Description

Seed:

 

Origin Agritech Limited, I believe, is one of the more interesting, long-term, investment opportunities I’ve come across to date.  Currently trading at a multiple of fiscal 2006 (yr. end Sept. 30) sales of 4.6x and an estimated 2.75x 2007 sales, Origin is conservatively priced based on its growth potential within an industry where acquisition multiples for market leaders have been between 2.9x to 3.3x sales.  As one of the first privately held and now premier, branded, hybrid, seed, companies in China, Origin is positioned to capitalize on this very fragmented, highly profitable, high barrier to entry, regulated market.

 

 To date, Origin represents roughly 2% of a $3+ billion seed market in China, which, as stated by management, makes Origin the largest vertically integrated seed company in China.  With expected revenues (recently reaffirmed by management) for fiscal 2006 of $55 - $60mm and adjusted net income at or above $11mm, Origin currently trades at 3.9x EV/Revenues and 21x EV/NI, respectively.  Although these multiples appear high based on Origin’s expected 2006 performance, sales in 2007 should nearly double based on expected organic growth of 30% - 35% (such an increase is likely, barring any unforeseen events, as Origin has already planted its crop for 2007) and a recent acquisition which should conservatively add between $15mm - $20mm in sales.  Such growth is expected to result in significant profitability for 2007, as the organic growth component is likely to generate margins of 15% - 20%, as it has done historically over the last three years, with growth from Origin’s recent acquisition also contributing to overall profits, but at margins that are less than Origin’s historical range (I’m not sure of the historical margins of the recently acquired company, just that they are less than Origin’s).  Profitability in 2007 should be further enhanced through Origin’s 34% interest in its Changrong joint venture, which currently generates corn seed sales of between $15mm – $20mm per year.  Beyond 2007, I believe Origin will continue to execute on its business strategy, continuing to grow its hybrid business at double digit rates, as well as capitalize on the emerging opportunity of GMO (Genetically Modified Organism) seeds in the Chinese market (more on this later).  

 

 

 

 

Company:

 

Origin Agritech Limited is a vertically integrated, nationally licensed operator engaged in the R&D, production, sale and distribution of hybrid seeds in China.  Primarily focused on corn, rice and cotton seeds, Origin, with its network of over 2500 first level distributors and 50,000 + second level distributors, supplies its product to all but one of the major provinces in China (I believe it’s Tibet). With the size of its core market estimated to be in excess of $3.0 billion, Origin, as the only nationally licensed seed company in China, continues to gain market share as it executes on its branding, service and product development initiatives. 

 

Origin began back in 1990, when its CEO and founder, Dr. Han, started petitioning the Chinese government to establish the first privately held hybrid seed company in China.  After years of soliciting the central government, Dr. Han, in December 1997, was permitted to begin operations, which he did so by licensing hybrid seed technology from the major agricultural universities in China.  Dr. Han’s use of licensed technology enabled Origin to begin its operations with only $400,000 of invested capital, launching its first commercial product beginning in 1998.  Origin has since begun developing its own proprietary seeds and as of calendar year ending 2005 (calendar year ending has since changed to fiscal year ending June 30) had 12 internally developed seeds approved by the Chinese Ministry of Agricultural and in commercial production and distribution.

 

 

Currently, Origin has 46 proprietary seeds in different stages of the regulatory process (usually a 3 year process) with the expectation of introducing between 40 and 50 new seeds per year into the government testing and approval cycle.  Of those seeds introduced, 5 to 8 will be approved following the 3 year regulatory process, which, over a 7 year cycle should result in the circulation of fifty commercially marketable seeds at any one time.  As a result, Origin’s distribution of revenues will gradually change from mostly licensed product today (96%) to mainly proprietary product by 2009 (70%).  With this change, margins should increase as licensing fees are reduced (such fees are nominal in their amounts) and as Origin introduces higher yielding, higher priced seeds into the market – an aspect of the hybrid seed market I find very compelling.

