Eco-Truth

We take a look at the latest noxious emission on the GEM - Eco-Tek, which sells a taxpayer-funded filter for diesel exhausts. The stock has shot up 161% since its highly concentrated placing, and we predict sales and profits are set to collapse. Join us as we walk through the history of this company which was built on equity of just HK$116k by the star of a previous Webb-site.com article...

Eco-Truth
28th January 2002

Sometimes we just gasp at the audacity of offerings on the GEM. The latest one to catch our eye is Eco-Tek Holdings Ltd (Eco-Tek), listed on 5-Dec-01. The company is one of the last to list with a less than two-year track record, the rules having changed on 31-Dec-01.

History

The story of Eco-Tek predates the company itself, beginning in 1996 with a research project conducted by Hong Kong Polytechnic University (PolyU), in the Department of Civil & Structural Engineering. They began to experiment with a filter to cut out some of the smoke emitted by Hong Kong's then notoriously dirty diesel taxis and other light diesel vehicles. A prototype was developed in Nov-98, and in Jul-99 the Government commissioned PolyU to conduct a feasibility study, including a trial launched in Aug-99 on 62 diesel light duty vehicles.

The project was initially funded HK$190k (US$24k) by the Taxi Dealers and Owners Association. Subsequently, PolyU put up another HK$1.3m, according to their final Jul-00 report on the trial, bringing the total research cost to $1.49m plus whatever the Government paid for the study. The report estimated that "if mass-produced, the direct cost is around HK$300 per trap".

Clearly we are not talking rocket-science. The trap is basically a stainless-steel sponge in a stainless-steel casing, which is attached to the end of an exhaust pipe. It quickly clogs up with soot, and has to be cleaned every 2-3 days (or daily on minibuses) to maintain efficiency. The tests showed that it would remove 20-30% of particulates depending on the vehicle, but this declines to almost nil after a week if you don't clean it. Cleaning it involves removing the filter and washing it (or getting someone else to), something that drivers may quickly tire of unless they are due for an emissions test.

Another problem euphemistically known in the report as "spontaneous soot regeneration" is that the soot has an annoying tendency to ignite if the exhaust gases get too hot, burning some of the stainless steel fibres in the filter. The report said that 6 taxis suffered from this problem, 3 of them recurrently. That's out of 21 taxis in the study, meaning a 28% problem rate. Amongst the 19 public light buses in the study, 5 also showed the problem even with daily filter changes. On taxis, it tended to be worse when the filter had not been washed for a few days, and when they had been operating at high engine loads. Anyone who's been to Hong Kong knows how hilly it is.

Another difficulty emerged in the "lug-down test" which involves running the vehicle at full power, something you are liable to do going up Old Peak Road with two gweilos in the back of your cab. The force of the exhaust blew out around one third of the accumulated soot. Shades of Chitty Chitty Bang Bang spring to mind.

All this is a lot more basic than the UK government's programme called CleanUp which provides a 75% government subsidy for oxidation catalysts costing GBP300-1000 (HK$3,330-11,100) for light vehicles and advanced particulate traps costing between GBP3,000-4,000 for heavy vehicles. These traps are far more advanced, often including catalytic converters and then the soot is intentionally burnt so that the filter "regenerates" or cleans itself and absorbs up to 95% of particulates. An example is Eminox's Continuously Regenerating Trap.

Anyway, the Hong Kong Government had good reason to skimp on the plan, because what they really want is for vehicles to progressively convert to Liquefied Petroleum Gas (LPG). The trap is a stop-gap solution so it doesn't have to work that well.

In May-00, the Government's Environmental Protection Department (EPD) briefed the Environmental Affairs Panel (EAP) of the Legislative Council, referring to an estimate that as of Mar-00 there were 42,400 "pre-Euro" vehicles (those registered before 1995 when the Euro-I standards were introduced) as follows:

After the EAP, the EPD went to the LegCo Finance Committee with a briefing paper which was discussed (see page 5 of the minutes) on 12-May-00. That paper broke down the estimated purchase cost to $1,000 for the trap and $200 for installation.

Credit to Jake van der Kamp at the SCMP for first reporting the discrepancy between that price and the "direct cost" of around HK$300 mentioned in the PolyU report 2 months later. The difference is a juicy $700, or 70% profit margin.

