David Riedel of Riedel Research Group recently published a report on New Dragon Asia (NWD), a leading manufacturer and distributor of flour, instant noodles and soybean products in China. The company has established strong brand identity and an extensive distribution network on a nationwide basis. Riedel believes that NWD's current low stock price makes the company a good future investment value.
As incomes in both rural and urban China increase, demand for better quality food products such as wheat flour and instant noodles also increase. Thus, management’s strategy to aggressively expanding its production capacity and vertically integrate its business through acquisitions of a noodle factory in Chengdu, a soybean product factory, a distribution company and a packaging company in the past year should provide a strong base for accelerating revenue and earnings growth in the coming few years. Meanwhile, the somewhat unexpected loss in the first quarter of FY2006 due to non-recurring, non-cash expense items has dampened sentiment in the stock and caused price weakness.
However, this should be considered an opportunity to buy the stock at lower levels. Based on our earnings projection and peer comparison, the stock appears attractive on the basis of forecast 2007 P/E and price-to-book ratio. Assuming a 10% discount to the estimated 2007 P/E for its close peers, Tingyi and Uni-President, we expect a price target of $2.30 for the stock over the coming 12-months. With over 50% upside potential, we rate the stock a BUY.
New Dragon Asia Corp., a Florida corporation, is headquartered in Shangdong Province, China and is engaged in the milling, sale and distribution of flour and related products, including instant noodles and soybean-derived products, to retail and wholesale customers throughout China. With a well-known brand name called “Long Feng”, the Company markets its well-established product line through a countrywide network of over 200 key distributors and 16 regional offices in 27 Chinese provinces.
In addition to domestic sales, New Dragon Asia also exports noodles to other countries such as South Korea, Australia, Malaysia and Indonesia. In 2005, export sales accounted for approximately 7% of instant noodle sales. As at the end of 2005, the Company has six manufacturing plants in the PRC with an aggregate annual production capacity of 110,000 tons of flour, approximately 1.1 billion packets of instant noodles and 4,500 tons of Soybean powder. Through acquisitions in the past year, the Company further expands its productioncapacity of instant noodles, export distributorship and packing materials businesses.
Sales and Production
For the year ended December 25, 2005, New Dragon Asia Corp’s product breakdown by sales was approximately 65% for flour products and 35% for instant noodles. The Company produces and markets a broad range of wheat flour for use in bread, dumplings, noodles and confectionary products. Its flour products are marketed under the well-recognized “Long Feng” brand name and sold throughout the country at both wholesale and retail levels. New Dragon Asia is one of the top manufacturers of flour related products in China’s wheat belt. It enjoys strong brand name recognition among the Chinese consumers and has access to a wide supply and distribution network in China.
The Company has developed a reputation in China for producing high quality food products. Its production plants operate to the highest level of hygiene and efficiency and all of its plants are certified under the ISO9002 standards. Most of its manufacturing equipment is imported from Switzerland, Japan and Korea. All productions are operated under strict quality control systems. As a matter of fact, the Company received orders for flour from certain KFC Corporation locations in China and KFC’s intermediary suppliers, which indicated the positive brand reputation and quality of Long Feng that can meet the rigorous quality requirements of multinational companies. Through addition of production lines, the aggregate production capacity of flour products now reaches 195,000 tons.
For the instant noodle business, New Asia Corp’s products can be separated into two broad categories for selling and marketing purposes: (i) packet noodles for home preparation and (ii) snacks and cup noodles for outdoor convenience. Flour and water are the two main ingredients used to produce noodle products. Flour is extracted from wheat through a milling process and wheat sourced by the Company’s milling operation in Shandong Province is generally regarded as being the highest quality available in China. In the noodle production process, flour is mixed with water and other ingredients and then a processing machine extrudes or rolls the mixture into the desire shape. The mixture then travels through a series of state-of-the-art dryers before being stabilized at room temperature. After stabilization, the noodles are steamed and cooked in deep fryers, cooled and then mixed with various seasonings and freeze dried additives such as chicken, vegetables or beef which are prepared from raw ingredients in a separate building within the Company’s production complex. The finished products are then packed, palletized and shipped to customers.