 

The bulk of Origin’s revenues are currently generated from corn seed sales.  When Origin began its operations in 1998 it focused exclusively on the corn market, but has since added cotton and rice as of 2001 and 2004.  Corn and rice seeds represent the largest markets for Origin at approximately $1.6 billion each, with cotton being the smallest at $150 million.    While cotton seeds will remain a small component of Origin’s overall sales due to the size of the market, Origin has specifically stated its goal of becoming 20% of both the rice and corn markets over the next several years, which appears likely as Origin continues to grow its business both organically and through acquisitions. 

 

Recently, Origin completed the acquisition of Denong Zhengcheng Seed Co., one of the largest hybrid rice companies in China, which will conservatively add between $15 - $20 million in sales in 2007.  At a valuation of $6.2 million, paid for in cash and at a multiple of sales of .41x, this accretive acquisition now establishes Origin as a meaningful operator in the hybrid rice market. Moreover, once Denong is fully integrated into Origin, further synergies should be realized as Origin applies its successful business strategy across this newly acquired platform. 

 

Origin, since its inception, has focused on meeting the unique needs of the Chinese farmer.  The elements to Origin’s business strategy that have contributed to its overall success are as follows:

 

• Licensing of key seed technology to build its business, but emphasizing, overtime, the internal development and production of proprietary product as the core revenue component of its business.

 

• Devising an efficient system to effectively deal with the regulatory approval process for bringing new seeds to market.

 

• Having a broad base of farmers (> 60,000) to participate in the seed development process and to produce crop seeds for commercial distribution.

 

•  Development of a distribution system that relies on a small network of primary distributors, one in each county, having exclusive rights to a particular territory.  In each territory, each primary distributor then sets up a base of secondary distributors for broader access to a market comprised roughly of 200 million farms.

 

• A marketing strategy used for branding Origin and its products.  The Company, as part of its strategy, uses print ads, TV advertisements, circulars, etc., to market to farmers.

 

• Customer service is provided to assist farmers during their growing season should they require help.  If a farmer’s problem can’t be resolved through Origin’s centralized call center, a field service representative is dispatched within 48 hours of a farmer’s call for help.

 

Clearly, Origin has been successful in executing its business strategy with growth rates exceeding 35% per year since the launch of its first commercial product in 1998.  Amazingly, such success hasn’t required additional capital over and above Dr. Han’s initial investment of $400,000 and prior to Origin’s reverse merger into a SPAC, to realize such significant growth.  To accomplish this, Origin devised a system whereby distributors are required to pre-pay for 10% - 30% of their projected on order at the expected price charged by the distributor to the retailer, prior to Origin’s harvest.  Following the harvesting and packaging of seeds at Origin’s 5 processing facilities (cost of building out a facility is approximately $4 million), distributors, as they begin to call in their orders, must pay, prior to being shipped, the balance owed on each shipment made at the same price charged when orders were initially placed.  Once a distributor’s open contract has been completely filled, Origin then reimburses the distributor for their mark up, which is set between 20% - 25% of Origin’s wholesale price.  By deferring payment to its distributors, Origin’s system enables it to grow entirely through 0% distributor financing, which is how Origin has been able to achieve high double digit growth rates, historically.

 

 

Competition:    

 

Origin faces competition at several levels, ranging from several large state owned and privately held Chinese seed companies, smaller local seed companies that are extensions of the Chinese bureaucracy and several multinationals focused on both the hybrid and GMO seed market in China.  It’s estimated that 75% of the seed market in China is still controlled by state owned enterprises, while the balance is represented by several, large, privately held companies -- Origin being one of them.  While the state owned enterprises represent the bulk of a very fragmented market (5000 seed companies throughout China’s various municipalities), they are the least of Origin’s concerns as they are inefficient, under funded and likely to be acquired or assumed as further privatization and industry consolidation occurs. 

 

Of the privately held companies, Origin acknowledges that it does face competition from several companies, but believes it’s only to a limited extent.  With its strong balance sheet ($30 million cash, no debt), robust proprietary pipeline of product and expansive, tiered, distribution system, Origin believes, as well as I do, that it is well positioned for continued growth, pointing out that its competition suffers from operational deficiencies that will inhibit their ability to compete effectively in the future, as it has in the past. 

 

[Although I haven’t been able to confirm or verify these operational deficiencies, Origin’s success, historically, and expected, top-notch performance in 2007, support, to some extent, managements view of the competitive landscape.]

 

Multinationals such as Monsanto, Pioneer and Sygenta do have a presence in China, and have had one for a number of years; however, their strategies haven’t resulted in any meaningful share of market.  Combined, as stated by Origin’s management, all three companies in 2005 shipped roughly one million kilograms of corn seed, while Origin shipped approximately fifty million kilograms.  Statements made by Origin’s management help to explain why such a disparity exists.  First, distributing $1 to $5 seed orders to half acre farms in China vs. shipping >$1 million orders to large farms in the U.S., makes for an entirely different distribution dynamic that multinationals appear to have struggled with.  Second, core to the multinationals business are GMO seeds, not hybrids, which, at the moment – with the exception of the BT cotton seed – are not allowed in China.   

 

It’s expected that China will eventually open its seed market to different GMO varieties, adding further competitive pressures to companies in the Chinese market as multinationals have well established products in this space.  However, it should be noted that multinationals intend to move very slowly into this emerging GMO market, due to strong IP piracy concerns.  As such, domestic companies, like Origin, are strategically advantaged as they can begin to build their share of market, largely unencumbered by large multinationals.

 

To date, Origin, with its 34% interest in Biocentury Transgene Co., Ltd. (Origin intends to own 100% of this Company over time), one of China’s leading biotechnology companies focused on developing GMO technology, is well positioned to capitalize on China’s emerging GMO market with several seeds currently under development and one seed – the BT cotton seed -- already being commercially distributed.  Monsanto has the only other BT cotton seed technology approved for commercial distribution in China.     

 

Hybrid Seeds:

 

Hybrid seeds are seeds produced by artificially cross-pollinated plants.  Such seeds are bred to improve the characteristics of the resulting plants, such as increased yield, greater uniformity, improved color, disease resistance, and so forth.  Today, hybrid seeds are predominant in agriculture, and are one of the primary contributing factors for the dramatic increase in agricultural output in the last half of the 20^th century.

 

Prior to the development of hybrid seeds, farmers relied upon the progeny (seeds) of open pollinated crops to plant the following year’s harvest, which thwarted, to a large extent, any opportunity to profit from the sale of seeds, as farmers utilized crop seeds saved from the prior year’s harvest.  This all changed however with the advent of the hybrid.  With the increase in crop yields and need to repurchase seeds on an annual basis due to lost hybrid vigor (yield) in seeds of hybrid crops, a profitable market emerged as farmers were now incentivised to purchase hybrids to benefit from increased crop production, which, in turn, resulted in increased profits as the marginal cost per additional yield was negligible.      

 

 Yield is the cornerstone of a farmer’s ability to profit from its harvest and is why hybrid seeds, even at their additional cost, are the Holy Grail of farming.  It’s important to note, however, that yield diminishes overtime (usually 7 years from its commercial release) as a seed’s resistance to environmental threats (disease, insects, etc.) is reduced due to general life cycle adaptations.  In order to counter such effects and insure that farm yields are always increasing, which is imperative for sustaining adequate food supplies as populations expand and land acreage from commercial development is reduced, the Chinese government mandates that for every new seed released into the market, each new seed must yield at least 8% more than a base seed (generally, the best performing seed within a province) for it to be approved for release.  Once approved, this newly released seed now represents the best yielding product within a specific geographical area and can therefore command a higher selling price.  Such yield enhancements therefore benefit the bottom lines of both seed companies and farmers.  An example will help illustrate this.

 

On average, Origin sells a bag of seeds for $1.  From one bag, the average Chinese farmer makes $1000 USD profit, annually.  When Origin introduces a new seed into the market yielding 8% more than the base seed, a farmer’s profit should increase overtime by $80 – all else being equal – as the farmer incrementally allocates more and more land to this new higher yielding variety.  This, in turn, enables Origin to charge a higher price as any increase levied by the Company would be incremental to the significant increase in profitability realized by the farmer. 

 

Generally, the price charged by Origin for a new seed is adjusted over its commercial life of 7 years, peaking in years three through six, following a gradual three year ramp.  In year seven, Origin either discontinues or scales back significantly a seed’s production and distribution. 

