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Chaoda Modern (682.HK)
Agriculture Sector
8 Jan. 2009
Photosynthesizing Growth
Chaoda Modern is the largest vegetable producer, best positioned for increasingly favorable agricultural policies in China. It operates 34 production bases in 15 provinces and cities. Land bank of 494,815 mu is strategically spread across a range of north-south latitudes and different altitudes, minimizing weather risks. Land expansion remains the major growth driver. Chaoda currently has only 0.2% market share (by land), indicating huge potential for domestic growth. Over FY04-08, revenue surged at a 28% CAGR and total production-base area at a 29% CAGR. A business model for government and farmers. Chaoda’s integrated business model is highly attractive. What Chaoda brings to the table is in line with government efforts to modernize agriculture and improve farmers’ incomes. The firm beats the nation average yield by 3X. Moreover, Chaoda currently pays farmers wages double the rural average income, already achieving what the government targets for the nation’s rural income earners by 2020. This does not even take into consideration the land premiums Chaoda pays the farmers for the use of their land. Sustained high profitability. Despite paying higher wages, Chaoda booked gross and net margins of 69.4% and 38.9% in FY08. Chaoda achieves high selling prices on its access to market information and ability to supply out-of-season vegetables. Upcoming debt repayments, tight cash flow. Chaoda faces a potential payment of RMB1.4bn, if all CB holders opt for early redemption in May 09, and a repayment of RMB1.5mn of senior notes. This may put pressures on cash flows. Dividend payouts should remain low. DPS was cut to HK￠3.2 in FY08 (FY07: HK￠5.6), for a low yield of 0.6% and payout ratio of only 3.5%. The HK￠2.4 cut in DPS would save the company only c. HK$60m, a minute amount in relation to the debt outstanding and capex plans.
Valuation compelling. The stock has plummeted 56% from its peak of HK$11.90 (May 2008) to a 5.9X FY08 P/E (just 4.8X, excluding non-cash items). In contrast with the current climate of poor earnings visibility, Chaoda’s profits are highly predictable as they are correlated to land expansion. Margins are double those of the HSI, and core EPS is expected to increase 15% next year against the HSI’s decline of 5%. Its historical P/E (excluding non-cash items) of 4.8X is close to a 50% discount to the HSI’s 9.5X. In light of its higher earnings visibility, superior earnings growth and higher margin cushion, the stock should at least trade at par to the market. A valuation in line with the HSI (9.5X P/E) would price the stock at HK$12.49.
Buy, 12-month target price HK$6.97, based on mean 12-month forward P/E since listing in 2000.
Figure 1: Earnings Summary
Year ending 30 Jun FY07 FY08 FY09F FY10F Net profit * – RMBm 1,732.7 1,955.8 2,819.9 3,282.1 Net-profit growth – % 27.6 12.9 44.2 16.4 EPS * – RMB fen 69.3 77.9 116.0 135.0 EPS growth – % 28.1 12.3 48.9 16.4 P/E – X 6.9 6.2 4.1 3.6 DPS – RMB fen 5.3 3.1 3.7 5.6 Dividend yield – % 1.1 0.6 0.8 1.2 BVPS – RMB 3.7 4.4 5.6 6.8 P/B – X 1.3 1.1 0.9 0.7 Operating cash flow per share – RMB fen 44.2 100.2 130.5 158.2 Free cash flow per share – RMB fen (17.0) (5.3) 31.6 59.3 Free-cash-flow yield – % (3.5) (1.1) 6.6 12.3 Net debt per share – RMB fen 62.7 10.2 32.9 (10.6) Net debt/ price – % 13.0 2.1 6.8 (2.2) Issued shares – millions 2,511.9 2,529.1 2,529.1 2,529.1
* Excluding non-cash items
Sources: Bloomberg and Sun Hung Kai Financial
Contents
Key Investment Positives (3)
Defensive sector
Long-term beneficiary of government policies
Win-win business model for government and farmers
What Chaoda brings to the table
Sustainable high profitability
Tight cost controls
Competitive Strengths (9)
Well-known brand, a beneficiary of the food crisis
Competitive against international peers
Competitive against domestic peers, with access to capital
Earnings Outlook (11)
Impressive track record
Land acquisitions remain the key revenue driver
Earnings assumptions
Valuation (13)
Key Risks (15)
Corporate governance
Government policy
Land in northern China
Natural disasters
Product-liability risk
Export/import regulations
Cyclical prices
Fertilizer supply and prices
Debt repayments, tight cash flow
Low dividends
Company Background (17)
Business model
Cost structure
Sales breakdown
Industry Outlook (20)
Financial Statements: Profit and Loss, Balance Sheet and Key Ratios (22)
Investment Highlights (24)
Key Investment Positives
Defensive sector
Vegetable growing is a highly defensive industry. Vegetables are daily necessities and consumption should be largely unaffected by economic performance. There have been no
significant cuts in consumer demand in the past. Vegetable wholesale prices have been rising since 2003, and the area devoted to vegetable production has increased 45% over the past 10 years, while land for grain production has dropped slightly.
