Description

Zhongpin, Inc.

Ticker: ZHNP.OB

Price: $9.00

Market Cap: $215 million

Shares Outstanding: 24 million (estimated)

Zhongpin is our favorite U.S.-traded Chinese stock. Zhongpin is a rapidly growing Chinese processor of value-added pork products with a goal of becoming the #1 consumer brand in China for fresh meats. The company’s product line includes over 235 unique meat products, including chilled and frozen pork, pig by-products and prepared meats that are sold both on a wholesale and a retail basis. The company also sells vegetables and fruits, mostly for export.

Zhongin produces chilled and frozen pork products, with a special emphasis on growing its higher value chilled pork category, which is both more profitable and faster growing relative to frozen. Chilled pork, where temperature is maintained between 32 and 39 degrees Fahrenheit, preserves the freshness, quality, and taste of the meat better than frozen, but chilled pork must be consumed within one week of slaughter due to its shorter shelf life. Zhongpin generally sells chilled pork products to customers such as food distributors and supermarkets that are located within a 500 kilometer radius of the processing facility due to the transportation time. Frozen pork products are sold to food and food processing companies, supermarkets, and fast food customers. 

Zhongpin’s history goes back to 1993 when a company called Henan Changge Meat Factory was spun off from a larger state-owned enterprise to become a regional state-owned operator of meat processing plants.  In 1997, the members of today’s executive team purchased Henan Changge Meat Factory from the government in a privatization. In early 2006, Zhongpin went public in the U.S. by way of a reverse merger of a shell company as part of the issuance of $27.6 million worth of Series A convertible stock and warrants. However, it has only been since early 2007 that a reasonably active market for the stock has developed on the OTC bulletin board market after a lengthy registration period.

Zhongpin has rapidly become a market leader for processed and packaged pork products in China. The company’s competitive advantages in this quickly modernizing industry are as follows:

• The company has a vertically-integrated supply chain from farming, processing, and wholesaling to retailing; the company owns and operates the high-margin processing part of the value chain, and controls but does not own the farming or retail ends of the value chain.

• Zhongpin has a wide distribution network that includes some of the largest supermarket chains and restaurant chains in the PRC with the highest product standards, including Lianhua, Carrefour, Metro, McDonalds, and KFC.

• The company has a well established brand name and is investing heavily to continue building the brand.

• Zhongpin has some of the highest quality, ISO 9001 certified state-of-the-art processing plants in China and a comprehensive logistics management infrastructure.

• Zhongpin has an innovative R&D program that is among the largest in its industry in China.

Zhongpin has a unique, branded distribution network that includes “showcase” stores, “network” stores, and supermarket counters that exclusively sell products with the company’s Zhongpin brand. As of 6/30/07 Zhongpin expanded its distribution network to include a total of 2,863 retail outlets.  Zhongpin is also a supplier to 16 large international and domestic fast food companies in the PRC and is the number one supplier of pork to McDonalds in the PRC, which has among the highest quality standards of any restaurant operator in China. The company also sells its products to over 1,500 school cafeterias, factory canteens, army posts, and other customers. Retail sales comprise about 45% of sales, while sales to restaurant operators account for about 27% of sales. Sales to the five largest customers accounted for about 20% of total revenue in 2006. No single customer accounts for as much as 10% of revenue. 

The company owns two slaughterhouses and six processing plants located in the Henan and Helongjiang provinces with a total of nine production lines in order to process and freeze, chill, or package the end products. The Henan location is strategic in the sense that Henan Province has a large number of pig farms and breeders, as well as close proximity to regional railway hubs. Zhongpin specifies the conditions under which the livestock it processes are raised, but does not own any farms or breeders. Zhongpin was awarded an ISO9001 certificate in 2002 and each of the production lines are certified under Good Manufacturing Practice standards. The company owns all of its facilities except for one leased facility (though of course the government owns the land underneath the facilities and ZHNP only holds long-term land use rights). 

Zhongpin exited 2006 with a total of 160,560 metric tons in annual production capacity of chilled and frozen pork, but has been ramping up production at an extraordinary rate. The company constructed a new $14 million production facility in southern Henan Province (Zhumadian), which came online in Q2 ’07 and adds 72,000 metric tonnes /yr capacity (60% chilled and 40% frozen).  In August 2006, the company announced a plan to invest $13.5 million to construct a new facility in northern Henan Province (Anyang), which is expected to come online in Q3 ’07. The Anyang facility will add 63,000 mt/yr of capacity (of which 60% is chilled and 40% frozen). 

The company has also announced plans to invest $14.5M to construct a new 70,000 mt / year (60% chilled, 40% frozen) production facility in western Henan Province (Luoyang) to come online in early 2008, and another $15M to construct a facility in eastern Henan Province (Shangqiu) expected to begin production in mid-‘08 with a total capacity of 80,000 mt/yr (75% chilled and 25% frozen).  Based on current announced expansion schedule and a recent acquisition, Zhongpin’s total production capacity for chilled and frozen pork is anticipated to reach approximately 350k mt/yr and 525k mt/yr at year-end 2007 and 2008, respectively.

One of Zhongpin’s competitive advantages is its strong logistics infrastructure, which is a critical component of the company’s business given the fact that its chilled pork products must get to the retail location and be sold and consumed by the end user within seven days. The company has invested heavily in state-of-the-art warehouse management and inventory control and transportation systems, and owns some 200 temperature-controlled delivery trucks. According to a company IR rep, ZHNP spent over $9 million on logistics investments in the six quarters ending Q1 ’07 alone.

The addressable market opportunity for Zhongpin is simply enormous. The PRC is the largest pork consuming nation in the world, consuming more than 50% of the world’s pork, and China is necessarily the world’s largest pork producer. Pork is the most popular meat in China, comprising about 65% of the total market for animal protein foods in the country.

There are two distinct catalysts that point to massive industry growth for modern, hygienically-processed, frozen, and chilled pork products. The first is the rising demand for meat in China as more people can afford it, and the second is a dramatic shift in how Chinese purchase their meat from traditional “wet markets” to modern retail stores.

Demand for meat in China is in a period of dramatic growth, with per capita meat consumption expected to rise from 49kg in 2004 to 70-80kg by 2010. Per capita meat consumption in urban areas in China is twice the national average, and the population continues to migrate from rural China to the cities in what has been the largest such migration in the history of the world. Finally, the number of “middle class” Chinese, defined as those with annual incomes of at least 40,000 RMB ($5,000 US) numbered about 60 million in 2002, and is expected to climb to at least 160 million by 2010.  

There is an even more important catalyst that we believe will drive demand for Zhongpin’s products. Traditionally, the vast majority of meat sales in China have taken place in what are called “wet markets”, most of which are in open-air or street markets. These markets involve fragmented farmers breeding pigs in unknown conditions, with slaughter typically done manually by the farmers themselves under conditions of poor sanitation and low quality control. The end products are often stored and displayed at room temperature or in the open air for a day or two, and the product often deteriorates in quality and hygiene during the time it is displayed. These wet markets continue to comprise as much as 70-80% market share in China today.

China is about to experience a significant transition as the country modernizes the meat and meat processing industry. As a result of new hygiene regulations introduced by the government in 1995, governmental agencies have recently encouraged the replacement of open air markets by supermarkets and convenience stores, and the market share of wet markets has been in continual decline. The PRC government is actively pursuing a plan for “safe meat” with a goal for raising the proportion of meat prepared through modern automated slaughtering and processing to 70% from the current 30%. The government has supported this initiative with grants, subsidies, financing, preferential tax policies, and other methods to allow Chinese companies to acquire and put into place state of the art technology and equipment in the meat preparation and packing industries. Obviously, large and well-performing companies such as Zhongpin get the bulk of these subsidies. Zhongpin appears to be perfectly positioned to benefit from a massive tailwind as China transitions from the “wet market” to modern supermarket and convenience stores as the preferred venue for buying fresh meat.  

Zhongpin is currently the fourth largest pork processing company in China and the fastest growing. The three larger competitors are Henan Shuanghui (Shineway) Food Co, also of Henan province, China Yurun Food Group Ltd, and People’s Food Holdings Ltd. Having looked at each of these three players, all three trade at multiple premiums to Zhongpin, and none is growing anywhere near as fast. There are of course numerous producers of processed meat products in China, but most of these producers have only one or two production facilities and are limited to selling their products in adjoining areas due to the lack of logistics capabilities. There are no national market leaders in the PRC, as no player yet has the logistic and distribution capabilities to reach the full country. Zhongpin could play the role of consolidator or could itself be bought out by one of the three larger players, either of which should benefit Zhongpin shareholders.

Zhongpin has primarily grown organically in the past, but it expects to also pursue acquisition where opportunities present themselves. In what is sure to be a rapidly consolidating industry, Zhongpin will likely find opportunities for accretive acquisitions. One recent example is the acquisition of a processing facility in Sichuang where ZHNP paid $6.6 million for 45,000 metric tons capacity. Based on reasonable assumptions, we believe that this facility can contribute $2-2.5 million in net income to ZHNP annually, such that the price paid was about 3X earnings.

Zhongpin’s growth is accelerating as a result of the additional investments in capacity and distribution funded by the capital it was able to raise in January of 2006 (prior to that, it was reliant upon bank lines of credit to fund its growth). Revenue almost doubled in 2006 from 2005, to $143.8 million from $73.4 million, after increasing 74% in 2005 and 45% in 2004. So far in the first half of 2007, sales have doubled again, to just short of $120 million. The company recently issued a press release upping 2007 full year revenue guidance to $265 million, which would be full year growth of 84%.

As far as profitability, the meat processing business is obviously a low-margin, somewhat capital intense business. However, Zhongpin has demonstrated a very nice profit profile even during a period where it is rapidly opening new plants and investing heavily in distribution and logistics. Gross profit margins have been around 15% historically. In 2006, gross profit on sales of $143.8 million was $20.6 million. The primary variable effecting gross margin is, as one would expect, the prices for live hogs. During 2004, hog prices rose sharply (up 35% from 2003) which reduced ZHNP gross margins to 14.3%. During 2005 and 2006, hog prices rose by 0.6% and 8%, respectively. Zhongpin can generally pass on price increases to consumers, but on a lagging basis.

Other operating expenses are almost ridiculously low. Total ongoing operating expenses in 2006 were $6.5 million (4.5% of sales), $4.7 million in 2005 (6.3% of sales), and $3.1 million in 2004 (7.1% of sales).  These may trend back towards 6% of sales due to costs associated with being a U.S. listed public company, but they are still low.

It should also be noted that in 2006 Zhongpin had a one-time $8.35 million expense that will not re-cur, which was a “liquidity damage” penalty that was included in its original financing agreement with its securities holders. The penalty was triggered because of a delay in the company’s registration of the shares for re-sale in the U.S. markets, which was partially due to a lengthy delay at the SEC office for virtually all such filings in 2006. Nevertheless, Zhongpin made a cash penalty payment of $1.04 million to the holders of these securities and issued 379,743 shares valued at $2.85 million plus warrants to purchase 884,799 shares of common stock valued at $4.46 million.

Even with the one-time make-good expense in 2006, Zhongpin turned an operating profit of $5.8 million. Absent this charge, operating profits would have been $14.1 million, or 9.8% of sales. The company’s operating margin has historically been very consistent at around 8-10% of sales despite the costs associated with growing the business. In 2005, the company produced $7.5 million in operating profit (10.1% of sales) and in 2004 $3.06 million (7.1% of sales).

Zhongpin paid an effective income tax rate of 4.5% in 2006 and 5.3% in 2005. The tax rate in the PRC in 2006 on income generated from prepared products was 33%, but there is no tax on income generated from sales of raw meat and fruit and vegetable products. According to the company’s CFO, this zero taxation on raw food products is not going away any time soon, and made it clear that though it may not remain indefinitely, it is safe to assume that it will last at least a few more years.

After factoring everything in, reported net income in 2006 was $6.4 million, but would have been about $14 million absent the charge and assuming an un-changed tax rate. Net profit was $5.9 million in 2005 and $2.8 million in 2004. The net profit margins would have been above 9% for 2006, compared to 8.1% in 2005, and 6.5% in 2004. These aren’t just accounting profits, either. Zhongpin generates significant operating cash flow. In 2006, the company generated $9.5 million in operating cash flow despite the significant working capital demands from doubling the size of its business. In 2005, the company generated $13.1 million in OCF.

Zhongpin is spending a lot of money on building new plants and expanding capacity, so FCF is negative at this stage. The company spent $26 million in 2006 on new plant and equipment, $13.2 million in 2005, and $2.5 million in 2004.

At June 30, ZHNP had $41 million in cash and $40 million in debt. ZHNP expects capital expenditures to be $27.5 million for the next year from March 31 2007 to March 31, 2008. ZHNP had a fully diluted share count as of March 31, 2007 of approximately 21 million shares. However, the company expects this to rise to about 24 million shares through warrant exercises. For our purposes, then, we will assume 24 million shares at $9, or a market cap of about $215 million. I will also assume that cap-ex will exceed operating cash flow and warrant proceeds over the next two years by about $10 million and essentially add that on as debt such that effective EV is $225 million or so. This is about 15X the 2006 operating income of $14.7 million (absent the one-time charge for the company’s late registration).

Assuming that ZHNP turns in an operating margin of 8.5% in 2007 on projected sales of $265 million, the company would generate about $22.5 million in normalized operating income. Given the low tax rate, normalized net income would be about $20 million. Thus, ZHNP appears to be trading at less than 12 times this year’s net income on an EV basis. Given the ramp in production between now and 2009, we expect ZHNP to be generating somewhere close to $55 million in operating income on sales of $600-650 million in 2009, implying a multiple on 2009 earnings of about 4 times. That's simply way too cheap for a company of this quality.

Catalyst