Following the acquisition of a 90% interest in the noodle manufacturing plant in Chengdu, Sichuan Province for $3.3 million in January this year, the Company will add 6 new production lines with planned production capacity of 360 million packs of instant noodles per year. This would increase New Dragon Asia Corp’s total production capacity of instant noodles by 30% to 1.5 billion packets per year.
In April 2005, New Dragon Asia Corp entered the soybean-derived products market by acquiring a soybean factory in Longkou, Shandong Province. The factory has an annual production capacity of 4,500 tons and the soybean products would be able to be sold through New Dragon Asia Corp’s existing sales and distribution network for flour and instant noodle products. In late 2005, the Company started producing two types of soybean products – soybean protein powder and soybean powder, which are principally supplied to food and beverage manufacturers. Among the well-known multinational food and beverage customers include Coca Cola (China) Beverages Ltd, which again reflects the premier quality of its soybean products that can meet the stringent quality requirements by MNCs.
Industry Background and Market Competition
The flour industry in China is huge and highly competitive, though the demand for flour and wheat products is also consider stable and huge, as flour and wheat products form a major part of the Chinese diet. The total population of China is currently 1.31 billion and is growing at an annual rate of just 0.6%. However, as incomes in both urban and rural China increase, demand for better quality food products such as wheat flour and instant noodles also increase. Given that New Dragon Asia Corp’s flour and instant noodles enjoy good reputation among consumers and that consumers in rural China have strong brand loyalty, we continue to see an uptrend in the demand for the Company’s flour and instant noodles.
According to information in the Company’s SEC filings, the Company’s largest competitors in flour business are Shandong Guang Rao Ban Qiu Flour and Hebei Wu De Li Flour in the Northern market and Shenzhen Nanshun Flour in the Southern market. As New Dragon Asia Corp is one of the top manufacturers of flour related products in China’s wheat belt, we believe the Company can continue to leverage on its widely recognized “Long Feng” brand, economies of scale in production and wide distribution network to compete effectively in the market.
As for the instant noodle market, New Dragon Asia is China’s fourth largest instant noodle manufacturers. The current market size of the instant noodle market in China is estimated at $5 billion and is highly competitive. New Dragon has to compete against well-established foreign companies and many smaller companies. Its largest competitors are the “Master Kang” brand manufactured by Tingyi (Cayman Island) Holdings Corporation and the “President” brand manufactured by Uni-President Group, both are based in Taiwan and are focused predominately in the more developed and competitive urban market, as compared to New Dragon’s focus on the rural market.
Looking forward, we expect the instant noodle market in China to sustain an annual growth rate of 10-15% due to the shift in consumption pattern, the urbanization of towns and villages and the migration of people from villages to cities. The new trend shows a decrease in consumption of whole grains and cereals and an increase in processed and convenience foods, especially among the youngsters. Urban people are becoming more adaptive to consume instant noodles and/or other fast foods for convenience and to save time for cooking.
Despite the keen competition in the domestic instant noodle market and strong competitors from Taiwan, we are not worrying about the growth prospects of New Dragon Asia. Based on the Company’s $15.3 million of revenue from instant noodles in FY2005, New Dragon Asia only accounted for 0.3% of the $5 billion instant noodle market in China. Thus, New Dragon Asia can leverage on its nationwide distribution network and brand reputation to focus on capturing business from other smaller, less efficient instant noodle manufacturers rather than competing directly with “Master Kang” and “President.”