Although grain supply may feel the strain from shortages of soybeans and corn, we do not expect this to result in pressure to switch farmland from vegetables to grain, due to:
Lower prices and massive consumption, which underline vegetables as essential staples.
The intensive nature of vegetable production, in terms of both labor and capital.
Vegetables provide more jobs per hectare than grain. Also, land transferred from vegetables to grain not only terminates the benefits from the capital invested, significant investment would be needed to convert this land back to vegetable growing.
Higher yields. If vegetable land is transferred to grain production, output will be cut. Vegetables, like rice, are fully geared to human consumption. Meanwhile, 70% of demand for soybean is for livestock feed and industrial markets.
Long-term beneficiary of government policies
The PRC government is determined to change its current unbalanced fiscal outlay and gradually increase spending on agriculture, farmers and rural areas. It has underlined this in a number of policy announcements, including:
The No. 1 Document in January 2008. The PRC government targeted agricultural infrastructure development as its priority last year. It implemented measures to protect rural areas against natural disasters, ensuring stable agricultural supply and prices.
The third plenary session of the 17th Central Committee, in October 2008. In view of continuing rapid urbanization and the great urban/rural disparity, the government has reiterated rural development as its top priority over the next decade.
Targets to be achieved by 2020 include: 1) integration of the rural and urban economies, 2) speeding up modernization in the sector, 3) doubling rural per capita incomes, 4) improving social infrastructure and social protection in line with urban areas, and 5) developing an environmentally friendly and resource-saving agricultural sector.
Figure 2: Per capita rural incomes are only ? of urban levels
Sources: Prismark and Sun Hung Kai Financial
The recent two-day Central Rural Work Conference . Further emphasis was
placed on preventing a drop in rural household incomes and grain production. “The deepening global financial crisis has directly affected the economic wellbeing of rural areas,” claimed a statement issued following the meeting. “We have to act decisively to prevent a drop in rural household income and grain production.”
According to the National Bureau of Statistics, around 9 million migrant workers have been laid off this year by urban employers in export-dependent coastal areas. Most have returned to their rural hometowns.
To help jobless migrant workers, Beijing has issued a series of measures including providing credit for small rural business start-ups, increasing subsidies for agricultural equipment and earmarking tens of billions of RMB in new funds for infrastructure-upgrade projects in rural areas.
A long-term policy goal to urbanize rural areas and temporary measures such as infrastructure works to employ more rural residents and job training should further accommodate the redundant laborers.
Win-win business model for government and farmers
The government strongly encourages agriculture industrialization and should continue to do so. Industrialization of farming can increase production, curb food-price inflation, increase farmers’ incomes, reduce the urban/rural income disparity, and promote ecological farming.
In view of the government’s ongoing efforts to modernize agriculture and improve farmers’ incomes, polices are highly likely to remain supportive of integrated agriculture companies like Chaoda. Not only do Chaoda’s standardized large-scale farms achieve higher productivity and efficiency, the firm reduces farmers’ risks and provides them with stable, double-the-average incomes.
Moreover, as long as urbanization continues and rural development remains a priority, Chaoda should receive further special treatment. As a “State-Level Dragon Head Agriculture Enterprise”, Chaoda is exempt from income tax and export tariffs (all of its subsidiaries used to also enjoy this tax break; however, those not engaged in qualified agricultural businesses are now subject to normal rates).
This kind of compatibility with the government’s objectives is essential. Chaoda’s land expansion, its major growth driver, relies on negotiating land-rights transfers with village-government-level representatives, to whom Chaoda’s business model is highly attractive.
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(RMB)
What Chaoda brings to the table
For local-government-level representatives:
Chaoda is the biggest and best-known company for China’s agricultural industrialization. As a result, it is currently heavily promoted in rural China.
The firm increases labor productivity to way above the national average. Attributable to industrialized methods of planting and growing, Chaoda achieves an annual yield per mu of 5.59 tons, about 3X China’s average, while averaging 1.5 farm workers per 15 mu of land, compared with the national average of 2.5 workers. (For every 255,000 mu of production land, Chaoda uses 17,000 farm laborers and a similar number of seasonal farmers. Seasonal farmers are assumed to be contracted for a half a year. Meanwhile, the average individual farming plot in China is 6 mu, mostly farmed by 1-2 family members from a household).
Given its large scale, Chaoda’s productivity should keep increasing steadily. Expansion of existing bases can take advantage of existing infrastructure and distribution networks. In the past few years, total production has increased faster than the number of workers employed.
For farmers:
Chaoda provides farmers with stable incomes and a higher standard of living. It pays a premium to farmers for land leases (c. RMB3,000/mu) with terms up to 30 years and monthly rentals of RMB400-500/mu. On top of the land premiums and rentals, farmers employed by Chaoda are also paid wages of RMB300-700 per month, depending on performance. This eliminates farmers’ risks, including poor techniques that lead to meager harvests and a lack of market information leading them to plant crops that are in oversupply.
