China Energy Corp (OTC BB:CHGY)

CHINA ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

See notes to the consolidated financial statements.

GeoTeam caluculated non-gaap EPS of $0.13 vs $0.10 in prior year quarter. Adjusting for $1.3 million government subsidy.

Fourth quarter Highlights:

• Revenue increased 49% year-over-year to $8.7 million due to higher selling prices, increased unit sales of Tianli market hogs plus retail sales of "Tianli An Puluo" hog meat.
• The retail division contributed $1.7 million of revenues in its second quarter of operations for the year.

Tianli's Chairwoman and CEO, Ms. Hanying Li, began, "We completed another successful year, which included the acquisition of our 11^th hog farm and the launch of our Tianli-branded retail pork products through our partnership with An Puluo Foods. While our fourth quarter results were negatively impacted by complications resulting from contaminated feed at a few of our farms, we responded quickly to contain the impact. Having implemented a series of additional safeguards, we expect the negative drag on our financials to subside in the first half of 2012."

"Our company is executing on the vision I had when we launched Tianli eight years ago," Ms. Li concluded. "The strong demand for pork in China is providing us with a tailwind to grow organically as our more recent farm acquisitions reach capacity. The retail expansion provides us with further opportunities to increase revenues and cash flows while establishing the Tianli brand through AnPuluo Foods. Our single most exciting strategy for 2012, Enshi Black Hog breeding and sales, is expected to be a major contributor in revenues and earnings for years to come"

Item 5.02

Mr. Fu Xu, who previously served as Chief Financial Officer of China Energy Corporation, a Nevada corporation (the “Company”) has been appointed, and shall act in the capacity of, Acting Chief Financial Officer until a replacement Chief Financial Officer is identified and appointed. The Board of Directors and the Company are actively seeking a permanent replacement for the role of Chief Financial Officer of the Company.

News from the GeoTeam.

(Please note that any protected blog posts and pages need the password GEOTEAM for access It is case sensitive)

Shengkai Innovations (NASDAQ:VALV) ($1.60)

Please see our thoughts on VALV's decision to change auditors.

China Ceramics Co (NASDAQ:CCCL) ($4.05)

Although many facets of the the OTGDD on CCCL were positive, we are still digging into the CCCL story, especially with regards to its SAIC filings and a related party transaction issue. The original SAIC filings that we pulled did not match the SEC filings. However, the SAIC filings that we pulled at a later date were on par with the SEC filings. Thank you for your patience as we develop this story.

We are neither long nor short shares of CCCL.

China Energy Corp (OTC BB:CHGY) ($0.44)

China Energy Corp has finally achieved a positive net working capital position for the first time since going public in late January 2007, reversing the trend of 4 straight years and 17 straight quarters of a negative net working capital position. However, a good deal of this reversal was generated from repayment of a related party note receivable that had been on the balance sheet for several quarters.

"As of May 31, 2011 we had a working capital surplus of $6,310,207, compared with a working capital deficit of $21,723,598 as of November 30, 2010. The improvement of liquidity was mainly due to (i) the full repayment of notes receivable amounting to $14.7 million which was lent for strategic purposes to related parties affiliated to the Company through family members of the Chairman; (ii) net income from the operating business in the first half of 2011; and (iii) proceeds from finance obligation amounting to $9.3 million. We anticipate that the combination of our sales and collection of accounts receivable with our longer accounts payable cycle, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs." (http://geoinvesting.com/companies/chgy_china_energy_corp/research)

Investors may also want to know that CHGY recently changed its corporate structure to a Variable Interest Entity (VIE) from a Foreign Invested Enterprise (FIE).

http://geoinvesting.com/companies/chgy_china_energy_corp/research/investor_alert/0026085

We have no position in CHGY

Please visit the following links:

Recent changes in short positions (JVA, TRIT, CMCI, GCHT) - http://blog.geoinvesting.com/?page_id=1256

Long positions (new) - http://blog.geoinvesting.com/?page_id=2489

China Co Conference calls and beats/misses (new) - http://blog.geoinvesting.com/?page_id=2443

Also make sure to subscribe to message boards to receive timely information on U.S. and ChinaHybrid companies. The following had been put out on TRIT:

http://geoinvesting.com/forums/yaf_postsm11526_Covered-TRIT-short-position-Price-now-fully.aspx#singleMsg.

We are also performing on-the-ground due diligence on a couple of companies for which we found positive initial findings, as well as on a few companies where the initial due diligence has been negative. Stay tuned!!!