 

To be clear, pricing for seeds is primarily a function of yield, with the economics of supply and demand having some impact but tending to be one sided in its effect.  If demand exceeds supply, pricing for seeds will be positively impacted, as occurred with Origin in 2003, but should supply exceed demand, its unlikely to impact pricing, as farmers will always pay up for yield.  Remember, farming is a subsidized industry in China, as it is in most parts of the world, so farmers can be assured to realize a specific level of income based on their production, which if increased as a result of yield, will only further benefit the farmer.  It can therefore be objectively stated that companies, like Origin, with a sound infrastructure, capable of bringing new seeds to market through their R&D, manufacturing and distribution platforms, will continue to prosper.

 

GMO Seeds:

 

Genetically modified seeds are the latest evolution in seed technology.  While GMO and hybrid seeds are processed in a similar manner, GMO seeds differ in that genetic traits, developed in a laboratory, are manually inserted into the DNA of a seed for further yield enhancement. Once inserted into the DNA, the trait becomes a permanent part of a seed’s genetic makeup (germplasm), which gets reproduced through the traditional hybrid growing process. As a result, the marginal cost of producing a GMO seed is negligible once the development cost is fully absorbed (Monsanto likes to make this point), creating a very profitable business opportunity as prices charged for GMO seeds are significantly higher than that of hybrids.  For example, Monsanto, for its Round Up Ready, Corn Bore and Root Worm products, charges between $4 to $5, $3.50 to $4.50 and $8.50 to $9.50 per half acre for these specific traits, respectively.  This is in addition to the $20 per half acre it charges for its germplasm (a.k.a hybrid seed).  Origin, on the other hand, charges between $1 to $5 for its germplasm per half acre (the disparity in price between China and the U.S. has to do with the currency conversion and general economics of producing in China) and $8 for its Bt cotton seed – its only GMO seed. 

 

Clearly, the economics for GMO seeds are very compelling, representing an enormous opportunity for Origin as the Chinese government begins to lift market restrictions -- as it has done with cotton -- on other seed varieties.  As this occurs, and as the market for GMO seeds evolves, the next stage of seed development will be the stacking of multiple traits per seed, adding another layer of market opportunity to be capitalized on by Origin.

 

                

Government Regulation:

 

The highly regulated, hybrid seed market in China requires two types of licenses: One for production and the other for distribution at the provincial or national level.  While obtaining a production license doesn’t appear to be difficult, a distribution license requires, among other things, specific levels of capital, which at the national level amounts to approximately $3,717,380.  Origin, as stated by management, is believed to be the only nationally licensed distributor in China. 

 

Aside from licensing requirements, the government mandates a strict regulatory process for bringing new seeds to market, particularly at the national level.  The procedure for national examination and approval requires the applicant to:

 

·        Submit the application to the Ministry of Agriculture

 

·        Go through two cycles of monitored production in at least five different locations.  Only seeds with an 8% or higher yield compared to control seeds, ranking in the top six of all other seeds being tested in that cycle can proceed to the second year of testing.

 

·        In the second year, testing must result in one successful cycle of trial production, also in at least five different locations.  If successful, a national examination certificate is granted and a public announcement is made.

 

 

Foreign Ownership Restrictions:

 

Currently in China, foreign entities are restricted from owning more than 49% of hybrid seed companies.  Origin being a British Virgin Island Holding Company falls into this category.  To circumvent this issue and establish control over its three, primary, operating, PRC subsidiaries – Henan Origin, Denong Zhengchen and Chanchung Origin – Origin, through its 100% owned subsidiary, State Harvest, entered into stock consignment agreements with the three primary shareholders of all three PRC subsidiaries – Han Gengchen (Origin’s Chairman and CEO), Yang Yasheng (Origin’s director and COO) and Yuan Liang (Origin’s Vice Chairman).  Each consigned (pledged) their individual equity interests in each subsidiary to State Harvest, indirectly providing Origin with all the rights of ownership other than title.    For further transfer of title to occur, either fully or partially, ownership restrictions must abate or be entirely removed.

 

While Origin’s unique ownership structure of its PRC subsidiaries raises some questions around the enforceability of such agreements in the event of a breach of contract, management’s counsel has indicated that Origin would have recourse if such an event were to occur.  Although the extent of legal recourse in China is difficult to measure, one should note that Origin has set up a separate100% wholly owned subsidiary, Origin Biotechnology, whereby the ownership of all seed technology, whether proprietary or licensed -- held by the PRC subsidiaries -- has been transferred to this entity for further investor protection.  Again, whether Origin can equitably enforce its rights in China remains to be seen, but management, at least, has a large vested interest (37%) in the Company’s success, aligning their interests with that of all shareholders.

 

Valuation:

 

Origin is currently trading at an enterprise value of $275 million and at a multiple of sales and earnings of 4.6x and 25x, respectively, based on recently re-affirmed fiscal year end estimates for 2006.  While these multiples on a trailing twelve month basis appear out of the range of what I would consider a value investment, conservative 2007 estimates indicate otherwise. 

 

For fiscal 2007, I expect Origin to generate $100 million in sales based on the following assumptions: $78 million in organic sales (30% year over year growth rate), plus $15 million in sales from the Denong acquisition, plus $5 million in sales from Origin’s 34% interest in the Changrong joint venture (I realize that this amount won’t reflect in sales, but I’ve included it as part of my projection).  As such, Origin’s current EV/Sales multiple should adjust to 2.75x down from 4.6x. 

 

Margins for 2007, while harder to forecast, should be between 15% - 20% (Origin’s three year historical range), which should persist as Origin continues to bring higher yielding, higher priced product to market.  Using this earnings range, Origin’s EV/E multiple should be between 18x – 14x vs. its trailing twelve month multiple of 25x.

 

 Based on the adjusted multiples, it appears that Origin is undervalued on both a relative and PEG basis, providing a reasonable margin of safety that should limit one’s downside risk.  First, on a relative basis, Origin EV/S ratio of 2.75x falls short of the acquisition multiples paid for top-tiered, state-side seed companies.  Two examples of this are Seminis and Delta & Pine Land.  Seminis, an unprofitable and highly levered company, was purchased by Monsanto in 2005 for about 2.9x EV/S; Delta and Pine Land Co, a well managed and profitable company, is in the process of being acquired by Monsanto for roughly 3.3x EV/S. While both companies are similar to Origin in that each is well positioned within their respective markets, they differ entirely from a growth perspective.

 

Organic growth for Origin continues at high double digit rates (30+%), while growth for Seminis and Delta and Pine Land Co are in the low to mid single digits, as the bulk of their sales come from mature markets -- this is also true for Monsanto and Syngenta.  As such, there’s a divergence between the PEG ratios of Origin and its peer group.  Where Monsanto, Syngenta and Delta and Pine Land Co (Seminis is excluded as it was acquired in 2005) trade at ratios of approximately 1.9x, 1.4x and 4.0x, respectively, Origin trades at a discounted multiple of roughly .71x.  While this discount may be justified in situations where future growth is constrained, Origin’s growth rate per year is likely to exceed 30% through 2009 and beyond, as management is well incentivised and market consolidation is likely to continue.

 

 As part of Origin’s valuation, one needs to fully understand management’s incentive plan, as it is dilutive.  The performance plan enables management to receive an additional 1.5 million shares per year, over the next 3 years, if they’re able to achieve 38% CAGR in earnings through 2009.  This breaks down as follows:

 

·        2007 - $16 million

·        2008 - $21 million

·        2009 - $29 million

 

If achieved, this represents total dilution of 20%, assuming no share repurchases over the next three years (management has already authorized a $10 million share repurchase program).  While this is significant, and likely alarming to many investors, I don’t find it to be entirely unreasonable.  If earnings can be increased at a 38% CAGR over this period, with Origin’s EV/E multiple remaining at its current level of 25x, an investor should realize a compounded annual return of 24%.  Even if Origin’s EV/E falls to 15x, which is unlikely at such high growth rates, a CARR of 6% would likely result.  At such growth rates, I would expect Origin to increase its current market share from 2% to 6% through 2009, with a remaining 14% to be realized, as Origin has a stated goal of achieving a 20% share of market. 

 

Beyond 2009, dilution should adjust to reasonable levels as the current management incentive plan will have expired.  I expect the board to provide additional incentives following the expiration of this plan, but anything approved would be far less dilutive than what’s currently in place, as the original plan was really an earn-out provision enacted at the time of the reverse merger.  So beyond 2009, dilution rates should be reduced significantly, while the bulk of Origin’s expected growth still remains – a formula I am comfortable with.