This effectively gives farmers an annual salary of up to RMB8,400 without considering land fees. Compared with the rural average of RMB4,700 p.a., Chaoda is already paying more or less the government’s target to double nationwide rural income in 12 years. Nonetheless, it is still able to achieve gross margins over 60%.
During the lease term, Chaoda also improves the farmland and spends capex of RMB3,000-130,000/mu to build infrastructure, roads, drainage systems, greenhouses and shelters to improve yields. In the long term, farmers would not only benefit from land improvements but also acquire industrialized-farming techniques.
Possible longer lease agreements
In addition, a recent new land policy allows farmers to lease their contracted farmland or transfer their land-use rights. As a result, Chaoda may be able to extend its lease agreements from 25-30 to 40-50 years. This will help the firm maximize returns from infrastructure capex.
Sustainable high profitability
Since FY04, Chaoda has achieved gross margins of over 66%. It posted a gross margin of 69% and a net margin of 39% in FY08.
Over FY04-08, the ASP has increased at a CAGR of 1.5%. In FY08 it rose 3% to RMB2.53/kg, 70% higher than the industry average (based on a slight discount to vegetable wholesale prices). FY08 sales and net profits (excluding exceptional items) grew 31% to RMB5bn and 40% to RMB2.6bn, respectively.
Margins seem sustainable, as not only are cost controls and tax exemptions still in place, but more importantly Chaoda’s business model ensures high profitability:
Strategic land acquisitions mean Chaoda can supply out-of-season vegetables .
Chaoda’s production bases are strategically located across a range of north-south latitudes and different altitudes, minimizing the risk of natural disasters and ensuring a year-round supply of 20-120 different products for export and the domestic market. By supplying out-of-season vegetables, the firm enjoys significantly higher selling prices, up to 4X-5X higher for green chili peppers, compared with when they are in season. Superior market information . Chaoda’s extensive sales network monitors price
data and reports to a centralized information center. The firm uses this information to guide production schedules and distribution plans for each base. Access to market information is critical. Prices vary dramatically by season and location, and supply and demand is highly localized. Oversupply in one region can cause prices to collapse. Chaoda can provide products to where supply is the lowest, maximizing revenues for highly perishable fresh vegetables. Individual farmers have limited information and product ranges, magnifying their business risks. Largest distribution network . Chaoda’s distribution network covers 15 of China’s
33 provinces and most major cities. The firm’s cold-chain facilities mean it can capitalize on its up-to-date market information and transfer products over long distances to capture high prices.
Figure 3: Chaoda – steady sales growth on climbing ASP and gross margins
Sources: The Company and Sun Hung Kai Financial
1,0002,000
3,000
4,0005,0006,000FY04
FY05FY06
FY07FY08
(RMBm)0
510152025303540
(%)64
6566676869
70FY04
FY05
FY06
FY07FY08
(%)
2.25
2.302.352.402.452.502.55
(RMB per KG of crops)
Tight cost controls
Business model eliminates middlemen. In China there are usually three layers of intermediaries in the supply chain between growers and end customers. Farmers either transport their produce to markets and secure buyers, or sell to traders that sell to local wholesale markets, who in turn sell to large municipal wholesale markets. The produce is then finally purchased by retailers.
Chaoda’s integrated business model eliminates the first two, or sometimes all three layers, and sells directly to large wholesale markets, its own-brand retail outlets, institutional clients and export-trading companies. This minimizes waste, allowing the company to command higher margins.
Figure 4: China’s inefficient and multi-layered supply chain
Sources: The Company and Sun Hung Kai Financial
Figure 5: Chaoda’s distribution network bypasses several layers of intermediaries
Sources: The Company and Sun Hung Kai Financial
Low raw-material costs. Chaoda is highly reliant on fertilizers to achieve high yields. Fertilizers are its largest input cost accounting for 30% of COGS. Because vegetables produce higher yields than most grains and oil seeds, vegetable farmland demands larger amounts and more frequent applications of nutrients such as nitrogen, phosphates and potassium.
Chaoda enjoys long-term supplies of organic fertilizers from its major shareholder’s company at below market prices. The firm should continue to use organic fertilizers given these stable prices. In comparison, synthetic-fertilizer prices have risen 25% in the past year, while prices of major phosphate-, potash- and nitrogen-based fertilizers have risen 76%, 88% and 33% since 2007.
Competitive Strengths
Well-known brand, a beneficiary of the food crisis
Along with other integrated agriculture companies, which can track produce throughout cultivation and distribution and ensure product quality, Chaoda is a beneficiary of the
food crisis. The recent dairy scandal has raised public awareness of food-safety issues. Chaoda should face little negative exposure from its dairy business, which accounts for only a very small percentage of revenue.