As for the soybean product market, China is currently the largest importer of soybean and the demand is on an upward trend. The Company is focused on higher margin soybean-derived products like soybean powder for food and beverage manufacturers rather than soybean meal and other soybean products. Given that the Company’s current production is just 4,500 tons per year and soybean powder enjoy much attractive gross margin than flour and instant noodles, management’s decision to enter this market appears to be a positive move. As this operation only started in 1Q06 and very limited information about the performance was reviewed in the first quarterly report, we will continue to monitor the progress and performance of this operation in the coming quarters.
Growth Strategy and Earnings Driver
Management has a clearly defined strategy for business expansion and to drive earnings growth in the coming years. The strategy is focused on the following key areas:
1. Regional and product growth – The Company will leverage on its established strong distribution network and recognized brand name to expand sales of all products in regional market. Following the acquisition of the noodle plant in Chengdu, Sichuan Province, New Dragon Asia now has established footholds in the East (Yantai), South (Yueyang), West (Chengdu) and North (Beijing) of China. Such strong nationwide network would facilitate the Company’s brand building, expanding sales of all products in regional markets, better utilization of sales force, establishing more cost-effective distribution network and lower transportation costs.
2. Increasing export of higher margin instant noodles – Following the acquisition of the noodle factory in Chengdu earlier this year, which would increase production capacity by 30% to 1.5 billion packets of instant noodles per year, New Dragon Asia now has the required capacity to increase export sales, which enjoy relatively higher margins than domestic sales. Export sales as a percentage of total revenues grew from 5% in 2004 to 8% in 2005. Export sales in 1Q06 rose mildly to 9% of total revenue on rising exports to Asian countries. However, management expects exports to rise sharply to account for 12-15% of total net revenue for FY2006 because the Company is expecting to receive the HACCP (Hazard Analysis, Critical Control Points) certification later this year, which will open the vast Europe market for its instant noodle exports. Longer-term, management is targeting strong growth of exports, which will account for 25% of total revenues by 2008. Higher percentage of exports sales would help improve overall margins of the Company.
3. Acquisition and consolidation – The Company has been looking for opportunities to acquire quality state-owned assets with synergistic potential to strengthen its regional positions, adding new growth products and increasing benefits of vertical integration. Other than the successful acquisition of the noodle factory in Chengdu in January this year to expand its production of instant noodles and the soybean factory in Longkou in April last year to expand into soybean product market, New Dragon Asia had also completed two other acquisitions in December 2005 and March 2006. The acquisition of Shangdong Xinlongya Distribution Company in December 2005 would give New Dragon better control over export strategy and foreign currency control. Meanwhile the acquisition of Longkou City Longyuan Packing Materials Company limited in March 2006 would allow better control over packaging costs, meeting the growing requirement for packaging and providing opportunities to grow third party sales by serving corporations in the neighborhood. We believe these vertical integration efforts would help improve operating efficiency and margins.
As shown in the profit and loss account below, the Company experienced a general uptrend in total net revenue, gross profit and income from operation in FY2003, FY2004 and FY2005. However, the bottom line figures were a bit discouraging, rising 70% YoY in FY2004 and followed by a 14% decline in FY2005. The decline in net income for FY2005 was primarily due to sharp increase in interest expense. According to the SEC filings, $1.22 million of the interest expense was related to the issuance of the Series A Preferred Stock and Series B Preferred Stock, for which the professional fees, placement agent fees and associated expenses were recorded as deferred financing costs and are being amortized over the term of both series of Preferred Stock as interest expense using the effective interest method.
For the first quarter of FY2006, the Company recorded a bottom line loss of $2.5 million due to $1.17 million of interest expense of which $924,000 were related to the amortization of deferred expense in connection with the issuance of Series A and Series B Preferred Stock. In addition, there was a $2.32 million stock-based compensation expense charged as general and administrative expenses.
Excluding such items, the first quarter results for FY2006 should have been profitable. While management indicated that the stock-based compensation is a non-cash item and investors should examine the Company’s 1Q06 results by isolating such one-off, non-cash expense, we believe the $2.5 million loss recorded in 1Q06 would certainly dampen sentiment on the stock.