 

Accounting Issues:

 

Origin has two accounting issues it must currently contend with: Revenue recognition and its fiscal year end audit for 2006.  While its always a concern when accounting issues surface, it should be stressed that there are reasonable explanations for the above items.

 

The issue of revenue recognition has to do primarily with how Origin sells to its distributors.  As was explained earlier, distributors are required to pay for all shipments upfront at the estimated “retail” price charged to the farmer.  Only after a distributor has been shipped its entire on order, following the October to June selling cycle, are they reimbursed by Origin for their share of the profits, based on their average selling price over this period.  Because the final selling price can’t be established until the end of a distributor’s selling cycle, all interim sales made by Origin must be accounted for as deferred revenues, as required by its accounting firm, Deloitte Touche.  As a result, deferred revenues at the end of calendar year 2005 jumped considerably, alarming many investors.

 

Management addressed this issue with Deloitte Touche, arguing that such conservative accounting is unreasonable when the final selling price, set by its distributors, deviates very little from the estimated price established at the start of the selling cycle, which management claims is supportable on an historical basis.  Management further states that when accounting for deferred revenues, they provide for a 5% allowance to capture any possible dilution related to the final selling price and/or returns -- which they believe is very conservative.  As a result of this disagreement, management has since decided to change accounting firms for 2007, and will be using BDO McCable, a BDO International member firm.  Management hasn’t disclosed if this change will alter how revenues are accounted for.

 

 Deloitte Touche is currently working on completing Origin’s delayed 2006 fiscal year end audit.  Much of the delay, it appears, stems from the Denong acquisition made earlier in the year.  Apparently, the hold up is due to indecisiveness on the part of the auditor in deciding which year Denong’s revenues should be recognized in, based on its calendar 2005 results, as Origin is on a fiscal year.  With Origin’s recently re-affirmed guidance for fiscal 2006, it appears that Denong’s revenues will be excluded from Origin’s year end numbers.  With this apparently resolved, Origin has now confirmed that the audit will be completed before the end of December.

 

Conclusion:

 

From a risk/return profile, I believe the investment case for Origin breaks down very simply: The upside opportunity outweighs the downside risk.   To recap:

 

·        Origin at its current enterprise value is trading at 14x – 18x expected 2007 earnings, with an anticipated growth rate in excess of 30%, in a fragmented, yet consolidating, industry, with very favorable economics, not only in China, but globally as well.

 

·         Origin’s core business currently accounts for 2% of the Chinese seed market, increasing to 3% in 2007 and a projected 6% by 2009 – not unreasonable when one considers that only three companies -- Monsanto, Pioneer and Syngenta -- account for most of the seed sales that occur outside of China.    

 

·        Management and shareholders have aligned interests with management owning 37% of Origin’s stock.

 

·        Management is well incentivised to achieve its projections with their rich earn-out plan.

 

There are many more highlights that could be included but these four appear to standout.  Now to recap several of the risks:

 

·        Execution risk is of some concern, but at Origin’s current valuation the downside appears limited.

 

·        Political risk is obviously a concern, but with large foreign investments being made in China’s banking industry -- its most regulated industry -- I’m less concerned with an investment in a hybrid seed company.

 

·        Further accounting risk is of marginal concern, but it still exists.

 

In general, the opportunity to invest in what could potentially be the next Monsanto of China certainly compensates for any of the associated risks one could encounter investing in China, especially at Origin’s discounted valuation.

 

 

Catalyst

Origin Agritech Limited, I believe, is one of the more interesting, long-term, investment opportunities I’ve come across to date. Currently trading at a multiple of fiscal 2006 (yr. end Sept. 30) sales of 4.6x and an estimated 2.75x 2007 sales, Origin is conservatively priced based on its growth potential within an industry where acquisition multiples for market leaders have been between 2.9x to 3.3x sales. As one of the first privately held and now premier, branded, hybrid, seed, companies in China, Origin is positioned to capitalize on this very fragmented, highly profitable, high barrier to entry, regulated market.