Chaoda was selected as a key Olympic supplier due to its ability to supply 117 varieties of high-quality vegetables. At the 2008 Beijing Olympics, it supplied over 50% of the vegetables used, delivering over 3,000 tonnes of vegetables to major venues and hotels where VIPs stayed. A total of 23,000 items in 715 product batches were tested against the food-safety standards set by the Beijing Olympics committee for chemicals pesticides and heavy metals. Tested items achieved a 100% pass rate and were certified by the quality-control center.
This was a good opportunity to show the quality and food-safety benefits that come from the integrated business model and underline the government’s support for Chaoda. The free coverage on national television also boosted Chaoda’s brand, featuring “safe, healthy and green” fruit and vegetables, which caters to the increasing demand for cleaner, safer, higher-quality foods.
Figure 6: Chaoda was a key supplier for the 2008 Beijing Olympics
Sources: The Company and Sun Hung Kai Financial
Competitive against international peers, stable exports
In China, Chaoda enjoys cheap rural labor. Although Chaoda’s standard wage of c. RMB8,000 p.a. is high by industry standards, this is still far below international standards at over a 90% discount to the annual salary of an ordinary agricultural worker in the U.S.
(c. US$15,000 or RMB127,000, according to a U.S. Agriculture Statistical Board publication in November 2000). Since vegetable growing is highly labor intensive,
China-based firms like Chaoda are highly competitive against their global peers.
Meanwhile, we expect export sales to provide steady cash flows to fuel domestic expansion. Despite stricter standards on imported agricultural products set by the Japanese government, Chaoda’s crop exports were unaffected and grew 27% in FY08. The firm is considering expanding exports to Europe and North America.
However, with overseas sales sensitive to potential international trade and political disputes, Chaoda does not intend to increase exports from the current 30% of revenue. We therefore believe domestic sales will be the major revenue driver while export sales provide steady cash flows to fund the domestic business. Unlike for grain, China’s government has at no stage considered regulatory controls on the quantity of vegetable exports.
Competitive against domestic peers, with access to capital
Chaoda is way ahead of its domestic peers and faces little threat from new entrants.
Industrialized vegetable farming is capital intensive. Since land cannot be used as collateral under the prevailing legal framework for land ownership, Chinese banks are not active lenders to the agriculture sector. Chaoda’s access to the capital market sets it ahead of its peers, as this plays vital role in funding.
Leveraging its access to capital, Chaoda has built up land reserves sufficient for 2-3 years of planned production-area growth. Potential peers not only need capital, but face years of lead time to secure individual land leases, build infrastructure for year-round and large-volume supply, and train staff. Chaoda can also leverage its cool-chain storage to transport perishables over long distances.
Earnings Outlook
Impressive track record
Revenue surged at a 28% CAGR over FY04-08, with the total production-base area increasing at a 29% CAGR. Chaoda is now the largest vegetable producer in China, with 33 production bases in 15 provinces, covering 450,000 mu of farmland. Meanwhile, the gross margin has climbed steadily, increasing 2.5 ppts in the past four years to reach 69% in FY08. The yield per mu has remained stable at 5.5-6.7 tons. FY08 sales grew 31% to RMB5bn. This was attributable to an increase in production base and focus on high-value crops. The net profit attributable to shareholders (excluding non-cash items) rose 40% to RMB2.57bn. The gross margin was 69% and net margin 51%.
Figure 7: Chaoda – land expansion to be the major revenue driver
Sources: The Company and Sun Hung Kai Financial
Land acquisitions remain the key revenue driver
China already has among the highest rates of vegetable consumption per capital in the world and should see little growth. In 2006, China accounted for nearly half of global vegetable consumption (based on production output). For FY09, we expect land expansion to remain the major revenue driver for Chaoda.
Although Chaoda is the largest producer, its land bank represents only 0.2% of the market. There is ample room for growth. As long as urbanization continues, we believe its business model and leasing and employment conditions will be attractive. Further land acquisitions should not be difficult.
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Earnings assumptions
Chaoda’s earnings are highly visible and correlated to its land under cultivation. Even so, we conservatively assume a slight drop followed by no growth in ASPs for crops and yield per mu.
Backed by land-bank expansion of 20% p.a. (100,000 mu in FY09 and 120,000 mu in FY10), in line with management guidance, we expect a sales CAGR of 19% over FY08-10, with an EPS CAGR of 16% (excluding exceptional items).
Chaoda’s capex costs are RMB3,000-13,000/mu. Based on FY08 annual yield of 5.59 tons per mu and ASP of RMB2.53/kg, Chaoda makes RMB12,000-13,000/mu. Assuming the higher levels of capex are only needed to develop new bases, Chaoda is quite profitable. We expect profits to further rise as the firm leverages its existing distribution network for its new land acquisitions and expansion of existing bases. We believe demand-side pressure is unlikely and do not see any material changes in the company. We also expect benefits from a small decrease in packaging costs and slowing RMB appreciation. Although we believe profitability can remain stable, we have factored in a conservative 0.2% drop in gross margin p.a over FY08-11. We estimate operating expenses to sales to rise by 0.5-1.0 ppts p.a.
