Description

First Natural Foods Holdings is a Chinese seafood processor that is trading for 4 times earnings and less than 25% of my valuation appraisal.

The company generated 171 million renminbi in operating profits in the twelve months ended June 30, 2005. I expect them to generate 190 million renminbi in operating profits in 2006. If we capitalize these profits at 10 times earnings and add to this result 369 million renminbi of estimated distributable net cash, then the stock is worth 2,269 million renminbi, or 2.07 Hong Kong dollars per share, based on about 1,054 million fully diluted shares outstanding and a 0.96 renminbi-Hong Kong dollar exchange rate. The current stock price: HK 48 cents.

Stated differently, First Natural Foods Holdings (FNFH) reported net income of 126 million renminbi, or 12.3 Hong Kong cents per share, for the twelve months ended 6/30/05. So the stock, at 48 cents, trades for 3.9 times that figure. If you back out the 35 cents of distributable net cash, the stock is selling for 1.1 times earnings.

FNFH pays a 3-cent dividend, so the yield on the shares is 6.3%.

The book value per share is HK 63.1 cents. So the stock is trading at a 24% discount to book value despite a 22% return on that book value (ROE). Cash net of debt is 386 million renminbi, or 36 cents per share.

And, to top it off, this ain’t no loamy cigar butt decomposing in the gutter. This is a fabulous little business that makes tons of money. FNFH generates operating margins of 38-42% and needs only $1 of assets to support $1.60 of sales. Operating return on assets, defined as operating profit as a proportion of assets needed to run the business, runs at 60%. You will find very few companies that earn these kinds of returns.

FNFH processes and freeze-packages seafood for export. Their plants in Fujian Province (on the Straits of Taiwan) and Guangxi Province (near China’s southernmost border) process eel, clams, octopus, flying fish roes, abalone, squid, mussels, and monkfish. Aqua farms supply 80-85% of FNFH’s seafood. About 70% of FNFH’s sales go to Japan and 25% go to the U.S., with the balance mostly to Europe. The Japanese gorge on seafood, eating 7 ounces per capita daily. More than one-third of the world’s seafood exports go to Japan. FNFH has recently expanded its sales base to the EU and China, which should provide some exciting new growth avenues.

Because FNFH is a seafood producer with high standards of quality, and because it carries relatively exotic varieties of seafood that are in high demand, FNFH can charge high prices. They eschew the bigger, more commoditized categories, which I assume would include cod, halibut, and tuna. Another factor in the high margins appears to be the presence of a big arbitrage between seafood harvest prices in China and wholesale prices in Japan and the U.S.

FNFH reports results in renminbi. The shares are listed in Hong Kong, so the stock price is denominated in Hong Kong dollars. Both the renminbi and the Hong Kong dollar are pegged to the US dollar and currently trade at 7.75 and 8.08 to the dollar, respectively. This is a small company, with the equivalent of about $55 million in sales. It was founded in 1995 and went public in February 2002 at HK 73 cents. All company news and financial reports going back to the IPO can be found at the HK Stock Exchange web site, http://www.hkex.com.hk/listedco/listconews/sehk/sehk01.asp ; enter the ticker symbol, 1076.

FNFH has a good growth record. Sales and operating profits have grown 17% per annum from 2001 to 2004. Normalized net profits have grown 15%. Production volumes have grown from 6,600 metric tons to 11,400 metric tons. In 2004, net profits before special items were up 7%, to 122 million renminbi, on a 15% increase in sales, to 434 million renminbi.

FNFH’s growth slowed in the first half of 2005. Revenue was up 2% while operating profits were up 6%. It looks like the main problem was lower than expected supplies from fishermen and aqua farmers, due to the weather. Also, some shipments got pushed into the second half.

There is a “Catch of the Day” element to FNFH’s business, in that the company never really knows for sure what quantities of each type of fish or shellfish will be available from day to day, or semester to semester. The supply from fishermen and aqua farmers is inconsistent. For example, volume in the “Frozen Marine Products” category, which comprises mostly clams and other shellfish, was off 4% in 2004 and 11% in the first half of 2005. Volume in the “Frozen Functional Foods” category, which comprises mostly eel and flying fish roes, was off 20% in 2002.

Fortunately, FNFH has a lower base of fixed costs than I would have expected for this type of business. Volume declines do not have big, disproportionate impacts on profits. In 2004, cost of goods was 236 million renminbi while SG&A was 32 million renminbi. Within cost of goods sold, fully 80% represent purchases of raw materials, a variable cost, while direct labor is just 5% of COGS and factory overhead is 15%.

Results for the latest period, i.e. H2 05, will look like crap. Fortunately, there were temporary factors at work here, so the lousy profit figures aren’t indicative of future results. The Chinese government imposed a nationwide ban on eel exports starting in August 2005, based on concerns about the presence of a fungicide called Malachite Green. Eel is FNFH’s biggest product by far, representing one-third of volume.

The export ban was lifted in November. Management says that shipments have returned to levels before the ban. According to the company, the Chinese regulatory authorities found no Malachite Green in any of FNFH’s products. It’s still not clear to me whether Malachite Green is actually a harmful substance.

The management thinks that the ban (which strikes me as an unnecessarily draconian move) will actually help FNFH because many competitors with low hygiene standards will be driven out of business.

FNFH appears to have excellent standards of hygiene. They’ve been inspected by China’s State Administration for Entry-Exit Inspection and Quarantine, by NSF Cook & Thurber, an Ann Arbor-based food-quality auditor commissioned by Sysco; and the US FDA, using its Hazard Analysis and Critical Control Point standards. FNFH is the first food processor in Fujian Province to achieve EU registration.

