China Minzhong (K2N:SI) - WordPress.com · At a last done price of S$0.69, we find China Minzhong Food Corporation Ltd (CMZ) to be very cheaply-valued with 3.15x T12M P/E & 0.65x

China Minzhong (K2N:SI)

Strong business model (but subjected to fraud risk): - High net margins (25-30%) - High ROE (19.5%), ROA (16.7%) & ROCE (20.3%)

But model is subjected to fraud risk: - No dividend payment - Transparency corporate governance & support by key cornerstone

investors to be discounted

Low cash position – new financing by equity or debt soon

Cheap valuation (3.88x T12M P/E & 0.80x P/B)

Executive Summary: At a last done price of S$0.69, we find China Minzhong Food Corporation Ltd (CMZ) to be very cheaply-valued with 3.15x T12M P/E & 0.65x P/B – with further room for plunging share price given current market sentiments. Despite its cheap valuation, CMZ financial figures continue to be impressive – posting high net margins & high ROE. However, a few key financial notes should be highlighted. This includes (1) no dividend being ever paid; (2) support of key cornerstone investors such as Tetrad Ventures (GIC) should be discounted as their cost of investment has been minimal after their vendor sales; (3) 1Q FY12 posted lower cash position which means CMZ might announce new financing via equity or debt.

*CMZ’s historical price performance

Business Model:

Demand driven production strategy: CMZ agricultural production is driven mainly by demand. Prior to cultivation, CMZ receives sales orders from its customers indicating the required product specifications & quantities. Upon its receipt, CMZ will assess the feasibility of fulfilling such a contract. If all is feasible, CMZ’s customers will be required to accept & sign a quotation and sales contract before commencing on the actual cultivation & processing. Such a demand-driven strategy helps CMZ to secure its margins, enhance its production efficiency and minimise unnecessary costs that may be incurred as a result of over production & wastage. Cultivation bases – Own Bases: CMZ’s cultivation bases consist of its Own Bases and its Contract Bases. In FY2011, its Own Bases are located across 7 provinces:

- Fujian, Hubei, Inner Mongolia, Sichuan, Shanghai, Tianjin & Jiangxi

And has an aggregate land area of approximately 85,457 mu (approx. 60 sq km). There are at least 20 species of vegetables being cultivated and these include:

- Champignon mushrooms, black fungus, German chives, capsicums, king oyster mushrooms & Shanghai greens

Champignon mushrooms, Black Fungus, German Chives

Capsicums, King Oyster Mushrooms, Shanghai Greens

CMZ’s production is demand-driven – less prone to sudden volatility and possibility of supply overload CMZ has currently approximately 60 sq km of farmland

As part of its supply chain management, CMZ also sell fresh vegetables produce from its Own Bases to Pre-Processing Agents based on prevailing market prices. The Pre-Processing Agents will sort & wash these fresh vegetables and CMZ may subsequently purchase fresh vegetables from the Pre-Processing Agents as raw materials for its processed vegetables products. Cultivation bases – Contract Bases: CMZ also obtain its raw materials from its Contract Bases & Other Certified Suppliers. These are farmers with their own farmland whom CMZ contract with for the supply of pre-determined harvest based on their requirements. Processing phase: CMZ then process its fresh vegetables at its own facilities. Such processing includes (depending on customers’ requirement):

- Freeze-drying, air-drying, fresh-packing and brining

Such processing techniques allow its processed products to have longer shelf lives & also enable them to be transported over longer distances while retaining its original freshness.

*CMZ's diversified cultivation base

CMZ hedging strategy against food inflation: Generally, CMZ is a beneficiary of food inflation and this is normally enjoyed by the extraordinary profits reaped from its fresh vegetables – despite the prices of its processed vegetables being already contracted before the cultivation season. Contrary, if vegetable prices are to fall, then as far as its working capital allows, CMZ will process the excess fresh vegetables and store them as inventories (which are good for 3 years) & sell them when prices have rebound.

CMZ has diversified cultivation bases to hedge against seasonal & weather effects CMZ is well-hedged against food inflation

*List of cultivation base (as of FY2011 Annual Report)

Farmland leasing model: All agricultural farmland in PRC is owned by the government & individual farmers only possess the farming rights to the farmland they are allocated. CMZ will typically enter into lease agreements for 10 years so as to lock in the lease cost & fully realise the investment made on land improvements on the farmlands (which CMZ will provide). Lease costs are expected be on the rising trend but CMZ has minimal risks from this given that its lease costs have been locked in for its existing farmlands (average of 7 to 8 years remaining till 2018) Farmers are typically given an upfront one-off payment for the lease & be paid monthly wages for the part-time labour they provide on the farmland.

