Chaoda is one mainland China’s leading integrated producer of agricultural products.  It is the market leader in vegetables (80% of company sales) despite a market share of less than 0.5%.  Nonetheless, over the last ten years, Chaoda has reached a level of scale and efficiency that gives it substantial and well protected competitive advantages.  The company has successfully and consistently translated these advantages into strong cash flow growth and there is little reason to doubt their ability to continue to execute on the business plan.  The company, which is listed in Hong Kong, should be able to continue to grow earnings at over 20% per year by executing the same business plan it has employed for the last 10 years within this highly fragmented market.  Despite that, the stock trades at 9x and 8x what I believe to be conservative estimates of 2007 and 2008 net income, respectively, and as such represents a compelling opportunity for long-term oriented investors. 

 

 

The gross output value and the yield of the agriculture industry in China have each grown at approximately 6% per year for the last 10 years.  So unlike the staggering growth in China of certain discretionary consumer goods and services, this more modest rate reflects population growth plus some upgrade in diet from grains to proteins and more fruits and vegetables.  The point is that the narrowing of the per capita spending gap between China and more developed economies, a feature of so many China stock ideas, is not a key driver here.  As I will cover in the business model section, this is a roll-up opportunity within a highly inefficient and fragmented market.

 

The supply/demand picture when looking at the vegetable market as a whole, as opposed to individual products, is quite stable.  Demand is expected to continue to grow at a mid-single digit clip while supply growth keeps pace predominately through productivity gains on farmland that is already in production.  As I will discuss, these gains come largely from companies like Chaoda slowly subsuming and then improving poorly operated family farms.  As evidence of the relatively stable price environment, the average selling prices in RBM per kilogram of all of Chaoda’s crops are shown below. Granted this masks any dramatic swings that may take place within a year, certain type of vegetable or between different end markets.

 

FYE 6/03                2.28 RMB/Kg

FYE 6/04                2.38

FYE 6/05                2.37

FYE 6/06                2.41

6-Mo 12/06            2.44

 

What makes the industry backdrop interesting is its staggering inefficiency.  The business of growing crops is highly capital intensive, more so for Chaoda’s core vegetable and fruit markets, and less so for the less profitable rice and wheat markets favored by small farmers.  Due to the significant capital requirements and the fact that it is generally all equity financed for small farmers, many farmers lack sufficient scale to earn a return on their investment of human and physical capital.  They generally grow a small number of crops and are therefore exposed to higher pricing volatility and weather-related impact on yields.  Even for those able to alternate plantings, they lack the market information and the storage and distribution infrastructure to capitalize on pricing-related opportunities.  Simply put, this is a scale driven business and one in which improvements in growing techniques, while incremental and slow to show results, lead insurmountable advantages for the larger and more advanced growers.

 

The upshot is that the estimated 200 million small farmers that make up the majority of the agriculture output in the PRC are working with farms that average less than one hectare (approximately 2.5 acres).  This inefficiency results in low and highly volatile income and thus the migratory stampede from the farms to the cities.  As I will detail further, this helps create the opportunity for Chaoda to assemble large tracts of land.  The government is well aware of the problems for small farmers and has enacted many policies to try and improve income levels.  Rather than flooding the market with subsidies, the state envisions a highly efficient agricultural industry where productivity gains allow for income levels to rise naturally.  Textbook example of the “Invisible Hand” at work.

 

 

Chaoda stands to benefit from this capitalistic transformation of the farming sector.  Its business model is quite simple.  The company negotiated with local governments to lease land owned by small local farmers.  The local officials, Chaoda and interested small farmers reach an agreement and sign a lease that is generally 20 to 30 years.  According to the company, the current average lease term across all of its acreage is over 20 years.  Lease terms involve an upfront prepayment, which is capitalized and amortized, as a show of good faith and creditworthiness and then ongoing rent payments

 

Chaoda then begins a multi-year investment in the land which ranges from irrigation and crop shelters to flattening the land and even building access roads.  The company often hires the farmers either full time or on a seasonal basis.  Chaoda’s system-wide efficiency allows them to offer the farmer the opportunity to earn a higher and more stable income.  This is, in effect, why both the local and federal government support Chaoda’s business model.

 

At the federal level, the most telling indication of this support is that Chaoda is one of a few hundred companies certified as a “State-Level Dragon Head Leading Enterprise”.  This is more than a plaque on the wall.  In fact, they pay no income taxes.  They aren’t the only company in their industry to have earned this distinction though I don’t know how many others have qualified.  This certification is evaluated and renewed every two years and the company just finished its latest renewal in early 2007.

 

At the local level, the evidence of governmental support and the sustainability of the business model is simply that Chaoda continues to strike deals with local governments to lease additional land.  The company currently has 21,000 hectares of productive land and another 15,000 hectares of land that has been leased but is not yet in production.  Management’s goal is to double its land holdings in the three years from 2006 to 2008.  As of my last conversation with them shortly before this posting, they indicated they are on track to meet this goal.  Remember that they have less than 1% market share and there are 250 million family farmers so there is plenty of room to reach this goal and set new ones that are similarly aggressive.  Another way to look at the land bank is that according to management, the 15,000 hectares in reserve will permit at least two years of sales growth in line with the 25% growth the company has achieved over the last several years.  The figures below represent the weighted average productive hectares for vegetables (81% of sales), i.e. excluding fruit (12%), rice (6%) and livestock (1%).  The CAGR works out to 27%.  To put the figures in perspective, the estimated total acreage dedicated to vegetable farming in the PRC is over 18mm hectares, so Chaoda hasn’t even scratched the surface.