FNFH sells to major distributors worldwide, including Maruha, Oceanfresh, Pacific Trading, KDM, and Great Asia Japanese Food Co. in Japan; and Sysco and Panapesca in the U.S.

FNFH did a singularly addlepated thing in March 2003, a year after the IPO. As part of a private bond issue, they issued warrants that can be converted into an unfixed and potentially very high number of new shares. Along with other adjustment mechanisms (e.g., from dividend payments), the warrants’ exercise price adjusts downward if the stock price sinks to new lows. The number of shares issuable on exercise of the warrants is calculated by dividing a fixed principal amount by the (variable) exercise price. An amazingly dumb move. FNFH allowed this clause because they thought this was necessary to broaden their shareholder base. All aboard the runaway warrants express!

To top it off, they paid a whopping 11% underwriting commission on the bond + warrant issue. Sheesh. Doesn’t make a 2.5% coupon look so cheap, does it?

There are currently US $3.55 million bonds outstanding, equivalent to about HK $27.5 million. The exercise price has been adjusted downward to 31 HK cents as of December 2005. So the number of shares currently issuable on exercise of the warrants is HK $27.5 million divided by 0.31, or 88.7 million shares. FNFH has 918 million basic shares outstanding.

If the stock price goes below 31 cents, then the exercise price will be adjusted to that new level, and the shares issuable increase proportionately.

Determining how many fully diluted shares will ultimately be outstanding is thus a tricky exercise. As Ben Graham said, when in doubt, be conservative, so I’m assuming for the time being that the ultimate exercise price will be 20 cents. The warrants expire in April 2008. I would think that the warrant holders would wait until 2008 before exercising, at which point the exercise price would have been adjusted down by at least 9 cents of cumulative dividends, to 22 cents.

At 20 cents, 138 million shares would be issuable, or 103 million fully diluted shares under the treasury stock method and an assumed repurchase price of 80 cents. I’m using 1,054 million fully diluted shares outstanding after factoring in unexercised stock options.

Obviously, external financing and capital allocation haven’t exactly been management’s strong suit. The management has been overly eager to expand their shareholder base. Instead they come off as a bunch of rubes. They clearly didn’t understand how ridiculously disadvantageous this deal was for shareholders.

I can live with the mistake because the CFO has told me that they have learned their lesson and won’t do a deal like this again. The warrants will be exercised, the management will take their lumps, and they’ll move on.

It’s bizarre that a company with this much cash on hand and this much cash flow (at least 100m renminbi of FCF per year) should be raising money from outside. Maybe it’s a cultural thing. FNFH has a revenue base of more than 400 million renminbi, with almost 400 million of net cash, yet they don’t buy back stock and actually did a secondary offering of 80 million shares in 2004. The chairman, who is also the de facto CEO, owns 369 million shares. So the dilutive moves hurt the instigator of the dilutive moves more than anybody else. Go figure.

Value Partners Ltd owns 64.9 million shares. The head of Value Partners, Cheah Cheng Hye, is considered the dean of value investors in Hong Kong. Like me, he’s dressed down the management for the warrant debacle.

FNFH carries extraordinarily low inventories for an industrial company. They ended 2004 with just 43 days’ worth of inventory. This was up from 28 days in 2003 and 19 days in 2002. At years’ end 2001 and 2002, they had only RMB 10 million of inventory, supporting RMB 340 million of sales! Either they’re zipping the goods onto the boats as fast as they can after processing, or else there’s something fishy going on (pun intended) and their inventories (and thus operating expenses) are understated.

I’ve put in a call to the auditor (who’s given FNFH a clean opinion), to ask the lead accountant how extensively he tested the cash and inventory balances. I don’t think that the management can fake the inventories, which are accounted for using average cost, without also faking the cash balances. I will need clearance from FNFH before getting more specific information, but, speaking in general terms about how he performs audits, the lead auditor described extensive procedures for verifying cash balances.

My current theory is that freshness is the priority and FNFH wants to deliver the goods to the customer as quickly as possible. More than 95% of inventories are finished goods. I did a quick check on U.S. Packaged Foods companies in Compustat and found that the median inventory level among those companies was 55 days, which isn’t too far off from the level at FNFH.

FNFH’s trade payables are even punier than inventory, at 3.1 million renminbi as of 6/30/05. Fishermen and aqua farmers in Fujian and Guangxi provinces are, quaintly, unwilling to sell their product to anyone on credit. That’s why I assume that not all of FNFH’s cash is distributable as a dividend, and that 17m renminbi in cash is needed on hand for purchases.

The bigger risks I intend to keep an eye on are that of over-fishing in FNFH’s areas, which would ultimately lead to shortages, and the risk of industry oversupply either at the supply end or the processing end, which would drive down prices and margins. (Cf. Nantembo’s excellent writeup on Cermaq for VIC.) Since 2001, FNFH’s indicated price realizations have been stable in shellfish at about $1.55 per pound. Meanwhile, indicated prices in “Frozen Functional Food Products” have risen from $3.42 in 2001 to $4.34 in 2004. But I think that this merely shows a shift in mix to higher-priced foods within the category.

I really like this stock, especially the breathtakingly cheap valuation. I mean, the stub (if they paid out the cash) trades at 13 cents, and it’s EARNING 12 cents. (Interest income is de minimus, in case you’re wondering.) The 75% discount to appraised value should be enough of a cushion to protect against the sundry risks mentioned above. This stock could easily quadruple in order to get to fair value. If FNFH goes back to growing at 15-20% per year, which seems very possible to me, then the intrinsic value could grow to HK $4.50 in five years’ time, and the stock could go up nine-fold from here.

I really like this stock.

Catalyst

Earnings growth
Possible early resolution of warrants issue