Government correctly insisted on going through a tendering process for the supply of traps, even though the EPD had been involved in the PolyU research. The government suggested to the Finance Committee that the minimum tender period should be "six weeks" or "42 days" under the WTO Agreement on Government Procurement - in fact that agreement says 40 days (see Article XI, paragraph 2).

Then on 2-Jun-00 Government published the invitation to tender forms for the traps, setting a deadline of just 21 days, so it appears that they broke WTO rules.

Bad Economic Governance?

The issue here is that the Government came up with a cost estimate of $1,200 per unit which it has yet to explain, even though PolyU thought the production cost would be only $300, and then gave the rest of the market only 21 days to beat it. Even allowing for a refund of PolyU's research and development costs, and a profit margin for their trouble, that is a very generous price. LegCo's Finance Committee approved the budget on the back of the EPD estimate, and as a result it was very unlikely that anyone would tender at less than the $1,200 price (including installation). So how did the EPD reach this estimate? The only logical assumption is that they asked PolyU what they would charge.

When the results were announced on 18-Aug-00, of 17 suppliers who pitched, only 2 suppliers had been accepted for subsidy, by far the cheaper of which was a previously unheard of company called Eco-Tek Co Ltd, with a bid of $1,300 per unit. Notice that is $100 more than expected. No mention was made of PolyU in the announcement.

On 15-Sep-00, the Government announced a subsidy per vehicle of $1,300, to cover the full cost of the Eco-Tek product. The offer was good for one year from 25-Sep-00. Now the profit margin looked more like $800, or 72.7% excluding installation, which was outsourced to Caltex stations.

As far as we know, LegCo was not asked for an increase in the budget, and we guess this may have something to do with a reduced number of eligible vehicles due to scrapping and LPG conversion since Mar-00, making room for the $100 increase per remaining vehicle.

The Making of Eco-Tek

The grand total of all the equity invested in Eco-Tek before its IPO is just HK$115,610, or an average of about $0.00028 per share. Of this, $100,000 was invested by Chairman Dr Lily Chiang (Dr Chiang) when the first group company was incorporated on 27-Oct-99, making her the sole owner. Another $790 (US$101) was invested in subsidiaries. The remaining $14,820 (US$1900) came in from other directors and staff who were allotted shares on 21-Nov-01, just before the prospectus was printed.

Dr Chiang is the daughter of Dr Chiang Chen, founder and Chairman of HK-listed plastic injection machinery maker Chen Hsong Holdings Ltd (Chen Hsong), of which she was an Executive Director until 1-Sep-00. She was invited to act as one of the industrial advisers on the project by PolyU in Jun-98.

In Sep-99, Dr Chiang and PolyU agreed to work together on the commercialisation and testing (respectively) of the product. This led to a memorandum of intent on 10-Feb-00 and another in Apr-00, leading to a formal technology licence agreement between Eco-Tek and PolyU in Aug-00, when the Tender was awarded and a PRC contractor was then awarded the manufacturing contract. On 9-Dec-00, the license agreement was scrapped in favour of the outright assignment of the patents by PolyU to Eco-Tek in return for a shareholding which eventually became just 16.10% after the IPO, while Dr Chiang has 54.15%.

E1 Media shows Eco-Tek in its client list of web sites, but the Eco-Tek prospectus makes no mention of any connected transaction for the web site design, although it does disclose that Eco-Tek shared offices with E1 Media for a while and paid them a management fee. Perhaps the web site was done for free.

Sales

Eco-trap

The Government estimated that at Mar-00 there were 42,393 pre-Euro vehicles suitable for the Eco-trap, of which 11,735 were taxis registered before 31-Dec-95. The prospectus states that by 21-Nov-01, 70% of the total taxi fleet of 18,000 had converted to LPG, leaving about 5,400 unconverted. That reduces the total pre-Euro population to about 36,000 at best, and more likely lower, as older cabs are more likely to be scrapped for LPG. Of course, no more pre-Euro vehicles of any sort have been registered since 1995, and some of the older ones around in Mar-00 are now on the scrap heap.

The taxi conversion to LPG was incentivised by government grants of up to $40k per cab, and this offer ended on 31-Dec-01 for taxis registered before 1995 (including almost all the pre-Euro models), and ends on 31-Dec-03 for the rest, so we can expect most cabs to convert by these deadlines. The Government has also waived fuel duty on LPG, making running costs a lot lower than diesel, although this is complicated by widespread sales of illegal duty-free diesel. Government plans to get all diesel taxis off the roads by 31-Dec-05.

The prospectus states that from 25-Sep-00 to 31-Oct-00, 1,247 Eco-traps were sold, and from 1-Nov-00 to 21-Nov-01, 15,583 were sold. This makes a total of 16,830. On the other hand, it also says that by 21-Nov-01, 16,735 units had been sold, which is obviously inconsistent. Maybe some were returned.

Eco-Tek estimates it has an 85% market share of the subsidy program, implying that about 19,700 vehicles have been retrofitted. This leaves a maximum HK target market of 16,300. Most important, Government's offer to pay for it expired on 17-Oct-01, so the chances are that most of these vehicles will not be retro-fitted. If they were going to fit it, they would have taken the subsidy.

An indication of this is the final results announcement for the year to 31-Oct-01, which records net profit of $8.221m on sales of $20.144m. The prospectus shows sales of $16.906m for the 9 months to 31-Jul-01, so the last quarter must be $3.238m. The prospectus also shows net profit of $7.180m for the first 9 months, and unaudited profit of $0.904m for the two months to 30-Sep-01. That means that October's net profit was only $0.137m.

The Eco-trap is essentially toast in Hong Kong, and although it may have potential in China, it would have to win orders in a less favourable environment, probably at much lower prices, and prove that it can get over its various technical difficulties.

Other products

The group also develops and sells hydraulic filters, although this must be a very small line, as 96% of sales in the 9 months to 31-Jul-01 were Eco-trap sales and the other 4% was "mainly" filter cartridges and adaptors for the trap.

Eco-Tek plans to compete for more government subsidies (when they are announced) to retrofit about 50,000 old heavy diesel vehicles with oxidation catalysts, but this time it is likely to see more vigorous competition in the tender. Again, this is a one-off retrofit project, as new vehicles must already reach high Euro-III standards.

The company is also planning a regenerative diesel oxidation catalyst "targeted at the higher end market, including government vehicles" (again, a tender would be needed).

Eco-Tek is also "committed to develop" a soundproof barrier, based on "Active Sound Edge" noise-cancellation technology from JAI Company Limited of Japan, in the development of which Dr Pau participated in 1998-1999. Whether they can persuade the Transport Department and KCRC to wire up all the highways and railways with microphones and loudspeakers (which in essence bounce back a phase-shifted reflection of the noise, cancelling it out) is another question. Don't hold your breath. The technology has not yet, as far as we can tell, been successfully commercialised anywhere else in the World.

Eco-Tek also plans to spend $1m to research and develop a waste plastic recycling process, and has retained Prof Georg Menges (Prof Menges), an expert in the area of plastic recycling and a professor in the Institute of Plastics Engineering, Technical University of Aachen, Germany, as the group's technical consultant. They want to convert waste plastic into "oil substances and finally, energy, in Hong Kong."

Connection: the prospectus does not mention that Prof Menges, who is about 77 years old, was a non-executive director of Chen Hsong until 1-Apr-00.

Financing

Apart from the equity of $116k, Eco-Tek was initially financed by loans from its three Executive Directors, which by the end of the track record on 31-Jul-01 amounted to $4,015k, being $2,767k from Dr Chiang, $935k from Dr Pau Kwok Ping (Dr Pau) and $313k from Shah Tahir Hussain (Mr Shah). Their remuneration as directors was $2,104k since inception, so the net advance was just $1,911k. All the loans were repaid in Nov-01.

The PCH connection

Dr Pau was an Executive Director of Dr Chiang's father's company, Chen Hsong until 20-Oct-00, having joined it in 1968. You may recall that Dr Pau was also an "independent third party" who took part in the dilutive placing by PCH in 2000, which followed E1 Media's attempt to inject a dot-com into PCH in return for nearly all of its cash, which was stopped by PCH minority shareholders. Mr Shah is also a director of PCH.

Oh come on now, don't by shy! What the prospectus doesn't state is that the company in question is PCH, that she controls it, and that the Petition alleged "that the affairs of [PCH] had been and/or were being conducted in a manner which is oppressive or unfairly prejudicial to the interests of some part of the [shareholders] of the company." If you were thinking of becoming a minority shareholder in Eco-Tek, that information might be relevant. Perhaps it should be renamed Eco-Truth for being so economical.

The Petitioner asked the court for an order that the company and/or Dr Chiang purchase the Petitioner's shares in PCH at a fair value to be determined by the court, or alternatively that PCH be wound up. The winding-up part of the request was rejected, and the rest of the case is still pending with no date fixed for a hearing. So far PCH has provided for $17m of shareholders' funds for its legal costs on the case.

Who are the INEDs?

The independent non-executive directors of Eco-Tek are Paul Cheng Ming Fun and Eden Woon Yi Teng. Connection: Mr Cheng is a former Chairman of the Hong Kong General Chamber of Commerce, of which Dr Woon is a director and of which Dr Chiang is Vice Chairman.

Incidentally, one of the INEDs appointed to PCH after Dr Chiang took over is Alexander Tzang Hing Chung. Connection: he is Deputy President of PolyU (where Dr Chiang's husband works) as well as a director of Chiang Industrial Charity Foundation, founded by Dr Chiang's father.

The Pre-IPO Option Scheme

Not content with their existing shareholdings amounting to 57.25% of the company after its IPO, the executive directors received options to subscribe a further 96.74m shares at $0.01 per share between 1 and 4 years after the IPO. The shares are equal to 17.5% of the post-IPO share capital, at a 96% discount to the IPO price, as a "recognition of the contribution of the executive directors to the growth of the Group".

PolyU, on the other hand, has an option to subscribe a further 13.82m shares, equal to 2.5% of the post-IPO share capital, at a 10% discount to the IPO price, or $0.2142 per share between 1 and 3 years after the IPO, "as a reward to PolyU's continuing support and collaboration with the Group and for the purpose of enhancing future cooperative relationship".

You can see whose contribution is valued higher, and the taxpayers who fund PolyU might begin to wonder if they are getting enough bang for their research buck.

Name	Post-IPO %	After Options %
Dr Chiang	54.15	53.46
Dr Pau	3.00	6.67
Mr Shah	0.10	2.17
Total directors	57.25	62.30
PolyU	16.10	15.50
Other management	1.65	1.38
Public	25.00	20.83
Total	100.00	100.00

The minimum public float under the listing rules is 25%, so that means that the insiders would have to sell down part of their stake if the options were exercised. And that is before they get going on the post-IPO Option Scheme, which has not yet been used.

On top of this, the 3 executive directors are on service contracts which promise them a bonus of 10% of the net profit (split equally) as long as it exceeds $5m, plus base salaries totalling $2.28m per annum.

The IPO

The IPO was done as a placing, meaning that the sponsors get to choose who gets the stock. The placing price was $0.238 per share (a lucky number in Cantonese), and the allotment announcement claims it was over-subscribed by 59 times.

The Stock Exchange really should scrap GEM Rule 10.12(4)(a) which requires a statement of the "level of interest" or subscription multiple in placings, because the figure is meaningless since placees don't have to put up cash for all the shares they "express interest" in - only the ones they are allocated. Hence it is easy to arrange exaggerated subscription multiples just by asking everyone to express interest in x-times what they will be allocated.

Regardless, the announcement warns that the allocations in this deal were highly concentrated with the top 5 placees getting 53.84%, the top 10 placees getting 74.88%, and the top 25 getting 90.36%. If that reflects their level of interest, then it implies that each one of them on average applied for more than twice the total issue size.

Incidentally, the company scored its first breach of the listing rules 2 days before listing - off to an impressive start.

The stock took off immediately and hit a high of $0.73 on 10-Dec-01, closing today at $0.62, up 161% on its placing price. That values Eco-Tek at $343m. Not bad for a company with net assets of about 6 cents per share, facing a collapse in sales and no certainty of making the 73% gross margins it is accustomed to if and when it wins future tenders.

If you own this stock, ask your investment adviser about getting out. Don't get Eco-trapped.

Important notice: All material on this site, except where otherwise accredited, is copyright to Webb-site.com. Media and researchers are welcome to quote from articles on this site, provided that such quotation is attributed to Webb-site.com. The information in this site should not be relied upon by any person in making any investment decision. No responsibility or liability is accepted by Webb-site.com or any person related to it for any loss arising from or in reliance upon the whole or any part of the contents of this site. Persons who are in any doubt about an investment or potential investment should take professional investment advice. From time to time parties associated with Webb-site.com may own long or short positions in securities issued by or related to companies or governments on which we comment.

Eco-Truth 28th January 2002