 

FYE 6/03                6,512 hectares

FYE 6/04                7,456

FYE 6/05                10,023

FYE 6/06                13,485

6-Mo 12/06            17,134

 

On a channel basis, sales to wholesalers are 64%, exports account for 30% and the balance is sold directly to large buyers.  Note that the export channel serves Japan, Korea, Russia and other regional neighbors and caters to the demand for more specialized, higher end products, many of which are organic.  By virtue of its scale and investment in information technology, the company can largely bypass smaller intermediaries, reduce time to market, and there for maximize profit.  Geographically, the business is organized into 29 production bases that include farming acreage and related processing, storage and distribution assets.  Chaoda’s operations are spread across 14 provinces with the vast majority in eastern China, which puts its products in closer proximity to the major cities.

 

 

The company has 2.43 billion fully diluted shares outstanding.  At the recent price of $6.2 HKD, the equity market cap is $14.3bn HKD (about USD$1.8bn) .  Debt is $3.2bn, $1.3bn of which is a convertible bond maturing in 2011 with a $6.72 strike.  Cash is $1.9bn so net debt including the convert is $1.3bn.  Total enterprise value is therefore $15.6bn HKD. Since the financials are reported in RMB, I will convert from HKD to RMB, which results in an equity market cap of 14.5bn RMB and an enterprise value of 15.8bn RMB.

 

In the table below, I’ve laid out a brief summary of the financial results.  Their fiscal year ends in June, the company reports each semi-annual period, and the most recent results are through December 2006.  Management said to expect the results for the six months ended June 2007 in the next two weeks.

 

 

mm RMB	FYE 6/03	FYE 6/04	FYE 6/05	FYE 6/06	6-Months 12/05	6-Months 12/06	LTM 12/06	Est CYE 12/07	Est CYE 12/08
Sales	1,485	1,862	2,238	2,798	1,286	1,697	3,209	3,851	4,621
YOY Growth	--	25%	20%	25%	NM	32%	NM	20%	20%
EBITDA	691	955	1,221	1,509	731	879	1,657	1,792	2,150
YOY Growth	--	38%	28%	24%	NM	20%	NM	19%	20%
Margin	47%	51%	55%	54%	57%	52%	52%	47%	47%
Multiple	--	16.5x	12.9x	10.5x	NM	NM	9.5x	8.8x	7.3x
Net Income	668	891	1,122	1,210	563	761	1,408	1,617	1,848
YOY Growth	--	33%	26%	8%	NM	NM	NM	34%	14%
Margin	45%	48%	50%	43%	44%	45%	44%	42%	40%
Multiple	--	16.3x	12.9x	12.0x	NM	NM	10.3x	9.0x	7.9x

 

 

Two adjustments worth mentioning: 1) I have excluded the impact of non-cash gains and losses from changes in the fair value estimates of the convertible bond and the biological assets, 2) in the calculation of EBITDA I do not add back the amortization of the prepayment made on new land leases as this is a true economic and cash cost of doing business.

 

The growth rates have been discussed and are fairly straightforward as the company is basically amassing enough acreage to grow its productive capacity (and then some) and spending the CAPEX necessary to bring that acreage into production for an indefinite amount of time.  Not to beat a dead horse, but one additional, and relatively simplistic way to get at this issue is to note that Chaoda’s sales volume has growth by approximately 30% per year since its IPO in 2000, 5 times the 6% annual growth in the overall PRC vegetable market.   The sales growth has mirrored the growth in total sales volume of crops indicating that pricing (inflation) has not been the driver of the company’s growth.

 

Margins warrant some discussion.  One of my biggest concerns remains the sustainability of their margins and at first glance my reaction was that there must be something shady going on for a vegetable grower to have EBITDA margins over 50%.  So how long will it take for other well capitalized, professionally managed companies to replicate the business model and erode the industry margins?  Of course I don’t know.  However I’m comfortable with the sustainability due to the following key barriers to entry:

 

1)       Large undeveloped land bank

2)       Difficulty and complexity of negotiating leases of new acreage from small farmers

3)       Large upfront CAPEX required to bring leased acreage to full scale production

4)       Established reputation and track record with federal and local government

5)       Highly developed distribution network with centralized production planning

 

Further to the margin issue, it is important to look at them in the context of ROA given the capital intensive nature of the business.  Chaoda’s ROA, adjusted for the non-cash gains/losses mentioned above, has hovered in the low to mid teens for the last several years and was 13% for the latest 12 months.   This is certainly an attractive rate of return, especially on a risk-adjusted basis given that they can safely assume their crops will grow.  However, it isn’t as jaw dropping as the margins and ultimately it is the economics as defined by ROA that will entice or dissuade competition.  It is important to note, however, that the ROA is depressed by the high initial growth CAPEX from adding land, including the significant upfront lease prepayments.  Should the company stop growing its asset base and incurring the initial lease payments the ROA would rise substantially.  Another way to think about the margins versus ROA is within the DuPont framework (yes I know that this is typically calculated as ROE not ROA).  The margins are high but the asset turnover, due to the capital intensive nature of the business, is low.

 

Lastly with respect to margins, the crop production cost breakdown for fiscal year 2006 is shown below.  Clearly there is exposure to labor, fertilizer and infrastructure construction and maintenance cost inflation.  I take some degree of comfort in the fact that the cost breakdown is fairly well diversified as opposed to dominated by any one component.  Labor would be of particular concern given the aforementioned flight from the country to the cities and its potential impact on farming wages.  Also, there would likely be a correlation between inflation of the selling price of the company’s output and its cost of goods.  Regardless, there is obviously plenty of operating room in margin to absorb some erosion.

 

Fertilizer    31%

Labor                        24

Other                         19

D&A                         16

Land Rental              10           

Total                       100%

 

As far as the projections for the calendar years ending 12/07 and 12/08 I used low end of the historic sales growth rates and modestly lower margins.  Management generally confirmed the reasonableness of my assumptions though they do not give guidance per se.  For whatever it is worth, my estimated are below those from Evolution Securities and J.P. Morgan, which covers the bonds.

 

As this is a VIC write-up after all, I should mention free cash flow.  It is negative.  In the fiscal year ended June 2006, total CAPEX was 1.8bn HKD versus EBITDA of 1.5bn.  Slightly less than half of this was for the prepaid premium component for land leases.  I consider this to be growth CAPEX.  Slightly more than half is for infrastructure.  It is not clear to me what portion of this spending is for routine maintenance of existing facilities such as greenhouses and roads and what portion is for new PP&E though the company indicated that the cost of maintaining existing facilities is relatively low.  Regardless, the company has ample operating cash flow and balance sheet capacity to fund its growth CAPEX without needing equity or debt financing.

 

The multiples speak for themselves in my opinion.  If you believe in the business model and the barriers to entry as well as the growth rates, then 9x estimated 2007 earnings is a bargain.  Note that the narrow gap between EBITDA and P/E multiples  are due to the fact that the company has little by way of net interest expense and, as addressed above, pays no income taxes.

 

 

In mid-July, China executed the former head of their food and drug safety administration for taking bribes and dereliction of duty amid a series of food and drug safety scandals.  The government pledged to improve its food regulation as both domestic and foreign importers expressed outrage with the prevalence of and response to the tainted items including pet food, seafood and ginger.  Chaoda’s CFO Jerry Lu had the following comment in an interview with Bloomberg regarding the proposed changes in safety standards:

 

“We actually welcome this because it helps consumers and it helps companies like us, which are trying to deliver to consumers what they want.  It is more obvious for our consumers who they should go to when such problems erupt.”

 

“Chaoda’s size and financial resources let the company track all its produce and provide consistent monitoring so that problems can be traced back to the box, growing area, person who picked it, and the materials used.”

Mr. Jerry Lu, CFO
[with some paraphrasing likely from Bloomberg reporter]

 

I haven’t seen the tracking systems and the regulatory changes have not yet been clearly defined.  Also, this is clearly a biased view given that it comes from the company.  As such, I’ll let the quotes speak for themselves rather than opine as to whether the more stringent safety standards will help or hurt Chaoda’s business.

 

 

First an important caveat.  I have not met management in person or seen the company’s operations.  I’ve spoken with them at length but haven’t had the chance to look them in the eye so to say.  I’d be very interested to hear from anyone who has spent time with them.  They said that they are in the U.S. twice a year and have more of their foreign investor base here than anywhere else.

 

There is a corporate governance overhang in the stock to be sure.  In June, the company’s Chairman and 22% stockholder sold approximately 18% of his holding at roughly $6.90 HKD per share in order to make “personal investments”.  That’s never a good sign of course, though he does continue to maintain holdings worth over $400mm USD.  To make matters worse, the stock sale preceded an announcement by the company that they were changing auditors for the second time since 2003.  Mr. Ho gave some fairly lame excuses for the timing of the share sale and the stock was punished mercilessly, down 30% in a little over a week.

 

The new auditor is Grant Thornton, obviously a reputable firm, and the old auditor, Baker Tilly, had no disagreement with accounting practices.  Management, which seemed more embarrassed than defiant with respect to the share sale debacle, intimated that the auditor change had to do with a fee dispute.  The nature of the firing was confirmed by J.P. Morgan’s Asian credit research team (incidentally they like the 7.75% bonds due in 2010). 

 

 

 

1)       Competitive pressures erode margins despite significant barriers to entry and extreme industry fragmentation

2)       Corporate governance concerns

3)       Labor cost inflation outstrips  food price increases

4)       More government regulation of the agricultural  sector may increase costs

5)       Relatively illiquid

6)       Natural disaster or contamination (mitigated by geographic and product diversification)

7)       Loss of tax exempt status