For the year ended 30 June 2008, Chaoda generated RMB2bn cash from operations and ended the year with RMB1.28bn cash and RMB3.6bn debt. This debt comprises RMB2.1bn of convertible bonds (carried at fair value, due in May 2011) and RMB1.5bn in senior notes (due in February 2010). Should all holders opt for early redemption in May 2009, Chaoda would need to repay about RMB1.4bn. With cash on hand of RMB1.2bn and healthy operating cash flow, the firm should be able to repay all its liabilities in the next two years.
However given Chaoda’s capex plan of RMB2.5bn p.a. (RMB2bn for expansion and RMB500m for maintenance) over the next two years and upcoming debt repayments, we forecast the low dividend payout of around 4% to be maintained. To retain cash, Chaoda cut its FY08 DPS to HK$0.032 (FY07: HK$0.056) and issued bonus shares. In the past, Chaoda and its subsidiaries have been exempt from taxes due to its status as a State-Level Agricultural Leading Enterprise. Tax holidays are likely to continue, though tax rates will likely increase. According to the PRC’s new tax law effective 1 Jan. 2008, only Chaoda’s principal subsidiary and others engaged in qualifying agricultural businesses are still entitled to a full exemption from enterprise income tax. All other Chaoda subsidiaries incorporated in the PRC and not engaged in qualifying businesses will be charged 25%.
Figure 8: Chaoda – key indicators and earnings assumptions
FY04 FY05 FY06 FY07 FY08 FY09F FY10F
Total production-base area (mu) 181,027 188,509 278,056 363,656 494,815 594,815 714,815 additions (mu)
25,712
7,482
89,547 85,600 131,159 100,000 120,000
% change 16.6 4.1 47.5 30.8 36.1 20.2 20.2 Weighted-average production area for vegetables (mu) 111,835 150,341 202,269 258,361 346,581 428,267 514,667 additions (Mu)
N/A
38,506 51,928 56,092 88,220 81,686 86,400
% change N/A 34.4 34.5 27.7 34.1 23.6 20.2 Yield per mu for vegetables (tonnes) 5.95 6.11 5.54 5.88 5.59 5.50 5.50ASP (RMB per kg for crops)
2.38 2.37 2.41 2.45 2.53 2.50 2.50
Sources: The Company and Sun Hung Kai Financial
C haoda’s Convertible Bonds
In May 2006, Chaoda issued
HK$1.344m (c. RMB1.4m at the time)of zero-coupon convertible bonds with a maturity date of 8 May 2011. Bond holders have the option to convert on and after 15 May 2006 up to and including 28 April 2011 into ordinary shares of the company at an initial conversion price of HK$6.72. The conversion price has since been adjusted three times.
The first adjustment to HK$6.61 was a result of bonus issues and dividend payments in previous years (December 2007). The second adjustment to HK$5.29 was in accordance to reset mechanisms (November 2008). The most recent adjustment to HK$5.08 was again a result of bonus issues (December 2008).
CB holders have been granted the option of early redemption in May 2009. Should all holders opt for early redemption then, Chaoda would need to repay about RMB1.4bn. Convertible bonds that are not converted into shares will be redeemed at 128.01% of their principal amounts on the maturity date.Source: The Company
Valuation
Chaoda has plummeted 56% from its peak of HK$11.90 on 2 May 2008, and now trades at a 5.9X FY08 P/E. Excluding non-cash items, the historical P/E is just 4.8X.
Based on the firm’s plans to expand its land 20% p.a. over the next two years, we estimate a core-EPS CAGR of 16% over FY08-10. This puts the stock at 4.2X FY09F earnings and 3.6X FY10F earnings, excluding non-cash items.
The DPS cut to HK$0.032 translates into a dividend yield of 0.6%, on a 3.5% payout ratio. In view of the upcoming CB and senior-notes repayments, dividend payouts should remain low.
Nevertheless, we see the current valuation as compelling. The firm faces little or no threat of its suppliers defecting. Chaoda operates land leases of 25-30 years, during which it can book gross margins of over 63%. Nor does it face threat from competitors eating away its market share as it sells its products to wherever prices are the highest. This means that even if earnings do not grow, the payback period would be just 4-5 years.
In contrast with the current climate of poor earnings visibility, Chaoda’s profits are highly predictable as they are highly correlated to land expansion. Chaoda’s profit margins are double those of the HSI, and core EPS is expected to increase 15% next year against the HSI’s decline of 5%. However, its historical P/E (excluding non-cash items) of 5.9X represents close to a 60% discount to the HSI’s historical P/E of 9.5X. In light of its higher earnings visibility, superior earnings growth and higher margin cushion, the stock should at least trade at par to the market.
A valuation in line with the HSI (9.5X P/E) would price the stock at HK$12.49.
Buy, 12-month target price HK$6.97, based on mean 12-month forward P/E of 5.3X since listing in 2000. Currently at 22% discount to this level, but we expect reversion to mean in the next year.
Figure 9: Chaoda – 12-month forward P/E band
Sources: Bloomberg and Sun Hung Kai Financial
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Figure 10: Peer comparison
Code Share price (LC) 3M change (%) YoY change (%) Market cap (HK$m)Dividend
yield (%)
FCF yield (%) FY0 P/E (X) FY1 P/E (X) FY2 P/E
(X) Agriculture operators
Chaoda Modern 682.HK 5.46 (16.9) (27.6) 13,827 0.6 (1.0) 6.2 4.1 3.5
China Green 904.HK 6.12 (1.3) (28.8) 5,410 2.7 8.9 10.0 9.2 7.7
Agriculture processors
China Agri-Industries 606.HK 3.68 (14.4) (41.1) 13,226 0.0 (5.4) 6.5 5.5 6.3 China Starch 3838.HK 0.57 (17.4) (19.0) 1,489 1.4 27.4 5.1 6.4 5.1 Global Bio-Chem 809.HK 1.23 (47.2) (57.6) 2,852 2.3 (28.5) 2.3 3.5 3.6 Global Sweeteners 3889.HK 0.66 (5.7) (63.5) 690 0.0 19.4 3.3 3.1 2.2 Xiwang Sugar 2088.HK 1.15 (30.3) (70.8) 955 13.7 (44.8) 2.1 2.7 2.4
Average 3.5 (6.4) 3.9 4.2 3.9
Fertilizers
China Bluechemical 3983.HK 3.46 (6.5) (44.4) 15,951 2.6 10.2 8.8 8.6 7.7 Sunshine 509.HK 0.19 (22.3) (62.2) 411 5.1 0.0 5.5 N/A N/A Sinofert 297.HK 4.08 16.9 (52.6) 28,588 0.7 (4.3) 19.4 11.9 9.6
Average 2.8 1.9 11.3 10.3 8.6
Gross margin (%) Operating margin (%) Net margin (%) ROAA (%) ROAE (%) FY1 EPS growth (%) FY2 EPS growth (%) Two-year earnings CAGR (%) Net debt to equity (%)
Dividend-payout ratio
(%) Agriculture Operators
Chaoda Modern 69.4 50.8 38.9 14.2 19.2 49.4 18.0 32.8 2.3 3.5 China Green 53.4 37.1 37.2 18.8 24.0 8.9 18.9 13.8 (62.2) 26.6
Agriculture processors
China Agri-Industries 6.9 3.3 3.8 5.9 13.4 121.7 (12.7) 39.1 21.5 0.0 China Starch 19.7 14.4 15.1 20.8 41.7 (36.0) 25.0 (10.6) (31.4) 8.8 Global Bio-Chem 23.5 14.9 13.9 7.9 16.1 (8.4) (3.5) (6.0) 40.4 7.4 Global Sweeteners 21.0 15.3 12.1 11.0 23.7 15.1 44.1 28.8 (29.7) 0.0 Xiwang Sugar 22.5 19.3 17.5 14.5 27.8 (7.6) 11.4 1.5 48.2 35.0 Average 18.7 13.4 12.5 12.0 24.5 17.0 12.9 10.6 9.8 10.2
Fertilizers
China Bluechemical 41.2 33.7 33.4 15.4 19.6 13.9 11.9 12.9 (33.1) 25.5 Sunshine 37.5 22.3 19.9 7.7 9.7 N/A N/A N/A (73.8) 27.2 Sinofert 9.4 6.8 2.3 4.6 10.8 212.6 24.8 97.5 33.0 29.1 Average 29.4 20.9 18.5 9.2 13.4 113.2 18.3 55.2 (24.6) 27.2
Sources: Bloomberg and Sun Hung Kai Financial
Key Risks
Tight cash flow: debt, CB payments total HK$2.9bn, divs low and falling Although Chaoda uses its operating cash flows to finance expansion, it has received
significant funding from convertible bonds and senior notes. This debt comprises
RMB2.1bn of CBs due on 8 May 2011 (carried at fair value) and RMB1.5bn of senior
notes due on 8 Feb. 2010. If all CB holders opt for early redemption in May 2009, the
firm would have to pay about RMB1.4bn.
Chaoda generates healthy operating cash flow, and had net cash of RMB 1.2bn as at 30
June 2008. However, repayment of senior debt and any CB redemption may put
pressure on cash flows. The conversion price for the CBs has been lowered three times,
from HK$6.61 to the current HK$5.08, due to reset mechanism and bonus issue of
shares.
The DPS was cut to HK￠3.2 in FY08 (FY07: HK￠5.6), for a low yield of 0.6% and
payout ratio of only 3.5%. During its interim-results presentation, management
explained the dividend cut was due to planned capex of RMB2.5bn p.a. over the next
two years coupled with upcoming debt repayments. However, the HK￠2.4 cut in DPS
would only save the company around HK$60m, a minute amount in relation to the debt outstanding and capex plans.