The interest expense of $1.22mn for FY2005 and $924,000 for 1Q06 appeared a bit large, though they are non-cash expense related to the warrants and options from the issuance of Series A and Series B Preferred Stocks under the new accounting policy where any stock-based compensation or even warrants and options compensation need to be treated as expenses.
For the full year 2006, we expect the Company to post a YoY 26% decline in net profit to $2.95 million, as the stock-base compensation and interest expense related to the issuance of Preferred Stock will drag down the bottom line figure. For FY2007, we forecast a robust 144% jump in net income to $7.2 million as the impacts from the above two expense items are diminished.
Peer Comparison and Valuation
We are comparing the valuation of New Dragon Asia with those of Tingyi Holdings and Uni-President from Taiwan on the basis of their core businesses in food and instant noodles. As shown in the following table, New Dragon Asia appears more attractive in terms of P/E, especially if we consider that New Dragon Asia’s estimated 2006 earnings and ROE have been distorted by the non-cash, stock-based compensation. On price/book basis, New Dragon Asia appears to be the most attractive counter. Based on a 10% discount to the estimated 2007 P/E of Tingyi and Uni-President for their larger and more established operations, we expect a 12-month target price of $2.33 per share when the negative impact of New Dragon’s first quarter loss diminishes and investors start factoring in the earnings prospects in FY2007. With 48.4% upside potential, we rate the stock a BUY.
The noodle, flour and soybean product markets in China are highly competitive. Many of the company’s competitors are larger and have greater financial resources, including its primary competitors, the manufacturers of each of the brand names “Master Kang” and “President”. New Dragon Asia may not be able to compete successfully with such competitors. Competition could cause it to lose market share, increase expenditures or reduce pricing and each of which could have a material adverse impact on its business and financial results.
Inability to Respond Quickly and Effectively to New Trends
Failure to maintain the company’s technological capabilities or to respond effectively to technological changes could adversely affect its ability to retain existing customers and secure new business. New Dragon needs to constantly seek out new products and develop new solutions to maintain competitive. If the Company unable to keep current with new trends, its competitors; technologies or products may render it noncompetitive and its products obsolete.
Limited Control Over Raw Material Costs
The main ingredients that New Dragon use to manufacture its products are wheat, soybeans and eggs. It also use paper products such as corrugated cardboard, as well as films and plastics to package it products. The prices of these materials have been, and expect to continue to be, subject to volatility and uncontrollable by New Dragon. The Company may not be able to pass price increases in these materials onto its customers, which could have an adverse impact on its earnings.
Risk Related to Plans for Expansion
If the Company unable to implement its acquisition strategy, it may be less successful in the future. A key component of its growth strategy is accomplished by acquiring additional flour, soybean and noodle factories. While there are many such companies in China, it may not always be able to identify and acquire companies meeting its acquisition criteria on acceptable terms. Additionally, financing to complete significant acquisition may not always be available on satisfactory terms. Further, its acquisition strategy presents a number of special risks to the Company such as possible adverse effects on its earnings after each acquisitions, diversion of management’s attention from its core business due to the special attention that a particular acquisition may required.
Risks of Doing Business in China
These include the economic reform policies or nationalization that could results in a total investment loss in the common stock, limited legal protection available to investors due to the less developed legal system in China, and impact of governmental regulation on the company’s operation.
Substantially all the company’s reveues and expenses are denominated in the Chinese Renminbi but the company uses the United States dollar for financial reporting purposes. Significant revaluation of the Chinese Renminbi may materially and adversely affect the company’s cash flows, revenues and financial condition. For example, to the extent that the company needs to convert Unites States dollars into Chinese Renminbi for its operation, appreciation of this currency against the United States dollar could have a material adverse effect on the company’s business, financial condition and results of operation.
NWD 1-yr chart: