A true contrarian play for the adventurous investor

Small company investors are no longer much interested in alternative energy. Many struggle to find their place in a business that is driven by highly unpredictable earnings. And that is especially true of Chinese companies. Many simply can’t be trusted.

So for the true contrarian in you, how about a Chinese manufacturer of bioethanol refineries that will depend on a handful of projects this year and is controlled by a handful on Chinese investors? 

If that is not enough to put the shares beyond the reach of even the longest bargepole, this is a business that is also highly sensitive to the price of oil – and who knows where that is heading?

About as popular in London as chicken feet

As you might expect, shares of China New Energy (AIM: CNEL) are about as popular in London as a dish of chickens’ feet. Since coming on to AIM a year ago at a price of 7p the share price has halved and the major shareholders are, I understand, looking for a bit more action and a greater appreciation of their efforts. They may have a point.

Let’s look at the numbers first. At this share price, China New Energy is valued at just £11m, well below 2011’s revenue of £15.4m and less than five times its recent annual rate of post-tax profitability. That is the sort of ungenerous rating normally applied to a business without much of a future, but that hardly seems to be the case here.

Bioethanol is a genuine alternative energy that can be mixed with conventional oil-based fuel without any appreciable dilution of performance. Already it is widely used as an additive in the USA, and the EU wants to see bioethanol provide 10% of road transport by 2020. So what is bioethanol?

Bioethanol is derived from biomass – plants such as sugar cane and corn. It is an alcohol and if you have a sip it will blow your head off, which is why its main commercial purpose is as a source of energy. A decade or so ago there was quite a boom in bioethanol production, with many refineries built in the USA and several more in China. Today, that does not look too smart.

What happened to the bioethanol boom?

The diversion of food crops away from hungry mouths and into the petrol tank hardly seemed to be a humane use of scarce resources. But what really scuppered the business was rising food costs. Bioethanol producers found themselves having to pay more and more for their raw material crops, and with much of the industry dependent upon government subsidies, the numbers failed to add up.

Nowhere did this hit harder than in China. The domestic price of corn rose by 30% in 2007, and in response the Chinese government imposed a moratorium on any new ethanol production. That was bad news for China New Energy, which is the dominant supplier of bioethanol refineries in the country. However, the business is by no means dead. The Chinese government still wants to increase the share of bioethanol in the country’s energy mix, and in future it can do so without plucking food out of hungry mouths.

New raw materials could lead to new prospects

The future of bioethanol lies with so-called ‘second generation’ refineries. Instead of taking food crops as a raw material, they use the parts of plants that are not eaten – stems, stalks and husks.

Production of fuel from this cellulosic waste is promising to recharge the industry, and China New Energy appears to have more than enough expertise and experience to satisfy this demand. For the time being, it is only working on about three projects per year and that lends an inevitable degree of uncertainty to its financial results.

But it has reacted to the recent dip in business by winning its first contracts outside China, including in Russia and Romania, and by extending its range of services beyond basic bioethanol refineries. Today, it can offer to convert an older refinery into one equipped for second generation biofuels. It can construct plants to make an advanced version of bioethanol called biobutanol.

It has expertise in energy saving for existing plants and has completed some projects in return for a share in the value of the energy savings. It can take waste product from the production of bioethanol and turn it into valuable biogas through the process of anaerobic fermentation. And finally, it is looking to improve its capabilities in the supply of yeast, the key ingredient in the bioethanol process.

So China New Energy could be worth a closer look. I understand that a research analyst has recently been to see the operations in China and is preparing a report that should give some reassurance to City investors. Assuming his conclusions are favourable, this could mark a turning point for an unloved share. Watch this space.

• This article is taken from Tom Bulford’s free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

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