How Chaoda is sometimes perceived by investors
Since listing, there has also been an arguable lack of transparency about its non-core investment decisions including an RMB120mn investment in the assets of China
Mining (340.HK) in 2006. Chaoda’s share price was especially volatile when
Chairman Ho sold off 120 million shares at an average price of HK$6.90 in June 2007
and when Chaoda announced a change in auditors to Grant Thornton a week after. The
share price dropped 13% over the week after the sell-down.
Government policy
Although current government policies have created a friendly environment for the agricultural industry, the widespread government subsidies and agricultural programs
could be discontinued.
Chaoda’s taxes have already begun to increase. The FY08 effective tax rate increased
to 1% from 0%. Although Chaoda’s principal subsidiary and others engaged in
qualifying agricultural businesses are still entitled to a full exemption from enterprise
income tax, subsidiaries incorporated in the PRC and not engaged in qualifying businesses will be charged 25%, according to the PRC’s new tax law effective 1 Jan.
2008. This upward trend may recur for land costs.
Chaoda’s ‘State-Level Dragon Head Leading Agriculture Enterprise’ status is reviewed
every two years, with the review up in 2009. Loss of this status may spark a jump in
overall tax rates. However, since Chaoda is a leader in the sector and was the sole
supplier for the Olympics, its status seems secure for now.
Land in northern China
Due to the increase in farmland in northern China, where cultivation periods are limited, the yield per mu fell almost 0.3 ppts in FY08. Although farmland in northern China has lower optimal utilization and efficiency, Chaoda has acquired this land to ensure year-round supply of vegetables.
Natural disasters
Chaoda has no business insurance; so natural disasters or unfavorable climate conditions that damage crops and cattle would hit its business.
Product-liability risk
Although Chaoda places strong emphasis on quality control, liability claims can occur and have a material impact on the firm, as it has no product-liability insurance. Export/import regulations
Food scandals such as the poisoned-milk incident have resulted in Japan (Chaoda’s main export destination) strengthening its import regulations to restrict agriculture products of poor quality. China has responded by strengthening quality controls on exports. This has increased export risks and costs, such as fees for government tests. Cyclical prices
Vegetable prices have risen steadily in the past five years at similar rates to inflation. However, prices are strongly cyclical, rising in winter and peaking in March and April. Price peaks in 2008 were much higher due to the recent severe winter. Going forward, ASPs are unlikely to increase as inflation slows.
Chinese vegetable producers will have to rely on competitive advantages, capturing more market share in this consolidating sector, and long-term brand building for growth.
Fertilizer supply and prices
Chaoda relies on organic fertilizers for its high yields, and profits would be hit if fertilizer prices rise.
The firm sources fertilizers from a company held by Mr. Kwok Ho (the chairman and largest shareholder of Chaoda); however, synthetic-fertilizer prices have risen substantially and may increase pressure on prices for organic fertilizers. Greater demand for organic fertilizers plus increased demand from Chaoda due to rapid expansion may put pressure on its supplier to meet demand. There is no visibility on its supplier’s financial position.
Company Background
Chaoda was established in Fujian province in 1994 and listed in 2000. The firm is the leading producer of vegetables in China. Through its subsidiaries, it produces and distributes vegetables and fruits (92% of FY08 sales, and 90% in FY07), breeds and sells livestock, and sells ancillary food produce.
Chaoda is the largest and the best-positioned player among small-scale producers, operating 34 production bases in 15 provinces and cities, with a land bank of 494,815 mu representing a 0.2% market share. This is strategically spread across a range of north-south latitudes and different altitudes, minimizing the impact of natural disasters. Chaoda enjoys much higher yields and selling prices than its peers due to its integrated business model, industrialized methods and ability to supply out-of-season vegetables. FY08 output was close to 2 million tonnes.
About 30% of crops are exported, mainly to Japan and other Asian countries, with 70% sold domestically. In the domestic market, 64% of crops are sold to wholesale buyers at the provincial and city level and 6% to institutional buyers, including major restaurant chains like McDonalds and KFC, hotels, universities and supermarket chains. Chaoda was also the major supplier of fresh vegetables for the 2008 Beijing Olympic Games. Chaoda is highly competitive, especially compared with China’s generally inefficient farming industry. Backed by its production scale, centralized information system, strong R&D and vertical integration, the firm can bypass middlemen and enjoys low-cost labor and inputs. It has long-term supply arrangements for fertilizers, seeds and plant-growth regulators from an unlisted company controlled by chairman Mr. Kwok Ho.
The firm is certified as a State-Level Dragon Head Agriculture Enterprise and receives special tax treatment.
