobile/fixed line) arising after the 4Q2009 government led telco restructuring (f) the additonal new Chinese 3G standard.




3. 
   
   The healthy PAT Margin of 30% for CY2009 and 27% for CY2010 onwards (a corporate tax of 7.5% will be incurred from next year onwards).




4. 
   
   
   
   I prefer Sinotel's focus in the connectivity solution rather than the equipment manufacturing business which has only 5-10% net margin. This focus brings Sinotel 20% ROA and 30% ROE which is more superior and consistent to their peers (Comba, China Grentech and Centron).




5. 
   
   
   
   After IPO, Sinotel had successfully delivered their promised CY2007 (PAT RMB85mil) and CY2008 (PAT RMB107mil) numbers to bankers and investors.




6. 
   
   
   
   Sinotel is currently trading at a CY2009 PE4x comparative to their peers who trade between 8x to 25x.




7. 
   
   Sinotel announced their intention to go for their ADR application last week, their stock had been re-rated from SGD0.28 to SGD0.42 within 7 market days. I believe their shares will be traded higher and closer to their competitors listed in Hong Kong and/or Nasdaq if their ADR application come true within six weeks from now.




8. 
   
   Baroon Investment, an US investment management fund who is specialising in small cap stock had recently announcened themselve as Sinotel major shareholder. I believe Sinotel had gotten attention of US investment community which could partly explain the strong retail following since then.




9. 
   
   Beware!!! Even Sinotel has a 30% net margin, but their industry has extremely long account receivables and inventory turnover days. Sinotel is operating in PRC, which most of the commercial banks do not lend to this kind of smaller companies. A careful inspection of the cash flow statement, we will notice Sinotel had been always using internal generated fund to finance their growing inventories and account receivables in order to support their 30% growth. This is extremely painful without the help of loan from commercial bank.




10. 
    
    However, we recently saw an increase of gearing from 8% to 14%, which is mainly from the increase of contract financing facilities from their existing bankers like DBS Beijing and HSBC Beijing. This is a positive sign indicating their bankers are more comfortable with them as compare to 2 years ago. This is important to us as going forward the increase of financial leverage to a healthy level of 0.7x, Sinotel will be (a) significantly improved their ROE, (b) able to accept more contract and (c) less dependent to raise equity capital to finance their order book growth.




11. So, what is the typical business cycle of the industry Sinotel is operating in? A typical business cycle start with Sinotel approaching building owners with proposal to link their buildings up to telco's backbone infrastructure. Sinotel will approach the three telco on the proposal. Sinotel might get 1-3 telco approval on their proposed connectivity design. With these telco approvals, Sinotel will source the necessary equipments from domestic suppliers (who guarantee a full replacement against all malfunctions covering from the first delivery to the final certification by the telco). Once the equipment is being delivered to the site (T-6 mth), it will be recognised as WIP in inventory, and the equipment suppliers will get paid one month later (T-5 mth). Sinotel will get the whole system fully installed within 6 months. The telco will conduct a first inspection and an initial certificate will be issued once the telco is satisfied with the inspection. Sinotel will only recognise their revenue once initial certificate is being issued (T). They will get 50% of their revenue paid 2 months after the issuance of the initial certificate (T+2 mth).




12. The telco will conduct a final inspection 6 months after the initial certificate (T+6 mth) and Sinotel will get another 45% of the revenue being paid two months after the issuance of final certificate (T+8 mth). The remaining 5% revenue will be paid after the expiry of the 12 months warranty period. Sinotel's revenue recognition is prudent and reliable; this will avoid the worry of account receivables to be written off arising from trade dispute. A cross check to Sinotel's low bad and doubtful debt number also give me some comfort on the collectability of the account receivables.




13. The total cash conversion cycle is from T-6 to T+8 minus a month account payable period, which translates to a long 13 months period. If the order book comes in stronger than 30%, we will see a negative operating cash figure. With Sinotel's revenue growing by more than 30%, it is very easy to understand why Sinotel is operating in a negative operating cashflow circle, growing number in inventory and accounts receivables turnover days.




14. 
    
    The equipment suppliers will provide a 100% replacement guarantee from the day of delivery up to the issuance date of final certificate. Hence, equipment which made up of 85% of the cost of good sold (COGS) had been adequately covered and risk being mitigated. Any equipment received and installed on site will be recognised as WIP in the balance sheet as revenue has yet to be recognised. The latest WIP figure as at 1H2009 amounting to RMB 212 Mil provides a good guide to estimate the next 6 months revenue, we just need to use the WIP and gross up by 60% COGS margin. However, I apply a 25% discount to the forecast revenue to take into any delay in the issuance of initial certification by the telco. My estimation also can be verified to Sinotel recently announced order book of RMB 347 Mil.




15. Sinotel's management had guided the market an earning of RMB120Mil for CY2009. However, the earning guidance do not match the earnings growth of their competitors of at least 40%-80%. After building an earning models for Sinotel. I use their announced order of RMB347mil and inventory WIP of RMB 212 Mil to forecast sinotel CY20o9 earnings would be around RMB150 mil. Hence, the CY2009 EPS should be SGD0.113/share which translate to CY2009 PE of 3.7x for Sinotel share price traded at SGD0.42/share. With an ADR in place, I believe Sinotel should be traded closer to 8x CY2009 PAT.





16. 
    
    This harsh long cash conversion circle indirectly deter new entrance of player and a strong push factor for industry consolidation (from 200 to 50 players now). Hence, the healthy net margin of 30% is sustainable. I believe, those solution providers ranked within top 10 (including Sinotel) and being listed in a stock exchange (i.e. accessable to both equity and loan financing) will continue to take market shares from the smaller players.




17. 
    
    Conclusion:- Sinotel operates in the BIGGEST telco market, experiences a strong industry booming cycle for next 5 years, a low 47% penetration rate, a healthy 30% net margin, a focus business model, good ROA and ROE margin, explainable and collectable account receivable, attractive valuation of 4x PE which is half of their peers. However, the negative operating cash flow indicate a low possibility of dividend ahead.




18. 
    
    Declaration:- I follows Sinotel since their IPO in Nov 2007. I bought at SGD0.50/share, averaging down from SGD0.30/share to SGD0.07/share when worldwide equities meltdown, S-chip crisis happened together with the selling pressure from Pre-IPO investors. Now I see a good re-rating of the stock to SGD0.42/share after Baroon's purchase and Sinotel's ADR application announcement. This stock has higher risk characteristic, it should only suit those season investors who know chinese telco industry well.