Its obviously been tough on the U.S. front for many of the micro companies we follow. Overall, the financial results have been mostly positive. GeoSpecial CMT came through with the best quarter thus far. http://geoinvesting.com/companies/cmt_core_molding_technologies/research/comments_business_outlook/0031718.

Management comments were particularly strong, going out on the limb to say that business looks good all the way to 2013. Once this market turns around, provided we don't enter a severe recession, we think this stock could easily double to $16.00. We tepidly bought some shares, but may be more aggressive as market sentiment improves

GeoSpecial VSR has seen shares recover today after it announced a potentially significant contract award this am. http://geoinvesting.com/companies/vsr_versar/alerts We are eagerly awaiting the release of the company's 2011 second quarter release to see if the company will set a new EPS barometer.

Sifco Industries (NYSE AMEX:SIF) ($18.14) reported dynamite quarterly numbers this morning. We will nibble at shares and look to code as a GeoSpecial if our review the 10Q is positive. A recently completed acquisition could propel EPS for the next few quarters.

Usa Mobility (NASDAQ:USMO) ($14.68) and Multi Color Corp (NASDAQ:LABL) ($21.03) are also beginning to pique our curiosity.

Please be aware that shares of CMT, VSR and SIF are thinly traded.

We will be sifting through the recent market carnage to identify companies whose shares were punished despite reporting strong second quarter financial results. There are plenty.

**All prices are as of business close August 10, 2011.

Sincerely,

The GeoTeam

As of May 31, 2011 we had a working capital surplus of $6,310,207, compared with a working capital deficit of $21,723,598 as of November 30, 2010. The improvement of liquidity was mainly due to (i) the full repayment of notes receivable amounting to $14.7 million which was lent for strategic purposes to related parties affiliated to the Company through family members of the Chairman; (ii) net income from the operating business in the first half of 2011; and (iii) proceeds from finance obligation amounting to $9.3 million.

We anticipate that the combination of our sales and collection of accounts receivables with our longer accounts payable cycle, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs.

Substantial portions of the cost of construction of the thermoelectric plant and of the costs of expansion projects at Heat Power and the coal mine were provided by stockholder loans. Balances are detailed below:

For the three months ended February 28, 2011, revenues for Coal Group were $16,256,425 compared to $16,247,966 in the comparable three months in 2010. The $8,459 increase was mainly due to the increase in the volume of proprietary trading of coal by 13% over last year. However, this increase was mitigated by the decrease of volume of coal produced and sold at our Laiyegou coal mine by 15%.

Coal Group produced approximately 132,383 metric tons of coal during the three months ended February 28, 2011, compared to 156,187 metric tons in the comparable three months in 2010. Volume of coal sold by our proprietary trading business was approximately 192,266 metric tons during the three months ended February 28, 2011, compared to 169,710 metric tons in the comparable three months in 2010. The decrease in coal production volume in the first quarter was mainly due to the temporary closure of the mine to allow the local government to perform a safety check and equipment maintenance. This scheduled inspection was due to a recently enacted law local government, and it will occur every year. We currently anticipate that the annual production volume for fiscal year ending November 30, 2011 will be on par with last year.

• Full year 2010 vs 2009: $0.27 vs. $0.07
• Fourth quarter 2010 vs. 2009:  $0.06 vs. $0.08

As of November 30, 2010 we had a working capital deficit of approximately $21,723,598, including $6,629,669 principal amount of loans from shareholders which are due on demand. We anticipate that the combination of our sales and collection of accounts receivables with our longer accounts payable cycle, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs. It is our view that, many of our current liabilities, which are included in the definition of working capital, do not impose strict and time sensitive cash repayment terms on us. For example, advances from customers to be repaid in coal (which we believe will be readily available), current portion of deferred income (which is the portion of pipeline construction reimbursement, already received by us, to be amortized in the next year), and shareholder loans (which we believe would not be called by a shareholder at a time adverse to the Company) amount to an aggregate of $15,095,490 of our current liabilities. However, we may require other sources of capital to reduce the impact of our working capital deficit.

CHGY changes ownership structure to variable interest entity (VIE) from  foreign invested enterprise (FIE).

China Energy Corporation has entered into a series of contractual arrangements pursuant to which the control and the economic benefits and costs of ownership of the two operating companies known as Inner Mongolia Tehong Coal And Power Group Co., Ltd. (“Coal Group”), and Inner Mongolia Heat Power Co., Ltd. (“Heat Power,” and together with the Coal Group, the “Operating Companies”) in the Peoples Republic of China (“PRC”) would flow directly to Beijing Tehong Energy Technology Consulting Co., Ltd. (the “WFOE”), an indirect, wholly owned subsidiary of the Company.

The Company first entered into a Termination And Restructuring Agreement with the Operating Companies, the WFOE, Pacific Projects Inc. (“PPI”) and the respective stockholders of the Operating Companies (collectively, the “PRC Shareholders”) dated November 30, 2010 pursuant to which the parties agreed (i) to terminate the Trust Agreement dated as of December 31, 2007 under which the PRC Shareholders agreed to hold their equity interests in the Operating Companies in trust for PPI, (ii) to the merger of PPI into the Company and (iii) to enter into Management and Control Agreements.

On November 30, 2010, the WFOE entered into (i) an Exclusive Business Cooperation Agreement with Coal Group, (ii) an Equity Interest Pledge Agreement and an Exclusive Option Agreement with Coal Group and the stockholders of Coal Group and (iii) a Power of Attorney, with each of the stockholders of the Coal Group.  The WFOE also entered into (i) an Exclusive Business Cooperation Agreement with Heat Power, (ii) an Equity Interest Pledge Agreement and an Exclusive Option Agreement with Heat Power and the stockholders of Heat Power and (iii) a Power of Attorney with each of the stockholders of Heat Power.  The foregoing agreements are herein collectively referred to as the “Management and Control Agreements.”

The Management and Control Agreements described below allow the WFOE to exercise control over, and derive all economic benefits from Coal Group and Heat Power.  Previously, our operating businesses were controlled pursuant to a trust arrangement which has been terminated as part of the restructuring described herein.

See page 6 of 2009 10K for history of this issue.

CHGY reverse split may be on the horizon:

To the Stockholders of China Energy Corporation:

This Notice and the accompanying Information Statement are being furnished to the stockholders of China Energy Corporation, a Nevada corporation (the “Company”), in connection with the approval of resolutions by the Company’s Board of Directors (“Board”) and action taken by the holders of a majority of the issued and outstanding voting securities of the Company, approving amendments to our Articles of Incorporation (the “Articles of Incorporation”) to (i) effect a reverse stock split of our common stock on the basis of one share for every three outstanding shares (the “Reverse Split”),  (ii) provide for a class of blank check preferred stock, (iii) confirm the number of directors that can be nominated to the board of the Company and (iv) make additional changes to the Articles of Incorporation as hereafter described in this Information Statement.  The implementation of the Reverse Split will be taken at such future date as determined by the Board of Directors, as evidenced by a filing with the Secretary of State of the State of Nevada, but in no event earlier than the 20th day after this Information Statement is mailed or furnished to the stockholders of record as of November 2, 2010.  Moreover, although the Reverse Split has been approved by the requisite number of stockholders, the Board reserves the right, in its discretion, to abandon the Reverse Split prior to the proposed effective date if it determines that abandoning the Reverse Split is in the best interests of the Company. The resolutions adopted by the Board and the written consents of the stockholders give us the authority to file a Certificate of Amendment reflecting the specific changes to the Articles of Incorporation (“Certificate of Amendment”) and a separate Amended and Restated Articles of Incorporation substantially in the form attached hereto as Exhibit A.

2010 Third Quarter Highlights:

Coal Group

• Revenues for Coal Group were $17,200,132 compared to $9,217,895 in the comparable three months in 2009.

"The $7,982,237 increase was due to the fact that the production at LaiYeGou coal mine was partially shut down for the installation of the long wall automatic mining equipments and normal production resumed in mid July 2009 with the completion of the installation and adjustment of the equipment and increases in the selling price of coal in the 2010 period.

In addition, the increase of the volume of proprietary trading of coal also contributed to the increase of revenue from Coal Group as compared to the prior comparable quarter in 2009."

Heat Transfer Group

• Revenues for Heat Power were $3,952,128 compared to $744,725 in the comparable three months in 2009.

Consolidated results

• Revenues rose to   $21.2 million from $10.0 million.
• Net income rose to $4.3 million from a loss.
• EPS increased to  $0.10  from  a loss of $(0.01).

"Due to our expanded production capacity and the efficiency of our long wall mining equipment, we expect revenue from coal production to remain robust, and expect incremental growth from our proprietary coal trading operation as we have been granted additional quota for space on trains from the local railway bureau," stated WenXiang Ding, chief executive officer and president. "Additionally, our momentum, financial strength, existing infrastructure, and proximity to additional coal resources in the region position the Company for expansion through potential acquisitions. We also expect the continued development of the XueJiaWan district to fuel growth in our Heat Power segment."