Figure 11: Chaoda’s Fujian production site
Sources: The Company and Sun Hung Kai Financial
Business model
Chaoda has a business model that provides farmers with a higher standard of living and local governments with higher land and labor productivity. In China, farmers are offered small pieces of farmland on a family basis, which are cultivated on a contract basis. However, their small-scale operations lack technology, making it difficult to grow high-value-added products efficiently. Chaoda’s collects these fragmented small-scale farms and transforms them into standardized large-scale farms, leading to greater efficiency and productivity.
Through village councils that collectively represent the individual farmers, Chaoda signs long-term leases of 25-30 years and pays farmers a premium at about RMB2,000/mu, on top of annual rents of RMB200-500 per mu for the use of their land. Farmers are paid RMB300-700 per month on top of the land premium. These long-term deals mean Chaoda is unaffected by land-price increases and can build the necessary infrastructure. Leases are negotiated with local governments and come under two categories: 1) prepaid time (prepayment plus fixed annual rent), and 2) no prepayment (but higher annual rent). These generally involve payments of RMB2,000/mu and fixed annual rents of RMB200/mu).
The firm then improves the fields and builds infrastructure such as roads, drainage systems, greenhouses and shelters to improve yields, with capex at RMB3,000-13,000/mu. Large-scale and standardized operations make it possible to take advantage of high-quality breeding, harvesting and grading of crops.
Chaoda’s production scale, centralized information system and strong, extensive distribution network have given it a vertically integrated business that bypasses middlemen, selling directly to institutional clients.
Cost structure
Chaoda’s gross margin has hovered at 67%-69% over the past three years. Most of the input costs have been relatively stable.
Figure 12:
Chaoda – COGS breakdown
Sources: The Company and Sun Hung Kai Financial
25%
15%
Land rental 10%
Others
Sales breakdown
Crop sales made up over 99% of FY08 turnover. Chaoda continues to focus on land acquisitions for vegetable farming. We expect this product mix to continue.
Figure 13:
Chaoda – sales by product and distribution channel
Sources: The Company and Sun Hung Kai Financial
Sale of crops
99%
Sale of livestock
1%
30%
Retail buyers
1%
Institutional buyers 6%63%
Industry Outlook
Since 2000, China’s agriculture value has risen at a 7.6% CAGR to over RMB2,000bn. Although the proportion of agriculture in the cumulative value of agriculture, forestry, grazing and fishery has fallen, it remains the largest value contributor at over 50%.
China has among the highest rates of vegetable consumption per capita in the world. By production output, it accounted for nearly half of global vegetable consumption in 2006 and 3% of vegetables traded internationally.
However, the nation’s farming industry remains highly fragmented. Over 250 million farming households form 98% of cultivation. Each household farms 0.1-0.2 ha of land. China uses inefficient traditional farming methods, coupled with an uneconomical supply chain, usually with 3-4 layers of intermediaries between growers and consumers. Farmers either transport their produce to markets and secure buyers, or sell to traders and brokers who aggregate farm produce at farms or regional wholesale markets. The produce is then sold at local wholesale markets and then, finally, to retailers. For vegetable produce, as much as 30% is wasted. Prices are marked up at each point, resulting in higher vegetable prices for consumers. Also, as a developing nation, China has relatively low sanitary standards for agriculture products, and producers are subject to stricter export regulations.
Urbanization remains a very strong trend in China. Urban population growth has tremendously outpaced the overall increase: in the past 30 years, the urban population has tripled to 600 million from 200 million, while the overall populace grew 30% from 1.0 billion to 1.3 billion. McKinsey estimates China’s urban population will reach 1 billion by 2030 and account for 66% of the overall populace. By 2025, China is estimated to have 221 cities with a population of over 1 million (compared with 35 today in Europe). China’s agriculture sector has struggled to meet surging demand. Going forward, the food-supply chain should transform amid government support for companies that enhance productivity and efficiency.
In the No. 1 Document in January 2008, the PRC government targeted agricultural infrastructure development as its priority this year. The third plenary session of the 17th Central Committee in October reiterated rural development as its top priority over the next decade. Targets to be achieved by 2020 include:
Integration of the rural and urban economies.
Speeding up modernization in the sector.
Doubling rural per capita incomes.
Improving social infrastructure and social protection in line with urban areas.
Developing an environmentally friendly and resource-saving agricultural sector.
A recent new land policy allows farmers to lease their contracted farmland or transfer their land-use rights. The PRC government is determined to change its current unbalanced fiscal outlay and gradually increase spending on agriculture, farmers and rural areas
In view of this, integrated agriculture companies that contribute to industrializing China’s agriculture should be the most defensive in this sector. Since they increase productivity and efficiency, they should benefit from government support, especially those firms that reduce farmers’ risks. Integration allows these companies to enjoy more stable input costs and cut out several layers in the distribution chain. With greater economies of scale, they can secure high margins while maintaining price stability. Since rural development has become a priority, Chaoda is strongly supported by the government. As long as China is faced with excess rural labor and urbanization, the firm’s business model will remain attractive.