Chinese Demand Drives Growth For Water Equipment Makers

• Amy Reeves
• On 5:49 pm EST, Thursday November 5, 2009

"Water, water everywhere/Nor any drop to drink," lamented Coleridge's Ancient Mariner. More and more, the Chinese know what that feels like.

China is a land of rivers and lakes, making it the world's fourth largest fresh water source. But over 70% of those lakes and rivers are polluted, according to government research. Thirty of the 32 largest cities have water shortages. That's led to increased spending on water infrastructure and a booming business for makers of water-treatment supplies.

Duoyuan Global Water (NYSE:DGW - News) is one beneficiary. The firm, founded in 1992 by physicist Wenhua Guo, has made money every year. In June, it came out on the Nasdaq, and the share price has more than doubled.

Duoyuan's first product line treated circulating water in heating and cooling systems as well as some types of industrial equipment. In 1998, it started selling water purification gear and in 2001 branched out into wastewater treatment. This breadth of offerings distinguishes Duoyuan in a crowded market, says Piper Jaffray analyst Michael Cox.

"The typical (Chinese water treatment) manufacturer sells a single product category, in some cases with a very thin product line," said Cox, whose employer participated in the IPO. "That makes it difficult to scale up."

Duoyuan has scaled up through its network of 80 distributors in 28 Chinese provinces and districts. The size of the network also differentiates it from its smaller rivals, who mostly self-distribute, says Cox.

Market share is less than 1% as Duoyuan's revenue totaled just $86 million last year. But the fragmented market gives it a chance to grow and consolidate, say analysts.

Circulating water treatment still provides 37% of Duoyuan's sales, as of the second quarter. There are 35 products in this segment, consisting mostly of filters and softeners. Treating the water helps prevent build-up that could impair the systems.

This segment's sales grew 20% in the quarter, but that was below the 25% growth rate of its overall market, according to Oppenheimer analysts. In a Sept. 25 report, the researchers said they expect growth to pick up, to 34% a year in 2011.

Water purification, a newer line, grew 26% in the quarter. Its 30 products clean drinking water and water for industries like food and drug making. That sector now provides 20% of sales. Helping this business is tightened water-quality standards the government rolled out in 2007, which tripled the number of substances classified as pollutants.

Wastewater treatment cleans sewage and industrial waste so the water can be reused. It's been the fastest growing segment, rising 47% last quarter, and took the leading share of revenue at 41%. This is a special area of interest for the government's 11th Five-Year Plan, which starts in 2011. The plan mandates that cities build plants that process at least 70% of wastewater.

"The current five-year plan puts an emphasis on municipal water treatment," said Cox. "The next should support wastewater treatment spending, and a shift in emphasis toward industrial water."

The recent economic stimulus package also set aside $51 billion for wastewater and solid-waste treatment, according to Frost & Sullivan.

The main disadvantage to wastewater treatment gear is that it yields lower margins than the other product categories. Operating margin crested at 41.3% in the second quarter, but Oppenheimer expects that to dwindle to 30% next year.

The company is planning to develop new technologies in the sector, however, including products to convert sewage sludge into energy. That would give the firm a chance to connect to that other booming environmental market, alternative energy.

"Sludge-to-energy could prove to be a significant category in the China market," said Cox.

Overall, sales in the second quarter rose 32% to $31.3 million. Profit jumped 44% to 23 cents a share.

So far, Duoyuan has developed its new products with its own research and development team. However, the plethora of small players in the industry gives it a chance to buy technologies, say analysts.

"If (the market) is as fragmented as it seems, there may be acquisition potential in the sector," said Matt Therian, analyst with Renaissance Capital. "They have a clean balance sheet -- they could be a buyer of small companies."

Some of its competitors, however, are quite large. One of its rivals, Zhejiang Omex Environmental Engineering, is a subsidiary of Dow Chemical (NYSE:DOW - News). General Electric (NYSE:GE - News) and Ashland (NYSE:ASH - News) are also players in the Chinese market.

Compared with these giants, "Duoyuan is at a disadvantage in terms of brand recognition, capital access, distribution channels and R&D capacities," wrote the Oppenheimer analysts in their Sept. 25 report.

Nonetheless, analysts expect growth to continue. The company is due to report third-quarter results on Nov. 9, and so executives were unable to comment for this article. But analysts polled by Thomson Reuters estimate profit of 44 cents a share, up 238% from a year ago, with sales rising 41% to $35.5 million.

Next year, sales are expected to grow 28% to $143.9 million. Earnings per share are seen at $1.45, down from this year, but that's not accounting for the increased number of shares due to the IPO. Adjusted for the share count, Cox expects 12.6% profit growth in 2010.

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