The Company is reaffirming its previously reported fiscal year guidance, and anticipates reporting between $17 million and $18 million in net income for its fiscal year ending November 30, 2010. The midpoint of this range represents an increase of 243% from fiscal year 2009.

GeoTeam® Note:

In the 2010 third quarter, CHGY received one-off government subsidies of $3,333,539 (included in revenues) in connection with providing heating at the reduced rates set by the government to ensure that the local residents can afford to make the payments.

Adjusting  2010 third quarter EPS for this item would be minimal, as the Heat Transfer Group contributes very little to the bottom line.

China Energy Corporation (the “Company”) is a Nevada corporation, formed on October 11, 2002 under the name Omega Project Consultations, Inc.  The name was changed to China Energy Corporation on November 3, 2004.  On November 30, 2004, the Company entered into a share exchange agreement with Inner Mongolia Tehong Coal Group Co., Ltd. (“Coal Group”), and Inner Mongolia Zhunger Heat Power Co. Ltd. (“Heat Power”) and their respective shareholders. The transaction was accounted for as a reverse merger, a procedure that treats the transaction as though Coal Group had acquired the Company.  Under the accounting for a reverse merger, the assets and liabilities of the Company, which were nil at the time, were recorded on the books of Coal Group, the continuing company, and the stockholders’ equity accounts of Coal Group were reorganized to reflect the shares issued in this transaction.

The share exchange agreement, which resulted in the Company’s acquisition of the Coal Group and Heat Power, was governed by and valid under Nevada law and was not perfected under the then People’s Republic of China (“PRC”) law.  It was not until certain changes in PRC law, which became definitive in 2006, that the series of procedures of governmental approvals and corporate actions were clarified and the Company acknowleged the condition precedents to that perfection.

The Company does not believe the lack of perfection impairs its ability to exercise control over the Coal Group and Heat Power as it continues to exercise control over them, consistent with the intent of the original shareholders.

The Company is in the process of completing the necessary actions to meet the current PRC legal requirements related to the acquisition of Coal Group and Heat Power.  On July 13, 2009, the Company entered into a framework agreement which detailed the actions contemplated for the restructuring of the Company, Coal Group and Heat Power under a "variable interest entity" (“VIE”) structure to meet the current requirements of applicable PRC law.

The framework agreement provides that (i) the Company will establish a newly-formed, indirect subsidiary of the Company incorporated in the PRC (“CEC China”), (ii) CEC China will enter an exclusive service agreement and option agreement with each of Coal Group and Heat Power (collectively, the “Operating Companies”) and a share pledge agreement with each of the Operating Companies and certain of their respective PRC Shareholders (“PRC Shareholders”). The framework agreement also requires the PRC Shareholders to fully authorize CEC China to exercise all shareholders’ rights that the PRC Shareholders can exercise in the Operating Companies. By entering into the framework agreement and subsequently setting up the structure involving the use of VIEs, the Company will have the control and the economic benefits and costs of ownership of the Operating Companies consistent with PRC regulatory requirements.

On July 16, 2010 we issued an alert that CHGY released its 2010 second quarter 10Q.

Points to ponder:

• Working capital deficit increases from the $15.O million figure contained in the 2010 first quarter.

"As of May 31, 2010 we had a working capital deficit of approximately $18,704,013. Please note that although shareholder loans are payable on demand and therefore classified as short-term loans, we may not need to pay back the loan within one year. We do not expect the shareholders to demand payment on such loans this year. We anticipate that the combination of our sales and collection of accounts receivables, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs."

• Debt increased from $19.2 million to $26.2 million.
  
• Debt to equity is 62.9%.
  
• $7.3 million in cash should be hitting the books within six months and dramatically increase operating cash flow.

"Term deposit represents amounts legally held by a bank which are not available for the Company’s general use. These deposits are held as collateral for issuance of notes to vendors for purchase of coal which generally mature between three to six months."

• Operating margins increased sequentially from the 2010 first to second quarter: 31.5% vs. 24.1%.
  
• Sales increased 343.7% to 41.3 million.
  
• EPS came at $0.17 vs. a loss of $0.03 in the prior year.
  
• We found it odd that the company did not include risk disclosures in its quarterly or annual filings.

"We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item."

Our intent over the short-term is to build a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)

GeoTeam® Note:

Please note: On July 6, 2010, the GeoTeam® removed all Chinese stocks that were on GeoBargains and GeoSpecial lists to respective Radar lists as we complete our "quality assessment."

Short term and risk adverse investors should be aware of the quality issues currently present in the ChinaHybrid Space, questioning the validity of what seem like solid fundamental stories. It is beginning to get ugly so be cautious and understand that more pain may have to be endured, as ChinaHybrids are easy prey for short investors. The broad brush that is being applied to theses stocks appears unfair, but we can’t ignore the psychological impact this can have on investors' portfolio decisions. If history is our guide, fear will eventually create an immense opportunity to invest in the companies that prove they can meet quality litmus tests enact shareholder friendly moves. Credibility can also be restored if independent legal/SEC opinions validate accounting practices currently in question. 

***Very Important GeoTeam® note. We have yet to verify if the Chinese filings for ChinaHybrid stocks we monitor match respective SEC filings. We are in the process of completing this task. Although we are not totally convinced that SAIC filings are an accurate represenation of financial statements the issue is impacting stock prices. Conservative investors may want to limit exposure or buy put options on stocks, that have this availability, as insurance against long positions, until we publish our findings. Odds are we will identify some promising companies that will fail this litmus test.

see relevant articles

HOHHOT CITY, China, June 23 /PRNewswire-Asia-FirstCall/ -- China Energy Corporation a leading Inner Mongolia producer and processor of raw coal for domestic heating, electrical generation, and coking purposes for steel production in the People's Republic of China, with operations in coal trading and heat and power supply, today announced that it anticipates reporting between $17 million and $18 million in net income for its fiscal year ending November 30, 2010. This would represent at least a 233% increase in net income as compared to the 2009 fiscal year.

Management anticipates sales of its Coal Group, which includes coal mining and sales as well as coal trading, will represent approximately 80% to 90% of revenues during 2010. The Company expects to produce an aggregate of approximately 800,000 metric tons of coal for the fiscal year ending November 30, 2010. China Energy produced approximately 156,000 metric tons of coal in the first quarter of 2010 with an average sales price of $37 per ton. In May 2010, the average sales price for coal was $43 per ton. The Company also expects higher level of sales in fiscal year 2010 from the Heat Power group due to an increase in coverage area of the Company's heating operations and an increase in the volume of electricity sold by its electric power operations. The Company's guidance does not include any contribution from future acquisitions by the Company. Management will continue to evaluate its business outlook as necessary and communicate any changes on a quarterly basis or when appropriate.

"We continue to capitalize on the efficiency of our longwall mining equipment which is now fully integrated at our LaiYeGou coal mine," stated WenXiang Ding, chief executive officer and president. "We expect incremental growth in China Energy's revenue and net income through fiscal year 2010 due to our expanded production capacity of approximately 800,000 metric tons per year at our LaiYeGou coal mine and growing demand for coal used in power generation, manufacturing and heating in China. We are also well positioned to expand our production and distribution capabilities through potential acquisition opportunities leveraging the rich coal resources in Inner Mongolia."

China Energy Corporation has performed nicely since our alert on March 2, 2010 @ $1.20, giving us a nice boost to our portfolios. (We have now taken some shares off the table). 

We have performed further due diligence to understand CHGY prospects for 2010 and beyond. China Energy's coal business derives revenues fromfour avenues: direct mining, proprietary coal trading activities, transportation coal trading activities and power generation.

China Energy's Revenue Streams

Direct Mining. As many readers may already realize, CHGY owns one mine located in Inner Mongolia. 60 to 70% of direct mining revenues occur in Inner Mongolia. Part of the success of a coal mine depends on the efficiency of what the GeoTeam calls the coal value chain

• Total Reserves: The total amount of coal available in a mine.
• Proven Reserves: Coal that has useful qualities for eventual production.
• Probable Reserves: The amount of coal that may have useful qualities for eventual production. Generally 40% to 70% of probable reserves will exhibit useful qualities.
• Non Mineable Reserves: The amount of coal that cannot be mined.
• Mined Out Reserves: 100% of proven reserves {PLUS} 60% of probable reserves {MINUS} non mineable reserves.
• Recovered Coal: The percentage of the mined out reserves available to sell to the end user (produced).
• Production Capacity- Given a company's equipment/labor position, the total amount of coal that can be produced annually.

Over time the total reserve will be depleted. In the case of CHGY, after going through the value chain, management has determined that it currently has 11 million metric tons of recoverable reserves and an annual production capacity of 800 thousand tons of coal (over a 10 year life span before coal mine is depleted). Recent infrastructure improvement efforts rest efforts have dramatically increased CHGY's recovery rate. This helped CHGY report a surprisingly strong 2009 fourth quarter and should also benefit 2010 results.