CMZ’s farmland leasing model provides a secured & stable income to the independent farmers

Growth strategies & its time-line:

i. Increasing cultivation capacity: - Local government of Putian City, Fujian Province has separately

reserved 160,000 mu of cultivation farmland suitable for organic cultivation;

- CMZ aims to add 90,000 mu of own cultivation bases by 2013

ii. Increasing processing capacity: - Expansion will be across different processing methods, including air-

drying, freeze-drying & brining; - 2Q FY12: Successfully launched its New Industrial Park (287 mu)

processing facilities in Putian City. (Processing capacity approximately 3 times FY11; achieve full utilisation by FY15)

iii. Product development: - Adding of more higher value-add vegetables (e.g. asparagus, king

oyster mushroom, black fungi) - Cultivation of organic vegetables on a large-scale commercial basis

over the next few years

- King oyster mushroom: 1Q FY11: In the midst of constructing a new king oyster mushroom cultivation facility in Tianjin City. Construction is expected to be completed by end-2011 & will raise cultivation capacity from 4 tons/day to 15 tons/day

- Black fungus: 2Q FY11: expanding its processing capacity in Sichuan to cater to the processing of black fungus. New facilities are expected to be completed by end 2011

- Organic vegetables: 1Q FY11: Started the sales of fresh organic vegetables in 2 major supermarkets in Fujian Province. Aiming to target BCS certification for processed vegetables

CMZ has a series of strong expansion plans to follow up within the next few years

Industry Overview: Industry has seasonality effect: A Kim Eng analyst report mentions that seasonally strong period for CMZ is the November-March period while seasonally weak period is between the months of April & May. Under CMZ’s IPO Prospectus, they did mention that CMZ has a diversified area of cultivation base which allows cultivation of different vegetables throughout the year.

Vegetable industry is definite for long-term bullish growth: Vegetables product, as a food staple, should definitely witness growing demand as global population increases. China, being the world’s top producer of vegetables, will definitely stand to gain from the increase global demand.

Vegetable industry is expected to grow given its food staple nature

Industry Peers: The fresh vegetables produce & processed vegetables industry is highly fragmented with a majority of farms being owned by individual farmers. Most large players in the industry are food processors or distributors who have their own farms, although a few also supplement their source of vegetables from contract farming.

Key features of the industry:

i. Estimated that 99.6% of the market is being dominated by small companies

ii. 9 key public-listed companies above is estimated to capture about 0.398% of the market, while the remaining captures 0.048%

iii. Evidently, there is still much room for CMZ to grow but the vastness of opportunity also questions why no other players are willing to share the profit

iv. Only close comparison of CMZ peers are Chaoda Modern & China Green; the other peers are engaged in agricultural business though in a different business model of CMZ

There is still significant room for CMZ to grow

Details of Competitors: Chaoda Modern Agriculture (Holdings) Limited (0682.HK) - link

- One of the largest fruits & vegetables producers in China - Has 44,282 hectares of farmland at 31 production bases which are

widely spread at 13 provinces in China - Chaoda has recently been accused of faking its financial statements

China Green (Holdings) Limited (0904.HK) - link - A leading green food provider in China supplying a wide range of

agricultural products including fresh produce, processed food to both domestic & international markets, and branded food & beverage products under “China Green” to domestic market in China

- Similar to CMZ, China Green operates a unique vertically integrated business model with complete control of cultivation (seeding, growing, irrigating, fertilizing & harvesting), production (sterilizing, processing and packaging) & logistics (storage & distribution)

- At end of April 2011, China Green had cultivation bases held under long-term leases with a total area of approximately 92,700 mu, supporting a cultivation capacity of around 380,000 tons per year

COFCO Xinjiang Tunhe Co. Ltd (600737.SH) - link - One of the largest tomato processor, one of the largest

manufacturer of apricot puree concentrate in the world and the largest beet sugar manufacturer in China

- 2010 & 2011 see a price decline in tomatoes; mainly due to an oversupply situation

*Similar to other reports (3M FY11 represents Jan to Mar 2011)

Given the fraud-prone nature of the business & recent hype over Chaoda, it is hard to establish a proper comparison to CMZ’s validity in its margins – only Chaoda & China Green are the better comparable peers.

Haitong Food Group Co Ltd (600537.SH) - link

- Mainly produces the “Kaiz” series foodstuff in 7 major categories & over 200 varieties, including quick-frozen vegetable, dehydrated vegetable, canned fruit & vegetable, concentrated juice, conditioned fruit & vegetable, fresh vegetable and preserved fruit & vegetables

Xinjiang Chalkis Co Ltd - link

- A leading processor of tomato & fruits in China - Operates 23 plants spreading over the areas of Xinjiang, Gansu,

Inner Mongolia, Tianjin & France and supplying worldwide customers with full-ranged tomato products and fruits juice concentrate products

- Similar to COFCO Xinjiang Tunhe, poor tomato market sentiment has affected its profitability adversely

Corporate Governance: More transparent company than its peers: Unlike Chaoda Modern & China Green, CMZ is more transparent with its company information such as releasing data on its leased farmland and organising site visit for analysts. New Big-4 auditor hiring: A Kim Eng analyst report mentioned that CMZ will switch to a Big-4 auditor by FY Jun 2013. Added corporate governance to be taken with a pinch of salt: Unfortunately, despite the added effort by CMZ to improve corporate governance, it should still be taken with a pinch of salt as such information disclosure is still unable to be confirmed with 100% authenticity.

CMZ has better corporate governance policy than its peers though that should still be taken with a pinch of salt

Substantial Shareholders: The one distinct difference between CMZ and other agricultural players in the China industry is the significance of CMZ’s key 3rd-party private shareholders. These include:

i. Tetrad Ventures; wholly owned by GIC (Ventures) Pte Ltd, which is in turn wholly owned by Ministry of Finance (Singapore)

ii. CMIA Capital Partners; CMIA is the manager of certain funds and investment vehicles; Lee Chong Min is a director & principal shareholder of CMIA while Anson Wang (Non-Exec Director of CMZ) is a managing partner of CMIA

iii. Olympus Leaf; an investment holding company wholly owned by OCA II Holdings LP; Lee Edan Kietchai (Non-Exec Director of CMZ) is a MD & VP of Olympus Capital Holdings Asia (Parent Company of Olympus Leaf)

iv. FIL Investment Management (“Fidelity HK”) v. OCBC Capital vi. Prudential Asset Management

Sell-off from High Focus International Limited (HFIL): HFIL, an investment company which is collectively owned by a number of funds that are run by boutique fund management CMIA, was initially one of the cornerstone investor of CMZ. However, due to an internal dispute, HFIL is no longer a shareholder of CMZ while CMIA had taken over a portion of the shares. A portion of the others have been sold in open market sale.

Key shareholders still earning large gains: Even at a price of S$0.69 per share, most of the key shareholders are still realising huge gains. This is so because much of their investment costs have already been covered by its vendor sales. As such, we feel that the investment incentives provided by the stakes of such key shareholders should not be applied with too much weightage.

CEO, COO & CTO stakes held under trust of its CFO: Minzhong (BVI) is an investment holding company which is solely owned by its CFO Siek Wei Ting and of which he hold an aggregate 77.78% of the shares on trust for CMZ CEO, Lin Guo Rong (33.34%), COO Wang Da Zhang (22.22%) & CTO Huang Bing Hui (22.22%). As of FY2011, Minzhong (BVI) has 5.36% stake in the company (29.8m shares) Insider stake movement: After Nov 2010 – May 2011 sell down by CMZ private investors, there were insider stake movement by the below parties. Though such movements do indicate a possibility of share price cheapness, appropriate discount should be applied to these indicators considering that (1) the additional amount invested is little & (2) given its holding before such acquisition, it is unsure if its average cost price is high or low.

GIC is still earning huge gains from CMZ investment. Hence, it is unlikely to predict that GIC has vested interest alongside retail investors

Income Statement Analysis:

High gross (40-41%) & net margins (25-30%): Comparing to its similar peers Chaoda & China Green, its margins have been lower though Chaoda has lately been accused of financial fraud.

Expects higher contribution from black fungus & king oyster mushrooms: In tandem with CMZ’s growth strategy, proportion of black fungus and king oyster mushroom sales should increase significantly in FY2012. Black fungus production is expected to increase 2-fold while king oyster mushroom to increase by 3-fold.

Less exposure to FX risk: Despite generating 65% of revenue from export sales, CMZ settles almost 85% of its sales in RMB currency. This is so because a majority of its export sales are sold to export distributors instead of foreign corporations. Given RMB expected appreciation in the future, CMZ is well hedged against such risk. However, a global slowdown may reduce its export sales as a portion of CMZ’s vegetables are premium products and they are not a strict necessity.

CMZ enjoys strong gross & net margins

CMZ does not face significant FX risk

Accounting policy for COGS: CMZ attributes a significant portion of its non-cash charges (depreciation & amortisation) to its COGS. According to its IPO Prospectus:

For processed vegetables production, manufacturing overheads mainly include utility charges, depreciation charges of PP&E, transportation expenses, consumables and other factory related costs.

For fresh vegetables production, cultivation overheads mainly include depreciation charge on land improvement costs, amortisation charges on operating lease prepayments, transportation expenses, utility charges, consumables & other cultivation related costs. Depreciation charges…and amortisation charges…generally form the bulk of our cultivation overheads Though it is common for such an accounting practice, we remain cautious of the possibility of inflating/deflating gross margins merely through the modification of depreciation policies. A comparison with Chaoda & China Green’s non-cash charges policy did not reveal any significant difference. A reasonable deflationary test on CMZ’s non-cash charges has also not inflated CMZ’s margins to Chaoda’s level (which is the benchmark for fraud).

CMZ accounting policy factor non-cash charges into its COGS item

Balance Sheet Analysis:

Significant accounting policies: Definition of certain balance sheet items are as follows:

- Biological assets: Growing crops of CMZ on the cultivation bases & bamboo shoots & trees in a bamboo plantation base. Bamboo shoots & trees under cultivation in the bamboo plantation base are listed as non-current assets. Growing crops on our cultivation bases that are to be harvested within the next 3 to 6 months are listed as current assets

- Other receivables & prepayment: A major portion relates to prepayments which are mainly prepaid land use rights, payments made to contractors for construction of buildings, fixtures & machinery & land improvement on farmlands which have not yet commenced

- Operating lease prepayments: This represents prepayments of long-term leases of cultivation bases & bamboo forest under operating leases

Low cash balances: At 1Q FY12 cash holdings of only RMB97.6m, it is possible that CMZ might need to refinance on either equity or debt. Also given that leased farmlands can’t be used as collateral against bank borrowings, equity or bonds financing might be the next closest possibility.

CMZ currently has a low cash balance which increase the likelihood of them requesting for share placement or bond issues.

Cultivation base expansion: High CAPEX incurred from FY11 onwards was mainly due to cultivation base expansion.

No dividend policy: Based on its IPO Prospectus, CMZ has not declared dividends in the past and they currently do not have a formal dividend policy.

Reasonable net gearing: CMZ is currently at a reasonable net gearing of 6.98%. We believe there is still room for more debt financing. However, it should be noted that leased farmlands are not allowed to be collateralised for debt borrowing. As such, for CMZ to finance its farmland expansion, only equity or bond financing is appropriate.

Healthy cash conversion days: CMZ has healthy cash conversion days of 35 for FY2011. Tis was a significant drop from its 55-65 range for FY08-10.

Reasonable ROE: As CMZ’s farmland expansion can only be financed via equity placement or bond issues, an analysis at its ROE figures will be more appropriate. CMZ has improved their ROE to 19.5% in FY11 as compared to FY10’s 16.0%. 3M FY2012’s ROE of 3.1% is still a little too early to allow any reliable judgement on its FY2012 ROE. However, ROE might take a slight dip given that there is some time lag for its new farmlands to contribute to its earnings.

CMZ has never pay any dividend before

Valuation:

*CMZ’s historical T12M P/E performance

*CMZ’s historical P/B performance

CMZ is at historical low valuation: At last done price of S$0.86 on 21 Dec 2011, CMZ is cheaply valued at 3.88x T12M P/E and 0.80x P/B. Poor sentiments over the validity of S-chips financial figures have caused CMZ shares to plunge earlier. However, a stock rally occurs for CMZ after its latest announcement on its commencement of its new processing facilities. Based on historical valuation, some statistical figures are as follow:

- Average T12M P/E ratio: 7.39 - Median T12M P/E ratio: 8.15 - Average P/B ratio: 1.36 - Median P/B ratio: 1.44

Conclusion:

A better quality S-chip: No doubt, CMZ is definitely a better S-chip company as compared to the others. And at the recent sell-down to 3.88x P/E, CMZ is valued cheaply. Though the nature of the business is vulnerable to fraud threat (as reported by Chaoda report here), the structure of CMZ business has so far proven to be far from being fraud-prone: *though not proven to be significant

- At least some due diligence done by GIC - Reasonable margin compared to Chaoda - Shareholding stake by Chairman is minimal & the notion of having

its CFO as the trust manager for his stake decrease possibility of fraud

However, the biggest risk for CMZ is them not paying out dividends. We believe dividend payment will not be occurring anytime soon. Hence, the lack of dividend payment reduces the significance of CMZ earning cash in its business. We feel CMZ is a good investment if the risk of nil dividends can be stomached.

CMZ is valued significantly below its historical means