Proprietary Coal Trading Activities. China Energy must meet increased demand from its customers outside Inner Mongolia. Since a good chunk of its direct mining operations serve Inner Mongolia China Energy has to purchase from a third party coal operators to meet the demand of customers outside Inner Mongolia.

Transportation Coal Trading Activities. Management indicated to us that China's coal markets can be broadly categorized into supply regions in the south and northwest and consuming regions in the east as well as the southeastern coast. Keep in mind that the supply region still does consume some coal.

Coal is transported by train, ultimately arriving at ports where it is then shipped to eastern/southern coastal regions. The challenge for coal producing/brokerage firms is that China places annual quotas on the amount of coal that companies can transport to consuming regions, leaving them with an excess supply. Consequently, this creates opportunities for firms like China Energy that have high quota limits, such as CHGY. The company transports the coal for the quota deficient client and upon arrival to its destination sells it back to the client with a mark up to cover transportation costs an a small profit

Given the three revenue streams above, China Energy, in a nutshell, can satisfy broad demand coverage; direct mining and proprietary Coal trading activities exist to meet local demand from customers; transportation coal trading operations gives CHGY exposure to regions it would not normally supply. In the case of direct mining operations the end users generally provide their own means of transportation, thus alleviating logistics costs for CHGY. At about 66%, the Gross margins on the direct mining operations are much higher than the trading operations which stand at about 7%.

"This year we expect to see margin improvement on trading since we will do more proprietary trading compared to quote trading."

Power Generation. China Energy also operates a thermoelectric power plant through its Heat Power division (utility) currently serving two purposes:

1. Supplies electricity to the XueJiaWan district in Ordos City, Inner Mongolia.
2. By the use of recycled water from its electric operation, supplies steam heating directly to end users throughout the XueJiaWan district in Ordos City, Inner Mongolia. This is significant as most residential dwellings do not contain boilers. China Energy utilizes twenty-one heat transfer stations and builds out piping infrastructure to transport steam.

In terms of contribution to the company's bottom line, its utility operations are at nearly break even while the coal group currently accounts for all of CHGY's net income.

Due to issues associated with limited coal production capacity and the lack of profitability from its electric utility business, it may be difficult for investors to determine CHGY's potential for EPS growth.

Putting growth aside, we have a company with...

1. A strong market position that will virtually stifle the likelihood of harmful competition in all its business lines.
   
   Coal Group
   
   
   • The Coal Group does not have competition [as is experienced by other businesses]. Although there are approximately 30,000 coal mining companies throughout China, because demand currently exceeds supply, competition is not a concern in the operation of our business."
   • CHGY favorable standing with the government enables it obtain high coal quotas.
   • In its efforts to improve the efficiencies in the coal mining industry, China is taking the approach of shutting down smaller mines or any mine which does not meet its specified basic production Coal Group requirements."
   
   Heat Power
   
   
   • "Heat Power does not have competition as it holds an exclusive license to supply heating and electricity to serviced areas. Competition in obtaining such license are largely mitigated by a good review of operating history by the PRC government."
   
   In essence, it could be argued that CHGY's role to supply electricity and heat, motivates the government to look upon the company somewhat favorably.
   
   
2. Predictable & Sustainable Revenue Streams...

• China Energy's direct coal mining business should be able to generate consistent annual revenue for over 10 years before resources are exhausted.
• As CHGY's electric supply business is one the only show in town ,it should also generate predictable revenue streams. However, the power plant operates at maximum capacity and adequately meets the electricity needs of its served market, so CHGY may not see much growth from this business. 

Validating China Energy's Growth

Can China Energy develop a plan to convince investors that it can aggressively grow its business beyond its current structure? Management indicated to us that there are at least three ways the company can pursue long-term growth.

Coal Business Demand Driven Growth. As the economies of Inner Mongolia and China expand so too should the need for the coal.

"The demand/supply imbalances should be intact for years to come."

With its current mining production capacity fixed at 800k tons, CHGY would have to utilize its coal trading operations to benefit from increased coal demand and/or experience an increase in coal prices. Business could also be enhanced from favorable increases in quotas limits. However, the challenge from this scenario is that the trading business carries low gross margins which would require extreme increases in revenue to drive EPS growth.

Coal Mine Acquisition. The obvious second opportunity would be to acquire another coal mine to add to its direct mining business. This strategy would carry the best margins. We estimate this tact would require from $50 to $60 million in funding. Not including the capex for mining equipment after the acquisition, funding requirements may be less.

In light of this potential need, dilution becomes the issue. Management is very aware of this and would like to minimize the likelihood of such an event. With regards to dilution, we would assume that acquiring a revenue generating mining operation could be immediately accretive to EPS, unless the coal mine does not have mining equipment installed, in which case it would take about 1.5 years or longer to have full production. Still, we suggested that the company consider ways to reduce it shares outstanding before taking on more capital and possibly waiting until the end of the year to make such a move, at which time the stock may be trading at higher levels. In doing this, CHGY could end 2010 on a positive note while entering 2011 with a new source of growth and a loaded gun.

Keep in mind that increasing coal trading activities and acquiring another mine are not mutually exclusive events. Elevated coal trading revenues are inevitable. Acquiring a mine could ultimately shift some proprietary trading revenues to direct mining operations and result in improved margins.

On an interesting side note, the government has the authority to assign coal mines to entities. If CHGY was the beneficiary of such an act, acquisition costs would be substantially reduced.

Heat transfer. As real estate expands so should the coverage area that CHGY serves. We will surmise that this segment can grow by another 20 to 30% in 2010. The good news for this division is that it seems to be close to contributing to the bottom line. However, we need to gain a better understanding of the cost equation of this business. We assume that the need for the construction of heat transfer plants and piping infrastructure will increase as area coverage expands.

To sum it up, CHGY must find a way to generate consistent EPS growth. Couple this with an enviable monopolistic like market position and investors may be inclined to assign its stock a premium multiple. It may be too early in the game to make a definitive conclusion, but the story is certainly worth following.

Concluding Thoughts:

Like many Chinese firms, CHGY likely loses two weeks worth of revenue during the March quarter. We estimate that CHGY will produce about 167 thousand tons of coal from its direct mining operations during its first quarter (vs. 300 thousand tons in the 2009 fourth quarter) and will produce about 211 thousand tons per quarter for the remainder of 2010 ($32 annually). Our coal trading revenue assumptions have a wide range (from $57 million to $92 million).

The Heat transfer business is seasonal, from October to April. This means that the revenues from the heat transfer group will be strongest in the first quarter and see no revenue in the third quarter. Overall, in 2009 the utility business grew 38.6% to $9.7 million. This growth rate is skewed somewhat as the power plant was shut down for the 2008 Olympics. We will assume a more modest growth rate of 25% for the heating transfer business for 2010 and estimate revenue of close to $12 million with no growth from the electric supply business. But in the end, since the heat power operation does not contribute to profits in will not play a big role in driving EPS.

For a rudimentary EPS forecast we analyzed the cost relationships over the past three years as a predictor of future revenues.

For our first group of EPS estimates we,

• Applied 2009 pre tax margins (minus government subsidies) to consolidated revenues.
• Used a 25% tax rate

For our second group of EPS estimates we,

• Applied 2009 segmented pre tax margins (minus government subsidies) to segmented revenues.
• Used a 25% tax rate  

Adjusting the 2009 fourth quarter for a more normalized coal production would have resulted in EPS of $0.10 vs. $0.11 (minus government subsidies). Annualizing this number, assuming no growth in its business, gives us a full year estimate of $0.40. Of all these scenarios we feel that the 99.5 revenue figure is most plausible with EPS falling in a range of $0.23 to $0.40. If investors choose to apply a P/E multiple of 15 to 25 they would arrive at potential valuation scenario range of $5.70 to $9.50, We will code CHGY as a GeoSpecial on the Radar as we await the first quarter release.

Potential Upside scenarios:

• Accretive acquisition
• Increased quotas
• Heat Power business turns profitable
• Margins Improve due to 2009 mining upgrade program
• Capital restructuring

We were just about to publish this article yesterday afternoon when we noticed that China Energy reported its 2010 first quarter. The company came in with fantastic numbers in its seasonally weakest quarter, giving us some confidence that 2010 EPS may approach the high end of our estimated range.

Please note that:

'As of February 28, 2010 we had a working capital deficit of approximately $15,000,000. We anticipate that the combination of our sales and collection of accounts receivables, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs. However we may require other sources of capital."

Other coal stocks include: Sinocoking Coal & Coke (NASDAQ:SCOK), L&L Energy (NASDAQ:LLEN),Songzai Intl Holdings (OTC BB:SGZH)

Other heat transfers stocks: Smartheat (NASDAQ:HEAT)

On March 2, 2009 we initiated a trading position in China Energy shares in the mid $1.00 area. The company reported it 2009 financial results via a 10K filing:  

There a couple of issues investor should be mindful of that could influence performance and P/E expansion:

• Net-working capital is negative which is reflected in a current ratio that is less than one.  Ideally, investors would probably prefer to see a current ratio of at least 2 to 1. 
• The Debt to equity ratio is 66.0%. Ideally, investors would probably prefer to see this ratio at less than 20%. 

Information we need to digest in order to gain insight into the near term growth potential of China Energy Corp:

China Energy has the rights to operate the LaiYeGou coal mine in Inner Mongolia.

China Energy Corp recently completed a two year infrastructure improvement project to its mine and now has the capacity to produce approximately up to 800,000 metric tons per year by the end of 2010.

"The expansion included the installation of “longwall” mining equipment, the construction of wider laneways for access to the mine and from mine to coal field, construction of seven work stations and emergency exits and improvements to the draught system."

2009 mining operations were temporarily hurt as these improvements were implemented. We found it interesting that  the LaiYe Gou mine has established proven and probable reserves of 26.09 million metric tons.

"China Energy does not expect to encounter further interruptions in its business operations."

It appears that China Energy Corp produced 453,430k metric tons of coal in 2009 of which about 300k metric tons were produced in the fourth quarter. (still need confirmation on this, as this seems large). What we need to know is how fast operations will reach full capacity.

We will provide more details if warranted.  Any input is appreciated.

Maj

Disclosure: Long

2009 10K Excerpts:

• China’s coal industry is growing and its customer base is chronically under-supplied. There are pressures from the government to use clean or alternative energies instead of coal due to environmental concerns; however, coal reserves in China are abundant and less expensive than switching to clean or alternative energies.
  
• Given the increase in demand for coal production for electricity and heating in China, the Central government is encouraging local governments to build more power stations, coking factories, calcium carbide factories and silicon iron factories across the country.
  
• For the Coal Group, we attempt to obtain contracts granted by the government, because in such cases transportation would be guaranteed from LaiYeGou coal mine to the final destination. Where contracts are privately arranged, transportation is arranged through the hire of third party transporters by customers. In some instances, coal is purchased by third parties in close proximity to train stations where transportation to customer destinations is more efficiently arranged. However, transportation to destinations is limited to those for which routes are in place.

• The Coal Group does not have competition in the usual sense of the term that most other businesses experience. Although there are approximately 30,000 coal mining companies throughout China, because demand currently exceeds supply, competition is not a concern in the operation of our business. The electricity and heating supply industry is also growing; however, the government is taking steps to monitor and control economic growth in the rural areas to ensure that the economy is developing at a stable rate.
  
• The NDRC, in its efforts to improve the efficiencies in the coal mining industry, is taking the approach of shutting down smaller mines or any mine which does not meet its specified basic production requirements. The LaiYeGou mine is considered one of the larger mines in the area, and, therefore, we do not believe it will be subject to such potential closure. Our production levels are determined by market demand.
  
• Our business of buying and selling coal on a proprietary basis expanded in 2009 as a result of our receipt of additional quota from the local railway bureau to transport coal by train. We were able to trade more coal as a result of our ability to deliver more coal to trading partners by rail. Quota is awarded by the local railway bureau based on an application prepared by us each year. Parties are awarded additional quota based on their successful use of quota in the previous year. We have received a larger amount of quota for 2010 than we held in 2009; however, our ability to use any or all of this quota in 2010 is not guaranteed and will vary with market conditions, and our ability to source commercially acceptable coal purchases and subsequent trades.
  
• Heat Power has two distinct operations: supplies steam heating directly to end users throughout the XueJiaWan district in Ordos City, Inner Mongolia: and it also supplies electricity through Electric Power Group. Revenues generated by Heat Power were $9,748,301 in 2009 compared to $7,008,528 in 2008. The $2,739,773 change was a result of an increase in sales volume resulting from an over 50% increase in the coverage area of Heat Power’s operations, and a 31% increase in megawatts sold by the electric Power Group. In addition, sales in 2008 were artificially low due to a temporary shutdown of electricity power plant operations for air quality control purposes in connection with the 2008 Beijing Olympics.
  
• We believe that cash flow from collection of accounts receivables, customer deposits and bank and shareholder loans will be sufficient to sustain our working capital needs.

As of August 31, 2009 we had a working capital deficit of $29,009,833. We anticipate that the combination of our sales and collection of accounts receivables, customer deposits and proceeds from bank and shareholder loans will generate sufficient cash flow to sustain our working capital needs. However we may require other sources of capital.

Source: SEC form 10Q (for the fiscal quarter ended August 31, 2009)